Summer/May 2012 Master in Business Administration Semester 3 MF0010 Security Analysis and Portfolio Management - 4 Credits (Book ID:

: B1208) Assignment Set- 1 (60 Marks) Note: Each question carries 10 Marks. Answer all the questions. Q.1 Discuss the different forms of market efficiency. Answer : The degree to which stock prices reflect all available, relevant information.

Market efficiency has varying degrees: strong, semi-strong, and weak. Stock prices in a perfectly efficient market reflect all available information. These differing levels, however, suggest that the responsiveness of stock prices to relevant information may vary. The efficient market hypothesis (EMH), a controversial principle stemming from the theory of market efficiency, states that a market cannot be outperformed because all available information is already built into all stock prices. Practitioners and scholars alike have a wide range of viewpoints as to how efficient the market actually is.

When money is put into the stock market, it is done with the aim of generating a return on the capital invested. Many investors try not only to make a profitable return, but also to outperform, or beat, the market. However, market efficiency - championed in the efficient market hypothesis (EMH) formulated by Eugene Fama in 1970, suggests that at any given time, prices fully reflect all available information on a particular stock and/or market. Thus, according to the EMH, no investor has an advantage in predicting a return on a stock price because no one has access to information not already available to everyone else. The Effect of Efficiency: Non-Predictability The nature of information does not have to be limited to financial news and research alone; indeed, information about political, economic and social events, combined with how investors perceive such information, whether true or rumored, will be reflected in the stock price. According to EMH, as prices respond only to information available in the market, and, because all market participants are privy to the same information, no one will have the ability to out-profit anyone else. In efficient markets, prices become not predictable but random, so no investment pattern can be discerned. A planned approach to investment, therefore, cannot be successful. This "random walk" of prices, commonly spoken about in the EMH school of thought, results in the failure of any investment strategy that aims to beat the market consistently. In fact, the EMH suggests that given the transaction costs involved in portfolio management, it

would be more profitable for an investor to put his or her money into an index fund. Anomalies: The Challenge to Efficiency In the real world of investment, however, there are obvious arguments against the EMH. There are investors who have beaten the market - Warren Buffett, whose investment strategy focuses on undervalued stocks, made millions and set an example for numerous followers. There are portfolio managers who have better track records than others, and there are investment houses with more renowned research analysis than others. So how can performance be random when people are clearly profiting from and beating the market? Counter arguments to the EMH state that consistent patterns are present. Here are some examples of some of the predictable anomalies thrown in the face of the EMH: the January effect is a pattern that shows higher returns tend to be earned in the first month of the year; "blue Monday on Wall Street" is a saying that discourages buying on Friday afternoon and Monday morning because of the weekend effect, the tendency for prices to be higher on the day before and after the weekend than during the rest of the week. Studies in behavioral finance, which look into the effects of investor psychology on stock prices, also reveal that there are some predictable patterns in the stock market. Investors tend to buy undervalued stocks and sell overvalued stocks and, in a market of many participants, the result can be anything but efficient. Paul Krugman, MIT economics professor, suggests that because of the mass mentality of the trendy, short-term shareholder, investors pull in and out of the latest and hottest stocks. This results in stock prices being distorted and the market being inefficient. So prices no longer reflect all available information in the market. Prices are instead being manipulated by profit seekers. The EMH Response The EMH does not dismiss the possibility of anomalies in the market that result in the generation of superior profits. In fact, market efficiency does not require prices to be equal to fair value all of the time. Prices may be over- or undervalued only in random occurrences, so they eventually revert back to their mean values. As such, because the deviations from a stock's fair price are in themselves random, investment strategies that result in beating the market cannot be consistent phenomena. Furthermore, the hypothesis argues that an investor who outperforms the market does so not out of skill but out of luck. EMH followers say this is due to the laws of probability: at any given time in a market with a large number of investors, some will outperform while other will remain average. How Does a Market Become Efficient? In order for a market to become efficient, investors must perceive that a market is inefficient

and possible to beat. Ironically, investment strategies intended to take advantage of inefficiencies are actually the fuel that keeps a market efficient. A market has to be large and liquid. Information has to be widely available in terms of accessibility and cost and released to investors at more or less the same time. Transaction costs have to be cheaper than the expected profits of an investment strategy. Investors must also have enough funds to take advantage of inefficiency until, according to the EMH, it disappears again. Most importantly, an investor has to believe that she or he can outperform the market. Degrees of Efficiency Accepting the EMH in its purest form may be difficult; however, there are three identified classifications of the EMH, which are aimed at reflecting the degree to which it can be applied to markets. 1. Strong efficiency - This is the strongest version, which states that all information in a market, whether public or private, is accounted for in a stock price. Not even insider information could give an investor an advantage. 2. Semi-strong efficiency - This form of EMH implies that all public information is calculated into a stock's current share price. Neither fundamental nor technical analysis can be used to achieve superior gains. 3. Weak efficiency - This type of EMH claims that all past prices of a stock are reflected in today's stock price. Therefore, technical analysis cannot be used to predict and beat a market. Conclusion EMH propagandists will state that profit seekers will, in practice, exploit whatever abnormally exists until it disappears. In instances such as the January effect (a predictable pattern of price movements), large transactions costs will most likely outweigh the benefits of trying to take advantage of such a trend. In the real world, markets cannot be absolutely efficient or wholly inefficient. It might be reasonable to see markets as essentially a mixture of both, wherein daily decisions and events cannot always be reflected immediately into a market. If all participants were to believe that the market is efficient, no one would seek extraordinary profits, which is the force that keeps the wheels of the market turning. In the age of information technology (IT), however, markets all over the world are gaining greater efficiency. IT allows for a more effective, faster means to disseminate information, and electronic trading allows for prices to adjust more quickly to news entering the market. However, while the pace at which we receive information and make transactions quickens, IT also restricts the time it takes to verify the information used to make a trade. Thus, IT

may inadvertently result in less efficiency if the quality of the information we use no longer allows us to make profit-generating decisions.
Q.2 Compare Arbitrage pricing theory with the Capital asset pricing model. Q.3 Perform an economy analysis on Indian economy in the current situation. Q.4 Identify some technical indicators and explain how they can be used to decide purchase of a companys stock. Q.5 From the website of BSE India, explain how the BSE Sense is calculated. Q.6 Frame the investment process for a person of your age group. Summer/May 2012 Master in Business Administration Semester 3 MF0010 Security Analysis and Portfolio Management - 4 Credits (Book ID: B1208) Assignment Set- 2 (60 Marks) Note: Each question carries 10 Marks. Answer all the questions. Q.1 Show how duration of a bond is calculated and how is it used. Answer : DURATION OF BONDS

Bond Duration is a measure of bond price volatility, which captures both price and reinvestment risk and which is used to indicate how a bond will react in different interest rate environments. The duration of a bond represents the length of time that elapses before the average rupee of present value from the bond is received. Thus duration of a bond is the weighted average maturity of cash flow stream, where the weights are proportional to the present value of cash flows. Formally, it is defined as: Duration = D = {PV (C1) x 1 + PV (C2) x 2+ ----- PV (Can) x n} / Current Price of the bond Where PV (Chi) 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 the value of Duration. Example: Calculate the duration of an 8% annual coupon 5 year bond that is priced to yield 10% (i.e. YTM = 10%). The face value of the bond is Rs.1000. Annual coupon payment = 8% x Rs. 1000 = Rs. 80 At 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) Annual PVIF Present Explanation Time x Explanation

Cash flow

@10%

1 2 3 4 5 Total

80 80 80 80 1080

0.90909 0.82645 0.75131 0.68301 0.62092

Value of Annual Cash Flow PV(Ct) 72.73 66.12 60.10 54.64 670.59 924.18

PV of cash flow = 80 x 0.90909 = 80 x 0.82645 = 80 x 0.75131 = 80 x 0.68301 = 1080 x 0.62092 72.73 132.24 180.3 218.56 3352.95 3956.78 = 1 x 72.73 = 2 x 66.12 = 3 x 60.1 = 4 x 54.64 = 5 x 670.59

Price of the bond= Rs 924.18 The proportional change in the price of a bond: (P/P) = - {D/ (1+ YTM)} x y 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 bond in the example above = 4.28 / (1+10%) = 3.89 years. This implies that the price of the bond will decrease by 3.89 x 1% = 3.89% for a 1% increase in the interest rates.

Q.1 Frame the investment process for a person of your age group.
Answer: It is rare to find investors investing their entire savings in a single security. Instead, they tend to invest in a group of securities. Such a group of securities is called a portfolio. Most financial experts stress that in order to minimize risk; an investor should hold a wellbalanced investment portfolio. The investment process describes how an investor must go about making. Decisions with regard to what securities to invest in while constructing a portfolio, how extensive the investment should be, and when the investment should be made. This is a procedure involving the following five steps: Set investment policy Perform security analysis Construct a portfolio Revise the portfolio Evaluate the performance of portfolio 1. Setting Investment Policy

This initial step determines the investors objectives and the amount of his investable wealth. Since there is a positive relationship between risk and return, the investment objectives should be stated in terms of both risk and return. This step concludes with the asset allocation decision: identification of the potential categories of financial assets for consideration in the portfolio 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 allocation that works best for an investor at any given point in his life depends largely on his time horizon and his ability to tolerate risk.

Time Horizon The time horizon is the expected number of months, years, or decades that an investor will be investing his money to achieve a particular financial goal. An investor with a longer time horizon may feel more comfortable with a riskier or more volatile investment because he can ride out the slow economic cycles and the inevitable ups and downs of the markets. By contrast, an investor who is saving for his teen-aged daughters college education would 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 his original investment in exchange for greater potential returns. An aggressive investor, or one with a 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 favour investments that will preserve 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, the investor also selects the portfolio management style (active vs. passive management).

Active Management is the process of managing investment portfolios by attempting to time the market and/or select undervalued stocks to buy and "overvalued stocks to sell, based upon research, investigation and analysis.

Passive Management is the process of managing investment portfolios by trying to match the performance of an index (such as a stock market index) or asset class of securities as closely as possible, 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 asset allocation decision, how does an investor select which securities to purchase. Security analysis involves examining a number of individual securities within the broad categories of financial assets identified in the previous step. One purpose of this exercise is to identify

those securities that currently appear to be mispriced. Security analysis is done either using Fundamental or Technical analysis (both have been discussed in subsequent units).

Fundamental analysis is a method used to evaluate the worth of a security by studying the financial data of the issuer. It scrutinizes the issuer's 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 market statistics. Unlike fundamental analysis, technical analysis disregards an issuer's financial statements. Instead, it relies upon market trends to ascertain investor sentiment to predict how a security will perform.

3. Portfolio Construction This step identifies those specific assets in which to invest, as well as determining the proportion of the investors wealth to put into each one. Here selectivity, timing and diversification issues are addressed. Selectivity refers to security analysis and focuses on price movements of individual securities. Timing involves forecasting of price movement of stocks relative to price movements of fixed income securities (such as bonds).

Diversification aims at constructing a portfolio in such a way that the investors risk is minimized. The following table summarizes how the portfolio is constructed for an active and a passive investor.

4. Portfolio Revision This step is the repetition of the three previous steps, as objectives might change and previously held portfolio might not be the optimal one.

5. Portfolio performance evaluation This step involves determining periodically how the portfolio has performed over some time period (returns earned vs. risks incurred).

Q.2 From the website of BSE India, explain how the BSE Sensex is calculated.

Answer:

SENSEX: Sensex is the stock market index for BSE. It was first compiled in 1986. It is made of 30 stocks representing a sample of large, liquid and representative companies. The base year of SENSEX is 1978-79 and the base value is 100. The Bombay Stock Exchange SENSEX (acronym of Sensitive Index) more commonly referred to as SENSEX or BSE 30 is a free-float market capitalization-weighted index of 30 well-established and financially sound companies listed on Bombay Stock Exchange. The 30 component companies which are some of the largest and most actively traded stocks, are representative of various industrial sectors of the Indian economy. Published since January 1, 1986, the SENSEX is regarded as the pulse of the domestic stock markets in India. The base value of the SENSEX is taken as 100 on April 1, 1979, and its base year as 1978-79. On 25 July, 2001 BSE launched DOLLEX-30, a dollar-linked version of SENSEX. As of 21 April 2011, the market capitalisation of SENSEX was about 29,733 billion (US$660 billion) (42.34% of market capitalization of BSE), while its free-float market capitalization was 15,690 billion (US$348 billion). The Bombay Stock Exchange (BSE) regularly reviews and modifies its composition to be sure it reflects current market conditions. The index is calculated based on a free float capitalization methoda variation of the market capitalisation method. Instead of using a company's outstanding shares it uses its float, or shares that are readily available for trading. The free-float method, therefore, does not include restricted stocks, such as those held by promoters, government and strategic investors. Initially, the index was calculated based on the full market capitalization method. However this was shifted to the free float method with effect from September 1, 2003. Globally, the free float market capitalization is regarded as the industry best practice. As per free float capitalization methodology, the level of index at any point of time reflects the free float market value of 30 component stocks relative to a base period. The market capitalization of a company is determined by multiplying the price of its stock by the number of shares issued by the company. This market capitalization is multiplied by a free float factor to determine the free float market capitalization. Free float factor is also referred as adjustment factor. Free float factor represent the percentage of shares that are readily available for trading. The calculation of SENSEX involves dividing the free float market capitalization of 30 companies in the index by a number called index divisor.The divisor is the only link to original base period value of the SENSEX. It keeps the index comparable over time and is the adjustment point for all index adjustments arising out of corporate actions, replacement of scrips, etc. The index has increased by over ten times from June 1990 to the present. Using information from April 1979 onwards, the long-run rate of return on the BSE SENSEX works out to be

18.6% per annum, which translates to roughly 9% per annum after compensating for inflation. Following is the list of the component companies of SENSEX as on Feb 26, 2010. Adj. Weight in Code Name Sector Factor Index(%) 500410ACC Housing Related 0.55 0.77 500103BHEL Capital Goods 0.35 3.26 532454Bharti Airtel Telecom 0.35 3 532868DLF Universal Limited Housing related 0.25 1.02 500300Grasim Industries Diversified 0.75 1.5 500010HDFC Finance 0.90 5.21 500180HDFC Bank Finance 0.85 5.03 500182Hero Honda Motors Ltd. Transport Equipments 0.50 1.43 Metal,Metal Products & 500440Hindalco Industries Ltd. 0.7 1.75 Mining 500696Hindustan Lever Limited FMCG 0.50 2.08 532174ICICI Bank Finance 1.00 7.86 500209Infosys Information Technology 0.85 10.26 500875ITC Limited FMCG 0.70 4.99 532532Jaiprakash Associates Housing Related 0.55 1.25 500510Larsen & Toubro Capital Goods 0.90 6.85 Mahindra & Mahindra 500520 Transport Equipments 0.75 1.71 Limited 532500Maruti Suzuki Transport Equipments 0.50 1.71 532541NIIT Technologies Information Technology 0.15 2.03 532555NTPC Power 0.15 2.03 500304NIIT Information Technology 0.15 2.03 500312ONGC Oil & Gas 0.20 3.87 532712Reliance Communications Telecom 0.35 0.92 500325Reliance Industries Oil & Gas 0.50 12.94 500390Reliance Infrastructure Power 0.65 1.19 500112State Bank of India Finance 0.45 4.57 Metal, Metal Products, and 500900Sterlite Industries 0.45 2.39 Mining Sun Pharmaceutical 524715 Healthcare 0.40 1.03 Industries 532540Tata Consultancy Services Information Technology 0.25 3.61 500570Tata Motors Transport Equipments 0.55 1.66 500400Tata Power Power 0.70 1.63 Metal, Metal Products & 500470Tata Steel 0.70 2.88 Mining 507685Wipro Information Technology 0.20 1.61

All BSE indices (except BSE-PSU index) are calculated using following formula: Free-float market capitalization of index constituents/ Base Market capitalization * Base Index Value

For calculation of BSE-PSU index, full market capitalization of index constituents is considered instead of free-float market capitalization. Dollex-30, Dollex-100 and Dollex-200 are dollar-linked versions of SENSEX, BSE-100 and BSE-200 index.BSE IPO index & BSE TASIS Shariah 50 Index is calculated using following formula:Capped market capitalization of index constituents/ Base Market capitalization * Base Index Value where capped market capitalisation for scrips in BSE IPO Index and BSE TASIS Shariah 50 Index is arrived by multiplying free-float adjusted market capitalisation of individual scrip with its respective capping factor. Such capping factor is assigned to the index constituent to ensure that no single scrip based on its free-float market capitalisation exceeds weightage of 20% in case BSE IPO Index and 8% in case of BSE TASIS Shariah 50 Index at the time of rebalancing. In case, weightage of all the constituents in the index is below 20% & 8% respectively, each company would be assigned capping factor of 1. Index Closure Algorithm The closing index value on any trading day is computed taking the weighted average of all the trades of index constituents in the last 30 minutes of trading session. If an index constituent has not traded in the last 30 minutes, the last traded price is taken for computation of the index closure. If an index constituent has not traded at all in a day, then its last day's closing price is taken for computation of index closure. The use of index closure algorithm prevents any intentional manipulation of the closing index value. Maintenance of BSE Indices One of the important aspects of maintaining continuity with the past is to update the base year average. The base year value adjustment ensures that replacement of stocks in Index, additional issue of capital and other corporate announcements like 'rights issue' etc. do not destroy the historical value of the index. The beauty of maintenance lies in the fact that adjustments for corporate actions in the Index should not per se affect the index values. The Department of BSE Indices does the day-to-day maintenance of the index within the broad index policy framework set by the BSE Index Committee. Department of BSE Indices ensures that all BSE Indices maintain their benchmark properties by striking a delicate balance between frequent replacements in index and maintaining its historical continuity. The BSE Index Committee comprises capital market expert, fund managers, market participants, members of BSE Governing Board. On - Line Computation of the Index During trading hours, value of the indices is calculated and disseminated on real time basis. This is done automatically on the basis of prices at which trades in index constituents are executed. Adjustment for Bonus, Rights and Newly Issued Capital Index calculation needs to be adjusted for issue of bonus and rights issue. If no adjustments were made, a discontinuity would arise between the current value of the index and its previous value despite the non-occurrence of any economic activity of substance. At the BSE Index Cell, the base value is adjusted, which is used to alter market capitalization of the component stocks to arrive at the index value.

Q.3 Perform an economy analysis on Indian economy in the current situation.

Answer:

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

1 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 is growing. Investors know that strong economic growth is good for companies and recessions or full-blown depressions cause share prices to decline, all other things being equal.

Inflation is important for investors, as excessive inflation undermines consumer

spending power (prices increase) and so can cause economic Security Analysis and Portfolio Management stagnation. However, deflation (negative inflation) can also hurt the economy, as it encourages consumers to postpone spending (as they wait for cheaper prices). The exchange rate affects the broad economy and companies in a number of ways. First, changes in 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 through supply and demand for the foreign currency. BOP reflects 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 in goods and services. The capital account is an account of the cross-border transactions in financial assets. A current account deficit occurs when a country imports more goods and services than it exports.

A capital account deficit occurs when the investments made in the country by foreigners is less than the investment in foreign countries made by local players. The currency of a country appreciates when there is more foreign currency coming into the country than leaving it. Therefore, a surplus in the current or capital account causes the currency to strengthen; a deficit causes the currency to weaken. The levels of interest rates (the cost of borrowing money) in the economy and the money supply (amount of money circulating in the economy) also have a bearing on the performance of businesses. All other things being equal, an increase in money supply causes the interest rates to fall; a decrease causes the interest rates to rise. If interest rates are low, the cost of borrowing by businesses is not expensive, and companies can easily borrow to expand and develop their activities. On the other hand, when the cost of borrowing becomes too high (when the interest rates go up), borrowing may become too costly and plans for expansion are postponed. Interest rates also have a significant effect on the share markets. In very broad terms, share prices improve when interest rates fall and decline when interest rates increase. There are two reasons for that: the intrinsic value estimate will increase as interest rates (and the linked discount rate) fall and underlying company profitability will improve, if interest payments reduce. 2 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. The performance of an investment is influenced by the business cycle. The direction in which an economy is heading has a significant impact on companies performance and ability to deliver earnings. If the economy is in a recession, it is likely that many business sectors will fail to generate profits. This is because the demand for most products decreases during economic declines, since people have less money with which to purchase goods and

services (since high levels of unemployment are common during economic crises). On the other hand, during times of economic prosperity, companies tend to expand their operations and in turn generate higher levels of earnings, as the demand for goods tends to grow. Security Analysis and Portfolio To some extent the business cycle can be predicted as it is cyclical in nature. The prediction can be done using economic indicators. Economic indicators are quantitative announcements (released as data), released at predetermined times according to a schedule, reflecting the financial, economical and social atmosphere of an economy. They are published by various agencies of the government or by the private sector. They are used to monitor the health and strength of an economy and they help to evaluate the direction of the business cycle. 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.

Q.4 Identify some technical indicators and explain how they can be used to decide purchase of a companys stock.
Answer:

A technical indicator is a series of data points that are derived by applying a formula to the 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 entered into the formula and a data point is produced. For example, say the closing prices of a stock for 3 days are Rs. 41, Rs. 43 and Rs. 43.

If a technical indicator is constructed using the average of the closing prices, then the average 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 to enable analysis. Thus we can have a 3 period moving average as a technical indicator, where we drop the earliest closing price and use the next closing price for calculations. By creating a time series of data points, a comparison can then be made between present and past levels. Technical indicators are usually shown in a graphical form above or below a securitys price chart for facilitating analysis. Once shown in graphical form, an indicator can then be compared with the corresponding price chart of the security. Sometimes indicators are plotted on top of the price plot for a more direct comparison. Technical indicators measure money flow, trends, volatility and momentum etc. They are used for two main purposes: to confirm price movement and the quality of chart patterns, and to form buy and sell signals. A technical indicator offers a different perspective from which to analyze the price action. Some, such as moving averages, are derived from simple formulae and they are relatively easy to understand. Others, like stochastic have complex formulae and require more effort to fully understand and appreciate. Technical indicators can provide unique perspective on the strength and direction of the underlying price action. Indicators filter price action with formulae. Therefore they are derivative measures and not direct reflections of the price action. This should be taken into account when analyzing the indicators. Any analysis of an indicator should be taken with the price action in mind. There are two main types of indicators: leading and lagging. A leading indicator precedes price movements; therefore they are used for prediction. A lagging indicator follows price movement and therefore is a confirmation. The main benefit of leading indicators is that they provide early signaling for entry and exit. Early signals can forewarn against a potential strength or weakness. Leading indicators can be used in trending markets. In a market that is trending up, the leading indicator helps identify oversold conditions for buying opportunities. In a market that is trending down, leading indicators can help identify overbought situations for selling opportunities. Some of the more popular leading indicators include Relative Strength Index (RSI) and Stochastic Oscillator. Lagging indicators follow the price action and are commonly referred to as trend-following indicators. Lagging indicators work best when the markets or securities develop strong trends. They are designed to get traders in and keep them in as long as the trend is intact. As such, these indicators are not effective in trading or sideways markets. Some popular trend-following indicators include moving averages and Moving Average Convergence Divergence (MACD). Technical indicators are constructed in two ways: those that fall in a bounded range and those 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 "overbought when prices have been trending higher in a relatively steep fashion for some time, to the extent that the number of market participants "long of the market significantly outweighs those on the sidelines or holding "shortpositions. This means that there are fewer participants to jump onto the 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 periods where the security is overbought (near 100) or oversold (near zero). Oscillators are the most common type of technical indicators. The technical indicators that are not bound within a range also form buy and sell signals and display strength or weakness in the market, but they can vary in the way they do this. The two main ways that technical indicators are used to form buy and sell signals is through crossovers and divergence. Crossovers occur when either the price moves through the moving average, or when two different moving averages cross over each other. Divergence happens when the direction of the price trend and the direction of the indicator trend are moving in the opposite direction. This indicates that the direction of the price trend is weakening. Technical indicators provide an extremely useful source of additional information. These indicators help identify momentum, trends, volatility and various other aspects in a security to aid in the technical analysis of trends. While some traders just use a single indicator for buy and sell 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 below for 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 the most widely used. A moving average, as the name suggests, represents an average of a certain series of data that moves through time. The most common way to calculate the moving average is to work from the last 10 days of closing prices. Each day, the most recent close (day 11) is added to the total and the oldest close (day 1) is subtracted. The new total is then divided by the total number of days (10) and the resultant average computed. The purpose of the moving average is to track the progress of a price trend. The moving average is a smoothing device. By averaging the data, a smoother line is produced, making it much easier to view the underlying trend. A moving average filters out random noise and offers a smoother perspective of the price action. 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-day exponential moving average. A 9-day moving average is generally used as a trigger line. When the MACD crosses this trigger and goes down it is a bearish signal and when it crosses it to go above it, it's a bullish signal. This indicator measures short-term momentum as compared to longer term momentum and signals the current direction of momentum. Traders use the MACD for 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 a fixed time interval. RSI helps to signal overbought and oversold conditions in a security. RSI is plotted in a range of 0-100. A reading above 70 suggests that a security is overbought, while a reading below 30 suggests that it is oversold. This indicator helps traders to identify whether a securitys price has been unreasonably pushed to its current levels and whether a reversal may be on the way. Stochastic Oscillator: The stochastic oscillator is one of the most recognized momentum indicators. This indicator provides information about the location of a current Security closing price in relation to the period's high and low prices. The closer the closing price is to the period's high, the higher is the buying pressure, and the closer the closing price is to the period's low, the more is the selling pressure. The idea behind this indicator is that in an uptrend, the price should be closing near the highs of the trading range, signaling upward momentum in the security. In downtrends, the price should be closing near the lows of the trading range, signaling downward momentum. The stochastic oscillator is plotted within a range of zero and 100 and signals overbought conditions above 80 and oversold conditions below 20.

Q.5 Compare Arbitrage pricing theory with the Capital asset pricing model.
Arbitrage Pricing Theory (APT)

Arbitrage Pricing Theory (APT) are two of the most commonly used models for pricing all risky assets based on their relevant risks. Capital Asset Pricing Model (CAPM) calculates the required rate of return for any risky asset based on the securitys beta. Beta is a measure of the movement of the securitys return with the return on the market portfolio, which includes all the securities that are available in the world and where the proportion of each security in the portfolio is its market value as a percentage of total market value of all the securities. The problem with CAPM is that such a market portfolio is hypothetical and not observable and we have to use a market index like the S&P 500 or Sensex as a proxy for the market portfolio. However, indexes are imperfect proxies for overall market as no single index includes all capital assets, including stocks, bonds, real estate, collectibles, etc. Another criticism of the CAPM is that the various different proxies that are used for the market portfolio do not fully capture all of the relevant risk factors in the economy. An alternative pricing theory with fewer assumptions, the Arbitrage Pricing Theory (APT), has been developed by Stephen Ross. It can calculate expected return without taking recourse to the market portfolio. It is a multi-factor model for determining the required rate

of return which means that it takes into account a number of economy wide factors that can affect the security prices. APT calculates relations among expected returns that will rule out arbitrage by investors.

The APT requires three assumptions: 1) Returns can be described by a factor model. 2) There are no arbitrage opportunities. 3) There are large numbers of securities that permit the formation of portfolios that diversify the firm-specific risk of individual stocks.

The Capital Asset Pricing Model (CAPM) is a model to explain why capital assets are priced the way they are. William Sharpe, Treynor and Lintner contributed to the development of this model. An important consequence of the modern portfolio theory as introduced by Markowitz was that the only meaningful aspect of total risk to consider for any individual asset is its contribution to the total risk of a portfolio. CAPM extended Harry Markowitzs portfolio theory to introduce the notions of systematic and unsystematic (or unique) risk. Arbitrage Pricing Theory vs. the Capital Asset Pricing Model The Arbitrage Pricing Theory (APT) and the Capital Asset Pricing Model are the two most influential theories on stock and asset pricing today. The APT model is different from the CAPM in that it is far less restrictive in its assumptions. APT allows the individual investor to develop their model that explains the expected return for a particular asset. Intuitively, the APT makes a lot of sense because it removes the CAPM restrictions and basically states that the expected return on an asset is a function of many factors and the sensitivity of the stock to these factors. As these factors move, so does the expected return on the stock - and therefore its value to the investor. However, the potentially large number of factors means that more factor sensitivities have to be calculated. There is also no guarantee that all the relevant factors have been identified. This added complexity is the reason arbitrage pricing theory is far less widely used than CAPM. In the CAPM theory, the expected return on a stock can be described by the movement of that stock relative to the rest of the stock market. The CAPM theory is really just a simplified version of the APT, where the only factor considered is the risk of a particular stock relative to the rest of the stock market - as described by the stock's beta. From a practical standpoint, CAPM remains the dominant pricing model used today. When compared to the Arbitrage Pricing Theory, the Capital Asset Pricing Model is both elegant and relatively simple to calculate. "The APT is derived from the premises that asset returns follow a linear returns generating process, and that in well-functioning financial markets, there will be no arbitrage opportunities. On the basis of these assumptions, one can show that there is an equilibrium linear relationship between the returns on risky assets and a small set of economy-wide common factors. While several macroeconomic variables do have some relationship with

different risky assets, the APT postulates that the pricing of risky assets depends only on the set of variables whose influence is felt significantly by risky assets together. This set of variables is known as the common factors of the APT." Investing in stocks is tricky. Betting on your perception of the public's perception of a how a company will successfully fulfill their perception of a market need is not easy. The Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT) have emerged as two models that have tried to scientifically measure the potential for assets to generate a return or a loss. They are similar in that they attempt to measure an asset's propensity to follow the overall market however APT attempts to divide market risk into smaller component risk. Regardless, it is very difficult to predict which companies are strategically positioned well into the future in the right growing markets from a product, market-share, distribution, and corporate culture standpoint. It is even harder if not impossible to predict what the investor public's reaction would be to such a success if you were to correctly envision it.

Q.6 Discuss the different forms of market efficiency.

Answer:

Forms of Market Efficiency A financial market displays informational efficiency when market prices reflect all available information about value. This definition of efficient market requires answers to two questions: "what is all available information? & "what does it mean to reflect all available information? Different answers to these questions give rise to different versions of market efficiency. 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, information that consists of past prices and all public information refers to the semi-strong version of market efficiency 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 are carried out at market prices, using the available information, are zero NPV activities. The weak form of EMH states that all past prices, volumes and other market statistics (generally referred to as technical analysis) cannot provide any information that would prove useful in predicting future stock price movements. The current prices fully reflect all security-market information, including the historical sequence of prices, rates of return, trading volume data, and other market-generated information. This implies that past rates of return and other market data should have no relationship with future rates of return. It

would mean that if the weak form of EMH is correct, then technical analysis is fruitless in generating excess returns. The semi-strong form suggests that stock prices fully reflect all publicly available information and all expectations about the future. Old information then is already discounted and cannot be used to predict stock price fluctuations. In sum, the semi-strong form suggests that fundamental analysis is also fruitless; knowing what a company generated in terms of earnings and revenues in the past will not help you determine 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, whether it be public (say in SEBI filings) or private (in the minds of the CEO and other insiders). So even with material non-public information, EMH asserts that stock prices cannot be predicted with any accuracy. An enormous debate in asset management centers on the question of whether markets are efficient or not. The answer is important because it determines whether one believes that actively managed investment portfolios can make profits other than by sheer chance. If one believes the market is efficient, then the best strategy is to hold a portfolio that mirrors the market; if not, then the best strategy is to find a smart active manager (or be one!). The fact that some managers have outperformed a simple buy the index strategy does not prove anything, unless one can convincingly show that which managers will outperform can be predicted ahead of time. Knowing what numbers worked last on a roulette wheel, for example, wont help us figure out what numbers come next, if the wheel is fair. One thing that is sure is that efficient or not it is tough to beat a passive index consistently. But what does one mean by an efficient market? In general, there appear to be two, possibly three meanings of efficiency. The most common meaning is informational efficiency, which essentially means that market prices adjust instantaneously to new information that could inform future prices. Many investors are familiar with in three forms of informational efficiency: weak, semi- strong, and strong forms. The weak form says that any information from past price behavior is already incorporated into the current price and is therefore useless for improving estimates of future returns. The semi-strong form says that all publicly available information (including that extracted from balance sheets and company fundamentals) is reflected in the price. The strong form says that all information, public and private, is reflected in current prices, and has the implication that profitable insider trading is logically impossible. There is another definition of efficient, which has to do with risk and portfolios. This approach, developed by William Sharpe for CAPM, suggests that the market is efficient because the market taken as a whole has no firm-specific risk. It is (by definition), fully diversified, and all firm-specific returns average out to zero. Since firm-specific risk generates no excess return, it is best to hold the market portfolio because it automatically maximizes the anticipated return for the level of risk.

Note that this second concept of market efficiency says nothing about how quickly information makes it into asset or index prices merely that other combinations of assets necessarily involve a greater degree of asset-specific risk without necessarily getting additional returns. Finally, there is a view of efficiency that looks at the economic allocation of capital. A capital market is efficient when all available capital moves to its optimal allocation in the economy, which means that capital moves to where it is most productive, and that any changes in the allocation of capital will result in reduced overall productivity. This is a definition of efficiency that is separate from the individual return on assets and may look to economic synergies in capital allocation that may not be obvious simply by looking at total returns. This view of efficiency is separate from the informational efficiency idea, and also distinct from the risk/reward approach. So when people say that one should hold the market portfolio because the market is efficient, they may be talking about unpredictability, or they may be talking about making sure that the risk will be compensated by higher returns. Investors probably arent talking about the efficiency of capital allocation in the economy as a whole, but economists usually are. One key question is whether the two types of investment efficiency are related. In some sense, the informational efficiency argument implies that market timing is difficult, because any information that would allow you to market time is incorporated quickly into prices. The risk efficiency argument implies that improved returns from security selection are difficult, since security selection almost by definition involves taking risks that are theoretically unpaid.

MF0010 [Security Analysis and Portfolio Management] Set1 Q1

Q. 1 It is very often observed that retail investors enter the market when index is very high and exit when index is very low (comparatively speaking). Describe qualities of a savvy investor. Also throw light upon mistakes committed while managing investments.

That culture has become a commodity of some sort is undeniable. Yet there is also a widespread belief that there is something so special about certain cultural products and events (be they in the arts, theatre, music, cinema, architecture or more broadly in localized ways of life, heritage, collective memories and affective communities) as to set them apart from ordinary commodities like shirts and shoes. While the boundary between the two sorts of commodities is highly porous (perhaps increasingly so) there are still grounds for maintaining an analytic separation. It may be, of course, that we distinguish cultural artefacts and events because we cannot bear to think of them as anything other than authentically different, existing on some higher plane of human creativity and meaning than that located in the factories of mass production and consumption. But even when we strip away all residues of wishful thinking (often backed by powerful ideologies) we are still left with something very special about those products designated as cultural'. How, then, can the commodity status of so many of these phenomena be reconciled with their special character? Furthermore, the conditions of labour and the class positionality of the increasing number of workers engaged in cultural activities and production (more than 150,000 artists' were registered in the New York metropolitan region in the early 1980s and that number may well have risen to more than 250,000 by now) is worthy of consideration. They form the creative core of what Daniel Bell calls the cultural mass' (defined as not the creators but the transmitters of culture in the media and elsewhere).1 The political stance of this creative core as well as of the cultural mass is not inconsequential. In the 1960s, recall, the art colleges were hot-beds of radical discussion. Their subsequent pacification and professionalization has seriously diminished agitational politics. Revitalizing such institutions as centres of political engagement and mobilizing the political and agitational powers of cultural producers is surely a worthwhile objective for the left even if it takes some special adjustments in socialist strategy and thinking to do so. A critical examination of the relations between culture, capital and socialist alternatives can here be helpful as a prelude to mobilizing what has always been a powerful voice in revolutionary politics.

I. MONOPOLY RENT AND COMPETITION

I begin with some reflections on the significance of monopoly rents to understanding how contemporary processes of economic globalization relate to localities and cultural forms. The category of monopoly rent' is an abstraction drawn from the language of political economy.2 To the cultural producers themselves, usually more interested in affairs of aesthetics (sometimes even dedicated to ideals of art for art's sake), of affective values, of social life and of the heart, such a term might appear far too technical and arid to bear much weight beyond the possible calculi of the financier, the developer, the real estate speculator and the landlord. But I hope to show that it has a much grander purchase: that properly constructed it can generate rich interpretations of the many practical and personal dilemmas arising in the nexus between capitalist globalization, local political-economic developments and the evolution of cultural meanings and aesthetic values.

All rent is based on the monopoly power of private owners of certain portions of the globe. Monopoly rent arises because social actors can realize an enhanced income stream over an extended time by virtue of their exclusive control over some directly or indirectly tradable item which is in some crucial respects unique and non-replicable. There are two situations in which the category of monopoly rent comes to the fore. The first arises because social actors control some special quality resource, commodity or location which, in relation to a certain kind of activity, enables them to extract monopoly rents from those desiring to use it. In the realm of production, Marx argues, the most obvious example is the vineyard producing wine of extraordinary quality that can be sold at a monopoly price. In this circumstance the monopoly price creates the rent'. The locational version would be centrality (for the commercial capitalist) relative to, say, the transport and communications network or proximity (for the hotel chain) to some highly concentrated activity (such as a financial centre). The commercial capitalist and the hotelier are willing to pay a premium for the land because of accessibility. These are the indirect cases of monopoly rent. It is not the land, resource or location of unique qualities which is traded but the commodity or service produced through their use. In the second case, the land or resource is directly traded upon (as when vineyards or prime real estate sites are sold to multinational capitalists and financiers for speculative purposes). Scarcity can be created by withholding the land or resource from current uses and speculating on future values. Monopoly rent of this sort can be extended to ownership of works of art (such as a Rodin or a Picasso) which can be (and increasingly are) bought and sold as investments. It is the uniqueness of the Picasso or the site which here forms the basis for the monopoly price. The two forms of monopoly rent often intersect. A vineyard (with its unique Chateau and beautiful physical setting) renowned for its wines can be traded at a monopoly price directly as can the uniquely flavoured wines produced on that land. A Picasso can be purchased for capital gain and then leased to someone else who puts it on view for a monopoly price. The proximity to a financial centre can be traded directly as well as indirectly to, say, the hotel chain that uses it for its own purposes. But the difference between the two rental forms is important. It is unlikely (though not impossible), for example, that Westminster Abbey and Buckingham Palace will be traded directly (even the most ardent privatizers might balk at that). But they can be and plainly are traded upon through the marketing practices of the tourist industry (or in the case of Buckingham Palace, by the Queen). Two contradictions attach to the category of monopoly rent. Both of them are important to the argument that follows. First, while uniqueness and particularity are crucial to the definition of special qualities', the requirement of tradability means that no item can be so unique or so special as to be entirely outside the monetary calculus. The Picasso has to have a money value as does the Monet, the Manet, the aboriginal art, the archaeological artefacts, the historic buildings, the ancient monuments, the Buddhist temples, and the experience of rafting down the Colorado, being in Istanbul or on top of Everest. There is, as is evident from such a list, a certain difficulty of market formation' here. For while markets have formed around works of art and, to some degree around archaeological artefacts (there are some well-documented cases, as with Australian Aboriginal art, of what happens when some art form gets drawn

into the market sphere) there are plainly several items on this list that are hard to incorporate directly into a market (this is the problem with Westminster Abbey). Many items may not even be easy to trade upon indirectly. The contradiction here is that the more easily marketable such items become the less unique and special they appear. In some instances the marketing itself tends to destroy the unique qualities (particularly if these depend on qualities such as wilderness, remoteness, the purity of some aesthetic experience, and the like). More generally, to the degree that such items or events are easily marketable (and subject to replication by forgeries, fakes, imitations or simulacra) the less they provide a basis for monopoly rent. I am put in mind here of the student who complained about how inferior her experience of Europe was compared to Disney World: At Disney World all the countries are much closer together, and they show you the best of each country. Europe is boring. People talk strange languages and things are dirty. Sometimes you don't see anything interesting in Europe for days, but at Disney World something different happens all the time and people are happy. It's much more fun. It's well designed. While this sounds a laughable judgement it is sobering to reflect on how much Europe is attempting to redesign itself to Disney standards (and not only for the benefit of American tourists). But, and here is the heart of the contradiction, the more Europe becomes Disneyfied, the less unique and special it becomes. The bland homogeneity that goes with pure commodification erases monopoly advantages. Cultural products become no different from commodities in general. The advanced transformation of consumer goods into corporate products or trade mark articles that hold a monopoly on aesthetic value', writes Wolfgang Haug, has by and large replaced the elementary or generic products', so that commodity aesthetics' extends its border further and further into the realm of cultural industries'.5 Conversely, every capitalist seeks to persuade consumers of the unique and non-replicable qualities of their commodities (hence name-brands, advertising, and the like). Pressures from both sides threaten to squeeze out the unique qualities that underlie monopoly rents. If the latter are to be sustained and realized, therefore, some way has to be found to keep some commodities or places unique and particular enough (and I will later reflect on what this might mean) to maintain a monopolistic edge in an otherwise commodified and often fiercely competitive economy. But why, in a neoliberal world where competitive markets are supposedly dominant, would monopoly of any sort be tolerated let alone be seen as desirable? We here encounter the second contradiction which, at root, turns out to be a mirror image of the first. Competition, as Marx long ago observed, always tends towards monopoly (or oligopoly) simply because the survival of the fittest in the war of all against all eliminates the weaker firms. The fiercer the competition the faster the trend towards oligopoly if not monopoly. It is therefore no accident that the liberalization of markets and the celebration of market competition in recent years has produced incredible centralization of capital (Microsoft, Rupert Murdoch, Bertelsmann, financial services, and a wave of takeovers, mergers and consolidations in airlines, retailing and even in older industries like automobiles, petroleum, and the like). This tendency has long been recognized as a troublesome feature of capitalist dynamics, hence the anti-trust legislation in the United States and the work of the monopolies and

mergers commissions in Europe. But these are weak defences against an overwhelming force. This structural dynamic would not have the importance it does were it not for the fact that capitalists actively cultivate monopoly powers. They thereby realize far-reaching control over production and marketing and hence stabilize their business environment to allow of rational calculation and long-term planning, the reduction of risk and uncertainty, and more generally guarantee themselves a relatively peaceful and untroubled existence. The visible hand of the corporation, as Alfred Chandler terms it, has consequently been of far greater importance to capitalist historical geography than the invisible hand of the market made so much of by Adam Smith and paraded ad nauseam before us in recent years as the guiding power in the neoliberal ideology of contemporary globalization. But it is here that the mirror image of the first contradiction comes most clearly into view: market processes crucially depend upon the individual monopoly of capitalists (of all sorts) over ownership of the means of production including finance and land. All rent, recall, is a return to the monopoly power of private ownership of any portion of the globe. The monopoly power of private property is, therefore, both the beginning point and the end point of all capitalist activity. A non-tradable juridical right exists at the very foundation of all capitalist trade, making the option of non-trading (hoarding, withholding, miserly behaviour) an important problem in capitalist markets. Pure market competition, free commodity exchange and perfect market rationality are, therefore, rather rare and chronically unstable devices for coordinating production and consumption decisions. The problem is to keep economic relations competitive enough while sustaining the individual and class monopoly privileges of private property that are the foundation of capitalism as a political-economic system. This last point demands one further elaboration to bring us closer to the topic at hand. It is widely but erroneously assumed that monopoly power of the grand and culminating sort is most clearly signalled by the centralization and concentration of capital in megacorporations. Conversely, small firm size is widely assumed, again erroneously, to be a sign of a competitive market situation. By this measure, a once competitive capitalism has become increasingly monopolized over time. The error arises in part because of a rather too facile application of Marx's arguments concerning the law of the tendency for the centralization of capital', ignoring his counter-argument that centralization would soon bring about the collapse of capitalist production if it were not for counteracting tendencies, which have a continuous decentralizing effect'.8 But it is also supported by an economic theory of the firm that generally ignores its spatial and locational context, even though it does accept (on those rare occasions where it deigns to consider the matt er) that locational advantage involves monopolistic competition'. In the nineteenth century, for example, the brewer, the baker and the candlestick maker were all protected to considerable degree from competition in local markets by the high cost of transportation. Local monopoly powers were omnipresent (even though firms were small in size), and very hard to break, in everything from energy to food supply. By this measure nineteenth century capitalism was far less competitive than now.

It is at this point that the changing conditions of transport and communications enter in as crucial determining variables. As spatial barriers diminished through the capitalist penchant for the annihilation of space through time', many local industries and services lost their local protections and monopoly privileges.9 They were forced into competition with producers in other locations, at first relatively close by, but then with producers much further away. The historical geography of the brewing trade is very instructive in this regard. In the nineteenth century most people drank local brew because they had no choice. By the end of the nineteenth century beer production and consumption in Britain had been regionalized to a considerable degree and remained so until the 1960s (foreign imports, with the exception of Guinness, were unheard of). But then the market became national (Newcastle Brown and Scottish Youngers appeared in London and the south) before becoming international (imports suddenly became all the rage). If one drinks local brew now it is by choice, usually out of some mix of principled attachment to locality or because of some special quality of the beer (based on the technique, the water, or whatever) that differentiates it from others. Plainly, the economic space of competition has changed in both form and scale over time. The recent bout of globalization has significantly diminished the monopoly protections given historically by high transport and communications costs while the removal of institutional barriers to trade (protectionism) has likewise diminished the monopoly rents to be procured by that means. But capitalism cannot do without monopoly powers and craves means to assemble them. So the question upon the agenda is how to assemble monopoly powers in a situation where the protections afforded by the so-called natural monopolies' of space and location, and the political protections of national boundaries and tariffs, have been seriously diminished if not eliminated. The obvious answer is to centralize capital in mega-corporations or to set up looser alliances (as in airlines and automobiles) that dominate markets. And we have seen plenty of that. The second path is to secure ever more firmly the monopoly rights of private property through international commercial laws that regulate all global trade. Patents and so-called intellectual property rights' have consequently become a major field of struggle through which monopoly powers more generally get asserted. The pharmaceutical industry, to take a paradigmatic example, has acquired extraordinary monopoly powers in part through massive centralizations of capital and in part through the protection of patents and licensing agreements. And it is hungrily pursuing even more monopoly powers as it seeks to establish property rights over genetic materials of all sorts (including those of rare plants in tropical rain forests traditionally collected by indigenous inhabitants). As monopoly privileges from one source diminish so we witness a variety of attempts to preserve and assemble them by other means. I cannot possibly review all of these tendencies here. I do want, however, to look more closely at those aspects of this process that impinge most directly upon the problems of local development and cultural activities. I wish to show first, that there are continuing struggles over the definition of the monopoly powers that might be accorded to location and localities and that the idea of culture' is more and more entangled with attempts to reassert such monopoly powers precisely because claims to uniqueness and authenticity can best be

articulated as distinctive and non-replicable cultural claims. I begin with the most obvious example of monopoly rent given by the vineyard producing wine of extraordinary quality that can be sold at a monopoly price'.

II. ADVENTURES IN THE WINE TRADE

The wine trade, like brewing, has become more and more international over the last thirty years and the stresses of international competition have produced some curious effects. Under pressure from the European Community, for example, international wine producers have agreed (after long legal battles and intense negotiations) to phase out the use of traditional expressions' on wine labels, which could eventually include terms like Chateau' and domaine' as well as generic terms like champagne', burgundy', chablis' or sauterne'. In this way the European wine industry, led by the French, seeks to preserve monopoly rents by insisting upon the unique virtues of land, climate and tradition (lumped together under the French term terroir') and the distinctiveness of its product certified by a name. Reinforced by institutional controls like appellation controle' the French wine trade insists upon the authenticity and originality of its product which grounds the uniqueness upon which monopoly rent can be based. Australia is one of the countries that agreed to this move. Chateau Tahbilk in Victoria obliged by dropping the Chateau' from its label, airily pronouncing that we are proudly Australian with no need to use terms inherited from other countries and cultures of bygone days'. To compensate, they identified two factors which, when combined, give us a unique position in the world of wine'. Theirs is one of only six worldwide wine regions where the meso-climate is dramatically influenced by inland water mass (the numerous lakes and local lagoons moderate and cool the climate). Their soil is of a unique type (found in only one other location in Victoria) described as red/sandy loam coloured by a very high Ferric-oxide content, which has a positive effect on grape quality and adds a certain distinctive regional character to our wines'. These two factors are brought together to define Nagambie Lakes' as a unique Viticultural Region (to be authenticated, presumably, by the Australian Wine and Brandy Corporation's Geographical Indications Committee, set up to identify Viticultural regions throughout Australia). Tahbilk thereby establishes a counter-claim to monopoly rents on the grounds of the unique mix of environmental conditions in the region where it is situated. It does so in a way that parallels and competes with the uniqueness claims of terroir' and domaine' pressed by French wine producers. But we then encounter the first contradiction. All wine is tradable and therefore in some sense comparable no matt er where it is from. Enter Robert Parker and the Wine Advocate which he publishes regularly. Parker evaluates wines for their taste and pays no particular mind to terroir' or any other cultural-historical claims. He is notoriously independent (most other guides are supported by influential sectors of the wine industry). He ranks wines on a scale according to his own distinctive taste. He has an extensive following in the United States, a major market. If he rates a Chateau wine from Bordeaux 65 pts and an Australian wine 95 pts then prices are affected. The Bordeaux wine producers are terrified of him. They

have sued him, denigrated him, abused him and even physically assaulted him. He challenges the bases of their monopoly rents. Monopoly claims, we can conclude, are as much an effect of discourse' and an outcome of struggle as they are a reflection of the qualities of the product. But if the language of terroir' and tradition is to be abandoned then what kind of discourse can be put in its place? Parker and many others in the wine trade have in recent years invented a language in which wines are described in terms such as flavor of peach and plum, with a hint of thyme and gooseberry'. The language sounds bizarre but this discursive shift, which corresponds to rising international competition and globalization in the wine trade, takes on a distinctive role, reflecting the commodification of wine consumption along standardized lines. But wine consumption has many dimensions that open paths to profitable exploitation. For many it is an aesthetic experience. Beyond the sheer pleasure (for some) of a fine wine with the right food, there lie all sorts of other referents within the Western tradition that track back to mythology (Dionysus and Bacchus), religion (the blood of Jesus and communion rituals) and traditions celebrated in festivals, poetry, song and literature. Knowledge of wines and proper' appreciation is often a sign of class and is analyzable as a form of cultural' capital (as Bourdieu would put it). Getting the wine right may have helped to seal more than a few major business deals (would you trust someone who did not know how to select a wine?). Style of wine is related to regional cuisines and thereby embedded in those practices that turn regionality into a way of life marked by distinctive structures of feeling (it is hard to imagine Zorba the Greek drinking Mondavi Californian jug wine, even though the latter is sold in Athens airport). The wine trade is about money and profit but it is also about culture in all of its senses (from the culture of the product to the cultural practices that surround its consumption and the cultural capital that can evolve alongside among both producers and consumers). The perpetual search for monopoly rents entails seeking out criteria of speciality, uniqueness, originality and authenticity in each of these realms. If uniqueness cannot be established by appeal to terroir' and tradition, or by straight description of flavour, then other modes of distinction must be invoked to establish monopoly claims and discourses devised to guarantee the truth of those claims (the wine that guarantees seduction or the wine that goes with nostalgia and the log fire, are current advertising tropes in the US).

In practice what we find within the wine trade is a host of competing discourses, all with different truth claims about the uniqueness of the product. But, and here I go back to my starting point, all of these discursive shifts and swayings, as well as many of the shifts and turns that have occurred in the strategies for commanding the international market in wine, have at their root not only the search for profit but also the search for monopoly rents. In this the language of authenticity, originality, uniqueness, and special unreplicable qualities looms large. The generality of a globalized market produces, in a manner consistent with the second contradiction I earlier identified, a powerful force seeking to guarantee not only the continuing monopoly privileges of private property but the monopoly rents that derive from depicting commodities as incomparable.

III. URBAN ENTREPRENEURIALISM, MONOPOLY RENT AND GLOBAL FORMS

Recent struggles within the wine trade provide a useful model for understanding a wide range of phenomena within the contemporary phase of globalization. They have particular relevance to understanding how local cultural developments and traditions get absorbed within the calculi of political economy through attempts to garner monopoly rents. It also poses the question of how much the current interest in local cultural innovation and the resurrection and invention of local traditions attaches to the desire to extract and appropriate such rents. Since capitalists of all sorts (including the most exuberant of international financiers) are easily seduced by the lucrative prospects of monopoly powers, we immediately discern a third contradiction: that the most avid globalizers will support local developments that have the potential to yield monopoly rents even if the effect of such support is to produce a local political climate antagonistic to globalization! Emphasizing the uniqueness and purity of local Balinese culture may be vital to the hotel, airline and tourist industry, but what happens when this encourages a Balinese movement that violently resists the impurity' of commercialization? The Basque country may appear a potentially valuable cultural configuration precisely because of its uniqueness, but ETA with its demand for autonomy and preparedness to take violent action is not amenable to commercialization. Let us probe a little more deeply into this contradiction as it impinges upon urban development politics. To do so requires, however, briefly situating that politics in relation to globalization. Urban entrepreneurialism has become important both nationally and internationally in recent decades. By this I mean that pattern of behaviour within urban governance that mixes together state powers (local, metropolitan, regional, national or supranational) and a wide array of organizational forms in civil society (chambers of commerce, unions, churches, educational and research institutions, community groups, NGOs, etc.) and private interests (corporate and individual) to form coalitions to promote or manage urban/regional development of some sort or other. There is now an extensive literature on this topic which shows that the forms, activities and goals of these governance systems (variously known as urban regimes', growth machines' or regional growth coalitions') vary widely depending upon local conditions and the mix of forces at work within them. The role of this urban entrepreneurialism in relation to the neoliberal form of globalization has also been scrutinized at length, most usually under the rubric of local-global relations and the so-called space-place dialectic'. Most geographers who have looked into the problem have rightly concluded that it is a categorical error to view globalization as a causal force in relation to local development. What is at stake here, they rightly argue, is a rather more complicated relationship across scales in which local initiatives can percolate upwards to a global scale and vice versa at the same time as processes within a particular definition of scale -- interurban and interregional competition being the most obvious examples -- can rework the local/regional configurations of what globalization is about. Globalization should

not be seen, therefore, as an undifferentiated unity but as a geographically articulated patterning of global capitalist activities and relations. But what, exactly, does it mean to speak of a geographically articulated patterning'? There is, of course, plenty of evidence of uneven geographical development (at a variety of scales) and at least some cogent theorizing to understand its capitalistic logic. Some of it can be understood in conventional terms as a search on the part of mobile capitals (with financial, commercial and production capital having different capacities in this regard) to gain advantages in the production and appropriation of surplus values by moving around. Trends can indeed be identified which fit with simple models of a race to the bottom' in which the cheapest and most easily exploited labour power becomes the guiding beacon for capital mobility and investment decisions. But there is plenty of countervailing evidence to suggest that this is a gross oversimplification when projected as a monocausal explanation of the dynamics of uneven geographical development. Capital in general just as easily flows into high wage regions as into low and often seems to be geographically guided by quite different criteria to those conventionally set out in both bourgeois and Marxist political economy. The problem in part (but not wholly) derives from the habit of ignoring the category of landed capital and the considerable importance of long-term investments in the built environment which are by definition geographically immobile (except in the relative accessibility sense). Such investments, particularly when they are of a speculative sort, invariably call for even further waves of investments if the first wave is to prove profitable (to fill the convention centre we need the hotels which require better transport and communications, which calls for an expansion of the convention centre...). So there is an element of circular and cumulative causation at work in the dynamics of metropolitan area investments (look, for example, at the whole Docklands redevelopment in London and the financial viability of Canary Wharf which pivots on further investments both public and private). This is what urban growth machines are often all about: the orchestration of investment process dynamics and the provision of key public investments at the right place and time to promote success in inter-urban and inter-regional competition.

Q.2 Explain the significance of index in general and stock market index in particular. What is risk involved in derivative products?
A stock market index is a method of measuring a section of the stock market. Many indices are cited by news or financial services firms and are used as benchmarks, to measure the performance of portfolios such as mutual funds.

Stock market indices may be classed in many ways. A 'world' or 'global' stock market index includes (typically large) companies without regard for where they are domiciled or traded. Two examples are MSCI World and S&P Global 100. A national index represents the performance of the stock market of a given nationand by proxy, reflects investor sentiment on the state of its economy. The most regularly quoted market indices are national indices composed of the stocks of large companies listed on a nation's largest stock exchanges, such as the American S&P 500, the Japanese Nikkei 225, and the British FTSE 100. The concept may be extended well beyond an exchange. The Wilshire 5000 Index, the original total market index, represents the stocks of nearly every publicly traded company in the United States, including all U.S. stocks traded on the New York Stock Exchange (but not ADRs or limited partnerships), NASDAQ and American Stock Exchange. Russell Investment Group added to the family of indices by launching the Russell Global Index. More specialised indices exist tracking the performance of specific sectors of the market. Some examples include the Wilshire US REIT which tracks more than 80 American Real Estate Investment Trusts and the Morgan Stanley Biotech Index which consists of 36 American firms in the biotechnology industry. Other indices may track companies of a certain size, a certain type of management, or even more specialized criteria one index published by Linux Weekly News tracks stocks of companies that sell products and services based on the Linux operating environment. Index versions Some indices, such as the S&P 500, have multiple versions. These versions can differ based on how the index components are weighted and on how dividends are accounted for. For example, there are three versions of the S&P 500 index: price return, which only considers the price of the components, total return, which accounts for dividend reinvestment, and net total return, which accounts for dividend reinvestment after the deduction of a withholding tax. As another example, the Wilshire 4500 and Wilshire 5000 indices have five versions each: full capitalization total return, full capitalization price, float-adjusted total return, float-adjusted price, and equal weight. The difference between the full capitalization, float-adjusted, and equal weight versions is in how index components are weighted. Weighting An index may also be classified according to the method used to determine its price. In a price-weighted index such as the Dow Jones Industrial Average, Amex Major Market Index, and the NYSE ARCA Tech 100 Index, the price of each component stock is the only consideration when determining the value of the index. Thus, price movement of even a single security will heavily influence the value of the index even though the dollar shift is less significant in a relatively highly valued issue, and moreover ignoring the relative size of the company as a whole. In contrast, a market-value weighted or capitalizationweighted index such as the Hang Seng Index factors in the size of the company. Thus, a relatively small shift in the price of a large company will heavily influence the value of the index. In a market-share weighted index, price is weighted relative to the number of shares, rather than their total value.

Traditionally, capitalization- or share-weighted indices all had a full weighting, i.e. all outstanding shares were included. Recently, many of them have changed to a floatadjustedweighting which helps indexing. A modified capitalization-weighted index is a hybrid between capitalization weighting and equal weighting. It is similar to a capitalization weighting with one main difference: the largest stocks are capped to a percent of the weight of the total stock index and the excess weight will be redistributed equally amongst the stocks under that cap. Moreover, in 2005, Standard & Poor's introduced the S&P Pure Growth Style Index and S&P Pure Value Style Index which was attribute-weighted. That is, a stock's weight in the index is decided by the score it gets relative to the value attributes that define the criteria of a specific index, the same measure used to select the stocks in the first place. For these two stocks, a score is calculated for every stock, be it their growth score or the value score (a stock can't be both) and accordingly they are weighted for the index. Criticism of capitalization-weighting The use of capitalization-weighted indices is often justified by the central conclusion of modern portfolio theory that the optimal investment strategy for any investor is to hold the market portfolio, the capitalization-weighted portfolio of all assets. However, empirical tests conclude that market indices are not efficient. This can be explained by the fact that these indices do not include all assets or by the fact that the theory does not hold. The practical conclusion is that using capitalization-weighted portfolios is not necessarily the optimal method. As a consequence, capitalization-weighting has been subject to severe criticism (see e.g. Haugen and Baker 1991, Amenc, Goltz, and Le Sourd 2006, or Hsu 2006), pointing out that the mechanics of capitalization-weighting lead to trend-following strategies that provide an inefficient risk-return trade-off. Also, while capitalization-weighting is the standard in equity index construction, different weighting schemes exist. First, while most indices use capitalization-weighting, additional criteria are often taken into account, such as sales/revenue and net income (see the Guide to the Dow Jones Global Titan 50 Index, January 2006). Second, as an answer to the critiques of capitalization-weighting, equity indices with different weighting schemes have emerged, such as "wealth"-weighted (Morris, 1996), fundamental-weighted (Arnott, Hsu and Moore 2005), diversity-weighted (Fernholz, Garvy, and Hannon 1998) or equalweighted indices. Indices and passive investment management There has been an accelerating trend in recent decades to create passively managed mutual funds that are based on market indices, known as index funds. Advocates claim that index funds routinely beat a large majority of actively managed mutual funds; one study claimed that over time, the average actively managed fund has returned 1.8% less than the S&P 500 index - a result nearly equal to the average expense ratio of mutual funds (fund expenses are a drag on the funds' return by exactly that ratio). Since index funds attempt to replicate the holdings of an index, they obviate the need for and thus many costs of the research entailed in active management, and have a lower "churn" rate (the turnover of

securities which lose fund managers' favor and are sold, with the attendant cost of commissions and capital gains taxes). Indices are also a common basis for a related type of investment, the exchange-traded fund or ETF. Unlike an index fund, which is priced daily, an ETF is priced continuously, is optionable, and can be sold short. Ethical stock market indices A notable specialised index type is those for ethical investing indices that include only those companies satisfying ecological or social criteria, e.g. those of The Calvert Group, KLD, FTSE4Good Index, Dow Jones Sustainability Index and Wilderhill Clean Energy Index. Another important trend is strict mechanical criteria for inclusion and exclusion to prevent market manipulation, e.g. in Canada when Nortel was permitted to rise to over 30% of the TSE 300 index value. Ethical indices have a particular interest in mechanical criteria, seeking to avoid accusations of ideological bias in selection, and have pioneered techniques for inclusion and exclusion of stocks based on complex criteria. Another means of mechanical selection is mark-to-future methods that exploit scenarios produced by multiple analysts weighted according to probability, to determine which stocks have become too risky to hold in the index of concern. Critics of such initiatives argue that many firms satisfy mechanical "ethical criteria", e.g. regarding board composition or hiring practices, but fail to perform ethically with respect to shareholders, e.g. Enron. Indeed, the seeming "seal of approval" of an ethical index may put investors more at ease, enabling scams. One response to these criticisms is that trust in the corporate management, index criteria, fund or index manager, and securities regulator, can never be replaced by mechanical means, so "market transparency" and "disclosure" are the only long-term-effective paths to fair markets. Environmental stock market indices An environmental stock market index aims to provide a quantitative measure of the environmental damage caused by the companies in an index. Indices of this nature face much of the same criticism as Ethical indices do that the 'score' given is partially subjective. However, whereas 'ethical' issues (for example, does a company use a sweatshop) are largely subjective and difficult to score, an environmental impact is often quantifiable through scientific methods. So it is broadly possible to assign a 'score' to (say) the damage caused by a tonne of mercury dumped into a local river. It is harder to develop a scoring method that can compare different types of pollutant for example does one hundred tonnes of carbon dioxide emitted to the air cause more or less damage (via climate change) than one tonne of mercury dumped in a river (and poisoning all the fish). Generally, most environmental economists attempting to create an environmental index would attempt to quantify damage in monetary terms. So one tonne of carbon dioxide might cause $100 worth of damage, whereas one tonne of mercury might cause $50,000 (as it is highly toxic). Companies can therefore be given an 'environmental impact' score,

based on the cost they impose on the environment. Quantification of damage in this nature is extremely difficult, as pollutants tend to be market externalities and so have no easily measurable cost by definition. A stock market or equity market is a public market (a loose network of economic transactions, not a physical facility or discrete entity) for the trading of company stock (shares) and derivatives at an agreed price; these are securities listed on a stock exchange as well as those only traded privately. The size of the world stock market was estimated at about $36.6 trillion USD at the beginning of October 2008. The total world derivatives market has been estimated at about $791 trillion face or nominal value, 11 times the size of the entire world economy. The value of the derivatives market, because it is stated in terms of notional values, cannot be directly compared to a stock or a fixed income security, which traditionally refers to an actual value. Moreover, the vast majority of derivatives 'cancel' each other out (i.e., a derivative 'bet' on an event occurring is offset by a comparable derivative 'bet' on the event not occurring). Many such relatively illiquid securities are valued as marked to model, rather than an actual market price. The stocks are listed and traded on stock exchanges which are entities of a corporation or mutual organization specialized in the business of bringing buyers and sellers of the organizations to a listing of stocks and securities together. The largest stock market in the United States, by market cap, is the New York Stock Exchange, NYSE. In Canada, the largest stock market is the Toronto Stock Exchange. Major European examples of stock exchanges include the London Stock Exchange, Paris Bourse, and the Deutsche Brse. Asian examples include the Tokyo Stock Exchange, the Hong Kong Stock Exchange, the Shanghai Stock Exchange, and the Bombay Stock Exchange. In Latin America, there are such exchanges as the BM&F Bovespa and the BMV. General Investment Glossary Keeping up with the increasing number of investment products and services in the marketplace today can be confusing. This comprehensive investing glossary is designed to help you understand some of the more common investment and financial terms you may encounter. Your financial advisor can explain these terms more completely and discuss with you those relevant to your situation. Absolute Return Index: A stock index designed to measure absolute returns. The absolute return index is actually a composite index made up of five other indexes. This index is used to compare the absolute returns posted by the hedge fund market as a whole against individual hedge funds. ADR (American Depositary Receipt): ADR stands for American Depositary Receipt. An American Depositary Receipt is a physical certificate evidencing ownership in one or several American Depositary Shares (ADS). The terms ADR and ADS can be used interchangeably. An ADS is a U.S. dollar denominated form of equity ownership in a non-U.S. company. For example, Toyota Motor Corp. is a Japanese company listed on the New York Stock Exchange. Some of Toyota's shares are held by a custodian bank in Japan for the direct representation on the NYSE.

It's important to note that some ADSs or ADRs represent more than one share of the actual stock. One "share" of Toyota's ADS on the NYSE gives an investor the rights of two shares of the actual company stock. After The Bell: The New York Stock Exchange (NYSE) closes its trading day with the ringing of a bell. Alligator Spread: Pricing models and a more efficient market can help reduce the traditional spread on a security, but it is commissions that create the alligator spread, not market inefficiencies. The commissions are dependent on a transaction's brokers. Investors should check the commission schedules carefully to avoid having their profits devoured by the alligator spread. Alternative Energy ETF: ETFs focused on alternative energy stocks represent a strong "green" investment, but the space is still in the beginning stages of commercial viability. Investors should expect to see high volatility as certain processes and technology rise to the forefront while others prove to be unsuccessful. Alternative energy has two important tailwinds funding its growth: the limitation of the world's natural resources and higher demand by environmentally conscientious consumers. Examples of ETFs in this space would include stocks from solar energy companies and "clean" fossil fuel production corporations. Anonymous Trading: Anonymous trades allow the high profile investors to execute transactions without the scrutiny and speculation of the market. Ask: The price a seller is willing to accept for a security, also known as the offer price. Along with the price, the ask quote will generally also stipulate the amount of the security willing to be sold at that price. Bear Market: A market condition in which the prices of securities are falling, and widespread pessimism causes the negative sentiment to be self-sustaining. As investors anticipate losses in a bear market and selling continues, which contributes to further pessimism. Although figures can vary, for many, a downturn of 20% or more in multiple broad market indexes, such as the Dow Jones Industrial Average (DJIA) or Standard & Poor's 500 Index (S&P 500), over at least a two-month period, is considered an entry into a bear market. Bear Market Rally: Although there are no official guidelines for a bear market rally, it is sometimes defined as an overall market increase of 10-20% during an overall bear market. There are many examples of bear market rallies in modern stock market history, including the bear market rally of the Dow Jones following the stock market crash of 1929, which eventually saw a bottoming out in 1932.

Bid: An offer made by an investor, a trader or a dealer to buy a security. The bid will stipulate both the price at which the buyer is willing to purchase the security and the quantity to be purchased. This is the opposite of the ask, which stipulates the price a seller is willing to accept for a security and the quantity of the security to be sold at that price. Blue-Chip Stock: A stock of a nationally recognized, well-established and financially sound company that is able to weather economic downturns due to a long record of stable and reliable growth. Bond Market: The environment in which the issuance and trading of debt securities occurs. The bond market primarily includes government-issued securities and corporate debt securities, and facilitates the transfer of capital from savers to the issuers or organizations requiring capital for government projects, business expansions and ongoing operations. Bubble: 1. An economic cycle characterized by rapid expansion followed by a contraction. 2. A surge in equity prices, often more than warranted by the fundamentals and usually in a particular sector, followed by a drastic drop in prices as a massive selloff occurs. 3. A theory that security prices rise above their true value and will continue to do so until prices go into freefall and the bubble bursts. Bull Market: A financial market of a group of securities in which prices are rising or are expected to rise. The term "bull market" is most often used to refer to the stock market, but can be applied to anything that is traded, such as bonds, currencies and commodities. Buy Down: A mortgage-financing technique with which the buyer attempts to obtain a lower interest rate for at least the first few years of the mortgage, but possibly its entire life. The builder or seller or the property usually provides payments to the mortgage-lending institution, which, in turn, lowers the buyer's monthly interest rate and therefore monthly payment. The home seller, however, increases the purchase price of the home to compensate for the costs of the buydown agreement. Buyer's Call: An agreement between a buyer and seller whereby a commodity purchase occurs at a specific price above a futures contract for an identical grade and quantity Buyer's Market: A market condition characterized by an abundance of goods available for sale. Call: The period of time between the opening and closing of some future markets wherein the prices are established through an auction process.

Call Option: An agreement that gives an investor the right (but not the obligation) to buy a stock, bond, commodity, or other instrument at a specified price within a specific time period. Clearing House: An agency or separate corporation of a futures exchange responsible for settling trading accounts, clearing trades, collecting and maintaining margin monies, regulating delivery and reporting trading data. Clearing houses act as third parties to all futures and options contracts - as a buyer to every clearing member seller and a seller to every clearing member buyer. Click And Mortar: A type of business model that includes both online and offline operations, which typically include a website and a physical store. A click-and-mortar company can offer customers the benefits of fast, online transactions or traditional, face to face service. This model is also referred to as "clicks and bricks". Closing Price: The final price at which a security is traded on a given trading day. The closing price represents the most up-to-date valuation of a security until trading commences again on the next trading day. Commodity: A basic good used in commerce that is interchangeable with other commodities of the same type. Commodities are most often used as inputs in the production of other goods or services. The quality of a given commodity may differ slightly, but it is essentially uniform across producers. When they are traded on an exchange, commodities must also meet specified minimum standards, also known as a basis grade. Commodity ETF: Because many commodity ETFs use leverage through the purchase of derivative contracts, they may have large portions of uninvested cash, which is used to purchase Treasury securities or other nearly risk-free assets. Currency: A generally accepted form of money, including coins and paper notes, which is issued by a government and circulated within an economy. Death Spiral: A type of loan investors give to a company in exchange for convertible debt, which, like convertiblebonds, typically has provisions that allow investors to convert the bonds into stock at below-market prices. This can cause the original shareholders to lose control of the company. Deficit: A situation in which liabilities exceed assets, expenditures exceed income, imports exceed exports, or losses exceed profits.

Deliverables: A project management term for the quantifiable goods or services that will be provided upon the completion of a project. Deliverables can be tangible or intangible parts of the development process, and are often specified functions or characteristics of the project. Derivatives Time Bomb: A possibile situation where the financial markets plunge into chaos if the massive derivatives positions owned by hedge funds and the large banks were to move against those parties. Institutional investors have increasingly used derivatives to either hedge their existing positions, or to speculate on given markets or commodities. The growing popularity of these instruments is both good and bad because although derivatives can be used to mitigate portfolio risk. Institutions that are highly leveraged can suffer huge losses if their positions move against them. Dividend: A distribution of a portion of a companys earnings to shareholders, as decided by its board of directors. It is most often calculated in dollar amount by predetermined dividends per share or in terms of a percent of the current market price. The Dow Jones Industrial Average: The Dow Jones Industrial Average is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the Nasdaq. Energy ETF: A broad class of ETFs that includes funds focused on oil and gas exploration, the generation, distribution and retail sale of gas and other refined products, electric utilities and alternative energy production. Energy ETFs may invest in only United States-based companies, globally based energy companies, or a blend of the two. The offerings within the energy ETF class include replications of the energy-sector stocks found in the S&P 500, U.S. energy producers, global energy producers and funds of a particular sub-sector designation, such as nuclear, coal, gas, etc. The weighting of stocks within these ETFs can be market-cap based, equally-weighted or fundamentally weighted, based on financial metrics like net earnings and dividend yield. Equity: Assets that the owner can readily sell for cash. This includes stocks as well as cars and houses with no outstanding debt. ETF (Exchange-Traded Fund): A security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange. ETFs experience price changes throughout the day as they are bought and sold. Federal Reserve Board - FRB: The governing body of the Federal Reserve System. The seven members of the board of governors are appointed by the president, subject to confirmation by the Senate.

Foreclosure - FCL: A situation in which a homeowner is unable to make principal and/or interest payments on his or her mortgage, so the lender, be it a bank or building society, can seize and sell the property as stipulated in the terms of the mortgage contract. Forex Market: The Forex Market, made up of banks, commercial companies, central banks, investment management firms, hedge funds, retail forex brokers and investors, is a market in which participants are able to buy, sell, exchange and speculate on currencies. The currency market is considered to be the largest financial market in the world, processing trillions of dollars worth of transactions each day. Fortune 500: An annual list of the 500 largest companies in the United States. The list is compiled using the most recent figures for revenue. Fundamental Analysis: A method of evaluating a security that attempts to measure its value by examining related economic, financial, quantitative and qualitative factors. The goal with this type of analysis is to produce a value that an investor can compare to the securities current price. This allows them to figure out what kind of position to take with that security, whether it is buy, sell, or hold. Gold Bull: A slang term for a market or investor who is bullish on gold. A gold bull anticipates the price of gold increasing over the next period of time. A gold bull market is one where the value of gold has a rising trend. Gold Standard: A monetary system in which a country's government allows its currency unit to be freely converted into fixed amounts of gold and vice versa. The exchange rate under the gold standard monetary system is determined by the economic difference for an ounce of gold between two currencies. The gold standard was mainly used from 1875 to 1914 and also during the interwar years. Hedge Fund: A hedge fund is an aggressively managed portfolio of investments with the goal of making high returns made possible by using advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets. Hedge funds are most often set up as private investment partnerships open to a limited number of investors and require a sizeable initial investment. Investments in hedge funds are illiquid, usually requiring investors to keep their money in the fund for at least a year. Housing Market Index: An index of over 300 home builders, which shows the demand for new homes. The index runs from 0-100, so a rating of 50 would mean that demand for new homes was average.

Index: A statistical measure of change in an economy or a securities market. In the case of financial markets, an index is an imaginary portfolio of securities representing a particular market or a portion of it. Each index has its own calculation methodology and is usually expressed in terms of a change from a base value. Thus, the percentage change is more important than the actual numeric value. IPO (Initial Public Offering): The first sale of a stock by a private company to the public. IPOs are often issued by smaller, younger companies seeking the capital to expand, but can also be done by large privately owned companies looking to become publicly traded. In an IPO, the issuer obtains the assistance of an underwriting firm, which helps it determine what type of security to issue (common or preferred), the best offering price and the time to bring it to market. Different aspects of credit risk: market risk, default rates and recovery rates The two aspects of credit risk are the market risk of the contracts into which we have entered with counterparties and the potential for some pejorative credit event such as default or downgrade. We know from previous articles on "Risk Measurement" that there are ways to quantify market risk, including most notably Value-at-Risk techniques. The difficult thing is to try and calculate the probability of default or of a negative credit event. There are different methodologies to try and calculate default risk using the credit spreads observed in the corporate bond market, historical default rates for a given class of credit, interpreting information available from financial statements and other public commentary from the counterparty's management. Check out the CreditMetrics technical document on the RiskMetrics web site at http://www.riskmetrics.com or CreditRisk+ at the Credit Suisse First Boston web site. Naturally, these calculations are complicated by international legal idiosyncrasies. Another difficulty in assessing credit risk is estimating the recovery rate. Let's say that ABC bank defaults and that we have an outstanding swap with ABC, the market value of which is $10 million in our favor. It is not automatically true that we are not going to see any of that $10 million once the smoke clears from the bankruptcy negotiations. We may be able to receive a partial payment. The recovery rate is the rate at which we are paid in the event of a negative credit event. If we are paid $2 million at the end of the day, then the recovery rate here is 20%. What was the expected value of the swap to us the day before ABC defaulted? Let's say that we had estimated an ex ante default probability of 5% and a recovery rate of 20%. Then, the expected value condition is straightforward. Expected Value Swap=0.95($10 million) + 0.05($10 million x 0.20)=$9.6 million This expected value of the swap is less than its current market value because of the possibility of default and less-than-total recovery of the value of the swap in the event of default.

Calculating credit risk and implications for derivative contracts There are two steps in calculating credit risk: estimating the credit exposure and calculating the probability of default. Once we have calculated these two statistics, we can quantify the credit risk. The credit exposure is equal to the greater of the current replacement value of the outstanding contracts plus the expected maximum increase in value of the contract over the remaining life of the contract for a given confidence interval or zero. This potential exposure can be calculated using the Value-at-Risk techniques we discussed in an earlier article. If the sum of the current replacement value and the potential increase in value of the contract is negative, then we have no exposure to the counterparty from a credit perspective because we are obligated to make payments to them. Credit risk is simply the product of this calculated credit exposure and the estimated probability of default. One can see that there are a number of complicating factors implicit in this calculation of credit risk. First, as we have noted, it is difficult to measure default probabilities. Our estimation of the credit risk for a given contract is limited by the reliability of our default probability forecast. Second, credit exposure is an increasing function of time because of the potential increase in value of the contract. The longer a contract's maturity, the greater the credit risk involved. This is significant for derivatives, particularly in the case of swaps, because of their long tenor, typically. Third, as time passes and the counterparty makes cash flow payments to us on contracts with a positive value for us, the credit risk of the contract in terms of potential fluctuations in value is usually reduced. One example of a case where credit risk is not reduced even as time passes is the currency swap because of its exchange of principal. The principal exchange risk outweighs the reduction in credit risk from the payment of cash flows. Fourth, on structures with amortized payments, it is possible to have the credit risk "frontloaded" in which most of the cash flows can be structured to take place early on in the tenor of the swap. Fifth, when we sell an option to a counterparty, there is no credit risk from the transaction other than settlement risk. Selling an option obliges us to make cash flows to the counterparty either by buying or selling the underlying asset in the case of a put or a call, respectively. However, if the counterparty exercises a call by buying the underlying asset, they must still deliver the funds for the stock. This delivery risk is called settlement risk or Herstatt risk. Sixth, current positions may not represent future credit risks. That is why we must include the potential favourable change in value of the swap. A swap with zero value at inception does not have zero credit risk. It has credit risk from its potential value in the future. Credit enhancement and derivatives

Because credit risk is such a tremendous overhang in any relationship, banks and dealers have worked with lawyers to develop techniques that help mitigate the credit exposure inherent in derivatives transactions. First among these techniques is the concept of netting. Netting takes different forms, depending upon the institutions involved. Imagine DEF Bank and Flying Boats Incorporated. They have a number of outstanding interest rate swap contracts on the books, some of which involve cash flows on the same day. DEF and Flying Boats have a netting agreement in place that compels them to net the cash flows on any given delivery date into its root payment. For example, if on July 5, DEF must pay $400,000 to Flying Boats and Flying Boats must pay a total of $600,000 to DEF, the net payment would be a $200,000 payment from Flying Boats to DEF. Second, DEF may ask Flying Boats to put up some collateral against the market value of the swap. This is the same kind of concept as the margining that is used on the futures exchanges. Once the market value moves against Flying Boats past a pre-set threshold, Flying Boats agrees to either top up the collateral account or to close the contract. This limits the credit exposure. Third, DEF might ask Flying Boats to put up a third-party guarantee. In this case, Flying Boats must find some other counterparty that will guarantee to pay DEF the difference between the market value of the contract before and after a negative Flying Boats credit event. This is insurance against the credit risk of the contract that Flying Boats must pay for. These are just some of the more simple examples of credit enhancement techniques. Credit risk is a significant element of any derivatives transaction. Because of the significance of credit risk, dealers must account for it when they conduct swaps transactions with their counterparties. This may mean that they charge a greater swap spread when pricing the swap curve for a particular counterparty or it may mean that they place greater conditions on the transaction.

Q.3 What do you understand by industry (give examples)? What is importance of industry life cycle? Is it possible to asses the intrinsic value of security?
In order to engage in the competitive process accurately, you need to understand the nature of your industry. Some things to consider:

 The current trends What are the current trends in the industry? Is your company part of these trends? How long do you think the trends will last? Future trends Do you have any insight into the future trends? How long do you think those will last? Product development What do you know about your industrys product development and research trends and capabilities? How does your company fit in to these? How about your competition? Industry growth How is your industry growing? Is it growing or is it stagnating? What is the future growth? This information will help you understand not only how your company fits into the industry, but also your competition.

What is industry lifecycle? Like other living creatures, industry also has its circle of life. The industry lifecycle imitates the human lifecycle. The stages of industry lifecycle include fragmentation, shake-out, maturity and decline (Kotler 2003). These stages will be described in the followings section. What are the main aspects of industry lifecycle? Fragmentation Stage Fragmentation is the first stage of the new industry. This is the stage when the new industry develops the business. At this stage, the new industry normally arises when an entrepreneur overcomes the twin problems of innovation and invention, and works out how to bring the new products or services into the market (Ayres et al., 2003). For example, air travel services of major airlines in Europe were sold to the target market at a high price. Therefore, the majority of airlines' customers in Europe were those people with high incomes who could afford premium prices for faster travel. In 1985, Ryanair made a huge change in the European airline industry. Ryanair was the first airline to engage low-cost airlines in Europe. At that time, Ryanair's services were perceived as the innovation of the European airline industry (Le Bel, 2005). Ryanair tickets are half the price of British Airways. Some of its sales promotions were as low as 0.01. This made people think that air travel was not just made for the rich, but everybody (Haley & Tan 1999). Ryanair overcame the twin problems of innovation and invention in the airline industry by inventing air travel services that could serve passengers with tight budgets and those who just wanted to reach their destination without breaking their bank savings. Ryanair achieved this goal by eliminating unnecessary services offered by traditional airlines (Kaynak & Kucukemiroglu, 1993). It does not offer free meals, uses paper-free air tickets, gets rid of mile collecting scheme, utilises secondary airports, and offers frequent flights. These techniques help Ryanair save time and costs spent in airline business operation (Haley & Tan 1999).

Shake-out Shake-out is the second stage of the industry lifecycle. It is the stage at which a new industry emerges. During the shake-out stage, competitors start to realise business opportunities in the emerging industry. The value of the industry also quickly rises (Ayres et al., 2003). For example, many people die and suffer because of cigarettes every year. Thus, the UK government decided to launch a campaign to encourage people to quit smoking. Nicorette, one of the leading companies is producing several nicotine products to help people quit smoking. Some of its well-known products include Nicorette patches, Nicolette gums and Nicorette lozenges (Nicorette 2007). Smokers began to see an easy way to quit smoking. The new industry started to attract brand recognition and brand awareness among its target market during the shake-out stage (Hendrickson et al., 2006). Nicorette's products began to gain popularity among those who wanted to quit smoking or those who wanted to reduce their daily cigarette consumption. During this period, another company realised the opportunity in this market and decided to enter it by launching nicotine product ranges, including Nic Lite gum and patches. It recently went beyond UK boarder after the UK government introduced non-smoking policy in public places, including pubs and nightclubs. This business threat created a new business opportunity in the industry for Nic Lite to launch a new nicotine-related product called Nic Time (ABC News 2006). Nic Time is a whole new way for smokers to "get a cigarette" an eight-ounce bottle contains a lemon-flavoured drink laced with nicotine, the same amount of nicotine as two cigarettes (ABC News 2006). Nic Lite was first available at Los Angeles airports for smokers who got uneasy on flights, but now the nicotine soft drinks are available in some convenience stores (ABC News 2006).

Maturity Maturity is the third stage in the industry lifecycle. Maturity is a stage at which the efficiencies of the dominant business model give these organisations competitive advantage over competition (Kotler, 2003). The competition in the industry is rather aggressive because there are many competitors and product substitutes. Price, competition, and cooperation take on a complex form (Gottschalk & Saether, 2006). Some companies may shift some of the production overseas in order to gain competitive advantage. For example, Toyota is one of the world's leading multinational companies, selling automobiles to customers worldwide. The export and import taxes mean that its cars lose competitiveness to the local competitors, especially in the European automobile industry. As a result, Toyota decided to open a factory in the UK in order to produce cars and sell them to customers in the European market (Toyota, 2007). The haute couture fashion industry is another good example. There are many westernbranded fashion labels that manufacture their products overseas by cooperating with overseas partners, or they could seek foreign suppliers who specialise in particular materials

or items. For instance, Nike has factories in China and Thailand as both countries have cheap labour costs and cheap, quality materials, particularly rubber and fabric. However, their overseas partners are not allowed to sell shoes produced for Adidas and Nike (Harrison & Boyle, 2006). The items have to be shipped back to the US, and then will be exported to countries worldwide, including China and Thailand.

Decline Decline is the final stage of the industry lifecycle. Decline is a stage during which a war of slow destruction between businesses may develop and those with heavy bureaucracies may fail (Segil, 2005). In addition, the demand in the market may be fully satisfied or suppliers may be running out (Ayres et al., 2003). In the stage of decline, some companies may leave the industry if there is no demand for the products or services they provide, or they may develop new products or services that meet the demand in the market. In such cases, this will create a new industry (Francis & Desai, 2005). For example, at the beginning of the communication industry, pagers were used as the main communication method among people working in the same organisation, such as doctors and nurses. Then, the cutting edge of the communication industry emerged in the form of the mobile phone. The communication process of pagers could not be accomplished without telephones. To send a message to another pager, the user had to phone the call-centre staff who would type and send the message to another pager. On the other hand, people who use mobile phones can make a phone-call and send messages to other mobiles without going through call-centre staff (Hui et al., 2002). In recent years, the features of mobile phones have been developing rapidly and continually. Now people can use mobiles to send multimedia messages, take pictures, check email, surf the internet, read news and listen to music (Hui et al., 2002). As mobile phone feature development has reached saturation, thus the new innovation of mobile phone technology has incorporated the use of computers. The launch of personal digital assistants (PDA) is a good example of the decline stage of the mobile phone industry as the features of most mobiles are similar. PDAs are hand-held computers that were originally designed as a personal organiser but it become much more multi-faceted in recent years. PDAs are known as pocket computers or palmtop computers (Wikipedia, 2007). They have many uses for both mobile phones and computers such as computer games, global positioning system, video recording, typewriting and wireless widearea network (Wikipedia, 2007).

How do you use industry lifecycle analysis? It is important for companies to understand the use of the industry lifecycle because it is a survival tool for businesses to compete in the industry effectively and successfully (Baum & McGahan, 2004). The main aspects in terms of strategic issues of the industry lifecycle are described below:

Competing over emerging industries The game rules in industry competition can be undetermined and the resources may be constrained. Thus, it is vital for firms to identify market segments that will allow them to secure and sustain a strong position within the industry (Ayres et al., 2003). The product in the industry may not be standardised so it is necessary for companies to obtain resources needed to support new product development and rapid company expansion (Ayres et al., 2003). The entry barriers may be low and the potential competition may be high, thus companies must adapt to shift the mobility barriers (Ayres et al., 2003). Consumers may be uncertain in terms of demand. As a result, determining the time of entry to the industry can help companies to take business opportunities before their rivals (Ayres et al., 2003).

Competing during the transition to industry maturity When competition in the industry increases, firms can have a sustainable competitive advantage that will provide a basis for competing against other companies (Baum & McGahan, 2004). The new products and applications are harder to come by, while buyers become more sophisticated and difficult to understand in the maturity stage of the industry lifecycle. Thus, consumer research should be carried out and this could help companies in building up new product lines (Baum & McGahan, 2004). Slower industry growth constrains capacity growth and often leads to reduced industry profitability and some consolidation. Therefore, companies can focus greater attention on costs through strategic cost analysis (Baum & McGahan, 2004). The change in the industry is rather dynamic, and an understanding of the industry lifecycle can help companies to monitor and tackle these changes effectively (Baum & McGahan, 2004). Firms can develop organisational structures and systems that can facilitate the transition (Baum & McGahan, 2004). Some companies may seek business opportunities overseas when the industries reach the maturity stage because during this stage, the demand in the market starts to decline (Baum & McGahan, 2004).

Competing in declining industries The characteristics of declining industries include the following: Declining demand for products Pruning of product lines Shrinking profit margins Falling research and development advertisement expenditure Declining number of rivals as many are forced to leave the industry

For companies to survive the dynamic environment, it is necessary for them to: Measure the intensity of competition (Baum & McGahan, 2004) Assess the causes of decline (Baum & McGahan, 2004) Single out a viable strategy for decline such as leadership, liquidation and harvest (Baum & McGahan, 2004).

Where do you find information on the industry lifecycle? The information, model and theory for the industry lifecycle can be found in many business management books. Several variations of lifecycle model have been developed to address the development and transition of products, market and industry. The models are similar but the number and names of each stage can be different (Baum & McGahan, 2004). The following are some of the major models: Fox, 1973: Pre-commercialisation introduction, growth, maturity and decline Wasson, 1974: Market Development rapid growth, competitive turbulence, saturation/maturity and decline Anderson & Zeithaml, 1984: introduction, growth, maturity and decline Hill & Jones, 1998: fragmentation, growth, shake-out, maturity and decline

This article is about the valuation of financial assets. For the philosophy of economic value, see Intrinsic theory of value. In finance, intrinsic value refers to the value of a security which is intrinsic to or contained in the security itself. It is also frequently called fundamental value. It is ordinarily calculated by summing the future income generated by the asset, and discounting it to the present value. 1. The actual value of a security, as opposed to its market price or book value. The intrinsic value includes other variables such as brand name, trademarks, and copyrights that are often dificult to calculate and sometimes not accurately reflected in the market price. One way to look at it is that the market capitalization is the price (i.e. what investors are willing to pay for the company) and intrinsic value is the value (i.e. what the company is really worth). Different investors use different techniques to calculate intrinsic value. 2. The amount by which a call option is in the money, calculated by taking the difference between the strike price and the market price of the underlier. For example, if a call option for 100 shares has a strike price of $35 and the stock is trading at $50 a share than the call option has an intrinsic value of $15 share, or $1500. If the stock price is less than the strike price the call option has no intrinsic value. 3. The amount by which a put option is in the money, calculated by taking the difference between the strike price and the market price of the underlier. For example, if a put option for 100 shares has a strike price of $35 and the stock is trading at $20 a share than the put

option has an intrinsic value of $15 per share, or $1500. If the stock price is greater than the strike price the put option has no intrinsic value.

Q. 4 Is there any logic behind technical analysis? Explain meaning and basic tenets of technical analysis.
In finance, technical analysis is a security analysis discipline for forecasting the direction of prices through the study of past market data, primarily price and volume. What is Technical Analysis? Technical Analysis is the study of prices and volume, for forecasting of future stock price or financial price movements. Technical analysis does not result in absolute predictions about the future. Instead, technical analysis can help investors anticipate what is "likely" to happen to prices over time. Technical analysis is not an exact science. It's an art and takes considerable experience. Not all studies work the same for every instrument traded. One study may give excellent buy and sell signals while another may not work for you at all. Stock Market Technical Analysis Basic Principles Technical Analysis is based on these three basic principles: Price Discounts Everything Prices move in trends History repeats itself

#1- Price Discounts Everything Technical analysts believe that the current price fully reflects all information. Because all information is already reflected in the price, it represents the fair value, and should form the basis for analysis. After all, the market price reflects the sum knowledge of all participants, including traders, and ... Stock Market Technical analysis utilizes the information captured by the price to interpret what the market is saying with the purpose of forming a view on the future. #2- Prices Move in Trends Technical analysts or chartists believe that profits can be made by following the trends. In other words if the price has risen, they expect it to continue rising; if the price has fallen, they expect it to continue falling. However, most technicians also acknowledge that there are periods when prices do not trend.

#3- History Repeats Itself Technical analysts believe that investors repeat their behavior and they assume that there is useful information hidden within price histories; that it is a way of analyzing the past actions of people in a particular market as reflected by their actual transactions. Principles Behind Technical Analysis Technical analysis refers to methods that aim to predict future price movements in the financial market by using charts and qualitative methods. Different methods are utilized in technical analysis but they all rely on the same principles, like price patterns and price trends exist in the market that can be identified and exploited. Understanding the basic underlying principles of technical analysis will help you to trade with a complete ease.

Lets check out the basic principles behind technical analysis:

Price discounts everything. This means that the actual price is the reflection of all the components that is known to affect the market, including some of the major factors like fundamentals, supply & demand, political and economic factors. Pure technical analysis is mainly concerned with up and down price movements, not with the reasons for those changes. This is one of the major technical analysis principles.

Price move in trends One of the other principles behind technical analysis is the theory that price moves in a trend. Technical analysis is used to identify various patterns of the behavior of a market that are known to be significant. For many given patterns there is always a high probability of producing the expected results.

History tend to repeat itself The other principle of technical analysis is the fact that history always repeats itself. The basis that history repeats is the foundation of technical analysis, which is the analysis of historical data to forecast future movements. In the chart patterns, forex markets have been noted for more than fifty years, and from that it can be observed that human nature does not change a drastic extent for a long period of time. Various patterns in charts of different years are always repeated. Political and economic situations in a country may always repeat itself. Sometimes, a country may experience prosperity when it comes to its political and economic arena; while other times, it may experience a huge slump. All these factors may happen time and time again, and there is really no definite means of controlling it as so many other factors would affect it. The above mentioned technical analysis principles will help you to understand why currency prices are the way they are.

Q.5 Show with the help of an example how portfolio diversification reduces risk.
Ans: The aim of portfolio diversification is to reduce the risk which is inherent in owning individual securities. The investment specific risk is dependent upon the degree of correlation between movements in different holdings within the portfolio. For example, if an investor has experience of banking and is, relatively speaking, an expert on banking subjects, it would make sense to be invested in that sector. However, if our private investor only heldinvestment positions in banking companies and they were all in the same market (eg the US or UK) there would actually be very high risks associated with these investments. It is reasonable to expect most or all companies in a sector to move in the same directions, broadly in line with each other. Such an example would be called Positive Correlation. this means that the profits, fortunes and prices of companies move up and down together. They will probably be impacted by the same or similar events. However, if the fortunes and prices of companies move in different directions in reaction to the same news, they show a Negative Correlation. If many such companies can be held together, a large degree of portfolio diversification has probably been achieved. There are some companies whose values and profits show no relation whatsoever to each other. These can be described as having No Correlation. The most effective portfolio diversification will come from making investments that show negative correlation to each other. However, simply by investing in companies who show returns that are not correlated perfectly to each other, the risk in the portfolio will be lower than the associated risk of anyindividual stock. There is a limit to how many investments need to be held to reduce risk. Many studies have shown that an ideal number is between 15 and 20 holdings. Beyond this number, portfolio diversification does not appear to reduce the risk any further. Any further risk is likely to be market risk and cannot be removed by simply adding more holdings.

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

The general definition of yield is the return an investor will receive by holding a bond to maturity. So if you want to know what your bond investment will earn, you should know how to calculate yield. Required yield, on the other hand, is the yield or return a bond must offer in order for it to be worthwhile for the investor. The required yield of a bond is usually the yield offered by other plain vanilla bonds that are currently offered in the market and have similar credit quality and maturity. Once an investor has decided on the required yield, he or she must calculate the yield of a bond he or she wants to buy. Let's proceed and examine these calculations. Calculating Current Yield A simple yield calculation that is often used to calculate the yield on both bonds and the dividend yield for stocks is the current yield. The current yield calculates the percentage return that the annual coupon payment provides the investor. In other words, this yield calculates what percentage the actual dollar coupon payment is of the price the investor pays for the bond. The multiplication by 100 in the formulas below converts the decimal into a percentage, allowing us to see the percentage return:

So, if you purchased a bond with a par value of $100 for $95.92 and it paid a coupon rate of 5%, this is how you'd calculate its current yield:

Notice how this calculation does not include any capital gains or losses the investor would make if the bond were bought at a discount or premium. Because the comparison of the bond price to its par value is a factor that affects the actual current yield, the above formula would give a slightly inaccurate answer - unless of course the investor pays par value for the bond. To correct this, investors can modify the current yield formula by adding the result of the current yield to the gain or loss the price gives the investor: [(Par Value Bond Price)/Years to Maturity]. The modified current yield formula then takes into account the discount or premium at which the investor bought the bond. This is the full calculation:

One thing to note, however, is whether you buy the bond between coupon payments. If you do, remember to use the dirty price in place of the market price in the above equation. The dirty price is what you will actually pay for the bond, but usually the figure quoted in U.S. markets is the clean price. Now we must also account for other factors such as the coupon payment for a zero-coupon bond, which has only one coupon payment. For such a bond, the yield calculation would be

as follows:

n = years left until maturity

If we were considering a zero-coupon bond that has a future value of $1,000 that matures in two years and can be currently purchased for $925, we would calculate its current yield with the following formula:

Calculating Yield to Maturity The current yield calculation we learned above shows us the return the annual coupon payment gives the investor, but this percentage does not take into account the time value of money or, more specifically, the present value of the coupon payments the investor will receive in the future. For this reason, when investors and analysts refer to yield, they are most often referring to the yield to maturity (YTM), which is the interest rate by which the present values of all the future cash flows are equal to the bond's price. An easy way to think of YTM is to consider it the resulting interest rate the investor receives if he or she invests all of his or her cash flows (coupons payments) at a constant interest rate until the bond matures. YTM is the return the investor will receive from his or her entire investment. It is the return that an investor gains by receiving the present values of the coupon payments, the par value and capital gains in relation to the price that is paid. The yield to maturity, however, is an interest rate that must be calculated through trial and error. Such a method of valuation is complicated and can be time consuming, so investors (whether professional or private) will typically use a financial calculator or program that is quickly able to run through the process of trial and error. If you don't have such a program, you can use an approximation method that does not require any serious mathematics. To demonstrate this method, we first need to review the relationship between a bond's price and its yield. In general, as a bond's price increases, yield decreases. This relationship is measured using the price value of a basis point(PVBP). By taking into account factors such as the bond's coupon rate and credit rating, the PVBP measures the degree to which a bond's price will change when there is a 0.01% change in interest rates.

The charted relationship between bond price and required yield appears as a negative curve. This is due to the fact that a bond's price will be higher when it pays a coupon that is higher than prevailing interest rates. As market interest rates increase, bond prices decrease. The second concept we need to review is the basic price-yield properties of bonds:

Premium bond: Coupon rate is greater than market interest rates. Discount bond: Coupon rate is less than market interest rates.

Thirdly, remember to think of YTM as the yield a bondholder receives if he or she reinvested all coupons received at a constant interest rate, which is the interest rate that we are solving for. If we were to add the present values of all future cash flows, we would end up with the market value or purchase price of the bond. The calculation can be presented as:

OR

Example 1: You hold a bond whose par value is $100 but has a current yield of 5.21% because the bond is priced at $95.92. The bond matures in 30 months and pays a semiannual coupon of 5%. 1. Determine the Cash Flows: Every six months you would receive a coupon payment of $2.50 (0.025*100). In total, you would receive five payments of $2.50, plus the future value of $100. 2. Plug the Known Amounts into the YTM Formula: Remember that we are trying to find the semi-annual interest rate, as the bond pays the coupon semi-annually.

3. Guess and Check: Now for the tough part: solving for i, or the interest rate. Rather than pick random numbers, we can start by considering the relationship between bond price and yield. When a bond is priced at par, the interest rate is equal to the coupon rate. If the bond is priced above par (at a premium), the coupon rate is greater than the interest rate. In our case, the bond is priced at a discount from par, so the annual interest rate we are seeking (like the current yield) must be greater than the coupon rate of 5%. Now that we know this, we can calculate a number of bond prices by plugging various annual interest rates that are higher than 5% into the above formula. Here is a table of the bond prices that result from a few different interest rates:

Because our bond price is $95.92, our list shows that the interest rate we are solving for is between 6%, which gives a price of $95, and 7%, which gives a price of $98. Now that we have found a range between which the interest rate lies, we can make another table showing the prices that result from a series of interest rates that go up in increments of 0.1% instead of 1.0%. Below we see the bond prices that result from various interest rates that are between 6.0% and 7.0%:

We see then that the present value of our bond (the price) is equal to $95.92 when we have an interest rate of 6.8%. If at this point we did not find that 6.8% gives us the exact price that we are paying for the bond, we would have to make another table that shows the interest rates in 0.01% increments. You can see why investors prefer to use special programs to narrow down the interest rates - the calculations required to find YTM can be quite numerous! Calculating Yield for Callable and Puttable Bonds Bonds with callable or puttable redemption features have additional yield calculations. A callable bond's valuations must account for the issuer's ability to call the bond on the call date and the puttable bond's valuation must include the buyer's ability to sell the bond at the pre-specified put date. The yield for callable bonds is referred to as yield-to-call, and the yield for puttable bonds is referred to as yield-to-put.

Yield to call (YTC) is the interest rate that investors would receive if they held the bond until the call date. The period until the first call is referred to as the call protection period. Yield to call is the rate that would make the bond's present value equal to the full price of the bond. Essentially, its calculation requires two simple modifications to the yield-to-maturity formula:

Note that European callable bonds can have multiple call dates and that a yield to call can be calculated for each. Yield to put (YTP) is the interest rate that investors would receive if they held the bond until its put date. To calculate yield to put, the same modified equation for yield to call is used except the bond put price replaces the bond call value and the time until put date replaces the time until call date. For both callable and puttable bonds, astute investors will compute both yield and all yieldto-call/yield-to-put figures for a particular bond, and then use these figures to estimate the expected yield. The lowest yield calculated is known as yield to worst, which is commonly used by conservative investors when calculating their expected yield. Unfortunately, these yield figures do not account for bonds that are not redeemed or are sold prior to the call or put date.

Bond valuation is the act of determining the fair price of a bond. As with any security or capital investment, the theoretical fair value of a bond is the present value of the stream of cash flows it is expected to generate. Hence, the value of a bond is obtained by discounting the bond's expected cash flows to the present using the appropriate discount rate. Determining this rate in practice - i.e. "pricing" the bond - is done with reference to other instruments. Once the price or value has been calculated, the sensitivity of the price can then be estimated; the various yields, which relate the price of the bond to its coupons, can also be determined. When the bond includes embedded options, the valuation is more specialized and combines option pricing with the cash flow based approach. Depending on the option as embedded, the option price as calculated is either added to or subtracted from the price of the "straight" portion. This total is then the value of the bond; the various yields can then be calculated for the total price.

Present value relationship

Here is the formula for calculating a bond's price, which uses the basic present value (PV) formula: F = face value iF = contractual interest rate C = F * iF = coupon payment (periodic interest payment) N = number of payments i = market interest rate, or required yield M = value at maturity, usually equals face value P = market price of bond

If the market price of bond is less than its face value (par value), bond is selling at a discount. Conversely, if the market price of bond is greater than its face value, bond is selling at a premium. In accounting for liabilities, bond discount or bond premium are amortized over the life of bond. Amortization amount in each period is calculated from the following formula: n = {0,1,..., N-1} an + 1 = amortization amount in period number "n+1" an + 1 = | iP C | (1 + i)n Bond Discount or Bond Premium = | F P | = a1 + a2 + ... + aN Bond Discount or Bond Premium =

With Respect to Different Interest Rate Model

The following partial differential is satisfied by any zero-coupon bond:-

Given a zero-coupon bond, the solution to the bond PDE is

where E*t is the expectation with respect to risk-neutral probabilities, and R(t,T) is the random variable for the interest rate to be integrated over time. When the bond is not valued precisely on a coupon date, the present value relationship as above, will incorporate accrued interest: i.e. any interest due to the owner of the bond since the previous coupon date; see day count convention. The price of a bond which includes this accrued interest is known as the "dirty price"; the "clean price" is the price excluding any interest that has accrued. The value returned by the above formula is thus the dirty price. Clean prices are generally more stable over time than dirty prices. This is because clean prices change for economic reasons ( for instance a change in interest rates or in the bond issuer's credit quality), whereas dirty prices change day to day depending on where the current date is in relation to the coupon dates, in addition to any economic reasons. It is market practice to quote bonds on a clean-price basis. When a bond settles the accrued interest is added to the value based on the clean price to reflect the full market value. Under this approach, the bond will be priced relative to a benchmark, usually a government security; Here, the yield to maturity on the bond is determined based on the bond's Credit rating relative to a government security with similar maturity or duration. The better the quality of the bond, the smaller the spread between its required return and the YTM of the benchmark. This required return is then used to discount the bond cash flows as above to obtain the price. he yield to maturity is the discount rate which returns the market price of the bond; it is identical to r (required return) in the above equation. YTM is thus the internal rate of return of an investment in the bond made at the observed price. Since YTM can be used to price a bond, bond prices are often quoted in terms of YTM.

To achieve a return equal to YTM, i.e. where it is the required return on the bond, the bond owner must: buy the bond at price P0, hold the bond until maturity, and redeem the bond at par.

Under this approach, the bond price will reflect its arbitrage-free price. Here, each cash flow (coupon or face) is separately discounted at the same rate as a zero-coupon bond corresponding to the coupon date, and of equivalent credit worthiness (if possible, from the same issuer as the bond being valued, or if not, with the appropriate credit spread). Here, in general, we apply the rational pricing logic relating to "Assets with identical cash flows". In detail: (1) the bond's coupon dates and coupon amounts are known with certainty. Therefore (2) some multiple (or fraction) of zero-coupon bonds, each corresponding to the bond's coupon dates, can be specified so as to produce identical cash flows to the bond. Thus (3) the bond price today must be equal to the sum of each of its cash flows discounted at the discount rate implied by the value of the corresponding ZCB. Were this not the case, (4) the abitrageur could finance his purchase of whichever of the bond or the sum of the various ZCBs was cheaper, by short selling the other, and meeting his cash flow commitments using the coupons or maturing zeroes as appropriate. Then (5) his "risk free", arbitrage profit would be the difference between the two values.

Coupon yield
The coupon yield is simply the coupon payment (C) as a percentage of the face value (F). Coupon yield = C / F Coupon yield is also called nominal yield.

Current yield
The current yield is simply the coupon payment (C) as a percentage of the (current) bond price (P). Current yield = C / P0.

Relationship
The concept of current yield is closely related to other bond concepts, including yield to maturity, and coupon yield. The relationship between yield to maturity and the coupon rate is as follows: When a bond sells at a discount, YTM > current yield > coupon yield. When a bond sells at a premium, coupon yield > current yield > YTM. When a bond sells at par, YTM = current yield = coupon yield amt

PRICE SENSITIVITY
The sensitivity of a bond's market price to interest rate (i.e. yield) movements is measured by its duration, and, additionally, by its convexity.

Duration is a linear measure of how the price of a bond changes in response to interest rate changes. It is approximately equal to the percentage change in price for a given change in yield, and may be thought of as the elasticity of the bond's price with respect to interest rates. For example, for small interest rate changes, the duration is the approximate percentage by which the value of the bond will fall for a 1% per annum increase in market interest rate. So a 15-year bond with a duration of 7 would fall approximately 7% in value if the interest rate increased by 1% per annum. Convexity is a measure of the "curvature" of price changes, and is thus a complement to duration. The necessity for this additional measure arises since, as mentioned, duration is a linear measure, whereas, in reality, as interest rates change, the price is a convex function of interest rates. (Specifically, duration can be formulated as the first derivative of the price function with respect to the interest rate, and convexity as the second derivative; see Bond duration closed-form formula; Bond convexity closed-form formula). Continuing the above example, for a more accurate estimate of sensitivity, the convexity score would be added to the value of 7 for duration.

Q. 1 Explain basic steps involved in PM. What is difference between PM and a Mutual Fund? What are various types of risk associated with PM?
Project management is the discipline of planning, organizing, securing and managing resources to bring about the successful completion of specific engineering project goals and objectives. It is sometimes conflated with program management, however technically that is actually a higher level construction: a group of related and somehow interdependent engineering projects. A project is a temporary endeavor, having a defined beginning and end (usually constrained by date, but can be by funding or deliverables), undertaken to meet unique goals and objectives, usually to bring about beneficial change or added value. The temporary nature of projects stands in contrast to business as usual (or operations), which are repetitive, permanent or semi-permanent functional work to produce products or services. In practice, the management of these two systems is often found to be quite different, and as such requires the development of distinct technical skills and the adoption of separate management. The primary challenge of project management is to achieve all of the engineering project goals and objectives while honoring the preconceived project constraints. Typical constraints are scope, time, and budget. The secondaryand more ambitiouschallenge is to optimize the allocation and integration of inputs necessary to meet pre-defined objectives. Project management has been practiced since early civilization. Until 1900 civil engineering projects were generally managed by creative architects and engineers themselves, among those for example Vitruvius (1st century BC), Christopher Wren (16321723) , Thomas Telford(17571834) and Isambard Kingdom Brunel (18061859). It was in the 1950s that organizations started to systematically apply project management tools and techniques to complex engineering projects. Henry Gantt (1861-1919), the father of planning and control techniques. As a discipline, Project Management developed from several fields of application including civil construction, engineering, and heavy defense activity. Two forefathers of project management are Henry Gantt, called the father of planning and control techniques, who is famous for his use of the Gantt chart as a project management tool; and Henri Fayol for his creation of the 5 management functions which form the foundation of the body of knowledge associated with project and program management. Both Gantt and Fayol were students of Frederick Winslow Taylor's theories of scientific management. His work is the forerunner to modern project management tools including work breakdown structure (WBS) and resource allocation. The 1950s marked the beginning of the modern Project Management era where core engineering fields come together working as one. Project management became recognized as a distinct discipline arising from the management discipline with engineering model. In

the United States, prior to the 1950s, projects were managed on an ad hoc basis using mostly Gantt Charts, and informal techniques and tools. At that time, two mathematical project-scheduling models were developed. The "Critical Path Method" (CPM) was developed as a joint venture between DuPont Corporation and Remington Rand Corporation for managing plant maintenance projects. And the "Program Evaluation and Review Technique" or PERT, was developed by Booz Allen Hamilton as part of the United States Navy's (in conjunction with the Lockheed Corporation) Polaris missile submarine program; These mathematical techniques quickly spread into many private enterprises.

PERT network chart for a seven-month project with five milestones At the same time, as project-scheduling models were being developed, technology for project cost estimating, cost management, and engineering economics was evolving, with pioneering work by Hans Lang and others. In 1956, the American Association of Cost Engineers (now AACE International; the Association for the Advancement of Cost Engineering) was formed by early practitioners of project management and the associated specialties of planning and scheduling, cost estimating, and cost/schedule control (project control). AACE continued its pioneering work and in 2006 released the first integrated process for portfolio, program and project management (Total Cost Management Framework). The International Project Management Association (IPMA) was founded in Europe in 1967, as a federation of several national project management associations. IPMA maintains its federal structure today and now includes member associations on every continent except Antarctica. IPMA offers a Four Level Certification program based on the IPMA Competence Baseline (ICB). The ICB covers technical competences, contextual competences, and behavioral competences. In 1969, the Project Management Institute (PMI) was formed in the USA. PMI publishes A Guide to the Project Management Body of Knowledge (PMBOK Guide), which describes project management practices that are common to "most projects, most of the time." PMI also offers multiple certifications. The American Academy of Project Management (AAPM) International Board of Standards 1996 was the first to institute post-graduate certifications such as the MPM Master Project Manager, PME Project Management E-Business, CEC Certified-Ecommerce Consultant, and CIPM Certified International Project Manager. The AAPM also issues the post-graduate standards body of knowledge for executives. There are a number of approaches to managing project activities including agile, interactive, incremental, and phased approaches.

Regardless of the methodology employed, careful consideration must be given to the overall project objectives, timeline, and cost, as well as the roles and responsibilities of all participants and stakeholders. The traditional approach A traditional phased approach identifies a sequence of steps to be completed. In the "traditional approach", we can distinguish 5 components of a project (4 stages plus control) in the development of a project:

Typical development phases of an engineering project Project initiation stage Project planning and design stage Project execution and construction stage Project monitoring and controlling systems Project completion

Not all the projects will visit every stage as projects can be terminated before they reach completion. Some projects do not follow a structured planning and/or monitoring stages. Some projects will go through steps 2, 3 and 4 multiple times. Many industries use variations on these project stages. For example, when working on a brick and mortar design and construction, projects will typically progress through stages like Pre-Planning, Conceptual Design, Schematic Design, Design Development, Construction Drawings (or Contract Documents), and Construction Administration. In software development, this approach is often known as the waterfall model, i.e., one series of tasks after another in linear sequence. In software development many organizations have adapted the Rational Unified Process (RUP) to fit this methodology, although RUP does not require or explicitly recommend this practice. Waterfall development works well for small, well defined projects, but often fails in larger projects of undefined and ambiguous nature. The Cone of Uncertainty explains some of this as the planning made on the initial phase of the project suffers from a high degree of uncertainty. This becomes especially true as software development is often the realization of a new or novel product. In projects where requirements have not been finalized and can change, requirements management is used to develop an accurate and complete definition of the behavior of software that can serve as the basis for software development. While the terms may differ from industry to industry, the actual stages typically follow common steps to problem solving "defining the problem, weighing options, choosing a path, implementation and evaluation." ETF is a basket of stocks that never changes and can be sold at any time during market hours.Example: a technology ETF might contain Apple, Cisco, Microsoft, Google, IBMetc.

A Mutual Fund has a financial manager at the helm.who makes portfolio decisions on your behalf. He/she buys a basket of diversified stocks on your behalf. The sum of the portfolio can be bought and sold only on a daily basis.at the closing NAV price. (not throughout the market day like ETFs). The portfolio changes all the time. Advantages of ETFs are that the basket of stocks is not being bought and sold. You buy the ETF (basket)the stocks stay in it and you decide when to sell. Disadvantage: You have to actively watch the ETF.when to buy or sell is up to you.you are responsible. Advantage of Mutual Funda manager makes the buy/sell decisions for you. You just buy it and rely on them. Disadvantage: You are relying on the managers expertise and will sink or swim with their buy/sell decisions. Commercial enterprises apply various forms of risk management procedures to handle different risks because they face a variety of risks while carrying out their business operations. Effective handling of risk ensures the successful growth of an organization.

Various types of risk management can be categorized into the following: Operational risk management: Operational risk management deals with technical failures and human errors Financial risk management: Financial risk management handles non-payment of clients and increased rate of interest Market risk management: Deals with different types of market risk, such as interest rate risk, equity risk, commodity risk, and currency risk Credit risk management: Deals with the risk related to the probability of nonpayment from the debtors Quantitative risk management: In quantitative risk management, an effort is carried out to numerically ascertain the possibilities of the different adverse financial circumstances to handle the degree of loss that might occur from those circumstances Commodity risk management: Handles different types of commodity risks, such as price risk, political risk, quantity risk and cost risk Bank risk management: Deals with the handling of different types of risks faced by the banks, for example, market risk, credit risk, liquidity risk, legal risk, operational risk and reputational risk Nonprofit risk management: This is a process where risk management companies offer risk management services on a non-profit seeking basis Currency risk management: Deals with changes in currency prices Enterprise risk management: Handles the risks faced by enterprises in accomplishing their goals Project risk management: Deals with particular risks associated with the undertaking of a project

 Integrated risk management: Integrated risk management refers to integrating risk data into the strategic decision making of a company and taking decisions, which take into account the set risk tolerance degrees of a department. In other words, it is the supervision of market, credit, and liquidity risk at the same time or on a simultaneous basis. Technology risk management: It is the process of managing the risks associated with implementation of new technology Software risk management: Deals with different types of risks associated with implementation of new softwares

Q. 2 Explain with the help of example how is it possible to reduce risk associated with portfolio with the help of diversification. Which risk are still bound to persist?
Theres a real temptation to push your product out onto the market and wing it from there. That approach succeeds just often enough to keep us doing it. But the successes are all that we see, most failures are quick, quiet, and invisible. If we saw them as clearly as we see the successes, wed be a lot more thoughtful and prepared in releasing a new product. Sun Tzu, in his fourth chapter, talks about how the general must control the situation before conflict starts. Unless the general understands both his own strategy and that of his enemy, his approach to battle is in doubt before it is even begun. First, carefully build a strong position while looking for weakness in the competition. There is no point in bringing a product to market unless it can stand on its own merits. It must be compelling enough to convince customers to spend money on it. Having defined the products attributes and strengths, you can then examine the competition to see if there are weak areas that can be exploited. A CEO is responsible for the companys strength; competitors, for their own weaknesses. You can make your company strong, but cannot make competitors weak. You can control (or at least influence) research, product development, and marketing in your own company. However, you have much less influence over the competition and cannot count on them being worse than they actually are. Indeed, there is a strong and dangerous temptation within a firm to underestimate the competition, to assume that theyll make the wrong moves or that they dont understand all that you do. This usually results in a series of unpleasant surprises as the competition does exactly the right things necessary to counter or undermine your efforts. You may even see how to succeed without being able to do so.

Put simply, a brilliant and/or superior product can fail if the competition is just too strong. It can also fail if the customers dont need or want it: look at what happened to the slide-rule market after the introduction of calculators, or the vinyl record industry after the introduction of compact discs. A defensive posture is for protecting market share and during times of weakness; an aggressive approach is for direct competition during times of strength. You maintain market share by convincing your customers that your product is superior (or at least good enough) and that the costs and risks of adopting a competing product are too high. You enter a defensive, entrenching posture when pressed by a competitor with a superior product, superior marketing or both, or when your company is having significant problems. The danger: if you are perceived as being in a defensive posture, the market will interpret it as a sign of weakness and instability, and it may further erode your position. You gain market share by attacking competing products and convincing the customer that the costs and risks of choosing (or staying with) a competing product are too high, or that the costs and risks of adopting or trying your product are low. When you have the upper hand in terms of product and marketing, you can choose your course and compel the competition to react accordingly. In the game of Go, this is known as sente: your opponent must respond to each move you make, leaving you free to choose each new move. Entrench the product so as to resist all attacks; view the market from a high level, rapidly moving into new market opportunities as you see them. By doing this, you can protect the company while gaining market share. There are two parts to this approach. First, you need to focus on defending your market share against all comers. Look for ways to so entrench your product and technology with customers that they will resist all competing solutions. The classic examples of this approach are IBM (mainframes in the 1960s), Microsoft (operating systems and applications in the 1990s), and Apple (digital music in the 2000s). Second, you need to be looking for additional opportunities. New market segments and niches open up on a regular basis, and its often a while before anyone notices. Keep thinking of new ways to apply existing technology, or new technologies that can be developed to coincide with the opening of a future market. IBM pretty much failed at this and Microsoft now appears to be failing as well; time will tell whether Apple can avoid their mistakes. Many successful companies have done so with such apparent ease that their achievements are downplayed. The CEOs of such firms are seldom credited with skill, brilliance, or courage. Still, their successes are not by accident or luck. they set things up to succeed before they ever competed, and they found ways ahead of time to make their competitors fail.

We forget how many pundits and industry analysts considered the iPod dead on arrival after its announcement by Apple in October 2001. Yet by the end of Q1 2007, Apple had sold over 100 million iPods and over 2.5 billion songs via its iTunes store, driving Apple stock to an all-time high. Likewise, many previous successes of the computer industry the Apple II, VisiCalc, MSDOS, Lotus 1-2-3, Turbo Pascal, dBase, WordPerfect, Windows, MS Office are dismissed as being due to luck or just filling the right need at the right time. Yet those who succeeded had what it took to be in that right place at that right time with the right product. Witness the number of people and firms who had similar opportunities and did not succeed. A successful company first sets up the conditions for success, then goes into the marketplace; and unsuccessful company dives into the marketplace, then tries to determine what it must do to succeed. Often a tremendous amount of time and money is poured into a product development, and it is only after the product has been launched that you try to find customers. At that point, you discover what it is that customers really wanted, which often is something quite different from what you developed. Product launch is then followed by product revisions and repositioning in an effort to gain acceptance and sales, and that is often followed by downsizing, assimilation, and evaporation. The entire history of the original pen computing market, with tens of millions of dollars poured into Momento, Go, EO, and others, bears eloquent witness of the dangers of building a product with no customers. A much better approach is to ensure that customers will want what you have to sell before your product is ever released. That is not as easy as it sounds, because what customers say they want is often quite different from what they are willing to adopt and buy. Furthermore, if youre selling a large organization, you often have to satisfy different people with different desires and expectations. User wants something more convenient and powerful, but not that different from what theyre currently using. Managers want something that will improve that bottom line. Information systems (IS) people dont want anything new or different unless its completely compatible with existing solutions. Those skilled in product development and marketing cultivate Tao and build their company upon strong principles. That way, they succeed where companies looking for shortcuts fail. In the technology industries, the half-life of the products, concepts, and technologies is short, as noted elsewhere, the distance from the leading edge to the trailing edge is getting smaller. Because of that, it is important build a team that can adapt and compete as it to build products. It is still critical to build products; think tank companies seldom make a decent return on investment. But the customers themselves are a moving target, so it is likewise critical that you build a teams that can do course corrections in the middle of product development without bickering, starting turf wars, or losing significant time. There are five keys to successful product development and marketing: Measurement of market size, both current and potential; The trick here is not deceive yourself or to be deceived by overly optimistic predictions of the market size. May CEOs look at vast markets out there (installed PCs, houses wired for

cable, etc.) and play the 5% game: If we capture just 5% of the market, well be successful! Market share isnt based solely on the number of possible customers for your product: thats merely the upper limit. The lower limit can be pretty small indeed close to zero in many cases. Market projections must be based on bottom-up projections, not on some hypothetical percentage of the total market. Assessment of competing products and likely market share; Several questions help you to further lower the upper bound on potential market share. First, how many people have a need or desire for the solution you offer? Second, what percentage of those do not yet have an acceptable solution (such as a competing product)? Third, what percentage of those have the money to purchase your product? Fourth, what percentage of those would rather spend that money on your product than on any of the other myriad things they could buy with it, especially competing products? Calculations of cash flow, capital and return on investment; You can have significant success in the marketplace and still lose money: it just depends on whether you spend more or less money than you bring in. (Car makers demonstrate this all the time, as do various divisions of IBM.) You can make a profit and still not have enough capital to do further development and marketing. You can make a profit, grow the company, and still never create an acceptable return on the initial and subsequent investments. Comparisons of different market approaches; There are various ways of marketing a given product. Success lies in knowing or discovering what they might be, in evaluating feasibility and potential results, and in choosing one or more approaches that will work. Success in product releases. The issue affecting the bottom line is product acceptance upon release. Many companies with promising technology have stumbled or even failed because of slow market penetration. Also, you only get one chance to make a first impression. The reputation that a product gets on initial release, deserved or not, can linger for years. Witness Apples stumble with the Newton hand-held computer, or Microsofts current woes with Windows Vista. Success comes from accurate comparisons, which come from accurate calculations, which come from accurate assessments, which come from accurate data, which comes from accurate market research. The same data, more or less, is out there for everyone. Success comes from gathering accurate information, interpreting it, making plans based on it, and choosing from among those plans. There is a dangerous temptation to make self-serving assumptions in this process; reality will always intrude, sooner or later, and its usually unpleasant when it happens. Thus, a successful company compares to an unsuccessful one like a boulder colliding with tumbleweed. When factors are lined up correctly beforehand, the successful company bursts into the marketplace like a flash flood.

A successful company can push through problems and obstacles, using its momentum and resources to carry it past the rough spots. An unsuccessful company gets hung up, blocked, or diverted easily. Evaluation, coordination, cooperation, and timing are all essential. To make all factors mesh is difficult and rare, or else everyone would do it. Again, it is the responsibility of the CEO to that that it happens, but it is the responsibility of everyone else in the company to see that it works.

Q.3 With the help of examples explain what is systematic (also called systemic) and unsystematic risk? All said and done CAPM is not perfect , do you agree?
In finance, systematic risk, sometimes called market risk, aggregate risk, or undiversifiable risk, is the risk associated with aggregate market returns. By contrast, unsystematic risk, sometimes called specific risk, idiosyncratic risk, residual risk, or diversifiable risk, is the company-specific or industry-specific risk in a portfolio, which is uncorrelated with aggregate market returns. Unsystematic risk can be mitigated through diversification, and systematic risk can not be. Systematic risk should not be confused with systemic risk, the risk of loss from some catastrophic event that collapses the entire financial system. Example For example, consider an individual investor who purchases $10,000 of stock in 10 biotechnology companies. If unforeseen events cause a catastrophic setback and one or two companies' stock prices drop, the investor incurs a loss. On the other hand, an investor who purchases $100,000 in a single biotechnology company would incur ten times the loss from such an event. The second investor's portfolio has more unsystematic risk than the diversified portfolio. Finally, if the setback were to affect the entire industry instead, the investors would incur similar losses, due to systematic risk. Systematic risk is essentially dependent on macroeconomic factors such as inflation, interest rates and so on. It may also derive from the structure and dynamics of the market. Systematic risk and portfolio management Given diversified holdings of assets, an investor's exposure to unsystematic risk from any particular asset is small and uncorrelated with the rest of the portfolio. Hence, the contribution of unsystematic risk to the riskiness of the portfolio as a whole may become negligible.

In the capital asset pricing model, the rate of return required for an asset in market equilibrium depends on the systematic risk associated with returns on the asset, that is, on the covariance of the returns on the asset and the aggregate returns to the market. Lenders to small numbers of borrowers (or kinds of borrowers) face unsystematic risk of default. Their loss due to default is credit risk, the unsystematic portion of which is concentration risk. What Does Systematic Risk Mean? The risk inherent to the entire market or entire market segment. Also known as "un-diversifiable risk" or "market risk." Investopedia explains Systematic Risk Interest rates, recession and wars all represent sources of systematic risk because they affect the entire market and cannot be avoided through diversification. Whereas this type of risk affects a broad range of securities, unsystematic risk affects a very specific group of securities or an individual security. Systematic risk can be mitigated only by being hedged.

MF0010 [Security Analysis and Portfolio Management] Set2 Q4

Q. 4 What do you understand by arbitrage? Make a critical comparison between APT & CAPM.
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 such as a bank or brokerage firm. The term is mainly applied to trading in financial instruments, such as bonds, stocks, derivatives, commodities and currencies.

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 for securities).

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

Examples

 Suppose that the exchange rates (after taking out the fees for making the exchange) in London are 5 = $10 = 1000 and the exchange rates in Tokyo are 1000 = $12 = 6. Converting 1000 to $12 in Tokyo and converting that $12 into 1200 in London, for a profit of 200, would be arbitrage. In reality, this "triangle arbitrage" is so simple that it almost never occurs. But more complicated foreign exchange arbitrages, such as the spotforward arbitrage are much more common. One example of arbitrage involves the New York Stock Exchange and the Chicago Mercantile Exchange. When the price of a stock on the NYSE and its corresponding futures contract on the CME are out of sync, one can buy the less expensive one and sell it to the more expensive market. Because the differences between the prices are likely to be small (and not to last very long), this can only be done profitably with computers examining a large number of prices and automatically exercising a trade when the prices are far enough out of balance. The activity of other arbitrageurs can make this risky. Those with the fastest computers and the most expertise take advantage of series of small differences that would not be profitable if taken individually. Economists use the term "global labor arbitrage" to refer to the tendency of manufacturing jobs to flow towards whichever country has the lowest wages per unit output at present and has reached the minimum requisite level of political and economic development to support industrialization. At present, many such jobs appear to be flowing towards China, though some which require command of English are going to India and the Philippines. In popular terms, this is referred to as offshoring. (Note that "offshoring" is not synonymous with "outsourcing", which means "to subcontract from an outside supplier or source", such as when a business outsources its bookkeeping to an accounting firm. Unlike offshoring, outsourcing always involves subcontracting jobs to a different company, and that company can be in the same country as the outsourcing company.) Sports arbitrage numerous internet bookmakers offer odds on the outcome of the same event. Any given bookmaker will weight their odds so that no one customer can cover all outcomes at a profit against their books. However, in order to remain competitive their margins are usually quite low. Different bookmakers may offer different odds on the same outcome of a given event; by taking the best odds offered by each bookmaker, a customer can under some circumstances cover all possible outcomes of the event and lock a small risk-free profit, known as a Dutch book. This profit would typically be between 1% and 5% but can be much higher. One problem with sports arbitrage is that bookmakers sometimes make mistakes and this can lead to an invocation of the 'palpable error' rule, which most bookmakers invoke when they have made a mistake by offering or posting incorrect odds. As bookmakers become more proficient, the odds of making an 'arb' usually last for less than an hour and typically only a few minutes. Furthermore, huge bets on one side of the market also alert the bookies to correct the market. Exchange-traded fund arbitrage Exchange Traded Funds allow authorized participants to exchange back and forth between shares in underlying securities held by the fund and shares in the fund itself, rather than allowing the buying and selling of shares in the ETF directly with the fund sponsor. ETFs trade in the open market, with prices set by market demand. An ETF may trade at a premium or discount to the value of the underlying assets. When a significant enough premium appears, an arbitrageur will buy the underlying securities, convert them to shares in the ETF, and sell them in the open market. When a discount appears, an arbitrageur will do the reverse. In this way, the arbitrageur makes a low-risk profit, while fulfilling a useful function in the ETF marketplace by keeping ETF prices in line with their underlying value. Some types of hedge funds make use of a modified form of arbitrage to profit. Rather than exploiting price differences between identical assets, they will purchase and sell securities,assets and derivatives with similar characteristics, and hedge any significant differences between the two assets. Any difference between the hedged positions

represents any remaining risk (such as basis risk) plus profit; the belief is that there remains some difference which, even after hedging most risk, represents pure profit. For example, a fund may see that there is a substantial difference between U.S. dollar debt and local currency debt of a foreign country, and enter into a series of matching trades (including currency swaps) to arbitrage the difference, while simultaneously entering into credit default swaps to protect against country risk and other types of specific risk. The CAPM is a theory about the way how assets are priced in relation to their risk. The CAPM was brought about to answer the question which came from Markowitzs meanvariance portfolio model. The question was how to identify tangency portfolio. Since then, the CAPM has developed into much, much more. CAPM shows that equilibrium rates of return on all risky assets are a function of their covariance with market portfolio. APT is another equilibrium pricing model. The return on any risky asset is seen to be a linear combination of various common factors that affect asset returns. These two models in fact are similar to each other in some way.

CAPM Assumptions: Investors are risk averse individuals and they maximise their expected utility of their end of period wealth. They have the same one period of time horizon. Investors are price takers (no single investor can affect the price of a stock) and have homogenous expectation about asset returns that have a joint normal distribution. Investors can borrow or lend money at the risk-free rate of return. The quantities of assets are fixed. All assets are marketable and perfectly divisible.

Asset markets are frictionless and information is costless and simultaneously available to all investors. There are no market imperfections such as taxes, no transaction costs or no restrictions on short selling.

As we can see, many of these assumptions behind the CAPM are not realistic. Although these assumptions do not hold in the real world, they are used to make the model simpler for us to use for financial decision making. Most of these assumptions can be relaxed.

The CAPM requires that in equilibrium the market portfolio must be an efficient portfolio. As long as all assets are marketable, divisible and investors have homogenous expectations, all individuals will perceive the same efficient set and all assets will be hold in equilibrium. If every individual holds a percentage of their wealth in efficient portfolios, and all assets are held, then the market portfolio must be also efficient because the market is simply the sum of all individual holdings and all individual holdings are efficient. Without the efficiency of the market portfolio the capital asset pricing model is untestable. The efficiency of market portfolio and the CAPM are inseparable joint hypothesis.

EI=EF +(EM EF)i i= Covim / Vm = im / 2m

is quantity of risk; it is the covariance between returns on the risky asset, I, and the market portfolio,M, divided by the variance of the market portfolio.

If we show how to derive the CAPM equation in a simple way: M:Market portfolio, EF:Riske free rate, I:Risky asset

The straight line connecting the risk-free asset and market portfolio is the capital market line. In equilibrium the market portfolio will consist of all marketable assets held in proportion to their value weights.

The equilibrium proportion of each asset in the market portfolio must be; wi=Market value of individual asset / Market value of all assets

A portfolio consisting of a % invested in risky asset I and (1-a) invested in the market portfolio will have the following mean and standard deviation; EP= aEI +(1-a)EM , SP={a2VI+(1-a)2VM+2a(1-a)CovIM}1/2 VI: The variance of the risky asset I and CovIM: The covariance between asset I and the market portfolio.

The opportunity set provided by various combinations of the risky asset and the market portfolio is the line IMI in figure 1.To determine the equilibrium price for risk at point M in figure 1:

Evaluating dEP/da at where a=0 gives us =EI-EM dSP/da where a=0 gives us (CovIM-VM)/SM

In equilibrium the market portfolio already has the value weight, wi percent, invested in the risky asset I. The percentage a is the excess demand for an individual risky asset. In equilibrium excess demand for any asset must be zero. dEp/da at a=0 is equal to dSp/da (EI-EM) (CovIM-VM)/SM

This is the slope of the efficiency frontier.

At equilibrium the slope of the opportunity set at point M,is equal to capital market line;(EM-EF)/SM .

At equilibrium (EM-EF)/SM =

(EI-EM) (CovIM-VM)/SM

We solve this for EI EI=EF+(EM-EF)CovIM/VM or EI=EF+(EM-EF) (See Copeland/Weston and Elton/Gruber for detailed proof how to derive the CAPM).

Equation above is known as the capital asset pricing model .It is shown in the figure 2 where it is also called security market line. Security market line depicts the tradeoff between risk and expected return for individual securities. The CAPM equation above describes the expected return for all assets and portfolios of assets in the economy .Em(market return) and Ef(return on riskless asset) are not functions of the assets we examine. Thus, the relationship between the expected return on any two assets can be related simply to their difference in .The higher is for any security, the higher must be its equilibrium return. Furthermore the relationship between and expected return is linear. This equation tells us something important that (systematic risk) is the only important element in determining expected returns and non-systematic risk plays no role. Thus, the CAPM verify what we learned from portfolio theory that an investor can diversify all the risk except the covariance of the risk with market portfolio. Consequently, the only risk which investors will pay a premium to avoid is covariance risk.

We made many assumptions for the CAPM. Are all these assumptions realistic? The CAPM may describe equilibrium returns on macro level, but from individual investors perspective, we all hold different portfolios. Therefore it can not be exactly true. Alternative versions of the CAPM have been derived to take into account these problems which violate its assumptions. Modifying some of its assumptions leaves the general model unchanged, whereas changing other assumptions leads to the appearance of the new terms in the equilibrium relationship or, in some cases, to the modification of old terms. However we should be careful, when we change assumptions simultaneously, the departure from standard CAPM may be serious (see Elton/Gruber).

There has been many empirical testing of the CAPM model(There are some problems inherent in the test of CAPM).To test the CAPM we must transform it from exante form to the expost form that uses observed data. When CAPM is tested, it is generally written in this form:RI=0+ 1I+I RI=RF+(RM-RF) I+I (RI-RF)=(RM-RF) I+I
,

1 =RM-RF

RI=the excess return; (RI-RF)

Conclusions from empirical tests; Estimated 0 is not equal zero, estimated 1 <RM-RF (low securities earn more than the CAPM would predict).

Tests shows that beta risk dominates the risk.The simpler linear model which is RI=0+ 1I+I fits the data best. It is linear also in .

They also found out that factors other than are successful in explaining that part of security returns not captured by . They also found out that price/earning ratios, size of the firm, management of the firm and other factors have effect in explaining returns.These showed there are other factors other than explaining returns. We should mention Rolls critique quickly; Roll pointed out that There is problem with testing efficient portfolio(Remember the Joint hypothesis).Roll said that there is nothing unique about the market portfolio.You can choose any efficient portfolio or an index(if performance is measured relative to an index),then find the minimum variance portfolio that is uncorrelated with the selected efficient index. If index turns out to be ex-post efficient,then every asset will exactly fall on the security market line.There will be no abnormal returns.If there are systematic abnormal returns, it simply means that the index that has been chosen is not ex-post efficient. Roll argues that tests performed with any portfolio other than the true market portfolio are not tests of the CAPM. They are simply tests of whether the portfolio chosen as a proxy for the market is efficient or not. Since over an interval of time efficient portfolios exist, a market proxy may be chosen that satisfies all the implications of the CAPM model, even when the market portfolio is inefficient. On the other hand, an inefficient portfolio may be chosen as proxy for the market and the CAPM rejected when the market itself is efficient. What Roll says, that we do not know the true market portfolio. Most tests use some portfolio of common stocks as the market, but the true market contains all risky assets (marketable and non marketable, human capital, coins, buildings, land etc).

APT offers a testable alternative to the CAPM. The CAPM predicts that security rates of return will be linearly related to a single common factor; the rate of return on the market portfolio. APT has similar assumptions as CAPM has, like perfectly competitive markets, frictionless capital markets, and assumption of homogenous expectations. APT replaces CAPMs assumption which is based on mean variance framework by assumption of the process generating security returns. Returns on any stock linearly related to asset of indices as shown below:

Ri =i+bi1I1+bi2I2++binIm+i , i=E(Ri) Im=the value of the index that affect the return to asset i;macro economic factors,size of firm,inflation,etc). bin=the sensivity of the ith asset to the nth factor. i=a random error term with mean equal to zero and variance equal to 2ei

In APT, We assume that covariances that exist between security returns can be attributed to the fact that the securities respond to one degree or another pull of one or more factors. We assume that the relationship between the security returns and the factors in linear. According to APT, in equilibrium all portfolios that can be selected from among the set of assets under consideration and that satisfy the conditions of (a)using no wealth and (b)having no risk must earn no return on average. These portfolios are called arbitrage portfolios.

Lets see a simple proof; wi = change in wealth in invested in asset i, as a percentage of an individuals total wealth,wi=0 Rp= wiRi= wi(i+bi1I1+bi2I2++binIm+i) To eliminate risk( diversiable and undiversiable) and get a riskless arbitrage portfolio;(1)choose small wi; percentage changes in investment ratios(2) diversify in a large number of asset in portfolio. wi bik=0, k=1,2.n. wi must be small, i must be large. wi1/n (n chosen to be a large number), wi bik=0 (this elimanetes all systematic risk).

Consequently, the return on our arbitrage portfolio becomes a constant. Correct choice of the weights has eliminated all uncertainity, so that RP is not a random variable. RP becomes; Rp= wi i

If the individual arbitrageur is in equilibrium, then return on any arbitrage portfolio must be zero. Rp= wi i =0 wi=0 , wi bik=0 , Rp= wi i =0= wiE(Ri)

These equations are statements in linear algebra. w e=0, w b=0 , w =0 ,underlined w,b, are vectors.e is the constant vector. must be linear combination of e and b, must be orthonogol to e and b as well. or E(Ri) must be linear combination of the constant vector and the coefficient vector.There must exist a set of k+1 coefficients, 0, 1,.. k. i =E(Ri)= 0 +1bi1++ kbik , ( remember bik are the factor loadings;sensivities of the returns on the ith security to the kth factor).

If there is a riskless asset with a riskless rates of returns;R F then, bik=0 and RF= 0 Rewrite the E(Ri) in excess returns form; E(Ri)- RF= 1bi1++ kbik, this is the APT equation. E(Ri)- RF is excess return on risk free asset. k = risk premium;price of risk in equilibrium for the k th factor. k=k-Rf , k; is expected returns on a portfolio with the unit sensitivity to the k th factor and zero sensitivity to all other factors. And so risk premium, k ,is equal to the difference between the expectation of a portfolio that has unit response to the k th factor and zero response to the other factors and Rf.

We can now rewrite APT equation in the following form; E(Ri)- RF=[ 1-Rf ] bi1+[2-Rf] bi2+..+[ k-Rf] bik If this equation is interpreted as a linear equation, then the coefficients b ik ,are defined in the same way as beta in the CAPM model; bik=Cov(Ri, k)/Var(k). Beta here will give relation of i to various factors.

The APT seems to be stronger than the CAPM; APT makes no assumptions about the distribution of asset returns. CAPM assumes that the probability distributions for portfolio returns are normally distributed. The APT does not make any strong assumptions about utility function(only risk averse).According to the CAPM investors are all risk averse individuals who maximise their expected utility of their end of period wealth.

 The APT allows the equilibrium returns of assets to be dependent on many factors not just one. The APT produces a statement about the relative pricing of any subset of assets; we do not need to measure the entire universe of assets in order to test the theory. There is no special role for the market portfolio in the APT, whereas the CAPM requires that the market portfolio be efficient. Before we go into detailed discussion of the two models, we should quickly mention some empirical tests about APT itself and its comparison with CAPM. Factor analysis is used in first empirical tests of APT. One problem with any approach to testing the APT is that the theory itself is completely silent with respect to the identity of the factor structure that is priced. Chen,Roll,Ross(1983) found that a collection of four macroeconomic variables that explained security returns fairly well. But Dhrymes, Friend, Gultekin (1984) point out that the more stocks you look at, the more factors you need to take into account. Chen(1983) compared CAPM and APT. First APT model was fitted to the data as in the following equation; Ri = ^0 +^1bi1++ ^kbik+i (APT) The CAPM was fitted to the same data;Ri= ^0 + ^1i+i (CAPM) Next the CAPM residuals i were regressed on the arbitrage factor loadings, ^k,and APT residuals, iwere regressed on the CAPM coefficients.The results showed that the APT could explain a statistically significant portion of the CAPM residual variance,but the CAPM could not explain the APT residuals.This shows that the APT is more reasonable model for explaining the cross sectional variation in asset returns.

Fama,French(1992) found that Beta did a relatively poor job at explaining differences in the actual returns of portfolios of US stocks. Instead Fama and French noted that there were other variables beside beta with respect to market that explained returns. These findings were interpreted as strong indications that CAPM does not work. Haugen(1999) tests with predictive power of APT with different factors. According to his findings APT appear to have predictive power. However, its power falls short of adhoc expected return factor models.

We so far tried to give some theoretical understanding of these two models. Lets go further to examine the two models; APT has a number of benefits; it is not as restrictive as the CAPM in its requirements about individual portfolio. It allows multiple sources of risk, indeed these provide an explanation of what moves stock returns. The APT demands that investors perceive the risk sources and that they can reasonably estimate factor sensitivities. In fact even professionals and

academics can not agree on the identity of the risk factors, and the more betas you have to estimate the more noise you must live with. The CAPM is theoretically pleasing, however its biggest criticism is that it is not testable. The APT came out as a testable alternative, but its testability is an open question as well. Some would argue that models should not be judged on the basis of the accuracy of their assumptions, but rather on the basis of their predictive power. The CAPM makes a single prediction, the efficiency of the market portfolio, which has been argued to be untestable. The power of the APT in predicting future stock returns falls short of adhoc expected return factor models. The problem may well be that the arbitrage process presumed in the APT is difficult; If not impossible to implement on a practical basis.The APT calls for arbitraging away nonlinearity in the relationship between expected returns and the factor betas. We arbitrage by creating riskless stock portfolios with differential expected returns. However, you will find that it is impossible to create riskless portfolios comprised exclusively of risky securities such as common stocks. In one important respect, both models exhibit a similar vulnerability. In the case of both models, we are looking for a benchmark for purposes of comparing the expost performance of portfolio managers,and the exante returns on real and financial investments. In the case of the CAPM, we can never determine the extent to which deviations from the security market line benchmark are due to something real or are due to obvious inadequacies in our proxies for the market portfolio. In the case of the APT,since theory gives us no direction as to the choice of factors, we can not determine whether deviations from an APT benchmark are due to something real or merely due to inadequacies in our choice of factors.As we know that the APT really makes no predictions about what the factors are. Given the freedom to select factors without restriction, it can be argued that you can literally make the performance of a portfolio anything you want it to be.

In the case of the CAPM, you can never know whether portfolio performance is due to management skill or to the fact that you have an inaccurate index of the true market portfolio. Another problem with CAPM that hedging motive does not enter in it, and therefore people hold the same portfolio of risky assets. In reality people might have different tastes and, it may make sense for them to hold different portfolios.The CAPM says that investors will price securities according to the contribution each makes to the risk of their overall portfolios. This is intuitively appealing. CAPM is an accepted model in the securities industry. It is used by firms to make capital budgeting and other decisions. It is used by some regulatory authorities to regulate utility rates(e.g. electric utilities). It is used by rating agencies to measure the performance of investment managers. The APT can also be applied to cost of capital and capital budgeting problems, but APT seems to be practically difficult for capital budgeting. There is a practical problem of the estimating the statecontingent prices of the comparison stock and the risk free asset.

If we summarize what we said so far; APT and CAPM generally address the same basic issues:

how should we measure the risk of a risky asset? how should we compute required return?

CAPM takes an oversimplified view of economy-wide news; consider a stock , according to the CAPM ,every time economy-wide news makes the market go up by 1%,we expect this stock to go up by 1% times beta of this stock. What type of economy-wide news made the market go up does not matter. The stock reacts the same way to all types of economy-wide news. But According to the APT ,what type of economy-wide news it is should matter.For example; BP would be more sensitive to an oil factor than Coca-Cola. CAPM assumes that a given stock is equally sensitive to different type of economy-wide news.APT assumes that a given stock has a different sensitivity to different types of economy-wide news.In the CAPM all economy-wide news is lumped together into one single equation, and stocks beta is the sensitivity to all types of economy-wide news. The APT assumes that random returns are given by the kth factor model instead of the market model. The single term representing economy-wide news in CAPM has been broken in to k separate terms. So there are k different types of economy wide-news. bi1 is the stock is sensitivity to type 1 news, bi2 is stock is sensitivity to type 2 news. Each of these Betas are different. CAPM lumps all systematic risk together into one term; so there is a single risk premium. APT says there are k types of systematic risk, so there are k risk premiums, one for each type of systematic risk.i1bi1 is the risk premium for type 1 risk.i2bi2 is the risk premium for type 2 risk. Just like CAPM, bi1 is the amount of type1 risk this stock has, and 1 is the market price for type 1 risk. The risk of a stock is measured jointly by its k betas, and then the required return is determined by the equation.

It is clear from all of our discussion that conceptually APT is an improved version of the CAPM, but why do we still use CAPM as well? Because, in practise, APT does not work better than CAPM. That happens because of estimation error. APT does not tell us how many factors we should use and it does not tell us what the factors are. The CAPM is more simple-minded model but we can estimate i and RM a lot more precisely, so the required return is reasonably accurate. The APT may be more advanced conceptually, but this is cancelled out by the greater estimation error. In practise, the required return we come up with is not more accurate than the CAPM. The CAPM is simpler to understand, easier to use. The APT is more difficult to understand much harder to use. APT is rarely used for computing required return, but it has useful applications in investment management.

After seeing both models, we can say that if we choose one against the other, then in each one unfortunately you win some and you lose some. Neither can the two models outperform each other completely. Rather than trying to persuade each other, one is better than the other. We should thoroughly understand their weakness as well as their

strengths, so that we will know when and how, which model we can rely on in making financial decision.

Q. 5 Diversification is key to good investment. What are pros and cons of foreign investment?
You may have already heard of the advice to go into diverse investment trading. This can be a good choice for you to make but you should be aware that there are serious implications to diversification. If you apply the concept, you might truly earn fantastic profits. It is possible however to also end up at the other end of the spectrum. Before you follow this piece of advice, you have to make sure it is the best decision for you to make. Diversification is actually a very simple concept that can significantly increase your profits. It simply means that as an investor, you should choose to put your money in not just one kind of market but in many. If for example, you already have a strong stock portfolio, you should take your capital and spread it across other assets such as real estate, commodities and assets. It's fairly clear what investors intend to achieve when they diversify. They want to earn more and they can reasonably expect to do so because they have their capital on a lot of different assets. The truth though is that there is a deeper and more convincing reason to opt to diversify. When you decide to invest in many assets, you choose to take a safe stand against profit stagnation and absolute loss. Having a diverse portfolio means you don't have to entirely go under in case one market crashes or experiences a lull. Your other investments can help prevent your boat from sinking. A market like the foreign exchange can keep you secure because it works independently of the stock market and remains unaffected by stock market problems. Investment trading that is diverse clearly has its advantages. Take not though that it may not always work well for all traders. In theory, it does seem extremely sensible to maintain several investment options. Many new traders and investors however still end up on the losing end. One reason for this is because they do not have the right level of mastery that can push them on top of every market. Common sense dictates that to make it big in a single market, one must invest considerable learning time in it. That means, you will hardly have enough time and energy to pour into studying other investment types. When you don't know what you are doing, you are likely to lose a lot. Initial specialization makes sense in the business of trading. This is a good way to protect you from losing a lot when you are still at the stage of learning what to do in a specific market. Find out what market you prefer to trade in initially by researching on the available options. It is often a good idea though to begin with the stock market first. Stocks are not leveraged and therefore do not present the possibility of overwhelming losses which you can

expect from leverage assets such as currencies. You shouldn't completely balk from the challenge of diversification. Diverse investment trading is still genuinely profitable. What you have to make sure of is that you take slow and careful steps. Conquer one income stream first before jumping into another. Don't put all of your eggs in one basket!" You've probably heard that over and over again throughout your life and when it comes to investing, it is very true. Diversification is the key to successful investing. All successful investors build portfolios that are widely diversified, and you should too. Diversifying your investments might include purchasing various stocks in many different industries. It may include purchasing bonds, investing in foreign exchange market,investing in money market accounts, or even in some real property. The key is to invest in several different areas not just one. Over time, research has shown that investors who have diversified portfolios usually see more consistent and stable returns on their investments than those who just invest in one thing. By investing in several different markets, you will actually be at less risk also.

For instance, if you have invested all of your money in one stock, and that stock takes a significant plunge, you will most likely find that you have lost all of your money. On the other hand, if you have invested in ten different stocks, and nine are doing well while one plunges, you are still in reasonably good shape. A good diversification will usually include stocks, foreign exchange, bonds, real property and cash. It may take time to diversify your portfolio. Depending on how much you have to initially invest, you may have to start with one type of investment, and invest in other areas as time goes by.This is okay, but if you can divide your initial investment funds among various types of investments, you will find that you have a lower risk of losing your money, and over time, you will see better returns. The role of foreign direct investment (FDI) in promoting growth and sustainable development has never been substantiated. There isn't even an agreed definition of the beast. In most developing countries, other capital flows - such as remittances - are larger and more predictable than FDI and ODA (Official Development Assistance). Several studies indicate that domestic investment projects have more beneficial trickledown effects on local economies. Be that as it may, close to two-thirds of FDI is among rich countries and in the form of mergers and acquisitions (M&A). All said and done, FDI constitutes a mere 2% of global GDP. FDI does not automatically translate to net foreign exchange inflows. To start with, many multinational and transnational "investors" borrow money locally at favorable interest rates and thus finance their projects. This constitutes unfair competition with local firms and crowds the domestic private sector out of the credit markets, displacing its investments in the process.

Many transnational corporations are net consumers of savings, draining the local pool and leaving other entrepreneurs high and dry. Foreign banks tend to collude in this reallocation of financial wherewithal by exclusively catering to the needs of the less risky segments of the business scene (read: foreign investors). Additionally, the more profitable the project, the smaller the net inflow of foreign funds. In some developing countries, profits repatriated by multinationals exceed total FDI. This untoward outcome is exacerbated by principal and interest repayments where investments are financed with debt and by the outflow of royalties, dividends, and fees. This is not to mention the sucking sound produced by quasi-legal and outright illegal practices such as transfer pricing and other mutations of creative accounting. Moreover, most developing countries are no longer in need of foreign exchange. "Third and fourth world" countries control three quarters of the global pool of foreign exchange reserves. The "poor" (the South) now lend to the rich (the North) and are in the enviable position of net creditors. The West drains the bulk of the savings of the South and East, mostly in order to finance the insatiable consumption of its denizens and to prop up a variety of indigenous asset bubbles. Still, as any first year student of orthodox economics would tell you, FDI is not about foreign exchange. FDI encourages the transfer of management skills, intellectual property, and technology. It creates jobs and improves the quality of goods and services produced in the economy. Above all, it gives a boost to the export sector. All more or less true. Yet, the proponents of FDI get their causes and effects in a tangle. FDI does not foster growth and stability. It follows both. Foreign investors are attracted to success stories, they are drawn to countries already growing, politically stable, and with a sizable purchasing power. Foreign investors of all stripes jump ship with the first sign of contagion, unrest, and declining fortunes. In this respect, FDI and portfolio investment are equally unreliable. Studies have demonstrated how multinationals hurry to repatriate earnings and repay interfirm loans with the early harbingers of trouble. FDI is, therefore, partly pro-cyclical. What about employment? Is FDI the panacea it is made out to be? Far from it. Foreign-owned projects are capital-intensive and labor-efficient. They invest in machinery and intellectual property, not in wages. Skilled workers get paid well above the local norm, all others languish. Most multinationals employ subcontractors and these, to do their job, frequently haul entire workforces across continents. The natives rarely benefit and when they do find employment it is short-term and badly paid. M&A, which, as you may recall, constitute 60-70% of all FDI are notorious for inexorably generating job losses. FDI buttresses the government's budgetary bottom line but developing countries invariably being governed by kleptocracies, most of the money tends to vanish in deep pockets, greased palms, and Swiss or Cypriot bank accounts. Such "contributions" to the hitherto

impoverished economy tend to inflate asset bubbles (mainly in real estate) and prolong unsustainable and pernicious consumption booms followed by painful busts.

MF0010 [Security Analysis and Portfolio Management] Set2 Q6

Q. 6 Explain in brief APT with single factor model. Arbitrage pricing theory (APT), in finance, is a
general theory of asset pricing, that has become influential in the pricing of stocks. APT holds that the expected return of a financial asset can be modeled as a linear function of various macro-economic factors or theoretical market indices, where sensitivity to changes in each factor is represented by a factor-specific beta coefficient. The modelderived rate of return will then be used to price the asset correctly - the asset price should equal the expected end of period price discounted at the rate implied by model. If the price diverges, arbitrage should bring it back into line. The theory was initiated by the economist Stephen Ross in 1976. The APT model Risky asset returns are said to follow a factor structure if they can be expressed as:

where E(rj) is the jth asset's expected return, Fk is a systematic factor (assumed to have mean zero), bjk is the sensitivity of the jth asset to factor k, also called factor loading, and j is the risky asset's idiosyncratic random shock with mean zero.

Idiosyncratic shocks are assumed to be uncorrelated across assets and uncorrelated with the factors.

The APT states that if asset returns follow a factor structure then the following relation exists between expected returns and the factor sensitivities:

where

RPk is the risk premium of the factor, rf is the risk-free rate,

That is, the expected return of an asset j is a linear function of the assets sensitivities to the n factors. Note that there are some assumptions and requirements that have to be fulfilled for the latter to be correct: There must be perfect competition in the market, and the total number of factors may never surpass the total number of assets (in order to avoid the problem of matrix singularity), Arbitrage and the APT Arbitrage is the practice of taking advantage of a state of imbalance between two (or possibly more) markets and thereby making a risk-free profit; see Rational pricing.

Arbitrage in expectations The CAPM and its extensions are based on specific assumptions on investors asset demand. For example: Investors care only about mean return and variance. Investors hold only traded assets.

Arbitrage mechanics In the APT context, arbitrage consists of trading in two assets with at least one being mispriced. The arbitrageur sells the asset which is relatively too expensive and uses the proceeds to buy one which is relatively too cheap. Under the APT, an asset is mispriced if its current price diverges from the price predicted by the model. The asset price today should equal the sum of all future cash flows discounted at the APT rate, where the expected return of the asset is a linear function of various factors, and sensitivity to changes in each factor is represented by a factor-specific beta coefficient. A correctly priced asset here may be in fact a synthetic asset - a portfolio consisting of other correctly priced assets. This portfolio has the same exposure to each of the macroeconomic factors as the mispriced asset. The arbitrageur creates the portfolio by identifying x correctly priced assets (one per factor plus one) and then weighting the assets such that portfolio beta per factor is the same as for the mispriced asset. When the investor is long the asset and short the portfolio (or vice versa) he has created a position which has a positive expected return (the difference between asset return and portfolio return) and which has a net-zero exposure to any macroeconomic factor and is

therefore risk free (other than for firm specific risk). The arbitrageur is thus in a position to make a risk-free profit:

Where today's price is too low: The implication is that at the end of the period the portfolio would have appreciated at the rate implied by the APT, whereas the mispriced asset would have appreciated at more than this rate. The arbitrageur could therefore:

Today: 1 short sell the portfolio 2 buy the mispriced asset with the proceeds.

At the end of the period: 1 sell the mispriced asset 2 use the proceeds to buy back the portfolio 3 pocket the difference.

Where today's price is too high: The implication is that at the end of the period the portfolio would have appreciated at the rate implied by the APT, whereas the mispriced asset would have appreciated at less than this rate. The arbitrageur could therefore:

Today: 1 short sell the mispriced asset 2 buy the portfolio with the proceeds.

At the end of the period: 1 sell the portfolio 2 use the proceeds to buy back the mispriced asset

3 pocket the difference.

Relationship with the capital asset pricing model[CAPM]

The APT along with the capital asset pricing model (CAPM) is one of two influential theories on asset pricing. The APT differs from the CAPM in that it is less restrictive in its assumptions. It allows for an explanatory (as opposed to statistical) model of asset returns. It assumes that each investor will hold a unique portfolio with its own particular array of betas, as opposed to the identical "market portfolio". In some ways, the CAPM can be considered a "special case" of the APT in that the securities market line represents a singlefactor model of the asset price, where beta is exposed to changes in value of the market. Additionally, the APT can be seen as a "supply-side" model, since its beta coefficients reflect the sensitivity of the underlying asset to economic factors. Thus, factor shocks would cause structural changes in assets' expected returns, or in the case of stocks, in firms' profitabilities. On the other side, the capital asset pricing model is considered a "demand side" model. Its results, although similar to those of the APT, arise from a maximization problem of each investor's utility function, and from the resulting market equilibrium (investors are considered to be the "consumers" of the assets). Using the APT Identifying the factors As with the CAPM, the factor-specific Betas are found via a linear regression of historical security returns on the factor in question. Unlike the CAPM, the APT, however, does not itself reveal the identity of its priced factors - the number and nature of these factors is likely to change over time and between economies. As a result, this issue is essentially empirical in nature. Several a priori guidelines as to the characteristics required of potential factors are, however, suggested: 1. their impact on asset prices manifests in their unexpected movements

2. they should represent undiversifiable influences (these are, clearly, more likely to be macroeconomic rather than firm-specific in nature) 3. 4. timely and accurate information on these variables is required the relationship should be theoretically justifiable on economic grounds

Chen, Roll and Ross (1986) identified the following macro-economic factors as significant in explaining security returns: surprises in inflation; surprises in GNP as indicated by an industrial production index;

 surprises in investor confidence due to changes in default premium in corporate bonds; surprise shifts in the yield curve.

As a practical matter, indices or spot or futures market prices may be used in place of macro-economic factors, which are reported at low frequency (e.g. monthly) and often with significant estimation errors. Market indices are sometimes derived by means of factor analysis. More direct "indices" that might be used are: short term interest rates; the difference in long-term and short-term interest rates; a diversified stock index such as the S&P 500 or NYSE Composite Index; oil prices gold or other precious metal prices Currency exchange rates

APT and asset management The linear factor model structure of the APT is used as the basis for many of the commercial risk systems employed by asset managers. These include MSCI Barra, APT, Northfield and Axioma.

Q1. Explain the modes of investment.

Ans:

Modes of Investment There are different types of securities conferring different sets of rights on the investors and different conditions under which these rights can be exercised. The various avenues for investment ranging from riskless to high risk investment opportunities consist of both security and non-security form of investment. As an investor you have a wide variety of investment alternatives available to choose

Marketable / Security form of investments: The term Security is generally used for those documents evidencing liabilities of the issuer. When you buy a financial instrument say fixed deposit from a bank, you are issued a

document called Fixed Deposit Receipt or Certificate. This receipt is a liability to the bank as the bank has to safe guard the investment; provide interest for using the funds and to return back the invested amount on maturity. This document also outlines the rights of the investor and sets conditions under which the investor can exercise his or her rights. Security forms of investment are those instruments which are transferable and traded in any organized financial market.

Equity Shares: Equity shares represent ownership capital. An equity shareholder enjoys both ownership stake and residual interest in income & wealth. The issue of equity shares could be in the form of initial public offer, rights issue, bonus issue, preferential allotment and private placement. Investors has a choice to select equity shares which are broadly differentiated as blue chip shares, growth shares, income shares, cyclical shares and speculative

Bonds/Debentures: Bonds represent long-term debt instruments. The issuer of a bond promises to pay a stipulated payment (interest and principal) to the bond holder. Bond indenture is a contract between the issuer and the bond holder, which specifies the detail of the issue such as par value of the bond, its coupon rate, maturity period, maturity date, call/put options etc. Internationally, a secured corporate debt instrument is called a corporate bond while an unsecured corporate debt instrument is called a corporate debenture. In India, corporate debt instrument is referred as debentures although they are secured. Government bonds are issued by Central and State Governments. These bonds are called gilt edged securities. There are different types of bond Straight bonds, Zero coupon bonds, Floating rate bonds, bonds with embedded options, commodity linked bonds etc. These are dealt in detail in the later units.

Money Market Instruments: Debt instruments which have a maturity of less than one year at the time of issue are called M.M Instruments. The important money market instruments are: a) Treasury Bills b) Commercial paper c) Certificate of deposits d) Repurchase Agreements Repos & Reverse Repos

Mutual Funds: Mutual funds are also known as indirect investments. It is an alternative route of buying equity shares or fixed income securities through various schemes floated by mutual funds companies. There are three broad types of mutual fund schemes. 1) Equity schemes 2) Debt schemes

3) Balance schemes Non Security form of financial Investment: Non security form of investments are neither transferable nor traded in any organized financial market

Life Insurance Policies: Life insurance may be viewed as an investment which suffices the protection and savings needs of an investor. Policies that provide protection benefits are designed to protect the policy holders from the financial consequences of unwelcome events such as death/long term sickness/accidents/disability etc. Policies that are designed as savings contracts allow the policyholders to build up funds to meet specific investment objectives such as income for a particular event, retirement planning or repayment of a loan. The important types of insurance policies in India are Endowment assurance policy, Money back policy, Term assurance policy, Unit linked Plan, Deferred Annuity and Whole life policy. Bank Deposits: Bank deposits are the simplest and most common form of investment. There are various kinds of deposit accounts: current account, savings account and fixed deposit account. The deposit made in current account does not earn any interest while deposit made in savings account and fixed deposit accounts earn interest. The interest rate depends upon the tenure. Bank deposit enjoys high liquidity due to premature withdrawals. Also loans can be raised on the fixed deposit certificates. Deposit Insurance Corporation provides guarantee to all deposits in schedule bank up to Rs.100000 per depositor of a bank. Post office Accounts There are various types of accounts namely post office savings account, post office time deposit account, Monthly income schemes, Kisan Vikas Patra, National Savings Certificates. Some are pure savings schemes, while others are tax savings schemes. Corporate Fixed Deposits

Certain large and small corporates raise funds through fixed deposits form the public. While fixed deposits mobilized by manufacturing companies are regulated by Company Law board and fixed deposit mobilized by finance companies are regulated by Reserve bank of India. A manufacturing firm can mobilize up to 25 percent of its net worth in the form of fixed deposit from public and an additional 10 percent of its net worth from its shareholders. The interest rates on company deposits are higher than those on bank fixed deposits. Security Analysis and Portfolio Employee Provident Fund Scheme Employee Provident Fund is an important component of savings for a salaried person. Each employee has a separate provident fund account in which both the employer and employee are required to contribute a certain sum of money on a monthly basis. While the contribution made by the employer is fully tax exempt, the contributions made by the employee is eligible for tax deductions under Sec 80C. The provident fund contribution earns compound interest rate that is totally exempt from taxes. The balance in provident fund account is fully exempt from wealth tax and it is not subject to attachment under any order or decree of a court. Public Provident Fund Scheme This scheme of post office is the most attractive investment option. Individuals and HUFs can invest in this scheme. The investment period is 15 years and the minimum deposit is Rs100 per year and the maximum permissible deposit per year is Rs.70000. Deposits in a PPF account is eligible for tax concession under Sec 80C.The deposit earns a compounded interest rate of 8 percent per annum which is totally exempt from tax.

Q2. This distribution of returns for share Y and the market portfolio M is given below.

You are required to calculate the expected return of security Y and the market portfolio, the covariance between the market portfolio and security Y and beta for the security. Hint: ERp= 17 ; Covariance PM = - 168.0 ; Beta= -0.636 Ans: Security Y

Q3. Briefly explain the Dow Theory.

Ans:

The Dow Theory was originated by Charles Dow. He was the founder of the Dow Jones Company and editor of the Wall Street Journal. The Dow Theory presumes that the market moves in persistent bull and bear trends. Dow Theory was originally used for market as a whole, but it is now used for individual securities as well.

The Dow Theory recognized that it is the actions of the people in the marketplace responding to news that cause prices to change rather than the news itself, and that once established a market trend tends to continue. The theory had originally focused on using general stock market trends as a barometer for general business conditions. It was not originally intended to forecast stock prices. However, subsequent work has focused almost exclusively on this use of the theory. The Dow Theory comprises the following assumptions: 1. The averages discount everything: An individual stock's price reflects everything that is known about the security. As new information arrives, market participants quickly disseminate the information and the price adjusts accordingly. Likewise, the market averages discount and reflect everything known by all stock market participants. 2. The market is comprised of three trends: At any given time in the stock market, three forces are in effect: the Primary trend, Secondary trends, and Minor trends. The Primary trend can either be a bullish (rising) market or a bearish (falling) market. The Primary trend usually lasts more than one year and may last for several years. If the market is making successive higher-highs and higherlows the primary trend is up. If the market is making successive lower-highs and lowerlows, the primary trend is down. Secondary trends are intermediate, corrective reactions to the Primary trend. These reactions typically last from one to three months. Minor trends are short-term movements lasting from one day to three weeks. Secondary trends are typically comprised of a number of Minor trends. The Dow Theory holds that, since stock prices over the short-term are subject to some degree of manipulation (Primary and Secondary trends are not), Minor trends are unimportant and can be misleading.

3. Primary trends have three phases: The Dow Theory says that : The first phase is made up of aggressive buying by informed investors in anticipation of economic recovery and long-term growth. The general feeling among most investors during this phase is one of "gloom and doom" and "disgust." The informed investors, realizing that a turnaround is inevitable, aggressively buy from these distressed sellers.

The second phase is characterized by increasing corporate earnings and improved economic conditions. Investors will begin to accumulate stock as conditions improve. The third phase is characterized by record corporate earnings and peak economic conditions. The general public (having had enough time to forget about their last "scathing") now feels comfortable participating in the stock market--fully convinced that the stock market is headed for the moon. They now buy even more stock, creating a buying frenzy. It is during this phase that those few investors who did the aggressive buying during the first phase begin to liquidate their holdings in anticipation of a downturn. 4. The volume confirms the trend: The Dow Theory focuses primarily on price action. Volume is only used to confirm uncertain situations. Volume should expand in the direction of the primary trend. If the primary trend is down, volume should decrease during market declines. If the primary trend is up, volume should increase during market advances. 5. A trend remains intact until it gives a definite reversal signal: An uptrend is defined by a series of higher-highs and higher-lows. In order for an up-trend to reverse, prices must have at least one lower high and one lower low (the reverse is true of a downtrend).

Q4. Explain the strategies for overcoming psychological biases.

Ans:

There are many psychological biases that impair the quality of investment decision making. The following are the few suggested strategies for overcoming these biases: Understand the biases Pogo, the folk philosopher created by the cartoonist Walt Kelly, provided an insight that is particularly relevant for investors, We have met the enemy - and it s us. So, understand your biases (the enemy within) as this is an important step in avoiding them. Focus on the Big Picture Develop an investment policy and put it down on paper. Doing so will make you react less impulsively to the gyration of market. Follow a set of quantitative investment criteria Quantitative investment criterias like price-earnings ratio not more than 15, the price to book ratio not more than 4, growth rate of earnings at least 12 % and so on are helpful. They tend to mitigate the influence of emotion, hearsay, rumor, and psychological biases.

Diversify If you own a fairly diversified portfolio of say 12 to 15 stocks from different industries, you are less prone to do something drastically when you incur losses in one or two stocks because these losses are likely to be offset by gains elsewhere. Control your investment environment If you are on diet, you should not have sweets and savories on your dining table. Likewise, if you want to discipline your investment activity, you should regulate your investment environment. Here are a few ways to do so: Check your stocks only once every month. Trade only once a month and preferably on the same day every month. Review your portfolio once or twice a year.

Strive to earn Market returns Seek to earn returns in line with what the market offers. If you strive to outperform the market, you are likely to succumb to psychological biases. Review your biases periodically Once in a year review your psychological biases. This will throw up useful pointers to contain such biases in future.

Q5. List the major types of investment risks.

Ans:

Major types of risk include:

Investment risk: Investment risk is the possibility that your investment value will fall. Standard deviation is commonly used to measure investment risk. It shows a stock or bond's volatility, or the tendency of its price to move up and down from its average. As standard deviation increases, so does the investment risk. Market risk: Market risk is the chance that the entire market where your investment trades will fall in value. Market risk cannot be eliminated through diversification. Interest rate risk: Interest rate risk is the possibility that the interest rates will change while you are holding an investment. Changes in interest rates affect the returns from investments.

Inflation risk: Bonds are especially vulnerable to inflation risk. Bonds are fixed income securities and therefore a bond's coupon payment and principal repayment are usually a fixed amount. When inflation rises, it erodes the purchasing power of the fixed payments received. Industry risk: Industry risk is the possibility that a set of factors that are particular to an industry group drags down the industry's overall investment performance. For example, wet summer months may adversely affect the sale of cold drinks or a cutback in capital spending might adversely affect the information technology industry. Credit risk: Credit risk is the possibility that a company that issues bonds is unable to make the contractual coupon and/ or principal payments and default on its debt. Liquidity risk: Liquidity risk is the possibility that your investment in a security (stock or bond) cannot be sold easily in the market because of a lack of buyers. Such a security is called a thinly traded security. As a result of a lack of liquidity, you may have to sell your investment at a price below its fair value. Prepayment risk: Prepayment risk is the possibility that borrowers repay debt ahead of schedule. As a result, investors are repaid sooner than expected and have to reinvest these prepayments at a rate which is lower than what they has been receiving on their debt instruments earlier. Borrowers prepay and refinance their debt when interest rates decline.

Q6. How are the factors identified for APT?

Ans:

APT does not identify the factors to be used in the theory; therefore, they need to be empirically determined. In practice, and in theory, one stock might be more sensitive to one factor than another. For example, the price of a share of ONGC might be very sensitive to the price of crude oil, while a share of Colgate might be relatively insensitive to the price of oil. In fact, the Arbitrage Pricing Theory leaves it up to the investor or the analyst to identify each of the factors for a particular stock. So the real challenge for the investor is to identify three things: Each of the factors affecting a particular stock The expected returns for each of these factors The sensitivity of the stock to each of these factors

Identifying and quantifying each of these factors is no trivial matter and is one of the reasons why the Capital Asset Pricing Model remains the dominant theory to describe the relationship between a stock's risk and return. Ross and others have identified the following macro-economic factors they feel play a significant role in explaining the return on a stock:

Growth rate in industrial production Rate of inflation Spread between long term and short term interest rates Spread between low grade and high grade bonds Growth rate in GNP (Gross National Product) Growth in aggregate sales in the economy Rate of return on S&P 500 Investor Confidence Shifts in the Yield Curve

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

MF0010 [Security Analysis and Portfolio Management] Set2 Q1

Q1. What are derivatives? How are they used to hedge risk?
Ans:

Derivatives are financial instruments that have no intrinsic value, but derive their value from something else. They hedge the risk of owning things that are subject to unexpected price fluctuations, e.g. foreign currencies, commodities (like wheat), stocks and bonds. The term derivative indicates that it has no independent value, i.e. its value is entirely derived from the value of the cash asset; e.g., price of a stock option depends on the underlying stock price and the price of currency future depends on the price of the underlying currency.

A derivative contract or product, or simply derivative, is to be distinguished from the underlying cash asset, i.e. the asset bought/sold in the cash market on normal delivery terms. The price of the cash instrument is referred to as the underlying price. Examples of cash instruments include actual shares in a company, commodities (crude oil, wheat), foreign exchange, etc. There are two types of derivative securities that are of interest to most investors futures and options.

Future contract is an agreement entered between two parties to buy or sell an asset at a future date for an agreed price. The party which agrees to purchase the asset is said to have a long position and the party which agrees to sell the asset is said to have a short position.

An Option is the right but not the obligation of the holder, to buy or sell underlying asset by a certain date at a certain price. The option represent a special kind of financial contract under which the option holder enjoys the right (for which he pays a price), but has no obligation, to do something.

There are two basic types of options: call options and put options. A call option gives the option holder the right to buy a fixed number of shares of a certain stock, at a given exercise price on or before the expiration date. To enjoy this option, the option buyer (holder) pays a premium to the option writer (seller) which is non-refundable. The writer (seller) of the call option is obliged to sell the shares at a specified price, if the buyer chooses to exercise his option.

A put option gives the option holder the right to sell a fixed number of shares of a certain stock at a given exercise price on or before the expiration date. To enjoy this right, the option buyer (holder) pays a nonrefundable premium to the option seller (writer). The writer of the put option is obliged to buy the shares at a specified price, if the option holder chooses to exercise the option.

Options and futures contracts are important to investors because they provide a way for investors to manage portfolio risk. Investors incur the risk of adverse currency price movements if they invest in foreign securities, or they incur the risk that interest rates will adversely affect their fixed-income securities (like bonds).

Options and futures contracts can be used to limit some, or all, of these risks, thereby providing risk-control (hedging) possibilities. For example, if you are holding Reliance shares, you can hedge against falling share price by purchasing a put option on the Reliance shares. Speculators can use derivatives to bet on the direction of future stock prices, interest rates, exchange rates, and commodity prices. In many cases, these transactions produce high returns if you guess right, but large losses if you guess wrong. Here, derivatives can increase risk

MF0010 [Security Analysis and Portfolio Management] Set2 Q2

Q2. How is company analysis useful in determining the intrinsic value of a security?
Ans:

Once the economic forecast and industry analysis has been completed,the fundamental analyst focuses on choosing the best positioned company in the chosen industry. Selecting a company involves an analysis of the company s management, the company s financial statements and the key drivers for future growth. The analyst is looking for companies with the best management, strong financials, great prospects, and that are undervalued by the market. While doing the analysis, it is to be remembered that the past is irrelevant, what you are looking at are future results.

Some areas of focus for company analysis are discussed below:

Business and financial risk

The return required by investors is proportional to the perceived risk associated with the company. The risk can be measured as variability of the companys after-tax cash flows. It is often useful to break down the companys risk into two components: business risk and financial risk.

Business risk is uncertainty about future operating income (EBIT), i.e., how well can you predict operating income. It does not include financing effects. Business risk is risk attributable to the composition of the companys assets. Factors affecting business risk include: (a) sensitivity of company sales to general economic conditions; (b) industry conditions including degree and size of competition, indust ry growth prospects, and the company ability to affect its selling and input prices; and, (c) company characteristics including size of the company, management, and operating leverage.

Operating leverage is the use of fixed operating costs as opposed to variable operating costs. A company with relatively high fixed operating costs will experience more variable

operating income if sales change. If most costs are fixed and hence do not decline when demand falls, then the company has high operating leverage.

Financial risk is the variability or uncertainty of a companys earnings per share (EPS) and the increased probability of insolvency that arises when a company uses financial leverage. Financial leverage is the use of fixedcost sources of financing (debt, preferred stock) rather than variable-cost sources (common stock). Financial risk is the additional risk concentrated on common stockholders as a result of financial leverage.

Financial statement analysis Analyzing a companys historical financial statements and financial ratios can provide end users with useful information for estimating the magnitude of future cash flows (earnings and dividends) and the risk inherent in these estimates. These estimates can then be used to assign a value to a companys assets and liabilities. Through financial statements, analysts determine the financial health and strength of companies. The analysts rely on three statements: Income statement, Balance sheetand the Statement of cash flows. The major tools for analysis are the ratio analysis and growth rates. The income statement provides us with information about the companys revenues and expenses over some previous time period (usually quarterly, semiannually, and annually).

It indicates a companys ability to g enerate profits. The key variables to watch are revenues, gross profit margins, operating profit margins, net profit margins and earnings per share (EPS). The analyst especially wants to evaluate the quality of the companys earnings. Under generally accepted accounting principles, companies are allowed fairly wide latitude on how they recognize revenues and handle extraordinary income and expenses. Many companies manage or smooth earnings, believing that it adds to the stability of the stock price over time. The analysts need to watch for such manipulations, as it may signal problems. Analysts also look for where the earnings are coming from increased sales, or decreased expenses.

Sales can increase forever, but costs can only be cut up to a limit. Generally, when costs are cut to increase profits, it is looked at only as a temporary boost. The balance sheet is a list of a company s assets (what a company owns), liabilities (what the company owes), and shareholders equity (the portion of the company that is owned by investors) at a point in time. It helps determine a companys financial soundness by revealing how much of its assets are financed by debt and how much are financed by capital investments. The key variables to watch on the balance sheet are cash, accounts receivable, inventories, and long-term debt. An interesting quote to remember while analyzing balance sheet comes from Benjamin Graham in his book Security Analysis: liabilities are real but the assets are of questionable value.

Finally, the cash flow statement shows investors how much revenue a company has generated, making adjustments for non-cash expenses such as depreciation. The cash flow statement explains how the company has performed in managing inflows and outflows of cash and better represents the companys ability to pay bills, creditors, and finance growth. The statement of cash flows is far more difficult to manipulate than the income statement, and can help to gauge the quality of earnings.

Financial ratios are commonly used to analyze a companys financial performance. A single ratio on its own provides very little information unless it is compared to another ratio (or other ratios). Analysts examine how these ratios are evolving through time. This enables them to compare the companys most recent performance with its performance in earlier periods. In addition, a companys ratios should be compared with the ratios of similar companies or industry averages. This comparison is a popular method of determining how well a company is performing in relation to its competitors.

Financial ratios fall into five categories: Liquidity: The current ratio, quick ratio and cash ratio all fall into this category. They help us to see if the company is able to meet its short term obligations. Efficiency: The efficiency ratios tell us how effectively management is using the firms assets to generate sales. Inventory turnover, accounts receivable turnover, days sales outstanding, fixed asset turnover, and total asset turnover all fall into this category. Leverage: Leverage ratios indicate the amount of debt that a firm has. Examples are the debt ratio and debt to equity ratio. A large amount of debt is good only as long as sales are increasing, but terrible if sales decline. Some debt is good, but too much can be disastrous. Coverage: Examples of coverage ratios include the times interest earned ratio and the fixed charge coverage ratio. They are most important to creditors, but whatever is important to creditors is important to shareholders too. Profitability: Investors tend to focus the most on profitability ratios. Examples include the gross profit margin, operating profit margin, net profit margin, return on assets and return on equity.

There are two key uses of financial ratios:

Trend analysis This involves looking for trends over time in ratios. For example, we would like to see that the inventory turnover ratio is rising. Normally, at least five years of data should be used for trend analysis. Comparison to industry averages If we assume that, on an average, the firms competitors are doing things right, then it makes sense to make these comparisons. This comparison can also help to identify areas of relative strengths and weaknesses for the company. Growth rates The growth rates of various variables are important for financial statement analysis. The key variables to calculate growth rates are revenues, operating profits, and free cash flow. Business plan The business plan, model or concept forms the foundation upon which everything else is built. If the plan, model or concepts do not work, there is little hope for the business. For a new business, the questions that fundamental analyst asks are: Does its business make sense? Is it feasible? Is there a market? Can a profit be made? For an established business, the questions may be: Is the company's direction clearly defined? Is the company a leader in the market? Can the company maintain leadership?

Management In order to execute a business plan, a company requires top-quality management. Investors might look at management to assess their capabilities, strengths and weaknesses. Even the best-laid plans in the most dynamic industries can go to waste with bad management. Alternatively even strong management can make for extraordinary success in a mature industry. Some of the questions that the fundamental analyst asks include: How talented is the management team? Do they have a track record? How long have they worked together? Can management deliver on its promises? If management is a problem, it is sometimes best not to invest.