Investment Analysis Homework - Analyzing Bonds and Efficient Markets

This document presents a detailed solution to an investment analysis homework assignment. Section A focuses on bond valuation, including calculations of bond price, duration, modified duration, and convexity for two different bonds. The analysis delves into the concept of yield curves, explaining downward sloping curves and their implications, as well as addressing interest rate risk and bond immunization strategies. Section B shifts to technical analysis, discussing the efficient market hypothesis and its implications for investment strategies. It examines the net present value of securities in an efficient market and explores the tenets of the efficient market, including weak, semi-strong, and strong forms, and how they relate to technical and fundamental analysis, and fund management activities. Finally, the solution outlines the roles of a portfolio manager in an efficient market, emphasizing diversification, tax considerations, and resource allocation to meet investor needs.

Investment analysis

TABLE OF CONTENTS
SECTION A...............................................................................................................................3
Question 1..............................................................................................................................3
SECTION B...............................................................................................................................3
Question 3 Technical Analysis...............................................................................................3
REFERENCES...........................................................................................................................5

SECTION A
Question 1
Question: 1
a)
BOND –A
Time cash
flows
P.V.
facto
r
PVC
F
Weight T * Weight T *
(t+1)*weight*(1/1+R)^2
1 10 0.909 9.09 0.09090
9
0.09090909
1
0.22
2 10 0.826 8.26 0.08260
8
0.16521652
2
0.599735974
3 10 0.751 7.51 0.07510
8
0.22532253
2
1.090561056
4 110 0.683 75.13 0.75137
5
3.00550055 18.18327833
Bond Price 99.99
Duration 3.48694869
5
modified
duration
3.41857715
2
Convexity 20.09357536
BOND – B
Time cash
flows
P.V.
facto
r
PVCF Weight T *
Weight
T *
(t+1)*weight*(1/1+R
)^2
1 9 0.91
7
8.253 0.0825
29
0.0825291
75
0.196105825
2 9 0.84
2
7.578 0.0757
79
0.1515584
84
0.540199906
3 9 0.77
2
6.948 0.0694
79
0.2084379
16
0.99058035
4 9 0.70
8
6.372 0.0637
19
0.2548774
51
1.514099499
5 109 0.65 70.85 0.7084
93
3.5424645
75
25.25281297
Bond Price 100.0
01
Duration 4.2398676
01
modified duration 4.1567329
42
Convexity 28.49379855
Yield 10%

change in yield 1%
New bond price -
percentage change
-4.01
New bond price 95.99
(b)
The yield curve slopes downward when the long-term yield falls below the short term yield.
It mainly occurs due to the reason that the perception of the long-term investors pertaining to
the interest rate which will decline in the future. This might happen because of the various
reasons and main reason among all is the decline in the inflation (Lavoie and Reissl, 2019).
As per the liquidity preference theory which points out that the investors mainly demand the
premium on their yield which they receive in return pertaining to tying up liquidity in the
long tern bonds. The theory holds that investors demand premium to compensate the interest
rate exposure and this premium rises with maturity. Thus, even after adding premium to the
yield curve, the outcome will still remain the same the downward sloping curve. Thus, it
actually fails to clearly explain the downward shape of the yield curve.
c)
Interest rate risk can be defined as the potential that leads to reduction in the value of the
bond or other fixed rate investment with the change in the overall rates of interest. Bond price
falls with the rise in interest rate and vice versa. This indicates that the market price of a bond
drops to offset the issue of new bond with more attractive rates.
Bond immunization is a strategy that can be adopted by bond portfolio manager to reduce the
risk associated with the interest rates resulting from investment in bonds by adjusting the
duration of portfolio to match with the time horizon of investor’s investment. They do this by
locking in a fixed rate of return during the amount of time an investor wishes to keep their
investment without cashing in it. Immunization results in locking a fixed rate of return during
the time horizon an investor is planning to keep the investment in bond without cashing in it.
Normally, there is an inverse effect on bond price due to interest rate, where rise in interest
rates leads to reduction in bond price. But when the bond portfolio is immunized, the
investors then receives a specific rate of return over a time period involved regardless of what
is the change happening in the interest rate during this time.
Linear programming techniques and robust optimization techniques are alternative
immunization techniques that the portfolio manager can use.

SECTION B
Question 3 Technical Analysis
(a)
Efficient market refers to the market in which the current price incorporates all the
available information. But this does not mean to randomly pick any of the stock from the
exchange. It does not mean that the one’s preferences is completely different or irrelevant
pertaining to investment decision. Investors have to deal with various situations like the
family issues, inherent risk preference, tax bracket etc. thus, there is a requirement to
optimize the portfolio which will result into attaining the maximum return and meet with the
desired objectives (Hamid and et.al., 2017). This measured through the way of analyzing the
entire portfolio’s return risk tradeoff. As suggested by Markowitz’s Portfolio’s theory, the
investor picks the risk level he/she is willing to take. Therefore, randomly picking of stock
does not guarantee any proper risk level nor guarantee the well-diversified portfolio.
Therefore, it is considered wrong to pick the stock considering it incorporates all the
available information.
(b)
The net present value of the securities will be considered zero under the case if the securities
market is efficient as it depicts the prices of the financial instruments which provides for
available information. When an investor pays, it is expected to receive the normal rate of
return and the when the firm sells it, it is expected to receive the fair value of the securities.
Therefore, net present value of the securities will be zero.
(c)
The efficient market assumes that the all-stock trade is at the fair value. There are mainly
three tenets pertaining to the efficient market which are the weak, semi-strong and the strong.
The implication of the used of three main investment strategies are given below:
(i) Technical analysis: Under the weak tenet it is made assumption that the current
rice of the stock depicts all the available information (Sushko and Turner, 2018).
In addition to this, it also states that the past performance is irrelevant in regard to
the future performance of the stock. Thus, it is assumed that the technical analysis
cannot be used to achieve the returns.
(ii) Fundamental Analysis: The semi strong tenet of the theory states that the stock
prices factored into all the information which is made publicly available. This

results into implication that the investors cannot make use of fundamental analysis
in order to beat the market along with making the significant gains.
(iii) Money/Fund Management Activities: This investment strategy is the strong
form of theory which involves all the information both public and private and is
also factored into the price of the stocks (Jovanovic, 2018). Therefore, it is
basically assumed that no one has any sort of advantage in respect to the
information available. Involving person from inside or out. Thus, it states that
market is perfect and thus, making additional gains from the market is impossible.
(d)
The three most appropriate role of portfolio manager in efficient market are described below.
Diversification to reduce firm’s specific risks: the primarily role of the portfolio manager is
to diversify the risk level of the investor by making investment into different types of
investment options which helps in reducing the level of market risk investor is exposed to.
Tax consideration for different investors: The portfolio manager is needed to consider tax
brackets which is reflected in the security choices made (Guerard Jr, Markowitz and Xu,
2020). The high tax bracket investor will not invest into the securities which the low tax
bracket finds favorable. Thus, portfolio manager is needed to account for this factor will
suggesting the security options of investment.
Resource allocation: Another important role is to tailor to the portfolio as per the needs of
the investor instead of attempting to beat the market. This mainly involves determining the
investor’s return needs along with the risk tolerance.

REFERENCES
Books and Journals
Guerard Jr, J. B., Markowitz, H. and Xu, G., 2020. The role of effective corporate decisions
in the creation of efficient portfolios. In HANDBOOK OF APPLIED INVESTMENT
RESEARCH (pp. 63-73).
Hamid, K., and et.al., 2017. Testing the weak form of efficient market hypothesis: Empirical
evidence from Asia-Pacific markets. Available at SSRN 2912908.
Jovanovic, F., 2018. Beyond performativity, how and why American courts should not have
used Efficient market hypothesis.
Lavoie, M. and Reissl, S., 2019. Further insights on endogenous money and the liquidity
preference theory of interest. Journal of Post Keynesian Economics. 42(4). pp.503-
526.
Sushko, V. and Turner, G., 2018. The implications of passive investing for securities
markets. BIS Quarterly Review, March.