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Investigating the under and overvalued stocks of PSU banks quoted on NSE under the CAPM.

To investigate the under and overvalued stocks of PSU banks. To provide information that can aid financial decisions.

Indian capital market since liberations has undergone tremendous changes and has evolved as a vibrant system of investment flows. The efficient fund allocation depends on the stock market efficiency in pricing the different securites traded in it.

There are various models for the valuation of stocks such as the discounted cash flows model(DCFM), the capital asset pricing model(CAPM) and the arbitrage- pricing model (APM) based on the limitations of market equilibrium and the existence of a perfect market.

Canara bank Indian overseas bank Allahabad bank Oriental bank of commerce State bank of india Bank of india

This model provides the expected return for risky assets. It tells us that a linear relationship exists between a securitys required rate of return and its beta. Here beta is used to measure the systematic risk. The model was developed in the early 1960s by Sharpe [1964], Lintner [1965] and Mossin [1966]. In its simple form, the CAPM predicts that the expected return on an asset above the risk-free rate is linearly related to the non-diversifiable risk, which is measured by the assets Beta.

Risk returns relationship for an efficient portfolio. Risk returns relationship for an individual asset/security. Identification of under and over valued assets traded in the market. Pricing of assets not yet traded in the market. Effect of leverage on cost of equity (rate of return required by equity shareholders). Capital budgeting decisions and cost of capital. vRisk of the firm through diversification of project portfolio

Capital market line (CML)

Security market line (SML)

The CML as the name suggests represents the efficient frontier formed by combining risk free rate of return (T-bill) with return on index of common stock. In other words CML tells us something about the market price of risk

SML is used to calculate the expected return on the equity. Under the SML, the market rewards for the systematic risk only which is measured by the Beta coefficient. The SML states that there is a linear relationship between the expected return on individual stock and beta. This relationship is known as SML Re = Rf + (Rm - Rf). Where, Re = Expected return on the security Rf = Risk free return Rm = Expected return on market port folio. = Systematic rate of asset.

The difference between the expected return on any two assets can be related simply to their difference in beta. The higher beta is for any security, the higher must be its expected return. The relation between beta and expected return is linear.

Risk- free rate Market risk premium Beta

Table 1

BANK OF INDIA

Month 10-Oct 10-Nov 10-Dec 11-Jan 11-Feb 11-Mar 11-Apr 11-May 11-Jun 11-Jul 11-Aug 11-Sep

1.28 1.1 1.12 0.97 0.91 0.93 0.95 0.49 0.41 0.3 0.91 0.72

HPR -90.12 -6.53 -6.61 -2.66 0.28 2.64 -4.8 6.62 -4.45 -6.78 -6.78 0.83

Re 1.36 7.62 -8.76 -6.92 0.44 4.43 -0.26 -3.55 0.41 -0.18 -2 -0.82

Rm -1.21 -6.99 -7.74 -7.24 0.41 4.71 -0.31 -7.98 -0.002 -2.27 -15.08 -1.41

Table 1(a) Month Oct.09 Nov.09 Dec.09 1.08 1.05 1.02 HPR -17.07 12.99 -1.28 Re -0.79 8.75 -2.29 Rm -0.69 8.32 -2.23

Jan.10
Feb.10 Mar.10 Apr.10 May.10 Jun.10 Jul.10 Aug.10 Sep.10

0.16
0.95 1.33 0.86 0.61 0.37 0.14 -0.33 0.87 Table 3(a)

-7.17
-8.04 -1.15 9.93 -13.69 8.54 15.01 0.67 14.58

-0.53
-2.18 6.53 6.97 -1.26 4.08 2.23 -2.01 2.59

-5.97
-2.31 5.03 7.99 -2.39 10.15 12.82 7.92 2.92

The above table (1) states that the stock of Bank of India has been undervalued in the months of October, November and February. Its HPR is negative in the months of October, November, December, January, April, June, July, August and September. Consequently this stock has generated no stocks excess return. The markets excess return 4.05% is generated only in the month of March and the same month has generated 3.76% stocks excess return (Markets Excess Return multiply by beta). Similarly table (1a), developed on the CAPM, shows irregularity regarding the HPR, Re , Market excess return and stocks excess returns on the various parameters used under the CAPM in the Indian market.

Table 2 IOB

Month

HPR

Re

Rm

10-Oct
10-Nov 10-Dec 11-Jan 11-Feb 11-Mar 11-Apr 11-May 11-Jun 11-Jul 11-Aug 11-Sep

1.01
1.01 1.29 0.97 1.17 0.49 0.97 0.79 0.82 0.98 0.7 0.75

17.32
-9.33 -4.8 -11.64 4.55 5.08 4.59 -11.49 -0.03 -6.35 -19.73 -15

-1.23
-7.07 -10.19 -7 0.38 2.64 -0.28 -6.16 0.13 -2.21 -10.34 -0.88

-1.21
-6.99 -7.74 -7.24 0.41 4.71 -0.31 -7.98 -0.002 -2.27 -15.08 -1.41

Table 4

Table2 (a) Month Oct.09 Nov.09 Dec.09 1.12 1.31 1.04 HPR -20.27 16.53 -6.12 Re -0.84 10.75 -2.36 Rm -0.69 8.32 -2.23

Jan.10
Feb.10 Mar.10 Apr.10 May.10 Jun.10 Jul.10 Aug.10 Sep.10

0.43
0.82 1.32 0.8 0.55 0.32 -0.19 -0.51 0.56 Table 4 (a)

-18.7
-4.49 0.55 4.18 -5.35 17.43 10.19 7.78 5.18

-2.27
-1.81 6.48 6.51 -1.09 3.56 -1.87 -3.29 1.86

-5.97
-2.31 5.03 7.99 -2.39 10.15 12.82 7.92 2.92

The investors of IOB have faced negative return on investment in the month of October, November, December, January, April, May, July and August (see table 4). The stock of the concern company is undervalued in the months of June and September on the parameters of SML. Accordingly the HPR for several months are performed negative because of the negative market return. Consequently, there are no chances for the markets excess return and stocks excess return for these months. The markets excess return and stocks excess return are performed 4.05% and 1.99% respectively in a single month of March (see table 4). similarly table 4a states that the higher Beta of the IOB's stock in the months of 09-October and 09-December (1.04) have not been properly compensate with the either higher HPR or Re in the respective months. Hence, irrespective of the higher Beta, , negative HPR and Re have been generated in these months which shows no proper risk-return trade off under the CAPM .

It is based on unrealistic assumptions It is difficult to test the validity of CAPM Betas do not remain stable over time

CAPM is not a suitable descriptor of asset prices in India over the chosen sample period. Moreover, residual variance, representing unsystematic risk, is also found significant in certain cases. Moreover, the regressions show poor explanatory power. It provides a usable measure of risk that helps investors to determine what return they deserve for putting their hard-earned money in stocks of PSU Banks in India.