Master of Business Administration- MBA Semester 3

MF0010 – Security Analysis and Portfolio Management - 4 Credits

(Book ID: B1035)
Assignment Set- 1 (60 Marks)
Note: Each question carries 10 Marks. Answer all the questions.

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

That culture has become a commodity of some sort is undeniable. Yet there is also a
widespread belief that there is something so special about certain cultural products and events
(be they in the arts, theatre, music, cinema, architecture or more broadly in localized ways of
life, heritage, collective memories and affective communities) as to set them apart from
ordinary commodities like shirts and shoes. While the boundary between the two sorts of
commodities is highly porous (perhaps increasingly so) there are still grounds for maintaining
an analytic separation. It may be, of course, that we distinguish cultural artefacts and events
because we cannot bear to think of them as anything other than authentically different,
existing on some higher plane of human creativity and meaning than that located in the
factories of mass production and consumption. But even when we strip away all residues of
wishful thinking (often backed by powerful ideologies) we are still left with something very
special about those products designated as ‘cultural'. How, then, can the commodity status of
so many of these phenomena be reconciled with their special character?

Furthermore, the conditions of labour and the class positionality of the increasing number of
workers engaged in cultural activities and production (more than 150,000 ‘artists' were
registered in the New York metropolitan region in the early 1980s and that number may well
have risen to more than 250,000 by now) is worthy of consideration. They form the creative
core of what Daniel Bell calls ‘the cultural mass' (defined as not the creators but the
transmitters of culture in the media and elsewhere).1 The political stance of this creative core
as well as of the cultural mass is not inconsequential. In the 1960s, recall, the art colleges
were hot-beds of radical discussion. Their subsequent pacification and professionalization has
seriously diminished agitational politics. Revitalizing such institutions as centres of political
engagement and mobilizing the political and agitational powers of cultural producers is surely
a worthwhile objective for the left even if it takes some special adjustments in socialist
strategy and thinking to do so. A critical examination of the relations between culture, capital
and socialist alternatives can here be helpful as a prelude to mobilizing what has always been
a powerful voice in revolutionary politics.

I. MONOPOLY RENT AND COMPETITION

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

All rent is based on the monopoly power of private owners of certain portions of the globe.
Monopoly rent arises because social actors can realize an enhanced income stream over an
extended time by virtue of their exclusive control over some directly or indirectly tradable
item which is in some crucial respects unique and non-replicable. There are two situations in
which the category of monopoly rent comes to the fore. The first arises because social actors
control some special quality resource, commodity or location which, in relation to a certain
kind of activity, enables them to extract monopoly rents from those desiring to use it. In the
realm of production, Marx argues, the most obvious example is the vineyard producing wine
of extraordinary quality that can be sold at a monopoly price. In this circumstance ‘the
monopoly price creates the rent'.3 The locational version would be centrality (for the
commercial capitalist) relative to, say, the transport and communications network or
proximity (for the hotel chain) to some highly concentrated activity (such as a financial
centre). The commercial capitalist and the hotelier are willing to pay a premium for the land
because of accessibility. These are the indirect cases of monopoly rent. It is not the land,
resource or location of unique qualities which is traded but the commodity or service
produced through their use. In the second case, the land or resource is directly traded upon (as
when vineyards or prime real estate sites are sold to multinational capitalists and financiers
for speculative purposes). Scarcity can be created by withholding the land or resource from
current uses and speculating on future values. Monopoly rent of this sort can be extended to
ownership of works of art (such as a Rodin or a Picasso) which can be (and increasingly are)
bought and sold as investments. It is the uniqueness of the Picasso or the site which here
forms the basis for the monopoly price.

The two forms of monopoly rent often intersect. A vineyard (with its unique Chateau and
beautiful physical setting) renowned for its wines can be traded at a monopoly price directly
as can the uniquely flavoured wines produced on that land. A Picasso can be purchased for
capital gain and then leased to someone else who puts it on view for a monopoly price. The
proximity to a financial centre can be traded directly as well as indirectly to, say, the hotel
chain that uses it for its own purposes. But the difference between the two rental forms is
important. It is unlikely (though not impossible), for example, that Westminster Abbey and
Buckingham Palace will be traded directly (even the most ardent privatizers might balk at
that). But they can be and plainly are traded upon through the marketing practices of the
tourist industry (or in the case of Buckingham Palace, by the Queen).

Two contradictions attach to the category of monopoly rent. Both of them are important to the
argument that follows.

First, while uniqueness and particularity are crucial to the definition of ‘special qualities', the
requirement of tradability means that no item can be so unique or so special as to be entirely
outside the monetary calculus. The Picasso has to have a money value as does the Monet, the
Manet, the aboriginal art, the archaeological artefacts, the historic buildings, the ancient
monuments, the Buddhist temples, and the experience of rafting down the Colorado, being in
Istanbul or on top of Everest. There is, as is evident from such a list, a certain difficulty of
‘market formation' here. For while markets have formed around works of art and, to some
degree around archaeological artefacts (there are some well-documented cases, as with
Australian Aboriginal art, of what happens when some art form gets drawn into the market
sphere) there are plainly several items on this list that are hard to incorporate directly into a
market (this is the problem with Westminster Abbey). Many items may not even be easy to
trade upon indirectly. The contradiction here is that the more easily marketable such items
become the less unique and special they appear. In some instances the marketing itself tends
to destroy the unique qualities (particularly if these depend on qualities such as wilderness,
remoteness, the purity of some aesthetic experience, and the like). More generally, to the
degree that such items or events are easily marketable (and subject to replication by forgeries,
fakes, imitations or simulacra) the less they provide a basis for monopoly rent. I am put in
mind here of the student who complained about how inferior her experience of Europe was
compared to Disney World:

At Disney World all the countries are much closer together, and they show you the best of
each country. Europe is boring. People talk strange languages and things are dirty. Sometimes
you don't see anything interesting in Europe for days, but at Disney World something
different happens all the time and people are happy. It's much more fun. It's well designed.4

While this sounds a laughable judgement it is sobering to reflect on how much Europe is
attempting to redesign itself to Disney standards (and not only for the benefit of American
tourists). But, and here is the heart of the contradiction, the more Europe becomes Disneyfied,
the less unique and special it becomes. The bland homogeneity that goes with pure
commodification erases monopoly advantages. Cultural products become no different from
commodities in general. ‘The advanced transformation of consumer goods into corporate
products or “trade mark articles” that hold a monopoly on aesthetic value', writes Wolfgang
Haug, ‘has by and large replaced the elementary or “generic” products', so that ‘commodity
aesthetics' extends its border ‘further and further into the realm of cultural industries'.5
Conversely, every capitalist seeks to persuade consumers of the unique and non-replicable
qualities of their commodities (hence name-brands, advertising, and the like). Pressures from
both sides threaten to squeeze out the unique qualities that underlie monopoly rents. If the
latter are to be sustained and realized, therefore, some way has to be found to keep some
commodities or places unique and particular enough (and I will later reflect on what this
might mean) to maintain a monopolistic edge in an otherwise commodified and often fiercely
competitive economy.

But why, in a neoliberal world where competitive markets are supposedly dominant, would
monopoly of any sort be tolerated let alone be seen as desirable? We here encounter the
second contradiction which, at root, turns out to be a mirror image of the first. Competition,
as Marx long ago observed, always tends towards monopoly (or oligopoly) simply because
the survival of the fittest in the war of all against all eliminates the weaker firms.6 The fiercer
the competition the faster the trend towards oligopoly if not monopoly. It is therefore no
accident that the liberalization of markets and the celebration of market competition in recent
years has produced incredible centralization of capital (Microsoft, Rupert Murdoch,
Bertelsmann, financial services, and a wave of takeovers, mergers and consolidations in
airlines, retailing and even in older industries like automobiles, petroleum, and the like). This
tendency has long been recognized as a troublesome feature of capitalist dynamics, hence the
anti-trust legislation in the United States and the work of the monopolies and mergers
commissions in Europe. But these are weak defences against an overwhelming force.

This structural dynamic would not have the importance it does were it not for the fact that
capitalists actively cultivate monopoly powers. They thereby realize far-reaching control over
production and marketing and hence stabilize their business environment to allow of rational
calculation and long-term planning, the reduction of risk and uncertainty, and more generally
guarantee themselves a relatively peaceful and untroubled existence. The visible hand of the
corporation, as Alfred Chandler terms it, has consequently been of far greater importance to
capitalist historical geography than the invisible hand of the market made so much of by
Adam Smith and paraded ad nauseam before us in recent years as the guiding power in the
neoliberal ideology of contemporary globalization.7

But it is here that the mirror image of the first contradiction comes most clearly into view:
market processes crucially depend upon the individual monopoly of capitalists (of all sorts)
over ownership of the means of production including finance and land. All rent, recall, is a
return to the monopoly power of private ownership of any portion of the globe. The
monopoly power of private property is, therefore, both the beginning point and the end point
of all capitalist activity. A non-tradable juridical right exists at the very foundation of all
capitalist trade, making the option of non-trading (hoarding, withholding, miserly behaviour)
an important problem in capitalist markets. Pure market competition, free commodity
exchange and perfect market rationality are, therefore, rather rare and chronically unstable
devices for coordinating production and consumption decisions. The problem is to keep
economic relations competitive enough while sustaining the individual and class monopoly
privileges of private property that are the foundation of capitalism as a political-economic
system.

This last point demands one further elaboration to bring us closer to the topic at hand. It is
widely but erroneously assumed that monopoly power of the grand and culminating sort is
most clearly signalled by the centralization and concentration of capital in mega-corporations.
Conversely, small firm size is widely assumed, again erroneously, to be a sign of a
competitive market situation. By this measure, a once competitive capitalism has become
increasingly monopolized over time. The error arises in part because of a rather too facile
application of Marx's arguments concerning the ‘law of the tendency for the centralization of
capital', ignoring his counter-argument that centralization ‘would soon bring about the
collapse of capitalist production if it were not for counteracting tendencies, which have a
continuous decentralizing effect'.8 But it is also supported by an economic theory of the firm
that generally ignores its spatial and locational context, even though it does accept (on those
rare occasions where it deigns to consider the matt er) that locational advantage involves
‘monopolistic competition'. In the nineteenth century, for example, the brewer, the baker and
the candlestick maker were all protected to considerable degree from competition in local
markets by the high cost of transportation. Local monopoly powers were omnipresent (even
though firms were small in size), and very hard to break, in everything from energy to food
supply. By this measure nineteenth century capitalism was far less competitive than now.

It is at this point that the changing conditions of transport and communications enter in as
crucial determining variables. As spatial barriers diminished through the capitalist penchant
for ‘the annihilation of space through time', many local industries and services lost their local
protections and monopoly privileges.9 They were forced into competition with producers in
other locations, at first relatively close by, but then with producers much further away. The
historical geography of the brewing trade is very instructive in this regard. In the nineteenth
century most people drank local brew because they had no choice. By the end of the
nineteenth century beer production and consumption in Britain had been regionalized to a
considerable degree and remained so until the 1960s (foreign imports, with the exception of
Guinness, were unheard of). But then the market became national (Newcastle Brown and
Scottish Youngers appeared in London and the south) before becoming international (imports
suddenly became all the rage). If one drinks local brew now it is by choice, usually out of
some mix of principled attachment to locality or because of some special quality of the beer
(based on the technique, the water, or whatever) that differentiates it from others. Plainly, the
economic space of competition has changed in both form and scale over time.

The recent bout of globalization has significantly diminished the monopoly protections given
historically by high transport and communications costs while the removal of institutional
barriers to trade (protectionism) has likewise diminished the monopoly rents to be procured
by that means. But capitalism cannot do without monopoly powers and craves means to
assemble them. So the question upon the agenda is how to assemble monopoly powers in a
situation where the protections afforded by the so-called ‘natural monopolies' of space and
location, and the political protections of national boundaries and tariffs, have been seriously
diminished if not eliminated.
The obvious answer is to centralize capital in mega-corporations or to set up looser alliances
(as in airlines and automobiles) that dominate markets. And we have seen plenty of that. The
second path is to secure ever more firmly the monopoly rights of private property through
international commercial laws that regulate all global trade. Patents and so-called ‘intellectual
property rights' have consequently become a major field of struggle through which monopoly
powers more generally get asserted. The pharmaceutical industry, to take a paradigmatic
example, has acquired extraordinary monopoly powers in part through massive centralizations
of capital and in part through the protection of patents and licensing agreements. And it is
hungrily pursuing even more monopoly powers as it seeks to establish property rights over
genetic materials of all sorts (including those of rare plants in tropical rain forests traditionally
collected by indigenous inhabitants). As monopoly privileges from one source diminish so we
witness a variety of attempts to preserve and assemble them by other means.

I cannot possibly review all of these tendencies here. I do want, however, to look more
closely at those aspects of this process that impinge most directly upon the problems of local
development and cultural activities. I wish to show first, that there are continuing struggles
over the definition of the monopoly powers that might be accorded to location and localities
and that the idea of ‘culture' is more and more entangled with attempts to reassert such
monopoly powers precisely because claims to uniqueness and authenticity can best be
articulated as distinctive and non-replicable cultural claims. I begin with the most obvious
example of monopoly rent given by ‘the vineyard producing wine of extraordinary quality
that can be sold at a monopoly price'.

II. ADVENTURES IN THE WINE TRADE

The wine trade, like brewing, has become more and more international over the last thirty
years and the stresses of international competition have produced some curious effects. Under
pressure from the European Community, for example, international wine producers have
agreed (after long legal battles and intense negotiations) to phase out the use of ‘traditional
expressions' on wine labels, which could eventually include terms like ‘Chateau' and
‘domaine' as well as generic terms like ‘champagne', ‘burgundy', ‘chablis' or ‘sauterne'. In this
way the European wine industry, led by the French, seeks to preserve monopoly rents by
insisting upon the unique virtues of land, climate and tradition (lumped together under the
French term ‘terroir') and the distinctiveness of its product certified by a name. Reinforced by
institutional controls like ‘appellation controlée' the French wine trade insists upon the
authenticity and originality of its product which grounds the uniqueness upon which
monopoly rent can be based.

Australia is one of the countries that agreed to this move. Chateau Tahbilk in Victoria obliged
by dropping the ‘Chateau' from its label, airily pronouncing that ‘we are proudly Australian
with no need to use terms inherited from other countries and cultures of bygone days'. To
compensate, they identified two factors which, when combined, ‘give us a unique position in
the world of wine'. Theirs is one of only six worldwide wine regions where the meso-climate
is dramatically influenced by inland water mass (the numerous lakes and local lagoons
moderate and cool the climate). Their soil is of a unique type (found in only one other
location in Victoria) described as red/sandy loam coloured by a very high Ferric-oxide
content, which ‘has a positive effect on grape quality and adds a certain distinctive regional
character to our wines'. These two factors are brought together to define ‘Nagambie Lakes' as
a unique Viticultural Region (to be authenticated, presumably, by the Australian Wine and
Brandy Corporation's Geographical Indications Committee, set up to identify Viticultural
regions throughout Australia). Tahbilk thereby establishes a counter-claim to monopoly rents
on the grounds of the unique mix of environmental conditions in the region where it is
situated. It does so in a way that parallels and competes with the uniqueness claims of ‘terroir'
and ‘domaine' pressed by French wine producers.10
But we then encounter the first contradiction. All wine is tradable and therefore in some sense
comparable no matt er where it is from. Enter Robert Parker and the Wine Advocate which he
publishes regularly. Parker evaluates wines for their taste and pays no particular mind to
‘terroir' or any other cultural-historical claims. He is notoriously independent (most other
guides are supported by influential sectors of the wine industry). He ranks wines on a scale
according to his own distinctive taste. He has an extensive following in the United States, a
major market. If he rates a Chateau wine from Bordeaux 65 pts and an Australian wine 95 pts
then prices are affected. The Bordeaux wine producers are terrified of him. They have sued
him, denigrated him, abused him and even physically assaulted him. He challenges the bases
of their monopoly rents.11

Monopoly claims, we can conclude, are as much ‘an effect of discourse' and an outcome of
struggle as they are a reflection of the qualities of the product. But if the language of ‘terroir'
and tradition is to be abandoned then what kind of discourse can be put in its place? Parker
and many others in the wine trade have in recent years invented a language in which wines
are described in terms such as ‘flavor of peach and plum, with a hint of thyme and
gooseberry'. The language sounds bizarre but this discursive shift, which corresponds to rising
international competition and globalization in the wine trade, takes on a distinctive role,
reflecting the commodification of wine consumption along standardized lines.

But wine consumption has many dimensions that open paths to profitable exploitation. For
many it is an aesthetic experience. Beyond the sheer pleasure (for some) of a fine wine with
the right food, there lie all sorts of other referents within the Western tradition that track back
to mythology (Dionysus and Bacchus), religion (the blood of Jesus and communion rituals)
and traditions celebrated in festivals, poetry, song and literature. Knowledge of wines and
‘proper' appreciation is often a sign of class and is analyzable as a form of ‘cultural' capital
(as Bourdieu would put it). Getting the wine right may have helped to seal more than a few
major business deals (would you trust someone who did not know how to select a wine?).
Style of wine is related to regional cuisines and thereby embedded in those practices that turn
regionality into a way of life marked by distinctive structures of feeling (it is hard to imagine
Zorba the Greek drinking Mondavi Californian jug wine, even though the latter is sold in
Athens airport).

The wine trade is about money and profit but it is also about culture in all of its senses (from
the culture of the product to the cultural practices that surround its consumption and the
cultural capital that can evolve alongside among both producers and consumers). The
perpetual search for monopoly rents entails seeking out criteria of speciality, uniqueness,
originality and authenticity in each of these realms. If uniqueness cannot be established by
appeal to ‘terroir' and tradition, or by straight description of flavour, then other modes of
distinction must be invoked to establish monopoly claims and discourses devised to guarantee
the truth of those claims (the wine that guarantees seduction or the wine that goes with
nostalgia and the log fire, are current advertising tropes in the US). In practice what we find
within the wine trade is a host of competing discourses, all with different truth claims about
the uniqueness of the product. But, and here I go back to my starting point, all of these
discursive shifts and swayings, as well as many of the shifts and turns that have occurred in
the strategies for commanding the international market in wine, have at their root not only the
search for profit but also the search for monopoly rents. In this the language of authenticity,
originality, uniqueness, and special unreplicable qualities looms large. The generality of a
globalized market produces, in a manner consistent with the second contradiction I earlier
identified, a powerful force seeking to guarantee not only the continuing monopoly privileges
of private property but the monopoly rents that derive from depicting commodities as
incomparable.

III. URBAN ENTREPRENEURIALISM, MONOPOLY RENT AND GLOBAL FORMS

Recent struggles within the wine trade provide a useful model for understanding a wide range
of phenomena within the contemporary phase of globalization. They have particular relevance
to understanding how local cultural developments and traditions get absorbed within the
calculi of political economy through attempts to garner monopoly rents. It also poses the
question of how much the current interest in local cultural innovation and the resurrection and
invention of local traditions attaches to the desire to extract and appropriate such rents. Since
capitalists of all sorts (including the most exuberant of international financiers) are easily
seduced by the lucrative prospects of monopoly powers, we immediately discern a third
contradiction: that the most avid globalizers will support local developments that have the
potential to yield monopoly rents even if the effect of such support is to produce a local
political climate antagonistic to globalization! Emphasizing the uniqueness and purity of local
Balinese culture may be vital to the hotel, airline and tourist industry, but what happens when
this encourages a Balinese movement that violently resists the ‘impurity' of
commercialization? The Basque country may appear a potentially valuable cultural
configuration precisely because of its uniqueness, but ETA with its demand for autonomy and
preparedness to take violent action is not amenable to commercialization. Let us probe a little
more deeply into this contradiction as it impinges upon urban development politics. To do so
requires, however, briefly situating that politics in relation to globalization.

Urban entrepreneurialism has become important both nationally and internationally in recent
decades. By this I mean that pattern of behaviour within urban governance that mixes together
state powers (local, metropolitan, regional, national or supranational) and a wide array of
organizational forms in civil society (chambers of commerce, unions, churches, educational
and research institutions, community groups, NGOs, etc.) and private interests (corporate and
individual) to form coalitions to promote or manage urban/regional development of some sort
or other. There is now an extensive literature on this topic which shows that the forms,
activities and goals of these governance systems (variously known as ‘urban regimes',
‘growth machines' or ‘regional growth coalitions') vary widely depending upon local
conditions and the mix of forces at work within them.12

The role of this urban entrepreneurialism in relation to the neoliberal form of globalization
has also been scrutinized at length, most usually under the rubric of local-global relations and
the so-called ‘space-place dialectic'. Most geographers who have looked into the problem
have rightly concluded that it is a categorical error to view globalization as a causal force in
relation to local development. What is at stake here, they rightly argue, is a rather more
complicated relationship across scales in which local initiatives can percolate upwards to a
global scale and vice versa at the same time as processes within a particular definition of scale
-- interurban and interregional competition being the most obvious examples -- can rework
the local/regional configurations of what globalization is about. Globalization should not be
seen, therefore, as an undifferentiated unity but as a geographically articulated patterning of
global capitalist activities and relations.13

But what, exactly, does it mean to speak of ‘a geographically articulated patterning'? There is,
of course, plenty of evidence of uneven geographical development (at a variety of scales) and
at least some cogent theorizing to understand its capitalistic logic. Some of it can be
understood in conventional terms as a search on the part of mobile capitals (with financial,
commercial and production capital having different capacities in this regard) to gain
advantages in the production and appropriation of surplus values by moving around. Trends
can indeed be identified which fit with simple models of ‘a race to the bottom' in which the
cheapest and most easily exploited labour power becomes the guiding beacon for capital
mobility and investment decisions. But there is plenty of countervailing evidence to suggest
that this is a gross oversimplification when projected as a monocausal explanation of the
dynamics of uneven geographical development. Capital in general just as easily flows into
high wage regions as into low and often seems to be geographically guided by quite different
criteria to those conventionally set out in both bourgeois and Marxist political economy.

The problem in part (but not wholly) derives from the habit of ignoring the category of landed
capital and the considerable importance of long-term investments in the built environment
which are by definition geographically immobile (except in the relative accessibility sense).
Such investments, particularly when they are of a speculative sort, invariably call for even
further waves of investments if the first wave is to prove profitable (to fill the convention
centre we need the hotels which require better transport and communications, which calls for
an expansion of the convention centre...). So there is an element of circular and cumulative
causation at work in the dynamics of metropolitan area investments (look, for example, at the
whole Docklands redevelopment in London and the financial viability of Canary Wharf
which pivots on further investments both public and private). This is what urban growth
machines are often all about: the orchestration of investment process dynamics and the
provision of key public investments at the right place and time to promote success in inter-
urban and inter-regional competition.

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

A stock market index is a method of measuring a section of the stock market. Many indices
are cited by news or financial services firms and are used as benchmarks, to measure the
performance of portfolios such as mutual funds.

Stock market indices may be classed in many ways. A 'world' or 'global' stock market index
includes (typically large) companies without regard for where they are domiciled or traded.
Two examples are MSCI World and S&P Global 100.

A national index represents the performance of the stock market of a given nation—and by
proxy, reflects investor sentiment on the state of its economy. The most regularly quoted
market indices are national indices composed of the stocks of large companies listed on a
nation's largest stock exchanges, such as the American S&P 500, the Japanese Nikkei 225,
and the British FTSE 100.

The concept may be extended well beyond an exchange. The Wilshire 5000 Index, the
original total market index, represents the stocks of nearly every publicly traded company in
the United States, including all U.S. stocks traded on the New York Stock Exchange (but
not ADRs or limited partnerships), NASDAQ and American Stock Exchange. Russell
Investment Group added to the family of indices by launching the Russell Global Index.

More specialised indices exist tracking the performance of specific sectors of the market.
Some examples include the Wilshire US REIT which tracks more than 80 American Real
Estate Investment Trusts and the Morgan Stanley Biotech Index which consists of
36 American firms in the biotechnology industry. Other indices may track companies of a
certain size, a certain type of management, or even more specialized criteria — one index
published by Linux Weekly News tracks stocks of companies that sell products and services
based on the Linux operating environment.
[edit]Index versions

Some indices, such as the S&P 500, have multiple versions.[1] These versions can differ based
on how the index components are weighted and on how dividends are accounted for. For
example, there are three versions of the S&P 500 index: price return, which only considers the
price of the components, total return, which accounts for dividend reinvestment, and net total
return, which accounts for dividend reinvestment after the deduction of a withholding tax.
[2]
As another example, the Wilshire 4500 and Wilshire 5000 indices have five versions each:
full capitalization total return, full capitalization price, float-adjusted total return, float-
adjusted price, and equal weight. The difference between the full capitalization, float-
adjusted, and equal weight versions is in how index components are weighted.[3][4]
[edit]Weighting

An index may also be classified according to the method used to determine its price. In
a price-weighted index such as the Dow Jones Industrial Average, Amex Major Market Index,
and the NYSE ARCA Tech 100 Index, the price of each component stock is the only
consideration when determining the value of the index. Thus, price movement of even a
single security will heavily influence the value of the index even though the dollar shift is less
significant in a relatively highly valued issue, and moreover ignoring the relative size of the
company as a whole. In contrast, a market-value weighted or capitalization-weighted index
such as the Hang Seng Index factors in the size of the company. Thus, a relatively small shift
in the price of a large company will heavily influence the value of the index. In a market-
share weighted index, price is weighted relative to the number of shares, rather than their total
value.

Traditionally, capitalization- or share-weighted indices all had a full weighting, i.e. all
outstanding shares were included. Recently, many of them have changed to a float-
adjustedweighting which helps indexing.

A modified capitalization-weighted index is a hybrid between capitalization weighting and

equal weighting. It is similar to a capitalization weighting with one main difference: the
largest stocks are capped to a percent of the weight of the total stock index and the excess
weight will be redistributed equally amongst the stocks under that cap. Moreover, in 2005,
Standard & Poor's introduced the S&P Pure Growth Style Index and S&P Pure Value Style
Index which was attribute-weighted. That is, a stock's weight in the index is decided by the
score it gets relative to the value attributes that define the criteria of a specific index, the same
measure used to select the stocks in the first place. For these two stocks, a score is calculated
for every stock, be it their growth score or the value score (a stock can't be both) and
accordingly they are weighted for the index.[5]
[edit]Criticism of capitalization-weighting

The use of capitalization-weighted indices is often justified by the central conclusion

of modern portfolio theory that the optimal investment strategy for any investor is to hold the
market portfolio, the capitalization-weighted portfolio of all assets. However, empirical tests
conclude that market indices are not efficient.[citation needed] This can be explained by the fact that
these indices do not include all assets or by the fact that the theory does not hold. The
practical conclusion is that using capitalization-weighted portfolios is not necessarily the
optimal method.

As a consequence, capitalization-weighting has been subject to severe criticism (see e.g.

Haugen and Baker 1991, Amenc, Goltz, and Le Sourd 2006, or Hsu 2006), pointing out that
the mechanics of capitalization-weighting lead to trend-following strategies that provide an
inefficient risk-return trade-off.

Also, while capitalization-weighting is the standard in equity index construction, different

weighting schemes exist. First, while most indices use capitalization-weighting, additional
criteria are often taken into account, such as sales/revenue and net income (see the “Guide to
the Dow Jones Global Titan 50 Index”, January 2006). Second, as an answer to the critiques
of capitalization-weighting, equity indices with different weighting schemes have emerged,
such as "wealth"-weighted (Morris, 1996), “fundamental”-weighted (Arnott, Hsu and Moore
2005), “diversity”-weighted (Fernholz, Garvy, and Hannon 1998) or equal-weighted indices.
[edit]Indices and passive investment management

There has been an accelerating trend in recent decades to create passively managed mutual
funds that are based on market indices, known as index funds. Advocates claim that index
funds routinely beat a large majority of actively managed mutual funds; one study[citation
needed]
claimed that over time, the average actively managed fund has returned 1.8% less than
the S&P 500 index - a result nearly equal to the average expense ratio of mutual funds (fund
expenses are a drag on the funds' return by exactly that ratio). Since index funds attempt to
replicate the holdings of an index, they obviate the need for — and thus many costs of — the
research entailed in active management, and have a lower "churn" rate (the turnover of
securities which lose fund managers' favor and are sold, with the attendant cost of
commissions and capital gains taxes).

Indices are also a common basis for a related type of investment, the exchange-traded fund or
ETF. Unlike an index fund, which is priced daily, an ETF is priced continuously, is
optionable, and can be sold short.
[edit]Ethical stock market indices
A notable specialised index type is those for ethical investing indices that include only those
companies satisfying ecological or social criteria, e.g. those of The Calvert
Group,KLD, FTSE4Good Index, Dow Jones Sustainability Index and Wilderhill Clean
Energy Index.

Another important trend is strict mechanical criteria for inclusion and exclusion to prevent
market manipulation, e.g. in Canada when Nortel was permitted to rise to over 30% of
theTSE 300 index value. Ethical indices have a particular interest in mechanical criteria,
seeking to avoid accusations of ideological bias in selection, and have pioneered techniques
for inclusion and exclusion of stocks based on complex criteria. Another means of mechanical
selection is mark-to-future methods that exploit scenarios produced by multiple analysts
weighted according to probability, to determine which stocks have become too risky to hold
in the index of concern.

Critics of such initiatives argue that many firms satisfy mechanical "ethical criteria", e.g.
regarding board composition or hiring practices, but fail to perform ethically with respect to
shareholders, e.g. Enron. Indeed, the seeming "seal of approval" of an ethical index may put
investors more at ease, enabling scams. One response to these criticisms is that trust in the
corporate management, index criteria, fund or index manager, and securities regulator, can
never be replaced by mechanical means, so "market transparency" and "disclosure" are the
only long-term-effective paths to fair markets.
[edit]Environmental stock market indices

An environmental stock market index aims to provide a quantitative measure of the

environmental damage caused by the companies in an index. Indices of this nature face much
of the same criticism as Ethical indices do — that the 'score' given is partially subjective.

However, whereas 'ethical' issues (for example, does a company use a sweatshop) are largely
subjective and difficult to score, an environmental impact is often quantifiable through
scientific methods. So it is broadly possible to assign a 'score' to (say) the damage caused by a
tonne of mercury dumped into a local river. It is harder to develop a scoring method that can
compare different types of pollutant — for example does one hundred tonnes of carbon
dioxide emitted to the air cause more or less damage (via climate change) than one tonne of
mercury dumped in a river (and poisoning all the fish).

Generally, most environmental economists attempting to create an environmental index

would attempt to quantify damage in monetary terms. So one tonne of carbon dioxide might
cause $100 worth of damage, whereas one tonne of mercury might cause $50,000 (as it is
highly toxic). Companies can therefore be given an 'environmental impact' score, based on the
cost they impose on the environment. Quantification of damage in this nature is extremely
difficult, as pollutants tend to be market externalities and so have no easily measurable cost
by definition.

A stock market or equity market is a public market (a loose network of economic

transactions, not a physical facility or discrete entity) for thetrading of company stock (shares)
and derivatives at an agreed price; these are securities listed on a stock exchange as well as
those only traded privately.

The size of the world stock market was estimated at about $36.6 trillion USD at the beginning
of October 2008.[1] The total world derivatives market has been estimated at about $791
trillion face or nominal value,[2] 11 times the size of the entire world economy.[3] The value of
the derivatives market, because it is stated in terms of notional values, cannot be directly
compared to a stock or a fixed income security, which traditionally refers to anactual value.
Moreover, the vast majority of derivatives 'cancel' each other out (i.e., a derivative 'bet' on an
event occurring is offset by a comparable derivative 'bet' on the event not occurring). Many
such relatively illiquid securities are valued as marked to model, rather than an actual market
price.

The stocks are listed and traded on stock exchanges which are entities of a corporation
or mutual organization specialized in the business of bringing buyers and sellers of the
organizations to a listing of stocks and securities together. The largest stock market in the
United States, by market cap, is the New York Stock Exchange, NYSE. In Canada, the largest
stock market is the Toronto Stock Exchange. Major European examples of stock exchanges
include the London Stock Exchange, Paris Bourse, and the Deutsche Börse. Asian examples
include the Tokyo Stock Exchange, theHong Kong Stock Exchange, the Shanghai Stock
Exchange, and the Bombay Stock Exchange. In Latin America, there are such exchanges as
theBM&F Bovespa and the BMV.

General Investment Glossary

Keeping up with the increasing number of investment products and services in the
marketplace today can be confusing. This comprehensive investing glossary is designed to
help you understand some of the more common investment and financial terms you may
encounter. Your financial advisor can explain these terms more completely and discuss with
you those relevant to your situation.

Absolute Return Index:

A stock index designed to measure absolute returns. The absolute return index is actually a
composite index made up of five other indexes. This index is used to compare the absolute
returns posted by the hedge fund market as a whole against individual hedge funds.
ADR (American Depositary Receipt):
ADR stands for American Depositary Receipt. An American Depositary Receipt is a physical
certificate evidencing ownership in one or several American Depositary Shares (ADS). The
terms ADR and ADS can be used interchangeably. An ADS is a U.S. dollar denominated
form of equity ownership in a non-U.S. company. For example, Toyota Motor Corp. is a
Japanese company listed on the New York Stock Exchange. Some of Toyota's shares are held
by a custodian bank in Japan for the direct representation on the NYSE.
It's important to note that some ADSs or ADRs represent more than one share of the actual
stock. One "share" of Toyota's ADS on the NYSE gives an investor the rights of two shares of
the actual company stock.
After The Bell:
The New York Stock Exchange (NYSE) closes its trading day with the ringing of a bell.
Alligator Spread:
Pricing models and a more efficient market can help reduce the traditional spread on a
security, but it is commissions that create the alligator spread, not market inefficiencies. The
commissions are dependent on a transaction's brokers. Investors should check the commission
schedules carefully to avoid having their profits devoured by the alligator spread.
Alternative Energy ETF:
ETFs focused on alternative energy stocks represent a strong "green" investment, but the
space is still in the beginning stages of commercial viability. Investors should expect to see
high volatility as certain processes and technology rise to the forefront while others prove to
be unsuccessful. Alternative energy has two important tailwinds funding its growth: the
limitation of the world's natural resources and higher demand by environmentally
conscientious consumers. Examples of ETFs in this space would include stocks from solar
energy companies and "clean" fossil fuel production corporations.
Anonymous Trading: Anonymous trades allow the high profile investors to execute
transactions without the scrutiny and speculation of the market.
Ask:
The price a seller is willing to accept for a security, also known as the offer price. Along with
the price, the ask quote will generally also stipulate the amount of the security willing to be
sold at that price.
Bear Market:
A market condition in which the prices of securities are falling, and widespread pessimism
causes the negative sentiment to be self-sustaining. As investors anticipate losses in a bear
market and selling continues, which contributes to further pessimism. Although figures can
vary, for many, a downturn of 20% or more in multiple broad market indexes, such as the
Dow Jones Industrial Average (DJIA) or Standard & Poor's 500 Index (S&P 500), over at
least a two-month period, is considered an entry into a bear market.
Bear Market Rally:
Although there are no official guidelines for a bear market rally, it is sometimes defined as an
overall market increase of 10-20% during an overall bear market. There are many examples
of bear market rallies in modern stock market history, including the bear market rally of the
Dow Jones following the stock market crash of 1929, which eventually saw a bottoming out
in 1932.
Bid:
An offer made by an investor, a trader or a dealer to buy a security. The bid will stipulate both
the price at which the buyer is willing to purchase the security and the quantity to be
purchased.
This is the opposite of the ask, which stipulates the price a seller is willing to accept for a
security and the quantity of the security to be sold at that price.
Blue-Chip Stock:
A stock of a nationally recognized, well-established and financially sound company that is
able to weather economic downturns due to a long record of stable and reliable growth.
Bond Market:
The environment in which the issuance and trading of debt securities occurs. The bond market
primarily includes government-issued securities and corporate debt securities, and facilitates
the transfer of capital from savers to the issuers or organizations requiring capital for
government projects, business expansions and ongoing operations.
Bubble:
1. An economic cycle characterized by rapid expansion followed by a contraction.
2. A surge in equity prices, often more than warranted by the fundamentals and usually in a
particular sector, followed by a drastic drop in prices as a massive selloff occurs.
3. A theory that security prices rise above their true value and will continue to do so until
prices go into freefall and the bubble bursts.
Bull Market:
A financial market of a group of securities in which prices are rising or are expected to rise.
The term "bull market" is most often used to refer to the stock market, but can be applied to
anything that is traded, such as bonds, currencies and commodities.
Buy Down:
A mortgage-financing technique with which the buyer attempts to obtain a lower interest rate
for at least the first few years of the mortgage, but possibly its entire life. The builder or seller
or the property usually provides payments to the mortgage-lending institution, which, in turn,
lowers the buyer's monthly interest rate and therefore monthly payment. The home seller,
however, increases the purchase price of the home to compensate for the costs of the
buydown agreement.
Buyer's Call:
An agreement between a buyer and seller whereby a commodity purchase occurs at a specific
price above a futures contract for an identical grade and quantity
Buyer's Market:
A market condition characterized by an abundance of goods available for sale.
Call:
The period of time between the opening and closing of some future markets wherein the
prices are established through an auction process.
Call Option:
An agreement that gives an investor the right (but not the obligation) to buy a stock, bond,
commodity, or other instrument at a specified price within a specific time period.
Clearing House:
An agency or separate corporation of a futures exchange responsible for settling trading
accounts, clearing trades, collecting and maintaining margin monies, regulating delivery and
reporting trading data. Clearing houses act as third parties to all futures and options contracts
- as a buyer to every clearing member seller and a seller to every clearing member buyer.
Click And Mortar:
A type of business model that includes both online and offline operations, which typically
include a website and a physical store. A click-and-mortar company can offer customers the
benefits of fast, online transactions or traditional, face to face service.
This model is also referred to as "clicks and bricks".
Closing Price:
The final price at which a security is traded on a given trading day. The closing price
represents the most up-to-date valuation of a security until trading commences again on the
next trading day.
Commodity:
A basic good used in commerce that is interchangeable with other commodities of the same
type. Commodities are most often used as inputs in the production of other goods or services.
The quality of a given commodity may differ slightly, but it is essentially uniform across
producers. When they are traded on an exchange, commodities must also meet specified
minimum standards, also known as a basis grade.
Commodity ETF:

Because many commodity ETFs use leverage through the purchase of derivative contracts,
they may have large portions of uninvested cash, which is used to purchase Treasury
securities or other nearly risk-free assets.

Currency:
A generally accepted form of money, including coins and paper notes, which is issued by a
government and circulated within an economy.
Death Spiral:
A type of loan investors give to a company in exchange for convertible debt, which, like
convertiblebonds, typically has provisions that allow investors to convert the bonds into stock
at below-market prices. This can cause the original shareholders to lose control of the
company.
Deficit:
A situation in which liabilities exceed assets, expenditures exceed income, imports exceed
exports, or losses exceed profits.
Deliverables:
A project management term for the quantifiable goods or services that will be provided upon
the completion of a project. Deliverables can be tangible or intangible parts of the
development process, and are often specified functions or characteristics of the project.
Derivatives Time Bomb:
A possibile situation where the financial markets plunge into chaos if the massive derivatives
positions owned by hedge funds and the large banks were to move against those parties.
Institutional investors have increasingly used derivatives to either hedge their existing
positions, or to speculate on given markets or commodities. The growing popularity of these
instruments is both good and bad because although derivatives can be used to mitigate
portfolio risk. Institutions that are highly leveraged can suffer huge losses if their positions
move against them.
Dividend:
A distribution of a portion of a company’s earnings to shareholders, as decided by its board of
directors. It is most often calculated in dollar amount by predetermined dividends per share or
in terms of a percent of the current market price.
The Dow Jones Industrial Average:
The Dow Jones Industrial Average is a price-weighted average of 30 significant stocks traded
on the New York Stock Exchange and the Nasdaq.
Energy ETF:
A broad class of ETFs that includes funds focused on oil and gas exploration, the generation,
distribution and retail sale of gas and other refined products, electric utilities and alternative
energy production. Energy ETFs may invest in only United States-based companies, globally
based energy companies, or a blend of the two.
The offerings within the energy ETF class include replications of the energy-sector stocks
found in the S&P 500, U.S. energy producers, global energy producers and funds of a
particular sub-sector designation, such as nuclear, coal, gas, etc. The weighting of stocks
within these ETFs can be market-cap based, equally-weighted or fundamentally weighted,
based on financial metrics like net earnings and dividend yield.
Equity:
Assets that the owner can readily sell for cash. This includes stocks as well as cars and houses
with no outstanding debt.
ETF (Exchange-Traded Fund):
A security that tracks an index, a commodity or a basket of assets like an index fund, but
trades like a stock on an exchange. ETFs experience price changes throughout the day as they
are bought and sold.
Federal Reserve Board - FRB:
The governing body of the Federal Reserve System. The seven members of the board of
governors are appointed by the president, subject to confirmation by the Senate.
Foreclosure - FCL:
A situation in which a homeowner is unable to make principal and/or interest payments on his
or her mortgage, so the lender, be it a bank or building society, can seize and sell the property
as stipulated in the terms of the mortgage contract.
Forex Market:
The Forex Market, made up of banks, commercial companies, central banks, investment
management firms, hedge funds, retail forex brokers and investors, is a market in which
participants are able to buy, sell, exchange and speculate on currencies. The currency market
is considered to be the largest financial market in the world, processing trillions of dollars
worth of transactions each day.
Fortune 500:
An annual list of the 500 largest companies in the United States. The list is compiled using
the most recent figures for revenue.
Fundamental Analysis:
A method of evaluating a security that attempts to measure its value by examining related
economic, financial, quantitative and qualitative factors. The goal with this type of analysis is
to produce a value that an investor can compare to the securities current price. This allows
them to figure out what kind of position to take with that security, whether it is buy, sell, or
hold.
Gold Bull:
A slang term for a market or investor who is bullish on gold. A gold bull anticipates the price
of gold increasing over the next period of time. A gold bull market is one where the value of
gold has a rising trend.
Gold Standard:
A monetary system in which a country's government allows its currency unit to be freely
converted into fixed amounts of gold and vice versa. The exchange rate under the gold
standard monetary system is determined by the economic difference for an ounce of gold
between two currencies. The gold standard was mainly used from 1875 to 1914 and also
during the interwar years.
Hedge Fund:
A hedge fund is an aggressively managed portfolio of investments with the goal of making
high returns made possible by using advanced investment strategies such as leveraged, long,
short and derivative positions in both domestic and international markets. Hedge funds are
most often set up as private investment partnerships open to a limited number of investors and
require a sizeable initial investment. Investments in hedge funds are illiquid, usually requiring
investors to keep their money in the fund for at least a year.
Housing Market Index:
An index of over 300 home builders, which shows the demand for new homes. The index
runs from 0-100, so a rating of 50 would mean that demand for new homes was average.
Index:
A statistical measure of change in an economy or a securities market. In the case of financial
markets, an index is an imaginary portfolio of securities representing a particular market or a
portion of it. Each index has its own calculation methodology and is usually expressed in
terms of a change from a base value. Thus, the percentage change is more important than the
actual numeric value.
IPO (Initial Public Offering):
The first sale of a stock by a private company to the public. IPOs are often issued by smaller,
younger companies seeking the capital to expand, but can also be done by large privately
owned companies looking to become publicly traded.
In an IPO, the issuer obtains the assistance of an underwriting firm, which helps it determine
what type of security to issue (common or preferred), the best offering price and the time to
bring it to market.

Different aspects of credit risk: market risk, default rates and recovery rates

The two aspects of credit risk are the market risk of the contracts into which we have entered
with counterparties and the potential for some pejorative credit event such as default or
downgrade.

We know from previous articles on "Risk Measurement" that there are ways to quantify
market risk, including most notably Value-at-Risk techniques.

The difficult thing is to try and calculate the probability of default or of a negative credit
event. There are different methodologies to try and calculate default risk using the credit
spreads observed in the corporate bond market, historical default rates for a given class of
credit, interpreting information available from financial statements and other public
commentary from the counterparty's management. Check out the CreditMetrics technical
document on the RiskMetrics web site at http://www.riskmetrics.com or CreditRisk+ at the
Credit Suisse First Boston web site. Naturally, these calculations are complicated by
international legal idiosyncrasies.

Another difficulty in assessing credit risk is estimating the recovery rate. Let's
say that ABC bank defaults and that we have an outstanding swap with ABC,
the market value of which is $10 million in our favor. It is not automatically
true that we are not going to see any of that $10 million once the smoke clears
from the bankruptcy negotiations. We may be able to receive a partial payment.
The recovery rate is the rate at which we are paid in the event of a negative credit event. If we
are paid $2 million at the end of the day, then the recovery rate here is 20%.

What was the expected value of the swap to us the day before ABC defaulted? Let's say that
we had estimated an ex ante default probability of 5% and a recovery rate of 20%. Then, the
expected value condition is straightforward.

Expected Value Swap=0.95($10 million) + 0.05($10 million x 0.20)=$9.6 million

This expected value of the swap is less than its current market value because of the possibility
of default and less-than-total recovery of the value of the swap in the event of default.

Calculating credit risk and implications for derivative contracts

There are two steps in calculating credit risk: estimating the credit exposure and calculating
the probability of default. Once we have calculated these two statistics, we can quantify the
credit risk.

The credit exposure is equal to the greater of the current replacement value of the outstanding
contracts plus the expected maximum increase in value of the contract over the remaining life
of the contract for a given confidence interval or zero. This potential exposure can be
calculated using the Value-at-Risk techniques we discussed in an earlier article. If the sum of
the current replacement value and the potential increase in value of the contract is negative,
then we have no exposure to the counterparty from a credit perspective because we are
obligated to make payments to them.

Credit risk is simply the product of this calculated credit exposure and the
estimated probability of default.

One can see that there are a number of complicating factors implicit in this
calculation of credit risk.

First, as we have noted, it is difficult to measure default probabilities. Our estimation of the
credit risk for a given contract is limited by the reliability of our default probability forecast.

Second, credit exposure is an increasing function of time because of the potential increase in
value of the contract. The longer a contract's maturity, the greater the credit risk involved.
This is significant for derivatives, particularly in the case of swaps, because of their long
tenor, typically.

Third, as time passes and the counterparty makes cash flow payments to us on contracts with
a positive value for us, the credit risk of the contract in terms of potential fluctuations in value
is usually reduced. One example of a case where credit risk is not reduced even as time passes
is the currency swap because of its exchange of principal. The principal exchange risk
outweighs the reduction in credit risk from the payment of cash flows.

Fourth, on structures with amortized payments, it is possible to have the credit risk "front-
loaded" in which most of the cash flows can be structured to take place early on in the tenor
of the swap.

Fifth, when we sell an option to a counterparty, there is no credit risk from the transaction
other than settlement risk. Selling an option obliges us to make cash flows to the counterparty
either by buying or selling the underlying asset in the case of a put or a call, respectively.
However, if the counterparty exercises a call by buying the underlying asset, they must still
deliver the funds for the stock. This delivery risk is called settlement risk or Herstatt risk.

Sixth, current positions may not represent future credit risks. That is why we must include the
potential favourable change in value of the swap. A swap with zero value at inception does
not have zero credit risk. It has credit risk from its potential value in the future.

Credit enhancement and derivatives

Because credit risk is such a tremendous overhang in any relationship, banks and dealers have
worked with lawyers to develop techniques that help mitigate the credit exposure inherent in
derivatives transactions.

First among these techniques is the concept of netting. Netting takes different forms,
depending upon the institutions involved. Imagine DEF Bank and Flying Boats Incorporated.
They have a number of outstanding interest rate swap contracts on the books, some of which
involve cash flows on the same day. DEF and Flying Boats have a netting agreement in place
that compels them to net the cash flows on any given delivery date into its root payment. For
example, if on July 5, DEF must pay $400,000 to Flying Boats and Flying Boats must pay a
total of $600,000 to DEF, the net payment would be a $200,000 payment from Flying Boats
to DEF.

Second, DEF may ask Flying Boats to put up some collateral against the market value of the
swap. This is the same kind of concept as the margining that is used on the futures exchanges.
Once the market value moves against Flying Boats past a pre-set threshold, Flying Boats
agrees to either top up the collateral account or to close the contract. This limits the credit
exposure.

Third, DEF might ask Flying Boats to put up a third-party guarantee. In this case, Flying
Boats must find some other counterparty that will guarantee to pay DEF the difference
between the market value of the contract before and after a negative Flying Boats credit
event. This is insurance against the credit risk of the contract that Flying Boats must pay for.

These are just some of the more simple examples of credit enhancement techniques.

Credit risk is a significant element of any derivatives transaction. Because of the significance
of credit risk, dealers must account for it when they conduct swaps transactions with their
counterparties. This may mean that they charge a greater swap spread when pricing the swap
curve for a particular counterparty or it may mean that they place greater conditions on the
transaction.
Q.3 What do you understand by industry (give examples)? What is importance of
industry life cycle? Is it possible to asses the intrinsic value of security?

In order to engage in the competitive process accurately, you need to understand the nature of
your industry.

Some things to consider:

• The current trends – What are the current trends in the industry? Is your company
part of these trends? How long do you think the trends will last?

• Future trends – Do you have any insight into the future trends? How long do you
think those will last?

• Product development – What do you know about your industry’s product

development and research trends and capabilities? How does your company fit in to
these? How about your competition?

• Industry growth – How is your industry growing? Is it growing or is it stagnating?

What is the future growth?

This information will help you understand not only how your company fits into the industry,
but also your competition.

What is industry lifecycle?

Like other living creatures, industry also has its circle of life. The industry lifecycle imitates
the human lifecycle. The stages of industry lifecycle include fragmentation, shake-out,
maturity and decline (Kotler 2003). These stages will be described in the followings section.

What are the main aspects of industry lifecycle?

Fragmentation Stage
Fragmentation is the first stage of the new industry. This is the stage when the new industry
develops the business. At this stage, the new industry normally arises when an entrepreneur
overcomes the twin problems of innovation and invention, and works out how to bring the
new products or services into the market (Ayres et al., 2003). For example, air travel services
of major airlines in Europe were sold to the target market at a high price. Therefore, the
majority of airlines' customers in Europe were those people with high incomes who could
afford premium prices for faster travel.

In 1985, Ryanair made a huge change in the European airline industry. Ryanair was the first
airline to engage low-cost airlines in Europe. At that time,Ryanair's services were perceived
as the innovation of the European airline industry (Le Bel, 2005). Ryanairtickets are half the
price of British Airways. Some of its sales promotions were as low as £0.01. This made
people think that air travel was not just made for the rich, but everybody (Haley & Tan 1999).

Ryanair overcame the twin problems of innovation and invention in the airline industry by
inventing air travel services that could serve passengers with tight budgets and those who just
wanted to reach their destination without breaking their bank savings.Ryanair achieved this
goal by eliminating unnecessary services offered by traditional airlines (Kaynak &
Kucukemiroglu, 1993). It does not offer free meals, uses paper-free air tickets, gets rid of mile
collecting scheme, utilises secondary airports, and offers frequent flights. These techniques
helpRyanair save time and costs spent in airline business operation (Haley & Tan 1999).

Shake-out
Shake-out is the second stage of the industry lifecycle. It is the stage at which a new industry
emerges. During the shake-out stage, competitors start to realise business opportunities in the
emerging industry. The value of the industry also quickly rises (Ayres et al., 2003).

For example, many people die and suffer because of cigarettes every year. Thus, the UK
government decided to launch a campaign to encourage people to quit smoking. Nicorette,
one of the leading companies is producing several nicotine products to help people quit
smoking. Some of its well-known products include Nicorette patches, Nicolette gums
and Nicorette lozenges (Nicorette 2007).

Smokers began to see an easy way to quit smoking. The new industry started to attract brand
recognition and brand awareness among its target market during the shake-out stage
(Hendrickson et al., 2006). Nicorette's products began to gain popularity among those who
wanted to quit smoking or those who wanted to reduce their daily cigarette consumption.

During this period, another company realised the opportunity in this market and decided to
enter it by launching nicotine product ranges, including Nic Lite gum and patches. It recently
went beyond UK boarder after the UK government introduced non-smoking policy in public
places, including pubs and nightclubs. This business threat created a new business
opportunity in the industry for Nic Lite to launch a new nicotine-related product called Nic
Time (ABC News 2006).

Nic Time is a whole new way for smokers to "get a cigarette" – an eight-ounce bottle contains
a lemon-flavoured drink laced with nicotine, the same amount of nicotine as two cigarettes
(ABC News 2006). Nic Lite was first available at Los Angeles airports for smokers who got
uneasy on flights, but now the nicotine soft drinks are available in some convenience stores
(ABC News 2006).

Maturity
Maturity is the third stage in the industry lifecycle. Maturity is a stage at which the
efficiencies of the dominant business model give these organisations competitive advantage
over competition (Kotler, 2003). The competition in the industry is rather aggressive because
there are many competitors and product substitutes. Price, competition, and cooperation take
on a complex form (Gottschalk & Saether, 2006). Some companies may shift some of the
production overseas in order to gain competitive advantage.

For example, Toyota is one of the world's leading multinational companies, selling
automobiles to customers worldwide. The export and import taxes mean that its cars lose
competitiveness to the local competitors, especially in the European automobile industry. As
a result, Toyota decided to open a factory in the UK in order to produce cars and sell them to
customers in the European market (Toyota, 2007).

The haute couture fashion industry is another good example. There are many western-branded
fashion labels that manufacture their products overseas by cooperating with overseas partners,
or they could seek foreign suppliers who specialise in particular materials or items. For
instance, Nike has factories in China and Thailand as both countries have cheap labour costs
and cheap, quality materials, particularly rubber and fabric. However, their overseas partners
are not allowed to sell shoes produced for Adidas andNike (Harrison & Boyle, 2006). The
items have to be shipped back to the US, and then will be exported to countries worldwide,
including China and Thailand.
Decline
Decline is the final stage of the industry lifecycle. Decline is a stage during which a war of
slow destruction between businesses may develop and those with heavy bureaucracies may
fail (Segil, 2005). In addition, the demand in the market may be fully satisfied or suppliers
may be running out (Ayres et al., 2003).

In the stage of decline, some companies may leave the industry if there is no demand for the
products or services they provide, or they may develop new products or services that meet the
demand in the market. In such cases, this will create a new industry (Francis & Desai, 2005).

For example, at the beginning of the communication industry, pagers were used as the main
communication method among people working in the same organisation, such as doctors and
nurses. Then, the cutting edge of the communication industry emerged in the form of the
mobile phone. The communication process of pagers could not be accomplished without
telephones. To send a message to another pager, the user had to phone the call-centre staff
who would type and send the message to another pager. On the other hand, people who use
mobile phones can make a phone-call and send messages to other mobiles without going
through call-centre staff (Hui et al., 2002).

In recent years, the features of mobile phones have been developing rapidly and continually.
Now people can use mobiles to send multimedia messages, take pictures, check email, surf
the internet, read news and listen to music (Hui et al., 2002). As mobile phone feature
development has reached saturation, thus the new innovation of mobile phone technology has
incorporated the use of computers.

The launch of personal digital assistants (PDA) is a good example of the decline stage of the
mobile phone industry as the features of most mobiles are similar. PDAs are hand-held
computers that were originally designed as a personal organiser but it become much more
multi-faceted in recent years. PDAs are known as pocket computers or palmtop computers
(Wikipedia, 2007). They have many uses for both mobile phones and computers such as
computer games, global positioning system, video recording, typewriting and wireless wide-
area network (Wikipedia, 2007).

How do you use industry lifecycle analysis?

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

Competing over emerging industries

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

Competing during the transition to industry maturity

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

Competing in declining industries

The characteristics of declining industries include the following:

• Declining demand for products

• Pruning of product lines
• Shrinking profit margins
• Falling research and development advertisement expenditure
• Declining number of rivals as many are forced to leave the industry

For companies to survive the dynamic environment, it is necessary for them to:

• Measure the intensity of competition (Baum & McGahan, 2004)

• Assess the causes of decline (Baum & McGahan, 2004)
• Single out a viable strategy for decline such as leadership, liquidation and harvest
(Baum & McGahan, 2004).

Where do you find information on the industry lifecycle?

The information, model and theory for the industry lifecycle can be found in many business
management books. Several variations of lifecycle model have been developed to address the
development and transition of products, market and industry. The models are similar but the
number and names of each stage can be different (Baum & McGahan, 2004). The following
are some of the major models:

• Fox, 1973: Pre-commercialisation – introduction, growth, maturity and decline

• Wasson, 1974: Market Development – rapid growth, competitive turbulence,
saturation/maturity and decline
• Anderson & Zeithaml, 1984: introduction, growth, maturity and decline
• Hill & Jones, 1998: fragmentation, growth, shake-out, maturity and decline

This article is about the valuation of financial assets. For the philosophy of economic value,
see Intrinsic theory of value.
In finance, intrinsic value refers to the value of a security which is intrinsic to or contained in
the security itself. It is also frequently called fundamental value. It is ordinarily calculated
by summing the future income generated by the asset, and discounting it to the present value.

Contents
[hi
Theactual valueof asecurity, as opposed to itsmarket priceorbook value. The
intrinsicvalueincludes othervariablessuch asbrand name,trademarks, andcopyrightsthat are
often dificult to calculate and sometimes not accurately reflected in themarketprice. One way
to look at it is that themarket capitalizationis the price (i.e. whatinvestorsare willing topayfor
thecompany) and intrinsic value is the value (i.e. what the company is reallyworth). Different
investors use differenttechniquesto calculate intrinsic value.

2. Theamountby which acall optionisin the money, calculated by taking the difference
between thestrike priceand the market price of theunderlier. For example, if a calloptionfor
100 shares has astrikeprice of $35 and thestockistradingat $50 asharethan the call option has
an intrinsic value of $15 share, or $1500. If the stock price is less than the strike price the call
option has no intrinsic value.

3. The amount by which aput optionis in themoney, calculated by taking the difference
between the strike price and the market price of the underlier. For example, if aputoption for
100 shares has a strike price of $35 and the stock is trading at $20 a share than the put option
has an intrinsic value of $15pershare, or $1500. If the stock price is greater than the strike
price the put option has no intrinsic value.

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

In finance, technical analysis is a security analysis discipline for forecasting the direction of
prices through the study of past market data, primarily price and volume.[1]

What is Technical Analysis?

Technical Analysis is the study of prices and volume, for forecasting of future stock price or
financial price movements. Technical analysis does not result in absolute predictions about
the future. Instead, technical analysis can help investors anticipate what is "likely" to happen
to prices over time.

Technical analysis is not an exact science. It's an art and takes considerable experience. Not
all studies work the same for every instrument traded. One study may give excellent buy and
sell signals while another may not work for you at all.

Stock Market Technical Analysis Basic Principles

Technical Analysis is based on these three basic principles:

Price Discounts Everything

Prices move in trends

History repeats itself

#1- Price Discounts Everything

Technical analysts believe that the current price fully reflects all information. Because all
information is already reflected in the price, it represents the fair value, and should form the
basis for analysis. After all, the market price reflects the sum knowledge of all participants,
including traders, and ...

Stock Market Technical analysis utilizes the information captured by the price to interpret
what the market is saying with the purpose of forming a view on the future.

#2- Prices Move in Trends

Technical analysts or chartists believe that profits can be made by following the trends. In
other words if the price has risen, they expect it to continue rising; if the price has fallen, they
expect it to continue falling. However, most technicians also acknowledge that there are
periods when prices do not trend.

#3- History Repeats Itself

Technical analysts believe that investors repeat their behavior and they assume that there is
useful information hidden within price histories; that it is a way of analyzing the past actions
of people in a particular market as reflected by their actual transactions.

Principles Behind Technical Analysis

Technical analysis refers to methods that aim to predict future price movements in the
financial market by using charts and qualitative methods. Different methods are utilized in
technical analysis but they all rely on the same principles, like price patterns and price trends
exist in the market that can be identified and exploited. Understanding the basic underlying
principles of technical analysis will help you to trade with a complete ease.
Let’s check out the basic principles behind technical analysis:
Price discounts everything.
This means that the actual price is the reflection of all the components that is known to affect
the market, including some of the major factors like fundamentals, supply & demand,
political and economic factors. Pure technical analysis is mainly concerned with up and down
price movements, not with the reasons for those changes. This is one of the major technical
analysis principles.
Price move in trends
One of the other principles behind technical analysis is the theory that price moves in a trend.
Technical analysis is used to identify various patterns of the behavior of a market that are
known to be significant. For many given patterns there is always a high probability of
producing the expected results.
History tend to repeat itself
The other principle of technical analysis is the fact that history always repeats itself. The basis
that history repeats is the foundation of technical analysis, which is the analysis of historical
data to forecast future movements. In the chart patterns, forex markets have been noted for
more than fifty years, and from that it can be observed that human nature does not change a
drastic extent for a long period of time. Various patterns in charts of different years are
always repeated.
Political and economic situations in a country may always repeat itself. Sometimes, a country
may experience prosperity when it comes to its political and economic arena; while other
times, it may experience a huge slump. All these factors may happen time and time again, and
there is really no definite means of controlling it as so many other factors would affect it.
The above mentioned technical analysis principles will help you to understand why currency
prices are the way they are.

Q.5 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.

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[1][2][3]. 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 efficient-market hypothesis was first expressed by Louis Bachelier, a French

mathematician, in his 1900 PhD thesis, "The Theory of Speculation".[4]His work was largely
ignored until the 1950s; however beginning in the 30s scattered, independent work
corroborated his thesis. A small number of studies indicated that US stock prices and related
financial series followed a random walk model.[5] Research by Alfred Cowles in the ’30s and
’40s suggested that professional investors were in general unable to outperform the market.
The efficient-market hypothesis was developed by Professor Eugene Fama at the University
of Chicago Booth School of Business as an academic concept of study through his published
Ph.D. thesis in the early 1960s at the same school. It was widely accepted up until the 1990s,
when behavioral financeeconomists, who had been a fringe element, became mainstream.
[6]
Empirical analyses have consistently found problems with the efficient-market hypothesis,
the most consistent being that stocks with low price to earnings (and similarly, low price to
cash-flow or book value) outperform other stocks.[7][8] Alternative theories have proposed
that cognitive biases cause these inefficiencies, leading investors to purchase
overpriced growth stocksrather than value stocks.[6] Although the efficient-market hypothesis
has become controversial because substantial and lasting inefficiencies are observed, Beechey
et al. (2000) consider that it remains a worthwhile starting point.[9]

The efficient-market hypothesis emerged as a prominent theory in the mid-1960s. Paul

Samuelson had begun to circulate Bachelier's work among economists. In 1964 Bachelier's
dissertation along with the empirical studies mentioned above were published in an anthology
edited by Paul Cootner.[10] In 1965 Eugene Fama published his dissertation arguing for the
random walk hypothesis,[11] and Samuelson published a proof for a version of the efficient-
market hypothesis.[12] In 1970 Fama published a review of both the theory and the evidence
for the hypothesis. The paper extended and refined the theory, included the definitions for
three forms of financial market efficiency: weak, semi-strong and strong (see below).[13]

Further to this evidence that the UK stock market is weak-form efficient, other studies of
capital markets have pointed toward their being semi-strong-form efficient. A study by Khan
of the grain futures market indicated semi-strong form efficiency following the release of
large trader position information (Khan, 1986). Studies by Firth (1976, 1979, and 1980) in the
United Kingdom have compared the share prices existing after a takeover announcement with
the bid offer. Firth found that the share prices were fully and instantaneously adjusted to their
correct levels, thus concluding that the UK stock market was semi-strong-form efficient.
However, the market's ability to efficiently respond to a short term, widely publicized event
such as a takeover announcement does not necessarily prove market efficiency related to
other more long term, amorphous factors. David Dreman has criticized the evidence provided
by this instant "efficient" response, pointing out that an immediate response is not necessarily
efficient, and that the long-term performance of the stock in response to certain movements
are better indications. A study on stocks response to dividend cuts or increases over three
years found that after an announcement of a dividend cut, stocks underperformed the market
by 15.3% for the three-year period, while stocks outperformed 24.8% for the three years
afterward after a dividend increase announcement.
nvestors and researchers have disputed the efficient-market hypothesis both empirically and
theoretically.Behavioral economists attribute the imperfections in financial markets to a
combination of cognitive biases such as overconfidence, overreaction, representative
bias, information bias, and various other predictable human errors in reasoning and
information processing. These have been researched by psychologists such as Daniel
Kahneman, Amos Tversky, Richard Thaler, and Paul Slovic. These errors in reasoning lead
most investors to avoid value stocks and buy growth stocks at expensive prices, which allow
those who reason correctly to profit from bargains in neglected value stocks and
the overreacted selling of growth stocks.

Empirical evidence has been mixed, but has generally not supported strong forms of the
efficient-market hypothesis[7][8][22] According to Dreman, in a 1995 paper, low P/E stocks have
greater returns.[23] In an earlier paper he also refuted the assertion by Ray Ball that these
higher returns could be attributed to higher beta,[24]whose research had been accepted by
efficient market theorists as explaining the anomaly[25] in neat accordance with modern
portfolio theory.

One can identify "losers" as stocks that have had poor returns over some number of past
years. "Winners" would be those stocks that had high returns over a similar period. The main
result of one such study is that losers have much higher average returns than winners over the
following period of the same number of years.[26]A later study showed that beta (β) cannot
account for this difference in average returns.[27] This tendency of returns to reverse over long
horizons (i.e., losers become winners) is yet another contradiction of EMH. Losers would
have to have much higher betas than winners in order to justify the return difference. The
study showed that the beta difference required to save the EMH is just not there.

Speculative economic bubbles are an obvious anomaly, in that the market often appears to be
driven by buyers operating on irrational exuberance, who take little notice of underlying
value. These bubbles are typically followed by an overreaction of frantic selling, allowing
shrewd investors to buy stocks at bargain prices. Rational investors have difficulty profiting
by shorting irrational bubbles because, as John Maynard Keynes commented, "Markets can
remain irrational far longer than you or I can remain solvent."[28] Sudden market crashes as
happened on Black Monday in 1987 are mysterious from the perspective of efficient markets,
but allowed as a rare statistical event under the Weak-form of EMH.

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

In the last section of this tutorial, we touched on the concept of required yield. In this section
we'll explain what this means and take a closer look into how various yields are
calculated. The general definition of yield is the return an investor will receive by holding a
bond to maturity. So if you want to know what your bond investment will earn, you should
know how to calculate yield. Required yield, on the other hand, is the yield or return a bond
must offer in order for it to be worthwhile for the investor. The required yield of a bond is
usually the yield offered by other plain vanilla bonds that are currently offered in the market
and have similar credit quality andmaturity.

Once an investor has decided on the required yield, he or she must calculate the yield of a
bond he or she wants to buy. Let's proceed and examine these calculations.
Calculating Current Yield
A simple yield calculation that is often used to calculate the yield on both bonds and the
dividend yield for stocks is thecurrent yield. The current yield calculates the percentage return
that the annual coupon payment provides the investor. In other words, this yield calculates
what percentage the actual dollar coupon payment is of the price the investor pays for the
bond. The multiplication by 100 in the formulas below converts the decimal into a
percentage, allowing us to see the percentage return:

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

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

Let's re-calculate the yield of the bond in our first example, which matures in 30 months and
has a coupon payment of $5:

The adjusted current yield of 6.84% is higher than the current yield of 5.21% because the
bond's discounted price ($95.92 instead of $100) gives the investor more of a gain on the
investment.

One thing to note, however, is whether you buy the bond between coupon payments. If you
do, remember to use the dirty price in place of the market price in the above equation. The
dirty price is what you will actually pay for the bond, but usually the figure quoted in U.S.
markets is the clean price.

Now we must also account for other factors such as the coupon payment for a zero-coupon
bond, which has only one coupon payment. For such a bond, the yield calculation would be as
follows:

n = years left until maturity

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

Calculating Yield to Maturity

The current yield calculation we learned above shows us the return the annual coupon
payment gives the investor, but this percentage does not take into account the time value of
money or, more specifically, the present value of the coupon payments the investor will
receive in the future. For this reason, when investors and analysts refer to yield, they are most
often referring to the yield to maturity (YTM), which is the interest rate by which the present
values of all the future cash flows are equal to the bond's price.

An easy way to think of YTM is to consider it the resulting interest rate the investor receives
if he or she invests all of his or her cash flows (coupons payments) at a constant interest rate
until the bond matures. YTM is the return the investor will receive from his or her entire
investment. It is the return that an investor gains by receiving the present values of the coupon
payments, the par value and capital gains in relation to the price that is paid.

The yield to maturity, however, is an interest rate that must be calculated through trial and
error. Such a method of valuation is complicated and can be time consuming, so investors
(whether professional or private) will typically use a financial calculator or program that is
quickly able to run through the process of trial and error. If you don't have such a program,
you can use an approximation method that does not require any serious mathematics.

To demonstrate this method, we first need to review the relationship between a bond's price
and its yield. In general, as a bond's price increases, yield decreases. This relationship is
measured using the price value of a basis point(PVBP). By taking into account factors such as
the bond's coupon rate and credit rating, the PVBP measures the degree to which a bond's
price will change when there is a 0.01% change in interest rates.

The charted relationship between bond price and required yield appears as a negative curve:

This is due to the fact that a bond's price will be higher when it pays a coupon that is higher
than prevailing interest rates. As market interest rates increase, bond prices decrease.

The second concept we need to review is the basic price-yield properties of bonds:

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

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

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

The calculation can be presented as:

OR
Example 1: You hold a bond whose par value is $100 but has a current yield of 5.21%
because the bond is priced at $95.92. The bond matures in 30 months and pays a semi-annual
coupon of 5%.

1. Determine the Cash Flows: Every six months you would receive a coupon payment of
$2.50 (0.025*100). In total, you would receive five payments of $2.50, plus the future value
of $100.

2. Plug the Known Amounts into the YTM Formula:

Remember that we are trying to find the semi-annual interest rate, as the bond pays the
coupon semi-annually.

3. Guess and Check: Now for the tough part: solving for “i,” or the interest rate. Rather than
pick random numbers, we can start by considering the relationship between bond price and
yield. When a bond is priced at par, the interest rate is equal to the coupon rate. If the bond is
priced above par (at a premium), the coupon rate is greater than the interest rate. In our case,
the bond is priced at a discount from par, so the annual interest rate we are seeking (like the
current yield) must be greater than the coupon rate of 5%.

Now that we know this, we can calculate a number of bond prices by plugging various annual
interest rates that are higher than 5% into the above formula. Here is a table of the bond prices
that result from a few different interest rates:

Because our bond price is $95.92, our list shows that the interest rate we are solving for is
between 6%, which gives a price of $95, and 7%, which gives a price of $98. Now that we
have found a range between which the interest rate lies, we can make another table showing
the prices that result from a series of interest rates that go up in increments of 0.1% instead of
1.0%. Below we see the bond prices that result from various interest rates that are between
6.0% and 7.0%:
We see then that the present value of our bond (the price) is equal to $95.92 when we have an
interest rate of 6.8%. If at this point we did not find that 6.8% gives us the exact price that we
are paying for the bond, we would have to make another table that shows the interest rates in
0.01% increments. You can see why investors prefer to use special programs to narrow down
the interest rates - the calculations required to find YTM can be quite numerous!

Calculating Yield for Callable and Puttable Bonds

Bonds with callable or puttable redemption features have additional yield calculations.
A callable bond's valuations must account for the issuer's ability to call the bond on the call
date and the puttable bond's valuation must include the buyer's ability to sell the bond at the
pre-specified put date. The yield for callable bonds is referred to as yield-to-call, and the yield
for puttable bonds is referred to as yield-to-put.

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

Note that European callable bonds can have multiple call dates and that a yield to call can be
calculated for each.

Yield to put (YTP) is the interest rate that investors would receive if they held the bond until
its put date. To calculate yield to put, the same modified equation for yield to call is used
except the bond put price replaces the bond call value and the time until put date replaces the
time until call date.

For both callable and puttable bonds, astute investors will compute both yield and all yield-to-
call/yield-to-put figures for a particular bond, and then use these figures to estimate the
expected yield. The lowest yield calculated is known as yield to worst, which is commonly
used by conservative investors when calculating their expected yield. Unfortunately, these
yield figures do not account for bonds that are not redeemed or are sold prior to the call or put
date.
Bond valuation is the act of determining the fair price of a bond. As with any security or
capital investment, the theoretical fair value of a bond is thepresent value of the stream of
cash flows it is expected to generate. Hence, the value of a bond is obtained by discounting
the bond's expected cash flows to the present using the appropriate discount rate. Determining
this rate in practice - i.e. "pricing" the bond - is done with reference to other instruments.
Once the price or value has been calculated, the sensitivity of the price can then be estimated;
the various yields, which relate the price of the bond to its coupons, can also be determined.

When the bond includes embedded options, the valuation is more specialized and
combines option pricing with the cash flow based approach. Depending on the option as
embedded, the option price as calculated is either added to or subtracted from the price of the
"straight" portion. This total is then the value of the bond; the various yields can then be
calculated for the total price. See further under Bond option.

Present value relationship

Here is the formula for calculating a bond's price, which uses the basic present value (PV)
formula:[1]

F = face value

iF = contractual interest rate

C = F * iF = coupon payment (periodic interest payment)

N = number of payments

i = market interest rate, or required yield

M = value at maturity, usually equals face value

P = market price of bond

If the market price of bond is less than its face value (par value), bond is selling at a discount.
Conversely, if the market price of bond is greater than its face value, bond is selling at
a premium.[2] In accounting for liabilities, bond discount or bond premium are amortized
over the life of bond. Amortization amount in each period is calculated from the following
formula:
an + 1 = amortization amount in period number "n+1"

an + 1 = | iP − C | (1 + i)n

Bond Discount or Bond Premium = | F − P | = a1 + a2 + ... + aN

Bond Discount or Bond Premium =

[edit]With Respect to Different Interest Rate Model

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

Given a zero-coupon bond, the solution to the bond PDE is [3]

where is the expectation with respect to risk-neutral probabilities, and R(t,T) is the
random variable for the interest rate to be integrated over time.

When the bond is not valued precisely on a coupon date, the present value relationship as
above, will incorporate accrued interest: i.e. any interest due to the owner of the bond since
the previous coupon date; see day count convention. The price of a bond which includes this
accrued interest is known as the "dirty price"; the "clean price" is the price excluding any
interest that has accrued. The value returned by the above formula is thus the dirty price.

Clean prices are generally more stable over time than dirty prices. This is because clean prices
change for economic reasons ( for instance a change in interest rates or in the bond issuer's
credit quality), whereas dirty prices change day to day depending on where the current date is
in relation to the coupon dates, in addition to any economic reasons.

It is market practice to quote bonds on a clean-price basis. When a bond settles the accrued
interest is added to the value based on the clean price to reflect the full market value.

Under this approach, the bond will be priced relative to a benchmark, usually a government
security; see Relative valuation. Here, the yield to maturity on the bond is determined based
on the bond's Credit rating relative to a government security with similar maturity or duration;
see Credit spread (bond). The better the quality of the bond, the smaller the spread between its
required return and the YTM of the benchmark. This required return is then used to discount
the bond cash flows as above to obtain the price. he yield to maturity is the discount rate
which returns the market price of the bond; it is identical to r (required return) in the above
equation. YTM is thus the internal rate of return of an investment in the bond made at the
observed price. Since YTM can be used to price a bond, bond prices are often quoted in terms
of YTM.

To achieve a return equal to YTM, i.e. where it is the required return on the bond, the bond
owner must:

 buy the bond at price P0,

 hold the bond until maturity, and
 redeem the bond at par.

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

The coupon yield is simply the coupon payment (C) as a percentage of the face value (F).

Coupon yield = C / F

Coupon yield is also called nominal yield.

Current yield

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

Current yield = C / P0.

elationship

The concept of current yield is closely related to other bond concepts, including yield to
maturity, and coupon yield. The relationship between yield to maturity and the coupon rate is
as follows:

 When a bond sells at a discount, YTM > current yield > coupon yield.
 When a bond sells at a premium, coupon yield > current yield > YTM.
 When a bond sells at par, YTM = current yield = coupon yield amt
Price sensitivity

Main articles: Bond duration and Bond convexity

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

Duration is a linear measure of how the price of a bond changes in response to interest rate
changes. It is approximately equal to the percentage change in price for a given change in
yield, and may be thought of as the elasticity of the bond's price with respect to interest rates.
For example, for small interest rate changes, the duration is the approximate percentage by
which the value of the bond will fall for a 1% per annum increase in market interest rate. So a
15-year bond with a duration of 7 would fall approximately 7% in value if the interest rate
increased by 1% per annum.

Convexity is a measure of the "curvature" of price changes, and is thus a complement to

duration. The necessity for this additional measure arises since, as mentioned, duration is a
linear measure, whereas, in reality, as interest rates change, the price is a convex function of
interest rates. (Specifically, duration can be formulated as the first derivative of the price
function with respect to the interest rate, and convexity as the second derivative; see Bond
duration closed-form formula; Bond convexity closed-form formula). Continuing the above
example, for a more accurate estimate of sensitivity, the convexity score would be added to
the value of 7 for duration.
Master of Business Administration- MBA Semester 3
MF0010 – Security Analysis and Portfolio Management - 4 Credits
(Book ID: B1035)
Assignment Set- 2 (60 Marks)
Note: Each question carries 10 Marks. Answer all the questions.

Q. 1 Explain basic steps involved in PM. What is difference between PM and a Mutual
Fund? What are various types of risk associated with PM?

Project management is the discipline of planning, organizing, securing

and managing resources to bring about the successful completion of specific engineering
project goals and objectives. It is sometimes conflated with program management, however
technically that is actually a higher level construction: a group of related and somehow
interdependent engineering projects. A project is a temporary endeavor, having a defined
beginning and end (usually constrained by date, but can be by funding or deliverables),
[1]
undertaken to meet unique goals and objectives,[2] usually to bring about beneficial change
or added value. The temporary nature of projects stands in contrast to business as usual (or
operations),[3] which are repetitive, permanent or semi-permanent functional work to produce
products or services. In practice, the management of these two systems is often found to be
quite different, and as such requires the development of distinct technical skills and the
adoption of separate management.

The primary challenge of project management is to achieve all of the engineering project
goals[4] and objectives while honoring the preconceived project constraints.[5] Typical
constraints are scope, time, and budget.[1] The secondary—and more ambitious—challenge is
to optimize the allocation and integration of inputs necessary to meet pre-defined objectives.

roject management has been practiced since early civilization. Until 1900 civil engineering
projects were generally managed by creativearchitects and engineers themselves, among those
for example Vitruvius (1st century BC), Christopher Wren (1632–1723) , Thomas
Telford(1757–1834) and Isambard Kingdom Brunel (1806–1859).[6] It was in the 1950s that
organizations started to systematically apply project management tools and techniques to
complex engineering projects.[7]
Henry Gantt (1861-1919), the father of planning and control techniques.

As a discipline, Project Management developed from several fields of application including

civil construction,engineering, and heavy defense activity.[8] Two forefathers of project
management are Henry Gantt, called the father of planning and control techniques,[9] who is
famous for his use of the Gantt chart as a project management tool; and Henri Fayol for his
creation of the 5 management functions which form the foundation of the body of knowledge
associated with project and program management.[10] Both Gantt and Fayol were students
of Frederick Winslow Taylor's theories of scientific management. His work is the forerunner
to modern project management tools including work breakdown structure (WBS)
and resource allocation.

The 1950s marked the beginning of the modern Project Management era where core
engineering fields come together working as one. Project management became recognized as
a distinct discipline arising from the management discipline with engineering model.[11] In the
United States, prior to the 1950s, projects were managed on an ad hoc basis using
mostly Gantt Charts, and informal techniques and tools. At that time, two mathematical
project-scheduling models were developed. The "Critical Path Method" (CPM) was
developed as a joint venture between DuPont Corporation and Remington Rand
Corporation for managing plant maintenance projects. And the "Program Evaluation and
Review Technique" or PERT, was developed by Booz Allen Hamilton as part of the United
States Navy's (in conjunction with the Lockheed Corporation) Polaris missile submarine
program;[12] These mathematical techniques quickly spread into many private enterprises.

PERT network chart for a seven-month project with five milestones

At the same time, as project-scheduling models were being developed, technology for project
cost estimating, cost management, and engineering economics was evolving, with pioneering
work by Hans Lang and others. In 1956, the American Association of Cost Engineers
(now AACE International; the Association for the Advancement of Cost Engineering) was
formed by early practitioners of project management and the associated specialties of
planning and scheduling, cost estimating, and cost/schedule control (project control). AACE
continued its pioneering work and in 2006 released the first integrated process for portfolio,
program and project management (Total Cost Management Framework).

The International Project Management Association (IPMA) was founded in Europe in 1967,
[13]
as a federation of several national project management associations. IPMA maintains its
federal structure today and now includes member associations on every continent except
Antarctica. IPMA offers a Four Level Certification program based on the IPMA Competence
Baseline (ICB).[14] The ICB covers technical competences, contextual competences, and
behavioral competences.

In 1969, the Project Management Institute (PMI) was formed in the USA.[15] PMI publishes A
Guide to the Project Management Body of Knowledge (PMBOK Guide), which describes
project management practices that are common to "most projects, most of the time." PMI also
offers multiple certifications.

The American Academy of Project Management (AAPM) International Board of Standards

1996 was the first to institute post-graduate certifications such as the MPM Master Project
Manager, PME Project Management E-Business, CEC Certified-Ecommerce Consultant, and
CIPM Certified International Project Manager. The AAPM also issues the post-graduate
standards body of knowledge for executives.

There are a number of approaches to managing project activities including agile, interactive,
incremental, and phased approaches.

Regardless of the methodology employed, careful consideration must be given to the overall
project objectives, timeline, and cost, as well as the roles and responsibilities of all
participants and stakeholders.
The traditional approach

A traditional phased approach identifies a sequence of steps to be completed. In the

"traditional approach", we can distinguish 5 components of a project (4 stages plus control) in
the development of a project:

Typical development phases of an engineering project

 Project initiation stage;

 Project planning and design stage;
  Project execution and construction stage;
 Project monitoring and controlling systems;
 Project completion.

Not all the projects will visit every stage as projects can be terminated before they reach
completion. Some projects do not follow a structured planning and/or monitoring stages.
Some projects will go through steps 2, 3 and 4 multiple times.

Many industries use variations on these project stages. For example, when working on a brick
and mortar design and construction, projects will typically progress through stages like Pre-
Planning, Conceptual Design, Schematic Design, Design Development, Construction
Drawings (or Contract Documents), and Construction Administration. In software
development, this approach is often known as the waterfall model,[16] i.e., one series of tasks
after another in linear sequence. In software development many organizations have adapted
the Rational Unified Process (RUP) to fit this methodology, although RUP does not require or
explicitly recommend this practice. Waterfall development works well for small, well defined
projects, but often fails in larger projects of undefined and ambiguous nature. The Cone of
Uncertainty explains some of this as the planning made on the initial phase of the project
suffers from a high degree of uncertainty. This becomes especially true as software
development is often the realization of a new or novel product. In projects
where requirements have not been finalized and can change, requirements management is
used to develop an accurate and complete definition of the behavior of software that can serve
as the basis for software development.[17] While the terms may differ from industry to
industry, the actual stages typically follow common steps to problem solving — "defining the
problem, weighing options, choosing a path, implementation and evaluation."
ETF is a basket of stocks that never changes and can be sold at any time during market
hours.Example: a technology ETF might contain Apple, Cisco, Microsoft, Google, IBM…etc.
A Mutual Fund has a financial manager at the helm….who makes portfolio decisions on your
behalf. He/she buys a basket of diversified stocks on your behalf. The sum of the portfolio
can be bought and sold only on a daily basis….at the closing NAV price. (not throughout the
market day like ETFs). The portfolio changes all the time.
Advantages of ETFs are that the basket of stocks is not being bought and sold. You buy the
ETF (basket)…the stocks stay in it and you decide when to sell. Disadvantage: You have to
actively watch the ETF….when to buy or sell is up to you….you are responsible.
Advantage of Mutual Fund…a manager makes the buy/sell decisions for you. You just buy it
and rely on them. Disadvantage: You are relying on the managers expertise and will sink or
swim with their buy/sell decisions.
Commercial enterprises apply various forms of risk management procedures to handle
different risks because they face a variety of risks while carrying out their business
operations.

Effective handling of risk ensures the successful growth of an organization.

Various types of risk management can be categorized into the following:

Operational risk management:

Operational risk management deals with technical failures and human errors

Financial risk management:

Financial risk management handles non-payment of clients and increased rate of interest

Market risk management:

Deals with different types of market risk, such as interest rate risk, equity risk, commodity
risk, and currency risk

Credit risk management:

Deals with the risk related to the probability of nonpayment from the debtors

• Quantitative risk management: In quantitative risk management, an effort is carried

out to numerically ascertain the possibilities of the different adverse financial
circumstances to handle the degree of loss that might occur from those circumstances
• Commodity risk management: Handles different types of commodity risks, such as
price risk, political risk, quantity risk and cost risk

• Bank risk management: Deals with the handling of different types of risks faced by
the banks, for example, market risk, credit risk, liquidity risk, legal risk, operational
risk and reputational risk
• Nonprofit risk management: This is a process where risk management companies
offer risk management services on a non-profit seeking basis
• Currency risk management: Deals with changes in currency prices
• Enterprise risk management: Handles the risks faced by enterprises in
accomplishing their goals
• Project risk management: Deals with particular risks associated with the
undertaking of a project
• Integrated risk management: Integrated risk management refers to integrating risk
data into the strategic decision making of a company and taking decisions, which take
into account the set risk tolerance degrees of a department. In other words, it is the
supervision of market, credit, and liquidity risk at the same time or on a simultaneous
basis.
• Technology risk management: It is the process of managing the risks associated
with implementation of new technology
• Software risk management: Deals with different types of risks associated with
implementation of new softwares
Q. 2 Explain with the help of example how is it possible to reduce risk associated with
portfolio with the help of diversification. Which risk are still bound to persist?

There’s a real temptation to push your product out onto the market and wing it from there.
That approach succeeds just often enough to keep us doing it. But the successes are all that
we see, most failures are quick, quiet, and invisible. If we saw them as clearly as we see the
successes, we’d be a lot more thoughtful and prepared in releasing a new product.
Sun Tzu, in his fourth chapter, talks about how the general must control the situation before
conflict starts. Unless the general understands both his own strategy and that of his enemy,
his approach to battle is in doubt before it is even begun.
First, carefully build a strong position while looking for weakness in the competition.
There is no point in bringing a product to market unless it can stand on its own merits. It must
be compelling enough to convince customers to spend money on it. Having defined the
product’s attributes and strengths, you can then examine the competition to see if there are
weak areas that can be exploited.
A CEO is responsible for the company’s strength; competitors, for their own weaknesses. You
can make your company strong, but cannot make competitors weak.
You can control (or at least influence) research, product development, and marketing in your
own company. However, you have much less influence over the competition and cannot count
on them being worse than they actually are.
Indeed, there is a strong and dangerous temptation within a firm to underestimate the
competition, to assume that they’ll make the wrong moves or that they don’t understand all
that you do. This usually results in a series of unpleasant surprises as the competition does
exactly the right things necessary to counter or undermine your efforts.
You may even see how to succeed without being able to do so.
Put simply, a brilliant and/or superior product can fail if the competition is just too strong. It
can also fail if the customers don’t need or want it: look at what happened to the slide-rule
market after the introduction of calculators, or the vinyl record industry after the introduction
of compact discs.
A defensive posture is for protecting market share and during times of weakness; an aggressive
approach is for direct competition during times of strength.
You maintain market share by convincing your customers that your product is superior (or at
least good enough) and that the costs and risks of adopting a competing product are too high.
You enter a defensive, entrenching posture when pressed by a competitor with a superior
product, superior marketing or both, or when your company is having significant problems.
The danger: if you are perceived as being in a defensive posture, the market will interpret it as
a sign of weakness and instability, and it may further erode your position.
You gain market share by attacking competing products and convincing the customer that the
costs and risks of choosing (or staying with) a competing product are too high, or that the
costs and risks of adopting or trying your product are low.
When you have the upper hand in terms of product and marketing, you can choose your
course and compel the competition to react accordingly. In the game of Go, this is known
as sente: your opponent must respond to each move you make, leaving you free to choose
each new move.
Entrench the product so as to resist all attacks; view the market from a high level, rapidly
moving into new market opportunities as you see them. By doing this, you can protect
the company while gaining market share.
There are two parts to this approach. First, you need to focus on defending your market share
against all comers. Look for ways to so entrench your product and technology with customers
that they will resist all competing solutions. The classic examples of this approach are IBM
(mainframes in the 1960s), Microsoft (operating systems and applications in the 1990s), and
Apple (digital music in the 2000s).
Second, you need to be looking for additional opportunities. New market segments and niches
open up on a regular basis, and it’s often a while before anyone notices. Keep thinking of new
ways to apply existing technology, or new technologies that can be developed to coincide
with the opening of a future market. IBM pretty much failed at this and Microsoft now
appears to be failing as well; time will tell whether Apple can avoid their mistakes.
Many successful companies have done so with such apparent ease that their achievements are
downplayed. The CEOs of such firms are seldom credited with skill, brilliance, or
courage. Still, their successes are not by accident or luck. they set things up to succeed
before they ever competed, and they found ways ahead of time to make their competitors
fail.
We forget how many pundits and industry analysts considered the iPod dead on arrival after
its announcement by Apple in October 2001. Yet by the end of Q1 2007, Apple had sold over
100 million iPods and over 2.5 billion songs via its iTunes store, driving Apple stock to an
all-time high.
Likewise, many previous successes of the computer industry — the Apple II, VisiCalc, MS-
DOS, Lotus 1-2-3, Turbo Pascal, dBase, WordPerfect, Windows, MS Office — are dismissed
as being due to luck or just filling the right need at the right time. Yet those who succeeded
had what it took to be in that right place at that right time with the right product. Witness the
number of people and firms who had similar opportunities and did not succeed.
A successful company first sets up the conditions for success, then goes into the marketplace;
and unsuccessful company dives into the marketplace, then tries to determine what it
must do to succeed.
Often a tremendous amount of time and money is poured into a product development, and it is
only after the product has been launched that you try to find customers. At that point, you
discover what it is that customers really wanted, which often is something quite different
from what you developed. Product launch is then followed by product revisions and
repositioning in an effort to gain acceptance and sales, and that is often followed by
downsizing, assimilation, and evaporation. The entire history of the original “pen
computing”ﾝ market, with tens of millions of dollars poured into Momento, Go, EO, and
others, bears eloquent witness of the dangers of building a product with no customers.
A much better approach is to ensure that customers will want what you have to sell before
your product is ever released. That is not as easy as it sounds, because what customers say
they want is often quite different from what they are willing to adopt and buy. Furthermore, if
you’re selling a large organization, you often have to satisfy different people with different
desires and expectations. User wants something more convenient and powerful, but not that
different from what they’re currently using. Managers want something that will improve that
bottom line. Information systems (IS) people don’t want anything new or different unless its
completely compatible with existing solutions.
Those skilled in product development and marketing cultivate Tao and build their company
upon strong principles. That way, they succeed where companies looking for shortcuts
fail.
In the technology industries, the half-life of the products, concepts, and technologies is short,
as noted elsewhere, the distance from the leading edge to the trailing edge is getting smaller.
Because of that, it is important build a team that can adapt and compete as it to build
products. It is still critical to build products; “think tank” companies seldom make a decent
return on investment. But the customers themselves are a moving target, so it is likewise
critical that you build a teams that can do course corrections in the middle of product
development without bickering, starting turf wars, or losing significant time.
There are five keys to successful product development and marketing:
Measurement of market size, both current and potential;
The trick here is not deceive yourself or to be deceived by overly optimistic predictions of the
market size. May CEOs look at vast markets out there (installed PCs, houses wired for cable,
etc.) and play the 5% game: “If we capture just 5% of the market, we’ll be successful!”
Market share isn’t based solely on the number of possible customers for your product: that’s
merely the upper limit. The lower limit can be pretty small indeed — close to zero in many
cases. Market projections must be based on bottom-up projections, not on some hypothetical
percentage of the total market.
Assessment of competing products and likely market share;
Several questions help you to further lower the upper bound on potential market share. First,
how many people have a need or desire for the solution you offer? Second, what percentage
of those do not yet have an acceptable solution (such as a competing product)? Third, what
percentage of those have the money to purchase your product? Fourth, what percentage of
those would rather spend that money on your product than on any of the other myriad things
they could buy with it, especially competing products?
Calculations of cash flow, capital and return on investment;
You can have significant success in the marketplace and still lose money: it just depends on
whether you spend more or less money than you bring in. (Car makers demonstrate this all the
time, as do various divisions of IBM.) You can make a profit and still not have enough capital
to do further development and marketing. You can make a profit, grow the company, and still
never create an acceptable return on the initial and subsequent investments.
Comparisons of different market approaches;
There are various ways of marketing a given product. Success lies in knowing or discovering
what they might be, in evaluating feasibility and potential results, and in choosing one or
more approaches that will work.
Success in product releases.
The issue affecting the bottom line is product acceptance upon release. Many companies with
promising technology have stumbled or even failed because of slow market penetration.
Also, you only get one chance to make a first impression. The reputation that a product gets
on initial release, deserved or not, can linger for years. Witness Apple’s stumble with the
Newton hand-held computer, or Microsoft’s current woes with Windows Vista.
Success comes from accurate comparisons, which come from accurate calculations, which
come from accurate assessments, which come from accurate data, which comes from
accurate market research.
The same data, more or less, is out there for everyone. Success comes from gathering accurate
information, interpreting it, making plans based on it, and choosing from among those plans.
There is a dangerous temptation to make self-serving assumptions in this process; reality will
always intrude, sooner or later, and it’s usually unpleasant when it happens.
Thus, a successful company compares to an unsuccessful one like a boulder colliding with
tumbleweed. When factors are lined up correctly beforehand, the successful company
bursts into the marketplace like a flash flood.
A successful company can push through problems and obstacles, using its momentum and
resources to carry it past the rough spots. An unsuccessful company gets hung up, blocked, or
diverted easily.
Evaluation, coordination, cooperation, and timing are all essential. To make all factors mesh
is difficult and rare, or else everyone would do it. Again, it is the responsibility of the CEO to
that that it happens, but it is the responsibility of everyone else in the company to see that it
works.

Q.3 With the help of examples explain what is systematic (also called systemic) and
unsystematic risk? All said and done CAPM is not perfect , do you agree?

In finance, systematic risk, sometimes called market risk, aggregate risk,

or undiversifiable risk, is the risk associated with aggregate market returns.
By contrast, unsystematic risk, sometimes called specific risk, idiosyncratic risk, residual
risk, or diversifiable risk, is the company-specific or industry-specific risk in a portfolio,
which is uncorrelated with aggregate market returns.

Unsystematic risk can be mitigated through diversification, and systematic risk can not be.[1]

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

For example, consider an individual investor who purchases $10,000 of stock in 10

biotechnology companies. If unforeseen events cause a catastrophic setback and one or two
companies' stock prices drop, the investor incurs a loss. On the other hand, an investor who
purchases $100,000 in a single biotechnology company would incur ten times the loss from
such an event. The second investor's portfolio has more unsystematic risk than the diversified
portfolio. Finally, if the setback were to affect the entire industry instead, the investors would
incur similar losses, due to systematic risk.

Systematic risk is essentially dependent on macroeconomic factors such as inflation, interest

rates and so on. It may also derive from the structure and dynamics of the market.
[edit]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
thecovariance of the returns on the asset and the aggregate returns to the market.

Lenders to small numbers of borrowers (or kinds of borrowers) face unsystematic risk of
default. Their loss due to default is credit risk, the unsystematic portion of which
is concentration risk.

What Does Systematic Risk Mean?

The risk inherent to the entire market or entire market segment.

Also known as "un-diversifiable risk" or "market risk."

Investopedia explains Systematic Risk

Interest rates, recession and wars all represent sources of systematic risk because they affect
the entire market and cannot be avoided through diversification. Whereas this type of risk
affects a broad range of securities, unsystematic risk affects a very specific group of securities
or an individual security. Systematic risk can be mitigated only by being hedged.
Q. 4 What do you understand by arbitrage? Make a critical comparison between APT
& CAPM.

In economics and finance, arbitrage (IPA: /ˈɑrbɨtrɑːʒ/) 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 flowat
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 orconvergence trades), as in merger arbitrage.

People who engage in arbitrage are called arbitrageurs (IPA: /ˌɑrbɨtrɑːˈʒɜr/)—such as a

bank or brokerage firm. The term is mainly applied to trading in financial instruments, such
asbonds, 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'.[note 1]

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.

[edit]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..

The CAPM is a theory about the way how assets are priced in relation to their risk. The
CAPM was brought about to answer the question which came from Markowitz’s
mean-variance portfolio model. The question was how to identify tangency portfolio. Since
then, the CAPM has developed into much, much more. CAPM shows that equilibrium rates
of return on all risky assets are a function of their covariance with market portfolio. APT is
another equilibrium pricing model. The return on any risky asset is seen to be a linear
combination of various common factors that affect asset returns. These two models in fact are
similar to each other in some way.
CAPM Assumptions:
• Investors are risk averse individuals and they maximise their expected utility of their end
of period wealth. They have the same one period of time horizon.
• Investors are price takers (no single investor can affect the price of a stock) and have
homogenous expectation about asset returns that have a joint normal distribution.
• Investors can borrow or lend money at the risk-free rate of return.
• The quantities of assets are fixed. All assets are marketable and perfectly divisible.
• Asset markets are frictionless and information is costless and simultaneously available to
all investors.
• There are no market imperfections such as taxes, no transaction costs or no restrictions on
short selling.
As we can see, many of these assumptions behind the CAPM are not realistic. Although these
assumptions do not hold in the real world, they are used to make the model simpler for us to
use for financial decision making. Most of these assumptions can be relaxed.

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

EI=EF +(EM – EF)βi βi= Covim / Vm = σim / σ2m

β is quantity of risk; it is the covariance between returns on the risky asset, I, and the market
portfolio,M, divided by the variance of the market portfolio.
If we show how to derive the CAPM equation in a simple way:
M:Market portfolio, EF:Riske free rate, I:Risky asset
The straight line connecting the risk-free asset and market portfolio is the capital market line.
In equilibrium the market portfolio will consist of all marketable assets
held in proportion to their value weights.

The equilibrium proportion of each asset in the market portfolio must be;
wi=Market value of individual asset / Market value of all assets
A portfolio consisting of a % invested in risky asset I and (1-a) invested in the market
portfolio will have the following mean and standard deviation;
EP= aEI +(1-a)EM , SP={a2VI+(1-a)2VM+2a(1-a)CovIM}1/2
VI: The variance of the risky asset I and
CovIM: The covariance between asset I and the market portfolio.
The opportunity set provided by various combinations of the risky asset and the market
portfolio is the line IMI’ in figure 1.To determine the equilibrium price for risk at point M in
figure 1:

Evaluating dEP/da at where a=0 gives us =EI-EM

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

At equilibrium the slope of the opportunity set

at point M,is equal to capital market line;(EM-EF)/SM .

At equilibrium (EM-EF)/SM = (EI-EM)

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

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

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

There has been many empirical testing of the CAPM model(There are some problems
inherent in the test of CAPM).To test the CAPM we must transform it from exante form to
the expost form that uses observed data.
When CAPM is tested, it is generally written in this form:RI=δ0+ δ1βI+εI
RI=RF+(RM-RF) βI+εI
(RI-RF)=(RM-RF) βI+εI , δ1 =RM-RF
RI=the excess return; (RI-RF)

Conclusions from empirical tests;

Estimated δ0 is not equal zero, estimated δ1 <RM-RF (low β securities earn more than the
CAPM would predict).
Tests shows that beta risk dominates the risk.The simpler linear model which is RI=δ0+
δ1βI+εI fits the data best.It is linear also in β.
They also found out that factors other than β are successful in explaining that part of security
returns not captured by β. They also found out that price/earning ratios, size of the firm,
management of the firm and other factors have effect in explaining returns.These showed
there are other factors other than β explaining returns.
We should mention Roll’s critique quickly; Roll pointed out that There is problem
With testing efficient portfolio(Remember the Joint hypothesis).Roll said that there is nothing
unique about the market portfolio.You can choose any efficient portfolio or an index(if
performance is measured relative to an index),then find the minimum variance portfolio that
is uncorrelated with the selected efficient index.If index turns out to be ex-post efficient,then
every asset will exactly fall on the security market line.There will be no abnormal returns.If
there are systematic abnormal returns, it simply means that the index that has been chosen is
not ex-post efficient. Roll argues that tests performed with any portfolio other than the true
market portfolio are not tests of the CAPM. They are simply tests of whether the portfolio
chosen as a proxy for the market is efficient or not. Since over an interval of time efficient
portfolios exist, a market proxy may be chosen that satisfies all the implications of the CAPM
model, even when the market portfolio is inefficient. On the other hand, an inefficient
portfolio may be chosen as proxy for the market and the CAPM rejected when the market
itself is efficient. What Roll says, that we do not know the true market portfolio. Most tests
use some portfolio of common stocks as the market, but the true market contains all risky
assets (marketable and non marketable, human capital, coins, buildings, land etc).

APT offers a testable alternative to the CAPM. The CAPM predicts that security rates of
return will be linearly related to a single common factor; the rate of return on the market
portfolio. APT has similar assumptions as CAPM has, like perfectly competitive markets,
frictionless capital markets, and assumption of homogenous expectations. APT replaces
CAPM’s assumption which is based on mean variance framework by assumption of the
process generating security returns.
Returns on any stock linearly related to asset of indices as shown below:
Ri =αi+bi1I1+bi2I2+……+binIm+εi , αi=E(Ri)
Im=the value of the index that affect the return to asset i;macro economic factors,size of
firm,inflation,etc).
bin=the sensivity of the ith asset to the nth factor.
εi=a random error term with mean equal to zero and variance equal to σ2ei
In APT, We assume that covariances that exist between security returns can be attributed to
the fact that the securities respond to one degree or another pull of one or more factors. We
assume that the relationship between the security returns and the factors in linear. According
to APT, in equilibrium all portfolios that can be selected from among the set of assets under
consideration and that satisfy the conditions of (a)using no wealth and (b)having no risk must
earn no return on average. These portfolios are called arbitrage portfolios.

Let’s see a simple proof;

wi = change in wealth in invested in asset i, as a percentage of an individual’s total
wealth,Σwi=0
Rp= ΣwiRi= Σwi(αi+bi1I1+bi2I2+……+binIm+εi)
To eliminate risk( diversiable and undiversiable) and get a riskless arbitrage portfolio;
(1)choose small wi; percentage changes in investment ratios(2) diversify in a large number of
asset in portfolio.
Σwi bik=0, k=1,2….n. wi must be small, i must be large.
wi≈1/n (n chosen to be a large number), Σwi bik=0 (this elimanetes all systematic risk).
Consequently, the return on our arbitrage portfolio becomes a constant. Correct choice of the
weights has eliminated all uncertainity, so that RP is not a random variable. RP becomes; Rp=
Σwi αi
If the individual arbitrageur is in equilibrium, then return on any arbitrage portfolio must be
zero.
Rp= Σwi αi =0
Σwi=0 , Σwi bik=0 , Rp= Σwi αi =0= ΣwiE(Ri)
These equations are statements in linear algebra.
w e=0, w b=0 , w α=0 ,underlined w,b, α are vectors.e is the constant vector.
α must be linear combination of e and b, α must be orthonogol to e and b as well.
α or E(Ri) must be linear combination of the constant vector and the coefficient vector.There
must exist a set of k+1 coefficients, λ0, λ1,….. λk.
αi =E(Ri)= λ0 +λ1bi1+……+ λkbik , ( remember bik are the factor loadings;sensivities of the
returns on the ith security to the kth factor).
If there is a riskless asset with a riskless rates of returns;RF then, bik=0 and RF= λ0
Rewrite the E(Ri) in excess returns form;
E(Ri)- RF= λ1bi1+……+ λkbik, this is the APT equation. E(Ri)- RF is excess return on risk free
asset.
λ k = risk premium;price of risk in equilibrium for the kth factor.
λ k=δk-Rf , δk; is expected returns on a portfolio with the unit sensitivity to the kth factor and
zero sensitivity to all other factors. And so risk premium, λ k ,is equal to the difference
between the expectation of a portfolio that has unit response to the kth factor and zero
response to the other factors and Rf.
We can now rewrite APT equation in the following form;
E(Ri)- RF=[ δ1-Rf ] bi1+[δ2-Rf] bi2+……..+[ δk-Rf] bik
If this equation is interpreted as a linear equation, then the coefficients bik ,are defined in the
same way as beta in the CAPM model; bik=Cov(Ri, δk)/Var(δk).
Beta here will give relation of i to various factors.
The APT seems to be stronger than the CAPM;
• APT makes no assumptions about the distribution of asset returns. CAPM assumes that
the probability distributions for portfolio returns are normally distributed.
• The APT does not make any strong assumptions about utility function(only risk
averse).According to the CAPM investors are all risk averse individuals who maximise
their expected utility of their end of period wealth.
• The APT allows the equilibrium returns of assets to be dependent on many factors not
just one.
• The APT produces a statement about the relative pricing of any subset of assets; we do
not need to measure the entire universe of assets in order to test the theory.
• There is no special role for the market portfolio in the APT, whereas the CAPM requires
that the market portfolio be efficient.

Before we go into detailed discussion of the two models, we should quickly mention some
empirical tests about APT itself and its comparison with CAPM.
Factor analysis is used in first empirical tests of APT. One problem with any approach to
testing the APT is that the theory itself is completely silent with respect to the identity of the
factor structure that is priced.
Chen,Roll,Ross(1983) found that a collection of four macroeconomic variables that explained
security returns fairly well. But Dhrymes, Friend, Gultekin (1984) point out that the more
stocks you look at, the more factors you need to take into account.
Chen(1983) compared CAPM and APT. First APT model was fitted to the data as in the
following equation; Ri = λ^0 +λ^1bi1+……+ λ^kbik+εi (APT)
The CAPM was fitted to the same data;Ri= λ^0 + λ^1βi+ηi (CAPM)
Next the CAPM residuals ηi were regressed on the arbitrage factor loadings, λ^k,and APT
residuals, εi were regressed on the CAPM coefficients.The results showed that the APT could
explain a statistically significant portion of the CAPM residual variance,but the CAPM could
not explain the APT residuals.This shows that the APT
is more reasonable model for explaining the cross sectional variation in asset returns.
Fama,French(1992) found that Beta did a relatively poor job at explaining differences in the
actual returns of portfolios of US stocks. Instead Fama and French noted that there were other
variables beside beta with respect to market that explained returns. These findings were
interpreted as strong indications that CAPM does not work.
Haugen(1999) tests with predictive power of APT with different factors. According to his
findings APT appear to have predictive power. However, its power falls short of adhoc
expected return factor models.

We so far tried to give some theoretical understanding of these two models.

Let’s go further to examine the two models;
APT has a number of benefits; it is not as restrictive as the CAPM in its requirements about
individual portfolio. It allows multiple sources of risk, indeed these provide an explanation of
what moves stock returns. The APT demands that investors perceive the risk sources and that
they can reasonably estimate factor sensitivities. In fact even professionals and academics can
not agree on the identity of the risk factors, and the more betas you have to estimate the more
noise you must live with.
The CAPM is theoretically pleasing, however its biggest criticism is that it is not testable. The
APT came out as a testable alternative, but its testability is an open question as well. Some
would argue that models should not be judged on the basis of the accuracy of their
assumptions, but rather on the basis of their predictive power. The CAPM makes a single
prediction, the efficiency of the market portfolio, which has been argued to be untestable. The
power of the APT in predicting future stock returns falls short of adhoc expected return factor
models. The problem may well be that the arbitrage process presumed in the APT is difficult;
If not impossible to implement on a practical basis.The APT calls for arbitraging away
nonlinearity in the relationship between expected returns and the factor betas. We arbitrage by
creating riskless stock portfolios with differential expected returns. However, you will find
that it is impossible to create riskless portfolios comprised exclusively of risky securities such
as common stocks.
In one important respect, both models exhibit a similar vulnerability. In the case of both
models, we are looking for a benchmark for purposes of comparing the expost performance of
portfolio managers,and the exante returns on real and financial investments. In the case of the
CAPM, we can never determine the extent to which deviations from the security market line
benchmark are due to something real or are due to obvious inadequacies in our proxies for the
market portfolio. In the case of the APT,since theory gives us no direction as to the choice of
factors, we can not determine whether deviations from an APT benchmark are due to
something real or merely due to inadequacies in our choice of factors.As we know that the
APT really makes no predictions about what the factors are. Given the freedom to select
factors without restriction, it can be argued that you can literally make the performance of a
portfolio anything you want it to be. In the case of the CAPM, you can never know whether
portfolio performance is due to management skill or to the fact that you have an inaccurate
index of the true market portfolio. Another problem with CAPM that hedging motive does not
enter in it, and therefore people hold the same portfolio of risky assets. In reality people might
have different tastes and, it may make sense for them to hold different portfolios.The CAPM
says that investors will price securities according to the contribution each makes to the risk of
their overall portfolios. This is intuitively appealing. CAPM is an accepted model in the
securities industry. It is used by firms to make capital budgeting and other decisions. It is used
by some regulatory authorities to regulate utility rates(e.g. electric utilities). It is used by
rating agencies to measure the performance of investment managers. The APT can also be
applied to cost of capital and capital budgeting problems, but APT seems to be practically
difficult for capital budgeting. There is a practical problem of the estimating the state-
contingent prices of the comparison stock and the risk free asset.

If we summarize what we said so far;

APT and CAPM generally address the same basic issues:
• how should we measure the risk of a risky asset?
• how should we compute required return?
CAPM takes an oversimplified view of economy-wide news; consider a stock , according to
the CAPM ,every time economy-wide news makes the market go up by 1%,we expect this
stock to go up by 1% times beta of this stock. What type of economy-wide news made the
market go up does not matter. The stock reacts the same way to all types of economy-wide
news.
But According to the APT ,what type of economy-wide news it is should matter.For example;
BP would be more sensitive to an oil factor than Coca-Cola.
CAPM assumes that a given stock is equally sensitive to different type of economy-wide
news.APT assumes that a given stock has a different sensitivity to different types of
economy-wide news.In the CAPM all economy-wide news is lumped together into one single
equation, and stock’s beta is the sensitivity to all types of economy-wide news. The APT
assumes that random returns are given by the kth factor model instead of the market model.
The single term representing economy-wide news in CAPM has been broken in to k separate
terms. So there are k different types of economy wide-news. bi1 is the stock i’s sensitivity to
type 1 news, bi2 is stock i’s sensitivity to type 2 news. Each of these Betas are different.
CAPM lumps all systematic risk together into one term; so there is a single risk premium.
APT says there are k types of systematic risk, so there are k risk premiums, one for each type
of systematic risk.λi1bi1 is the risk premium for type 1 risk.λi2bi2 is the risk premium for type 2
risk. Just like CAPM, bi1 is the amount of type1 risk this stock has, and λ1 is the market price
for type 1 risk. The risk of a stock is measured jointly by its k betas, and then the required
return is determined by the equation.

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

After seeing both models, we can say that if we choose one against the other, then in each one
unfortunately you win some and you lose some. Neither can the two models outperform each
other completely. Rather than trying to persuade each other, one is better than the other. We
should thoroughly understand their weakness as well as their strengths, so that we will know
when and how, which model we can rely on in making financial decision.

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

You may have already heard of the advice to go into diverse investment trading. This can be a
good choice for you to make but you should be aware that there are serious implications to
diversification. If you apply the concept, you might truly earn fantastic profits. It is possible
however to also end up at the other end of the spectrum. Before you follow this piece of
advice, you have to make sure it is the best decision for you to make.

Diversification is actually a very simple concept that can significantly increase your profits. It
simply means that as an investor, you should choose to put your money in not just one kind of
market but in many. If for example, you already have a strong stock portfolio, you should take
your capital and spread it across other assets such as real estate, commodities and assets.

It's fairly clear what investors intend to achieve when they diversify. They want to earn more
and they can reasonably expect to do so because they have their capital on a lot of different
assets. The truth though is that there is a deeper and more convincing reason to opt to
diversify. When you decide to invest in many assets, you choose to take a safe stand against
profit stagnation and absolute loss. Having a diverse portfolio means you don't have to
entirely go under in case one market crashes or experiences a lull. Your other investments can
help prevent your boat from sinking. A market like the foreign exchange can keep you secure
because it works independently of the stock market and remains unaffected by stock market
problems.

Investment trading that is diverse clearly has its advantages. Take not though that it may not
always work well for all traders. In theory, it does seem extremely sensible to maintain
several investment options. Many new traders and investors however still end up on the
losing end. One reason for this is because they do not have the right level of mastery that can
push them on top of every market. Common sense dictates that to make it big in a single
market, one must invest considerable learning time in it. That means, you will hardly have
enough time and energy to pour into studying other investment types. When you don't know
what you are doing, you are likely to lose a lot.

Initial specialization makes sense in the business of trading. This is a good way to protect you
from losing a lot when you are still at the stage of learning what to do in a specific market.
Find out what market you prefer to trade in initially by researching on the available options. It
is often a good idea though to begin with the stock market first. Stocks are not leveraged and
therefore do not present the possibility of overwhelming losses which you can expect from
leverage assets such as currencies.
You shouldn't completely balk from the challenge of diversification. Diverse investment
trading is still genuinely profitable. What you have to make sure of is that you take slow and
careful steps. Conquer one income stream first before jumping into another.
Don't put all of your eggs in one basket!" You've probably heard that over and over again
throughout your life and when it comes to investing, it is very true. Diversification is the key
to successful investing. All successful investors build portfolios that are widely diversified,
and you should too.
Diversifying your investments might include purchasing various stocks in many different
industries. It may include purchasing bonds, investing in foreign exchange market,investing
in money market accounts, or even in some real property. The key is to invest in several
different areas – not just one.
Over time, research has shown that investors who havediversified 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.

he 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.

Arbitrage pricing theory (APT), in finance, is a general theory of asset pricing, that has
become influential in the pricing of stocks.

APT holds that the expected return of a financial asset can be modeled as a linear function of
various macro-economic factors or theoretical market indices, where sensitivity to changes in
each factor is represented by a factor-specific beta coefficient. The model-derived rate of
return will then be used to price the asset correctly - the asset price should equal the expected
end of period price discounted at the rate implied by model. If the price
diverges, arbitrage should bring it back into line.

The theory was initiated by the economist Stephen Ross in 1976.

he APT model

Risky asset returns are said to follow a factor structure if they can be expressed as:

where

 E(rj) is the jth asset's expected return,

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

Idiosyncratic shocks are assumed to be uncorrelated across assets and uncorrelated

with the factors.

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

where

 RPk is the risk premium of the factor,

 rf is the risk-free rate,

That is, the expected return of an asset j is a linear function of the assets
sensitivities to the n factors.

Note that there are some assumptions and requirements that have to be
fulfilled for the latter to be correct: There must be perfect competition in
the market, and the total number of factors may never surpass the total
number of assets (in order to avoid the problem of matrix singularity),
[edit]Arbitrage and the APT

Arbitrage is the practice of taking advantage of a state of imbalance

between two (or possibly more) markets and thereby making a risk-free
profit; see Rational pricing.
[edit]Arbitrage in expectations

The CAPM and its extensions are based on specific assumptions on

investors’ asset demand. For example: • Investors care only about mean
return and variance. • Investors hold only traded assets.
 [edit]Arbitrage mechanics

In the APT context, arbitrage consists of trading in two assets – with at

least one being mispriced. The arbitrageur sells the asset which is
relatively too expensive and uses the proceeds to buy one which is
relatively too cheap.

Under the APT, an asset is mispriced if its current price diverges from
the price predicted by the model. The asset price today should equal the
sum of all future cash flows discounted at the APT rate, where the
expected return of the asset is a linear function of various factors, and
sensitivity to changes in each factor is represented by a factor-
specific beta coefficient.

A correctly priced asset here may be in fact a synthetic asset -

a portfolio consisting of other correctly priced assets. This portfolio has
the same exposure to each of the macroeconomic factors as the
mispriced asset. The arbitrageur creates the portfolio by identifying x
correctly priced assets (one per factor plus one) and then weighting the
assets such that portfolio beta per factor is the same as for the mispriced
asset.

When the investor is long the asset and short the portfolio (or vice
versa) he has created a position which has a positive expected return
(the difference between asset return and portfolio return) and which has
a net-zero exposure to any macroeconomic factor and is therefore risk
free (other than for firm specific risk). The arbitrageur is thus in a
position to make a risk-free profit:

Where today's price is too low:

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

Today:

1 short sell the portfolio

2 buy the mispriced asset with the proceeds.
At the end of the period:

1 sell the mispriced asset

2 use the proceeds to buy back the portfolio
3 pocket the difference.
 Where today's price is too high:

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

Today:

1 short sell the mispriced asset

2 buy the portfolio with the proceeds.
At the end of the period:

1 sell the portfolio

2 use the proceeds to buy back the mispriced asset
3 pocket the difference.
[edit]Relationship with the capital asset pricing
model[CAPM]

The APT along with the capital asset pricing model (CAPM)
is one of two influential theories on asset pricing. The APT
differs from the CAPM in that it is less restrictive in its
assumptions. It allows for an explanatory (as opposed to
statistical) model of asset returns. It assumes that each
investor will hold a unique portfolio with its own particular
array of betas, as opposed to the identical "market portfolio".
In some ways, the CAPM can be considered a "special case"
of the APT in that the securities market line represents a
single-factor model of the asset price, where beta is exposed
to changes in value of the market.

Additionally, the APT can be seen as a "supply-side" model,

since its beta coefficients reflect the sensitivity of the
underlying asset to economic factors. Thus, factor shocks
would cause structural changes in assets' expected returns, or
in the case of stocks, in firms' profitabilities.

On the other side, the capital asset pricing model is

considered a "demand side" model. Its results, although
similar to those of the APT, arise from a maximization
problem of each investor's utility function, and from the
resulting market equilibrium (investors are considered to be
the "consumers" of the assets).
[edit]Using the APT

[edit]Identifying the factors

As with the CAPM, the factor-specific Betas are found via

a linear regression of historical security returns on the factor
in question. Unlike the CAPM, the APT, however, does not
itself reveal the identity of its priced factors - the number and
nature of these factors is likely to change over time and
between economies. As a result, this issue is
essentially empirical in nature. Several a priori guidelines as
to the characteristics required of potential factors are,
however, suggested:

1. their impact on asset prices manifests in

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

Chen, Roll and Ross (1986) identified the following macro-

economic factors as significant in explaining security returns:

 surprises in inflation;
 surprises in GNP as indicated by an industrial
production index;
 surprises in investor confidence due to changes in
default premium in corporate bonds;
 surprise shifts in the yield curve.

As a practical matter, indices or spot or futures market prices

may be used in place of macro-economic factors, which are
reported at low frequency (e.g. monthly) and often with
significant estimation errors. Market indices are sometimes
derived by means of factor analysis. More direct "indices"
that might be used are:

 short term interest rates;

 the difference in long-term and short-term interest
rates;
 a diversified stock index such as the S&P
500 or NYSE Composite Index;
 oil prices
 gold or other precious metal prices
 Currency exchange rates

[edit]APT and asset management

The linear factor model structure of the APT is used as the

basis for many of the commercial risk systems employed by
asset managers. These include MSCI
Barra, APT, Northfieldand Axioma