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MBA FINANCE

Semester 3

MF0010 Security Analysis and Portfolio

Management

Assignment Set- 1

Submitted By:

Student Name : Yogesh Kumar

Roll No : 521056970

LC Name & Code : NIPSTec Ltd. 1640

Date of Submission : 20/12/2011

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Q.1.Frame the investment process for a person of your age group.Ans.

THE INVESTMENT PROCESS

It is rare to find investors investing their entire savings in a single security. Instead, theytend to invest in a group of securities. Such a group of securities is called a portfolio. Mostfinancial experts stress that in order to minimize risk; an investor should hold a well-balanced

investment portfolio. The investment process describes how an investor must go about makingdecisions with regard to what securities to invest in while constructing a portfolio, how extensivethe investment should be, and when the investment should be made. This is a procedureinvolving the following five steps:

1. Setting Investment Policy

This initial step determines the investors objectives and the amount of his investablewealth. Since there is a positive relationship between risk and return, the investment objectivesshould be stated in terms of both risk and return. This step concludes with the asset allocationdecision: identification of the potential categories of financial assets for consideration in theportfolio that the investor is going to construct. Asset allocation involves dividing an investment

portfolio among different asset categories, such as stocks, bonds and cash. The asset allocationthat works best for an investor at any given point in his life depends largely on his time horizonand his ability to tolerate risk.

Time Horizon The time horizon is the expected number of months, years, or decades that aninvestor will be investing his money to achieve a particular financial goal. An investor with alonger time horizon may feel more comfortable with a riskier or more volatile investmentbecause he can ride out the slow economic cycles and the inevitable ups and downs of the

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markets. By contrast, an investor who is saving for his teen-aged daughters college educationwould be less likely to take a large risk because he has a shorter time horizon.Risk Tolerance Risk tolerance is an investors ability and willingness to lose some or all of hisoriginal investment in exchange for greater potential returns. An aggressive investor, or one witha high-risk tolerance, is more likely to risk losing money in order to get better results. A

conservative investor, or one with a low-risk tolerance, tends to favor investments that willpreserve his or her original investment. The conservative investors keep a "bird in the hand,"while aggressive investors seek "two in the bush." While setting the investment policy, theinvestor also selects the portfolio management style (active vs. passive management).

Active Management is the process of managing investment portfolios by attempting to time themarket and/or select undervalued stocks to buy and overvalued stocks to sell, based uponresearch, investigation and analysis.Passive Management is the process of managing investment portfolios by trying to match theperformance of an index (such as a stock market index) or asset class of securities as closely aspossible, by holding all or a representative sample of the securities in the index or asset class.This portfolio management style does not use market timing or stock selection strategies.

2. Performing Security Analysis

This step is the security selection decision: Within each asset type, identified in the assetallocation decision, how does an investor select which securities to purchase. Security analysisinvolves examining a number of individual securities within the broad categories of financialassets identified in the previous step. One purpose of this exercise is to identify those securitiesthat currently appear to be mispriced. Security analysis is done either using Fundamental orTechnical analysis (both have been discussed in subsequent units).

Fundamental analysisis a method used to evaluate the worth of a security by studying the financialdata of the issuer. It scrutinizes the issuers income and expenses, assets and liabilities,management, and position in its industry. In other words, it focuses on the basics of the

business.

Technical analysis is a method used to evaluate the worth of a security by studying marketstatistics. Unlike fundamental analysis, technical analysis disregards an issuers financialstatements. Instead, it relies upon market trends to ascertain investor sentiment to predict how asecurity will perform.

3. Portfolio Construction

This step identifies those specific assets in which to invest, as well as determining the proportionof the investors wealth to put into each one. Here selectivity, timing and diversification issuesare addressed. Selectivity refers to security analysis and focuses on price movements ofindividual securities. Timing involves forecasting of price movement of stocks relative to pricemovements of fixed income securities (such as bonds). Diversification aims at constructing aportfolio in such a way that the investors risk is minimized. The following table summarizeshow the portfolio is constructed for an active and a passive investor.

Asset Allocation Security Selection

Active investor Market timing Stock picking

Passive investor Maintain pre-determinedTry to track a well-known

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selections market index like Nifty, Sensex

4. Portfolio Revision

This step is the repetition of the three previous steps, as objectives might change and previouslyheld portfolio might not be the optimal one.

5. Portfolio performance evaluation

This step involves determining periodically how the portfolio has performed over some timeperiod (returns earned vs. risks incurred).Q.2.From the website of BSE India, explain how the BSE Sensex is calculated.Ans.

STOCK EXCHANGES: NSE, BSE AND OTCEI

Stock exchanges are organized markets for buying and selling securities which includestocks, bonds, options and futures. Most stock exchanges have specific locations where the

trades are completed. For the securities to be traded at these exchanges, they must be listed atthese exchanges. Stock exchange transactions involve the activities of brokers and dealers. Theseindividuals facilitate the buying and selling of financial assets. Brokers execute trades on behalfof clients and receive commissions and fees in exchange for matching buyers and sellers.

Dealers, on the other hand, buy and sell from their own portfolios (inventories ofsecurities). Dealers earn income by selling a financial instrument at a price that is greater thanthe price they paid for the instrument. Some exchange participants perform both roles. Thesedealer-brokers sometimes act purely as a clients agent and at other times buy and sell from theirown inventory of financial assets. Stock exchanges essentially function as secondary markets. Byproviding investors the opportunity to trade financial instruments, the stock exchanges support

the performance of the primary markets.

In India, the two main exchanges are National Stock Exchange (NSE) and Mumbai(Bombay) Stock Exchange (BSE). These exchanges are de-mutualised exchanges (it means thatthe ownership, management and trading are in separate hands).

Mumbai (Bombay) Stock Exchange Limited (BSE) is the oldest stock exchange in Asia.It was established in 1875. More than 6000 stocks are listed here.

National Stock Exchange (NSE) was promoted by leading Financial Institutions at thebehest of the Government of India and was incorporated in November 1992. There is also an

Over the Counter Exchange of India (OTCEI) which allows listing of small and medium-sizedcompanies. The regulatory agency which oversees the functioning of stock markets is theSecurities and Exchange Board of India (SEBI), which is also located in Mumbai.

Indias equity market was earlier dominated by the BSE a market where trading wasdone by open outcry, without designated market makers, and without any computerization. Thequality of this market was widely considered to be poor, in terms of transparency, liquidity andmarket efficiency. The great scam of 1992 resulted in the finance ministry and SEBI seeking

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radical reform in the functioning of the equity market. This task was achieved through therequirement that the BSE must evolve screen-based trading and through the creation of theNSE.

STOCK MARKET INDICES

An index is a statistical indicator providing a representation of the value of the securitieswhich constitute it. Indexes often serve as barometers for a given market or industry andbenchmarks against which financial or economic performance is measured. A stock indexreflects the price movement of shares while a bond index captures the manner in which bondprices go up and down.

For more than hundred years, people have tracked the markets daily ups and downsusing various indices of overall market performance. There are currently thousands of indicescalculated by various information providers. Internationally, the best known indices are providedby Dow Jones & Co, S & P, Morgan Stanley Capital Markets (MSCI), Lehman Brothers (bond

indices). Dow Jones alone currently publishes more than 3,000 indices. Some of the well-knownindices are Dow Jones Industrial Average (DJIA), Standard & Poors 500 Index (S&P 500),Nasdaq Composite, Nasdaq 100, Financial Times-Stock Exchange 100 (FTSE 100), Nikkei 225Stock Average, Hang Seng Index, Deutscher Aktienindex (DAX). In India the best knownindices are Sensex and Nifty.

SENSEX:Sensex is the stock market index for BSE. It was first compiled in 1986. It is made of30 stocks representing a sample of large, liquid and representative companies. The base year ofSENSEX is 1978-79 and the base value is 100.

Sensex till August 31, 2003 was constructed on the basis of full market capitalization. A need

was felt to switch over to free float wherein non-promoter and non-strategic shareholdings areeliminated and only those outstanding shares that are available for trading are included. Sensexsince 31st September, 2003, is being constructed on free float market capitalization.

NIFTY:Nifty is the stock market index for NSE. S&P CNX Nifty is a 50 stock index accountingfor 23 sectors of the economy. The base period selected for Nifty is the close of prices onNovember 3, 1995, which marked the completion of one-year of operations of NSEs capitalmarket segment. The base value of index was set at 1000.

The other indices are BSE 200, BSE 500, BSE TECK, BSE IT, BSE FMCG, BSE CD, BSEMetal, BSE PSU, BSE Mid cap, BSE small cap, BSE auto, BSE Pharma, BSE realty, Nifty Jr,

BSE MCK.SENSEX CALCULATION METHODOLOGY

SENSEX is calculated using the "Free-float Market Capitalization" methodology,wherein, the level of index at any point of time reflects the free-float market value of 30component stocks relative to a base period. The market capitalization of a company isdetermined by multiplying the price of its stock by the number of shares issued by the company.

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This market capitalization is further multiplied by the free-float factor to determine the free-floatmarket capitalization.

The base period of SENSEX is 1978-79 and the base value is 100 index points. This isoften indicated by the notation 1978-79=100. The calculation of SENSEX involves dividing thefree-float market capitalization of 30 companies in the Index by a number called the Index

Divisor. The Divisor is the only link to the original base period value of the SENSEX. It keepsthe Index comparable over time and is the adjustment point for all Index adjustments arising outof corporate actions, replacement of scrips etc. During market hours, prices of the index scrips, atwhich latest trades are executed, are used by the trading system to calculate SENSEX on acontinuous basis.Q.3.Perform an economy analysis on Indian economy in the current situation.Ans.

ECONOMY ANALYSIS

In addition to the economy analysis, fundamental analysis helps investors determine whether theeconomic climate offers a positive and encouraging investing environment. Economic analysis is

done for two reasons: first, a companys growth prospects are, ultimately, dependent on theeconomy in which it operates; second, share price performance is generally tied to economicfundamentals, as most companies generally perform well when the economy is doing the same.

FACTORS TO BE CONSIDERED IN ECONOMY ANALYSIS

The economic variables that are considered in economic analysis are:

gross domestic product (GDP) growth rate,

exchange rates,

the balance of payments (BOP),

the current account deficit,

government policy (fiscal and monetary policy),

domestic legislation (laws and regulations),

unemployment (the percent of the population that wants to work and is currently not working),

public attitude (consumer confidence)

inflation (a general increase in the price of goods and services), interest rates,

productivity (output per worker),

capacity utilization (output by the firm) etc .

GDP is the total income earned by a country. GDP growth rate shows how fast the economy isgrowing. Investors know that strong economic growth is good for companies and recessions orfull-blown depressions cause share prices to decline, all other things being equal.

Inflationis important for investors, as excessive inflation undermines consumer spending power(prices increase) and so can cause economic stagnation. However, deflation (negative inflation)can also hurt the economy, as it encourages consumers to postpone spending (as they wait forcheaper prices).

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The exchange rate affects the broad economy and companies in a number of ways. First, changesin the exchange rate affect the exports and imports. If exchange rate strengthens, exports are hit;if the exchange rate weakens, imports are affected. The BOP affects the exchange rate throughsupply and demand for the foreign currency.

BOPreflects a countrys international monetary transactions for a specific time period. It consists

of the current account and the capital account. The current account is an account of the trade ingoods and services. The capital account is an account of the cross-border transactions in financialassets. A current account deficit occurs when a country imports more goods and services than itexports.

A capital account deficitoccurs when the investments made in the country by foreigners is less thanthe investment in foreign countries made by local players. The currency of a country appreciateswhen there is more foreign currency coming into the country than leaving it. Therefore, a surplusin the current or capital account causes the currency to strengthen; a deficit causes the currencyto weaken. The levels of interest rates (the cost of borrowing money) in the economy and themoney supply (amount of money circulating in the economy) also have a bearing on theperformance of businesses. All other things being equal, an increase in money supply causes theinterest rates to fall; a decrease causes the interest rates to rise. If interest rates are low, the costof borrowing by businesses is not expensive, and companies can easily borrow to expand anddevelop their activities.ECONOMIC ANALYSIS ON INDIAN ECONOMY

India economic analysis provides various inputs on economic condition of this south-eastAsian country. It can be done both at a microeconomic as well as a macroeconomic level. Indiaeconomic analysis could also be described as being an explanation of various economicphenomena going on in this country.

RECENT MACROECONOMIC DEVELOPMENTS IN INDIA

In April 2008, industrial sector in India had recorded a growth of 7 percent. However,this figure is lesser than 11 percent development, which had been achieved in April 2007. Muchof this critical condition could be attributed to an increase in prices of oil. Measures that havebeen taken by Reserve Bank of India, like upward revision of repo rate and CRR, have alsocontributed to decrease in industrial production. Manufacturing and electric sector have sufferedas well in recent times. Their growth rates have come down too. For manufacturing sector it was7.5 percent and for electricity sector, rate of development stood at 1.4 percent in April 2008. Thisrate is significantly low when compared to statistics of April 2007, when rates of developmentfor manufacturing and electricity were 12.4 percent and 8.7 percent respectively. In case of

manufacturing sector much of this slump could be attributed to increase in input costs likeexpenses of oil, raw materials, rates of interest and prices of goods and services. Mining sectorhas been comparatively better off as it has managed to grow at a rate of 8 percent in April 2008compared to 2.6 percent that was achieved in April 2007. In core infrastructural industries, therehas been deceleration as well, but it is still better off compared to non infrastructural industries inIndia. Growth in April 2008 has been around 3.6 percent, which is less than 5.9 percent achievedin April 2007. Industries like crude oil production, electricity and petroleum refinery have been

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performing below expectations but coal, finished steel and cement have performed better thanApril 2007.

INFLATION IN INDIA

In financial year 2007-08, average inflation in India was around 4.66 percent. This rate

was lower than average inflation of financial year 2006-07. In 2007-08, fiscal high prices of fooditems were primary cause behind high rates of inflation. That high rate of inflation had to becontrolled by banning a number of necessary commodities as well as various financial steps.High prices of oil were responsible for proportionately high rate of inflation in 2008-09.

Q.4. Identify some technical indicators and explain how they can be used to decidepurchase of a companys stock.

Ans.

TECHNICAL INDICATORS

A technical indicator is a series of data points that are derived by applying a formula tothe price and/or volume data of a security. Price data can be any combination of the open, high,low or closing price over a period of time. Some indicators may use only the closing prices,while others incorporate volume and open interest into their formulae. The price data is enteredinto the formula and a data point is produced. For example, say the closing prices of a stock for 3days are Rs. 41, Rs. 43 and Rs. 43.

If a technical indicator is constructed using the average of the closing prices, then theaverage of the 3 closing prices is one data point ((41+43+43)/3=42.33). However, one data point

does not offer much information. A series of data points over a period of time is required toenable analysis. Thus we can have a 3 period moving average as a technical indicator, where wedrop the earliest closing price and use the next closing price for calculations.

Technical indicators are constructed in two ways: those that fall in a bounded range andthose that do not. The technical indicators that are bound within a range are called oscillators.Oscillators are used as an overbought / oversold indicator. A market is said to be overboughtwhen prices have been trending higher in a relatively steep fashion for some time, to the extentthat the number of market participants long of the market significantly outweighs those on thesidelines or holding short positions. This means that there are fewer participants to jump ontothe back of the trend. The oversold condition is just the opposite. The market has been trending

lower for some time and is running out of fuel for further price declines.

Oscillator indicators move within a range, say between zero and 100, and signal periodswhere the security is overbought (near 100) or oversold (near zero). Oscillators are the mostcommon type of technical indicators. The technical indicators that are not bound within a rangealso form buy and sell signals and display strength or weakness in the market, but they can varyin the way they do this.

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The two main ways that technical indicators are used to form buy and sell signals isthrough crossovers and divergence. Crossovers occur when either the price moves through themoving average, or when two different moving averages cross over each other. Divergencehappens when the direction of the price trend and the direction of the indicator trend are movingin the opposite direction. This indicates that the direction of the price trend is weakening.

Technical indicators provide an extremely useful source of additional information. Theseindicators help identify momentum, trends, volatility and various other aspects in a security toaid in the technical analysis of trends. While some traders just use a single indicator for buy andsell signals, it is best to use them along with price movement, chart patterns and other indicators.

A number of technical indicators are in use. Some of the technical indicators are discussed belowfor the purpose of illustration of the concept:

Moving average:

The moving average is a lagging indicator which is easy to construct and is one of themost widely used. A moving average, as the name suggests, represents an average of a certainseries of data that moves through time. The most common way to calculate the moving averageis to work from the last 10 days of closing prices. Each day, the most recent close (day 11) isadded to the total and the oldest close (day 1) is subtracted. The new total is then divided by thetotal number of days (10) and the resultant average computed. The purpose of the movingaverage is to track the progress of a price trend. The moving average is a smoothing device. Byaveraging the data, a smoother line is produced, making it much easier to view the underlyingtrend. A moving average filters out random noise and offers a smoother perspective of the priceaction.

Moving Average Convergence Divergence (MACD):

MACD is a momentum indicator and it is made up of two exponential moving averages.The MACD plots the difference between a 26-day exponential moving average and a 12-dayexponential moving average. A 9-day moving average is generally used as a trigger line. Whenthe MACD crosses this trigger and goes down it is a bearish signal and when it crosses it to goabove it, its a bullish signal. This indicator measures short-term momentum as compared tolonger term momentum and signals the current direction of momentum. Traders use the MACDfor indicating trend reversals.

Relative Strength Index:

The relative strength index (RSI) is another of the well-known momentum indicators.Momentum measures the rate of change of prices by continually taking price differences for afixed time interval. RSI helps to signal overbought and oversold conditions in a security. RSI isplotted in a range of 0-100. A reading above 70 suggests that a security is overbought, while areading below 30 suggests that it is oversold. This indicator helps traders to identify whether asecuritys price has been unreasonably pushed to its current levels and whether a reversal may beon the way.

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Stochastic Oscillator:

The stochastic oscillator is one of the most recognized momentum indicators. Thisindicator provides information about the location of a current closing price in relation to theperiods high and low prices. The closer the closing price is to the periods high, the higher is thebuying pressure, and the closer the closing price is to the periods low, the more is the selling

pressure. The idea behind this indicator is that in an uptrend, the price should be closing near thehighs of the trading range, signaling upward momentum in the security. In downtrends, the priceshould be closing near the lows of the trading range, signaling downward momentum. Thestochastic oscillator is plotted within a range of zero and 100 and signals overbought conditionsabove 80 and oversold conditions below 20.Q.5. Compare Arbitrage pricing theory with the Capital asset pricing model.

Ans.

In economics and finance, arbitrage is the practice of taking advantage of a price

difference between two or more markets: striking a combination of matching deals that capitalize

upon the imbalance, the profit being the difference between the market prices. When used by

academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic

or temporal state and a positive cash flow in at least one state; in simple terms, it is the

possibility of a risk-free profit at zero cost. In principle and in academic use, an arbitrage is risk-

free; in common use, as in statistical arbitrage, it may refer to expected profit, though losses may

occur, and in practice, there are always risks in arbitrage, some minor (such as fluctuation of

prices decreasing profit margins), some major (such as devaluation of a currency or derivative).

In academic use, an arbitrage involves taking advantage of differences in price of a single asset

or identical cash-flows; in common use, it is also used to refer to differences between similar

assets (relative value or convergence trades), as in merger arbitrage. People who engage in

arbitrage are called arbitrageurs (IPA: / rb tr r/ )such as a bank or brokerage firm. Theterm is mainly applied to trading in financial instruments, such as bonds, stocks, derivatives,

commodities andcurrencies.

Conditions for arbitrage:

Arbitrage is possible when one of three conditions is met:

1. The same asset does not trade at the same price on all markets ("the law of one price").

2. Two assets with identical cash flows do not trade at the same price.

3. An asset with a known price in the future does not today trade at its future price

discounted at the risk-free interest rate (or, the asset does not have negligible costs of

storage; as such, for example, this condition holds for grain but not forsecurities).

Arbitrage is not simply the act of buying a product in one market and selling it in another for a

higher price at some later time. The transactions must occur simultaneously to avoid exposure to

market risk, or the risk that prices may change on one market before both transactions are

complete. In practical terms, this is generally only possible with securities and financial products

which can be traded electronically, and even then, when each leg of the trade is executed the

prices in the market may have moved. Missing one of the legs of the trade (and subsequently

http://en.wikipedia.org/wiki/Economicshttp://en.wikipedia.org/wiki/Economicshttp://en.wikipedia.org/wiki/Financehttp://en.wikipedia.org/wiki/Financehttp://en.wikipedia.org/wiki/Markethttp://en.wikipedia.org/wiki/Market_pricehttp://en.wikipedia.org/wiki/Cash_flowhttp://en.wikipedia.org/wiki/Statistical_arbitragehttp://en.wikipedia.org/wiki/Arbitrage#Riskshttp://en.wikipedia.org/wiki/Arbitrage#Riskshttp://en.wikipedia.org/wiki/Relative_value_(economics)http://en.wikipedia.org/wiki/Convergence_tradehttp://en.wikipedia.org/wiki/Merger_arbitragehttp://en.wikipedia.org/wiki/Merger_arbitragehttp://en.wikipedia.org/wiki/Wikipedia:IPA_for_Englishhttp://en.wikipedia.org/wiki/Wikipedia:IPA_for_Englishhttp://en.wikipedia.org/wiki/Financial_instrumentshttp://en.wikipedia.org/wiki/Financial_instrumentshttp://en.wikipedia.org/wiki/Bond_(finance)http://en.wikipedia.org/wiki/Stockhttp://en.wikipedia.org/wiki/Stockhttp://en.wikipedia.org/wiki/Derivative_(finance)http://en.wikipedia.org/wiki/Commodityhttp://en.wikipedia.org/wiki/Currencyhttp://en.wikipedia.org/wiki/Currencyhttp://en.wikipedia.org/wiki/Law_of_one_pricehttp://en.wikipedia.org/wiki/Discountinghttp://en.wikipedia.org/wiki/Risk-free_interest_ratehttp://en.wikipedia.org/wiki/Risk-free_interest_ratehttp://en.wikipedia.org/wiki/Security_(finance)http://en.wikipedia.org/wiki/Security_(finance)http://en.wikipedia.org/wiki/Financehttp://en.wikipedia.org/wiki/Markethttp://en.wikipedia.org/wiki/Market_pricehttp://en.wikipedia.org/wiki/Cash_flowhttp://en.wikipedia.org/wiki/Statistical_arbitragehttp://en.wikipedia.org/wiki/Arbitrage#Riskshttp://en.wikipedia.org/wiki/Relative_value_(economics)http://en.wikipedia.org/wiki/Convergence_tradehttp://en.wikipedia.org/wiki/Merger_arbitragehttp://en.wikipedia.org/wiki/Wikipedia:IPA_for_Englishhttp://en.wikipedia.org/wiki/Financial_instrumentshttp://en.wikipedia.org/wiki/Bond_(finance)http://en.wikipedia.org/wiki/Stockhttp://en.wikipedia.org/wiki/Derivative_(finance)http://en.wikipedia.org/wiki/Commodityhttp://en.wikipedia.org/wiki/Currencyhttp://en.wikipedia.org/wiki/Law_of_one_pricehttp://en.wikipedia.org/wiki/Discountinghttp://en.wikipedia.org/wiki/Risk-free_interest_ratehttp://en.wikipedia.org/wiki/Security_(finance)http://en.wikipedia.org/wiki/Economics

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having to trade it soon after at a worse price) is called 'execution risk' or more specifically 'leg

risk'.[note 1] In the simplest example, any good sold in one market should sell for the same price

in another. Traders may, for example, find that the price of wheat is lower in agricultural regions

than in cities, purchase the good, and transport it to another region to sell at a higher price. This

type of price arbitrage is the most common, but this simple example ignores the cost of transport,

storage, risk, and other factors. "True" arbitrage requires that there be no market risk involved.

Where securities are traded on more than one exchange, arbitrage occurs by simultaneously

buying in one and selling on the other.Mathematically it is defined as follows:

and where Vt means a portfolio at time t.

ARBITRAGE PRICING THEORY VS. THE CAPITAL ASSET PRICING MODEL

APT applies to well diversified portfolios and not necessarily to individual stocks.

With APT it is possible for some individual stocks to be mispriced - not lie on the SML.

APT is more general in that it gets to an expected return and beta relationship without the

assumption of the market portfolio.

APT can be extended to multifactor models.

Both the CAPM and APT are risk-based models. There are alternatives.

Empirical methods are based less on theory and more on looking for some regularities in

the historical record.

Be aware that correlation does not imply causality.

Related to empirical methods is the practice of classifying portfolios by style e.g.

o Value portfolio

o Growth portfolio

The APT assumes that stock returns are generated according to factor models such as:

As securities are added to the portfolio, the unsystematic risks of the individual securities

offset each other. A fully diversified portfolio has no unsystematic risk.

The CAPM can be viewed as a special case of the APT.

Empirical models try to capture the relations between returns and stock attributes that can

be measured directly from the data without appeal to theory.

Difference in Methodology

=FFFRR SSGDPGDPII ++++=

http://en.wikipedia.org/wiki/Arbitrage#cite_note-0http://en.wikipedia.org/wiki/Merchanthttp://en.wikipedia.org/wiki/Arbitrage#cite_note-0http://en.wikipedia.org/wiki/Merchant

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CAPM is an equilibrium model and derived from individual portfolio optimization.

APT is a statistical model which tries to capture sources of systematic risk. Relation

between sources determined by no Arbitrage condition.

Difference in Application

APT difficult to identify appropriate factors. CAPM difficult to find good proxy for market returns.

APT shows sensitivity to different sources. Important for hedging in portfolio

formation.

CAPM is simpler to communicate, since everybody agrees upon.

Q.6. Discuss the different forms of market efficiency.

Ans.

FORMS OF MARKET EFFICIENCY

A financial market displays informational efficiency when market prices reflect allavailable information about value. This definition of efficient market requires answers to twoquestions: what is all available information? & what does it mean to reflect all availableinformation? Different answers to these questions give rise to different versions of marketefficiency.

What information are we talking about? Information can be information about past prices, information that is public information and information that is private information.

Information about past prices refers to the weak form version of market efficiency, informationthat consists of past prices and all public information refers to the semi-strong version of marketefficiency and all information (past prices, all public information and all private information)refers to the strong form version of market efficiency.

Prices reflect all available information means that all financial transactions which arecarried 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 analysis) cannot provide any information that would proveuseful 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 volumedata, and other market-generated information. This implies that past rates of return and othermarket data should have no relationship with future rates of return. It would mean that if theweak form of EMH is correct, then technical analysis is fruitless in generating excess returns.

The semi-strong form suggests that stock prices fully reflect all publicly availableinformation and all expectations about the future. Old information then is already discountedand cannot be used to predict stock price fluctuations. In sum, the semi-strong form suggests that

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fundamental analysis is also fruitless; knowing what a company generated in terms of earningsand revenues in the past will not help you determine what the stock price will do 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, whetherit be public (say in SEBI filings) or private (in the minds of the CEO and other insiders). So evenwith material non-public information, EMH asserts that stock prices cannot be predicted withany accuracy.

MBA FINANCE

Semester 3

MF0010 Security Analysis and Portfolio

Management

Assignment Set- 2

Submitted By:

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Student Name : Yogesh Kumar

Roll No : 521056970

LC Name & Code : NIPSTec Ltd. 1640

Date of Submission : 20/12/2011

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Q.1. Differentiate between ADRs and GDRs

Ans.

ADRS and GDRS

1. Global depository receipt (GDR) is compulsory for foreign company toaccess in any other countrys share market for dealing in stock. ButAmerican depository receipt (ADR) is compulsory for non us companiesto trade in stock market of USA.

2. ADRs can get from level -1 to level III. GDRs are already equal to highpreference receipt of level II and level III.

3. Indian companies prefer to get GDR due to its global use for gettingforeign investment for own business projects.

4. ADRs up to level I need to accept only general condition of SEC of USAbut GDRs can only be issued under rule 144 A after accepting strict rulesof SEC of USA .

5. GDR is negotiable instrument all over the world but ADR is only negotiablein USA.

6. Many Indian Companies listed foreign stock market through foreign banksGDR. Names of these Indian Companies are following :- (A) Bajaj Auto (B)Hindalco (C) ITC ( D) L&T (E) Ranbaxy Laboratories (F) SBI Some of IndianCompanies are listed in USA stock exchange only through ADRs :- (A)Patni Computers (B) Tata Motors

7. Even both GDR & ADR is the proxy way to sell shares in foreign market byIndia companies ADRs is not substitute of GDRs but GDRs can use on theplace of ADRs.

8. Investors of UK can buy GDRs from London stock exchange andLuxemburg stock exchange and invest in Indian companies without anyextra responsibilities. Investors of USA can buy ADRs from New york stockexchange (NYSE) or NASDAQ (National Association of Securities DealersAutomated Quotation).

9. American investors typically use regular equity trading accounts forbuying ADRs but not for GDRs.

10.The US dollar rate paid to holders of ADRs is calculated by applying theexchange rate used to convert the foreign dividend payment (net of localwithholding tax) to US dollars, and adjusting the result according to theordinary share but GDRs is calculated on numbers of Shares. One GDR'sValue may be on two or six shares

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Q.2. Using financial ratios, study the financial performance of any particular company of

your interest.

Ans.

Financial ratios illustrate relationships between different aspects of a small business's

operations. They involve the comparison of elements from a balance sheet or income statement,and are crafted with particular points of focus in mind. Financial ratios can provide small business owners and managers with a valuable tool to measure their progress againstpredetermined internal goals, a certain competitor, or the overall industry. In addition, trackingvarious ratios over time is a powerful way to identify trends as they develop. Ratios are also usedby bankers, investors, and business analysts to assess various attributes of a company's financialstrength or operating results. Ratios are determined by dividing one number by another, and areusually expressed as a percentage. They enable business owners to examine the relationshipsbetween seemingly unrelated items and thus gain useful information for decision-making. "Theyare simple to calculate, easy to use, and provide a wealth of information that cannot be gottenanywhere else," James O. Gill noted in his book Financial Basics of Small Business Success.

But, he added, "Ratios are aids to judgment and cannot take the place of experience. They willnot replace good management, but they will make a good manager better. They help to pinpointareas that need investigation and assist in developing an operating strategy for the future."

Virtually any financial statistics can be compared using a ratio. In reality, however, smallbusiness owners and managers only need to be concerned with a small set of ratios in order toidentify where improvements are needed. "As you run your business you juggle dozens ofdifferent variables," David H. Bangs, Jr. wrote in his book managing by the Numbers. "Ratioanalysis is designed to help you identify those variables which are out of balance." It is importantto keep in mind that financial ratios are time sensitive; they can only present a picture of thebusiness at the time that the underlying figures were prepared. For example, a retailer calculatingratios before and after the Christmas season would get very different results. In addition, ratioscan be misleading when taken singly, though they can be quite valuable when a small businesstracks them over time or uses them as a basis for comparison against company goals or industryStandards. As a result, business owners should compute a variety of applicable ratios and attemptto discern a pattern, rather than relying on the information provided by only one or two ratios.Gill also noted that small business owners should be certain to view ratios objectively, ratherthan using them to confirm a particular strategy or point of view.

Perhaps the best way for small business owners to use financial ratios is to conduct aformal ratio analysis on a regular basis. The raw data used to compute the ratios should berecorded on a special form monthly. Then the relevant ratios should be computed, reviewed, andsaved for future comparisons. Determining which ratios to compute depends on the type ofbusiness, the age of the business, the point in the business cycle, and any specific informationsought. For example, if a small business depends on a large number of fixed assets, ratios thatmeasure how efficiently these assets are being used may be the most significant. In general,financial ratios can be broken down into four main categoriesprofitability or return oninvestment, liquidity, leverage, and operating or efficiencywith several specific ratiocalculations prescribed within each.

Google reported revenues of $6.77 billion for the quarter ended March 31, 2010, an increase of23% compared to the first quarter of 2009. Google reports its revenues, consistent with GAAP,

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on a gross basis without deducting traffic acquisition costs (TAC). In the first quarter of 2010,TAC totaled $1.71 billion, or 26% of advertising revenues. Google reports operating income,operating margin, net income, and earnings per share (EPS) on a GAAP and non-GAAP basis.The non-GAAP measures, as well as free cash flow, an alternative non-GAAP measure ofliquidity, are described below and are reconciled to the corresponding GAAP measures in the

accompanying financial tables. GAAP operating income in the first quarter of 2010 was $2.49billion, or 37% of revenues. This compares to GAAP operating income of $1.88 billion, or 34%of revenues, in the first quarter of 2009. Non-GAAP operating income in the first quarter of 2010was $2.78 billion, or 41% of revenues. This compares to non-GAAP operating income of $2.16billion, or 39% of revenues, in the first quarter of 2009. GAAP net income in the first quarter of2010 was $1.96 billion, compared to $1.42 billion in the first quarter of 2009. Non-GAAP netincome in the first quarter of 2010 was $2.18 billion, compared to $1.64 billion in the firstquarter of 2009. GAAP EPS in the first quarter of 2010 was $6.06 on 323 million diluted sharesoutstanding, compared to $4.49 in the first quarter of 2009 on 317 million diluted sharesoutstanding. Non-GAAP EPS in the first quarter of 2010 was $6.76, compared to $5.16 in thefirst quarter of 2009. Non-GAAP operating income and non-GAAP operating margin exclude the

expenses related to stock-based compensation (SBC). Non-GAAP net income and non-GAAPEPS exclude the expenses related to SBC and the related tax benefits. In the first quarter of 2010,the charge related to SBC was $291 million, compared to $277 million in the first quarter of2009. The tax benefit related to SBC was $65 million in the first quarter of 2010 and $64 millionin the first quarter of 2009. Reconciliations of non-GAAP measures to GAAP operating income,operating margin, net income, and EPS are included at the end of this release. InternationalRevenues - Revenues from outside of the United States totaled $3.58 billion, representing 53%of total revenues in the first quarter of 2010, compared to 53% in the fourth quarter of 2009 and52% in the first quarter of 2009. Excluding gains related to our foreign exchange riskmanagement program, had foreign exchange rates remained constant from the fourth quarter of2009 through the first quarter of 2010, our revenues in the first quarter of 2010 would have been$112 million higher. Excluding gains related to our foreign exchange risk management program,had foreign exchange rates remained constant from the first quarter of 2009 through the firstquarter of 2010, our revenues in the first quarter of 2010 would have been $242 million lower.Revenues from the United Kingdom totaled $842 million, representing 13% of revenues in thefirst quarter of 2010, compared to 13% in the first quarter of 2009. In the first quarter of 2010,we recognized a benefit of $10 million to revenues through our foreign exchange riskmanagement program, compared to $154 million in the first quarter of 2009. Paid Clicks Aggregate paid clicks, which include clicks related to ads served on Google sites and the sites ofour AdSense partners, increased approximately 15% over the first quarter of 2009 and increasedapproximately 5% over the fourth quarter of 2009. Cost-Per-Click Average cost-per-click,which includes clicks related to ads served on Google sites and the sites of our AdSense partners,increased approximately 7% over the first quarter of 2009 and decreased approximately 4% overthe fourth quarter of 2009.

TAC - Traffic Acquisition Costs, the portion of revenues shared with Googles partners,increased to $1.71 billion in the first quarter of 2010, compared to TAC of $1.44 billion in thefirst quarter of 2009. TAC as a percentage of advertising revenues was 26% in the first quarter of2010, compared to 27% in the first quarter of 2009. The majority of TAC is related to amountsultimately paid to our AdSense partners, which totaled $1.45 billion in the first quarter of 2010.TAC also includes amounts ultimately paid to certain distribution partners and others who direct

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traffic to our website, which totaled $265 million in the first quarter of 2010. Other Cost ofRevenues - Other cost of revenues, which is comprised primarily of data center operationalexpenses, amortization of intangible assets, content acquisition costs as well as credit cardprocessing charges, increased to $741 million, or 11% of revenues, in the first quarter of 2010,compared to $666 million, or 12% of revenues, in the first quarter of 2009. Operating Expenses -

Operating expenses, other than cost of revenues, were $1.84 billion in the first quarter of 2010,or 27% of revenues, compared to $1.52 billion in the first quarter of 2009, or 28% of revenues.Stock-Based Compensation (SBC) In the first quarter of 2010, the total charge related to SBCwas $291 million, compared to $277 million in the first quarter of 2009. We currently estimateSBC charges for grants to employees prior to April 1, 2010 to be approximately $1.2 billion for2010. This estimate does not include expenses to be recognized related to employee stock awardsthat are granted after March 31, 2010 or non-employee stock awards that have been or may begranted.

Operating Income - GAAP operating income in the first quarter of 2010 was $2.49billion, or 37% of revenues. This compares to GAAP operating income of $1.88 billion, or 34%of revenues, in the first quarter of 2009. Non-GAAP operating income in the first quarter of 2010

was $2.78 billion, or 41% of revenues. This compares to non-GAAP operating income of $2.16billion, or 39% of revenues, in the first quarter of 2009. Interest Income and Other, Net Interestincome and other, net increased to $18 million in the first quarter of 2010, compared to $6million in the first quarter of 2009. Income Taxes Our effective tax rate was 22% for the firstquarter of 2010. Net Income GAAP net income in the first quarter of 2010 was $1.96 billion,compared to $1.42 billion in the first quarter of 2009. Non-GAAP net income was $2.18 billionin the first quarter of 2010, compared to $1.64 billion in the first quarter of 2009. GAAP EPS inthe first quarter of 2010 was $6.06 on 323 million diluted shares outstanding, compared to $4.49in the first quarter of 2009 on 317 million diluted shares outstanding. Non-GAAP EPS in the firstquarter of 2010 was $6.76, compared to $5.16 in the first quarter of 2009. Cash Flow and CapitalExpenditures Net cash provided by operating activities in the first quarter of 2010 totaled $2.58billion, compared to $2.25 billion in the first quarter of 2009. In the first quarter of 2010, capitalexpenditures were $239 million, the majority of which was related to IT infrastructureinvestments, including data centers, servers, and networking equipment. Free cash flow, analternative non-GAAP measure of liquidity, is defined as net cash provided by operatingactivities less capital expenditures. In the first quarter of 2010, free cash flow was $2.35 billion.

FORWARD-LOOKING STATEMENTS

This press release contains forward-looking statements that involve risks and uncertainties.These statements include statements regarding our plans to heavily invest in innovation, ourexpected stock-based compensation charges and our plans to make significant capitalexpenditures. Actual results may differ materially from the results predicted, and reported resultsshould not be considered as an indication of future performance. The potential risks and

uncertainties that could cause actual results to differ from the results predicted include, amongothers, unforeseen changes in our hiring patterns and our need to expend capital to accommodatethe growth of the business, as well as those risks and uncertainties included under the captionsRisk Factors and Managements Discussion and Analysis of Financial Condition and Resultsof Operations in our Annual Report on Form 10-K for the year ended December 31, 2009,which is on file with the SEC and is available on our investor relations website atinvestor.google.com and on the SEC website at www.sec.gov.

http://www.sec.gov/http://www.sec.gov/

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Q.3. As an investor how would you select an equity mutual fund scheme?

Ans.How do I choose a Scheme

But to begin your selection start from the very beginning:Specify your investment needsWhile we are on the topic of what returns to expect, someone might as well wish for a

Fund that assures returns. Some of the mutual funds have floated "assured" return Funds andmore funds. There is no end to verbosity when educating on funds. But getting to actually choosea fund may not be eased with more funds. It often turns out, like with most ventures in life, thatpicking your fund is like crossing the saddle point the first time is always the most difficult.There are more than 350 schemes and choosing one of them is not an easy task. We will provideyou an easy way to filter this huge number down to a more manageable size so that you can lookspend more time looking at schemes in greater detail. What are you looking for when investingin mutual funds? What are your investment needs? The more well defined these answers are theeasier it is to find schemes best for you. So how do you assess your needs? The answersobviously lie with you. But the questions investors ask to assess their needs are possibly thesame. You might ask yourself: At my age what am I expecting out of investing? To assess theneeds investors look at their lifestyles, financial independence, family commitments, and level ofincome and expenses among other things. Questions can be many but to get cracking askyourself these two: What are the returns you want on your investments? Do you have well-defined time period for the returns you expect on your investment? The father of an aspiringengineer who would have to shell out the boy's institute fees soon enough, could reply: I want afixed monthly income of about Rs.5000 per month. To the second query he might say: Yes, forthe next four years. When asked, the just out-of-B-school graduate planning for his new Zencould reply: I should make about Rs. 60,000 by the end of one year.

Getting the right answers to these questions does a lot to simply your fund pickingexercise. Having defined the needs that direct you to invest, one can find a category of funds thatcome close to satisfy your needs with their objectives. schemes that guarantee a certain annualreturn or guarantee a buyback at a specified price after a specified period. Examples of theseinclude funds floated by the UTI, SBI Mutual Fund, etc. Many of these funds have not earnedreturns that they promised and the asset management companies of the respective mutual fundsor their sponsors have made good their promises. Nowadays, there are very few funds that comeout with such schemes as the funds have realized it is not viable to assure returns in a volatilemarket.Assess the risk you can takeContrary to the commonplace thinking, mutual funds do carry risks. And there are some that canbecome as risky as stocks. Given the almost diverse objectives with which schemes operate,there are some with more risks and some relatively safer. Ask yourself if you are ready for ascheme whose investment value might fluctuate every week or one that gives a minimum amountof risk? Or are you in for a short-term loss in order to achieve a long-term potential gain? At thispoint it is good to ask oneself how will you take it if your investment fails to deliver the returnsyou expected or makes losses. Knowing this will reduce your chances (or even temptation) toselect a fund that doesnt come close to your objective. Investors comfortable with numericalrecipes do a technical check of what the returns of a scheme would be in the worst case. Theycheck is done with the Sharpe ratio .The higher the Sharpe ratio, the better the fund's historical

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risk-adjusted performance. Evaluate a scheme by looking at how its NAV has behaved over thepast. Do you see the scheme behaving rather erratically i.e., the NAV changes just too often?More the volatility more are the risks involved. Great returns are not the only thing to look for ina scheme. If you feel while researching a scheme, which we will do later, that its returns aremodest and steady and good enough for your needs, avoid other schemes that have recently

delivered high returns. Because great returns in the past are no guarantee for the fabulous performance to continue in the future. Never forget one of the commonplace morals ofinvestment: The schemes that are expected to give the highest returns have the greatestprobability to fall flat!Decide how long you can park your cash

Is the cash you have earmarked for your investment meant to be spent for somethingelse? Do you need a regular cash flow? Or you dont mind locking your cash in the scheme sothat your assets can appreciate over time? Settle this question upfront on what your cash flowrequirements will be till the time your money is invested in mutual fundsGetting the right Fund.Investment mix:If you know of an industry that has been doing particularly well, you can

select schemes that have invested in that industry. You can also select schemes that haveinvested in companies with a dazzling performance. A mixed basket for your diverse needs Onceagain, back to the basic question. You came here looking for schemes that can suffice yourinvestment needs. You might be like many others who actually have multiple needs. Considergoing for a combination of schemes.

Yet another recap of the basics:one of the things that made these mutual funds greatwas diversification. While you might have selected a scheme that has a diversified portfolio, youcan also go for more than one scheme to further diversify your investments. It is well possiblethat just by picking more than one scheme from one fund house you can achieve enoughdiversification. In fact many investors who have tried out a fund The success of your investmentdepends in a large measure on the objective you define. Having defined that, choosing a fundisnt difficult. Through a search of schemes on our advanced search you can draw up a list ofschemes that come close to the objectives you have set. Our search allows you to set criteriabased on your objectives. The criteria you can set are:The schemes expense:All schemes have a minimum requirement for the total amountof money you can invest. Usually they begin from a minimum of Rs.5000. Do a check for theexpense ratio and sales charges the fund has. The NAV is good enough to know what each unitof the scheme will cost you. But, remember a low NAV (sometimes even below the usual offerprice of Rs.10) may make a scheme more affordable as you can acquire more units but chancesare the scheme is not performing well. The schemes performance: Returns from schemes arecalculated over various periods from a week to one year or more. For each time period specifythe returns. While you enter returns figures the maximum, minimum and average returns for allschemes in the category you have chosen are also displayed.The schemes fund house:Over the years fund houses in India have established a namefor themselves for their investment style and their performance. Hence, some investors usuallytry to satisfy their diverse investments through one fund house. If you have been recommended afund house choose the fund to list all schemes under it. House for long and developed a trustwith the fund, prefer to pick another scheme from the funds but convenience sometimes leads tovenerable prejudices that might deprive you of trying something new and better. There could be

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a better-managed scheme in a different fund house that you are missing out on if you decide tostick to your old fund house for convenience sake basket for their new investment needs

Q.4. Show how duration of a bond is calculated and how is it used.

Ans.

DURATION OF BONDS

Bond Duration is a measure of bond price volatility, which captures both price and reinvestmentrisk and which is used to indicate how a bond will react in different interest rate environments.The duration of a bond represents the length of time that elapses before the average rupee ofpresent value from the bond is received. Thus duration of a bond is the weighted averagematurity of cash flow stream, where the weights are proportional to the present value of cashflows. Formally, it is defined as:Duration = D = {PV (C1) x 1 + PV (C2) x 2+ ----- PV (Cn) x n} / Current Price of the bondWhere 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 & 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 thevalue of Duration.Example: Calculate the duration of an 8% annual coupon 5 year bond that is priced toyield 10% (i.e. YTM = 10%). The face value of the bond is Rs.1000.Annual coupon payment = 8% x Rs. 1000 = Rs. 80At the end of 5 years, the principal of Rs. 1000 will be returned to the investor. Therefore cash

flows in year 1-4= Rs. 80.Cash flow in year 5= Principal + Interest = Rs. 1000 + Rs. 80 = Rs. 1080

(t) AnnualCashflow

PVIF@10%

PresentValueof AnnualCash FlowPV(Ct)

Explanation Time xPV ofcashflow

Explanation

1 80 0.90909 72.73 = 80 x 0.90909 72.73 = 1 x 72.73

2 80 0.82645 66.12 = 80 x 0.82645 132.24 = 2 x 66.12

3 80 0.75131 60.10 = 80 x 0.75131 180.3 = 3 x 60.1

4 80 0.68301 54.64 = 80 x 0.68301 218.56 = 4 x 54.64

5 1080 0.62092 670.59 = 1080 x0.62092

3352.95

= 5 x 670.59

Total 924.18 3956.78

Price of the bond= Rs 924.18The proportional change in the price of a bond:(P/P) = - {D/ (1+ YTM)} x y

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Where y =change in Yield, and YTM is the yield-to-maturity.The term D / (1+YTM) is also known as Modified Duration. The modified duration for the bondin the example above = 4.28 / (1+10%) = 3.89 years. This implies that the price of the bond willdecrease by 3.89 x 1% = 3.89% for a 1% increase in the interest rates.

Q.5. Show with the help of an example how portfolio diversification reduces risk

Ans.

PORTFOLIO DIVERSIFICATION

'Don't put all your eggs in one basket' is a well-known proverb, which summarizes themessage that there are benefits from diversification. If you carry your breakable items in severalbaskets there is a chance that one will be dropped, but you are unlikely to drop all your basketson the same trip. Similarly, if you invest all your wealth in the shares of one company, there is achance that the company will go bust and you will lose all your money. Since it is unlikely thatall companies will go bust at the same time, a portfolio of shares in several companies is less

risky. This may sound like the idea of risk-pooling, which we discussed earlier in this chapter,and risk-pooling is certainly an important reason for diversification. We will use the notion ofrisk-pooling to explain some forms of financial behavior, but a full understanding of portfoliodiversification involves a slightly wider knowledge of the nature of risk than what is involved incoin-tossing. The key difference between risk in the real world of finance and the risk of coin-tossing is that many of the potential outcomes are not independent of other outcomes. If you andI toss a coin, the probability of yours turning up heads is independent of the probability of mythrowing a head. However, the return on an investment in, say, BP is not independent of thereturn on an investment in Shell. This is because these two companies both compete in the sameindustry. On the other hand, all oil companies might do well when oil prices are high and badlywhen they are low. The important matter here is that the fortunes of these two companies are not

independent of each other.Assets differ in expected return and variability in returns. Part (i) illustrates the

return on two assets in two different situations. Asset A has a high return in situation 2 and a lowreturn in situation 1. The reverse is true for asset B. A portfolio of both assets has the sameexpected return but lower risk than a holding of either asset on its own. In (ii) both assets have ahigh return in situation 2 and a low return in situation 1. For the risk-averse investor asset Adominates asset B. Consider part (i) of the table. In this case both assets have the same expectedreturn (20 per cent) and the same degree of risk. (The possible range of outcomes is between 10and 30 per cent on each asset.) If all that mattered in investment decisions were the risk andreturn of individual shares, the investor would be indifferent between assets A and B. Indeed, ifthe choice were between holding only A or only B, all investors should be indifferent (whether

they were risk-averse, risk-neutral, or risk-loving) because the risk and expected return areidentical for both assets.

However, this is not the end of the story, because the returns on these assets are notindependent. Indeed, there is a perfect negative correlation between them: when one is high theother is low, and vice versa. What would a sensible investor do if permitted to hold somecombination of the two assets? Clearly, there is no possible combination that will change theoverall expected return, because it is the same on both assets. However, holding some of eachasset can reduce the risk. Let the investor decide to hold half his wealth in asset A and half in

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asset B. His risk will then be reduced to zero, since his return will be 20 per cent whicheversituation arises. This diversified portfolio will clearly be preferred to either asset alone by risk-averse investors. The risk-neutral investor is indifferent to all combinations of A and B becausethey all have the same expected return, but the risk lover may prefer not to diversify. This isbecause, by picking one asset alone, the risk lover still has a chance of getting a 30 per cent

return and the extra risk gives positive pleasure. Risk-averse investors will choose the diversifiedportfolio, which gives them the lowest risk for a given expected rate of return, or the highestexpected return for a given level of risk.

Diversification does not always reduce the riskiness of a portfolio, so we need to be clearwhat conditions matter. Consider the example in part (ii) of Table 2. As in part (i), both assetshave an expected return of 20 per cent. But asset B is riskier than asset A and it has returns thatare positively correlated with A's. Portfolio diversification does not reduce risk in this case. Risk-averse investors would invest only in asset A, while risk-lovers would invest only in asset B.Combinations of A and B are always riskier than holding A alone. Thus, we could say that forthe risk-averse investor asset A dominates asset B, as asset B will never be held so long as assetA is available. The key difference between the example in part (ii) of Table 2 and that in part (i)

is that in the second example returns on the two assets are positively correlated, while in theformer they are negatively correlated. The risk attached to a combination of two assets will besmaller than the sum of the individual risks if the two assets have returns that are negativelycorrelated.

Diversifiable and non-diversifiable risk

Not all risk can be eliminated by diversification. The specific risk associated with anyone company can be diversified away by holding shares of many companies. But even if youheld shares in every available traded company, you would still have some risk, because the stockmarket as a whole tends to move up and down over time. Hence we talk about market risk andspecific risk. Market risk is non-diversifiable, whereas specific risk is diversifiable through risk-pooling. Box 3 discusses the issue of whether all firms should diversify the activities in order toreduce risk. Beta It is now common to use a coefficient called beta to measure the relationshipbetween the movements in a specific company's share price and movements in the market. Ashare that is perfectly correlated with an index of stock market prices will have a beta of 1. Abeta higher than 1 means that the share moves in the same direction as the market but withamplified fluctuations. A beta between 1 and 0 means that the share moves in the same directionas the stock market but is less volatile. A negative beta indicates that the share moves in theopposite direction to the market in general. Clearly, other things being equal, a share with anegative beta would be in high demand by investment managers, as it would reduce a portfolio'srisk. The capital asset pricing model, or CAPM, predicts that the price of shares with higherbetas must offer higher average returns in order to compensate investors for their higher risk.For example,

Two stocks whose returns move in exactly together have a coefficient of +1.0. Twostocks whose returns move in exactly the opposite direction have a correlation of -1.0. Toeffectively diversify, you should aim to find investments that have a low or negative correlation.The banking stocks (or the technology stocks) would have a high positive correlation as theirshare prices are driven by common factors. As you increase the number of securities in yourportfolio, you reach a point where you have diversified as much as is reasonably possible. Whenyou have about 30 securities in your portfolio you have diversified most of the risk.

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Q.6.Study the performance of any emerging market of your choice.

Ans.

EMERGING MARKET

With emerging market economies like India and China growing at nearly 10%, you maybe feeling pain from all the criticism from pundits and advisers that you are a myopic, short-sighted American for not allocating enough to emerging market equities. According toVanguard, the average allocation to emerging market equities among US household investors isstill only 6%. Shouldn't the percentage of your equity portfolio invested in emerging marketsequities be roughly in line with the proportionate share of emerging-market stocks to total global

stock-market capitalization or around 10% to 15% of an investor's total equity portfolio? Itseems natural to expect that the powerful economic growth of emerging markets such as Braziland China will lead to higher stock market returns than in the slower growing markets such asthe U.S. and Europe. So should emerging market equities be a bigger part of your portfolio? Infact, US household investors may, at least for the moment, be properly weighted in emergingmarkets. For the following reasons higher potential growth may not justify investing heavilyright now in emerging market equities and instead you may want to be gradually increasing yourallocation over time: First, 12% economic growth in a country like India has not necessarilymeant 12% market returns. While there is certainly reasonable evidence to support expectationsof long-term growth in markets like India, China, Brazil, etc., as reported in this Wall StreetJournal article - studies suggest that strong economic growth often does not translate into strong

stock returns. One study, which looked at market returns in 32 nations since the 1970s,concluded that stock gains and economic performance can diverge dramatically. University ofFlorida finance professor Jay Ritter found, for example, that stocks in Sweden posted a meanreturn of better than 8% a year from 1970 through 2002, even though GDP grew at an annualizedpace of just 1.8%. In contrast, while GDP expanded more than 5% annually in South Korea from1988 to 2002, the mean stock return was only 0.4% a year. 'A healthy economy isn't a guaranteethat established companies will attract enough capital and labor to expand sales and earningsstronglypartly because they have to compete with newer ventures for resources,' Dr. Rittersays.

More basically, since markets are largely efficient, investors have long ago anticipatedpotential for equities in places like China. Right now, by many measures, it would appear that

valuations for US and MSCI Emerging Markets Index on a trailing P/E basis are roughly inline.Second, even if average annual returns from emerging markets exceed developed markets,emerging markets are still materially more volatile, and this volatility will not just keep youawake at night, it will erode your returns over time through the process of volatility drag. Mycolleague explains in this article how volatility drag will reduce your returns. Right now, the 3-year standard deviation of emerging market returns is 32.83 versus 24.27 for the S&P500, adifference that translates into roughly a 3% drag on your cumulative return. And while the 60-day volatility on US Large-Cap Equities has now dropped all the way down to 10.99%, the 60-

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day emerging market volatility actually rose slightly this quarter to 19.55% (see chart below forperiod ending December 31, 2010):

Third, emerging market indexes are less efficient investment vehicles which makes a big difference over time for prudent, long-term investors. Most emerging market funds aresignificantly more expensive than US funds - often hundreds of basis points more. Our firmrecommends low cost funds such as Shares MSCI Emerging Market Index (EEM), and VanguardEmerging Markets (VWO). But even these low-cost funds face higher costs than US equityfunds. Compare Vanguard's VWO at 0.27 expense ratio vs. Vanguards S&P500 Index Fund(VOO) at 0.06%. If you are investing within a fund family such as Fidelity, your choice foremerging markets is an actively managed fund with an annual cost of 1.14% versus Fidelity'sS&P500 Index at only 0.10% (This is why if you really seek more exposure to emerging marketseconomic growth, a more efficient way to gain exposure is through multinationals traded on US

exchanges S&P500 companies derive about 50% of their revenue from abroad, with about athird of that coming from emerging markets). So higher economic growth may not lead to higherreturns on emerging markets equities, volatility drag is likely to erode much of this potentialhigher return, and higher investment costs are certain to drag the return down even further. In ourdynamic asset allocation process, emerging markets allocations are likely to grow along withother equity allocations over the next few years assuming volatility continues to decline. But,right now, it appears that the average American household is not necessarily being naive andxenophobic when they choose to be underweighted in emerging market equities.