You are on page 1of 13

Q1.

Financial markets bring the providers and users in


direct contact without any intermediary. Financial markets
permits the businesses and governments to raise the
funds needed by sale of securities. Describe the money
market/capital market features and its composition
Answer:

Money market: A segment of the financial market in which financial


instruments with high liquidity and very short maturities are traded. The
money market is used by participants as a means for borrowing and
lending in the short term, from several days to just under a year. Money
market securities consist of negotiable certificates of deposit (CDs),
bankers acceptances, U.S. Treasury bills, commercial paper, municipal
notes, federal funds and repurchase agreements (repos).
Features of Money Market: The money market is subsection of the
fixed income market. Fixed income often is considered the same thing
as bonds or investments that have a specific set return rather than a
variable one. A money market is an efficient investment arena for
businesses, governments and other large institutions, but it also provides
extra safety and liquidity for individual investors. A money market is the
best place for the cash component of your portfolio because it offers
interest income while maintaining easy access to cash.
Securities
Money markets specialize in short-term--less than one year--debt
securities. This short maturation time provides the same benefits as
liquid cash for the investor. Basically, a money market security is an IOU
from a government, financial institution or other large corporation. Money
market securities are safer than most other securities and therefore offer
lower returns.
Mutual Funds
Money market mutual funds are the most accessible money market
instrument for individuals. Mutual fund firms and brokerage companies
sell shares in these funds to investors at low risk. Taxable mutual funds
place money in Treasury bills, commercial papers or other securities that
pay out interest subject to federal taxes.
Deposit Accounts
Money market deposit accounts are special FDIC-insured bank
accounts. Like a mutual fund, the deposit account puts your money in
short-term investments with a fixed income. The return is generally
higher than on a standard savings account. Usually, you can access
your money with checks or a debit card. Unlike other money market

instruments, the deposit account doesnt charge fees for early


withdrawal, so you can use the funds whenever you want.
Instruments
Money market securities come in many forms--some with higher
payouts, some with better liquidity and some that are just quite safe.
Government agencies issue instruments such as Treasury bills, federal
agency notes or short-term tax-exempts. A certificate of deposit, or CD,
is a deposit through a financial institution with a specific maturity date-on average, three months to five years. Other common instruments
include the commercial paper, bankers acceptance, Eurodollars
(international investments) and repos.
Money Market
The money market is a dealer market. Dealer markets rely on firms
selling and buying securities from their own accounts and at their own
risk. Money market mutual funds and deposit accounts offer the highest
liquidity and most access but the lowest returns.
Composition of Money Market
Money market is the center of dealing in short term monetary assets like
bill of exchange, short term govt. securities and other short term loans.
The main dealers of money markets are the banks and financial
institutions. They get and give loan or purchase and sell short terms bill
in this market. This is not fix place but this system in which they deal with
each other.
Composition of Money market
Structure means support on the basis body will stand. So there are
following composition which support the whole money market.
In the structure of money market, there are two components are included
1st Composition or component Financial institution
There are two parts of financial institution in money market:a) organized sector
In this sector there following dealer who deal short term loans in money
market.
I) RBI:RBI means reserve bank of India. This is central bank of India. It is issue
short term loan when any bank has any need of short term money.
II) Commercial Banks:In commercial banks, there are SBI , Nationalize bank , rural banks ,
private banks which deals in short term loans with each other , one bank
can take or give short term loan to each other when they need or extra

money , they want to invest in short term govt. security.


III) Co-operative banks:The co-operative banks are also take part in money market. In the top
dealer in this market is state cooperative bank. In the district level central
cooperative bank do dealing in short term loan.
b) Unorganized Sector
In this sector indigenous banks, money lenders deals with each other or
with organized sector.
2nd Composition or component Financial Instruments or papers
1) Call money market
Call money market is the market which deals in short term loans. This
loan can be given for one hour to one or two days .This call loans is
given without any security. The borrower or loan taker will repay the loan
at call. So this loan is also called call loan in this market. The rate of this
loan is very high.
II) Treasury bill Market
Treasury bills are the bill which is issued by central govt. This bill is sold
by RBI on the behalf of Govt. There is dealing of treasury bills in
Treasury bill market. The main dealer of T.B are the UTI & LIC. This is 90
loan acceptance bill. This bill can be discounted from any other bank.
III) Commercial bill market
a) Promissory Notes: - In this bill, the loan taker give the promise to
pay certain amount after certain period.
b) Bill of Exchange: Under this bill firms can sell the good. In this bill
loan giver order that his amount must be given to him or his ordered
person after certain period. This bill can also discounted from bank.

Capital Market
Markets for buying and selling equity and debt instruments. Capital
markets channel savings and investment between suppliers of capital
such as retail investors and institutional investors, and users of capital
like businesses, government and individuals. Capital markets are vital to
the functioning of an economy, since capital is a critical component for
generating economic output. Capital markets include primary markets,
where new stock and bond issues are sold to investors, and secondary
markets, which trade existing securities.
Feature of Capital Market
Capital market is a market for medium and long term funds. It includes
all the organizations, institutions and instruments that provide long term
and medium term funds.
Features
1. Link between Savers and Investment Opportunities:

Capital market is a crucial link between saving and investment process.


The capital market transfers money from savers to entrepreneurial
borrowers.
2. Deals in Long Term Investment:
Capital market provides funds for long and medium term. It does not
deal with channelizing saving for less than one year.
3. Utilizes Intermediaries:
Capital market makes use of different intermediaries such as brokers,
underwriters, depositories etc. These intermediaries act as working
organs of capital market and are very important elements of capital
market.
4. Determinant of Capital Formation:
The activities of capital market determine the rate of capital formation in
an economy. Capital market offers attractive opportunities to those who
have surplus funds so that they invest more and more in capital market
and are encouraged to save more for profitable opportunities.
5. Government Rules and Regulations:
The capital market operates freely but under the guidance of
government policies. These markets function within the framework of
government rules and regulations, e.g., stock exchange works under the
regulations of SEBI which is a government body.
Composition of Capital Market:
Capital market is the market for long term funds, just as the money
market is the market for short term funds. It refers to all the facilities and
the institutional arrangements for borrowing and lending term funds
(medium-term and long-term funds).it does not deal in capital goods but
is concerned with the raising of money capital for purposes of
investment.
The demand for long-term memory capital comes predominantly from
private sector manufacturing industries and agriculture and from the
government largely for the purpose of economic development. As the
central and state governments are investing not only on economic
overheads like transport, irrigation and power development but also on
basic industries and sometimes even in consumer goods industries, they
require substantial sums from the capital market.
The supply of funds for the capital market comes largely from individual
savers, corporate savings, banks, insurance companies specialized
financing agencies and the government. Among the institutions, we may
refer to the following:
Commercial banks are important investors, but are largely interested in
govt. securities and, to a small extent, debentures of companies;
LIC and GIC are of growing importance in the Indian capital market,
though their major interest is in government securities;

Provident funds constitute a major medium of savings but their


investment too are mostly in govt. securities; and
Special institutions set up since independence , viz, IFCI, ICICI, IDBI,
UTI, etc. generally called development financial institutions (DFIs) aim
at supplying long term capital to the private sector.
There are financial intermediaries in the capital market, such as
merchant bankers, mutual funds leasing companies etc. which help in
mobilizing savings and supplying funds to investors.
Like all markets, the capital market is also composed of those who
demand funds (borrowers) and those who supply funds (lenders).an
ideal capital attempts to provide adequate capital at reasonable rate of
return for any business which offers a prospective yield high enough to
make borrowing worthwhile.
The capital market is broadly divided into two the gilt-edged market and
the industrial securities market. The gilt-edged market refers to the
market for government and semi govt. securities, backed by the RBI.
The securities traded in this market are stable in value and are much
sought after by banks and other institutions.
The new issue market often referred to as primary market- refers to
raising of new capital in the form of shares and debentures whereas the
old issue market commonly known as stock exchange or stock marketdeals with securities already issued by the companies. It is also known
as the secondary market. Both markets are equally important, but often
the issue market IS MUCH MORE IMPORTANT from the point of view of
economic growth.

Q2. Risk is the likelihood that your investment will either


earn money or lose money. Explain the factors that affect
risk.
Mr. Rahul invests in equity shares of Wipro. Its anticipated
returns and associated probabilities are given below:
Return
-15
-10
5
10
15
20
30
Probability 0.05 0.10 0.15 0.25 0.30 0.10 0.05
You are required to calculate the expected ROR and risk in
terms of standard deviation.
Answer:
Factors that affect Risks
Past market trends
Sometimes history repeats itself; sometimes markets learn from their
mistakes. You need to understand how various asset classes have
performed in the past before planning your finances.

Your risk appetite


The ability to tolerate risk differs from person to person. It depends on
factors such as your financial responsibilities, your environment, your
basic personality, etc. Therefore, understanding your capacity to take on
risk becomes a crucial factor in investment decision making.
Investment horizon
How long can you keep the money invested? The longer the timehorizon, the greater are the returns that you should expect. Further, the
risk element reduces with time.
Investible surplus
How much money are you able to keep aside for investments? The
investible surplus plays a vital role in selecting from various asset
classes as the minimum investment amounts differ and so do the risks
and returns.
Investment need
How much money do you need at the time of maturity? This helps you
determine the amount of money you need to invest every month or year
to reach the magic figure.
Expected returns
The expected rate of returns is a crucial factor as it will guide your choice
of investment. Based on your expectations, you can decide whether you
want to invest heavily into equities or debt or balance your portfolio.
Solutions:

Return
-10
-10
5
10
15
20
30
55

Probability R X P
0.05
0.10
0.15
0.25
0.30
0.10
0.05

-0.75
-1.00
0.75
2.50
4.50
2.00
1.50
R
=9.50

R
R
-24.50
-19.50
-4.50
0.50
5050
10.50
20.50

(R R )2

600.25
380.25
20.25
0.25
30.25
110.25
420.25

(R R
)2 xP
30.0125
38.025
3.0375
0.625
9.0750
11.0250
21.0125
112.8125

2 = P(R R )2
2

=
SD = 112.8125 = 10.62 % (answer)

Q3. Explain the business cycle and leading coincidental &


lagging indicators. Analyse the issues in fundamental
analysis
Answer: Assorted economic statistics that provide valuable information
about the expansions and contractions of business cycles. These
statistics are grouped into three sets--lagging, coincident, and leading.
Leading economic indicators tend to move up or down a few months
BEFORE business-cycle expansions and contractions. Coincident
economic indicators tend to reach their peaks and troughs AT THE
SAME TIME as business cycles. Lagging economic indicators tend to
rise or fall a few months AFTER business-cycle expansions and
contractions.
Business cycle indicators are a series of economic measures compiled
from a variety of sources by The Conference Board that track monthly
business cycle activity. They provide consumers, business leaders, and
policy makers with a bit of insight into the current state of the economy
and glimpse into where the economy might be headed.
The actual measures used as business cycle indicators are collected by
several different government agencies and private organizations,
including the Bureau of Labor Statistics, the Federal Reserve System,
and the Dow Jones Company. These measures are then compiled by
economists and number crunchers at the Conference Board into leading,
coincident, and lagging indicators used to analyze business-cycle
instability.
The Big Three
The business cycle indicators compiled by the Conference Board are
grouped into one of three categories--leading, coincident, and lagging.
Leading Economic Indicators: This group includes ten measures that
generally indicate business cycle peaks and troughs three to twelve
months before they actually occur. The ten leading indicators are: (1)
manufacturers' new orders for consumer goods and materials, (2) an
index of vendor performance, (3) manufacturers' new orders for
nondefense capital goods, (4) the Standard & Poor's 500 index of stock
prices, (5) new building permits for private housing, (6) the interest rate
spread between U.S. Treasury bonds and Federal Funds, (7) the M2 real
money supply, (8) average workweek in manufacturing, (9) an index of
consumer expectations, and (10) average weekly initial claims for
unemployment insurance.
Coincident Economic Indicators: This category contains four measures
that indicate the actual incidence of business cycle peaks and troughs at
the time they actually occur. In fact, coincident economic indicators are a
primary source of information used to document the "official" business

cycle turning points. The coincident indicators are: (1) the number of
employees on nonagricultural payrolls, (2) industrial production, (3) real
personal income (after subtracting transfer payments), and (4) real
manufacturing and trade sales.
Lagging Economic Indicators: This is a group of seven measures that
generally indicate business cycle peaks and troughs three to twelve
months after they actually occur. The lagging indicators are: (1) labor
cost per unit of output in manufacturing, (2) the average prime interest
rate, (3) the amount of outstanding commercial and industrial debt, (4)
the Consumer Price Index for services, (5) consumer credit as a fraction
of personal income, (6) the average duration of unemployment, and (7)
the ratio of inventories to sales for manufacturing and trade.
Handy Composites
The individual indicators are useful in their own right, but when combined
as composite measures, they provide even greater insight into the
business cycle activity. The ten separate leading economic indicators are
combined into a handy composite index of leading economic indicators.
So too are the four coincident and seven lagging indicators combined
into handy composite indicators.
How They Track
The exhibit to the right can be used to illustrate each of the three sets of
business cycle indicators individually and how they relate to the official
tracking of business cycle peaks and troughs.
First, take note of the somewhat jagged red line displayed in the exhibit.
It provides a hypothetical tracking of real gross domestic product over
several months. Two peaks are evident, labeled with P. One trough is
displayed as well, marked by T.
A composite for any of the three groups of indicators can be
displayed by clicking the corresponding [Leading], [Coincident],
and [Lagging] buttons. Or to display all three simultaneously,
click the [All] button.

Leading: A click of the [Leading] button reveals a thin blue line that
rises and falls a few months before real GDP rises and falls, thus
anticipating the peaks and troughs of the business cycle. In effect,
this blue leading indicator line parallels movements of the red real GDP
line, but it does so earlier.

Coincident: A click of the [Coincident] button reveals a


thin green line that rises and falls together with the rise and fall of real
GDP, tracking along with the peaks and troughs of the business cycle.
This green coincident indicator line lies virtually on top of the red real
GDP line.

Lagging: A click of the [Lagging] button reveals a thin purple line


that rises and falls a few months after real GDP rises and falls. In this

case, the purple lagging indicator line also parallels movements of


the red real GDP line, but it does so after the fact.

Business Life Indicators

Valuable Information
Tracking business cycle activity, especially peak and trough turning
points, can be quite useful. At the very least, this information can help
anticipate and possibly avoid the problems of unemployment
and inflationthat tend to arise during specific business cycle phases.
If, for example, Dan Dreiling works in an industry that tends to
suffer high rates of unemployment during contractions, then identifying
business cycle peaks that mark the onset of contractions can help him
prepare for an upcoming layoff. He might want to postpone
expenditures, add a little extra into his savings account, or even search
for other employment.
Alternatively, if Winston Smythe Kennsington III has a great deal
offinancial wealth that could be reduced by inflation, then identifying
business cycle troughs that mark the onset of expansions can also
provide valuable information. Knowing that an expansion is about to
begin, he might want to rearrange his investment portfolio, transferring
his financial wealth between stocks, bonds, and assorted bank accounts.
While individuals can personally benefit from business cycle
indicators, this information is perhaps even more useful to
government policy makers (especially the President, Congress,
and Chairman of the Federal Reserve System). Because the
public has entrusted these folks with the responsibility of
solving economic problems and guiding the country to
prosperity, they MUST stay informed about business cycle

activity. NOT staying informed is just the sort of thing that can
transform a President into an EX-President or an elected
politician into a lobbyist.
Working Together
Of the three sets of indicators, leading indicators tend to get the most
notoriety. The reason is probably obvious--by virtue of forecasting
coming events. All three, however, have important roles to play in
tracking business cycles.
On the Horizon: Leading indicators "predict" what the economy will
be doing a few months down the road. In contrast, coincident indicators
document what the economy is currently doing and lagging indicators
reinforce what happened to the economy a few months back. Knowing
what WILL happen is almost always more important that knowing what
IS happening or what DID happen already.
However, while leading indicators TEND to predict business
cycles, they are not always correct. In fact, leading indicators
have actually predicted "12 of the last 9 contractions." In other
words, they predicted 3 contractions that never happened.
The Here and Now: While leading indicators might predict
business cycles, it is nice to document the actual event, which is the role
of coincident indicators. Having accurate information about CURRENT
economic conditions is not as easy as it might seem. Collecting,
processing, and analyzing data takes time
Over and Done: At this point there might be some question about
the usefulness of lagging indicators. Of what good is knowing the state
of the economy several months AFTER the fact? In the wacky world of
economic number crunching, lagging indicators actually have a useful
role. In particular, lagging indicators are needed to "finalize" the most
recent contraction. Lagging indicators must mark the trough of the
previous contraction before leading indicators can signal the peak of the
current expansion and the beginning of the next contraction. In other
words, the next recession cannot start until the lagging indicators
indicate that the last one is over.

Q4. Discuss the implications of EMH for security analysis


and portfolio management.
Answer: Active investing is like betting on who will win the Super Bowl,
while passive investing would be like owning the entire NFL, and thus
collecting profits on gross ticket and merchandise sales, regardless of
which team wins each year. Active investing means you (or a mutual
fund manager or other investment advisor) are going to use an
investment approach that typically involves research such as

fundamental analysis , micro and macroeconomic analysis and/or


technical analysis, because you think picking investments in this way
can deliver a better outcome than owning the market in its entirety. Using
the NFL analogy, you would study all the players and coaches, go to
preseason training, and based on your research make an educated bet
as to which teams would be on top for the year. Would you be willing to
bet your money on your ability to choose right? An active investor or
active strategy is doing just that. With a passive approach you would buy
index funds and own the entire spectrum of available stocks and bonds.
It would be like owning the NFL; not every team is going to win, but you
don't care because you know some merchandise is bound to be sold
each year. With a passive approach you simply want to make money
based on the collective outcome of all stocks and bonds pooled together.
Passive Captures the Return of an Entire Market
When you take this analogy, and apply it to investing, first you look at the
entire market of available stocks. A passive investor wants to own all the
stocks, because they think as a whole, over long periods of time,
capitalism works, and they are likely to receive higher returns from
investing in the entire stock market than by trying to pick the individual
stocks which will outperform the market as a whole.
Actively Managed Funds vs. Passive Funds
When you look at mutual funds, an actively managed large cap mutual
fund will try to pick the best 100-200 stocks listed in the S&P 500 Index.
A passive fund, or index fund, would own all 500 stocks that are listed in
the S&P 500 Index with no attempt to pick and choose among them.
Each year academic studies are conducted to compare the returns of
actively managed funds to the returns of passive funds. Studies show
that in the aggregate over long periods of time actively managed funds
do not generally deliver returns higher than their passive counterparts. I
explain why in How to Find the Best Mutual Funds. The reason why has
to do with fees. Active funds incur higher costs and the fund manager
must first garner additional returns to cover the costs before the investor
would begin to see performance that was higher than the comparable
index fund. Why does an active approach cost more? It takes time to do
research, and actively managed funds spend more money on overhead
and staffing.
Passive Can Be More Tax Efficient
Passive funds do not do a lot of trading, which means not only do they
have lower fees, but they also have less capital gains distributions that
will flow through to your tax return. If you invest using non-retirement
accounts this means a passive approach used consistently may reduce
your ongoing tax bill. If you want to combine active and passive

approaches you may look at putting actively managed funds inside tax
sheltered accounts like IRAs, while using a passive approach or a taxmanaged fund for non-retirement accounts.
Misunderstandings About Active vs Passive
Most of the time the active vs. passive debate is focused around
whether a mutual fund can outperform its index. For example, studies
may look at how many large cap funds outperform the S&P 500 Index.
However, many funds and investment approaches are not restricted to a
type of stock or bond. For example multi-cap funds may be able to own
large or small cap stocks depending on what the research analysts think
might offer the best performance. In this case you might measure the
long term results of such a fund against something like Vanguard's Total
Stock Market Index Fund. Additional confusion comes from the fact that
Investment advisors may use passive index funds, but use a tactical
asset allocation approach to decide when the portfolio should own more
or less of a particular asset class. In this way passive funds are being
used within an active or semi-active approach.
Passive Investing Best for Most
I believe most investors are better off following a passive investment
approach. If you are not the do-it-yourself type, then work with an
investment advisor who uses passive funds. If you find you have the
time to do your own research and you enjoy spending hours a day at the
computer working on your portfolio, than a more active approach might
work.

Implication of investors and companies


EMH and Technical Analysis
Technical analysis bases decisions on past results. EMH, however,
believes past results cannot be used to outperform the market. As a
result, EMH negates the use of technical analysis as a means to
generate investment returns.
With respect to fundamental analysis, the EMH also states that all
publicly available information is reflected in security prices and as such,
abnormal returns are not achievable through the use of this information.
This negates the use of fundamental analysis as a means to generate
investment returns.
EMH and the Portfolio Management Process
as we have discussed, the portfolio management process begins with an
investment policy statement, including an investor's objectives and
constraints. Given EMH, the portfolio management process should thus,

not focus on achieving above-average returns for the investor. The


portfolio management process should focus purely on risks given that
above average returns are not achievable.
A portfolio manager's goal is to outperform a specific benchmark with
specific investment ideas. The EMH implies that this goal is
unachievable. A portfolio manager should not be able to achieve above
average returns.
Why Invest in Index Funds?
Given the discussion on the EMH, the overall assumption is that no
investor is able to generate an abnormal return in the market. If that is
the case, an investor can expect to make a return equal to the market
return. An investor should thus focus on the minimizing his costs to
invest. To achieve a market rate of return, diversification in a numerous
amounts of stocks is required, which may not be an option for a smaller
investor. As such, an index fund would be the most appropriate
investment vehicle, allowing the investor to achieve the market rate of
return in a cost effective manner.
Conclusion
Within this section we have discussed the organization and function of
securities markets, the composition and characteristics of the various
weighting schemes, and the various implications of the efficient market
hypothesis.