SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT

Question-01: Differentiate between ADRs and GDRs. A n s w e r : 1. Global depository receipt (GDR) is compulsory for foreign company to access in anyo t h e r c o u n t r y s s h a r e m a r k e t f o r d e a l i n g i n s t o c k . B u t A m e r i c a n d e p o s i t o r y r e c e i p t (ADR) is compulsory for non us companies to trade in stock market of usa . 2. ADRs can get from level -1 to level III. GDRs are already equal to high preferencer e c e i p t o f l e v e l I I a n d l e v e l I I I . 3. Indian companies prefer to get GDR due to its global use for getting foreigninvestment for own business projects. 4. ADRs up to level I need to accept only general condition of SEC of USA but GDRscan only be issued und er rule 144 A after accepting strict rules of SEC of USA . 5. GDR is negotiable instrument all over the world but ADR is only negotiable inU S A . 6. Many Indian Companies listed foreign stock market through f o r e i g n b a n k s G D R . Names of these Indian Companies are following :(A) Bajaj Auto (B) Hindalco (C) I T C ( D ) L & T ( E ) R a n b a x y Laboratories (F) SBI Some of Indian Companies arelisted in USA stock exchange only through ADRs :- (A) Patni Computers (B) TataM o t o r s 7. Even both GDR & ADR is the proxy way to sell shares in f o r e i g n m a r k e t b y I n d i a companies ADRs is not substitute of GDRs but GDRs can use on the place of ADRs.

8. Investors of UK can buy GDRs from London stock exchange and luxemberg stocke x c h a n g e a n d i n v e s t i n I n d i a n c o m p a n i e s w i t h o u t a n y e x t r a r e s p o n s i b i l i t i e s . Investors of USA can buy ADRs from New york stock exchange (NYSE) orNASDAQ (National Association of Securities Dealers Automated Quotation). 9. American investors typically use regular equity trading accounts for buying ADRsbut not for GDRs. 10. The US dollar rate paid to holders of ADR s is calculated b y appl yin g the exchangerate used to convert the foreign d i v i d e n d p a y m e n t ( n e t o f local withholding tax) toUS dollars, and adjusting the result a c c o r d i n g t o t h e o r d i n a r y s h a r e b u t G D R s i s calculated on numbers of Shares. One GDR's Value may be on two or six shares Question 2: Using financial ratios, study the financial performance of any particularcompanyofyour interest. A n s w e r : Financial ratios illustrate relationships between different aspects of a small business's operations.They involve the comparison of elements from a balance sheet or income statement, and are craftedwith particular points of focus in mind. Financial ratios can provide small business owners andmanagers with a valuable tool to measure their progress against predetermined internal goals, acertain competitor, or the overall industry. In addition, tracking various ratios over time is apowerful way to identify trends as they develop. Ratios are also used by bankers, investors, andbusiness analysts to assess various attributes of a company's financial strength or operating results.Ratios are determined by dividing one number by another, and are usually expressed as apercentage. They enable business owners to examine the relationships between seemingly unrelateditems and thus gain useful information for decision-making. "They are simple to calculate, easy touse, and provide a wealth of information that cannot be gotten anywhere else," James O. Gill notedin his book Financial Basics of Small Business Success. But, he added, "Ratios are aids to judgmentand cannot take the place of experience. They will not replace good management, but they willmake a good manager better. They help to pinpoint areas that need investigation and assist indeveloping an operating strategy for the future."Virtually any financial statistics can be compared using a ratio. In reality, however, small businessowners and managers only need to be concerned with a small set of ratios in order to identify whereimprovements are needed. "As you run your business you juggle dozens of different variables,"David H. Bangs, Jr. wrote in his book Managing by the Numbers. "Ratio analysis is designed to helpyou identify those variables which are out of balance."It is important to keep in mind that financial ratios are time sensitive; they can only present a

pictureof the business at the time that the underlying figures were prepared. For example, a retailercalculating ratios before and after the Christmas season would get very different results. In addition,ratios can be misleading when taken singly, though they can be quite valuable when a small businesstracks them over time or uses them as a basis for comparison against company goals or industrystandards. As a result, business owners should compute a variety of applicable ratios and attempt todiscern a pattern, rather than relying on the information provided by only one or two ratios. Gill alsonoted that small business owners should be certain to view ratios objectively, rather than using themto confirm a particular strategy or point of view.Perhaps the best way for small business owners to use financial ratios is to conduct a formal ratioanalysis on a regular basis. The raw data used to compute the ratios should be recorded on a specialform monthly. Then the relevant ratios should be computed, reviewed, and saved for futurecomparisons. Determining which ratios to compute depends on the type of business, the age of thebusiness, the point in the business cycle, and any specific information sought. For example, if a small business depends on a large number of fixed assets, ratios that measure how efficiently theseassets are being used may be the most significant. In general, financial ratios can be broken downinto four main categoriesprofitability or return on investment, liquidity, leverage, and operating orefficiencywith several specific ratio calculations prescribed within each. Q 1 F i n a n c i a l S u m m a r y Google reported revenues of $6.77 billion for the quarter ended March 31, 2010, anincrease of 23% compared to the first quarter of 2009. Google reports it s revenues,c o n s i s t e n t w i t h GAAP, on a gross basis without deducting traffic acquisition costs(TAC). In the first quarter of 2010, TAC totaled $1.71 b i l l i o n , o r 2 6 % o f a d v e r t i s i n g revenues.G o o g l e r e p o r t s o p e r a t i n g i n c o m e , o p e r a t i n g m a r g i n , n e t i n c o m e , a n d e a r n i n g s p e r share (EPS) on a GAAP and non-GAAP basis. The non -GAAP measures, as well as free c a s h f l o w , an alternative non -GAAP measure of liquidit y, are described below and arereconciled to the corresponding GAAP measures in the accompan ying financial tables.GAAP operating income in the first quarter of 2010 was $2.49 billion, or 37% ofrevenues. This compares to GAAP operating income of $1.88 billion, or 34% of r e v e n u e s , i n t h e f i r s t q u a r t e r o f 2 0 0 9 . N o n - G A A P o p e r a t i n g i n c o m e i n t h e f i r s t q u a r t e r of 2010 was $2.78 billion, or 41% of revenues. This compares to non -GAAP operatingincome of $2.16 billion, or 39% of revenues, in the first quarter of 2009.GAAP net income in the first quarter of 2010 was $1.96 billion, compared to $1.42b i l l i o n i n t h e f i r s t q u a r t e r o f 2 0 0 9 . N o n GAAP net income in the first quarter of 2010was $2.18 billion, compared to $1.64 billion in the first quarter of 2009.GAAP EPS in the first quarter of 2010 was $6.06 on 323 million diluted sharesoutstanding, compared to $4.49 in the first

q u a r t e r o f 2 0 0 9 o n 3 1 7 m i l l i o n d i l u t e d shares outstanding. NonGAAP EPS in the first quarter of 2010 was $6.76, compared t o $ 5 . 1 6 i n t h e f i r s t q u a r t e r o f 2 0 0 9 . Non-GAAP operating income and non -GAAP o p e r a t i n g m a r g i n e x c l u d e t h e e x p e n s e s related to stock-based compensation (SBC). Non-GAAP net income and non -GAAP EPSe x c l u d e t h e e x p e n s e s related to SBC and the related tax benefits. In the first quarter o f 2010, the charge related to SBC was $291 million, compared to $277 million in the firstq u a r t e r o f 2 0 0 9 . T h e t a x b e n e f i t r e l a t e d t o S B C was $65 million in the first quarter of2010 and $64 million in t h e f i r s t q u a r t e r o f 2 0 0 9 . R e c o n c i l i a t i o n s o f n o n - G A A P measures to GAAP operating income, operating margin, net income, and EPS areincluded at the end of this release.Internation al Revenues - Revenues from outside of the United States totaled $3.58billion, representing 53% of total revenues in the first quarter of 2010, compared to 5 3 % i n t h e fourth quarter of 2009 and 52% in the first quarter of 2009. E x c l u d i n g g a i n s related to our foreign exchange risk management program, had foreign exchange rates r e m a i n e d c o n s t a n t f r o m t h e fourth quarter of 2009 through the first quarter of 2010,our revenues in the first quarter of 2010 would have been $112 m i l l i o n h i g h e r . Excluding gains related to our foreign exchange risk management program, hadf o r e i g n e x c h a n g e r a t e s r e m a i n e d c o n s t a n t f r o m t h e f i r s t q u a r t e r o f 2 0 0 9 t h r o u g h t h e first quarter of 2010, our revenues in the first quarter of 2010 would have been $242 m i l l i o n l o w e r . Revenues from the Unit ed Kingdom totaled $842 million, representing 13% ofr e v e n u e s i n t h e f i r s t q u a r t e r o f 2 0 1 0 , compared to 13% in the first quarter of 2009.In the first quarter of 2010, we recognized a benefit of $10 million to revenues t h r o u g h our foreign exchange risk manage ment program, compared to $154 million in the firstquarter of 2009.Paid Clicks Aggregate paid c l i c k s , w h i c h i n c l u d e c l i c k s r e l a t e d t o a d s s e r v e d o n Google sites and the sites of our AdSense partners, increased approximately 15% over t h e f i r s t quarter of 2009 and increased approximately 5% over the fourth q u a r t e r o f 2009.C o s t - P e r - C l i c k A v e r a g e c o s t - p e r - c l i c k , w h i c h i n c l u d e s clicks related to ads served onGoogle sites and the sites of our AdSense partners, increased approximately 7% over t h e f i r s t q u a r t e r o f 2 0 0 9 and decreased approximately 4% over the fourth quarter o f 2009.T A C - T r a f f i c A c q u i s i t i o n C o s t s , t h e p o r t i o n o f r e v e n u e s s h a r e d with Googles partners,increased to $1.71 billion in the first quarter of 2010, compared to TAC of $1.44 billionin the first quarter of 2009. TAC as a percentage of advertising revenues was 26% in t h e f i r s t q u a r t e r o f

2010, compared to 27% in the first quarter of 2009.The majority of TAC is related to amounts ultimately paid to our AdSense partners,which totaled $1.45 billion in the first quarter of 2010. TAC also includes amountsu l t i m a t e l y p a i d t o c e r t a i n distribution partners and others who direct traffic to o u r website, which totaled $265 million in the first quarter of 2 0 1 0 . Other Cost of Revenues - Other cost of revenues, which is comprised primarily of datacenter operational expenses, amortization of i n t a n g i b l e a s s e t s , c o n t e n t a c q u i s i t i o n costs as well as credit card processing charges, increased to $741 million, or 11% of r e v e n u e s , i n t h e f i r s t q u a r t e r o f 2010, compared to $666 million, or 12% of revenues, int h e f i r s t q u a r t e r o f 2 0 0 9 . Operating Expenses - Operating expenses, other than cost of revenues, were $1.84b i l l i o n i n t h e f i r s t q u a r t e r o f 2 0 1 0 , o r 2 7 % o f r e v e n u e s , c o m p a r e d t o $ 1 . 5 2 b i l l i o n i n t h e first quarter of 2009, or 28% of revenues.Stock -Based Compensation (SBC) In the first quarter of 2010, the total charger e l a t e d t o S B C w a s $ 2 9 1 m i l l i o n , c o m p a r e d t o $ 2 7 7 m i l l i o n i n t h e f i r s t q u a r t e r o f 2 0 0 9 . We currently estimate SBC charges for grants to emplo yees prior to April 1, 2010 to beapproximately $1.2 billion for 2010. This estimate does not include ex penses to berecogniz ed related to emplo yee s tock awards that are granted after March 31, 2010 ornon -emplo yee stock awards that have been or may be grante d.Operating Income - GAAP operating income in the first quarter of 2010 was $2.49billion, or 37% of revenues. This compares to GAAP operating income of $1.88 billion, o r 3 4 % o f revenues, in the first quarter of 2009. Non-GAAP operating i n c o m e i n t h e first quarter of 2010 was $2.78 billion, or 41% of revenues. This compares to non -GAAPoperating income of $2.16 billion, or 39% of revenues, in the first quarter of 2009.
FORWARD-LOOKING STATEMENTS This press release contains forward -looking statements that involv e risks anduncertainties. These statements include statements regarding our plans to heavilyinvest in innovation, our expected stock -based compensation charges and our plans tom a k e s i g n i f i c a n t c a p i t a l e x p e n d i t u r e s . A c t u a l r e s u l t s m a y d i f f e r m a t e r i a l l y f r o m t h e results predicted, and reported results should not be considered as an indication of f u t u r e p e r f o r m a n c e . T h e p o t e n t i a l r i s k s a n d u n c e r t a i n t i e s t h a t c o u l d c a u s e a c t u a l results to differ from the results predicted include, among others, unforeseen changesi n o u r h i r i n g p a t t e r n s a n d o u r n e e d t o e x p e n d c a p i t a l t o a c c o m m o d a t e t h e g r o w t h o f the business, as well as those risks and uncertainties included under the captionsRisk Factors and Managements

Discussion and Analysis of Financial Condition and R e s u l t s o f O p e r a t i o n s i n o u r A n n u a l R e p o r t o n F o r m 1 0 - K f o r t h e y e a r e n d e d December 31, 2 0 0 9 , w h i c h i s o n f i l e w i t h t h e S E C a n d i s a v a i l a b l e o n o u r i n v e s t o r relations website at investor.google.com and on the SEC website at www.sec.gov. A d d i t i o n a l information will also be set forth in our Quarterly Report on Form 10-Q forthe quarter ended March 31, 2010, which we expect to file with the SEC in May 2010.All information provided in this release and in the attachments is as of April 15, 2010,and Google undertakes no duty to update this information. Question 3 : Asaninvestorhowwouldyouselectanequitymutualfundscheme . A n s w e r : How do I choose a SchemeB u t t o b e g i n y o u r s e l e c t i o n s t a r t f r o m t h e v e r y b e g i n n i n g : Specify your investment needsWhile we are on the topic of what returns to expect, someone might as well wish for a f u n d t h a t a s s u r e s returns. Some of the mutual funds have floated "assured" r e t u r n Fundas and more fundas. There is no end to verbosity when educating on funds. Butg e t t i n g t o a c t u a l l y c h o o s e a f u n d m a y n o t b e e a s e d w i t h more fundas. It often turnsout, like with most ventures in life, that picking your fund is like crossing the saddlepoint the first time i s a l w a y s t h e m o s t d i f f i c u l t . T h e r e a r e m o r e t h a n 3 5 0 s c h e m e s and choosing one of them is not an easy task. We will provide you an easy way to filterthis huge number down to a more manageable size so that you can look spend moret i m e l o o k i n g a t s c h e m e s i n g r e a t e r d e t a i l . W h a t a r e y o u looking for when investing in mutual funds? What a re your i n v e s t m e n t needs? The more well defined these answers are the easier it is to find schemes best foryou. So how do you assess your needs?T h e a n s w e r s o b v i o u s l y l i e w i t h you. But the questions investors ask to assess theirneeds are possibly the same. You might ask yourself: At my age what am I expectingout of investing? To assess the needs investors look at their lifestyles, f i n a n c i a l independence, family commitments, and level of income and expenses among othert h i n g s . Q u e s t i o n s c a n b e m a n y b u t t o g e t c r a c k i n g a s k y o u r s e l f t h e s e two:W h a t a r e t h e r e t u r n s y o u w a n t o n y o u r i n v e s t m e n t s ? Do you have well-defined time period for the returns you expect on your investment? T h e father of an aspiring engineer who would have to shell out the b o y ' s i n s t i t u t e f e e s soon enough, could reply: I want a fixed monthly income of about Rs.5000 per month.To the second query he might say: Yes, for the next four years. When asked, the just -out-of-B-school graduate p l a n n i n g f o r h i s n e w Z e n c o u l d r e p l y : I s h o u l d m a k e a b o u t R s . 60,000 by the end of one year.B e l i e v e u s , b u t g e t t i n g t h e r i g h t a n s w e r s t o t h e s e q u e s t i o n s does a lot to simply yourfund picking exercise. Assess the risk you can takeC o n t r a r y t o t h e c o m m o n p l a c e t h i n k i n g , m u t u a l f u n d s d o c a r r y r i s k s . A n d t h e r e a r e some that can become as risky as stocks. Given the almost diverse objectives withwhic h schemes

operate, there are some with more risks and some relatively safer.A s k yourself if you are ready for a scheme whose investment value might fluctuateevery week or one that gives a minimum amount of risk? Or are you in for a short-termloss in order to achieve a longterm potential gain? At this point it is good to askoneself how will you take it if your investment fails to deliver the returns you e x p e c t e d or makes losses. Knowing this will reduce your chances (or even t e m p t a t i o n ) t o s e l e c t a fund that doesnt come close to your objective. I n v e s t o r s comfortable with numerical recipes do a technical check of what t h e r e t u r n s of a scheme would be in the worst case. They check is done with the Sharpe ratio. The h i g h e r t h e S h a r p e r a t i o , t h e b e t t e r t h e f u n d ' s h i s t o r i c a l r i s k - a d j u s t e d p e r f o r m a n c e . Evaluate a scheme by looking at how its NAV has behaved over the past. Do you seethe scheme behaving rather erratically i.e., the NAV changes just to o often? More thev o l a t i l i t y m o r e a r e t h e r i s k s i n v o l v e d . G r e a t r e t u r n s a r e n o t t h e o n l y t h i n g t o l o o k f o r i n a s c h e m e . I f y o u f e e l w h i l e researching a scheme, which we will do later, that its returns are modest and steadyand good enough for your needs, avoid other schemes that have recently delivered highr e t u r n s . B e c a u s e g r e a t r e t u r n s i n t h e p a s t a r e n o g u a r a n t e e f o r t h e f a b u l o u s performance to continue in the future. Never forget one of the commonplace morals ofinvestment: The schemes that are expected to give the highest returns have the g r e a t e s t p r o b a b i l i t y t o f a l l f l a t ! Ask : How long can you park your cash ??Is the cash you have earmarked for your investment meant to be spent for somethingelse? Do you n e e d a r e g u l a r c a s h f l o w ? O r y o u d o n t m i n d l o c k i n g y o u r c a s h i n t h e scheme so that your assets can appreciate over time?

The success of your investment depends in a large measure on the objective you define.H a v i n g d e f i n e d t h a t , c h o o s i n g a f u n d i s n t d i f f i c u l t . T h r o u g h a s e a r c h o f s c h e m e s o n our advanced search you can draw up a list of schemes that come close to the objectives y o u h a v e s e t . O u r s e a r c h a l l o w s y o u t o s e t criteria based on your objectives. Thecriteria you can set are: T esc e ese pn : h hm x e se A l l s c h e m e s h a v e a m i n i m u m r e q u i r e m e n t f o r t h e t o t a l a m o u n t of money you can invest. Usually they begin from a minimum of Rs.5000. Do a checkfor the expense ratio and sales charges the fund has. The NAV is good enough to knowwhat each unit of the scheme will cost you. B u t , r e m e m b e r a l o w N A V ( s o m e t i m e s e v e n below the usual offer price of Rs.10) may make a scheme more affordable as you can a c q u i r e m o r e u n i t s b u t chances are the scheme is not performing well. Theschemesperformance: Returns from schemes are calculated over various periodsfrom a week to one year or more. For each time period specif y the returns. W hile youe n t e r r e t u r n s f i g u r e s t h e m a x i m u m , m i n i m u m a n d a v e r a g e r e t u r n s f o r a l l s c h e m e s i n the category you have chosen are also displayed. T esc e esf n h u : h hm u d o se

Over the years fund houses in I ndia have established a namefor themselves for their investment st yle and their performance. Hence, some investors u s u a l l y t r y t o s a t i s f y t h e i r d i v e r s e i n v e s t m e n t s
t h r o u g h o n e f u n d h o u s e . I f y o u h a v e been recommended a fund house choose the fund to list all schemes under it. Investment mix : If you know of an industry that has been doing particularly well, y o u can select schemes that have invested in that industry. You can also select schemesthat have invested in companies with a dazzling p e r f o r m a n c e . A m i x e d b a s k e t f o r y o u r d i v e r s e n e e d s Once again, back to the basic question. You came here looking for schemes that can s u f f i c e y o u r i n v e s t m e n t n e e d s . Y o u m i g h t b e l i k e m a n y o t h e r s w h o a c t u a l l y h a v e multiple needs. Consider going for a combination of schemes.Yet ano ther recap of the basics: one of the things that made these mutual funds greatwas diversification. While you might have selected a scheme that has a diversifiedportfolio, you can also go for more than one scheme to further diversify youri n v e s t m e n t s . It is well possible that just by picking more than one scheme from one fund house you c a n a c h i e v e e n o u g h d i v e r s i f i c a t i o n . I n f a c t m a n y i n v e s t o r s w h o h a v e t r i e d o u t a f u n d house for long and developed a trust with the fund, prefer to pick another scheme from t h e fund's. Question 4: Show how duration of a bond is calculated and how is it used . A n s w e r : Duration of Bonds Bond Duration is a measure of bond price volatility, which captures both price andreinvestment risk and which is used to indicate how a bond will r e a c t i n d i f f e r e n t i n t e r e s t r a t e e n v i r o n m e n t s . The duration of a bond represents the length of time that elapses before the averagerupee of present value from the bond is received. Thus duration of a bond i s thew e i g h t e d average maturity of cash flow stream, where the weights are p r o p o r t i o n a l t o the present value of cash flows. Formally, it is defined as: Duration = D = {PV (C1) x 1 + PV (C2) x 2+ ----- PV (Cn) x n} / Current Price of the bondWhere PV (Ci) is the present values of cash flow at time i. Steps in calculating duration: Step 1 : Find present value of each coupon or principal payment. S t e p 2 : Multiply this present value by the year in which the cash flow is to b e r e c e i v e d . Step 3 : Repeat steps 1 & 2 for each year in the life of the bond.Step 4 : Add the values obtained in step 2 and divide by the price of the bond to get the v a l u e o f D u r a t i o n . Example: Calculate the duration of an 8% annual coupon 5 year bond that is p r i c e d t o yield 10% (i.e. YTM = 10%). The face value of the bond is Rs.1000. Annual coupon payment = 8% x Rs. 1000 = Rs. 80

At the end of 5 years, the principal of Rs. 1000 will be returned to the investor. Therefore cash flows in year 1 -4= Rs. 80. Cash flow in year 5= Principal + Interest = Rs. 1000 + Rs. 80 = Rs. 1080

XXX Price of the bond= Rs 924.18T h e p r o p o r t i o n a l c h a n g e i n t h e p r i c e o f a bond: (P/P) = - {D/ (1+ YTM)} x y Where y = c h a n g e i n Y i e l d , a n d Y T M i s t h e y i e l d - t o - m a t u r i t y . T h e t e r m D / ( 1 + Y T M ) i s a l s o k n o w n a s Modified Duration. The modified duration for the bond in the example above = 4.28 / ( 1 + 1 0 % ) = 3.89years. This implies that the price of the bond will decrease by 3.89 x 1% = 3.89% for a 1%i n c r e a s e i n t h e i n t e r e s t r a t e s . Example A bond having R s.1000 face value and 8 % coupon bond with 4 years to maturity isp r i c e d t o p r o v i d e a Y T M o f 1 0 % . F i n d t h e d u r a t i o n o f t h e b o n d . Ans: P 0 = 80 x P VIFA 10% , 4 years + 1000 x P VIFA 10%, 4 years
= 80 x 3.170 + 1000 x .683 = 937 rc = 80/937 = 0.857 (current yield)r d = Y T M n = 4 yearsDuration = PVIFA (rd ,n) (1+rd) + [1 ] n d c r r r d r c = 3.170 (1.10) + [ 1 ] 4 .10 .0854 .10 .0854 = 2.977 + .584 = 3.561 years Generally speaking, bond duration possesses the following properties: Bonds with higher coupon rates have shorter durations. Bonds with longer maturities have longer durations. Bonds with higher YTM lead to shorter durations. Duration of a bond with coupons is always less than its term to maturity becauseduration gi ves w e i g h t t o t h e i n t e r i m p a y m e n t s . Azero-couponbonds durationisequalto its maturity. Question 5: Show with the help of an example how portfolio diversification reducesr i s k . A n s w e r : Portfolio diversification 'Don't put all your eggs in one basket' is a well-known proverb, which summarizes themessage that there are benefits from diversification. If you carry your breakable itemsin several baskets there is a chance that one will be dropped, but you are unlikely todr o p a l l yo ur b a s ke t s o n t he s a me t ri p . S i mi l ar l y, i f yo u i n v e s t a l l y o u r w e a l t h i n t h e shares of one company, there is a chance that the company will go bust and you will l o s e a l l y o u r m o n e y . S i n c e i t i s u n l i k e l y t h a t a l l c o m p a n i e s w i l l g o b u s t a t t h e s a m e time, a portfolio of shares in several companies is less risky. T h i s m a y s o u n d l i k e the idea of risk-pooling, which we discussed earlier in thischapter,

and risk-pooling is certainly an important reason for diversification. We willuse the notion of risk-pooling to explain some forms of financial behaviour, but a full understanding of portfolio diversification involves a slightly wider knowledge of thenature of risk than what is involved in cointossing.

Diversified portfolios may produce combinations of risk and return that dominate non-diversified portfolios. This is an important statement that requires a little closer investigation. Thatinvestigation will help to identify the circumstances under which diversification isbeneficial. It will also clarify what we mean by the word 'dominate'. Table 2 sets out two simple examples. In both there are two as sets that an investor canhold, and there are two possible situations which are assumed to be equally likely.T h u s , t h e r e i s a p r o b a b i l i t y o f 0 . 5 a t t a c h e d t o e a c h s i t u a t i o n a n d t h e i n v e s t o r h a s n o advance knowledge of which is g o i n g t o h a p p e n . T h e t w o s i t u a t i o n s m i g h t b e a h i g h exchange rate and a low exchange rate, a booming and a depressed economy, or any o t h e r a l t e r n a t i v e s that have different effects on the earnings of different assets. Table 2: Combinations of risk and return XXX Assets differ in expected return and variability in returns. P a r t ( i ) i l l u s t r a t e s t h e return on two assets in two different situations. Asset A has a high return in situation2 and a low return in situation 1. The reverse is true for asset B. A portfolio of b o t h assets has the same expected return but lower risk than a holding of either asset on itso w n . I n ( i i ) b o t h a s s e t s h a v e a h i g h r e t u r n i n s i t u a t i o n 2 a n d a l o w r e t u r n i n s i t u a t i o n 1. For the risk-averse investor asset A dominates asset B. Consider part (i) of the table. In this c ase both assets have the same e x p e c t e d r e t u r n (20 per cent) and the same degree of risk. (The possible range of outcomes is between1 0 a n d 3 0 p e r c e n t o n e a c h a s s e t . ) I f a l l t h a t m a t t e r e d i n investment decisions were ther i s k a n d r e t u r n o f i n d i v i d u a l s h a r e s , t h e i n v e s t o r w o u l d b e i n d i f f e r e n t b e t w e e n a s s e t s A and B. Indeed, if the choice were between holding only A or only B , all investorss h o u l d b e indifferent (whether they were risk-averse, risk-neutral, or riskl o v i n g ) because the risk and expected return are identical for both assets. However, this is notthe end of the story, because the returns on these assets are not independent. Indeed,there is a perfect negative correlation b e t w e e n t h e m : w h e n o n e i s h i g h t h e o t h e r i s l o w , and vice versa.

Risk-averseinvestorswillchoosethediversifiedportfolio,whichgivesthemthelowestrisk for a given expected rate of return, or the highest expected return for a given levelof risk. Diversification does not always reduce the riskiness of a portfolio, so we need to bec l e a r w h a t c o n d i t i o n s m a t t e r . C o n s i d e r t h e e x a m p l e i n p a r t ( i i ) o f T a b l e 2 . A s i n p a r t (i), both assets have an expected return of 20 per cent. But asset B is riskier than asset A a n d i t h a s r e t u r n s t h a t a r e p o s i t i v e l y c o r r e l a t e d w i t h A ' s . P o r t f o l i o d i v e r s i f i c a t i o n does not reduce risk in this case. Risk-averse investors would invest only in asset A,w h i l e r i s k - l o v e r s w o u l d i n v e s t o n l y i n a s s e t B . C o m b i n a t i o n s o f A and B are alwaysriskier than holding A alone. Thus, we could say that for the risk-averse investor assetA dominates asset B, as asset B will never be held so long as asset A is available. Thek e y difference between the example in part (ii) of Table 2 and that in p a r t ( i ) i s t h a t i n the second example returns on the two assets a re positively correlated, while the inf o r m e r t h e y a r e n e g a t i v e l y correlated. The risk attached to a combination of two assets will be smaller than the sum of theindividual risks if the two assets have returns that are negatively correlated. Diversifiable and non-diversifiable risk Not all risk can be eliminated by diversification. The specific risk a s s o c i a t e d w i t h a n y one company can be diversified away by holding shares of many companies. But even ifyou held shares in every available traded company, you would still have some risk,because the stock market as a whole tends to move up and down over time. Hence we t a l k a b o u t m a r k e t r i s k and specific risk. Market risk is non-diversifiable, whereasspecific risk is diversifiable through risk-pooling. For example ,t w o s t o c k s w h o s e r e t u r n s m o v e i n e x a c t l y t o g e t h e r h a v e a c o e f f i c i e n t o f +1.0. Twostocks whose returns move in exactly the opposite direction have a correlation of -1.0.T o e f f e c t i v e l y d i v e r s i f y , y o u s h o u l d a i m t o f i n d i n v e s t m e n t s t h a t h a v e a l o w o r n e g a t i v e correlation. The banking stocks (or the technology stocks) would have a high positivecorrelation as their share prices are driven by common factors.As you increase the number of securities in your portfolio, you reach a point where youhave diversified as much as is reasonably possible. When you have about 30 securities i n y o u r portfolio you have diversified most of the risk. Question6:Studytheperformanceofanyemergingmarketofyourchoice. A n s w e r : emerging market With emerging market economies like Indi a and China growing at nearly 10%, youmay be feeling pain from all the criticism from p u n d i t s a n d a d v i s e r s t h a t y o u a r e a myopic, short-sighted American for not allocating enough to emerging market equities.According to Vanguard, the average allocation to e merging market equities among UShousehold

investors is still only 6%.S h o u l d n ' t t h e p e r c e n t a g e o f y o u r e q u i t y portfolio invested in emerging marketsequities be roughly in line w i t h t h e p r o p o r t i o n a t e s h a r e o f e m e r g i n g - m a r k e t s t o c k s t o total global stock-market capitalization or around 10% to 15% of an investor's totalequity portfolio? It seems natural to expect that the powerful economic growth ofe m e r g i n g m a r k e t s s u c h a s B r a z i l a n d C h i n a w i l l l e a d t o h i g h e r s t o c k m a r k e t r e t u r n s than in the slower growing mark ets such as the U.S. and Europe. So should emerging m a r k e t e q u i t i e s b e a b i g g e r p a r t o f y o u r p o r t f o l i o ? In fact, US household investors may, at least for the moment, be properly weighted in e m e r g i n g m a r k e t s . F o r t h e f o l l o w i n g reasons higher potential growth may not justifyinvesting heavily right now in emerging market equities and instead you may want tobe gradually increasing your allocation over time:First, 12% economic growth in a country like India has not necessarily meant 1 2 % market returns. While there i s certainly reasonable evidence to support expectations ofl o n g - t e r m g r o w t h i n m a r k e t s l i k e I n d i a , C h i n a , B r a z i l , e t c . , a s r e p o r t e d i n t h i s W a l l Street Journal article - studies suggest that strong economic growth often does not t r a n s l a t e i n t o s t r o n g s t o c k returns. One study, which looked at market returns in 32 nations since the 1970s, concludedthat stock gains and economic performance can diverge dramatically. University ofFlo rida finance professor Jay Ritter found, for example, that stocks in Sweden posted am e a n r e t u r n o f b e t t e r t h a n 8 % a y e a r f r o m 1 9 7 0 t h r o u g h 2 0 0 2 , e v e n t h o u g h G D P g r e w at an annualized pace of just 1.8%. In contrast, while GDP expanded more than 5%a n n u a l l y i n S o u t h K o r e a f r o m 1 9 8 8 t o 2 0 0 2 , t h e m e a n s t o c k return was only 0.4% ayear. 'A healthy economy isn't a guarantee t h a t e s t a b l i s h e d c o m p a n i e s w i l l a t t r a c t enough capital and labor to expand sales and earnings strongly partly because theyhave to compete with newer ventures for resources,' Dr. Ritter says. Second, even if average annu al returns from emerging markets exceed developedm a r k e t s , e m e r g i n g m a r k e t s a r e s t i l l m a t e r i a l l y m o r e v o l a t i l e , a n d t h i s v o l a t i l i t y w i l l not just keep you awake at night, it will erode your returns over time through theprocess of volatility drag. My colleague explains in this article how volatility drag willreduce your returns. Right now, the 3 -year standard deviation of emerging marketreturns is 32.83 versus 24.27 for the S&P500, a difference that translates into roughlya 3% drag on your cumulative return. And while the 60-day volatility on US LargeC a p Equities has now dropped all the way down to 10.99%, the 60 -day emerging marketv o l a t i l i t y a c t u a l l y r o s e s l i g h t l y t h i s q u a r t e r t o 1 9 . 5 5 % ( s e e c h a r t b e l o w f o r p e r i o d ending December 31, 2010): XXX Third, emerging market indexes are less efficient investment vehicles which makes ab i g d i f f e r e n c e o v e r t i m e f o r p r u d e n t , l o n g - t e r m i n v e s t o r s . M o s t e m e r g i n g m a r k e t f u n d s are significantly more expensive than US funds - often hundreds of basis points more. O u r f i r m r e c o m m e n d s

l o w c o s t f u n d s s u c h a s i S h a r e s M S C I E m e r g i n g M a r k e t I n d e x (EEM) , a n d V a n g u a r d E m e r g i n g M a r k e t s ( VWO). But even these low -cost funds face higher costs than US equity funds. Compare Vanguard's VWO at 0.27 expense r a t i o v s . V a n g u a r d s S & P 5 0 0 I n d e x F u n d ( VOO) a t 0 . 0 6 % . I f y o u a r e investing within a fundfamily such as Fidelity, your choice for e m e r g i n g m a r k e t s i s a n a c t i v e l y m a n a g e d f u n d with an annual cost of 1.14% versus Fidelity's S&P500 Index at only 0.10% (This iswhy if you really seek more exposure to emerging markets economic growth, a moree f f i c i e n t w a y t o g a i n e x p o s u r e i s t h r o u g h m u l t i n a t i o n a l s t r a d e d o n U S e x c h a n g e s S&P500 companies derive about 50% of their revenue from abroad, with about a thirdo f t h a t c o m i n g f r o m e m e r g i n g m a r k e t s ) . So higher economic growth may not lead to higher returns on emerging marketse q u i t i e s , v o l a t i l i t y d r a g i s l i k e l y t o e r o d e m u c h o f t h i s p o t e n t i a l h i g h e r r e t u r n , a n d higher investment costs are certain to drag the return down even fur ther. In o u r dynamic asset allocation process, emerging markets allocations are likely to growa l o n g w i t h o t h e r e q u i t y a l l o c a t i o n s o v e r t h e n e x t f e w y e a r s assuming volatilitycontinues to decline. But, right now, it appears t h a t t h e a v e r a g e A m e r i c a n h o u s e h o l d i s not necessarily being naive and xenophobic when they choose to be underweighted in e m e r g i n g m a r k e t equities.