SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT PART – A Q1. Discuss the characteristics of investors, speculators, and gamblers. Explain the impact of each on the investment programme process.? Solution: The term “investment” has grown. It has grown to encompass a lot more activities as “investment” and a lot more people as “investors” than it ever did in past decades. Specifically, it has grown to absorb activities that once would have been properly identified as “speculation” and participants who would properly have been termed “speculators.” Speculator is one who takes unusually high risks in order to make unusually high returns, if he is successful. An investor puts his money into funds or stocks because he understands the business, and believes that it will be successful. In all of the above, the terms are subjective. What seems like a high risk or high reward to one person may seem commonplace to another. Now there is an element of gambling in all of this, because there is an element of chance. It is totally false, however, to equate trading stocks and mutual funds with what is done at the casinos in Vegas. The gambler at a casino is playing with the odds against him. When he pulls the lever of the slot machine, the expected value of his winnings is less than the money he puts in. The house takes its cut. So this gambler is someone who plays with the odds against him for the joy of watching the money move, and for the irrational hope that he will get lucky. Sometimes speculative purchasing can cause particular prices to rise above their “real value” simply because the speculative purchasing is artificially increasing the demand. Speculative selling can also cause prices to fall below “true value” in a similar fashion. In some situations price rises due to speculative purchasing cause further speculative purchasing in the hope that the price will continue to rise.
Transcript
SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT
PART – A
Q1. Discuss the characteristics of investors, speculators, and gamblers. Explain the
impact of each on the investment programme process.?
Solution:
The term “investment” has grown. It has grown to encompass a lot more activities as “investment” and a lot more people as “investors” than it ever did in past decades. Specifically, it has grown to absorb activities that once would have been properly identified as “speculation” and participants who would properly have been termed “speculators.”
Speculator is one who takes unusually high risks in order to make unusually high returns, if he is successful. An investor puts his money into funds or stocks because he understands the business, and believes that it will be successful.
In all of the above, the terms are subjective. What seems like a high risk or high reward to one person may seem commonplace to another.
Now there is an element of gambling in all of this, because there is an element of chance. It is totally false, however, to equate trading stocks and mutual funds with what is done at the casinos in Vegas. The gambler at a casino is playing with the odds against him. When he pulls the lever of the slot machine, the expected value of his winnings is less than the money he puts in. The house takes its cut.
So this gambler is someone who plays with the odds against him for the joy of watching the money move, and for the irrational hope that he will get lucky.
Sometimes speculative purchasing can cause particular prices to rise above their “real value” simply because the speculative purchasing is artificially increasing the demand. Speculative selling can also cause prices to fall below “true value” in a similar fashion. In some situations price rises due to speculative purchasing cause further speculative purchasing in the hope that the price will continue to rise.
Investor
“A person whose principal concern in the purchase of a security is the minimizing of risk, compared to the speculator who is prepared to accept calculated risk in the hope of making better-than-average profits, or the ‘gambler’ who is prepared to take even greater risks.More generally it refers to people who invest money in investment products.”“An individual who makes investments. An investor can act on behalf of others, for example, stock brokers or mutual fund managers make investments for others. Or else an investor can make investments for ones own personal account.”
To clearly understand these terms let us study difference between investors and
speculators.
Planning Horizon
An investor has a relatively longer planning horizon. His holding period is usually atleast one year.A speculator has a very short planning horizon. His holding may be a few to a days to a few months.
Risk DispositionAn investor risk is lessA speculator risk is high
Return ExpectationAn investor usually seeks moderate rate of returnA speculator looks for a high rate of return
Basis for Decisions
An investor attaches greater significance to fundamental factors and attempts a
careful evaluation of the growth of the enterprise.
A speculator relies more on hear say, technical charts and market psychology.
Leverage
An investor uses his own funds avoid borrowed fundsA speculator normally takes to borrowings, which can be very substantial, to supplement his personal resources.
Gambling
“Taken risk in the hope of a favourable outcome.” Gambling most often refers specifically to the wagering of money on games of chance or more broadly to engaging in high risk behaviour. Gambling refers to an act of involving an element of risk. A gambling involves taking on risk without demanding compensation in the form of increased expected return.
Characteristics of Gambling
An important characteristics of gambling• Gambling is a typical, chronic and repetitive experience• Gambling absorbs all other interests• The Gambler displays persistent optimism without winning• The gambler never steps while wining• The gambler eventually take more risk• The gambler seeks and enjoys a strange thrill from gambling• The gambler seeks pleasure and pain from gambling• In gambling artificial and unnecessary risks are created
Q2. Discuss the features of an investment programme?
Solution:
Features of an investment programme consist of the following factors:
• Safety of principal amount
Safety refers to the protection of investor principal amount and expected rate of return.Safety is also one of the essential and crucial elements of investment. Investor prefers safety about his capital. Capital is the certainty of return without loss of money or it will take time to retain it. If investor prefers less risk securities, he chooses Government bonds. In the case, investor prefers high rate of return investor will choose private Securities and Safety of these securities is low.
• Liquidity of the investment
Liquidity refers to an investment ready to convert into cash position. In other words, it is available immediately in cash form. Liquidity means that investment is easily realisable, saleable or marketable. When the liquidity is high, then the return may be low. For example, UTI units. An investor generally prefers liquidity for his investments, safety of funds through a minimum risk and maximisation of return from an investment.
• Income stability of the investment
It refers to constant return from an investment. Another major characteristic feature of the Investment is the stability of income. Stability of income must look for different path just as security of principal. Every investor always considers stability of monetary income and stability of purchasing power of income.
• Appreciation and purchasing power stability of the investor investment
It refers to the buying capacity of investment in market. Purchasing power stability has become one of the import traits of investment. Investment always involves the commitment of current funds with the objective of receiving greater amounts of future funds.
Q3. What are the main functions of a stock exchange? In what ways is a stock
exchange indispensable for an economy?
A3. Main Function of a Stock Exchange are given below:
1. Continuous and ready market for securities:
Stock exchange provides a ready and continuous market for purchase and sale of
securities. It provides ready outlet for buying and selling of securities. Stock
exchange also acts as an outlet/counter for the sale of listed securities.
2. Facilitates evaluation of securities:
Stock exchange is useful for the evaluation of industrial securities. This enables
investors to know the true worth of their holdings at any time. Comparison of
companies in the same industry is possible through stock exchange quotations (i.e
price list).
3. Encourages capital formation:
Stock exchange accelerates the process of capital formation. It creates the habit of
saving, investing and risk taking among the investing class and converts their
savings into profitable investment. It acts as an instrument of capital formation. In
addition, it also acts as a channel for right (safe and profitable) investment.
4. Provides safety and security in dealings:
Stock exchange provides safety, security and equity (justice) in dealings as
transactions are conducted as per well-defined rules and regulations. The managing
body of the exchange keeps control on the members. Fraudulent practices are also
checked effectively. Due to various rules and regulations, stock exchange functions
as the custodian of funds of genuine investors.
5. Regulates company management:
Listed companies have to comply with rules and regulations of concerned stock
exchange and work under the vigilance (i.e supervision) of stock exchange
authorities.
6. Facilitates public borrowing:
Stock exchange serves as a platform for marketing Government securities. It enables
government to raise public debt easily and quickly.
7. Provides clearing house facility:
Stock exchange provides a clearing house facility to members. It settles the
transactions among the members quickly and with ease. The members have to pay
or receive only the net dues (balance amounts) because of the clearing house
facility.
8. Facilitates healthy speculation:
Healthy speculation, keeps the exchange active. Normal speculation is not
dangerous but provides more business to the exchange. However, excessive
speculation is undesirable as it is dangerous to investors & the growth of corporate
sector.
9. Serves as Economic Barometer:
Stock exchange indicates the state of health of companies and the national
economy. It acts as a barometer of the economic situation / conditions.
10. Facilitates Bank Lending:
Banks easily know the prices of quoted securities. They offer loans to customers
against corporate securities. This gives convenience to the owners of securities.
Brief description about indispensability of Stock market for an Economy are
given below:
Stock market is an important part of the economy of a country. The stock market
plays a play a pivotal role in the growth of the industry and commerce of the country
that eventually affects the economy of the country to a great extent. That is reason
that the government, industry and even the central banks of the country keep a close
watch on the happenings of the stock market. The stock market is important from
both the industry’s point of view as well as the investor’s point of view.
Whenever a company wants to raise funds for further expansion or settling up a new
business venture, they have to either take a loan from a financial organization or they
have to issue shares through the stock market. In fact the stock market is the primary
source for any company to raise funds for business expansions. If a company wants
to raise some capital for the business it can issue shares of the company that is
basically part ownership of the company. To issue shares for the investors to invest
in the stocks a company needs to get listed to a stocks exchange and through the
primary market of the stock exchange they can issue the shares and get the funds for
business requirements. There are certain rules and regulations for getting listed at a
stock exchange and they need to fulfill some criteria to issue stocks and go public.
The stock market is primarily the place where these companies get listed to issue the
shares and raise the fund. In case of an already listed public company, they issue
more shares to the market for collecting more funds for business expansion. For the
companies which are going public for the first time, they need to start with the Initial
Public Offering or the IPO. In both the cases these companies have to go through the
stock market.
This is the primary function of the stock exchange and thus they play the most
important role of supporting the growth of the industry and commerce in the country.
That is the reason that a rising stock market is the sign of a developing industrial
sector and a growing economy of the country.
Of course this is just the primary function of the stock market and just an half of the
role that the stock market plays. The secondary function of the stock market is that
the market plays the role of a common platform for the buyers and sellers of these
stocks that are listed at the stock market. It is the secondary market of the stock
exchange where retail investors and institutional investors buy and sell the stocks. In
fact it is these stock market traders who raise the fund for the businesses by
investing in the stocks.
For investing in the stocks or to trade in the stock the investors have to go through
the brokers of the stock market. Brokers actually execute the buy and sell orders of
the investors and settle the deals to keep the stock trading alive. The brokers
basically act as a middle man between the buyers and sellers. Once the buyer places
a buy order in the stock market the brokers finds a seller of the stock and thus the
deal is closed. All these take place at the stock market and it is the demand and
supply of the stock of a company that determines the price of the stock of that
particular company.
So the stock market is not only providing the much required funds for boosting the
business, but also providing a common place for stock trading. It is the stock market
that makes the stocks a liquid asset unlike the real estate investment. It is the stock
market that makes it possible to sell the stocks at any point of time and get back the
investment along with the profit. This makes the stocks much more liquid in nature
and thereby attracting investors to invest in the stock market.
Q4. Briefly trace the history of stock markets in India.
Solution: History of Indian Stock Exchange: The Bombay Stock Exchange (BSE) is known as the oldest exchange in Asia. It traces its history to the 1850s, when stockbrokers would gather under banyan trees in front of Mumbai’s Town Hall. The location of these meetings changed many times, as the number of brokers constantly increased. The group eventually moved to Dalal Street in 1874 and in 1875 became an official organization known as ‘The Native Share & Stock Brokers Association’. In 1956, the BSE became the first stock exchange to be recognized by the Indian Government under the Securities Contracts Regulation Act. The Bombay Stock Exchange developed the BSE Sensex in 1986, giving the BSE a means to measure overall performance of the exchange. In 2000 the BSE used this index to open its derivatives market, trading Sensex futures contracts. The development of Sensex options along with equity derivatives followed in 2001 and 2002, expanding the BSE’s trading platform. Historically an open-cry floor trading exchange, the Bombay Stock Exchange switched to an electronic trading system in 1995. It took the exchange only fifty days to make this transition. Capital market reforms in India and the launch of the Securities and Exchange Board of India (SEBI) accelerated the integration of the second Indian stock exchange called the National Stock Exchange (NSE) in 1992. After a few years of operations, the NSE has become the largest stock exchange in India. Three segments of the NSE trading platform were established one after another. The Wholesale Debt Market (WDM) commenced operations in June 1994 and the Capital Market (CM) segment was opened at the end of 1994. Finally, the Futures and Options segment began operating in 2000. Today the NSE takes the 14th position in the top 40 futures exchanges in the world. In 1996, the National Stock Exchange of India launched S&P CNX Nifty and CNX Junior Indices that make up 100 most liquid stocks in India. CNX Nifty is a diversified index of 50 stocks from 25 different economy sectors. The Indices are owned and managed by India Index Services and Products Ltd (IISL) that has a consulting and licensing agreement with Standard & Poor’s. In 1998, the National Stock Exchange of India launched its web-site and was the first exchange in India that started trading stock on the Internet in 2000. The NSE has also proved its leadership in the Indian financial market by gaining many awards such as ‘Best IT Usage Award’ by Computer Society in India (in 1996 and 1997) and CHIP Web Award by CHIP magazine (1999).
Q5. Explain the meaning of the term ‘New Issue Market’. How does it differ from the
‘Secondary Market’? Are they connected to each other?
A5. New issue market is a market where companies can raise finance by issuing new
shares, or by a flotation.
The new issue market is ruled by controlling stockholders and corporations who can
usually select the timing of offerings. Understandably these sellers are not going to
offer any bargains. It's rare you'll find X being sold for half X. Indeed, in the case of
common stock offerings, selling shareholders are often motivated to unload only
when they feel the market is overpaying.
The secondary market is the financial market for trading of securities that have
already been issued in an initial private or public offering. Alternatively, secondary
market can refer to the market for any kind of used goods. The market that exists in a
new security just after the new issue is often referred to as the aftermarket. Once a
newly issued stock is listed on a stock exchange, investors and speculators can
easily trade on the exchange, as market makers provide bids and offers in the new
stock.
So it is cleared that there is no direct connection between New issue market and
Secondary market.
PART - B
Q1. Discuss the procedure to be followed by a listed company for rights issue.?
Solution:
The procedure of right issue as given in the Companies Act may be followed as
follows:
First, the offer must be made by giving a notice to the existing shareholders,
mentioning therein the number of shares offered and the time within which the offer
must be accepted. Such period shall not be less than 15 days from the date of offer,
however it may be more than 15 days keeping in mind that shareholders must have
sufficient time to make up their mind judiciously. The notice must also indicate that if
the offer is not accepted within the specified period, it shall be deemed to have been
declined. Again the notice must also state that they have the right to renounce all or
any of the shares offered to them in favour of their nominee(s).
Shareholders shall inform the company within stipulated period, of other acceptance
of right or the name of the nominee to whom he wants to renounce his right.
An existing shareholder may also apply for the additional shares but a shareholder
who has renounced his right in favour of any person is not entitled to apply for
additional shares.
The Controller of Capital Issues takes decision an application for right issue in
concurrence with the company. Certain conditions are imposed by him on the
company making an offer of right. If the right shares are not fully taken up, the
balance left over shall be distributed equally among the applicants for additional
shares with reference to the shares held by them in the company. Subject to stock
exchange on which the company's shares are listed. Any balance left after making
allotment of additional shares, the company may deal with in any manner it likes.
Checklist of rights issue in case of a listed company
Applicable only in case of listed companies coming out with a rights issue in excess of Rs.50 lakhs.
Check for the following:
Whether the rights issue is authorized by the AOA? If not, take steps to amend the artilces.
1) Whether within the authorized share capital of the company?
IF NOT, take steps to increase the authorized capital. Also file Form No.5 with the ROC and Form No. 23, if applicable.
2) Notify the stock exchange concerned the date of Board meeting at which the rights issue is proposed to be considered at least 7 days in advance of the meeting.
3) Rights issue shall be kept open for at least 30 days and not more than 60 days.
4) Convene board meeting and place before it the proposal for the rights issue.
The Board should decide on the following:
Quantum of issue and the proportion of rights shares. Alteration of share capital, if necessary. Fixation of record date/book closure. Appointment of merchant bankers and other intermediaries (merchant
bankers take care of appointment of intermediaries, provided the same has been provided for in the MOU).
Approval of the draft letter of offer or authorization of Managing director/company secretary to finalize the letter of offer in
consultation with the managers to the issue, the stock exchange and the SEBI.
The letter of offer should conform to the requirements of the Companies Act, 1956 as prescribed in Form No.2A under Section 56(3) of the Act.
Full justification and parameters used for issue price should clearly mentioned in the letter of offer.
5) Immediately after the Board Meeting notify the concerned stock exchanges about the particulars of Board’s decision.
6) Where offering shares to persons other than existing shareholders in terms of Section 81(1A):
Pass a special resolution in the general meeting of the company. Where no special resolution could be passed, but the votes cast in favour
exceeds the votes cast against: Get the approval of the Central Government on the application made by the
Board of Directors.
7) If rights shares are to be offered to NRI’s obtain RBI’s approval.
8) Forward 6 sets of letter of offer to the concerned stock exchanges.
9) Six copies of all notices, resolutions and circulars relating to new issue of capital prior to their despatch to the shareholders;
10) Despatch letters of offer to shareholders by registered post.
11) Advertisement requirements:
Check that an advertisement giving the date of completion of despatch of letter of offer has bee released in at least an English National Daily, one hindi national paper and a regional language daily where registered office of the issuer company is situated.
Check that the advertisement contains the list of centres where shareholders or person entitled to rights may obtain duplicate copies of compositeapplication forms (CAFs) in case they do not receive original application form alongwith the prescribed format on which application may be made.
12) The applications of shareholders who apply on plain paper and also in a standard form are liable to be rejected.
13) Make arrangement with bankers for acceptance of share application forms.
14) If the company does not receive 90% of the issue amount including the devolvement from underwriters, the entire amount of subscription is required to be refunded within 42 days from the date of closure of the issue.
If there is delay in the refund of subscription by more than 8 days after the company becomes liable to pay subscription amount, the company will pay interest for the delayed period as per section 73(2)(2A) of the companies act, 1956.
15) Prepare a scheme of allotment in consultation with the stock exchange.
16) Convene a board meeting and make allotment of shares.
17) File the return of allotment in Form No.2 with the registrar of companies within 30 days of allotment.
18) Make an application to the stock exchange(s) where the company’s shares are listed for permission of listing new shares.
19) Check that a 3 day and 50 day monitoring report has been sent to the SEBI.
Q2. P. S. Gupta is considering investing in a bond currently selling for Rs. 8785.07.
The bond has four years to maturity, a Rs. 10,000 face value and a 8 per cent
coupon rate. The next annual interest payment is due one year from today. The
approximate discount factor for investments of similar risk is 10 percent.
a. Calculate the intrinsic value of the bond. Based on this calculation, should
Gupta purchase the bond?
b. Calculate the YTM of the bond. Based on this calculation, should Gupta
purchase the bond?
Solution:
a. To determine the intrinsic value of a bond, we simply apply the concept of time value of money to determine the present values of all the cash flows (i.e. interest payments and principal) generated by the bond throughout its lifetime. In other words, the intrinsic value of a bond is simply the present value of all its interest payments plus the present value of its principal, which is expressed by the formula below:
where P0 is the intrinsic value of a bond, Ci is the coupon (or interest) payment from period i, and r is the nominal market interest rate.
Coupon payments= Rs.10000*8%= Rs. 800
Based on the formula mentioned above Intrinsic value of bond= Rs. 9366.03
Presently bond is selling at Rs. 8785.07
So, Mr. Gupta should purchase the bond.
b. See the excel sheet attached for calculation of YTM, which is 12% in this
case.
YTM of bond is more then its coupon rate, it means that the bond is selling at
a discount.
So, Mr. Gupta should purchase the bond.
Q3. What part do the growth rate of earnings, dividend, and the future P/E play in the
valuation equation?
Solution:
Price to Earnings (P/E). The most common valuation technique used by analysts, the price to earnings ratio, or P/E. To compute this figure, take the stock price and divide it by the annual EPS figure. For example, if the stock is trading at $10 and the EPS is $0.50, the P/E is 20 times. To get a good feeling of what P/E multiple a stock trades at, be sure to look at the historical and forward ratios.
Historical P/Es are computed by taking the current price divided by the sum of the EPS for the last four quarters, or for the previous year. You should also look at the historical trends of the P/E by viewing a chart of its historical P/E over the last several years. Specifically you want to find out what range the P/E has traded in so that you can determine if the current P/E is high or low versus its historical average.
Forward P/Es reflect the future growth of the company into the figure. Forward P/Es are computed by taking the current stock price divided by the sum of the EPS estimates for the next four quarters, or for the EPS estimate for next calendar of fiscal year or two.
P/Es change constantly. If there is a large price change in a stock you are watching, or if the earnings (EPS) estimates change, the ratio is recomputed.
Growth Rate. Valuations rely very heavily on the expected growth rate of a company. One must look at the historical growth rate of both sales and income to get a feeling for the type of future growth expected. However, companies are constantly changing, as well as the economy, so solely using historical growth rates to predict the future is not an acceptable form of valuation. Instead, they are used as guidelines for what future growth could look like if similar circumstances are encountered by the company. Calculating the future growth rate requires personal investment research. This may take form in listening to the company's quarterly conference call or reading press release or other company article that discusses the company's growth guidance. However, although companies are in the best position to forecast their own growth, they are far from accurate, and unforeseen events could cause rapid changes in the economy and in the company's industry.
And for any valuation technique, it's important to look at a range of forecast values. For example, if the company being valued has been growing earnings between 5 and 10% each year for the last 5 years, but believes that it will grow 15 - 20% this year, a more conservative growth rate of 10 - 15% would be appropriate in valuations. Another example would be for a company that has been going through restructuring. They may have been growing earnings at 10 - 15% over the past several quarters / years because of cost cutting, but their sales growth could be only 0 - 5%. This would signal that their earnings growth will probably slow when the cost cutting has fully taken effect. Therefore, forecasting an earnings growth closer to the 0 - 5% rate would be more appropriate rather than the 15 - 20%. Nonetheless, the growth rate method of valuations relies heavily on gut feel to make a forecast. This is why analysts often make inaccurate forecasts, and also why familiarity with a company is essential before making a forecast.
Calculating the Growth Rate
When we talk about growth rate, we're talking primarily about the future earnings per
share (EPS) growth rate. The most relevant numbers -- earnings estimates -- are the
ones that haven't been reported yet. A whole industry has sprung up to guesstimate
those numbers and provide them to investors.
The future EPS growth rate for a single year is quite simple to calculate. Let's say
Addict Your Toddlers Toys has just reported EPS of $0.60 this year, and analysts
estimate that it will earn $0.90 EPS for the upcoming year. The one-year growth rate,
a straight percentage gain calculation, is 50%.
How did we calculate that? By using a simple formula, we can figure out the single
year future EPS growth rate:
(Earnings Est. for upcoming year -Current Earnings) x 100
Current Earnings
So what does this really mean? In this case, the company is currently earning $0.60
per share and we expect that to grow by 50% over the coming year to $0.90 per
share.
Dividend Model
The value of a share is given by the dividend discount model as a simple function of future dividends; but the actual determination of the share price is rarely based upon the direct estimation of these future dividends. A ranking of the valuation models used by analysts and fund managers shows a preference for ‘unsophisticated’ valuation using, for example, the dividend yield rather than the dividend discount model. This finding is shown to depend upon the practical difficulty of using currently-available information to forecast future cash flows. This difficulty limits the quantitative basis of valuations to short forecast horizons, while the subjective, qualitative estimation of terminal value assumes great importance. Crucially, both analysts and fund managers use their own assessment of management quality to underpin the estimation of terminal value, on the basis that superior quality causes outperformance and that, whereas management quality can be assessed now, future performance itself is unobservable. Linked with this and with information asymmetry, valuation is a dynamic, company-specific process, focused on personal communication with management and embodying ongoing signalling and implicit contracting, using both dividends and other variables. This method of valuation causes formal valuation models such as the dividend yield to play only a limited role. They offer a benchmark of relative price differences, which serves as a basis from which to conduct subjective, company-specific analysis and to make investment decisions; but valuation models are not used exclusively, in themselves, to value shares.
Q4. What is the money market? Explain the objectives and needs of money market
instruments.?
Solution:
The money market is a subsection of the fixed income market. We generally think of the term fixed income as being synonymous to bonds. In reality, a bond is just one type of fixed income security. The difference between the money market and the bond market is that the money market specializes in very short-term debt securities (debt that matures in less than one year). Money market investments are also called cash investments because of their short maturities.
Money market securities are essentially IOUs issued by governments, financial institutions and large corporations. These instruments are very liquid and considered extraordinarily safe. Because they are extremely conservative, money market securities offer significantly lower returns than most other securities.
One of the main differences between the money market and the stock market is that most money market securities trade in very high denominations. This limits access for the individual investor. Furthermore, the money market is a dealer market, which means that firms buy and sell securities in their own accounts, at their own risk. Compare this to the stock market where a broker receives commission to acts as an agent, while the investor takes the risk of holding the stock. Another characteristic of a dealer market is the lack of a central trading floor or exchange. Deals are transacted over the phone or through electronic systems.
The easiest way for us to gain access to the money market is with a money market mutual funds, or sometimes through a money market bank account. These accounts and funds pool together the assets of thousands of investors in order to buy the money market securities on their behalf. However, some money market instruments, like Treasury bills, may be purchased directly. Failing that, they can be acquired through other large financial institutions with direct access to these markets.
Need for money market instruments.
1. it provides an equilibrating mechanism for demand and supply of short-term funds
2. it enables borrowers and lenders of short-term funds to fulfil their borrowing and investment requirements at an efficient market clearing price
3. it provides an avenue for central bank intervention in influencing both quantum and cost of liquidity in the financial system, thereby transmitting monetary policy impulses to the real economy.
4. The diminishing role of quantitative controls and search for alternatives gave rise to three major market-oriented instruments, viz., short-term securities, repurchase operations and swaps. These instruments prompted the central banks to create, stimulate and support the development of markets particularly, inter-bank deposit market and short-term securities market. In the absence of an efficient interbank market, there was a pressing need for the central banks to create adequate instruments to absorb liquidity and stimulate the formation of markets for alternative short-term assets. The emergence of the short-term securities market added a new dimension to liquidity management by central banks. In the absence of outright transactions in the
securities market, the existence of a liquid securities segment in the money market is often believed to facilitate the central bank’s operations by providing collateral to repurchase agreements and similar collateralised transactions.
5. A well developed money market helps the industries to secure short term
loans for meeting their working capital requirements. It thus saves a number
of industrial units from becoming sick.
6. An outward and a well knit money market system play an important role in
financing the domestic as well as international trade. The traders can get
short term finance from banks by discounting bills of exchange. The
acceptance houses and discount market help in financing foreign trade.
7. The money market helps the commercial banks to earn profit by investing
their surplus funds in the purchase of. Treasury bills and bills of exchange,
these short term credit instruments are not only safe but also highly liquid.
The banks can easily convert them into cash at a short notice.
8. The money market is useful for the commercial banks themselves. If the
commercial banks are at any time in need of funds, they can meet their
requirements by recalling their old short term loans from the money market.
9. The well developed money market helps the central bank in shaping and
controlling the flow of money in the country. The central bank mops up excess
short term liquidity through the sale of treasury bills and injects liquidity by
purchase of treasury bills.
10. If the money market is well organized, it safeguards the liquidity and safety of
financial asset This encourages the twin functions of economic growth,
savings and investments.
11. The organized money market helps the government of a country to borrow
funds through the sale of Treasury bills at low rate of interest The government
thus would not go for deficit financing through the printing of notes and
issuing of more money which generally leads to rise in an increase in general
prices.
12. In the money market, the demand for and supply of loan able funds are brought at equilibrium The savings of the community are converted into investment which leads to pro allocation of resources in the country.
Q5. State the meaning, rationale, procedure and limitations of the Fundamental
Analysis.?
Solution:
Fundamental analysis is the cornerstone of investing. In fact, some would say that
you aren't really investing if you aren't performing fundamental analysis. Because the
subject is so broad, however, it's tough to know where to start. There are an endless
number of investment strategies that are very different from each other, yet almost all
use the fundamentals.
This is a method of analyzing the value of a company’s stock price by studying the
financial data of the company. It considers the company’s earnings and expenses,
profit, assets and liabilities, management experience and industry dynamics. In other
words it focuses on the business and tries to work out what the stock price should be.
An investor using Fundamental Analysis to make investment decisions will rely heavily on the following sources of information:
• Company Balance Sheet and Profit and loss a/c
• Annual report
• Newspapers
• Company announcements
• Industry news.
When talking about stocks, fundamental analysis is a technique that attempts to determine a security’s value by focusing on underlying factors that affect a company's actual business and its future prospects. On a broader scope, you can perform fundamental analysis on industries or the economy as a whole. The term simply refers to the analysis of the economic well-being of a financial entity as opposed to only its price movements.
Fundamental analysis serves to answer questions, such as:
Is the company’s revenue growing? Is it actually making a profit? Is it in a strong-enough position to beat out its competitors in the future? Is it able to repay its debts? Is management trying to "cook the books"?
Fundamentals: Quantitative and Qualitative You could define fundamental analysis as “researching the fundamentals”, but that doesn’t tell you a whole lot unless you know what fundamentals are. The big problem with defining fundamentals is that it can include anything related to the economic
well-being of a company. Obvious items include things like revenue and profit, but fundamentals also include everything from a company’s market share to the quality of its management.
The various fundamental factors can be grouped into two categories: quantitative and qualitative. The financial meaning of these terms isn’t all that different from their regular definitions.
Quantitative – capable of being measured or expressed in numerical terms. Qualitative – related to or based on the quality or character of something,
often as opposed to its size or quantity.
In our context, quantitative fundamentals are numeric, measurable characteristics about a business. It’s easy to see how the biggest source of quantitative data is the financial statements. You can measure revenue, profit, assets and more with great precision.
Turning to qualitative fundamentals, these are the less tangible factors surrounding a business - things such as the quality of a company’s board members and key executives, its brand-name recognition, patents or proprietary technology.
Quantitative Meets Qualitative Neither qualitative nor quantitative analysis is inherently better than the other. Instead, many analysts consider qualitative factors in conjunction with the hard, quantitative factors. Take the Coca-Cola Company, for example. When examining its stock, an analyst might look at the stock’s annual dividend payout, earnings per share, P/E ratio and many other quantitative factors. However, no analysis of Coca-Cola would be complete without taking into account its brand recognition. Anybody can start a company that sells sugar and water, but few companies on earth are recognized by billions of people. It’s tough to put your finger on exactly what the Coke brand is worth, but you can be sure that it’s an essential ingredient contributing to the company’s ongoing success.
The Concept of Intrinsic Value Before we get any further, we have to address the subject of intrinsic value. One of the primary assumptions of fundamental analysis is that the price on the stock market does not fully reflect a stock’s “real” value. After all, why would you be doing price analysis if the stock market were always correct? In financial jargon, this true value is known as the intrinsic value.
For example, let’s say that a company’s stock was trading at $20. After doing extensive homework on the company, you determine that it really is worth $25. In other words, you determine the intrinsic value of the firm to be $25. This is clearly relevant because an investor wants to buy stocks that are trading at prices significantly below their estimated intrinsic value. This leads us to one of the second major assumptions of fundamental analysis: in the long run, the stock market will reflect the fundamentals. There is no point in buying a stock based on intrinsic value if the price never reflected that value. Nobody knows how long “the long run” really is. It could be days or years.
This is what fundamental analysis is all about. By focusing on a particular business, an investor can estimate the intrinsic value of a firm and thus find opportunities where he or she can buy at a discount. If all goes well, the investment will pay off over time as the market catches up to the fundamentals.
The big unknowns are:
1)You don’t know if your estimate of intrinsic value is correct; and 2)You don’t know how long it will take for the intrinsic value to be reflected in the marketplace.
Criticisms of Fundamental Analysis
The biggest criticisms of fundamental analysis come primarily from two groups: proponents of technical analysis and believers of the “efficient market hypothesis”.
Technical analysis is the other major form of security analysis. We’re not going to get into too much detail on the subject.
Put simply, technical analysts base their investments (or, more precisely, their trades) solely on the price and volume movements of securities. Using charts and a number of other tools, they trade on momentum, not caring about the fundamentals. While it is possible to use both techniques in combination, one of the basic tenets of technical analysis is that the market discounts everything. Accordingly, all news about a company already is priced into a stock, and therefore a stock’s price movements give more insight than the underlying fundamental factors of the business itself.
Followers of the efficient market hypothesis, however, are usually in disagreement with both fundamental and technical analysts. The efficient market hypothesis contends that it is essentially impossible to produce market-beating returns in the long run, through either fundamental or technical analysis. The rationale for this argument is that, since the market efficiently prices all stocks on an ongoing basis, any opportunities for excess returns derived from fundamental (or technical) analysis would be almost immediately whittled away by the market’s many participants, making it impossible for anyone to meaningfully outperform the market over the long term.
PART – C
Q1. Define the Efficient Market Hypothesis in each of its three forms. What are its
implications?
Solution:
The efficient market hypothesis asserts that it would be impossible consistently tooutperform the market—which reflects the composite judgment of millions of participants—in an environment characterized by many competing investors, each with similar objectives and equal access to the same information. In the context of this hypothesis, “efficient” means that the market is capable of quickly digesting new information on the economy, an industry, or the value of an enterprise and accurately impounding it into securities prices. In such markets participants can expect to earn no more, nor less, than a fair return for the risks undertaken.
In an efficient market, for example, news of an earnings increase would be quickly and accurately assessed by the combined actions of literally millions of investors and immediately reflected in the price of the stock. The purported result of this efficiency is that whether you buy the stock before, during, or after the earnings news, or whether another stock is purchased, only a fair market rate of return can be expected—commensurate with the risk of owning whatever security is bought.
THE FORMS OF THE EFFICIENT MARKET HYPOTHESIS
The efficient market hypothesis does not by any means deny the profitability of investing. It merely states that the rewards obtainable from investing in highly competitive markets will be fair, on the average, for the risks involved. Importantly, however, the three forms of the efficient market hypothesis hold that acting on publicly available information cannot improve one’s performance beyond the market’s assessment of a fair rate of return.
The weak form of the efficient market hypothesis describes a market in which historical price data are efficiently digested and, therefore, are useless for predicting subsequent stock price changes. This is distinguished from a semistrong form under which all publicly available information is assumed to be fully discounted in current securities prices. Finally, the strong form describes a market in which not even those with privileged information can obtain superior investment results.
If the stock market efficiently digests all available information, as the progressively stronger forms of the hypothesis imply, there is little justification for seeking extraordinary gains from investing. However, this does not lessen the importance of investing. It merely changes the underlying investment philosophy of a prudent and knowledgeable investor from that of trying to beat the other person to one of seeking a rate of return that is consistent with the level of risk accepted.
Thus, rather than being the all-encompassing specter of gloom which some people assume it to be, the efficient market hypothesis in its various forms provides a useful benchmark. From its perspective, researchers can determine how “efficiently” or “inefficiently” information is processed. It is thus possible to scrutinize the market’s ability to impound various kinds of information into securities prices. Most importantly, if research can determine which information is efficiently processed, investors can avoid analyzing this useless, fully discounted information-thefirst step in the successful and prudent application of MPT techniques!
Q2. Explain how the efficient frontier is determined using the Markowotz approach.
Use a two security approach.?
Solution:
Efficient Frontier tool is a powerful portfolio optimizer that is based on key concepts of modern portfolio theory. Professor Harry Markowitz, a nobel-prize winning economist, introduced the concept of the Efficient Frontier. This tool analyzes trade-offs between risk and expected return of various portfolios composed of various asset weightings. Changing asset weightings will change both the expected return and expected risk (measured by standard deviation) of the portfolio. The Efficient Frontier tool analyzes all possible portfolio combinations (by varying asset weights) and finds the ones that offer the best expected return for a given level of risk. It plots these portfolios on a curve called the Efficient Frontier. The Efficient Frontier curve corresponds to the most efficient investment strategies. Any given portfolio on the Efficient Frontier is said to dominate all other possible portfolios that have either the same level of expected return or standard deviation. All results are based on analysis of historical prices of each security in the portfolio.
After plotting the Efficient Frontier curve, the tool then determines an optimal portfolio. It does this by selecting the portfolio that falls at the point of tangency with the straight line starting at the risk-free rate of return on the y-axis. This line, sometimes called the capital market line, assumes that the investor will either invest in cash (at the risk-free interest rate) or a portfolio on the efficient curve. The point of tangency maximizes the slope of the capital market line, which is given by the equation:
This slope is also known as the Sharpe Ratio, which is a ratio of reward to risk. The higher the Sharpe Ratio, the better. The Efficient Frontier tool finds the point on the efficient frontier that maximizes the Sharpe Ratio.
Suppose you have data for a collection of securities (like the S & P 500 stocks, for example), and you graph the return rates and standard deviations for these securities, and for all portfolios you can get by allocating among them. Markowitz showed that you get a region bounded by an upward-sloping curve, which he called the efficient frontier.
It's clear that for any given value of standard deviation, you would like to choose a portfolio that gives you the greatest possible rate of return; so you always want a portfolio that lies up along the efficient frontier, rather than lower down, in the interior of the region. This is the first important property of the efficient frontier: it's where the best portfolios are.
The second important property of the efficient frontier is that it's curved, not straight. This is actually significant -- in fact, it's the key to how diversification lets you improve your reward-to-risk ratio. To see why, imagine a 50/50 allocation between just two securities. Assuming that the year-to-year performance of these two securities is not perfectly in sync -- that is, assuming that the great years and the lousy years for Security 1 don't correspond perfectly to the great years and lousy years for Security 2, but that their cycles are at least a little off -- then the standard deviation of the 50/50 allocation will be less than the average of the standard deviations of the two securities separately. Graphically, this stretches the possible allocations to the left of the straight line joining the two securities.
In statistical terms, this effect is due to lack of covariance. The smaller the covariance between the two securities -- the more out of sync they are -- the smaller the standard deviation of a portfolio that combines them. The ultimate would be to find two securities with negative covariance (very out of sync: the best years of one happen during the worst years of the other, and vice versa).
Q3. Why must the market portfolio be a combination of all securities, each in
proportion to market value outstanding?
Solution:
Market Portfolio must be a combination of all securities. This is known as
diversification strategy.
Investment strategy matters when it comes to investing in any financial market. If you want to invest, you must deal with the ups and downs of the market. A good week in the market leaves an investor feeling like a genius; a bad week makes an investor feel downright foolish.
In order to protect yourself from a market downturn, you must diversify. Advantages of diversification:
1. Risk ReductionYou can't eliminate risk completely, but you can manage your level of risk. Every investment has some amount of risk. Young investors should embrace risk because the long-term rewards can make it worthwhile. Older investors may view risk as an
enemy, because too much risk can annihilate retirement plans. In fact, many senior citizens experienced great losses to their retirement portfolios during the economic downturn.
Some investors failed to diversify amongst asset classes, and were far too exposed to stock market risk. Diversifying into safer fixed income assets may have helped to reduce their risk and maximize their returns. Using capital preservation and diversification as investment strategies can also reduce investment portfolio risk.
2. Capital PreservationSome investors strive for capital appreciation, while some investors use capital preservation as an investment strategy. Capital preservation allows you to protect the capital you have, rather than focusing on the rate of return for your investments. Diversification makes it much easier for an investor to protect their capital, allocating money to different investments.
Investing in a variety of assets reduces risk, especially when compared to investing in a limited number of stocks. You do not have to worry about a Lehman Brothers or Enron crushing your retirement portfolio, if you lessen the impact that these stocks have on your portfolio by diversifying your investments. In addition to investment risk management and capital preservation, you can also hedge your portfolio when you employ diversification as an investment strategy.
3. Ability to Hedge Your PortfolioDiversification can enable a portfolio to grow both when markets boom and returns crumble in one sector. Investors who have had 100% equity portfolios over the past eleven years have likely seen very poor returns. If these investors had diversified their portfolios to include investing in metals, commodities, and bonds, their portfolios would have experienced greater returns. Diversification gives an investor the chance to achieve positive returns in one market when another market is generating negative returns.
Diversification offers investors a number of benefits. Diversification is appropriate for the risk averse and works well for prudent investors. Diversification helps protect your capital from the wild swings of the market, while achieving long-term growth at the same time.
Q4. Under the CAPM, what is the efficient set called/ If there is buying and selling of
a risk-free asset, what happens to the efficient set?
Solution:
The Capital Asset Pricing Model (CAPM) is a model to explain why
capital assets are priced the way they are.
The CAPM was based on the supposition that all investors employ
Markowitz Portfolio Theory to find the portfolios in the efficient set.
Then, based on individual risk aversion, each of them invests in one of
the portfolios in the efficient set.
Note, that if this supposition is correct, the Market Portfolio would be
efficient because it is the aggregate of all portfolios. If we combine two
or more portfolios on the minimum variance set, we get another
portfolio on the minimum variance set.
The CAPM With Unlimited Borrowing & Lending at a Risk-Free Rate of Return
First, using the Markowitz full covariance model we need to generate an
efficient set based on all risky assets in the universe:
Expected Return
Standard Deviation of returns
Next, the risk-free asset is introduced. The Capital Market Line (CML) is
then determined by plotting a line that goes through the risk-free rate of
return, and is tangent to the Markowitz efficient set. This point of
tangency identifies the Market Portfolio (M). The CML equation is:
)σ(r)σ(r
r)E(rr)E(r p
M
FMFp
Portfolio Risk and the CML
Note that all points on the CML except the Market Portfolio dominate all
points on the Markowitz efficient set (i.e., provide a higher expected
return for any given level of risk). Therefore, all investors should invest
in the same risky portfolio (M), and then lend or borrow at the risk-free
rate depending on their risk preferences.
That is, all portfolios on the CML are some combination of two assets:
(1) the risk-free asset, and (2) the Market Portfolio. Therefore, for
portfolios on the CML:
Q5. Discuss the growth of financial derivatives in the global financial markets.?
Solution:
A future is defined as the form of financial derivatives that require the party to purchase the given security at the specified date in future. The Options is a kind of financial derivative that gives the holders a choice of purchasing fixed amount of stock or security at a particular price during the specified date in future.
The futures contract obliges owners to buy the assets according to the terms and condition from the exchange regarding the quantity and quality of underlying asset and the expiration date. This will in turn, allow the futures contract to have minimum liquidity risks than the forward contracts and the same can be traded like the common stocks on the secondary markets.
Also, the futures contract have less default risk or credit risk as compared to the forward contracts as both the parties are required to make deposit of the funds in the margin account, that is generally 3 to 6 % of the price of contract. The funds are
either subtracted or added from this margin account on day to day basis and the same reflects the changes in the prices in futures contract. Therefore the futures market is daily cash settled.
Also, the options may allow the investors to sell the known quantity of stock at certain price and at a certain time in future. Generally, the options require pre existing quantity of stock which is generally called as the option premium.
The option contract mechanism doesn’t oblige a holder to exercise his right. This is the reason why the options, futures and the forwards differ from each other. In the forwards and the futures, the holder is actually supposed to sell or purchase the asset. If you buy an option, it will carry minimum risk of losses. In case of selling an option, it gives limited opportunity to gain the option premium in case if the option gets expired worthless and the unlimited losses risk depends on the strike rate and price of the asset diverge.
Here are the following factors that drive growth of the financial derivatives:
The Increased volatility in the asset prices in the financial markets lead to growth of the financial derivatives.
When there is increased integration of the global financial market it drives the growth of the financial derivatives
When there is marked improvement in the communication facilities and very sharp decline in the costs also tends to drive the growth of the financial derivatives.
When there is development of the best risk management tools, the same provides the economic agents to have a wider choice in the strategies of the risk management and the same leads to the growth of the financial derivatives.
There is growth of the financial derivatives when there is innovation in the derivative markets which will optimally add up the returns and the risks over a huge amount of financial assets. This will lead to high returns, reduced risk and reduced transaction cost as compared to the individual financial asset.
