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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 corporations 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
corporations 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 would not 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:
the
interest
rate
risk
and
the
two
10