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Q1. Financial markets bring the providers and users in direct contact without any intermediary.
Financial markets permits the businesses and governments to raise the funds needed by sale of
securities. Describe the money market/capital market features and its composition.
(Money market- features and composition, Capital market-features and composition)
Answer:

Money Market Features and Composition
The money market exists as a result of the interaction between the suppliers and demanders of short-
term funds (those having a maturity of a year or less). Most money market transactions are made in
marketable securities which are short-term debt instruments such as T-bills and commercial paper.
Money (currency) is not actually traded in the money markets. These crudities traded in the money
market are short-term with high liquidity and low-risk; therefore they are close to being money. Money
market provides investors a place for parking surplus funds for short periods of time. It also provides
low-cost source of temporary funds to borrowers like firms, government and financial intermediaries.
The money markets are associated with the issuance and trading of short-term (less than 1 year) debt
obligations of large corporations, financial institutions (FIs) and governments. Only high-quality entities
can borrow in the money markets. Individual issues are large. Thus the money market mischaracterized
by low default risk and large denomination of instruments.
The characteristics of money market instruments are:
Short-term debt instruments (maturity of less than 1 year)
Services immediate cash needs
o Borrowers need short-term working capital.
o Lenders need an interest-earning parking space for excess funds.
Instruments trade in an active secondary market.
o Liquid market provides easy entry & exit for participants.
o Speed and efficiency of transactions allows cash to be active even
for very short periods of time (over night).
Large denominations
o Transactions costs are low in relative terms.
o Individual investors do not actively participate in this market.
Low default risk
o Only high quality borrowers participate.
o Short maturities reduce the risk of changes in borrower quality.
Insensitive to interest rate changes
o They mature in one year or less from their issue date.

Maturity of less than 1 year is too short for securities to be adversely affected, in general, by changes in
rates. In theory, the banking industry should handle the needs for short-term loans and accept short-
term deposits and therefore there should not be any need for money markets to exist. Banks have an
information advantage on the creditworthiness of participants they are better able to deal with the
asymmetric information between savers and borrowers. However banks have certain disadvantages.
Regulation creates a distinct cost advantage for money markets over banks. Banks also have to deal with
reserve requirements; these create additional expense for banks that money markets do not have. Also
money markets deal with creditworthy entities- governments, large corporations and banks; therefore
the problem of asymmetric information is not severe for money markets. Thus money market exists for
short term loans and short term deposits of high-quality entities like governments, large corporations
and banks.

Capital Market Features and Composition
The capital markets are the markets in equity (shares) and long-term debt (bonds); in other words, the
markets for long-term capital. In this market, the capital funds comprising both equity and debt are
issued and traded. Capital market can be further divided into primary and secondary markets. Primary
market is a market where securities are offered to public for subscription for the purpose of raising
capital. The primary market is the first-sale market. Secondary market is a market where already
existing (pre-issued)securities are traded amongst investors. On the equity side, the primary market
includes initial public offerings and rights issues; on the fixed income side, it consists of Treasury
auctions (i.e. auctions of Treasury bonds) and original issues of company bonds. The term placement
refers to a transaction on the primary market: the issuer is placing its securities with investors.

Although corporations do not directly benefit from secondary market transactions, the managers of a
corporation closely monitor the price of the corporations stock in secondary markets. One reason for
this concern involves the cost of raising new funds for further business expansion. The price of a
companys stock in the secondary market influences the amount of funds that can be raised by issuing
additional stock in the primary market. Corporate managers also pay attention to the price of the
companys stocking secondary markets because it affects the financial wealth of the corporations
owners the stockholders. If the price of the stock rises, then the stockholders become wealthier. This
is likely to make them happy with the companys management. Typically, managers own only small
amounts of a corporations outstanding shares. If the price of the stock declines, the shareholders
become less wealthy and are likely to be unhappy with management. If enough shareholders become
unhappy, they may move to replace the corporation managers. Most corporate managers also receive
options to buy company stock at a selected price, so they are motivated to increase the value of the
stock in the secondary market.

Q2. Risk is the likelihood that your investment will either earn money or lose money. Explain the
factors that affect risk. Mr. Rahul invests in equity shares of Wipro. Its anticipated returns and
associated probabilities are given below:


Return -15 -10 5 10 15 20 30
Probability 0.05 0.10 0.15 0.25 0.30 0.10 0.05


You are required to calculate the expected ROR and risk in terms of standard deviation.
(Explanation of all the 4 factors that affect risk, Calculation of expected ROR and risk in terms of
standard deviation)

Answer:

Factors that affect risk
Some common risk factors are:
Business risk: This is the possibility that the company holding your money will not pay the interest or
dividend due, or the principal amount,
when your bond matures. This may be caused by a variety of factors like heightened competition,
emergence of new technologies, development of substitute products, shifts in consumer preference,
inadequate supply of essential inputs, changes in governmental policies and so on. The poor business
performance definitely affects the interest of equity shareholders, who have a residual claim on the
income and wealth of the firm. It can also affect the interest of debentures holders if the ability of the
firm to meet its interest and principal payment obligation is impaired.
Inflation risk: Inflation risk is the chance that the purchasing power of the invested rupees will decline.
This is the risk that the rupee you get when you sell your asset will buy less than the rupee you originally
invested in the asset.
Interest rate risk: The variability in a securitys return resulting from changes in the level of interest
rates is referred to as interest rate risk. This is the possibility that a fixed debt instrument, such as a
bond, will decline in value due to a rise in interest rates. As the interest rate goes up, the market price of
existing fixed income securities fall, and vice versa. This happens because the buyer of a fixed income
security wouldnot buys it at its par value or face value if its fixed interest rate is lower than the
prevailing interest rate on a similar security.
Market risk: Market risk is the variability in a securitys returns resulting from fluctuations in the
aggregate market (such as the stock market).This is the risk that the unit price or value of your
investment will decrease because of a decline in market. The market tends to move in cycles. John Train
says You need to get deeply into your bones the sense that any market, and certainly the stock market,
moves in cycles, so that you will infallibly get wonderful bargains every few years, and have a chance to
sell again at ridiculously high prices a few years later.

Calculation of expected ROR and risk in terms of standard deviation



SD = 112.8125 = 10.62 %

Q3. Explain the business cycle and leading coincidental & lagging indicators. Analyse the issues in
fundamental analysis
(Explanation of business cycle-leading coincidental and lagging indicators, Analysis and explanation of
the issues in fundamental analysis all the four points)

Answer:

Business cycle and leading coincidental and lagging indicators
All economies experience recurrent periods of expansion and contraction. This recurring pattern of
recession and recovery is called the business cycle. The business cycle consists of expansionary and
recessionary periods. When business activity reaches a high point, it peaks; a low point on the cycle is a
trough. Troughs represent the end of a recession and the beginning of an expansion. Peaks represent
the end of an expansion and the beginning of a recession. In the expansion phase, business activity is
growing, production and demand are increasing, and employment is expanding. Businesses and
consumers normally borrow more money for investment and consumption purposes. As the cycle
moves into the peak, demand for goods overtakes supply and prices rise. This creates inflation. During
inflationary times, there is too much money chasing a limited amount of goods. Therefore, businesses
are able to charge more for their items causing prices to rise. This, in turn, reduces the purchasing
power of the consumer. As prices rise, demand slackens which causes economic activity to decrease.
The cycle then enters the recessionary phase. As business activity contracts, employers lay off workers
(unemployment increases) and demand further
slackens. Usually, this causes prices to fall. The cycle enters the trough. Eventually, lower prices
stimulate demand and the economy moves into the expansion phase.

Economists use three types of indicators that provide data on the movement of the economy as the
business cycle enters different phases. The three types are leading, coincident, and lagging indicators.
Leading indicators tend to precede the upward and downward movements of the business cycle and
can be used to predict the near term activity of the economy. Thus they can help anticipate rising
corporate profits and possible stock market price increases. Examples of leading indicators are: Average
weekly hours of production workers, money supply etc.
Coincident indicators usually mirror the movements of the business cycle. They tend to change directly
with the economy. Example includes industrial production, manufacturing and trade sales etc.
Lagging Indicators are economic indicators that change after the economy has already begun to follow a
particular pattern or trend. Lagging Indicators tend to follow (lag) economic performance. Examples:
ratio of trade inventories to sales, ratio of consumer installment credit outstanding to personal income
etc.

Issues of Fundamental Analysis
Time constraints: Fundamental analysis may offer excellent insights, but it can be extraordinarily time-
consuming. Time-consuming models often produce valuations that are contradictory to the current
price prevailing in the stock markets.
Industry/company specific: Valuation techniques vary depending on the industry group and the
specifics of each company. For this reason, a different technique and model is required for different
industries and different companies. This can get quite time-consuming and limit the amount of research
that can be performed. A subscription-based model may work for an Internet Service Provider (ISP), but
is not likely to be the best model to value an oil company.
Subjectivity: Fair value is based on a number of assumptions. Any changes to growth or multiplier
assumptions can greatly change the ultimate valuation.
Analyst bias: The majority of the information that goes into the fundamental analysis comes from the
company itself. Companies can manipulate information that is released and ultimately used by analysts.
Also, most of the analysis is done by analysts who work for the big brokers who are in turn involved in
underwriting and investment banking for the companies. Even though there are safeguards in place to
prevent a conflict of interest, the brokers have an ongoing relationship with the company under
analysis.
Definition of fair value: When market valuations extend beyond historical norms, there is pressure to
adjust growth and multiplier assumptions to compensate. If the market values a stock at 50 times
earnings and the current assumptions are 30 times, the analyst would be pressured to revise this
assumption higher.

Q4. Discuss the implications of EMH for security analysis and portfolio management.
(Implications for active and passive investment, Implications for investors and
companies)
Answer:

Implications for active and passive investment
Proponents of the efficient market hypothesis often advocate passive as opposed to active investment
strategies. Active management is the art of stock-picking and market-timing. The policy of passive
investors is to buy and hold a broad-based market index. Passive investors spend neither on market
research nor on frequent purchase and sale of shares. However, passive strategies may be tailored to
meet individual investor requirements. The efficient market debate plays an important role in the
decision between active and passive investing. Active managers argue that less efficient markets provide
the opportunity for skillful managers to outperform the market. However, it is important to realize that
a majority of active managers in a given market will underperform the appropriate benchmark in the
longrun whether or not the markets are efficient.

If markets are efficient, then what is the role for investment professionals? Those who accept the EMH
generally reason that the primary role of portfolio manager consists of analyzing and investing
appropriately based on an investor's tax considerations and risk profile. Optimal portfolios will vary
according to factors such as age, tax bracket, risk aversion, and employment. The role of the portfolio
manager in an efficient market is to tailor a portfolio to those needs, rather than to beat the market.
Implications for investors and companies
The efficient market hypothesis has a number of implications for both the
investors and the companies.
For investors:
With the passage of time, interest rate changes in the market. The cash flows from a bond (coupon
payments and principal repayment) however, remain fixed. As a result, the value of a bond fluctuates.
Thus interest rate risk arises because the changes in the market interest rates affect the value of the
bond. The return on a bond comes from coupons payments, the interest earned from re-investing
coupons (interest on interest), and capital gains. Since coupon payments are fixed, a change in the
interest rates affects interest on interest and capital gains or losses. An increase in interest rates
decreases the price of a bond (capital loss) but increases the interest received on reinvested coupon
payments (interest on interest). A decrease in interest rates increases the price of a bond (capital gain)
but decreases the interest received on reinvested coupon payments. Much of the existing evidence
indicates that the stock market is highly efficient, and therefore, investors have little to gain from active
management strategies. Attempts to beat the market are not only useless, but they can reduce returns
due to the costs incurred in active management (management fees, transaction costs, taxes, etc).
Investors should therefore follow a passive investment strategy, which makes no attempt to beat the
market. This does not mean that there is no role for portfolio management. Returns can be optimized
through diversification and asset allocation, and by minimization of investment costs and taxes. In
addition, the portfolio manager must choose a portfolio that is geared toward the time horizon and risk
profile of the investor. The appropriate mixture of securities may vary according to the age, goals, tax
bracket, employment, and risk aversion of the investor. Investors, however, will have to make efforts to
obtain a greater volume of timely information. Semi-strong form of market efficiency depends on the
quality and quantity of publicly available information. Therefore, companies should be encouraged by
investor pressure, accounting bodies, government rulings and stock market regulation to provide as
much information as inconsistent with the companies need of secrecy to prevent competitors from
gaining useful knowledge.
The perception of a fair and efficient market can be improved by more constraints and deterrents
placed on insider trading.
For companies:
The EMH also has a number of implications for companies:
The companies should focus on substance, not on window dressing by manipulating accounting data:
Some managers believe that they can fool shareholders. For example creative accounting is used to
show a more impressive performance than that actually happened. Most of the time, these tricks are
spotted by the investors. They are able to see through the manipulation and interpret the real position,
and consequently security prices do not rise as a result of manipulation of accounting data.
The timing of security issues does not have to be fine-tuned: A
company need not delay a share issue thinking that its shares are currently under-priced because the
market is low and hoping that the market will rise to a more normal level later. This thinking defies the
logic of the EMH if the market is efficient the shares are already correctly priced and it is just as likely
that the next move in prices will be down as up.

Q5. Explain about the interest rate risk and the two components in it.

An investor is considering the purchase of a share of XYZ Ltd. If his required rate of return is 10%, the
year-end expected dividend is Rs. 5 and year-end price is expected to be Rs. 24, Compute the value of
the share.
(Introduction of interest rate risk, Explanation of two components of interest rate risk, Calculation of
value of the share)


Answer:

Interest Rate Risk: With the passage of time, interest rate changes in the market. The cash flows from a
bond (coupon payments and principal repayment) however, remain fixed. As a result, the value of a
bond fluctuates. Thus interest rate risk arises because the changes in the market interest rates affect the
value of the bond. The return on a bond comes from coupons payments, the interest earned from re-
investing coupons (interest on interest), and capital gains. Since coupon payments are fixed, a change in
the interest rates affects interest on interest and capital gains or losses. An increase in interest rates
decreases the price of a bond (capital loss) but increases the interest received on reinvested coupon
payments (interest on interest). A decrease in interest rates increases the price of a bond (capital gain)
but decreases the interest received on reinvested coupon payments.

Thus there are two components of Interest Rate Risk:
Price risk is the risk that bond prices will decrease with an increase in interest rates.
Reinvestment rate risk is the uncertainty about future or target date portfolio value that results from
the need to re-invest bond coupons at yields that are not known in advance. Interest rate increases act
to decrease bond prices (price risk) but increase the future value of reinvested coupons (reinvestment
rate risk), and vice versa.

Calculation of value of the share

Given,
R=.10
D1=5
And P1=24,
Then,
[D1/(1+r)]+[P1/(1+r)]
=(5/1.10)+(26/1.10)
=4.545+23.636
=28.181

Q6. Elucidate the risk and returns of foreign investing. Analyze international listing.
(Explanation of all the points in risks and returns from foreign investing, Introduction of international
listing)
Answer:
Risks and Returns from Foreign Investing
International investing provides superior returns adjusted for risk. Allocating some portion of one's
portfolio to foreign assets provides better risk adjusted reruns than a portfolio of domestic assets alone.
International equities also offer access to a broader spectrum of economies and opportunities that can
provide for further diversification benefits. Some of the best performing companies in the world like
General Electric, Exxon Mobil and Microsoft have shares that are listed on overseas stock markets. If an
investor wants to profit from the growth of large global companies, he would have to invest
internationally. However, there are costs and risks of international investing. International investing can
be more expensive than investing in domestic companies. In smaller markets, an investor may have to
pay a premium to purchase shares of popular companies. In some countries, there may be unexpected
taxes, such as withholding taxes on dividends. Transaction costs such safes, brokers commissions, and
taxes can be higher than in domestic markets. Mutual funds that invest abroad often have higher fees
and expenses than funds that invest in domestic stocks, in part because of the extra expense of trading
in foreign markets.
There are risks involved in international investing. Some of the risks are:
1) Changes in currency exchange rates
When the exchange rate between the foreign currency (in which the international investment is
denominated) and the home currency (say, Rupee for an Indian) changes, it can increase or decrease the
investment return.
2) Dramatic changes in market value
Foreign markets, like all markets, can experience dramatic changes in market value. One way to reduce
the impact of these price changes is to invest for the long term and try to ride out sharp upswings and
downturns in the market.
3) Political, economic and social events
It is difficult for investors to understand all the political, economic, and social factors that influence
foreign markets. These factors provide diversification, but they also contribute to the risk of
international investing.
4) Lack of liquidity
Foreign markets may have lower trading volumes and fewer listed companies.
5) Less information
Many foreign companies do not provide investors with the same type of information as domestic
companies. It may be difficult to locate up-to-date information, and the information the company
publishes may not be in English or in a language that the investor understands.
6) Reliance on foreign legal remedies
If an investor has a problem with his investment, he may not be able to sue the company in his own
countrys courts. Even if he is able to sue successfully in a domestic court, he may not be able to collect
on a home country judgment against a foreign company
7) Different market operations
Foreign markets often operate differently from the major domestic countrys trading markets. For
example, there may be different periods for clearance and settlement of securities transactions. Some
foreign markets may not
report stock trades as quickly as home markets.
International Listing
In addition to issuing stock locally, companies can also obtain funds by issuing stock in international
markets. This will enhance the companys image and recognition, and diversify its shareholder base. A
stock offering may also be more easily digested when it is issued in several markets. Also, a company
may decide to cross-list its shares. Cross-listing of shares is listing of its equity by a firm on one or more
foreign stock exchanges in addition to its domestic exchange. By cross-listing its shares, a company
benefits from the access to foreign investors and subsequent increased liquidity and lower cost of
capital.
A company must choose one or more stock markets on which to cross-list its shares and sell new equity.
Just where a company goes depends mainly on the companys specific motives and the willingness of
the host stock market to accept the company. The locations of a companys operations can influence the
decision about where to place its stock, in view of the cash flows needed to cover dividend payments.
Market characteristics are important too. Stock markets may differ in size, trading activity level, and
proportion of individual versus institutional share ownership. Cross-listing attempts to accomplish one
or more of many objectives:
Improve the liquidity of its existing shares and support a liquid secondary market for new equity
issues in foreign markets.
Increase its share price by overcoming mispricing in a segmented and illiquid home capital
market.
Increase the companys visibility.
Establish a secondary market for shares used to acquire other firms.
Create a secondary market for shares that can be used to compensate local management and
employees in foreign subsidiaries.