The Required Rate of Return is the return that is required by an investor based on the

risk of the investment. It has three main components:

1. Risk Free Rate (RFR)

2. Expected Inflation Rate Premium (IP)
3. Risk Premium
the two sources are ;interest income and roll yield

Rate of return on investment is the income generated from the investment that
the investor would expect according to the market condition.

Rate of return is that number of percentage return which should compensate

the investor in such a way that the risk he has taken is reflected by the return
of investment.

Rate of return comprises of risk free rate+ liquidity risk +default risk premium +
inflation+ others factors .

Risk free rate is the least rate of return that can be achieved by holding zero
risk , example -interest in bank deposit or fixed deposit , if an investor buys
mutual fund he has to be compensated for liquidity premium i.e , not
withdrawing amount for stated period or the lock in period , risk of default
which is always there because any company can default anytime and thus it
has to be compensated , inflation ,other economic and market factors.

The rate of return of return can be derived for every investment asset - i.e ,
stocks , bonds , real estate , gold , etc. Rate of return is based on how much
risky the asset class is.  

Required Rate of return = risk free rate + beta (return on market -risk free
return)

Thus, return on market - risk free return is called as market risk premium. This
is the excess return which is earned by an investor for selecting the market
security. 

Example - risk free rate -4%

Market risk premium - 3%

Beta - 1.2 

Thus , required rate of return is -

4+1.2*3 

=7.6% 

Required rate of return is also called as CAPM i.e , capital asset pricing
method, thus It also helps in deciding whether to add an additional security in
the portfolio or not . Required rate helps in getting an view of what actual
return can be of the security, hence helping with prediction to buy /sell an
asset/security.

DIFFERENCE BETWEEN CAPITAL MARKET THEORY AND PORTFOLIO THEORY

Portfolio theory- This theory is also called Modern portfolio theory, it was

pioneered by Harry Markowitz who was awarded Nobel prize for MPT. This
theory tells how risk averse investors can construct portfolios to maximize the
expected return according to a given level of market risk. This theory takes
into consideration that higher risk higher reward. This theory states that only
risk and return should not be viewed rather how the investment affects the
portfolio's risk and return.

Capital market theory- It is the theory of analysis of the security. It basically

follows Capital asset pricing model. CAPM states the relationship between
expected return and risk of a security.

Formula: Re = Rf+Beta (Rm-Rf)

Where Re = Return on equity, Rf is risk free return Beta is market beta

(measure of sensitivity), Rm is market return.

Similarities between assumptions of portfolio theory and capital market

theory- 

In both the theories, Investors are rational and maximize utility function based
on expected return and standard deviation of the returns of portfolio. 

Difference between assumptions of Portfolio theory and Capital market

theory- Are as following:

Assumptions as per portfolio theory- Are as following:

  The markets are efficient and important and relevant information is
available in public domain.
 Investors are risk averse and they maximize the return by taking more
risk.
 Investors have easy access to correct and fair information.

Assumptions as per capital market theory- Are as following:

 Capital markets are perfectly competitive and are in equilibrium.

 There are no transaction cost and taxes.
 All investors can borrow/lend money on a risk free rate.

Optimal portfolio & Efficient frontier- This is the portfolio that provides

maximum return. It is the highest return to risk combination. Markowitz
efficient frontier is the combination of portfolios that generate maximum
return at various level of risk. Different combination of securities provide
different percentage of return, Efficient frontier describes the best combination
of securities that produces best return at a given level of risk.

6 Biggest Bond Risks

1. Interest Rate Risk and Bond Prices
The first thing a bond buyer should understand is the inverse
relationship between interest rates and bond prices. As interest rates fall,
bond prices rise. Conversely, when interest rates rise, bond prices tend
to fall.1

This happens because when interest rates are on the decline, investors try to
capture or lock in the highest rates they can for as long as they can. To do
this, they will scoop up existing bonds that pay a higher interest rate than the
prevailing market rate. This increase in demand translates into an increase in
bond prices.

On the flip side, if the prevailing interest rate is on the rise, investors would
naturally jettison bonds that pay lower interest rates. This would force bond
prices down.

2. Reinvestment Risk and Callable Bonds

Another danger bond investors face is reinvestment risk, which is the risk of
having to reinvest proceeds at a lower rate than what the funds were
previously earning. One of the main ways this risk presents itself is when
interest rates fall over time and callable bonds are exercised by the issuers.2

The callable feature allows the issuer to redeem the bond prior to maturity. As

a result, the bondholder receives the principal payment, which is often at a
slight premium to the par value.

However, the downside to a bond call is the investor is then left with a pile of
cash they might not be able to reinvest at a comparable rate. This
reinvestment risk can adversely impact investment returns over time.

To compensate for this risk, investors receive a higher yield on the bond than
they would on a similar bond that isn't callable. Active bond investors can
attempt to mitigate reinvestment risk in their portfolios by staggering the
potential call dates of differing bonds. This limits the chance that many bonds
will be called at once.

3. Inflation Risk
When an investor buys a bond, they essentially commit to receiving a rate of
return, either fixed or variable, for the time that the bond is held. And what
happens if the cost of living and inflation increase dramatically, and at a faster
rate than income investment? When this happens, investors will see
their purchasing power erode, and they may actually achieve a negative rate
of return when factoring in inflation.

4. Credit/Default Risk
When an investor purchases a bond, they are actually purchasing a
certificate of debt. Simply put, this is borrowed money the company must
repay over time with interest. Many investors don't realize that corporate
bonds aren't guaranteed by the full faith and credit of the U.S. government
but instead depend on the issuer's ability to repay that debt.4

Investors must consider the possibility of default and factor this risk into their
investment decision. As one means of analyzing the possibility of default,
some analysts and investors will determine a company's coverage
ratio before initiating an investment. They will analyze the company's income
and cash flow statements, determine its operating income and cash flow, and
then weigh that against its debt service expense. The theory is the greater
the coverage (or operating income and cash flow) in proportion to the debt
service expenses, the safer the investment.
5. Rating Downgrades
A company's ability to operate and repay its debt issues is frequently
evaluated by major rating institutions such as Standard & Poor's Ratings
Services or Moody's Investors Service. Ratings range from AAA for
high credit quality investments to D for bonds in default. The decisions made
and judgments passed by these agencies carry a lot of weight on investors.

If an issuer's corporate credit rating is low or its ability to operate and repay is

questioned, banks and lending institutions will take notice and may charge a
higher interest rate for future loans. This can adversely impact the company's
ability to satisfy its debts and hurt existing bondholders who might have been
looking to unload their positions.4

6. Liquidity Risk
While there is almost always a ready market for government bonds, corporate
bonds are sometimes entirely different animals. There is a risk an investor
might not be able to sell their corporate bonds quickly due to a thin
market with few buyers and sellers for the bond.

Low buying interest in a particular bond issue can lead to substantial price
volatility and adversely impact a bondholder's total return upon sale.5 Much
like stocks that trade in a thin market, you may be forced to take a far lower
price than expected when selling your position in the bon

ROE
By measuring the earnings a company can generate from assets, ROE offers
a gauge of profit-generating efficiency. ROE helps investors determine
whether a company is a lean, profit machine or an inefficient operator.
How Should Return on Equity (ROE) Be Interpreted?
ROE offers a useful signal of financial success since it might indicate whether
the company is earning profits without pouring new equity capital into the
business. A steadily increasing ROE is a hint that management is giving
shareholders more for their money, which is represented by shareholders'
equity. Simply put, ROE indicates how well management is using investors'
capital.

It turns out, however, that a company cannot grow earnings faster than its
current ROE without raising additional cash. That is, a firm that now has a
15% ROE cannot increase its earnings faster than 15% annually without
borrowing funds or selling more shares. However, raising funds comes at a
cost. Servicing additional debt cuts into net income, and selling more shares
shrinks earnings per share (EPS) by increasing the total number of shares
outstanding.

In addition to return and risk objectives, the IPS has to be cognizant of other investment
constraints such as liquidity requirements, the investment time horizon, tax concerns,
legal and regulatory factors, and unique circumstances.

Liquidity
The IPS should detail the likely withdrawal of funds from the portfolio. For institutions,
there could be rules around this, like spending requirements in the case of endowment
funds. When a client has a known liquidity requirement, the portfolio manager should
allocate a portion of the portfolio to cover this liability by ensuring that the allocated
assets can quickly be converted to cash whenever the obligation needs to be met.
Allocating to a bond that has a maturity profile which matches the liability time horizon is
an often-used strategy.

Time Horizon
The IPS should state the time horizon over which the client is investing. Illiquid or risky
assets may be unsuitable for an investor with a short time horizon as they may not have
sufficient time to recover from investment losses.

Tax Concerns
Different investors will have different tax status. The tax status should be stated in the
IPS. Often, tax regimes will treat capital gains and income differently. Capital gains may
be subject to a lower tax rate payable only when they are realized rather than when they
are received. In this instance, there is a time value of money benefit to deferring tax. A
taxable investor may, for example, wish to hold a portfolio which emphasizes capital
gains over dividend income. A tax-exempt investor, on the other hand, may be relatively
indifferent to the two.

Legal and Regulatory Factors

The IPS should outline any applicable legal or regulatory restrictions. In some countries,
pension funds are subject to restrictions on their portfolio composition. In the case of
individuals, they may have access to privileged information on a particular listed
company by virtue of directorship and as such are restricted from trading on that
company ahead of the release of company financial results.

Unique Circumstances
The IPS should also cover any unique circumstances that are applicable. A client may
have religious or ethical objections to investing in particular stocks or sectors. These
types of considerations are often referred to as ESG (environment, social, governance)
factors and investing in accordance with ESG factors is referred to as SRI (socially
responsible investing).
Difference between traditional finance model and behavioural
based model are as follows;
 

              In traditional finance, there is the assumption that the investor

and the market are rational. They receive all the information they need
and their decisions are based on that data.                                              
In behavioral finance, psychology has a role in how people make
financial decisions or investments. Behavioral finance explains that
people are irrational
                 Traditional finance simply states that investors don't make
financial decisions on emotions. While in behavioural finance, our own
emotions and bias have a role to play .
                 In traditional finance , investors receive unlimited knowledge,
data, and information that are perfect. Therefore there's complete
rationality. But in behavioral finance, investors have bounded rationality
so the investor doesn't process all information.investors are  bound to
make an error in judgment.
                  Traditional finance states that the market is efficient and is a
representation of the financial market's true value.      But behavioral
finance believes that the market is volatile and that's why there are
market anomalies.
                  In traditional finance people view all decisions through
transparent and objective lens of risk and return. This is known as
inconsequential frame definition.      But in behavioural finance
perceptions of risk and return are significantly influenced by how
decisions problems are framed. This is onown as frame dependence. 
                Traditional finance carefully consider all information and not
confused by how information is presented.  Whereas behavioural
finance act based on imperfect information and how informtion is
presented.
 

Deviation of investors in a real world from ration behaviour are simply

because of the way our brains are wired .We can overcome some of our
behavioural tendencies that cause deviation from rational behaviour by
learning and understanding the impact of human psychology. Possible
deviations arise in following ways;
Overconfidence bias, is a tendency to hold a false and misleading
assessment of our skills, intellect, or talent. It is  a belief that we’re better than
we actually are. It can be a dangerous bias and is very prolific in behavioral
finance.

Loss aversion, an aspect of prospect theory, asserts that losses loom larger
than gains .

Self serving bias, is a tendency in behavioral finance to attribute good

outcomes to our skill bad outcomes to sheer luck.Most of us can think of
things that we’ve done and determined that when everything is going
according to plan, it’s clearly due to our skill. Then, when things don’t go
according to plan, clearly we’ve just had bad luck.

Cognitive errors, which cause a person’s decisions to deviate from

rationality, fall into two subcategories :

1. Belief preservation errors refer to the tendency to cling to one’s initial

belief even after receiving new information that contradicts it.
2.  Information processing errors refer to mental shortcuts .

Emotional errors arise as a result of attitudes or feelings that cause one to

deviate from rationality .

To account for the deviations from rationality, economic issues are looked at
through a psychological lens that more accurately predicts and explains
human behavior.

DIFFERENCES BETWEEN CAPITAL MARKET LINE AND SECURITY

MARKET LINE
The security market line (SML) is a graph that is drawn with the values obtained from the
capital asset pricing model (CAPM). It is a theoretical presentation of expected returns of assets
that are based on systematic risk.
Non-diversifiable risk is not represented by the SML. In a broader sense, the SML shows the
expected market returns at a given level of market risk for marketable security. The overall level
of risk is measured by the beta of the security against the market level of risk.

Security Market Line Assumptions

Since the security market line is a representation of the CAPM, the assumptions for CAPM are
also applicable to SML. The most notable factor is CAPM is a one-factor model that is based
only on the level of systematic risk the securities are exposed to.
The more the risk the more are the expected returns that are applicable in CAPM are also
applicable in the case of SML.
 All market investors are risk-averse and they cannot affect the price of a security.
 The investment scope for all investors is the same.
 No short sales take place in the market.
 No taxes or transaction costs are applicable.
 Only one risk-free asset is there in the portfolio
 There are numerous risky assets.
 All market participants have access to all necessary information.
The Capital Market Line (CML)
Capital Market Line (CML) represents the portfolios that accurately combine both risk and
return. It is a graphical representation that shows s a portfolio’s expected return based on a
particular level of risk given.
The portfolios on the CML optimize the risk and return relationship. it maximizes the
performance. The slope CML is called the Sharpe Ratio of the portfolio. It is usually popularly
discussed among investors that one should buy assets if the Sharpe ratio is above the CML and
sell if the ratio falls below the CML.

Drawbacks of CML
 Presence of friction − CML considers that there is always some friction in the
market irrespective of the volume and size.
 Taxes and transaction costs − Taxes and transaction costs are needed to be paid by
the investors and these costs can vary from person to person and also in different
geographies.
 The difference in investors worldwide − In the practical world, all investors do not
have access to all the information required to make a good investment decision
Moreover, CML takes into consideration that all investors will behave rationally,
which is not necessary all of the time.
 Absence of risk-free asset − The CML concept is built on the principle of the
existence of risk-free assets. In reality, there is hardly any asset that is a risk-free
asset.
Difference between SML and CML
The security line is derived from the capital market line. CML is used to see a specific
portfolio’s rate of return while the SML shows a market risk and a given time’s return. SML
also shows the anticipated returns of individual assets.
CML shows the total risk and measures it in terms of the SML (beta or systematic risk). Fair-
priced securities are always plotted on the SML and CML. The notable factor is that the
securities which generate higher results for a certain risk, are usually found above the SML or
CML, and they are always underpriced and vice versa.

What are the Different Types of Government Securities in India?

There are several types of government securities offered by the
Reserve Bank of India. Let’s look at the given below:

 Treasury Bills
Treasury bills, also called T-bills, are short term government
securities with a maturity period of less than one year issued by
the central government of India.
Treasury bills are short term instruments and issued three
different types:
1) 91 days
2) 182 days
3) 364 days
Several financial instruments pay interest to you on your
investment; treasury bills do not pay interest because they are
also called zero-coupon securities.
These securities do not pay any interest; instead, they are issued
at a discount rate and redeemed at face value on the date of the
maturity.
For example a 91 day T-bill with a face value of Rs. 200 may be
issued at Rs.196, with a discount of RS. 4 and redeemed at face
value of Rs. 200.
However, RBI performs weekly auctions to issue treasury bills.

 Cash Management Bills (CMBs)

 Cash management bills are new securities introduced in the
Indian financial market. The government of India and the Reserve
Bank of India introduced this security in the year 2010.
Cash management bills are similar to treasury bills because they
are short term securities issued when required.
However, one primary difference between both of these is its
maturity period. CMBs are issued for less than 91 days of a
maturity period which makes these securities an ultra-short
investment option.
Generally, the government of India use these securities to fulfil
temporary cash flow requirements.

 Dated Government Securities

Dated Government securities are a unique type of securities
because they either have fixed or a floating rate of interest also
called the coupon rate.
They are issued at face value at the time of issuance and remains
constant till redemption.
Unlike treasury and cash management bills, government
securities are recognized as long-term market instruments
because they provide a wide range of tenure starting from 5 years
up to 40 years.
The investors investing in dated government securities are called
primary dealers. There are nine different types of dated
government securities issued by the Government of India given
below:
1) Capital Indexed Bonds
2) Special Securities
3) 75% Savings (Taxable) Bonds, 2018
 4) Bonds with Call/Put Options
5) Floating Rate Bonds
6) Fixed Rate Bonds
7) Special Securities
8) Inflation Indexed Bonds
9) STRIPS

 State Development Loans

State development loans are dated government securities issued
by the State government to meet their budget requirements.
The issue is auctioned once every two weeks with the help of the
Negotiated Dealing System.
SDL support the same repayment method and features a variety
of investment tenures. But when it comes to rates, SDL is a little
higher compared to dated government securities.
The major difference between dated government securities and
state development loans is that G-Securities are issued by the
central government while SDL is issued by the state government
of India.

 Treasury Inflation-Protected Securities (TIPS)

Treasury Inflation-Protected Securities (TIPS) are available based
on five, 10 or 30 year term periods. These securities deliver
interest payments to all users every six months.
TIPS are similar to conventional treasury bonds, but it comes with
one major difference. The same principle is issued during the
entire term of the bond in a standard treasury bond.
However, the par value of TIPS will increase gradually to match
up with the Consumer Price Index (CPI) to keep the bond’s
principle on track with inflation.
 If inflation increases during the year, there will be an increase in
the security value during that year. It means you will have a bond
that maintains its value throughout life instead of a bond that’s
worthless after maturity.

 Zero-Coupon Bonds
Zero-coupon bonds are generally issued at a discount to face
value and redeemed at par. These bonds were issued on January
19th 1994.
The securities do not carry any coupon or interest rate as the
tenure is fixed for the security. In the end, the security is
redeemed at face value on its maturity date.

 Capital Indexed Bonds

In these securities, the interest comes in a fixed percentage over
the wholesale price index, which offers investors an effective
hedge against inflation.
The capital indexed bonds were floated on a tap basis on
December 29th 1997.

 Floating Rate Bonds

Floating rate bonds does not come with a fixed coupon rate. They
were first issued in September 1995 as floating rate bonds are
issued by the government.

Investment management also referred to as portfolio

management, is a complex process or activity that may
be divided into eight broad phases / elements.
Phase 1: Review of Investment Avenues: The first step in the investment management
process is to understand the broad characteristics of various investment avenues
available.

Phase 2: Specification of investment Objective and Constraints: The second step in

the portfolio management process is to list down investment objectives and constraints.

Investment objective can be:

1.      Income: to provide a steady stream of income through regular interest / dividend

payment.
2.      Growth: to increase the value of the principal amounts through capital
appreciation.
3.      Stability: to protect the principal amounts invested from the risk of loss.

Investment objectives depend on the risk taking ability of the risk of loss. Investment
selection is the risk return trade off which is affected by the following constraints:

a.      Liquidity / Marketability.
b.      Taxes: Tax shelters should be incorporated while making investment decision.
c.       Times horizon: Long term / Short term.

Phase 3: Choice of Assets Mix: From a wide variety of investment avenues generally

top priority is accorded to residential house and a suitable insurance cover. In
additional, one must maintain a comfortable liquid balance in a convenient form to
meet excepted and unexpected expenses in the short run. While choosing the Debt
equity mix an investor has to understand the two key factors that have a bearing on the
asset mix decision.

a.      Risk tolerance i.e. Risk averse / Risk neutral / Risk seeker.

b.      Investment horizon i.e. Short term / Long term.

Phase 4: Formulation of Portfolio Strategy: After choosing a certain asset mix next

step is to formulate an appropriate portfolio strategy. Two broad choices are available in
this respect, and active portfolio strategy or passive portfolio strategy.
 

1.      Active Portfolio Strategy: An active portfolio strategy is followed by most

investment professionals and aggressive investors who strive to earn superior returns
after adjustment for risk. It involves aggressive management of portfolio with a view to
obtain superior risk adjustment return. The four principal areas of an active strategy are:
a.      Market Timing: In this case according to the market trend forecasts, the portfolios
are churned. E.g. if equity stocks are likely to perform better then bond market then the
proportions of equity is increased in the portfolio and vice versa. It is obvious that
switching from offensive and defensive portfolio is subject to risk.
b.      Sector Rotation: Sector or group rotation may apply to both the stocks based on
their assessed outlooks. For e.g. if infrastructure and engineering goods sectors would
do well in the forthcoming period then stocks portfolio should be titled more towards
these sectors.
c.       Security Selection: Security selection involves a search for under priced securities.
If we resort to active stocks selection we may employ fundamental and / or technical
analysis to identify stocks which seem to promise superior returns.
d.      Use of Specialization Investment Concept: A fourth possible approach to
achieve superior returns is to employ a specialized concept or philosophy particularly
with respect to investment in stocks. Some of the concept that have been exploited
successfully by investment practitioners are;

 Growth stocks.
 Technology stocks.
 Cyclic stocks.

 
2.      Passive Strategy: The passive strategy is based on the premises that the capital
market is fairly efficient with respect to the available information. It involves adhering to
the following guidelines:
Create a well-diversified portfolio at a predetermine level of risk.

a.      Hold the portfolio relatively unchanged over times, unless it becomes inadequately
diversified or inconsistent with the investor’s risk – return preference.

Phase 5: Selection of Securities:

 
1.      Selection of fixed incomes avenues(bonds)

An investor should carefully evaluate the following factors in selecting fixed income

avenues:

a.      Yield to maturity.
b.      Risk of default.
c.       Tax shield.
d.      Liquidity.
2.      Selection of Stocks: Three broad approaches are employed for the selection of
equity shares.a.      Technical analysis: This analysis looks at price behavior and volume
data to determine whether the share will move up or down or remain trend less.
b.      Fundamental analysis: Fundamental analysis focuses on fundamental factors like
earning level, growth prospect and risk exposure to establish the intrinsic value of a
share.
c.       The random selection approach: It is based on the premises that the market is
efficient and securities are properly prices.
3.      Selection of Real Estate / Commodities.

Phase 6: Portfolio Execution: This step is to implement the portfolio plan by buying

and / or selling specified securities in given amounts as planned.

Phase 7: Portfolio Revision: Portfolio revision means changing the assets allocation
of a portfolio.

Due to dynamic developments in the capital markets and the changes in the
circumstance, even a well constructed portfolio tends to become inefficient and hence
need to be monitored and revised periodically. This usually entails two things i.e.
Portfolio rebalancing and portfolio upgrading.

Portfolio rebalancing: This involves reviewing and revising the portfolio composition /

mix i.e. shifting from stocks to bonds or vice-versa. There are three basic policies in
portfolio rebalancing.

a.      Buy and hold policy: where no change is effected and portfolio mix of debt
equity is allowed to drift.
b.      Constant mix policy: where the desired target proportion of debt and equity is
maintained when relative values of debt and equity in the portfolio changes. E.g. if the
target debt equity mix was 50:50 portfolio rebalancing is done to maintain this target of
50:50 when any changes takes place in their market values.
c.       Portfolio insurance policy: increasing the exposure to stocks when portfolio
appreciates in value and vice- versa.

Portfolio updating: This involves re-assessing the risk-return characteristics of various

securities, selling the over – priced securities and buying the under – priced securities. It
also entails other change the investor may consider necessary to enhance the
performance of the portfolio.

Phase 8: Performance Evaluation: The key dimension of portfolio performance

evaluation is the rate of return and risk. Also the performance index models are
commonly used to evaluated the portfolios.

(a)   Assessment of return: The return of the portfolio can be calculated by applying

the Holding period return, Annualized return formulas. In case of intermediate additions
the technique of internal rate of return can be applied to find out the return on the
portfolio.

(b)   Risks: The risk of a portfolio can be measured in various ways. The two most
commonly used measures of risk are variance and beta.

The capital markets can be divided into primary

markets and secondary markets. Newly formed (issued)
securities are bought or sold in primary markets, such as during initial public
offerings. Secondary markets allow investors to buy and sell existing
securities. The transactions in primary markets exist between issuers and
investors, while secondary market transactions exist among investors.

Liquidity is a crucial aspect of securities that are traded in secondary markets.

Liquidity refers to the ease with which a security can be sold without a loss of
value. Securities with an active secondary market mean that there are many
buyers and sellers at a given point in time. Investors benefit from liquid
securities because they can sell their assets whenever they want; an illiquid
security may force the seller to get rid of their asset at a large discount.

Secondary financial markets play a critical role in the accumulation of capital

and the production of goods and services. The price of credit and returns on
investment provide signals to producers and consumers which are financial
market participants. Those signals help direct funds (from savers, mainly
households and businesses) to the consumers, businesses, governments,
and investors that would like to borrow money by connecting those who value
the funds most highly (i.e., are willing to pay a higher price, or interest rate), to
willing lenders. In a similar way, the existence of robust financial markets and
institutions also facilitates the international flow of funds between countries.

In addition, efficient secondary financial markets and institutions tend to lower

search and transactions costs in the economy. By providing a large array of
financial products, with varying risk and pricing structures as well as maturity,
a well-developed financial system offers products to participants that provide
borrowers and lenders with a close match for their needs. Individuals,
businesses, and governments in need of funds can easily discover which
financial institutions or which financial markets may provide funding and what
the cost will be for the borrower. This allows investors to compare the cost of
financing to their expected return on investment, thus making the investment
choice that best suits their needs. In this way, financial markets direct the
allocation of credit throughout the economy and facilitate the production of
goods and services.

WHAT ARE CALLABLE BONDS

A callable bond (CB), also termed as a redeemable (RB) bond, is one that can be redeemed by
the issuer before the maturity date. This enables the issuing firm to settle its debt ahead of
schedule. If market (IR) interest rates fall, a company may decide to call their bond, allowing
them to refinance at a reduced rate. CB compensates investors for this risk by typically offering a
higher IR or coupon (CR) rate because of this callable nature.
Embedded Option
A CB includes a call option. This call option is also valuable. As a result, the CB has a lower
value than a regular bond.
1. Life (L)
A CB has two lives. The first is normal maturity, and the second is the shorter life it has as a
result of undertaking the call option.
2. Yield (Y)
A CB, like two lives, has two yields.
3. Maturity Yield (YTM)
This is the bond's yield assuming it is held until maturity. It is identical to the yield on a
conventional bond with a comparable CR and maturity.
 4. Yield to Call (YTC)
If the bond is called before actual maturity, this is the YTC. It will be approximated if users
understand the callable windows and the price or rate at which the bond will be called.
The reason for issuing the CB by the companies
Corporations issue CB to take advantage of possible future IR decreases. The issuing company
may redeem CB before the maturity date in conformity with the terms of the bond. If IR falls, the
company can redeem outstanding bonds and reissue debt at a lower IR. This lowers the cost of
(Kc) capital. A bond is equivalent to a loan borrower remortgaging at a lower IR. The prior
mortgage with the higher IR is settled, and the borrower receives a new mortgage with a lower
IR.

Explain with suitable example as how to analyze the sensitivity of an

industry to the
business cycle.

Analyzing the sensitivity of an industry to the business cycle involves assessing how changes in the
overall economic climate affect the performance of that particular industry. A highly cyclical industry will
experience significant fluctuations in demand and profitability depending on the stage of the business
cycle, while a less cyclical industry will be more stable and less affected by economic fluctuations.

To analyze the sensitivity of an industry to the business cycle, one approach is to examine its historical
performance during different phases of the business cycle. For example, during an economic expansion,
consumer spending tends to increase, leading to higher demand for goods and services. Industries that
are highly sensitive to the business cycle, such as the automobile industry, may experience significant
growth during this phase as consumers purchase new cars and trucks.

However, during a recession or economic downturn, consumer spending tends to decrease, leading to
lower demand for goods and services. Industries that are highly sensitive to the business cycle, such as
the construction industry, may experience significant declines during this phase as demand for new
homes and commercial buildings decreases.

To further illustrate, let's consider the retail industry. During an economic expansion, consumers tend to
have more disposable income, which can lead to increased spending on non-essential items such as
clothing and electronics. As a result, the retail industry is generally more sensitive to the business cycle
than industries that provide essential goods and services such as healthcare or utilities.
During a recession or economic downturn, however, consumers tend to cut back on non-essential
spending, which can lead to a decline in demand for retail goods. As a result, the retail industry may
experience a significant decline in sales and profitability during this phase.

By analyzing the sensitivity of an industry to the business cycle, investors can gain a better understanding
of the risks and opportunities associated with investing in that industry. For example, if an investor
believes that an economic expansion is imminent, they may choose to invest in industries that are highly
sensitive to the business cycle, such as the automobile or construction industries, in anticipation of
increased demand and profitability. Conversely, if an economic downturn is expected, investors may
choose to invest in less cyclical industries that are less sensitive to economic fluctuations, such as the
healthcare or utility industries.

INDEX IN WHICH THE STOCK GETS SPLIT

a price-weighted index, the divisor does not need to be adjusted when a component stock launches a
secondary offering. However, the divisor needs to be modified when a component stock issues a stock
dividend or undergoes a stock split.

The divisor is altered when a component issues new stock through a secondary offering in a market
capitalisation-weighted index. However, the divisor does not need an adjustment when a component
issues a stock dividend or undergoes a stock split.

As Dow Jones is a price-weighted index, it adjusts its divisor for corporate actions, such as dividend
payments and stock splits.

MEASURES EMPLOYED FOR PORTFOLIO PERFORMANCE

Many investors mistakenly base the success of their portfolios on returns
alone. Few investors consider the risk involved in achieving those returns.
Since the 1960s, investors have known how to quantify and measure risk with
the variability of returns, but no single measure actually looked at both risk
and return together. Today, there are three sets of performance measurement
tools to assist with portfolio evaluations. The Treynor, Sharpe, and Jensen
ratios combine risk and return performance into a single value, but each is
slightly different.
Treynor Measure
Treynor suggested that there were really two components of risk: the risk
produced by fluctuations in the stock market and the risk arising from the
fluctuations of individual securities.

Treynor introduced the concept of the security market line, which defines the
relationship between portfolio returns and market rates of returns whereby
the slope of the line measures the relative volatility between the portfolio and
the market (as represented by beta). The beta coefficient is the volatility
measure of a stock portfolio to the market itself. The greater the line's slope,
the better the risk-return tradeoff.

Sharpe Ratio
The Sharpe ratio is almost identical to the Treynor measure, except that the
risk measure is the standard deviation of the portfolio instead of considering
only the systematic risk as represented by beta. Conceived by Bill Sharpe,
this measure closely follows his work on the capital asset pricing
model (CAPM) and, by extension, uses total risk to compare portfolios to
the capital market line.

Unlike the Treynor measure, the Sharpe ratio evaluates the portfolio manager
on the basis of both the rate of return and diversification (it considers total
portfolio risk as measured by the standard deviation in its denominator).
Therefore, the Sharpe ratio is more appropriate for well-diversified portfolios
because it more accurately takes into account the risks of the portfolio.

Jensen Measure
Similar to the previous performance measures discussed, the Jensen
measure is calculated using the CAPM. Named after its creator, Michael C.
Jensen, the Jensen measure calculates the excess return that a portfolio
generates over its expected return. This measure of return is also known
as alpha.1

The Jensen ratio measures how much of the portfolio's rate of return is
attributable to the manager's ability to deliver above-average returns,
adjusted for market risk. The higher the ratio, the better the risk-adjusted
returns. A portfolio with a consistently positive excess return will have a
positive alpha while a portfolio with a consistently negative excess return will
have a negative alpha.