Q1. Define Investment? What do you understand by it?

What are the differences between speculation

and gambling?

In simple terms, Investment refers to purchase of financial assets. While Investment Goods are those
goods, which are used for further production.

Investment implies the production of new capital goods, plants and equipments. John Keynes refers
investment as real investment and not financial investment.

Investment is a conscious act of an individual or any entity that involves deployment of money (cash) in
securities or assets issued by any financial institution with a view to obtain the target returns over a
specified period of time.

Target returns on an investment include:

Increase in the value of the securities or asset, and/or Regular income must be available from the
securities or asset.

Types of investment

1. Autonomous Investment

Investment which does not change with the changes in income level, is called as Autonomous or
Government Investment. Autonomous Investment remains constant irrespective of income level. Which
means even if the income is low, the autonomous, Investment remains the same. It refers to the
investment made on houses, roads, public buildings and other parts of Infrastructure. The Government
normally makes such a type of investment.

2. Induced Investment

Investment which changes with the changes in the income level, is called as Induced Investment.Induced
Investment is positively related to the income level. That is, at high levels of income entrepreneurs are
induced to invest more and vice-versa. At a high level of income, Consumption expenditure increases this
leads to an increase in investment of capital goods, in order to produce more consumer goods.

3. Financial Investment

Investment made in buying financial instruments such as new shares, bonds, securities, etc. is considered
as a Financial Investment. However, the money used for purchasing existing financial instruments such
as old bonds, old shares, etc., cannot be considered as financial investment. It is a mere transfer of a
financial asset from one individual to another. In financial investment, money invested for buying of new
shares and bonds as well as debentures have a positive impact on employment level, production and
economic growth.

4. Real Investment
Investment made in new plant and equipment, construction of public utilities like schools, roads and
railways, etc., is considered as Real Investment.Real investment in new machine tools, plant and
equipments purchased, factory buildings, etc. increases employment, production and economic growth
of the nation. Thus real investment has a direct impact on employment generation, economic growth,
etc.

5. Planned Investment

Investment made with a plan in several sectors of the economy with specific objectives is called as
Planned or Intended Investment. Planned Investment can also be called as Intended Investment because
an investor while making investment make a concrete plan of his investment.

6. Unplanned Investment

Investment done without any planning is called as an Unplanned or Unintended Investment. In

unplanned type of investment, investors make investment randomly without making any concrete plans.
Hence it can also be called as Unintended Investment. Under this type of investment, the investor may
not consider the specific objectives while making an investment decision.

7. Gross Investment

Gross Investment means the total amount of money spent for creation of new capital assets like Plant
and Machinery, Factory Building, etc.It is the total expenditure made on new capital assets in a period.

8. Net Investment

Net Investment is Gross Investment less (minus) Capital Consumption (Depreciation) during a period of
time, usually a year.It must be noted that a part of the investment is meant for depreciation of the
capital asset or for replacing a worn-out capital asset. Hence it must be deducted to arrive at net
investment.

Difference between Speculation and Investment

It is well nigh impossible to define the term ‘speculation’ with any precision. Investment and speculation
are somewhat different and yet similar because speculation requires an investment and investments are
at least somewhat speculative.

Investment usually involves putting money into an asset which is not necessarily marketable in the short
run in order to enjoy a series of returns the investment is expected to yield. On the other hand,
speculation is usually a more short-run phenomenon.

Speculators tend to buy assets with the expectation that a profit can be earned from a subsequent price
change and sale. Accordingly, they buy marketable assets which they do not plan to own for very long.

Probably the best way to make a distinction between investment and speculation is by considering the
role of expectations. Investments are usually made with the expectation that a certain stream of income
or a certain price which has existed will not change in the future. Speculations, on the other hand, are
usually based on the expectation that some change will occur. An expected change is a basis for
speculation but not for an investment.
Speculation involves a higher level of risk and a more uncertain expectation of returns but in many cases
the investors are also in the same boat. The investor who thinks that the market fluctuations of his
investments are not of interest to him because he is buying solely for income can very well be compared
with the ostrich burying its head in the ground during danger and feeling himself secure.

The trained speculator takes action only when the probabilities are higher in his favour. Though the
speculator should not swing with each fresh current but this does not imply inflexible behaviour on his
part. When the evidence builds up unmistakably against his view, he must be able to change it without
becoming disorganized. His notions of prestige must not attach irrationality to his opinions.

For the speculator, pride of opinion is the costliest luxury. In fact, the speculator must have the courage
to make decisions when the general atmosphere is one of panic, despair, or great optimism and yet go
against the current. The crowds is wildly bullish at tops and in a panic at bottom, and these emotions are
highly contagious.

The truth of the matter is that everything we do in this world is a speculation, whether we regard it as
such or not, and the man who comes out in the open and uses his judgment to forecast the probable
course of events, and then acts on it, is the one who would reap the returns of his endeavour.

This is a peculiar psychology that makes many investors avoid certain sound stocks or bonds because
their broker speaks of “speculative possibilities”. These investors judge safety by yield. If a security pays
beyond certain percentage it is classed as “speculative”, and is not for them.

What is the solution of the problem of investing primarily for income and yet relating the very important
and useful quality of ready marketability without loss? It is best solved by never making an investment
that does not appear after investigation, to be an equally good speculation.

It follows that speculative investment may be undertaken with the expectation of success only by those
specialists who are able, out of their knowledge and experience, to weigh carefully the possible
outcomes.

Furthermore, because of the great risk, what is expected by the speculator is not that he will not make
errors of judgment, but that his substantial resources and superior judgment will permit him on balance
to expect to maximize aggregate gains.

Another point often raised is, “can the man of limited mean afford to speculate?” The reply to that
question depends on what is inferred by the word ‘speculate’. If one means to buy rapidly fluctuating
stocks on margin in the hope of getting aboard the right one, the answer is emphatically “No”! But if
one’s idea of speculation is the right one that is, to buy sound stocks for cash after a careful study of
factors apt to affect their future prices, it is certainly good policy. Indeed, no man ever becomes wealthy
without speculating in something.

There is no such thing as something for nothing. Those who come to the stock market with visions of
easy money are apt to leave it sadder, if not wiser. We get out of things what we put into them, and
brains and money used in an honest effort to secure reasonable income on profits in the stock market
generally receive a just reward.
In a sense, all purchase and ownership of securities are speculative. However, there are important
differences between speculation and investment. Here we will contrast the behavior characteristics
between an investor a speculator.

First, we want to identify the characteristics of an investor:

1. An investor is interested in long-term holding of a security he buys. The minimum holding period is
one year.

2. An investor is only willing to take up moderate risk. Usually, he buys securities issued by established
companies.

3. An investor is interested in current return in the form of interest income or dividend as well as
possibilities of capital appreciation.

4. An investor expects a moderate rate of return in exchange for moderate risk assumed.

5. An investor’s decision to buy is arrived at through careful analysis of the past performance and future
prospects of the issuing company and the industry it is in. The analysis may be performed by the investor
or by someone he believes in.

6. An investor uses his own money to buy securities.

Characteristics of an investor

Having identified the behavior characteristics of an investor, we now turn to identify those of a
speculator:

1. A speculator is usually interested in short-term holdings, holding a security for maybe a couple of days,
weeks, or months.

2. A speculator is willing to assume high risks. Usually he buys volatile issues (meaning wide price
fluctuation) or lower grade securities.

3. A speculator is primarily interested in price appreciation. Current income in the form of interest or
dividends is considered insignificant.

4. He expects a high rate of return in exchange for the risk assumed.

5. The desire to buy is usually based on intuition, rumours, charts, or market analysis which concerns
itself with the analysis of the stock market itself.

6. A speculator usually borrows money from brokerage firms using his securities as collateral. The
purpose is to either semi-investors or semi-speculators in different degrees.

From a social stand point speculation must be differentiated from investment on different grounds.
Directly, it is of no significance to society whether a given purchase (transfer of ownership of capital) is
speculative or non-speculative.
So far as the social capital fund is concerned, the same amount of capital is being employed all the time.
Indirectly, there must be distinction, for there can be devastating repercussions of the resultant profits
or losses.

If social definition of a speculation is to be created it must apparently include the four functions of
speculation as a process: 1. smoothening of the price fluctuation process; 2. maintenance of temporary
equilibrium between capital supply and demand; 3. consideration of future business prospects in
determining the business value of existing capital funds; and 4.equating the risk to return in the infinitely
varied utilisations of the social capital fund.

The several differences between speculation and investment which have the doubtful merits of public
support, may be summarised as under:

From the foregoing discussion it follows that speculation needs no defence. Sometimes it may run riot
and end in disaster, but that is due to its abuse. In fact, good investment management is difficult to
distinguish at times from what appears to be speculative activity, and vice versa.

However, it would be foolish to suppose from this that speculators are imbued with any idea that on
them the responsibility rests of rectifying the injustice of a stagnant market. Their motives may be as
selfish as those of any other businessmen, but the speculators of a market are there to act when
opportunity arises and their presence is a benefit.

The speculator who attempts to corner a market is menace. His aim is to create an artificial value; that in
itself is bad. But speculation when undertaken with a full sense of market responsibilities, of market
reputation and of market traditions, falls into a distinctly different category.

In fact, speculation may be a service and has its place in the scheme of economics, when the adjustment
of prices in responding to the law of supply and demand may be so slow that we would constantly be in
a state of “slack-water”. In fact, there are days when buying in the market is in homeopathic doses;
consumers will not give the lead lest prices should drop still further.

When the professional speculators take a stand they buy in quantities that at once affect the market,
and the timid consumer also comes in and fills his forward as well as his immediate requirements. Those
who have delayed are ready to pay any reasonable advance on the last quotation.

Everyone is buoyant, everyone is happy again; the speculator has performed his good work. There are
some who argue that it is all a matter of degree. If there were no speculators, then there would be
nothing to make the consumer’s purchase appear too insignificant to influence the market; that the
speculator is a parasite whose buying dwarfs the legitimate trading to such an extent that nothing short
of exaggerated buying will react on prices.

Let us accept a market without speculation, a market on miniature scale, one that by constant demand
has reached prices that have stimulated production so that there is now a surplus offering. Of course,
prices should recede, but what would really happen in that case is that the producers would combine to
maintain the price. Competition, it is argued, is enough to check the evil of price agreements; but
competition is only another of the blessings that can be abused, and it is kept in bounds by the righting
arm of speculation.
Some will concede all this, but argue that it only establishes the place of the speculator to come in at the
two extremes of the statistical position, whereas he is known to be operating almost daily, at any rate
much often than during extremes of a statistical position.

That is true, but the law of supply and demand is not the whole of marketing. Prices must fluctuate by
variations of credit, and credit alters from moment to moment. The changes are mere fractional
changes, and the professional operator is the medium through whom these niceties of the price are
introduced. Speculator does not get excessive reward for his invaluable services.

His only reward is derived from the differences on the amount he is prepared to risk. Of course, his real
task is small. If he is dealing in some commodity the risk is that the price may go up or down contrary to
his expectations. There is no chance of the value disappearing entirely or that it may rise without
affording him an opportunity to cut his loss. Thus the remuneration is ample, but not excessive.

Speculation vs. Gambling: An Overview

Speculation and gambling are two different actions used to increase wealth under conditions of risk or
uncertainty. However, these two terms are very different in the world of investing. Gambling refers to
wagering money in an event that has an uncertain outcome in hopes of winning more money, whereas
speculation involves taking a calculated risk in an uncertain outcome. Speculation involves some sort of
positive expected return on investment—even though the end result may very well be a loss. While the
expected return for gambling is negative for the player—even though some people may get lucky and
win.

Speculation

Speculation involves calculating risk and conducting research before entering a financial transaction. A
speculator buys or sells assets in hopes of having a bigger potential gain than the amount he risks. A
speculator takes risks and knows that the more risk he assumes, in theory, the higher his potential gain.
However, he also knows that he may lose more than his potential gain.

For example, an investor may speculate that a market index will increase due to strong economic
numbers by buying one contract in one market futures contract. If his analysis is correct, he may be able
to sell the futures contract for more than he paid, within a short- to medium-term period. However, if he
is wrong, he can lose more than his expected risk.

Gambling

Converse to speculation, gambling involves a game of chance. Generally, the odds are stacked against
gamblers. When gambling, the probability of losing an investment is usually higher than the probability
of winning more than the investment. In comparison to speculation, gambling has a higher risk of losing
the investment.

For example, a gambler opts to play a game of American roulette instead of speculating in the stock
market. The gambler only places his bets on single numbers. However, the payout is only 35 to 1, while
the odds against him winning are 37 to 1. So if he bets Rs 2 on a single number, his potential  gambling
income is Rs70 (35*Rs 2) but the odds of him winning is approximately 1/37.

Key Differences
Although there may be some superficial similarities between the two concepts, a strict definition of both
speculation and gambling reveals the principle differences between them. A standard dictionary defines
speculation as a risky type of investment, where investing means to put money to use, by purchase or
expenditure, in something offering profitable returns, especially interest or income. The same dictionary
defines gambling as follows: To play at any game of chance for stakes. To stake or risk money, or
anything of value, on the outcome of something involving chance; bet; wager.

Speculation refers to the act of conducting a financial transaction that has a substantial risk of losing
value but also holds the expectation of a significant gain or other major value. With speculation, the risk
of loss is more than offset by the possibility of a substantial gain or other recompense. Some market
pros view speculators as gamblers, but a healthy market is made up of not only hedgers and
arbitrageurs, but also speculators. A hedger is a risk-averse investor who purchases positions contrary to
others already owned. If a hedger owned 500 shares of Marathon Oil but was afraid that the  price of
oil may soon drop significantly in value, he or she may short sell the stock, purchase a put option, or use
one of the many other hedging strategies.

While speculation is risky, it does often have a positive expected return, even though that return may
never manifest. Gambling, on the other hand, always involves a negative expected return—the house
always has the advantage. Gambling tendencies run far deeper than most people initially perceive and
well beyond the standard definitions. Gambling can take the form of needing to socially prove one's self
or acting in a way to be socially accepted, which results in taking action in a field one knows little about.

Gambling in the markets is often evident in people who do it mostly for the emotional high they receive
from the excitement and action of the markets. Finally, relying on emotion or a must-win attitude to
create profits rather than trading in a methodical and tested system, indicates the person is gambling in
the markets and is unlikely to succeed over the course of many trades.

Q2. What do you understand by Financial Markets ? Explain its functions

The financial system plays the key role in the economy by stimulating economic growth, influencing
economic performance of the actors, affecting economic welfare. This is achieved by financial
infrastructure, in which entities with funds allocate those funds to those who have potentially more
productive ways to invest those funds. A financial system makes it possible a more efficient transfer of
funds. As one party of the transaction may possess superior information than the other party, it can lead
to the information asymmetry problem and inefficient allocation of financial resources. By overcoming
the information asymmetry problem the financial system facilitates balance between those with funds to
invest and those needing funds. According to the structural approach, the financial system of an
economy consists of three main components:
1) financial markets;
2) financial intermediaries (institutions);
3) financial regulators. Each of the components plays a specific role in the economy. According to the
functional approach, financial markets facilitate the flow of funds in order to finance investments by
corporations, governments and individuals. Financial institutions are the key players in the financial
markets as they perform the function of intermediation and thus determine the flow of funds. The
financial regulators perform the role of monitoring and regulating the participants in the financial
system. Financial markets studies, based on capital market theory, focus on the financial system, the
structure of interest rates, and the pricing of financial assets. An asset is any resource that is expected to
provide future benefits, and thus possesses economic value. Assets are divided into two categories:
tangible assets with physical properties and intangible assets. An intangible asset represents a legal claim
to some future economic benefits. The value of an intangible asset bears no relation to the form,
physical or otherwise, in which the claims are recorded. Financial assets, often called financial
instruments, are intangible assets, which are expected to provide future benefits in the form of a claim
to future cash. Some financial instruments are called securities and generally include stocks and bonds.
Any transaction related to financial instrument includes at least two parties:
1) the party that has agreed to make future cash payments and is called the issuer;
2) the party that owns the financial instrument, and therefore the right to receive the payments made by
the issuer, is called the investor. Financial assets provide the following key economic functions.
 they allow the transfer of funds from those entities, who have surplus funds to invest to those
who need funds to invest in tangible assets;
 they redistribute the unavoidable risk related to cash generation among deficit and surplus
economic units. The claims held by the final wealth holders generally differ from the liabilities
issued by those entities who demand those funds. They role is performed by the specific entities
operating in financial systems, called financial intermediaries. The latter ones transform the final
liabilities into different financial assets preferred by the public.
Financial markets and their economic functions A financial market is a market where financial
instruments are exchanged or traded. Financial markets provide the following three major economic
functions:
1) Price discovery
2) Liquidity
3) Reduction of transaction costs
1) Price discovery function means that transactions between buyers and sellers of financial instruments
in a financial market determine the price of the traded asset. At the same time the required return from
the investment of funds is determined by the participants in a financial market. The motivation for those
seeking funds (deficit units) depends on the required return that investors demand. It is these functions
of financial markets that signal how the funds available from those who want to lend or invest funds will
be allocated among those needing funds and raise those funds by issuing financial instruments.
2) Liquidity function provides an opportunity for investors to sell a financial instrument, since it is
referred to as a measure of the ability to sell an asset at its fair market value at any time. Without
liquidity, an investor would be forced to hold a financial instrument until conditions arise to sell it or the
issuer is contractually obligated to pay it off. Debt instrument is liquidated when it matures, and equity
instrument is until the company is 8 either voluntarily or involuntarily liquidated. All financial markets
provide some form of liquidity. However, different financial markets are characterized by the degree of
liquidity.
3) The function of reduction of transaction costs is performed, when financial market participants are
charged and/or bear the costs of trading a financial instrument. In market economies the economic
rationale for the existence of institutions and instruments is related to transaction costs, thus the
surviving institutions and instruments are those that have the lowest transaction costs. The key
attributes determining transaction costs are
 asset specificity,
 uncertainty,
 frequency of occurrence.
Asset specificity is related to the way transaction is organized and executed. It is lower when an asset can
be easily put to alternative use, can be deployed for different tasks without significant costs.
Transactions are also related to uncertainty, which has
(1) external sources (when events change beyond control of the contracting parties), and
(2) depends on opportunistic behavior of the contracting parties. If changes in external events are readily
verifiable, then it is possible to make adaptations to original contracts, taking into account problems
caused by external uncertainty. In this case there is a possibility to control transaction costs. However,
when circumstances are not easily observable, opportunism creates incentives for contracting parties to
review the initial contract and creates moral hazard problems. The higher the uncertainty, the more
opportunistic behavior may be observed, and the higher transaction costs may be born. Frequency of
occurrence plays an important role in determining if a transaction should take place within the market or
within the firm. A one-time transaction may reduce costs when it is executed in the market. Conversely,
frequent transactions require detailed contracting and should take place within a firm in order to reduce
the costs. When assets are specific, transactions are frequent, and there are significant uncertainties
intra-firm transactions may be the least costly. And, vice versa, if assets are non-specific, transactions are
infrequent, and there are no significant uncertainties least costly may be market transactions. The
mentioned attributes of transactions and the underlying incentive problems are related to behavioural
assumptions about the transacting parties. The economists (Coase (1932, 1960, 1988), Williamson (1975,
1985), Akerlof (1971) and others) have contributed to transactions costs economics by analyzing
behaviour of the human beings, assumed generally self-serving and rational in their conduct, and also
behaving opportunistically. Opportunistic behaviour was understood as involving actions with
incomplete and distorted information that may intentionally mislead the other party. This type of
behavior requires efforts of ex ante screening of transaction parties, and ex post safeguards as well as
mutual restraint among the parties, which leads to specific transaction costs. Transaction costs are
classified into:
1) costs of search and information,
2) costs of contracting and monitoring,
3) costs of incentive problems between buyers and sellers of financial assets.
1) Costs of search and information are defined in the following way: 9 search costs fall into categories of
explicit costs and implicit costs
. Explicit costs include expenses that may be needed to advertise one’s intention to sell or purchase a
financial instrument. Implicit costs include the value of time spent in locating counterparty to the
transaction. The presence of an organized financial market reduces search costs.
 information costs are associated with assessing a financial instrument’s investment attributes.
In a price efficient market, prices reflect the aggregate information collected by all market
participants.
2) Costs of contracting and monitoring are related to the costs necessary to resolve information
asymmetry problems, when the two parties entering into the transaction possess limited information on
each other and seek to ensure that the transaction obligations are fulfilled.
3) Costs of incentive problems between buyers and sellers arise, when there are conflicts of interest
between the two parties, having different incentives for the transactions involving financial assets. The
functions of a market are performed by its diverse participants. The participants in financial markets can
be also classified into various groups, according to their motive for trading:
 Public investors, who ultimately own the securities and who are motivated by the returns from
holding the securities. Public investors include private individuals and institutional investors,
such as pension funds and mutual funds.
 Brokers, who act as agents for public investors and who are motivated by the remuneration
received (typically in the form of commission fees) for the services they provide. Brokers thus
trade for others and not on their own account.
 Dealers, who do trade on their own account but whose primary motive is to profit from trading
rather than from holding securities. Typically, dealers obtain their return from the differences
between the prices at which they buy and sell the security over short intervals of time.
 Credit rating agencies (CRAs) that assess the credit risk of borrowers. In reality three groups are
not mutually exclusive. Some public investors may occasionally act on behalf of others; brokers
may act as dealers and hold securities on their own, while dealers often hold securities in excess
of the inventories needed to facilitate their trading activities. The role of these three groups
differs according to the trading mechanism adopted by a financial market.

Financial instruments There is a great variety of financial instrument in the financial marketplace. The
use of these instruments by major market participants depends upon their offered risk and return
characteristics, as well as availability in retail or wholesale markets.
A financial instrument can be classified by the type of claims that the investor has on the issuer. A
financial instrument in which the issuer agrees to pay the investor interest plus repay the amount
borrowed is a debt instrument. A debt instrument also referred to as an instrument of indebtedness, can
be in the form of a note, bond, or loan. The interest payments that must be made by the issuer are fixed
contractually. For example, in the case of a debt instrument that is required to make payments in Euros,
the amount can be a fixed Euro amount or it can vary depending upon some benchmark. The investor in
a debt instrument can realize no more than the contractual amount. For this reason, debt instruments
are often called fixed income instruments.
Fixed income instruments forma a wide and diversified fixed income market.
In contrast to a debt obligation, an equity instrument specifies that the issuer pays the investor an
amount based on earnings, if any, after the obligations that the issuer is required to make to investors of
the firm’s debt instruments have been paid. Common stock is an example of equity instruments. Some
financial instruments due to their characteristics can be viewed as a mix of debt and equity. Preferred
stock is a financial instrument, which has the attribute of a debt because typically the investor is only
entitled to receive a fixed contractual amount. However, it is similar to an equity instrument because the
payment is only made after payments to the investors in the firm’s debt instruments are satisfied.
Another “combination” instrument is a convertible bond, which allows the investor to convert debt into
equity under certain circumstances. Because preferred stockholders typically are entitled to a fixed
contractual amount, preferred stock is referred to as a fixed income instrument. Hence, fixed income
instruments include debt instruments and preferred stock. The classification of debt and equity is
especially important for two legal reasons. First, in the case of a bankruptcy of the issuer, investor in
debt instruments has a priority on the claim on the issuer’s assets over equity investors. Second, the tax
treatment of the payments by the issuer can differ depending on the type of financial instrument class.

Q3. Explain the Investment alternatives available?

Every investment has some risk attached to it, high or low. Here are 9 investment options with varying
degrees of risk that are considered good options.
When investors look for the 'best' investment option, they want something that will earn them the
maximum return with the least amount of risk. However, such an investment product does not really
exist. This is because every investment has some risk attached to it, high or low.
You should not invest in something just to generate high returns because such products come with
commensurate risk, and a higher chance of you losing the money that you have invested.
Here are nine investment options with varying degrees of risk that are considered good options in India:

1. Public Provident Fund

The Public Provident Fund (PPF) is one of the most popular investment options in India because of its
sovereign guarantee. Some of its features are:
a) Investment offers tax benefit under section 80C, interest earned and maturity are also exempt from
tax.
b) The scheme has a lock-in period of 15 years.
c) Post maturity, the account can be extended in block of five years for any number of times.
d) The interest rate is reviewed by the Government every quarter. Currently, for the April-June 2018
quarter, interest rate offered is 7.6 percent a year.
e) The scheme also offers loan and partial withdrawals.
2.Bank fixed deposits
Bank fixed deposits (FDs) is another popular investment option which offers fixed returns. One can invest
in a bank FD by visiting his/her branch or via Net-banking. Here are some of its key features:
a) FDs are available in a wide range of tenures. Banks like the State Bank of India (SBI) and HDFC Bank
offer FDs with minimum tenure of 7 days and maximum of up to 10 years. One can invest in any tenure
depending on his/her time horizon at the rates offered by banks.
b) Most bank FDs offer the option of premature withdrawal by paying a penalty. However, this should be
checked at the time of opening the FD account.
c) A bank FD is insured by the Deposit Insurance and Credit Guarantee Corporation (DICGC) rules only up
to Rs 1 lakh (principal plus interest) is insured per person per bank.
d) Currently, SBI is offering interest rate between 6.40 percent and 6.75 percent for FD tenures of 1 year
to up to 10 years. Senior citizens get an extra 0.50 percent.
Bank FDs offer cumulative and non-cumulative options. In the cumulative option, the interest is re-
invested and payable on maturity whereas, in the non-cumulative option, interest is payable periodically
(monthly, quarterly or annually depending on the bank). Interest is added to your income and taxed as
per your income tax slabs. Interest is subject to tax deducted source (TDS)

3. Mutual fund debt fixed maturity plans

Fixed maturity plans (FMPs) are close-ended debt funds offered by mutual funds. The maturity date of
FMPs is fixed. Features of FMPs are:
a) These plans invest in various types of fixed income options such as bonds, bank certificate of
deposits etc. which mature on or before the maturity date.
b) Unlike a bank FD where returns are fixed, FMP returns are not fixed or guaranteed.
c) FMPs have a tax advantage over bank FDs. Capital gains on debt FMPs, held for more than 36
months, qualify for long-term capital gains (LTCG) taxation. It is taxed at 20 percent post-
indexation benefit. Also, if you have incurred long-term capital losses, you can set off the loss
against the LTCG before calculating tax payable.
d) As LTCG from debt FMPs are taxed at 20 percent with indexation these, on an average, give
better post-tax returns than bank FDs for individuals in the higher tax brackets.

4. Debt mutual funds

Apart from FMPs, which are close-ended debt funds, mutual funds also offer open-ended debt funds.
These open-ended funds are considered less volatile than equity thereby offering stable returns as
compared to equities.
a) They also invest in various debt instruments such as corporate bonds, treasury bills, government
securities etc. These schemes are professionally managed by debt fund managers.
b) There are different types of debt mutual funds. etc.
c) These funds invest in various instruments of different time horizons and carrying different levels of
risk. An investor can invest in these funds depending on his/her time horizon and risk appetite.
Debt Schemes:
Liquid Funds invest in highly liquid money market instruments. They invest in securities with a residual
maturity of not more than 91 days. Investors can park money in them for a few days to few months.
Ultra Short-Term Funds invest mostly in very short-term debt securities and a small portion in longer-
term debt securities. Investors can park their short-term surplus for a few months to a year in these
funds.
Fixed Maturity Plans are closed-ended debt mutual funds that work almost like fixed deposits. They
invest in debt instruments with less than or equal to the maturity date of the scheme. Securities are
redeemed on or before maturity and proceeds are paid to the investors. FMPs are a good alternative to
fixed deposits for investors in the higher tax bracket.
Short-Term Funds invest mostly in debt securities with an average maturity of one to three years. They
perform well when short term interest rates are high. They are suitable to invest with a horizon of a few
years.
Dynamic Bond Funds invest across all classes of debt and money market instruments with varying
maturities. These funds have an actively-managed portfolio that varies dynamically with the interest rate
view of the fund manager. They are ideal for investors who want to leave the job of taking call on
interest rates to the fund manager.
Income Funds invest in corporate bonds, government bonds and money market instruments with long
maturities. They are highly vulnerable to the changes in interest rates. They are suitable for investors
who are ready to take high risk and have a long term investment horizon. The right time to invest in
these funds is when the interest rates are likely to fall.
Gilt Funds invest in government securities. They do not have the default risk because the bonds are
issued by the government. However, they are highly vulnerable to the changes in interest rates and
other economic factors. These funds have high interest rate risk. Invest with a long-term horizon.
Debt-oriented hybrid funds, as the name suggests, invest mostly in debt and a small part of the corpus in
equity. The equity part of the portfolio would provide extra returns, but the exposure also makes them a
little risky. Invest with a horizon of three years or more.

Equity Funds:
Equity-oriented hybrid funds invest a mix of equity (at least 65 per cent of the corpus) and debt. These
schemes are less volatile than pure equity funds because of the mixed portfolio. The debt investments
provide stability in times of volatility. These funds are suitable for new stock investors and very
conservative equity investors.
Largecap funds invest mostly in big companies. Funds identify these companies by their market
capitalisation. These companies are considered safe to invest because they are likely to be well-
established players and leaders in their respective filed. This is the reason why largecap funds are
considered suitable for conservative equity investors. These funds are likely to offer modest returns as
they carry relatively less risk.
Diversified funds invest across market capitalisations, depending on the market view of the fund
manager. Since the portfolio is spread across different market capitalisations, they are less risky than
mid- and small-cap funds, but a little riskier than large cap funds. They are suitable for investors with
modest risk appetite.
Equity Linked Savings Schemes or tax planning mutual funds are suitable for investors looking to save
taxes under Section 80 C of the Income Tax Act. Investments in these funds qualify for a tax deduction of
up to Rs 1.5 lakh. They come with a mandatory lock-in period of three years.
Midcap funds invest mostly in medium-sized companies. These companies can be risky as they may or
may not realise their full potential. However, if they succeed, they will become large companies and
investors will be rewarded handsomely. Investors with high risk appetite should bet on these funds.
Smallcap funds invest in small companies. These companies can be extremely risky, as there will be very
little information about them available in the public domain. However, they can also offer phenomenal
return. They are suitable only for investors with a very high risk appetite.
Sector funds invest mostly in a particular sector or along the lines of a defined theme. Since the
investments are concentrated on a single sector or theme, sector funds are considered extremely risky. It
is very important to time the entry into and exit from them as the fortunes of sectors changing in
different cycles in the economy. They are meant for investors with an intimate knowledge about a
particular sector. Investors should take only a small exposure in them.

5. Equity-oriented mutual fund schemes

As the name suggests, equity-oriented mutual funds are those schemes that invest at least 65 percent of
the scheme corpus in stocks of domestic companies.
a) They invest in stocks based on the mandate of the scheme and can be open-ended or close-
ended. For instance, some schemes may invest only in stocks of large-cap companies whereas
others may invest only in stocks of mid-cap companies. Then there are those that invest in both
large-cap and mid-cap shares.
b) b) These schemes are professionally managed by equity fund managers. Returns of these
schemes are market-linked and volatile. In last 5 years (2013-2018), large-cap MFs have delivered
returns between 13 percent and 20 percent.
c) Financial advisors recommend that one should invest in equities for the long term, say a
minimum five years or more, to beat inflation in the long run.
d) Equity mutual funds are a simple way to do this for a lay investor who cannot understand the
intricacies of direct equity investing.
There are equity-linked savings schemes (ELSS) which offer tax-benefit under section 80C of the
Income-tax Act. These schemes have lock-in of 3 years which is shortest in the entire tax-saving
instruments basket.
6. Direct equity
Aggressive investors who understand the workings of the stock market and are willing to take
risks on their own could look at investing directly in equities.
 a) Direct equities are considered risky because of the wide and quick price fluctuations (i.e.,
volatility) and one can lose one's capital as well.
b) One needs to do due diligence before investing directly in shares of a company.
c) Investors might also find it difficult to know when to enter and exit the stock market depending
on domestic and global factors. Currently, returns from Sensex in last 1, 2 and 5 years are: 13.63
percent, 16.94 percent, and 11.47 percent, respectively.Buying and selling of shares can be done
through demat account only.

7. National Pension System (NPS)

Investors who wish to receive a pension in their retirement years can look to invest in the National
Pension System (NPS). It is a defined contribution system where your contribution is invested in various
assets - equity, bonds, government securities, and alternative investments as per your choice.
a) The scheme offers two choices: Auto choice and Active choice. In auto choice mode, your contribution
is divided among various assets based on your age (Life Cycle Fund). On the other hand, under the active
choice, you decide the ratio in which funds are to be invested in different asset classes.
b) The scheme matures when the investor turns 60 years of age. The lock-in period depends on the entry
age of the investor. For example, if you start investing in NPS at the age of 25 years, then the lock-in
period will be 35 years.
c) The returns of NPS are market-linked. Amount of pension you will receive post-maturity will  ..
NPS offers tax benefit under section 80C for a maximum of Rs 1.5 lakh and an additional tax benefit of Rs
50,000 under section 80CCD (1B). However, at the time of maturity, only 40 percent of the corpus, if
redeemed as a lump sum, will be tax-exempt. Pension received will be fully taxable as per your income.
No tax is payable during the accumulation period.

8. Gold
One can buy in gold in various forms-physical, paper, and digital. These forms include jewellery, ullion,
sovereign gold bonds, digital gold etc.
a) According to an Economic Times report, gold bought on Akshaya Tritya 10-20 years ago has given
double digit returns.
b) The returns in recent years, however, have diminished.Gold prices usually go up during times of
uncertainty. Financial advisors recommend one should invest only a certain limited percentage in
gold to hedge against other risks and not much beyond this limit.

9. Real estate
People buy a house either for self-occupation or to earn rental income and capital gains from it.
However, as per most financial advisors, investing in real estate to earn rental income is not considered
as a good investment. This is because:
a) Rental income earned from house ranges usually between 2-3 per cent a year.
 b) The appreciation in the prices of house property depends on various factors such as size, locality,
location etc.
c) Before m making an investment in property, one must evaluate based on safety, liquidity,
returns and other similar parameters.

Q4. Explain the various types of risk associated with financial markets.

Types mean different classes or various forms / kinds of something or someone.

Risk implies the extend to which any chosen action or an inaction that may lead to a loss or some
unwanted outcome. The notion implies that a choice may have an influence on the outcome that exists
or has existed.
However, in financial management, risk relates to any material loss attached to the project that may
affect the productivity, tenure, legal issues, etc. of the project.

In finance, different types of risk can be classified under two main groups, viz.,
1.       Systematic risk.
2.       Unsystematic risk.

Systematic risk is uncontrollable by an organization and macro in nature.

Unsystematic risk is controllable by an organization and micro in nature.

A. Systematic Risk

Systematic risk is due to the influence of external factors on an organization. Such factors are normally
uncontrollable from an organization's point of view.
It is a macro in nature as it affects a large number of organizations operating under a similar stream or
same domain. It cannot be planned by the organization.
The types of systematic risk are depicted and listed below.

1.       Interest rate risk,

2.       Market risk and
3.       Purchasing power or inflationary risk.
Now let's discuss each risk classified under this group.

1. Interest rate risk

Interest-rate risk arises due to variability in the interest rates from time to time. It particularly affects
debt securities as they carry the fixed rate of interest.
The types of interest-rate risk are depicted and listed below.

·         Price risk and

·         Reinvestment rate risk.
Price risk arises due to the possibility that the price of the shares, commodity, investment, etc. may
decline or fall in the future.
Reinvestment rate risk results from fact that the interest or dividend earned from an investment can't
be reinvested with the same rate of return as it was acquiring earlier.

2. Market risk
 Market risk is associated with consistent fluctuations seen in the trading price of any particular shares or
securities. That is, it arises due to rise or fall in the trading price of listed shares or securities in the stock
market.

The types of market risk are depicted and listed below.

·         Absolute risk,
·         Relative risk,
·         Directional risk,
·         Non-directional risk,
·         Basis risk and
·         Volatility risk.
The meaning of different types of market risk is as follows:

Absolute risk is without any content. For e.g., if a coin is tossed, there is fifty percentage chance of
getting a head and vice-versa.
Relative risk is the assessment or evaluation of risk at different levels of business functions. For e.g. a
relative-risk from a foreign exchange fluctuation may be higher if the maximum sales accounted by an
organization are of export sales.
Directional risks are those risks where the loss arises from an exposure to the particular assets of a
market. For e.g. an investor holding some shares experience a loss when the market price of those
shares falls down.
Non-Directional risk arises where the method of trading is not consistently followed by the trader. For
e.g. the dealer will buy and sell the share simultaneously to mitigate the risk
Basis risk is due to the possibility of loss arising from imperfectly matched risks. For e.g. the risks which
are in offsetting positions in two related but non-identical markets.
Volatility risk is of a change in the price of securities as a result of changes in the volatility of a risk-
factor. For e.g. it applies to the portfolios of derivative instruments, where the volatility of its underlying
is a major influence of prices.

3. Purchasing power or inflationary risk

Purchasing power risk is also known as inflation risk. It is so, since it emanates (originates) from the fact
that it affects a purchasing power adversely. It is not desirable to invest in securities during an
inflationary period.
The types of power or inflationary risk are depicted and listed below.

·         Demand inflation risk and

·         Cost inflation risk.

Demand inflation risk arises due to increase in price, which result from an excess of demand over
supply. It occurs when supply fails to cope with the demand and hence cannot expand anymore. In other
words, demand inflation occurs when production factors are under maximum utilization.
Cost inflation risk arises due to sustained increase in the prices of goods and services. It is actually
caused by higher production cost. A high cost of production inflates the final price of finished goods
consumed by people.

B. Unsystematic Risk
Unsystematic risk is due to the influence of internal factors prevailing within an organization. Such
factors are normally controllable from an organization's point of view.
 It is a micro in nature as it affects only a particular organization. It can be planned, so that necessary
actions can be taken by the organization to mitigate (reduce the effect of) the risk.
The types of unsystematic risk are depicted and listed below.

1.       Business or liquidity risk,

2.       Financial or credit risk and
3.       Operational risk.
Now let's discuss each risk classified under this group.

1. Business or liquidity risk

Business risk is also known as liquidity risk. It is so, since it emanates (originates) from the sale and
purchase of securities affected by business cycles, technological changes, etc.
The types of business or liquidity risk are depicted and listed below.
·         Asset liquidity risk and
·         Funding liquidity risk.

Asset liquidity risk is due to losses arising from an inability to sell or pledge assets at, or near, their
carrying value when needed. For e.g. assets sold at a lesser value than their book value.
Funding liquidity risk exists for not having an access to the sufficient-funds to make a payment on time.
For e.g. when commitments made to customers are not fulfilled as discussed in the SLA (service level
agreements).

2. Financial or credit risk

Financial risk is also known as credit risk. It arises due to change in the capital structure of the
organization. The capital structure mainly comprises of three ways by which funds are sourced for the
projects. These are as follows:
Owned funds. For e.g. share capital.
Borrowed funds. For e.g. loan funds.
Retained earnings. For e.g. reserve and surplus.
The types of financial or credit risk are depicted and listed below.

·         Exchange rate risk,

·         Recovery rate risk,
·         Sovereign risk and
·         Settlement risk.
The meaning of types of financial or credit risk is as follows:

Exchange rate risk is also called as exposure rate risk. It is a form of financial risk that arises from a
potential change seen in the exchange rate of one country's currency in relation to another country's
currency and vice-versa. For e.g. investors or businesses face it either when they have assets or
operations across national borders, or if they have loans or borrowings in a foreign currency.
Recovery rate risk is an often neglected aspect of a credit-risk analysis. The recovery rate is normally
needed to be evaluated. For e.g. the expected recovery rate of the funds tendered (given) as a loan to
the customers by banks, non-banking financial companies (NBFC), etc.
Sovereign risk is associated with the government. Here, a government is unable to meet its loan
obligations, reneging (to break a promise) on loans it guarantees, etc.
Settlement risk exists when counterparty does not deliver a security or its value in cash as per the
agreement of trade or business.
 3. Operational risk
Operational risks are the business process risks failing due to human errors. This risk will change from
industry to industry. It occurs due to breakdowns in the internal procedures, people, policies and
systems.
The types of operational risk are depicted and listed below.
·         Model risk,
·         People risk,
·         Legal risk and
·         Political risk.
The meaning of types of operational risk is as follows:
Model risk is involved in using various models to value financial securities. It is due to probability of loss
resulting from the weaknesses in the financial-model used in assessing and managing a risk.
People risk arises when people do not follow the organization’s procedures, practices and/or rules. That
is, they deviate from their expected behavior.
Legal risk arises when parties are not lawfully competent to enter an agreement among themselves.
Furthermore, this relates to the regulatory-risk, where a transaction could conflict with a government
policy or particular legislation (law) might be amended in the future with retrospective effect.
Political risk occurs due to changes in government policies. Such changes may have an unfavorable
impact on an investor. It is especially prevalent in the third-world countries.

Q5. Write short notes on Sharpe Ratio, Treynor Ratio 7 Jensen Performance Index

Sharpe ratio is the measure of risk-adjusted return of a financial portfolio. A portfolio with a higher
Sharpe ratio is considered superior relative to its peers. The measure was named after William F Sharpe,
a Nobel laureate and professor of finance, emeritus at Stanford University.

Sharpe ratio is a measure of excess portfolio return over the risk-free rate relative to its standard
deviation. Normally, the 90-day Treasury bill rate is taken as the proxy for risk-free rate.

The formula for calculating the Sharpe ratio is {R (p) – R (f)} /s (p)
Where
R (p): Portfolio return
R (f): Risk free rate of return
s (p): Standard deviation of the portfolio

Realised historical return is used to calculate ex-post Sharpe ratio while ex-ante Sharpe ratio employs
expected return.
If two funds offer similar returns, the one with higher standard deviation will have a lower Sharpe ratio.
In order to compensate for the higher standard deviation, the fund needs to generate a higher return to
maintain a higher Sharpe ratio. In simple terms, it shows how much additional return an investor earns
by taking additional risk. Intuitively, it can be inferred that the Sharpe ratio of a risk-free asset is zero.
Portfolio diversification with assets having low to negative correlation tends to reduce the overall
portfolio risk and consequently increases the Sharpe ratio. For instance, let’s take a portfolio that
comprises 50 per cent equity and 50 per cent bonds with a portfolio return of 20 per cent and a standard
deviation of 10 per cent. Let’s take the risk-free rate to be 5 per cent. In this case, the Sharpe ratio will be
1.5 [(20%-5%)/10%]. Let’s add another asset class to the portfolio, namely a hedge fund, and tweak the
portfolio allocation to 50 per cent in equity, 40 per cent in bonds and 10 per cent in the hedge fund.
After the addition, the portfolio return becomes 25 per cent and standard deviation remains at 10 per
cent. If the risk-free rate is taken as 5 per cent, the new Sharpe ratio will be 2 [(25%-5%)/10%].

This shows that the addition of a new asset can give a fillip to the overall portfolio return without adding
any undue risk. This has the effect of augmenting the Sharpe ratio.

The Sharpe ratio, however, is a relative measure of risk-adjusted return. If considered in isolation, it does
not provide much information about the fund’s performance. Moreover, the measure considers
standard deviation, which assumes a symmetrical distribution of returns. For asymmetrical return
distribution with a Skewness greater or lesser than zero and Kurtosis greater or lesser than 3, the Sharpe
ratio may not be a good measure of performance.

Considering standard deviation as a proxy for risk has its pitfalls. Standard deviation takes into account
both the positive as well as the negative deviation in returns from the mean, hence it doesn’t accurately
measure the downside risk. Measures like Sortino, which only considers negative deviation from the
mean return, can remove the limitation of Sharpe ratio to some extent.

Treynor ratio shows the risk adjusted performance of the fund. Here the denominator is the beta of the
portfolio. Thus, it takes into account the systematic risk of the portfolio.

Description: Jack Treynor extended the work of William Sharpe by formulating treynor ratio. Treynor
ratio is similar to Sharpe ratio, but the only difference between the ratios is that of the denominator.

Formula for Treynor ratio: (Rp-Rf)/Beta

where,

Rp: Return on the portfolio

Rf: Risk free rate

B: Beta, the sensitivity of the portfolio to changes in the overall market.

Unlike Sharpe, Treynor uses beta in the denominator instead of the standard deviation. The beta
measures only the portfolio's sensitivity to the market movement, while the standard deviation is a
measure of the total volatility both upside as well as downside. A fund with a higher Treynor ratio implies
that the fund has a better risk adjusted return than that of another fund with a lower Treynor ratio.

Jensen's measure is a statistical measurement of the portion of a security's or portfolio's return that is
not explained by the market or the security's relationship to the market but rather by the skill of the
investor or portfolio manager. It is also called alpha.

Mathematically, Jensen's measure (which was developed in 1968 by Michael Jensen) is the rate of
return that exceeds what was expected or predicted by models like the capital asset pricing model
(CAPM). To understand how it works, consider the CAPM formula:

r   =   Rf  + beta x (Rm - Rf )   +   Jensen's measure (alpha)

where:
r = the security's or portfolio's return
Rf  = the risk-free rate of return
beta = the security's or portfolio's price volatility relative to the overall market
Rm  = the market return

The bulk of the CAPM formula (everything but the alpha factor) calculates what the rate of return on a
certain security or portfolio ought to be under certain market conditions. So if this portion of the model
predicts that your portfolio of 10 stocks should return 12%, but it actually returns 15%, we would call the
3% difference (the "excess return") alpha, or Jensen's measure.

Note that two similar portfolios might carry the same amount of risk (that is, they have the same beta)
but because of differences in Jensen's measure, one might generate higher returns than the other. This is
a fundamental quandary for investors, who always want the highest return for the least amount of
acceptable risk.

Jensen's measure is a measurable way to determine whether a manager has added value to a portfolio,
because alpha is the return attributable to the skill of the portfolio manager rather than the
general market conditions.

The very existence of alpha is controversial, however, because those who believe in the
efficient market hypothesis (which says, among other things, that it is impossible to beat the market)
believe alpha is attributable to luck rather than skill; they support this idea with the fact that many active
portfolio managers don't make much more for their clients than those managers who simply follow
passive, indexing strategies. Thus, investors who believe managers add value accordingly expect above-
market or above-benchmark returns -- that is, they expect alpha.

Q6 What do you understand by Bonds? Explain its Features and portfolio management strategies.
Bonds are debt securities – the bondholder is a creditor of the entity issuing the bond. The bondholder
makes a loan of the face value to the issuer. The issuer (borrower) promises to repay to the lender
(investor) the principal on maturity date plus coupon interest over its life.
Bond terms
Par value (face value): Face amount paid at maturity.
Coupon rate: Percentage of the par value that will be paid out annually in the form of interest.
par valueAnnual interest payment on bond = coupon rate
Maturity: The duration of time until the par value must be repaid.
Example
A bond with par value of $1,000 and coupon rate of 8% might be sold to a buyer for  ` 1,000) per year, for
the stated life of the bond, say 30 years. The ` 80 payment typically comes in two semi-annual
instalments of ` 40 each. At the end of the 30-year life of the bond, the issuer also pays the ` 1,000 par
value to the bondholder.` 1,000. The bondholder is then entitled to a payment of ` 80 (= 8%
Call Provisions on Corporate Bonds
The call provision allows the issuer to repurchase the bond at a specified call price before the maturity
date. If a company issues a bond with a high coupon rate, when market interest rates are high, and
interest rates later fall, the firm might like to retire the high-coupon debt and issue new bonds at a lower
coupon rate to reduce interest payments. This is called refunding. The call price of a bond is commonly
set at an initial level near par value plus one annual coupon payment. The call price falls as time passes,
gradually approaching par value.
Callable bonds typically come with a period of call protection, an initial time during which the bonds are
not callable. Such bonds are referred to as deferred callable bonds. The option to call the bond is
valuable to the firm, allowing it to buy back the bonds and refinance at lower interest rates when market
interest rates fall. From the bondholder’s perspective, the proceeds then will have to be reinvested in a
lower interest rate. To compensate investors for this risk, callable bonds are issued with higher coupon
rates and promised yields than non-callable bonds.
Convertible Bonds
Convertible bonds give the bondholders an option to exchange each bond for a specified number of
shares of common stocks of the firm. The conversion ratio gives the number of shares for which each
bond may be exchanged. Suppose a convertible bond that is issued at par value of $1,000 is convertible
into 40 shares of a firm's stock. The current stock price is $20 per share, so the option to convert is not
profitable now. However, should the stock price later rise to $30, each bond may be converted profitably
into $1,200 worth of stock.
The market conversion value is the current value of the shares for which the bonds may be exchanged.
At the $20 stock price, the bond’s conversion value is $800. The conversion premium is the excess of the
bond value over its conversion value. If the bond is selling currently at $950, its premium will be $150.
Valuation of Bonds
To value a security, we discount its expected cash flows by the appropriate discount rate. The cash flows
from a bond consist of coupon payments until the maturity date plus the final payment of par value.
Where r is the interest rate that is appropriate for discounting cash flows and T is the maturity date. The
present value (PV) of a ` 1 annuity that lasts for T periods when the interest rate equals r is:

Price-Yield Relationship
Nominal yield: This is simply the yield stated on the bond’s coupon. If the coupon is paying 5%, the
bondholder receives 5%.
Current yield: Current yield = Annual interest/Current price. This calculation takes into consideration the
bond market price fluctuations and represents the present yield that a bond buyer would receive upon
purchasing a bond at a given price. As mentioned above, bond market prices move up and down with
interest rate changes. If the bond is selling for a discount, then the current yield will be greater than the
coupon rate. For instance, an 8% bond selling at par has a current yield that is equivalent to its nominal
yield, or 8%.
Current Yield = Annual interest/Current price = (8% x ` 1000) / ` 1000 = 8%.
However, a bond that is selling for less than par, or at a discount, has a current yield that is higher than
the nominal yield. Thus if you buy a bond with a par value of ` 1000, coupon rate of 8% and the current
price of ` 950, the Current Yield= Annual interest/Current price
= (8 % x ` 1000) / ` 950
= ` 80 / ` 950 = 8.42 %

Yield-to-maturity (YTM): This measures the investor’s total return if the bond is held to its maturity date.
This includes the annual interest payments plus the difference between what the investor paid for the
bond and the amount of principal received at maturity.
YTM is the annual rate of return that a bondholder will earn under the assumption that the bond is held
to maturity and the interest payments are reinvested at the YTM. YTM is the same as the bond’s internal
rate of return (IRR). YTM or simply the yield is the discount rate that equates the current market price of
the bond with the sum of the present value of all cash flows expected from this investment.

Previously, we had calculated the price of bond value when the discount rate (r) was given. This discount
rate was the YTM. In YTM calculations, the market price of the bond is given, and we have to calculate
the discount rate that equates the present values of all the coupon payments and the principal
repayment to the market price.
We do this by using trial and error or an approximation formula.

Yield-to-Call: When a bond is callable, the market also looks to the yield-to-call (YTC). Normally if a bond
is called, the bondholder is paid a premium over the face value (known as the call premium). YTC
calculation assumes that the bond will be called, so the time for which the cash flows (coupon and
principal) occur is shortened. YTC is calculated exactly like YTM, except that the call premium is added to
the face value for calculating the redemption value, and the first call date is used instead of the maturity
date.
Bond Investment Strategies
Bond investors can choose from many different investment strategies, depending on the role or roles
that bonds will play in their investment portfolios. Passive investment strategies include buying and
holding bonds until maturity and investing in bond funds or portfolios that track bond indexes. Passive
approaches may suit investors seeking some of the traditional benefits of bonds, such as capital
preservation, income and diversification, but they do not attempt to capitalize on the interest-rate,
credit or market environment. Active investment strategies, by contrast, try to outperform bond indexes,
often by buying and selling bonds to take advantage of price movements. They have the potential to
provide many or all of the benefits of bonds; however, to outperform indexes successfully over the long
term, active investing requires the ability to form opinions on the economy, the direction of interest
rates and/or the credit environment; trade bonds efficiently to express those views; and manage risk.
 Passive Strategies: Buy-and-Hold Approaches Investors seeking capital preservation, income and/or
diversification may simply buy bonds and hold them until they mature. The interest rate environment
affects the prices buy-and-hold investors pay for bonds when they first invest and again when they need
to reinvest their money at maturity. Strategies have evolved that can help buy-and-hold investors
manage this inherent interest-rate risk. One of the most popular is the bond ladder. A laddered bond
portfolio is invested equally in bonds maturing periodically, usually every year or every other year. As the
bonds mature, money is reinvested to maintain the maturity ladder. Investors typically use the laddered
approach to match a steady liability stream and to reduce the risk of having to reinvest a significant
portion of their money in a low interest-rate environment.

 Another buy-and-hold approach is the barbell, in which money is invested in a combination of short-
term and long-term bonds; as the short-term bonds mature, investors can reinvest to take advantage of
market opportunities while the long-term bonds provide attractive coupon rates.

Other Passive Strategies

Investors seeking the traditional benefits of bonds may also choose from passive investment strategies
that attempt to match the performance of bond indexes. For example, a core bond portfolio in the U.S.
might use a broad, investment-grade index, such as the Barclays Capital Aggregate Bond Index, as a
performance benchmark, or guideline. Similar to equity indexes, bond indexes are transparent (the
securities in it are known) and performance is updated and published daily. Many exchange-traded funds
(ETFs) and certain bond mutual funds invest in the same or similar securities held in bond indexes and
thus closely track the indexes’ performances. In these passive bond strategies, portfolio managers
change the composition of their portfolios if and when the corresponding indexes change but do not
generally make independent decisions on buying and selling bonds.
Active Strategies
Investors that aim to outperform bond indexes use actively managed bond strategies. Active portfolio
managers can attempt to maximize income or capital (price) appreciation from bonds, or both. Many
bond portfolios managed for institutional investors, many bond mutual funds and an increasing number
of ETFs are actively managed. One of the most widely used active approaches is known as total return
investing, which uses a variety of strategies to maximize capital appreciation. Active bond portfolio
managers seeking price appreciation try to buy undervalued bonds, hold them as they rise in price and
then sell them before maturity to realize the profits – ideally “buying low and selling high.” Active
managers can employ a number of different techniques in an effort to find bonds that could rise in price.
Credit analysis: Using fundamental, “bottom-up” credit analysis, active managers attempt to identify
individual bonds that may rise in price due to an improvement in the credit standing of the issuer. Bond
prices may increase, for example, when a company brings in new and better management. n
Macroeconomic analysis: Portfolio managers use top-down analysis to find bonds that will rise in price
due to economic conditions, a favorable interest-rate environment or global growth patterns. For
example, as the emerging markets have become greater drivers of global growth in recent years, many
bonds from governments and corporate issuers in these countries have risen in price.
Sector rotation: Based on their economic outlook, bond managers invest in certain sectors that have
historically increased in price during a particular phase in the economic cycle and avoid those that have
underperformed at that point. As the economic cycle turns, they sell bonds in one sector and buy in
another.
Market analysis: Portfolio managers can buy and sell bonds to take advantage of changes in supply and
demand that cause price movements.

Duration management: To express a view on and help manage the risk in interest-rate changes, portfolio
managers can adjust the duration of their bond portfolios. Managers anticipating a rise in interest rates
can attempt to protect bond portfolios from a negative price impact by shortening duration, possibly by
selling some longer-term bonds and buying short-term bonds. Conversely, to maximize the positive
impact of an expected drop in interest rates, active managers can lengthen duration on bond portfolios.
Yield curve positioning: Active bond managers can adjust the maturity structure of a bond portfolio
based on expected changes in the relationship between bonds with different maturities, a relationship
illustrated by the “yield curve.” While yields normally rise with maturity, this relationship can change,
creating opportunities for active bond managers to position a portfolio in the area of the yield curve that
is likely to perform the best in a given economic environment.
Roll down: When short-term interest rates are lower then longer-term rates (known as a “normal”
interest rate environment), a bond is valued at successively lower yields and higher prices as it
approaches maturity or “rolls down the yield curve.” A bond manager can hold a bond for a period of
time as it appreciates in price and sell it before maturity to realize the gain. This strategy can continually
add to total return in a normal interest rate environment.
Derivatives: Bond managers can use futures, options and derivatives to express a wide range of views,
from the creditworthiness of a particular issuer to the direction of interest rates. An active bond
manager may also take steps to maximize income without increasing risk significantly, perhaps by
investing in some longer-term or slightly lower rated bonds, which carry higher coupons.
Active vs. Passive Strategies

 Investors have long debated the merits of active management, such as total return investing, versus
passive management and ladder/ barbell strategies. A major contention in this debate is whether the
bond market is too efficient to allow active managers to consistently outperform the market itself. An
active bond manager, such as PIMCO, would counter this argument by noting that both size and
flexibility help enable active managers to optimize short- and long-term trends in efforts to outperform
the market. Active managers can also manage the interest-rate, credit and other potential risks in bond
portfolios as market conditions change in an effort to protect investment returns. A word about risk: Past
performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is
subject to certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may
be worth more or less than the original cost when redeemed. Investing in foreign denominated and/or
domiciled securities may involve heightened risk due to currency fluctuations, and economic and political
risks, which may be enhanced in emerging markets. Mortgage and asset-backed securities may be
sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in
response to the market’s perception of issuer creditworthiness; while generally supported by some form
of government or private guarantee there is no assurance that private guarantors will meet their
obligations. High-yield, lower-rated, securities involve greater risk than higher-rated securities; portfolios
that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not.
Duration is the measure of a bond’s price sensitivity to interest rates and is expressed in years. 

Q7. Short notes - Risks in Debt Securities

Interest rate risk: The cash flows from a bond (coupon payments and principal repayment) remain fixed
though interest rate keeps changing. As a result, the value of a bond fluctuates. Thus interest rate risk
arises because the changes in the market interest rates affect the value of the bond. The return on a
bond comes from coupons payments, the interest earned from re-investing coupons (interest on
interest), and capital gains. Since coupon payments are fixed, a change in the interest rates affects
interest on interest and capital gains or losses. An increase in interest rates decreases the price of a bond
(capital loss) but increases the interest received on reinvested coupon payments (interest on interest). A
decrease in interest rates increases the price of a bond (capital gain) but decreases the interest received
on reinvested coupon payments.
Thus there are two components of Interest rate risk.
Reinvestment rate risk is the uncertainty about future or target date portfolio value that results from
the need to reinvest bond coupons at yields that are not known in advance.
Interest rate increases tend to decrease bond prices (price risk) but increase the future value of
reinvested coupons (reinvestment rate risk), and vice versa.
Default risk or credit risk refers to the possibility of having the issuer defaulting on the payments of the
bond. It is the risk that the borrower will not honour, in full or in part, its promise to repay the interest
and principal. The realised return on a bond will deviate from the expected return if the issuer fails to
meet the obligations to make interest and principal payments.
Most investors do not directly assess a bond’s default risk, but instead use the credit ratings provided by
credit rating agencies such as CRISIL, ICRA, Moody’s and S&P to evaluate the degree of risk. Credit ratings
are the most common benchmark used when assessing corporate bond default risk. These securities are
backed by the issuing companies, rather than by government/agency guarantees or insurance. Credit
ratings provide an indication of an issuer's ability to make timely interest and principal payments on a
bond.
The two most recognised rating agencies, known worldwide, that assign credit ratings to corporate bond
issuers are Moody's Investors Service (Moody’s) and Standard & Poor's Corporation (S&P). In India, the
credit rating agencies are ICRA and CRISIL among others.
Call risk: If a company issues a bond with a high coupon rate when market interest rates are high, and
interest rates later fall, the firm might like to retire the high-coupon debt and issue new bonds at a lower
coupon rate to reduce interest payments. If a bond has a call provision, then the company can
repurchase the bond at a specified call price before the maturity date. From the bondholder’s
perspective it is a disadvantage, as the proceeds will then have to be reinvested at a lower interest rate.
This is the call risk faced by the bondholder.
Liquidity risk: Bonds have varying degrees of liquidity. There is an enormous number of bond issues most
of which do not trade on a regular basis. As a result, if a bondholder wants to sell quickly, he will
probably not get a good price for his bond. This is the liquidity risk.

Q8 What do you understand by Duration of Bonds? Briefly explain bond value theorems.
Bond duration is a measure of bond price volatility, which captures both price and reinvestment risk and
which is used to indicate how a bond will react in different interest rate environments.
The duration of a bond is the weighted average maturity of cash flow stream, where the weights are
proportional to the present value of cash flows. It is defined as:
Duration = D = {PV (C1) x 1 + PV (C2) x 2+ ----- PV (Cn) x n} / Current price of the bond
Where PV (Ci) is the present values of cash flow at time i.
Steps in calculating duration:
Step 1: Find present value of each coupon or principal payment.
Step 2: Multiply this present value by the year in which the cash flow is to be received.
Step 3: Repeat steps 1 and 2 for each year in the life of the bond.
Step 4: Add the values obtained in step 2 and divide by the price of the bond to get the value of duration.
Generally speaking, bond duration possesses the following properties:
bonds with higher coupon rates have shorter durations
bonds with longer maturities have longer durations
bonds with higher YTM lead to shorter durations
duration of a bond with coupons is always less than its term to maturity because duration gives weight
to the interim payments. A zero-coupon bond’s duration is equal to its maturity.
Duration and Immunization
If the interest rate goes up, the price of the bond falls but return on re-investment of interest income
increases. If the interest rate goes down, the price of the bond rises but return on re-investment of
interest income decreases. Thus the interest rate change has two effects (price risk and reinvestment
risk) in opposite directions.
Can an investor ensure that these two effects are equal so that he is immunised against interest rate
risk? Yes, it is possible, if the investor chooses a bond whose duration is equal to his investment horizon.
Forexample, if an investor’s investment horizon is 5 years, he must choose a bond whose duration is
equal to 5 years if he wants to insulate himself against interest rate risk. If he does so, whenever there is
a change in interest rate, losses (or gains) in price is exactly offset by gains (or losses) in re-investment.
Bond Portfolio Management
The volatility of a bond is determined by its coupon and maturity. The lower the coupon and the higher
the maturity, the more volatile are the bond prices. If market rates are expected to decline, bond prices
will rise. Therefore, you would want bonds with maximum price volatility. Maximum price increase
(capital gain) results from holding long-term, low coupon bonds. (This is the same as saying hold bonds
with long durations).
If market rates are expected to rise, bond prices will fall. Therefore, you would want bonds with
minimum price volatility. Therefore, invest in short term, high coupon bonds to minimise price volatility
and capital loss. (This is the same as saying ‘hold bonds with short durations’).

Bond Theorems
1. Price and interest rates move inversely
2. A decrease in interest rates raises bond prices by more than a corresponding increase in rates
lowers the price
3. Price volatility is inversely related to coupon
4. Price volatility is directly related to maturity
5. Price volatility increases at a diminishing rate as maturity increases

 Lets understand the theorems with illustrations:

Theorem-1 : Price and interest rates move inversely
Lets assume 3 year 10% coupon paying bond for illustration
When YTM = 10% Price = 100
When YTM = 11% Price = 97.55
When YTM = 9% Price = 102.53
Hence it can be concluded that as yield increase price of the bond decline and vice-versa.
Theorem-2 : A decrease in interest rates raises bond prices by more than a corresponding increase in
rates lowers price
Lets assume 3 year 10% coupon paying bond for illustration
When YTM = 10% Price = 100
When YTM = 11% Price = 97.55 Change in price = -2.45%
When YTM = 9% Price = 102.53 Change in price = +2.53%
This the most important theorem of bond which says that price movement of bond with change is
interest rate either side is not equal. Price of the bond increases more than it declines when equal
change in interest rate is given. In above illustration you can clearly see that when yield declines by 1%
price increases by 2.53% while in case of increase in yield by 1%, price decline is 2.45%. As price curve of
the bond is convex, you gain more than you lose.
Theorem-3 : Price volatility is inversely related to coupon
Lets assume 3 year 10% coupon paying bond and 3 year 11% coupon paying bond for illustration.
3 year 10% coupon paying bond
When YTM = 10% Price = 100
When YTM = 11% Price = 97.55 Change in price = -2.45%
When YTM = 9% Price = 102.53 Change in price = +2.53%
3 year 11% coupon paying bond
When YTM = 10% Price = 102.48
When YTM = 11% Price = 100 Change in price = -2.42%
When YTM = 9% Price = 105.06 Change in price = +2.52%
Lets assume current YTM is 10% and then it increases to 11% and declines to 9%. You can clearly see in
the above tables that price movement of the 11% coupon bond is lower than 10% coupon bond. It can
be concluded that higher coupon bonds are less volatile than smaller coupon bonds.

Q9. Discuss the various steps involved in portfolio investment process?

Portfolio is a combination of securities such as stocks, bonds and money market instruments. The
process of blending together the broad asset classes so as to obtain optimum return with minimum risk
is called portfolio construction. Individual securities have risk return characteristics of their own.
Portfolios may or may not take on the aggregate characteristics of their individual parts. Diversification
of investment helps to spread risk over many assets. A diversification of securities gives the assurance of
obtaining the anticipated return on the portfolio. In a diversified portfolio, some securities may not
perform as expected, but others may exceed the expectation and making the actual return of the
portfolio reasonably close to the anticipated one. Keeping a portfolio of single security may lead to a
greater likelihood of the actual return somewhat different from that of the expected return. Hence, it is a
common practice to diversify securities in the portfolio. Commonly, there are two approaches in the
construction of the portfolio of securities viz. traditional approach and Markowitz efficient frontier
approach. In the traditional approach, investor’s needs in terms of income and capital appreciation are
evaluated and appropriate securities are selected to meet the needs of the investor. The common
practice in the traditional approach is to evaluate the entire financial plan of the individual. In the
modern approach, portfolios are constructed to maximise the expected return for a given level of risk. It
views portfolio construction in terms of the expected return and the risk associated with obtaining the
expected return.
Traditional approach - The traditional approach basically deals with two major decisions. They are:
 (a) Determining the objectives of the portfolio.
 (b) Selection of securities to be included in the portfolio.
Normally, this is carried out in four to six steps. Before formulating the objectives, the constraints of the
investor should be analysed. Within the given framework of constraints, objectives are formulated. Then
based on the objectives, securities are selected. After that, the risk and return of the securities should be
studied. The investor has to assess the major risk categories that he or she is trying to minimise.
Compromise on risk and non-risk factors has to be carried out. Finally relative portfolio weights are
assigned to securities like bonds, stocks and debentures and then diversification is carried out.The
traditional approach basically deals with two major decisions. They are: (a) Determining the objectives of
the portfolio. (b) Selection of securities to be included in the portfolio. Normally, this is carried out in
four to six steps. Before formulating the objectives, the constraints of the investor should be analysed.
Within the given framework of constraints, objectives are formulated. Then based on the objectives,
securities are selected. After that, the risk and return of the securities should be studied. The investor
has to assess the major risk categories that he or she is trying to minimise. Compromise on risk and non-
risk factors has to be carried out. Finally relative portfolio weights are assigned to securities like bonds,
stocks and debentures and 1. Analysis of constraints- The constraints normally discussed are:then
diversification is carried out. income needs, liquidity, time horizon, safety, tax considerations and the
temperament.

Income needs- The income needs depend on the need for income in constant rupees and current rupees.
The need for income in current rupees arises from the investor’s need to meet all or part of the living
expenses. At the same time inflation may erode the purchasing power, the investor may like to offset the
effect of the inflation and so, needs income in constant rupees.
a) Need for current income: The investor should establish the income which the portfolio should
generate. The current income need depends upon the entire current financial plan of the investor. The
expenditure required to maintain a certain level of standard of living and all the other income generating
sources should be determined. Once this information is arrived at, it is possible to decide how much
income must be provided for the portfolio of securities.
(b) Need for constant income: Inflation reduces the purchasing power of the money. Hence, the investor
estimates the impact of inflation on his estimated stream of income and tries to build a portfolio which
could offset the effect of inflation. Funds should be invested in such securities where income from them
might increase at a rate that would offset the effect of inflation. The inflation or purchasing power risk
must be recognised but this does not pose a serious constraint on portfolio if growth stocks are selected.
 Liquidity- Liquidity need of the investment is highly individualistic of the investor. If the investor prefers
to have high liquidity, then funds should be invested in high quality short term debt maturity issues such
as money market funds, commercial papers and shares that are widely traded. Keeping the funds in
shares that are poorly traded or stocks in closely held business and real estate lack liquidity. The investor
should plan his cash drain and the need for net cash inflows during the investment period.
Safety of the principal- Another serious constraint to be considered by the investor is the safety of the
principal value at the time of liquidation, investing in bonds and debentures is safer than investing in the
stocks. Even among the stocks, the money should be invested in regularly traded companies of
longstanding. Investing money in the unregistered finance companies may not provide adequate safety.
Time horizon- Time horizon is the investment-planning period of the individuals. This varies from
individual to individual. Individual’s risk and return preferences are often described in terms of his ‘life
cycle’. The states of the life cycle determine the nature of investment. The first stage is the early career
situation. At the career starting point assets are lesser than their liabilities. More goods are purchased on
credit. His house might have been built with the help of housing loan scheme. His major asset may be
the house he owns. His priority towards investments may be in the form of savings for liquidity purposes.
He takes life insurance for protecting him from unforeseen events like death and accidents and then he
thinks of the investments. The investor is young at this stage and has long horizon of life expectancy with
possibilities of growth in income, he can invest in high-risk and growth oriented investments. The other
stage of the time horizon is the mid-career individual. At this stage, his assets are larger than his
liabilities. Potential pension benefits are available to him. By this time he establishes his investment
program. The time horizon before him is not as long as the earlier stage and he wants to protect his
capital investment. He may wish to reduce the overall risk exposure of the portfolio but, he may
continue to invest in high risk and high return securities. The final stage is the late career or the
retirement stage. Here, the time horizon of the investment is very much limited. He needs stable income
and once he retires, the size of income he needs from investment also increases. In this stage, most of
his loans are repaid by him and his assets far exceed the liabilities. His pension and life insurance
programmes are completed by him. He shifts his investment to low return and low risk category
investments, because safety of the principal is given priority. Mostly he likes to have lower risk with high
interest or dividend paying component to be included in his portfolio. Thus, the time horizon puts
restrictions on the investment decisions.
Tax consideration- Investors in the income tax paying group consider the tax concessions they could get
from their investments. For all practical purpose, they would like to reduce the taxes. For income tax
purpose, interests and dividends are taxed under the head “income from other sources”. The capital
appreciation is taxed under the head “capital gains” only when the investor sells the securities and
realises the gain. The tax is then at a concessioanl rate depending on the period for which the asset has
been held before being sold. From the tax point of view, the form in which the income is received i.e.
interest, dividend, short term capital gains and long term capital gains are important. If the investor
cannot avoid taxes, he can delay the taxes. Investing in government bonds and NSC can avoid taxation.
This constraint makes the investor to include the items which will reduce the tax.
 Temperament- The temperament of the investor himself poses a constraint on framing his investment
objectives. Some investors are risk lovers or takers who would like to take up higher risk even for low
return. While some investors are risk averse, who may not be willing to undertake higher level of risk
even for higher level of return. The risk neutral investors match the return and the risk. For example, if a
stock is highly volatile in nature then the stock may be selling in a range of Rs. 100-200, and returns may
fluctuate between Rs. 00- 100 in a year. Investors who are risk averse would find it disturbing and do not
have the temperament to invest in this stock. Hence, the temperament of the investor plays an
important role in setting the objectives.
2. Determination of objectives Portfolios have the common objective of financing present and future
expenditures from a large pool of assets. The return that the investor requires and the degree of risk he
is willing to take depend upon the constraints. The objectives of portfolio range from income to capital
appreciation. The common objectives are stated below:
Current income
Growth in income
Capital appreciation
Preservation of capital
The investor in general would like to achieve all the four objectives, nobody would like to lose his
investment. But, it is not possible to achieve all the four objectives simultaneously. If the investor aims at
capital appreciation, he should include risky securities where there is an equal likelihood of losing the
capital. Thus, there is a conflict among the objectives.
3. Selection of portfolio The selection of portfolio depends on the various objectives of the investor. The
selection of portfolio under different objectives are dealt subsequently.
Objectives and asset mix- If the main objective is getting adequate amount of current income, sixty per
cent of the investment is made on debts and 40 per cent on equities. The proportions of investments on
debt and equity differ according to the individual’s preferences. Money is invested in short term debt
and fixed income securities. Here the growth of income becomes the secondary objective and stability of
principal amount may become the third. Even within the debt portfolio, the funds invested in short term
bonds depends on the need for stability of principal amount in comparison with the stability of income.
If the appreciation of capital is given third priority, instead of short term debt the investor opts for long
term debt. The period may not be a constraint. Growth of income and asset mix- Here the investor
requires a certain percentage of growth in the income received from his investment. The investor’s
portfolio may consist of 60 to 100 per cent equities and 0 to 40 per cent debt instrument. The debt
portion of the portfolio may consist of concession regarding tax exemption. Appreciation of principal
amount is given third priority. For example computer software, hardware and non-conventional energy
producing company shares provide good possibility of growth in dividend.
Capital appreciation and asset mix- Capital appreciation means that the value of the original investment
increases over the years. Investment in real estates like land and house may provide a faster rate of
capital appreciation but they lack liquidity. In the capital market, the values of the shares are much
higher than their original issue prices. For example Satyam Computers, share value was Rs. 306 in April
1998 but in October 1999 the value was Rs. 1658. Likewise, several examples can be cited. The market
capitalisation also has increased. Next to real assets, the stock markets provide best opportunity for
capital appreciation. If the investor’s objective is capital appreciation, 90 to 100 per cent of his portfolio
may consist of equities and 0-10% of debts. The growth of income becomes the secondary objective.
Safety of principal and asset mix- Usually, the risk averse investors are very particular about the stability
of principal. According to the life cycle theory, people in the third stage of life also give more importance
to the safety of the principal. All the investors have this objective in their mind. No one like to lose his
money invested in different assets. But, the degree may differ. The investor’s portfolio may consist more
of debt instruments and within the debt portfolio more would be on short term debts.
4. Risk and return analysis: The traditional approach to portfolio building has some basic assumptions.
First, the individual prefers larger to smaller returns from securities. To achieve this goal, the investor has
to take more risk. The ability to achieve higher returns is dependent upon his ability to judge risk and his
ability to take specific risks. The risks are namely interest rate risk, purchasing power risk, financial risk
and market risk. The investor analyses the varying degrees of risk and constructs his portfolio. At first, he
establishes the minimum income that he must have to avoid hardships under most adverse economic
condition and then he decides risk of loss of income that can be tolerated. The investor makes a series of
compromises on risk and non-risk factors like taxation and marketability after he has assessed the major
risk categories, which he is trying to minimise. The methods of calculating risk and return of a portfolio is
classified in following pages of this chapter.
5. Diversification: Once the asset mix is determined and the risk and return are analysed, the final step is
the diversification of portfolio. Financial risk can be minimised by commitments to top-quality bonds, but
these securities offer poor resistance to inflation. Stocks provide better inflation protection than bonds
but are more vulnerable to financial risks. Good quality convertibles may balance the financial risk and
purchasing power risk. According to the investor’s need for income and risk tolerance level portfolio is
diversified. In the bond portfolio, the investor has to strike a balance between the short term and long
term bonds. Short term fixed income securities offer more risk to income and long term fixed income
securities offer more risk to principal. In the stock portfolio, he has to adopt the following steps which
are shown in the following figure.

As investor, we have to select the industries appropriate to our investment objectives. Each industry
corresponds to specific goals of the investors. The sales of some industries like two wheelers and steel
tend to move in tandem with the business cycle, the housing industry sales move counter cyclically. If
regular income is the criterion then industries, which resist the trade cycle should be selected. Likewise,
the investor has to select one or two companies from each industry. The selection of the company
depends upon its growth, yield, expected earnings, past earnings, expected price earning ratio, dividend
and the amount spent on research and development. Selecting the best company is widely followed by
all the investors but this depends upon the investors’ knowledge and perceptions regarding the
company. The final step in this process is to determine the number of shares of each stock to be
purchased. This involves determining the number of different stocks that is required to give adequate
diversification. Depending upon the size of the portfolio, equal amount is allocated to each stock. The
investor has to purchase round lots to avoid transaction costs.

Modern approach: We have seen that the traditional approach is a comprehensive financial plan for the
individual. It takes into account the individual needs such as housing, life insurance and pension plans.
But these types of financial planning approaches are not done in the Markowitz approach. Markowitz
gives more attention to the process of selecting the portfolio. His planning can be applied more in the
selection of common stocks portfolio than the bond portfolio. The stocks are not selected on the basis of
need for income or appreciation. But the selection is based on the risk and return analysis. Return
includes the market return and dividend. The investor needs return and it may be either in the form of
market return or dividend. They are assumed to be indifferent towards the form of return. Among the
list of stocks quoted at the Bombay Stock Exchange or at any other regional stock exchange, the investor
selects roughly some group of shares say of 10 or 15 stocks. For these stocks’ expected return and risk
would be calculated. The investor is assumed to have the objective of maximising the expected return
and minimising the risk. Further, it is assumed that investors would take up risk in a situation when
adequately rewarded for it. This implies that individuals would prefer the portfolio of highest expected
return for a given level of risk. In the modern approach, the final step is asset allocation process that is to
choose the portfolio that meets the requirement of the investor. The risk taker i.e. who are willing to
accept a higher probability of risk for getting the expected return would choose high risk portfolio.
Investor with lower tolerance for risk would choose low level risk portfolio. The risk neutral investor
would choose the medium level risk portfolio

Q10. Explain the concept of Portfolio Analysis and Diversification of Risk? Or Explain Markowitz
portfolio theory of diversification of risk?

The Concept of Portfolio Analysis and Diversification of Risk

Harry Markowitz in the 1950s developed a theory of portfolio choice that dealt with the households' and
firms' investment in financial assets under uncertainty.
A basic tenet of Economics is that due to the scarcity of resources all economic decisions involve trade-
offs. Markowitz identified the trade-off facing the investor as the one between risk and expected return.
(Markowitz took standard deviation of returns, also known as volatility, as a measure of risk).
Markowitz’s theory analyses how wealth can be optimally invested in portfolios which are made up of
assets with different expected returns and risks. At the heart of Markowitz’s analysis is the insight that
while the return on a portfolio composed of risky assets is the value-weighted average of each risky
asset’s return, the risk of the portfolio is not a linear, weighted average value. The risk of a portfolio
depends not only on individual variances of the different assets comprising the portfolio but on the pair-
wise covariances between them.
The lower the covariances between assets (i.e. the lesser the correlation between their returns) the
lower is the risk of the portfolio composed of these assets. This makes it possible to reduce the risk of a
portfolio by diversification. Markowitz showed that diversification can reduce the risk of a portfolio by
including in assets whose returns have low correlation with each other.
Markowitz's work compels investors to consider the relationship between individual securities’ returns.
Stocks influenced by similar industry-wide conditions will all move together in step. While in good times
they all will perform well, during bad times they all will perform badly and adversely affect the portfolio’s
value and return. Markowitz was the first to formally prove this intuitive finding. He showed that
imperfect correlation between securities in the portfolio is the key reason why diversification reduces
portfolio risk.
Accordingly he proposed that investors should focus on selecting portfolios based on their overall risk-
reward characteristics rather than merely Security Analysis and compiling portfolios from securities that
individually had attractive risk-reward characteristics. In a nutshell, inventors should select portfolios and
not individual securities.
Assumptions of Markowitz Model
Markowitz’s model identifies the trade-off facing the investor as one between expected return (mean)
and risk (variance). It makes the following assumptions concerning the investment market and investors’
behaviour in those markets.
 All investors have the same expected single period investment horizon. At the beginning of the
period, the investor allocates his wealth among various assets, assigning a non-negative weight to
each asset. During the period, each asset generates a random rate of return so that at the end of
the period, his wealth has been changed by the weighted average of the returns.
 Investors are rational and behave in a manner so as to maximise their utility. They seek to
maximise the expected return of total wealth.
 Investors base decisions on expected returns and risk (variance or standard deviation of these
returns from the mean). They are risk-averse and try to minimise the risk and maximise return.
They prefer higher returns to lower returns for a given level of risk.
 Investors have free access to fair and correct information on the returns and risk. All markets are
perfectly efficient.
 There are no taxes and no transaction costs.
Efficient Frontier or Efficient Set
Efficient frontier represents the trade-off between risk and expected return faced by an investor when
forming his portfolio. Efficient frontier was first defined by Harry Markowitz as part of his portfolio
theory considers a universe of risky investments and explores what might be an optimal portfolio based
upon investments in these risky securities.
Assume a one-year holding period for investment in these securities. Today's values for all the risky
investments are known. The returns on these investments (reflecting price changes, coupon payments,
dividends, stock splits, etc.) till the end of the holding period are random. So we can calculate expected
returns and variances of returns for these securities.
Correlation of returns between individual pairs of securities must then be calculated. Using these inputs,
we then calculate the expected return and variance of the portfolio as a whole. The notion of ‘optimal
portfolio’ can be defined in one of two ways:
1. For any level of volatility consider all the portfolios which have that volatility (standard deviation).
From among them all, select the one which has the highest expected return.
2. For any expected return, consider all the portfolios which have that expected return. From among
them all, select the one which has the lowest volatility.

Each definition produces a set of optimal portfolios. Definition (1) produces an optimal portfolio for
different levels of risk. Definition (2) produces an optimal portfolio for different levels of expected return.
The set of optimal portfolios obtained using either definition is exactly the same and is called the
efficient frontier.
In the following diagram, numerous portfolio combinations of all the available assets have been plotted.
This is the attainable set ). From this attainable set of all possible portfolios, we locate the subset known
as theof portfolios. The y-axis represents the expected return and the x-axis represents the total risk as
measured by standard deviation, efficient set which is composed of portfolios that offer the lowest risk
for given level of return (or alternatively, the highest return for a given level of risk). This is the curved
line EF shown in the diagram. All other portfolios in the attainable set are dominated by the efficient set.
Thus the Markowitz portfolio selection model generates a frontier of efficient portfolios which are
equally good. An Security Analysis and investor selects the single portfolio from this ‘efficient’ set that
meets his needs.
The Markowitz efficient frontier is usually composed only of portfolios as only portfolios benefit from
diversification. Individual assets contain both diversifiable and non-diversifiable risk and are generally
not efficient investments. However, the most efficient portfolio may sometimes consist of a single
security if it is the only way the investor can obtain the desired return with a given amount of risk.

Criticism of Markowitz Model

The Markowitz model was a brilliant innovation in the field of portfolio selection. Markowitz showed us
that all the information that was needed to choose the best portfolio for any given level of risk is
contained in three simple statistics, which are mean of securities’ returns, standard deviations of returns
and correlation between securities’ returns.
The model requires no information about dividend policy, earnings, market share, strategy, and quality
of management. In short, Harry Markowitz fundamentally altered the thinking on investment decisions.
Today almost every portfolio manager uses the basic framework of the risk-return trade-offs even if they
do not adopt the Markowitz model entirely.
Why does not then everyone use the Markowitz model to solve their investment problems? The answer
lies in the statistics that are required as inputs for the model. The historical mean return of securities
may be a poor estimate of their future mean return. As we increase the number of securities, we
increase the number of correlations that we must estimate and they must be estimated correctly to
obtain the right answer.
In fact, with more than thousands of stocks listed on the BSE and NSE, it is almost certain that we will
find correlations that are widely inaccurate for the purpose of estimating future correlations.
Unfortunately, the Markowitz model does not deal well with incorrect inputs. That is why the model is
best applied to allocation decisions across asset classes (such as between stocks and bonds). For these
the number of correlations is low, and the statistics (mean, standard deviation and correlation) are well-
estimated.
Meaning of Risk
Risk is the likelihood that your investment will either earn money or lose money. It is the degree of
uncertainty regarding your expected returns from your investments, including the possibility of losing
some or all of your investment. Risk includes not only adverse outcomes (lower returns than expected)
but good outcomes (higher returns). Both downside and upside risks are considered while measuring
risk.
 Measurement of risk
The thumb rule for all investments is smaller the risk smaller the return; and higher the risk, higher the
return. Higher returns compensate for the percent of risk taken. The risk is dependent largely on your
risk appetite, which in turn changes with your age, personality and environment. The daily fluctuations of
the market tend to smoothen out your long term investment (Historically the stock market has always
shown a gradually increasing trend irrespective of short-term declines). But when you are old or close to
your monetary goal, you cannot afford to make losses.
Investing in equity because they could give the highest returns automatically increases the risk
coefficient. You may gain substantially when the markets are buoyant, but run the risk of losing your
entire capital if market tumbles. If you put all your savings in ‘safe and familiar’ investments you may
only earn fewer returns in the long run. For example a 7% assured rate of return which looks attractive
today may not be profitable due to rising inflation or taxes. An investor always likes to yield higher
returns. For that you must be prepared to take the risk of trying out various investment options.
Risk is commonly measured using variance, standard deviation and beta. Variance is the mean of the
square of deviations of individual returns around their average value. Standard deviation is the square
root of variance. Beta reflects the volatility of the returns in relation to market movements.
 Factors that affect Risk
The common risk factors are:
 Business risk: As a security holder you get dividends, interest or principal (on maturity in case of
securities like bonds) from the firm. But there is a possibility that the firm may not be able to pay you
due to poor financial performance. This possibility is termed as business risk. The poor financial
performance could be due to economic slowdown, poor demand for the firm’s goods and services and
large operating expenses. Such a performance affects the equity and the debt holder. The equity holder
may not get dividends and residual claim on the income and wealth of the firm. Similarly a debt holder
may not get interest and principal payments.
 Inflation risk: It is the possibility that the money you invested will have less purchasing power when
your financial goal is met. This means, the rupee you get when you sell your asset buys lesser than the
rupee you originally invested in the asset.
Interest rate risk: The variability in a security’s return resulting from changes in the level of interest rates
is referred to as interest rate risk. For example the value of a bond may reduce due to rising interest
rates. When the interest rate rises, the market price of existing fixed income securities fall, and vice
versa. This happens because the buyer of a fixed income security would not buy it at its par value or face
value if its fixed interest rate is lower than the prevailing interest rate on a similar security. This occurs
due to interest fixed rate lower being lower than the present rate on a similar security. Hence as a buyer
you would pay less than the face or par value for such a security. The changes in interest also have an
indirect effect on effect equity prices. That means the prices are affected by changes in the relative yields
of debentures.
 Market risk: Market risk is the changes in returns from a security resulting from ups and downs in the
aggregate market (like stock market). This type of risk arises when unit price or value of investment
decreases due to market decline. The market tends have a cyclic pattern. John Train says “You need to
get deeply into your bones the sense that any market, and certainly the stock market, moves in cycles, so
that you will infallibly get wonderful bargains every few years, and have a chance to sell again at
ridiculously high prices a few years later”.
The market risk represents a part of the total risk of a security that can be attributed to economic factors
like government spending, GDP growth rate money supply, inflation and interest rate structure. Market
risk is unavoidable as the economic factors have an effect on all firms to some degree. Market risk is
therefore known as systematic risk or non-diversifiable risk.
Risk Preference
An investor with a certain risk tolerance and information on the expected return and standard deviation
decides on various investments. Usually investors want to invest in securities which give higher returns
at lower standard deviations. According to diminishing marginal utility, as a person gets additional
wealth his utility for it increases at a declining rate.
A risk-averse investor will choose Investments with the least standard deviation from a bunch with equal
rates of return, or investments with the highest return from a bunch with equal standard deviations.
A risk-seeking investor likes investment with higher risk irrespective of the rate of return. In reality, most
investors are risk-averse.
Risk Premium =f (Business risk, Financial Risk, Liquidity risk, Exchange risk, Country risk)
(or)
Risk Premium =f (Systematic Market Risk)
Risk Preference
Normal Distribution and Standard Deviation
The normal distribution is a bell shaped curve that is smooth, symmetric and continuous without
skewness. The spread of the normal distribution is characterised by the standard deviation. What is the
probability of obtaining a return exceeding or lower than the expected (mean) return? In case of
normally distributed returns, it depends only on the standard deviation. It is useful to notice certain
properties of a normal distribution.

The area under the curve sums to 1.

The curve reaches its maximum at the expected value (mean) of the distribution and one-half of the
area lies on the either side of the mean.
Approximately 50 percent of the area lies within 0.67 standard deviations of the expected value ; about
68 percent of the area lies within 1.0 standard deviations of the expected value; 95 percent of the area
lies within .96 standard deviation of the expected value and 99 percent of the area lies within 3.0
standard deviation of the expected value
The normal probability table can be used to determine the area under the normal curve for various
standard deviations. The probability of occurrence can be read from the normal probability table. This
table is the ‘right tail’ of the distribution; that is probabilities of the unknown quantity being greater than
X standard deviations from the expected value (mean) are given in the table. The distribution tabulated
is a normal distribution with mean zero and standard deviation of 1. Such a distribution is known as
standard normal distribution. However, any normal distribution can be standardised and hence the table
of normal probabilities will serve for any normal distribution.The formula to standardise is:
S = R- E (R )/σ
R is the outcome (return) in which we are interested, E (R) is mean or expected return and S is the
number of standard deviations from the ex

Q11. Explain Efficient Market Hypothesis (EMH)?

Efficient Market Hypothesis (EMH) asserts that financial markets are ’efficient’, meaning the prices of
traded assets (Example stocks and bonds) reflect all known information. The prices of assets reflect the
collective beliefs of all investors about future prospects. EMH implies that it is not possible to
consistently outperform the market, appropriately adjusted for risk, by using any information that the
market already knows, except through luck. Only new information affects price of assets.
Information or news in the EMH is defined as anything that may affect asset prices. Prices react to
information. Flow of information is random. Therefore price changes are random. In the early 1900s,
Louis Bachelier is credited with developing the idea that the stock prices are governed by a random walk.
The random walk theory asserts that price movements will not follow any patterns or trends and that
past price movements cannot be used to predict future price movements.
Eugene Fama was the first to formally propose EMH. He stated that all relevant information is fully and
immediately reflected in a security's market price. Fama made the argument that in an active market
which has many well-informed and intelligent investors, securities will be appropriately priced and
reflect all available information.
He argued that in an efficient market, competition among the market participants leads to a situation
where, at any point in time, actual prices of securities reflect the events that have happened and the
events that the market expects to take place. (Fama defined an 'efficient' market as a market where
large numbers of rational, profit-maximisers actively compete with each other and try to predict future
market values of individual securities, and where important current information is almost freely available
to all participants.)
The implication of EMH is that in an efficient market the actual price of a security will always be a good
estimate of its intrinsic value. If this hypothesis is correct, no investor will be able to earn anything more
than an equilibrium rate of return on investments (or it is not possible to “beat” the market).
Most people who buy and sell securities do so under the assumption that securities bought are worth
more than the price paid, while securities sold are worth less than the selling price. However, if EMH is
correct and security prices fully reflect all available information, it would not be worth an investor’s time
and effort to find undervalued securities. Buying and selling securities in an attempt to outperform the
market will effectively be a game of chance rather than skill. However, if EMH is not correct and
prices do not fully reflect all available information, investors can find and use that information and
perhaps make a killing in the market.
EMH has been the subject of intense debate among academics and financial professionals. Whether
markets are efficient has been extensively researched and remains controversial. This unit deals with this
concept in detail.
Concept of ‘Efficient Market’
The performance of a financial market depends on how efficiently capital is allocated by the market.
Three related types of market efficiency are used to describe the performance of financial markets,
which are allocation efficiency, operational efficiency, and informational efficiency.
Allocation efficiency: A financial system exhibits allocation efficiency if it allocates capital to its best
(most productive) use. For example, stock market investors shun security offers from firms in declining
industries, but welcome offerings from firms in more promising industries.
Operational efficiency: Operational efficiency refers to the impact of transaction costs and market
frictions on the operation of a market.
Informational efficiency: Informational efficiency refers to whether prices reflect ‘true value’. In a
market exhibiting informational efficiency, asset prices incorporate all relevant information fully and
instantaneously. For example, when company A receives a takeover bid from company B that seems
certain to succeed, the stock price of A increases immediately to reflect the per share bid premium.
Efficient market hypothesis (EMH) deals with informational efficiency.
Market efficiency refers to a condition in which current prices reflect all the publicly available
information about a security. The basic idea underlying market efficiency is that competition will drive all
information into the price quickly. In the financial market, the maximum price that investors are
willing to pay for a financial asset is actually the present value of future cash inflows discounted at a rate
to compensate for the uncertainty in the cash flow projections. Therefore the investors are actually
trading information about future cash flows and their degree of certainty as a "commodity" in financial
markets.
Efficient market emerges when new information is quickly incorporated into the price so that it reflects
up-to-date information. Under these conditions, the current market price in any financial market could
be the best unbiased estimate of the value of the investment.
In an efficient market therefore prices react to new information quickly and precisely. There is no free
lunch in an efficient market. The only way you can get higher returns is by taking on more risk. But no
information is available to construct strategies that can earn higher returns on a consistent basis.
The Value of an Efficient Market
It is important that financial markets are efficient for at least three reasons.
 To encourage share buying: Accurate pricing is required if individuals are to be encouraged to invest in
companies. If shares are incorrectly priced, many savers will refuse to invest because of fear that when
they sell their shares the price may not represent the fundamentals of the firm. This will seriously reduce
the availability of funds to companies and retard economic growth. Investors need the assurance that
they are paying a fair price for acquiring shares and that they will be able to sell their holdings at a fair
price – that the market is efficient.
 To give correct signals to company managers: Maximisation of shareholder wealth is the goal of
managers of a company. Managers will be motivated to take the decisions that maximise the share price
and hence the shareholder wealth, only when they know that their wealth maximising decisions are
accurately signalled to the market and get incorporated in the share price. This is possible only when the
market is efficient.
 To help allocate resources: If a badly run company in a declining industry has shares that are highly
valued because the stock market is not pricing them correctly, it will be able to issue new capital by
issuing shares. This will attract more of economy’s savings for its use. This would be bad for the economy
as these funds would be better utilised elsewhere.
Random Walk Theory
EMH is associated with the idea of a “random walk”. Random walk is a term used to characterise a price
series where all subsequent price changes represent random deviations from previous prices. The logic
of the random walk idea is that if the flow of information is not hindered and if information is
immediately incorporated and reflected in the stock prices, it follows that tomorrow’s security price will
incorporate tomorrow’s news and security price changes tomorrow will be independent of the price
changes today. Since news by definition is unpredictable and random, the resulting price changes must
be random too.
The theory asserts that prices have no memory; therefore past and present prices cannot be used to
predict future prices (as implied in technical analysis). Prices move at random, since new information is
random, and adjust to new information as it becomes available. The adjustment to this new information
is so fast that it is impossible to profit from it. Furthermore, news and events are also random and trying
to predict these (fundamental analysis) is useless.
The theory implies that the prices fully reflect all known information, and even uninformed investors
buying a diversified portfolio at the market prices will obtain a rate of return equal to that achieved by
the experts. In his book “A Random Walk Down Wall Street”, Burton G Malkiel states that a blindfolded
chimpanzee throwing darts at the Wall Street Journal can select a portfolio that would perform as well as
the portfolio that is selected by the experts. The advice to the investors is not to ask a chimpanzee to
throw darts and select a portfolio for them, but to buy and hold a broad-based index fund.
 Random Walk and EMH
Statistical research has shown that stock prices seem to follow a random walk with no apparent
predictable patterns that investors can exploit to their advantage. These findings are now taken to be
evidence of market efficiency, i.e. market prices reflect all currently available information. Only new
information will move stock prices, and this information is equally likely to be good or bad news.
Therefore stock prices movements are random.
Random walk theory usually starts from the assumption that the major security exchanges are good
examples of efficient markets where there are large numbers of rational profit-maximisers actively
competing with one another, trying to predict future market values of individual securities. In an efficient
market important current information is almost always freely available to all participants.
In an efficient market, actual prices of individual securities at any point in time reflect the information
based both on past and future events. This is the result of competing actions of many intelligent market
participants. In an efficient market the actual price of a security is a good estimate of its  intrinsic value.
In an uncertain world market, participants will disagree on the intrinsic value of the security, leading to
discrepancies between actual prices and intrinsic values. But in an efficient market the actions of the
many competing participants cause the actual price of a security to wander randomly about its intrinsic
value.
If the differences between actual prices and intrinsic values are systematic rather than random in nature,
as predicted by theory, then intelligent market participants should be able to predict the path by which
the actual prices move towards their intrinsic values. However, when many intelligent traders attempt to
take advantage of this knowledge, they would tend to neutralise such systematic behaviour in price
series. Although uncertainty concerning intrinsic values will remain, actual prices of securities will
wander randomly about their intrinsic values.
The intrinsic values change all the time as a result of new information coming in. The new information is
about factors that may affect a company’s prospects, such as the success of a current R&D program, a
change in management, a new tax imposed on the industry’s products in foreign countries etc. In an
efficient market, on an average, competition between market players will cause the full effects of new
information on intrinsic value to be reflected “instantaneously” in actual prices. This “instantaneous
adjustment” property of an efficient market implies that successive price changes in individual securities
will be independent. A market where successive price changes in individual securities are independent is,
by definition, a random-walk market.
The random-walk hypothesis may not be an exact description of the behaviour of stock market prices.
However, for practical purposes, the model may be accepted. Thus, although successive price changes
may not be strictly independent, the actual amount of dependence may be so small as to be
unimportant.
Forms of Market Efficiency
Informational efficiency is all about reflecting all available information in the price of a security. Two
questions arise here are:
(1) What is all available information?
(2) What does reflection of available information mean?
Different answers to these questions give rise to different versions of market efficiency.
Available information: This is at three levels of strength. Basic information about the past prices refers
to the weak version of EMH. Price information together with all published and publicly available data
refers to the semi-strong version. Information about price, public data as well as private data refers to
the strong version of EMH.
“Prices reflect all available information” means all financial transactions that are carried out at market
prices, using the available information, are zero NPV activities.The weak form of EMH states that all past
prices, volumes and other market statistics (generally referred to as technical data) cannot provide any
information that would prove useful in predicting future stock price movements. The current prices
fully reflect all security market information, including the historical sequence of prices, rates of return,
trading volume data, and other market-generated information. This implies that past rates of return and
other market data should have no relationship with future rates of return. It would mean that if the
weak form of EMH is correct, then technical analysis cannot generate excess returns.
The semi-strong form suggests that stock prices fully reflect all publicly available information and all
expectations about the future. “Old” information is to be discarded and not to be used to predict stock
price fluctuations. The semi-strong form suggests that fundamental analysis is also fruitless knowing
what a company generated in terms of earnings and revenues in the past will not help you determine
stock price in the future. This implies that decisions made on new information after it is public should not
lead to above-average risk-adjusted profits from those transactions.
Lastly, the strong form of EMH suggests that stock prices reflect all information, whether it be public
(say in SEBI filings) or private (in the minds of the CEO and other insiders). So even with material non-
public information, EMH asserts that stock prices cannot be predicted with any accuracy.

Empirical Tests of EMH

The debate about efficient markets has resulted in a plethora of empirical studies attempting to
determine whether specific markets are in fact ‘efficient’ and if so to what degree. Academic studies
have attempted to prove or disprove each of these forms of EMH, via testing of correlations (month-to-
month and day-to-day returns), relative strengths, stock splits, earnings announcements, book
value/market capitalisation correlation studies etc.
To test weak form efficiency, profitability of trading is tested to see whether past price or volume
contains useful information. Auto correlation tests and filter rule tests are used to test weak form
efficiency. An auto correlation test investigates whether the returns are statistically dependent on one
another, i.e. can past stock return data predict future stock return data. A filter rule is a trading rule
regarding the actions to be taken when shares rise or fall in value by x%. Filter rules should not work if
markets show weak form of efficiency.
Semi-strong form efficiency denotes that any new information about the stock is incorporated into the
price so quickly that the investor cannot act upon it and gain excess returns. The main line of research in
this area is to watch the stock price just before and after a public announcement. These are called  event
studies. Event studies involving phenomena occurring at known points in time, such as a stock split or
the announcement of corporate earnings, are frequently used in tests of the semi-strong form of market
efficiency, to see whether public information is reflected immediately.
To test strong-form efficiency performance of professional managers or insiders is assessed to see
whether they have superior information unknown to public investors. A tremendous amount of evidence
supports the weak form of efficient market hypothesis. Technical trading rules are not consistently
profitable. Serial correlation in daily stock returns is close to zero. The history of share prices cannot be
used to predict the future in any abnormally profitable way. Early tests of the EMH focused on technical
analysis. It is the technical analysts whose existence is threatened the most by EMH. The vast majority of
studies of technical theories have found these strategies to be completely useless in predicting securities
prices.
Recently though, there have been some studies which show that in certain circumstances some of the
schemes technical analysts use might be of help in reaping excess returns, although the trading costs
involved might eat up the higher returns.
Semi-strong form of EMH is generally supported by the data. Prices react to news quickly. Studies have
looked, among other things, at the reaction of the stock market to the announcement of various events
such as earnings, stock splits, capital expenditure, divestitures and takeovers. The usefulness or
relevance of the information was judged based on the market activity associated with a particular event.
In general, typical results from event studies have showed that security prices adjust to new information
within a day of the event announcement, an inference that is consistent with the semi-strong form EMH.
Some evidence for and against the semi-strong form of market efficiency has been discovered in the
following:
Information announcements: Can trading in shares, immediately following announcement of new
information, (for example announcements on dividends or profit figures) produce abnormal returns?
Evidence supports the semi-strong form of EMH, as excess returns, are nil. It is seen that most of the
information in financial results or dividend announcements are reflected in share prices before the
announcement is made.
Stock splits: When stock splits are made, no new money is raised by the company and existing
shareholders receive more shares for the same value of stock. As the firm does not receive money and
the fundamentals have not changed, prices should not react purely to a stock split. However, splits tend
to occur when companies are doing well, and are seen as confirmation that the company anticipates
continued growth in profits and dividends. Researches have shown that share prices rise steeply before
the split, but not following it. So investors would not be able to profit by purchasing stock on the split
date. This evidence is consistent with the semi-strong form of EMH.
Manipulation of earnings: Release of financials is an important source of information about a company.
Most companies present a truthful account of their business, but some do creative accounting (which
obeys the letter of the law and accounting rules but involves the manipulation of the accounts to show
the most favourable figures). Market efficiency tests have shown that investors certainly ingest
accounting information in their decision, but doubts have been raised about market efficiency to large-
scale creative accounting.
Evidence does not support strong form EMH. Insiders can make a profit on their knowledge, and people
go to jail, get fined, or get suspended from trading for doing so. One does not even have to look at the
studies done in this area. All the news stories of people making excess returns by participating in insider
trading, (e.g. Ken Lay and Jeff Skilling, former Enron executives who allegedly participated in insider
trading), contradict the strong form of the EMH. It is well-known that people can and do make abnormal
gains using information that is not in the public domain. In this respect stock markets are not strong form
efficient. Those who do not have the private information feel cheated by insider trading. To avoid a loss
of confidence in the market, most stock exchanges attempt to curb insider trading and it is a criminal
offence in most exchanges.
There is also negative evidence for EMH as given below:
1. Stock market crash of 1987: There was no apparent exogenous news that could cause the crash which
resulted in an enormous and discontinuous price drop. On October 19, 1987, the Dow Jones Industrial
Average fell by 22 percent. The effect was felt worldwide and there was no immediate bouncing back
from the crash. There was heavy institutional selling (one institution sold $1.7 billion). The suspects for
the crash were index arbitrage and portfolio insurance whose collective mass selling caused the market
to fall.
2. Smooth dividends but volatile prices (research conducted by Shiller): The volatility of share prices
relative to variables that affect share prices can be studied to test market efficiency. Shiller’s study of
share price volatility revealed significant volatility in the stock market. Shiller inferred that the
fluctuations in actual prices which were greater than those implied by changes in the fundamental
variables were the result of fads or waves of optimistic or pessimistic market psychology.

 Misconceptions about EMH

There are three classic misconceptions:
Any share portfolio will perform as well as or better than a special trading rule designed to outperform
the market: Market efficiency does not mean that it does not make a difference how you invest. The
risk-return trade-off applies at all times, and it is important that the portfolio is broad-based and
diversified. EMH only cautions you not to expect to consistently "beat the market" on a risk-adjusted
basis, using costless trading strategies.
There should be fewer price fluctuations: Again, EMH does not mean stability of stock prices. In fact
constant fluctuation of market prices is really an indication that markets are efficient. New information
impacting security prices arrives constantly and causes continuous adjustment of prices.
EMH presumes that all investors have to be informed, skilled, and able to constantly analyse the flow
of new information. Still, the majority of common investors are not trained financial experts.
Therefore market efficiency cannot be achieved: This too is wrong. Not all investors have to be
informed. In fact, market efficiency can be achieved even if only a relatively small core of informed and
skilled investors trade in the market. It only needs a few trades by informed investors using all the
publicly available information to drive the share price to its semi-strong-form efficient price.
EMH, Technical Analysis and Fundamental Analysis
Technical analysis is a general term for a number of investing techniques that attempt to forecast
securities prices by studying past prices and related statistics. Fundamental analysis focuses on the
determinants of the underlying value of the stock or security, such as a firm's profitability and growth
prospects. As both types of analysis are based on public information, neither should generate excess
profits if markets are operating efficiently.
Weak-form EMH states that the current prices fully reflect all security-market information, including the
historical sequence of prices, rates of return, trading volume data, and other market-generated
information. This implies that past rates of return and other market data should have no relationship
with future rates of return.
Technical analysis searches for profitable trading strategies based on recurring patterns in stock prices.
Many people do price charting to predict share prices. However, examining recent trends in price and
other market data in order to predict prices would be a waste of time if the market is weak-form
efficient. Investors cannot devise an investment strategy to yield abnormal profits on the basis of an
analysis of past price patterns.
Under the weak form of EMH, technical analysis is useless. Technical analysis relies on sluggish
response of stock prices to fundamental supply and demand factors. This possibility is diametrically
opposed to the notion of an efficient market. Stock prices follow random walks, and past returns are
entirely useless for predicting future returns.
Empirical studies of technical analysis do not generally support the hypothesis that these can generate
trading profits. Only very short-term filters seem to offer any hope for profits, yet these are extremely
expensive in terms of trading costs. These costs exceed potential profits even in the case of floor traders.
The majority of researchers that have tested technical trading systems (and the weak-form EMH) have
found that prices adjust rapidly to stock market information and that technical analysis is unlikely to
provide any advantage to investors who use them.
However, others argue that all this does not negate technical analysis.
Semi-strong form EMH states that the current security prices reflect all public information, including
market and non-market information implies that decisions made on new information after it becomes
public should not lead to above-average risk-adjusted profits from those transactions.
Implications of semi-strong form EMH: The semi-strong form tests focus on the question of whether it is
worthwhile to acquire and analyse publicly available information. If semi-strong efficiency is true, it
undermines the work of fundamental analysts whose trading rules cannot be applied to produce
abnormal returns because all publicly available information is already reflected in the share price. An
analysis of balance sheets, income statements, product line, announcements of dividend changes or
stock splits, or any other public information about a company will not yield abnormal profits if the
market is semi-strong form efficient.
Several anomalies (discussed in this unit) regarding semi-strong form of EMH have been uncovered.
These include the P/E effect, the small-firm effect, the neglected-firm effect, and the market-to-book
effect. The anomalies seem to contradict the semi-strong version of EMH.
Strong-form EMH states that stock prices fully reflect all information from public and private sources.
This would require perfect markets in which all information is cost-free and available to everyone at the
same time (which is clearly not the case). Implication of strong-form EMH is that not even “insiders”
would be able to “beat the market” on a consistent basis.
 Implications of EMH for Security Analysis and Portfolio Management
 Implications for active and passive investment
Proponents of EMH often advocate passive as opposed to active investment strategies. Active
management is the art of stock-picking and market-timing.The policy of passive investors is to buy and
hold a broad-based market index. Passive investors spend neither on market research, on frequent
purchase nor on sale of shares.
The efficient market debate plays an important role in the decision between active and passive investing.
Active managers argue that less efficient markets provide the opportunity for skilful managers to
outperform the market. However, it is important to realise that a majority of active managers in a given
market will underperform the appropriate benchmark in the long run whether or not the markets are
efficient. This is because active management is a zero-sum game in which the only way a participant can
profit is for another less fortunate active participant to lose. However, when costs are added, even
marginally successful active managers may underperform the market. By and large, performance record
of professionally managed funds does not support the claim that active managers can consistently beat
the market. The empirical evidence is that investing in passively managed funds such as index fund has
outperformed actively managed funds for the last several decades.
If markets are efficient, what is the role for investment professionals? Those who accept EMH generally
reason that the primary role of a portfolio manager consists of analysing and investing appropriately
based on an investor's tax considerations and risk profile. Optimal portfolios will vary according to
factors such as age, tax bracket, risk aversion, and employment. The role of the portfolio manager in an
efficient market is to tailor a portfolio to those needs, rather than to beat the market.
Implications for investors and companies
EMH has a number of implications for both investors and companies.
For investors: Much of the existing evidence indicates that the stock market is highly efficient, and
therefore, investors have little to gain from active management strategies. Attempts to beat the market
are not only useless but can reduce returns due to the costs incurred in active management
(management fees, transaction costs, taxes, etc.). Investors should therefore follow a passive investment
strategy, which makes no attempt to beat the market.
This does not mean that there is no role for portfolio management. Returns can be optimised through
diversification and asset allocation, and by minimisation of investment costs and taxes. In addition, the
portfolio should be geared to the time horizon and risk profile of the investor.
Public information cannot be used to earn abnormal returns. Therefore, the implication is that
fundamental analysis is a waste of time and money and as long as market efficiency is maintained, the
average investor should buy and hold a suitably diversified portfolio.
Investors, however, will have to make efforts to obtain timely information. Semi-strong form of market
efficiency depends on the quality and quantity of publicly available information. Therefore, companies
should be encouraged by investor pressure, accounting bodies, government rulings and stock market
regulation to provide as much information as feasible, subject to the need for secrecy.
The perception of a fair and efficient market can be improved by more constraints and deterrents placed
on insider trading.
For companies: EMH also has implications for companies.
 Companies should focus on substance, not on window-dressing accounting data: Some managers
believe that they can fool shareholders through creative accounting but investors are able to see through
the manipulation and interpret the real position, and consequently security prices do not rise.
 The timing of security issues does not have to be fine-tuned: A company need not delay a share issue
thinking that its shares are currently under-priced because the market is low and hoping that the market
will rise to a more ‘normal level’ later. This thinking defies the logic of the EMH – if the market is efficient
the shares are already correctly priced and it is just as likely that the next move in prices will be down as
up.

Q12. Write short notes on Factor models?

Two-factor Models and Variance

Single Factor Model and Variance

The simplest factor model, given below, is a one-factor model:
The return on a security ri is given by:
Where F = the factor
ai = the expected return on the security i if the factor has a value of zero
bi = the sensitivity of security i to this factor
εi = the random error term.
The returns on security i are related to two main components. The first of these involves the factor F.
Factor F affects all security returns but with different sensitivities. The sensitivity of security i is return to
F is bi. Securities that have small values for this parameter will react only slightly as F changes, whereas
when bi is large, variations in F cause large movements in the return on security i.
As a concrete example, think of F as the return on a market index (e.g. the Sensex or the Nifty), the
variations in which cause variations in individual security returns. Hence, this term causes movements in
individual security returns that are related. If two securities have positive sensitivities to the factor, both
will tend to move in the same direction.
The second term in the factor model is a random error term, which is assumed to be uncorrelated across
different stocks. We denote this term εi and call it the idiosyncratic return component for stock i. An
important property of the idiosyncratic component is that it is assumed to be uncorrelated with F, the
common factor in stock returns. The expected value of random error term is zero.
According to one factor model, the expected return on security i, can be written as:

FWhere denotes the expected value of the factor. The random error term drops out as the expected
value of the random error term is zero.
This equation can be used to estimate the expected return on the security. For example, if the factor F is
the GDP growth rate, and the expected GDP growth rate is 5%, ai = 4% and bi = 2, then the expected
return is equal to 4% + 2 x 5% = 14%.
The variance of any security in the single factor model is equal to:

F2 = the variance of the factor FWhere

εi 2 = the variance of the random error term εi.
F2 = 0.0003Thus if the variance of the factor
εi 2 = 0.0015Variance of the random error term
bi = 2
Variance of the security = 22 x 0.0003 + 0.0015 = 0.0027
Standard deviation of the security = √variance =√0.0027 = 0.0520 = 5.2 %.
In a single factor model, the covariance between any two securities i and j is equal to:

Where bi and bj = the factor sensitivities of the two securities SDsF2 = the variance of the factor F

Q13. Explain Capital asset pricing model with its assumptions and criticisms.
Capital asset pricing means defining an appropriate risk-adjusted rate of return for a given asset. Capital
Asset Pricing Model (CAPM) is a model that helps in this exercise.
William Sharpe, Treynor and Lintner contributed to the development of this model. An important
consequence of the modern portfolio theory as introduced by Markowitz was that the only meaningful
aspect of total risk to consider for any individual asset is its contribution to the total risk of a portfolio.
CAPM extended Harry Markowitz’s portfolio theory to introduce the notions of systematic and
unsystematic (or unique) risk.
With the introduction of risk-free lending and borrowing, the efficient frontier of Markowitz was
expanded and it was shown that only one risky portfolio (the tangency portfolio) mattered in evaluating
the portfolio risk contribution characteristics of any asset. CAPM demonstrated that the tangency
portfolio was nothing but the market portfolio consisting of all risky assets in proportion to their market
capitalisation.
Since the market portfolio includes all the risky assets in their relative proportions, it is a fully diversified
portfolio. The inherent risk of each asset that can be eliminated by belonging to the portfolio has already
been eliminated. Only the market risk (also called systematic risk) will remain. This has been discussed in
detail in the last unit.
The CAPM is a model for risky asset pricing. Using a statistical technique called linear regression, the
total risk of each risky asset is separated into two components:
 variability in its returns (i.e., risk) that is related with the variability of returns in the market
portfolio (its contribution to systematic risk)
 variability in its returns that is unrelated with the variability of returns in the market portfolio
(called unsystematic risk).
Systematic and Unsystematic Risk
Every investment portfolio has a risk element, which is the investor will always not be certain whether
the investment will be able to generate income as per investor’s requirement. The degree of risk defers
from industry to industry but also from company to company. It is not possible to eliminate the
investment risk altogether but with careful diversification the risk might be minimised. Provided that the
investor diversify their investments in a suitably wide portfolio, the investments which perform well and
those which perform badly, should tend to cancel each other out, and much risk is diversified away.
Risks that can be reduced through diversification are referred to as unsystematic risk as they are
associated with a particular company or sector of the business. Remember investors are supposed to be
compensated for any risk assumed, but with unsystematic risk the investor will not be have any extra risk
premium as it can be eliminated through diversification.

Some investments are by their nature more risky than others. These risks are called as systematic risk
which will always remain in an investment despite holding a well diversified investment opportunities. If
an investor would not take systematic risk, then should be prepared to settle for risk free return which
has a lower level of return. Where an investor assumes the systematic risk, and then should expect to
earn a return which is higher than a risk free rate of return. The amount of systematic risk in an
investment varies between different types of investment. The systematic risk in the operating cash flows
of a tourism company which is highly sensitive to consumer’s spending power might be greater than the
systematic risk for a company which operates a chain of supermarkets. Systematic risk of a risky asset
exists in the market portfolio and cannot be eliminated by portfolio diversification. Investors who want
to hold the market portfolio must be and are rewarded. Unsystematic risk for any risky asset cannot be
eliminated by holding the market portfolio (which includes the risky asset in question).
Thus the major conclusion of CAPM is that expected return on an asset is related to its systematic and
not to its total risk or standard deviation. Its systematic risk is given by its beta coefficient (β). An asset’s
beta is a measure of its co-movement with the market index.
Assumptions of CAPM
 All investors are assumed to follow the mean-variance approach, i.e. the risk-averse investor will
ascribe to the methodology of reducing portfolio risk by combining assets with counterbalancing
correlations.
 Assets are infinitely divisible.
 There is a risk-free rate at which an investor may lend or borrow. This risk-free rate is the same
for all investors.
 Taxes and transactions costs are irrelevant.
 All investors have same holding period.
 Information is freely and instantly available to all investors.
 Investors have homogeneous expectations i.e. all investors have the same expectations with
respect to the inputs that are used to derive the Markowitz efficient portfolios (asset returns,
variances and correlations).
 Markets are assumed to be perfectly competitive i.e. the number of buyers and sellers is
sufficiently large, and all investors are small enough relative to the market, so that no individual
investor can influence an asset’s price.
Consequently all investors are price takers. Market price is determined by matching supply and demand.
Investors are considered to be a homogeneous group. They have the same expectations, same one-
period horizon, same risk-free rate and information is freely and instantly available to all investors. This is
an extreme case, but it allows the focus to change from how an individual should invest to what would
happen to security prices if everyone invested in a similar manner.
 Some of these assumptions of CAPM are clearly unrealistic. But relaxing many of these assumptions
would have only minor influence on the model and would not change its main implications or
conclusions. The primary way to judge a theory is to see how well it explains and helps predict
behaviour. While CAPM does not completely explain the variation in stock returns, it remains the most
widely used method for calculating the cost of capital.
Market Portfolio
If investors have the same expectations, same one-period horizon, same risk-free rate and if information
is freely and instantly available to all investors, it can be shown that the portfolio of risky assets lying on
the efficient frontier that the investors hold (the tangency portfolio) is the same for everyone. It is
the market portfolio.
Market portfolio consists of all assets available to investors, and each asset is held in proportion to its
market value relative to the total market value of all assets.
The tangency portfolio should be the market portfolio. Reason being the tangency portfolio is a portfolio
that every rational investor would hold. If a risky asset was not included in this portfolio there would be
no demand for it and it would not exist.
As far as the proportion of each risky asset in this market portfolio is concerned, market efficiency and
equilibrium ensure that the demand for each asset is reflected in its price so that the relative market
capitalisation of each asset (as a percentage of the entire market for risky assets) would be the weight or
proportion of each asset in the market portfolio.
The Beta Factor and Risk Free Rate of Return
A share’s beta factor is the measures of measure of its volatility in terms of market risk. The beta factor
of the market as a whole is 1.0. Market risk makes market returns volatile and the beta factor is simply a
yardstick against which the risk of other investments can be measured. Risk or uncertainty describes a
situation where there is not first one possible outcome but array of potential returns. Risk is measured as
the beta factor or B.
·         Negative beta - A beta less than 0 - which would indicate an inverse relation to the market - is possible
but highly unlikely. Some investors used to believe that gold and gold stocks should have negative betas
because they tended to do better when the stock market declined, but this hasn't proved to be true over
the long term.
·         Beta of 0 - Basically, cash has a beta of 0. In other words, regardless of which way the market moves,
the value of cash remains unchanged (given no inflation).
·         Beta between 0 and 1 - Companies with volatilities lower than the market have a beta of less than 1
(but more than 0). As we mentioned earlier, many utilities fall in this range.
·         Beta of 1 - A beta of 1 represents the volatility of the given index used to represent the overall market,
against which other stocks and their betas are measured. is such an index. If a stock has a beta of one, it
will move the same amount and direction as the index. So, an index fund that mirrors the S&P 500 will
have a beta close to 1.
·         Beta greater than 1 - This denotes a volatility that is greater than the broad-based index. Again, as we
mentioned above, many technology companies on the Sensexhave a beta higher than 1.
·         Beta greater than 100 - This is impossible as it essentially denotes a volatility that is 100 times greater
than the market. If a stock had a beta of 100, it would be expected to go to 0 on any decline in the stock
market. If you ever see a beta of over 100 on a research site it is usually the result of a statistical error,
or the given stock has experienced large swings due to low liquidity, such as an over-the-counter stock.
For the most part, stocks of well-known companies rarely ever have a beta higher than 4.
·         - The market as a whole has B = 1
- Risk free security has a B = 0
- A security with a B < 1 is lesser risky than average Market
- A security with a B > 1 has risk above market
Essentially, beta expresses the fundamental tradeoff between minimizing risk and maximizing return.
Let's give an illustration. Say a company has a beta of 2. This means it is two times as volatile as the
overall market. Let's say we expect the market to provide a return of 10% on an investment. We would
expect the company to return 20%. On the other hand, if the market were to decline and provide a
return of -6%, investors in that company could expect a return of -12% (a loss of 12%). If a stock had a
beta of 0.5, we would expect it to be half as volatile as the market: a market return of 10% would mean a
5% gain for the company.)
The Capital Market Line (CML)
The CML says that the expected return on a portfolio is equal to the risk-free rate plus a risk premium.
Where, rf = risk-free rate, rm = return on market portfolio, σm = standard deviation of the return on
market portfolio, σp = standard deviation of the return on the portfolio. Graphically, the CML can be
drawn as below:
EF is the efficient frontier, M is the market portfolio and the line tangent to the efficient frontier and
joining the risk-free rate (rf) with the market portfolio (M) and going beyond is the Capital Market Line
(CML).
The risk-free rate compensates investors for the time value of money while the risk premium
compensates investors for bearing risk. The risk premium is equal to the market price of risk times the
quantity of risk for the portfolio (as measured by the standard deviation of the portfolio).
m is the risk of the market portfolio. Thus, the slope of the CML measures the reward per unit of market
risk. It determines the additional return needed to compensate for a unit change in risk. It is also called
the market price of risk.The term (rm – rf) is the expected return of the market beyond the risk-free
return. It is a measure of the reward for holding the risky market portfolio rather than the risk-free asset.
The term
Capital Market Line (CML) leads all investors to invest in the tangency portfolio (M portfolio) which is
the investment decision. Individual investors differ in position on the CML depending on risk preferences
(which leads to the financing decision). Risk-averse investors will lend part of the portfolio at the risk-free
rate (rf) and invest the remainder in the market portfolio (points left of M). Aggressive investors would
borrow funds at the risk-free rate and invest everything in the market portfolio (points to the right of M)

The Security Market Line (SML)

For an individual risky asset, the relevant risk measure is the covariance of its returns with the return on
the market portfolio. An extension of covariance called beta coefficient of an asset, βi is defined as:

Where σ i,M = covariance of the return on the asset and the return on the market portfolio.
σ2M = variance of return on the market portfolio.
The CAPM equation, whose graphical representation is the Security Market Line (SML), describes a linear
relationship between risk and return for an individual asset. Risk, in this case, is measured by beta (β).
Required rate of return for a particular asset in a market depends on its sensitivity to the movement of
the market portfolio (i.e. the broader market). This sensitivity is known as the asset beta (β) and reflects
systematic risk of the asset. For the market portfolio, beta of the portfolio, βM = 1 by definition. More
sensitive assets have a higher beta while less sensitive assets have lower beta. Expected return on any
security or portfolio is equal to the risk-free rate plus a risk premium.

Thus expected return on a security (ri) depends on the risk-free rate, (rf,) which is the pure time value of
money, (rM – rf,) the reward for bearing systematic risk and βi, the amount of unsystematic risk.

CML and SML

The Security Market Line (SML) and the Capital Market Line (CML) are sometimes confused with each
other. CML is a straight line on a plot of absolute returns versus risk that begins at the point of the risk-
free asset and extends to its point of tangency with the efficient frontier for risky assets that we call the
market portfolio and beyond. Along CML, there are only differing proportions of investing in the market
portfolio and borrowing or lending at the risk-free rate to either increase or decrease the exposure to
the market portfolio.
SML allows us to represent the risk and return characteristics of every asset in the market portfolio.
Instead of dealing with the market portfolio as a whole or as a single entity, SML disaggregates the
market portfolio into its individual risky assets and plots return against the only meaningful (or
rewarded) aspect of total risk for each asset that is rewarded (its beta).
Thus CML shows the relation between the expected return from a portfolio and its standard deviation
and helps investors in their capital allocation problem, while SML shows the relation between expected
return and beta and helps investors in security selection and individual asset pricing.

Limitations of Capital Asset Pricing Model

 CAPM is a single period model.
 It is a single factor linear model. It defines risky asset returns solely as a function of the asset’s
contribution to the systematic risk of the market portfolio.
 The true market portfolio defined by the theory behind the CAPM is unobservable. Therefore,
one has to select and use a market portfolio such as Nifty or Sensex as “proxy.”
 If we use historical data to estimate the inputs for the basic CAPM (risk-free rate, beta and
market risk premium), we are making the assumption that the past (specifically the period that
we select for the historical data) is the best predictor of the future.

Over the years, a lot of research has been done to test the validity of CAPM but there are problems
encountered in doing this research. CAPM is a theory about expected returns whereas we can only
measure actual returns. This makes it difficult to test the theory as it is conceived. Another problem in
testing CAPM is that the market portfolio should include all assets, not just stocks traded in stock
exchanges. In practice, most of the tests use stock market indexes such as the S & P 500 as proxies for
the market portfolio.
The results of the research, in general, indicate that the model fails a rigorous test of validity. The results
do generally indicate that any asset’s returns are, as CAPM asserts, a linear function of its non-
diversifiable risk. But these studies, strictly interpreted find a different intercept and a different slope for
SML than the one predicted by CAPM—SML seems flatter than that predicted by CAPM.
In spite of its limitations, most observers regard CAPM as the best tool to describe how assets are priced
in efficient markets at equilibrium. The model has found its way into the practical tool kit of many
security analysts, portfolio designers, financial managers, investors etc. Corporations often use CAPM to
help estimate the cost of equity financing, which is in turn an important component of the weighted
average cost of capital (WACC).
Q14. Explain Arbitrage Pricing Theory (APT) with its assumptions and criticisms.

 Modern portfolio theory helps an investor to identify his optimal portfolio from umpteen number of
security portfolios that can be constructed. We have seen in earlier units how the risk-return framework
(using expected return and standard deviation of return of securities) along with all the covariances
between the securities’ return is used to derive the curved efficient set of Markowitz. For a given risk-
free rate, the investor identifies the tangency portfolio and determines the linear efficient set (Capital
Market Line). The investor invests in the tangency portfolio and either borrows or lends at the risk-free
rate, the amount of borrowing or lending depends on his risk-return preferences.
With a large numbers of securities, the number of statistical inputs required for using the Markowitz
model is tremendous. The correlation or covariance between every pair of securities must be evaluated
in order to estimate portfolio risk.
The task of identifying the curved Markowitz efficient set can be greatly simplified by introducing
a return-generating process. Return generating process is a statistical method that explains how the
return on a security is generated. we have studied one type of return-generating model, i.e. the market
model. This is a single-factor model which relates a security’s return to a single factor, which is the return
on a market index.
However, the return on a security may depend on more than a single factor, necessitating the use of
multiple factor models. Multiple factor models relate the return on a security to different factors in the
economy, like the expected inflation, GDP growth rate, interest rate, tax rate changes etc.
Factor models or index models assume that the return on a security is sensitive to the movement of
multiple factors. To the extent that returns are indeed affected by a variety of factors, the multiple factor
models are seen to be more useful than the market model.
Arbitrage Pricing Theory (APT) is a factor model that was developed by Stephen Ross. It starts with the
assumption that security returns are related to an unknown number of unknown factors. It does not
specify what these factors are. Unlike CAPM, APT does not rely on measuring the performance of the
market. Instead, it directly relates the price of the security to fundamental factors. What these factors
are is not indicated by the theory, and needs to be empirically determined.
Capital Asset Pricing Model (CAPM), and Arbitrage Pricing Theory (APT) are two of the most commonly
used models for pricing risky assets based on their relevant risks.
CAPM calculates the required rate of return for any risky asset based on the security’s beta. Beta is a
measure of the movement of the security’s return with the return on the market portfolio, which
includes all available securities and where the proportion of each security in the portfolio is its market
value as a percentage of total market value of all securities.
The problem with CAPM is that such a market portfolio is hypothetical and not observable and we have
to use a market index like the S&P 500 or Sensex as a proxy for the market portfolio.
However, indexes are imperfect proxies for overall market as no single index includes all capital assets,
including stocks, bonds, real estate, collectibles, etc. Besides, the indexes do not fully capture the
relevant risk factors in the economy.
An alternative pricing theory with fewer assumptions, the Arbitrage Pricing Theory (APT), has been
developed by Stephen Ross. It can calculate expected return without taking recourse to the market
portfolio. It is a multi-factor model for determining the required rate of return which means that it takes
into account economy factors as well. APT calculates relations among expected returns that will rule out
arbitrage by investors.
APT requires three assumptions:
1) Returns can be described by a factor model.
2) There are no arbitrage opportunities.
3) There are large numbers of securities that permit the formation of portfolios that diversify the firm-
specific risk of individual stocks.

APT starts with the assumption that security returns are related to an unknown number of unknown
factors. These factors can be GDP (Gross domestic product), market interest rate, the rate of inflation, or
any random variable that impacts security prices. For simplicity, let us assume that there is only one
factor (such as the GDP growth rate) that impacts the security price. In this one-factor APT model, the
security return is:

Where F1 = Factor
ai = Expected return on the security i if the factor has a value of zero
bi = Sensitivity of security i to this factor (also known as factor loading for security i)
ε I = Random error term.
Imagine an investor holds 3 stocks and the market value of stock 1 is $250,000, of stock 2 is $250,000
and of stock 3 is $1,000,000. Thus the investor’s wealth is equal to $1,500,000. These three stocks have
the following returns and sensitivities.

Do these expected returns and factor sensitivities represent an equilibrium condition? If not, what
happens to restore equilibrium?

Principle of Arbitrage or Arbitrage Theory

APT shows that for well-diversified portfolios, if the portfolio’s expected return (price) is not equal to the
expected return predicted by the portfolio’s sensitivities (bi), then there will be an arbitrage opportunity.
According to APT, an investor will explore the possibility of forming an arbitrage portfolio to increase the
expected return on his current portfolio without increasing risk. An arbitrage opportunity arises if an
investor can construct a zero investment portfolio with no risk, but with a positive profit. Since no
investment is required, an investor can create large positions to secure large levels of profits.
An arbitrage portfolio does not require any additional commitment of funds. Let Xi represent the change
in the investor’s holding of security i (as a proportion of total wealth. It is therefore, the proportion of
security i in the arbitrage portfolio). Thus the requirement of no new investment can be expressed as:
X1 + X2 + X3 =0
An arbitrage portfolio has no sensitivity to any factor. Sensitivity of a portfolio is the weighted average of
the sensitivities of the securities in the portfolio to that factor, this requirement can be expressed as
b1X1 + b2X2 + b3X3 =0
In the current example,
1.0 X1 + 2.5 X2 + 2.0 X3 =0
At this point we have two equations and three unknowns. As there are more unknowns than equations,
an infinite number of combinations of X1, X2 and X3 will satisfy the requirements. As a way of finding
one such arbitrage portfolio, arbitrarily assign a value of 0.2 to X1. Thus we have 2 equations and 2
unknowns.
0.2 + X2 + X3 =0
0.2 + 2.5 X2 + 2.0 X3 =0
Solving these two equations gives a value of X2 = 0.4 and X3 = -0.6
Hence, a possible arbitrage portfolio is one with X1= 0.2, X2= 0.4 and X3 = -0.6.
The expected return of an arbitrage portfolio must be greater than 0. Thus to see whether an arbitrage
portfolio has actually been identified, its expected return must be determined. If it is positive an
arbitrage portfolio has been identified.
Thus the last requirement is:
X1 r1 + X2 r2 + X3 r3 > 0
Or 10% X1 + 18% X2 + 12% X3
Substituting the values:
= 10% x 0.2 + 18% x 0.4 + 12% x (-0.6) = 2%. Since this is positive, an arbitrage portfolio has been
identified.
The arbitrage portfolio involves buying 0.2 x $1,500,000 = $300,000 of stock 1, 0.4 x $1,500,000 =
$600,000 of stock 2 and selling 0.6 x $1,500,000 = $900,000 of stock 3.
Return on old portfolio
Return on new portfolio
Weights of new portfolio
Stock 1: 0.1667 + 0.2 = 0.3367
Stock 2: 0.1667 + 0.4 = 0.5667
Stock 3: 0.6666 – 0.6 = 0.0666
Thus, we see that the new portfolio gives a return which is 14.67% - 12.67% = 2 % more than the old
portfolio as the calculations above have indicated.

Sensitivity of old portfolio: 0.1667 x 1.0 + 0.1667 x 2.5 + 0.6666 x 2.0 = 1.916

Sensitivity of new portfolio: 0.3667 x 1.0 + 0.5667 x 2.5 + 0.0666 x 2.0 = 1.916
Thus, the sensitivity of the old portfolio is the same as that of the new one. The risk would also be
approximately the same as the difference in the risk is only due to non-factor risk.
What is the effect of buying stocks 1 and 2 and selling stock 3? As everyone would be doing it to exploit
the arbitrage opportunity, the prices of stocks 1 and 2 will rise because of the buying pressure and the
price of stock 3 will fall due to the selling pressure. Consequently, the return on stocks 1 and 2 will fall
and the return on stock 3 will increase. This buying and selling will continue till all arbitrage possibilities
are significantly reduced or eliminated. At this point, there exists a linear relationship between expected
returns and sensitivities:

1= 4 for the example above,0 = 5 and This equation is the asset pricing equation of the APT when
returns are generated by a single factor. As an illustration, suppose,
Thus, the expected returns of stocks 1 and 2 have fallen from 10% and 18% to 9% and 15% respectively,
due to buying pressure and the expected return of stock 3 has increased from 12% to 13% because of
selling pressure.
Thus, in equilibrium, the expected return on any security is a linear function of the security’s sensitivity
to the factor, bi.

is the return on an asset that has no sensitivity to the factor (bi =0). Hence, it is the risk free rate (rf).
Thus, we can write the equation for expected return as:

Identifying the Factors in the APT

APT does not identify the factors to be used in the theory. Therefore, they need to be empirically
determined. In practice, and in theory, one stock might be more sensitive to one factor than another. For
example, the price of ONGC shares will be sensitive to the price of crude oil, but not Colgate shares. In
fact, APT leaves it up to the investor or the analyst to identify each of the factors for a particular stock.
So the real challenge for the investor is to identify three things:
 the factors affecting a particular stock
 the expected returns for each of these factors
 the sensitivity of the stock to each of these factors.

Identifying and quantifying each of these factors is no trivial matter and is one of the reasons why CAPM
remains the dominant theory to describe the relationship between a stock's risk and return.
Ross and others have identified the following macro-economic factors as significant in explaining the
return on a stock:
 growth rate in industrial production
 rate of inflation
 spread between long-term and short-term interest rates
 spread between low grade and high grade bonds
 growth rate in GNP (Gross national product)
 growth in aggregate sales in the economy
  rate of return on S&P 500
 investor confidence
 shifts in the yield curve.

With that as guidance, the rest of the work is left to the stock analyst to identify specific factors for a
particular stock.

Arbitrage Pricing Theory vs. the Capital Asset Pricing Model

APT and CAPM are the two most influential theories on stock and asset pricing today. The APT model is
different from the CAPM in case of less restrictiveness in its assumptions. APT allows the individual
investor to develop their model that explains the expected return for a particular asset.
Intuitively, the APT hold true because it removes the CAPM restrictions and basically states that the
expected return on an asset is a function of many factors and the sensitivity of stock to these factors. As
these factors change, so does the expected return on the stock, and therefore its value to the investor.
However, the potentially large number of factors means that more factor sensitivities have to be
calculated. There is also no guarantee that all the relevant factors have been identified. This added
complexity is the reason APT is less widely used than CAPM.
In the CAPM theory, the expected return on a stock can be described by the movement of that stock
relative to the rest of the stock market. The CAPM theory is a simplified version of the APT, where the
only factor considered is the risk of a particular stock relative to the rest of the stock market–as
described by the stock's beta.
From a practical standpoint, CAPM remains the dominant pricing model used today. When compared to
the APT, CAPM is more refined and relatively simpler to calculate.