Q1. Frame the investment process for a person of your age group.

Ans:As investors, we would all like to beat the market handily, and we would all like to pick "great" investments on instinct. However, while intuition is u n d o u b t e d l y a p a r t o f the process of investing, it is just part of the process. As investors, it is not surprising that we focus so much of our energy and efforts on investment philosophies and s t r a t e g i e s , a n d s o l i t t l e o n t h e investment process. It is far more interesting to read about how Peter Lynch picks stocks and what makes Warren Buffett a valuable investor, than it is to talk about the steps involved in creating a portfolio or in executing trades. Though it does not get sufficient a t t e n t i o n , u n d e r s t a n d i n g t h e investment process is critical for every investor for several reasons: 1. The investment process outlines the steps in creating a portfolio, and emphasizes the sequence of actions involved from understanding the investors risk preferences to asset allocation and selection to performance evaluation. By emphasizing the sequence, it provides for an orderly way in which an investor can create his or her own portfolio or a portfolio for someone else. 2. The investment process provides a structure that allows investors to see the source of different investment strategies and philosophies. By so doing, it allows investors to take the hundreds of strategies that they see described in the common press and

in investment newsletters and to trace them to their common roots. 3. The investment process emphasizes the different components that are needed for an investment strategy to by successful, and by so doing explain why so many strategies that look good on paper never work for those who use them. The best way of describing this book is by noting what it does not do. It does not emphasize individual investors or push an investment philosophy. It does not focus h e a v i l y on coming up with strategies that beat the market, t h o u g h t h e r e i s r e f e r e n c e t o some of them in the course of the book. Instead, it talks about the process of investing and how this process is the same no matter what investment philosophy one might have. The book is built around the investment process. The process always starts with the investor and understanding his or her needs and preferences. For a portfolio manager, the investor is a client and the first and often most s i g n i f i c a n t p a r t o f t h e i n v e s t m e n t process understands the clients needs the clients tax status and most importantly, his or her risk preferences. For an i n d i v i d u a l i n v e s t o r c o n s t r u c t i n g h i s o r her own portfolio, this may seem simpler, but understanding ones own needs and p r e f e r e n c e s i s j u s t a s i m p o r t a n t a first step as it is for the portfolio manager. The next part of the process is the actual c o n s t r u c t i o n o f t h e p o r t f o l i o , w h i c h w e d i v i d e into three sub-parts. The first of these is the decision on how to allocate the portfolio across different asset classes defined broadly as equities, fixed income securities and real assets (such as real estate, commodities and other assets). This asset

allocation decision can also be framed in terms of investments in domestic assets versus foreign assets, and the factors driving this decision. The second component is the assets election decision, where individual assets are picked within each asset class to makeu p t h e p o r t f o l i o . I n practical terms, this is the step where the stocks that m a k e u p t h e equity component, the bonds that make up the fixed income component and the real assets that make up the real asset component are picked. The final component is e x e c u t i o n , w h e r e t h e p o r t f o l i o is actually put together, where investors have to trade off transactions cost against transactions speed. While the importance of execution will vary across investment strategies, there are many investors who have failed at this stage in the process. The final part of the process, and often the most painful one for professional money managers, is the performance evaluation. Investing is after all focused on one objective and one objective alone, which is to make the most money you can, given the risk c o n s t r a i n t s y o u operate under. Investors are not forgiving of failure a n d u n w i l l i n g t o accept even the best of excuses, and loyalty to money managers is not a commonly f o u n d t r a i t . B y t h e same token, performance evaluation is just as i m p o r t a n t t o t h e individual investor who constructs his or her own portfolio, since the feedback from it s h o u l d largely determine how that investor approaches investing in the future. These parts of the process are summarized in Figure 1 , a n d w e w i l l r e t u r n t o t h i s figure to emphasize the steps in the process as we move through the book. The book is b u i l t a r o u n d t h e s a m e s t r u c t u r e . I t b e g i n s w i t h a c h a p t e r t h a t p r o v i d e s a n o v e r v i e w o f investment management as a business. The first major section is on understanding c l i e n t n e e d s a n d p r e f e r e n c e s , w h e r e w e l o o k a t n o t o n l y h o w t o t h i n k a b o u t r i s k i n investing but also at how to measure an investors willingness to take

risk. The second section looks at the asset allocation decision, while the third section examines different approaches to selecting assets. The fourth section takes a brief look at the execution decision, and the fifth section develops different approaches to evaluating performance

Q.2 From the website of BSE India, explain how the BSE Sensex is calculated. Ans:-- Introduction
SENSEX, first compiled in 1986, was calculated on a " M a r k e t C a p i t a l i z a t i o n - Weighted" methodology of 30 component stocks representing large, well -established and financially sound companies across key sectors. The base year of SENSEX was taken as 1978 -79. SENSEX today is widely reported in both domestic and international m a r k e t s through print as well as electronic media. It is s c i e n t i f i c a l l y d e s i g n e d a n d i s based on globally accepted construction and review methodology. Since September 1, 2003, SENSEX is being calculated on a free -float market capitalization methodology . The "free-float market capitalization -weighted" methodology is a widely followed index construction methodology on which majority of global equity indices are based; all major index providers like MSCI, FTSE, STOXX, S&P and Dow Jones use the free float methodology The growth of the equity market in India has been phenomenal in the present decade. Right from early nineties, the stock market witnessed heightened activity in terms of various bull and bear runs. In the late nineties, the Indian market witnessed a huge frenzy in the 'TMT' sectors. More recently, real estate c a u g h t t h e f a n c y o f t h e investors. SENSEX has captured all these happenings in the most judicious manner. O n e can identify the booms and busts of the Indian equity market through SENSEX.As the oldest index in the country, it provides the time series data over a fairly l o n g period of time (from 1979 onwards). Small wonder,

the SENSEX has become one of the m o s t p r o m i n e n t brands in the country.

SENSEX Calculation Methodology SENSEX is calculated using the "Free-float Market Capitalization" methodology, where in, the level of index at any point of time reflects the free-float market value of 30 component stocks relative to a base period. The market capitalization of a company is determined by multiplying the price of its stock by the number of shares issued by the company. This market capitalization is further multiplied by the freefloat factor to determine the free-float market capitalization.

The base period of SENSEX is 1978-79 and the base value is 100 index points. This is often indicated by the notation 1978-79=100. The calculation of SENSEX involves dividing the free-float market capitalization of 30 companies in the Index by a number called the Index Divisor. The Divisor is the only link to the original base period value of the SENSEX. It keeps the Index comparable over time and is the adjustment point for all Index adjustments arising out of corporate actions, replacement of scrips etc. During market hours, prices of the index scrips, at which latest trades are executed, are used by the trading system to calculate SENSEX on a continuous basis. Dollex-30 BSE also calculates a dollar-linked version of SENSEX and historical values of Dollex series of BSE indices') this index are available since its inception. SENSEX - Scrip Selection Criteria Equities of companies listed on Bombay Stock Exchange Ltd. (excluding companies classified in Z group, listed mutual funds, scrips suspended on the last day of the month prior to review date, scrips objected by the Surveillance department of the Exchange and those that are traded under permitted category) shall be considered eligible. Listing History: The scrip should have a listing history of at least three months at BSE. An exception may be granted to one month, if the average free-float market capitalization of a newly listed company ranks in the top 10 of all companies listed at BSE. In the event that a company is listed on account of a merger / demerger / amalgamation, a minimum listing history is not required. The scrip should have been traded on each and every trading day in the last three months at BSE. Exceptions can be made for extreme reasons like scrip suspension etc.

 Companies that have reported revenue in the latest four quarters from its core activity are considered eligible. From the list of constituents selected through Steps 1-4, the top 75 companies based on free-float market capitalisation (avg. 3 months) are selected as well as any additional companies that are in the top 75 based on full market capitalization (avg. 3 months). The filtered list of constituents selected through Step 5 (which can be greater than 75 companies) is then ranked on absolute turnover (avg. 3 months). Any company in the filtered, sorted list created in Step 6 that has Cumulative Turnover of >98%, are excluded, so long as the remaining list has more than 30 scrips. The filtered list calculated in Step 7 is then sorted by free float market capitalization. Any company having a weight within this filtered constituent list of <0.50% shall be excluded All remaining companies will be sorted on sector and sub-sorted in the descending order of rank on free-float market capitalization. Industry/Sector Representation: Scrip selection will generally attempt to maintain index sectoral weights that are broadly in-line with the overall market. Track Record: In the opinion of the BSE Index Committee, all companies included within the SENSEX should have an acceptable track record.

Understanding Free-float Methodology Concept Free-float methodology refers to an index construction methodology that takes into consideration only the free-float market capitalization of a company for the purpose of index calculation and assigning weight to stocks in the index. Free-float market capitalization takes into consideration only those shares issued by the company that are readily available for trading in the market. It generally excludes promoters' holding, government holding, strategic holding and other locked-in shares that will not come to the market for trading in the normal course. In other words, the market capitalization of each company in a free-float index is reduced to the extent of its readily available shares in the market. Subsequently all BSE indices with the exception of BSEPSU index have adopted the free-float methodology. Major advantages of Free-float Methodology A Free-float index reflects the market trends more rationally as it takes into consideration only those shares that are available for trading in the market. Free-float Methodology makes the index more broad-based by reducing the concentration of top few companies in Index. A Free-float index aids both active and passive investing styles. It aids active managers by enabling them to benchmark their fund returns vis- -vis an investible index. This enables an apple-toapple comparison thereby facilitating better evaluation of performance of active managers. Being a perfectly replicable portfolio of stocks, a Free-float adjusted index is best suited for the passive managers as it enables them to track the index with the least tracking error. Free-float Methodology improves index flexibility in terms of including any stock from the universe of listed stocks. This

improves market coverage and sector coverage of the index. For example, under a Full-market capitalization methodology, companies with large market capitalization and low free-float cannot generally be included in the Index because they tend to distort the index by having an undue influence on the index movement. However, under the Free-float Methodology, since only the free-float market capitalization of each company is considered for index calculation, it becomes possible to include such closely-held companies in the index while at the same time preventing their undue influence on the index movement. Globally, the Free-float Methodology of index construction is considered to be an industry best practice and all major index providers like MSCI, FTSE, S&P and STOXX have adopted the same. MSCI, a leading global index provider, shifted all its indices to the Free-float Methodology in 2002. The MSCI India Standard Index, which is followed by Foreign Institutional Investors (FIIs) to track Indian equities, is also based on the Freefloat Methodology. NASDAQ-100, the underlying index to the famous Exchange Traded Fund (ETF) - QQQ is based on the Free-float Methodology. Definition of Free-float Shareholding of investors that would not, in the normal course come into the open market for trading are treated as 'Controlling/ Strategic Holdings' and hence not included in free-float. Specifically, the following categories of holding are generally excluded from the definition of Free-float: Shares held by founders/directors/ acquirers which has control element Shares held by persons/ bodies with "Controlling Interest" Shares held by Government as promoter/acquirer Holdings through the FDI Route Strategic stakes by private corporate bodies/ individuals Equity held by associate/group companies (cross-holdings)

 Equity held by Employee Welfare Trusts Locked-in shares and shares which would not be sold in the open market in normal course. The remaining shareholders fall under the Free-float category. Determining Free-float Factors of Companies BSE has designed a Free-float format, which is filled and submitted by all index companies on a quarterly basis. (Format available on www.bseindia.com). BSE determines the Free-float factor for each company based on the detailed information submitted by the companies in the prescribed format. Free-float factor is a multiple with which the total market capitalization of a company is adjusted to arrive at the Free-float market capitalization. Once the Free-float of a company is determined, it is rounded-off to the higher multiple of 5 and each company is categorized into one of the 20 bands given below. A Free-float factor of say 0.55 means that only 55% of the market capitalization of the company will be considered for index calculation. Free-float Bands:

Index Closure Algorithm The closing SENSEX on any trading day is computed taking the weighted average of all the trades on SENSEX constituents in the last 30 minutes of trading session. If a SENSEX constituent has not traded in the last 30 minutes, the last traded price is taken for computation of the Index closure. If a SENSEX constituent has not traded at all in a day, then its last day's closing price is taken for computation of Index closure. The use of Index Closure Algorithm prevents any intentional manipulation of the closing index value. Maintenance of SENSEX One of the important aspects of maintaining continuity with the past is to update the base year average. The base year value adjustment ensures that replacement of stocks in Index, additional issue of capital and other corporate announcements like 'rights issue' etc. do not destroy the historical value of the index. The beauty of maintenance lies in the fact that adjustments for corporate actions in the Index should not per se affect the index values. The BSE Index Cell does the day-to-day maintenance of the index within the broad index policy framework set by the BSE Index Committee. The BSE Index Cell ensures that SENSEX and all the other BSE indices maintain their benchmark properties by striking a delicate balance between frequent replacements in index and maintaining its historical continuity. The BSE Index Committee comprises of capital market expert, fund managers, market participants and members of the BSE Governing Board. On-Line Computation of the Index During trading hours, value of the Index is calculated and disseminated on real time basis. This is done automatically on the basis of prices at which trades in Index constituents are executed. Adjustment for Bonus, Rights and Newly Issued Capital

SENSEX calculation needs to be adjusted for issue of Bonus or Rights shares If no adjustments were made, a discontinuity would arise between the current value of the index and its previous value despite the non-occurrence of any economic activity of substance. At the BSE Index Cell , the base value is adjusted, which is used to alter market capitalization of the component stocks to arrive at the SENSEX value. The BSE Index Cell keeps a close watch on the events that might affect the index on a regular basis and carries out daily maintenance of all BSE Indices. Adjustments for Rights Issues:- When a company, included in the compilation of the index, issues right shares, the free-float market capitalization of that company is increased by the number of additional shares issued based on the theoretical (ex-right) price. An offsetting or proportionate adjustment is then made to the Base Market capitalization (see 'Base Market capitalization Adjustment' below). Adjustments for Bonus Issue:- When a company, included in the compilation of the index, issues bonus shares, the market capitalization of that company does not undergo any change. Therefore, there is no change in the Base Market capitalization, only the 'number of shares' in the formula is updated. Other Issues:- Base Market capitalization adjustment is required when new shares are issued by way of conversion of debentures, mergers, spin-offs etc. or when equity is reduced by way of buyback of shares, corporate restructuring etc. Base Market capitalization Adjustment The formula for adjusting the Base Market capitalization is as follows: New Base Market capitalization = Old Base Market capitalization x New Market capitalization / Old Market capitalization

To illustrate, suppose a company issues right shares which increases the market capitalization of the shares of that company by say, Rs.100 crores. The existing Base Market capitalization (Old Base Market capitalization), say, is Rs.2450 crores and the aggregate market capitalization of all the shares included in the index before the right issue is made is, say Rs.4781 crore. The "New Base Market capitalization " will then be: 2450 x (4781+100) ------------------------------- = Rs.2501.24 crores 4781 This figure of Rs. 2501.24 crore will be used as the Base Market capitalization for calculating the index number from then onwards till the next base change becomes necessary. Index Review Frequency The BSE Index Committee meets every quarter to discuss index related issues. In case of a revision in the Index constituents, the announcement of the incoming and outgoing scrips is made six weeks in advance of the actual implementation of the revision of the Index.

Q.3 Perform an economy analysis on Indian economy in the current situation. Ans:-- Economy Analysis
In addition to the economy analysis, fundamental analysis helps investors determine whether the economic climate offers a positive and encouraging investing environment. Economic analysis is done for two reasons: first, a companys growth prospects are, ultimately, dependent on the economy in which it operates; second, share price performance is generally tied to economic fundamentals, as most companies generally perform well when the economy is doing the same. Factors to be considered in economy analysis The economic variables that are considered in economic analysis are: Gross domestic product (GDP) growth rate, Exchange rates, The balance of payments (BOP), The current account deficit, Government policy (fiscal and monetary policy), Domestic legislation (laws and regulations), Unemployment (the percent of the population that wants to work and is currently not working), Public attitude (consumer confidence) Inflation (a general increase in the price of goods and services), interest rates, productivity (output per worker), Capacity utilization (output by the firm) etc . GDP is the total income earned by a country. GDP growth rate shows how fast the economy is growing. Investors know that strong economic

growth is good for companies and recessions or full-blown depressions cause share prices to decline, all other things being equal. Inflation is important for investors, as excessive inflation undermines consumer spending power (prices increase) and so can cause economic stagnation. However, deflation (negative inflation) can also hurt the economy, as it encourages consumers to postpone spending (as they wait for cheaper prices). The exchange rate affects the broad economy and companies in a number of ways. First, changes in the exchange rate affect the exports and imports. If exchange rate strengthens, exports are hit; if the exchange rate weakens, imports are affected. The BOP affects the exchange rate through supply and demand for the foreign currency. BOP reflects a countrys international monetary transactions for a specific time period. It consists of the current account and the capital account. The current account is an account of the trade in goods and services. The capital account is an account of the cross-border transactions in financial assets. A current account deficit occurs when a country imports more goods and services than it exports. A capital account deficit occurs when the investments made in the country by foreigners is less than the investment in foreign countries made by local players. The currency of a country appreciates when there is more foreign currency coming into the country than leaving it. Therefore, a surplus in the current or capital account causes the currency to strengthen; a deficit causes the currency to weaken. The levels of interest rates (the cost of borrowing money) in the economy and the money supply (amount of money circulating in the economy) also have a bearing on the performance of businesses. All other things being equal, an increase in money supply causes the interest rates to fall; a decrease causes the interest rates to rise. If interest rates are low, the cost of borrowing by businesses is not expensive, and companies can easily borrow to expand and develop their activities.

On the other hand, when the cost of borrowing becomes too high (when the interest rates go up), borrowing may become too costly and plans for expansion are postponed. Interest rates also have a significant effect on the share markets. In very broad terms, share prices improve when interest rates fall and decline when interest rates increase. There are two reasons for that: the intrinsic value estimate will increase as interest rates (and the linked discount rate) fall and underlying company profitability will improve, if interest payments reduce. Inflation in India In financial year 2007-08, average inflation in India was around 4.66 percent. This rate was lower than average inflation of financial year 2006-07. In 2007-08, fiscal high prices of food items were primary cause behind high rates of inflation. That high rate of inflation had to be controlled by banning a number of necessary commodities as well as various financial steps. High prices of oil were responsible for proportionately high rate of inflation in 2008-09.

Q 4. Identify some technical indicators and explain how they can be used to decide purchase of a companys stock. Ans:-- Technical Indicators
A technical indicator is a series of data points that are derived by applying a formula to the price and/or volume data of a security. Price data can be any combination of the open, high, low or closing price over a period of time. Some indicators may use only the closing prices, while others incorporate volume and open interest into their formulae. The price data is entered into the formula and a data point is produced. For example, say the closing prices of a stock for 3 days are Rs. 41, Rs. 43 and Rs. 43. If a technical indicator is constructed using the average of the closing prices, then the average of the 3 closing prices is one data point ((41+43+43)/3=42.33). However, one data point does not offer much information. A series of data points over a period of time is required to enable analysis. Thus we can have a 3 period moving average as a technical indicator, where we drop the earliest closing price and use the next closing price for calculations. By creating a time series of data points, a comparison can then be made between present and past levels. Technical indicators are usually shown in a graphical form above or below a securitys price chart for facilitating analysis. Once shown in graphical form, an indicator can then be compared with the corresponding price chart of the security. Sometimes indicators are plotted on top of the price plot for a more direct comparison. Technical indicators measure money flow, trends, volatility and momentum etc. They are used for two main purposes: to confirm price movement and the quality of chart patterns, and to form buy and sell signals. A technical indicator offers a different perspective from which to analyze the price action. Some, such as moving averages, are derived from simple formulae and they are relatively easy to understand.

Others, like stochastics have complex formulae and require more effort to fully understand and appreciate. Technical indicators can provide unique perspective on the strength and direction of the underlying price action. Indicators filter price action with formulae. Therefore they are derivative measure and not direct reflections of the price action. This should be taken into account when analyzing the indicators. Any analysis of an indicator should be taken with the price action in mind. There are two main types of indicators: leading and lagging. A leading indicator precedes price movements; therefore they are used for prediction. A lagging indicator follows price movement and therefore is a confirmation. The main benefit of leading indicators is that they provide early signaling for entry and exit. Early signals can forewarn against a potential strength or weakness. Leading indicators can be used in trending markets. In a market that is trending up, the leading indicator helps identify oversold conditions for buying opportunities. In a market that is trending down, leading indicators can help identify overbought situations for selling opportunities. Some of the more popular leading indicators include Relative Strength Index (RSI) and Stochastic Oscillator. Lagging indicators follow the price action and are commonly referred to as trend following indicators. Lagging indicators work best when the markets or securities develop strong trends. They are designed to get traders in and keep them in as long as the trend is intact. As such, these indicators are not effective in trading or sideways markets. Some popular trend-following indicators include moving averages and Moving Average Convergence Divergence (MACD). Technical indicators are constructed in two ways: those that fall in a bounded range and those that do not. The technical indicators that are bound within a range are called oscillators. Oscillators are used as an overbought / oversold indicator. A market is said to be overbought when prices have been trending higher in a relatively steep fashion for some time, to the extent that the number of market participants long

of the market significantly outweighs those on the sidelines or holding short positions. This means that there are fewer participants to jump onto the back of the trend. The oversold condition is just the opposite. The market has been trending lower for some time and is running out of fuel for further price declines. Oscillator indicators move within a range, say between zero and 100, and signal periods where the security is overbought (near 100) or oversold (near zero). Oscillators are the most common type of technical indicators. The technical indicators that are not bound within a range also form buy and sell signals and display strength or weakness in the market, but they can vary in the way they do this. The two main ways that technical indicators are used to form buy and sell signals is through crossovers and divergence. Crossovers occur when either the price moves through the moving average, or when two different moving averages cross over each other. Divergence happens when the direction of the price trend and the direction of the indicator trend are moving in the opposite direction. This indicates that the direction of the price trend is weakening. Technical indicators provide an extremely useful source of additional information. These indicators help identify momentum, trends, volatility and various other aspects in a security to aid in the technical analysis of trends. While some traders just use a single indicator for buy and sell signals, it is best to use them along with price movement, chart patterns and other indicators. A number of technical indicators are in use. Some of the technical indicators are discussed below for the purpose of illustration of the concept:

Moving average The moving average is a lagging indicator which is easy to construct and is one of the most widely used. A moving average, as the name suggests, represents an average of a certain series of data that moves through

time. The most common way to calculate the moving average is to work from the last 10 days of closing prices. Each day, the most recent close (day 11) is added to the total and the oldest close (day 1) is subtracted. The new total is then divided by the total number of days (10) and the resultant average computed. The purpose of the moving average is to track the progress of a price trend. The moving average is a smoothing device. By averaging the data, a smoother line is produced, making it much easier to view the underlying trend. A moving average filters out random noise and offers a smoother perspective of the price action. Moving Average Convergence Divergence (MACD): MACD is a momentum indicator and it is made up of two exponential moving averages. The MACD plots the difference between a 26-day exponential moving average and a 12-day exponential moving average. A 9-day moving average is generally used as a trigger line. When the MACD crosses this trigger and goes down it is a bearish signal and when it crosses it to go above it, its a bullish signal. This indicator measures short-term momentum as compared to longer term momentum and signals the current direction of momentum. Traders use the MACD for indicating trend reversals. Relative Strength Index: The relative strength index (RSI) is another of the well-known momentum indicators. Momentum measures the rate of change of prices by continually taking price differences for a fixed time interval. RSI helps to signal overbought and oversold conditions in a security. RSI is plotted in a range of 0-100. A reading above 70 suggests that a security is overbought, while a reading below 30 suggests that it is oversold. This indicator helps traders to identify whether a securitys price has been unreasonably pushed to its current levels and whether a reversal may be on the way.

Stochastic Oscillator: The stochastic oscillator is one of the most recognized momentum indicators. This indicator provides information about the location of a current closing price in relation to the periods high and low prices. The closer the closing price is to the periods high, the higher is the buying pressure, and the closer the closing price is to the periods low, the more is the selling pressure. The idea behind this indicator is that in an uptrend, the price should be closing near the highs of the trading range, signaling upward momentum in the security. In downtrends, the price should be closing near the lows of the trading range, signaling downward momentum. The stochastic oscillator is plotted within a range of zero and 100 and signals overbought conditions above 80 and oversold conditions below 20.

Q5. Compare Arbitrage pricing theory with the Capital asset pricing model. Ans:-- In economics and finance, arbitrage is the practice of taking
advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices. When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, it is the possibility of a risk-free profit at zero cost. In principle and in academic use, an arbitrage is risk-free; in common use, as in statistical arbitrage, it may refer to expected profit, though losses may occur, and in practice, there are always risks in arbitrage, some minor (such as fluctuation of prices decreasing profit margins), some major (such as devaluation of a currency or derivative). In academic use, an arbitrage involves taking advantage of differences in price of a single asset or identical cash-flows; in common use, it is also used to refer to differences between similar assets (relative value or convergence trades), as in merger arbitrage. People who engage in arbitrage are called arbitrageurs (IPA: /rbtrr/)such as a bank or brokerage firm. The term is mainly applied to trading in financial instruments, such as bonds, stocks, derivatives, commodities and currencies. Conditions for arbitrage Arbitrage is possible when one of three conditions is met: 1. The same asset does not trade at the same price on all markets ("the law of one price"). 2. Two assets with identical cash flows do not trade at the same price. 3. An asset with a known price in the future does not today trade at its future price discounted at the risk-free interest rate (or, the

asset does not have negligible costs of storage; as such, for example, this condition holds for grain but not for securities). Arbitrage is not simply the act of buying a product in one market and selling it in another for a higher price at some later time. The transactions must occur simultaneously to avoid exposure to market risk, or the risk that prices may change on one market before both transactions are complete. In practical terms, this is generally only possible with securities and financial products which can be traded electronically, and even then, when each leg of the trade is executed the prices in the market may have moved. Missing one of the legs of the trade (and subsequently having to trade it soon after at a worse price) is called 'execution risk' or more specifically 'leg risk'.[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:

where Vt means a portfolio at time t. Examples Suppose that the exchange rates (after taking out the fees for making the exchange) in London are 5 = $10 = 1000 and the exchange rates in Tokyo are 1000 = $12 = 6. Converting 1000 to $12 in Tokyo and converting that $12 into 1200 in London,

for a profit of 200, would be arbitrage. In reality, this "triangle arbitrage" is so simple that it almost never occurs. But more complicated foreign exchange arbitrages, such as the spot-forward arbitrage (see interest rate parity) are much more common. One example of arbitrage involves the New York Stock Exchange and the Chicago Mercantile Exchange. When the price of a stock on the NYSE and its corresponding futures contract on the CME are out of sync, one can buy the less expensive one and sell it to the more expensive market. Because the differences between the prices are likely to be small (and not to last very long), this can only be done profitably with computers examining a large number of prices and automatically exercising a trade when the prices are far enough out of balance. The activity of other arbitrageurs can make this risky. Those with the fastest computers and the most expertise take advantage of series of small differences that would not be profitable if taken individually. Economists use the term "global labor arbitrage" to refer to the tendency of manufacturing jobs to flow towards whichever country has the lowest wages per unit output at present and has reached the minimum requisite level of political and economic development to support industrialization. At present, many such jobs appear to be flowing towards China, though some which require command of English are going to India and the Philippines. In popular terms, this is referred to as offshoring. (Note that "offshoring" is not synonymous with "outsourcing", which means "to subcontract from an outside supplier or source", such as when a business outsources its bookkeeping to an accounting firm. Unlike offshoring, outsourcing always involves subcontracting jobs to a different company, and that company can be in the same country as the outsourcing company.) Sports arbitrage numerous internet bookmakers offer odds on the outcome of the same event. Any given bookmaker will weight their odds so that no one customer can cover all outcomes at a

profit against their books. However, in order to remain competitive their margins are usually quite low. Different bookmakers may offer different odds on the same outcome of a given event; by taking the best odds offered by each bookmaker, a customer can under some circumstances cover all possible outcomes of the event and lock a small risk-free profit, known as a Dutch book. This profit would typically be between 1% and 5% but can be much higher. One problem with sports arbitrage is that bookmakers sometimes make mistakes and this can lead to an invocation of the 'palpable error' rule, which most bookmakers invoke when they have made a mistake by offering or posting incorrect odds. As bookmakers become more proficient, the odds of making an 'arb' usually last for less than an hour and typically only a few minutes. Furthermore, huge bets on one side of the market also alert the bookies to correct the market. Exchange-traded fund arbitrage Exchange Traded Funds allow authorized participants to exchange back and forth between shares in underlying securities held by the fund and shares in the fund itself, rather than allowing the buying and selling of shares in the ETF directly with the fund sponsor. ETFs trade in the open market, with prices set by market demand. An ETF may trade at a premium or discount to the value of the underlying assets. When a significant enough premium appears, an arbitrageur will buy the underlying securities, convert them to shares in the ETF, and sell them in the open market. When a discount appears, an arbitrageur will do the reverse. In this way, the arbitrageur makes a low-risk profit, while fulfilling a useful function in the ETF marketplace by keeping ETF prices in line with their underlying value. Some types of hedge funds make use of a modified form of arbitrage to profit. Rather than exploiting price differences between identical assets, they will purchase and sell securities, assets and derivatives with similar characteristics, and hedge any significant differences between the two assets. Any difference between the hedged positions represents any remaining risk (such

as basis risk) plus profit; the belief is that there remains some difference which, even after hedging most risk, represents pure profit. For example, a fund may see that there is a substantial difference between U.S. dollar debt and local currency debt of a foreign country, and enter into a series of matching trades (including currency swaps) to arbitrage the difference, while simultaneously entering into credit default swaps to protect against country risk and other types of specific risk.

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

As securities are added to the portfolio, the unsystematic risks of the individual securities offset each other. A fully diversified portfolio has no unsystematic risk. The CAPM can be viewed as a special case of the APT.

Empirical models try to capture the relations between returns and stock attributes that can be measured directly from the data without appeal to theory. Difference in Methodology CAPM is an equilibrium model and derived from individual portfolio optimization. APT is a statistical model which tries to capture sources of systematic risk.

Relation between sources determined by no Arbitrage condition. Difference in Application APT difficult to identify appropriate factors. CAPM difficult to find good proxy for market returns. APT shows sensitivity to different sources. Important for hedging in portfolio formation. CAPM is simpler to communicate, since everybody agrees upon.

Q 6. Discuss the different forms of market efficiency. Ans:-- A financial market displays informational efficiency when
market prices reflect all available information about value. This definition of efficient market required answers to two questions: what is all available information? & what does it mean to reflect all available information?Different answers to these questions give rise to different versions of market efficiency. What information are we talking about? Information can be information about past prices, information that is public information and information that is private information. Information about past prices refers to the weak form version of market efficiency, information that consists of past prices and all public information refers to the semistrong version of market efficiency and all information (past prices, all public information and all private information) refers to the strong form version of market efficiency. Prices reflect all available information means that all financial transactions which are carried out at market prices, using the available information, are zero NPV activities. The weak form the EMH states that all past prices, volumes and other market statistics (generally referred to as technical analysis) cannot provide any information that would prove useful in predicting future stock price movements. The current prices fully reflect all securitymarket information, including the historical sequence of prices, rates of return, trading volume data, and other market-generated information. This implies that past rates of return and other market data should have no relationship with future rates of return. It would mean that if the weak form of EMH is correct, then technical analysis is fruitless in generating excess returns. the semi-strong form suggests that stock prices fully reflect all publicly available information and all expectations about the future. OLD information then is already discounted and cannot be used to predict stock price fluctuations. In sum, the semi

strong form suggests that fundamental analysis is also fruitless; knowing what a company generated in terms of earnings and revenues in the past will not help you determine what the stock price will do in the future. This implies that decisions made on new information after it is public should not lead to above-average risk-adjusted profits from those transactions. Lastly, the strong form the EMH suggests that stock prices reflect all information, whether it be public (say in SEBI filings) or private (in the minds of the CERO and other insiders). So even with material nonpublic information, EMH asserts that stock prices cannot be predicted with any accuracy.

Q.1 Study the intensity of competition in the automobile industry using Michael Porters five factors model. Ans:-- Michael Porter has written extensively on the issue of
competitive strategy. The intensity of competition in an industry determines that industrys ability to sustain above-average returns. This intensity of competition can be explained by the following five factors: 1. Threat of new entrants: New entrants put pressure on price and profits. Therefore barriers to entry can be a key determinant of industrys profitability. The most attractive segment has high entry barriers and low exit barriers. Although any firm should be able to enter and exit a market, each industry often presents varying levels of difficulty, commonly driven by economies. Manufacturing-based industries are more difficult to enter than many service-based industries. The barriers to entry protect profitable areas for firms and inhibit additional rivals from entering the market. 2. Bargaining power of buyers: The power of buyers describes the impact customers have on an industry. 3. Rivalry between existing competitors: Firms make efforts to establish a competitive advantage over their rivals. The intensity of rivalry varies within each industry. Industries that are concentrated, versus fragmented, often display the highest level of rivalry. 4. Threat of substitute products or services: Substitute products are those products that are available in other industries that meet an identical or similar need for the end user. As more substitutes become available and affordable, the demand becomes more elastic since customers have more alternatives. Substitute products may limit the ability of firms within an industry to raise prices and improve margins.

5. Bargaining power of suppliers: An industry that produces goods requires raw materials. This leads to buyer-supplier relationships Depending on where the power lies, suppliers may be able to exert an influence on the producing industry.

Because the strength of these five factors varies across industries (and can change over time), industries differ from each other in terms of inherent profitability. These five competitive forces determine industry profitability because they influence the components of return on investment. The strength of each of these factors is a function of industry structure. Fundamental analysts analyze industry structure to assess the strength of the five competitive forces, which in turn determine industry profitability.

Q2. Using financial ratios, study the financial performance of any particular company of your interest. Ans:-Financial ratios illustrate relationships between different aspects of a small business's operations. They involve the comparison of elements from a balance sheet or income statement, and are crafted with particular points of focus in mind. Financial ratios can provide small business owners and managers with a valuable tool to measure their progress against predetermined internal goals, a certain competitor, or the overall industry. In addition, tracking various ratios over time is a powerful way to identify trends as they develop. Ratios are also used by bankers, investors, and business analysts to assess various attributes of a company's financial strength or operating results. Ratios are determined by dividing one number by another, and are usually expressed as a percentage. They enable business owners to examine the relationships between seemingly unrelated items and thus gain useful information for decision-making. "They are simple to calculate, easy to use, and provide a wealth of information that cannot be gotten anywhere else," James O. Gill noted in his book Financial Basics of Small Business Success. But, he added, "Ratios are aids to judgment and cannot take the place of experience. They will not replace good management, but they will make a good manager better. They help to pinpoint areas that need investigation and assist in developing an operating strategy for the future." Virtually any financial statistics can be compared using a ratio. In reality, however, small business owners and managers only need to be concerned with a small set of ratios in order to identify where improvements are needed. "As you run your business you juggle dozens of different variables," David H. Bangs, Jr. wrote in his book Managing by the Numbers. "Ratio analysis is designed to help you identify those variables which are out of balance."

It is important to keep in mind that financial ratios are time sensitive; they can only present a picture of the business at the time that the underlying figures were prepared. For example, a retailer calculating ratios before and after the Christmas season would get very different results. In addition, ratios can be misleading when taken singly, though they can be quite valuable when a small business tracks them over time or uses them as a basis for comparison against company goals or industry standards. As a result, business owners should compute a variety of applicable ratios and attempt to discern a pattern, rather than relying on the information provided by only one or two ratios. Gill also noted that small business owners should be certain to view ratios objectively, rather than using them to confirm a particular strategy or point of view. Perhaps the best way for small business owners to use financial ratios is to conduct a formal ratio analysis on a regular basis. The raw data used to compute the ratios should be recorded on a special form monthly. Then the relevant ratios should be computed, reviewed, and saved for future comparisons. Determining which ratios to compute depends on the type of business, the age of the business, the point in the business cycle, and any specific information sought. For example, if a small business depends on a large number of fixed assets, ratios that measure how efficiently these assets are being used may be the most significant. In general, financial ratios can be broken down into four main categoriesprofitability or return on investment, liquidity, leverage, and operating or efficiencywith several specific ratio calculations prescribed within each.

Q1 Financial Summary Google reported revenues of $6.77 billion for the quarter ended March 31, 2010, an increase of 23% compared to the first quarter of 2009. Google reports its revenues, consistent with GAAP, on a gross basis without deducting traffic acquisition costs (TAC). In the first quarter of 2010, TAC totaled $1.71 billion, or 26% of advertising revenues.

Google reports operating income, operating margin, net income, and earnings per share (EPS) on a GAAP and non-GAAP basis. The nonGAAP measures, as well as free cash flow, an alternative non-GAAP measure of liquidity, are described below and are reconciled to the corresponding GAAP measures in the accompanying financial tables. GAAP operating income in the first quarter of 2010 was $2.49 billion, or 37% of revenues. This compares to GAAP operating income of $1.88 billion, or 34% of revenues, in the first quarter of 2009. NonGAAP operating income in the first quarter of 2010 was $2.78 billion, or 41% of revenues. This compares to non-GAAP operating income of $2.16 billion, or 39% of revenues, in the first quarter of 2009. GAAP net income in the first quarter of 2010 was $1.96 billion, compared to $1.42 billion in the first quarter of 2009. Non-GAAP net income in the first quarter of 2010 was $2.18 billion, compared to $1.64 billion in the first quarter of 2009. GAAP EPS in the first quarter of 2010 was $6.06 on 323 million diluted shares outstanding, compared to $4.49 in the first quarter of 2009 on 317 million diluted shares outstanding. Non-GAAP EPS in the first quarter of 2010 was $6.76, compared to $5.16 in the first quarter of 2009. Non-GAAP operating income and non-GAAP operating margin exclude the expenses related to stock-based compensation (SBC). NonGAAP net income and non-GAAP EPS exclude the expenses related to SBC and the related tax benefits. In the first quarter of 2010, the charge related to SBC was $291 million, compared to $277 million in the first quarter of 2009. The tax benefit related to SBC was $65 million in the first quarter of 2010 and $64 million in the first quarter of 2009. Reconciliations of non- GAAP measures to GAAP operating income, operating margin, net income, and EPS are included at the end of this release.

International Revenues - Revenues from outside of the United States totaled $3.58 billion, representing 53% of total revenues in the first quarter of 2010, compared to 53% in the fourth quarter of 2009 and 52% in the first quarter of 2009. Excluding gains related to our foreign exchange risk management program, had foreign exchange rates remained constant from the fourth quarter of 2009 through the first quarter of 2010, our revenues in the first quarter of 2010 would have been $112 million higher. Excluding gains related to our foreign exchange risk management program, had foreign exchange rates remained constant from the first quarter of 2009 through the first quarter of 2010, our revenues in the first quarter of 2010 would have been $242 million lower. Revenues from the United Kingdom totaled $842 million, representing 13% of revenues in the first quarter of 2010, compared to 13% in the first quarter of 2009. In the first quarter of 2010, we recognized a benefit of $10 million to revenues through our foreign exchange risk management program, compared to $154 million in the first quarter of 2009. Paid Clicks Aggregate paid clicks, which include clicks related to ads served on Google sites and the sites of our AdSense partners increased approximately 15% over the first quarter of 2009 and increased approximately 5% over the fourth quarter of 2009. Cost-Per-Click Average cost-per-click, which includes clicks related to ads served on Google sites and the sites of our AdSense partners, increased approximately 7% over the first quarter of 2009 and decreased approximately 4% over the fourth quarter of 2009. TAC - Traffic Acquisition Costs, the portion of revenues shared with Googles partners, increased to $1.71 billion in the first quarter of 2010, compared to TAC of $1.44 billion in the first quarter of 2009. TAC as a percentage of advertising revenues was 26% in the first quarter of 2010, compared to 27% in the first quarter of 2009.

The majority of TAC is related to amounts ultimately paid to our AdSense partners, which totaled $1.45 billion in the first quarter of 2010. TAC also includes amounts ultimately paid to certain distribution partners and others who direct traffic to our website, which totaled $265 million in the first quarter of 2010. Other Cost of Revenues - Other cost of revenues, which is comprised primarily of data center operational expenses, amortization of intangible assets, content acquisition costs as well as credit card processing charges, increased to $741 million, or 11% of revenues, in the first quarter of 2010, compared to $666 million, or 12% of revenues, in the first quarter of 2009. Operating Expenses - Operating expenses, other than cost of revenues, were $1.84 billion in the first quarter of 2010, or 27% of revenues, compared to $1.52 billion in the first quarter of 2009, or 28% of revenues. Stock-Based Compensation (SBC) In the first quarter of 2010, the total charge related to SBC was $291 million, compared to $277 million in the first quarter of 2009. We currently estimate SBC charges for grants to employees prior to April 1, 2010 to be approximately $1.2 billion for 2010. This estimate does not include expenses to be recognized related to employee stock awards that are granted after March 31, 2010 or non-employee stock awards that have been or may be granted. Operating Income - GAAP operating income in the first quarter of 2010 was $2.49 billion, or 37% of revenues. This compares to GAAP operating income of $1.88 billion, or 34% of revenues, in the first quarter of 2009. Non-GAAP operating income in the first quarter of 2010 was $2.78 billion, or 41% of revenues. This compares to nonGAAP operating income of $2.16 billion, or 39% of revenues, in the first quarter of 2009.

Interest Income and Other, Net Interest income and other, net increased to $18 million in the first quarter of 2010, compared to $6 million in the first quarter of 2009. Income Taxes Our effective tax rate was 22% for the first quarter of 2010. Net Income GAAP net income in the first quarter of 2010 was $1.96 billion, compared to $1.42 billion in the first quarter of 2009. Non GAAP net income was $2.18 billion in the first quarter of 2010, compared to $1.64 billion in the first quarter of 2009. GAAP EPS in the first quarter of 2010 was $6.06 on 323 million diluted shares outstanding, compared to $4.49 in the first quarter of 2009 on 317 million diluted shares outstanding. Non-GAAP EPS in the first quarter of 2010 was $6.76, compared to $5.16 in the first quarter of 2009. Cash Flow and Capital Expenditures Net cash provided by operating activities in the first quarter of 2010 totalled $2.58 billion, compared to $2.25 billion in the first quarter of 2009. In the first quarter of 2010, capital expenditures were $239 million, the majority of which was related to IT infrastructure investments, including data canters, servers, and networking equipment. Free cash flow, an alternative non-GAAP measure of liquidity, is defined as net cash provided by operating activities less capital expenditures. In the first quarter of 2010, free cash flow was $2.35 billion.

We expect to continue to make significant capital expenditures. A reconciliation of free cash flow to net cash provided by operating activities, the GAAP measure of liquidity, is included at the end of this release. Cash As of March 31, 2010, cash, cash equivalents, and short-term marketable securities were $26.5 billion. On a worldwide basis, Google

employed 20,621 full-time employees as of March 31, 2010, up from 19,835 full-time employees as of December 31, 2009.

FORWARD-LOOKING STATEMENTS

This press release contains forward-looking statements that involve risks and uncertainties. These statements include statements regarding our plans to heavily invest in innovation, our expected stock-based compensation charges and our plans to make significant capital expenditures. Actual results may differ materially from the results predicted, and reported results should not be considered as an indication of future performance. The potential risks and uncertainties that could cause actual results to differ from the results predicted include, among others, unforeseen changes in our hiring patterns and our need to expend capital to accommodate the growth of the business, as well as those risks and uncertainties included under the captions Risk Factors and Managements Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2009, which is on file with the SEC and is available on our investor relations website at investor.google.com and on the SEC website at www.sec.gov. Additional information will also be set forth in our Quarterly Report on Form 10-Q for the quarter ended March 31, 2010, which we expect to file with the SEC in May 2010.

All information provided in this release and in the attachments is as of April 15, 2010, and Google undertakes no duty to update this information.

Q3. How is your view of a companys shares different when viewing technically and when viewing fundamentally. Ans:-Differences between Fundamental and Technical analysis: 1. Charts vs. Financial statements: A technical analyst approaches a security from the charts, while a fundamental analyst studies the financial statements. Technical analysis is the study of price action and trend, while fundamental analysis focuses on economic supply and demand relationships, in order to calculate the intrinsic value of a financial instrument. Technically, instruments in an uptrend are candidates to be purchased, while instruments in a downtrend are candidates to be sold. Fundamentally, instruments that are below intrinsic value are undervalued and are candidates to be purchased, while instruments that are above intrinsic value are overvalued and are candidates to be sold. By looking at the financial statements (the income statement, the cash flow statement, and the balance sheet) a fundamental analyst determines a companys value. A fundamental analyst tries to uncover the companys intrinsic value. The investment decision based on fundamental analysis is: if the price of a stock trades below its intrinsic value, it is a good investment. Technical analyst sees no reason for analyzing the companys fundamentals as he believes that they are already accounted for in the stocks price. All the information that a technical analyst desires is there in the price of the securities that can be found in the charts. 2. Time horizon: Fundamental analysts take a longer term view of the market when compared to the technical analysts. Technical analysis has a timeframe of weeks, days or even minutes whereas fundamental analysis often looks at data over a number of years. The difference in the time frames is because of the different investing styles of fundamental and technical analysis. It can take a long time for an undervalued stock, uncovered by fundamental analysis, to reach its correct value. Fundamental analysis assumes that if the short-term market is wrong (in valuing a stock at less than its intrinsic value) the price of the stock will correct itself over the long run. This long run can be a number of years in some cases. Also, the data that is analyzed by the fundamental analysts are released over a long period of time. Balance sheet, income statement, cash flow statement, earnings per share that the fundamental analysts use are not published on a daily basis. In contrast, the price and volume data that the technical analysts use are generated on a continuous basis. Thus, part of the reason that the fundamental analysts use a long-term timeframe, is

therefore due to the fact that the data they use to analyze a stock is generated much more slowly than the price and volume data used by technical analysts. 3. Trading vs. investing: The goals of technical and fundamental analysis are different. In general, fundamental analysis is used to make an investment, whereas technical analysis is used for a trade. While the distinction between investment and trading is not very clear cut, we can say that investors buy assets that they believe can increase in value, while traders buy assets that they believe they can sell to somebody else at a greater price. 4. Cause vs. effect: While both approaches have the same objective (that is, to predict the direction of prices), the fundamental analyst studies the causes of market movements, while the technical analyst studies the effect of market movements. The fundamental analyst needs to know why the prices have moved. The technical analyst, on the other hand, attempts to measure the projected effect of the price movements. Although technical analysis and fundamental analysis may seem to be poles apart, many market participants have achieved some success by combining the two. Thus a fundamental analyst may use technical analysis techniques to figure out the best time to enter into an undervalued security. Often, this opportunity is present when the security is severely oversold. By timing entry into a security, the gains on the investment can be greatly improved. Similarly, some technical traders might look at fundamentals to add strength to a technical signal. For example, if a sell signal is obtained after technical analysis, a technical trader might look at fundamental data before going ahead with the decision.

Q4. Show how duration of a bond is calculated and how is it used. Ans:-Duration of Bonds

Bond Duration is a measure of bond price volatility, which captures both price and reinvestment risk and which is used to indicate how a bond will react in different interest rate environments. The duration of a bond represents the length of time that elapses before the average rupee of present value from the bond is received. Thus duration of a bond is the weighted average maturity of cash flow stream, where the weights are proportional to the present value of cash flows. Formally, it is defined as: Duration = D = {PV (C1) x 1 + PV (C2) x 2+ ----- PV (Cn) x n} / Current Price of the bond Where PV (Ci) is the present values of cash flow at time i. Steps in calculating duration: Step 1 : Find present value of each coupon or principal payment. Step 2 : Multiply this present value by the year in which the cash flow is to be received. Step 3 : Repeat steps 1 & 2 for each year in the life of the bond. Step 4 : Add the values obtained in step 2 and divide by the price of the bond to get the value of Duration. Example: Calculate the duration of an 8% annual coupon 5 year bond that is priced to yield 10% (i.e. YTM = 10%). The face value of the bond is Rs.1000.

Annual coupon payment = 8% x Rs. 1000 = Rs. 80 At the end of 5 years, the principal of Rs. 1000 will be returned to the investor. Therefore cash flows in year 1-4= Rs. 80. Cash flow in year 5= Principal + Interest = Rs. 1000 + Rs. 80 = Rs. 1080

Price of the bond= Rs 924.18 The proportional change in the price of a bond: (P/P) = - {D/ (1+ YTM)} x y Where y =change in Yield, and YTM is the yield-to-maturity. The term D / (1+YTM) is also known as Modified Duration. The modified duration for the bond in the example above = 4.28 / (1+10%) = 3.89 years. This implies that the price of the bond will decrease by 3.89 x 1% = 3.89% for a 1% increase in the interest rates. Example: A bond having Rs.1000 face value and 8 % coupon bond with 4 years to maturity is priced to provide a YTM of 10%. Find the duration of the bond.

Ans: P0 = 80 x PVIFA 10%, 4 years + 1000 x PVIFA 10%, 4 years = 80 x 3.170 + 1000 x .683 = 937 rc = 80/937 = 0.857 (current yield) rd = YTM n = 4 years Duration = PVIFA (rd ,n) (1+rd) + [1 ] n dc rr rd rc = 3.170 (1.10) + [ 1 ] 4 .10 .0854 .10 .0854 = 2.977 + .584 = 3.561 years Generally speaking, bond duration possesses the following properties: Bonds with higher coupon rates have shorter durations. Bonds with longer maturities have longer durations. Bonds with higher YTM lead to shorter durations. Duration of a bond with coupons is always less than its term to maturity because duration gives weight to the interim payments. A zerocoupon bonds duration is equal to its maturity.

Q5. Show with the help of an example how portfolio diversification reduces risk. Ans:-- Portfolio diversification
'Don't put all your eggs in one basket' is a well-known proverb, which summarizes the message that there are benefits from diversification. If you carry your breakable items in several baskets there is a chance that one will be dropped, but you are unlikely to drop all your baskets on the same trip. Similarly, if you invest all your wealth in the shares of one company, there is a chance that the company will go bust and you will lose all your money. Since it is unlikely that all companies will go bust at the same time, a portfolio of shares in several companies is less risky. This may sound like the idea of risk-pooling, which we discussed earlier in this chapter, and risk-pooling is certainly an important reason for diversification. We will use the notion of risk-pooling to explain some forms of financial behaviour, but a full understanding of portfolio diversification involves a slightly wider knowledge of the nature of risk than what is involved in coin-tossing. The key difference between risk in the real world of finance and the risk of coin-tossing is that many of the potential outcomes are not independent of other outcomes. If you and I toss a coin, the probability of yours turning up heads is independent of the probability of my throwing a head. However, the return on an investment in, say, BP is not independent of the return on an investment in Shell. This is because these two companies both compete in the same industry. If BP does especially well in attracting new business, it may be at the expense of Shell. So high profits at BP may be associated with low profits at Shell, or vice versa. On the other hand, all oil companies might do well when oil prices are high and badly when they are low. The important matter here is that the fortunes of these two companies are not independent of each other. The fact that the risks of individual investments may not be independent has important implications for investment allocations, or

what is now called portfolio theory. Investments can be combined in different proportions to produce risk and return characteristics that cannot be achieved through any single investment. As a result, institutions have grown up to take advantage of the benefits of diversification. Diversified portfolios may produce combinations of risk and return that dominate non diversified portfolios. This is an important statement that requires a little closer investigation. That investigation will help to identify the circumstances under which diversification is beneficial. It will also clarify what we mean by the word 'dominate'. Table 2 sets out two simple examples. In both there are two assets that an investor can hold, and there are two possible situations which are assumed to be equally likely. Thus, there is a probability of 0.5 attached to each situation and the investor has no advance knowledge of which is going to happen. The two situations might be a high exchange rate and a low exchange rate, a booming and a depressed economy, or any other alternatives that have different effects on the earnings of different assets. Table 2: Combinations of risk and return

Assets differ in expected return and variability in returns. Part (i) illustrates the return on two assets in two different situations. Asset A has a high return in situation 2 and a low return in situation 1. The reverse is true for asset B. A portfolio of both assets has the same expected return but lower risk than a holding of either asset on its own. In (ii) both assets have a high return in situation 2 and a low return in situation 1. For the risk-averse investor asset A dominates asset B. Consider part (i) of the table. In this case both assets have the same expected return (20 per cent) and the same degree of risk. (The possible range of outcomes is between 10 and 30 per cent on each asset.) If all that mattered in investment decisions were the risk and return of individual shares, the investor would be indifferent between assets A and B. Indeed, if the choice were between holding only A or only B, all investors should be indifferent (whether they were riskaverse, risk-neutral, or risk-loving) because the risk and expected return are identical for both assets. However, this is not the end of the story, because the returns on these assets are not independent. Indeed, there is a perfect negative correlation between them: when one is high the other is low, and vice versa. What would a sensible investor do if permitted to hold some combination of the two assets? Clearly, there is no possible combination that will change the overall expected return, because it is the same on both assets. However, holding some of each asset can reduce the risk. Let the investor decide to hold half his wealth in asset A and half in asset B. His risk will then be reduced to zero, since his return will be 20 percent which ever situation arises. This diversified portfolio will clearly be preferred to either asset alone by risk-averse investors. The risk-neutral investor is indifferent to all combinations of A and B because they all have the same expected return, but the risk lover may prefer not to diversify. This is because, by picking one asset

alone, the risk lover still has a chance of getting a 30 per cent return and the extra risk gives positive pleasure. Risk-averse investors will choose the diversified portfolio, which gives them the lowest risk for a given expected rate of return, or the highest expected return for a given level of risk. Diversification does not always reduce the riskiness of a portfolio, so we need to be clear what conditions matter. Consider the example in part (ii) of Table 2. As in part (i), both assets have an expected return of 20 per cent. But asset B is riskier than asset A and it has returns that are positively correlated with A's. Portfolio diversification does not reduce risk in this case. Risk-averse investors would invest only in asset A, while risk-lovers would invest only in asset B. Combinations of A and B are always riskier than holding A alone. Thus, we could say that for the risk-averse investor asset A dominates asset B, as asset B will never be held so long as asset A is available. The key difference between the example in part (ii) of Table 2 and that in part (i) is that in the second example returns on the two assets are positively correlated, while in the former they are negatively correlated [Note]. The risk attached to a combination of two assets will be smaller than the sum of the individual risks if the two assets have returns that are negatively correlated. Diversifiable and non-diversifiable risk Not all risk can be eliminated by diversification. The specific risk associated with any one company can be diversified away by holding shares of many companies. But even if you held shares in every available traded company, you would still have some risk, because the stock market as a whole tends to move up and down over time. Hence we talk about market risk and specific risk. Market risk is nondiversifiable, whereas specific risk is diversifiable through risk-pooling.

Box 3 discusses the issue of whether all firms should diversify the activities in order to reduce risk. Beta It is now common to use a coefficient called beta to measure the relationship between the movements in a specific company's share price and movements in the market. A share that is perfectly correlated with an index of stock market prices will have a beta of 1. A beta higher than 1 means that the share moves in the same direction as the market but with amplified fluctuations. A beta between 1 and 0 means that the share moves in the same direction as the stock market but is less volatile. A negative beta indicates that the share moves in the opposite direction to the market in general. Clearly, other things being equal, a share with a negative beta would be in high demand by investment managers, as it would reduce a portfolio's risk. The capital asset pricing model, or CAPM, predicts that the price of shares with higher betas must offer higher average returns in order to compensate investors for their higher risk. For example, Two stocks whose returns move in exactly together have a coefficient of +1.0. Two stocks whose returns move in exactly the opposite direction have a correlation of -1.0. To effectively diversify, you should aim to find investments that have a low or negative correlation. The banking stocks (or the technology stocks) would have a high positive correlation as their share prices are driven by common factors. As you increase the number of securities in your portfolio, you reach a point where you have diversified as much as is reasonably possible. When you have about 30 securities in your portfolio you have diversified most of the risk.

Q6. Study the performance of any emerging market of your choice. Ans:-Emerging market

With emerging market economies like India and China growing at nearly 10%, you may be feeling pain from all the criticism from pundits and advisers that you are a myopic, short-sighted American for not allocating enough to emerging market equities. According to Vanguard, the average allocation to emerging market equities among US household investors is still only 6%. Shouldn't the percentage of your equity portfolio invested in emerging markets equities be roughly in line with the proportionate share of emerging-market stocks to total global stock-market capitalization or around 10% to 15% of an investor's total equity portfolio? It seems natural to expect that the powerful economic growth of emerging markets such as Brazil and China will lead to higher stock market returns than in the slower growing markets such as the U.S. and Europe. So should emerging market equities be a bigger part of your portfolio? In fact, US household investors may, at least for the moment, be properly weighted in emerging markets. For the following reasons higher potential growth may not justify investing heavily right now in emerging market equities and instead you may want to be gradually increasing your allocation over time: First, 12% economic growth in a country like India has not necessarily meant 12% market returns. While there is certainly reasonable evidence to support expectations of long-term growth in markets like India, China, Brazil, etc., as reported in this Wall Street Journal article - studies suggest that strong economic growth often does not translate into strong stock returns. One study, which looked at market returns in 32 nations since the 1970s, concluded that stock gains and economic performance can diverge dramatically. University of Florida finance professor Jay Ritter

found, for example, that stocks in Sweden posted a mean return of better than 8% a year from 1970 through 2002, even though GDP grew at an annualized pace of just 1.8%. In contrast, while GDP expanded more than 5% annually in South Korea from 1988 to 2002, the mean stock return was only 0.4% a year. 'A healthy economy isn't a guarantee that established companies will attract enough capital and labor to expand sales and earnings stronglypartly because they have to compete with newer ventures for resources,' Dr. Ritter says. More basically, since markets are largely efficient, investors have long ago anticipated potential for equities in places like China. Right now, by many measures, it would appear that valuations for US and MSCI Emerging Markets Index on a trailing P/E basis are roughly inline. Second, even if average annual returns from emerging markets exceed developed markets, emerging markets are still materially more volatile, and this volatility will not just keep you awake at night, it will erode your returns over time through the process of volatility drag. My colleague explains in this article how volatility drag will reduce your returns. Right now, the 3-year standard deviation of emerging market returns is 32.83 versus 24.27 for the S&P500, a difference that translates into roughly a 3% drag on your cumulative return. And while the 60-day volatility on US Large-Cap Equities has now dropped all the way down to 10.99%, the 60-day emerging market volatility actually rose slightly this quarter to 19.55% (see chart below for period ending December 31, 2010):
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Third, emerging market indexes are less efficient investment vehicles which makes a big difference over time for prudent, long-term investors. Most emerging market funds are significantly more expensive than US funds - often hundreds of basis points more. Our firm recommends low cost funds such as iShares MSCI Emerging Market Index (EEM), and Vanguard Emerging Markets (VWO). But even these low-cost funds face higher costs than US equity funds. Compare Vanguard's VWO at 0.27 expense ratio vs. Vanguards S&P500 Index Fund (VOO) at 0.06%. If you are investing within a fund family such as Fidelity, your choice for emerging markets is an actively managed fund with an annual cost of 1.14% versus Fidelity's S&P500 Index at only 0.10% (This is why if you really seek more exposure to emerging markets economic growth, a more efficient way to gain exposure is through multinationals traded on US exchanges S&P500 companies derive about 50% of their revenue from abroad, with about a third of that coming from emerging markets). So higher economic growth may not lead to higher returns on emerging markets equities, volatility drag is likely to erode much of this potential higher return, and higher investment costs are certain to drag the return down even further. In our dynamic asset allocation process, emerging markets allocations are likely to grow along with other equity allocations over the next few years assuming volatility continues to decline. But, right now, it appears that the average American household is not necessarily being naive and xenophobic when they choose to be underweighted in emerging market equities.