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Q1. Financial markets bring the providers and users in direct contact
without any intermediary. Financial markets permits the businesses and
governments to raise the funds needed by sale of securities. Describe the
money market/capital market features and its composition.
(Money market- features and composition, Capital market-features and
composition)
Answer:
Money Market Features and Composition
The money market exists as a result of the interaction between the suppliers and
demanders of short-term funds (those having a maturity of a year or less). Most
money market transactions are made in marketable securities which are short-term
debt instruments such as T-bills and commercial paper. Money (currency) is not
actually traded in the money markets. These crudities traded in the money market
are short-term with high liquidity and low-risk; therefore they are close to being
money. Money market provides investors a place for parking surplus funds for short
periods of time. It also provides low-cost source of temporary funds to borrowers
like firms, government and financial intermediaries. The money markets are
associated with the issuance and trading of short-term (less than 1 year) debt
obligations of large corporations, financial institutions (FIs) and governments. Only
high-quality entities can borrow in the money markets. Individual issues are large.
Thus the money market mischaracterized by low default risk and large
denomination of instruments.
The characteristics of money market instruments are:
Short-term debt instruments (maturity of less than 1 year)
Services immediate cash needs
o Borrowers need short-term working capital.
o Lenders need an interest-earning parking space for excess funds.
Instruments trade in an active secondary market.
o Liquid market provides easy entry & exit for participants.
o Speed and efficiency of transactions allows cash to be active even
for very short periods of time (over night).
Large denominations
o Transactions costs are low in relative terms.
o Individual investors do not actively participate in this market.
Low default risk
o Only high quality borrowers participate.
o Short maturities reduce the risk of changes in borrower quality.
Insensitive to interest rate changes
o They mature in one year or less from their issue date.

Maturity of less than 1 year is too short for securities to be adversely affected, in
general, by changes in rates. In theory, the banking industry should handle the
needs for short-term loans and accept short-term deposits and therefore there
should not be any need for money markets to exist. Banks have an information
advantage on the creditworthiness of participants they are better able to deal with
the asymmetric information between savers and borrowers. However banks have
certain disadvantages. Regulation creates a distinct cost advantage for money
markets over banks. Banks also have to deal with reserve requirements; these
create additional expense for banks that money markets do not have. Also money
markets deal with creditworthy entities- governments, large corporations and
banks; therefore the problem of asymmetric information is not severe for money
markets. Thus money market exists for short term loans and short term deposits of
high-quality entities like governments, large corporations and banks.
Capital Market Features and Composition
The capital markets are the markets in equity (shares) and long-term debt (bonds);
in other words, the markets for long-term capital. In this market, the capital funds
comprising both equity and debt are issued and traded. Capital market can be
further divided into primary and secondary markets. Primary market is a market
where securities are offered to public for subscription for the purpose of raising
capital. The primary market is the first-sale market. Secondary market is a market
where already existing (pre-issued)securities are traded amongst investors. On the
equity side, the primary market includes initial public offerings and rights issues; on
the fixed income side, it consists of Treasury auctions (i.e. auctions of Treasury
bonds) and original issues of company bonds. The term placement refers to a
transaction on the primary market: the issuer is placing its securities with
investors.
Although corporations do not directly benefit from secondary market transactions,
the managers of a corporation closely monitor the price of the corporation s stock
in secondary markets. One reason for this concern involves the cost of raising new
funds for further business expansion. The price of a companys stock in the
secondary market influences the amount of funds that can be raised by issuing
additional stock in the primary market. Corporate managers also pay attention to
the price of the companys stocking secondary markets because it affects the
financial wealth of the corporations owners the stockholders. If the price of the
stock rises, then the stockholders become wealthier. This is likely to make them
happy with the companys management. Typically, managers own only small
amounts of a corporations outstanding shares. If the price of the stock declines,
the shareholders become less wealthy and are likely to be unhappy with
management. If enough shareholders become unhappy, they may move to replace
the corporation managers. Most corporate managers also receive options to buy
company stock at a selected price, so they are motivated to increase the value of
the stock in the secondary market.
Q2. Risk is the likelihood that your investment will either earn money or
lose money. Explain the factors that affect risk. Mr. Rahul invests in equity
shares of Wipro. Its anticipated returns and associated probabilities are
given below:

Return
-15
-10
5
10
15
20
30
Probabilit
y
0.05 0.10 0.15 0.25 0.30 0.10 0.05
You are required to calculate the expected ROR and risk in terms of
standard deviation.
(Explanation of all the 4 factors that affect risk, Calculation of expected
ROR and risk in terms of standard deviation)
Answer:
Factors that affect risk
Some common risk factors are:
Business risk: This is the possibility that the company holding your money will not
pay the interest or dividend due, or the principal amount,
when your bond matures. This may be caused by a variety of factors like
heightened competition, emergence of new technologies, development of substitute
products, shifts in consumer preference, inadequate supply of essential inputs,
changes in governmental policies and so on. The poor business performance
definitely affects the interest of equity shareholders, who have a residual claim on
the income and wealth of the firm. It can also affect the interest of debentures
holders if the ability of the firm to meet its interest and principal payment obligation
is impaired.
Inflation risk: Inflation risk is the chance that the purchasing power of the invested
rupees will decline. This is the risk that the rupee you get when you sell your asset
will buy less than the rupee you originally invested in the asset.
Interest rate risk: The variability in a securitys return resulting from changes in
the level of interest rates is referred to as interest rate risk. This is the possibility
that a fixed debt instrument, such as a bond, will decline in value due to a rise in
interest rates. As the interest rate goes up, the market price of existing fixed income
securities fall, and vice versa. This happens because the buyer of a fixed income
security wouldnot buys it at its par value or face value if its fixed interest rate is
lower than the prevailing interest rate on a similar security.
Market risk: Market risk is the variability in a securitys returns resulting from
fluctuations in the aggregate market (such as the stock market).This is the risk that
the unit price or value of your investment will decrease because of a decline in
market. The market tends to move in cycles. John Train says You need to get
deeply into your bones the sense that any market, and certainly the stock market,
moves in cycles, so that you will infallibly get wonderful bargains every few years,
and have a chance to sell again at ridiculously high prices a few years later.
Calculation of expected ROR and risk in terms of standard deviation

SD = 112.8125 = 10.62 %
Q3. Explain the business cycle and leading coincidental & lagging
indicators. Analyse the issues in fundamental analysis
(Explanation of business cycle-leading coincidental and lagging indicators,
Analysis and explanation of the issues in fundamental analysis all the four
points)
Answer:
Business cycle and leading coincidental and lagging indicators
All economies experience recurrent periods of expansion and contraction. This
recurring pattern of recession and recovery is called the business cycle. The
business cycle consists of expansionary and recessionary periods. When business
activity reaches a high point, it peaks; a low point on the cycle is a trough. Troughs
represent the end of a recession and the beginning of an expansion. Peaks
represent the end of an expansion and the beginning of a recession. In the
expansion phase, business activity is growing, production and demand are
increasing, and employment is expanding. Businesses and consumers normally
borrow more money for investment and consumption purposes. As the cycle moves
into the peak, demand for goods overtakes supply and prices rise. This creates
inflation. During inflationary times, there is too much money chasing a limited
amount of goods. Therefore, businesses are able to charge more for their items
causing prices to rise. This, in turn, reduces the purchasing power of the consumer.
As prices rise, demand slackens which causes economic activity to decrease. The
cycle then enters the recessionary phase. As business activity contracts, employers
lay off workers (unemployment increases) and demand further
slackens. Usually, this causes prices to fall. The cycle enters the trough. Eventually,
lower prices stimulate demand and the economy moves into the expansion phase.
Economists use three types of indicators that provide data on the movement of the
economy as the business cycle enters different phases. The three types are
leading, coincident, and lagging indicators.

Leading indicators tend to precede the upward and downward movements of the
business cycle and can be used to predict the near term activity of the economy.
Thus they can help anticipate rising corporate profits and possible stock market
price increases. Examples of leading indicators are: Average weekly hours of
production workers, money supply etc.
Coincident indicators usually mirror the movements of the business cycle. They
tend to change directly with the economy. Example includes industrial production,
manufacturing and trade sales etc.
Lagging Indicators are economic indicators that change after the economy has
already begun to follow a particular pattern or trend. Lagging Indicators tend to
follow (lag) economic performance. Examples: ratio of trade inventories to sales,
ratio of consumer installment credit outstanding to personal income etc.
Issues of Fundamental Analysis
Time constraints: Fundamental analysis may offer excellent insights, but it can be
extraordinarily time-consuming. Time-consuming models often produce valuations
that are contradictory to the current price prevailing in the stock markets.
Industry/company specific: Valuation techniques vary depending on the industry
group and the specifics of each company. For this reason, a different technique and
model is required for different industries and different companies. This can get quite
time-consuming and limit the amount of research that can be performed. A
subscription-based model may work for an Internet Service Provider (ISP), but is not
likely to be the best model to value an oil company.
Subjectivity: Fair value is based on a number of assumptions. Any changes to
growth or multiplier assumptions can greatly change the ultimate valuation.
Analyst bias: The majority of the information that goes into the fundamental
analysis comes from the company itself. Companies can manipulate information
that is released and ultimately used by analysts. Also, most of the analysis is done
by analysts who work for the big brokers who are in turn involved in underwriting
and investment banking for the companies. Even though there are safeguards in
place to prevent a conflict of interest, the brokers have an ongoing relationship with
the company under analysis.
Definition of fair value: When market valuations extend beyond historical norms,
there is pressure to adjust growth and multiplier assumptions to compensate. If the
market values a stock at 50 times earnings and the current assumptions are 30
times, the analyst would be pressured to revise this assumption higher.
Q4. Discuss the implications of EMH for security analysis and
portfolio management.
(Implications for active and passive investment, Implications
for investors and companies)
Answer:
Implications for active and passive investment
Proponents of the efficient market hypothesis often advocate passive as opposed to
active investment strategies. Active management is the art of stock-picking and
market-timing. The policy of passive investors is to buy and hold a broad-based
market index. Passive investors spend neither on market research nor on frequent
purchase and sale of shares. However, passive strategies may be tailored to meet
individual investor requirements. The efficient market debate plays an important

role in the decision between active and passive investing. Active managers argue
that less efficient markets provide the opportunity for skillful managers to
outperform the market. However, it is important to realize that a majority of active
managers in a given market will underperform the appropriate benchmark in the
longrun whether or not the markets are efficient.
If markets are efficient, then what is the role for investment professionals? Those
who accept the EMH generally reason that the primary role of portfolio manager
consists of analyzing and investing appropriately based on an investor's tax
considerations and risk profile. Optimal portfolios will vary according to factors such
as age, tax bracket, risk aversion, and employment. The role of the portfolio
manager in an efficient market is to tailor a portfolio to those needs, rather than to
beat the market.
Implications for investors and companies
The efficient market hypothesis has a number of implications for both the
investors and the companies.
For investors:
With the passage of time, interest rate changes in the market. The cash flows from
a bond (coupon payments and principal repayment) however, remain fixed. As a
result, the value of a bond fluctuates. Thus interest rate risk arises because the
changes in the market interest rates affect the value of the bond. The return on a
bond comes from coupons payments, the interest earned from re-investing coupons
(interest on interest), and capital gains. Since coupon payments are fixed, a change
in the interest rates affects interest on interest and capital gains or losses. An
increase in interest rates decreases the price of a bond (capital loss) but increases
the interest received on reinvested coupon payments (interest on interest). A
decrease in interest rates increases the price of a bond (capital gain) but decreases
the interest received on reinvested coupon payments. Much of the existing evidence
indicates that the stock market is highly efficient, and therefore, investors have little
to gain from active management strategies. Attempts to beat the market are not
only useless, but they can reduce returns due to the costs incurred in active
management (management fees, transaction costs, taxes, etc). Investors should
therefore follow a passive investment strategy, which makes no attempt to beat the
market. This does not mean that there is no role for portfolio management. Returns
can be optimized through diversification and asset allocation, and by minimization
of investment costs and taxes. In addition, the portfolio manager must choose a
portfolio that is geared toward the time horizon and risk profile of the investor. The
appropriate mixture of securities may vary according to the age, goals, tax bracket,
employment, and risk aversion of the investor. Investors, however, will have to
make efforts to obtain a greater volume of timely information. Semi-strong form of
market efficiency depends on the quality and quantity of publicly available
information. Therefore, companies should be encouraged by investor pressure,
accounting bodies, government rulings and stock market regulation to provide as
much information as inconsistent with the companies need of secrecy to prevent
competitors from gaining useful knowledge.
The perception of a fair and efficient market can be improved by more constraints
and deterrents placed on insider trading.
For companies:
The EMH also has a number of implications for companies:

The companies should focus on substance, not on window dressing by

manipulating accounting data: Some managers believe that they can fool
shareholders. For example creative accounting is used to show a more impressive
performance than that actually happened. Most of the time, these tricks are spotted
by the investors. They are able to see through the manipulation and interpret the
real position, and consequently security prices do not rise as a result of
manipulation of accounting data.
The timing of security issues does not have to be fine-tuned: A
company need not delay a share issue thinking that its shares are currently underpriced because the market is low and hoping that the market will rise to a more
normal level later. This thinking defies the logic of the EMH if the market is
efficient the shares are already correctly priced and it is just as likely that the next
move in prices will be down as up.
Q5. Explain about
components in it.

the

interest

rate

risk

and

the

two

An investor is considering the purchase of a share of XYZ Ltd. If his

required rate of return is 10%, the year-end expected dividend is Rs. 5 and
year-end price is expected to be Rs. 24, Compute the value of the share.
(Introduction of interest rate risk, Explanation of two components of
interest rate risk, Calculation of value of the share)
Answer:
Interest Rate Risk: With the passage of time, interest rate changes in the market.
The cash flows from a bond (coupon payments and principal repayment) however,
remain fixed. As a result, the value of a bond fluctuates. Thus interest rate risk
arises because the changes in the market interest rates affect the value of the
bond. The return on a bond comes from coupons payments, the interest earned
from re-investing coupons (interest on interest), and capital gains. Since coupon
payments are fixed, a change in the interest rates affects interest on interest and
capital gains or losses. An increase in interest rates decreases the price of a bond
(capital loss) but increases the interest received on reinvested coupon payments
(interest on interest). A decrease in interest rates increases the price of a bond
(capital gain) but decreases the interest received on reinvested coupon payments.
Thus there are two components of Interest Rate Risk:
Price risk is the risk that bond prices will decrease with an increase in interest
rates.
Reinvestment rate risk is the uncertainty about future or target date portfolio
value that results from the need to re-invest bond coupons at yields that are not
known in advance. Interest rate increases act to decrease bond prices (price risk)
but increase the future value of reinvested coupons (reinvestment rate risk), and
vice versa.
Calculation of value of the share
Given,

R=.10
D1=5
And P1=24,
Then,
[D1/(1+r)]+[P1/(1+r)]
=(5/1.10)+(26/1.10)
=4.545+23.636
=28.181
Q6. Elucidate the risk and returns of foreign investing. Analyze
international listing.
(Explanation of all the points in risks and returns from foreign investing,
Introduction of international listing)
Answer:
Risks and Returns from Foreign Investing
International investing provides superior returns adjusted for risk. Allocating some
portion of one's portfolio to foreign assets provides better risk adjusted reruns than
a portfolio of domestic assets alone. International equities also offer access to a
broader spectrum of economies and opportunities that can provide for further
diversification benefits. Some of the best performing companies in the world like
General Electric, Exxon Mobil and Microsoft have shares that are listed on overseas
stock markets. If an investor wants to profit from the growth of large global
companies, he would have to invest internationally. However, there are costs and
risks of international investing. International investing can be more expensive than
investing in domestic companies. In smaller markets, an investor may have to pay a
premium to purchase shares of popular companies. In some countries, there may be
unexpected taxes, such as withholding taxes on dividends. Transaction costs such
safes, brokers commissions, and taxes can be higher than in domestic markets.
Mutual funds that invest abroad often have higher fees and expenses than funds
that invest in domestic stocks, in part because of the extra expense of trading in
foreign markets.
There are risks involved in international investing. Some of the risks are:
1) Changes in currency exchange rates
When the exchange rate between the foreign currency (in which the international
investment is denominated) and the home currency (say, Rupee for an Indian)
changes, it can increase or decrease the investment return.
2) Dramatic changes in market value
Foreign markets, like all markets, can experience dramatic changes in market value.
One way to reduce the impact of these price changes is to invest for the long term
and try to ride out sharp upswings and downturns in the market.
3) Political, economic and social events
It is difficult for investors to understand all the political, economic, and social factors
that influence foreign markets. These factors provide diversification, but they also
contribute to the risk of international investing.
4) Lack of liquidity
Foreign markets may have lower trading volumes and fewer listed companies.
5) Less information
Many foreign companies do not provide investors with the same type of information
as domestic companies. It may be difficult to locate up-to-date information, and the

information the company publishes may not be in English or in a language that the
investor understands.
6) Reliance on foreign legal remedies
If an investor has a problem with his investment, he may not be able to sue the
company in his own countrys courts. Even if he is able to sue successfully in a
domestic court, he may not be able to collect on a home country judgment against
a foreign company
7) Different market operations
Foreign markets often operate differently from the major domestic countrys trading
markets. For example, there may be different periods for clearance and settlement
of securities transactions. Some foreign markets may not
report stock trades as quickly as home markets.
International Listing
In addition to issuing stock locally, companies can also obtain funds by issuing stock
in international markets. This will enhance the companys image and recognition,
and diversify its shareholder base. A stock offering may also be more easily
digested when it is issued in several markets. Also, a company may decide to crosslist its shares. Cross-listing of shares is listing of its equity by a firm on one or more
foreign stock exchanges in addition to its domestic exchange. By cross-listing its
shares, a company benefits from the access to foreign investors and subsequent
increased liquidity and lower cost of capital.
A company must choose one or more stock markets on which to cross-list its shares
and sell new equity. Just where a company goes depends mainly on the companys
specific motives and the willingness of the host stock market to accept the
company. The locations of a companys operations can influence the decision about
where to place its stock, in view of the cash flows needed to cover dividend
payments. Market characteristics are important too. Stock markets may differ in
size, trading activity level, and proportion of individual versus institutional share
ownership. Cross-listing attempts to accomplish one or more of many objectives:
Improve the liquidity of its existing shares and support a liquid secondary
market for new equity issues in foreign markets.
Increase its share price by overcoming mispricing in a segmented and illiquid
home capital market.
Increase the companys visibility.
Establish a secondary market for shares used to acquire other firms.
Create a secondary market for shares that can be used to compensate local
management and employees in foreign subsidiaries.