PRINCIPLES OF INVESTMENT – NOV 2013
SECTION A SUGGESTED ANSWERS
1 a) any two of the following for 2 Marks
 Equity
 Debt instrument
 Real estate.
 Rare stamps
 Currencies
 Fixed Income Security e.g. bond ,shares
b) Financial risk is the possibility that future events will diminish the value of an investment
while non – financial risk is uncertainty which not monetary in nature e.g. health and safety
risks
2 Marks
c) Holding Period Return (HPR) = End investment value / Initial investment value
1 Mark
= 5,250,000 / 3,495,000
Annual HPR
Therefore Annual HPY
= 1.50
1 Mark
= 1.50 to the power of 3
1 Mark
= 3.38
1 Mark
= 3.38 – 1
= 2.38
=238 %
1 Mark
d)
i) Call Markets are those where stock can trade at a specific time and bids for stocks are
collected and then trade at a specific time and at one price and because of this , this type of
market is conducive to smaller markets. 3 Marks
1
Ii) Continuous Markets.
Continuous markets are those that trade any time as long as the market is open. Buyers and
sellers are matched up on continuous basis and prices are determined by an auction or a bid –
ask price.
3 Marks
2 a) Characteristic line also know as security market line is a line that graphs systematic and
market risks verses return of the whole market at a certain time and shows all risky market
securities. On the graph X- axis and Y – axes are represented by risk (beta) and expected return
respectively. 3 Marks
On the graph, the market risk premium is determined from the slope of the line. The
characteristic line is a useful tool in determining whether an asset being considered for
inclusion on the portfolio is offering reasonable expected return for risk. 3 Marks
Any security above the line is said to be undervalued as it is expected to give higher return for
the inherent risk. Likewise a security below the line is said to be overvalued and by accepting it
on the portfolio, the investor is accepting less return compared to the risk assumed. 3 Marks
b)Beta for Portfolio A = (0.15 X 1.25 )+(0.25 X 1.10 )+(0.18 X 1.20)+(0.30 X 1.22)+(0.12 X 1.05)
1 Mark
=0.19 + 0.28 + 0.22 + 0.37 + 0.13
= 1.19
1 Mark
Beta for Portfolio B = ( 0.11 x 0.95)+( 0.19 x 0.75)+( 0.31 x 0.85 )+( 0.24 x 0.45)+(0.15 x 1.35)
1 Mark
= 0.10 + 0.14 + 0.26 + 0.11 + 0.20
= 0.81
1 Mark
Beta for portfolio A is 1.19 while for portfolio B is 0.81. Based on this finding, A will be more
volatile than the market and hence risky but certainly it will give higher returns compared to
Portfolio B 2 Marks
2
3 a)
i) Bond market is a financial market where participants buy and sell debt securities.The
market takes place between broker – dealer and large institution in a decentralized
over the counter market.The market has liquidity and lack credit risk but is very
sensitive to interest rates or the shape of the yield curve. 2 Marks
ii) Stock market is shares are issued and traded either through exchange or over the
counter markets.The market gives companies access to capital and investors slices of
ownership in the company with the potential to realize gains based on its future
performances . 2 Marks
b) FV = PV X (1.00 + I )to the power n
1 Mark
n = 4 x2
=8
1 Mark
= 500,000 x (1.00 + 0.03)to the power 8
1 Mark
= 500,000 x (1.03) to the power 8
=500,000 x 8.16 1 Mark
=4,080,000
1 Mark
c) Expected rate of return is the rate expected to be realized from an investment and is
calculated by the probabilities of occurrencies of their outcomes.2 Marks
The required rate of return is the minimum return an investor would require from an
investment, given the riskiness of the financial instruction. 2 Marks
If the expected return is less than required return,the investment is not worthy pursuing hence
funds will not be allocated to that cause and an investor will look for somewhere else.
2 Marks
4 a)- The markets should universally access high speed and advance systems of pricing analysis
2Marks
-
The markets should universally accept analysis system of pricing stocks . 2 Marks
The markets should have absolute absence of human emotion in investment decision
making. 2 Marks
3
-
There should be willingness of all investors to accept that their returns or losses will be
exactly identical to all other market participants 2 Marks
b) i) Annuities are essentially series of fixed payments required to be paid or are to be received
at specified frequency over the course of a fixed period of time.There are two types of annuities
namely ordinary annuity whose payments are required at the end of each period. Eg straight
bond coupon and annuity due – whose payments are required at the beginning of the period eg
rent. 4 Marks
ii) Internal rate of Return is a sophisticated capital budgeting technique and is a discount rate
that equites the NPV of an investment with 0 because the present value cashflow is the initial
investment.The technique believes that it is the compound annual rate of return that the firm
will earn if it invests in the project and receives the given cash inflow. 3 Marks
5 a)
i)
RELATIVE PRICE APPROACH
Under this approach , the bond will be priced relative to a benchmark,usually government
security.The YTM on the bond is determined based on the bond`s credit rating relative to a
govt. security with similar maturity orduration.The better the quality of the bond,the smaller
the spread between its required rate of return and the YTM of the benchmark.The required
rate of return is then used to discount bond cashflows to obtain the price. 5 Marks
ii)
PRICE SENSITITY APPROACH
The sensitivity of a bond`s market price to interest( yield ) movements is measured by its
duration and additionally by its convexity.In this case duration is a linear measure of how the
price of the bond changes in response to interest rate changes.The percentage change in yield
is approximately equal to duration.
Convexity in bond price sensitivity refers to a measure of curvature of price changes and is thus
a complement to duration.In reality as interest rates changes, the price becomes the convex
function of rates. 5 Marks
b) – The specificity of the individual bond issues .
- Lack of liquidity in many smaller issues .
1 Mark
1 Mark
4
c) Participants include Any three for 3 Marks




Institutional investors
Government
Traders
Individual
SECTION B SUGGESTED ANSWERS
6 a) Any four of the following;





Preference to dividend
Preference to assets in event of liquidation
Convertible into common stock
Callable at the option of the issuer
Non voting rights
b) i ) Setting the investment objective
This step calls for an investor to set his investment objective. The object will vary from one
investor to another .For instance a pension or mutual fund or insurance company may wish to
have a cash flow specification to satisfy liabilities at different future times. The liabilities would
include redemption. Dividends or claim settlement payout. An individual investor may wish to
maximize return and optimal risk.
4 Marks
ii) Establishment of investment policy
This is where the investor will set asset allocation / portions within his portfolio among assets
classes available in the capital or money market and could include securities such as equity,
debt and fixed income securities. This will be done by taking into account environmental
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constraints and investors constraints. Environmental constraints include government rules and
regulations while investor constraints include financial capability, availability of time and
understanding of investment environment.
4 Marks
iii) Selection of the portfolio strategy
The investor will choose the strategy in conformity with both his objective and policy guidelines
as non conformity might lead to breakdown and loses. The strategy might either be active ie
where the investor has higher expectation about factors that are expected to influence the
performance of the asset class or passive ie where the investor has minimum expectation of the
input. 4 Marks
iv) Measurement and Evaluation of portfolio performance.
Under this step, the investor measures and evaluates portfolio performance against realistic
benchmarks. The portfolio is measured in terms of both absolute and relative terms. Further,
measurement will be relative to objectives and other predetermined performance parameters.
Other aspects to be included are risk and return. The investor will consider where the returns
were worth the risk taken. This step will help in the portfolio and its management process in
future. 4 Marks
7 a) Bottom – up valuation overlooks economic conditions and industry`s potential and focuses
on a firms individual attributes.The approach focuses on fundamental such as sales, earning
figure ,balance sheet and cashflow statement.The investor also look at potential market size as
this provide good projection of earnings potential a firm can achieve.The approach asserts that
successful firms consistently increase in their market share and expand into new markets with
solid growth prospects. 5 Marks
On the other hand, Top- down approach asserts that economic environment has a significant
effect on the firm`s earnings and there is a relationship between stock prices and economic
expansions and contractions .More so changes in individual stock returns are explained by
changes in rates of return of the firms industry.This approach is most preffered because it is
not subject to subjective preferences and plain figures . 5 Marks
b) EMH is an investment theory which states that it is impossible to beat the market because
stock market efficiency causes existing share prices to always incorporate and reflect
information.This therefore means that stocks always trade at their fair value on stock exchange
making it impossible for investors to either purchase under or over valued stocks or sell at
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inflated prices.The theory argue that it is pointless to search for undervalued stocks or to try to
predict trends in the markets through either fundamental or technical analysis. 5 Marks
Regards of the EMH beliefs , the realities of the world argue against it, examples being the case
a successful investor- Waren Buffet whose strategy of focusing on undervalued stocks made
him make money on the stock market.The other example is that of fund managers who have
better track records of renown research analysis and out of this, they have profited and been
able to beat the market.It has also been suggested that mass mentality of trendy short-term
investors pull in and out of latest and hottest stocks .This distorts the market and results in
inefficient markets.
5 Marks
8 a)




Security XY will be most preferred because it is the one giving higher return at lowest
risk possible.
2 Marks
PQ cannot be considered for inclusion on the portfolio as it has the highest risk
compared to the rest.
2 Marks
UV will be preferred to KL as it is able to give higher return than what KL can deliver but
at the same level.
2 Marks
RS is suitable for a risk taker as it is more rewarding and able to compensate for the
higher risk taken.
2 Marks
b) Expected return = rf +beta( rm –rf)
1 Mark
=0.095 + 1.15(0.1395 – 0.095)
1 Mark
=0.095 + 0.051
1 Mark
= 0.146
=14.6 %
1 Mark
c) It is very important for the investor to be aware of the beta of the security he want to
consider for inclusion on the portfolio in that the value of more than 1 means that the security
is more volatile and hence riskier. Such security can be considered only if it will give higher
return which outweighs the risk assumed. 3 Mark
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If the beta is less than one, then the security is less volatile as such the portfolio will preserve
the capital value though at a lower return. Any risk averse investor will definitely prefer such
security.
3 Mark
d) Risk of a security is a measure of how likely the issuer is to make all payments on time and in
full and as promised in the agreement. 2 Marks
OR
Risk of a security is the likelihood that the expected returns on the security will materialize or
not.
9 a Expected Return of the fund
%
Treasury bills 0.25 x 16
= 4.00 1 Mark
NITL shares
0.32 x 18
=5.76
1 Mark
NICO shares
0.28 x 24
= 6.76
1 Mark
Unlisted shares 0.15 x 20 = 3.00
1 Mark
Fund expected return
= 19.48% 1 Mark
Fund variance
Rate of Return
Expected Return
R- E
(R - E)X( R-E) Proportion Weight (%)
16
19.48
- 3.48
12.11
0.25
3.03 3 Marks
18
19.48
- 1.48
2.19
0.32
0.70 3 Marks
24
19.48
4.52
20.43
0.28
5.72 3 Marks
8
20
19.48
0.52
0.27
Fund variance
b)
-
0.15
0.52 3 Marks
9.49% 1Marks
Any two of the following
Time value of money
The expected inflation during the investment period
The risk involved
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i) Primary markets
These are markets dealing in the issue of new securities. These issues can be
initial public offering for public companies, Government bonds or other public or
private sector funding programs. In this market, the security is sold directly to the
investors from the issuer. 3 marks
ii) Secondary markets
Once a security has passed through primary market, it will then be made available
in the secondary market such as stock exchanges or through a brokerage firm.
There may be a specified period before the issue can be sold on the secondary
market to allow it to preserve the strength and integrity of the offering. They are
the after markets and securities can be bought based on demand and supply. 5
Marks
iii) Convertible preferred stock
These are preferred issues that the holder can exchange for a predetermined
number of the company`s common stock. The exchange can occur at any time the
investor chooses regardless of the current market price of the common stock. It is
one way deal so one cannot convert the common stock back to preferred stock
3 marks
9
b. The following are the bond types
1
General Obligation Bonds
These bonds promise to repay based on full faith and credit of the issuer and are
considered to be more secure that’s why they attract lower interest
2
Revenue Bond
These promise to repay from specified streams of future income such as income
generated from water utility payments
3
Assessment Bond
These promise repayment based on property tax assessment of properties
location within the issuer`s boundaries
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