Investment Management

Course code: Fin-423

Chapter note 1
Prepared by ABM Fahad Hossain
Dept. of Finance & Banking (5th Batch)
Islamic University, Kushtia
In need: FB: Abm Fahad Hossain
Email: abmfahadhossain@[Link]

Chapter 1: Introduction

1. Define investment environment and states the components of investment environment.

Describe the types of security
2. Why do secondary security markets not generate capital for the issuers of securities
traded in those markets?
3. Explain why the rate of return on an investment represents the investor’s relative
increase in wealth from that investment?
4. ‘Why are Treasury bills considered to be a risk free investment? In what way do
investors bear risk when they own Treasury bills?
5. When sensible investment strategies are compared with one another, risk and return
tend to go together?
6. Why are corporate bonds riskier than U.S. government bonds?
7. How many stages are generally followed by an investor in an investment process?
8. Why does it not make sense to establish an investment objective of making a lot Of
money”?
9. What factors might an individual investor take into account in determining his
investment policy?
10. Distinguish between technical and fundamental security analysis
 Prepared by ABM Fahad Hossain
Dept. of Finance & Banking (5th Batch)
1. Define investment environment and states the components of investment environment.
Ans: The investment environment includes the kinds of marketable securities and where and how
they are bought and sold. There are three main elements of the investment environment. These are
given below:
1. Securities (also known as financial investments or financial assets),
2. Security markets (also known as financial markets), and
3. Financial intermediaries (also known as financial institutions).
2. Describe the types of security
Ans: The types of security are described below:
1. Treasury bills: Treasury bill is a short-term debt issued by a national government with a
maximum maturity of one year. Treasury bills are sold at discount. The difference between
purchase price and the value at maturity is the amount of interest. Treasury bills are fully
guaranteed by the government and free from default risk. There are three types of
government T-bills such as 91 days, 182 days, and 364 days.
2. Long term bonds: The second and third types of securities are bonds and loaning money. It
includes long term treasury bonds and corporate bonds. Each type of bond represents a long-
term commitment of the issuer to the investor. This commitment is to make cash payments
each year up to some point in time and the principal will also be made at the maturity date.
The long-term government bonds involve approximately 20-year loans.
3. Common stock: The final type of security is common stocks. Common stock represents the
legal ownership of the company and gives voting rights to the holders. They also determines
the policy of the organization.

3. Describe the types of security markets.

Points Money market Capital Market
Meaning Money market is a segment of the Capital market is a segment of
financial market which is designed for financial market which is designed for
the making of short term loans. making long term loan.
Nature Informal market Formal market
Maturity Within a year More than one year
Financial Treasury Bills, commercial papers, Share, debentures, bonds, retained
instruments trade credit etc. earnings.
Risk factor Low high

Points Primary market Secondary market

Meaning Primary market is used for trading new Secondary market is used for
securities. previously issued securities.
Nature Direct purchasing Indirect purchasing
Sale of Only one time Multiple time
securities
Parties Buying and selling between company Buying and selling between investors.
and investors.
Intermediary Underwriters Brokers
Price Fixed price Price depends on the demand and
supply.
Example IPO (Initial Public Offering) Stock markets
 Prepared by ABM Fahad Hossain
Dept. of Finance & Banking (5th Batch)
4. Why do secondary security markets not generate capital for the issuers of securities traded
in those markets?
Ans: Issuers receive the net amount of securities sales when their securities are initially sold in
the primary market. These securities represent claims on the issuing entities. For publicly, these
claims can be transferred through sales of the securities. This trading among investors takes place
in the secondary markets, where the issuers have no direct involvement. When an investor sells
his or her shares of a particular security in the secondary market, the issuer has no right to receive
any additional funds as a result of the trade.

5. Explain why the rate of return on an investment represents the investor’s relative increase
in wealth from that investment?

Ans: The rate of return measures the wealth associated with a particular investment at the end of
a period. Therefore the difference in the beginning and ending wealth figures represents the
increase in the investors wealth derived from the investment. The rate of return expresses this
difference relative to the initial wealth associated with the investment.

6. ‘Why are Treasury bills considered to be a risk free investment? In what way do investors
bear risk when they own Treasury bills?
Ans: Because the Govt. guarantees the payment of interest and principal on Treasury bills. An
investor can be certain of the return on a Treasury bill investment. The government has the
unlimited authority to tax and print money to repay its debts, Therefore its ability to make these
promised payments is unquestioned.

This certain Treasury bill return does not account for the effects of inflation. If inflation rises
sharply and unexpectedly during the time that an investor held Treasury bills, he would not be
compensated for the resulting lost purchasing power.

7. When sensible investment strategies are compared with one another, risk and return tend
to go together?
Ans: Securities that have higher average returns tend to have greater amounts of risk. That’s
why; sensible investment strategies are compared with one another, risk and return tend to go
together.

8. Why are corporate bonds riskier than U.S. government bonds?

Ans: Corporate bonds always bear the risk that tile issuer might default on its debts. On the other
hand, The U.S. government has an unlimited ability to satisfy its debt obligations. So, corporate
bonds are riskier than US government bonds.

9. How many stages are generally followed by an investor in an investment process?

Ans: The investment process describes how an investor should go about making decisions with
regard to what marketable securities to invest in, how extensive the investments should be, and when
the investments should be made. The different stages of investment management process are
described below:
1. Set investment policy: The initial step of investment management process is setting
investment policy. It involves determining the investor's objectives and the amount of his
investable wealth. Investment objectives should be made on the basis of both risk and return.
This step involves with the identification of the potential categories of financial assets for
 Prepared by ABM Fahad Hossain
Dept. of Finance & Banking (5th Batch)
making portfolio. This identification will be based on the investment objectives, amount of
investable wealth, and tax status of the investor.
2. Perform security analysis: The second step in the investment process is performing security
analysis. It involves examining several individual securities (or groups of securities) within
the broad categories of financial assets previously identified. There are many approaches to
security analysis. However, these approaches have two classifications. One is technical
analysis and another is fundamental analysis. Analysts who use the technical approach to
security analysis are known as technical analysts and those who use fundamental analysis are
known as fundamental analysts. In technical analysis, future performance will be measured
on the basis of past performance. But in fundamental analysis, future performance will be
measured on the basis of fundamental performance. Intrinsic value is the basis of
fundamental analysis.
3. Construct a portfolio: The third step in the investment process is portfolio construction. It
involves identifying those specific assets in which to invest as well as determining the
proportions of the investment in each asset. Here, selectivity, timing, and diversification are
considered by the investor. Selectivity is also known as micro-forecasting. It focuses on
forecasting price movements of individual securities. Timing is also known as macro-
forecasting. It involves the forecasting of price movements of common stocks in general
relative to fixed-income securities, such as corporate bonds and Treasury bills.
Diversification involves constructing the investor's portfolio in such a manner that risk is
minimized.
4. Revise the portfolio: The fourth step in the investment process is portfolio revision. It
concerns the periodic repetition of the previous three steps. Revision is needed if the investor
may change investment objectives. Another motivation for revising a given portfolio. The
investor can add or revoke an asset with his portfolio through revising.
5. Evaluate the performance of the portfolio. The fifth step in the investment process is
evaluating the performance of portfolio. It, involves determining periodically how the
portfolio performed not only the return but also the risk experienced by the investor. Here,
appropriate measures of return and risk as well as benchmarks are needed. After evaluating
the portfolio, the investor takes necessary steps where necessary.
10. Why does it not make sense to establish an investment objective of making a lot Of
money”?
Ans: It is not a sense to establish an investment objective of making a lot Of money because returns
on financial assets are directly related to risk. Making a lot of money means maximizing returns that
increases levels of risk. The investors should establish investment by considering desired levels of
return and risk jointly.

11. What factors might an individual investor take into account in determining his investment
policy?
Ans: Many factors could influence an investor’s investment policy. Some obvious factors would
take into consideration in determining investment policy. These are given below:
 The investor’s financial objectives
 The investor’s willingness to bear risk,
 The investors current financial circumstances, and
 The investor’s investment time horizon.
 Prepared by ABM Fahad Hossain
Dept. of Finance & Banking (5th Batch)
12. Distinguish between technical and fundamental security analysis
Ans: The differences between technical and fundamental security analysis are given below:
Points Technical Security Analysis Fundamental security analysis
Definition Technical analysis attempts to forecast the Fundamental analysis attempts to forecast the
movement in the prices of securities based on movement in the prices of securities based on
historical price trends. fundamental performance of the securities.
Analysts Analysts who use the technical approach to Analysts who use fundamental analysis are
security analysis are known as technical known as fundamental analysts.
analysts.
Basis Historical performance or data Intrinsic Value
 Prepared by ABM Fahad Hossain
Dept. of Finance & Banking (5th Batch)
 Investment Management
Course code: Fin-423
Chapter note 2
Prepared by ABM Fahad Hossain
Dept. of Finance & Banking (5th Batch)
Islamic University, Kushtia
In need: abmfahadhossain@[Link]

Chapter 8: Risk free borrowing and lending

1. Distinguish between reinvestment-rate risk and interest-rate risk.

2. The covariance between a risk-free asset and a risky asset is zero. Explain why this is the
case and demonstrate it mathematically.
3. How does the efficient set change when risk-free borrowing and lending are introduced
into the Markowitz model? Explain with words and graphs.
4. How does the feasible set change when riskfree borrowing and lending are introduced into
the Markowitz model? Explain with words and graphs.
5. With the Markowitz model extended to include riskfree borrowing and lending, draw the
indifference curves, efficient set, and optimal portfolio for an investor with high risk
aversion and an investor with low risk aversion.
6. What does the efficient set look like if riskfree borrowing is permitted but no lending is
allowed? Explain with words and graphs.
7. What will be the effect on total portfolio expected return and risk if you borrow money at
the riskfree rate and invest in the optimal risky portfolio?
 Prepared by ABM Fahad Hossain
Dept. of Finance & Banking (5th Batch)
1. Distinguish between reinvestment-rate risk and interest-rate risk.
Ans: The differences between reinvestment-rate risk and interest-rate risk are given below:
Points Reinvestment risk Interest rate risk
Definition Reinvestment risk is the probability Interest rate risk is the chance that an
that an investor will be unable to unexpected change in interest rates will
reinvest cash flows at a rate negatively affect the value of an investment.
comparable to the current
investment's rate of return.
Reason If the investor's holding period is If the investor's holding period precedes the
longer than the life of the security. maturity date of the security, then the
investor will be uncertain as to what price he
or she will ultimately be able to sell the
security.

2. The covariance between a risk-free asset and a risky asset is zero. Explain why this is the
case and demonstrate it mathematically.
Ans: The standard deviation of a risk free asset's return is zero by definition. That is, its return is
certain. Thus its return must be completely unrelated to the returns on any other asset. Therefore, the
covariance between a risk free asset and a risky asset must be zero.
𝜎 ij = 𝜎 ij  𝜎 i  𝜎 j
And if the asset i is the risk free asset then 𝜎 i = 0. Thus:
𝜎 ij = 𝜎 ij  0  𝜎 j = 0

3. How does the efficient set change when risk-free borrowing and lending are introduced into
the Markowitz model? Explain with words and graphs.
Ans: The efficient set becomes all the portfolios that can be constructed through a combination of a
single risky portfolio and lending or borrowing at the riskfree rate. The efficient set will therefore
consist of all portfolios along a ray emanating from the riskfree asset, tangent to the curved Markowitz
efficient set (that is, the efficient set without riskfree borrowing or lending), and continuing on out into
risk-return space. The tangency point represents the optimal combination of risky assets for the
investor.

4. How does the feasible set change when riskfree borrowing and lending are introduced into
the Markowitz model? Explain with words and graphs.
Ans: The feasible set now becomes the area between two rays, each emanating from the riskfree asset.
The ray to the northwest is the efficient set. The ray to the southeast will connect the riskfree asset and
generally the lowest expected return asset. Any combination of risk and return between these two rays
can be created by appropriately combining a risky portfolio with riskfree borrowing or lending.

5. With the Markowitz model extended to include riskfree borrowing and lending, draw the
indifference curves, efficient set, and optimal portfolio for an investor with high risk
aversion and an investor with low risk aversion.
Ans: The efficient set will be the same for both investors because it represents investment opportunities,
not preferences. (Of course, the two investors may have different expectations regarding available
expected returns and risks.)
The more risk-averse investor's indifference curves will be more steeply sloped than the indifference
 Prepared by ABM Fahad Hossain
Dept. of Finance & Banking (5th Batch)
curves of the less risk-averse investor.
The optimal portfolio of the more risk-averse investor will lie to the southwest of the less risk-averse
investor's optimal portfolio. Both optimal portfolios, of course, will lie on the efficient set. The more
risk-averse investor's optimal portfolio likely will lie to the southwest of the tangency portfolio,
implying lending at the riskfree rate. Conversely, the less risk-averse investor's optimal portfolio likely
will lie to the northeast of the tangency portfolio, implying borrowing at the risk-free rate.

6. What does the efficient set look like if riskfree borrowing is permitted but no lending is
allowed? Explain with words and graphs.
Ans: The efficient set would be composed of the southwest portion of the curved Markowitz efficient
set (that is, the efficient set without riskfree borrowing or lending) up to the tangency portfolio (when
both riskfree borrowing and lending are permitted), where it would then become a ray emanating from
the tangency portfolio and extending out into risk-return space. If this ray were extended to the
southwest, it would intersect the return axis at the riskfree rate.

7. What will be the effect on total portfolio expected return and risk if you borrow money at
the riskfree rate and invest in the optimal risky portfolio?
Ans: The effect is to increase both expected return and risk. The investor is leveraging his or her
invested position. Since the optimal risky portfolio has a higher expected return than the riskfree asset,
the expected return on the leveraged risky portfolio is higher than that of the unleveraged portfolio.
However, because the risky portfolio's return is variable, the leveraged risky portfolio's return is more
variable and hence more risky than the return on the unleveraged risky portfolio.
 Prepared by ABM Fahad Hossain
Dept. of Finance & Banking (5th Batch)
 Investment Management
Course code: Fin-423
Chapter note 3
Prepared by ABM Fahad Hossain
Dept. of Finance & Banking (5th Batch)
Islamic University, Kushtia
In need: FB: Abm Fahad Hossain
Email: abmfahadhossain@[Link]

Chapter 9: Capital Asset Pricing Model

1. Describe the key assumptions underlying the CAPM.

2. Many of the underlying assumptions of the CAPM are violated to some degree in the real
world. Does that fact invalidate the model's conclusions? Explain.
3. What is the separation theorem? What implications does it have for the optimal portfolio
of risky assets held by investors?
4. What constitutes the market portfolio? What problems does one confront in specifying the
composition of the true market portfolio? How have researchers and practitioners
circumvented these problems?
5. In the equilibrium world of the CAPM, is it possible for a security not to be part of the market
portfolio? Explain
6. Describe the price adjustment process that equilibrates the market's supply and demand for
securities. What conditions will prevail under such equilibrium?
7. Distinguish between the capital market line and the security market line.
8. Explain the significance of the slope of the SML. How might the slope of the SML change
over time?
9. Why should the expected return for a security be directly related to the security's
covariance with the market portfolio?
10. The risk of a well-diversified portfolio to an investor is measured by the standard deviation
of the portfolio's returns. Why shouldn't the risk ofan individual security be calculated in
the same manner?
11. The SML describes an equilibrium relationship between risk and expected return. Would
you consider a security that plotted above the SML to be an attractive investment? Why?
12. The CAPM permits the standard deviation of a security to be segmented into market and
non-market risk. Distinguish between the two types of risk.
13. Is an investor who owns any portfolio of risky assets other than the market portfolio
exposed to some non-market risk? Explain.
14. Describe how the SML is altered when the riskfree borrowing rate exceeds the riskfree
lending rate.
 ABM Fahad Hossain
Dept. of Finance & Banking (5th Batch)
1. Describe the key assumptions underlying the CAPM.
Ans: There are ten key assumptions underlying the CAPM:

1. Investors evaluate portfolios by analyzing expected returns and standard deviations over a
one-period time horizon.
2. Everything else equal, investors prefer portfolios with greater expected returns.
3. Everything else equal, investors prefer portfolios with lower standard deviations.
4. Assets are infinitely divisible.
5. Investors may borrow or lend at a single risk free interest rate.
6. Taxes and transaction costs are immaterial.
7. All investors have the same one-period time horizon.
8. All investors borrow and lend at the same risk free rate.
9. All investors have immediate and costless access to all relevant information.
10. Investors possess homogeneous expectations regarding the expected returns and risks of
securities
2. Many of the underlying assumptions of the CAPM are violated to some degree in the real
world. Does that fact invalidate the model's conclusions? Explain.
Ans: The many of the CAPM assumptions are violated in the "real world" but it does not invalidate the
CAPM's primary conclusions. The "reasonableness" of a model's assumptions are of little concern.
The true test of a model helps the interested parties to understand and predict the process of the model
and market situation.

3. What is the separation theorem? What implications does it have for the optimal portfolio of
risky assets held by investors?
Ans: The separation theorem states that an investor's optimal risky portfolio can be determined without
investor's risk-return preferences.

Assuming that every investor has the same expectations on the expected returns and risks for available
securities, and assuming that everyone faces the same riskfree rate, therefore the efficient set must be the
same for all investors. It indicates that every investor will hold the same risky portfolio. The only
difference in portfolios held by investors will depend on the investors' individual risk-return preferences.

4. What constitutes the market portfolio? What problems does one confront in specifying the
composition of the true market portfolio? How have researchers and practitioners
circumvented these problems?
Ans: The market portfolio consists of all securities where the proportion invested in each security equals
the market value of the security divided by the sum of the market values of all securities.

Specifying the "true" market portfolio is impossible. One must be able to identify and value of all assets
held by investors. These assets range from easily valued assets such as publicly-traded common stocks
to difficult-to-value assets such as foreign real estate.

To overcome these difficulties, researchers and practitioners have restricted their definition of the
market portfolio. They should include easily identifiable and valued securities, such as the stocks of
S&P 500.
 ABM Fahad Hossain
Dept. of Finance & Banking (5th Batch)
5. In the equilibrium world of the CAPM, is it possible for a security not to be part of the market
portfolio? Explain
Ans: The market portfolio is composed of all assets held by investors. Each asset is weighted by the
proportion of its market value to the market value of all assets.

As derived from the separation theorem, all investors will hold the same risky portfolio. Therefore, in
equilibrium, every security must be included in the market portfolio. If a security were not included in
the market portfolio, no investor would own it and its equilibrium market price would be zero.

6. Describe the price adjustment process that equilibrates the market's supply and demand
for securities. What conditions will prevail under such equilibrium?
Ans: If investors wish to hold more units of a security than are available, then they will bid up the price
of the security that reduces the expected return. Due to lower expected return, investors will reduce
their holdings of the security.

Conversely, if investors wish to hold fewer units of a security than are available, then they will bid
down the security's price that increases the expected return. Due to higher expected return, investors
will wish to hold more units of the security.

This process will drive the price of the security in equilibrium at which the number of units investors
wish to hold will equal the number of units outstanding. This equilibrating process will produce market
clearing prices for all securities.

7. Distinguish between Capital Market Line (CML) and Security Market Line(SML)
Ans: The differences between Capital Market Line (CML) and Security Market Line (SML) are
given below:
Points Capital Market Line (CML) Security Market Line(SML)
Definition Capital Market Line represents the SML is a graphical presentation of the market
equilibrium relationship between expected risk and return at a given period.
return and standard deviation only for
efficient portfolios
Measure CML measures risk by standard deviation or SML measures risk by Beta.
total risk.
Defines CML graph defines only efficient portfolios SML defines both efficient and non-efficient
portfolios.
Determined The market portfolio and risk free assets are All security factors are determined by the
determined by the CML. SML.

8. Explain the significance of the slope of the SML. How might the slope of the SML change
over time?
Ans: The slope of the SML indicates the level of aggregate investor risk aversion. It indicates how
much demand of the investors for bearing the risk to hold the market portfolio.
As investors in aggregate become more (less) risk averse, the slope of the SML will rise
(decline). Therefore, investors will demand a higher expected return over the riskfree rate for bearing
the risk on the market portfolio.
 ABM Fahad Hossain
Dept. of Finance & Banking (5th Batch)
9. Why should the expected return for a security be directly related to the security's
covariance with the market portfolio?
Ans: According to the CAPM, all investors will hold the market portfolio combined with riskfree
borrowing or lending. Therefore all investors will be concerned with the risk or standard deviation of
the market portfolio. The standard deviation can be shown to be a function of the covariances of each
security of the market portfolio. Therefore the expected return for a security is directly related to the
covariance with the market portfolio. Risk averse investors will demand higher returns from securities
which have higher covariances with the market portfolio.

10. The risk of a well-diversified portfolio to an investor is measured by the standard deviation
of the portfolio's returns. Why shouldn't the risk ofan individual security be calculated in
the same manner?
Ans: With respect to risk, the investor is concerned with the standard deviation of his portfolio. For
evaluating a well-diversified portfolio, the relevant measure of risk is standard deviation. However, a
portfolio's standard deviation is not the standard deviation of the security. The appropriate measure of a
security's risk is the contribution that it makes to the standard deviation of a well-diversified portfolio.
This contribution is reflected in the security's covariance with the portfolio.
11. The SML describes an equilibrium relationship between risk and expected return. Would
you consider a security that plotted above the SML to be an attractive investment? Why?
Ans: A security that plots above the SML would be considered an attractive investment. The expected
return is greater than risk of such security. Investors should wish to add such a security to their
portfolios.

12. The CAPM permits the standard deviation of a security to be segmented into market and
non-market risk. Distinguish between the two types of risk.
Ans: Market risk is the portion of a security's total risk that is related to movements in the market
portfolio. It is also known as systematic risk and denoted by beta. This systematic risk can’t be reduced
through diversification.

Nonmarket risk is the portion of a security's total risk that is not related to moves in the market portfolio.
It is also known as unsystematic risk or unique risk. It is related to events specific to the security. As a
result, unique risk can be reduced through diversification.

13. Describe how the SML is altered when the riskfree borrowing rate exceeds the riskfree
lending rate.
Ans: The answer to this question depends on the location of the market portfolio on the efficient
combination of risky portfolios. A meaningful answer requires the market portfolio to lie between the
tangency portfolios derived under the assumption of riskless lending taking place at a rate less than the
riskfree borrowing rate. In this case the SML would intersect the vertical axis at the expected return
associated with a zero beta return. Like the original version of the SML, this altered SML will pass
through the market portfolio coordinates (rM,1). Because the zero beta return is greater than the riskfree
lending rate, the altered SML will have a flatter slope than the original SML.
 Investment Management
Course code: Fin-423
Chapter note 4
Prepared by ABM Fahad Hossain
Dept. of Finance & Banking (5th Batch)
Islamic University, Kushtia
In need: abmfahadhossain@[Link]

Chapter 10: Factor Models

1. What do you mean by factor model?

2. Discuss one factor model with an example.
3. What are the assumptions of market model
4. Discuss the Two Important Features of One-Factor Models
5. What do you mean by two factor models?
6. Why do factor models greatly simplify the process of deriving the curved Markowitz
efficient set?
7. What are two critical assumptions underlying any factor model? Cite hypothetical
examples of violations of those assumptions.
8. On the basis of the discussion of factor and nonfactor risk and given a set of securities
that can be combined into various portfolios, what might be a useful measure of the
relative diversification of each of the alternative portfolios?
9. Discuss the factors that could reasonably be expected to pervasively affect security
returns.
10. Compare and contrast the three approaches to estimating factor models.
11. Why investor expectations about future factor values are more relevant to security
returns than are the historical value of the factors?
12. Are factor models consistent with the CAPM? If returns are determined by a one-
factor model (where that factor is the return on the market portfolio) and the CAPM
holds, what relationships must exist between the two models?
 Prepared by ABM Fahad Hossain
Dept. of Finance and Banking (5th Batch)
1. What do you mean by factor model?
Ans: A Factor model is a return generating process that relates return on securities to the movement
in one or more factors. It assumes that the return on a security is sensitive to the movements of
various factors. Factor model also assumes that the returns on two securities will be correlated. It can
supply the information needed to calculate expected returns, variances, and covariance for every
security which is a necessary condition for determining the curved Markowitz efficient set. As a
result, a factor model is a powerful tool for portfolio management

2. Discuss one factor model with an example.

Ans: Some investors argue that the return-generating process for securities involves a single factor.
For example, the returns on securities depend on gross domestic product (GDP).

GDP
The horizontal axis represents the growth rate in GDP; the vertical axis represents the return on a
stock. This line has a positive slope that indicates there is a positive relationship between GDP
growth rates and returns. Higher rates of GDP growth are associated with higher returns. This
relationship can be expressed by the following equation:
r t = a + bGDP t + e t
where:
r t = the return on stock in period t
GDP rt = the rate of growth in GDP in period t
e, = the unique or specific return on stock in period t
b =sensitivity of return to GDP growth'
a = the zero factor for GDP
3. What are the assumptions of market model?
Ans: In the market model, individual security value depends on market index. If market index goes
up, price of security also goes up. On the other hand, Ii market index goes down, price of security
also goes down. The return on security on basis of market model can be calculated through following
formula:
 Prepared by ABM Fahad Hossain
Dept. of Finance and Banking (5th Batch)

4. Discuss the Two Important Features of One-Factor Models

Ans: Two features of one-factor models are the tangency portfolio and diversification. These are
discussed below:
1. The Tangency Portfolio: First, the assumption of one factor model helps to identify the
tangency portfolio. To determine the composition of the tangency portfolio, the investor
needs to estimate all of the securities' expected returns, variances, and covariances. This task
can be accomplished with a one-factor model.
2. Diversification: The second interesting feature of one-factor models is diversification.
Diversification leads to an averaging of market risk and a reduction in unique risk. In this
assumption, factor risk and nonfactor risk are used.

5. What do you mean by two factor models?

Ans: A two-factor model assumes that the return-generating process contains two factors. The
equation of two-factor model is given below:

Where, F1 and F2 are the two factors that influences on security returns, and b1 and b2 are the
sensitivities of security i to those two factors, e is a random error term and ai is the expected return
on security.

6. Why do factor models greatly simplify the process of deriving the curved Markowitz
efficient set?
Ans: In order to derive the curved Markowitz efficient set, the investor needs to estimate the
expected returns, variances, and covariances for all assets. The factor model can supply the
information for calculating the expected returns, variances, and covariances for every security. For
this reason, this model greatly simplifies the process of deriving the curved Markowitz efficient set.

7. What are two critical assumptions underlying any factor model? Cite hypothetical
examples of violations of those assumptions.
Ans: Factor model relationships are based on two critical assumptions. These are described below:
1. The random error term and the factor are uncorrelated. This assumption indicates that the
outcome of the factor has no impact on the outcome of the random error term.
2. The random error terms of two securities are uncorrelated. This assumption indicates that the
outcome of the random error term of one security has no impact on the outcome of the
random error term of other security.
 Prepared by ABM Fahad Hossain
Dept. of Finance and Banking (5th Batch)
As a violation of the first assumption, consider a one-factor model like growth in GDP. If a
security had a positive random error term and all time GDP was higher than expected, then the factor
model has been misspecified and should be adjusted the unexplained sensitivity.
As a violation of the second assumption, if security A had a positive random error term value,
security B also had a positive random error term value, then the factor model has been misspecified.

8. On the basis of the discussion of factor and nonfactor risk and given a set of securities that
can be combined into various portfolios, what might be a useful measure of the relative
diversification of each of the alternative portfolios?
Ans: A useful measure of diversification is the portfolios' levels of unique risk. A perfectly
diversified portfolio would have zero non-factor risk. The larger is the unique risk of portfolio, the
less diversified is possible for the portfolio.

9. Discuss the factors that could reasonably be expected to pervasively affect security returns.
Ans: Some factors affect security returns that are viewed as "macroeconomic" or "microeconomic
factors. There are several possible macroeconomic factors include:
1. Growth in money supply
2. The size of the budget deficit (or surplus),
3. The size of the trade deficit (or surplus),
4. The level of consumer confidence.
Microeconomic factors that affect security returns include:
1. dividend yield,
2. earnings growth rate,
3. earnings growth,
4. book value-to-price ratio,
5. market capitalization, and
6. Financial leverage.
10. Compare and contrast the three approaches to estimating factor models.
Ans: The three approaches for estimating factor models are discussed below:
1. The time-series approach: In this approach, the factor model estimation begins with the
assumption that the factors are known in advance. In this method, the factors are identified
by the analysis of the economics of the firms. Then, historical information and security
returns are collected from period to period. These data are used to estimate securities'
sensitivities to the factors, zero factors, unique returns, the standard deviations and their
correlations.
2. The cross-sectional approach: This approach assumes that the securities’ sensitivities
depend on certain factors. In this approach, the values of the factors are estimated based on
the securities' returns and their sensitivities to the factors. Then, standard deviations and
correlations can be computed.
3. The factor analysis approach: In this approach, the factor model estimation begins with a
set of securities and their returns. A statistical procedure is used to identify the number of
factors and the sensitivities as well as the standard deviations and the correlations.
 Prepared by ABM Fahad Hossain
Dept. of Finance and Banking (5th Batch)
11. Why investor expectations about future factor values are more relevant to security returns
than are the historical value of the factors?
Ans: Security prices represent investors’ expectations about the future prospects for the firms. Thus,
past factor values will already be incorporated into security prices. Past factor values will have no
effect on security price changes and security returns. That is why; the expectation of investors about
the value of factors in the future should be related to security price changes and security returns.

12. Are factor models consistent with the CAPM? If returns are determined by a one-factor
model (where that factor is the return on the market portfolio) and the CAPM holds, what
relationships must exist between the two models?
Ans: Factor models and the CAPM can coexist. However, if security returns are determined by a
one-factor model (where the factor is the return on the market portfolio) and the CAPM holds, then
the factor sensitivity of a stock must equal its beta and the zero-factor must equal (1 - ßi)  rf.
 Prepared by ABM Fahad Hossain
Dept. of Finance and Banking (5th Batch)
 Investment Management
Course code: Fin-423
Chapter note 5
Prepared by ABM Fahad Hossain
Dept. of Finance & Banking (5th Batch)
Islamic University, Kushtia
In need: FB: Abm Fahad Hossain
Email: abmfahadhossain@[Link]

Chapter 11: Arbitrage portfolio

1) In what significant ways does the APT differ from the CAPM?
2) Why would an investor wish to form an arbitrage portfolio?
3) What three conditions define an arbitrage portfolio?
4) Why must the variance of a well-diversified arbitrage portfolio be small?
5) Why is the concept of arbitrage central to the asset-pricing mechanism of the APT?
6) According to APT, why must the relationship between a security's equilibrium return and
its factor sensitivities be linear?
7) What is a pure factor portfolio? How may such a portfolio be constructed?
8) Is it true that if the APT is a correct theory of asset pricing, then the risk-return
relationship derived from the CAPM is necessarily incorrect? Why?
9) If the CAPM and APT both hold, why must it be the case that the factor-risk premium
is negative for a factor that is negatively correlated with the market portfolio? Explain
both mathematically and intuitively.
 ABM Fahad Hossain
Dept. Finance & Banking (5th Batch)
1. In what significant ways does the APT differ from the CAPM?
Ans: In general, APT is a less restrictive equilibrium asset pricing theory than the CAPM. The CAPM
utilizes certain strong assumptions about investor preferences, while APT merely assumes that investors
prefer more wealth to less.

Another important difference between the two pricing theories is that APT assumes that security returns
are generated by a factor model. On the other hand, the CAPM states that security returns must be
proportional to the covariance of those returns to the market portfolio.

2. Why would an investor wish to form an arbitrage portfolio?

Ans: An investor wish to form arbitrage portfolio for the following reasons:

1) Arbitrage portfolio involves opportunities for an investor to increase the expected return
on his/her current portfolio without increasing the portfolio’s risk. This type of investment
should be attractive to all risk-averse and risk-neutral investors.
2) Arbitrage portfolios are self-financing; the investor is not required to put up any
additional funds. This feature permits the investor to avoid the costs of financing the arbitrage
portfolio investment.

3. What three conditions define an arbitrage portfolio?

Ans: An arbitrage portfolio is defined by three conditions:
1. It is self-financing. It does not require any additional funds from the investor.
2. It is riskless. That is, it has no sensitivity to any factor. Further, it has zero variance and
hence zero covariance with other portfolios. It also has negligible nonfactor risk.
3. It has a positive expected return.

4. Why must the variance of a well-diversified arbitrage portfolio be small?

Ans: By definition, the factor sensitivity of an arbitrage portfolio is zero. Assuming that the arbitrage
portfolio is well-diversified and has no nonfactor risk, its total risk is given by bp2 F2 . Because bp equals
zero, the arbitrage portfolio's risk (variance) must equal zero.

5. Why is the concept of arbitrage central to the asset-pricing mechanism of the APT?
Ans: The concept of arbitrage central to the asset-pricing mechanism is the actions of investors
forming arbitrage portfolios that forces securities' expected returns. Investors seek arbitrage portfolios to
risklessly enhance their expected portfolio returns. In creating these arbitrage portfolios, investors buy
securities offering expected returns exceeding the necessary amount to compensate for their associated
factor risks. Conversely, investors sell securities with expected returns insufficient to compensate for
their associated factor risks. If all arbitrage possibilities have been eliminated, there will exist a linear
relationship between security expected returns and security factor sensitivities.

6. According to APT, why must the relationship between a security's equilibrium return and
its factor sensitivities be linear?
Ans: The process of investors buying and selling securities through arbitrage portfolios will result in
linear relationships between securities' factor sensitivities and securities' equilibrium expected
returns. Securities (with expected returns greater) that justified by these relationships will be
purchased by investors. These actions will drive up the prices of the excessively-high expected return
 ABM Fahad Hossain
Dept. Finance & Banking (5th Batch)
securities and push down the prices of the securities of sold short. There will exist a linear
relationship between security expected returns and security factor sensitivities when all arbitrage
possibilities have been eliminated.

7. What is a pure factor portfolio? How may such a portfolio be constructed?

Ans: A pure factor portfolio possesses a unit (1.0) sensitivity to the particular factor and zero sensitivity
to any other factor. Further, it has zero non-factor risk.
A pure factor portfolio can be formed by buying and short selling a large number of securities in
appropriate proportions to produce the [Link].

8. Is it true that if the APT is a correct theory of asset pricing, then the risk-return
relationship derived from the CAPM is necessarily incorrect? Why?
Ans: The CAPM is consistent with a world in which security returns are generated by a factor model.
The CAPM does require that certain restrictive assumptions be satisfied that APT does not require. But
if these assumptions are met, the CAPM can coexist with APT.

Security betas can be derived from APT by calculating the factor betas and the sensitivity of each
security to the factors. With this information, and knowledge of the riskfree rate and expected return on
the market portfolio, the SML asset pricing relationship can be stated.

9. If the CAPM and APT both hold, why must it be the case that the factor-risk premium is
negative for a factor that is negatively correlated with the market portfolio? Explain both
mathematically and intuitively.

Ans:
If both the CAPM and APT hold, it can be shown that a security's
beta (in a one-factor world) equals:

COV ( F , rM )
i  bi
 M2

Thus the CAPM expression for a security's equilibrium return must

be:

COV ( F , rM )
r i = rf + bi  ( r M - rf)
 M2

Because the APT expression for a security's equilibrium expected

return is stated as:

r i = rf + bi

then the factor risk premium, , must equal:

 = ( r M - rf)  COV ( 2F , rM )
M
Thus the factor risk premium is directly related to the covariance between the factor and the
market portfolio. If that correlation (or equivalently, the covariance) is negative, then the factor
risk premium must also be negative.
 ABM Fahad Hossain
Dept. Finance & Banking (5th Batch)

Intuitively, if the correlation between a factor and the market portfolio is negative, a portfolio with
a unit sensitivity to the factor acts as a strong diversifying investment. Investors will desire to
hold this diversifying portfolio, bidding up its price and driving down its expected return, thereby
producing a negative factor risk premium.
 ABM Fahad Hossain
Dept. Finance & Banking (5th Batch)
 Investment Management
Course code: Fin-423
Chapter note 6
Prepared by ABM Fahad Hossain
Dept. of Finance & Banking (5th Batch)
Islamic University, Kushtia
In need: FB: Abm Fahad Hossain
Email: abmfahadhossain@[Link]

Chapter 14: Bond Analysis

1. Why is it easy to use Treasury securities as a starting point for analyzing bond yields?
2. Distinguish between yield-to-first-call and yield-to-maturity
3. What is the effect of a call provision on a bond's potential for price appreciation?
4. What is the primary purpose of bond ratings? Given the importance attached to bond ratings
by bond investors, why don't common stock investors focus on quality ratings of entire
companies in making their investment decisions?
5. According to Lave Cross, "Agency ratings indicate relative levels of risk instead of absolute
levels of risk." Explain the meaning of Lave's statement.
6. High-yield bonds are often viewed by investors as having financial characteristics much
more akin to common stocks than to high-grade corporate bonds. Why?
7. Explain the rationale underlying the observed relationship (positive or negative) between
each of the variables and the yield spread.
8. How would you expect yield spreads to respond to the following macroeconomic events:
recession, high inflation, tax cuts, stock market decline, improved trade balance? Explain the
reasoning behind each of your answers
9. What are the attributes of bond? Discuss.
10. How probability of default can be assessed
11. How financial ratios predict default risk?
12. Which factors affect the rating of bonds?
 ABM Fahad Hossain
Dept. of Finance & Banking (5th Batch)
1. Why is it easy to use Treasury securities as a starting point for analyzing bond yields?
Ans: Treasury securities represent default-free securities. As a result, they offer a baseline instrument
for analyzing the underlying factors to determine the yields on fixed-income securities. The yields-to-
maturity on default-free securities are viewed as forming the yield structure. Risk premiums depend on
some factors like call and put provisions, tax status, marketability, and the likelihood of default. That’s
why; it is easy to use treasury securities as a starting point for analyzing bond yields.

2. Distinguish between yield-to-first-call and yield-to-maturity

Ans: Yield-to-first-call is the interest rate that equates the price of a bond to the discounted value of
promised cash flows. This process assumes that the bond is called at the earliest possible date.

On the other hand, Yield-to-maturity is the interest rate that equates the price of a bond to the discounted
value of all the bond's promised cash flows through its maturity date.

3. What is the effect of a call provision on a bond's potential for price appreciation?
Ans: A call provision indicates the right of the issuers to buy back the securities before the maturity
date. It will limit the price appreciation of a bond because of reducing interest rates. Investors know that
if interest rates fall below the bond's coupon rate, then the issuer will call the bond.

4. What is the primary purpose of bond ratings? Given the importance attached to bond
ratings by bond investors, why don't common stock investors focus on quality ratings of
entire companies in making their investment decisions?
Ans: Bond ratings are designed to indicate the creditworthiness of particular bonds. By this rating, it
has been identified that the bond issuer will make full and timely interest and principal payments on the
bond.
Valuation of common stock is more complex process than examining the default on a bond. A single
quality rating can’t provide useful information to an investor for understanding the factors that affect a
company's long-term earnings growth.

5. According to Lave Cross, "Agency ratings indicate relative levels of risk instead of absolute
levels of risk." Explain the meaning of Lave's statement.
Ans: Agency ratings indicate the degree of default of a bond issuer than other bond issuers. Bonds are
not reclassified as economic conditions change. As a result, the probability of default of various bond
rating classes changes as economic conditions change. One would expect that yield spreads between
securities would adjust equally.

Conversely, if bond ratings indicated absolute levels of risk, the bonds would be reclassified as
economic conditions changed. One would expect to constant yield spreads. Since the constant yield
spreads are not observed, the agency ratings do not indicate absolute levels of risk.

6. High-yield bonds are often viewed by investors as having financial characteristics much
more akin to common stocks than to high-grade corporate bonds. Why?
Ans: Junk bonds are issued by firms with low credit ratings with high yields. The payment capability of
the firms is more insecure than that of more creditworthy firms. Junk bondholders' returns are directly
related to the financial success of the issuing firms. It is the same way, the common stockholders' returns
are also directly related to the financial success of the firms. If junk bond issuers experience financial
 ABM Fahad Hossain
Dept. of Finance & Banking (5th Batch)
difficulties, the bondholders and stockholders will experience significant losses. Conversely, if the firm
experience strong performance, its bondholders and stockholders will earn sizable returns.

7. Explain the rationale underlying the observed relationship (positive or negative) between
each of the variables and the yield spread.
Ans: Earnings variability should be positively associated with a bond's yield spread. The more variable
an issuer's earnings, the greater the probability of negative earnings. It decreases the issuer's ability to
meet scheduled interest and principal payments.
The time without default should be negatively related to a bond's yield spread. The longer the time
without default, the more stable the issuer's financial situation.

The equity/debt ratio should be negatively related to a bond's yield spread. The equity/debt ratio
indicates the issuer's equity resources relative to its debt burden. The larger that relative burden, the
more the issuer will be unable to meet its obligations.

The level of total debt is a measure of the marketability of the issuer's bonds. As investors prefer more
liquid assets to less liquid assets, this factor should be directly related to a bond's yield spread.

8. How would you expect yield spreads to respond to the following macroeconomic events:
recession, high inflation, tax cuts, stock market decline, improved trade balance? Explain
the reasoning behind each of your answers
Ans: At the time of a recession, high inflation, or a stock market decline, yield spreads should increase.
A recession indicates poor economic times and issuers will have more trouble to meet their debt
obligations. At the time of high inflation and stock market declines, the bondholders are concerned
about the issuers' abilities to meet debt obligations.
Conversely, tax cuts and an improved trade balance decreases the yield spreads. Tax cuts should
stimulate the economy and increase corporate earnings. An improved trade balance is associated with
improved economic conditions in which issuers should be better able to meet their debt obligations.

9. What are the attributes of bond? Discuss.

Ans: There are six primary attributes of a bond that have importance in bond valuation:
1. Length of time until maturity
2. Coupon rate
3. Call and put provisions
4. Tax status
5. Marketability
6. Likelihood of default

1. Coupon rate & Length of time until maturity: The coupon rate and length of time to
maturity are important attributes of a bond because they determine the size and timing of the
cash flows that are promised to the bondholder by the issuer. If a bond's current market price is
known, these attributes can be used to determine the bond's yield-to-maturity.
2. Call and put provisions: There are times when yields-to-maturity are relatively high. Bonds
issued during such times may appear to be attractive investments. However, deeper analysis
indicates that this is not necessarily the case.
 ABM Fahad Hossain
Dept. of Finance & Banking (5th Batch)
3. Tax status: Taxation can also affect bond prices and yields in various ways. For example, any
low-coupon taxable bond selling at a discount provides return in two forms: coupon payments
and gains from price appreciation.

4. Marketability: Marketability refers to the ability of an investor to sell an asset quickly without
any loss of money and time. Sometimes it is also referred to as liquidity. Marketability can
also affect bond prices and yields in various ways.
5. Likelihood of default: Bonds can be classified into various categories like AAA, A, BBB, BB
etc. These categories are done by the creditworthiness of the bonds issuers. The possibility of
default depends on the creditworthiness of the bonds issuers. For corporate bonds, better ratings
and default of bonds depends on the following factors:

1. Lower financial leverage:

2. Larger firm size:
3. Larger and steadier profits:
4. Larger cash flow:
5. Lack of subordination to other debt issues.

10. How probability of default can be assessed?

Ans: Four measures were used to assess the probability of default:
1. The extent of net income of the firm had varied over the preceding nine years
2. The length of time that the firm had operated without forcing any creditors to take a loss
3. The ratio of the market value of the firm's equity to the par value of its debt
4. The market value of the firm's outstanding debt.

11. How financial ratios predict default risk?

Ans: Specific procedures have been developed to predict default with such ratios. Univariate
analysis attempts to find the best single predictor, whereas multivariate analysis searches for the best
combination of two or more predictors.
1. Univariate Methods: Cash inflows can be viewed as contributions to the firm's cash balance,
whereas cash outflows can be viewed as drains on that balance. When the balance falls below
zero, default is to occur. The probability of default will be greater for the firm when (I) the
existing cash balance is smaller, (2) the expected net cash flow is smaller, and (3) the net cash
flow is more variable. The various measures are used to assess these factors. The ratio of net
cash flow to total debt is particularly useful methods.

2. Multivariate Methods Combinations of certain financial ratios and cash flow variables have
been considered as possible predictors of default. The most accurate method of predicting
default involved calculating a firm's default-risk rating, known as its Z-score. It can be
calculated by the following formula:

Where the following five ratios were calculated from information contained in the firm's most recent
income statement and balance sheet:
X1 = (current assets- current liabilities)/total assets
X2 = retained earnings/total assets
 ABM Fahad Hossain
Dept. of Finance & Banking (5th Batch)
X3= earnings before interest and taxes/total assets
X4 = market value of equity/book value of total debt
X5 = sales/total assets
Any firm with a Z-score below 1.8 was considered a candidate for default, and the lower the score,
the greater the likelihood.

12. Which factors affect the rating of bonds?

Ans: For corporate bonds, better ratings are generally associated with:

1. Lower financial leverage: for example, having a smaller debt-to-equity ratio and a larger
current ratio or quick ratio.
2. Larger firm size: for example, having a larger amount of total assets.
3. Larger and steadier profits: for example, having a consistently high rate of return on equity
or rate of return on total assets.
4. Larger cash flow: for example, having a large cash flow to debt ratio.
5. Lack of subordination to other debt issues.

These observations are used in the development of models for predicting the initial ratings of new
bonds as well as for predicting changes in the ratings of outstanding bonds.
 ABM Fahad Hossain
Dept. of Finance & Banking (5th Batch)
 Investment Management
Course code: Fin-423
Chapter note 7
Prepared by ABM Fahad Hossain
Dept. of Finance & Banking (5th Batch)
Islamic University, Kushtia
In need: FB: Abm Fahad Hossain
Email: abmfahadhossain@[Link]

Chapter 15: Bond portfolio Management

1. Why must the duration of a coupon-bearing bond always be less than the time to its
maturity date?
2. Distinguish between modified duration and effective duration.
3. Explain why immunization permits a bond investor to be confident of meeting a given
liability on a predetermined future date.
4. What are the advantages and disadvantages of meeting promised cash outflows through
cash matching as opposed to duration matching?
5. Why can nonparallel shifts in the yield curve cause problems for an investor seeking to
construct an immunized bond portfolio?
6. Describe the four components of return on a bond investment over a given holding period.
7. Distinguish between a substitution swap and an intermarket spread swap
8. What are the theorems of bond pricing?
9. Define convexity wit graph.
10. Define Duration. How can it calculate?
11. What are the Relationship between Convexity and Duration?
12. Define Immunization How it Is Accomplished?
13. Define Bond swaps and state the types of bond swaps.
 ABM Fahad Hossain
Dept. of Finance & Banking (5th Batch)
1. Why must the duration of a coupon-bearing bond always be less than the time to its
maturity date?
Ans: Duration is the average time to recover the present value of the of bond’s cash flows. If the
bond's present value is recovered before the bond's maturity date, then the average time of the
present value cash flows is less than the time to the bond's maturity date.

2. Distinguish between modified duration and effective duration.

Ans: Modified duration is a formula that expresses the measurable changes in the bond’s price due to
changes in bond’s yield. It assumes that the bond’s yield and bond price moves in opposite direction.
The modified duration has not embedded option.
On the other hand, effective duration is defined as the sensitivity of a bond’s price against the
changes in a benchmark yield curve. It is duration of a bond that has an embedded option. For a
bond without embedded options, its modified duration will equal its effective duration.

3. Explain why immunization permits a bond investor to be confident of meeting a given

liability on a predetermined future date.
Ans: Immunization is a process of selecting a fixed income portfolio whose duration matches with
the duration of a liability. By this technique, a bond portfolio manager is able to meet a promised
cash outflows certainly. Thus, the investor can determine the necessary investment amount in order
to meet the future liability.

Immunization is effective because the two risks (reinvestment rate risk and interest rate risk)
have opposite effects on the bond investor's wealth. Reinvestment rate risk produces wealth effects
in the same direction as the change in interest rates, while interest rate risk produces wealth effect in
the inverse direction of the change in interest rates. When a bond investment is immunized, the
wealth effects of reinvestment rate risk and interest rate risk offset one another.

From the above discussion, it can be said that immunization permits a bond investor to be
confident of meeting a given liability on a predetermined future date.

4. What are the advantages and disadvantages of meeting promised cash outflows through
cash matching as opposed to duration matching?
Ans: Cash matching provides the most certain measures of meeting a promised cash outflows. If
high quality bonds can be found, then there is no situation for defaults that could prevent the
matching of cash inflows with promised outflows.

Conversely, duration matching is a less certain measures of meeting promised cash outflows.
Due to nonparallel shifts in the yield curve, the value of the bond portfolio can be changed in
unpredictable ways.
Cash matching may be difficult to implement because the appropriate bonds may not be
available.
Duration matching provides a more flexible measure because various combinations of bonds are
available to create a particular duration portfolio.

5. Why can nonparallel shifts in the yield curve cause problems for an investor seeking to
construct an immunized bond portfolio?

Ans: Classical immunization is based on the assumption that the yield curve is horizontal and will
shift in a parallel manner. If the yield curve shifts in a nonparallel manner, the wealth effects of
reinvestment rate risk and interest rate risk may not completely offset one another. For the above
reason, the nonparallel shifts in the yield curve can cause problems for an investor seeking to
construct an immunized bond portfolio.
 ABM Fahad Hossain
Dept. of Finance & Banking (5th Batch)
6. Describe the four components of return on a bond investment over a given holding period.
Ans: A bond's return over a given holding period is a function of four components: the time effect,
the yield change effect, coupon payments, and interest income from the reinvestment of coupon
payments.
a. The time effect refers to the fact that as time passes a bond's price will approach its face
value.
b. The yield change effect is the change in a bond's value caused by shifts in the yield
structure over the holding period.
c. Coupon payments represent the cash payments made by the bond over the holding period.
d. Finally, interest income from the reinvestment of coupon payments. It refers to the
coupon payments are reinvested in short-term fixed-income securities that generate
additional interest income for the bondholder.

7. Distinguish between a substitution swap and an intermarket spread swap

Ans: A substitution swap is the exchange of one bond for another bond that has characteristics that
are identical to the original bond. The goal of the swap is to trade a lower-yield bond for a similar
higher-yield bond.
An intermarket swap is the exchange of two bonds with different parts of same market that helps
to produce more yield spread. The goal is to identify the underpriced or overpriced in the market.

8. What are the theorems of bond pricing?

Ans: Bond pricing theorems deal with the change in bond prices due to change in the bonds' yields-
to-maturity. The theorems are as follows:
1. If a bond's market price increases, then its yield must decrease; conversely, if a bond's
market price decreases, then its yield must increase. As an example,
Consider bond A, its par value is $1,000, and pays coupons annually of $80 with 5 years
maturity. Its yield is 8% because it is currently selling for $1,000. However, if its price
increases to $1,100, then its yield will fall to 5.%. Conversely, if its price falls to $900, then
its yield will rise to 10%.
2. If a bond's yield does not change over its life, then the size of its discount or premium will
decrease as its life gets shorter. As an example,
Consider bond B, which has a life of five years, a par value of $1,000, and pays coupons
annually of $60. Its current market price is $883.31, indicating that it has a yield of 9%. After
one year, if it still has a yield of 9%, it will be selling for $902.81. Thus its discount has
decreased from $116.69 (=$1,000 - $883.31) to $97.19 (=$1,000 - $902.81), for a change
of$19.50 (=$116.69 - $97.19).
3. If a bond s yield does not change over its life, then the size of its discount or premium will
decrease at an increasing rate as its life gets shorter. As an example,
Consider bond B again. After two years, if it still has a yield of 9%, it will be selling for
$924.06. Thus its discount has decreased to $75.9 = ($1,000 - $924.06). Now the amount of
the change in the discount from five years to four years was $19.50 (=$116.69 - $97.19) for a
percentage change from par of 1.950%. However, the amount of the change from four years
to three years is larger that is $21.25 and a percentage change from par of 2.125%.
4. A decrease in a bonds yield will raise the bond's price by an amount that is greater than the
price of bond if there were an equal sized increase in the bonds yield. As an example,
Consider bond C, which has a life of five years and a coupon rate of 7%. Because it is
currently selling at its par value of $1,000, its yield is 7%. If its yield rises by 1% to 8%, then
it will be selling for $960.07, a change of $39.93. Alternatively, if its yield falls by 1% to 6%,
then it will be selling for $1,042.12, a change of $42.12, which is of greater than $39 .93.
 ABM Fahad Hossain
Dept. of Finance & Banking (5th Batch)
5. The percentage change in a bond's price owing to a change in its yield will be smaller if its
coupon rate is higher.
As an example, compare bond D with bond C. Bond D has a coupon rate of 9%, which is 2%
larger than C's. However, bond D has the same life (five years) and yield (7%) as C. Thus D's
current market price is $1,082.00. Now if the yield on both C and D increases to 8%, then
their prices will be $960.07 and $1,039 .93, respectively. This change represents a decrease in
the price of C equal to $39.93 (=$1,000 - $960.07), or 3.993% (=$39.93/$1,000) . For D, the
decrease in price is equal to $42.07 (= $1,082 - $1,039.93), or 3.889% (= $42.07/$1,082).
Because D had the higher coupon rate, it has the smaller percentage change in price.

9. Define convexity wit graph.

Ans: The first and fourth bond pricing theorems of bond valuation are known as convexity.
According to theorem I, bond prices and yields are inversely related. However, this relationship is
not linear, according to theorem 4. This relationship can be seen by following example and graph.
The price and the current yield-to-maturity for the bond are denoted by P and y, respectively.
First, an increase in the yield to y+ that decreases bond's price to P-, and a decrease in the yield to y-
that increases bond's price to P+. This movement is associated with the first bond theorem.

Second, the size of the rise in the bond's price from P to p+ is greater than the size of the bond's price
from P to P-. This relation is associated with the fourth bond theorem.

The curved line in the figure that shows the relationship between bond prices and yields is convex
because it opens upward. Accordingly, the relationship is referred to as convexity.

10. Define Duration. How can it calculate?

Ans: Duration is the average time to recover the present value of the of bond’s cash flows. The
formula for measuring duration is given below:

 D is Macaulay duration,
 PV (C,) denotes the present value of the cash flow to be received at time t;
 Po denotes the current market price of the bond, and T denotes the bond's remaining life.
 ABM Fahad Hossain
Dept. of Finance & Banking (5th Batch)
For example, a bond with annual coupon payments of $80, a remaining life of three years, and a par
value of $1,000. Because it has a current market price of $950.25, it has a yield-to-maturity of 10 %,
its duration is 2.78 years.

11. What are the Relationship between Convexity and Duration?

Ans: The first and fourth bond pricing theorems of bond valuation are known as convexity.
According to theorem I, bond prices and yields are inversely related. On the other hand, Duration is
the average time to recover the present value of the of bond’s cash flows. The following figure
represents the relationship between convexity and duration.
Suppose a bond that is currently selling for P and has a yield-to-maturity of y. If the bond's yield
increases to y+, then the associated price of the bond will fall to P-. Conversely, if the bond's yield
decreases to y-, then the associated price of the bond will rise to P+.
However, if the yield decreases to y-, the estimated price will be p+D, and if the yield increases to
y+ the estimated price will be P-D. For this reason, the relationship between the bond's price, yield,
and duration is not exact. Hence, the new price of bond is represented by the straight line and leading
to an error that is a consequence of convexity.

12. Define Immunization How it Is Accomplished?

Ans: Immunization is a process of selecting a fixed income portfolio whose duration matches with
the duration of a given liability. This technique allows a bond portfolio manager is able to meet a
given promised stream of cash outflows certainly.
Immunization is accomplished simply by calculating the duration of the promised outflows
and then investing in a portfolio of bonds that has an identical duration. The advantage of the
observation is that the duration of a portfolio of bonds is equal to the weighted average of the
durations of the individual bonds in the portfolio.
 ABM Fahad Hossain
Dept. of Finance & Banking (5th Batch)
For example, if a portfolio has one-third of its funds invested in bonds having a duration of
six years and two-thirds in bonds having a duration of three years, then the portfolio itself has a
duration of four years [= (1/3 X 6) + (2/3 X 3)].
Consider a portfolio has two securities; one has one year class life and another is 3 years class life. In
case of one year bond, there is a risk of reinvestment rate and incase of three years bond, there is an
interest rate risk.
At this situation, immunization can help to identify optimal portfolio that helps to offset loss
of one security by gaining from another security. According to the theory, if yields rise, then the
portfolio's losses by selling of the three-year bonds will be offset by the gains from reinvesting the
one-year bonds at higher rate. Alternatively, if yields fall, then the loss from one-year bond will be
offset by being able to sell the three-year bonds at a premium.

Thus, the portfolio is immunized from the effect of any movements in interest rates in the future.

13. Define Bond swaps and state the types of bond swaps.
Ans: A bond swap consists of selling one bond and using the proceeds for purchasing another bond.
In making a swap, the portfolio manager believes that an overpriced bond is being exchanged for an
underpriced bond. Some swaps are based on the belief that the market will correct mispriced in a
short period of time, whereas other types of swaps are based on a belief that corrections will never
take place or take place over a long period of time.

1. Substitution swap: This swap is an exchange of a bond for a perfect substitute bond. The
motivation is temporary price advantage that is resulting from an imbalance between supply
and demand conditions in the market.
2. Intermarket spread swap: An intermarket swap is the exchange of two bonds with different
parts of same market that helps to produce more yield spread.
3. Rate anticipation swap: This type of swap is generated profits from an anticipated
movement in overall market rates.
4. Pure yield pickup swap: A swap in which two investors exchange two bonds, one with a
lower yield and shorter maturity & one with a higher yield and longer maturity. This is a high
risk transaction for the holder of the lower yield bond.