Course Name : Financial Investment and Security Analysis

Course Code : FIN-4703

Final Syllabus Chapter

Chapter-1 : Portfolio Analysis
Chapter-2 : Portfolio Selection
Chapter-3 : Capital Asset Pricing Model
Chapter-4 : Technical Analysis
Chapter-5 : Bond Analysis
Chapter-6 : Forward and Future
Chapter-7 : Option

References:
1. Class Lecture
2. Security Analysis and Portfolio Management, S. Kevin
3. Investment Analysis and Portfolio Management, Frank Reilly & Keith
Brown
4. Investments Analysis and management, Charles P. Jones

Acknowledgement:
Md. Amzad Hossain
Lecturer in Finance,
IIUC.

Prepared by : M. S. Sojib Chowdhury

Contact No. : 01826101558
Keep in Touch : https://www.facebook.com/M.S.Sojib.Chowdhury
 1

Chapter-1
Portfolio Analysis
Portfolio Analysis:
 Portfolio Analysis is concern with the analysis of investment
alternatives to diversifying risk by maximum return.
 Portfolio Analysis is a quantitative method for selecting an optimal
portfolio that can strike a balance between maximizing the return
and minimizing the risk in various uncertain environments.

Objectives of Portfolio Analysis:

When a portfolio is build, following objectives are to be kept in mind by
the portfolio manager based on an individual‟s expectation.
1. Capital Growth
2. Diversification of risk
3. Consistent returns
4. Reduce transaction cost
5. To get advertise opportunity

Expected Return:
The expected return of a portfolio of assets is simply the weighted
average of the return of the individual securities held in the portfolio. The
formula for the calculation of expected portfolio return is-
∑
Where, = Expected return of the portfolio
= Expected return of security i.
= Proportion of funds invested in security i.

Covariance and Coefficient of Correlation:

Covariance is the statistical measure that indicates the interactive risk of
a security relative to others in a portfolio of securities. The covariance
between two securities X and Y may be calculated using the formula:
∑( ̅ )( ̅ ) ∑ ∑
Where, ̅ = ; ̅ =
 2

Coefficient of Correlation measure the relationship between two securities.

i.e, X and Y. The correlation coefficients may range from -1 to 1. The
formula of coefficient of correlation is:

= Where,

∑( ̅ ) ∑( ̅ )
=√ ; =√

Variance ( Or Risk) And Standard Deviation:

The variance of a portfolio is not simply a weighted average of the
variance of the individual securities in the portfolio. The variance of a
portfolio with only two securities in it may be calculated by;

Portfolio standard deviation can be obtained by taking the square root of

portfolio variance.
√

Problem -1:
You are considering to construct portfolio with two securities. Returns, Risk
and Correlation of two securities are given below-
X Y

Return 10% 12%

Risk 4% 7%
Correlation ( ) 0.50
You have the following alternatives for constructing the portfolio.
X Y
A 50% 50%
B 30% 70%
C 40% 60%
D 20% 80%
 3

Calculated:
1. Portfolio Return
2. Total Risk (SD)
3. CV

1. We know, portfolio return = ∑

Therefore, A = (0.10 × 0.50) + (0.12 × 0.50) = 0.11 or 11%

B = (0.10 × 0.30) + (0.12 × 0.70) = 0.114 or 11.4%

C = (0.10 × 0.40) + (0.12 × 0.60) = 0.112 or 11.2%

D = (0.10 × 0.20) + (0.12 × 0.80) = 0.116 or 11.6%

2. We know, portfolio risk =√

⸫A =√

= 0.043

⸫B =√

= 0.05

⸫C=√

= 0.05

⸫D=√

= 0.06

3. We know, covariance of variance (CV) =

⸫A = = 0.36

⸫B = = 0.44
 4

⸫C = = 0.45

⸫D = = 0.52
Comment: If you want to take low risk and low returns, then portfolio A
will be more profitable alternative. If you want to take high risk and high
returns, then portfolio D will be more profitable alternative.

Problem-2:
The historical rates of return of two securities over the past ten years are
given.
Year 1 2 3 4 5 6 7 8 9 10
Security-
0.12 0.08 0.07 0.14 0.16 0.15 0.18 0.20 0.16 0.22
X
Security-
0.20 0.22 0.24 0.18 0.15 0.20 0.24 0.25 0.22 0.20
Y
Calculate; 1. Covariance
2. Standard Deviation
3. Correlation of the two securities.
Solution;
( ( ( ( ( ̅ )(
Year
̅ ) ̅ ) ̅ ) ̅ ) ̅ )

1 .12 .20 -0.01 1.44 -0.01 4.00 0.028

2 .08 .22 -0.068 0.64 0.01 4.84 -0.068
3 .07 .24 -0.078 0.49 0.03 5.76 -0.234
4 .14 .18 -0.008 1.96 -0.03 3.24 0.024
5 .16 .15 0.012 2.56 -0.06 2.25 -0.072
6 .15 .20 0.002 2.25 -0.01 4.00 -0.002
7 .18 .24 0.032 3.24 0.03 5.76 0.096
8 .20 .25 0.052 4.00 0.04 6.25 0.208
9 .16 .22 0.012 2.56 0.01 4.84 0.012
10 .22 .20 0.072 4.84 -0.01 4.00 -0.072
0.148 0.21 23.98 44.94 -0.08
 5

∑( ̅ )( ̅ )
Req-1: Covariance;
=
= 0.089; or 0.89%

Req-2: Standard Deviation of security X;

∑( ̅ )
=√

=√
= 1.63

Standard Deviation of security Y;

∑( ̅ )
=√

=√
= 2.23

Req-3: Correlation of the two securities;

=

=

=
= 0.024
 6

Chapter-2
Portfolio Selection
Modern Portfolio Theory (MPT):
Modern Portfolio Theory (MPT) is a hypothesis put forth by Harry
Markowitz in his paper “Portfolio Selection” (published in 1952 by the
Journal of Finance). His method of portfolio selection has come to be
known as the Markowitz model.
The MPT suggests that, it is possible to construct an “efficient frontier” of
optimal portfolios, offering the maximum possible expected return for
given level of risk.

Optimal Portfolio:
The idea of optimal portfolio comes from the Modern Portfolio Theory.
Among other things, this theory assumes that investors focus their efforts
on minimizing risk while striving to attain the highest possible return.
According to this theory, investors will act rationally within these
parameters, and they will always make decisions with the goal of
maximizing return for a given acceptable level of risk.
Optimal portfolio is also known as the efficient portfolio.

portfolio selection:
The process of finding the optimal portfolio is described as portfolio
selection. The selection of portfolios by the investor will be guided by
two criteria;
1. Given two portfolios with the same expected return, the investor
would prefer the one with the lower risk.
2. Given two portfolios with the same risk, the investor would prefer
the one with the highest return.
Selected those portfolio known as the efficient set of portfolio.
For example,
Security Name Risk Return
A 10% 19%
B 12% 16%
 7

C 9% 16%
D 10% 13%
According to the selecting criteria, security “A and C” are selected for
investment. “A and C” is the set of efficient portfolio.

Limitation of Markowitz Model:

1. Calculation Complex: One of the main problems with Markowitz
model is the large number of input data required for calculations. An
investor must obtain estimates of return, risk and also correlation of
returns for each pair of securities included in the portfolio, which is
create more complexity in calculation.
2. Taken time: Due to the Markowitz model a large number of securities
obtain here. For this reason it taken long time for calculations its risk
and returns.
3. Difficulty to collect data: The third problem of Markowitz model is
difficulty to collect data. If we do not fined data of any securities, it
may also create complexity to calculated portfolio risk and return.
Single Index Model:
The single index model is that all stocks are affected by movements in the
stock market. The return of an individual security is assumed to depend
on the return on the market index. Using the single index model, expected
return of an individual security may be expressed as:
̅
Where, ̅ = Expected return of an individual security.
= Component of security i‟s return.
= Market risk.
= Market return.
= Standard error.
The portfolio risk may be expressed as:
∑
Where, = risk of the portfolio.
= Market related risk.
= Securities risk.
 8

Multi Index Model:

A multi index model augments the single index model by incorporating
these extra market factors as additional independent variables.
̅

Problem-1: Consider a portfolio of four securities with the following

characteristics:
Residual
Weightage Alpha Beta variance
Security
( ) ( ) ( )
( )
A 0.2 2.0 1.7 370
B 0.2 3.5 0.5 240
C 0.4 1.5 0.7 410
D 0.3 0.75 1.3 285
Assume that market return 15% and market return variance is 320. Calculate
i. Portfolio return.
ii. Portfolio risk.
Solution;
Req-1:
We know, Portfolio return;
̅
Here, =∑
=( ) ( ) ( ) ( )
= 1.575
=∑
=( ) ( ) ( ) ( )
= 1.06
= 15% or 0.15 (which is given in the question)
Now,
̅
= 1.575 + ( )
= 17.475%
 9

Req-2:
Portfolio risk;
∑
( ) ( ) ( ) ( ) ( )

= 468.002

Problem-2: An investor owns a portfolio of four securities with the

following characteristics:
Residual
Alpha Beta variance
Security
( ) ( )
( )
A -1.50 1.25 0.24
B 2.15 1.47 0.47
C 1.70 0.69 0.36
D 0.83 0.88 0.30
Assume that market return 17.5% and market return variance is 28%.
Which single stock would an investor prefer to own from a risk return
perspective?

Solution;
We know,
Expected return (mean);
̅
̅ = ( )=
̅ = ( ) =
̅ = ( ) =
̅ = ( ) =
Security risk (SD);

( ) =
 10

( ) =
( ) =
( ) =

Now, CV of Security A = =

Security B = = 2.23

Security C = = 3.71

Security D = = 1.88

Comment: The investor would prefer “security C” as it provides the

highest return per unit of risk.

Problem-3: Consider a portfolio of five securities with the following

characteristics:
Random error (in
Weightage Beta %)
Security
( ) ( )
( )
A 0.10 1.35 25
B 0.20 1.05 81
C 0.15 0.80 16
D 0.30 1.50 144
E 0.25 1.12 64
If the standard deviation of the market index is 20 per cent, what is the total
risk of the portfolio?

Solution;
We know, Portfolio risk;
∑
Here,
=∑
=( ) ( ) ( ) ( ) (
)
= 1.195
 11

Security risk =∑
=( ) ( ) ( ) ( ) ( )
= 20.81

Therefore,
∑
=( ) ( ) 20.81
= 571.21+ 20.81
= 592.02

Problem-4: Consider a portfolio composed of five securities. All the

securities have a beta of 1.0 and unique or specific risk (standard deviation)
of 25%. The portfolio distributes weight equally among its component
securities. If the standard deviation of the market index is 18%, calculate the
total risk of the portfolio.

-Try yourself.
 12

Chapter-3
Capital Asset Pricing Model
Capital Asset Pricing Model (CAPM):
The Capital Asset Pricing Model (CAPM) was developed in mid-1960s
by three researchers William Sharpe, John Lintner and Jan Mossin
independently.
The Capital Asset Pricing Model derives the relationship between
the expected return and risk of individual securities and portfolios in the
capital markets.
According to the CAPM theory, the higher the risk of a security,
the higher would be the expected return from it and the lower the risk of a
security, the lower would be the expected return from it.

Assumption of CAPM:
The capital asset pricing model id based on certain explicit assumption
regarding the behavior of investors. The assumptions are listed below:
1. Investors make decisions based on expected return and risk.
2. The purchase or sale of a security can be undertaken in infinitely
divisible units.
3. Purchases and sales by a single investor cannot affect prices. That
means that there is perfect competition.
4. There are no transaction costs.
5. There are on personal income taxes.
6. The investor can lend or borrow any amount of funds desired at a
rate of interest equal to the rate for riskless securities.
7. The investor can sell short any amount of any shares.
8. Investors share homogeneity of expectations.
Capital Market Line:
The capital market line is one, which describes the risk-return relationship
for efficient portfolio. In CML, the risk is defined as total risk and is
measured by Standard Deviation (SD). There is a linear relationship
between the risk and expected return for these efficient portfolios. The
 13

CML is the basis of the capital market theory. All efficient portfolios of
all investors will lie along this capital market line.

Security Market Line (SML):

The Security Market Line describing the risk-return relationship for all
efficient portfolios as well as individual securities. In the SML risk is
defined as systematic risk and is measured by Beta ( ). Security Market
Line is the basis of the Capital Asset Pricing Model (CAPM).
Pricing of Securities with CAPM:
The capital asset pricing model can also be used for evaluating the pricing
of securities. The CAPM provides a framework for assessing whether a
security is underpriced, overpriced or correctly priced. According to
CAPM, each security is expected to provide a return commensurate with
its level of risk. A security may by offering more returns than the
expected return, making it more attractive. On the contrary, another
security may be offering less return than the expected return, making it
less attractive.
The expected return on a security can be calculated using the CAPM
formula;
̂ ( )
Where,
̂ = Expected return/required return.
= Risk free return.
= Market premium.
The estimated return can be calculated by;
( )

Where,
= Current market price.
= Estimated market price after one year.
= Dividend for one year.
 14

Problem-1: The following data are available to you as portfolio manager:

Standard
Estimated return
Security Beta deviation
(per cent)
(per cent)
A 30 2.0 50
B 25 1.5 40
C 20 1.0 30
D 11.5 0.8 25
E 10 0.5 20
Market index 15 1.0 18
Govt. security 7 0 0

(a) In terms of the security market line, which of the securities listed
above are underpriced?
(b) Assuming that a portfolio is constructed using equal proportions
of the five securities listed above, calculate the expected return and risk
of such a portfolio.
Solution;
Req-(a) Given, = 15%
= 7%
Expected return, ̂ ( )
Now, Security A = ( ) = 23%
Security B = ( ) = 19%
Security C = ( ) = 15%
Security D = ( ) = 13.4%
Security e = ( ) = 11%
Expected return Estimated return
Security
(per cent) (per cent)
A 23 30
B 19 25
C 15 20
D 13.4 11.5
E 11 10
 15

Comment: which estimated return is greater than the expected return those
are underpriced. Accordingly, Securities A, B and D are underpriced.

Req-(b):
We know, Portfolio Expected return,
̅ ( )
Here, = ( ) ( ) ( ) ( )
( )
= 1.16
Therefore, ̅ (̅ )
= 7 + 1.16 (15-7)
= 16.28%
And, Systematic risk of the portfolio, = 1.16

Problem-2: A Security pays a dividend of TK. 3.85 and sells currently at

TK. 83. The security is expected to sell at TK. 90 at the end of the year. The
security has a beta of 1.15. The risk free is 5% and the expected return on
market index is 12%. Assess whether the security is correctly priced.

Given,
D = 3.85
= 83
= 90
= 1.15
= 5%
= 12%
 16

Now,
Expected return, ̂ ( )
= ( )
= 13.05
( )
Estimated return,
( )
=

= 13.07
Comment: As the estimated return on the security is more or less
equal to the expected return, the security can be assessed as fairly priced.
 17

Chapter-4
Technical Analysis
Meaning of Technical Analysis:
The technical analysis is the study of stock price behavior and forecasting
techniques that utilize historical share price data.
The basic premise of technical analysis is that prices move in trends
which may be upward or downward. It is believed that the present trends
are influence by the past trends and that the projection of future trends is
possible by an analysis of past price trends.

Dow Theory:
Charles Dow formulated a hypothesis that the stock market does not
move on a random basis but is influenced by three distinct cyclical trends
that guide its direction. According to Dow theory, the market has three
movements and these movements are simultaneous in nature. These
movements are the primary movements, secondary reactions and minor
movements.

Y
Prices
Primary trend

Secondary
reactions

Secondary
reactions
O
Days X
Fig-4.1: Primary trend and Secondary
reactions.

The primary movement is the long range cycle that carries the entire
market up or down. This is the long-term trend in the market.
 18

The secondary reactions act as a restraining force on the primary

movement. These is the opposite direction to the primary movement and
last only for a short while.
The third one is minor movement, which are the day-to-day fluctuations
in the market. These are not significant and have no analytical value as
they are of very short duration.

Bullish Trend:
According to Dow theory, the formation of higher bottoms and higher
tops indicates a bullish trend.

Y
Price 𝑇
s
𝑇

O
Days X

Fig-4.2: Three phases of a bull market.

The line chart would exhibit the formulation of three phases. Each phase
would be followed by a bottom formed by the secondary reaction. Each
phase would be higher than the previous phase; each successive bottom
would be higher than the previous bottom.

Bearish Trend:
Bearish market shows the general decline in the market over a period of
time. It indicates the decline of prices of a single security or asset, or the
securities market as a whole
 19

Y 𝑇
Price 𝑇
s

O
Days X
Fig-4.3: Three phases of bear market.

Price Charts:
Charting represents a key activity in technical analysis. The price chart is
the basic tool used by the technical analyst to study the share price
movement. Three types of price charts are currently used by technical
analysts. These are the line chart, the bar chart and the Japanese
candlestick chart.

Closing Highest Lowest

Day Opening Price
Price Price Price
1 30 50 60 25
2 50 30 50 20
3 30 80 80 30
4 80 80 90 40
5 80 100 120 90
Table-4.1: Price Charts of a share for five days.

1. Line chart: Line chart is measured by the closing price of a share.A

line chart is illustrated the closing prices of a share are plotted on the
graph on day to day basis. The closing price of each day would be
represented by a point on the graph. All this point would be connected
by a straight line which would indicate the trend of the market.
 20

Price

120

100

80

60

40

20

0
1 2 3 4 5 Days

Fig-4.4: Line Chart of closing prices.

2. Bar Chart: Bar chart is concerned with the highest prices and lowest
prices.

Price
140

120

100
High price
80
Low price
60
Closing price
40

20

0 Days
1 2 3 4 5

Fig-4.5: Price bar chart.

In fig-4.5 shows the highest price, lowest price and the closing price of
each day are plotted on a day-to-day basis. A bar is formed by joining
the highest price and the lowest price of a particular day by a vertical
line. The top of the bar represent the highest price of the day, the bottom
 21

of the bar represent the lowest prices of the day and arrow sing represent
the closing price of each day.
3. Japanese candlestick chart: The Japanese candlestick chart shows the
highest price, the lowest price, the opening price and the closing price of
share on a day-to-day basis. There are mainly three types of
candlesticks-
 White: A white candlestick used when the closing price is higher
than the opening price.
 Black: A Black candlestick used when the closing price is lower
than the opening price.
 Doji: A doji candlestick is the one where the opening price and
the closing price of a day are same.
Japanese candlestick chart is illustrated in fig-4.6.

Price
140

120 Doji candlestick

White candlestick
100
Black candlestick
80
High
60 Open = Close
Close Open
40
Open Close
20 Low
0 Days
1 2 3 4 5

Fig-4.6: Japanese candlestick

Mathematical Indicators:
The analyst can use the mathematical tool of moving averages to
smoothen out the apparent erratic movements of share prices and
highlight the underlying tend. There are two types of mathematical
indicators use to calculate price movement.
 22

1. Moving Averages (MA):

A moving average represents the underlying trend in the share price
movement. The closing prices of shares are generally used for the
calculation of moving averages. Two types of MA are commonly used
by analysts – the simple MA and exponential MA.
Simple Moving Averages: In a SMA, a set of averages are
calculated for a specific number of days, each average being calculated
by including a new price and excluding an old price.

Calculation of Five-day Simple MA

Total of prices of 5
Days Closing Price Five day MA
days
1 33 - -
2 35 - -
3 37.5 - -
4 36 - -
5 39 180.5 36.1
6 40 187.5 37.5
7 40.5 193 38.6

2. Oscillators:
It calculated with the help f closing price data. They help to identify
overbought and oversold conditions and also the possibility of trend
reversals. These indicators are called oscillators.
Rate of Charge Indicator (ROC): It is a very popular oscillator
which measures the rate of change of the current price as compared to
the price a certain number of days or weeks back.

Closing price Price

Days Closing Price ROC = Ratio - 1
7 days ago Ratio
1 70 - - -
2 72 - - -
3 73 - - -
4 70 - - -
 23

5 74 - - -
6 76 - - -
7 77 - - -
8 75 70 1.07 0.07
9 78 72 1.08 0.08
10 80 73 1.1 0.1

 Graghcal analysis of ROC:

In figure, X and Y axis represents the time and the values of the ROC.
The ROC values oscillate across the zero line. The overbought zone is above
the zero line and the oversold zone is below the zero line. Upside crossing
(from below to above the zero line) indicates a buying opportunity, while a
downside crossing (from above to the zero line) indicates a selling
opportunity.

ROC
values Y

0.2
Overbought
0.15

0.1

0.05

0 X
1 2 3 4 5 6 7 8
-0.05

-0.1

-0.15 Oversold
-0.2
Fig: ROC chart.
 24

Chapter-5
Bond Analysis
Defination of Bond:
A bond is a fixed income investment in which an investor loans money to
an entity (typically corporate or governmental) which borrows the funds
for a defined period of time at a variable or fixed interest rate.
Types of Bond:
The major categories of bonds are-
1. Governmant bond: It is issued by a national govt., generally with a
promise to pay periodic interest payment and to repay the face value
n the maturity date. It is safest bond with the lowest interest rate. It
is also known as the Treasury Bond.
2. Corporate bond: A bond which is issued by a corporation in order
to raise financing for a verity of reasons, such as to ongoing
operations or to expend business. It is usullay longer term debt
instrument, at least one year.
3. Municipal Bond: A bond issued by state or local govt. or any of
there agencies. Interest from these bonds is generally tax-free to
residents. It is secured by specific revenue.
4. Zero Coupon Bond: It is a debt sccurity that doesn‟t pay interest
but is traded at a discount, rendering profit at maturity when the
bond is redeemed for its full face value.

Features of the Bond:

The most important features of a bond are;
1. Par Value – face value of the bond, which is paid at maturity date.
2. Yield to Maturity – rate of return earned on abond held until maturity
(also called the promised yield)
3. Coupon/Interest rate – interest rate (generally fixed) paid by the
issuer.
 25

4. Coupon dates – The dates on which the issuer pays the coupon to the
bond holders. It can be paid quarterly, semi-annually or annually.
5. Embodied Option

Bond Risks:
Bonds are considered to be less risky than equity shares; nevertheless they
are not enlirely risk free. Below, we‟ll explain the risks that could effect
bond profits.
1. Default Risk: Default risk refers to the possiblitiy that a company may
fail to pay the interest or principal on the stipulated dates. Poor
financial performance of the company leads to such default.
2. Interest Rate Risk and Bond Prices: there have an inverse
relationship; as interest rates fall, the price of bonds trading in the
marketplace generally rises and vice-versa.
3. Reinvestment risk: Risk that is concern that if interest rate will fall
and future cash flows will have to be reinvested at lower rates, hence
reducing income.

Bond Returns:
Bond returns can be calculated and expressed in different ways. Such as;
1. Bond Value: The value of Bond can be calculated by;
( )
[ ] ( )

2. Current Yield: The current yield relates the annual interest receivable
on a bond to its current market price. It can be expressed as;

3. Yield To Maturity (YTM): It may be defined as the compounded rate

of return an investor is expected to receive from a bond purchased at
the current market price and held to maturity. It can be expressed as;
 26

4. Yield To Call (YTC): The rate of return that an investor would earn if
te bought a callable bond at its current market price and held it until the
call date given that the bond was called on the call date. It can be
expressed as;

5. Bond Duration: Measure of the weighted average life of a bond which

considers the size and timing of each cash flow. The formula for
computing duration „d‟ is:
( ) ( )

Mathamethical Problem and Solution:

1. If a bond of face value TK. 1000 and a coupon rate of 12% is currently
selling for Tk. 800. What would be the current yield?
Given,
= 1000
coupon rate = 12% or 0.12 CF = (1000 × 0.12) = 120
market price = 800

Now,

= = 0.15 or 15%

2. ABC issues a 5-years bond with 5% coupon rate. The bond is currently
sell at TK. 800. Which par value is TK. 1000, market interest rate is 10%.
Will you purchase bond?
Here,
CF = (1000 × 5%) = TK. 50
K = 0.10
N =5
Pav value = TK. 1000
 27

Now,
( )
[ ] ( )

( )
[ ] ( )

= 811
Comment: Yes, I will purchase this bond. Because the value of bond is
grater than the market price.

3. From the following information you are requested to determine yield to

call: Bond par value TK. 1000, Coupon rate 11.5%, Call price TK. 1090,
Current market price TK. 1180 and No. of period to call 3 years.

Now,

= 11.23% (Answer)

4. An investor has a 14% bond with a face value of TK. 1000 that matures at
per in 15 years. The bond is callable in 5 years at TK. 1140. It currently
selling for TK. 1050. Calculate each of the following for the bond:
a. Current Yield
b. Yield to Call
c. Yield to Maturity
Given,
Par value = TK. 1000 CF = (1000 × 0.14) = 140
n = 15 years
Coupon rate = 14%
Call price = TK. 1140
No. of period to call = 5 years
 28

Market price = 1050

a. CY

b.

= 11.14%

c. YTM =

= 13.98%

5. A bond with 12% coupon interest rate issued 3 years age is redeemable
after 5 years from now at a premium of 5%. The interest rate prevailing in
the market is 14%. Determine value of the bond and bond duration.
Assume,
Par value = TK. 1000
Given, Coupon rate= 12%
n = 5 years
Premium = 5%
K = 14%
CF = (1000 × 0.12) = 120
 29

Now,
( )
[ ] ( )

( )
[ ] ( )

= 932

Therefore,

Duration; D =
( ) ( ) ( ) ( ) ( )

= 2.33 (Answer).`
 30

Chapter-6
Forward and Future
Defination of Derivatives:
A derivative is a contract between two parties which derives its
value/price from an underlying asset. Forward and Future are the most
common types of derivates.

Forward Contract:
Forward contract is a contract between two parties to buy or sell an
underlying asset in future date at pre-determined price.

Future Contract:
Future contract is a contract between two parties to buy or sell an
underlying asset in future date at pre-determined price. It is a standardized
contract.

Difference Between Forward and Future Contract:

Basis for
Forward Contract Future Contract
Comparison
Forward contract is an A contract in which the
agreement between parties parties agree to exchange
to buy and sell the the asset for cash at a fixed
Meaning underlying asset at a price and at a future
specified date and agreed specified date is known as
rate in future. future contract.
It is a standardized
What is it It is a tailor made contract.
contract.
Over the counter, i.e. there
Traded on Organized stock exchange.
is no secondary market.
Settlement On maturity date. On a daily basis.

Risk High Low

As they are private
Default agreement, the chances of No such probability.
default are relatively high.
 31

As per the terms of

Maturity Pre-determind date.
contract.
Regulation Self regulated By stock exchange.

Position in Forward and Future Contract:

There are two terms of position-
1. Long Position (Buyer):- Long position is An agreement to purchase
an asset at a specified future date at a specified price.
2. Short Position (Seller):- Short position is An agreement to sell an
asset at a specified future date at a specified price.

Pay-off Diagram from forward and future contract:

For better understand of pay-off from future contractr, we will discusses
a example here. Suppose, an investor enter into a long/short future
contract with strike price TK. 80. Draw the pay-off for investor.

In figure, vertical and horizontal axis represents the profit and the Sport
rate. The strike price (TK. 80) across the zero line.
 32

In the long position;

negative pay-off.
In the long position;

negative pay-off.

Long position represent the investor opportunity and Short position

represent the issuer opportunity. Investor and issuer has a negative
relationship. When investors make profit then the issuers has become
loss.

Market to Market:
In futures trading, it s the process of valuing assets covered in a futures
contract at the end of each trading day and then profit and loss is settled
between the long and the short.
For example; Lets say for futures comtract of stock ABC, X buys a future
and Y sells a futures at spot price of 2000. Lets say the size of the contract
is 500 shares. Now if the contract moves to oprice of 1990, X buys (2000-
1990)× 500 = 5000 and Y gains equal amount 5000. This money is called
marked to market in futures contract.
At the end of day, 5000 will be deducted from account of X and 5000 will
be credited to the account of Y.

Operation Margin:
1. Initial Margin: The amount that must be deposited at the time the
contract is entered into is known as the initial margin.
2. Maintenance Margin: Maintenance margin is the minimum amount
of equity that must be maintained in a margin account.
3. Call Margin: If the balance in the margin account falls below the
maintenance margin, the investor receives a margin call and is
expected to top up the margin account to the initial margin level the
next day.
 33

Specification of Future Contract:

Specification of contract basically means a summary of essential and very
important information about the asset futures contract in acomprehensive
and transparent form. Following are the sppecifications required of a
futures contract.
1. Contract Size: Information about the quantity of the underlying asset
in one futures contract.
2. Contract price: when reading a price quote for this underlying asset
you need to know what the value represents.
3. Delivery time.
4. Delivery mode.
5. Contract months traded.

Stock Index:
It is a statistical indicator used in measurement and reporting of changes
in the market value of a group of stocks/share.
It is a tool used by investors and financial managers to describe the
market, and to compare the return on specific investments.

Hedgingh an Equity profit portfolio:

A hedge is an investment position intended to offset potential losses or
gains that may be incrurred by a compainion investment. Portfolio
managers, individual investors and corporations use dedging techniques
to reduce their exposure to various risks.
Number of contract =
Where, P = Portfolio/Stock Price
F = Future contract value
= Market Risk
 34

Mathamethical Problem and Solution:

1. An investor who contacts his broker at June 5 to buy two December 200
oinces of gold at current futures price Tk. 600 per ounce.Operation of
margins for a long position in the fold futures contracts. The initial
margin is Tk. 4000 and the maintenance margin is Tk. 3000. The contract
is entered into on June 5 and closed out on June 16 at the following
futures price.
Day June-5 June-6 June-9 June-10 June-11 June-12 June-13 June-16

Futures 597 596.10 598.20 597.10 596.70 595.40 593.30 593.60

Price
(TK)

i. Investor which amount can withdraw on June-11?

ii. On June 13 which amount required for additional call margin?
Solution;
Day Futures price Daily gain/ loss Margin account
balance
600 4,000
June-5 597 (600) 3,400
June-6 596.10 (180) 3,220
June-9 598.20 420 3,640
June-10 597.10 (220) 3,420
June-11 596.70 (80) 3,340
June-12 595.40 (260) 3,080
June-13 593.30 (420) 2,660
June-16 593.60 60 4,060

Req-1: On June-11, withdrawal amount = (Margin A/C – Maintenance

margin)
= (3,340 - 3,000)
= 340 TK.
 35

Req-2: On June-13, Additional call margin = (Initial Margin – Margin A/C)

= (4,000 - 2,660)
= 1,340 TK.

2. A futures contract with 4 months to maturity is used to hedge the value of

a portfolio over the next 3 months in the following situation:
Value of S&P 500 index = 1,000
S&P 500 futures price = 1,010
Value of portfolio = Tk. 5,050,000
Risk-free interest rate = 4%
Dividend yield on index = 1%
Beta of portfolio = 1.5
Value of index in 3 months 900 950

Futures porice of index today 1,010 1,010

Futures price of index in 3 952
902
months

One futures contract is for delivery of Tk. 250 times the index. Calculate
the performance of stock index hedge for column 1 and 2.
Given,
n = 4 months
Hedge period = 3 months
= 4%
Dividend yield = 1%
Beta = 1.5
F = (1,010 × 250) = 252,500
We know,

N = = = 30
 36

Performance of stock index hedge for column-1

Step-1:
Gain from future contract =( – )
= TK. 810,000
Step-2:
Loss from index; =

= -10%
Divident = = 0.25%

= = 1%

Return from equity = -10 + 0.25

= -9.75%
Portfolio return = ( )
= 1 + ( -9.75 -1) 1.5
= -15.125%
Step-3:
Loss from the portfolio, = ( )
= 7,638,123
After loss portfolio value =
= 4,286,187
Step-4:
Gain from position in 3 month = 810,000 + 4,286,187
= 5,096,187
 37

Performance of stock index hedge for column-2

Step-1:
Gain from future contract =( – )
= TK. 435,000
Step-2:

Loss from index; =

= -5%
Divident = = 0.25%

= = 1%

Return from equity = -5 + 0.25

= -4.75%
Portfolio return = ( )
= 1 + ( -9.75 -1) 1.5
= -7.625%
Step-3:
Loss from the portfolio, = ( )
= 385,063
After loss portfolio value =
= 4,664,938
Step-4:
Gain from position in 3 month = 435,000 + 4,664,938
= 5,099,937
 38

Chapter-7
Option
Definition of Option:
 An option is a contract between two parties where second party is
obliged to settle the contract if first party wishes.
 Option is a formal contract between a seller (the optioner) and a
buyer (the optionee) the right (but not the obligation) to buy or sell a
specific property at a fixed price (called Strike price) on a fixed
date.

Types of Option:
1. Call Option: Call options are contracts that give the owner (seller
rights) the right to buy the underlying asset in the future at an
agreed price. You would buy a call if you believed that the
underlying asset was likely to increase in price over a given period
of time.
2. Put Option: Put Option are essentially the opposite of call option.
The owner of a put has the right to sell the underlying asset in the
future at a pre-determined price.

 Option Premium or Option Price: an option premium is the income

received by an investor who sells an contract to another party.
Pay-off Diagram of Call and Put option Contract:
Pay-off diagrams are an illustrative way to estimate at glance the
maximum positive or negative revenue from an options position, if held
until expiration.

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