MBA – FINANCE Semester 3

MF0010 – Security Analysis and Portfolio Management

Assignment Set- 1

Submitted By:

Student Name Roll No
LC Name & Code

: Yogesh Kumar : 521056970 : NIPSTec Ltd. 1640 : 20/12/2011

Date of Submission

Q.1. Frame the investment process for a person of your age group. Ans. THE INVESTMENT PROCESS It is rare to find investors investing their entire savings in a single security. Instead, they tend to invest in a group of securities. Such a group of securities is called a portfolio. Most financial experts stress that in order to minimize risk; an investor should hold a well-balanced investment portfolio. The investment process describes how an investor must go about making decisions with regard to what securities to invest in while constructing a portfolio, how extensive the investment should be, and when the investment should be made. This is a procedure involving the following five steps:

1. Setting Investment Policy This initial step determines the investor’s objectives and the amount of his investable wealth. Since there is a positive relationship between risk and return, the investment objectives should be stated in terms of both risk and return. This step concludes with the asset allocation decision: identification of the potential categories of financial assets for consideration in the portfolio that the investor is going to construct. Asset allocation involves dividing an investment portfolio among different asset categories, such as stocks, bonds and cash. The asset allocation that works best for an investor at any given point in his life depends largely on his time horizon and his ability to tolerate risk. The time horizon is the expected number of months, years, or decades that an investor will be investing his money to achieve a particular financial goal. An investor with a longer time horizon may feel more comfortable with a riskier or more volatile investment because he can ride out the slow economic cycles and the inevitable ups and downs of the
Time Horizon –

markets. By contrast, an investor who is saving for his teen-aged daughter’s college education would be less likely to take a large risk because he has a shorter time horizon. Risk Tolerance – Risk tolerance is an investor’s ability and willingness to lose some or all of his original investment in exchange for greater potential returns. An aggressive investor, or one with a high-risk tolerance, is more likely to risk losing money in order to get better results. A conservative investor, or one with a low-risk tolerance, tends to favor investments that will preserve his or her original investment. The conservative investors keep a "bird in the hand," while aggressive investors seek "two in the bush." While setting the investment policy, the investor also selects the portfolio management style (active vs. passive management). is the process of managing investment portfolios by attempting to time the market and/or select ‘undervalued’ stocks to buy and ‘overvalued’ stocks to sell, based upon research, investigation and analysis. Passive Management is the process of managing investment portfolios by trying to match the performance of an index (such as a stock market index) or asset class of securities as closely as possible, by holding all or a representative sample of the securities in the index or asset class. This portfolio management style does not use market timing or stock selection strategies.
Active Management

2. Performing Security Analysis This step is the security selection decision: Within each asset type, identified in the asset allocation decision, how does an investor select which securities to purchase. Security analysis involves examining a number of individual securities within the broad categories of financial assets identified in the previous step. One purpose of this exercise is to identify those securities that currently appear to be mispriced. Security analysis is done either using Fundamental or Technical analysis (both have been discussed in subsequent units).
Fundamental analysis is

a method used to evaluate the worth of a security by studying the financial data of the issuer. It scrutinizes the issuer’s income and expenses, assets and liabilities, management, and position in its industry. In other words, it focuses on the ‘basics’ of the business. is a method used to evaluate the worth of a security by studying market statistics. Unlike fundamental analysis, technical analysis disregards an issuer’s financial statements. Instead, it relies upon market trends to ascertain investor sentiment to predict how a security will perform.
Technical analysis

3. Portfolio Construction This step identifies those specific assets in which to invest, as well as determining the proportion of the investor’s wealth to put into each one. Here selectivity, timing and diversification issues are addressed. Selectivity refers to security analysis and focuses on price movements of individual securities. Timing involves forecasting of price movement of stocks relative to price movements of fixed income securities (such as bonds). Diversification aims at constructing a portfolio in such a way that the investor’s risk is minimized. The following table summarizes how the portfolio is constructed for an active and a passive investor.
Asset Allocation Security Selection

Active investor Passive investor

Market timing Stock picking Maintain pre-determinedTry to track a well-known

selections 4. Portfolio Revision

market index like Nifty, Sensex

This step is the repetition of the three previous steps, as objectives might change and previously held portfolio might not be the optimal one. 5. Portfolio performance evaluation This step involves determining periodically how the portfolio has performed over some time period (returns earned vs. risks incurred). Q.2.From the website of BSE India, explain how the BSE Sensex is calculated. Ans. STOCK EXCHANGES: NSE, BSE AND OTCEI Stock exchanges are organized markets for buying and selling securities which include stocks, bonds, options and futures. Most stock exchanges have specific locations where the trades are completed. For the securities to be traded at these exchanges, they must be listed at these exchanges. Stock exchange transactions involve the activities of brokers and dealers. These individuals facilitate the buying and selling of financial assets. Brokers execute trades on behalf of clients and receive commissions and fees in exchange for matching buyers and sellers. Dealers, on the other hand, buy and sell from their own portfolios (inventories of securities). Dealers earn income by selling a financial instrument at a price that is greater than the price they paid for the instrument. Some exchange participants perform both roles. These dealer-brokers sometimes act purely as a client’s agent and at other times buy and sell from their own inventory of financial assets. Stock exchanges essentially function as secondary markets. By providing investors the opportunity to trade financial instruments, the stock exchanges support the performance of the primary markets. In India, the two main exchanges are National Stock Exchange (NSE) and Mumbai (Bombay) Stock Exchange (BSE). These exchanges are de-mutualised exchanges (it means that the ownership, management and trading are in separate hands). Mumbai (Bombay) Stock Exchange Limited (BSE) is the oldest stock exchange in Asia. It was established in 1875. More than 6000 stocks are listed here. National Stock Exchange (NSE) was promoted by leading Financial Institutions at the behest of the Government of India and was incorporated in November 1992. There is also an Over the Counter Exchange of India (OTCEI) which allows listing of small and medium-sized companies. The regulatory agency which oversees the functioning of stock markets is the Securities and Exchange Board of India (SEBI), which is also located in Mumbai. India’s equity market was earlier dominated by the BSE – a market where trading was done by open outcry, without designated market makers, and without any computerization. The quality of this market was widely considered to be poor, in terms of transparency, liquidity and market efficiency. The great scam of 1992 resulted in the finance ministry and SEBI seeking

radical reform in the functioning of the equity market. This task was achieved through the requirement that the BSE must evolve ‘screen-based trading’ and through the creation of the NSE. STOCK MARKET INDICES An index is a statistical indicator providing a representation of the value of the securities which constitute it. Indexes often serve as barometers for a given market or industry and benchmarks against which financial or economic performance is measured. A stock index reflects the price movement of shares while a bond index captures the manner in which bond prices go up and down. For more than hundred years, people have tracked the market’s daily ups and downs using various indices of overall market performance. There are currently thousands of indices calculated by various information providers. Internationally, the best known indices are provided by Dow Jones & Co, S & P, Morgan Stanley Capital Markets (MSCI), Lehman Brothers (bond indices). Dow Jones alone currently publishes more than 3,000 indices. Some of the well-known indices are Dow Jones Industrial Average (DJIA), Standard & Poor’s 500 Index (S&P 500), Nasdaq Composite, Nasdaq 100, Financial Times-Stock Exchange 100 (FTSE 100), Nikkei 225 Stock Average, Hang Seng Index, Deutscher Aktienindex (DAX). In India the best known indices are Sensex and Nifty. Sensex is the stock market index for BSE. It was first compiled in 1986. It is made of 30 stocks representing a sample of large, liquid and representative companies. The base year of SENSEX is 1978-79 and the base value is 100.

Sensex till August 31, 2003 was constructed on the basis of full market capitalization. A need was felt to switch over to free float wherein non-promoter and non-strategic shareholdings are eliminated and only those outstanding shares that are available for trading are included. Sensex since 31st September, 2003, is being constructed on free float market capitalization.
NIFTY: Nifty

is the stock market index for NSE. S&P CNX Nifty is a 50 stock index accounting for 23 sectors of the economy. The base period selected for Nifty is the close of prices on November 3, 1995, which marked the completion of one-year of operations of NSE’s capital market segment. The base value of index was set at 1000. The other indices are BSE 200, BSE 500, BSE TECK, BSE IT, BSE FMCG, BSE CD, BSE Metal, BSE PSU, BSE – Mid cap, BSE small cap, BSE auto, BSE Pharma, BSE realty, Nifty Jr, BSE MCK. SENSEX CALCULATION METHODOLOGY SENSEX is calculated using the "Free-float Market Capitalization" methodology, wherein, the level of index at any point of time reflects the free-float market value of 30 component stocks relative to a base period. The market capitalization of a company is determined by multiplying the price of its stock by the number of shares issued by the company.

This market capitalization is further multiplied by the free-float factor to determine the free-float market capitalization. The base period of SENSEX is 1978-79 and the base value is 100 index points. This is often indicated by the notation 1978-79=100. The calculation of SENSEX involves dividing the free-float market capitalization of 30 companies in the Index by a number called the Index Divisor. The Divisor is the only link to the original base period value of the SENSEX. It keeps the Index comparable over time and is the adjustment point for all Index adjustments arising out of corporate actions, replacement of scrips etc. During market hours, prices of the index scrips, at which latest trades are executed, are used by the trading system to calculate SENSEX on a continuous basis. Q.3. Perform an economy analysis on Indian economy in the current situation. Ans. ECONOMY ANALYSIS In addition to the economy analysis, fundamental analysis helps investors determine whether the economic climate offers a positive and encouraging investing environment. Economic analysis is done for two reasons: first, a company’s growth prospects are, ultimately, dependent on the economy in which it operates; second, share price performance is generally tied to economic fundamentals, as most companies generally perform well when the economy is doing the same. FACTORS TO BE CONSIDERED IN ECONOMY ANALYSIS The economic variables that are considered in economic analysis are: · gross domestic product (GDP) growth rate, · exchange rates, · the balance of payments (BOP), · the current account deficit, · government policy (fiscal and monetary policy), · domestic legislation (laws and regulations), · unemployment (the percent of the population that wants to work and is currently not working), · public attitude (consumer confidence) · inflation (a general increase in the price of goods and services), interest rates, · productivity (output per worker), · capacity utilization (output by the firm) etc . is the total income earned by a country. GDP growth rate shows how fast the economy is growing. Investors know that strong economic growth is good for companies and recessions or full-blown depressions cause share prices to decline, all other things being equal.

is important for investors, as excessive inflation undermines consumer spending power (prices increase) and so can cause economic stagnation. However, deflation (negative inflation) can also hurt the economy, as it encourages consumers to postpone spending (as they wait for cheaper prices).

The exchange rate affects the broad economy and companies in a number of ways. First, changes in the exchange rate affect the exports and imports. If exchange rate strengthens, exports are hit; if the exchange rate weakens, imports are affected. The BOP affects the exchange rate through supply and demand for the foreign currency.
BOP reflects

a country’s international monetary transactions for a specific time period. It consists of the current account and the capital account. The current account is an account of the trade in goods and services. The capital account is an account of the cross-border transactions in financial assets. A current account deficit occurs when a country imports more goods and services than it exports.
A capital account deficit occurs

when the investments made in the country by foreigners is less than the investment in foreign countries made by local players. The currency of a country appreciates when there is more foreign currency coming into the country than leaving it. Therefore, a surplus in the current or capital account causes the currency to strengthen; a deficit causes the currency to weaken. The levels of interest rates (the cost of borrowing money) in the economy and the money supply (amount of money circulating in the economy) also have a bearing on the performance of businesses. All other things being equal, an increase in money supply causes the interest rates to fall; a decrease causes the interest rates to rise. If interest rates are low, the cost of borrowing by businesses is not expensive, and companies can easily borrow to expand and develop their activities. ECONOMIC ANALYSIS ON INDIAN ECONOMY India economic analysis provides various inputs on economic condition of this south-east Asian country. It can be done both at a microeconomic as well as a macroeconomic level. India economic analysis could also be described as being an explanation of various economic phenomena going on in this country. RECENT MACROECONOMIC DEVELOPMENTS IN INDIA In April 2008, industrial sector in India had recorded a growth of 7 percent. However, this figure is lesser than 11 percent development, which had been achieved in April 2007. Much of this critical condition could be attributed to an increase in prices of oil. Measures that have been taken by Reserve Bank of India, like upward revision of repo rate and CRR, have also contributed to decrease in industrial production. Manufacturing and electric sector have suffered as well in recent times. Their growth rates have come down too. For manufacturing sector it was 7.5 percent and for electricity sector, rate of development stood at 1.4 percent in April 2008. This rate is significantly low when compared to statistics of April 2007, when rates of development for manufacturing and electricity were 12.4 percent and 8.7 percent respectively. In case of manufacturing sector much of this slump could be attributed to increase in input costs like expenses of oil, raw materials, rates of interest and prices of goods and services. Mining sector has been comparatively better off as it has managed to grow at a rate of 8 percent in April 2008 compared to 2.6 percent that was achieved in April 2007. In core infrastructural industries, there has been deceleration as well, but it is still better off compared to non infrastructural industries in India. Growth in April 2008 has been around 3.6 percent, which is less than 5.9 percent achieved in April 2007. Industries like crude oil production, electricity and petroleum refinery have been

performing below expectations but coal, finished steel and cement have performed better than April 2007. INFLATION IN INDIA In financial year 2007-08, average inflation in India was around 4.66 percent. This rate was lower than average inflation of financial year 2006-07. In 2007-08, fiscal high prices of food items were primary cause behind high rates of inflation. That high rate of inflation had to be controlled by banning a number of necessary commodities as well as various financial steps. High prices of oil were responsible for proportionately high rate of inflation in 2008-09. Q.4. Identify some technical indicators and explain how they can be used to decide purchase of a company’s stock. Ans. TECHNICAL INDICATORS A technical indicator is a series of data points that are derived by applying a formula to the price and/or volume data of a security. Price data can be any combination of the open, high, low or closing price over a period of time. Some indicators may use only the closing prices, while others incorporate volume and open interest into their formulae. The price data is entered into the formula and a data point is produced. For example, say the closing prices of a stock for 3 days are Rs. 41, Rs. 43 and Rs. 43. If a technical indicator is constructed using the average of the closing prices, then the average of the 3 closing prices is one data point ((41+43+43)/3=42.33). However, one data point does not offer much information. A series of data points over a period of time is required to enable analysis. Thus we can have a 3 period moving average as a technical indicator, where we drop the earliest closing price and use the next closing price for calculations. Technical indicators are constructed in two ways: those that fall in a bounded range and those that do not. The technical indicators that are bound within a range are called oscillators. Oscillators are used as an overbought / oversold indicator. A market is said to be ‘overbought’ when prices have been trending higher in a relatively steep fashion for some time, to the extent that the number of market participants ‘long’ of the market significantly outweighs those on the sidelines or holding ‘short’ positions. This means that there are fewer participants to jump onto the back of the trend. The ‘oversold’ condition is just the opposite. The market has been trending lower for some time and is running out of ‘fuel’ for further price declines. Oscillator indicators move within a range, say between zero and 100, and signal periods where the security is overbought (near 100) or oversold (near zero). Oscillators are the most common type of technical indicators. The technical indicators that are not bound within a range also form buy and sell signals and display strength or weakness in the market, but they can vary in the way they do this.

The two main ways that technical indicators are used to form buy and sell signals is through crossovers and divergence. Crossovers occur when either the price moves through the moving average, or when two different moving averages cross over each other. Divergence happens when the direction of the price trend and the direction of the indicator trend are moving in the opposite direction. This indicates that the direction of the price trend is weakening. Technical indicators provide an extremely useful source of additional information. These indicators help identify momentum, trends, volatility and various other aspects in a security to aid in the technical analysis of trends. While some traders just use a single indicator for buy and sell signals, it is best to use them along with price movement, chart patterns and other indicators. A number of technical indicators are in use. Some of the technical indicators are discussed below for the purpose of illustration of the concept: Moving average: The moving average is a lagging indicator which is easy to construct and is one of the most widely used. A moving average, as the name suggests, represents an average of a certain series of data that moves through time. The most common way to calculate the moving average is to work from the last 10 days of closing prices. Each day, the most recent close (day 11) is added to the total and the oldest close (day 1) is subtracted. The new total is then divided by the total number of days (10) and the resultant average computed. The purpose of the moving average is to track the progress of a price trend. The moving average is a smoothing device. By averaging the data, a smoother line is produced, making it much easier to view the underlying trend. A moving average filters out random noise and offers a smoother perspective of the price action. Moving Average Convergence Divergence (MACD): MACD is a momentum indicator and it is made up of two exponential moving averages. The MACD plots the difference between a 26-day exponential moving average and a 12-day exponential moving average. A 9-day moving average is generally used as a trigger line. When the MACD crosses this trigger and goes down it is a bearish signal and when it crosses it to go above it, it’s a bullish signal. This indicator measures short-term momentum as compared to longer term momentum and signals the current direction of momentum. Traders use the MACD for indicating trend reversals. Relative Strength Index: The relative strength index (RSI) is another of the well-known momentum indicators. Momentum measures the rate of change of prices by continually taking price differences for a fixed time interval. RSI helps to signal overbought and oversold conditions in a security. RSI is plotted in a range of 0-100. A reading above 70 suggests that a security is overbought, while a reading below 30 suggests that it is oversold. This indicator helps traders to identify whether a security’s price has been unreasonably pushed to its current levels and whether a reversal may be on the way.

Stochastic Oscillator: The stochastic oscillator is one of the most recognized momentum indicators. This indicator provides information about the location of a current closing price in relation to the period’s high and low prices. The closer the closing price is to the period’s high, the higher is the buying pressure, and the closer the closing price is to the period’s low, the more is the selling pressure. The idea behind this indicator is that in an uptrend, the price should be closing near the highs of the trading range, signaling upward momentum in the security. In downtrends, the price should be closing near the lows of the trading range, signaling downward momentum. The stochastic oscillator is plotted within a range of zero and 100 and signals overbought conditions above 80 and oversold conditions below 20. Q.5. Compare Arbitrage pricing theory with the Capital asset pricing model. Ans. In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices. When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, it is the possibility of a risk-free profit at zero cost. In principle and in academic use, an arbitrage is riskfree; in common use, as in statistical arbitrage, it may refer to expected profit, though losses may occur, and in practice, there are always risks in arbitrage, some minor (such as fluctuation of prices decreasing profit margins), some major (such as devaluation of a currency or derivative). In academic use, an arbitrage involves taking advantage of differences in price of a single asset or identical cash-flows; in common use, it is also used to refer to differences between similar assets (relative value or convergence trades), as in merger arbitrage. People who engage in arbitrage are called arbitrageurs (IPA: /ˌɑrbɨtrɑːˈʒɜr/)—such as a bank or brokerage firm. The term is mainly applied to trading in financial instruments, such as bonds, stocks, derivatives, commodities and currencies. Conditions for arbitrage: Arbitrage is possible when one of three conditions is met: 1. The same asset does not trade at the same price on all markets ("the law of one price"). 2. Two assets with identical cash flows do not trade at the same price. 3. An asset with a known price in the future does not today trade at its future price discounted at the risk-free interest rate (or, the asset does not have negligible costs of storage; as such, for example, this condition holds for grain but not for securities). Arbitrage is not simply the act of buying a product in one market and selling it in another for a higher price at some later time. The transactions must occur simultaneously to avoid exposure to market risk, or the risk that prices may change on one market before both transactions are complete. In practical terms, this is generally only possible with securities and financial products which can be traded electronically, and even then, when each leg of the trade is executed the prices in the market may have moved. Missing one of the legs of the trade (and subsequently

having to trade it soon after at a worse price) is called 'execution risk' or more specifically 'leg risk'.[note 1] In the simplest example, any good sold in one market should sell for the same price in another. Traders may, for example, find that the price of wheat is lower in agricultural regions than in cities, purchase the good, and transport it to another region to sell at a higher price. This type of price arbitrage is the most common, but this simple example ignores the cost of transport, storage, risk, and other factors. "True" arbitrage requires that there be no market risk involved. Where securities are traded on more than one exchange, arbitrage occurs by simultaneously buying in one and selling on the other.Mathematically it is defined as follows:
and where Vt means a portfolio at time t.

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

= R = R + β I F I + βGDP FGDP + β S FS + ε

• • • •

As securities are added to the portfolio, the unsystematic risks of the individual securities offset each other. A fully diversified portfolio has no unsystematic risk. The CAPM can be viewed as a special case of the APT. Empirical models try to capture the relations between returns and stock attributes that can be measured directly from the data without appeal to theory. Difference in Methodology

 CAPM is an equilibrium model and derived from individual portfolio optimization.  APT is a statistical model which tries to capture sources of systematic risk. Relation between sources determined by no Arbitrage condition. Difference in Application  APT difficult to identify appropriate factors.  CAPM difficult to find good proxy for market returns.  APT shows sensitivity to different sources. Important for hedging in portfolio formation.  CAPM is simpler to communicate, since everybody agrees upon.

Q.6. Discuss the different forms of market efficiency. Ans. FORMS OF MARKET EFFICIENCY A financial market displays informational efficiency available information about value. This definition of efficient questions: ‘what is all available information?’ & ‘what does information?’ Different answers to these questions give rise efficiency. when market prices reflect all market requires answers to two it mean to reflect all available to different versions of market

What information are we talking about? Information can be information about past prices, information that is public information and information that is private information. Information about past prices refers to the weak form version of market efficiency, information that consists of past prices and all public information refers to the semi-strong version of market efficiency and all information (past prices, all public information and all private information) refers to the strong form version of market efficiency. “Prices reflect all available information” means that all financial transactions which are carried out at market prices, using the available information, are zero NPV activities. The weak form of EMH states that all past prices, volumes and other market statistics (generally referred to as technical analysis) cannot provide any information that would prove useful in predicting future stock price movements. The current prices fully reflect all securitymarket information, including the historical sequence of prices, rates of return, trading volume data, and other market-generated information. This implies that past rates of return and other market data should have no relationship with future rates of return. It would mean that if the weak form of EMH is correct, then technical analysis is fruitless in generating excess returns. The semi-strong form suggests that stock prices fully reflect all publicly available information and all expectations about the future. “Old” information then is already discounted and cannot be used to predict stock price fluctuations. In sum, the semi-strong form suggests that

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

MBA – FINANCE Semester 3

MF0010 – Security Analysis and Portfolio Management

Assignment Set- 2

Submitted By:

Student Name Roll No
LC Name & Code

: Yogesh Kumar : 521056970 : NIPSTec Ltd. 1640 : 20/12/2011

Date of Submission

Q.1. Differentiate between ADRs and GDRs Ans. ADR’S and GDR’S
1. Global depository receipt (GDR) is compulsory for foreign company to access in any other country’s share market for dealing in stock. But American depository receipt (ADR) is compulsory for non –us companies to trade in stock market of USA. 2. ADRs can get from level -1 to level –III. GDRs are already equal to high preference receipt of level –II and level –III. 3. Indian companies prefer to get GDR due to its global use for getting foreign investment for own business projects. 4. ADRs up to level –I need to accept only general condition of SEC of USA but GDRs can only be issued under rule 144 A after accepting strict rules of SEC of USA . 5. GDR is negotiable instrument all over the world but ADR is only negotiable in USA. 6. Many Indian Companies listed foreign stock market through foreign bank’s GDR. Names of these Indian Companies are following :- (A) Bajaj Auto (B) Hindalco (C) ITC ( D) L&T (E) Ranbaxy Laboratories (F) SBI Some of Indian Companies are listed in USA stock exchange only through ADRs :- (A) Patni Computers (B) Tata Motors 7. Even both GDR & ADR is the proxy way to sell shares in foreign market by India companies ADRs is not substitute of GDRs but GDRs can use on the place of ADRs. 8. Investors of UK can buy GDRs from London stock exchange and Luxemburg stock exchange and invest in Indian companies without any extra responsibilities. Investors of USA can buy ADRs from New york stock exchange (NYSE) or NASDAQ (National Association of Securities Dealers Automated Quotation). 9. American investors typically use regular equity trading accounts for buying ADRs but not for GDRs. 10. The US dollar rate paid to holders of ADRs is calculated by applying the exchange rate used to convert the foreign dividend payment (net of local withholding tax) to US dollars, and adjusting the result according to the ordinary share but GDRs is calculated on numbers of Shares. One GDR's Value may be on two or six shares

Q.2. Using financial ratios, study the financial performance of any particular company of your interest. Ans. Financial ratios illustrate relationships between different aspects of a small business's operations. They involve the comparison of elements from a balance sheet or income statement, and are crafted with particular points of focus in mind. Financial ratios can provide small business owners and managers with a valuable tool to measure their progress against predetermined internal goals, a certain competitor, or the overall industry. In addition, tracking various ratios over time is a powerful way to identify trends as they develop. Ratios are also used by bankers, investors, and business analysts to assess various attributes of a company's financial strength or operating results. Ratios are determined by dividing one number by another, and are usually expressed as a percentage. They enable business owners to examine the relationships between seemingly unrelated items and thus gain useful information for decision-making. "They are simple to calculate, easy to use, and provide a wealth of information that cannot be gotten anywhere else," James O. Gill noted in his book Financial Basics of Small Business Success. But, he added, "Ratios are aids to judgment and cannot take the place of experience. They will not replace good management, but they will make a good manager better. They help to pinpoint areas that need investigation and assist in developing an operating strategy for the future." Virtually any financial statistics can be compared using a ratio. In reality, however, small business owners and managers only need to be concerned with a small set of ratios in order to identify where improvements are needed. "As you run your business you juggle dozens of different variables," David H. Bangs, Jr. wrote in his book managing by the Numbers. "Ratio analysis is designed to help you identify those variables which are out of balance." It is important to keep in mind that financial ratios are time sensitive; they can only present a picture of the business at the time that the underlying figures were prepared. For example, a retailer calculating ratios before and after the Christmas season would get very different results. In addition, ratios can be misleading when taken singly, though they can be quite valuable when a small business tracks them over time or uses them as a basis for comparison against company goals or industry Standards. As a result, business owners should compute a variety of applicable ratios and attempt to discern a pattern, rather than relying on the information provided by only one or two ratios. Gill also noted that small business owners should be certain to view ratios objectively, rather than using them to confirm a particular strategy or point of view. Perhaps the best way for small business owners to use financial ratios is to conduct a formal ratio analysis on a regular basis. The raw data used to compute the ratios should be recorded on a special form monthly. Then the relevant ratios should be computed, reviewed, and saved for future comparisons. Determining which ratios to compute depends on the type of business, the age of the business, the point in the business cycle, and any specific information sought. For example, if a small business depends on a large number of fixed assets, ratios that measure how efficiently these assets are being used may be the most significant. In general, financial ratios can be broken down into four main categories—profitability or return on investment, liquidity, leverage, and operating or efficiency—with several specific ratio calculations prescribed within each. Google reported revenues of $6.77 billion for the quarter ended March 31, 2010, an increase of 23% compared to the first quarter of 2009. Google reports its revenues, consistent with GAAP,

on a gross basis without deducting traffic acquisition costs (TAC). In the first quarter of 2010, TAC totaled $1.71 billion, or 26% of advertising revenues. Google reports operating income, operating margin, net income, and earnings per share (EPS) on a GAAP and non-GAAP basis. The non-GAAP measures, as well as free cash flow, an alternative non-GAAP measure of liquidity, are described below and are reconciled to the corresponding GAAP measures in the accompanying financial tables. GAAP operating income in the first quarter of 2010 was $2.49 billion, or 37% of revenues. This compares to GAAP operating income of $1.88 billion, or 34% of revenues, in the first quarter of 2009. Non-GAAP operating income in the first quarter of 2010 was $2.78 billion, or 41% of revenues. This compares to non-GAAP operating income of $2.16 billion, or 39% of revenues, in the first quarter of 2009. GAAP net income in the first quarter of 2010 was $1.96 billion, compared to $1.42 billion in the first quarter of 2009. Non-GAAP net income in the first quarter of 2010 was $2.18 billion, compared to $1.64 billion in the first quarter of 2009. GAAP EPS in the first quarter of 2010 was $6.06 on 323 million diluted shares outstanding, compared to $4.49 in the first quarter of 2009 on 317 million diluted shares outstanding. Non-GAAP EPS in the first quarter of 2010 was $6.76, compared to $5.16 in the first quarter of 2009. Non-GAAP operating income and non-GAAP operating margin exclude the expenses related to stock-based compensation (SBC). Non-GAAP net income and non-GAAP EPS exclude the expenses related to SBC and the related tax benefits. In the first quarter of 2010, the charge related to SBC was $291 million, compared to $277 million in the first quarter of 2009. The tax benefit related to SBC was $65 million in the first quarter of 2010 and $64 million in the first quarter of 2009. Reconciliations of non-GAAP measures to GAAP operating income, operating margin, net income, and EPS are included at the end of this release. International Revenues - Revenues from outside of the United States totaled $3.58 billion, representing 53% of total revenues in the first quarter of 2010, compared to 53% in the fourth quarter of 2009 and 52% in the first quarter of 2009. Excluding gains related to our foreign exchange risk management program, had foreign exchange rates remained constant from the fourth quarter of 2009 through the first quarter of 2010, our revenues in the first quarter of 2010 would have been $112 million higher. Excluding gains related to our foreign exchange risk management program, had foreign exchange rates remained constant from the first quarter of 2009 through the first quarter of 2010, our revenues in the first quarter of 2010 would have been $242 million lower. Revenues from the United Kingdom totaled $842 million, representing 13% of revenues in the first quarter of 2010, compared to 13% in the first quarter of 2009. In the first quarter of 2010, we recognized a benefit of $10 million to revenues through our foreign exchange risk management program, compared to $154 million in the first quarter of 2009. Paid Clicks – Aggregate paid clicks, which include clicks related to ads served on Google sites and the sites of our AdSense partners, increased approximately 15% over the first quarter of 2009 and increased approximately 5% over the fourth quarter of 2009. Cost-Per-Click – Average cost-per-click, which includes clicks related to ads served on Google sites and the sites of our AdSense partners, increased approximately 7% over the first quarter of 2009 and decreased approximately 4% over the fourth quarter of 2009. TAC - Traffic Acquisition Costs, the portion of revenues shared with Google’s partners, increased to $1.71 billion in the first quarter of 2010, compared to TAC of $1.44 billion in the first quarter of 2009. TAC as a percentage of advertising revenues was 26% in the first quarter of 2010, compared to 27% in the first quarter of 2009. The majority of TAC is related to amounts ultimately paid to our AdSense partners, which totaled $1.45 billion in the first quarter of 2010. TAC also includes amounts ultimately paid to certain distribution partners and others who direct

traffic to our website, which totaled $265 million in the first quarter of 2010. Other Cost of Revenues - Other cost of revenues, which is comprised primarily of data center operational expenses, amortization of intangible assets, content acquisition costs as well as credit card processing charges, increased to $741 million, or 11% of revenues, in the first quarter of 2010, compared to $666 million, or 12% of revenues, in the first quarter of 2009. Operating Expenses Operating expenses, other than cost of revenues, were $1.84 billion in the first quarter of 2010, or 27% of revenues, compared to $1.52 billion in the first quarter of 2009, or 28% of revenues. Stock-Based Compensation (SBC) – In the first quarter of 2010, the total charge related to SBC was $291 million, compared to $277 million in the first quarter of 2009. We currently estimate SBC charges for grants to employees prior to April 1, 2010 to be approximately $1.2 billion for 2010. This estimate does not include expenses to be recognized related to employee stock awards that are granted after March 31, 2010 or non-employee stock awards that have been or may be granted. Operating Income - GAAP operating income in the first quarter of 2010 was $2.49 billion, or 37% of revenues. This compares to GAAP operating income of $1.88 billion, or 34% of revenues, in the first quarter of 2009. Non-GAAP operating income in the first quarter of 2010 was $2.78 billion, or 41% of revenues. This compares to non-GAAP operating income of $2.16 billion, or 39% of revenues, in the first quarter of 2009. Interest Income and Other, Net – Interest income and other, net increased to $18 million in the first quarter of 2010, compared to $6 million in the first quarter of 2009. Income Taxes – Our effective tax rate was 22% for the first quarter of 2010. Net Income – GAAP net income in the first quarter of 2010 was $1.96 billion, compared to $1.42 billion in the first quarter of 2009. Non-GAAP net income was $2.18 billion in the first quarter of 2010, compared to $1.64 billion in the first quarter of 2009. GAAP EPS in the first quarter of 2010 was $6.06 on 323 million diluted shares outstanding, compared to $4.49 in the first quarter of 2009 on 317 million diluted shares outstanding. Non-GAAP EPS in the first quarter of 2010 was $6.76, compared to $5.16 in the first quarter of 2009. Cash Flow and Capital Expenditures – Net cash provided by operating activities in the first quarter of 2010 totaled $2.58 billion, compared to $2.25 billion in the first quarter of 2009. In the first quarter of 2010, capital expenditures were $239 million, the majority of which was related to IT infrastructure investments, including data centers, servers, and networking equipment. Free cash flow, an alternative non-GAAP measure of liquidity, is defined as net cash provided by operating activities less capital expenditures. In the first quarter of 2010, free cash flow was $2.35 billion. FORWARD-LOOKING STATEMENTS This press release contains forward-looking statements that involve risks and uncertainties. These statements include statements regarding our plans to heavily invest in innovation, our expected stock-based compensation charges and our plans to make significant capital expenditures. Actual results may differ materially from the results predicted, and reported results should not be considered as an indication of future performance. The potential risks and uncertainties that could cause actual results to differ from the results predicted include, among others, unforeseen changes in our hiring patterns and our need to expend capital to accommodate the growth of the business, as well as those risks and uncertainties included under the captions “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the year ended December 31, 2009, which is on file with the SEC and is available on our investor relations website at and on the SEC website at

Q.3. As an investor how would you select an equity mutual fund scheme? Ans. How do I choose a Scheme But to begin your selection start from the very beginning: Specify your investment needs While we are on the topic of what returns to expect, someone might as well wish for a Fund that assures returns. Some of the mutual funds have floated "assured" return Funds and more funds. There is no end to verbosity when educating on funds. But getting to actually choose a fund may not be eased with more funds. It often turns out, like with most ventures in life, that picking your fund is like crossing the saddle point – the first time is always the most difficult. There are more than 350 schemes and choosing one of them is not an easy task. We will provide you an easy way to filter this huge number down to a more manageable size so that you can look spend more time looking at schemes in greater detail. What are you looking for when investing in mutual funds? What are your investment needs? The more well defined these answers are the easier it is to find schemes best for you. So how do you assess your needs? The answers obviously lie with you. But the questions investors ask to assess their needs are possibly the same. You might ask yourself: At my age what am I expecting out of investing? To assess the needs investors look at their lifestyles, financial independence, family commitments, and level of income and expenses among other things. Questions can be many but to get cracking ask yourself these two: What are the returns you want on your investments? Do you have welldefined time period for the returns you expect on your investment? The father of an aspiring engineer who would have to shell out the boy's institute fees soon enough, could reply: I want a fixed monthly income of about Rs.5000 per month. To the second query he might say: Yes, for the next four years. When asked, the just out-of-B-school graduate planning for his new Zen could reply: I should make about Rs. 60,000 by the end of one year. Getting the right answers to these questions does a lot to simply your fund picking exercise. Having defined the needs that direct you to invest, one can find a category of funds that come close to satisfy your needs with their objectives. schemes that guarantee a certain annual return or guarantee a buyback at a specified price after a specified period. Examples of these include funds floated by the UTI, SBI Mutual Fund, etc. Many of these funds have not earned returns that they promised and the asset management companies of the respective mutual funds or their sponsors have made good their promises. Nowadays, there are very few funds that come out with such schemes as the funds have realized it is not viable to assure returns in a volatile market. Assess the risk you can take Contrary to the commonplace thinking, mutual funds do carry risks. And there are some that can become as risky as stocks. Given the almost diverse objectives with which schemes operate, there are some with more risks and some relatively safer. Ask yourself if you are ready for a scheme whose investment value might fluctuate every week or one that gives a minimum amount of risk? Or are you in for a short-term loss in order to achieve a long-term potential gain? At this point it is good to ask oneself how will you take it if your investment fails to deliver the returns you expected or makes losses. Knowing this will reduce your chances (or even temptation) to select a fund that doesn’t come close to your objective. Investors comfortable with numerical recipes do a technical check of what the returns of a scheme would be in the worst case. They check is done with the Sharpe ratio .The higher the Sharpe ratio, the better the fund's historical

risk-adjusted performance. Evaluate a scheme by looking at how its NAV has behaved over the past. Do you see the scheme behaving rather erratically i.e., the NAV changes just too often? More the volatility more are the risks involved. Great returns are not the only thing to look for in a scheme. If you feel while researching a scheme, which we will do later, that it’s returns are modest and steady and good enough for your needs, avoid other schemes that have recently delivered high returns. Because great returns in the past are no guarantee for the fabulous performance to continue in the future. Never forget one of the commonplace morals of investment: The schemes that are expected to give the highest returns have the greatest probability to fall flat! Decide how long you can park your cash Is the cash you have earmarked for your investment meant to be spent for something else? Do you need a regular cash flow? Or you don’t mind locking your cash in the scheme so that your assets can appreciate over time? Settle this question upfront on what your cash flow requirements will be till the time your money is invested in mutual funds Getting the right Fund. Investment mix: If you know of an industry that has been doing particularly well, you can select schemes that have invested in that industry. You can also select schemes that have invested in companies with a dazzling performance. A mixed basket for your diverse needs Once again, back to the basic question. You came here looking for schemes that can suffice your investment needs. You might be like many others who actually have multiple needs. Consider going for a combination of schemes. Yet another recap of the basics: one of the things that made these mutual funds great was diversification. While you might have selected a scheme that has a diversified portfolio, you can also go for more than one scheme to further diversify your investments. It is well possible that just by picking more than one scheme from one fund house you can achieve enough diversification. In fact many investors who have tried out a fund The success of your investment depends in a large measure on the objective you define. Having defined that, choosing a fund isn’t difficult. Through a search of schemes on our advanced search you can draw up a list of schemes that come close to the objectives you have set. Our search allows you to set criteria based on your objectives. The criteria you can set are: The scheme’s expense: All schemes have a minimum requirement for the total amount of money you can invest. Usually they begin from a minimum of Rs.5000. Do a check for the expense ratio and sales charges the fund has. The NAV is good enough to know what each unit of the scheme will cost you. But, remember a low NAV (sometimes even below the usual offer price of Rs.10) may make a scheme more affordable as you can acquire more units but chances are the scheme is not performing well. The scheme’s performance: Returns from schemes are calculated over various periods from a week to one year or more. For each time period specify the returns. While you enter returns figures the maximum, minimum and average returns for all schemes in the category you have chosen are also displayed. The scheme’s fund house: Over the years fund houses in India have established a name for themselves for their investment style and their performance. Hence, some investors usually try to satisfy their diverse investments through one fund house. If you have been recommended a fund house choose the fund to list all schemes under it. House for long and developed a trust with the fund, prefer to pick another scheme from the funds but convenience sometimes leads to venerable prejudices that might deprive you of trying something new and better. There could be

a better-managed scheme in a different fund house that you are missing out on if you decide to stick to your old fund house for convenience sake basket for their new investment needs Q.4. Show how duration of a bond is calculated and how is it used. Ans. DURATION OF BONDS Bond Duration is a measure of bond price volatility, which captures both price and reinvestment risk and which is used to indicate how a bond will react in different interest rate environments. The duration of a bond represents the length of time that elapses before the average rupee of present value from the bond is received. Thus duration of a bond is the weighted average maturity of cash flow stream, where the weights are proportional to the present value of cash flows. Formally, it is defined as: Duration = D = {PV (C1) x 1 + PV (C2) x 2+ ----- PV (Cn) x n} / Current Price of the bond Where PV (Ci) is the present values of cash flow at time i. Steps in calculating duration: Step 1 : Find present value of each coupon or principal payment. Step 2 : Multiply this present value by the year in which the cash flow is to be received. Step 3 : Repeat steps 1 & 2 for each year in the life of the bond. Step 4 : Add the values obtained in step 2 and divide by the price of the bond to get the value of Duration. Example: Calculate the duration of an 8% annual coupon 5 year bond that is priced to yield 10% (i.e. YTM = 10%). The face value of the bond is Rs.1000. Annual coupon payment = 8% x Rs. 1000 = Rs. 80 At the end of 5 years, the principal of Rs. 1000 will be returned to the investor. Therefore cash flows in year 1-4= Rs. 80. Cash flow in year 5= Principal + Interest = Rs. 1000 + Rs. 80 = Rs. 1080 (t) Annual PVIF Present Explanation Time x Explanation Cash @10% Value PV of flow of Annual cash Cash Flow flow PV(Ct) 1 80 0.90909 72.73 = 80 x 0.90909 72.73 = 1 x 72.73 2 80 0.82645 66.12 = 80 x 0.82645 132.24 = 2 x 66.12 3 80 0.75131 60.10 = 80 x 0.75131 180.3 = 3 x 60.1 4 80 0.68301 54.64 = 80 x 0.68301 218.56 = 4 x 54.64 5 1080 0.62092 670.59 = 1080 x 3352.9 = 5 x 670.59 0.62092 5 Total 924.18 3956.7 8 Price of the bond= Rs 924.18 The proportional change in the price of a bond: (ΔP/P) = - {D/ (1+ YTM)} x Δ y

Where Δ y =change in Yield, and YTM is the yield-to-maturity. The term D / (1+YTM) is also known as Modified Duration. The modified duration for the bond in the example above = 4.28 / (1+10%) = 3.89 years. This implies that the price of the bond will decrease by 3.89 x 1% = 3.89% for a 1% increase in the interest rates. Q.5. Show with the help of an example how portfolio diversification reduces risk Ans. PORTFOLIO DIVERSIFICATION 'Don't put all your eggs in one basket' is a well-known proverb, which summarizes the message that there are benefits from diversification. If you carry your breakable items in several baskets there is a chance that one will be dropped, but you are unlikely to drop all your baskets on the same trip. Similarly, if you invest all your wealth in the shares of one company, there is a chance that the company will go bust and you will lose all your money. Since it is unlikely that all companies will go bust at the same time, a portfolio of shares in several companies is less risky. This may sound like the idea of risk-pooling, which we discussed earlier in this chapter, and risk-pooling is certainly an important reason for diversification. We will use the notion of risk-pooling to explain some forms of financial behavior, but a full understanding of portfolio diversification involves a slightly wider knowledge of the nature of risk than what is involved in coin-tossing. The key difference between risk in the real world of finance and the risk of cointossing is that many of the potential outcomes are not independent of other outcomes. If you and I toss a coin, the probability of yours turning up heads is independent of the probability of my throwing a head. However, the return on an investment in, say, BP is not independent of the return on an investment in Shell. This is because these two companies both compete in the same industry. On the other hand, all oil companies might do well when oil prices are high and badly when they are low. The important matter here is that the fortunes of these two companies are not independent of each other. Assets differ in expected return and variability in returns. Part (i) illustrates the return on two assets in two different situations. Asset A has a high return in situation 2 and a low return in situation 1. The reverse is true for asset B. A portfolio of both assets has the same expected return but lower risk than a holding of either asset on its own. In (ii) both assets have a high return in situation 2 and a low return in situation 1. For the risk-averse investor asset A dominates asset B. Consider part (i) of the table. In this case both assets have the same expected return (20 per cent) and the same degree of risk. (The possible range of outcomes is between 10 and 30 per cent on each asset.) If all that mattered in investment decisions were the risk and return of individual shares, the investor would be indifferent between assets A and B. Indeed, if the choice were between holding only A or only B, all investors should be indifferent (whether they were risk-averse, risk-neutral, or risk-loving) because the risk and expected return are identical for both assets. However, this is not the end of the story, because the returns on these assets are not independent. Indeed, there is a perfect negative correlation between them: when one is high the other is low, and vice versa. What would a sensible investor do if permitted to hold some combination of the two assets? Clearly, there is no possible combination that will change the overall expected return, because it is the same on both assets. However, holding some of each asset can reduce the risk. Let the investor decide to hold half his wealth in asset A and half in

asset B. His risk will then be reduced to zero, since his return will be 20 per cent whichever situation arises. This diversified portfolio will clearly be preferred to either asset alone by riskaverse investors. The risk-neutral investor is indifferent to all combinations of A and B because they all have the same expected return, but the risk lover may prefer not to diversify. This is because, by picking one asset alone, the risk lover still has a chance of getting a 30 per cent return and the extra risk gives positive pleasure. Risk-averse investors will choose the diversified portfolio, which gives them the lowest risk for a given expected rate of return, or the highest expected return for a given level of risk. Diversification does not always reduce the riskiness of a portfolio, so we need to be clear what conditions matter. Consider the example in part (ii) of Table 2. As in part (i), both assets have an expected return of 20 per cent. But asset B is riskier than asset A and it has returns that are positively correlated with A's. Portfolio diversification does not reduce risk in this case. Riskaverse investors would invest only in asset A, while risk-lovers would invest only in asset B. Combinations of A and B are always riskier than holding A alone. Thus, we could say that for the risk-averse investor asset A dominates asset B, as asset B will never be held so long as asset A is available. The key difference between the example in part (ii) of Table 2 and that in part (i) is that in the second example returns on the two assets are positively correlated, while in the former they are negatively correlated. The risk attached to a combination of two assets will be smaller than the sum of the individual risks if the two assets have returns that are negatively correlated. Diversifiable and non-diversifiable risk Not all risk can be eliminated by diversification. The specific risk associated with any one company can be diversified away by holding shares of many companies. But even if you held shares in every available traded company, you would still have some risk, because the stock market as a whole tends to move up and down over time. Hence we talk about market risk and specific risk. Market risk is non-diversifiable, whereas specific risk is diversifiable through riskpooling. Box 3 discusses the issue of whether all firms should diversify the activities in order to reduce risk. Beta It is now common to use a coefficient called beta to measure the relationship between the movements in a specific company's share price and movements in the market. A share that is perfectly correlated with an index of stock market prices will have a beta of 1. A beta higher than 1 means that the share moves in the same direction as the market but with amplified fluctuations. A beta between 1 and 0 means that the share moves in the same direction as the stock market but is less volatile. A negative beta indicates that the share moves in the opposite direction to the market in general. Clearly, other things being equal, a share with a negative beta would be in high demand by investment managers, as it would reduce a portfolio's risk. The capital asset pricing model, or CAPM, predicts that the price of shares with higher betas must offer higher average returns in order to compensate investors for their higher risk. For example, Two stocks whose returns move in exactly together have a coefficient of +1.0. Two stocks whose returns move in exactly the opposite direction have a correlation of -1.0. To effectively diversify, you should aim to find investments that have a low or negative correlation. The banking stocks (or the technology stocks) would have a high positive correlation as their share prices are driven by common factors. As you increase the number of securities in your portfolio, you reach a point where you have diversified as much as is reasonably possible. When you have about 30 securities in your portfolio you have diversified most of the risk.

Q.6. Study the performance of any emerging market of your choice. Ans. EMERGING MARKET With emerging market economies like India and China growing at nearly 10%, you may be feeling pain from all the criticism from pundits and advisers that you are a myopic, shortsighted American for not allocating enough to emerging market equities. According to Vanguard, the average allocation to emerging market equities among US household investors is still only 6%. Shouldn't the percentage of your equity portfolio invested in emerging markets equities be roughly in line with the proportionate share of emerging-market stocks to total global stock-market capitalization – or around 10% to 15% of an investor's total equity portfolio? It seems natural to expect that the powerful economic growth of emerging markets such as Brazil and China will lead to higher stock market returns than in the slower growing markets such as the U.S. and Europe. So should emerging market equities be a bigger part of your portfolio? In fact, US household investors may, at least for the moment, be properly weighted in emerging markets. For the following reasons higher potential growth may not justify investing heavily right now in emerging market equities and instead you may want to be gradually increasing your allocation over time: First, 12% economic growth in a country like India has not necessarily meant 12% market returns. While there is certainly reasonable evidence to support expectations of long-term growth in markets like India, China, Brazil, etc., as reported in this Wall Street Journal article - studies suggest that strong economic growth often does not translate into strong stock returns. One study, which looked at market returns in 32 nations since the 1970s, concluded that stock gains and economic performance can diverge dramatically. University of Florida finance professor Jay Ritter found, for example, that stocks in Sweden posted a mean return of better than 8% a year from 1970 through 2002, even though GDP grew at an annualized pace of just 1.8%. In contrast, while GDP expanded more than 5% annually in South Korea from 1988 to 2002, the mean stock return was only 0.4% a year. 'A healthy economy isn't a guarantee that established companies will attract enough capital and labor to expand sales and earnings strongly—partly because they have to compete with newer ventures for resources,' Dr. Ritter says. More basically, since markets are largely efficient, investors have long ago anticipated potential for equities in places like China. Right now, by many measures, it would appear that valuations for US and MSCI Emerging Markets Index on a trailing P/E basis are roughly inline. Second, even if average annual returns from emerging markets exceed developed markets, emerging markets are still materially more volatile, and this volatility will not just keep you awake at night, it will erode your returns over time through the process of volatility drag. My colleague explains in this article how volatility drag will reduce your returns. Right now, the 3year standard deviation of emerging market returns is 32.83 versus 24.27 for the S&P500, a difference that translates into roughly a 3% drag on your cumulative return. And while the 60day volatility on US Large-Cap Equities has now dropped all the way down to 10.99%, the 60-

day emerging market volatility actually rose slightly this quarter to 19.55% (see chart below for period ending December 31, 2010):

Third, emerging market indexes are less efficient investment vehicles – which makes a big difference over time for prudent, long-term investors. Most emerging market funds are significantly more expensive than US funds - often hundreds of basis points more. Our firm recommends low cost funds such as Shares MSCI Emerging Market Index (EEM), and Vanguard Emerging Markets (VWO). But even these low-cost funds face higher costs than US equity funds. Compare Vanguard's VWO at 0.27 expense ratio vs. Vanguard’s S&P500 Index Fund (VOO) at 0.06%. If you are investing within a fund family such as Fidelity, your choice for emerging markets is an actively managed fund with an annual cost of 1.14% versus Fidelity's S&P500 Index at only 0.10% (This is why if you really seek more exposure to emerging markets economic growth, a more efficient way to gain exposure is through multinationals traded on US exchanges – S&P500 companies derive about 50% of their revenue from abroad, with about a third of that coming from emerging markets). So higher economic growth may not lead to higher returns on emerging markets equities, volatility drag is likely to erode much of this potential higher return, and higher investment costs are certain to drag the return down even further. In our dynamic asset allocation process, emerging markets allocations are likely to grow along with other equity allocations over the next few years assuming volatility continues to decline. But, right now, it appears that the average American household is not necessarily being naive and xenophobic when they choose to be “underweighted” in emerging market equities.

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