MF0001 (mMF0010) Solved Assignemnt (Set 1 & 2)

8/8/2019 MF0001 (mMF0010) Solved Assignemnt (Set 1 & 2)

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Q. 1 It is very often observed that retail investors enter the market when index is very high

and exit when index is very low (comparatively speaking). Describe qualities of a savvy

investor. Also throw light upon mistakes committed while managing investments.

Ans: Retail investors in mutual funds are known to chase returns, making large investments atmarket highs and staying away during its lows.

Systematic Investment Plans or SIPs were devised mainly to prevent this. However, data on SIPinvestments for 17 leading fund houses now show that investors follow the same practice fortheir SIP investments as well. They decide to start paying the monthly installments on SIPs onlyafter markets have rallied and stop them if the stock market is falling.

SIPs jump as Sensex rises

The number of new SIP accounts these funds added in the April-June 2010 quarter was over 50per cent higher than the number added in the same quarter of 2009.

The number of SIPs added every month averaged 1.79 lakh accounts in the latest quarter, against1.2 lakh accounts in the same period of 2009.

The Sensex ranged between 17,000 and 18,000 in April-June 2010, compared with 11,000-15,500 levels in April-June 2009.

Failed SIPs

The other disturbing trend is that of a good number of investors are discontinuing their SIPs mid-way. Even as funds added between one lakh and 1.9 lakh accounts each month over the last oneyear, the number of failed' SIPs was quite large at 1.2-1.7 lakh accounts a month.

The instances of SIPs failing' peaked during March, April and May 2009. In hindsight, that wasthe best time to invest in equity funds.

Stopping SIPs when market is down would defeat the purpose of cost averaging (buying moreshares when prices are low and fewer shares when prices are high) that monthly investing issupposed to serve.

SIP collections rising

Overall, however, fund houses have seen a steady improvement in the new SIP accounts as themarkets have climbed over the past year. Between 1.7 and 1.9 lakh SIPs have been added inrecent months.


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In all, the 17 mutual funds had about 25.6 lakh SIP accounts by end of June 2010.

Together, they managed SIP assets of Rs 20,600 crore.

In spite of improved market conditions compared to 2008-09, the average ticket size of new SIPaccounts has not increased substantially. The national average has moved to Rs 2,190 from Rs2,100 reported in 2008-09.

QUALITIES OF A SMART INVESTOR:

1) Smart investors have a plan for investing, and they stick to it: It is very easy to betempted by a tip about a hot stock. However this is not the way Smart investors invest. Forexample, if they are 40 years old and have twenty years until retirement, they implement a 20-year investment plan. They only buy securities that they have researched.

2) Smart investors invest consistently: They generally use to methods to do this. First, theyinvest a part of their funds in securities with a growth potential (like stock & mutual funds).Second, they keep adding to their investment principal regularly.

3) Smart investors are patient: It often takes time for a good investment to show results. Theyunderstand this, and therefore do not get excited about the daily ups and downs of the market.Smart investors dont expect instant growth.

4)Smart investors are not emotionally tied to their investment positions: They know that tobe successful, they must not be emotional towards their investment. No matter how attractive an

investment looks or how badly an investment has performed recently, selling at the right time isjust as imporant as buying. They are aware that no investment will move up forever, and theyare able to sell it when right.

Common errors in Investment Management

Investment mistakes happen for a multitude of reasons, including the fact that decisions are madeunder conditions of uncertainty that are irresponsibly downplayed by market gurus andinstitutional spokespersons. Losing money on an investment may not be the result of a mistake,and not all mistakes result in monetary losses. But errors occur when judgment is unduly

influenced by emotions, when the basic principles of investing are misunderstood, and whenmisconceptions exist about how securities react to varying economic, political, and hystericalcircumstances. Avoid these ten common errors to improve your performance:

1. Investment decisions should be made within a clearly defined Investment Plan. Investing is agoal-orientated activity that should include considerations of time, risk-tolerance, and futureincome... think about where you are going before you start moving in what may be the wrong


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direction. A well thought out plan will not need frequent adjustments. A well-managed plan willnot be susceptible to the addition of trendy, speculations.

2. The distinction between Asset Allocation and Diversification is often clouded. AssetAllocation is the planned division of the portfolio between Equity and Income securities.Diversification is a risk minimization strategy used to assure that the size of individual portfoliopositions does not become excessive in terms of various measurements. Neither are "hedges"against anything or Market Timing devices. Neither can be done with Mutual Funds or within asingle Mutual Fund. Both are handled most easily using Cost Basis analysis as defined in theWorking Capital Model.

3. Investors become bored with their Plan too quickly, change direction too frequently, and makedrastic rather than gradual adjustments. Although investing is always referred to as "long term",it is rarely dealt with as such by investors who would be hard pressed to explain simple peak-to-

peak analysis. Short-term Market Value movements are routinely compared with various un-portfolio related indices and averages to evaluate performance. There is no index that compareswith your portfolio, and calendar divisions have no relationship whatever to market or interestrate cycles.

4. Investors tend to fall in love with securities that rise in price and forget to take profits,particularly when the company was once their employer. It's alarming how often accounting andother professionals refuse to fix these single-issue portfolios. Aside from the love issue, thisbecomes an unwilling-to-pay-the-taxes problem that often brings the unrealized gain to theSchedule D as a realized loss. Diversification rules, like Mother Nature, must not be messedwith.

5. Investors often overdose on information, causing a constant state of "analysis paralysis". Suchinvestors are likely to be confused and tend to become hindsightful and indecisive. Neitherportends well for the portfolio. Compounding this issue is the inability to distinguish betweenresearch and sales materials... quite often the same document. A somewhat narrow focus oninformation that supports a logical and well-documented investment strategy will be more productive in the long run. But do avoid future predictors.

6. Investors are constantly in search of a short cut or gimmick that will provide instant successwith minimum effort. Consequently, they initiate a feeding frenzy for every new, product andservice that the Institutions produce. Their portfolios become a hodgepodge of Mutual Funds,

iShares, Index Funds, Partnerships, Penny Stocks, Hedge Funds, Funds of Funds, Commodities,Options, etc. This obsession with Product underlines how Wall Street has made it impossible forfinancial professionals to survive without them. Remember: Consumers buy products; Investorsselect securities.

7. Investors just don't understand the nature of Interest Rate Sensitive Securities and can't dealappropriately with changes in Market Value... in either direction. Operationally, the income


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portion of a portfolio must be looked at separately from the growth portion. A simple assessmentof bottom line Market Value for structural and/or directional decision-making is one of the mostfar-reaching errors that investors make. Fixed Income must not connote Fixed Value and most

investors rarely experience the full benefit of this portion of their portfolio.

8. Many investors either ignore or discount the cyclical nature of the investment markets andwind up buying the most popular securities/sectors/funds at their highest ever prices. Illogically,they interpret a current trend in such areas as a new dynamic and tend to overdo theirinvolvement. At the same time, they quickly abandon whatever their previous hot spot happenedto be, not realizing that they are creating a Buy High, Sell Low cycle all their own.

9. Many investment errors will involve some form of unrealistic time horizon, or Apples toOranges form of performance comparison. Somehow, somewhere, the get rich slowly path toinvestment success has become overgrown and abandoned. Successful portfolio development is

rarely a straight up arrow and comparisons with dissimilar products, commodities, or strategiessimply produce detours that speed progress away from original portfolio goals.

10. The "cheaper is better" mentality weakens decision making capabilities and leads investors todangerous assumptions and short cuts that only appear to be effective. Do discount brokers seek"best execution"? Can new issue preferred stocks be purchased without cost? Is a no load fund afreebie? Is a WRAP Account individually managed? When cheap is an investor's primaryconcern, what he gets will generally be worth the price.

Compounding the problems that investors have managing their investment portfolios is thesideshowesque sensationalism that the media brings to the process. Investing has become a

competitive event for service providers and investors alike. This development alone will leadmany of you to the self-destructive decision making errors that are described above. Investing isa personal project where individual/family goals and objectives must dictate portfolio structure,management strategy, and performance evaluation techniques. Is it difficult to manage a portfolio in an environment that encourages instant gratification, supports all forms of"uncaveated" speculation, and that rewards short term and shortsighted reports, reactions, andachievements?

Q.2 Explain the significance of index in general and stock market index in particular. What

is risk involved in derivative products?

Ans: - Before dealing in derivative products (futures and options) the client (investor) mustassess the risks in trading these products. It must be aware that the loss it may incur could behigher than the amount initially exchanged (paid or received) or deposited. The loss in tradingderivative products is potentially unlimited and is not proportional to the initial amount investedor exchanged (paid or received).


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The client should not deal in derivative products unless it understands the nature of the contract itis entering into, the extent of its obligations and exposure to risk, and is satisfied that the contractis suitable for it in light of its skills, objectives and financial resources.

Although derivative products can be utilised to limit or hedge against risk, the client should beaware that derivative products are not suitable for all investors.

The client's exposure to risk may vary according to the product, market and type of transaction.Commitments entered into and the protection offered by Calyon Financial and the clearinghouses may vary depending on the product, market and type of transaction.

The information available relating to derivative products is not always complete and exhaustive.Derivative products may be tailored for some clients or markets and may differ in detail from theoutline set forth herein. The terms of particular transactions will prevail over the product

descriptions and information given in this Risk Disclosure Statement.

The client must assess the suitability of its investment, in particular in light of its skills,objectives and financial resources.

The main risks linked to derivative products are:

1. Leverage: When an investor trades derivative products it must provide a deposit and/orexchange (pay or receive) a premium. The amount provided as the deposit or exchanged as apremium represents only a fraction of the derivative product's value.

Transactions in derivative products involve significant leverage as a relatively small fluctuationin the price of the underlying instrument can have a proportionately greater impact on the cash oron the value of any other guarantee deposited by the investor. This can work for and against theclient. If the market moves in an unfavourable direction, the investor may not only lose morethan the full amount of the initial margin deposit, but also pay an additional margin and meetmargin calls. To maintain the investor's position, new margin payments can be requested on veryshort notice, occasionally during a market session. If the investor does not meet margin callswithin the required time limit, its position may be liquidated and the investor will be liable forany debit balance on its account.

Losses may therefore be far greater than the margin initially deposited with the clearing house or

than the premium exchanged.2. Liquidity and price fluctuations: Derivatives markets can be illiquid. If the market is notsufficiently liquid, the investor may be unable to liquidate or even partially close out a futuresposition at the desired time. In addition, the difference between the bid price and the offer priceof a given contract may be significant.


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Prices on derivatives markets can fluctuate considerably, depending on a number of factors thatare difficult to forecast. The price and liquidity of any investment depends upon the availabilityand value of the underlying asset, which can be affected by a number of extrinsic factors

including, but not limited to, political, environmental and technical. Such factors can also affectthe ability to settle or perform on time or at all. The impact of these events on the liquidity andprices increases as the maturity date is near.

3. Orders aimed at limiting a loss (stop-limit, stop-loss): Trading conditions on futures marketsallow investors to place orders with a stop-limit price and orders with a trigger threshold, whichare also referred to as stop orders. These orders were designed to limit losses that could occuras a result of market fluctuations. The use of such orders does not provide a guarantee that losseswill be limited to the intended amounts. Placing contingent orders, such as "stop-loss" or "stop-limit" orders, will not necessarily limit its losses to the intended amounts, since marketconditions on the exchange where the order is placed may make it difficult or impossible to

execute such orders.4. Commission, fees and taxes: All charges relating to a futures transaction reduce the investor'sprofit or increase its loss. Commission, agreed upon between the broker and investor, is paid inaddition to the fees due to the markets and clearing houses. Before concluding a transaction,investors must be informed of all fees and costs to be paid. Any payments made or received inrelation to any investment may be subject to tax and the Client should seek professional advice inthis respect.

5. Seller and buyer obligations : Transactions in derivative products involve the obligation tomake, or to take, delivery of the underlying asset of the contract at a future date, or in some cases

to settle the position with cash, in accordance with the applicable market conditions.(a) Obligation to deliver :Unless it is able to offset its position before the delivery dateand thereby free itself from its obligation, the seller of a futures contract or a call optionmay be required to deliver a predetermined quantity of the underlying instrument, inaccordance with the relevant market and clearing house rules. The terms and conditionsof trading require the seller to deliver the underlying asset in accordance with thecharacteristics of the contract. If the seller does not comply with this obligation, it mayrisk incurring additional costs and penalties.

(b) Obligation to take delivery :Unless it is able to offset its position before the

delivery date and thereby free itself from its obligation, the buyer of a futures contract orthe seller of put option must accept delivery of and pay for the underlying instrument, inaccordance with the relevant market and clearing house rules. It may have to pay anamount higher than the margin deposited with the clearing house.

For commodities, it may be required to agree to the necessary storage, to organisetransport and to take responsibility for any subsequent related costs. If the buyer is not the


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end buyer of the commodity or a trader in commodities of this type, it may encounterdifficulties relating to storage or sales, due to the fact that it cannot use the commodity inquestion. Furthermore, there is a risk of loss if it decides to sell the commodity on the

spot market.

The margin deposited by the buyer of a futures contract serves solely as a guarantee andis not valid for the partial execution of its obligations.

6. Option contracts : There are many different types of options with different characteristics.They are subject to the following conditions:

Buying options: Buying options involves less risk than selling options because, if theprice of the underlying asset moves against the Client, the Client can simply allow theoption to lapse. The maximum loss is limited to the premium, plus any commission or

other transaction charges. However, if the Client buys a call option on a futures contractand later exercises the option, it will acquire the future. This will expose the Client to therisks described in this document.

Writing (selling) options: If the Client writes an option, the risk involved is considerablygreater than buying options. The Client may be liable for margin to maintain its positionand a loss may be sustained well in excess of the premium received. By writing anoption, the Client accepts a legal obligation to purchase or sell the underlying asset if theoption is exercised against it however far the market price has moved away from theexercise price. If the Client already owns the underlying asset which it has contracted tosell (when the options will be known as covered call options) the risk is reduced. If the

Client does not own the underlying asset (uncovered call options) the risk can beunlimited. Only experienced persons should contemplate writing uncovered options, andthen only after securing full details of the applicable conditions andpotential risk exposure.

7. Derivative instruments and the spot market : It is important to understand the relationshipbetween prices of derivative products and those of the spot market. Although market forces tendto balance prices on derivatives markets against those on spot markets for a given underlyinginstrument, thereby neutralising any differences on the delivery date, many factors linked to themarket, including supply and demand, may have the effect of maintaining differences.

8. Non-fungibility of contracts : Calyon Financial is a Trader/Clearing Agent specialising in thederivatives markets. As such, the orders we execute on behalf of our clients are carried out onregulated markets and in some cases on over-the-counter markets.

Cases in which the same instrument can be traded on different markets, and where twoinstruments are fungible, are exceptional.


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Before placing an order relating to a product and prior to selecting a market, the client mustassess the market and its historical performance in order to take into account, in particular, its

liquidity.

Where the Client is unable to transfer a particular instrument which it holds, to exit itscommitment under that instrument, the Client may have to offset its position by either buyingback a short position or selling a long position. Such an offsetting transaction may have to beover the counter and the terms of such a contract may not match entirely those of the initialinstrument. For example, the price of such a contract may be more or less than the Clientreceived or paid for the sale or purchase of the initial instrument

9. Foreign markets and emerging markets : Foreign markets will involve different risks fromthe French markets. In some cases the risks will be greater. On request, Calyon Financial will

provide an explanation of the relevant risks and protections (if any) which will operate in anyforeign markets, including the extent to which it will accept liability for any default of a foreignfirm through whom it deals. The potential for profit or loss from transactions on foreign marketsor in foreign denominated contracts will be affected by fluctuations in foreign exchange rates.Such transactions may also be affected by exchange controls that could prevent or delayperformance.

10. Clearing houses : On many markets, the performance of a transaction by Calyon Financial(or third party with whom Calyon Financial is dealing on the Clients behalf) is guaranteed bythe market or clearing house. However, this guarantee is unlikely in most circumstances to coverthe Client, and may not protect the Client if Calyon Financial or another party defaults on its

obligations to the Client. Not all markets act in the same way.11. Risk of default or insolvency : Calyon Financial insolvency or default, or that of any otherbrokers involved with the Clients transaction, may lead to positions being liquidated or closedout without the Clients consent. In certain circumstances, the Client may not get back the actualassets which it lodged as collateral and the Client may have to accept any available payments incash. On request, Calyon Financial must provide an explanation of the extent to which it willaccept liability for any insolvency of, or default by, other firms involved with the Clients.

12. Calyon Financial policy with regard to clients classified as non-professional clients:Non-professional clients will be only allowed to trade commodity derivative products for hedging

purposes.13. General information: Futures contracts are not subject to a prospectus.

Exchange-traded futures and options may give rise to liabilities for the investor, calculated inaccordance with market or clearing house rules.


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Calyon Financial may not deal directly in the relevant market but may act through one or more brokers or intermediaries. In such cases, the Clients positions may be affected by theperformance of those third parties in addition to the performance of Calyon Financial.

In addition, settlement of such transactions may not be effected via the market itself but may beeffected on CFs books or of a broker or intermediary if such transactions can be crossed withequal but opposite orders of another participant transacting through the same firm, broker orintermediary.

The Clients rights in such circumstances differ from those it would enjoy if its transaction waseffected in the market.

Q.3 What do you understand by industry (give examples)? What is importance of industrylife cycle? Is it possible to asses the intrinsic value of security?

Ans;- Industry refers to the people or companies engaged in a particular kind of commercialenterprise. It is described it as the manufacturing of a good or service within a category. It is thesecondary sector in economics, also coming under the private sector.

Industry has been divided into four major sectors. Economies tend to follow a developmentalprogress that takes them from a heavy reliance to agriculture and mining to manufacturingindustry, and then move on to a more service based economy.

1. Primary sector: mainly includes raw material extraction industries such as mining andfarming. It is mainly the conversion of natural resources into primary products that are used asraw material by other industries. The manufacturing industries that aggregate, package, purify orprocess the raw material near the primary producers are normally considered part of this sector,especially if the raw material is unsuitable for use in its original form, or if it is difficult totransport it to long distances. Developing countries are more dependent on this sector. Indeveloped the same sector becomes more mechanized and high-tech, requiring smallermanpower. Hence, while developing countries have a major part of the workforce involved inthis industry, the developed countries have a higher percentage involved in secondary andtertiary sectors as compared to the primary sector.

2. Secondary sector: involves refining, construction, and manufacturing. This sector creates afinished and useable product. The sector is divided into light and heavy industry. The sectorconsumes large amount of energy and needs factories and often heavy machinery to convert rawmaterial into a finished product. These also produce large amount of waste product in theprocess, often environmentally hazardous. However, manufacturing is an important part ofeconomic growth and development. It increases export possibilities, thus improving GDP of the


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country. This ion turn funds infrastructure in the economy and health facilities, among other lifeinitiatives. This sector is more open to international trade and competition than service.

3. Tertiary sector: deals with services (such as law and medicine) and distribution ofmanufactured goods. When contrasted to the wealth producing sectors like secondary andprimary sectors, tertiary sector is a wealth consuming sector. When the wealth consuming andwealth producing sectors are balanced, the economy grows, but if the tertiary sector grows biggerthan the first two, the economy declines. Service sector, as it is called, offers services or'intangible goods'. The services are provided to businesses and final consumers. It may involvedistribution or transport and sales of goods from producer to consumer. This sector also includesthe soft parts of the economy such as the insurance, tourism, banking, education, retail.Typically, the output is in the form of content (info), advice, service, attention experience ordiscussion. Service economy refers to a model where as much economic activity as possible istreated as service.

4. Quaternary sector: knowledge industry focusing on technological research, design anddevelopment such as computer programming, and biochemistry. It is a comparatively newdivision. It is an extension of the three-sector hypothesis of industrial evolution. It principallyconcerns the intellectual services: information generation, information sharing, consultation,education and research and development. It is sometimes incorporated into the tertiary sector butmany argue that intellectual services are distinct enough to warrant a separate sector.Entertainment is also an important part of this sector.

Importance of Industry life cycle

An industry lifecycle is a series of stages of development an industry moves through, from thetime of emergence to an eventual decline. Like biological lifecycles, industry lifecycles areinevitable and they can be easily followed and projected. Innovation and other measures canprolong an industry's life cycle, but ultimately companies must be prepared to be adaptable toadjust to changing business, industry, and economic climates. Without flexibility, businesses cango bankrupt when the industry lifecycle catches up with them.

The industry life cycle is made up of the following stages:


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Pioneering Stage: During this stage the market for the industrys product or service is small, thefirm or firms involved have to incur major development costs both in regard to the productand in regard to the market. The product is yet to be proved in the commercial market.

Hence, the industry experiences modest sales growth and very small or negative profitmargins and profits.

Rapidly accelerating industry growth: This stage starts when the product of the industry isaccepted by the market. Further demand increases rapidly. The number of firms in theindustry is limited at this stage and hence the firms can experience substantial backlogs oforders. Hence prices can be increased or discounts can be decreased and therefore profitmargins are high. The capacity utilization goes up and even though productive capacity isincreased, sales increase more rapidly. Hence high profit margins occur simultaneouslywith high sales growth. Profits explode. Sales growth can be high up to even 50 percentyear and profits can grow over 100 percent a year as a result of the low earnings base and

high profit margins and increasing efficiency of the firms.Mature industry growth: During mature growth stage, the rapid growth in sales comes down

match the growth industry definition. The definition of growth industry is that it has agrowth rate which is double that of economy. Growth no longer accelerates. The rapidgrowth attracts more number of firms, which causes an increase in supply and lower prices.This will force margins to decline from the levels witnessed in accelerating growth phase.

Stabilization and market maturity: This phase could the longest phase for the industry. Thegrowth now becomes approximately equal to the growth rate in the economy. Competitionproduces tight profit margins and rates of return on capital are competitive. There will bedifferences in profitability of industries as well as in profitability of companies due to

competitive structure and ability to control costs.

Decline: In this stage first the growth rates decline below that of growth in the economy.Substitutes offering better output may appear at this stage. Profit margins get squeezed andsome firms experience low profits or even losses.

Intrinsic value of securities

After studying the conditions and the outlook for the economy, the industry, and the company,the fundamental analyst determines the intrinsic value of a security. This estimated intrinsicvalue can then be compared to the current market price of the security. The fundamental analyst

thus determines whether the company is overvalued or undervalued, if a share is undervalued ,then the fundamental analyst will buy it, and hold it until other investors in the market realize itsvalue, and push it towards its fair share price by increasing demand on it. On the other hand, if ashare is over priced in the market in comparison with its intrinsic value, then fundamental analystwill only buy the share after the share price declines, or will, alternatively, sell the shares thatthey already hold of that stock. By this, the fundamental analyst aim to capitalize on perceivedprice discrepancies between the market prices of stocks and the intrinsic value of company


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shares. In other words, investors using fundamental analyst make use of the valuation gapbetween the intrinsic value of stocks, and reap capital gains when price corrections take place inthe market in the long run.

In equilibrium, the current market price of a security reflects the average of the intrinsic valueestimates made by all the investors. An investor whose intrinsic value estimate differs from themarket price is, in effect, differing from the market consensus as to the estimate of eitherexpected return or risk, or both. Investor who can perform good fundamental analysis and spotdiscrepancies should be able to profit by acting before the market consensus reflects the correctinformation.

Q. 4 Is there any logic behind technical analysis? Explain meaning and basic tenets of

technical analysis.

Answer: Technical analysis is a method that is used to evaluate the worth of a security byanalyzing the statistics that are generated by market activity, such as past prices and volume.Technical analysts do not attempt to measure a security's intrinsic value, as is done by thefundamental analyst, but instead use charts and other tools to identify patterns that can suggestfuture activity.

Meaning and Basic Tenets

Unlike fundamental analysts, technical analysts don't care whether a stock is undervalued or not -the only thing that matters to them is a security's past trading data and what information that thisdata can provide about where the security is moving in the future. Technical analysis disregardsthe financial statements of the issuer (the company that has issued the security). Instead, it relies

upon market trends to ascertain investor sentiments that can be used to predict how a securitywill perform.

Technicians, chartists or market strategists (as they are variously known), believe that there aresystematic statistical dependencies in asset returns - that history tends to repeat itself. They make price predictions on the basis of price and volume data, looking for patterns and possiblecorrelations, andapplying rules of thumb to charts to assess 'trends', 'support' and 'resistance levels'. From these,they develop buy and sell signals.

The field of technical analysis is based on three assumptions:

1. The market discounts everything: Technical analysis assumes that, at any given point intime, a security's price incorporates all the factors that can impact the price including thefundamental factors. Technical analysts believe that the company's fundamentals, along with broader economic factors and market psychology are all built into the security price andtherefore there is no need to study these factors separately. Thus the analysis is confined to ananalysis of the price movement. Technical analysis considers the market value of a security to be


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solely determined by supply and demand.

2. Price moves in trends: Technical analysis believes that the security prices tend to move in

trends that persist for long periods of time. This means that after a trend has been established, thefuture price movement is more likely to be in the same direction as the trend than to be against it.Any shifts in supply and demand cause reversals in trends. These shifts can be detected incharts/graphs.

3. History tends to repeat itself: History tends to repeat itself, mainly in terms of pricemovements. Many chart patterns tend to repeat themselves. Market psychology is considered tobe the reason behindthe repetitive nature of price movements: market participants react in a consistent manner tosimilar market stimuli over a period of time. Technical analysis is based on the assumption thatmarkets are driven more by psychological factors than fundamental values. Its proponents

believe that asset prices reflect not only the underlying 'value' of the assets but also the hopes andfears of those in the market. They assume that the emotional makeup of investors does notchange, that in a certain set of circumstances, investors will react in a similar manner to how theydid in the past and that the resultant price moves are likely to be the same. Technical analysts usechart patterns to analyze market movements and to predict security prices.

Although many of these charts have been used for more than 100 years, technical analystsbelieve them to be relevant even now, as they illustrate patterns in price movements that oftenrepeat themselves. Technical analysis can be applied to any security which has historical tradingdata. This includes stocks, bonds, futures, foreign exchange etc.

Q.2 Explain role played by efficient market in economy. Apply the parameters of efficientmarket to Indian stock markets and find out whether they are efficient.

Answer: In finance, the efficient-market hypothesis (EMH) asserts that financial markets are"informationally efficient". That is, one cannot consistently achieve returns in excess of averagemarket returns on a risk-adjusted basis, given the information publicly available at the time theinvestment is made.

There are three major versions of the hypothesis: "weak", "semi-strong", and "strong". WeakEMH claims that prices on tradedassets (e.g., stocks,bonds, or property) already reflect all past publicly availableinformation. Semi-strong EMH claims both that prices reflect all publiclyavailable information and that prices instantly change to reflect new public information. StrongEMH additionally claims that prices instantly reflect even hidden or "insider" information. Thereis evidence for and against the weak and semi-strong EMHs, while there is powerful evidenceagainst strong EMH.
http://en.wikipedia.org/wiki/Financehttp://en.wikipedia.org/wiki/Financial_marketshttp://en.wikipedia.org/wiki/Stock_market#United_States_stock_market_returnshttp://en.wikipedia.org/wiki/Risk-weighted_assethttp://en.wikipedia.org/wiki/Assetshttp://en.wikipedia.org/wiki/Assetshttp://en.wikipedia.org/wiki/Stockshttp://en.wikipedia.org/wiki/Bondshttp://en.wikipedia.org/wiki/Bondshttp://en.wikipedia.org/wiki/Informationhttp://en.wikipedia.org/wiki/Informationhttp://en.wikipedia.org/wiki/Financial_marketshttp://en.wikipedia.org/wiki/Stock_market#United_States_stock_market_returnshttp://en.wikipedia.org/wiki/Risk-weighted_assethttp://en.wikipedia.org/wiki/Assetshttp://en.wikipedia.org/wiki/Stockshttp://en.wikipedia.org/wiki/Bondshttp://en.wikipedia.org/wiki/Informationhttp://en.wikipedia.org/wiki/Finance


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The validity of the hypothesis has been questioned by critics who blame the belief in rationalmarkets for much of the financial crisis of 20072010. Defenders of the EMH caution thatconflating market stability with the EMH is unwarranted; when publicly available information is

unstable, the market can be just as unstable.

The (now largely discredited) theory that all market participants receive and act on all of therelevant information as soon as it becomes available. If this were strictly true, no investmentstrategy would be better than a coin toss. Proponents of the efficient market theory believe thatthere is perfect information in the stock market. This means that whatever information isavailable about a stock to one investor is available to all investors (except, of course, insiderinformation, but insider trading is illegal). Since everyone has the same information about astock, the price of a stock should reflect the knowledge and expectations of all investors. Thebottom line is that an investor should not be able to beat the market since there is no way forhim/her to know something about a stock that isn't already reflected in the stock's price.Proponents of this theory do not try to pick stocks that are going to be winners; instead, theysimply try to match the market'sperformance. However, there is ample evidence to dispute thebasic claims of this theory, and most investors don't believe it.

Studies on Indian Stock Market Efficiency

The efficient market hypothesis is related to the random walk theory. The idea that asset pricesmay follow a random walk pattern was introduced by Bachelier in 1900. The random walkhypothesis is used to explain the successive price changes which are independent of each other.Fama (1991) classifies market efficiency into three forms - weak, semi-strong and strong. In its

weak form efficiency, equity returns are not serially correlated and have a constant mean. Ifmarket is weak form efficient, current prices fully reflect all information contained in thehistorical prices of the asset and a trading rule based on the past prices can not be developed toidentify miss-priced assets. Market is semi-strong efficient if stock prices reflect any new publicly available information instantaneously. There are no undervalued or overvaluedsecurities and thus, trading rules are incapable of producing superior returns. When newinformation is released, it is fully incorporated into the price rather speedily. The strong formefficiency suggests that security prices reflect all available information, even private information.Insiders profit from trading on information not already incorporated into prices. Hence the strongform does not hold in a world with an uneven playing field. Studies testing market efficiency in

emerging markets are few. Poshakwale (1996) showed that Indian stock market was weak forminefficient; he used daily BSE index data for the period 1987 to 1994. Barua (1987), Chan, Gupand Pan (1997) observed that the major Asian markets were weak form inefficient. Similarresults were found by Dickinson and Muragu (1994) for Nairobi stock market; Cheung et al(1993) for Korea and Taiwan; and Ho and Cheung (1994) for Asian markets. On the other hand,Barnes (1986) showed a high degree of efficiency in Kuala Lumpur market. Groenewold and
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Kang (1993) found Australian market semi-strong form efficient. Some of the recent studies,testing the random walk hypothesis (in effect testing for weak form efficiency in the markets)are; Korea (Ryoo and Smith, 2002; this study uses a variance ratio test and find the market to

follow a random walk process if the price limits are relaxed during the period March 1988 to Dec1988), China, (lee et al 2001; find that volatility is highly persistent and is predictable, authorsuse GARCH and EGARCH models in this study), Hong Kong (Cheung and Coutts 2001; authorsuse a variance ratio test in this study and find that Hang Seng index on the Hong Kong stockexchange follow a random walk), Slovenia (Dezlan, 2000), Spain (Regulez and Zarraga, 2002),Czech Republic (Hajek, 2002), Turkey (Buguk and Brorsen, 2003), Africa (Smith et al. 2002;Appiah-kusi and Menyah, 2003) and the Middle East (Abraham et al. 2002; this study usesvariance ratio test and the runs test to test for random walk for the period 1992 to 1998 and findthat these markets are not efficient).

METHODOLOGY & DATA:- To test historical market efficiency one can look at the patternof short-term movements of the combined market returns and try to identify the principal processgenerating those returns. If the market is efficient, the model would fail to identify any patternand it can be inferred that the returns have no pattern and follow a random walk process. Inessence the assumption of random walk means that either the returns follow a random walkprocess or that the model used to identify the process is unable to identify the true returngenerating process. If a model is able to identify a pattern, then historical market data can beused to forecast future market prices, and the market is considered not efficient. There are anumber of techniques available to determine patterns in time series data. Regression, exponential

smoothing and decomposition approaches presume that the values of the time series beingpredicted are statistically independent from one period to the next. Some of these techniques arereviewed in the following section and appropriate techniques identified for use in this study.

Runs test (Bradley 1968) and LOMAC variance ratio test (Lo and MacKinlay 1988) are used totest the weak form efficiency and random walk hypothesis. Runs test determines if successiveprice changes are independent. It is non-parametric and does not require the returns to benormally distributed. The test observes the sequence of successive price changes with the samesign. The null hypothesis of randomness is determined by the same sign in price changes. Theruns test only looks at the number of positive or negative changes and ignores the amount of

change from mean. This is one of the major weaknesses of the test. LOMAC variance ratio test iscommonly criticised on many issues and mainly on the selection of maximum order of serialcorrelation (Faust, 1992). Durbin-Watson test (Durbin and Watson 1951), the augmentedDickey-Fuller test (Dickey and Fuller 1979) and different variants of these are the mostcommonly used tests for the random walk hypothesis in recent years (Worthington and Higgs2003; Kleiman, Payne and Sahu 2002; Chan, Gup and Pan 1997). Under the random walk


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hypothesis, a market is (weak form) efficient if most recent price has all available informationand thus, the best forecaster of future price is the most recent price. In the most stringent versionof the efficient market hypothesis, t is random and stationary and also exhibits no

autocorrelation, as disturbance term cannot possess any systematic forecast errors. In this studywe have used returns and not prices for test of market efficiency as expected returns are morecommonly used in asset pricing literature (Fama (1998). Returns in a market conforming torandom walk are serially uncorrelated, corresponding to a random walk hypothesis withdependant but uncorrelated increments. Parametric serial correlations tests of independence andnon-parametric runs tests can be used to test for serial dependence. Serial correlation coefficienttest is a widely used procedure that tests the relationship between returns in the current periodwith those in the previous period. If no significant autocorrelation are found then the series areexpected to follow a random walk. A simple formal statistical test was introduced was Durbinand Watson (1951). Durbin-Watson (DW) is a test for first order autocorrelation. It only tests forthe relationship between an error and its immediately preceding value. One way to motivate thistest is to regress the error of time t with its previous value.

ut = ut-1 + vt where vt ~ N(0,2v).

DW test can not detect some forms of residual autocorrelations, e.g. if corr(ut, ut-1) = 0 butcorr(ut, ut-2) 0, DW as defined earlier will not find any autocorrelation. One possible way is todo it for all possible combinations but this is tedious and practically impossible to handle. Thesecond-best alternative is to test for autocorrelation that would allow examination of the

relationship between ut and several of its lagged values at the same time. The Breusch- Godfreytest is a more general test for autocorrelation for the lags of up to rth order.

Because of the abovementioned weaknesses of the DW test we do not use the DW test in ourstudy. An alternative model which is more commonly used is Augmented Dickey Fuller test(ADF test). Three regression models (standard model, with drift and with drift and trend) areused in this study to test for unit root in the research, (Chan, Gup and Pan 1997; Brooks 2002). Inthis study we followed the test methodologies from Brooks (2002) with slight adjustments.


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Where: St = the stock price u* and u** = the drift terms T = total number of observations t, t*,t** = error terms that could be ARMA processes with time dependent variances.

Where St is the logarithm of the price index seen at time t, u is an arbitrary drift parameter, isthe change in the index and t is a random disturbance term. Equation (3) is for the standardmodel; (4) for the standard model with a drift and (5) for the standard model with drift and trend.Augmented Dickey-Fuller (ADF) unit root test of nonstationarity is conducted in the form of thefollowing regression equation. The objective of the test is to test the null hypothesis that = 1 in:

against the one-sided alternative < 1. Thus the hypotheses to be tested are:

H0: Series contains a unit root against H1: Series is stationary

In this study we calculate daily returns using daily index values for the Mumbai Stock Exchange(BSE) and National Stock Exchange (NSE) of India. The data is collected from the Datastreamdata terminal from Macquarie University. The time period for BSE is from 24th May 1991 to26th May 2006 and for NSE 27th May to 26th May 2006. Stock exchanges are closed for tradingon weekends and this may appear to be in contradiction with the basic time series requirementthat observations be taken at a regularly spaced intervals. The requirement however, is that thefrequency be spaced in terms of the processes underlying the series. The underlying process of

the series in this case is trading of stocks and generation of stock exchange index based on thestock trading, as such for this study the index values at the end of each business day isappropriate (French 1980). Table 1 presents the characteristics of two data sets used in this study.During the period covered in this study, the mean return of the NSE index is much lower thanthat of the BSE, similarly the variance of NSE is lower as compared with BSE index suggestinga lower risk and a lower average return at NSE as compared with BSE. It is relevant to note thatNSE was established by the government of India to improve the market efficiency in Indianstock markets and to break the monopolistic position of the BSE. NSE index is a morediversified one as compared to the same of BSE. This can also be due to the unique nature ofIndias equity markets, the settlement system on BSE was intermittent (Badla system up until

2nd July 2001) and on NSE it was always cash.


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RESULTS:- This study conducts a test of random walk for the BSE and NSE markets in India,using stock market indexes for the Indian markets. It employs unit root tests (augmented Dickey-Fuller (ADF)). We perform ADF test with intercept and no trend and with an intercept and trend.

We further test the series using the Phillips-Perron tests and the KPSS tests for a confirmatorydata analysis. In case of BSE and NSE markets, the null hypothesis of unit root is convincinglyrejected, as the test statistic is more negative than the critical value, suggesting that these marketsdo not show characteristics of random walk and as such are not efficient in the weak form. Wealso test using Phillip-Perron test and KPSS test for confirmatory data analysis and find theseries to be stationary. Results are presented in Table 2. For both BSE and NSE markets, theresults are statistically significant and the results of all the three tests are consistent suggestingthese markets are not weak form efficient.

Results of the study suggest that the markets are not weak form efficient. DW test, which is a test

for serial correlations, has been used in the past but the explanatory power of the DW can bequestioned on the basis that the DW only looks at the serial correlations on one lags as such maynot be appropriate test for the daily data. Current literature in the area of market efficiency usesunit root and test of stationarity. This notion of market efficiency has an important bearing forthe fund managers and investment bankers and more specifically the investors who are seekingto diversify their portfolios internationally. One of the criticisms of the supporters of theinternational diversification into emerging markets is that the emerging markets are not efficientand as such the investor may not be able to achieve the full potential benefits of the internationaldiversification.

CONCLUSIONS & IMPLICATIONS:- This paper examines the weak form efficiency in twoof the Indian stock exchanges which represent the majority of the equity market in India. Weemploy three different tests ADF, PP and the KPSS tests and find similar results. The results ofthese tests find that these markets are not weak form efficient. These results support the commonnotion that the equity markets in the emerging economies are not efficient and to some degreecan also explain the less optimal allocation of portfolios into these markets. Since the results of


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the two tests are contradictory, it is difficult to draw conclusions for practical implications or forpolicy from the study. It is important to note that the BSE moved to a system of rollingsettlement with effect from 2nd July 2006 from the previously used Badla system. The

Badla system was a complex system of forward settlement which was not transparent and wasnot accessible to many market participants. The results of the NSE are similar (NSE had a cashsettlement system from the beginning) to BSE suggesting that the changes in settlement systemmay not significantly impact the results. On the contrary a conflicting viewpoint is that theresults of these markets may have been influenced by volatility spillovers, as such the resultsmay be significantly different if the changes in the settlement system are incorporated in theanalysis. The research in the area of volatility spillover has argued that the volatility istransferred across markets (Brailsford, 1996), as such the results of these markets may beinterpreted cautiously. For future research, using a computationally more efficient model likegeneralized autoregressive conditional heteroskesdasticity (GARCH) could help to clear this.

Q. 6 What do you understand by yield? Explain the concept of YTM with the help of

example Fall 2010

Answer: Yield is a term that defines a return on a capital investment of various forms. Typically,yield is expressed as a percentage and is used as an annual figure. An example of yield would bean investment inreal estate or a business deal that generates a ten percent return. It is then saidthat that investment yielded a ten percent return. In the stock market yield essentiallycommunicates a rate of return made form an investment in common and preferred stocks. Thisparticular yield comes in form of a dividend and is also called a dividend yield. Yield is also a

function of the bond market. One of its applications is current yield, which is a coupon rate ofinterest divided by the bond's purchase price. Additionally, yield is a rate of return on a bond thattakes into account the sum annual interest payment, the purchase price, the redemption value, aswell as the time period remaining until maturity. This is also referred to as maturity yield oryieldto maturity.

Yield To Maturity (YTM)

The yield to maturity is the annual rate of return that a bondholder will earn under theassumption that the bond is held to maturity and the interest payments are reinvested at the

YTM. The yield to maturity is the same as the bonds internal rate of return (IRR). The yield tomaturity or simply the yield is the discount rate that equates the current market price of the bondwith the sum of the present value of all cash flows expected from this investment.

T

Market price = Coupon + per value
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=1 (1+ytm)t (1+ytm)T

In the yield to maturity calculations, the market price of the bond is given, and we have tocalculate the discount rate or the YTM that will equate the present values of all the couponpayments and the principal repayment to the current market price of the bond.

To calculate YTM, we use trial and error until we get a discount rate that equate the presentvalue of coupon payments and principal repayments to the current market price of the bond. Wecan also use approximation formula for calculating the yield to maturity.

Coupon

+ (Face value - Price)yiel

d=

Maturity

(Price + Face value)

2

Example: Suppose a company can issue 9% annual coupon, 20 year bond with a face value ofRs.1000 fro Rs. 980. What is the yield-to-maturity on this bond?

Coupon = 9& X Rs. 1000 = Rs. 90

Face Value = Rs. 1000

Price = Rs. 980

Maturity = 20 year

Yield

= 90 + ( 1000 - 980) / 20( 1000 + 980 ) / 2

= 91 / 990

= .0919 or 9.19 %


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Q. 1 Explain basic steps involved in PM. What is difference between PM and a Mutual

Fund? What are various types of risk associated with PM?

Ans:- Portfolio management is challenging, but it's also exciting. Some people prefer to

have their portfolios managed by a professional. However, it's not impossible to

manage your own portfolio. It just takes time and a basic understanding of the

process.

Portfolio management involves 6 steps in an ongoing process.

1. Determine Objectives/Constraints2. Formulate a Strategy3. Design an Investment Policy4. Implement Asset Allocation5. Monitor Performance

6. Evaluate Performance

As an ongoing process, it is the responsibility of the portfolio manager (whether that's you or aprofessional) to go through the process (beginning at "Determine Objectives and Constraints")and upon reaching the "Evaluate Performance" stage, start again.

Why is it an ongoing process? Because life is not static. People move, they change jobs, they getmarried, they get divorced, they get remarried, they have children, they make large purchases,they make wise decisions, they make unwise decisions, they are faced with windfalls andtragedies. Each of those (and many, many other) events will affect how they manage their

portfolio.

very individual has different needs and wants. The first step to successfully manage yourinvestment needs is to identify them by drafting an investment plan. This plan should state yourgoals. It is simply a mission statement of what you endeavor to achieve. Be as specific as youcan, so that you can determine what to invest in, and how your portfolio will be structured torealize your dream.


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Knowing yourself is critical to creating and managing a portfolio that will do what you want it to

do. This knowledge will help you set realistic future financial goals and will help you to decidehow much risk to include in your investment strategy

There are several constraints that may work against your desire to build up a healthy nest egg.These are all challenges of having money. Unfortunately, many of them are unavoidable butthat doesn't mean that they're not manageable. The best thing to do is know that they exist anddevelop strategies to help you over come them. Some of the considerations include evaluatingyour Risk & Return Profile, Investment Time Horizon, Liquidity Requirement, Legal andTaxation Structure, etc.

And also, do you remember the popular saying, "Don't put all your eggs in one basket" ? Thereason why you should achieve diversification in your portfolio is that the value of different assetclasses tends to behave and perform very differently. Some assets move in tandem or in a similardirection with each other, while others move in opposite directions. What may surprise you isthat for the same rate of return, you can actually combine different asset classes to achieve thisexpected return. Thus the secret to successful portfolio management is to create a portfolio byinvesting in different types of asset classes, that generate the lowest risk factor to achieve yourinvestment objectives.

As you manage your portfolio, different factors will have an effect on its performance. Theeconomy, for example, may go up or down and cause the value of your holdings to rise or fall.Perhaps you followed some advice from a friend on a "can't lose" stock and ended up losing.Whatever the case may be, it is crucial to monitor the performance of your portfolio at all timesso that you can react if something happens.

We will review the 6 steps in our upcoming series of articles and I really hope you will benefitfrom it.

Difference between PM and a Mutual Fund

Portfolio means collection of investment allowed by company or individual person .orcombination of various investments. the combination may be equity shares and prefrencce sharesand bonds and mutual funds,

Mutual fund is a one of the financial service. Collecting saving from the public and the savingswill be investment in different companies stocks, bonds and debenchers.this function done byfund manager.


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While the concept remains the same of collecting money from investors, pooling them andinvesting the funds, the target investors are different. In the case of portfolio management thetarget investors are high networth investors while in case of mutual funds the target investors are

the retail investors.

Features PM Mutual Fund

Management Provide ongoing, personalized access toprofessional money management services

Provide access to professionalmoney management services

Customization Portfolio can be tailored to address eachinvestor's specific needs

Portfolio structured to meet thefund's stated investment objectives

Management Provide ongoing, personalized access toprofessional money management services

Provide access to professionalmoney management services

Ownership Investors directly own the individualsecurities in their portfolio, allowing for taxmanagement flexibility

Shareholders own shares of thefund and cannot influence buy andsell decisions or control theirexposure to incurring tax liabilities

Liquidity Although managers may hold cash, they arenot required to hold cash to meet redemptions

Mutual funds generally hold somecash to meet redemptions

Minimums Significantly higher minimum investmentsthan mutual funds. Generally, minimumranges from:

Rs. 1 Crore + for Equity Options Rs. 5 Crore + for Fixed IncomeOptions

Rs. 20 Lacs + for Structured Products

Provide ongoing, personalizedaccess to professional moneymanagement services

Flexibility Generally more flexible than mutual funds.The Portfolio Manager may move to 100%cash if required.The Portfolio Manager may take his owntime in building up the portfolio. ThePortfolio Manager can also manage a

portfolio with disproportionate allocation toselect compelling opportunities

Comparatively less flexible

Mutual funds and PM are the two SEBI approved investment alternatives in India. A mutual fundpools the assets of a large number of investors into one scheme and all the investors' money is


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collectively managed. A PM treats each client as an individual client, and tailors a portfolio forthe client's individual needs. A PM investment is made in the individual client's name.

Mutual funds are a more regulated structure that provides a common portfolio to all investors,while PM is a more flexible, but still regulated structure, where the investment depends on theagreement with the client. Mutual fund investments cater to individuals with smaller ticket sizes(under Rs 5 lakh) while PM investments cater to individuals with more money to invest.

Risk associated with Portfolio Management: Risk is the uncertainly that you may not earnyour expected return on your investments. For example, you may expect to earn 20% on yourequity mutual fund every year., but your actual rate of return may be much lower . Major typesof risk include:

Investment riskis the possibility that your investment value will fall. Standard deviationis commonly used to measure investment risk. It shows a stock or bonds volatility, orthe tendency of its price to move up and down from its average. As standard deviationincreases, so does the investment risk.

Market riskis the chance that the entire market will decline, thus affecting the pricesand values of securities. Market risk, in turn, is influenced by outside factors such asembargoes and interest rate changes.

Interest rate riskis the risk that interest rates will rise, resulting in a current investment'sloss of value. A bondholder, for example, may hold a bond earning 6% interest and thensee rates on that type of bond climb to 7%.

Inflation riskis the danger that the dollars one invests will buy less in the future becauseprices of consumer goods rise. When the rate of inflation rises, investments have lesspurchasing power. This is especially true with investments that earn fixed rates of return.As long as they are held at constant rates, they are threatened by inflation. Inflation risk istied to interest rate risk, because interest rates often rise to compensate for inflation.

Industry riskis the chance that a specific industry will perform poorly. When problems plague one industry, they affect the individual businesses involved as well as thesecurities issued by those businesses. They may also cross over into other industries. Forexample, after a national downturn in auto sales, the steel industry may suffer financially.

Credit Riskis the possibility that a company that issues bonds is unable to make thecontractual coupon and/or principal payments and default on its debt.


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Liquidity riskis the possibility that your investment in a security (stock or bond) cannotbe sold easily in the market because of a lack of buyers. Such a security is called a thinlytraded security. As a result of a lack of liquidity, you may have to sell your investment at

a price below its fair value.

Prepayment risk is the possibility that borrowers repay debt ahead of schedule. As aresult, investors are repaid sooner that expected and have to reinvest these prepayments ata rate which is lower than what they has been receiving on their debt instruments earlier.Borrowers prepay and refinance their debt when interest rates decline.

Q. 2 Explain with the help of example how is it possible to reduce risk associated with

portfolio with the help of diversification. Which risk are still bound to persist?

Ans: The total risk of a portfolio can be reduced by diversification: there is a reduction in the

size of the portfolios unique risk while the portfolios market risk remains approximately of thesame size.

Generally, the more diversified the portfolio (the larger the number of stocks in the portfolio),the smaller the proportion of each stock in the portfolio Xi. This does not cause any significantchange in the portfolio beta p, unless a deliberate attempt is made to include stocks with veryhigh or low betas.

The portfolio beta is an average of the beta of the portfolio stocks and there is no reason whyincreasing the diversification will cause the portfolio beta and therefore the market risk of theportfolio to either increase or decrease. However, an increase in diversification and therefore a

reduction in the proportion of each stock X I, leads to a reduction in the unique risk and in turn,the total risk of portfolio.

Example:

Consider 3 securities A, B and C with the following betas and standard deviation of randomerror terms:

A: = 1.2, = 6.06 %

B: = 0.8, = 4.76 %

C: = 1.0, = 5.5 %

The variance and the standard deviation of returns of the three stocks, A, B and C are:

A

Market risk = 2M2= 0.0092 =1.2 2 X 0.08 2


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Unique risk= 2= 0.0037 =0.0606 2Total risk= 0.0129Standarddeviation= 0.0129= 0.1136 Or 11.36%

B

Market risk = 2M2= 0.0041 =0.8 2 X 0.08 2


C

Market risk = 2M2= 0.0064 =1 ^ 2 X 0.08 2


Let us combine the stocks A and B in a portfolio where each has a proportion of 0.5 and C has a

proportion of 0 (i.e. C is not present in the portfolio).

The variance and standard deviation of this portfolio are :

Beta

Portfolio= x i i = 1 =0.5 X 1.2 + 0.5 X 0.8Market risk ofPortfolio= p 2M2= 0.0064 =1 X 0.08 2

Unique risk= x i2 2= 0.0015=0.055 ^ 2 X 0.0606 ^ 2 + 0.5 ^ 2 X0.0476 ^ 2

Total risk= 0.0079

Standarddeviation= 0.0079= 8.89%

Now, let us introduce C in the portfolio. Let each stock has an equal proportion of 0.33 in theportfolio.


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The variance and standard deviation of this portfolio are:

Beta of

Portfolio= x i i = 0.99 =0.33 X 1.2 + 0.33 X 0.8 + 0.33 X 1Market risk ofPortfolio= p 2M2= 0.0063 =0.99 X 0.08 2

Unique risk= x i2 2= 0.001 =0.33 ^ 2 X 0.0606 ^ 2 + 0.33 ^ 2 X0.0476 ^ 2 + 0.33 ^ 2 X 0.55 ^ 2

Total risk= 0.0073Standarddeviation= 0.0073= 8.54%

Thus we see that the introduction of the third stock reduces the variance ( from 0.0079 to 0.0073)and therefore, the total risk of the portfolio.

Risk are still bound to persist

It assumed that capital market is perfect. But this assumption is unrealistic. The capital marketbeing imperfect a discrepancy between the market values of levered and unleveled firms isbound to persist.

The risk of insolvency increases with the amount of debts in a levered firm. Due to the risk ofinsolvency and also due to the possibility of lower value of the assets in the event of insolvency,investment in this firm will be less attractive. Hence, its market value will persist at a low level.

It is assumed under this approach that investors borrow funds on personal account and invest inunleveled firm. This is an undesirable activity. The person indulging in personal leverage inplace of corporate leverage faces a greater risk. If the unleveled company goes bankrupt he losesnot only his own money but he will lose the borrowed fund also. For this reason personalleverage is rarely resorted to. Hence, switching over of investment from levered firm A tounleveled firm B does not take place; arbitrage does not operate.

The existence of transaction costs also interferes with the working of arbitrage. Because of thecosts involved in the buying and selling of securities a smaller amount of money will beavailable for new investment. Hence return on new investment will be low.


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Q.3 With the help of examples explain what is systematic (also called systemic) and

unsystematic risk? All said and done CAPM is not perfect , do you agree?

Answer: The total risk of a portfolio (indeed of a security) consists of two categories:

Systematic risk : In finance, systematic risk, sometimes called market risk, aggregate risk, orundiversifiable risk, is the riskassociated with aggregate marketreturns.

Systematic risk should not be confused with systemic risk, the risk of loss from somecatastrophic event that collapses the entire financial system.

It is the risk which is due to the factors which are beyond the control of the people working in the

market and that's why risk free rate of return in used to just compensate this type of risk inmarket. Interest rates, recession and wars all represent sources of systematic risk because theyaffect the entire market and cannot be avoided through diversification. Whereas this type of riskaffects a broad range of securities, unsystematic risk affects a very specific group of securities oran individual security. Systematic risk can be mitigated only by being hedged. Even a portfolioof well-diversified assets cannot escape all risk.

Example

Examples of systematic risk include uncertainty about general economic conditions, such asGNP, interest rates or inflation.

For example, consider an individual investor who purchases $10,000 of stock in 10biotechnology companies. If unforeseen events cause a catastrophic setback and one or twocompanies' stock prices drop, the investor incurs a loss. On the other hand, an investor whopurchases $100,000 in a single biotechnology company would incur ten times the loss from suchan event. The second investor's portfolio has more unsystematic risk than the diversifiedportfolio. Finally, if the setback were to affect the entire industry instead, the investors wouldincur similar losses, due to systematic risk.

Systematic risk is essentially dependent on macroeconomic factors such as inflation, interestrates and so on. It may also derive from the structure and dynamics of the market.

Systematic risk and portfolio management

Given diversified holdings of assets, an investor's exposure to unsystematic risk from anyparticular asset is small and uncorrelated with the rest of the portfolio. Hence, the contribution ofunsystematic risk to the riskiness of the portfolio as a whole may become negligible.
http://en.wikipedia.org/wiki/Financehttp://en.wikipedia.org/wiki/Market_riskhttp://en.wikipedia.org/wiki/Market_riskhttp://en.wikipedia.org/wiki/Financial_riskhttp://en.wikipedia.org/wiki/Financial_markethttp://en.wikipedia.org/wiki/Financial_markethttp://en.wikipedia.org/wiki/Systemic_riskhttp://en.wikipedia.org/wiki/Systemic_riskhttp://en.wikipedia.org/wiki/Financial_systemhttp://en.wikipedia.org/wiki/Financial_systemhttp://en.wikipedia.org/wiki/Stockhttp://en.wikipedia.org/wiki/Stockhttp://en.wikipedia.org/wiki/Financehttp://en.wikipedia.org/wiki/Market_riskhttp://en.wikipedia.org/wiki/Financial_riskhttp://en.wikipedia.org/wiki/Financial_markethttp://en.wikipedia.org/wiki/Systemic_riskhttp://en.wikipedia.org/wiki/Financial_systemhttp://en.wikipedia.org/wiki/Stock


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In thecapital asset pricing model, the rate of return required for an asset in market equilibriumdepends on the systematic risk associated with returns on the asset, that is, on the covariance of

the returns on the asset and the aggregate returns to the market.

Lenders to small numbers of borrowers (or kinds of borrowers) face unsystematic risk of default.Their loss due to default is credit risk, the unsystematic portion of which is concentration risk.

Unsystematic risk : By contrast, unsystematic risk, sometimes called specific risk, idiosyncraticrisk, residual risk, or diversifiable risk, is the company-specific or industry-specific risk in aportfolio, which is uncorrelated with aggregate market returns.

Unsystematic risk can be mitigated through diversification, and systematic risk can not be.This is the risk other than systematic risk and which is due to the factors which are controllableby the people working in market and market risk premium is used to compensate this type ofrisk.Total Risk = Systematic risk + Unsystematic Risk

The risk that is specific to an industry or firm. Examples of unsystematic risk include lossescaused by labor problems, nationalization of assets, or weather conditions. This type of risk canbe reduced by assembling a portfolio with significant diversification so that a single event affectsonly a limited number of the assets.

Company- or industry-specific risk as opposed to overall market risk; unsystematic risk can bereduced through diversification. As the saying goes, Don't put all of your eggs in one basket.Also known as specific risk, diversifiable risk, and residual risk.

Example

On the other hand, announcements specific to a company, such as a gold mining companystriking gold, are examples of unsystematic risk.

Risk: Systematic and Unsystematic

We can break down the risk, U, of holding a stock into two components: systematic risk andunsystematic risk:
http://en.wikipedia.org/wiki/Capital_asset_pricing_modelhttp://en.wikipedia.org/wiki/Capital_asset_pricing_modelhttp://en.wikipedia.org/wiki/Covariancehttp://en.wikipedia.org/wiki/Credit_riskhttp://en.wikipedia.org/wiki/Concentration_riskhttp://en.wikipedia.org/wiki/Modern_portfolio_theory#Asset_pricinghttp://en.wikipedia.org/wiki/Portfolio_(finance)http://en.wikipedia.org/wiki/Diversification_(finance)http://en.wikipedia.org/wiki/Diversification_(finance)http://en.wikipedia.org/wiki/Capital_asset_pricing_modelhttp://en.wikipedia.org/wiki/Covariancehttp://en.wikipedia.org/wiki/Credit_riskhttp://en.wikipedia.org/wiki/Concentration_riskhttp://en.wikipedia.org/wiki/Modern_portfolio_theory#Asset_pricinghttp://en.wikipedia.org/wiki/Portfolio_(finance)http://en.wikipedia.org/wiki/Diversification_(finance)


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CAPM is not perfect:-

The model assumes that either asset returns are (jointly) normally distributed random

variables or that investors employ a quadratic form of utility. It is however frequentlyobserved that returns in equity and other markets are not normally distributed. As a result,large swings (3 to 6 standard deviations from the mean) occur in the market morefrequently than the normal distribution assumption would expect.

The model assumes that the variance of returns is an adequate measurement of risk. Thismight be justified under the assumption of normally distributed returns, but for generalreturn distributions other risk measures (like coherent risk measures) will likely reflectthe investors' preferences more adequately. Indeed risk in financial investments is notvariance in itself, rather it is the probability of losing: it is asymmetric in nature.

The model assumes that all investors have access to the same information and agreeabout the risk and expected return of all assets (homogeneous expectations assumption).

The model assumes that the probability beliefs of investors match the true distribution ofreturns. A different possibility is that investors' expectations are biased, causing market prices to be informationally inefficient. This possibility is studied in the field ofbehavioral finance, which uses psychological assumptions to provide alternatives to theCAPM such as the overconfidence-based asset pricing model of Kent Daniel, DavidHirshleifer, and Avanidhar Subrahmanyam (2001).

The model does not appear to adequately explain the variation in stock returns. Empiricalstudies show that low beta stocks may offer higher returns than the model would predict.Some data to this effect was presented as early as a 1969 conference in Buffalo, NewYorkin a paper byFischer Black,Michael Jensen, and Myron Scholes. Either that fact isitself rational (which saves the efficient-market hypothesis but makes CAPM wrong), or

it is irrational (which saves CAPM, but makes the EMH wrong indeed, this possibilitymakes volatility arbitrage a strategy for reliably beating the market). The model assumes that given a certain expected return investors will prefer lower risk

(lower variance) to higher risk and conversely given a certain level of risk will preferhigher returns to lower ones. It does not allow for investors who will accept lower returnsfor higher risk. Casino gamblers clearly pay for risk, and it is possible that some stocktraders will pay for risk as well.
http://en.wikipedia.org/wiki/Normal_distributionhttp://en.wikipedia.org/wiki/Normal_distributionhttp://en.wikipedia.org/wiki/Normal_distributionhttp://en.wikipedia.org/wiki/Randomhttp://en.wikipedia.org/wiki/Coherent_risk_measurehttp://en.wikipedia.org/wiki/Behavioral_financehttp://en.wikipedia.org/wiki/David_Hirshleiferhttp://en.wikipedia.org/wiki/David_Hirshleiferhttp://en.wikipedia.org/wiki/Buffalo,_New_Yorkhttp://en.wikipedia.org/wiki/Buffalo,_New_Yorkhttp://en.wikipedia.org/wiki/Fischer_Blackhttp://en.wikipedia.org/wiki/Fischer_Blackhttp://en.wikipedia.org/wiki/Fischer_Blackhttp://en.wikipedia.org/wiki/Michael_Jensenhttp://en.wikipedia.org/wiki/Michael_Jensenhttp://en.wikipedia.org/wiki/Myron_Scholeshttp://en.wikipedia.org/wiki/Myron_Scholeshttp://en.wikipedia.org/wiki/Efficient-market_hypothesishttp://en.wikipedia.org/wiki/Volatility_arbitragehttp://en.wikipedia.org/wiki/Problem_gamblinghttp://en.wikipedia.org/wiki/Normal_distributionhttp://en.wikipedia.org/wiki/Randomhttp://en.wikipedia.org/wiki/Coherent_risk_measurehttp://en.wikipedia.org/wiki/Behavioral_financehttp://en.wikipedia.org/wiki/David_Hirshleiferhttp://en.wikipedia.org/wiki/David_Hirshleiferhttp://en.wikipedia.org/wiki/Buffalo,_New_Yorkhttp://en.wikipedia.org/wiki/Buffalo,_New_Yorkhttp://en.wikipedia.org/wiki/Fischer_Blackhttp://en.wikipedia.org/wiki/Michael_Jensenhttp://en.wikipedia.org/wiki/Myron_Scholeshttp://en.wikipedia.org/wiki/Efficient-market_hypothesishttp://en.wikipedia.org/wiki/Volatility_arbitragehttp://en.wikipedia.org/wiki/Problem_gambling


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The model assumes that there are no taxes or transaction costs, although this assumptionmay be relaxed with more complicated versions of the model.

The market portfolio consists of all assets in all markets, where each asset is weighted by

its market capitalization. This assumes no preference between markets and assets forindividual investors, and that investors choose assets solely as a function of their risk-return profile. It also assumes that all assets are infinitely divisible as to the amountwhich may be held or transacted.

The market portfolio should in theory include all types of assets that are held by anyoneas an investment (including works of art, real estate, human capital...) In practice, such amarket portfolio is unobservable and people usually substitute a stock index as a proxyfor the true market portfolio. Unfortunately, it has been shown that this substitution is notinnocuous and can lead to false inferences as to the validity of the CAPM, and it has beensaid that due to the inobservability of the true market portfolio, the CAPM might not beempirically testable. This was presented in greater depth in a paper by Richard Roll in

1977, and is generally referred to as Roll's critique. The model assumes just two dates, so that there is no opportunity to consume andrebalance portfolios repeatedly over time. The basic insights of the model are extendedand generalized in the intertemporal CAPM (ICAPM) of Robert Merton, and theconsumption CAPM (CCAPM) of Douglas Breeden and Mark Rubinstein.

CAPM assumes that all investors will consider all of their assets and optimize one portfolio. This is in sharp contradiction with portfolios that are held by individualinvestors: humans tend to have fragmented portfolios or, rather, multiple portfolios: foreach goal one portfolio.

Q. 4 What do you understand by arbitrage? Make a critical comparison between APT &

CAPM.

Answer: In economics and finance, arbitrage is the practice of taking advantage of a pricedifference between two or more markets: striking a combination of matching deals that capitalizeupon the imbalance, the profit being the difference between the market prices. When used byacademics, an arbitrag

MF0001 (mMF0010) Solved Assignemnt (Set 1 & 2)

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