NMIMS

CAPITAL MARKET
APPLICABLE FOR JUNE 2022 EXAMINATIONS

1. Are Investment and gambling the same? Justify your answer explaining the concept
andcharacteristics of Investment.

Answer:

Concept and importance of investment:

Investing is committing your funds to one or more assets that will be heldover some future
time period. When you invest your money in a fixed deposit, stock or mutual fund you do
so, because you think its value will appreciate over a period of time. The funds that you
invest come from savings or from borrowing money or by liquidating assets already owned
by you. By foregoing consumption today and investing the savings, we expect to enhance
our future consumption possibilities. An investment is a sacrifice of current money or other
resources for future benefit. It denotes conversion of cash or money into a monetary asset
or claim on future money for a return. The two key factors that determine investment
decisions are return and risk.

The concept of investment fundamentals includes analysing the factors influencing the
investment decisions and estimating the possible results. Diversification is another
important factor that helps you to manage your investments by avoiding risk. Preparing an
investment management plan is an essential fundamental of investment. Prepare an
investment management plan that includes the amount you are ready to invest, the types of
investments that you want to make, the risks involved with the planned investments, and
the benefits that would be gained from these investments.By doing so, you will be aware
ofthe possible outcomes of your investment and figure out the alternative to overcome the
losses if any.

Factors that affect investment decisions of a person

  Risk Tolerance of the Investor: It is important to understand the amount of risk that
an investor can bear as all investment schemes carry some form of risk with them.
 Market Dynamics: The condition of market of the particular portfolio helps in
deciding whether it will be profitable to invest or not. For example, the real estate
market in India is at a low point for the past few years and is not able to generate the
returns as expected by the investors.
 Status of the Investor: Factors such as the number of dependents, the disposable
income for investment, tax liability, etc. affect an investor’s decision. For example, a
person with dependents such as parents, wife, and children would prefer to invest
his money for purchasing insurance policies.
 Time Horizon: How long the investor wants to keep his money invested also affects
investment decision. The longer the time horizon, the greater are the returns that an
individual can expect as the risk element reduces with time.
 Knowledge about Investment: An investor must be educated or must have some
knowledge about investment and how it can help him/her utilise the money and
finances effectively. The investor must also have the habit of saving money, as a
reckless and spendthrift person will not be able to invest wisely.

Difference between investment and gambling

Following qualities are essential for a commitment to be known as a ‘secureinvestment’:

• It expects gains while bearing associated risks.
• It is based upon thorough analysis.
• It has a high degree of security of returns and principal.

On the basis of aforementioned properties, you can differentiate gamblingfrom investing.

Gambling would refer to a commitment when following propertiesexist:
• It expects gains while bearing associated risks
• It is not based upon analysis.
• It does not ensure any safety and surety of principal and return.
Similarly, there are speculative investments that can be termed as acommitment of money
when:
• There are expectations of gains while bearing associated risks.
• Thorough analysis is involved.
• There is no safety and surety of principal and return.

Characteristics of investment

Returns: Utility of an investment is calculated primarily on the basis of returns it

generates.Returns can accrue in any of the two forms, capital gains or income. Capitalgains
refer to appreciation in prices of securities whereas income may comprisesources such as
dividends, interest or bonus etc.Every investor is concerned about the future returns that he
can expectduring the course of investment. Such returns are termed as expected
returnsfrom an investment and are symbolized by E(R). In case of secure investments such
as Bank Deposits, T-Bills orgovernment securities, it is very easy to estimate expected
returns, as it iscontractual and mentioned well in advance. However; in case of
speculativeinvestments such as equity shares, commodities, or real estate etc.,
whereexpected return is not guaranteed by issuer, it is not so easy to estimate it.

Risk: In layman’s terms, the term ‘risk’ is the potential that a selected action or activitywill
result in a loss. It is the likelihood of loss or less-than-expected returns. It isoften ignored
traitof an investment.There are various techniques of quantifying financial risk of a
security,though we shall talk about the most commonly accepted version,
StandardDeviations in returns of an asset.

Relationship with existing assets in investment portfolio: Many investors ignore this aspect
of investment alternatives; however; it ismathematically proven as most important factor in
determination of overallportfolio risk. To put it in a simple manner, if new investment
alternative is verydifferent from existing portfolio, it provides good diversification to
portfolio. Adiversified portfolio is always safer because it is not dependent only upon
oneinvestment to generate returns.

Liquidity: Next important trait of an investment to be observed is ‘how easily an

investmentcan be converted into cash at prevailing market prices’ (also known as
conversionat fair value).If an investment can be easily sold without causing its prices to
significantlychange as a result, it is said to be liquid in nature. Example of the most
liquidasset is foreign currencies that have one of the most liquid markets of all otherasset
classes.

2. You are given the following data:

Name of the company Expected Expected return in percent

Beta
A 0.95 12
B 0.80 15
C 0.65 13.50
D 0.64 10
E 0.90 12.5
F 0.60 16.5
G 1.25 18

Expected return of the Market - 14%; Risk free rate of return - 5%. With the help of above
given information find the stocks which you would recommendto buy or sell? Which
technique would you employ to calculate the same? List down theother applications if
any?

Answer:

As mentioned in the question, we have:

  Expected beta of the stock
 Expected return in percent
 Expected return of the market
 Risk free rate of return

With the help of this information, we need to recommend which stocks to buy or sell. We
can do this with the help of capital asset pricing model (CAPM) technique.

Capital asset pricing model

The Capital Asset Pricing Model (CAPM) in finance is used to ascertaina suitable rate of
return of an asset, if it is to be included to awell-diversified portfolio, given the non-
diversifiable risk. The modelconsiders the sensitivity of the asset to non-diversifiable risk,
alsocalled systematic risk or market risk, shown with the quantity beta (β)in the financial
industry, the expected return of the market and theprojected return of a hypothetical risk-
free asset

CAPM = Risk-Free Rate of Return +Beta (Return of Market – Risk-Free Rate of Return)

CAPM = Rf + β (Rm – Rf)

Name of the company Expected Expected return in percent

Beta
A 0.95 12
B 0.80 15
C 0.65 13.50
D 0.64 10
E 0.90 12.5
F 0.60 16.5
 G 1.25 18

Expected return of the Market - 14%; Risk free rate of return - 5%.

Company A
CAPM = Rf + β (Rm – Rf)
= 5 + 0.95 (14-5)
= 5 + 0.95(9)
= 5+8.55
= 13.55

Company B
CAPM = Rf + β (Rm – Rf)
= 5+ 0.80 (14-5)
= 5+ 0.80(9)
= 5+7.2
=12.2

Company C
CAPM = Rf + β (Rm – Rf)
= 5+ 0.65 (14-5)
= 5+0.65(9)
= 5+5.85
= 10.85

Company D
CAPM = Rf + β (Rm – Rf)
= 5+ 0.64 (14-5)
= 5+0.64 (9)
= 5+ 5.76
= 10.76
Company E
CAPM = Rf + β (Rm – Rf)
= 5+ 0.90 (14-5)
= 5+0.90 (9)
= 5+ 8.1
= 13.1

Company F
CAPM = Rf + β (Rm – Rf)
= 5+ 0.60 (14-5)
= 5+0.60 (9)
= 5+5.4
= 10.4

Company G
CAPM = Rf + β (Rm – Rf)
= 5+ 1.25 (14-5)
= 5+1.25 (9)
= 5+11.25
= 16.25

Name of the CAPM Expected return in Buy/ Sell

company percent
A 13.55 12 Overvalued- Sell
B 12.2 15 Undervalued- Buy
C 10.85 13.50 Undervalued- Buy
D 10.76 10 Overvalued- Sell
E 13.1 12.5 Overvalued- Sell
F 10.4 16.5 Undervalued- Buy
G 16.25 18 Undervalued- Buy
If the CAPM is high than expected return, it is overvalued and should be sell-off and vice-
versa.
3. According to Lord Keynes “Given market prices, investors driven by the
speculativemotive, would trade on forecasts of the future market price of stocks, rather
than stocks’intrinsic values.” As a security analyst:
a. Comment on the given statement
b. Given this statement, why do we need fundamental analysis?

Answer:

A)

The study of investments is important as almost everyone who ownswealth in some form,
would be faced with investment decisions sometimein their lives. Individuals have different
financial objectives atdifferent stages of their lives. For example, a retired person may
simplywant to maximise his/her amount of income received. However, ayoungster may
have long-term objectives of building financial securityhis/her entire family. Traditionally,
the investment decision processis divided into security analysis and portfolio management.
Securityanalysis involves the analysis and valuation of individual securities.Portfolio
management utilises the results of security analysis toconstruct security portfolios.

According to Lord Keynes “Given market prices, investors driven by the speculative motive,
would trade on forecasts of the future market price of stocks, rather than stocks’ intrinsic
values.”The economists who followed Keynes and developed Keynesian economics focused
their attention on the debt market but not the stock market. They did so with good reason,
as debt comprises the lion’s share of corporate external financing. However, in The General
Theory Keynes had many important things to say about the stock market and its role in the
economy.

Keynes used the term “enterprise motive” to describe what might motivate an investor to
undertake such an analysis. However, he then argued that the enterprise motive would not
be the primary driver of investors’ trading behavior. Instead, he asserted that another
motive, which he called the “speculative motive,” would primarily drive stock trades. Given
market prices, investors driven by the speculative motive, Keynes said, would trade on
forecasts of the future market price of stocks, rather than stocks’ intrinsic values.

Keynes was clear to say that investors might not believe that the future price of a stock will
coincide with its intrinsic value. Referring to the U.S. stock market, he wrote: “In the
greatest investment market…New York, the influence of speculation…is enormous…When
he purchases an investment, the American is attaching his hopes, not so much to its
prospective yield, as to a favourable change in the conventional basis of valuation.”

One of Keynes’ most important insights about the stock market is his idea about
“conventional basis of valuation.” He explains this phrase to mean that the investor is
anticipating what average opinion expects the average opinion to be. In other words,
investors’ base their forecasts of the future price of a stock on what they estimate are the
forecasts of other investors, rather than their own judgments of intrinsic value.

B)

Fundamental analysis is a technique that is used to evaluate the value of asecurity by

studying the financial data of the issuer of the security. It studiesthe issuer's income and
expenses, its assets and liabilities, its management,and its position in the industry, in short,
focusing on the "basics" of thebusiness, to arrive at the fair value of a security. In contrast,
technicalanalysis analyzes statistics that aregenerated by market activity, such as historical
prices of securities andvolume of trade information, to evaluate securities.

The typical approach to analyzing a company’s security involves four basic steps:
 Determine the condition of the general economy.
 Determine the condition of the industry.
 Determine the condition of the company.
 Determine the value of the company's shares.

Different aspects of fundamental analysis

Economy Analysis: In addition to the economy analysis, fundamental analysis helps
investorsdetermine whether the economic climate offers a positive and
encouraginginvesting environment. Economic analysis is done for two reasons: first,
acompany’s growth prospects are, ultimately, dependent on the economy inwhich it
operates; second, share price performance is generally tied toeconomic fundamentals, as
most companies generally perform well whenthe economy is doing the same.

Industry Analysis: Many times; it is more important to be in the right industry than in the
right stock. While the individual company is still important, its industry group islikely to
exert just as much, if not more, influence on the share price.Industries as a whole tend to
react differently towards different economiccycles. Other factors being equal, companies
from similar industries tend torespond alike towards certain economic conditions; when the
share pricesmove, they usually move as groups.Industries are not only affected by the
varying economic cycles; they arealso influenced by industry-specific news, such as new
product launches, enactment of economic legislation related to the industry or new
rulesframed by the regulatory body that is regulating the industry. The factorsthat the
industry analysis considers to assess the potential of an industryinclude the industry
structure, overall growth rate, market size, importanceto the economy, competition, supply-
demand relationships, product quality,cost elements, government regulation, business cycle
exposure, etc.

Company Analysis: Once the economic forecast and industry analysis has been completed,
the fundamental analyst focuses on choosing the best positioned company inthe chosen
industry. Selecting a company involves an analysis of thecompany’s management, the
company’s financial statements and the keydrivers for future growth. The analyst is looking
for companies with the bestmanagement, strong financials, great prospects, and that are
undervaluedby the market. While doing the analysis, it is to be remembered that the pastis
irrelevant, what you are looking at are future results.