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.

Ans: Retail investors in mutual funds are known to chase returns, making large investments at
market highs and staying away during its lows.

Systematic Investment Plans or SIPs were devised mainly to prevent this. However, data on SIP
investments for 17 leading fund houses now show that investors follow the same practice for
their SIP investments as well. They decide to start paying the monthly installments on SIPs only
after markets have rallied and stop them if the stock market is falling.

SIPs jump as Sensex rises

The number of new SIP accounts these funds added in the April-June 2010 quarter was over 50
per cent higher than the number added in the same quarter of 2009.

The number of SIPs added every month averaged 1.79 lakh accounts in the latest quarter, against
1.2 lakh accounts in the same period of 2009.

The Sensex ranged between 17,000 and 18,000 in April-June 2010, compared with 11,000-
15,500 levels in April-June 2009.

Failed SIPs

The other disturbing trend is that of a good number of investors are discontinuing their SIPs mid-
way. Even as funds added between one lakh and 1.9 lakh accounts each month over the last one
year, the number of ‘failed' SIPs was quite large at 1.2-1.7 lakh accounts a month.

The instances of SIPs ‘failing' peaked during March, April and May 2009. In hindsight, that was
the best time to invest in equity funds.

Stopping SIPs when market is down would defeat the purpose of cost averaging (buying more
shares when prices are low and fewer shares when prices are high) that monthly investing is
supposed to serve.

SIP collections rising

Overall, however, fund houses have seen a steady improvement in the new SIP accounts as the
markets have climbed over the past year. Between 1.7 and 1.9 lakh SIPs have been added in
recent months.
In all, the 17 mutual funds had about 25.6 lakh SIP accounts by end of June 2010.

Together, they managed SIP assets of Rs 20,600 crore.

In spite of improved market conditions compared to 2008-09, the average ticket size of new SIP
accounts has not increased substantially. The national average has moved to Rs 2,190 from Rs
2,100 reported in 2008-09.

QUALITIES OF A SMART INVESTOR:

1) Smart investors have a plan for investing, and they stick to it: It is very easy to be
tempted by a tip about a hot stock. However this is not the way Smart investors invest. For
example, if they are 40 years old and have twenty years until retirement, they implement a 20-
year investment plan. They only buy securities that they have researched.

2) Smart investors invest consistently: They generally use to methods to do this. First, they
invest a part of their funds in securities with a growth potential (like stock & mutual funds).
Second, they keep adding to their investment principal regularly.

3) Smart investors are patient: It often takes time for a good investment to show results. They
understand this, and therefore do not get excited about the daily ups and downs of the market.
Smart investors don’t expect instant growth.

4) Smart investors are not emotionally tied to their investment positions: They know that to
be successful, they must not be emotional towards their investment. No matter how attractive an
investment looks or how badly an investment has performed recently, selling at the right time is
just as imporant as buying. They are aware that no investment will move up forever, and they
are able to sell it when right.

Common errors in Investment Management

Investment mistakes happen for a multitude of reasons, including the fact that decisions are made
under conditions of uncertainty that are irresponsibly downplayed by market gurus and
institutional spokespersons. Losing money on an investment may not be the result of a mistake,
and not all mistakes result in monetary losses. But errors occur when judgment is unduly
influenced by emotions, when the basic principles of investing are misunderstood, and when
misconceptions exist about how securities react to varying economic, political, and hysterical
circumstances. Avoid these ten common errors to improve your performance:

1. Investment decisions should be made within a clearly defined Investment Plan. Investing is a
goal-orientated activity that should include considerations of time, risk-tolerance, and future
income... think about where you are going before you start moving in what may be the wrong
direction. A well thought out plan will not need frequent adjustments. A well-managed plan will
not be susceptible to the addition of trendy, speculations.

2. The distinction between Asset Allocation and Diversification is often clouded. Asset
Allocation is the planned division of the portfolio between Equity and Income securities.
Diversification is a risk minimization strategy used to assure that the size of individual portfolio
positions does not become excessive in terms of various measurements. Neither are "hedges"
against anything or Market Timing devices. Neither can be done with Mutual Funds or within a
single Mutual Fund. Both are handled most easily using Cost Basis analysis as defined in the
Working Capital Model.

3. Investors become bored with their Plan too quickly, change direction too frequently, and make
drastic rather than gradual adjustments. Although investing is always referred to as "long term",
it is rarely dealt with as such by investors who would be hard pressed to explain simple peak-to-
peak analysis. Short-term Market Value movements are routinely compared with various un-
portfolio related indices and averages to evaluate performance. There is no index that compares
with your portfolio, and calendar divisions have no relationship whatever to market or interest
rate cycles.

4. Investors tend to fall in love with securities that rise in price and forget to take profits,
particularly when the company was once their employer. It's alarming how often accounting and
other professionals refuse to fix these single-issue portfolios. Aside from the love issue, this
becomes an unwilling-to-pay-the-taxes problem that often brings the unrealized gain to the
Schedule D as a realized loss. Diversification rules, like Mother Nature, must not be messed
with.

5. Investors often overdose on information, causing a constant state of "analysis paralysis". Such
investors are likely to be confused and tend to become hindsightful and indecisive. Neither
portends well for the portfolio. Compounding this issue is the inability to distinguish between
research and sales materials... quite often the same document. A somewhat narrow focus on
information that supports a logical and well-documented investment strategy will be more
productive in the long run. But do avoid future predictors.

6. Investors are constantly in search of a short cut or gimmick that will provide instant success
with minimum effort. Consequently, they initiate a feeding frenzy for every new, product and
service that the Institutions produce. Their portfolios become a hodgepodge of Mutual Funds,
iShares, Index Funds, Partnerships, Penny Stocks, Hedge Funds, Funds of Funds, Commodities,
Options, etc. This obsession with Product underlines how Wall Street has made it impossible for
financial professionals to survive without them. Remember: Consumers buy products; Investors
select securities.

7. Investors just don't understand the nature of Interest Rate Sensitive Securities and can't deal
appropriately with changes in Market Value... in either direction. Operationally, the income
portion of a portfolio must be looked at separately from the growth portion. A simple assessment
of bottom line Market Value for structural and/or directional decision-making is one of the most
far-reaching errors that investors make. Fixed Income must not connote Fixed Value and most
investors rarely experience the full benefit of this portion of their portfolio.

8. Many investors either ignore or discount the cyclical nature of the investment markets and
wind up buying the most popular securities/sectors/funds at their highest ever prices. Illogically,
they interpret a current trend in such areas as a new dynamic and tend to overdo their
involvement. At the same time, they quickly abandon whatever their previous hot spot happened
to be, not realizing that they are creating a Buy High, Sell Low cycle all their own.

9. Many investment errors will involve some form of unrealistic time horizon, or Apples to
Oranges form of performance comparison. Somehow, somewhere, the get rich slowly path to
investment success has become overgrown and abandoned. Successful portfolio development is
rarely a straight up arrow and comparisons with dissimilar products, commodities, or strategies
simply produce detours that speed progress away from original portfolio goals.

10. The "cheaper is better" mentality weakens decision making capabilities and leads investors to
dangerous assumptions and short cuts that only appear to be effective. Do discount brokers seek
"best execution"? Can new issue preferred stocks be purchased without cost? Is a no load fund a
freebie? Is a WRAP Account individually managed? When cheap is an investor's primary
concern, what he gets will generally be worth the price.

Compounding the problems that investors have managing their investment portfolios is the
sideshowesque sensationalism that the media brings to the process. Investing has become a
competitive event for service providers and investors alike. This development alone will lead
many of you to the self-destructive decision making errors that are described above. Investing is
a personal project where individual/family goals and objectives must dictate portfolio structure,
management strategy, and performance evaluation techniques. Is it difficult to manage a
portfolio in an environment that encourages instant gratification, supports all forms of
"uncaveated" speculation, and that rewards short term and shortsighted reports, reactions, and
achievements?

Q.2 Explain the significance of index in general and stock market index in particular. What
is risk involved in derivative products?

Ans: - Before dealing in derivative products (futures and options) the client (investor) must
assess the risks in trading these products. It must be aware that the loss it may incur could be
higher than the amount initially exchanged (paid or received) or deposited. The loss in trading
derivative products is potentially unlimited and is not proportional to the initial amount invested
or exchanged (paid or received).
The client should not deal in derivative products unless it understands the nature of the contract it
is entering into, the extent of its obligations and exposure to risk, and is satisfied that the contract
is suitable for it in light of its skills, objectives and financial resources.

Although derivative products can be utilised to limit or hedge against risk, the client should be
aware that derivative products are not suitable for all investors.

The client's exposure to risk may vary according to the product, market and type of transaction.
Commitments entered into and the protection offered by Calyon Financial and the clearing
houses may vary depending on the product, market and type of transaction.

The information available relating to derivative products is not always complete and exhaustive.
Derivative products may be tailored for some clients or markets and may differ in detail from the
outline set forth herein. The terms of particular transactions will prevail over the product
descriptions and information given in this Risk Disclosure Statement.

The client must assess the suitability of its investment, in particular in light of its skills,
objectives and financial resources.

The main risks linked to derivative products are:

1. Leverage: When an investor trades derivative products it must provide a deposit and/or
exchange (pay or receive) a premium. The amount provided as the deposit or exchanged as a
premium represents only a fraction of the derivative product's value.

Transactions in derivative products involve significant leverage as a relatively small fluctuation

in the price of the underlying instrument can have a proportionately greater impact on the cash or
on the value of any other guarantee deposited by the investor. This can work for and against the
client. If the market moves in an unfavourable direction, the investor may not only lose more
than the full amount of the initial margin deposit, but also pay an additional margin and meet
margin calls. To maintain the investor's position, new margin payments can be requested on very
short notice, occasionally during a market session. If the investor does not meet margin calls
within the required time limit, its position may be liquidated and the investor will be liable for
any debit balance on its account.

Losses may therefore be far greater than the margin initially deposited with the clearing house or
than the premium exchanged.

2. Liquidity and price fluctuations: Derivatives markets can be illiquid. If the market is not
sufficiently liquid, the investor may be unable to liquidate or even partially close out a futures
position at the desired time. In addition, the difference between the bid price and the offer price
of a given contract may be significant.
Prices on derivatives markets can fluctuate considerably, depending on a number of factors that
are difficult to forecast. The price and liquidity of any investment depends upon the availability
and value of the underlying asset, which can be affected by a number of extrinsic factors
including, but not limited to, political, environmental and technical. Such factors can also affect
the ability to settle or perform on time or at all. The impact of these events on the liquidity and
prices increases as the maturity date is near.

3. Orders aimed at limiting a loss (stop-limit, stop-loss): Trading conditions on futures markets
allow investors to place orders with a stop-limit price and orders with a trigger threshold, which
are also referred to as “stop orders”. These orders were designed to limit losses that could occur
as a result of market fluctuations. The use of such orders does not provide a guarantee that losses
will be limited to the intended amounts. Placing contingent orders, such as "stop-loss" or "stop-
limit" orders, will not necessarily limit its losses to the intended amounts, since market
conditions on the exchange where the order is placed may make it difficult or impossible to
execute such orders.

4. Commission, fees and taxes: All charges relating to a futures transaction reduce the investor's
profit or increase its loss. Commission, agreed upon between the broker and investor, is paid in
addition to the fees due to the markets and clearing houses. Before concluding a transaction,
investors must be informed of all fees and costs to be paid. Any payments made or received in
relation to any investment may be subject to tax and the Client should seek professional advice in
this respect.

5. Seller and buyer obligations : Transactions in derivative products involve the obligation to
make, or to take, delivery of the underlying asset of the contract at a future date, or in some cases
to settle the position with cash, in accordance with the applicable market conditions.

(a) Obligation to deliver :Unless it is able to offset its position before the delivery date
and thereby free itself from its obligation, the seller of a futures contract or a call option
may be required to deliver a predetermined quantity of the underlying instrument, in
accordance with the relevant market and clearing house rules. The terms and conditions
of trading require the seller to deliver the underlying asset in accordance with the
characteristics of the contract. If the seller does not comply with this obligation, it may
risk incurring additional costs and penalties.

(b) Obligation to take delivery :Unless it is able to offset its position before the
delivery date and thereby free itself from its obligation, the buyer of a futures contract or
the seller of put option must accept delivery of and pay for the underlying instrument, in
accordance with the relevant market and clearing house rules. It may have to pay an
amount higher than the margin deposited with the clearing house.

For commodities, it may be required to agree to the necessary storage, to organise

transport and to take responsibility for any subsequent related costs. If the buyer is not the
 end buyer of the commodity or a trader in commodities of this type, it may encounter
difficulties relating to storage or sales, due to the fact that it cannot use the commodity in
question. Furthermore, there is a risk of loss if it decides to sell the commodity on the
spot market.

The margin deposited by the buyer of a futures contract serves solely as a guarantee and
is not valid for the partial execution of its obligations.

6. Option contracts : There are many different types of options with different characteristics.
They are subject to the following conditions:

Buying options: Buying options involves less risk than selling options because, if the
price of the underlying asset moves against the Client, the Client can simply allow the
option to lapse. The maximum loss is limited to the premium, plus any commission or
other transaction charges. However, if the Client buys a call option on a futures contract
and later exercises the option, it will acquire the future. This will expose the Client to the
risks described in this document.

Writing (selling) options: If the Client writes an option, the risk involved is considerably
greater than buying options. The Client may be liable for margin to maintain its position
and a loss may be sustained well in excess of the premium received. By writing an
option, the Client accepts a legal obligation to purchase or sell the underlying asset if the
option is exercised against it however far the market price has moved away from the
exercise price. If the Client already owns the underlying asset which it has contracted to
sell (when the options will be known as “covered call options”) the risk is reduced. If the
Client does not own the underlying asset (“uncovered call options”) the risk can be
unlimited. Only experienced persons should contemplate writing uncovered options, and
then only after securing full details of the applicable conditions and
potential risk exposure.

7. Derivative instruments and the spot market : It is important to understand the relationship
between prices of derivative products and those of the spot market. Although market forces tend
to balance prices on derivatives markets against those on spot markets for a given underlying
instrument, thereby neutralising any differences on the delivery date, many factors linked to the
market, including supply and demand, may have the effect of maintaining differences.

8. Non-fungibility of contracts : Calyon Financial is a Trader/Clearing Agent specialising in the

derivatives markets. As such, the orders we execute on behalf of our clients are carried out on
regulated markets and in some cases on over-the-counter markets.

Cases in which the same instrument can be traded on different markets, and where two
instruments are fungible, are exceptional.
Before placing an order relating to a product and prior to selecting a market, the client must
assess the market and its historical performance in order to take into account, in particular, its
liquidity.

Where the Client is unable to transfer a particular instrument which it holds, to exit its
commitment under that instrument, the Client may have to offset its position by either buying
back a short position or selling a long position. Such an offsetting transaction may have to be
over the counter and the terms of such a contract may not match entirely those of the initial
instrument. For example, the price of such a contract may be more or less than the Client
received or paid for the sale or purchase of the initial instrument

9. Foreign markets and emerging markets : Foreign markets will involve different risks from
the French markets. In some cases the risks will be greater. On request, Calyon Financial will
provide an explanation of the relevant risks and protections (if any) which will operate in any
foreign markets, including the extent to which it will accept liability for any default of a foreign
firm through whom it deals. The potential for profit or loss from transactions on foreign markets
or in foreign denominated contracts will be affected by fluctuations in foreign exchange rates.
Such transactions may also be affected by exchange controls that could prevent or delay
performance.

10. Clearing houses : On many markets, the performance of a transaction by Calyon Financial
(or third party with whom Calyon Financial is dealing on the Client’s behalf) is “guaranteed” by
the market or clearing house. However, this guarantee is unlikely in most circumstances to cover
the Client, and may not protect the Client if Calyon Financial or another party defaults on its
obligations to the Client. Not all markets act in the same way.

11. Risk of default or insolvency : Calyon Financial insolvency or default, or that of any other
brokers involved with the Client’s transaction, may lead to positions being liquidated or closed
out without the Client’s consent. In certain circumstances, the Client may not get back the actual
assets which it lodged as collateral and the Client may have to accept any available payments in
cash. On request, Calyon Financial must provide an explanation of the extent to which it will
accept liability for any insolvency of, or default by, other firms involved with the Client’s.

12. Calyon Financial policy with regard to clients classified as non-professional clients:Non-
professional clients will be only allowed to trade commodity derivative products for hedging
purposes.

13. General information: Futures contracts are not subject to a prospectus.

Exchange-traded futures and options may give rise to liabilities for the investor, calculated in
accordance with market or clearing house rules.
Calyon Financial may not deal directly in the relevant market but may act through one or more
brokers or intermediaries. In such cases, the Client’s positions may be affected by the
performance of those third parties in addition to the performance of Calyon Financial.

In addition, settlement of such transactions may not be effected via the market itself but may be
effected on CF’s books or of a broker or intermediary if such transactions can be crossed with
equal but opposite orders of another participant transacting through the same firm, broker or
intermediary.

The Client’s rights in such circumstances differ from those it would enjoy if its transaction was
effected in the market.

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?

Ans;- Industry refers to the people or companies engaged in a particular kind of commercial
enterprise. It is described it as the manufacturing of a good or service within a category. It is the
secondary sector in economics, also coming under the private sector.

Industry has been divided into four major sectors. Economies tend to follow a developmental
progress that takes them from a heavy reliance to agriculture and mining to manufacturing
industry, and then move on to a more service based economy.

1. Primary sector: mainly includes raw material extraction industries such as mining and
farming. It is mainly the conversion of natural resources into primary products that are used as
raw material by other industries. The manufacturing industries that aggregate, package, purify or
process the raw material near the primary producers are normally considered part of this sector,
especially if the raw material is unsuitable for use in its original form, or if it is difficult to
transport it to long distances. Developing countries are more dependent on this sector. In
developed the same sector becomes more mechanized and high-tech, requiring smaller
manpower. Hence, while developing countries have a major part of the workforce involved in
this industry, the developed countries have a higher percentage involved in secondary and
tertiary sectors as compared to the primary sector.

2. Secondary sector: involves refining, construction, and manufacturing. This sector creates a
finished and useable product. The sector is divided into light and heavy industry. The sector
consumes large amount of energy and needs factories and often heavy machinery to convert raw
material into a finished product. These also produce large amount of waste product in the
process, often environmentally hazardous. However, manufacturing is an important part of
economic growth and development. It increases export possibilities, thus improving GDP of the
country. This ion turn funds infrastructure in the economy and health facilities, among other life
initiatives. This sector is more open to international trade and competition than service.

3. Tertiary sector: deals with services (such as law and medicine) and distribution of
manufactured goods. When contrasted to the wealth producing sectors like secondary and
primary sectors, tertiary sector is a wealth consuming sector. When the wealth consuming and
wealth producing sectors are balanced, the economy grows, but if the tertiary sector grows bigger
than the first two, the economy declines. Service sector, as it is called, offers services or
'intangible goods'. The services are provided to businesses and final consumers. It may involve
distribution or transport and sales of goods from producer to consumer. This sector also includes
the soft parts of the economy such as the insurance, tourism, banking, education, retail.
Typically, the output is in the form of content (info), advice, service, attention experience or
discussion. Service economy refers to a model where as much economic activity as possible is
treated as service.

4. Quaternary sector: knowledge industry focusing on technological research, design and

development such as computer programming, and biochemistry. It is a comparatively new
division. It is an extension of the three-sector hypothesis of industrial evolution. It principally
concerns the intellectual services: information generation, information sharing, consultation,
education and research and development. It is sometimes incorporated into the tertiary sector but
many argue that intellectual services are distinct enough to warrant a separate sector.
Entertainment is also an important part of this sector.

Importance of Industry life cycle

An industry lifecycle is a series of stages of development an industry moves through, from the
time of emergence to an eventual decline. Like biological lifecycles, industry lifecycles are
inevitable and they can be easily followed and projected. Innovation and other measures can
prolong an industry's life cycle, but ultimately companies must be prepared to be adaptable to
adjust to changing business, industry, and economic climates. Without flexibility, businesses can
go bankrupt when the industry lifecycle catches up with them.

The industry life cycle is made up of the following stages:

Pioneering Stage: During this stage the market for the industry’s product or service is small, the
firm or firms involved have to incur major development costs both in regard to the product
and in regard to the market. The product is yet to be proved in the commercial market.
Hence, the industry experiences modest sales growth and very small or negative profit
margins and profits.

Rapidly accelerating industry growth: This stage starts when the product of the industry is
accepted by the market. Further demand increases rapidly. The number of firms in the
industry is limited at this stage and hence the firms can experience substantial backlogs of
orders. Hence prices can be increased or discounts can be decreased and therefore profit
margins are high. The capacity utilization goes up and even though productive capacity is
increased, sales increase more rapidly. Hence high profit margins occur simultaneously
with high sales growth. Profits explode. Sales growth can be high up to even 50 percent
year and profits can grow over 100 percent a year as a result of the low earnings base and
high profit margins and increasing efficiency of the firms.

Mature industry growth: During mature growth stage, the rapid growth in sales comes down
match the growth industry definition. The definition of growth industry is that it has a
growth rate which is double that of economy. Growth no longer accelerates. The rapid
growth attracts more number of firms, which causes an increase in supply and lower prices.
This will force margins to decline from the levels witnessed in accelerating growth phase.

Stabilization and market maturity: This phase could the longest phase for the industry. The
growth now becomes approximately equal to the growth rate in the economy. Competition
produces tight profit margins and rates of return on capital are competitive. There will be
differences in profitability of industries as well as in profitability of companies due to
competitive structure and ability to control costs.

Decline: In this stage first the growth rates decline below that of growth in the economy.
Substitutes offering better output may appear at this stage. Profit margins get squeezed and
some firms experience low profits or even losses.

Intrinsic value of securities

After studying the conditions and the outlook for the economy, the industry, and the company,
the fundamental analyst determines the intrinsic value of a security. This estimated intrinsic
value can then be compared to the current market price of the security. The fundamental analyst
thus determines whether the company is overvalued or undervalued, if a share is undervalued ,
then the fundamental analyst will buy it, and hold it until other investors in the market realize its
value, and push it towards its fair share price by increasing demand on it. On the other hand, if a
share is over priced in the market in comparison with its intrinsic value, then fundamental analyst
will only buy the share after the share price declines, or will, alternatively, sell the shares that
they already hold of that stock. By this, the fundamental analyst aim to “capitalize on perceived
price discrepancies” between the market prices of stocks and the intrinsic value of company
shares. In other words, investors using fundamental analyst make use of the valuation gap
between the intrinsic value of stocks, and reap capital gains when price corrections take place in
the market in the long run.

In equilibrium, the current market price of a security reflects the average of the intrinsic value
estimates made by all the investors. An investor whose intrinsic value estimate differs from the
market price is, in effect, differing from the market consensus as to the estimate of either
expected return or risk, or both. Investor who can perform good fundamental analysis and spot
discrepancies should be able to profit by acting before the market consensus reflects the correct
information.

Q. 4 Is there any logic behind technical analysis? Explain meaning and basic tenets of
technical analysis.

Answer: Technical analysis is a method that is used to evaluate the worth of a security by
analyzing the statistics that are generated by market activity, such as past prices and volume.
Technical analysts do not attempt to measure a security's intrinsic value, as is done by the
fundamental analyst, but instead use charts and other tools to identify patterns that can suggest
future activity.

Meaning and Basic Tenets

Unlike fundamental analysts, technical analysts don't care whether a stock is undervalued or not -
the only thing that matters to them is a security's past trading data and what information that this
data can provide about where the security is moving in the future. Technical analysis disregards
the financial statements of the issuer (the company that has issued the security). Instead, it relies
upon market trends to ascertain investor sentiments that can be used to predict how a security
will perform.

Technicians, chartists or market strategists (as they are variously known), believe that there are
systematic statistical dependencies in asset returns - that history tends to repeat itself. They make
price predictions on the basis of price and volume data, looking for patterns and possible
correlations, and
applying rules of thumb to charts to assess 'trends', 'support' and 'resistance levels'. From these,
they develop ‘buy and sell’ signals.

The field of technical analysis is based on three assumptions:

1. The market discounts everything: Technical analysis assumes that, at any given point in
time, a security's price incorporates all the factors that can impact the price including the
fundamental factors. Technical analysts believe that the company's fundamentals, along with
broader economic factors and market psychology are all built into the security price and
therefore there is no need to study these factors separately. Thus the analysis is confined to an
analysis of the price movement. Technical analysis considers the market value of a security to be
solely determined by supply and demand.

2. Price moves in trends: Technical analysis believes that the security prices tend to move in
trends that persist for long periods of time. This means that after a trend has been established, the
future price movement is more likely to be in the same direction as the trend than to be against it.
Any shifts in supply and demand cause reversals in trends. These shifts can be detected in
charts/graphs.

3. History tends to repeat itself: History tends to repeat itself, mainly in terms of price
movements. Many chart patterns tend to repeat themselves. Market psychology is considered to
be the reason behind
the repetitive nature of price movements: market participants react in a consistent manner to
similar market stimuli over a period of time. Technical analysis is based on the assumption that
markets are driven more by psychological factors than fundamental values. Its proponents
believe that asset prices reflect not only the underlying 'value' of the assets but also the hopes and
fears of those in the market. They assume that the emotional makeup of investors does not
change, that in a certain set of circumstances, investors will react in a similar manner to how they
did in the past and that the resultant price moves are likely to be the same. Technical analysts use
chart patterns to analyze market movements and to predict security prices.

Although many of these charts have been used for more than 100 years, technical analysts
believe them to be relevant even now, as they illustrate patterns in price movements that often
repeat themselves. Technical analysis can be applied to any security which has historical trading
data. This includes stocks, bonds, futures, foreign exchange etc.

Q.2 Explain role played by efficient market in economy. Apply the parameters of efficient
market to Indian stock markets and find out whether they are efficient.

Answer: In finance, the efficient-market hypothesis (EMH) asserts that financial markets are
"informationally efficient". That is, one cannot consistently achieve returns in excess of average
market returns on a risk-adjusted basis, given the information publicly available at the time the
investment is made.

There are three major versions of the hypothesis: "weak", "semi-strong", and "strong". Weak
EMH claims that prices on traded assets (e.g., stocks, bonds, or property) already reflect all past
publicly available information. Semi-strong EMH claims both that prices reflect all publicly
available information and that prices instantly change to reflect new public information. Strong
EMH additionally claims that prices instantly reflect even hidden or "insider" information. There
is evidence for and against the weak and semi-strong EMHs, while there is powerful evidence
against strong EMH.
The validity of the hypothesis has been questioned by critics who blame the belief in rational
markets for much of the financial crisis of 2007–2010. Defenders of the EMH caution that
conflating market stability with the EMH is unwarranted; when publicly available information is
unstable, the market can be just as unstable.

The (now largely discredited) theory that all market participants receive and act on all of the
relevant information as soon as it becomes available. If this were strictly true, no investment
strategy would be better than a coin toss. Proponents of the efficient market theory believe that
there is perfect information in the stock market. This means that whatever information is
available about a stock to one investor is available to all investors (except, of course, insider
information, but insider trading is illegal). Since everyone has the same information about a
stock, the price of a stock should reflect the knowledge and expectations of all investors. The
bottom line is that an investor should not be able to beat the market since there is no way for
him/her to know something about a stock that isn't already reflected in the stock's price.
Proponents of this theory do not try to pick stocks that are going to be winners; instead, they
simply try to match the market's performance. However, there is ample evidence to dispute the
basic claims of this theory, and most investors don't believe it.

Studies on Indian Stock Market Efficiency

The efficient market hypothesis is related to the random walk theory. The idea that asset prices
may follow a random walk pattern was introduced by Bachelier in 1900. The random walk
hypothesis is used to explain the successive price changes which are independent of each other.
Fama (1991) classifies market efficiency into three forms - weak, semi-strong and strong. In its
weak form efficiency, equity returns are not serially correlated and have a constant mean. If
market is weak form efficient, current prices fully reflect all information contained in the
historical prices of the asset and a trading rule based on the past prices can not be developed to
identify miss-priced assets. Market is semi-strong efficient if stock prices reflect any new
publicly available information instantaneously. There are no undervalued or overvalued
securities and thus, trading rules are incapable of producing superior returns. When new
information is released, it is fully incorporated into the price rather speedily. The strong form
efficiency suggests that security prices reflect all available information, even private information.
Insiders profit from trading on information not already incorporated into prices. Hence the strong
form does not hold in a world with an uneven playing field. Studies testing market efficiency in
emerging markets are few. Poshakwale (1996) showed that Indian stock market was weak form
inefficient; he used daily BSE index data for the period 1987 to 1994. Barua (1987), Chan, Gup
and Pan (1997) observed that the major Asian markets were weak form inefficient. Similar
results were found by Dickinson and Muragu (1994) for Nairobi stock market; Cheung et al
(1993) for Korea and Taiwan; and Ho and Cheung (1994) for Asian markets. On the other hand,
Barnes (1986) showed a high degree of efficiency in Kuala Lumpur market. Groenewold and
Kang (1993) found Australian market semi-strong form efficient. Some of the recent studies,
testing the random walk hypothesis (in effect testing for weak form efficiency in the markets)
are; Korea (Ryoo and Smith, 2002; this study uses a variance ratio test and find the market to
follow a random walk process if the price limits are relaxed during the period March 1988 to Dec
1988), China, (lee et al 2001; find that volatility is highly persistent and is predictable, authors
use GARCH and EGARCH models in this study), Hong Kong (Cheung and Coutts 2001; authors
use a variance ratio test in this study and find that Hang Seng index on the Hong Kong stock
exchange follow a random walk), Slovenia (Dezlan, 2000), Spain (Regulez and Zarraga, 2002),
Czech Republic (Hajek, 2002), Turkey (Buguk and Brorsen, 2003), Africa (Smith et al. 2002;
Appiah-kusi and Menyah, 2003) and the Middle East (Abraham et al. 2002; this study uses
variance ratio test and the runs test to test for random walk for the period 1992 to 1998 and find
that these markets are not efficient).

METHODOLOGY & DATA:- To test historical market efficiency one can look at the pattern
of short-term movements of the combined market returns and try to identify the principal process
generating those returns. If the market is efficient, the model would fail to identify any pattern
and it can be inferred that the returns have no pattern and follow a random walk process. In
essence the assumption of random walk means that either the returns follow a random walk
process or that the model used to identify the process is unable to identify the true return
generating process. If a model is able to identify a pattern, then historical market data can be
used to forecast future market prices, and the market is considered not efficient. There are a
number of techniques available to determine patterns in time series data. Regression, exponential
smoothing and decomposition approaches presume that the values of the time series being
predicted are statistically independent from one period to the next. Some of these techniques are
reviewed in the following section and appropriate techniques identified for use in this study.

Runs test (Bradley 1968) and LOMAC variance ratio test (Lo and MacKinlay 1988) are used to
test the weak form efficiency and random walk hypothesis. Runs test determines if successive
price changes are independent. It is non-parametric and does not require the returns to be
normally distributed. The test observes the sequence of successive price changes with the same
sign. The null hypothesis of randomness is determined by the same sign in price changes. The
runs test only looks at the number of positive or negative changes and ignores the amount of
change from mean. This is one of the major weaknesses of the test. LOMAC variance ratio test is
commonly criticised on many issues and mainly on the selection of maximum order of serial
correlation (Faust, 1992). Durbin-Watson test (Durbin and Watson 1951), the augmented
Dickey-Fuller test (Dickey and Fuller 1979) and different variants of these are the most
commonly used tests for the random walk hypothesis in recent years (Worthington and Higgs
2003; Kleiman, Payne and Sahu 2002; Chan, Gup and Pan 1997). Under the random walk
hypothesis, a market is (weak form) efficient if most recent price has all available information
and thus, the best forecaster of future price is the most recent price. In the most stringent version
of the efficient market hypothesis, εt is random and stationary and also exhibits no
autocorrelation, as disturbance term cannot possess any systematic forecast errors. In this study
we have used returns and not prices for test of market efficiency as expected returns are more
commonly used in asset pricing literature (Fama (1998). Returns in a market conforming to
random walk are serially uncorrelated, corresponding to a random walk hypothesis with
dependant but uncorrelated increments. Parametric serial correlations tests of independence and
non-parametric runs tests can be used to test for serial dependence. Serial correlation coefficient
test is a widely used procedure that tests the relationship between returns in the current period
with those in the previous period. If no significant autocorrelation are found then the series are
expected to follow a random walk. A simple formal statistical test was introduced was Durbin
and Watson (1951). Durbin-Watson (DW) is a test for first order autocorrelation. It only tests for
the relationship between an error and its immediately preceding value. One way to motivate this
test is to regress the error of time t with its previous value.

ut = ρut-1 + vt where vt ~ N(0,σ2v).

DW test can not detect some forms of residual autocorrelations, e.g. if corr(ut, ut-1) = 0 but
corr(ut, ut-2) ≠ 0, DW as defined earlier will not find any autocorrelation. One possible way is to
do it for all possible combinations but this is tedious and practically impossible to handle. The
second-best alternative is to test for autocorrelation that would allow examination of the
relationship between ut and several of its lagged values at the same time. The Breusch- Godfrey
test is a more general test for autocorrelation for the lags of up to r‟th order.

Because of the abovementioned weaknesses of the DW test we do not use the DW test in our
study. An alternative model which is more commonly used is Augmented Dickey Fuller test
(ADF test). Three regression models (standard model, with drift and with drift and trend) are
used in this study to test for unit root in the research, (Chan, Gup and Pan 1997; Brooks 2002). In
this study we followed the test methodologies from Brooks (2002) with slight adjustments.
Where: St = the stock price u* and u** = the drift terms T = total number of observations εt, εt*,
εt** = error terms that could be ARMA processes with time dependent variances.

Where St is the logarithm of the price index seen at time t, u is an arbitrary drift parameter, α is
the change in the index and εt is a random disturbance term. Equation (3) is for the standard
model; (4) for the standard model with a drift and (5) for the standard model with drift and trend.
Augmented Dickey-Fuller (ADF) unit root test of nonstationarity is conducted in the form of the
following regression equation. The objective of the test is to test the null hypothesis that θ = 1 in:

against the one-sided alternative θ < 1. Thus the hypotheses to be tested are:

H0: Series contains a unit root against H1: Series is stationary

In this study we calculate daily returns using daily index values for the Mumbai Stock Exchange
(BSE) and National Stock Exchange (NSE) of India. The data is collected from the Datastream
data terminal from Macquarie University. The time period for BSE is from 24th May 1991 to
26th May 2006 and for NSE 27th May to 26th May 2006. Stock exchanges are closed for trading
on weekends and this may appear to be in contradiction with the basic time series requirement
that observations be taken at a regularly spaced intervals. The requirement however, is that the
frequency be spaced in terms of the processes underlying the series. The underlying process of
the series in this case is trading of stocks and generation of stock exchange index based on the
stock trading, as such for this study the index values at the end of each business day is
appropriate (French 1980). Table 1 presents the characteristics of two data sets used in this study.
During the period covered in this study, the mean return of the NSE index is much lower than
that of the BSE, similarly the variance of NSE is lower as compared with BSE index suggesting
a lower risk and a lower average return at NSE as compared with BSE. It is relevant to note that
NSE was established by the government of India to improve the market efficiency in Indian
stock markets and to break the monopolistic position of the BSE. NSE index is a more
diversified one as compared to the same of BSE. This can also be due to the unique nature of
India‟s equity markets, the settlement system on BSE was intermittent (Badla system up until
2nd July 2001) and on NSE it was always cash.
RESULTS:- This study conducts a test of random walk for the BSE and NSE markets in India,
using stock market indexes for the Indian markets. It employs unit root tests (augmented Dickey-
Fuller (ADF)). We perform ADF test with intercept and no trend and with an intercept and trend.
We further test the series using the Phillips-Perron tests and the KPSS tests for a confirmatory
data analysis. In case of BSE and NSE markets, the null hypothesis of unit root is convincingly
rejected, as the test statistic is more negative than the critical value, suggesting that these markets
do not show characteristics of random walk and as such are not efficient in the weak form. We
also test using Phillip-Perron test and KPSS test for confirmatory data analysis and find the
series to be stationary. Results are presented in Table 2. For both BSE and NSE markets, the
results are statistically significant and the results of all the three tests are consistent suggesting
these markets are not weak form efficient.

Results of the study suggest that the markets are not weak form efficient. DW test, which is a test
for serial correlations, has been used in the past but the explanatory power of the DW can be
questioned on the basis that the DW only looks at the serial correlations on one lags as such may
not be appropriate test for the daily data. Current literature in the area of market efficiency uses
unit root and test of stationarity. This notion of market efficiency has an important bearing for
the fund managers and investment bankers and more specifically the investors who are seeking
to diversify their portfolios internationally. One of the criticisms of the supporters of the
international diversification into emerging markets is that the emerging markets are not efficient
and as such the investor may not be able to achieve the full potential benefits of the international
diversification.

CONCLUSIONS & IMPLICATIONS:- This paper examines the weak form efficiency in two
of the Indian stock exchanges which represent the majority of the equity market in India. We
employ three different tests ADF, PP and the KPSS tests and find similar results. The results of
these tests find that these markets are not weak form efficient. These results support the common
notion that the equity markets in the emerging economies are not efficient and to some degree
can also explain the less optimal allocation of portfolios into these markets. Since the results of
the two tests are contradictory, it is difficult to draw conclusions for practical implications or for
policy from the study. It is important to note that the BSE moved to a system of rolling
settlement with effect from 2nd July 2006 from the previously used „Badla‟ system. The
„Badla‟ system was a complex system of forward settlement which was not transparent and was
not accessible to many market participants. The results of the NSE are similar (NSE had a cash
settlement system from the beginning) to BSE suggesting that the changes in settlement system
may not significantly impact the results. On the contrary a conflicting viewpoint is that the
results of these markets may have been influenced by volatility spillovers, as such the results
may be significantly different if the changes in the settlement system are incorporated in the
analysis. The research in the area of volatility spillover has argued that the volatility is
transferred across markets (Brailsford, 1996), as such the results of these markets may be
interpreted cautiously. For future research, using a computationally more efficient model like
generalized autoregressive conditional heteroskesdasticity (GARCH) could help to clear this.

Q. 6 What do you understand by yield? Explain the concept of YTM with the help of
example Fall 2010

Answer: Yield is a term that defines a return on a capital investment of various forms. Typically,
yield is expressed as a percentage and is used as an annual figure. An example of yield would be
an investment in real estate or a business deal that generates a ten percent return. It is then said
that that investment yielded a ten percent return. In the stock market yield essentially
communicates a rate of return made form an investment in common and preferred stocks. This
particular yield comes in form of a dividend and is also called a dividend yield. Yield is also a
function of the bond market. One of its applications is current yield, which is a coupon rate of
interest divided by the bond's purchase price. Additionally, yield is a rate of return on a bond that
takes into account the sum annual interest payment, the purchase price, the redemption value, as
well as the time period remaining until maturity. This is also referred to as maturity yield or yield
to maturity.

Yield To Maturity (YTM)

The yield to maturity is the annual rate of return that a bondholder will earn under the
assumption that the bond is held to maturity and the interest payments are reinvested at the
YTM. The yield to maturity is the same as the bond’s internal rate of return (IRR). The yield to
maturity or simply the yield is the discount rate that equates the current market price of the bond
with the sum of the present value of all cash flows expected from this investment.

T
Market price = ∑ Coupon + per value
 τ=1 (1+ytm)t (1+ytm)T

In the yield to maturity calculations, the market price of the bond is given, and we have to
calculate the discount rate or the YTM that will equate the present values of all the coupon
payments and the principal repayment to the current market price of the bond.

To calculate YTM, we use trial and error until we get a discount rate that equate the present
value of coupon payments and principal repayments to the current market price of the bond. We
can also use approximation formula for calculating the yield to maturity.

Coupo (Face value - Price)

+
yiel n Maturity
=
d (Price + Face value)
2

Example: Suppose a company can issue 9% annual coupon, 20 year bond with a face value of
Rs.1000 fro Rs. 980. What is the yield-to-maturity on this bond?

Coupon = 9& X Rs. 1000 = Rs. 90

Face Value = Rs. 1000

Price = Rs. 980

Maturity = 20 year

Yiel 90 + ( 1000 - 980) / 20

=
d ( 1000 + 980 ) / 2

= 91 / 990
= .0919 or 9.19 %
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?

Ans:- Portfolio management is challenging, but it's also exciting. Some people prefer to
have their portfolios managed by a professional. However, it's not impossible to
manage your own portfolio. It just takes time and a basic understanding of the
process.

Portfolio management involves 6 steps in an ongoing process.

1. Determine Objectives/Constraints
2. Formulate a Strategy
3. Design an Investment Policy
4. Implement Asset Allocation
5. Monitor Performance
6. Evaluate Performance

As an ongoing process, it is the responsibility of the portfolio manager (whether that's you or a
professional) to go through the process (beginning at "Determine Objectives and Constraints")
and upon reaching the "Evaluate Performance" stage, start again.

Why is it an ongoing process? Because life is not static. People move, they change jobs, they get
married, they get divorced, they get remarried, they have children, they make large purchases,
they make wise decisions, they make unwise decisions, they are faced with windfalls and
tragedies. Each of those (and many, many other) events will affect how they manage their
portfolio.

very individual has different needs and wants. The first step to successfully manage your
investment needs is to identify them by drafting an investment plan. This plan should state your
goals. It is simply a mission statement of what you endeavor to achieve. Be as specific as you
can, so that you can determine what to invest in, and how your portfolio will be structured to
realize your dream.
Knowing yourself is critical to creating and managing a portfolio that will do what you want it to
do. This knowledge will help you set realistic future financial goals and will help you to decide
how much risk to include in your investment strategy

There are several constraints that may work against your desire to build up a healthy nest egg.
These are all challenges of having money. Unfortunately, many of them are unavoidable… but
that doesn't mean that they're not manageable. The best thing to do is know that they exist and
develop strategies to help you over come them. Some of the considerations include evaluating
your Risk & Return Profile, Investment Time Horizon, Liquidity Requirement, Legal and
Taxation Structure, etc.

And also, do you remember the popular saying, "Don't put all your eggs in one basket" ? The
reason why you should achieve diversification in your portfolio is that the value of different asset
classes tends to behave and perform very differently. Some assets move in tandem or in a similar
direction with each other, while others move in opposite directions. What may surprise you is
that for the same rate of return, you can actually combine different asset classes to achieve this
expected return. Thus the secret to successful portfolio management is to create a portfolio by
investing in different types of asset classes, that generate the lowest risk factor to achieve your
investment objectives.

As you manage your portfolio, different factors will have an effect on its performance. The
economy, for example, may go up or down and cause the value of your holdings to rise or fall.
Perhaps you followed some advice from a friend on a "can't lose" stock and ended up losing.
Whatever the case may be, it is crucial to monitor the performance of your portfolio at all times
so that you can react if something happens.

We will review the 6 steps in our upcoming series of articles and I really hope you will benefit
from it.

Difference between PM and a Mutual Fund

Portfolio means collection of investment allowed by company or individual person .or

combination of various investments. the combination may be equity shares and prefrencce shares
and bonds and mutual funds,

Mutual fund is a one of the financial service. Collecting saving from the public and the savings
will be investment in different companies stocks, bonds and debenchers.this function done by
fund manager.
While the concept remains the same of collecting money from investors, pooling them and
investing the funds, the target investors are different. In the case of portfolio management the
target investors are high networth investors while in case of mutual funds the target investors are
the retail investors.

Features PM Mutual Fund

Management Provide ongoing, personalized access to Provide access to professional
professional money management services money management services
Customization Portfolio can be tailored to address each Portfolio structured to meet the
investor's specific needs fund's stated investment objectives
Management Provide ongoing, personalized access to Provide access to professional
professional money management services money management services
Ownership Investors directly own the individual Shareholders own shares of the
securities in their portfolio, allowing for tax fund and cannot influence buy and
management flexibility sell decisions or control their
exposure to incurring tax liabilities
Liquidity Although managers may hold cash, they are Mutual funds generally hold some
not required to hold cash to meet redemptionscash to meet redemptions
Minimums Significantly higher minimum investments Provide ongoing, personalized
than mutual funds. Generally, minimum access to professional money
ranges from: management services

• Rs. 1 Crore + for Equity Options

• Rs. 5 Crore + for Fixed Income
Options

• Rs. 20 Lacs + for Structured Products

Flexibility Generally more flexible than mutual funds. Comparatively less flexible
The Portfolio Manager may move to 100%
cash if required.
The Portfolio Manager may take his own
time in building up the portfolio. The
Portfolio Manager can also manage a
portfolio with disproportionate allocation to
select compelling opportunities

Mutual funds and PM are the two SEBI approved investment alternatives in India. A mutual fund
pools the assets of a large number of investors into one scheme and all the investors' money is
collectively managed. A PM treats each client as an individual client, and tailors a portfolio for
the client's individual needs. A PM investment is made in the individual client's name.

Mutual funds are a more regulated structure that provides a common portfolio to all investors,
while PM is a more flexible, but still regulated structure, where the investment depends on the
agreement with the client. Mutual fund investments cater to individuals with smaller ticket sizes
(under Rs 5 lakh) while PM investments cater to individuals with more money to invest.

Risk associated with Portfolio Management: Risk is the uncertainly that you may not earn
your expected return on your investments. For example, you may expect to earn 20% on your
equity mutual fund every year., but your actual rate of return may be much lower . Major types
of risk include:

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 is the chance that the entire market will decline, thus affecting the prices
and values of securities. Market risk, in turn, is influenced by outside factors such as
embargoes and interest rate changes.

Interest rate risk is the risk that interest rates will rise, resulting in a current investment's
loss of value. A bondholder, for example, may hold a bond earning 6% interest and then
see rates on that type of bond climb to 7%.

Inflation risk is the danger that the dollars one invests will buy less in the future because
prices of consumer goods rise. When the rate of inflation rises, investments have less
purchasing power. This is especially true with investments that earn fixed rates of return.
As long as they are held at constant rates, they are threatened by inflation. Inflation risk is
tied to interest rate risk, because interest rates often rise to compensate for inflation.

Industry risk is the chance that a specific industry will perform poorly. When problems
plague one industry, they affect the individual businesses involved as well as the
securities issued by those businesses. They may also cross over into other industries. For
example, after a national downturn in auto sales, the steel industry may suffer financially.

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 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 is the possibility that borrowers repay debt ahead of schedule. As a
result, investors are repaid sooner that 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.

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?

Ans: The total risk of a portfolio can be reduced by diversification: there is a reduction in the
size of the portfolio’s unique risk while the portfolio’s market risk remains approximately of the
same size.

Generally, the more diversified the portfolio (the larger the number of stocks in the portfolio),
the smaller the proportion of each stock in the portfolio Xi. This does not cause any significant
change in the portfolio beta βp, unless a deliberate attempt is made to include stocks with very
high or low betas.

The portfolio beta is an average of the beta of the portfolio stocks and there is no reason why
increasing the diversification will cause the portfolio beta and therefore the market risk of the
portfolio to either increase or decrease. However, an increase in diversification and therefore a
reduction in the proportion of each stock X I, leads to a reduction in the unique risk and in turn,
the total risk of portfolio.

Example:

Consider 3 securities A, B and C with the following betas and standard deviation of random
error terms:

A: β= 1.2, ơ ε = 6.06 %

B: β= 0.8, ơ ε = 4.76 %

C: β= 1.0, ơ ε = 5.5 %

The variance and the standard deviation of returns of the three stocks, A, B and C are:
A
Market risk = β 2ơ M2= 0.0092 =1.2 ^ 2 X 0.08 ^ 2
Unique risk= ơ ε2= 0.0037 =0.0606 ^ 2
Total risk= 0.0129
Standard
deviation= √0.0129= 0.1136 Or 11.36%

B
Market risk = β 2ơ M2= 0.0041 =0.8 ^ 2 X 0.08 ^ 2
Unique risk= ơ ε2= 0.0023 =0.0476 ^ 2
Total risk= 0.0064
Standard
deviation= √0.0064= 0.08 Or 8.00%

C
Market risk = β 2ơ M2= 0.0064 =1 ^ 2 X 0.08 ^ 2
Unique risk= ơ ε2= 0.003 =0.055 ^ 2
Total risk= 0.0094
Standard
deviation= √0.0094= 0.097 Or 9.70%

Let us combine the stocks A and B in a portfolio where each has a proportion of 0.5 and C has a
proportion of 0 (i.e. C is not present in the portfolio).

The variance and standard deviation of this portfolio are :

Beta
Portfolio= x i β i = 1 =0.5 X 1.2 + 0.5 X 0.8
Market risk of
Portfolio= βp 2ơ M2= 0.0064 =1 X 0.08 ^ 2
=0.055 ^ 2 X 0.0606 ^ 2 + 0.5 ^ 2 X
Unique risk= xi2 ơ ε2= 0.0015 0.0476 ^ 2
Total risk= 0.0079
Standard
deviation= √0.0079= 8.89%

Now, let us introduce C in the portfolio. Let each stock has an equal proportion of 0.33 in the
portfolio.
The variance and standard deviation of this portfolio are:

Beta of
Portfolio= x i β i = 0.99 =0.33 X 1.2 + 0.33 X 0.8 + 0.33 X 1
Market risk of
Portfolio= βp 2ơ M2= 0.0063 =0.99 X 0.08 ^ 2

Unique risk= xi2 ơ ε2= 0.001 =0.33 ^ 2 X 0.0606 ^ 2 + 0.33 ^ 2 X

0.0476 ^ 2 + 0.33 ^ 2 X 0.55 ^ 2
Total risk= 0.0073
Standard
deviation= √0.0073= 8.54%

Thus we see that the introduction of the third stock reduces the variance ( from 0.0079 to 0.0073)
and therefore, the total risk of the portfolio.

Risk are still bound to persist

It assumed that capital market is perfect. But this assumption is unrealistic. The capital market
being imperfect a discrepancy between the market values of levered and unleveled firms is
bound to persist.

The risk of insolvency increases with the amount of debts in a levered firm. Due to the risk of
insolvency and also due to the possibility of lower value of the assets in the event of insolvency,
investment in this firm will be less attractive. Hence, its market value will persist at a low level.

It is assumed under this approach that investors borrow funds on personal account and invest in
unleveled firm. This is an undesirable activity. The person indulging in personal leverage in
place of corporate leverage faces a greater risk. If the unleveled company goes bankrupt he loses
not only his own money but he will lose the borrowed fund also. For this reason personal
leverage is rarely resorted to. Hence, switching over of investment from levered firm A to
unleveled firm B does not take place; arbitrage does not operate.

The existence of transaction costs also interferes with the working of arbitrage. Because of the
costs involved in the buying and selling of securities a smaller amount of money will be
available for new investment. Hence return on new investment will be low.
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?

Answer: The total risk of a portfolio (indeed of a security) consists of two categories:

Systematic risk : In finance, systematic risk, sometimes called market risk, aggregate risk, or
undiversifiable risk, is the risk associated with aggregate market returns.

Systematic risk should not be confused with systemic risk, the risk of loss from some
catastrophic event that collapses the entire financial system.

It is the risk which is due to the factors which are beyond the control of the people working in the
market and that's why risk free rate of return in used to just compensate this type of risk in
market. 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. Even a portfolio
of well-diversified assets cannot escape all risk.

Example
Examples of systematic risk include uncertainty about general economic conditions, such as
GNP, interest rates or inflation.

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.

Unsystematic risk : 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.
This is the risk other than systematic risk and which is due to the factors which are controllable
by the people working in market and market risk premium is used to compensate this type of
risk.
Total Risk = Systematic risk + Unsystematic Risk
The risk that is specific to an industry or firm. Examples of unsystematic risk include losses
caused by labor problems, nationalization of assets, or weather conditions. This type of risk can
be reduced by assembling a portfolio with significant diversification so that a single event affects
only a limited number of the assets.

Company- or industry-specific risk as opposed to overall market risk; unsystematic risk can be
reduced through diversification. As the saying goes, “Don't put all of your eggs in one basket.”
Also known as specific risk, diversifiable risk, and residual risk.

Example
On the other hand, announcements specific to a company, such as a gold mining company
striking gold, are examples of unsystematic risk.

Risk: Systematic and Unsystematic

We can break down the risk, U, of holding a stock into two components: systematic risk and
unsystematic risk:
CAPM is not perfect:-
σ
• The model assumes that either asset returns are (jointly) normally distributed random

T
ota
variables or that investors employ a quadratic form of utility. It is however frequently
lr
observed that returns in equity and other markets are not normally distributed. As a result,
large swings (3 to 6 standard deviations from the mean) occur in the market more
frequently than the normal distribution assumption would expect.
• The model assumes that the variance of returns is an adequate measurement of risk. This
might be justified under the assumption of normally distributed returns, but for general

ε
return distributions other risk measures (like coherent risk measures) will likely reflect
the investors' preferences more adequately. Indeed risk in financial investments is not
variance in itself, rather it is the probability of losing: it is asymmetric in nature.
• The model assumes that all investors have access to the same information and agree
about the risk and expected return of all assets (homogeneous expectations assumption).
• The model assumes that the probability beliefs of investors match the true distribution of
returns. A different possibility is that investors' expectations are biased, causing market
prices to be informationally inefficient. This possibility is studied in the field of
behavioral finance, which uses psychological assumptions to provide alternatives to the

•
N
on
CAPM such as the overconfidence-based asset pricing model of Kent Daniel, David
Hirshleifer, and Avanidhar Subrahmanyam (2001). s
yste
The model does not appear to adequately explain the variation in stock returns. Empirical
studies show that low beta stocks may offer higher returns than the model would predict.
Some data to this effect was presented as early as a 1969 conference in Buffalo, New
York in a paper by Fischer Black, Michael Jensen, and Myron Scholes. Either that fact is

S
y
itself rational (which saves the efficient-market hypothesis but makes CAPM wrong), or
it is irrational (which saves CAPM, but makes the EMH wrong – indeed, this possibility
makes volatility arbitrage a strategy for reliably beating the market).
• The model assumes that given a certain expected return investors will prefer lower risk
(lower variance) to higher risk and conversely given a certain level of risk will prefer
higher returns to lower ones. It does not allow for investors who will accept lower returns
for higher risk. Casino gamblers clearly pay for risk, and it is possible that some stock
traders will pay for risk as well.
 • The model assumes that there are no taxes or transaction costs, although this assumption
may be relaxed with more complicated versions of the model.
• The market portfolio consists of all assets in all markets, where each asset is weighted by
its market capitalization. This assumes no preference between markets and assets for
individual investors, and that investors choose assets solely as a function of their risk-
return profile. It also assumes that all assets are infinitely divisible as to the amount
which may be held or transacted.
• The market portfolio should in theory include all types of assets that are held by anyone
as an investment (including works of art, real estate, human capital...) In practice, such a
market portfolio is unobservable and people usually substitute a stock index as a proxy
for the true market portfolio. Unfortunately, it has been shown that this substitution is not
innocuous and can lead to false inferences as to the validity of the CAPM, and it has been
said that due to the inobservability of the true market portfolio, the CAPM might not be
empirically testable. This was presented in greater depth in a paper by Richard Roll in
1977, and is generally referred to as Roll's critique.
• The model assumes just two dates, so that there is no opportunity to consume and
rebalance portfolios repeatedly over time. The basic insights of the model are extended
and generalized in the intertemporal CAPM (ICAPM) of Robert Merton, and the
consumption CAPM (CCAPM) of Douglas Breeden and Mark Rubinstein.
• CAPM assumes that all investors will consider all of their assets and optimize one
portfolio. This is in sharp contradiction with portfolios that are held by individual
investors: humans tend to have fragmented portfolios or, rather, multiple portfolios: for
each goal one portfolio.

Q. 4 What do you understand by arbitrage? Make a critical comparison between APT &
CAPM.

Answer: 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.

See rational pricing, particularly arbitrage mechanics, for further discussion.

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 spot-
forward arbitrage (see interest rate parity) 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.

Comparison between APT & CAPM

• APT applies to well diversified portfolios and not necessarily to individual stocks.
• With APT it is possible for some individual stocks to be mispriced - not lie on the SML.
• APT is more general in that it gets to an expected return and beta relationship without the
assumption of the market portfolio.
• APT can be extended to multifactor models.
• Both the CAPM and APT are risk-based models. There are alternatives.
• Empirical methods are based less on theory and more on looking for some regularities in
the historical record.
• Be aware that correlation does not imply causality.
• Related to empirical methods is the practice of classifying portfolios by style e.g.
o Value portfolio
o Growth portfolio
• The APT assumes that stock returns are generated according to factor models such as:

R = R + βI FI + βGDP FGDP + βS FS + ε
 • As securities are added to the portfolio, the unsystematic risks of the individual securities
offset each other. A fully diversified portfolio has no unsystematic risk.
• The CAPM can be viewed as a special case of the APT.
• Empirical models try to capture the relations between returns and stock attributes that can
be measured directly from the data without appeal to theory.
• Difference in Methodology
 CAPM is an equilibrium model and derived from individual portfolio optimization.
 APT is a statistical model which tries to capture sources of systematic risk. Relation
between sources determined by no Arbitrage condition.
• Difference in Application
 APT difficult to identify appropriate factors.
 CAPM difficult to find good proxy for market returns.
 APT shows sensitivity to different sources. Important for hedging in portfolio
formation.
 CAPM is simpler to communicate, since everybody agrees upon.

Q. 5 Diversification is key to good investment. What are pros and cons of foreign
investment?

Ans: 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.

Pros and Cons Foreign Investments

Several studies indicate that domestic investment projects have more beneficial trickle-down
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.

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 trickle-down
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 inter-firm 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.

Q. 6 Explain in brief APT with single factor model.

Answer: Arbitrage Pricing Theory (APT) is a factor model that was developed by Stephen Ross.
It starts with the assumption that security returns are related to an unknown number of unknown
factors. Its does not specify what these factors are. Unlike CAPM, Arbitrage Pricing Theory does
not rely on measuring the performance of the market. Instead, APT directly relates the price of
the security to the fundamental factors driving it. The problem with this is that the theory in itself
provides no indication of what these factors are, so they need to be empirically determined.
Single Factors Model

A special case of the arbitrage pricing theory that is derived from the one-factor model by using
diversification and arbitrage. It shows that the expected return on any risky asset is a linear
function of a single factor.The simplest factor model, given below, is a one-factor model:

The return on a security, r I is given by:

r I= a I+ b IF + ε i

Where F is the factor, a I is the expected return on the security I if the factor has a value of zero,
b I is the sensitivity of security I to this factor, and ε I is the random error term.

The returns on security I are related to two main components. The first of these involves the
factor F. Factor F affects all securities returns but with different sensitivities. The sensitivity of
security is return to F is b I . Securities that have small values for this parameter will react only
slightly as F changes, whereas when b I is large, variations in F cause very large movements in
the return on security I .

As a concrete example, think of F as the return on a market index ( e.g. the Sensex or the Nifty),
the variations in which cause in individual security returns. Hence, this term causes movements
in individual security returns that are related. If two securities have positive sensitivities to the
factor, both will tend to move in the same direction.

The second term in t5he factor model is random error term, which is assumed to be uncorrelated
across different stocks. We denotes this term ε I and call it the idiosyncratic return
component for stock I . An important property of the idiosyncratic component is that it is
assumed to be uncorrelated with F, the common factor in stock returns. The expected value of
random error term is zero.

According to one factor model, the expected return on security I , r I can be written as :

_ _
r I= a I+ b IF

_
Where F denotes the expected value of the factor. The random error term drops out as the
expected value of the random error term is zero.

This equation can be used to estimate the expected return on the security. For example, if the
factor F is the GDP growth rate, and the expected GDP growth rate is 5 % , a I and b I = 2 then
the expected return is equal to 4% + 2 X 5% = 14 %
The variance of any security in the factor model is equal to

2 2
ơ = b ơ 2 + ơ 2
i i F εi

Where Ơ F2 is the variance of the factor F and Ơ εi 2 is the variance of the random error term ε
I.

Thus if the variance of the factor Ơ F2 is 0.0003 and the variance of the random error term Ơ εi 2
is equal to 0.0015 and b I = 2, then the variance of the security is equal to 2 2 X 0.0003 + 0.0015
= 0.0027 and the standard deviation of the security is equal to √ variance = √0.0027 = 0.0520 =
5.2%

In a single factor model, the covariance between any two securities I and j is equal to :

ơ b 2
= bj ơ
ij i
F

Where b I are the b j are the factor sensitivities of the two securities and Ơ F2 is the variance of
the factor F.

Example: If the factor sensitivities of two securities are 2 and 4 respectively, and if the
variance of the factor Ơ F2 is 0.0003, then the covariance between the two securities is equal to
2 X 4 X 0.0003 = 0.0024.

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