PRINCIPLES OF INVESTMENT – NOV 2012 ANSWERS SECTION A
1.b ,
2.d , 3.b ,
4. d , 5. c , 6. a , 7. a , 8 .a
9.d , 10.c , 11.d , 12. b , 13. a
, 14. c , 15 . a , 16 . d
17.a , 18.d , 19.c , 20. B, 21. d , 22. c ,23.b , 24.c , 25.d ,
26. b , 27.c
,28. d , 29. c , 30 . b
ANSWER SECTION B
Question 31 a
i)
Beta of portfolio P = (.4x 1.5)+(.35 x0.95) +(.25 x 1.35)
= 0.6 +0.4 +0.34
= 1.34
ii)
2 marks
Beta of portfolio Q = (.3 x1.30)+(.3 x.95)(.4 x1.45)
= 1.26
2 marks
Portfolio P has the beta of 1.34 while Q has a beta of 1.26.This means that P is
more risky and responsible to changes in the market and is likely to give higher
returns.
(2 marks)
Portfolio Q on the other hand is less riskier than P and as such its returns are not
expected to surpass those of P.
( 2 marks)
As to which on the investor will choose will depend on how much risk is willing to
take. Hence if he is a risk taker .he will choose Portfolio P but if he is risk averse,
he will choose portfolio Q.
(2 marks)
1
(b)
Arbitrage Pricing Theory is an asset pricing model which is based on the
idea that assets returns can be predicted using the relationship between
same assets and may have common risk factors. The theory describes the
price where a misplaced asset is expected to be. It is often viewed as an
alternative to capital asset pricing model since it has more flexibility
assumption requirement. Where CAPM require market expected returns,
APT uses risky assets expected returns and risk premium of a number of
macro-economic factors.Arbitrageous use the APT model to make profit by
taking advantage of misplaced securities in the sense that a misplaced
security will have a price that differ the theoretical price predicted by the
model.
By going short on overpriced security while concurrently going long on the
portfolio,an arbitrageur is in a position to make a theoretical risk free profit
(10 marks)
QUESTION 32
a) Retail market is that money market involving smaller amounts of funds
usually below K 20 million .Most participants in this market are
individuals,and small to medium enterprises .These participants invest in
the following securities
Call accounts
Notice deposit accounts
Motor vehicle deposit accounts
Overdrafts
(6 marks)
b) The smaller investors can indirectly participate through the following ways
i)
Money market deposit accounts
This account gives the investors a high rate of interest for as long as
funds are invested in the account. The account provides easy access to
money and flexibility of transacting from the account.
(2 marks)
2
ii)
Money Market Unit Trust Fund.
A fund that pools investors funds through the retail market and invest
them in the money market securities
( 2 marks)
iii)
Money Market Life Products
Similar to the money market unit trust, the only difference being the
holding structure through which the investors money is held. (2 marks)
c) The following factors have to be accepted if the markets are to be efficient
- Universal access to high speed and advanced system of pricing analysis
- A universally accepted analysis of system of pricing stocks
- Absolute absence of human emotions in the investment decision making
- The willingness of all investors to accept that their return or losses will
be exactly identical to all other market participants.
(8 marks)
QUESTION 33
The theory say that investing is overall rational in the pricing of a stock at any
given amount represents a rational evaluation of known information that bear on
the future value of the company. By equities being priced efficiently the theory
say they accurately represent the expected value of the stock as best it can be
known at a given moment. In other words prices are as a result of discounted
expected future cash flows.
The theory then brings the consequences in the stock pricing
a) The expected value is required to add a small premium due to financial risk
otherwise investors can shift from equity to much safer lower risk non –
equity investment.
b) Because the price of a share at every given moment is an efficient reflection
of expected value, the relative to the curve of expected return prices will
follow a random walk determined by emergence of information. In this
regard, professional equity investors immerse themselves in the flow of
3
information seeking to gain advantage over their competitor by intelligently
interpreting the emerging information flow.
However the model does not give a complete description of the process of equity
price determination in that stock markets are more volatile than the model`s
thinking. For example stock markets in recent times have witnessed not to be
perfectly efficient perhaps due to emerging markets which are not dominated by
well informed investors.
( 20 Marks)
QUESTION 34
3 marks for each
The following factors should be taken into account in buying out of the company
i)
Economic analysis
The investors will have to assess the economic environment of the country. In this
case facts such as demographic statistics, taxation and interest regimes have to be
looked into.
ii)
Industry analysis
Knowledge of the industry`s prospects and risks associated are integral aspects to
the valuation process as the performance of the business depend on industry
trends, conditions and other external factors. The investor will have to look at the
historic and prospective financial information on the basis of the anticipated
outlook of the industry.
iii)
Financial statement analysis
Financial performance and volatility provide essential insights into what the
investor might reasonably expect from future performance and it offers an
overview of the company`s risk profile. The key to valuation however is not just to
compute ratios and financial gauges but to actually use them to assess the
company risk.
4
iv)
SWOT analysis
This analysis involves analysis of strength, weakness and opportunities and
threats. It culminate from the risk assessment process and is based on an analysis
of a company`s qualitative characteristics, historical operating results, the
national and local economic trends that directly impact the company.
b. Over-the- counter are less formal stock exchanges where both listed and
unlisted stocks can trade. The market operate as an order driven market where
buyers and seller submit bids and a dealer buys and sell the stock from his own
inventory.
Unlike a national exchange where a broker matches the buyers and sellers bids,
OTC market comprise of any security for which there is a market. As a result this
market is referred to as a negotiated market. 8 marks
5