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BKID: B1035 Assignment Set- 1 (30 Marks) Note: Each question carries 10 Marks. Answer all the questions.

Q. 1 Is there any logic behind technical analysis? Explain meaning and basic tenets of technical analysis. Ans: No, there is no logic behind technical analysis. Technical analysis is based on the assumption that markets are driven more by psychological factors than fundamental values. While fundamental analysts examine earnings, dividends, new products, research and the like, technical analysts examine what investors fear or think about those developments and whether or not investors have the where with all to back up their opinions; these two concepts are called psych (psychology) and supply/demand. In the M = P/E equation, technicians assess M, the multiple investors do/may pay - if they have the money - for the fundamentals they envision. Technicians employ many techniques, one of which is the use of charts. Using charts, technical analysts seek to identify price patterns and trends in financial markets and attempt to exploit those patterns. Technicians use various methods and tools, the study of price charts is but one. Supply/demand indicators monitor investors' liquidity; margin levels, short interest, cash in brokerage Accounts, etc., in an attempt to determine whether they have any money left. Other indicators monitor The state of psych - are investors bullish or bearish? - And are they willing to spend money to back up their beliefs. A spent-out bull cannot move the market higher, and a well heeled bear won't; investors need to know which they are facing. In the end, stock prices are only what investors think; therefore determining what they think is every bit as critical as an earnings estimate. Technicians using charts search for archetypal price chart patterns, such as the well-known head and Shoulders or double top/bottom reversal patterns, study indicators, moving averages, and looks for forms Such as lines of support, resistance, channels, and more obscure formations such as flags, pennants, Balance days and cup and handle patterns. Technical analysts also widely use market indicators of many sorts, some of which are mathematical Transformations of price, often including up and down volume, advance/decline data and other inputs. These indicators are used to help access whether an asset is trending, and if it is, its probability of its Direction and of continuation. Technicians also look for relationships between price/volume indices and Market indicators. Examples include the relative strength index, and MACD. Other avenues of study Include correlations between changes in options (implied volatility) and put/call ratios with price. Also Important are sentiment indicators such as Put/Call ratios, bull/bear ratios, short interest and Implied Volatility, etc. There are many techniques in technical analysis. Adherents of different techniques (for example, Candlestick charting, Dow Theory, and Elliott wave theory) may ignore the other approaches, yet many traders combine elements from more than one technique. Some technical analysts use subjective

Technical analysis is frequently contrasted with fundamental analysis. Some traders use technical or fundamental analysis exclusively. ii) Unlike fundamental analysts. while others use both types to make trading decisions which conceivably is the most rational approach. Some prefer the term Technical market analyst or simply market analyst. . An older term. Users of technical analysis are often called technicians or market technicians. These shifts can be detected in charts / graphs. Fundamental indicators are subject to the same limitations. is sometimes used. ii) Any shifts in supply & demand cause reversals in trends. chartist. but as the discipline has expanded and modernized. iii) Technical analysis disregards the financial statements of the issuer. Many chart patterns tend to repeat themselves. imperfect as they may be. c) History tends to repeat itself: i) It is in terms of price movements.random price patterns and trends in financial markets and attempt to exploit those patterns. Uncovering those trends is what technical indicators are designed to do. technical analysts do not care whether a stock is undervalued or not – the only thing that matters to them is a security’s past trading data and what information this data can provide about where the security is moving in the future. a) The market discounts everything: i) Technical analysis assumes that any given point of time. b) Price moves in trends: i) Technical analysis believes that security prices tend to move trends that persist for long periods of time. Meaning & basic tenets of technical analysis: i) Technical analysis identifies non. Technical analysis holds that prices already reflect all such trends before investors are aware of them. along with broader economic factors and market psychology are all built into the security price and therefore there is no need to study these factors separately. Others employ a strictly mechanical or systematic approach to pattern identification and interpretation. Below are the three basic tenets of the technical analysis: 1) the market discounts everything 2) price moves in trends and 3) history trends to repeat itself. a security’s price incorporates all the factors that can impact the price including the fundamental factors. Instead it relies upon market trends to ascertain investor sentiments that can be used to predict how a security will perform. as it is only one aspect of technical analysis.judgment to decide which pattern(s) a particular instrument reflects at a given time. and what the interpretation of that pattern should be. the study of economic factors that influence the way investor’s price financial markets. naturally. ii) Technical analysts believe that the company’s fundamentals. the use of the term chartist has become less popular.

If this were strictly true.Accurate pricing is required if individuals are to be encouraged to invest in companies.ii) Market psychology is considered to be the reason behind the repetitive nature of price movements: market participants react in a consistent manner to similar market stimuli over a period of time. . many savers will refuse to invest.Maximization of shareholder wealth is the goal of the manager of a company. then the company will be able to issue new capital by issuing shares.. ii) To give correct signals to company managers .It is important that managers receive feedback on their decisions from the share market. i) To encourage share buying . There are three major versions of the hypothesis: "weak". This would be bad for the economy as these funds would be better utilized elsewhere The validity of the hypothesis has been questioned by critics who blame the belief in rational markets for Much of the financial crisis of 2007–2010. and thus attract more of economy’s savings for its use. the efficient-market hypothesis (EMH) asserts that financial markets are "information ally Efficient". stocks. so that they are encouraged to pursue shareholder wealth strategies.The high price will seriously reduce the availability of funds to companies and retard the growth in the economy. and "strong". Semi-strong EMH claims both that prices reflect all publicly available information and that Prices instantly change to reflect new public information. or property) already reflect all past publicly available Information. one cannot consistently achieve returns in excess of average market returns on a risk adjusted basis. That is. given the information publicly available at the time the investment is made. Weak EMH claims Those prices on traded assets (e.Investors need assurance that they are paying the fair price for their acquisition of shares & that they will be available to sell their holdings at a fair price. bonds.2 Explain role played by efficient market in economy. the market can be just as Unstable. Answer: 1In finance. "semi-strong". Apply the parameters of efficient market to Indian stock markets and find out whether they are efficient. no investment strategy .g. iii) To help allocate resources: If a badly run company in a declining industry has shares that are highly valued because the stock market is not pricing them correctly. Strong EMH additionally claims that prices instantly reflect even hidden or "insider" information. Q. There is evidence for and against the weak and Semi-strong EMHs. The performance of a financial market depends on how efficiently the capital is allocated by the market. Defenders of the EMH caution that conflating market stability With the EMH is unwarranted. The (now largely discredited) theory that all market participants receive and act on all of the Relevant information as soon as it becomes available. . because of fear that when they have to sell their shares. while there is powerful evidence against strong EMH. If shares are incorrectly priced. when publicly available information is unstable. .

Groenewold and Kang (1993) found Australian market semi-strong form efficient. On the other hand. 2002. Korea (Ryoo and Smith.would be better than a coin toss. In its weak form efficiency. find that volatility is highly persistent and is predictable. the price of a stock should reflect the knowledge And expectations of all investors. Insiders profit from trading on information not already incorporated into prices. this study uses a variance ratio test and find the market to follow a random walk process if the price limits are relaxed during the period March 1988 to Dec 1988). but insider trading is illegal). 2002). 2002). . of course.weak. Slovenia (Dezlan. Hence the strong form does not hold in a world with an uneven playing field. Some of the recent studies. Proponents of this theory do not try to pick stocks that are going to be winners. (lee et al 2001. equity returns are not serially correlated and have a constant mean. current prices fully reflect all information contained in the historical prices of the Asset and a trading rule based on the past prices can not be developed to identify miss-priced assets. he used daily BSE index data for the period 1987 to 1994. Studies testing market Efficiency in emerging markets is few. The random walk hypothesis is used to explain the successive price changes which are independent Of each other. Gup and Pan (1997) observed that the major Asian markets were weak form inefficient. This means that whatever information is available about a stock to one Investor is available to all investors (except. The idea that asset prices may follow a random walk pattern was introduced by Bachelier in 1900. Spain (Regulez and Zarraga. Chan. authors use GARCH and EGARCH models in this study). authors use a variance ratio test in this study and find that Hang Seng index on the Hong Kong stock exchange follow a random walk). The strong form efficiency suggests that security prices reflect all available information. Cheung et al (1993) for Korea and Taiwan. Poshakwale (1996) showed that Indian stock market was weak Form inefficient. If market Is weak form efficient. When new information is released. even private information. they simply try to match the market's performance. China. trading rules are incapable Of producing superior returns. Studies on Indian Stock Market Efficiency: The efficient market hypothesis is related to the random Walk theory. Since everyone has the same information about a stock. instead. Market is semi-strong efficient if stock prices reflect any new publicly available information Instantaneously. Hong Kong (Cheung and Coutts 2001. testing the random walk hypothesis (in effect testing for weak form efficiency in the markets) are. There are no undervalued or overvalued securities and thus. there is ample evidence to dispute the basic claims of this theory. Fama (1991) classifies market efficiency into three forms . Similar results were found By Dickinson and Muragu (1994) for Nairobi stock market. However. semi-strong and strong. Proponents of the efficient market theory believe that there is perfect Information in the stock market. and most investors don't believe it. and Ho and Cheung (1994) for Asian markets. Czech Republic (Hajek. Barua (1987). The bottom line is that an investor should not be able to beat the market since there is no way for him/her to know something about a stock that isn't already reflected in the stock's price. Barnes (1986) showed a high degree of Efficiency in Kuala Lumpur market. 2000). insider information. it is fully incorporated into the price rather speedily.

The test observes the sequence of successive price changes with the same sign. It is non-parametric and does not require the returns to be normally distributed. 2003). 2003) and the Middle East (Abraham et al. εt is random and stationary and also exhibits no autocorrelation. the augmented Dickey-Fuller test (Dickey and Fuller 1979) and different variants of these are the most commonly used tests for the random walk hypothesis in recent years (Worthington and Higgs 2003. 2002. Gup and Pan 1997).Turkey (Buguk and Brorsen. Chan. Appiah-kusi and Menyah. this study uses variance ratio test and the runs test to test for random walk for the period 1992 to 1998 and find that these markets are not efficient). Runs test determines if successive price changes are independent. Runs test (Bradley 1968) and LOMAC variance ratio test (Lo and MacKinlay 1988) are used to test the weak form efficiency and random walk hypothesis. 1992). and the market is considered not efficient. In essence the assumption of random walk means that either the returns follow a random walk process or that the model used to identify the process is unable to identify the true return generating process. exponential smoothing and decomposition approaches presume that the values of the time series being predicted are statistically independent from one period to the next. It only tests for the relationship between an error . In this study we have used returns and not prices for test of market efficiency as expected returns are more commonly used in asset pricing literature (Fama (1998). Regression. LOMAC variance ratio test is commonly criticised on many issues and mainly on the selection of maximum order of serial correlation (Faust. Durbin-Watson test (Durbin and Watson 1951). Kleiman. as disturbance term cannot possess any systematic forecast errors. DurbinWatson (DW) is a test for first order autocorrelation. 2002. Serial correlation coefficient test is a widely used procedure that tests the relationship between returns in the current period with those in the previous period. Returns in a market conforming to random walk are serially uncorrelated. the best forecaster of future price is the most recent price. If no significant autocorrelation are found then the series are expected to follow a random walk. If a model is able to identify a pattern. Some of these techniques are reviewed in the following section and appropriate techniques identified for use in this study. There are a number of techniques available to determine patterns in time series data. The null hypothesis of randomness is determined by the same sign in price changes. a market is (weak form) efficient if most recent price has all available information and thus. Africa (Smith et al. Payne and Sahu 2002. METHODOLOGY & DATA:-To test historical market efficiency one can look at the pattern of short-term movements of the combined market returns and try to identify the principal process generating those returns. If the market is efficient. then historical market data can be used to forecast future market prices. the model would fail to identify any pattern and it can be inferred that the returns have no pattern and follow a random walk process. Parametric serial correlations tests of independence and nonparametric runs tests can be used to test for serial dependence. A simple formal statistical test was introduced was Durbin and Watson (1951). This is one of the major weaknesses of the test. The runs test only looks at the number of positive or negative changes and ignores the amount of change from mean. corresponding to a random walk hypothesis with dependant but uncorrelated increments. Under the random walk hypothesis. In the most stringent version of the efficient market hypothesis.

Brooks 2002). Gup and Pan 1997.g. Three regression models (standard model. The second-best alternative is to test for autocorrelation that would allow examination of the relationship between ut and several of its lagged values at the same time. In this study we followed the test methodologies from Brooks (2002) with slight adjustments. The objective of the test is to test the null hypothesis that θ = 1 in: against the one-sided alternative θ < 1. if corr(ut. Because of the abovementioned weaknesses of the DW test we do not use the DW test in our study. One way to motivate this test is to regress the error of time t with its previous value.σ2v). εt** = error terms that could be ARMA processes with time dependent variances. εt*. ut = ρut-1 + vt where vt ~ N(0. DW as defined earlier will not find any autocorrelation. (Chan. DW test can not detect some forms of residual autocorrelations. e.and its immediately preceding value. Equation (3) is for the standard model. ut-1) = 0 but corr(ut. with drift and with drift and trend) are used in this study to test for unit root in the research. Where St is the logarithm of the price index seen at time t. Thus the hypotheses to be tested are: H0: Series contains a unit root against H1: Series is stationary . An alternative model which is more commonly used is Augmented Dickey Fuller test (ADF test). (4) for the standard model with a drift and (5) for the standard model with drift and trend. The Breusch. Where: St = the stock price u* and u** = the drift terms T = total number of observations εt. ut2) ≠ 0.Godfrey test is a more general test for autocorrelation for the lags of up to r‟th order. One possible way is to do it for all possible combinations but this is tedious and practically impossible to handle. u is an arbitrary drift parameter. Augmented DickeyFuller (ADF) unit root test of nonstationarity is conducted in the form of the following regression equation. α is the change in the index and εt is a random disturbance term.

suggesting that these markets do not show characteristics of random walk and as such are not efficient in the weak form. The time period for BSE is from 24th May 1991 to 26th May 2006 and for NSE 27th May to 26th May 2006. similarly the variance of NSE is lower as compared with BSE index suggesting a lower risk and a lower average return at NSE as compared with BSE.In this study we calculate daily returns using daily index values for the Mumbai Stock Exchange (BSE) and National Stock Exchange (NSE) of India. During the period covered in this study. the settlement ‟ system on BSE was intermittent (Badla system up until 2nd July 2001) and on NSE it was always cash. Stock exchanges are closed for trading on weekends and this may appear to be in contradiction with the basic time series requirement that observations be taken at a regularly spaced intervals. The underlying process of the series in this case is trading of stocks and generation of stock exchange index based on the stock trading. using stock market indexes for the Indian markets.This study conducts a test of random walk for the BSE and NSE markets in India. Results are presented in Table 2. RESULTS:. We further test the series using the Phillips-Perron tests and the KPSS tests for a confirmatory data analysis. For both BSE and NSE markets. The data is collected from the Datastream data terminal from Macquarie University. We also test using Phillip-Perron test and KPSS test for confirmatory data analysis and find the series to be stationary. Table 1 presents the characteristics of two data sets used in this study. It is relevant to note that NSE was established by the government of India to improve the market efficiency in Indian stock markets and to break the monopolistic position of the BSE. . In case of BSE and NSE markets. the results are statistically significant and the results of all the three tests are consistent suggesting these markets are not weak form efficient. as such for this study the index values at the end of each business day is appropriate (French 1980). It employs unit root tests (augmented Dickey-Fuller (ADF)). This can also be due to the unique nature of India s equity markets. We perform ADF test with intercept and no trend and with an intercept and trend. the null hypothesis of unit root is convincingly rejected. the mean return of the NSE index is much lower than that of the BSE. as the test statistic is more negative than the critical value. is that the frequency be spaced in terms of the processes underlying the series. The requirement however. NSE index is a more diversified one as compared to the same of BSE.

Since the results of the two tests are contradictory. These results support the common notion that the equity markets in the Emerging economies are not efficient and to some degree can also explain the less optimal allocation of Portfolios into these markets. The results of these tests find that these markets are Not weak form efficient. as such the results may be significantly different if the changes in the settlement system are incorporated in the analysis. This notion of market efficiency has an important bearing for the fund managers and investment bankers and more specifically the investors who are seeking to diversify their portfolios internationally. It is important to note that the BSE moved to a system of rolling settlement with effect from 2nd July 2006 from the previously used „Badla‟ system. One of the criticisms of the supporters of the international diversification into emerging markets is that the emerging markets are not efficient and as such the investor may not be able to achieve the full potential benefits of the international diversification. On the contrary a conflicting viewpoint is that the results of these markets may have been influenced by volatility spillovers. For future research. PP and the KPSS tests and find similar results. . which is a test for serial correlations. it is difficult to draw Conclusions for practical implications or for policy from the study. We employ three different tests ADF. has been used in the past but the explanatory power of the DW can be questioned on the basis that the DW only looks at the serial correlations on one lags as such may not be appropriate test for the daily data. as such the results of these markets may be interpreted cautiously. The results of the NSE are similar (NSE had a cash settlement system from the beginning) to BSE suggesting that the changes in settlement system may not significantly impact the results.This paper examines the weak form efficiency in two of the Indian stock exchanges which represent the majority of the equity market in India. DW test. CONCLUSIONS & IMPLICATIONS: . Current literature in the area of market efficiency uses unit root and test of stationarity.Results of the study suggest that the markets are not weak form efficient. 1996). The research in the area of volatility spillover has argued that the volatility is transferred across markets (Brailsford. using a computationally more efficient model like generalized autoregressive conditional heteroskesdasticity (GARCH) could help to clear this. The „Badla system was a complex system of forward settlement which was ‟ not transparent and was not accessible to many market participants.

• If the yield to maturity for a bond is less than the bond's coupon rate. 3 What do you understand by yield? Explain the concept of YTM with the help of example Meaning of Yield is the discount rate that equates the current market price of the bond with the sum of present value of all cash flows expected from this investment. then the bond is selling at a discount. a) Bond market prices move up & down with interest rate changes. • If a bond's coupon rate is equal to its YTM. then the current yield will be greater than the coupon rate. If the bond is selling for a discount. c) The yield is usually quoted without making any allowance for tax paid by the investor on the return. and is then known as "gross redemption yield". 20 year bond with a face value of Rs. Example : if the bond is selling for a discount .Yield-to Maturity : This is the investor’s total return if the bond is held to its maturity date. then the bond is selling at par iii) Yield to call : Yield on a bond computed on the basis of assumption that its issuer will redeem it at the first call date stated in the bond's prospectus (indenture agreement). b) It is the annual rate of return that a bondholder will earn under the assumptions that the bond is held to maturity and the interest payments are reinvested at the YTM. Different types of yields: i) Current yield: It is annual interest / current price. • If a bond's coupon rate is less than its YTM. plus the difference between what the investor paid for the bond and the amount of principal received at maturity a) The YTM is same as the bond’s internal rate of return ( IRR) . then the bond is selling at a premium. then the (clean) market value of the bond is greater than the par value (and vice versa). It is a less precise and less complex method of yield than yield to maturity. Example for the concept for YTM is as below: The company has issued 10% annual coupon. YTM calculation as below : Yeild = Coupon + (Face value – Price) / Maturity _________________________________ . 980. This calculation takes into consideration the bond market price fluctuations and represents the present yield that a bond buyer would receive upon purchasing a bond at given price. then the current yield will be greater than the coupon rate. ii) YTM . It also does not make any allowance for the dealing costs incurred by the purchaser (or seller). 1000 for Rs.Q. It includes the annual interest payments. • If a bond's coupon rate is more than its YTM.

1000 Price = Rs.(Price + face value)/ 2 Coupon = 10% of 1000 = Rs 100. 980 Maturity = 20 year Yield = 100+ (1000-980)/20 ________________ (1000+980)/2 is approximate formula for calculating the YTM = 100/990 = 10. Face value = Rs. .1 % i) The YTM is the annual rate of return that a bondholder will earn under the assumptions that the bond is held to maturity and interest payments are reinvested at the YTM.

In the capital asset pricing model.MBA Semester 3 MF0001 – Security Analysis and Portfolio Management . sometimes called specific risk. if the setback were to affect the entire industry instead. unsystematic risk. the risk of loss from some catastrophic event that collapses the entire financial system. It may also derive from the structure and dynamics of the market.2 (30 Marks) Note: Each question carries 10 Marks. unsystematic risk affects a very specific group of securities or an individual security.2 Credits BKID: B1035 Assignment Set. Interest rates. Systematic risk and portfolio management Given diversified holdings of assets. interest rates and so on. sometimes called market risk. Lenders to small numbers of borrowers (or kinds of borrowers) face unsystematic risk of default. the unsystematic portion of which is concentration risk. is the risk associated with aggregate market returns. that is. the rate of return required for an asset in market equilibrium depends on the systematic risk associated with returns on the asset. do you agree? Ans: Systematic risk: In finance. On the other hand. Even a portfolio of well diversified assets cannot escape all risk. Systematic risk is essentially dependent on macroeconomic factors such as inflation.1 With the help of examples explain what is systematic (also called systemic) and unsystematic risk? All said and done CAPM is not perfect. Systematic risk should not be confused with systemic risk. the investors would incur similar losses. or .000 of stock in 10 biotechnology companies. an investor's exposure to unsystematic risk from any particular asset is small and uncorrelated with the rest of the portfolio. Q. on the covariance of the returns on the asset and the aggregate returns to the market. Whereas this type of risk affects a broad range of securities. idiosyncratic risk. Their loss due to default is credit risk. residual risk. systematic risk.000 in a single biotechnology company would incur ten times the loss from such an event. recession and wars all represent sources of systematic risk because they affect the entire market and cannot be avoided through diversification. aggregate risk. It is the risk which is due to the factors which are beyond the control of the people working in the market and that's why risk free rate of return in used to just compensate this type of risk in market. Unsystematic risk By contrast. or Un diversifiable risk. Hence. Finally. the investor incurs a loss. If unforeseen events cause a catastrophic setback and one or two companies' stock prices drop. consider an individual investor who purchases $10. interest rates or inflation. the contribution of unsystematic risk to the riskiness of the portfolio as a whole may become negligible. Example Examples of systematic risk include uncertainty about general economic conditions. Answer all the questions. For example. The second investor's portfolio has more unsystematic risk than the diversified portfolio. such as GNP.Master of Business Administration. an investor who purchases $100. Systematic risk can be mitigated only by being hedged. due to systematic risk.

Some data to this effect was presented as early as a 1969 conference in Buffalo. are examples of unsystematic risk. causing market prices to be informationally inefficient. such as a gold mining company striking gold. This type of risk can be reduced by assembling a portfolio with significant diversification so that a single event affects only a limited number of the assets. Example On the other hand.diversifiable risk. Total Risk = Systematic risk + Unsystematic Risk The risk that is specific to an industry or firm.” Also known as specific risk. This is the risk other than systematic risk and which is due to the factors which are controllable by the people working in market and market risk premium is used to compensate this type of risk. and systematic risk can not be. Risk: Systematic and Unsystematic We can break down the risk. nationalization of assets.or industry-specific risk as opposed to overall market risk. Indeed risk in financial investments is not variance in itself. of holding a stock into two components: systematic risk and unsystematic risk: Total CAPM is not perfect:The model assumes that either asset returns are (jointly) normally distributed random variables or that investors employ a quadratic form of utility. The model assumes that the variance of returns is an adequate measurement of risk. The model assumes that all investors have access to the same information and agree about the risk and expected return of all assets (homogeneous expectations assumption). announcements specific to a company. rather it is the probability of losing: it is asymmetric in nature. The model does not appear to adequately explain the variation in stock returns. large swings (3 to 6 standard deviations from the mean) occur in the market more frequently than the normal distribution assumption would expect. A different possibility is that investors' expectations are biased. which is uncorrelated with aggregate market returns. and residual risk. Unsystematic risk can be mitigated through diversification. The model assumes that the probability beliefs of investors match the true distribution of returns. or weather conditions. which uses psychological assumptions to provide alternatives to the CAPM such as the overconfidence-based asset pricing model of Kent Daniel. Company. As a result. is the company-specific or industry-specific risk in a portfolio. As the saying goes. Examples of unsystematic risk include losses caused by labor problems. unsystematic risk can be reduced through diversification. diversifiable risk. and AvanidharSubrahmanyam (2001). New York in a paper by Fischer . David Hirshleifer. U. Empirical studies show that low beta stocks may offer higher returns than the model would predict. This might be justified under the assumption of normally distributed returns. This possibility is studied in the field of behavioral finance. It is however frequently observed that returns in equity and other markets are not normally distributed. but for general return distributions other risk measures (like coherent risk measures) will likely reflect the investors' preferences more adequately. “Don't put all of your eggs in one basket.

the profit being the difference between the market prices. it has been shown that this substitution is not innocuous and can lead to false inferences as to the validity of the CAPM. In principle and in academic use. The basic insights of the model are extended and generalized in the intertemporal CAPM (ICAPM) of Robert Merton. multiple portfolios: for each goal one portfolio. This was presented in greater depth in a paper by Richard Roll in 1977.) In practice. The market portfolio should in theory include all types of assets that are held by anyone as an investment (including works of art. the CAPM might not be empirically testable. where each asset is weighted by its market capitalization.. It also assumes that all assets are infinitely divisible as to the amount which may be held or transacted. but makes the EMH wrong – indeed. 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. so that there is no opportunity to consume and rebalance portfolios repeatedly over time. This assumes no preference between markets and assets for individual investors.. human capital. Ans: In economics and finance. This is in sharp contradiction with portfolios that are held by individual investors: humans tend to have fragmented portfolios or. 2 What do you understand by arbitrage? Make a critical comparison between APT & CAPM. rather. although this assumption may be relaxed with more complicated versions of the model. or it is irrational (which saves CAPM. some minor (such as fluctuation of prices decreasing profit margins). It does not allow for investors who will accept lower returns for higher risk. as in statistical arbitrage. and the consumption CAPM (CCAPM) of Douglas Breeden and Mark Rubinstein. it may refer to expected profit. though losses may occur. and it has been said that due to the inobservability of the true market portfolio. The model assumes that given a certain expected return investors will prefer lower risk (lower variance) to higher risk and conversely given a certain level of risk will prefer higher returns to lower ones.Black. and Myron Scholes. The market portfolio consists of all assets in all markets. Michael Jensen. in common use. this possibility makes volatility arbitrage a strategy for reliably beating the market). some major (such as . and is generally referred to as Roll's critique. there are always risks in arbitrage. and in practice. in simple terms. When used by academics. such a market portfolio is unobservable and people usually substitute a stock index as a proxy for the true market portfolio. CAPM assumes that all investors will consider all of their assets and optimize one portfolio. and it is possible that some stock traders will pay for risk as well. Casino gamblers clearly pay for risk. Either that fact is itself rational (which saves the efficient-market hypothesis but makes CAPM wrong). 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 model assumes that there are no taxes or transaction costs. real estate. an arbitrage is risk-free. it is the possibility of a risk-free profit at zero cost. and that investors choose assets solely as a function of their risk-return profile. Q. Unfortunately. The model assumes just two dates.

for example. it is also used to refer to differences between similar assets (relative value or convergence trades). would be arbitrage. for a profit of ¥200. 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. risk. In reality. Converting ¥1000 to $12 in Tokyo and converting that $12 into ¥1200 in London. the asset does not have negligible costs of storage. for example. When the price of a stock on the NYSE and its corresponding futures contract on the CME are out of sync. 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. one can buy the less expensive one and sell it to the more expensive market. The term is mainly applied to trading in financial instruments. this "triangle arbitrage" is so simple that it almost never occurs. and transport it to another region to sell at a higher price.devaluation of a currency or derivative). 3. find that the price of wheat is lower in agricultural regions than in cities. this condition holds for grain but not for securities). Mathematically it is defined as follows: and whereVt means a portfolio at time t. when each leg of the trade is executed the prices in the market may have moved. People who engage in arbitrage are called arbitrageurs—such as a bank or brokerage firm. such as the spot-forward arbitrage (see interest rate parity) are much more common. This type of price arbitrage is the most common. Where securities are traded on more than one exchange. The transactions must occur simultaneously to avoid exposure to market risk. any good sold in one market should sell for the same price in another. such as bonds. The same asset does not trade at the same price on all markets ("the law of one price"). but this simple example ignores the cost of transport. an arbitrage involves taking advantage of differences in price of a single asset or identical cash-flows. But more complicated foreign exchange arbitrages. In academic use. In the simplest example. in common use. particularly arbitrage mechanics. Traders may. See rational pricing. Those with the fastest computers and the most expertise take . as in merger arbitrage. and other factors. "True" arbitrage requires that there be no market risk involved. In practical terms. stocks. 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. 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'. or the risk that prices may change on one market before both transactions are complete. for further discussion. arbitrage occurs by simultaneously buying in one and selling on the other. 2. Two assets with identical cash flows do not trade at the same price. storage. Conditions for arbitrage Arbitrage is possible when one of three conditions is met: 1. 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. derivatives. One example of arbitrage involves the New York Stock Exchange and the Chicago Mercantile Exchange. The activity of other arbitrageurs can make this risky. this is generally only possible with securities and financial products which can be traded electronically. purchase the good. as such. commodities and currencies. Because the differences between the prices are likely to be small (and not to last very long). and even then.

ETFs trade in the open market. (Note that "offshoring" is not synonymous with "outsourcing". known as a Dutch book. such as when a business outsources its bookkeeping to an accounting firm. When a discount appears. and that company can be in the same country as the outsourcing company. the odds of making an 'arb' usually last for less than an hour and typically only a few minutes. Comparison between APT & CAPM APT applies to well diversified portfolios and not necessarily to individual stocks. even after hedging most risk. Different bookmakers may offer different odds on the same outcome of a given event. this is referred to as offshoring. the belief is that there remains some difference which. assets and derivatives with similar characteristics. the arbitrageur makes a low-risk profit. Some types of hedge funds make use of a modified form of arbitrage to profit. they will purchase and sell securities. an arbitrageur will do the reverse. Furthermore. a fund may see that there is a substantial difference between U. many such jobs appear to be flowing towards China. which means "to subcontract from an outside supplier or source". 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. though some which require command of English are going to India and the Philippines. Any given bookmaker will weight their odds so that no one customer can cover all outcomes at a profit against their books. an arbitrageur will buy the underlying securities. In this way. rather than allowing the buying and selling of shares in the ETF directly with the fund sponsor. with prices set by market demand. and sell them in the open market. which most bookmakers invoke when they have made a mistake by offering or posting incorrect odds. However. dollar debt and local currency debt of a foreign country. At present. outsourcing always involves subcontracting jobs to a different company.advantage of series of small differences that would not be profitable if taken individually. huge bets on one side of the market also alert the bookies to correct the market. When a significant enough premium appears. . For example. One problem with sports arbitrage is that bookmakers sometimes make mistakes and this can lead to an invocation of the 'palpable error' rule. As bookmakers become more proficient. while fulfilling a useful function in the ETF marketplace by keeping ETF prices in line with their underlying value. a customer can under some circumstances cover all possible outcomes of the event and lock a small risk-free profit. In popular terms. while simultaneously entering into credit default swaps to protect against country risk and other types of specific risk. This profit would typically be between 1% and 5% but can be much higher. Unlike offshoring.S. represents pure profit. An ETF may trade at a premium or discount to the value of the underlying assets. in order to remain competitive their margins are usually quite low. convert them to shares in the ETF. Any difference between the hedged positions represents any remaining risk (such as basis risk) plus profit. Rather than exploiting price differences between identical assets. by taking the best odds offered by each bookmaker.) Sports arbitrage – numerous internet bookmakers offer odds on the outcome of the same event. and enter into a series of matching trades (including currency swaps) to arbitrage the difference. and hedge any significant differences between the two assets. 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.

Relation between sources determined by no Arbitrage condition. Be aware that correlation does not imply causality. 3 Explain in brief APT with single factor model. Ans : Arbitrage pricing theory (APT). the unsystematic risks of the individual securities offset each other. Difference in Methodology CAPM is an equilibrium model and derived from individual portfolio optimization. A fully diversified portfolio has no unsystematic risk. Empirical models try to capture the relations between returns and stock attributes that can be measured directly from the data without appeal to theory. Empirical methods are based less on theory and more on looking for some regularities in the historical record. There are alternatives.the asset price should equal the expected end of period price discounted at the .not lie on the SML. is a general theory of asset pricing. The CAPM can be viewed as a special case of the APT. CAPM difficult to find good proxy for market returns. Related to empirical methods is the practice of classifying portfolios by style e. APT holds that the expected return of a financial asset can be modeled as a linear function of various macro-economic factors or theoretical market indices. Important for hedging in portfolio formation. Difference in Application APT difficult to identify appropriate factors.g. since everybody agrees upon Q. where sensitivity to changes in each factor is represented by a factor-specific beta coefficient. CAPM is simpler to communicate. APT shows sensitivity to different sources. in finance. Both the CAPM and APT are risk-based models. APT can be extended to multifactor models. The model-derived rate of return will then be used to price the asset correctly . APT is a statistical model which tries to capture sources of systematic risk. APT is more general in that it gets to an expected return and beta relationship without the assumption of the market portfolio. 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.With APT it is possible for some individual stocks to be mispriced . that has become influential in the pricing of stocks.

clearly. however. the relationship should be theoretically justifiable on economic grounds Chen. As a result.the number and nature of these factors is likely to change over time and between economies. The APT model Risky asset returns are said to follow a factor structure if they can be expressed as: where E(rj) is the jth asset's expected return.rate implied by model. however. their impact on asset prices manifests in their unexpected movements 2. That is. also called factor loading. rf is the risk-free rate. does not itself reveal the identity of its priced factors . RRβI FI βGDP FGDP βS FS ε The APT states that if asset returns follow a factor structure then the following relation exists between expected returns and the factor sensitivities: where RPk is the risk premium of the factor. timely and accurate information on these variables is required 4. Note that there are some assumptions and requirements that have to be fulfilled for the latter to be correct: There must be perfect competition in the market. andεj is the risky asset's idiosyncratic random shock with mean zero. this issue is essentially empirical in nature. and the total number of factors may never surpass the total number of assets (in order to avoid the problem of matrix singularity). Idiosyncratic shocks are assumed to be uncorrelated across assets and uncorrelated with the factors. Using the APT Identifying the factors As with the CAPM. arbitrage should bring it back into line. the factor-specific Betas are found via a linear regression of historical security returns on the factor in question. Roll and Ross (1986) identified the following macro-economic factors as significant in explaining . suggested: 1. Several a priori guidelines as to the characteristics required of potential factors are. The theory was initiated by the economist Stephen Ross in 1976. the APT. they should represent undiversifiable influences (these are. Fk is a systematic factor (assumed to have mean zero). the expected return of an asset j is a linear function of the assets sensitivities to the n factors. bjk is the sensitivity of the jth asset to factor k. more likely to be macroeconomic rather than firm-specific in nature) 3. Unlike the CAPM. If the price diverges.

j = 1. surprises in investor confidence due to changes in default premium in corporate bonds.security returns: surprises in inflation. the expected value of the random error. Market indices are sometimes derived by means of factor analysis. As a practical matter. n whererj is the rate of return on asset (or portfolio) j. that is. monthly) and often with significant estimation errors. that is. F1 denotes the factor’s value. a diversified stock index such as the S&P 500 or NYSE Composite Index. bj0 and bj1 are parameters. conditional upon the value of the factor. and "j denotes an unobserved random error. surprises in GNP as indicated by an industrial production index. oil prices gold or other precious metal prices Currency exchange rates Single factor model rj = bj0 + bj1F1 + €j. indices or spot or futures market prices may be used in place of macro-economic factors. . the difference in long-term and short-term interest rates. 2. the risk premium corresponds to the source of the systematic risk. : : : . More direct "indices" that might be used are: short term interest rates. APT prediction. single factor model: The weight λ1 is interpreted as the risk premium associated with the factor. is zero. which are reported at low frequency (e. It is assumed that E[€jl F1] = 0.g. surprise shifts in the yield curve.

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