AC 414: TUTORIAL QUESTIONS

1. Distinguish investment and speculation.

2. Differentiate between real assets and financial assets with examples.
3. Securities are traded on the market. Explain briefly the following financial markets:
(a) Call market
(b) Auction market
(c) Over-the-counter market
(d) Money market
(e) Continuous market
4. Differentiate between systematic and unsystematic risk
5. What are the differences between technical and fundamental analysis?

Technical analysis and fundamental analysis are two different approaches used to
analyze financial markets. The main differences between technical and fundamental
analysis are as follows:

1. Approach: Technical analysis is a method that involves analyzing past market data,
such as price and volume, to make predictions about future market trends.
Fundamental analysis, on the other hand, is based on an analysis of economic,
financial, and other qualitative and quantitative factors that affect the underlying
value of a security.

2. Focus: Technical analysis focuses on the study of charts and patterns in order to
identify potential entry and exit points for trades. Fundamental analysis, on the other
hand, focuses on understanding the underlying financial and economic factors that
drive the performance of a particular asset.

3. Timeframe: Technical analysis is typically used by short-term traders who are looking
to profit from short-term market movements. Fundamental analysis, on the other
hand, is used by long-term investors who are interested in buying and holding assets
for the long term.

4. Data Sources: Technical analysts primarily use price and volume data, as well as
technical indicators like moving averages and oscillators, to identify trading
opportunities. In contrast, fundamental analysts use a wider range of data sources,
including financial statements, industry reports, and economic indicators, to evaluate
the intrinsic value of a security.

5. Usefulness: Both technical and fundamental analysis have their own strengths and
weaknesses. Technical analysis can be effective in identifying short-term trading
opportunities, while fundamental analysis can provide insight into the long-term
prospects of a particular asset. Ultimately, the choice of which approach to use will
depend on the individual investor's investment goals, time horizon, and risk
tolerance.

6. Explain why the issues of selectivity, timing and diversification are important when
forming the investment portfolio.

7. What does covariance measure? If two assets are said to have positive covariance, what
does it mean?
8. How do you understand an investment risk and what statistic tools can be used to measure
it?

9. For each of the following probability distributions, calculate

(i) Expected return for stock and bond
(ii) Variance and Standard deviation of stock and bond
(iii) Covariance between stock and bond
(iv) Correlation coefficient between stock and bond
(v) Coefficient of determination

State Probability Stock Return Bond Return

Good 0.30 $60 $25
Normal 0.50 $30 $30
Bad 0.20 $20 $82

10. Using the efficient market hypothesis, differentiate between a weak form efficiency,
semi-strong form, and strong form efficiency.

11. Explain why most investors prefer to hold a diversified portfolio of securities as opposed
to placing all of their wealth in a single asset.

12. The following investment portfolios are evaluated by investor:

Portfolio Expected rate of return % Standard deviation

A 12 15
B 10 8
C 10 9

Using portfolio theory explain the choice for investor between Portfolios A, B and C.

13. Investor owns the portfolio composed of three stocks. The Betas of these stocks and their
proportions in portfolio are shown in the table. What is the Beta of the investor’s
portfolio?
Stock Beta Proportion in portfolio %
A 0.8 30
B 1.2 40
C -0.9 30

14. If the investor wants to reduce risk in his portfolio how he could restructure his portfolio?

13. The new little known firm is analyzed from the prospect of investments in its shares by
two friends. The firm paid dividends last year 3 EURO per share. Tomas and Arnas examined
the prices of similar stocks in the market and found that they provide 12 % expected return.
The forecast of Tomas is as follows: 4 % of growth in dividends indefinitely. The forecast of
Arnas is as follows: 10% of growth in dividends for the next two years, after which the
growth rate is expected to decline to 3 % for the indefinite period.
a)What is the intrinsic value of the stock of the firm according to Tomas forecast?
b)What is the intrinsic value of the stock of the firm according to Arnas forecast?
c)If the stocks of this firm currently are selling in the market for 40 EURO per share, what
would be the decisions of Tomas and Arnas, based on their forecasting: is this stock attractive
investment? Explain.

a) According to Tomas' forecast, the intrinsic value of the stock can be calculated
using the Gordon Growth Model, which is given by:

Intrinsic Value = D / (r - g)

where D is the current dividend per share, r is the expected return, and g is the
expected growth rate in dividends.

Here, D = 3 EURO, r = 12%, and g = 4%. Plugging these values into the formula, we
get:

Intrinsic Value = 3 / (0.12 - 0.04) = 37.5 EURO per share

Therefore, according to Tomas' forecast, the intrinsic value of the stock is 37.5 EURO
per share.

b) According to Arnas' forecast, the intrinsic value of the stock can be calculated
using the Two-Stage Dividend Discount Model, which is given by:

Intrinsic Value = [D1 / (1 + r)^1] + [D2 / (1 + r)^2] + [(D2 * (1 + g2)) / (r - g2) * (1

+ r)^2]

where D1 is the current dividend per share, D2 is the dividend per share after two
years, r is the expected return, g2 is the expected growth rate in dividends after two
years, and (D2 * (1 + g2)) / (r - g2) represents the present value of all future
dividends beyond year 2.

Here, D1 = 3 EURO, D2 = 3 * 1.10 = 3.30 EURO (assuming a 10% growth rate in

dividends for the next two years), r = 12%, g2 = 3%. Plugging these values into the
formula, we get:

Intrinsic Value = [3.30 / (1+0.12)^1] + [3.30 / (1+0.12)^2] + [(3.30 * 1.03) / (0.12 -

0.03) * (1+0.12)^2] = 37.71 EURO per share

Therefore, according to Arnas' forecast, the intrinsic value of the stock is 37.71 EURO
per share.

c) If the stocks of this firm are currently selling in the market for 40 EURO per share,
both Tomas and Arnas would compare this market price with their respective
intrinsic values.

According to Tomas' forecast, the intrinsic value is 37.5 EURO per share, which
means the stock is overvalued in the market. In this case, Tomas would not consider
buying the stock as it is not an attractive investment.

According to Arnas' forecast, the intrinsic value is 37.71 EURO per share, which is
slightly higher than the market price of 40 EURO per share. In this case, Arnas may
consider buying the stock as it seems to be undervalued in the market. However,
Arnas should also consider the uncertainty associated with the growth rate beyond
year 2, which could affect the future dividends and the intrinsic value of the stock.
14. Bond with face value of 1000 EURO, 2 years’ time to maturity and 10 % coupon rate,
makes semi-annual coupon payments and provides 8% yield to maturity.
a) Calculate the price of the bond.
b) If the yield-to-maturity would increase to 9%, what will be the price of the bond? How this
change in the yield-to-maturity would influence bond price?

To calculate the price of the bond, we need to first determine the semi-annual
coupon payment and the number of semi-annual periods over the life of the bond.

The semi-annual coupon payment is calculated as (10% x 1000)/2 = 50 EURO.

The number of semi-annual periods over the life of the bond is 2 years x 2 = 4.

Using these values and the given yield to maturity of 8%, we can calculate the
present value of the bond's cash flows using the following formula:

PV = (C/(1+r)^1) + (C/(1+r)^2) + (C/(1+r)^3) + (C+Face Value)/(1+r)^4

Where: C = Semi-annual coupon payment = 50 r = Yield to maturity / 2 = 4% Face

Value = 1000

Solving this equation, we get the price of the bond as 965.44 EURO.

If the yield-to-maturity were to increase to 9%, we would need to recalculate the

present value of the bond's cash flows using the new yield. Using the same formula,
we get:

PV = (C/(1+r)^1) + (C/(1+r)^2) + (C/(1+r)^3) + (C+Face Value)/(1+r)^4

Where: C = Semi-annual coupon payment = 50 r = New yield to maturity / 2 = 4.5%

Face Value = 1000

Solving this equation, we get the new price of the bond as 944.27 EURO.

As we can see, an increase in the yield-to-maturity from 8% to 9% leads to a

decrease in the price of the bond from 965.44 EURO to 944.27 EURO. This is because
a higher yield-to-maturity means that investors require a higher return on their
investment, which in turn reduces the present value of the bond's cash flows.

15. Distinguish the two strategies/approaches to management of portfolio:

i. Passive portfolio management and;
ii. Active portfolio management.

16. Why benchmark portfolios are important in investment portfolio management?

17. Briefly describe each of the portfolio performance measures and explain how they are
used:
a) Sharpe’s ratio;
b) Treynor’s ratio;
c) Jensen’s Alpha.
18. In stock analysis, explain what is meant by top-down forecasting approach and bottom-up
forecasting approach.

19. What is the duration in years of a 4 year 8% bond with a par value of $1 000 and a YTM
of 10%?

20. Explain in brief what is meant by each of the following examples of derivatives:
i. Forwards
ii. Interest rate swaps
iii. Futures
iv. Options

21. (i) Describe what the Capital Asset Pricing Model (CAPM) is intended to explain.

(ii) What assumptions does the CAPM make? Which of these assumptions are not made by
the Markovitz model of portfolio choice? What is the consequence of the additional
assumptions?
(iii) What is the security market line? If the CAPM is true, will all securities have observed
returns that are on the security market line? Explain your answer. [10 marks]
(iv) How can you use CAPM to value a new issue of stock?

22. Comment the differences between investment in financial and physical assets using
following characteristics:
a) Divisibility
b) Liquidity
c) Holding period
d) Information ability

a) Divisibility: One key difference between financial and physical assets is their
divisibility. Financial assets, such as stocks or bonds, are typically highly divisible,
meaning that investors can buy or sell small portions of these assets as needed.
Physical assets, on the other hand, may not be as divisible, as they often require a
minimum investment amount due to their high transaction costs.

b) Liquidity: Another major difference between financial and physical assets is

liquidity. Financial assets are generally more liquid, meaning that they can be
bought or sold quickly and easily without significantly affecting their price. Physical
assets, on the other hand, may be less liquid, as it can take more time and effort to
find a buyer or seller and negotiate a price.

c) Holding period: The holding period for financial and physical assets can also differ.
Financial assets may be held for shorter periods of time, as they can be bought and
sold quickly and easily. Physical assets, on the other hand, may require a longer
holding period, as they may appreciate in value over time and may require
significant time and effort to sell.

d) Information ability: Finally, the amount and type of information available about
financial and physical assets can also differ. Financial assets are often subject to
greater levels of public scrutiny and regulation, which can make information about
them more widely available and easier to access. Physical assets, on the other hand,
may be subject to less regulation and may have less publicly available information,
making it more difficult for investors to assess their value and potential risks.
23. Why Treasury bills considered being a risk free investment?

Treasury bills are considered to be a risk-free investment because they are backed
by the full faith and credit of the government that issues them. In the case of
Treasury bills issued by the U.S. government, for example, investors view them as
being completely safe because they are backed by the U.S. government's ability to
tax its citizens and print money. This means that there is virtually no risk that the
U.S. government will default on its obligations to pay back the principal and interest
on the Treasury bill.

Additionally, Treasury bills have a short-term maturity, typically ranging from 4

weeks to 52 weeks. Because of their short-term nature, Treasury bills are not
affected by market fluctuations in the same way that longer-term investments like
stocks, bonds, and real estate are. This makes them an attractive investment option
for investors who want to preserve their capital and minimize the risk of losing
money.

24. Explain the differences between

a) Money market and capital market;
b) Primary market and secondary market.

a) Money market and capital market are two different segments of the overall
financial market.

The money market is a segment of the financial market where short-term debt
securities such as treasury bills, commercial papers, certificates of deposit, etc., are
traded by individuals, corporations, and governments. The maturity period for these
instruments is typically less than one year, and they are considered to be low-risk
investments.

On the other hand, the capital market is the segment of the financial market where
long-term securities such as stocks, bonds, options, derivatives, etc., are traded.
These securities have a maturity period exceeding one year and are considered to
be high-risk investments.

b) The primary market and secondary market refer to the stages at which securities
are bought and sold.

The primary market refers to the first stage of issuing securities to the public, where
companies issue new stocks or bonds through an initial public offering (IPO). In this
stage, companies raise capital by selling their securities to the public directly, and
the proceeds go to the company.

The secondary market refers to the stage where securities that have already been
issued in the primary market are traded among investors. This market allows
investors to buy and sell securities among themselves, and the proceeds go to the
investor rather than the company. Examples of secondary markets include stock
exchanges such as NASDAQ and NYSE, where stocks are traded among investors
who buy and sell them on a daily basis.

25. Explain why the issues of selectivity, timing and diversification are important when
forming the investment portfolio.
 26. What factors might an individual investor take into account in determining his/her
investment policy?

27. Distinguish between historical returns and expected returns.

Historical returns and expected returns are two different measures of investment
performance.

Historical returns refer to the actual returns that an investment has generated in the
past. These returns are calculated by taking the sum of all cash flows (such as
dividends or interest payments) and capital gains or losses over a specific period,
usually one year or longer. Historical returns are a measure of what has happened in
the past and can be used to evaluate the performance of an investment over a given
time period.

Expected returns, on the other hand, are the returns that investors anticipate an
investment will generate in the future. Expected returns take into account a variety
of factors such as current market conditions, economic trends, industry performance,
and company-specific factors. Expected returns are often estimated using statistical
models, financial analysis, and expert opinions. They are a forward-looking measure
of how much an investor expects to earn from an investment over a certain period.

While historical returns are based on past performance and offer insights into how an
investment has performed in the past, expected returns are based on future
projections and are subject to change based on market conditions and other factors.
Investors should consider both historical returns and expected returns when
evaluating potential investments, as well as other factors such as risk tolerance,
investment goals, and diversification.

28. What does covariance measure? If two assets are said to have positive covariance, what
does it mean?

29. How do you understand an investment risk and what statistic tools can be used to measure
it?

Investment risk can be understood as the possibility that an investment's actual

return will differ from its expected return. In other words, it is the uncertainty or
variability of returns associated with an investment.

There are several statistical tools that can be used to measure investment risk.
Some commonly used ones include:

1. Standard deviation: This measures the degree of variation of returns around the
average return of an investment over a certain period. The higher the standard
deviation, the greater the risk.

2. Beta: This measures the sensitivity of an investment's returns to changes in the

market. A beta of 1 indicates that the investment's returns move in line with the
market, while a beta greater than 1 indicates higher volatility and risk.

3. Value at Risk (VaR): This estimates the maximum potential loss of an investment
within a specified time frame and confidence level. It provides an estimate of the
worst-case scenario for an investment's potential loss.
4. Sharpe ratio: This measures the excess return earned by an investment per unit of
risk taken. A higher Sharpe ratio indicates better risk-adjusted returns.

5. Sortino ratio: This is similar to the Sharpe ratio but only considers downside risk. It
measures the excess return earned per unit of downside risk taken.

30. What is the interpretation of the coefficient of determination for the investor? If the
coefficient of correlation for two securities is 0,7, what is the coefficient of determination?

31. Describe the Beta factor.

32. What does the characteristic line tells to investor? Why stock characteristic lines are
different for the securities traded in the same market?

The characteristic line tells investors how the returns of a particular stock or security
are related to the returns of a market index, such as the S&P 500. The line is created
by plotting the returns of the stock on the y-axis and the returns of the market index
on the x-axis.

The slope of the characteristic line, also known as beta, indicates the level of
systematic risk associated with the stock. A beta of 1 indicates that the stock has the
same level of systematic risk as the overall market. If the beta is greater than 1, it
indicates that the stock is more volatile than the market, while a beta less than 1
indicates that the stock is less volatile than the market.

Stock characteristic lines can be different for securities traded in the same market
because each stock has its own unique set of characteristics and risks. Factors such
as industry, company size, management, competitive position, and financial health
can all affect a stock's performance and risk level. Additionally, even within the same
industry, stocks may have different levels of exposure to macroeconomic factors
such as interest rates, inflation, or political conditions. All these factors can
contribute to variations in the characteristic line and the degree of systematic risk
associated with a particular stock.

33. Refer to the following information on joint stock returns for stock 1, 2, and 3 in the table
Probability return return return
Stock 1 Stock 2 Stock 3
0.20 0.20 0.25 0.10
0.30 -0.05 0.10 0.05
0.25 0.10 0.05 0
0.25 0 -0.10 -0.05

Required
If you must choose only two stocks to your investment portfolio, what would be your choice?
a) stocks 1 and 2; b) stocks 1 and 3; c) stocks 2 and 3; d) other decision.

34. Present your arguments and calculations, to explain your decision.

Month Rate of return Rate of return
 Stock A Market Portfolio
1 0.30 0.12
2 0.24 0.08
3 -0.04 -0.10
4 0.10 -0.02
5 0.06 0.08
6 0.10 0.07

a) Calculate the main statistic measures to explain the relationship between stock A and the
market portfolio:
• The sample covariance between rate of return for the stock A and the market;
• The sample Beta factor of stock A;
• The sample correlation coefficient between the rates of return of the stock A and the
market;
• The sample coefficient of determination associated with the stock A and the market.
b) Draw in the characteristic line of the stock A and give the interpretation – what does it
show for the investor?

a)

To calculate the main statistic measures for the relationship between stock A and the
market portfolio, we first need to calculate the mean rate of return and the standard
deviation of both stock A and the market portfolio. We can then use these values to
calculate the sample covariance, the sample Beta factor, the sample correlation
coefficient, and the sample coefficient of determination.

Using the data provided, we can calculate the means and standard deviations as
follows:

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Stock A:
Mean = (0.30 + 0.24 - 0.04 + 0.10 + 0.06 + 0.10) / 6 = 0.12
Standard Deviation = SQRT(((0.30 - 0.12)^2 + (0.24 - 0.12)^2 + (-0.04 - 0.12)^2 +
(0.10 - 0.12)^2 + (0.06 - 0.12)^2 + (0.10 - 0.12)^2) / 5) = 0.107

Market Portfolio:
Mean = (0.12 + 0.08 - 0.10 - 0.02 + 0.08 + 0.07) / 6 = 0.057
Standard Deviation = SQRT(((0.12 - 0.057)^2 + (0.08 - 0.057)^2 + (-0.10 -
0.057)^2 + (-0.02 - 0.057)^2 + (0.08 - 0.057)^2 + (0.07 - 0.057)^2) / 5) = 0.076
Next, we can calculate the sample covariance between stock A and the market
portfolio using the following formula:

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Sample Covariance = SUM[(Ri - Rmean) * (Rm - Rm_mean)] / (n - 1)

Where Ri is the rate of return for stock A, Rmean is the mean rate of return for stock
A, Rm is the rate of return for the market portfolio, and Rm_mean is the mean rate of
return for the market portfolio.

Plugging in the values we get:

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Sample Covariance = [(0.30 - 0.12) * (0.12 - 0.057) + (0.24 - 0.12) * (0.08 -
0.057) + (-0.04 - 0.12) * (-0.10 - 0.057) + (0.10 - 0.12) * (-0.02 - 0.057) + (0.06
- 0.12) * (0.08 - 0.057) + (0.10 - 0.12) * (0.07 - 0.057)] / 5
Sample Covariance = 0.005
Next, we can calculate the Beta factor of stock A using the following formula:

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Beta = Sample Covariance / Market Portfolio Variance

Where Market Portfolio Variance is the variance of the market portfolio's rate of
return. We can calculate this value as follows:

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Market Portfolio Variance = (0.076)^2 = 0.005776

Plugging these values into the formula we get:

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Beta = 0.005 / 0.005776 ≈ 0.866

We can now calculate the sample correlation coefficient between the rates of return
of stock A and the market using the following formula:

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Sample Correlation Coefficient = Sample Covariance / (Stock A Standard Deviation *

Market Portfolio Standard Deviation)
Plugging in the values we get:

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Sample Correlation Coefficient = 0.005 / (0.107 * 0.076) ≈ 0.688

Finally, we can calculate the sample coefficient of determination associated with
stock A and the market using the following formula:

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Sample Coefficient of Determination = Sample Correlation Coefficient^2

Plugging in the value we get:

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Sample Coefficient of Determination = (0.688)^2 ≈ 0.474

b)

The characteristic line of stock A is a graph that plots the rate of return for stock A
on the y-axis against the rate of return for the market portfolio on the x-axis. Each
point on the line represents one of the six data points provided in the question.

The slope of the characteristic line is equal to the Beta factor we calculated earlier,
which was approximately 0.866. The intercept of the line represents the expected
rate of return for stock A when the market portfolio has a rate of return of zero.

35. Explain why most investors prefer to hold a diversified portfolio of securities as opposed
to placing all of their wealth in a single asset.
 36. In terms of the Markowitz portfolio model, explain, how an investor identify his /her
optimal portfolio. What specific information does an investor need to identify optimal
portfolio?

In the Markowitz portfolio model, an investor can identify their optimal portfolio by
considering two key factors:

1. Expected returns: The investor needs to determine the expected returns for each
asset or security in which they are interested. This requires analysis of historical
performance, current market trends, and other relevant factors that may impact
future performance.

2. Risk tolerance: The investor also needs to consider their risk tolerance, which is their
willingness to accept losses in exchange for potentially higher returns. This will
depend on factors such as their age, investment goals, financial situation, and
personal preferences.

Using these factors, the investor can construct a portfolio that maximizes their
expected return given their level of risk tolerance. Mathematically, the optimal
portfolio is the one that lies on the efficient frontier, which is the curve representing
the set of portfolios with the highest expected return for a given level of risk (or the
lowest risk for a given level of expected return).

To identify the optimal portfolio, the investor needs specific information such as:

1. Historical returns and volatility of different assets or securities.

2. Correlations between these assets or securities.
3. The investor's risk tolerance, expressed as a maximum acceptable level of volatility
or loss.
4. The investor's investment goals and time horizon.
5. Information about any constraints or limitations on the investor's ability to invest in
certain assets or securities.

By using this information, the investor can construct a portfolio that is tailored to
their individual risk-return preferences and investment objectives.

37. Comment on the risk of the stocks presented below. Which of them are more /less risky
and why?
Stock Beta
A 0.92
B 2.20
C 0.97
D -1.12
E 1.18
G 0.51

38. What is meant by an efficient market? What are the benefits to the economy from an
efficient market?
39. If the efficient market hypothesis is true, what are the implications for the investors?
If stock’s prices are assumed to reflect any information that may be contained in the past
history of the stock price itself, this is
a) Strong form of efficiency;
b) Semi-strong form of efficiency;
c) Weak form of efficiency;
d) Not enough information to determine form of efficiency.
40. The following table presents the three-stock portfolio.
Stock Portfolio weight Coefficient Beta Expected return Standard
deviation
A 0.25 0.50 0.40 0.07
B 0.25 0.50 0.25 0.05
C 0.50 1.0 0.21 0.07

Variance of the market returns is 0,06.

a) What is the Beta coefficient of the portfolio?
b) What is the expected rate of return on the portfolio?
c) What is an actual variance of the portfolio, if the following actual covariance between the
stock’s returns is given:
Cov (rA, rB) = 0,020
Cov (rA, rC) = 0,035
Cov (rB, rC) = 0,035

41. Common stock hasn‘t term to maturity. How then can a stock that does not pay dividends
have any value? Give an examples of such firms listed in the domestic market of your
country.

Common stock represents ownership in a company and its value is determined by

the market demand and supply. The value of a stock without dividends depends on
the expected future earnings potential of the company, which includes factors such
as growth prospects, profitability, and market position. Investors buy stocks with the
expectation that the company will generate profits and increase the value of their
investment over time.

For example, a technology company that operates in a high-growth industry may not
pay dividends because it reinvests its earnings into research and development to
drive further growth and expansion. In this case, investors may be interested in
buying the company's stock based on their expectation that the company will
continue to grow and generate higher profits in the future.

Another example of a company listed on the domestic market in my country that

does not pay dividends but still has value is Amazon.com Inc. (AMZN). Amazon is a
large e-commerce company that has experienced significant growth over the years.
Despite not paying dividends, the company's stock has increased in value due to its
strong market position, continued growth potential, and profitability. Investors value
Amazon's stock based on their expectation that the company will continue to
generate profits and maintain its dominant position in the online retail industry.
 42. What is the difference between blue chip and income stocks?

43. Give examples of defensive stocks in the domestic market of your country.

44. Present the examples of blue chip stocks in the domestic market Explain, why did you
categorize them as blue chips.

Blue chip stocks are shares of large, well-established companies with a long history
of stable earnings growth and a reputation for reliability and quality. These
companies typically have an established track record of paying dividends to
shareholders, which helps to provide a steady stream of income.

In the domestic market, examples of blue chip stocks include:

1. Apple Inc. (AAPL) - Apple is one of the largest technology companies in the world,
known for its iconic iPhone, iPad, and Mac products. The company has a strong brand
and a loyal customer base, and consistently delivers solid financial results.

2. Microsoft Corporation (MSFT) - Another leading technology company, Microsoft is a

household name thanks to its Windows operating system and Office productivity
suite. The company has a diverse range of businesses, including cloud computing
services, gaming, and hardware.

3. Johnson & Johnson (JNJ) - A healthcare giant, Johnson & Johnson is known for its
consumer health products, such as Band-Aids and Tylenol, as well as its
pharmaceuticals and medical devices. The company has a long history of steady
growth and consistent dividends.

4. Coca-Cola Co. (KO) - One of the world's largest beverage companies, Coca-Cola is
famous for its namesake soft drink as well as other popular brands like Sprite and
Fanta. The company has a strong global presence and a history of dependable
financial performance.

I categorized these stocks as blue chips because they are all large, well-established
companies that have a proven track record of delivering solid financial results over
time. They are leaders in their respective industries and have built strong brand
reputations, which gives them a competitive advantage. Additionally, these
companies have a history of paying dividends to shareholders, which indicates a
commitment to providing value to investors. All of these factors make these stocks a
relatively safe investment choice, with lower risk compared to smaller, less
established companies.

45. What is the purpose of bond ratings? If the bonds ratings are so important to the investors
why don‘t common stock investors focus on quality ratings of the companies in making their
investment decisions?

The purpose of bond ratings is to provide investors with an assessment of the

creditworthiness of a bond issuer, or the likelihood that the issuer will be able to
meet its debt obligations in a timely manner. Bond ratings are assigned by rating
agencies such as Standard & Poor's, Moody's, and Fitch, based on a variety of factors
such as the issuer's financial strength, market position, and management quality.

Bond ratings are important to investors because they provide a quick and easy way
to assess the risk associated with a particular bond investment. A high bond rating
indicates that the issuer is more likely to make timely interest and principal
payments, while a low rating suggests a higher risk of default. This information can
help investors make informed decisions about which bonds to buy or sell, and at
what price.

On the other hand, common stock investors typically focus more on the company's
financial performance, growth prospects, and other fundamental factors when
making their investment decisions. They may consider factors such as revenue
growth, profitability, market share, and competitive position when evaluating a
potential investment. While bond ratings can be an important consideration for
investors, they are not necessarily as relevant for common stock investors who are
looking for long-term growth opportunities rather than fixed income investments.
Furthermore, stock investors are typically more interested in assessing the overall
quality of a company's business model, management team, and growth potential,
rather than just its ability to pay off its debt obligations.

46. How would you expect interest rates to respond to the following economic events (what
would be the direction of the interest rates changes)? Explain why.
a) Increase in investments;
b) Increase in savings level;
c) Decrease in export;
d) Decrease in import;
e) Increase in government spending;
f) Increase in Taxes.

47. What is a key factor in analyzing bonds? Why?

One key factor in analyzing bonds is the bond's yield, which represents the return an
investor can expect to receive by holding the bond until maturity. Yield is important
because it reflects the market's assessment of the issuer's creditworthiness, as well
as current economic conditions and interest rates. Additionally, a bond's yield can
help investors compare the relative value of different bonds with varying maturities,
credit ratings, and other features. Ultimately, understanding a bond's yield is
essential for making informed investment decisions and managing risk within a
diversified portfolio.
48. Distinguish between yield-to-call and yield-to-maturity.

49. What is the difference between the market expectation theory and the liquidity preference
theory?

The market expectation theory and the liquidity preference theory are two different
theories that attempt to explain how interest rates are determined in financial
markets.

The market expectation theory, also known as the pure expectations theory, holds
that the current long-term interest rate is equal to the average of the expected
short-term interest rates over the same period. This theory assumes that investors
are indifferent between investing in a series of short-term securities or a single long-
term security with the same maturity. In other words, it suggests that the shape of
the yield curve reflects only the market's expectation of future interest rates, and
not any additional factors.
 On the other hand, the liquidity preference theory, developed by economist John
Maynard Keynes, argues that investors demand a premium for holding longer-term
bonds because they prefer investments that are more liquid and less risky.
According to this theory, investors have a preference for shorter-term securities
because they offer greater flexibility and the ability to respond more quickly to
changes in market conditions. As a result, the yield curve is upward sloping, with
longer-term bonds yielding higher returns than shorter-term bonds.

In summary, the main difference between the two theories lies in their assumptions
about the driving forces behind interest rate movements. The market expectation
theory assumes that interest rates are driven solely by expectations of future rates,
while the liquidity preference theory suggests that investors have a preference for
shorter-term, more liquid securities, which results in an upward sloping yield curve.

50. Distinguish between a put and a call.

51. What does it mean to say „an option buyer has a right but not an obligation?

52. Explain the following terms used with the options:

a) „In the money“
b) „Out of money“
c) „At the money“
53. Assume you hold a well-diversified portfolio of common stocks. Under what conditions
might you want to hedge it using a stock index option?
a) Explain how these options can be used for hedging.
b) What happens with your hedged portfolio if the stock market will fall?
c) What happens with your hedged portfolio if the stock market will grow?
54. Assume that you plan to construct a portfolio aimed at achieving your stated objectives.
The portfolio can be constructed by allocating your money to the following asset classes:
common stock, bonds, and short-term securities.
a) Identify state and comment your investment objectives.
b) Determine an asset allocation to these three classes of assets considering your stated
investment objectives. Explain your decision.
c) What reasons could cause you to make changes in your asset allocations?
55. Give the arguments for active portfolio management.

56. What are the reasons which cause investors managing their portfolios passively to make
changes their portfolios?
There are a number of reasons why investors managing their portfolios
passively may make changes to their portfolios. Some of the most common
reasons include:
 Rebalancing: Passive investors often use a set allocation of assets, such as
a 60/40 stock/bond split. Over time, the value of these assets may change,
causing the allocation to drift away from the desired allocation. To maintain
the desired allocation, passive investors may periodically rebalance their
portfolios.
 Tax-loss harvesting: Passive investors may also make changes to their
portfolios to take advantage of tax-loss harvesting opportunities. This
 involves selling losing positions to offset gains in other positions, which can
help to reduce the overall tax bill.
 Changes to the underlying index: Passive investors may also make
changes to their portfolios when the underlying index changes. For example,
if a stock is removed from an index, a passive investor may sell that stock.
 Changes in personal circumstances: Passive investors may also make
changes to their portfolios due to changes in their personal circumstances,
such as retirement or changes in their risk tolerance.

57. What are the major differences between active and passive portfolio management?

Active portfolio management involves actively buying and selling stocks or other
securities in an attempt to outperform the market. An active manager will typically
use various strategies such as fundamental analysis, technical analysis, and
quantitative analysis to select investments.

Passive portfolio management, on the other hand, involves investing in a pre-

determined basket of securities that track a particular index. Passive managers do
not attempt to outperform the market; rather, they aim to match its performance.

The major differences between active and passive portfolio management are:

1. Goals: The goal of active portfolio management is to beat the market, while the goal
of passive portfolio management is to match the market.

2. Strategy: Active portfolio managers use various strategies to select investments,

while passive managers simply invest in a pre-determined basket of securities that
track a particular index.

3. Trading frequency: Active portfolio managers tend to trade more frequently than
passive managers since they are constantly trying to find undervalued securities or
take advantage of short-term market movements. Passive managers, on the other
hand, typically only trade when there are changes to the underlying index.

4. Fees: Active portfolio management tends to be more expensive since it requires

more research and trading activity. Passive management, by comparison, tends to
be less expensive since it simply tracks an index with minimal trading activity.

5. Risk: Active portfolio management is generally considered riskier than passive

management because the manager's investment decisions can have a significant
impact on returns. Passive management, by contrast, is designed to minimize risk by
broadly diversifying across an entire market index.

58. Explain the role of revision in the process of managing a portfolio.

Revision plays a crucial role in managing a portfolio as it ensures that the portfolio
remains aligned with the investor's goals and objectives over time. The process of
revision involves reviewing the performance of the portfolio periodically and making
necessary adjustments to keep it on track.

The main goal of portfolio revision is to ensure that the portfolio continues to meet
the investor's needs and risk tolerance while adapting to changes in the market and
 economy. This may involve re-balancing the portfolio by adjusting the allocation of
assets or adding or removing securities from the portfolio.

Regular revisions also help investors to stay disciplined and avoid impulsive
decisions based on short-term market fluctuations. By sticking to a long-term
investment strategy and making informed, data-driven decisions, investors can
increase their chances of achieving their financial goals.

Overall, the process of portfolio revision plays a critical role in effective portfolio
management by helping investors to maintain a well-diversified portfolio that is
optimized for their individual goals and risk tolerance.

59. Distinguish strategic and tactical asset allocation.

Strategic asset allocation and tactical asset allocation are two different approaches
to managing a portfolio of assets.

Strategic asset allocation refers to the process of setting long-term target

allocations for various asset classes based on an investor's goals, risk tolerance,
and investment horizon. This typically involves investing in a diversified mix of asset
classes such as equities, fixed income, real estate, and alternative investments. The
goal of strategic asset allocation is to create a well-diversified portfolio that can
generate returns consistent with an investor's objectives over the long term.

On the other hand, tactical asset allocation refers to the process of making short-
term adjustments to a portfolio's asset allocation based on changes in market
conditions or other factors. Tactical asset allocation typically involves deviating from
the long-term target allocations set by the strategic asset allocation process in order
to take advantage of perceived opportunities or to manage risks in the short term.

In summary, strategic asset allocation is a long-term approach to portfolio

management that sets target allocations based on an investor's objectives, while
tactical asset allocation is a shorter-t

There are several different types of asset allocation strategies that investors can use
to manage their portfolios. Here are OTHER types:

1. Strategic Asset Allocation: This is a long-term approach to asset allocation that

involves setting target allocations for each asset class and periodically rebalancing
the portfolio to maintain those targets. The goal is to achieve a balance between risk
and reward that aligns with the investor's objectives and risk tolerance.

2. Tactical Asset Allocation: This is a more active approach to asset allocation that
involves making short-term adjustments to the portfolio based on market
conditions or other factors. The goal is to take advantage of opportunities for higher
returns or to reduce risk during periods of market volatility.

3. Constant-Weighting Asset Allocation: This approach involves maintaining a

constant allocation to each asset class over time, regardless of market conditions.
This strategy is designed to provide consistent returns and reduce the impact of
market fluctuations on the portfolio.

4. Dynamic Asset Allocation: This approach involves making adjustments to the

portfolio based on changes in market conditions, economic trends, or other factors.
 The goal is to optimize returns and minimize risk by adapting to changing market
dynamics.

5. Integrated Asset Allocation: This approach takes into account both traditional
asset classes (such as stocks and bonds) and alternative assets (such as
commodities and real estate). The goal is to create a diversified portfolio that can
generate returns across multiple asset classes and adapt to changing market
conditions.

Overall, the choice of asset allocation strategy will depend on an investor's goals,
risk tolerance, and investment philosophy. Each strategy has its own strengths and
weaknesses, and investors should carefully consider their options before selecting a
particular approach.

erm approach that makes adjustments to those allocations based on market

conditions.

60. What role does current market information play in managing investment portfolio?

Current market information can play a significant role in managing an investment

portfolio as it provides valuable insights into the performance of various asset
classes, industries, and individual securities. By keeping track of market trends,
investors can make informed decisions about when to buy, hold or sell investments
within their portfolio. For example, if the market is experiencing a downturn,
investors may choose to sell their more volatile holdings and invest in more stable
assets such as bonds or cash. Conversely, if the market is doing well, investors may
choose to take on more risk by investing in growth stocks or other higher-risk assets.
Overall, staying up-to-date with current market information can help investors
optimize their portfolio for their financial goals and risk tolerance
61. Why is the asset allocation decision the most important decision made by investors?

The asset allocation decision is often considered the most important decision made
by investors because it has a significant impact on the overall performance and risk
of an investment portfolio. Asset allocation refers to how an investor distributes their
investments across different asset classes, such as stocks, bonds, and cash.

Studies have shown that asset allocation is responsible for over 90% of a portfolio's
returns, with individual stock selection and market timing playing a much smaller
role. By diversifying across different asset classes, investors can potentially reduce
their exposure to any one particular risk and improve the overall risk-return tradeoff
of their portfolio. Additionally, asset allocation helps investors align their portfolio
with their specific investment goals, time horizon, and risk tolerance.

62. What is the point of investment portfolio rebalancing?

he point of investment portfolio rebalancing is to maintain the desired level of risk

and return in an investor's portfolio. Over time, the value of different assets in a
portfolio will change at different rates, causing the portfolio to become unbalanced.
 Rebalancing involves selling some assets and buying others to restore the original
allocation or to adjust to a new target allocation based on the investor's goals and
risk tolerance.

There are several benefits to rebalancing an investment portfolio:

1. Maintaining the desired risk level: Rebalancing helps ensure that the portfolio's risk
level remains consistent with the investor's risk tolerance. Without rebalancing, a
portfolio can become overly concentrated in high-risk assets, exposing the investor
to potentially large losses in a market downturn.

2. Capturing gains: Rebalancing allows investors to capture gains from assets that have
performed well and reinvest them in underperforming assets. This process locks in
profits and helps to maintain the desired allocation.

3. Reducing costs: Rebalancing can help reduce transaction costs and tax liabilities by
consolidating trades into fewer transactions. This can be especially important for
investors who trade frequently or have a large portfolio.

4. Aligning with investment goals: Rebalancing allows investors to realign their

portfolios with their investment goals. As an investor's goals change over time, so
should their investment strategy. Regular rebalancing ensures that the portfolio
remains aligned with the investor's goals.

Overall, investment portfolio rebalancing is an important tool for maintaining the

desired risk level, capturing gains, reducing costs, and aligning with investment
goals. It helps investors to achieve their long-term financial objectives with greater
confidence.

63. What changes in investor’s circumstances cause the rebalancing of the investment
portfolio? Explain why.

here are several changes in an investor's circumstances that may cause the need for
rebalancing of their investment portfolio. Here are some common examples:

1. Changes in investment goals: If an investor's goals change, they may need to adjust
their investment portfolio accordingly. For example, if they become more risk-
averse, they may need to rebalance their portfolio to reduce exposure to high-risk
assets.

2. Market fluctuations: Changes in market conditions and fluctuations can cause an

investor's portfolio to become unbalanced. For example, if one asset in the portfolio
experiences a significant increase in value while others stay the same, the portfolio
may become overweighted in that asset class. Rebalancing can help bring the
portfolio back to its original allocation.

3. Life events: Major life events such as marriage, divorce, or retirement can also
trigger the need for portfolio rebalancing. For example, an investor who is nearing
retirement may want to shift their portfolio towards more conservative investments
and away from riskier assets.

4. New investments: When an investor adds new investments to their portfolio, it can
alter the balance of the existing portfolio. Rebalancing will ensure that the portfolio
remains aligned with the investor's goals and risk tolerance.
 Overall, rebalancing an investment portfolio ensures that it continues to align with
the investor's goals and risk tolerance over time, helping to maintain a consistent
level of risk and return.

64. Why is portfolio revision not free of cost?

Portfolio revision typically involves a number of costs, such as transaction fees and
taxes. When you revise your portfolio, you may need to sell some assets and buy
new ones, which can trigger capital gains taxes or other taxes. Additionally, there
may be fees associated with buying and selling assets, such as brokerage
commissions or bid-ask spreads. These costs can add up over time and reduce the
overall return on your investment. However, it's important to remember that
regularly revising your portfolio can also help to improve its performance and align it
with your goals, so it may be worth the cost in the long run.

65. Why benchmark portfolios are important in investment portfolio management?

Benchmark portfolios are important in investment portfolio management for several

reasons:

1. Performance Measurement: Benchmark portfolios provide a standard against which

the performance of an investment portfolio can be measured. By comparing the
returns of a portfolio to its benchmark, investors can evaluate whether the portfolio
manager has generated alpha (excess return) or underperformed the market.

2. Risk Management: Benchmark portfolios also help portfolio managers manage risk
by providing a reference point for assessing the risks associated with their portfolio.
A portfolio manager who manages a high-risk portfolio may compare it to a
benchmark portfolio with similar characteristics to ensure that the risk profile is
appropriate.

3. Asset Allocation: Benchmark portfolios can also assist in asset allocation decisions by
providing a guide to how different asset classes perform relative to one another.
Portfolio managers can use benchmark portfolios as a starting point for constructing
their investment portfolios.

4. Communication: Benchmark portfolios can be a useful tool for communicating with

clients and stakeholders. Clients may have specific expectations regarding the
performance of their portfolio, and benchmark portfolios can provide a clear way to
discuss how the portfolio is performing relative to those expectations.

Overall, benchmark portfolios help investors evaluate the performance of their

investments, manage risk, make informed asset allocation decisions, and
communicate effectively about their investment strategies.