Solutions of Group Test Questions

Group 1

1. Consider the following information for three mutual funds A, B and C and the market.

Mean Return (%) Standard Deviation (%) Beta

A 12 18 1.1
B 10 15 0.9
C 13 20 1.2
Market Index 11 17 1.0
The mean risk-free rate was 6%. Calculate the Treynor measure, Sharpe measure and Jensen
measure for the three mutual funds and the market index.

Answers:

Funds Treynor Measure Sharpe Measure Jensen Measure

A 5.45 0.333 0.5

B 4.44 0.267 - 0.5
C 5.83 0.350 1.0
Market 5.00 0.294 0.0

2. Based on five years of monthly data, you derive the following information for the companies
listed:

rim denotes the correlation coefficient between the stock and the market.

a) Compute the beta coefficient for each stock.

b) Assuming a risk-free rate of 8 percent and an expected return for the market portfolio of
15 percent, compute the expected (required) return for all the stocks.

c) If the followings are the expected returns of the companies in the following year, which
stocks are undervalued or overvalued.

Intel 20 percent
Ford 15 perent
 Anheuser Busch 19 percent
Merck 10 percent

COVi,m COVi,m
Bi and ri,m
2
m i m (a).
Where, COVi,m = (ri,m)(i)( m)
For Intel:
.00479 .00479
Beta 1.597
(.055) 2 .0030 COV = (.72)(.1210)(.0550) = .00479
i,m

For Ford:
COV i,m = (.33)(.1460)(.0550) = .00265
.00265
Beta .883
.0030
For Anheuser Busch:
COV i,m = (.55)(.0760)(.0550) = .00230
.00230
Beta .767
.0030
For Merck:
COV i,m = (.60)(.1020)(.0550) = .00337
.00337
Beta 1.123
.0030

(b). E(Ri) = RFR + i(RM - RFR)

= .08 + i(.15 - .08)
= .08 + .07i
Stock Beta E(Ri) = .08 + .07i
E(R) Alpha Remarks
Intel 1.597 0.08 + 0.1118 = 0.1918 0.20 0.82% UV
Ford 0.883 0.08 + 0.0618 = 0.1418 0.15 0.82%
UV
Anheuser Busch 0.767 0.08 + 0.0537 = 0.1337 0.19 5.63%
UV
Merck 1.123 0.08 + 0.0786 = 0.1586 0.10 5.86%
OV

3. An investor buys one October call option on a share of ABB at a premium of Rs. 12 per
share. The strike price is Rs.350 . He also sells an October call option on a share of ABB at a
premium of Rs. 71 and a strike price of Rs. 270 . Draw the payoff table and diagram of this
option strategy. Also name this strategy.

Its a Bear Spread

S E1 E2 p Payoff Net Profit

240 270 350 59 0 59

260 270 350 59 0 59

270 270 350 59 0 59

280 270 350 59 -10 49

300 270 350 59 -30 29

320 270 350 59 -50 9

340 270 350 59 -70 -11

350 270 350 59 -80 -21

360 270 350 59 -80 -21

Group 2
1. A stock is currently selling for Rs 60. The call option on the stock exercisable a year from
now at an exercise price of Rs 55 is currently selling for Rs 15. The risk-free interest rate is
 12%. The stock price can either rise or fall after a rise. It can fall by 30%. By what percent it
can rise ?

Solving this for u, we get u =1.35

So the stock can rise by 35%

3. The stock of Box limited performs relatively well to other stocks during recessionary periods.
The stock of Cox limited, on the other hand, does well during growth periods. Both the
stocks are currently selling for Rs 100 per share. You assess the rupee return (Dividend plus
Price) of these stocks for next year as follows:
Economic Condition
High Growth Low Growth Stagnation Recession
Probability 0.3 0.4 0.2 0.1
Return on Boxs Stock (Rs) 100 110 120 140
Return on Coxs Stock (Rs) 150 130 90 60
Calculate the standard deviation of investing:
Rs 1000 in the equity of Box Limited
Solution:
3. You have been employed as a financial planner by Acme Investments, which, inter alia,
advises clients on their investments.
You have been assigned the task of developing an appropriate asset mix for three clients,
Mahesh, Praveen and Deepika.

Mahesh: A retiree with modest means:

Mahesh retired recently from government service. He owns an apartment where he lives
with his wife who is a housewife. Ramesh received a sum of Rs 14 lakh from provident
fund, gratuity, and so on from his employer at the time of retirement. In addition, he has
other savings of Rs 2 lakh. Ramesh is entitled to a pension income of about Rs 75,000 per
year which will probably move in line with inflation over time. Rameshs primary
investment goal is to generate an additional income of at least Rs 75,000 a year to meet
his living expenses. In addition, he would like to prevent erosion of his capital as he and
his wife do not have a ability to earn income outside their portfolio. Finally, he wants to
increase his wealth to some extent.

Praveen: A young executive with a promising future

Praveen is an ambitions 25 years old who graduated recently from a prestigious business
school. He is working as a credit officer in a multinational bank drawing a handsome
salary. Praveen expects his earnings to rise substantially over time as his career advances.
Praveen recently inherited a legacy of Rs 1,000,000 from his grandfathers estate.
Praveen wants to build a sizable portfolio in next twenty years or so to achieve financial
freedom to retire early and pursue other interests in life or even start a venture of his own.
 Deepika: A handicapped millionaire
Deepika is an unmarried 19-year old girl who recently met with a crippling accident that
has created a life long disability. It also forced her to abandon her studies midway.
Deepika inherited Rs 6,000,000 from her fathers estate-this is her only financial asset.
She plans to stay alone in an owned or rented with a live-in maid and work as a volunteer
for the Home for the Disabled to spend her time gainfully. Apart from rent, Deepika
expects her living expenses to be Rs 1,20,000 a year. Of course, they are expected to
increase overtime in the wake of inflation. If she buys an apartment, for her use, it will
cost Rs 18,00,000. Otherwise, she will have to pay a rent of about Rs 90,000 per year
which will be periodically revised upwards. Deepika attaches almost equal importance to
current income as well as growth in income to protect her from the ravages of inflation
(which may be 6% per year)

Solution: