Security Analysis and Portfolio Management – Model Exam Assignment

Azgar S MBA2309
PART A
1. Differentiate systematic and unsystematic Risk.
Systematic Risk Unsystematic Risk
Also known as market risk, it Also known as specific or
affects the entire market or idiosyncratic risk, it affects a
a large segment of the particular company or
market. industry.
Caused by external factors Caused by internal factors
such as economic, political, such as management
or social events. decisions or company-
specific events.
Cannot be eliminated Can be reduced or
through diversification. eliminated through
diversification.

2. State the attributes of investment that are used in evaluating

investment
Option.
 Risk: The potential for losing some or all of the invested capital,
considering both systematic and unsystematic risks.
 Return: The gain or loss on an investment over a specified period,
usually expressed as a percentage.
 Liquidity: The ease with which an investment can be converted into
cash without significantly affecting its price.
 Time Horizon: The duration for which an investor plans to hold an
investment before liquidating it.

3. What is diffusion Index?

 A Diffusion Index is a statistical measure used to summarize the
overall direction of change in a set of data points.
 It indicates the percentage of components that are increasing or
expanding.
 Commonly used in economic and financial analysis to assess trends
and economic activity.

4. Which are the variables that are used in explaining in P/E Ratio?
  Earnings Growth: The expected rate at which a company's earnings
are projected to grow.
 Risk: The level of risk associated with the company, including market
and firm-specific risks.
 Interest Rates: Prevailing interest rates, which influence the
attractiveness of equities relative to other investments.
 Market Conditions: Overall economic and market environment
impacting investor sentiment and valuations.

5. What is Bollinger band?

 Bollinger Bands are a type of statistical chart characterizing the
prices and volatility of a financial instrument over time.
 They consist of a moving average (middle band) and two standard
deviation lines (upper and lower bands) plotted above and below the
moving average.
 Used by traders to identify overbought or oversold conditions,
trends, and potential price reversals.

6. What is the significance of the trend reversal?

 Market Signals: Trend reversals indicate a significant change in the
market direction, helping traders identify potential buying or selling
opportunities.
 Risk Management: Recognizing trend reversals can help investors
mitigate losses and adjust their strategies accordingly.
 Forecasting: They provide insights into future price movements,
assisting in better decision-making and planning.

7. How is covariance used in portfolio management?

 Covariance measures the degree to which two asset returns move in
relation to each other.
 In portfolio management, it helps assess the diversification benefits
by combining assets with different covariances, reducing overall
portfolio risk.

8. Define an Optimal portfolio.

 - An Optimal Portfolio is a collection of investments that offers the
highest expected return for a given level of risk, or the lowest risk for
a given level of expected return.
  - It is constructed using the principles of diversification and modern
portfolio theory to achieve the best possible balance between risk
and return.

9. What is Beta?
 Beta is a measure of a stock's volatility in relation to the overall
market.
 It indicates the sensitivity of a stock's returns to changes in the
market returns.
 A beta greater than 1 indicates higher volatility than the market,
while a beta less than 1 indicates lower volatility.

10. State the benefits of Index data.

 Benchmarking: Provides a standard for evaluating the performance
of individual investments or portfolios.
 Market Insight: Offers a comprehensive view of market trends,
sectors, and overall economic health.
 Diversification: Facilitates the creation of diversified investment
portfolios by replicating index compositions.
 Risk Assessment: Helps in identifying and managing market risks by
analyzing index movements and volatility.

PART B
11. A) Explain the investment process in detail.
Investment Process: A Detailed Explanation
The investment process involves a structured approach to selecting and
managing financial assets to achieve specific financial goals. It consists of
various interrelated steps that guide investors from goal setting to
portfolio evaluation. Below is a comprehensive explanation:

1. Establishing Investment Objectives

 Purpose: The foundation of the investment process begins with
identifying the investor’s financial goals.
 Factors Considered:
 Risk tolerance
  Investment horizon
 Expected returns
 Liquidity needs
Example: An individual saving for retirement may focus on long-term
growth, while a business may prioritize short-term liquidity.

2. Assessing Risk and Return Preferences

 Risk Tolerance: Understanding the level of risk an investor is willing
and able to take.
 Return Expectations: Defining the desired return that aligns with the
investor's objectives.
 Tools such as risk questionnaires and historical performance data
can help in assessment.

3. Analyzing Market Opportunities

 Market Research: Identifying potential investment opportunities in
equity, debt, mutual funds, or alternative investments.
 Macroeconomic Analysis: Studying economic trends, interest rates,
and inflation.
 Industry and Sector Analysis: Evaluating promising sectors based on
market conditions.

4. Asset Allocation
 Definition: Dividing the investment portfolio among different asset
classes to balance risk and return.
 Types:
 Strategic Asset Allocation: Long-term allocation based on goals.
 Tactical Asset Allocation: Adjustments based on short-term
opportunities.
 Example: Allocating 60% to equities, 30% to bonds, and 10% to cash
for a balanced portfolio.
5. Security Selection
 Criteria:
 Fundamental Analysis: Assessing financial health through ratios
and performance metrics.
 Technical Analysis: Using charts and trends to forecast price
movements.
 Quantitative Models: Applying statistical methods for
predictions.
 Example: Selecting a high-growth stock based on its P/E ratio and
revenue growth.

Conclusion
The investment process is dynamic and requires careful planning,
execution, and evaluation. By following these steps, investors can
systematically achieve their financial goals while managing risks
effectively. Each stage plays a crucial role in shaping the overall success
of the investment strategy.

12. A) Discussed the traditional approaches used by analysts to assess

the outlook of a firm's earning over a future holding period.
Traditional Approaches to Assess a Firm's Earnings Outlook
The traditional approaches used by analysts to evaluate a firm's earnings
outlook over a future holding period focus on examining its historical
performance, industry conditions, and financial metrics. These methods
provide insights into the firm’s profitability, stability, and growth
potential. Below are the primary traditional approaches in detail:

1. Fundamental Analysis
 Definition: An in-depth study of a firm's financial statements,
management, and market conditions to estimate its future earnings.
 Key Components:
 Financial Statement Analysis:
  Income Statement: Evaluates revenues, expenses, and net
profit trends.
 Balance Sheet: Assesses assets, liabilities, and equity for
financial stability.
 Cash Flow Statement: Analyzes cash inflows and outflows
to gauge liquidity.
 Ratio Analysis:
 Profitability Ratios (e.g., Net Profit Margin, Return on
Equity)
 Efficiency Ratios (e.g., Asset Turnover Ratio)
 Leverage Ratios (e.g., Debt-to-Equity Ratio)
 Example: A firm with consistent revenue growth and strong profit
margins indicates a positive earnings outlook.

2. Technical Analysis
 Definition: Uses historical price and volume data to predict future
price and earnings trends.
 Key Tools:
 Charts and Patterns:
 Head and Shoulders, Double Tops/Bottoms for trend
reversals.
 Indicators:
 Moving Averages: Identify trends.
 Relative Strength Index (RSI): Measures momentum.
 Limitation: Focuses on market trends rather than intrinsic financial
value.

3. Economic Analysis
 Definition: Studies macroeconomic factors affecting the firm's
performance.
 Key Factors:
  Interest Rates: Higher rates increase borrowing costs, reducing
profitability.
 Inflation: Impacts input costs and consumer purchasing power.
 GDP Growth: A growing economy supports higher firm earnings.
 Example: A firm operating in a booming economy is likely to
experience increased demand and profitability.

4. Industry Analysis
 Definition: Evaluates the competitive position and growth prospects
of the firm’s industry.
 Key Models:
 Porter’s Five Forces: Analyzes industry structure, competition,
and profitability.
 Lifecycle Analysis: Determines the industry’s stage (e.g.,
growth, maturity).
 Example: A firm in a high-growth sector like technology may have
better earnings potential compared to one in a declining industry like
traditional publishing.

5. Management Evaluation
 Definition: Assesses the competence and vision of the firm's
management team.
 Key Aspects:
 Leadership quality and experience.
 Strategic initiatives and innovation.
 Past decisions impacting earnings stability.
 Example: Strong management often correlates with consistent
earnings growth.
 Example: Firms with stable earnings in past recessions are often
resilient.
Conclusion
The traditional approaches to assessing a firm’s earnings outlook rely
heavily on historical data, market conditions, and financial metrics. By
combining these methods, analysts can create a comprehensive view of a
firm’s potential profitability and risks over the future holding period.
These approaches remain fundamental in financial analysis despite
advancements in predictive models.

13. A) Discuss and illustrate how Relative strength index can be used to
predict the stock price movement
Relative Strength Index (RSI) and Its Use in Predicting Stock Price
Movements
The Relative Strength Index (RSI) is a widely used momentum indicator in
technical analysis. It measures the speed and magnitude of price
movements to evaluate whether a stock is overbought or oversold.
Developed by J. Welles Wilder, the RSI helps traders and investors predict
potential price reversals and trends.

1. Understanding RSI
The RSI value ranges from 0 to 100.
 Key Levels:
 Above 70: Indicates an overbought condition, suggesting a
potential price decline.
 Below 30: Indicates an oversold condition, suggesting a
potential price increase.

2. Steps to Use RSI for Predicting Stock Price Movements

 Step 1: Calculate RSI
 Analyze historical price data to calculate the average gains and
losses over a specific period (commonly 14 days).
 Step 2: Interpret RSI Levels
 Identify overbought and oversold levels to predict price
reversals.
  Step 3: Combine RSI with Price Trends
 Use RSI in conjunction with chart patterns, support/resistance
levels, or moving averages for confirmation.

3. Applications of RSI
 Identifying Overbought Conditions:
 When RSI exceeds 70, it signals that the stock is overvalued
and may experience a price correction.
 Example: A stock’s RSI reaches 75, and its price starts to
consolidate or decline after a bullish rally.
 Identifying Oversold Conditions:
 When RSI drops below 30, it indicates that the stock is
undervalued and may rebound.
 Example: A stock’s RSI touches 25 after a prolonged decline,
signaling a potential recovery.
 Divergence Analysis:
 Bullish Divergence: RSI rises while the stock price falls,
indicating a potential upward reversal.
 Bearish Divergence: RSI falls while the stock price rises,
signaling a possible downward reversal.
 Support and Resistance Breakouts:
 RSI can confirm breakout trends. For instance, an RSI crossing
above 50 can signal bullish momentum.

4. Advantages of RSI
 Simple and intuitive for identifying overbought/oversold conditions.
 Useful for short-term and swing trading strategies.
 Enhances accuracy when combined with other technical indicators.

5. Limitations of RSI
  False Signals: In strong trends, RSI can remain overbought/oversold
for an extended period.
 Dependence on Parameters: Results vary based on the time period
used (default is 14 days).

Conclusion
The Relative Strength Index is a powerful tool to predict stock price
movements by identifying overbought and oversold conditions. Its
simplicity and reliability make it essential for traders and investors.
However, RSI should be used in combination with other indicators and
market analysis to improve accuracy and reduce the risk of false signals.

14. B) Explain in detail the traditional process of portfolio construction.

Traditional Process of Portfolio Construction
Portfolio construction is the process of selecting a mix of investment
assets to achieve specific financial goals while managing risks. The
traditional approach to portfolio construction is rooted in fundamental
principles such as diversification, risk assessment, and return
optimization. Below is a detailed explanation of the traditional process of
portfolio construction:

1. Understanding Investor Objectives

 Definition: The foundation of portfolio construction begins with
understanding the investor’s financial goals, risk tolerance, and time
horizon.
 Key Aspects:
 Financial Goals: Retirement planning, wealth accumulation, or
regular income.
 Risk Appetite: Conservative, moderate, or aggressive.
 Time Horizon: Short-term (1–3 years) or long-term (10+ years).
 Example: A young investor with a long-term horizon may prefer
equity-heavy portfolios, while a retiree may prioritize fixed-income
assets.
2. Determining Asset Allocation
 Definition: Asset allocation involves dividing the portfolio among
major asset classes like equities, bonds, and cash to balance risk
and return.
 Types of Asset Allocation:
 Strategic Allocation: Establishes a fixed allocation based on
long-term objectives.
 Tactical Allocation: Adjusts allocation based on short-term
market opportunities.
 Examples:
 Conservative Portfolio: 20% equities, 60% bonds, 20% cash.
 Aggressive Portfolio: 80% equities, 10% bonds, 10% cash.

3. Security Selection
 Definition: Choosing specific securities within each asset class to
include in the portfolio.
 Approaches:
 Fundamental Analysis: Evaluates financial health using metrics
like earnings growth, P/E ratio, and debt levels.
 Technical Analysis: Focuses on price charts, volume trends, and
momentum indicators.
 Example: Within equities, selecting stocks from high-growth
industries; within bonds, choosing government or corporate bonds
based on credit ratings.

4. Diversification
 Definition: Spreading investments across different asset classes,
industries, and geographies to reduce risk.
 Importance:
 Minimizes the impact of poor performance in a single asset or
sector.
  Balances risks and returns across the portfolio.
 Example: Investing in technology stocks, healthcare stocks,
international equities, and bonds to mitigate sector-specific risks.

5. Portfolio Optimization
 Definition: Achieving the best possible risk-return trade-off using
historical data and statistical tools.
 Methods:
 Mean-Variance Optimization: Maximizing returns for a given
level of risk.
 Efficient Frontier: Identifying the set of optimal portfolios that
offer the highest expected return for a defined level of risk.
 Example: Selecting a mix of assets that minimizes standard
deviation while maximizing returns.

Conclusion
The traditional process of portfolio construction offers a structured and
methodical way to build investment portfolios. By focusing on asset
allocation, diversification, and consistent monitoring, it provides a strong
foundation for achieving financial goals. However, integrating modern
techniques and tools can enhance its effectiveness in today’s dynamic
financial markets.

15. B) Explain the CAPM theory and its validity in the stock market.
Capital Asset Pricing Model (CAPM) and Its Validity in the Stock Market
The Capital Asset Pricing Model (CAPM) is a foundational theory in finance
that describes the relationship between expected return and risk of an
investment. It helps investors determine the required rate of return for a
security, based on its systematic risk relative to the market. Developed
by William F. Sharpe, John Lintner, and others, CAPM has been extensively
used in portfolio management and asset pricing.

1. CAPM Theory
a) Concept
CAPM states that the expected return of a security is determined by its
sensitivity to market risk, represented by beta (ββ), and compensates
investors only for non-diversifiable risk.
b) Formula
E(Ri)=Rf+βi[E(Rm)−Rf]E(Ri)=Rf+βi[E(Rm)−Rf]
Where:
 E(Ri)E(Ri): Expected return of the security.
 RfRf: Risk-free rate of return (e.g., treasury bonds).
 βiβi: Beta coefficient of the security (measure of market risk).
 E(Rm)E(Rm): Expected return of the market portfolio.
 [E(Rm)−Rf][E(Rm)−Rf]: Market risk premium.

c) Assumptions
CAPM relies on the following key assumptions:
 Investors are rational and risk-averse.
 Markets are efficient, and all information is available to investors.
 There are no transaction costs or taxes.
 All investors can borrow or lend at the risk-free rate.
 Investors have identical expectations of risk and return.

2. Components of CAPM
a) Risk-Free Rate (RfRf)
 Represents the return on a riskless investment (e.g., government
securities).
 Serves as the baseline return for any investment.
b) Beta (ββ)
 Measures the sensitivity of a security's returns to market
movements.
 β>1β>1: Security is more volatile than the market.
  β<1β<1: Security is less volatile than the market.
 β=0β=0: No correlation with the market (e.g., cash).
c) Market Risk Premium (E(Rm)−RfE(Rm)−Rf)
 The extra return investors expect for taking on market risk.
 Reflects the overall market’s risk-return tradeoff.

3. Validity of CAPM in the Stock Market

a) Strengths of CAPM
 Simplicity: Offers a straightforward way to calculate expected
returns.
 Widely Accepted: Used for capital budgeting, project evaluation, and
portfolio management.
 Systematic Risk Focus: Differentiates between systematic and
unsystematic risks.
b) Applications in the Stock Market
 Portfolio Construction: Helps investors choose securities based on
their risk tolerance and expected returns.
 Valuation: Used to estimate the cost of equity for firms.
 Risk Management: Guides investors in balancing risk and reward.

c) Limitations and Criticism

 Unrealistic Assumptions: Assumptions like efficient markets and
identical expectations do not hold true in practice.
 Single Factor Model: Ignores other factors like size, value, and
momentum that can influence returns.
 Beta’s Stability: Beta is assumed to remain constant, but it can vary
over time.
 Empirical Evidence: Studies show mixed results about CAPM’s
accuracy in predicting stock returns.

4. Empirical Validity of CAPM

a) Supportive Evidence
 Some studies confirm a positive relationship between beta and
expected returns.
 CAPM works well as a benchmark for cost of equity estimation in
corporate finance.
b) Contradictory Evidence
 Fama-French Three-Factor Model: Shows that size and value factors
also affect returns.
 Low-Beta Anomaly: Stocks with low beta often outperform high-beta
stocks, contrary to CAPM predictions.

5. Practical Relevance in the Stock Market

 Despite its limitations, CAPM remains widely used due to its
simplicity and theoretical elegance.
 Investors often use CAPM as a starting point and combine it with
other models for a comprehensive analysis.

6. Conclusion
CAPM is a significant theory that links risk and return, providing a
framework for investment decisions. While it has limitations and faces
challenges in empirical validation, its simplicity and focus on systematic
risk make it an enduring tool in finance. Adapting CAPM with other models
and approaches can enhance its effectiveness in the stock market.

Part C
16. A) Technical Analysis is always a better tool than fundamental
analysis Discuss
Technical Analysis vs. Fundamental Analysis: Which is Better?
Technical analysis and fundamental analysis are two widely used
methodologies in stock market evaluation. While technical analysis
focuses on price movements and market trends, fundamental analysis
examines the intrinsic value of securities based on financial performance
and economic factors. The debate over which method is better has
persisted for decades, and the choice often depends on the investor’s
goals, timeframe, and risk tolerance.

1. Understanding Technical Analysis

a) Definition
Technical analysis involves studying past price data, volume, and chart
patterns to predict future price movements. It is based on the assumption
that prices move in trends and that history tends to repeat itself.
b) Key Tools in Technical Analysis
 Charts: Line, bar, and candlestick charts to visualize price
movements.
 Indicators: Moving averages, RSI (Relative Strength Index), MACD
(Moving Average Convergence Divergence), etc.
 Patterns: Head-and-shoulders, double tops, and triangles for trend
analysis.
c) Core Assumptions
 Market prices reflect all available information.
 Price movements are not random but follow trends.

2. Understanding Fundamental Analysis

a) Definition
Fundamental analysis evaluates a security's intrinsic value by analyzing
economic, financial, and qualitative factors. It focuses on the company’s
financial statements, management, industry position, and macroeconomic
conditions.
b) Key Elements in Fundamental Analysis
 Quantitative Analysis: Revenue, earnings, P/E ratio, and debt levels.
 Qualitative Analysis: Management quality, industry trends, and
competitive advantages.
 Macroeconomic Indicators: GDP growth, inflation, and interest rates.
c) Core Assumptions
  Markets may not always be efficient.
 Intrinsic value will eventually be reflected in the stock price.

3. Why Technical Analysis is Considered a Better Tool

a) Focus on Market Behavior
 Technical analysis prioritizes market trends and investor sentiment,
which are often more immediate and actionable than long-term
fundamentals.
 Example: Traders use RSI to identify overbought or oversold
conditions and execute trades promptly.
b) Short-Term Trading Advantages
 Suitable for day traders and swing traders who focus on short-term
price movements.
 Offers insights into entry and exit points based on historical price
trends.
c) Efficiency in Market Timing
 Technical analysis helps identify precise moments to buy or sell
stocks.
 Tools like moving averages and Bollinger Bands provide signals for
trend reversals or continuations.
d) Universality Across Assets
 Can be applied to all asset classes, including equities, commodities,
forex, and cryptocurrencies.
 No dependency on company-specific data, making it adaptable to
global markets.
e) Avoiding Fundamental Pitfalls
 Fundamental analysis may mislead during economic shocks or
unexpected market events where price does not align with intrinsic
value.
 Example: During the 2020 pandemic, many fundamentally strong
companies saw sharp price declines due to market sentiment, which
technical analysis could capture better.
4. Limitations of Technical Analysis
a) Dependency on Historical Data
 Relies on the assumption that past price patterns will repeat, which
may not always hold true.
 Fails to account for sudden news events or changes in company
fundamentals.
b) Subjectivity
 Interpretation of chart patterns and indicators can vary between
analysts, leading to inconsistent results.
c) Not Suitable for Long-Term Investing
 Lacks insights into the intrinsic value of a company, which is critical
for long-term investors.

5. Role of Fundamental Analysis

While technical analysis has advantages, fundamental analysis also holds
significant merit:
a) Long-Term Value Assessment
 Helps identify undervalued or overvalued stocks by analyzing
intrinsic value.
 Example: Warren Buffett’s value investing strategy relies heavily on
fundamental analysis.
b) Understanding Business Health
 Provides a comprehensive view of a company's financial
performance and growth potential.
 Evaluates management quality and industry positioning.
c) Economic and Market Context
 Analyzes macroeconomic factors that influence industries and
companies, giving a broader picture of market dynamics.

6. Conclusion
While technical analysis offers advantages in short-term trading and
market timing, it is not necessarily better than fundamental analysis. The
choice depends on the investor's objectives and investment horizon. A
combination of both approaches often yields the best results, leveraging
the strengths of each method to navigate the complexities of financial
markets effectively.