Financial Management

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Q.1.(a) Distinguish between a negotiable certificate of deposit and the certificates of deposit discussed in the section "Non-marketable securities".

Ans. NEGOTIABLE CERTIFICATE OF DEPOSIT (CD)

Basically Negotiable Certificate of Deposits are marketable receipts for large deposits held by a bank for a specified time period and interest rate. For example ABC Bank sells a $ 100,000 CD for 6 months at 8.5%. The holder can resell the CD any time prior to 6 months. Banks use CDs to gather funds from Corporations and other institutions to finance their operations. CDs have denominations of $ 5000 to $ 10 million, pay both interest and principal at maturity, and usually have maturities of 6 months or less. The return on CDs suggest that CDs are riskier than Treasury Bills. While there is an organized and active secondary market for the CDs of larger banks, the holders of CDs recognize that deposits over $ 100,000 are uninsured. Thus the risk of default exists for CDs although the probability of such a default is small.

NON-MARKETABLE SECURITIES

The non-marketable securities are not actively traded. In common use, marketability is interchangeable with liquidity as the ability to buy or sell an instrument with significant price concessions. There are different kinds and classes of Certificate of deposits which have a greater chance of default and lack of a good secondary market. Promissory note is one of them, which is unsecured issued by a Corporation in a small size of the issue, sells at a discount, in domination of $ 1000 and over and maturities upto 70 days. Since these are unsecured, only those corporations with the highest credit rating can sell these instruments. As a general rule, the larger the size of the instrument, the greater its marketability. For investor's view point, the rate of return on it is slightly higher than that on treasury bills.

(b) On which financial instruments can futures contracts be purchased?

Ans. FUTURES CONTRACT

Agreement to buy or sell a specific amount of a commodity or financial instrument at a particular price on stipulated future date is called Futures Contract. The price is established between buyer and seller on the floor of a commodity exchange, using the open outcry system. A futures contract obligates the buyer to purchase the underlying commodity and the seller to sell it, unless the contract is sold to another before settlement date, which may happen if a trader waits to take a profit or cut a loss. This contrasts with options trading, in which the option buyers may choose whether or not to exercise the option by the exercise date.

FINANCIAL INSTRUMENTS THAT ARE USED TO PURCHASE FUTURES CONTRACTS

Futures Contract based on a financial instrument is called Financial Future. Such contracts usually move under the influence of interest rates. As rates rise, contacts fall in value; as rates fall, contracts gain in value. Examples of instruments underlying financial futures contracts are Treasury Bills, Treasury Notes, Government National Mortgage Association pass-through, foreign currencies, and certificates of deposit. Trading in these contracts is governed by the Federal Commodities Futures Trading Commission. Traders use these futures to speculate on the direction of interest rates. Financial institutions (banks, insurance companies, brokerage firms) use them to hedge financial portfolios against adverse fluctuations in interest rates. Future market is the place (commodity exchange) where FCs are traded. Different exchanges specialize in particular kinds of contracts. The major exchanges are Amex Commodity Exchange, the New York Futures Exchange, etc.

(c) Distinguish between a serial bond and a term bond.

Ans. SERIAL BOND

Serial Bond issues with several different maturities for separate amounts of the total issue. Various maturity dates scheduled at regular intervals until the entire issue is retired. Each bond in the series has an indicated redemption date. The issue is offered to investors by underwriters who attach different coupons to the different maturities. The serial bond exist to enable the state and local government to repay the issue over a series of years rather than in one lump sum at one time.

TERM BOND

Term bond is issued with a longer-term maturity date. Such bonds can range in length from one year to ten years, though the most popular term bonds are those for one or two years. Term Bond holders usually receive a fixed rate of interest, payable semi-annually during the term, and are subject to costly term "early withdrawal penalties". Early withdrawal penalty charge assessed against holders if they withdraw their money before maturity. Such a penalty would be assessed, for instance, if someone who has a six months term bond withdraw the money after four months.

Q..(a) Discuss the advantages and disadvantages of a limit order versus a market order. How does a stop order differs from a limit order?

Ans. ADVANTAGES AND DISADVANTAGES OF LIMIT ORDER VERSUS A MARKET ORDER

LIMIT ORDER

Limit orders instruct a broker to buy or sell a stock at a stated price 'or better'. When a buyer or seller of stock feels that he can purchase or sell a stock at a slight advantage to himself within the next two or three days, he may place a limited order to sell at a specified price. A limit order protects the customer against paying more or selling for less than intended. A limit order, therefore, specifies the maximum or minimum price the investor is willing to accept for his trade. The only risk attached to a limit order is that the investor might lose the desired purchase or sale altogether for a trifle margin. For example, if an investor instructs his broker to buy 10 shares of company, Z at limit price of Rs. 0/-, the market price at the time of this limit order is placed Rs. 1/-. The order will 'go on' the broker's records at Rs. 0/- and 'stay in' for however long the investor specifies. It cannot be executed except at Rs. 0/-. Indeed it may never be executed at all. On the other hand, if he wishes to sell stock which is selling at Rs. 1/- in the market and he enters a limit order of Rs. /-, he runs the risk that the stock may never go up to Rs. /- and he may not be able to sell, on the contrary the price may go down.

MARKET ORDER

Market orders are instructions to a broker to buy or sell at the best price immediately available. Market orders are commonly used when trading in active stock or when a desire to buy or sell is urgent. With this order a broker is to obtain the best price he can for his customer- that is the lowest price if it is an order to buy and highest price if it is one to sell at the time when the order is executed.

STOP ORDER DIFFERS FROM A LIMIT ORDER

As already defined in the above, the limit orders instruct a broker to buy or sell a stock at a stated price 'or better'. Whereas another type of order that may be used to limit the amount of losses or to protect the amount of capital gains is called the stop order. This order is sometimes also called the "Stop loss order". Stop orders are useful to both speculators and investors. Stop orders to sell can be used to sell out holdings automatically in case a major decline in the market occurs. Stop orders to buy can be used to limit possible losses on a short position. It may also be used to buy if a market price seems to indicate a major upswing in the market. Stop orders are most frequently used as a basis for selling a stock once its price reaches a certain point. Suppose that an investor owns securities in a company X whose current market price is Rs. 44/-. After an analysis he finds that the market condition is uncertain and the price can move either way. To minimize the potential loss he stops order at Rs 4/-. If the market price rises, he has nothing to lose. On the contrary, if the market price rises to 50, to ensure some gain on this price rise the investor might raise the stop loss order at 48. The investor may gain if all his securities are sold at 48. Most likely he will not be able to off-load all at the price but he will ensure that no loss arises out of this transaction. He might even be expecting some profit.

The market order, limit order and the stop order are three main kinds of orders. There are various other discretionary orders also in the securities market. Some examples are the Best Rate Order, Net Rate Order. These orders are executed through various trading techniques.

(b) What does selling securities on a "regular way" basis mean?

Ans. Selling securities on a "regular way" means completion of securities transaction at the office of the purchasing broker on (but not before) the fifth full business day following the date of the transaction, as required by the New York Stock Exchange. Saturday, Sunday and a legal holiday would not be counted. Government delivery and settlement of securities transactions are an exception; for them, "regular way" means delivery and settlement the next business day following a transaction.

Basically securities transaction is execution of an order to buy or sell a security or commodity futures contract. After the buyer and seller have agreed on a price, the seller is obligated to deliver the security or commodity involved and the buyer is obligated to accept it. They "regular way" is binding for the broker to complete all the relevant formalities within the prescribed time limit so that no one party suffer. This phenomenon has been changed and a new Central Depository System has been introduced in the way of selling securities. This system provides computerized completion of securities transaction.

(c) What are the advantages and disadvantages of using a street name?

Ans. "STREET NAME' phrase describing securities held in the name of a broker or another nominee instead of a customer.

ADVANTAGES

• Since the securities are in the broker's custody, transfer of the shares at the time of sale is easier than if the stock were registered in the customer's name and physical certificates had to be transferred.

• Customer gains without showing his actual wealth.

• Customers is not liable to pay tax on these transactions.

• Traders can act quickly to buy security in London and sell it in New York for a profit.

• Short-sellers use short-selling technique which is sale of a security not owned by the seller to take advantage of an anticipated decline in the price or to protect a profit in long position.

DISADVANTAGES

• When securities are held by a broker in street name he will enjoys the benefits of ownership, even though for convenience or other reason the broker keep it.

• If during this time dividend is declared, the holder will be beneficial.

• This act some times also creates conflict between seller and buyers about the price and not provides riskless transaction.

• Real trading in the stock exchange cannot be ascertained.

Q.(a) Define risk. How does the use of the standard deviation as a measure of risk relate to this definition of risk?

Ans. RISK

Risk and uncertainty are an integral part of an investment decision. Technically "risk" can be defined as a situation where the possible consequences of the decision that is to be taken is known. "Uncertainty" is generally defined to apply to situations where the probabilities cannot be estimated. However, risk and uncertainty are used interchangeably.

Risk is composed of the demands that bring in variations in return of income. The main forces contributing to risk are price and interest. Risk is also influenced by external and internal consideration. External risk are uncontrollable and broadly affect the investments. These external risks are called systematic risk. Risks due to internal environment of a firm or those affecting a particular industry are referred to as unsystematic risk.

Systematic risk is non-diversifiable and is associated with the securities market as well as the economic sociological, political, and legal considerations of the prices of all securities in the economy. The effect of these factors is to put pressure on all securities in such a way that the prices of all stock will move in the same direction. For example, during a boom period prices of all securities will rise and indicate that the economy is moving towards prosperity.

USE OF STANDARD DEVIATION AS A MEASURE OF RISK

The most useful method for calculating the variability is the standard deviation and variance. Standard Deviation is the square root of variance. Risk arises out of variability. Risk has many connotations. Farming might be considered a risky business because of the large changes in farm product prices from year to year. Prospecting for gold might be considered risky because of the low probability of success. We associate investment risk with the variability of rates of return. The more variable the return, the more risky the investment. The standard deviation represents one measure of this variability of returns. There are other measures of variability, such as the range, semivariance, and mean absolute deviation which might be considered as a measure of risk. In general standard deviation is preferable analytically because knowledge of standard deviation allows one to make probability statements for most types of distributions. The standard deviation of a portfolio's return can be determined from (among other things) the standard deviations of the returns of its component securities, no matter what the distribution. No other relationship of comparable simplicity exists for most other variability measures.

Thus there are a number of reasons for choosing standard deviation as a measure of risk.

(b) How can the standard deviation for a particular stock be estimated? How reliable is the estimate for a particular stock compared with a portfolio of stocks?

Ans. Standard deviation is statistical measure of the degree to which an individual value in a probability distribution tends to vary from the mean of the distribution. For example, where the past performance of securities is used to determine the range of possible future performances and a probability is attached to each performance, the standard deviation of performance can then be calculated for each security and for the portfolio as a whole.

To estimate a particular stock the actual rate of return can be viewed as a random variable subject to a probability distribution which is a set of possible values that a random variable can assume and their associated probabilities of occurrence. Standard deviation which is the conventional measure of dispersion, use to complete the two-parameter description of return distribution. The standard deviation can be expressed mathematically as

First calculate the weighted average of squared deviation of possible occurrences from the mean value of the distribution, with the weights being the probabilities of occurrence. Then the square root of this figure provides with the standard deviation.

Portfolio which is combination of holding of more than one stock, bond, commodity, real estate investment, standard deviation is widely applied in modern portfolio theory. The purpose of a portfolio is to reduce risk by diversification. With the use of standard deviation an investor classify, estimate and control both the kind and the amount of expected risk and return. The expected return from a portfolio of investments is simply a weighted average of the expected returns of the securities comprising that portfolio. The weights are equal to the proportion of total funds invested in each security. Essentials to portfolio are its quantification of the relationship between risk and return and the assumption that investors must be compensated for assuming risk. The standard deviation can sometimes be misleading in comparison the risk, or uncertainty, surrounding alternative investments if they differ in size. To adjust for the size, or scale, problem, the standard deviation can be divided by the expected return to compute the Coefficient of variation which is a measure of risk per unit of expected return.

Q.4 (a) Assume you purchased a rental property for Rs. 50,000 and sold it one year later for Rs. 55,000 (there was no mortgage on the property). At the time of the sale, You paid Rs. ,000 in commissions and Rs. 600 in taxes. If you received Rs. 6000 in rental income (all of it received at the end of the year). What annual rate did you earn?

(a) 15.%

(b) 15.%

(c) 16.8%

(d) 17.1%

Ans.

Property sold

Less Commission ,000

Taxes 600

,600 55,000

5,400

Add Rental income (all of it received at the end of the year) 6,000

58,400

Less investment 50,000

Total Earning 8,400

Annual rate of earning

8,400/50,000 x 100 = 16.8%

Q.5 (a) Distinguish between vanilla bond, a zero-coupon bond, and a floating rate bond. How can a bond be guaranteed?

VANILLA BOND

"Vanilla Bond" is a traditional name of corporate bond issued by corporations at the time when there is no inflation. The other characteristics are the bonds which will pay back the principal on its maturity date, will pay a specified amount of interest on specific dates, and does not carry a conversion privilege or other special feature is called Vanilla Bond.

ZERO COUPON BOND

The bond that makes no periodic interest payments but instead is sold at a deep discount from its face value is called "Zero-Coupon Bond". The buyer of such a bond receives the rate of return by the gradual appreciation of the security, which is redeemed at face value on a specified maturity date.

FLOATING RATE BOND

A debt instrument with a variable interest rate. Interest adjustments are made periodically, often every six months, and are tied to a money market index such as Treasury Bill rates. Floating rate bonds usually have a maturity of about five years. They provide holders with protection against rises in interest rates, but pay lower yields than fixed rate notes of the same maturity. Also known as Floater.

BOND - GUARANTEE

Guarantee is a contract to discharge the liability of a third party in case of default. Guarantee may be specific or continuing. Special guarantee covers only one particular transaction. Continuing guarantee covers a series of transactions. Guarantee may also be "unsecured" or 'secured' with tangible assets. Bond which are issued by Government or its agencies, Government have direct obligations and carry full faith and credit. Municipal bonds are obligation of a state or local government entity. There are other private purpose bonds i.e., Hospital Revenue Bond; Industrial Development Bond; Special Assessment Bond which are issued by different agencies for specific purpose, the issuing agencies specifically disclosed about the guarantee of such bonds. Corporate Bonds which are issued by corporations, these are obligations of the said corporation.

(b) How do junk bonds originate? What is meant by event risk?

Ans. JUNK BOND

Junk bonds are issued by companies without long track records of sales and earnings, or by those with questionable credit strength. Although commonly used, the term has a pejorative connotation, and issuers and holders prefer the securities be called "High-yield Bonds". They are a popular means of financing "Takeovers". Since they are more volatile and pay higher yields than investment grade bonds, may risk-oriented investors specialize in trading them. Institutions with fiduciary responsibilities are regulated. Crediting rating of Junk Bond is "BB" or lower by rating agencies.

EVENT RISK

Risk that a bond will suddenly decline in credit quality and warrant a lower rating because of a "takeover-related" development, such as additional debt or a recapitalization. Corporations whose indentures include protective covenants, such as poison put provisions, are assigned "Event Risk Covenant Rankings" by Standard and Poor's Corporation. Ratings range from E-1, the highest, to E-5 and supplement basic bond ratings.

(c) What are the disadvantages to an investor of purchasing 10 or 15 years corporate bonds?

CORPORATE BONDS

Corporate Bonds are senior securities in a firm. They represent a promise by a company to the bond-holder to pay a specified rate of interest during a stated time period annually and the return of the principal sum on the date of maturity. Date of maturity is also called the date of retirement of a bond. Bonds are of many kinds. The difference in bonds is due to the terms and conditions and features of each bond bears. Bonds may be distinguished according to their repayment provisions, type of security pledged, time of maturity and technical factors.

DISADVANTAGES

• Corporate bonds offer investors an often bewildering array of choices because of the amount and variety of bonds in the market.

• Rates of return on corporate bonds exceed that on US Treasury bonds because of their relative lack of liquidity and greater likelihood of default.

• A secondary market exists for only those corporate bonds with large total issue sizes, typically for issues of $ 100 million or more. Secondary market dealers generally trade bonds in $ 100,000 round lots. Consequently, small investors will typically earn a substantially lower yield because of higher transaction costs associated with odd-lot trades.

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