Master of Business Administration- MBA Semester 3

MF0001 – Security Analysis and Portfolio Management - 2

Credits

(Book ID: B1035)

Assignment Set- 2 (30 Marks)

Ans.1 (a) If the required rate of return is 12%

VALUE OF THE BOND = 60*PVIFA(6%,20Y)
+1000*PVIFA(6%,20Y)
= 60*11.464+1000*.312
= 687.84+312
= 999.84

If the required rate of return is 16%

VALUE OF THE BOND = 60*PVIFA(8%,20Y)
+1000*PVIFA(8%,20Y)
= 60*9.817+1000*.215
= 589.02+215
= 804.02

(b)
Ans.2 The thought of markets being efficient is a paradox in
itself. If everyone believed in efficient markets then nobody would
bother looking for anomalies, so if anomalies existed they
wouldn’t be found and the market would be inefficient without
anybody realizing. However, if people believe the markets are
inefficient then they look for anomalies and take advantage of
them, and in turn eliminate the opportunities that they bring. This
contributes to making the markets more efficient.

Researchers have uncovered numerous stock market anomalies

that seem to contradict the efficient market hypothesis. The search
for anomalies is effectively the search for systems or patterns that
can be used to outperform passive and/or buy-and-hold strategies.
Theoretically though, once an anomaly is discovered, investors
attempting to profit by exploiting the inefficiency should result in
its disappearance. In fact, numerous anomalies that have been
documented via back-testing have subsequently disappeared.

Some of the main anomalies that have been identified are as

follows:
THE LOW PE EFFECT: Some evidence indicates that
low PE stocks outperform higher PE stocks of similar risk.
Students shows that stocks of companies with low P/E ratios
earned a premium for investors. An investor who held the low P/E
ratio portfolio earned higher returns than an investor who held the
entire sample of stocks. These results also contradict the EMH.

LOW-PRICED STOCKS: Many people believe that the

price of every stock has an optimum trading range.

SMALL FIRM EFFECT: Small-firm effect is also known

as the ‘size effect’. Studies have revealed that excess returns would
have been earned by holding stocks of low capitalization
companies. If the market were efficient, one would expect the
prices of stocks of these companies to go up to a level where the
risk adjusted returns to future investors would be normal. But ths
did not happen.

THE NEGLECTED FIRM EFFECT: Neglected firms

seem to offer superior returns with surprising regularity.

OVER/UNDER REACTION OF STOCK

PRICES TO EARNINGS ANNOUNCEMENTS:
There is substantial documented evidence on both over and under-
reaction to earnings announcements. Studies present evidence that
is consistent with stock prices over-reacting to current changes in
earnings. They report positive (negative) estimated abnormal stock
returns for portfolios that previously generated inferior (superior)
stock price and earning performance. This could be construed as
the prior period stock price behaviour over-reacting to earnings
developments. Thus, the evidence suggests that information is not
impounded in prices instantaneously as the EMH would predict.
THE JANUARY EFFECT: Studies have documented
evidence of higher mean returns in January as compared to other
months.

THE WEEKEND EFFECT(OR MONDAY

EFFECT): Studies have found that there is a tendency for
returns to be negative for Mondays whereas they are positive on
the other days of the week, with Friday being the best of all.

OTHER SEASONAL EFFECTS: Holiday and turn of

the month effects have been well-documented over time and across
countries. Studies show that US stock returns are significantly
higher at the turn of the month, defined as the last and first three
trading days of the month.

THE PERSISTENCE OF TECHNICAL

ANALYSIS: If the EMH is true, technical analysis should be
useless. Each year, however, an immense amount of literature
based in varying degrees on the subject is printed.

STANDARD & POOR’S (S&P) INDEX EFFECT:

Studies find a surprising increase in share price (up to 3%) on the
announcement of a stock’s inclusion into the S&P 500 index. Since
in an efficient market only information should change prices, the
positive stock price reaction appears to be contrary to the EMH
because there is no new information about the firm other than its
inclusion in the index.

THE WEATHER: Sunshine puts people in a good mood in

temperate climates. People in good moods make more optimistics
choices and judgments. Studies show that the new york stock
exchange index tends to be negative when it is cloudy. Recent
studies that have analyzed data for 26 countries from 1982-1997
found that stock market returns are positively correlated with
sunshine in in almost all of the countries studied. Interestingly,
they find that snow and rain have no predictive power!

These phenomena have been rightly referred to as anomalies

because they cannot be explained within the existing paradigm of
EMH. It clearly suggests that information alone is not moving the
prices. These anomalies have led researchers to question the EMH
and to investigate alternate modes of theorizing market behavior.

Ans.3 CRITICISM TO MARKOWITZ MODEL:

The Markowitz model was a brilliant innovation in the field of
portfolio selection. Markowitz showed us that all the information
that was needed to choose the best portfolio for any given level of
risk is contained in three simple statistics: mean of securities
returns, standard deviations of returns and correlation between
securities returns.

The model requires no information about dividend policy,

earnings, market share, strategy, and quality of management-
things with which the investment analysts concern themselves. In
short, Harry Markowitz fundamentally altered how the investment
decisions were made. Today, almost every portfolio manager uses
the basis framework of the risk and return trade-offs even they may
not be following the recommendation of the Markowitz model
exactly.

Why doesn’t then everyone use the Markowitz model to solve their
investment problems? The answer lies in the statistics that are
required as inputs for the model. The historical mean return of
securities may be a poor estimate of their future mean return. As
we increase the number of securities, we increase the number of
correlations that we must estimate-and they must be estimated
correctly to obtain the right answer.
In fact, with more than thousands of stocks listed on the BSE and
NSE, it is almost certain that we will find correlations that are
widely inaccurate for the purpose of estimating future correlations.
Unfortunately, the markowitz model does not deal well with
incorrect inputs. That is why the model is best applied to allocation
decisions across asset classes are well-estimated.