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Q.1 Frame the investment process for a person of your age group. Answer: It is rare to find investors investing their entire savings in a single security. Instead, they tend to invest in a group of securities. Such a group of securities is called a portfolio. Most financial experts stress that in order to minimize risk; an investor should hold a well-balanced investment portfolio. The investment process describes how an investor must go about making. Decisions with regard to what securities to invest in while constructing a portfolio, how extensive the investment should be, and when the investment should be made. This is a procedure involving the following five steps: Set investment policy Perform security analysis Construct a portfolio Revise the portfolio Evaluate the performance of portfolio 1. Setting Investment Policy This initial step determines the investors objectives and the amount of his investable wealth. Since there is a positive relationship between risk and return, the investment objectives should be stated in terms of both risk and return. This step concludes with the asset allocation decision: identification of the potential categories of financial assets for consideration in the portfolio that the investor is going to construct. Asset allocation involves dividing an investment portfolio among different asset categories, such as stocks, bonds and cash. The asset allocation that works best for an investor at any given point in his life depends largely on his time horizon and his ability to tolerate risk. Time Horizon The time horizon is the expected number of months, years, or decades that an investor will be investing his money to achieve a particular financial goal. An investor with a longer time horizon may feel more comfortable with a riskier or more volatile investment because he can ride out the slow economic cycles and the inevitable ups and downs of the markets. By contrast, an investor who is saving for his teen-aged daughters college education would be less likely to take a large risk because he has a shorter time horizon. Risk Tolerance - Risk tolerance is an investors ability and willingness to lose some or all of his original investment in exchange for greater potential returns. An aggressive investor, or one with a high-risk tolerance, is more likely to risk losing money in order to get better results. A conservative 1
4. Portfolio Revision This step is the repetition of the three previous steps, as objectives might change and previously held portfolio might not be the optimal one. 5. Portfolio performance evaluation This step involves determining periodically how the portfolio has performed over some time period (returns earned vs. risks incurred).
Q.2 From the website of BSE India, explain how the BSE Sensex is calculated. Answer: SENSEX: Sensex is the stock market index for BSE. It was first compiled in 1986. It is made of 30 stocks representing a sample of large, liquid and representative companies. The base year of SENSEX is 1978-79 and the base value is 100. The Bombay Stock Exchange SENSEX (acronym of Sensitive Index) more commonly referred to as SENSEX or BSE 30 is a free-float market capitalization-weighted index of 30 well-established and financially sound companies listed on Bombay Stock Exchange. The 30 component companies which are some of the largest and most actively traded stocks, are representative of various industrial sectors of the Indian economy. Published since January 1, 1986, the SENSEX is regarded as the pulse of the domestic stock markets in India. The base value of the SENSEX is taken as 100 on April 1, 1979, and its base year as 1978-79. On 25 July, 2001 BSE launched DOLLEX-30, a dollar-linked version of SENSEX. As of 21 April 2011, the market capitalization of SENSEX was about 29,733 billion (US$660 billion) (42.34% of market capitalization of BSE), while its free-float market capitalization was 15,690 billion (US$348 billion). The Bombay Stock Exchange (BSE) regularly reviews and modifies its composition to be sure it reflects current market conditions. The index is calculated based on a free float capitalization methoda variation of the market capitalisation method. Instead of using a company's outstanding shares it uses its float, or shares that are readily available for trading. The free-float method, therefore, does not include restricted stocks, such as those held by promoters, government and strategic investors. Initially, the index was calculated based on the full market capitalization method. However this was shifted to the free float method with effect from September 1, 2003. Globally, the free float market capitalization is regarded as the industry best practice. As per free float capitalization methodology, the level of index at any point of time reflects the free float market value of 30 component stocks relative to a base period. The market capitalization of a company is determined by multiplying the price of its stock by the number of shares issued by the company. This market capitalization is multiplied by a free float factor to 4
Mahindra & Mahindra Transport Equipments Limited Maruti Suzuki NIIT Technologies NTPC NIIT ONGC Reliance Communications Reliance Industries Reliance Infrastructure State Bank of India Sterlite Industries Transport Equipments
Information Technology 0.15 Oil & Gas Telecom Oil & Gas Power Finance Metal, Metal and Mining Products, 0.20 0.35 0.50 0.65 0.45 0.45
Sun Pharmaceutical Healthcare 0.40 Industries Tata Consultancy Information Technology 0.25 Services Tata Motors Tata Power Tata Steel Wipro Transport Equipments Power 0.55 0.70
Q.3 Perform an economy analysis on Indian economy in the current situation. Answer: Economic analysis is done for two reasons: first, a companys growth prospects are, ultimately, dependent on the economy in which it operates; second, share price performance is generally tied to economic fundamentals, as most companies generally perform well when the economy is doing the same. 7
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Q.4 Identify some technical indicators and explain how they can be used to decide purchase of a companys stock. Answer: A technical indicator is a series of data points that are derived by applying a formula to the price and/or volume data of a security. Price data can be any combination of the open, high, low or closing price over a period of time. Some indicators may use only the closing prices, while others incorporate volume and open interest into their formulae. The price data is entered into the formula and a data point is produced. For example, say the closing prices of a stock for 3 days are Rs. 41, Rs. 43 and Rs. 43. If a technical indicator is constructed using the average of the closing prices, then the average of the 3 closing prices is one data point ((41+43+43)/3=42.33). However, one data point does not offer much information. A series of data points over a period of time is required to enable analysis. Thus we can have a 3 period moving average as a technical indicator, where we drop the earliest closing price and use the next closing price for calculations. By creating a time series of data points, a comparison can then be made between present and past levels. Technical indicators are usually shown in a graphical form above or below a securitys price chart for facilitating analysis. Once shown in graphical form, an indicator can then be compared with the corresponding price chart of the security. Sometimes indicators are plotted on top of the price plot for a more direct comparison. Technical indicators measure money flow, trends, volatility and momentum etc. They are used for two main purposes: to confirm price movement and the quality of chart patterns, and to form buy and sell signals. A technical indicator offers a different perspective from which to analyze the price action. Some, such as moving averages, are derived from simple formulae and they are relatively easy to understand. Others, like stochastics have complex formulae and require more effort to fully understand and appreciate. Technical indicators can provide unique perspective on the strength and direction of the underlying price action. Indicators filter price action with formulae. Therefore they are derivative measures and not direct reflections of the price action. This should be taken into account when analyzing the indicators. Any analysis of an indicator should be taken with the price action in mind. There are two main types of indicators: leading and lagging. A leading indicator precedes price movements; therefore they are used for prediction. A lagging indicator follows price movement and therefore is a confirmation. The main benefit of leading indicators is that they provide early signaling for entry and exit. Early signals can forewarn against a potential strength or 11
Q.5 Compare Arbitrage pricing theory with the Capital asset pricing model. Answer: Arbitrage Pricing Theory (APT) Arbitrage Pricing Theory (APT) are two of the most commonly used models for pricing all risky assets based on their relevant risks. Capital Asset Pricing Model (CAPM) calculates the required rate of return for any risky asset based on the securitys beta. Beta is a measure of the movement of the securitys return with the return on the market portfolio, which includes all the securities that are available in the world and where the proportion of each security in the portfolio is its market value as a percentage of total market value of all the securities. The problem with CAPM is that such a market portfolio is hypothetical and not observable and we have to use a market index like the S&P 500 or Sensex as a proxy for the market portfolio. However, indexes are imperfect proxies for overall market as no single index includes all capital assets, including stocks, bonds, real estate, collectibles, etc. Another criticism of the CAPM is that the various different proxies that are used for the market portfolio do not fully capture all of the relevant risk factors in the economy. An alternative pricing theory with fewer assumptions, the Arbitrage Pricing Theory (APT), has been developed by Stephen Ross. It can calculate expected return without taking recourse to the market portfolio. It is a multifactor model for determining the required rate of return which means that it 14
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Q.6 Discuss the different forms of market efficiency. Nov 2010 Answer: Forms of Market Efficiency A financial market displays informational efficiency when market prices reflect all available information about value. This definition of efficient market requires answers to two questions: what is all available information? & what does it mean to reflect all available information? Different answers to these questions give rise to different versions of market efficiency. What information are we talking about? Information can be information about past prices, information that is public information and information that is private information. Information about past prices refers to the weak form version of market efficiency, information that consists of past prices and all public information refers to the semi-strong version of market efficiency and all information (past prices, all public information and all private information) refers to the strong form version of market efficiency. 16
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