Book 02
Book 02
Book 02
1
Chapter-One
Understanding of
Investments
Investment Defined
Investments can be defined as the utilization or deployment of
funds in the expectation of future positive returns. The concept
of investment may be divided into the broader or customary
sense and in the narrower sense. The broader or customary
sense of the term ‘investment’ is any asset or property right
acquired or held for the purpose of preserving capital or earning
an income. In the narrower sense the term ‘investment’ is used
to suggest a commitment which is relatively free from risk of
loss. Again, investment is the purse of security(s) that, upon an
appropriate analysis, offers safely of principal and satisfactory
yield, commensurate with the risks assumed. In other words,
investment is defined as the commitment of funds in
anticipation of receiving a larger future flow of funds. Lastly,
investment is defined as the postpone of the present
consumption of asset with the expectation of receiving future
resources compensating the investor for the time the funds are
committed, the expected rate of inflation, and the uncertainty of
the future payments of both principal and returns thereon.
However, investments refer to investing money in certificates of
deposits, government and corporate bonds, common stocks, or
mutual funds. Moreover, investments also include other paper
assets like warrants, puts and calls, futures contracts, and
convertible securities.
Deployment of funds in real assets like gold, silver, diamonds,
arts, house, buildings, real estate, and other tangible assets are
also termed as investments. In finance technology, investments
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include both real assets and financial assets. Marketable
securities are financial assets that are generally traded in the
financial markets. Our main objective concerned in this text
generally refers to the analysis of financial assets and in
particular to marketable securities.
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Investment Categories
There are various types of investments prevailing in the
securities markets. Considering various concepts and nature of
investments, they are classified into four broad categories as
follows:
i) Consumer investment: The concept of the
consumer investment relates to the purchase of
durable consumer goods by the consumer. Typically,
this is not investing one’s funds but it is a savings-
process. Usually, the income derived from the
purchase of durable consumer goods comes not in the
form of money but in the form of services and
amenities of property ownership.
ii) Business or economic investment: The concept of
business or economic investment refers to a situation
where money is used to purchase business assets
that will produce income which will be adequate
compensation for the risk involved in the venture.
Profit motive is the main object in this concept of
investment. The businessman is thoroughly willing to
purchase productive assets to earn a profit and is
aware of the risk involved. Economic or business
investment, therefore, is any investment in assets
which brings about the production of goods and
services and real terms for the purpose of earning a
profit commensurate with the risk involved.
iii) Financial or security investment: Financial or
security investment refers to the purchase of an asset
in the form of securities producing a profit for the
investors. The investor assuming of all the risk
involved in such a purchase tries to keep the risk to a
minimum and at the sametime he maximizes the
profit. Financial or security investment may broadly
be categorized, which are our main focus, are subject
to the discussion in accordance with their sources of
issuance and the nature of the buyer commitment.
iv) Analyst’s investment: An analyst’s investment
refers to the operations that promise safety of
principal and an adequate return.
These are the various types of investments out of which an
investor can select to invest his/her investible funds
commensurate with his objective.
Types of Investors
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Investors are broadly classified into two categories viz., i) local
investor and ii) foreign investor. Local investors are those who
invest their unutilized fund in their own country in various
sectors they like depending upon the prospective future returns
and assuming minimum risk. Local investors are also be
subdivided into two categories as follows:
a) Individual investors: Individual investors are those who
deploy their funds individually in local market to
purchase securities like shares, bonds, debentures,
stocks etc. and to deposit into their bank accounts and to
invest their funds in purchasing insurance policies and
the like. The main objective of the individual investors is
to earn maximum return assuming minimum risk.
b) Institutional investors: Institutional investors include
firms, companies, corporate bodies or financial
institutions like banks, insurance companies, investment
companies that invest funds institutionally in the capital
market through purchasing shares, stocks, bonds,
debentures and/or other securities with the help of
recognized brokers. Institutional investors do not have a
problem of having available funds but the individual
investors have an unique problem of surplus funds.
Foreign investors are those who invest their funds in the
overseas capital market independently or under joint venture
arrangement through purchasing securities of oversea’s vendor
companies or of government. The foreign investors also invest
directly in establishing oversea’s industry. They help the
oversea’s industrialization under joint venture ownership. The
objectives of foreign investors are mainly to earn profit and to
capture the foreign market in order to flourish their local
merchandise.
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Inflation
Risk-free rate usually refers to the rate of return for government
securities like Treasury-bills, Treasury-notes, and Treasury-
bonds etc. Other than fixed income securities, a major factor
influencing the investment/consumption decisions of an investor
is the risk involved. If the future benefits from an investment are
not known with certainty then individuals will require an even
higher expected return on the investment. Risk premium is the
additional return to nominal rate of return for taking risk of
return on equities or bonds. So, we can merely identify three
major factors determining the expected return that an investor
requires in order to forego current consumption and therefore
invest:
i) risk-free real rate for time preference of consumption,
ii) expected rate of inflation and
iii) associated risk on investment
Therefore, the required rate of return (RRR) would be:
Required rate of return = Nominal rate of return +
Risk premium
Again, if we combine the real rate of return and the inflation
premium, we get risk-free rate of return. It compensates the
investor for the current use of funds and for the loss in
purchasing power due to inflation but not for taking risk. Thus,
the risk-free rate is calculated as:
Risk-free rate = [(1+ real rate)(1+
Inflation)] −1
Investment Process
Investment includes the various methods and steps adopted by
the prudent investors during the development of their funds in
order to earn profit and to minimize risks involved therein. The
main steps in the investment process may be furnished with the
diagram given below:
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Goals
settings
↓
Identifying risk
↓
Measuring risk-
return
↓
Formation of
portfolios
↓
Review of the
performance
↓
Portfolio Revision
i) To set goals and objectives: The first step in the
investment process is to identify the goals and
objectives f the investors. A systematic investment
decision requires the formulation of a set of long-term
or short-term goals which can serve as a guide for
managerial decisions. This step also includes the
determination of the quantum of investment in
different shares and debentures quoted in the capital
market.
ii) To determine appropriate risk level: The second
step in the investment process is to determine the
amount of risk that an investor is willing to assume to
achieve the investment objective. This step will
largely determine the mix of assets to be held in the
investment portfolio and attempt will be made to
quantify the risk and measurement of the same by
applying appropriate tools.
iii) To estimate the risk and return: The third step in
the investment process is to estimate the risk and
return for the investors to take their decisions,
because risk and return go hand in hand. Investors
must balance risk with return.
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iv) To form optimal portfolio: The fourth step in the
investment process is to construct optimal portfolio
which includes estimate of risk and return for
individual securities and to maintain relationship
between securities, portfolios and the like. An
investment portfolio is the list of investment securities
both common stock and bonds that an investor owns.
v) To make the analysis of the performance: The
fifth and the last step in the investment process is to
analyze the performance of the vendor company’s
financial statement in order to take investment
decision.
vi) To review the portfolio: The investor should
monitor the results of their portfolios for determining
the goals and objectives and review the performance
of the portfolios. This may provide some insights
which will improve their security analysis and portfolio
selection techniques.
Underatanding of Investment
In order to accomplish the investment process an investor
should have the following knowledge:-
Firstly, an investor must be aware of the risks
associated with the investment.
Secondly, an investor must be aware that the
investment requires the availability of surplus fund now or in
future.
Thirdly, an investor must possess knowledge of
individual securities that are available.
Fourthly, an investor must have a method of analysis
that will allow as to make an intelligent selection of securities.
Fifthly, an investor must be aware of the sources of
information that will allow him to make a complete and
intelligent analysis of an industry.
Sixthly, an investor must have sufficient knowledge of
buying and selling of shares and other securities in the stock
market.
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investment and speculation because the main objective of both
investment and speculation is to earn profit.
Investment
An investment can be defined as the utilization of funds in
assets committing a positive return in over some future time
identified as holding period. Investment comes from savings.
Speculation
Speculation can be defined as the activity seeking opportunities
promising very large return earned quickly which involve more
risk. Investment differs from speculation with respect of three
major factors viz., i) risk, ii) capital gains, iii) time period.
The points of distinction between investment and speculation
may be depicted in the following chart:
Investment Speculation
i. An investment is a i. Speculation means the
commitment of funds made in deliberate assumption of risks
the expectation of positive in ventures which offers the
rate of return. hope of commensurate gains.
The oped for gains may
come in the form of larger
incomes than a safe
investment would supply.
ii. The investors invest their ii. The speculators invest
surplus funds for a relatively their investible funds for a
long period of time. relatively short time.
iii. Investors receive a stable iii. Speculators maximize the
return and capital profit by capitalizing the price
appreciation over a period of changes. They are interested
time. in capital gains.
iv. The investors assume iv. The speculators assume
minimum risk with the hope relatively high risk with the
of consistent rate of return. hope of abnormal extremely
high rate of return.
v. The investors give v. The speculators do not
emphasis upon the principle give emphasis upon the
of conservatism for the safety principle of conservatism for
of their principal. the safety of their principal.
vi. The investors are vi. The speculators are
interested in the internal usually interested in trading
conditions of the company securities. They ignore
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and devote their energy to dividends and are interested
determine the financial in technical market position.
security of the company and
its earnings power.
vii. The investors desire a vii. The speculators always
modest rate of dividend or desire short-term price
profit or long-term growth appreciation and do not
prospect of the company. bother for long-term growth
prospect of the company.
From the above discussion it is clear that the difference
between investment and speculation is matter of time horizon,
degree of risk, normal and abnormal rate of return and long-
term or short-term growth prospect of the vendor company.
Determinants of Investment
Investment has widespread scope in the capital market and
other sectors of the country. But the functions of the investors
are influenced positively or negatively by the following factors:-
General price level: It is the first factor influencing the
functions of an investor, because the general price level always
shows rising tendency due to the inflation prevailing in the
economy. The rising tendency of the general price level creates
elements of uncertainty and confusion into the thinking of
investors which cause fear of safety of principal.
Business conditions and profits: Business conditions
and profits are the second important factor influencing the
functions of an investor. Because the investors invest their
funds in shares, stocks, bonds, debentures and the like after
analyzing the vendor company’s growth prospect of the
business in terms of profits, earning capacity and the liquidity.
Dividends: The third factor influencing the functions of
an investor is the payment of dividends declared by the
company to its shareholders. The stable rate of dividends
always attracts the investors to invest in the shares and stocks
of the vendor company and any fluctuation of profit discourages
the investors to invest their funds in the form of shares, and
stocks of the same.
Interest rate: Interest rate is the fourth and one of he
most important factors influencing the investors to invest in
debentures and bonds of the vendor company. The investors
will invest money in the form of bonds and debentures of the
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vendor company which pay high rate of interest. The investors
feel encourage to invest their investible fund if the rate of
interest commensurates with the rate of inflation prevailing in
the economy.
Security prices: The fifth and the last factor influencing
the functions of an investor is the security price. The security
prices may be labelled by the two systems viz., stock price
cycles system and stock price swings system. The security price
quoted under stock price cycles system is consistently and
somewhat revolving system. But the security price is quoted
inconsistently and fluctuates under the stock price swing
system. The investors feel encourage to invest their funds under
the stock price cycles system rather than stock price swing
system.
In fine, these are the factors influencing the functions of an
prospective investor. A prudent investor must consider the
above mentioned factors and analyze them very carefully while
making an investment decision.
Investment Media
In financial markets, an investor has various alternatives to
invest. Some investment medias are simple and direct; some
present complex problems of analysis and investigation. Some
are familiar, some are relatively strange. Some are more
appropriate for one type of investor than for another. This
section will analyze various forms in which investment media
are classified.
a. Insurance and retirement fund:
▪ Life insurance
▪ Fixed and variable annuities
▪ Government retirement fund for social security
▪ Private pension fund
b. Deposit fund:
▪ Savings and time deposit with commercial banks
▪ Deposits in mutual savings banks
▪ Deposits savings and loan associations
▪ Shares in credit union
▪ Eurodollar certificates of deposit
▪ Eurodollar deposit
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c. Short-term investment:
▪ Short-term government securities
▪ Commercial papers
▪ Banker’s acceptance
▪ Certificates of deposit
▪ Negotiable bank certificates of deposit
▪ Repurchase agreement
d. Long-term securities:
▪ Bonds, notes, and stocks of business or commercial
enterprises
▪ Bonds, and shares of investment companies
▪ Bonds, and shares of commercial banks
▪ Shares in savings and loan associations
▪ Loans and shares in insurance companies
▪ Government bonds, and other long-term obligations
▪ Local government and municipal bonds
▪ Securities of foreign governments
e. Real estate and other immovable properties:
▪ Investment for occupancy or residential purpose
▪ Investment for income and/or commercial purpose
▪ Bonds, and shares in real estate companies and
syndicates
▪ Real estate mortgages
▪ Mortgage-backed securities
▪ Shares in real estate investment trusts
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Questions and Problems
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Chapter-Two
Investment Alternatives
Investment Portfolio
Basically investments involve two categories viz., real assets
and financial assets. Real assets include those assets which are
tangible, material things like furnitures, land, building,
ornaments, automobiles etc. Financial assets, on the other
hand, include pieces of paper representing an indirect claim to
real assets held by individuals or firms or any corporate body.
Being pieces of paper, financial assets represent debt or equity
commitments in the form of I owe you (IOU) or stock
certificates. Stock exchanges are alternative vehicle for
investments in financial assets. Both bond market and equity
market instruments are transacted in stock exchanges.
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Liquidity being one of the special interest to investors
distinguishes real assets from financial assets. Obviously, real
assets are less liquid than financial assets as because the
former are more heterogeneous and yield benefits only in
cooperation with other productive factors. Moreover, returns on
real assets are frequently more difficult to measure accurately.
However, our principal concern in analyzing investment is more
concern with financial assets rather than real assets. Investors
in securities always have an alternative to direct investing.
Indirect investing refers to buying and selling of shares of
investment companies that, in turn, hold portfolios of securities.
Investors purchasing shares of a particular portfolio managed by
an investment company are purchasing an ownership interest in
that portfolio of securities and are entitled to a prorata share of
the dividends, interest, and capital gains generated by the
portfolio. A direct investor, however, have the following
investment categories:
i. Government securities
ii. Corporate bonds
iii. Corporate common stocks
iv. Preferred stocks and
v. Derived securities
Investments in the above assets may, further, be categorized
according to their source of issuance and the nature of the
buyer’s commitment as debt instruments and equities. To this
end, investments in securities can also be classified on the basis
of income or return they earn each year of their life as fixed
income securities and variable income securities. Fixed income
securities are those which have a defined limited money claim.
The money received from those investments will never exceed
this promised claim, although they can fall short of promise in
the case of default. Variable income securities, on the other
hand, have a residual claim to the earnings of a company. These
claimants are entitled to whatever is left after all the other
securityholders have exercised their claims to the firm’s
earnings. While the stockholder’s claim to the earnings is
residual, it is also unlimited in amount. If the firm proves to be a
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huge success, the stockholders may reap huge gains, while the
bondholders receive only their fixed claim.
Direct investing
Indirect investing
(
Mutual funds)
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Direct investing
Treasury bills
Treasury notes
Money market Treasury bonds
Instruments Commercial papers
Eurodollars deposit
Bankers’ acceptances
Repurchase agreements
Eurodollar certificates of
deposit
Negotiable certificates of
deposits
Treasuries
Debentures
Income bond
Capital Callable bonds
market Debts Putable bond
Instruments Corporate bond
Mortgage bond
Convertible bond
Sinking fund
Equities Preferred stock
Common stock
Money market deposits
Nonmarketable Savings deposits
Certificates of deposits
Government savings bonds
Options (puts and calls)
Derivatives market Warrants
Futures contracts
Indirect investing
Annuities
Insurance policies
Equities Unit investment trusts
Open-end investment
companies
Closed-end investment
companies
Table-2.2: Shows major types of Securities.
Debt Instruments
Debt instruments include all types of fixed-income securities
promising the investors that they will receive specific cash flows
at specific times in the future. Securities generating one cash
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flow are known as pre-discount securities or zero-coupon
securities. On the other hand, it may involve multiple cash
flows. If all the cash flows are of equal amount, they are
generally referred to as coupon payments. The date beyond
which the investors will no longer receive cash flows is known
as maturity date. On this date investors will receive the principal
along with the last coupon payment. Although these cash flows
are promised, they may not be received due to the risk
associated with such investments. Financial assets issued by
government, firms, and individuals often take the form of IOUs
calling for fixed periodic payments, termed as interest and the
repayment of the amount borrowed, termed as principal. Debt
instruments represent money loaned rather than ownership to
the investors.
Deposits and Contracts
Currency, in real sense, is a government IOU. Money and
savings accounts referred to as demand and time deposits are
loans to banks and other like financial institutions. Demand and
savings and other time deposits cannot be withdrawn without
notice, although financial institutions provide this advantage to
the depositholders. Savings accounts draw interest, and some
forms like certificates of deposits (CDs) have specific maturities.
CDs pay higher interest than normal saving accounts do.
Government Securities
Government securities are those securities which are issued by
the government to finance deficit in budget when revenues fall
short of expenditures. Government securities are all most
invariably bond issues of various types. These bonds are issued
by the government at all levels. Because it can print money, the
securities of the government are not subject to default. The
government securities are riskless, defaultfree and earn a fixed
rate of interest income. Being issued by the government debt
securities differ in quality, yield, and maturity. In the national
and international financial market, we usually find the
governments securities as mentioned below:
Treasury Bills: Treasury bills are short-term notes that
mature in three months, six months, nine months and maximum
one year from the date of issue. These securities can be
redeemed only at maturity. Treasury bills can be easily sold in
the money market at prices that reflect prevailing interest rate
and on a discount basis before maturity. The discount to the
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investors is the difference between the less-than-face-value
price they pay and face value they receive at the maturity.
Certificate of Indebtness or Treasury Certificate:
Certificate of indebtness differs from Treasury bills because they
are issued at par value and pay fixed interest rates. These fixed
interest rates are called coupon rates. Every bond issue of this
type promises to pay a coupon rate of interest that is printed on
the bond and never changes. The bond investor collects this
interest income by tearing perforated coupon slip off the edge
of the certificate and cashing the coupons at the banks and post
offices or other government approved authorities. Treasury
certificate matures within one year from the date of issue.
Treasury Notes: Treasury notes are similar to the
treasury certificate accept with regard to time of maturity.
Notes typically have a maturity of one to ten years when they
are newly issued. Like treasury certificate, however, they are
sold at face value in the money market and pay fixed coupon
interest payments each year of their life.
Treasury Bonds: Treasury bonds make up the smallest
segment of the government debts. Bonds differ from notes and
certificates with respect to maturity; bonds mature and repay
their face value within a period from ten to thirty years from the
date of issue. Some bond issues are callable or redeemable
prior to maturity.
Private Issues
Private debt securities are issued by corporations and/or both
financial and nonfinancial institutions which run the spectrum in
quality and yield. The categories of these types of securities are
furnished below:
Corporate Bonds: When corporations go to the capital
markets to obtain money for all corporate purposes, the single
most important sources of funds is through the sale of debt
securities. It is a long-term written promise to pay under seal a
certain sum of money at a certain time for specific rate of
interest. Bondholders have the right to receive fixed rate of
interest payment before any dividends may be distributed to
the equity owners. In addition, the bondholders have what is
termed as fixed claim on the assets of the firm. This means that
when the bonds mature, or in the event of liquidation of the
firm, the bondholders are entitled to receive a stated amount
and this claim has priority over any of the claim of the equity
owners.
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Corporate bond is long-term debt securities issued by
corporations help to finance their operations. It is similar to
other kinds of fixed-income securities in that it promises to
make specific payments at specified times and provides legal
remedies in the event of default. Different names are often used
for the same type of bond, and occasionally the same name will
be used for different bonds. However, the following types of
bonds are available in the financial market:
Debentures: Debentures are general obligations of the
issuing corporation and thus represent unsecured credit. Their
claim is fixed but based only on the firm’s ability to generate
cash flow. To protect the holders of such bonds, the indenture
will usually limit the future issuance of secured debt as well as
any additional unsecured debt.
Income bond: All interest on bonds must be paid before
any dividends are distributed to the shareholders. Income bond
is a security on which interest is paid only if earnings are
sufficient. These are infrequently sold to raise new capital
because of the residual nature of interest payments. In some
income bonds, the interest payment must be approved and
declared by the board of directors as much the same way as
dividends are paid on preferred stocks. If the interest on bond is
not paid, it may be cumulative and payable at a later time.
Income bonds are still debt instruments but they are closely
related to stock in the essential characteristic of interest
payment.
Mortgage bond: Mortgage bond represents debt which
is secured by the pledge of subject security. In case of default,
the bondholder is entitled to obtain the property and to sell it to
offset his claims on the firm.
Equipment trust certificate/bond: Any way in which
the principal of a bond issue is secured through the pledge of
equipment. The title to the property or machinery usually
remains in the hands of the trustee until the debt is repaid. The
corporation receives the title to the equipment only when all
scheduled payments are made. Each six month after the
purchase of equipment, a principal and interest payment would
be paid to the trustee. The trustee in turn would retire some of
the equipment trust certificates and pay the interest on the
outstanding debts.
Convertible bond: The convertible bond provides the
holder with an option to exchange his bond for a predetermined
number of common shares at any time period to maturity. The
convertible bonds offer the promise of sharing the capital
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growth. If the stocks increase in value, the bonds also will
increase. If the stock remains at the same price, the bonds will
still provide a good yield.
Callable bond: The callable bond gives the issuing firm
to retire the bonds at a stated call price. The call option usually
becomes operative after a stated period of call protection which
is usually either five or ten years after originally issuance. The
call price usually begins at a value close to the sum of the
principal plus one annual interest payment and steadily declines
to the value of the principal at maturity. The promise to redeem
bonds at maturity can be altered or modified by what is called
call future providing the benefit for the issuer.
Putable bond: A putable bond gives holder the option to
exchange his bond for cash equal to the face value of the same.
Registered bond: One other safeguard might be
indicated in the indenture which assures the basic security of
the bond. A bond may be registered to protect the owners from
loss. When the bond principal is registered the name and
address of the bondholders are recorded with the issuing
company. The registration of the principal does not guarantee
that the bondholder will receive principal repayment at
maturity, but it does provide him with protection from loss
should the bond certificate be lost or destroyed.
Collateral trust bond: Some bond issues pledge stocks
or bonds as additional security for the money borrowed. This
type of bond is referred to as collateral trust bond. The collateral
is usually the personal property of the corporation that is issuing
the bond.
Sinking fund: A sinking fund is a specific type of
security issued for the benefit of the investors. A part of the
principal of debt is paid each year reducing the amount
outstanding at maturity. Sinking fund operates by having the
corporation transmit cash to the trustee who can then purchase
bonds in the open market.
Receivers certificates: Receivers certificates are debt
instruments that arise out of reorganization. When a corporation
in reorganization needs capital, the receivers or the trustees
have the power to raise additional funds. The securities issued
are known as receivers certificates and the principal value of
these claims takes precedence over any other debt outstanding.
This priority places them in a superior position with respect to
other debt.
Bond indenture: The special promises that are made to
the bondholder are set forth in the bond indenture. It is an
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agreement between corporation issuing the bonds and a
corporate trustee, usually a commercial bank or trust company
who represents the bondholder. The usual items that are found
in the bond indenture are: the authorization of the issue, the
exact wording of the bond, the interest or coupon rate, the
trustee’s certificate, the registration and endorsement, the
property pledged as security if any, and the agreements,
restrictions and remedies of the trustee.
Commercial Papers: Commercial paper is an unsecured
short-term promissory note issued by both financial and
nonfinancial companies. These securities are issued to
supplement bank credit and are sold by companies of prime
credit standing. Commercial papers representing short-term
unsecured promissory notes are generally issued by large firms
of unquestionable financial soundness.
Banker’s Acceptance: Banker’s acceptance are time
draft drawn on and accepted by a bank which has agreed to do
so for an importer or a holder of merchandise, thus substituting
bank credit for commercial credit. Such instruments are widely
used in foreign trade. The buyer of the goods may issue a
written promise to the seller to pay a certain amount within a
short period of time the maturity of which is less than one year.
This written promise offering liability to both the bank and the
buyer of the goods is termed as banker’s acceptance.
Certificates of Deposits: Certificates of deposits (CDs)
are special type of interest-bearing deposits at commercial
banks or savings and loan associations. Time deposits of large
corporate in commercial banks are often of certain minimum
amounts for a specified time period. Unlike time deposits, these
certificates of deposit are negotiable.
Eurodollar Certificates of Deposits: In the world of
international trade and finance, large short-term certificates of
deposit denominated in dollars and issued by banks outside the
United States are known as Eurodollar certificates of deposit
(henceforth Euro CDs). Euro CDs are negotiable.
Eurodollar Deposits: Dollar-denominated time deposits
in commercial banks outside United States are commonly
known as Eurodollar deposits. Eurodollar deposits cannot be
traded and thus they are not negotiable.
Repurchase Agreements: A money market instrument
may be traded between two investors. The seller of such
instrument may agree to repurchase it for a agreed-on price at
a later date. This agreement is like a collateralized loan from
buyer to seller.
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Equity Instruments
Equity refers to as investment media representing an ownership
position on assets in which the investor is an owner of the firm
and is thus entitled to a residual share of profits. Equity
instruments differ from fixed income securities in that their
returns are not contractual. Returns can be much better or
much worse than those from a bond. The equity ownership,
however, arises out of the indirect equity investment and direct
equity investment. Before going to describe the direct and
indirect equity investment, we need to identify the components
of equities.
Components of Equities
Capital structure refers to long-term sources of financing for a
firm. It is consisted of long-tern debt and equities. Shareholders’
equity is a residual item that is not fixed. It is the difference
between the assets and all other liabilities of a firm which is
found as:
Assets – Liabilities =
Equity
However, the equities of a firm are comprised of the following
components:
i. Common stock: The amount of money paid by the
owners of the organization measured as the product of
par value (face value) and number of shares
outstanding.
ii. Surplus: The excess amount above each share of
stock’s par value paid by the shareholders.
iii. Undistributed profit: The net earnings after tax that
is retained in the business rather than distributing to
the shareholders as dividends
iv. Equity reserves: Representing any fund for
contingencies, providing a reserve for dividend
expected, and a sinking fund to retire stock or debt in
the future.
v. Preferred stock: The amount which is measured by
the par value of any shares outstanding promising to
pay a fixed rate of return in the form of fixed dividend.
vi. Subordinated debentures: Long-term debt carrying
a convertible feature. The holders of them have the
right to exchange their debt for shares of stock.
vii. Equity commitment notes: Debt security repayable
only from the sale of stock.
23
viii. Minority interest in consolidated debentures: The
holdings of ownership shares of other business
enterprises.
24
Common stock may be sold by its holder to any willing
buyer.
The earnings on the common stockholder’s equity may
be unstable.
Dividends may fluctuate. It must depend on earnings,
cash position, surplus position, expansion needs, debt
situation and management policy.
Common stock prices fluctuate extensively.
Common stocks in general are a price-level hedge. That
is, they tend to earn, pay dividends and bring market
prices at levels which are vaguely related to the general
commodity price level.
Dividends are normally less than the earnings on the
common stockholders’ equity.
Common stockholders have voting power to vote for the
board of directors and for against major issues of the
corporation.
Common stockholders have pre-emptive right to
subscribe to any new issue of stock so that they can
maintain their previous fraction of the total number of
shares sold.
Par value common stock just like preferred stock can be
par or no par.
The market value of common stock is the variable of concern to
investors. The aggregate market value of a corporation which is
calculated by multiplying the market price per share of the
stock by the number of shares outstanding determines the total
value of the firm as estimated in the market place. Dividends
are the cash payments which are distributed to the common
shareholders by the corporation. However, the followings are
the types of dividend concerned:
◘ Dividend yield: It is the amount of dividend per share
divided by market price of the same. This income
component of a stock’s return is stated on a percentage
basis.
◘ Dividend payout ratio (D/P ratio): It refers to the ratio
of dividends to earnings. It indicates the percentage of a
firm’s earnings paid out in cash to its shareholders.
◘ Retention ratio: It is the complement of payout ratio
indicating the percentage of firm’s current earnings
retained by it for reinvestment purposes.
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Preferred stock: Preferred stock is a hybrid sorts
between a fixed and variable income security. It is an equity
security with an intermediate claim between bondholders and
stockholders on a firm’s assets and earnings. In the event of
liquidation, preferred stockholders have a claim on available
assets before the common stockholders. In addition preferred
stockholders get their stated dividends before common
stockholders receive any dividends. Many issues of preferred
stock are callable at a stated redemption price. Preferred stocks
are usually perpetual securities having no maturity date,
although there are exceptions to the general rule. However,
followings are the special features of preferred stock:
Some preferred stockholders have voting rights and
some preferred stockholders do not have this right and
voice in the management.
Preferred stockholders have pre-emptive right to
subscribe to additional issues of common stock but non-
voting preferred stock have no pre-emptive right.
Most preferred stock have par value. In this case, the
shares’ cash dividend rights are usually stated at a
percentage of par value.
Cash dividends are the most significant aspect of
preferred stock in which the stockholders should get
more gain from dividends than from capital appreciation.
Preferred stocks can be categorized as follows:
Cumulative preferred stock: Holders of cumulative
preferred stocks are entitled to a dividend whether the
firms earn profit or not. If the corporation misses a
preferred dividend or any part of the ones, it is not lost
but must be made up in a later year before any cash
dividends can be paid the common stockholders.
Non-cumulative preferred stock: Holders of non-
cumulative preferred stocks are entitled to a dividend if
firm earns profit. If the corporation does not earn any
profit, the dividend is lost to the preferred stockholders.
Participating preferred stocks: Participating preferred
stock is somewhat uncommon which is entitled to a
stated rate dividend/ interest and a share of earnings
available to be paid to the common stock holders. The
holders of participating preferred stocks are entitled to
receive extra dividends when earnings permit.
Convertible preferred stocks: At the option of the
holders, convertible preferred stocks may be converted
26
into another security (generally firm’s common stock) on
stated terms.
Trust preferred stocks: These types of stocks are
structured so that their dividend payments are treated as
tax-deductible interest by the issuer.
Adjustable-rate preferred stocks: Adjustable-rate
preferred stocks have the cash dividends that fluctuate
from quarter to quarter in accordance with the current
market interest rates. These stocks are created to make
cash dividend yield on preferred stock fluctuate with
market conditions and thus be more competitive with
bond investments.
Money market preferred stocks: Money market
preferred stocks have finite life that expires very soon
after they are used- some issues mature even after
seven weeks. They typically offer a large denomination
because they are targeted at large corporate investors.
Stock Dividends: In stead of and some times in addition
to cash dividends, investors can receive dividend in the form of
stock. Often firms pay stock dividends as a replacement for or a
supplement to the payment of cash dividends. A stock dividend
is a payment of stock to existing owners.
Stock Splits: Stock splits have similar effect upon a
firm’s share price as do stock dividends. Stock splits are
commonly used to lower the market price of the firm’s stock. To
enhance the trading activity high-priced firms often believe to
lower the price of the same.
Stock Repurchases: Stock repurchases refer to the firm
buying its own stock. Repurchased stock is called treasury
stock. A corporation can repurchase its shares in one of the
following ways: open market purchase, private negotiated
transactions or a tender offer.
From the above discussion, we may conclude that preferred
stock possesses some characteristics similar to bonds and some
to common stock. However, the different characteristics of
common stock, preferred stock and bond are summarized in
Table-2.3. Direct investments and indirect investments are
shown in Figure 2.1.
27
Priority Residual Fixed Fixed
Amount
Claim on
assets: Last Second First
Priority Residual Fixed Fixed
Amount
Claim: Discretionary Discretionary
Mandator
y
Maturity Perpetual Perpetual Fixed
Table-2.3: Features and Characteristics of Different Securities.
Investor
Holds
Portfolio of
Assets
Investor
holds shares in
which is a
Portfolio of
Assets
28
Figure-2.1: Direct invest vs. Indirect investment.
Questions/Exercises
1. How does an investor organize the financial assets?
2. What does debt instrument mean? State the characteristics
of debt instruments.
3. Discuss the different types of debt instruments available in
the securities markets.
4. What do you mean by equity? How do equities differ from
debt instruments?
5. What are the basic characteristics of common stock?
6. Enumerate different elements/components of equities of a
firm.
7. Show the priority on claims on the earnings of the company
held by:
a) Common stockholders,
b) Bondholders, and
c) Preferred stockholders.
8. Show the returns from direct investments and those of
indirect investments.
9. Explain different types of derivative instruments.
10. Briefly discuss the different types of bonds offered by a
corporation for making investment by investors.
Chapter-Three
29
Securities Markets
In the economic sense, investment means the commitment of
funds to capital assets. Accordingly the investors are users of
funds which they own or acquire in the market. Investors supply
the funds by acquiring debt and equity instruments with their
savings and they also transfer these instruments among each
other. In this connection investment market includes the
markets for funds both short and long term. A market is a
mechanism that brings buyer and seller together to aid in the
transfer of goods and services. It is not a physical location
where physical commodities are found ready to be bought and
sold. Rather it is a process by which buyer and seller can
communicate regarding the relevant aspects of the transaction.
So, financial market is a mechanism that brings buyer and seller
of financial assets together for fixing the price of a particular
security. Under such mechanism, those who establish and
administer the market do not own the assets. They provide a
physical location or an electronic system allowing potential
buyers and sellers to interact. They provide necessary
information and logistic support to transfer the ownership of the
securities being traded.
Characteristic of a market
Individuals enter into the securities markets to buy or sell their
securities at a price justified by the prevailing supply and
demand of the subject securities. An efficient market is that
where the participants must have timely and accurate
information on the volume and prices of past transactions and
on all currently outstanding bids and offers. A sound securities
market possesses the following characteristics:
▪ Investors will be able to get accurate and quick
information necessary for the security transactions.
▪ A market should operate in a position where the ability
to buy or sell an asset at fixed price is not substantially different
from the price for prior transaction, assuming no new
information is available.
▪ A market should ensure the price continuity meaning
that prices do not change much from one transaction to the
next unless substantial new information becomes available. A
30
continuous market without large price changes between trades
is a characteristic of a liquid market.
▪ The buyers and sellers trade at prices above and below
the current market price.
▪ An efficient or good market is one in which the
transaction cost is minimum i.e., the market should be internally
efficient.
▪ A market should reflect all the information available
regarding the supply and demand factors in the market. This
condition refers to as external or informational efficiency.
31
nation and even from foreign countries. The stock exchange
also provides a service to industry by directly aiding new
financing. The ease with which the investors can trade issues
makes them more willing to invest in new issues. One way in
which the securities market may be classified is the types of
securities bought and sold there. The broadest classification is
based upon whether the securities are new issues or are already
outstanding and owned by investors. New issues are made
available in the primary markets; securities that are already
outstanding and owned by investors are usually bought and sold
through the secondary market. Another classification is by
maturity; securities with maturity of one year or less are
normally traded in the money market; those with maturities of
more than one year are bought and sold in the capital market.
However, highly liquid debt securities that have short terms
until they mature and involve little or no risk of default are call
money market securities. All money market securities are debts
that mature within 270 days or less. Money market securities
are frequently issued instead of long-term debt securities in
order to avoid administrative cost. Money market securities pay
continuously fluctuating rates of interest that exceed the rate of
inflation only slightly.
Investors also benefit from the market mechanisms. They would
hesitant to acquire the securities that are not readily
marketable and such reluctance would reduce the total quantity
of funds available to finance industry and government. Those
who own securities must be assured of a fast, fair, orderly and
open system of purchase and sell at known prices. The
classification of market we are most interested in is the one that
differentiates between old and new securities- the primary and
secondary markets. It is obvious found that the investors who
bought stock at the offering price enjoyed a profit. In recent
years, the secondary markets have been further fragmented,
creating ‘third’ and ‘fourth’ markets- where the third market
represents over-the-counter trading of shares which are listed
on an organized exchange and the fourth market represents
direct trading of a huge number of shares between two
investors viz., large institutional investors without intermediary.
Once the investors have purchased the new issues, they change
hands in the secondary markets: the organized exchanges and
over-the-counter (OTC) market. Organized exchanges are
physical marketplaces where the agents of buyers and the
sellers operate through the auction process. Unlike the
organized exchange, the over-the-counter market has no central
32
location where the securities are traded. Being traded over-the-
counter market implies that the trade takes place by telephone
or electronic device and that dealers stand ready to buy or sell
specific securities for their own accounts. They will buy at a bid
price and sell at an asked price that reflects the competitive
market conditions. The organized exchange being a self-policy
organization of dealers requires at least two market makers
(dealers) for each security, but often there are five or ten or
even twenty for government securities. So, the multiple dealer
function in the OTC market is an attractive feature for many
countries in comparison to the single specialist arrangement on
the organized exchange. In an organized exchange the majority
of the securities consist of equities, in terms of both volume and
value. The opposite dimension of the market is for the debt
securities. It is safe to say that most long-term bond trading
takes place in the OTC market, while all the trading in the short-
term government securities takes place in the OTC market.
However, debt securities can be categorized by the issuers of
securities. Corporate bonds, the most popular debt securities,
are traded both on the exchange and over-the-counter,
although most of the trading takes place OTC.
33
market. Entrepreneurs are supposed to be provided capital
procuring other factors of production that would ensure full-
employment and create more productive capacity in the
economy. A securities market can achieve this type of objective.
Securities markets can augment the growth; development and
stability of a country’s financial structure increase the allocation
of savings, allocation of existing real wealth and ensure the
distribution of income. In economic development of a country
the problem is mainly two-fold viz., increase or creation of
domestic savings and transformation of more funds to
investment. Securities markets can ensure efficient allocation of
savings to productive investment by the creation/development
of money and capital market.
In the economic sense, capital formation is the change in the
stock of the capital goods represented by producers’ durable
equipment, and business inventories. In modern capitalistic
economy, capital formation would be impossible without a
market or group of markets for the transfer of savings to those
seeking funds for investment in economic goods and services. In
this connection, a variety of instruments representing money
and claims to money are employed. Savers provide the funds
and in return expect to receive dividends, interest, or rent and
the investors offer the hope of income and price appreciation. In
the financial sense, a securities market is the market for
instruments representing longer-term funds. It is consisted of
institutions and mechanism whereby intermediate-term funds
and long-term funds are pooled and made available to business,
government, and individuals, and where outstanding
instruments are transferred. On the other hand, money market
focuses on debt instruments only with maturities ranging from
one day to one year. It engages in purchasing and selling of new
instruments rather than trading in outstanding claims. In
financial terminology, the investment market includes the
markets for funds both short and long term. Both long term and
short term segment of investment market includes the primary
sale and purchase and secondary transactions in instruments.
Business firms invest capital in amounts that are beyond their
capacity to save in any reasonable period of time.
Securities markets play a crucial role for the proper functioning
of capitalistic economy. They serve to channel funds from
savers to borrowers. Another important function that the
securities market does is the allocative function by channeling
funds to those who can make best use of them. The existence of
34
the secondary market ensures the purchasers of the primary
securities that they can quickly sell their securities. Since there
are no guarantees in the financial market, sales may involve
losses. Such a loss may be much preferred to having no cash at
all if the securities cannot be sold readily.
Classification of Securities
Before analyzing securities, it is essential for financial analysts,
economists, business policymakers, investors in securities,
academicians to study and develop an understanding of
different classes of securities. Depending upon a wide variety of
considerations, securities can be categorized into four broad
groups viz.:
i. Bond
ii. Common stock
iii. Preferred stock and
iv. Derivative securities
Bonds: Bonds are fixed income securities with a fixed
maturity. There is a specified date at which time the firm must
pay all liabilities it owes to the bondholders who do typically
have the fixed claim on the income of the firm. In addition,
bondholders have fixed claim on the assets of the firm. More
specifically, when the bonds mature or in the event of
liquidation of the firm, the bondholders are entitled to receive
their principal having a priority over any of the claims of the
equity owners.
Common stocks: Equity shares or common stocks
called to be perpetual lie on the other side of the securities
spectrum. Common stocks or equities have no maturity period.
They exist as long as the corporation exists. Common
stockholders have the residual claim against the income and
assets of the firm.
Preferred stocks: Preferred stock basically called the
hybrid security lies somewhere between those of common stock
and bonds. Like bondholders, the holders of preferred stock
have a fixed claim on the income of the corporation. On the
other hand, like common stock preferred stock is a perpetual
liability of the firm.
Derivatives: Derivative securities include warrants,
options, futures contracts. Part, if not all, of their value is
derived from the value of another security.
35
Securities Markets Distinguished
Investment is defined as the changes in capital stocks. In the
economic sense, capital formation is the change in the stock of
the capital goods. According to the views of capitalistic
economy, capital formation or accumulation of capital for
investment and industrial development of an economy would,
no doubt, be meaningless without an organized market or group
of markets. In this connection, it is sine-qua-non to transfer the
savings from surplus unit to those seeking funds for investment
in economic goods and services for the rapid economic
development and emancipation. To make effective this transfer,
a variety of instruments representing money and claims to
money are employed. Savers provide the funds and expect to
get a reasonable return. Users of the funds are supposed to get
income, price appreciation, or both.
A) On the basis of the maturity (term) of the securities
traded, markets are:
i. Money market
ii. Capital market
B) On the basis of the trading mechanism of the securities,
markets are:
iii. Primary mafrket
iv. Secondary market
Money market
It focuses on debt instruments only the maturities of which
range from one day to one year. It also involves a complex of
instruments dominated by the central bank as agent of the
government and commercial banks. It purchases and sells new
instruments rather than trading in outstanding claims.
Characteristics of Money Market
Money market is not the unique place or mechanism where
short term debt instruments are traded among the investors
rather there are several locations where direct transactions take
place between borrowers and lenders. Under an efficient system
to handle any amount and volume of transactions at any time,
regional submarkets are also linked together with the centrally
organized market. However, the basic characteristics of money
market are given below:
◘ Short-term securities with maturity of less than one year
are traded in the money market
◘ Central and regional short-term markets create a national
short-tern interest rate structure.
36
◘ They also create a national short-term credit.
◘ Idle funds are transferred through the intermediaries
from all over the country to the central open market.
◘ Funds are largely transferred on a wholesale basis,
although the large institutions deal directly with each
other.
◘ The whole role of the institutions involved in the money
market is controlled by the monetary and credit system
of the country.
◘ The major participants in the money markets are the
central bank, commercial banks, and other finance
companies.
Money Market Instruments
Money market instruments are summarized below:
◘ Treasury bills
◘ Treasury notes
◘ Bankers’ acceptance
◘ Commercial paper
◘ Certificates of deposits-CDs
◘ Negotiable CDs
◘ Drafts/Bills
Any firm distinction between money and capital market is some
what arbitrary. Suppliers of funds may direct them to one or
both the market and users of fund may draw funds from either
market. Furthermore, funds flow back and forth between two.
Any institution serves both the market. Rates of interest or fund
acquisition costs are interrelated with changes in the general
demand and supply of funds.
Capital Market
In the financial sense, the capital market is the market for the
instruments representing long-term funds requirement of the
corporation. It consists of a sprawling complex of institutions
and mechanism whereby intermediate-term funds and long-
term funds are pooled and made available to business,
government, and individuals. In this mechanism outstanding
instruments collecting the funds are transferable.
Characteristics of Capital Market
The characteristics of the capital market and its elements may
be classified and measured in varieties of ways. There are a
number of submarkets having distinguished features and
independent rates of yield. However, the capital markets
assume the following characteristics:
37
◘ Debt and equities instruments traded in the capital
markets are intermediate or longer-term in maturity.
◘ The scope of the market is very wide.
◘ The supply of the new funds comes from the same
sectors although it is funneled within the markets through
financial institutions.
◘ The demand for the capital market instruments comes
from the categories like individuals and households, businesses
and financial corporations, central government, local
government, and foreign government.
◘ Under the auspice of capital markets, both negotiated
and open markets are widely used.
◘ Transactions in open markets influence the prices and
yields of longer-term instruments immediately.
◘ Lon-term instruments in the open market are
transferred among the investors in the over-the-counter market
and organized exchanges rather than the raising of new funds in
the primary markets.
Capital Market Instruments
The major instruments traded in the capital markets are
medium and longer-term in maturity which are discussed below:
◘ Treasury Bonds
◘ Government securities with maturity of more than one
year. They are marketable and their yields vary with changing
credit and capital market conditions
◘ Longer-term debt owned by the government.
◘ Privately owned longer-term debt that is sponsored by
the government.
◘ Long-term debt of local government.
◘ Long-term corporate bonds including corporate
mortgage debt.
◘ Common stocks
◘ Preferred stocks
◘ Mortgage including residential, commercial, and
industrial lien.
Both money market and capital market instruments facilitate
the issuers and the firms to raise capital requirements and
necessary funds for the smooth operation of the business. These
instruments are alternative vehicles providing the opportunity to
invest the funds for getting required return. Since these
instruments are marketable securities, they are transacted in
the financial markets.
Primary Market
38
Primary market is a security market where new securities are
being sold for the first time. It is a market where new issues of
common stock, preferred stock or bonds are sold by
government or firms to acquire new capital. A primary market is
one in which a borrower issues new securities in exchange for
cash from an investor. When securities are initially offered to
the public, they are said to be to be sold in the primary market.
Primary markets are those in which the sellers of the securities
are also the issuers of the securities i.e. the issuing firms are the
sellers of the securities. If the existing corporations issue
additional shares, these would be sold in what is called the
primary market. A primary issue occurs when the issuer gets the
proceeds from an initial public offering (IPO) of stocks or bonds.
An intermediary that finds out the buyers for IPOs is termed as
investment banker.
New treasury bills, stocks, or bonds all take place in the primary
markets. The issuers of these securities receive cash from the
buyers of these new securities, who in turn receive financial
claims that previously did not exist.
39
potential investors to assess the quality of the new issue. The
information that must be published in registration statements is
set by law. After filing the registration statement with the
Securities and Exchange Commission, there is usually only a
brief waiting period until the new issue may be offered for sale.
Underwriting Functions: Underwriting refers to the
guarantee taken by investment banker that the issuer of the
new securities will receive a certain amount cash for them. The
managing underwriter forms an underwriting syndicate the
members of which literally buy the securities from the issuing
firm on the day of the offering. When the securities are actually
sold to the public, they are sold either by members of the
underwriting syndicate or by members of the selling group. The
members of the selling group are broker-dealer firms buying the
securities from the underwriters and in turn resell them to their
customers.
Distribution Functions: Investment bankers distribute the
new issues to investors in several ways viz.,
i) Underwriting-by which they buy the issues and then sell
them to the public investors. They also bring together
issuer and investors as an intermediary.
ii) Private placement- meaning that investment banker
finds one buyer (typically large institution) for an entire
issue and arrange for direct sale from the issuer to this
large investor.
iii) Best-efforts basis- where the investment banker may
agree to distribute new issues assuming no financial
responsibility if all the securities can not be sold. The
commission or compensation for the investment banker
for best-efforts offerings are typically more than for a
direct placement but less than for a fully underwriting
public offering.
Pricing Functions: The investment bankers must
stabilize the pricing of a new issue during the distribution period
to prevent it from drifting downward. The underwriting manager
supports the price by placing orders to buy the newly issued
security at a specified price in a secondary market where the
new securities are trading.
Floatation Costs
The underwriter offering the highest net cash proceeds for the
IPOs gets the deal. Investment bankers make profits by selling
IPOs at price above what they paid for them. The difference
between the buying and selling prices is called the spread. The
spread in a security issue is typically divided into three parts:
40
The management fee, the underwriting fee, and the selling
concession. These are explained below:
The originator or the managing underwriter keeps a
certain point for originating and managing the syndicate.
The entire underwriting group earns a specific
percentage of the total profit.
The members of the selling group earn the remaining
portion of the total profit.
The precise composition of these fees may vary from offering to
offering but the general rule of thumb is 20 percent, 20 percent
and 60 percent respectively to originator, investment bankers
and selling group. In case where the originator sells to the
ultimate buyers without the involvement of other parties, he
receives the total spread.
Isuuer
Originating investment
banker
Selling Group
41
Investing Public
Issuer
Sells securities to the underwriters
Receives cash/capital to acquire assets
Originating investment banker
Advises issuer
Forms syndicate
Buys/underwrites securities from issuer
Resells securities to public or selling group
Investment banker
Buys/underwrites securities from issuer
Resells securities to public or selling group
Selling group
Sells securities to the investors
Collects proceeds from the investors
Seasoned and Unseasoned Public Offerings
Primary issues of securities commonly known as initial public
offerings (IPOs) are sold by the firm known as issuer to the
investors through the investment bankers. When the issuer is
selling the securities in the primary market, these are known as
initial public offerings. Such type of securities can be
categorized into two groups viz., seasoned issues and
unseasoned issues.
Seasoned Issues: Sales of common stocks of a publicly
traded company are called seasoned issues. Broadly speaking,
an offering of seasoned issues would involve the issuance of
additional shares of existing companies having common stocks
outstanding. A seasoned public offerings is a new offering of
securities by a firm that has already issued securities to the
public. Three types of seasoned issues are available in the field
of IPOs as follows:
i. Primary seasoned offering: It refers to the offering of
new issues of securities by a firm that has already done
an initial public offering. The principal object of such
offering is to raise new capital for the firm.
42
ii. Secondary seasoned offering: Also known as secondary
placement, a secondary public offering refers to the
purchase of the securities by the underwriters directly
from the firm’s founder, other prepublic owners, and
other post-public holders of the securities not from the
firm. The principal objective of secondary seasoned
offering is to cash out the firm.
iii. Combined seasoned offering: It is partly primary and
partly secondary seasoned issue which is generally used
to both raise new capital for the firm and to cash out
some of the prepublic owners.
Unseasoned Issues: Initial public offerings which are
being offered to the public for the first time are known as
unseasoned issues. There is no established market price for
them rather is negotiated between the investment bankers and
the issuing firm.
Secondary Markets
Primary issues of securities occur relatively infrequently. When
an investor buys a security, the seller is another investor. Such
trade occurs in what are called secondary markets. When
investment bankers underwrite IPOs in the primary markets, the
issuers receive the cash proceeds. In the secondary markets
one investor sell securities to another investor and the issuing
firm is not involved. The secondary market is an effective
mechanism existing for the resale of the new issues. The
secondary market gives investors the means to trade existing
securities. The securities continue to trade between investors in
a market called secondary market. In secondary markets issuer
no longer receive any cash proceeds. The secondary markets
perform a wide variety of activities like:
◘ A secondary market brings the investors together so that
transaction can be made immediately at a price that
varies little from transaction to transaction.
◘ A secondary market gives investors the means to trade
existing securities.
◘ A secondary market continues to maintain the
marketability of the tradable assets.
◘ Market fixes the price of the security by the transaction
that flow from the investors’ demand and supply
preferences.
◘ A secondary market makes the transaction price public
which helps investors making better decisions.
43
◘ A secondary market stimulates new financing
encouraging the investors to invest in IPOs.
◘ Being a self-regulatory organization, a secondary market
regulates and monitors the activities of members,
employees, listed firms etc. A secondary market also
exists for trading of common stock, preferred stock,
bonds, debentures, warrants, options, and futures
contracts. However, the structure of the secondary
market is given below:
Secondary Markets
Type of Markets
securities
Organized stock
Equities exchanges
Over-the-counter (OTC)
market
Third market
Fourth market
Organized exchanges
Bonds (a relatively small
amount)
Over-the-counter market
Puts and calls Organized stock exchange
Organized Exchanges
In the secondary markets individual investor can sell securities
to another investor without the presence and involvement of the
44
firm that issued the securities. Such type of secondary trading
takes place on the organized stock exchanges. An organized
stock exchange is called the First market of secondary market.
The OTC Market
Over-the –counter market is an impotant alternative to
organized stock exchange and measured in terms of total
volume of trading. It is a telephone- and computer- linked
network of dealers who trade over the telephone. Transactions
in the OTC market are usually done between two financial
institutions or between a financial institution and one of its
clients like corporate houses ,and fund managers. In past times
securities were traded over-the-counter of banks or in the
offices of security dealers. Today over-the-counter trades occur
in brokers’ offices, dealers’ offices, homes, over the phone,
electrically, and any place or even any transport whole over the
country and in foreign countries. The over-the-counter (OTC)
market includes trading in all securities not listed on one of the
exchanges. It also includes trading in listed stocks referring to
as third market. Though unlisted securities trading market, OTC
is one the most modern and efficient securities market in the
world. OTC market is not physically located market in any one
place. This over the counter market is called the second market
of the secondary market. It consists of a number of broker-
dealers throughout the country who are linked together through
an e-mail or electronic and telecommunications network. Any
security can be traded on the OTC market as long as a
registered dealer is willing to make a market in the security. The
OTC market competes with investment bankers and organized
exchanges as OTC dealers can operate as both a primary and a
secondary market.
Risk-free securities, government and corporate bonds, common
stocks etc. are traded in over-the-counter market. Corporate
bonds are preferably traded in the OTC market because
organized exchanges prefer to trade stocks of corporations
instead of their bonds as the commissions of common stock are
higher. The OTC broker-dealers are organized as sole
proprietorships, some as partnerships, and many as
corporations. However, the broker-dealers in the OTC market
can be categorized as follows:
45
OTC house- An OTC house is specialized in OTC issues
and rarely belongs to an exchange.
Investment banking house- An investment banking house
is specialized in IPOs and may diversify by acting as
dealer in both listed and OTC securities.
Commercial bank- A commercial bank may be an OTC
dealer or broker when it trades securities.
Stock exchange member house- It can work as OTC
broker or dealer having a separate department
specifically formed to carry on trading in OTC market.
Bond house- A bond house may deal in government and
autonomous bond issues trading in OTC.
Third and Fourth Markets
The secondary markets can occasionally be categorized into
four parts. The first market represents organized exchanges
where listed securities are traded. Second market is the over-
the-counter market where the unlisted securities are traded.
The third market represents over-the-counter trading of
securities which are listed on an exchange while the fourth
market represents direct trading between two investors
bypassing the activities usually done by the brokerage firms.
The Third Market: The third market is an OTC marketing
stocks associated with an exchange. Although most transactions
in listed stocks take place on an exchange, a brokerage firm
without being a member of an exchange can make a market in
a listed stock. A number of broker-dealers who are not members
of Dhaka Stock Exchange (DSE) can make markets in stocks of
DSE listed firms. The OTC dealers making up the third market
provide minimal services for their clients-only execution of buy-
sell orders and record keeping. They are always ready to
execute large trades at much lower commissions. The success
or failure of the third market depends on whether the OTC
market in these stocks is as good as the exchange market and
whether the relative cost of the OTC transaction compares
favorably with the cost on the exchange.
The Fourth Market: The method of reducing commission costs
in the security transactions sometimes would be the complete
elimination of broker-dealer firm as a middleman. When one
investor sells security directly to another investor without a
46
broker-dealer as middleman, they are said to be trading in the
fourth market. In all most all cases, both parties involved in
each transaction of fourth market are institutions. Direct
investor-to-investor trades occur through a communications
network between block traders. A block is a single transaction
involving 10,000 or more shares. The participants of fourth
market bypass the normal dealer system. However, the
organizer of the fourth market collects only a small commission
for helping to arrange block transaction. However, the segments
of secondary market are Figure 3.2.
Third
market
The OTC
Organized
market
exchange
Fourth
market
47
Price concession the seller must grant to the buyer to
execute a quick sale.
The bid-asked spread, the size of which varies inversely
with the liquidity of the subject security.
The compensation required to find the other party of the
transaction.
Commissions of the brokerage firms.
Taxes.
In fine, liquidity of an asset is the ability to buy or sell the same
quickly without causing any significant change in its price.
Liquidity varies inversely with the costs incurred when buying
and selling. Liquidity of a security increases as the volume of
trading in it increases.
48
A dealer, on the other hand, may take positions in various
securities. A dealer may buy or/and sell securities for its own
account. If the dealer has a long position i. e., owns the stock
and the stock declines in price, the dealer losses money. On the
other hand, if the dealer has a short position in a stock, he has
temporarily sold more stocks than it owns. Under this
circumstance, if the stock increases in price, the dealer will loss
money if covers its short position through purchasing stock in
the market prices higher than the dealer originally sold the
stock for. The difference between bid price and ask price is the
compensation (profit/loss) for the dealer. Bid price refers to the
price that dealer wishes to pay to the seller of the securities and
ask prices is the price at which he will sell a security. Dealers
are called market makers as they will sell or buy the securities
for their own account in order to balance customers’ orders. If a
party of the transaction is not available, the dealer will become
the second party to constitute the transaction. A vast majority
of the securities firms act as both brokers and dealers.
Types of Brokers
Membership in the organized stock exchange are frequently
referred to as seats, though tradingis conducted without chairs.
Being an investor an individual will fill out a form disclosing
information about his personal income and finance. An investor
will deal with a broker who will probably be his connection with
the market for the same time. The broker will provide the
investor with information about the company he is interested in,
about general economic trends, and about other investments of
interest. However, the brokers are categorized as under:
Commission Brokers: The vast majority of the seats of
an organized stock exchange are owned by the commission
brokers. They are the agents on the exchange floor who buy
and sell securities for the clients of brokerage houses. They act
like employees of a brokerage house. They communicate via
telephone with brokerage, receive transactions from the
brokerages that employ their services and they send back
confirmation messages. They may also act dealers and seek
profits by trading for their own account.
Floor Brokers: Floor brokers execute orders for
commission brokers having more orders than they can handle.
From the brokerage house, orders of the clients will be phoned
to floor of the exchange to a person called a floor broker. Floor
49
brokers basically buy and sell securities on the floor of the
exchange. They are free-lance members of the exchange and
help prevent backlogs of orders, and allow many firms to
operate with fewer exchange memberships than would be
needed without their services.
Floor Traders: Floor traders are sometime called as
registered traders. They differ from floor brokers as they trade
primarily for their own accounts. They are speculators searching
the exchange floor for profitable buying and selling
opportunities. They trade free of commission as they deal for
their own accounts. They can buy and sell the same security on
the same day in order to profit from price movements.
Specialists: The floor brokers purchase securities from a
person called a specialist. Specialists are assigned to trade on
floor where they make a market in one or more stocks assigned
to them by the exchange. These market makers act as both a
dealer and a broker in the stocks assigned to them. As a broker,
they execute orders for other brokers for commission and as a
dealer; they buy and sell shares of their assigned stock for their
own accounts. The specialists keep an investor in one or more
stocks and buy and sell out of that inventory. They publicize
prices at which they are willing to buy a stock and prices at
which they are willing to sell. Specialists must accept the
obligation to maintain a fair and orderly market for their
assigned stocks.
50
in the market outstanding and
existing
v. Gain from secondary Gains v. Investor can gain
transaction is not from the secondary
possible in the primary market
market
vi. Original issuer Effects vi. Investors will be
remains unaffected due affected by the price
to the price changes changes
According to their operation, the securities markets are
categorized as primary market and secondary market. Each of
these markets can further be dividend into money market and
capital market on the basis of economic unit issuing the
securities. Figure 3.3 shows each of the major segments of the
securities markets and the functions they perform.
Money Capital
market market
Primary
market
A B
Secondar
C D
y market
51
short-term government instruments
debt ,commercial papers
Subject to very slight price Shows considerable
risk price variation
Stock Exchanges
When securities are traded between investors, issuers no longer
receive any cash proceeds. Investors usually initiate securities
purchases in the secondary markets by calling a security
brokerage house. After an account has been opened, a broker
relays the client’s order to a dealer making a market in the
securities the investors want. Since the secondary market
involves the trading of securities initially sold in the primary
market, it provides liquidity to the individuals who acquired
these securities. The primary market benefits greatly from the
liquidity provided by the secondary market because investors
would hesitate to purchase securities in the primary market if
they could not subsequently sell them in the secondary market.
However, the basic functions of the secondary market may be
summarized below:
Providing a market placing: A stock exchange provides a
market place for purchasing and selling securities in the
secondary markets. Investors would be able to buy and
sell securities at any time, as stock exchange provides
the facility for continuous trading in securities like shares,
bonds, debentures etc.
Continuous/active trading: Secondary markets maintain
active trading so that investors can buy or sell
immediately at a price that varies little from transaction
to transaction. A continuous trading increasing liquidity of
the assets traded in the secondary markets.
Providing liquidity: An organized stock exchange provides
the investors with a place to liquidate their holdings
meaning that securities can be sold in the stock
exchanges at any time.
Media of asset pricing: Security price is determined by
the transaction that flow from investor’ demand and
supply preferences. A secondary market usually makes
their transactions prices public that help investors make
better decisions.
Stimulate new financing: If the investors can trade their
securities in a liquid secondary market, they will be
52
encouraged to invest in IPOs that will directly help the
issuing authority to collect new finance.
Monitoring activities: Being self-regulatory organization a
secondary market can monitor the integrity of members,
employees, listed firms, clients, and other related
bodies/persons.
Provide risk premium: Without an active secondary
market, the issuers would have to provide a much higher
rate of return to compensate investors for the substantial
liquidity risk.
An indicator of the economy: An organized stock plays
the role as an indicator of the state of health of the
economy of a nation as a whole.
Savings-investment linkage: Providing the linkage
between savings and investment, stock exchanges help
in mobilizing savings and channelizing them into the
corporate sectors as securities.
Furthermore, the prevailing market price of the securities is
being determined by transactions made in the secondary
market. New issues of outstanding securities to be sold in the
primary market are based on the prices and yields in the
secondary market. Hence, the capital costs of the corporations
are determined by investor expectations and perceptions that
are reflected in market price prevailing in the secondary market.
In addition to that, nonpublic IPOs may also be priced based on
the prices and values of comparable stocks or bonds in the
public secondary market.
Trading System
Trading system in the organized stock exchange is the floor
trading under which trading took place through an open outcry
system on the trading floor. In floor trading buyers and sellers
53
transact business face to face using a variety of signals. Now-a-
days this trading system is abolished by a new one called
screen-based trading system introducing a fully automated
computerized mode of trading. The screen-based trading
systems are of two types:
i. Quote driven system: Being the market maker,
dealer in a particular security inputs two-way quotes. One is for
buying (bid price) and the other is for selling (offer/ask price).
Investors then place their orders on the basis of the bid-ask
quotes.
ii. Order driven system: Under this system investors
can place their buy orders or sell orders which are then fed into
the system.
Orders
Several orders are discussed below:
Market Order: The market order being the most
frequent type of order is an order to buy or sell a stock at the
best current market price. It indicates that the investor is willing
to buy or sell at the best price currently prevails in the stock
exchanges. Hence, a market buy order is what the investor wills
to pay the lowest price available, a market sell order, on the
other hand, indicates that the investor is willing to sell the
security at the highest bid price currently available. A market
order provides immediate liquidity for investor willing to accept
the prevailing market price. Market orders are used if the
investors want to trade a small quantity of stock quickly in the
hope that the price of whose will not change the current market
price substantially.
Limit Order: A limit order indicates that the investor
specifies the price at which he will buy or sell securities. So, a
limit buy order specifies the maximum price the investor wants
to pay for some expected securities. A limit sell order, on the
other hand, stipulates the minimum price at which an investor
wants to sell some quantity of securities. The order shall be
executed only if the broker obtains the desired price. A limit
order may either be day order or open order. A limit day order
exists until the end of the current trading day. A limit open order
is good until cancelled.
Stop Order: Stop order is an order that specifies a
certain price at which a market order takes effect. Sometimes
called stop loss order it is executed to protect an investor’s
existing profit or to limit losses. More specifically, a stop-loss-
order is an order by which an investor instructs his broker to sell
54
certain number of securities if the price goes down to whatever
level the former specifies.
Stop Limit Order: It is an order specifying both the stop
price and the limit price at which the investor wants to buy or
sell securities. The investor will take the risk of no trade if the
security price will not reach the limit price. A stop limit order to
buy is the reverse of a stop limit order to sell. As soon as the
stock price reaches the stop level, the order to buy will be
executed at the limit level or better indicating that below the
limit price the order will not be executed.
Day Order: It is an order that remains effective only for
a day it is brought to the floor. The majority of orders are day
orders. If not executed it is cancelled.
Good-till-cancelled Order: It is an order that remains
effective indefinitely. It is known as open order since the
investors are willing to wait until the price reaches some limit
the set.
Fill or kill Order: It is an order that must be executed
immediately. Being unexecuted such an order is cancelled.
An order is round lot that indicates 100 shares or multiple of
100 shares. On the other hand, an odd lot is any number of
shares between 1 and 99.
Brokerage Accounts
Brokerage accounts are account agreements that individual
investors maintain with the broker. Through these accounts
broker settle the trasactions of the investors and extends
credits. Such types of accounts are given below:
Cash Accounts
It refers to the brokerage account in which all transactions of
the investor are executed in cash. Broker will withdraw money
from this account against the purchase and depodit money to
this account against the sell of securities by investor.
Margin Accounts
It is the brokerage accounts in which investor can buy and sell
securities on credit to a certain limit. Margin is the proportion
of the value of an investment which the investor supplies. This
amount of investment value is not borrowed. Call money rate
is the specified interest rate the broker pays to borrow funds
from bank for lending to investor’s margin accounts. Initial
margin is the amount of money that must be supplied by the
investor to purchase the securities. The minimum margin that
must be present at all times in a margin account is known as
maintenance margin. A Margin call is the demand for more
55
funds which occurs when the margin in an account drops below
the maintenance margin.
Margin Trading
The accounts maintained by the clients with the brokerage firms
can either be cash accounts or margin accounts. A margin can
be defined as the part of the value of a transaction that a client
must pay to initiate the transaction with the remainder part of
the transaction being borrowed from the brokerage house.
Borrowing money from a brokerage house or from a bank to
execute a security transaction is referred to as marging trading.
Opening a margin account requires some deposit of cash. With
a margin account, the clients of the brokerage house can pay
part of the total amount due and borrow the remainder from
broker. A brokerage house, in turn, typically borrows from a
bank to finance its clients. The bank charges the broker the
“broker call rate”. The broker, in turn, charges its clients a
“margin interest rate” which is the broker call rate plus a
percentage added on by the brokerage house. The objectives of
margin accounts are summarized below:
Facilitating to purchase additionl securities by leveraging
the value of the eligible shares.
Helping the investors to buy more securities.
Facilitating the investors to borrow money from a
brokerage account for personal purposes.
The margin interest is lower and it is comparable to the
bank’s prime rate.
Providing overdraft protection in amounts up to the loan
value of the marginable securities.
The initial margin induces the investors taking
investment decisions.
The customer’s margin can be calculated as:
Customer’s equities
Margin (%) =
Market value of the securities
The effect of fluctuating market prices on the customer’s margin
is largely regulated by the stock exchange and the generally
more restrictive policies of the brokerage houses themselves.
Equity is simply the market value of the customer’s portfolio
less margin debt, or the market value of the securities that were
sold short. An initial margin is referred to as the margin
requirement that an investor should have as initial equity. It is
the policy of the authority to specify the initial margin to
56
influence the economy. Investor’s equity changes on the
changes in the market price of the security. If the investor’s
equity exceed the initial margin, the excess margin can be
withdrawn from the account or more stockscan be purchased
without additional cash required. On the other hand, problem
may arise if the investor’s equity decline below the initial
margin. It is at this point that the maintenance margin must be
considered. The guidelines of the brokers regarding the margin
are referred to as maintenance margin requirements. A
brokerage house may maintain maintenance call commonly
known as margin call. A margin call is the demand from the
broker for additional cash or securities as a result of the actual
margin declining below the maintenance margin. However, let
us take a typical example:
Suppose initial margin is 50 per cent on a transaction of Tk.
25,000 (100 shares of Tk. 250 each) with a maintenance margin
requirement of 30 per cent and the price of the share declines
from Tk. 250 to Tk. 225 per share. The actual margin
requirement would, therefore, be:
Market value of the securities – Amount
borrowed
Actual margin =
--------------------------------------------------------------
Market value of the securities
= [Tk. 22500 – Tk. 12500]/ Tk. 22500
= 44.44 %.
The actual margin requirement is between the initial margin and
maintenance margin. A brokerage house calculates the actual
margin daily to determine whether a margin call is required.
Stocks that fall prices must be absorbed by the customer’s
equity because the debt has not been repaid. Also the broker’s
(lender’s) stake is rising because borrowed funds represent a
larger part of the total value of the share. The broker’s risk is
rising. The maintenance margin would be reached under the
following conditions:
Loan
Market value of securities =
----------------------------------
1 ─ Maintenance
margin (%)
For short sales the maintenance margin would reach under the
following conditions:
Initial proceeds +
Initial margin
57
Market value of securities =
------------------------------------------
1 + Maintenance
margin (%)
Short Selling
Investor purchases security in the expectation that the price of
the security would rise. But what will happen if the price of the
seurity declines? If the investor owns it, it might be wise to sell.
If the security is not owned, the investor wishing to make profit
from the expected decline in the price can sell the security
short. Short selling can be defined as the sale of a stock having
not owned with a view to taking the advantage of an expected
decline in the price of the stock. In other words, if stocks in
general are expected to decline in price the best way to behave
is to stay out of the market. However, astute speculators use
the technique of short selling to capitalize on downward
movement in stock prices. The short sale necessitates the
purchase of the security by the seller some time in the future to
eliminate the deficiency. Investors sell short to make profit.
They expect that their purchase price would be lower than the
sale proceeds, thus, the difference would become profits. If the
purchase price is greater than proceeds, the difference would
become losses. Short selling creates an artificial supply of
securities. But at the same time short selling also satisfies an
aggregrate demand and thereby moderning the otherwise
violent effect that demand would have upon price. Let us take
an example: suppose you own 100 shares of IBM with a market
price of Tk. 250 per share costing a total sum of Tk. 25,000 (Tk.
250×100). After one month the market price falls to Tk. 240 per
share. You can purchase 100 shares for Tk. 24,000 making a
profit of Tk. 1000 from the short sale.
Clearing Procedures
Securities are traded on the daily basis. But the settlement date
includes three business or working days after the trade day.
Purchaser becomes the legal owner of the securities he bought
on the settlement date on which the seller gives them up. At
that day both the buyer and seller settle with the brokerage
firm. Most of the customers allow their brokerage firm to keep
their securities in the name of the brokerage firm. The client
receives a monthly statement showing his cash position,
58
securities held, any funds borrowed from the brokerage and so
on.
Book Building
The public issue is open for subscription by the public on the
pre-announcing opening date. The application form and
application money are received by the branches of the bankers
to the issue and forwarded by these bankers to the Registrar to
issue. Company raises capital from the primary market by way
of public issue, right issue, or private placement. A public issue
can be defined as the selling of securities to the public in the
primary market. Generally, the procedure of issuing securities to
the public is through the fixed price method. The price of the
securities is fixed by the issuing authority while offering for
subscription to the public. Another method of offering securities
to the public is book building method. Book building is the
method of offering securities where the prices are not fixed in
advance. Rather invrstors will determine the prices of the
securities they will purchase from the markets. It is the that the
investors are ready to pay for the security they wish to
purchase.. The security price determined under the book
building method is the weighted average at which majority of
the investors are willing to pay for the issue. Therefore, under
the book building method, security price, for the subscription, is
determined by the interaction of demand for and supply of the
security in the market. According to Securities abd Exchange
Board of India (SEBI), book building is defined as:
A process undertaken by which a demand for the
securities proposed to be issued by a body corporate is
elicited and built up and the price for such securities is
assessed for the determination of the quantum of such
securities to be issued by means of a notice, circular,
advertisement, document or information memoranda
or offer document.
It is the method of determining the price of the security
whereby new securities are valued on the basis of of the
demand feedback following a period of marketing. It is an
alternative method to the existing system of fixing security
price. The book building method is common and popular
practice in the developed markets. This concept is relatively
new in the emerging markets like India, Pakistan, Bangladesh.
59
To raise capital a firm sells debt and equity to investors
in the financial markets through financing decisions.
The funds raised by the firm is invested in the investment
activities of the firm called investment decision or capital
budgeting.
The invested funds generate cash for the firm through its
operation.
Cash is paid to the debtors for using external funds as
the cost of debt like interest if any.
Cash is paid to the government as taxes.
Cash is paid to the equityholders as dividends.
Retained cash flows are invested in the firm sometimes
by distributing stock dividend or bonus shares to the
existing equityholders that also increases capital.
60
the stock splits and changes in the sample over time. The
divisor is adjusted so that the index value will be the same
before and after the split. The DJIA is calculated as:
N
DJIAt =∑ Pit / D ad
i=1
where,
DJIAt = index of DJIA at time t
Pit = closing price of i th stock at time t
Dad = adjusted divisor at time t
Let us consider Table 3.1 to demonstrate. Suppose stock A splits
three for one.
Table-3.1: Shows the price-weighted index:
Prices
Stock
Before split After split
A 300 100
B 200 200
C 100 100
D 200 200
Total 800 600
N
DJIA t =∑ Pit / D ad
i=1
= 800/4 = 200
The Table demonstrates the procedure used to derive a new
divisor for the DJIA when stock splits. Since the divisor is
adjusted to keep the index values same before and after the
split, the divisor becomes smaller after splits. The adjusted
(new) divisor (X) after split would become:
N
DJIA t =∑ Pit / D ad
i=1
= 600/X = 200
Therefore,
X = 600/200 = 3
Since, this index is price-weighted, a highly priced stock carries
more weight than a lower priced stock.. Consider Table 3.2.
Table-3.2: Shows the price-weighted index with
percentage of changes:
Stock Period T Period T + 1
Case- Case-2 Case-3
1
A 500 510 480 530
61
B 450 420 400 480
C 650 670 600 620
D 300 320 250 290
E 200 190 210 220
Total 2100 2110 1940 2140
Divisor 5 5 5 5
Average 420 422 388 428
% --- 0.48 – 8.06 10.31
Change
Value-weighted index
A value weighted index is one where the values of stocks are
taken under consideration. A value weighted index is calculated
by deriviing the initial total market price of all the stocks used in
the series. The market value is the product of current market
price and numbers of shares outstanding. The initial value is
established as the base value in the index. The market value for
all the stock can be calculated for any time and compared to the
initial base value to determine the percentage of change which
in turn be applied to the beginning index value. However, the
value –weighted index can be calculated as:
N
∑ P it Qit
i=1
Index t = N
× Baseindex
∑ Pib Qib
i=1
Where,
Pit = ending price for stock i at time t
Qit = number of outstanding shares for stock i at time t
Pib = ending price for stock i on base time
Qib = number of outstanding shares for stock i at base
time
N = number of stocks
An example has been demonstrated to understand the value-
weighted index where the stock splits are automatically
adjusted. Because the decrease in stock price is offset by an
increase in the number of share outstanding. Consider Table 3.3
to understand value weighted index.
62
Tk Tk
A 10,00 120
1,200,00 125 1,250,00
0 0 0
B 15,00 210 3,150,00 190 2,850,00
0 0 0
C 9,000 250 2,250,00 285 2,565,00
0 0
D 20,00 350 7,000,00 390 7,800,00
0 0 0
E 25,00 190 4,750,00 200 5,000,00
0 0 0
Tota 18,350,0 19,465,0
l 00 00
Assume that the index for January 31, 2011 is 100. Therefore,
the value weighted index for February 28, 2011 can be
calculated as:
N
∑ Pit Qit
i=1
= N
׿ ¿
∑ Pib Qib
Index (for February) i=1 Index (for January as
base)
Tk.19 ,465 ,000
= ×100
Tk .18 ,350 ,000
= 106.08
The general price level for the increases 6.08 per cent at
February base on January.
Questions/Problems
1. Enumerate the characterisitics of securities markets.
2. State the nature of securities markets.
3. Discuss the role and importance of securities markets in
economic development of a country.
4. State different segments of securities markets.
5. Differentiate primary market from secondary market.
6. What is secondary market? Define different segments of
secondary markets.
7. Differentiate money market from capital market.
63
8. State different money market instruments and capital
market instruments.
9. “A stock exchange is an alternative vehicle for
investment”— Explain this statement.
10. Define investment banker. Explain the functions and
importance of investment banker.
11. Define floatation costs. State the underwriting process of
primary market.
12. State the process for a primary offering of securities by
investment bankers.
13. What do you mean by initial public offerings (IPOs)?
Distinguish between seasoned and unseasoned public
offerings.
14. What do you mean by liquidation in the secondary
markets? Discuss the concepts of liquidation of the
securities markets.
15. What is an organized stock exchange? Enumerate the
functions of an organized stock exchange.
16. What is a brokerage firm? Draw the functions of a broker.
Differentiate broker from dealer.
17. What is trading in the secondary markets? State the
trading systems of securities in the securities markets.
18. What is an order? State different types of orders in the
secondary markets.
19. How are returns from common stock referred to as
residual claims?
20. What is meant by private placement? State the
advantages for the firms issuing securities.
21. What is meant by stock market indicator series? State
the uses of stock market indexes.
22. Distinguish between price-weighted index and value-
weighted index.
23. You are the following information:
Stock Price before split No of shares (Before
(Tk.) split)
A 200 100,000
B 250 50,000
C 210 200,000
D 300 300,000
Assume that 2 for 1 split for stock A and 3 for 1 split for
stock B. Explain how a price-weighted index and a value
weighted index adjust for the stock splits.
24. Consider the following information:
64
2011 2011
Stoc No of Price per Price per Share
k Shares Share Tk Tk
A 16,000 128 120
B 14,000 216 197
C 10,000 254 280
D 17,000 358 396
E 9,000 196 205
Calculate value-weighted index.
Chapter-Four
Investment Companies
65
the company may generate. Investment companies act like
financial intermediaries. Unlike any company, an investment
company issues shares of stock to the investors who are
stockholders. The stockholders own the investment companies
directly and thus own the financial assets indirectly that the
company itself owns. Stockhoders are the only investors of the
investment companies. They own the investment company
directly and indirectly the financial assets the company owns.
There are two reasons for the investment in the shares of
investment companies viz., economies of scale and professional
management. Economies of scale helps investment companies
to provide diversification at a lower cost of investment than that
in direct investment by the individual investors. To get the
benefits of both diversification and reduction in the brokerage
commission, investors invest in the shares of investment
companies. In addition, an investor can turn over all the market
activities to a professional money manager known as portfolio
manager.
Types
Investment companies are classified as:
i. Unit investment trusts
ii. Managed investment companies.
Managed investment companies can further be categorizes as:
a) Closed-end investment companies
b) Open-end investment companies.
66
holders by the trustee. Changes in the original set of securities
are made only under exceptional circumstances otherwise fund
remains unchanged. The sponsor of the unit investment trust is
compensated by setting a selling price for the shares that
exceeds the costs of underlying assets. For example a sponsor
may purchase a worth of bond of Tk. 1000,000 and place them
in a unit investment trust to issue 10,000 shares of Tk. 100
each. Each share might be offered for Tk. 105 to the public.
When all the shares would be sold, the sponsor would receive a
total of Tk. 1,050,000 (equal to Tk. 105 × 10,000). A sum amount
of Tk. 50,000 is enough to cover the selling expenses and
marked up profit of the sponsor.
Scondary Market: Once upon a time shares of unit
investment trust are purchased, an investor generally can not
sell them in the secondary market. These shares can be sold
back to the trust at net value of the assets. The net asset value
of the share is calculated as the market value of the fund per
share. Having determined the per share price, the trustee may
sell one or more securities to raise the required cash for the
repurchase.
67
10 shares. If the net asset value per share is Tk. 100, the choice
of the shareholder would be between Tk. 1200 or 12 shares.
Open-end investment companies: Commonly known
as mutual funds an open-end investment company stands ready
to purchase its own shares at or near net asset value. It can also
offer new shares to the public for a price at or near their net
asset value. Since the capitalization of oepn-end investment
company is open, the number of shares outstanding changes on
a daily basis. The mutual fund’s shares can be sold to the public
by either of two methods viz., direct marketing and the use of a
sales force. Under the direct marketing method, an open-end
investment company can sell shares directly to the investors
without the involvement of financial intermediary. Commonly
known as no-load funds, the funds sell their shares at a price
equal to their net asset value. On the other hand, under sales
force method, the funds sell shares on the commission basis.
Sales force method involves financial intermediaries like,
brokerage firms, specialists, investment bankers, merchant
bankers, commerciak banks, insurance companies etc.
Unit Fund
Unit fund refers to the fund constituted of all the assets for the
time being held or deemed to be held on account of the
investment corporation of Banagladesh (hence forth ICB) Unite
Certificate excluding any amount standing to the credit of
dividend distribution account, any sum payable to the
Corporation as its management charge and other charges in
establishment and administration of the fund and any amount
for purposes of meeting any requirement of the fund. The
Corporation can issue Unit Certificate against Unit Fund. Unit
certificate is the document or certificate issued by the
corporation for the share of the Unit Fund. The fundamental
objective of the unit fund is to mobilize savings through sale of
its units to small investors and invest these funds in marketable
securities. Thus, the fund induces the small and medium savers
to participate in the activities of industrial development of the
country. Once upon a time ICB Unit Fund was called an open-
end mutual fund but now it is not open ended closed ended
mutual fund since close ended mutual funds are default in the
security exchange and open ended mutual funds are directly
deal by the ICB. Now-a-days ICB does not sell any new Unit. This
is why we can say that ICB Unit Funds are neither open ended
nor close ended mutual funds. Howeve, the pros and cons of
Unit Fund are as follows:
68
◘ Investment in Unit certificate is secured
◘ It enjoys liquidity
◘ It is transferable
◘ Bank loan and advances are available against pledge of units
◘ It offers attractive regular income
◘ Investment allowance for Income Tax purpose is available
◘ Dividend income is tax exempted.
69
number of mutual fund shares issued. The mathematical
expression of net asset value (NAV) is given below:
[ MP t −LIABt ]
NAV t =
MF t
and
[ MP t −LIABt ]
NAV t =
NOSt
Where,
NAVt = net asset value of the investment company at
time t
MPt = market price of the investment company at time t
LIABt = liability of the investment company at time t
MFt = mutual funds at time t
NOSt = number of shares outstanding of the investment
company at time t.
70
Return on Funds
The return on any fund can be calculated by adding the changes
in net asset value to the amount of income and capital gains
(losses) during a particular period shown as below:
( NAV t −NAV t−1 )+I t +C t
rt =
NAV t −1
where,
rt = return for a fund at time t
NAVt = net asset value of the fund at time t
NAVt –1 = net asset value of the fund at time t –1
It = current income like the amount of dividends or
interests of the fund at time t
Ct = capital gains of the fund at time t
Consider the following example:
Asse Share Purchasin Marke Paid up Market
t s g t capital capitalizati
price price on
A 1000 180 200
180,00 200,000
B 2000 225 230 0 460,000
C 1500 190 205
440,00 307,500
D 2500 200 195 0 487,500
E 3000 350 400
285,00 1,200,000
0
500,00
0
1,050,0
00
Fun 10,00 2,455,0 2,655,000
d 0 00
The market capitalization rate (MCR) of the fund can be
calculated as:
MarketCapitalizatio
MCR=
PaidupCapital
71
2,655 ,000
= =1.08
2,455 ,000
That is market capitalization is 1.08 time of paid up capital.
Annuities
Under some circumstances, employees are permitted to have
certain portions of their salaries withheld by their employers for
investment in variable annuities. The amount invested in the
variable annuities is not taxable until it is withdrawn. Investor of
such scheme may withdraw during retirement when he is in a
lower tax bracket. It is also a device for deferring the payment
of income taxes. The organization managing the annuity invests
the proceeds of all participants in the plan of a portfolio.
Insurance policies
Like insurance policy is another name of indirect investment
when the policy is purchased from a mutual insurance company,
the insured becomes an owner of the company.
Mutual funds
Mutual funds, the popular name for open-end-investment
companies sell and redeem their own shares. It is characterized
by the continual selling and redeeming of its shares. In the other
word, a mutual fund does not have a fixed capitalization. It sells
its shares to the investing public whenever it can at their net
asset value per share. It also stands ready to repurchase these
shares directly from the shareholders for their net asset value
per share. Owners of Funds’ shares can sell them back to the
company any time they choose. The mutual fund is legally
obligated to redeem them. Investors purchase new shares and
redeem their existing shares at the net asset value (NAV). The
NAV of an investment company share is computed by
calculating the total market value of the securities in the
portfolio minus any trade payables and dividing by the number
of the Fund’s shares currently outstanding. Mutual funds are
categorized as:
Growth fund
72
Balaced income fund
Industry-specialized fund
Others
Measuring Performance
The performance of the murual fund depends upon its activities. One of the
widely used methods of measuring performance of the management is by
comparing the yields of the managed portfolio with the market or with a random
portfolio. The formula for calculating portfolio yield can be shown as below:
NAV t + D t
Y P= −1
NAV t −1
Where,
YP = yield of the mutual fund
NAVt = net asset vale per share at the end of year t
NAVt– 1 = net asset vale per share at the end of the
previous year, t-1
Dt = distribution to the shareholders in the form of both
income and capital gains per share
Suppose, net asset vale per share at the end of year of a fund is
Tk. 110, net asset vale per share at the end of the previous year
was Tk. 100, the distribution of cash to the shareholders per
share in the form of dividend is Tk. 10. What would be the yield
of the fund?
Solution:
NAV t + D t
Y P= −1
NAV t −1
Tk .(110+10)
= −1
100
Tk .120
= −1=1 . 2−1
Tk .100
=. 20
= 20%
The yields of different portfolios thus calculated by using this
formula are then compared. The portfolios with higher one-year
holding period yield are considered to be better portfolios.
73
Questions/Exercises
Chapter-Five
74
concerned with change in wealth resulting from the investment.
Such change in wealth can either be due to cash inflows in the
form of interest or dividends, or caused by a change in the price
of the asset. The period during which an investor deploys funds
(wealth) is termed as its holding period and the return for that
period is called holding period return (HPR). HPR is calculated
as:
Ending value of the
investment
HPR =
Beginning value of the
investment
An investor can convert HPR to an annual percentage rate to
derive a percentage return commonly known as holding period
yield (HPY). HPY is further being calculated as:
HPY = HPR−1
Again, annual holding period return can be calculated as:
Annual HPR = [HPR] 1/N
Where, N is the number of years an investment holds. Suppose
an investment is made by Tk. 200 the value of which would
become art Tk.250 after 2 years. The holding period return from
the investment is:
Endingvalue
HPR = Beginningvalue
Tk . 250
= Tk . 200 = 1.25
Annual HPR = [1.25]1/N
= [1.25]1/2
= √1.25
= 1.1180
Therefore,
Annual HPY = Annual HPR−1
= 1.1180 −1= 0.1180 =11.80%
If the investment is held for a period of 3 years, the holding
period yield then would become:
Annual HPR = [1.25]1/N
= [1.25]1/3
3
= √ 1.25
= 1.08
Therefore,
75
Annual HPY = Annual HPR−1
= 1.08 −1= 0.08 = 8%.
Alternatively, holding period return can be defined as the capital
gains plus dividend per taka invested in the stock like:
Capita lg ain+Dividend
HPR = Investments
HPR = [(Ending price – Beginning price) + Cash
dividends]/Beginning price
The ending value of the investment can be the result of a
change in the price for the investment. Annual holding period
yield assumes a constant annual yield for each year.
Another calculation of return is called geometric mean which is
the nth root of the product of the holding period returns for n
years. Geometric mean, therefore, is:
GM = [πHPR]1/N −1
Where,
π = the product of the annual holding period return calculated
as:
[HPR1] × [HPR2] × ------- × [HPRn]
Suppose holding period returns for three consecutive years from
an investment are 1.10, 1.15 and 1.20 respectively. The
geometric mean return from the investment can be calculated
as:
GM = [(1.10) × (1.15) × (1.20)] 1/3 − 1
= [1.518] 1/3 −1 = 1.1493−1= 0.1493 =
14.93%.
Example-01:
Suppose the market price of a share is Tk. 250. An investor
expects that the next dividend will be of Tk. 10 per share and
the share can be sold for Tk. 275 after one year. What would be
the expected return from the investment?
Solution:
The expected rate of return from the investment can be
calculated as:
Dividend +Endingprice
E(r )= −1
Beginningprice
Tk . 10+Tk .275
= −1
Tk . 250
= 1.14 – 1 = 0.14 + 14%
Example-02:
76
A share of IBM is currently sellin for Tk. 200. The expected
dividend per share of IBM is Tk. 5. The share can be sold for Tk.
210 at the end of the year. Calculate the expected return of the
share of IBM.
Solution:
D+[ P 1−P0 ]
E(r )=
P0
E(r) = Expected return,
D = Dividend from the share during the period,
P1 = Ending price of the share,
P0 = Beginning price of the share,
Therefore, the expected rate of return would be:
Tk . 5+[ Tk . 210−Tk . 200 ]
E(r )=
Tk .200
= 0.075 = 7.5%
Patterns of Returns
Returns can be calculated in different patterns. The
understanding and concepts of returns can be summarized as:
Total Return (TR): Total return is the composition of current
income, annual return, periodical income during period of
holding of the security and the cpital gains/losses. It can be
defined as the difference between initial value and the terminal
value of the security. TR can be computed as:
Totalm Return (TR) = Current income + Capital
Gains (losses)
Relative Return (RR): It is the return per unit of investment. It
is calculated deviding total return by the investments:
RR = TR /Investments
Rate of Return (R): It is known as percentage of return.
Amount of excess money from each one hundred taka is known
as rate of return. It is expressed in terms of per centage. By
percentage of returns, we know: how much an investor gets for
each taka s/he invests. Suppose Pt is the price of the stock at
the beginning of the year and Dt+1 is the amount of dividends
paid on the stock during the year, the percentage of return
would be:
Dividend yield = [Dt+1/Pt] × 100
If we express this dividend as percentage of the beginning price
of the stock, result is known as dividend yield. The another
component of total return is the capital gains yield which can be
calculated as:
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Capital gains yield = [(Pt+1−Pt)/Pt] × 100
Therefore, percentage of return would be;
R = Dividend yield + Capital gains yield
= {[Dt+1/Pt] + [(Pt+1−Pt)/Pt]} × 100
Effective Annual Rate of return (EAR): If percentage of
return is converted into yearly rate of return, the result is called
effective rate of return. It can be calculated as:
EAR = [(1 + R)1/N]−1
Alternatively,
1+ EAR = (1 + Holding period percentage returm) m
Therefore,
EAR = (1 + Holding period percentage returm) m
−1
where, m is the number of holding periods in a year. If the
holding period is 4 months, there are three periods in a year (12
months/4 months = 3). If holding period is 5 years, then m will
be 1/5 (1 year/5years = 1/5).
78
market price /terminal value, retrun is called estimated
return/accounting return.
Concept of Risk
Risk analysis of investment is one of the most complex,
controversial and slippery areas in finance. Business decisions
are generally made under conditions of uncertainty rather than
under conditions approaching certainty. In fact, both risk and
uncertainty are the extreme end of the same spectrum. The
word “risk” shall be used to connote the idea of the twofold
possibility of loss or gain. Some people things that investments
are inclined to give emphasis to possibilities of loss but it is a
negative pessimistic and depressing approach. But some people
things that investments are inclined to give emphasis to
possibilities of gain which is optimistic.
In formal term, risk associated with a project o investment may
be defined as the variability that is likely to occur in the future
returns or investment. Therefore, we relate risk to variability of
return i.e., the degree to which the return on an investment
varies unpredictably.
Parts of Risk
Shortly speaking risk is the variability of return from an
investment. Returns on investment may vary from the
expectation of the investors. So risk may be defined as the
likelihood that the actual return from an investment will be less
than the expected return. Depending upon the elements of risk,
it may be broadly divided into two categories like systematic
risk and unsystematic risk. Some elements of risk that are
external to the firm cannot be controlled and effect large
numbers of securities are the sources of systematic risk. On the
other hand, controllable, internal factors somewhat peculiar to
industries and/or firms are referred to as elements of
unsystematic risk. The risk associated with macro, pervasive
factor such as a national economy is called systematic risk. On
the other hand, the micro risks associated with factors particular
to a company are called unsystematic or unique risk.
Investment manager can do little about systematic risk,
although they can do much about unsystematic or unique risk.
Systematic risk
Systematic risk refers to that portion of total variability in return
on investment caused by factors affecting the prices of all
securities in the portfolio. Systematic risk is known as market
risk. Economical, political, sociological changes are the sources
79
of systematic risk. Their effect is to cause prices of nearly all
individual assets like common stocks, bonds, and other
securities in the market to move together in the same manner.
Systematic risk affects the economic or financial system as a
whole. Systematic risk some times called as pervasive risk may
include the sourses which are categorized under the following
means:
Market risk: The price of common stock changes occur
frequently in the process of bought and sold by the investor or
speculator in the market place. The price of a stock may
fluctuate daily and cyclically even though earnings maintain
unchanged and some common stocks have a seasonal pattern.
Because of the changes in the market prices of the stock the
investors can lose money. Variability in return on most common
stocks that is due to basic sweeping changes in investor
expectations is referred to as market risk. Expectations of lower
corporate profits in general may cause the larger body of
common stocks to fall in price.
Investment prices vary because investors vacillate in their
preference for different forms of investments or simply because
they sometimes have money to invest and sometimes do not
have. The extensive vagaries of the stock market, the
uncertainty and stowness of real estate markets and the
irregular markets for mortgages and second-grand bond issues
all illustrate in the presence of market risk.
Interest-rate-risk: Interest-rate-risk may be defined as
the fluctuation in market price of fixed income securities owing
to changes in levels of interest rate. Fixed income securities
mean notes and bonds, mortgage-loans and preferred stocks
paying a definite amount of interest or dividends annually to
investors. Interest is the price paid for the use of money and like
other prices fluctuates with demand and supply forces operating
in the market. The degree of fluctuation in the market prices of
fixed income securities resulting from interest-rate-risk depends
firstly on the amount of change in interest rates. With any
change in the market rate of return on a bond, the market price
of stocks changes inversely. The second factor affecting the
degree of fluctuation is the length of period of maturity. Every
business or price of property is subject to the possibility that its
earning power or usefulness may wane because of competition,
change in demand, uncontrollable costs, managerial error,
government action or some similar circumstances.
Purchasing power risk: Purchasing power risk is the
uncertainty of purchasing power of the amount to be received. It
refers to the impact of inflation or deflation on an investment.
80
Rising prices on goods and services are normally associated
with what is referred to as inflation. On the other hand, falling
prices on goods and services are termed deflation. Purchasing
power risk or inflation risk has received considerable publicity in
recent years. When investor holds his surplus funds in the safety
deposit box, he suffers from purchasing power risk. The risk of
loss of income or principal because of decreased purchasing
power of money is also known as purchasing power risk. For
some investors, purchasing power risk is very important.
Individuals or institutions using their income to buy goods and
services are greatly concerned over any changes in the
purchasing power of their income. Investors who fear inflation
usually invest partially in common stocks and real estate with
the hope that will rise in value. Rationale investors should
include in their estimate of expected return, an allowance for
purchasing power risk, in the form of an expected annual
percentage change in prices.
Default risk: Another source of systematic risk is default
risk. This type of risk arises because firms may eventually go
bankrupt. Default risk seems to be undiversifiable or
uncontrollable as it is systematically related to the business
cycle affecting all most all investment even though some
default risk may be diversified away in a portfolio of
independent investments.
Exchange rate risk: The chance that return will be
affected by changes in rates of exchange because investments
have been made in international markets whose promise to pay
dividends, interest, or principal is not denominated in domestic
currency risk or exchange risk. Exchange rate risk is the
uncertainty due to the determination of an investment in a
country other than that of the investor’s own country. The
likelihood of incurring this risk is becoming greater as investor
buy and sell assets around the world, as opposed to only assets
within their own countries.
Political risk: Also called country risk, political risk is the
uncertainty due to the possibility of major political change in the
country where an investment is located. The chance that
returns will be affected by the policies and stability of nations is
called political risk. The danger of debt repudiation or failure to
meet debt service, expropriation of assets, differences in taxes,
restrictions on repatriating funds, and the prohibition against
exchanging foreign currency into domestic currency are typical
political risks.
Liquidity risk: Liquidity risk is the possibility of not
being able to sell an asset for fair market value. When an
81
investor acquires an asset, he expects that the investment will
mature or what it could be sold to someone else. In either case,
the investor expects to be able to convert the security into cash
and use the proceeds for current consumption or other
investment. The more difficult it is to make this conversion, the
greater the liquidity risk.
Real estate risk: Such type of systematic risks is unique
and generally not found in most investments rather than real
estate. The specific risk inherited in real estate investments are
given below:
As there is no continuous auction trading market, quoted
price may not represent intrinsic value of the property.
It is more difficult to find a buyer and seller raising the
cost of transacting.
Real estate markets are inefficient as they are likely to be
segmented.
The cost of acquiring information is greater.
Property value is more influenced by changes in the rates
of interest than other equities.
Returns on real estate assets are determined by the
going rates on default-free assets.
Real estate is less liquid than financial instruments.
Unsystematic risk
A portion of total risk that is unique or peculiar to a firm or an
industry above and beyond that affecting securities market in
general may be termed as unsystematic risk. Management
capability, consumer preference, labor strikes are the elements
of unsystematic risk. However, the unsystematic risk of an
investment consists of two major components: credit risk and
sector risk:
Credit risk:
Credit risk sometimes called company risk consists of business
risk and financial risk. Business risk is the risk inherent in the
nature of the business. On the other hand, financial risk is the
risk in addition to business risk arising from using financial
leverage. Credit risk is associated with the ability of the firm
that issues securities to meet its promise on those securities.
The fundamental promise of every investment is a return
commensurate with its risk. So the credit risk analyzed is the
ability to deliver returns that are consistent with the risk
assumed. However, business risk and financial risk are
discussed below:
82
Business risk: The loss or income on capital associated
with the ability of some companies to maintain their competitive
position and to maintain their earnings growth is sometimes
refers to as the business risk. Common stock and to some
extent preferred stock and bond posses this risk. The risk that
results is either temporary or permanent. The business risk is
not only associated with the weaker companies that have
suffered a total loss but also happened in the case of some
quality companies when a deficit earnings or a sharp drop
earnings sustained which have resulted in substantial losses to
investors.
In other words business risk is defined as the change that the
firm will not have the ability to compete successfully with the
assets that it purchases. As for example, the firm may acquire a
machine that may not operate properly, that may not produce
salable products or that may face other operating or market
difficulties that cause losses. Any operational problems are
classed as business risk.
Business risk can be divided into two categories: external and
internal. Internal business risk is largely associated with the
efficiency with which a firm conducts its operations within the
broader operating environment imposed upon it. On the other
hand, external business risk is the result of operating conditions
imposed upon the firms by circumstances beyond its control.
Each firm faces its own set of external risk, depending upon the
specific operating environment factors that it must deal with.
Financial risk: Financial risk is associated with the way
in which a company finances its investment activities. It may be
defined as the change that an investment will not generate
sufficient cash flows to cover interest payments on money
borrowed to finance it or principal payments on the debt or to
provide profits to the firm. We usually gauge financial risk by
looking at the capital structure of a firm. The presence of
borrowed money in the capital structure creates fixed payments
in the form of interest that must be sustained by the firm. The
financial risk is avoidable risk to the extent that managements
have the freedom to decide to borrow or not to borrow funds. A
firm with no debt financing has no financial risk.
Sector risk:
Sector or industry risk refers to the risk of doing better or worse
than expected as a result of investing in one sector of the
economy instead of another. Sector investing implicitly
acknowledges that the impact of individual investment decisions
is less critical, certainly to large portfolios, than investing in the
83
proper sector at the proper time. Sector rotation is a portfolio
management style shifting resources to sectors that are
expected to be more promising and are overweighted in a
portfolio in contrast to other sectors which are underweighted.
As the number of stocks in the portfolio is increased, the
unsystematic or residual risk of the individual securities is
diversified away leaving only the systematic or market-related
risk.
We assume that all rationale profit maximizing investors want to
hold a completely diversified market portfolio of the risky assets
and they borrow or lend to arrive at a risk level that is
consistent with their risk preferences. Under such conditions,
the relevant risk measure for an individual asset is its
comovement with the market portfolio. This comovement
measured by an asset’s covariance with the market portfolio is
its systematic risk.
Finally, we may draw conclusion as- we can divide total risk into
two components viz., a general or market component and a
specific or issuer component. An investor can construct a
diversified portfolio and eliminate part of the total risk called
diversifiable or nonmarket risk. The systematic risk known as
nondiversifiable or market risk is directly associated with overall
movements in the general market or economy. Table 5.1
summarizes different sources of risk.
Categories of risk Sources of risk
Market risk
Interest rate risk
Purchasing power risk
Exchange rate risk
Systematic risk Political
Liquidity risk
Default risk
Real estate risk
Credit risk
Unsystematic risk Business risk
Financial risk
Sector risk
Table-5.1: Different sources of risk.
Different connotation of risk can be shown as under:
Total risk = General risk + Specific risk
= Systematic risk + Unsystematic
risk
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= Nondiversifiable risk + Diversifiable
risk
= Market risk + Issuer risk
Systematic risk and Unsystematic risk Distinguished
Before identifying the differences between systematic risk and
unsystematic risk we should have clear understanding about the
terminologies. However, they are defined as below:
Systematic risk: Nondiversifiable risk is call systematic
risk. It is the portion of total risk which can not be eliminated,
controlled through diversification of assets.
Unsystematic risk: Diversifiable risk is called
unsystematic risk. It is that portion of total risk which can be
eliminated, controlled through diversification of assets.
The major differences between them can be summarized below:
Systematic risk Unsystematic risk
i. It relates to market risk i. It does relate to market
affecting all the risk.
securities in the market.
ii. It can not be diversified ii. It can be diversified
away through making through making portfolio
portfolio of assts. of assets.
iii. It is related to market- iii. It is related to business
wide factors. specific factors.
iv. It arises due to economic iv. It arises due to business
uncertainty phenomenon.
v. It is termed as common v. It is termed as unique
risk. risk.
vi. It is measured by the vi. Unique risk of the
movement of individual individual securities can
securities with the totally be eliminated by
changes in the market. putting them in a group.
vii Security’s beta is the vii Unsystematic risk is total
. standardized measure of . risk minus systematic
systematic risk. risk.
Business risk and Financial risk Distinguished
Business risk Financial risk
i. Business risk is i. Financial risk is the
uncertainty of expected uncertainty of return if
return on asset if the the company takes debt.
company does not use
debt.
ii. It is calculated from the ii. It arises if the total debt
overall asset invested in of the firm is more in the
the business. capital structure.
iii. It is related to the total iii. It is related to the
85
profit of the business. financial profit of the
business.
iv. It is related to the iv. It is related to both
investment policy of the investment policy and
firm. capital structure of the
firm.
v. It relates operating v. It relates financial
leverage. leverage.
vi. Owners and creditors vi. Owners of the business
are concerned with this are concerned with this
risk. risk.
vii Owners as well as vii Only the owners of the
. creditors can control this . business can control this
risk. risk.
vii This is unavoidable risk. vii This is avoidable risk.
i. i.
ix. Capital structure is not Capital
ix. structure is
considered in analyzing considered in analyzing
business risk. financial risk.
The concluding characteristics of risk can be summarized as
below:
Risk measures the changes in product price.
The more the debt in the business, the riskier the
investment.
The larger the margin of safety, the lower the risk.
The more the variability of the return, the more risky the
investment.
Measurement of Returns
Investments are made to generate income, to appreciate capital
and to preserve capital. An investment periodically generates
cash for the investor in the form of interest, dividends, or rent.
The market price or the value of an investment may rise or fall
over time. A capital gain arises when the market value of an
asset is above the price what is paid to acquire the asset.
Capital loss arises when the market price fall below what is paid
for the asset. In order to measure the return generated by an
investment, one should account for both the income generated
by the investment during the period the asset was held and the
change in the price. Investors in common stock consider the
change in price and the amount of dividends declared by the
company during the holding period of the asset. For bonds, the
holding period return is equal to the price change and interest
received. Investors are concerned to measure the return and
choose among alternative investment assets. To meet this, the
86
investors are likely to measure both historical (ex post) and
expected (ex ante) rates of return. Historical returns are often
used by the investors with a view to estimating the expected
rates of return. The first measure of return from an individual
investment is the historical rate of return during the period the
investment is held. The second measure of return is the
measure of expected rate of return for an investment.
The period during which an investor owns an asset is termed as
its holding period and the percentage return from the
investment and price changes during this period is called
holding period return. For a perpetual security like stock, the
holding period return for a particular period of time is equal to
the sum of the price change plus dividends received for that
period divided by the price at the beginning of the time period.
For fixed income security like bond, the holding period return is
equal to the price change plus interest received divided by the
beginning price. However, in general, the holding period return
is calculated as follows:
[( P it − P it−1 )+D it ]
r it =
Pit−1
where,
rit = Return for stock i at time t,
Pit = Price of the stock i at time t,
Pit1 = Price of the stock i at time t1 (previous price) and
Dit = Dividends declared for stock i during t–1 and t
To measure the return generated by an investment, the price
change and the cash flow derived from the investment during
the period must be taken into account. To illustrate such return,
consider the following data for stock i.
Beginning price
Tk.120
Ending price
Tk.150
Dividends
Tk. 15
Thus, the return for stock i for a particular period would be:
[ (150−120 )+15 ]
ri =
120
87
= .375 = 37.5%
The ex post or historical average return for stock i may be
calculated as follows:
1
r= (r i1 +r i2 +.... ....+r iN )
N
N
1
r= ∑ r it
N t=1
where, N denotes the number of time periods. The following
Table illustrates data relating to the above formula:
Time 1 2 3 4 5 6 7 8 9 10
Retur .0 .12 .0 . . .0 .10 .15 .04 .0
n 9 3 04 14 2 5
The historical mean return for stock i is computed as:
1
ri = 10 [(.09) +.12 + (.03) +.04 +.14 + (.02) +.10
+.15 +.04 + (.05)]
1 1
= 10 × [0.59 0.19] = 10 (.40) = .04 = 4 %.
Analysis of Return
Security analysts often use the probability distribution of return
to determine expected return and the risk as well. The expected
return of the investmentcan be defined as the weighted
average of the possible returns. It can be estimated by
multiplying each return by its associated probability and then
adding the results together. The weighted average return called
as the expected average return lies at the center of the
distribution. Most of the possible outcomes lie either above or
below it.
After calculating the historical rate of return of a security it is
essential to calculate its expected (ex ante) return. The
expected rate of return is the ex ante return that an investor
expects to earn over some future holding period. An investor
determines how certain the expected rate of return on an
investment is by analyzing estimates of expected returns. In this
connection, an investor assigns probability values to all possible
returns. These probability values range from zero (zero per
cent) indicating no change of the return to one (hundred per
88
cent) indicating complete certainty that the investment will
generate the specific rate of return. For sure, for a fruitful
estimation, these probabilities are based on the historical
performance of the investment or similar investments modified
by the investor’s expectations for the future. To describe the
outcome from a particular probability distribution, it is essential
for an investor to estimate its expected value. The expected
value is the average of all possible return outcomes, where each
outcome is weighted by its respective probability of occurrence.
If the possible returns are denoted by r i, and the related
probabilities are pi, the expected rate of return, E(r) from an
investment can be calculated as:
N
E( r )=∑ pi r i
i =1
where,
E(r) = the expected return on security in subject,
ri = the i th possible return,
pi = the probability of i th return (ri) and
n = the number of possible returns
Example-03:
From the following information calculate the expected rate of
return.
Return Possible .10 .12 .09 .11 .05 .15
(ri)
Probability (pi) .15 .20 .25 .10 .12 .18
Solution:
The expected rate of return for the stock can be calculated as:
Return Possible .10 .12 .09 .11 .05 .15 Tota
(ri) l
Probability (pi) .15 .20 .25 .10 .12 .18 1.00
(pi)(ri) .015 .024 . .011 . .027 .
022 006 105
5 5
N
E(r )=∑ hi r i
i=1
= .1055 = 10.55%
The return lies between 5% to 15%.
Example-04:
From the following probability distribution calculated expected
rate of return for the stock i:
89
Possible .09 .12 .03 .04 .14 .02 .10 .15 .04 .05
return (ri)
Probability (pi) .10 .10 .10 .10 .10 .10 .10 .10 .10 .10
Solution:
From the above ex ante data the expected rate of return for
stock i may be computed as:
Possible .09 . .03 . . .02 . . . .05
return 12 04 14 10 15 04
(ri)
Prob. (pi) .10 . .10 . . .10 . . . .10
10 10 10 10 10 10
(pi)× (ri) .00 . .00 . . .00 .01 . . .00
9 01 3 00 01 2 01 00 5
2 4 4 5 4
Here,
N
∑ pi r i
i=1 = [.10 (.09) +.10 (.12) +.10 (.03) +.10
(.04) +.10 (.14) +
.10 ( .02) +.10 (.10) +.10 (.15) +.10
(.04) +.10 (.05)]
= [0.059 0.019] = 0.040 = 4%.
Alternatively,
N
E(r )=∑ pi r i
i=1
= 0.040 = 4%
Therefore, the expected return is 4 % which lies, according to its
property, between – 9 % to 15 %.
Example-05:
Suppose the market price of a stock which pays no dividend is
Tk. 200. The possible prices of the stock with respective
probabilities are given below:
Expected Price 210 195 200 211 205 215 220
(P1)
Probability (pi) .10 .20 .15 .10 .25 .10 .10
Calculate the expected rate of return.
Solution:
Here, the expected rate of return can be calculated through the
probability distribution of return. The probable returns for each
of the expected prices can be calculated by using the following
formula:
90
D+[ P1−P 0 ]
E(r i )= ×100
P0
Calculation of probable returns:
Current price 200
(P0)
Price (P1) 210 195 20 211 205 215 22
0 0
[P1 – P0] 10 –5 00 11 5 15 20
E(ri) = .05 –.02 00 .055 .025 .075 .
[P1 – P0]/P0 × 5 10
100
91
Year end expected price (P1) 160 175 155 158
[P1 – P0] 10 25 5 8
E(ri) = [{D + (P1–P0)}/P0] × .067 .167 . .053
100 033
Measures of Risk
Risk arises from the expected volatility in asset’s return over
time caused by one or more of the following sources of returns
on investment:
▪ Fluctuations in expected income
▪ Fluctuations in the expected future price of the asset
▪ Fluctuations in the amount an investor can reinvest
▪ Fluctuations in returns an investor can earn from
reinvestment.
92
Under these circumstances, we examine the measures of risk
arising from an investment. There are two methods of
measuring risk viz., i) absolute measure and ii) relative measure
of risk. The absolute measures of risk for an investment are:
▪ Variance of rates of return (σ2i)
▪ Standard deviation of rates of return (σi)
▪ Covariance (σim, σij)
These measures of risk can be influenced by the magnitude of
original numbers. Hence, to compare series with greatly
different values, we need a relative measure of dispersion. The
relative/standardized measures of risk for investments are:
▪ Coefficient of variation (CV) of rates of return which is
calculated as:
σi
CVi = E (r i )
▪ Correlation coefficient (rij), being a statistical measure
of the extent to which two variables are associated which is
calculate as:
σ ij
r ij =
σ iσ j
▪ Covariance of returns with the market portfolio is called
beta (i) which is calculated as:
σ
β i= 2im
σ m
or
r σ σ
β i= im 2i m
σ m
Statistical measures allow an investor to compare the return
and risk measures for alternative investments directly. Variance
and standard deviation of the estimated distribution of expected
returns are, however, two possible measures of uncertainty.
Calculation of the expected return of the probability distribution
is essential to calculate the variance and standard deviation.
Standard deviation
Standard deviation is a measure of the dispersion of forecasted
returns when such returns approximate a normal probability
distribution. It is a statistical concept and is widely used to
measure risk from holding a single asset. The standard
deviation is derived so that a high standard deviation represents
93
a large dispersion of return and is a high risk; a low deviation is
a small dispersion and represents a low risk. Standard deviation
of the rates of return is simply the square root of the variance of
the rates of return which tells us about the potential for
deviation of the return from its expected values.
Variance
Variance is directly related to the standard deviation and is of
considerable importance in finance. However, the variance is
simply the standard deviation squared (or the standard
deviation is the root of the variance). The following is the
formula for calculating the variance of historical returns (using
ex post data):
N
1 ∑
r=
2 N−1 t=1 (rit ri)2
Dividing by N1 gives us an unbiased estimate for the variance
when the sample is relatively a small size (lower than 30). In
case of historical data the computation of the variance would be
as follows:
Time 1 2 3 4 5 6 7 8 9 10
Retur .0 .12 .0 . . .0 .10 .15 .04 .0
n 9 3 04 14 2 5
The historical mean return for stock i:
ri = 0 .04
Therefore, variance and standard deviation can be calculated
as:
Time Return (rit-¯ri)2
(ri)
1 .09 (.09 .04)2 = (.13)2 =
2 .12 0.0169
3 .03 (.12 .04) 2
= (.08) 2
= 0.0064
4 .04 (.03 .04)2 = (.07)2 =
5 .14 0.0049
6 .02 (.04.04)2 = (00)2 = 0 0000
7 .10 (.14 .04)2 = (.10)2 = 0.0100
8 .15 (.02 .04)2 = (.06)2 =
9 .04 0.0036
10 .05 (.10 .04) 2
= (.06) 2
= 0.0036
(.15 .04)2 = (.11)2 = 0.0121
94
(.04 .04)2 = (00)2 = 0 0000
(.04 .04)2 = (.09)2 = 0.0081
ri =0.04 = 0.0656
N
1 ∑
=
2
r
N−1 t=1 (rit ri)2
1
= 9 (.0656)
2
r
= .0073
Standard deviation is the positive square root of the variance.
2
r = √σ r
= .0073 √
= .085 = 8.5 %
The variance of expected rates of return by using ax ante data
can be found as follows:
N
2 2
r
σ =∑ pi [ r i −E( r ) ]
i =1
Suppose the following case:
Possible .09 .12 .03 .04 .14 .02 .10 .15 .04 .05
return (ri)
Probability (pi) .10 .10 .10 .10 .10 .10 .10 .10 .10 .10
In case of the example the expected rate of return can be given
as below against probability distribution. The variance of the
population by using ex ante data is computed as follows:
Expecte E(ri) = pi pi[ri E(r)]2 pi[ri E(r)]2
d return (ri)
(ri)
.09 .10 (.09) .10(.09 = .10(.13)2 =
.12 .10 (.12) .04)2 0.00169
2
.03 .10 (.03) .10(.12.04)2 = .10(.08) =
.04 .10 (.04) .10(.03 0.00064
.14 .10 (.14) .04)2 = .10(.07)2 =
.02 .10(.02) .10 0.00049
.10 .10(.10) (.04.04) 2
= .10 (00)2 =
.15 .10(.15) .10(.14.04)2 0.00000
.04 .10(.04) . = .10(.10)2 =
95
.05 .10(.05) 10(.02.04) 0.00100
= .10(.06)2 =
2
.10(.10.04) 0.00036
2
.10(.15.04)2 = .10(.06)2 =
.10(.04.04)2 0.00036
.10(.05 = .10(.11)2 =
.04)2 0.00121
= .10(00)2 =
0.00000
= .10(.09)2 =
0.00081
= 0.040 = 0.00656
N
E(r )=∑ pi r i
i=1
= 0.04
N
2 2
σ r =∑ pi [ r i −E( r ) ]
i =1
2r = .00656
Also, = .00656
√
= .081 = 8.1%
Thus, the ex ante standard deviation is considered as a
weighted average of the potential deviations from the expected
returns and a reasonable measure of risk. Both variance and
standard deviation are absolute measures of dispersion. They
are influenced by the magnitude of the original numbers.
Coefficient of variation
A relative measure of dispersion is the coefficient of variation
(CV). To compare series with greatly different values, we need a
relative measure of dispersion which can be calculated as:
Standard deviation of
Return
Coefficient of variation (CV) =
Expected Rate of
Return
96
Covariance:
The expected rates of return and the variance provide the
information about the natures of the probability distribution of a
single stock or a portfolio of stocks indicating nothing about the
returns on securities interrelated. Certainly a stock may
generate a rate of return above its expected value. If it is known
in advance, will it impact on the expected rate of return on
other stock? If one stock generates a rate of return above its
expected value, will other stock produce the same? A statistical
measure giving answer to these questions is the variance
between two stocks. Covariance refers to the measure of the
degree of association between the returns of a pair of securities.
It is defined as the extent to which two random variables covary
over time. However, the properties of covariance are given
below:
▪ A positive covariance: The returns on two securities
tend to move in the same direction at the same time indicating
that if one increases (decreases), the other does the same.
▪ A negative covariance: The returns on two securities
tend to move inversely at the same time indicating that if one
increases (decreases), the other decreases (increases).
▪ Zero covariance: The returns on two securities are
independent having no tendency to move in the same or
opposite directions together.
To understand the concept of covariance, let us assume that we
have two stocks called stock A and stock B. In a period of six
months the stocks produce the following rates of return:
Month Jan Feb Mar Apl May Jun Mean
Stock-A .12 .14 .10 .08 .04 .04 .04
Stock-B .09 .12 .06 .10 .09 .08 .06
We like to estimate the covariance from the sample of the six
monthly returns. As the data given above are historical returns,
the sample covariance may be computed by using the following
formula:
N
1 ∑
im = t=1 [(r,it ri)( rm,t rm)]
N−1
Using the data in our example, we can estimate the covariance
of the returns from stock A and stock B as follows:
Return
(rAt rA) ( rBt rB) [(rAt rA) ( rBt rB)]
rA rB
97
.12 .09 (.12 .04) (.09 .06) (.08)(.03) = .0024
.14 .12 (.14 .04) (.12 .06) (.10)(.06) = .0060
10 .06 (10 .04) (.06 .06) (.14)(00) = 0000
.08 .10 (.08 .04) (.10 .06) (.04)(.04) = .0016
.04 .09 (.04 .04) (.09 .06) (.08)(.15) = .0120
.04 .08 (.04 .04) (.08 .06) (00)(.02) = 0000
rA=.04 rB =.06 Total = 0.0220
N
1 ∑
AB = N−1 t=1 [(rA,t rA)( rB,t rB)]
1
= σ AB 5 (0.022)
= 0.0044
The above measure is used to calculate the covariance from a
sample of paired returns. Now the question arises when the
actual probabilities of getting various pairs of returns at the
same time. The probabilities of getting various pairs of returns
on two investments at the same time could be presented in the
joint probability distribution. If we have the actual probability
distribution rather than a sample estimate, the population
covariance of underlying joint distribution may be estimated by
applying the following formula: N
∑
σ im = t=1 pt [rit E(ri)][ rmt E(rm)]
Covariance describes the comovement of the returns of two
securities. Suppose we have the following observation about the
expected rates of return from two stocks A and B. We compute
the population covariance as follows:
Prob Return
abili E(rA) E(rB) pt× E( rA) pt×E( rB) pt [ rAt E(rA)] [ rBt E(rB)]
ty
.20 .02 .24 .20×.02 .20×.24 .20(.02 .09)(.24 .10) =
.25 .07 .18 .25×.07 .25×.18 .00196
98
.30 .10 .10 .30×.10 .30×.10 .25 (.07 .09)(.18 .10) =
.15 .11 -.01 .15×.11 .15×-.01 .0004 .
.10 .21 -.12 .10×.21 .10×-.12 30(.10 .09)(.10 .10) =
0000 .15(.13 .09)(.01 .10)
= .00066 .10(.21 .09)(
.12 .10) = .00264
1.0 E( rA)=. E( rB)=.1 = .00566
0 09 0
N
∑
σ AB = t=1 pt [rAt E(rA)][ rBt E(rB)]
σ AB = .00566
The calculation of covariance is very important since it is a
critical input in determining the variance of a portfolio of stocks.
However, it doesn’t accurately describe the nature of the
relationship between two investments. Furthermore, we can
standardize the covariance obtaining a better descriptor called
the correlation coefficient.
Correlation coefficient: Correlation coefficient is a statistical
measure of the relative comovements between returns on
securities. It measures the extent to which the returns on any
two securities are related. As the covariance number is
unbounded, we can bound it by dividing it by the product of the
standard deviations for the two investments say security A and
security B which can be given as follows: σ AB
r AB =
σ A σB
The resulting number of the above equation is called the
coefficient of correlation falling within the range 1 to + 1. With
perfect positive correlation, the returns on securities have a
perfect direct linear relationship indicating that the return on
one security allows an investor to forecast perfectly what the
other security will result. With perfect negative correlation, the
returns on securities have a perfect inverse linear relationship
to each other indicating that the return on one security provides
knowledge about the return on the other security i.e. when
return on one security is high, the other is low. With zero
correlation, there exists no relationship between the returns on
two securities indicating that the return on one security
provides no value in predicting the return on the other security.
However, we can rewrite the covariance as the product of the
correlation coefficient and the standard deviations of the two
stocks as:
99
σ AB =r AB ×σ A×σ B
If we square the correlation coefficient we obtain a number
called the coefficient of determination. Coefficient of
determination (CD) tells the fraction of the variability in the
returns on the one investment that can be associated with the
variability in the returns on the other.
CD = (R 2) = (rim)2
Table-5.2: Different Aspects of Statistical Measures of
Returnsand risk on Securities.
Ex post (historical) Ex ante (expected)
Mean return: Expected return:
N N
1 ∑ ∑
ri = N t=1 rit E(r) = i=1 piri
Variance Variance:
N N
1 ∑ ∑
i= 2 N−1 t=1 (rit ri) 2
(r) =
2 i=1 ∑ pi [ri E(r)]2
100
post standard deviations are convenient, they are subject to
error.
Ri Charateristic
line
·
·
·
·
·
·
rf ·
·
· · 0· · · · · · · · · Rm
The straight line in Figure 5.1 represents the line of best fit
between the return on stock i and market return. In the
regression analysis, the random-error term will have a mean
value of zero and is assumed to be uncorrelated with the market
returns, the error terms of other securities, and error terms of
the same security over time. The most interesting parameters in
the line are the intercept and beta coefficient.
101
Systematic risk (Beta factor): Systematic risk is the
variability of returns of individual security caused by changes in
the economy or the market. All the securities in the market are
affected by such changes. The systematic risk of a security can
be measured by relating the variability of that security with the
variability in the market index. The higher the variability, the
higher the systematic risk and vice-versa. The systematic risk of
a security can be measured by a statistical weapon called beta.
Beta picks up the risk that cannot be diversified away. As the
effective diversification eliminates almost all of an asset’s
unique risk, the relative measure of a single asset’s risk is not
its standard deviation, but its beta. Beta indicates an asset’s
contribution to the total risk of a portfolio. Since the
characteristic line is a straight line, it can be fully described by
its slope and the point where it passes through the vertical axis.
The slope of the characteristic line is commonly known as the
stock’s beta factor. The beta factor of an individual stock is an
indicator of the degree to which the stock responds to changes
in the return produced by the market. That is, beta measures
the covariance of return on individual stock with market divided
by the variance of market return. Since beta indicates the
manner in which the returns on security change systematically
with changes in the returns on market, it is frequently referred
to as the measure of a security’s systematic or market risk. The
input data required to estimate beta are the historical data of
returns of the individual security and the returns of the market
index as well. If the market’s return increased by 10%, then a
stock with beta of .75 is expected to increase its return by 7.5%
(.75 × 10%). Two statistical approaches are the appropriate
methods of estimating beta. They are; i. correlation method
and/or regression method. From the historical data of returns
from both individual security and the market, beta can be
calculated by using correlation method as follows:
σ
β i= 2im
σ m
and
άi = ri βirm
where,
i,m = the covariance of return on the stock i with the
return on the market,
2 rm = the variance of return on market,
βi = beta factor of stock i,
102
άi = intercept, the return on stock i when market return
is zero and
ri ,rm = mean return on stock i and market respectively.
Hence, this formula can be modified to estimate historical beta
for individual security as:
σ im
r im=
σi σ m
or
σ im=r im×σ i ×σ m
r im×σ i×σ m
β i= 2
m
Again, σ
σi
=r im
( )
σm
The second menthod of calculating beta is the use of regression
method. This model postulates a linear relationship between a
dependent variable and an independent variable. This model
also helps to calculate the values of two constants viz., ά and β.
Beta measures the change in the dependent variable in
response to unit change in the dependent variable. Intercept
term (ά) measures the value of the dependent variable even
when the independent variable has zero value.
The regression model can be given below:
Y = ά + βX
Where,
Y = Dependent variable,
X = Independent variable
ά and β are constant terms
Where ά and β are given by the following equations
respectively;
α=Y−β X
and
N ∑ XY −( ∑ X )( ∑ Y )
β= 2
N ∑ X 2−( ∑ X )
Therefore, for the calculation of beta of individual security, its
return is taken as dependent variable and the return of the
market index is taken as independent variable. The regression
equation, thus, can be expressed as:
ri = ά + β rm
103
The beta of stock i is equal to the correlation coefficient for
stock i and market portfolio, multiplied by the ratio of the
standard deviation of stock i to the standard deviation of the
market return. In another way, the beta of stock i is a function
of the correlation of the returns on stock i with those of the
market (rim) and the variability of the returns on stock i relative
to the variability of the market returns (i/ m).
The covariance of market return with itself is the variance of
market return:
mm = 2m
Thus, the beta for the market index would be:
σ
β m= mm2
σ m
2
m
σ
= 2m
=1
σ
We can, now, classify the systematic or market risk of securities
by using the beta of market index into two categories. A stock
having a beta of greater than 1 has above-average market-
related or systematic risk and a stock having beta of less than 1
has below-average market-related or systematic risk. Hence;
β 1: stock holds systematic risk more than
average
β 1: stock holds systematic risk less than
average
β = 1: Stock holds systematic risk equal to
average
β = 0: Stock holds no systematic risk
β is negative, the return would be less than risk-
free return.
The standardized measure of systematic risk is commonly
known as beta (). The covariance of the subject stock (stock i)
with the market portfolio (im) is the relevant risk measure. Beta
defining as im /2m is a standardized measure of risk because it
relates this covariance to the variance of the market portfolio.
As a result, the market portfolio has a beta of 1. If the beta of
the subject stock is above 1, the stock has higher normalized
systematic risk than the market assuming that it is more volatile
than the overall market portfolio. The notion that individual
stock prices may be related to market returns is shown in the
following chart:
Beta Description Type of
104
company
Greater than Stock price moves in the Volatile/Aggressi
one same direction, but ve
>1 return move quickly and
higher than market
Less than one Stock moves less quickly Defensive
<1 than market and stock
return is less than
market return
Equal to one Stock moves with Cyclical
=1 market and the return is
equal to market return
Equal to zero Stock return is equal to Risk less
=1 risk free return
Negative Stock return moves Worse
below the risk-free
return
# A company having beta less than one means that the
company’s stock returns do not closely track changes in market
returns and vice-versa.
# The closer the beta to zero, the less relation there is to
market returns.
# When the beta of a stock is greater than one, the
stock returns for that company move in the same direction, but
to a much greater degree.
Estimating Beta
Beta is a mathematical value that measures the risk of one
asset in terms of its effects on the risk of a group of assets
called portfolio. It is concerned solely with market related risk,
as would be concern for an investor holding stocks and bonds. It
is derived mathematically so that a high beta indicates a high
level of risk, a low beta represents low level of risk. There are
different methods of estimating beta like historical beta using ex
post return, ex ante beta using ex ante return, and ex ante beta
using adjusted historical betas. The following Table represents
historical returns on stock i and market.
Time
Retur stock-i (ri) .03 .09 .12 -.04 .08 .14
n market (rm) .02 -.04 .08 .03 .02 .13
105
ri rm (rit ri)( rm t rm) ( rm t rm)2
.03 .02 (.03 .07) (.02 .04) = . (.02 .04)2 = .
.09 .04 0008 0004
.12 .08 (.09 .07) (.04 .04) = . (.04 .04)2 = .
.04 .03 0016 0064
.08 .02 (.12 .07) (.08 .04) = . (.08 .04)2 = .
.14 .13 0020 0016
(.04 .07) (.03 .04) = . (.03 .04)2 = .
0011 0001
(.08 .07) (.02 .04) = (.02 .04)2 = .
.0002 0004
(.14 .07) (.13 .04) = . (.13 .04)2 = .
0063 0081
r i
r m ∑(rit¯ri)(rm trm) =.0084
∑( rmt rm)2 = .
= .07 =.04 0170
N
1 ∑
2
m = N−1 t=1 (rmt rm)2
1
= × 0.017
6−1
= 0.0034
Thus, the beta factor and intercept using ex post return can be
estimated as:
σ im
β i= 2
σ m
.00168
= .0034
= .49
The intercept is:
αi =ri βi rm
106
= .07 .49 (.04) =.07 .0196 =.0504
In the above case, the beta factor for stock i is .49 which
indicates that if the market return goes to be higher by 1 per
cent, the return for stock i tends to increase by .49 per cent.
The ex ante or expected beta can be estimated from probability
distribution. The following information are given to find beta.
Probability .20 .25 .30 .25
Return on stock-i .18 .16 .12 .40
Return on market .09 .08 .16 .20
portfolio
From the above information the following estimations are made:
Probabili Return
pi ×
ty stock marke pi × E(ri) pi [ rit E(ri)]2
E(rm)
(pi) E(ri) t E(rm)
.20 .18 .09 .036 .018 .20(.32)2
.25 .16 .08 .040 .020 =.0205
.30 .12 .16 .036 .048 .25(.02)2
.25 .40 .20 .100 .050 =.0001
.30(.02)2
=.00012
.25(.26)2
=.0169
.140 .098 =.03762
Table contd.
Prob Return
abilit stoc marke pi [ rit E(ri)] [ rmt
pi [ rmt E(rm)]2
y k t E(rm) E(rm)]
(pi) E(ri)
.20 .18 .09 .20(.188)2 = . .20(.32) (.188)
.25 .16 .08 0071 =.0120
.30 .12 .16 .25(.018)2 = . .25(.02) (.018) =
.25 .40 .20 0008 .00009
.30(.062)2 = . .30(.02) (.062) =
0012 .00037
.25(.102)2 = . .25(.26) (.102)
0026 =.0066
= .01098 = .01814
Expected return:
107
N
∑
E(ri) = t=1 pi × E(ri)
= .140
N
∑
E(rm) = t=1 pi × E(rm)
= .098
1
Variance:
N
∑
i = t=1 pi [ rit E(ri)]2
2
= .03762
N
∑
2m = t=1 pi [ rmt E(rm)]2
= .01098
Standard deviation:
2
i = √σ i
= 0.03762
√
= 0.1940
and
2
m = √σ m
= 0.01098
√
= 0.1048
Covariance:
N
∑
= t=1 pi [ rit E(ri)] [ rmt E(rm)]
im
= .01814
Correlation coefficient:
108
σ im
r im=
σi σ m
0 . 01814
= ( . 1940)( .1048 )
= 0.89
Beta coefficient:
σ im
β i= 2
m
σ
0 . 01814
= 0. 01098 = 1.65
Again,
σi
β i=r im
( )
σm
0 .1940
= .89 × 0 .1048 = 1.65
Problem-07:
Suppose you are given the following observation:
Time T1 T2 T3 T4 T5 T6
Stock-A .02 .04 .02 .08 .04 .04
Stock-B .02 .03 .06 .03 .04 .08
You are required to-
i. find out the sample mean return for each of the stock
ii. find out the variance and standard deviation for the
stocks
iii. compute the covariance and correlation coefficient
between the return on the stocks
iv. find out the coefficient of determination and comment
on the result
Solution:
Tim Return on (rAt rA)
(rAt ( rBt ( rBt
e Stoc Stoc (rAt rA)2 ×
rA) rB) rB) 2
k-A k-B (rBt rB)
T1 .02 .02 00 0000 .01 .0001 0000
T2 .04 .03 .02 .0004 00 0000 0000
T3 .02 .06 .04 .0016 .03 .0009 .0012
T4 .08 .03 .06 .0036 00 0000 0000
T5 .04 .04 .06 .0036 .07 .0049 .0042
109
T6 .04 .08 .02 .0004 .05 .0025 .0010
.12 .18 .0096 .0084 .0040
Sample mean:
Stock-A N
1 ∑
rA = N t=1 rAt
1
= 6 × .12 = .02
Stock-B N
1 ∑
rB = N t=1 rBt
1
= 6 × .18 = .03
Sample variance:
For Stock-A N
1 ∑
= 2
A N−1
t=1 (rAt rA)2
1
= 6−1 × 0.0096
= 0.00192
For Stock-B N
1 ∑
2
B = N−1 t=1 (rBt rB)2
1
= 6−1 × 0.0084
= 0.00168
Standard deviation:
For Stock-A N
σA=
1
√
∑ ( r −r )2
N −1 t=1 At A
110
1
= √ 6−1
×0 . 0096
= .00192
√
= 0.0438 = 4.38%
For Stock-B N
σ B=
√ 1
∑
N −1 t=1
( r Bt −r B )2
1
= √ 6−1
×0 . 0084
= .00168
√
=.0410 = 4.10%
Covariance:
For stock A and B N
1
σ AB = ∑ ( r −r )( r −r )
N−1 t=1 [ At A Bt B ]
1
= 6−1 ×.0040
= 0.0008
Correlation coefficient:
For stock A and B σ AB
r AB =
σ A σB
0 . 0008
= ( 0. 0438)( 0 .0410 )
= .45
Again,
= rA,B (A)(B)
AB
= (.45) × (.0438) × (.0410)
= 0.0008
Coefficient od determination:
CD = (rAB)2
= (.45) 2 = .20
Problem-08:
Suppose following information are the information about ex ante
data:
Probabilit .20 .25 .30 .15 .10
111
y
Stock-A .16 .12 .08 .04 .02
Stock-B .02 .07 .10 .13 .21
You are required to-
i. find out the expected rate of return for each of the
stocks
ii. compute the variance and standard deviation for the
stocks
iii. compute the covariance and correlation coefficient
between the return on the stocks
iv. find out the coefficient of determination of the stocks
and comment on the result
Solution:
Calculation of expected rate of return
Prob. Return pi × E(rAi) pi × E(rBi)
(Pi) Stock Stock (rB)
(rA)
.20 .16 .02 .20 × .16 = . .20 × .02 = .
.25 .12 .07 032 004
.30 .08 .10 .25 × .12 = . .25 × .07 = .
.15 .04 .13 030 018
.10 .02 .21 .30 × .08 = . .30 × .10 = .
024 030
.15 × .04 = . .15 × .13 = .
006 0195
.10 × .02 = . .10 × .21 = .
002 021
1.00 .094 .0925
Expected rate of return:
Stock-A
N
∑
E(rA) = i =1 pi × E(rAi)
= .094 = 9.4%
Stock-B
N
∑
E(rB) = i =1 pi × E(rBi)
= .0925 = 9.25%
Contd. Table
Calculation of variance and standard deviation
112
Pro Return
b. Stoc Stoc
pi × [rAi E(rA)]2 pi × [rBi E(rA)] 2
(Pi) k k
(rA) (rB)
.20 .16 .02 .20 (.16 .094) = . .20 (.02 .0925) = .
.25 .12 .07 00087 00101
.30 .08 .10 .25 (.12 .094) = . .25 (.07 .0925) = .
.15 .04 .13 00017 000127
.10 .02 .21 .30 (.08 .094) = . .30 (.10 .0925) =
000059 0000169
.15 (.04 .094) = . .15 (.13 .0925) = .
00044 000211
.10 (.02 .094) = . .10 (.21 .0925) = .
00055 00138
1.0 .0021 .00274
0
Variance:
Stock-A
N
∑
2(rA) = i=1 pi [rAi E(rA)]2
= .0021
Stock-B
N
∑
2(rB) = i=1 pi[rBi E(rA)] 2
= .00274
Standard deviation:
Stock-A
(rA) = √ σ 2(r A )
= √ 0.0021
= .046 = 4.6%
Stock-B
(rB) = √ σ 2(r B )
= √ 0.00274
= .0523 = 5.23%
113
Contd. Table
Calculation of covariance
Prob. Return
(Pi) Stock Stock (rB) pi × [rAi E(rA)][rBi E(rA)]
(rA)
.20 .16 .02 .20 (.16 .094) (.02 .0925) =
.25 .12 .07 .000957
.30 .08 .10 .25 (.12 .094) (.07 .0925) =
.15 .04 .13 .000146
.10 .02 .21 .30 (.08 .094) (.10 .0925) =
.0000315
.15 (.04 .094) (.13 .0925) =
.000295
.10 (.02 .094) (.21 .0925) =
.00087
1.00 = .0023
Covariance:
N
∑
AB = i =1 pi × [rAi E(rA)][rBi E(rA)]
= 0.0023
Correlation coefficient:
σ AB
r AB =
σAσB
= 0. 0023 / [(.046)(.0523]
= 0.97
Again,
AB = rA,B (A)(B)
= ( 0.97) (.046)(.0523)
= 0.0023
Coefficient of determination (R2):
CD = (rAB)2
= (0.97)2 = .94
Problem-09:
Suppose you are given the following information:
Probability .20 .25 .30 .15 .10
Return on Stock-i .16 .12 .08 .04 .02
Return on market .02 .07 .10 .13 .21
portfolio-M
114
You are required to-
find out the beta factor for stock i and comment on the
result.
Solution:
Calculation of expected rate of return
Prob. Return pt × E(rit) pt × E(rmt)
(Pt) Stock Market
(ri) (rm)
.20 .16 .02 .20 × .16 = . .20 × .02 = .
.25 .12 .07 032 004
.30 .08 .10 .25 × .12 = . .25 × .07 = .
.15 .04 .13 030 018
.10 .02 .21 .30 × .08 = . .30 × .10 = .
024 030
.15 × .04 = . .15 × .13 = .
006 0195
.10 × .02 = . .10 × .21 = .
002 021
1.00 .094 .0925
Expected rate of return:
Stock-i
N
∑
E(ri) = t =1 pt × E(rit)
= .094 = 9.4%
Market portfolio return
N
∑
E(rm) = t =1 pt × E(rmt)
= .0925 = 9.25%
115
.0000315
.15 (.04 .094) (.13 .0925) =
.000295
.10 (.02 .094) (.21 .0925) =
.00087
1.00 = .0023
Variance of market:
N
∑
2(rm) = t =1 pt[rmt E(rm)] 2
= .00274
Therefore,
σ im
2m
βi = σ
−0. 0023
βi = 0. 00274
= 0.84
116
The beta factor for stock i is negative () 0.84. This indicates
that if the market return goes to be higher by 1 per cent, the
return for stock i is expected to decrease by .84 per cent for the
next time period and vice versa.
If the market return goes to be higher by 10 per cent, the return
for stock i is expected to decrease by 10 (.84) = 8.4 per cent
and if the market return goes to be higher by 100 per cent, the
return for stock i is expected to decrease by 100(.84) = 84 per
cent for the next period and vice versa.
Residual variance
Another dimension of the relationship between the return on
individual stock and that of market is the propensity of the stock
to produce returns that derive from the characteristic line. The
measure describing this propensity is called the residual
variance. The variance of stock describes the stock’s propensity
to produce returns that derive from its expected value. The
residual variance describes the propensity of the stock to
produce returns that derive from its characteristic line. It is the
vertical distance between the pair of returns and the
characteristic line. The residual for a stock can be calculated by
using the following formula from the market model as:
r it = αi + β i (rmt) + εit
and
εit = rit [αi + βi (rmt)]
Like the variance of stock the residual variance is computed by
squaring the deviations from the expected value as:
N
1
N−2 ∑
Residual variance (2 εi) = t =1 2 εit
Problem-10:
From the following information find out the residual variance.
Time T1 T2 T3 T4 T5
Return on Stock-i .02 .03 .06 .04 .
08
Return on market .04 .0 .08 .04 .
portfolio-M 2 04
Solution:
Calculation table
Time Return on
Stock- Market (rit ri) (rmt rm) (rmt rm)2
i
T1 .02 .04 (.02 .03)(.04 .02) = .0004
117
T2 .03 .02 .0002 .0016
T3 .06 .08 (.03 .03)( .02 .02) = .0036
T4 .04 .04 0000 .0036
T5 .08 .04 (.06 .03)(.08 .02) = . .0004
0018
(.04 .03)( .04 .02) = .
0042
(.08 .03)(.04 .02) = .
0010
ˉri=.03 ˉrm=.02 =.0068 .0096
Covariance Between stock i and market
N
1
N−1 ∑
i, m = t=1
(ritri)(rm trM)
1
= 5−1 (.0068)
= 0.0017
Market variance
N
1
N−1 ∑
2m = t=1 ( rm t rm)2
1
= 5−1 (.0096)
= 0.0024
118
T3 .03 [.0158 + .708 (.02)] (.02836)2
T4 =.02836 =.000804
T5 .06 [.0158 + .708 (.08)] = (.0124)2
.0124 =.000154
.04 [.0158 + .708 (.04)] = (.0275)2
.0525 =.000756
.08 [.0158 + .708 (.04)] = . (.0359)2
0359 =.001289
= .003584
Residual variance for stock i:
N
2
it
2
∑ε
σ εi
= t =1
N −2
1
= ×0. 003584
5−2
= 0.001195
119
utility values are assigned to investments with more
attractive risk-return profiles. Association of Investment
Management and Research (AIMR) assigns the following
equation for an investment with expected return E(r),
variance of returns (σ 2) and the utility score:
U =E ( r )−.005 A σ 2
Where,U is the utility value and A is an index of
the investor’s risk aversion. The factor of .005 is a
scaling convention that allows us to express the
expected return and standard deviation of the
investment. The expression is consistent with the notion
that utility is enhanced by high expected returns and
diminished by high risk. The extent to which variance
lowers utility depends on the degree of risk aversion of
the investor. More risk-averse investors penalize risky
investments more severely. Investors prefer among
competing investments providing the highest utility
level. Risk aversion affects investors’ appropriate risk-
return trade-off.
Exercises
1. What is meant by return from investment?
2. Elucidate the determinants of return from investment.
3. Define investment risk. What are different types of risk?
4. Briefly explain the different sources of risk in investment.
5. Define the following terms:
i. Variance ii. Standard deviation iii. Covariance iv.
Coefficient of variation v. Correlation coefficient v.
Coefficient of determination vi. Total return vii. Return
relative viii. Relative measure and absolute measure of risk
6. Define systematic risk. How is it determined? Why is beta
called systematic risk?
7. “Risk-averse investor will never assume risk”- Would you
agree? Justify your stand.
8. Why is standard deviation called the best measure of risk?
9. Point out the relationship between return and risk?
10. What are the measures of return and risk?
11. Differentiate systematic risk from unsystematic risk.
120
12. Point the fundamental factors affecting the risk premium of
an investment.
13. A stock costing Tk. 110 pays no dividends. The possible
prices that stock might sell at the end of the year with the
respective probabilities as follows:
Probable price (P1) 115 12 125 12 12 98
2 4 6
Probability .10 . .20 . .14 .
15 25 16
Calculate expected return and standard deviation of return
of the stock.
14. Suppose the market price of a stock which pays no dividend is Tk.200.
The possible prices of the stock with respective probabilities are given
below:
Price (P1) 210 195 200 211 205 215 220
Probability (pi) .10 .20 .15 .10 .25 .10 .10
Requirement:
Calculate the expected rate of return of the stock.
15. From the following information calculate the coefficient of
variation (CV) for stock i.
Return Possible (ri) .03 .10 .10 .13 .05 .15
Probability (hi) .15 .20 .25 .10 .14 .16
16. From the following information calculate the expected rate of return for
stock i and market.
Return Possible (ri) .10 .12 .09 .11 .05 .15
Return Possible (rm) .09 .03 .06 -.02 .10 .13
Probability (pi) .15 .20 .25 .10 .12 .18
17. Calculate the total return and return relative for the
following assets:
i. A preferred stock bought for Tk. 150, held one year
with Tk. 12 per share dividends are collected and sold for
Tk. 160.
ii. A 10%, Tk. 1000 boud bought for Tk. 890, held three
years during which interest is collected and sold for Tk.
950.
18. You are given the following information:
Time T1 T2 T3 T4 T5
Expecte Stock-i (ri) .11 .10 .09 .07 .04
d Market .04 .06 .07 .10 .11
Returns (rm)
Requirements:
Calculate beta factor for stock i.
121
19. Determine the expected rate of return and level of risk
based on the following information:
Current Future price Dividend Probability (Pi)
price (P0) (P1) income
(D1)
260 40%
220 200 30 35%
205 25%
20. Suppose you are given the following information:
Time T1 T2 T3 T4 T5
Return on Stock-i .03 .05 .04 .07 .
08
Return on market .04 .02 .08 .04 .
portfolio-M 03
Calculate the residual variance for stock i.
Part-Two
Security Analysis
122
Chapter Six: Economy Analysis
Chapter Seven: Industry Analysis
Chapter Eight: Company Analysis
Chapter Nine: Technical Analysis
123
Chapter-Six
Economy Analysis
The pragmatic objective of the investor is to create surplus from
the investment in the securities markets. This motivates the
investors to buy securities for the purpose of selling the same
subsequently at higher price that generate capital gains from
the investment. In some cases, investors wish to receive
dividends from the investment. To some other extent, risk
averter investors receive a fixed income from the investment in
the form of interest. Whatever the case may, these are the
components of return from the investment in the securities
market. Furthermore, the investors are interested to be sure
about the future return from the investment. Investors wish to
receive a large amount of money in the form of dividend and
simultaneously, higher price for the shares. But, both dividend
and capital gains are uncertained and depend on the financial
strength of the company. Rather these are primarily determined
by the performance of the company which in turn is influenced
by the performance of the company, industry to which the
company belongs to, and the micro-economic, macro-economic,
socio-political scenario of the country.
124
the industry, management, technological change, employee-
owner relationship (agency problem), foreign competition etc.
should be analyzed for fundamental analysis of the company.
Subsequently, fundamental analysis can be defined as a
systematic approach to estimating the expected dividends and
future stock price. However, the economic fundamentals,
industry fundamentals, and company fundamentals are taken
into consideration while analyzing securities for investment
purpose. Under the regime of fundamental analysis, each
security is priced on the basis of the present economic position
and future earning capacity of the company.
The objective of the fundamental analysis is to estimate the
present and future capacity of a stock on the basis of economic,
industry and company fundamentals with a view to assessing
the intrinsic (fundamental) value of the stock. For the
investment purpose, an investor can compare the intrinsic value
with the market value of the stock. If the intrinsic value of the
stock is higher than the market value, the investor should
purchase the stock. It assumes that the stock is under priced
and near future the price will rise and be equal to the intrinsic
value. On the other hand, if the intrinsic value of the stock is
lower than the market value, the investor should sell the stock
assuming that the stock is over-priced and near future the price
will fall and be equal to the intrinsic value. Therefore,
fundamental analysis provides a rational investment decision.
This analytical framework is known as economy-industry-
company (EIC) analysis and insists investors from making
investment decision on the basis of tips and rumours.
Economy-Industry-Company (EIC) Analysis
The economy, industry, and company analysis constitutes the
main spirit of the fundamental approach of security analysis.
Different micro-economic and macro-economic factors affecting
the prices of the securities can be categorized as under:
i. Economy-wide factors: These include growth rate
of the economy, interest rate, real rate, inflation,
foreign exchange rate, savings rate, investment rate,
national resources, percapita income etc. which affect
all the securities of all the companies.
ii. Industry-wide factors: These include demand-
supply gap in the industry, product substitutions,
emergence of new companies in the industry,
government industrial policy, investment environment
regarding the industry, etc., which affect the prices of
125
the stocks of the companies belonging to the
particular industry.
iii. Company-specific factors: Company-specific
factors include the quality of management, agency
problem, age of the company, asset size of the
company, ownership-pattern of the company, demand
for the products, labor-management relationship,
profitability of the company, pattern of dividend,
earnings expectation in future, etc. The performance
of the individual company in terms of these factors
can make differences from those of other companies
in the same industry.
Fundamental analysis helps investors making their buy and sell
decisions based on the fundamental information about the
economy, industry to which the company belongs to, and
company. Thus, investors as well as fundamentalists make use
of the economy-industry-company framework of analysis.
Therefore, fundamental analysis includes the following steps:
[3] Economy
Analysis
[2] Industry
Analysis
[1] Company
Analysis
EIC Analysis
Economy Analysis
All the companies working in the economy are affected by any
economic factor. So, the performance of the company depends
on the performance of the economy. If the economy is
depressed economy, the performance of the industry as well as
the company would generally be worsened. If the economy is
booming, the performance of the industry as well as the
company would generally tend to be prosperous. However, the
following economic factors are vital and investors should
monitor them while making investment decision.
Growth of the Economy
126
An investor should consider the position of the national
economy while making investment decision. Gross national
product (GNP), net national product (NNP), and gross domestic
product (GDP) etc. are the sophisticated measures or indicators
of the total income or total output of the country. The growth
rates of these indicators indicate the growth rates of the
economy. An economy has typically four stages like depression,
recovery, boom and recession. Depression is the worsened
situation of the economy where demands become low, inflation
and interest rates often tend to be unexpectedly high. When
demands pick up leading to more investment, the position of
the economy is termed as recovery. At this stage production,
employment, and profits tend to increase. In a boom position,
demands increase, production rate would become higher; profits
of the companies would become higher. In the time horizon, the
economy will downturn in demands, production, and
employment. As a result, the profits of the company start to
decline. This position of the economy is called recession. While
making investment decision, investor should determine the
stage of the economy.
Interest Rates
Interest is the cost of funds borrowed by the company for
investment purpose. Interest rates determine the cost and
availability of the credit of the company. A lower rate of interest
stimulates investors to borrow money from the market easily at
a cheapest cost to finance which generates higher profit. It
implies that in a regime of low interest investors have the
opportunities to earn higher profit by creating a large surplus.
Higher interest rates, on the other hand, result in higher cost of
production leading to lower profitability and lower demand as
well. Interest rates, being a most crucial determinant of stock
price, are the basic component of discount rates with the two
usually moving together. Therefore, interest rates can influence
the price of a stock as well as the investment decisions of the
investors.
Inflation
Inflation measures the percentage change in a specific cost of
living index at various points in time. The percentage change in
the cost of living index during a given time period is measure of
the inflation from the beginning of the period to the end of the
period. It is the situation of the economy where the price of the
essential commodities increases generally keeping the
purchasing power of money lower. Additional money should be
127
spent for the same amount of goods that the consumer could
purchase at a lower amount of money before a particular period
of time say one year. On the other hand, consumers should
forgo a certain amount of consumption they could consume
before the price appreciation. The tent amount of postponed
consumption can also be treated as inflation. Whatever the case
may be inflation has considerable impact on the performance of
the company. An economy with higher inflation can upset
business plans resulting in a squeeze on profit margin as a
result of the lower demand for the products. This situation of the
economy affects the performance of the company adversely. In
an economy with lower inflation, company experiences growth
and development. An investor in the financial market should
evaluate the inflation rate prevailing in the economy and also
the expected rate of inflation in near future.
Savings Rates
The theory of economy says that the savings of individuals as
well as the society as a whole are converted into investment so
the money saved can offset the rate of inflation. Saving is the
amount of postponed consumption. Thus, savings rates can
affect the price of the stock and the investment decisions of the
investors as well.
Monetary and Fiscal Policy
Financial theory asserts that dividend policy of a firm is closely
related to the movement of macroeconomic factors. The
uncertainty of fiscal and monetary policy is significantly
correlated to earnings of the firm, which is also related with the
amount of its dividend payments. Monetary and Fiscal Policy of
the government can influence the performance of the company.
Monetary policy controls the credit and keeps the supply of
money at an optimum level which affects the borrowings of the
company. As interest rates of the economy are controlled by the
monetary policy, it affects the profitability of the company which
in turn affects the price of stock. Fiscal policy, on the other
hand, influences the performance of the company. In the world
of perfect market, the stock price is not affected by the fiscal
policy of the government. But any market imperfection causes
the fluctuation in the price of the stock of company. Stock price
is affected by the clientele effect. If any income from the
securities in the form of dividends and capital gains are treated
as taxable income in an economy with market imperfections.
Taxes
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Economists argue that the corporate tax as well as dividend
policy is irrelevant to the value of the firm. When personal taxes
are introduced with a capital gain tax and tax on individual
income, investors’ expectation of dividends will be changed.
High rate tax-payers tend to favor high retention ratio and
hence low yields from shares when taxes are imposed on
dividend income. If dividends are taxed more heavily than
capital gains, investors would be habituated to invest in stock
with low dividend yield and hence they should accept a lower
pre-tax rate of return from securities offering returns in the form
of capital gains rather than dividends.
Foreign Exchange Rates
The profitability of the company is affected by the exchange
rates of local currency against the currencies of the rest of the
world. A depreciation of the local currency improves the
competitive position of local products in foreign markets
stimulating exporters to export more in order earn more profits.
The higher the profits, the more the productions. A depreciation,
on the other hand, makes imports more expensive and the
company depending on foreign goods finds devaluation of local
currency affecting its profitability adversely. The exchange rates
of local currency are affected by the balance of trade deficit, the
balance of payment deficit, and the foreign exchange reserves
of the country. If these deficits increase, there is a possibility
that the local currency may depreciate in value. Balance of
payment deficit declines in foreign exchange reserves as the
deficit has to be met from the reserves. Therefore, the size of
the foreign exchange reserve is the measure of the strength of
the local currency on external account. Large foreign exchange
reserves help increasing the value of local currency against the
other currencies. The balance of trade deficit, the balance of
payment deficit, and the foreign exchange reserves of the
country will help to predict the future trends in exchange rates
which in turn helps investors in making investment decision.
Infrastructure
To some extent, the development of economy depends on the
infrastructure like electricity, roads and railways to transfer raw
materials and finished goods, communication network to keep in
touch with suppliers and customers. These infrastructure
facilities affect the performance of the company as the
productivity depends upon them. An investor should consider
the infrastructure facilities an industry as well as a company
requires while making investment decision.
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Investment Environment
In an agro-based economy like Bangladesh, the performance of
some industries and companies depends on the performance of
agriculture because of the strong forward and backward
linkages agriculture and industry. Moreover, the performance of
the agriculture to a very great extent depends on the monsoon.
The adequacy of the monsoon determines the success or failure
of the agriculture of a country like ours.
Investment Policy of the Government
No industry and company can grow and prosper in the midst of
political turmoil. Government intervention obviously influences
the investment decisions of the investors. A sound and smooth
government policy for industrialization will help establishing
companies.
Political Stability
For a steady, smooth and stable economic growth, a stable
political regime is essential. A stable government policy with
long-term objectives will be required for better performance of
the economy, industry and company. Political unrest is not
desired at all for better economic performance.
Economic Forecasting
Being the first stage of the fundamental analysis, economy
analysis starts with an analysis of the historical performance of
the economy. Investors are very much optimistic about the
future performance of the economy and its various segments.
Forecasting the economy is very important activity in the
economy analysis. An investor should consider the following
situations of the economy while forecasting the economy in
near future:
i. Recession and higher rate of interest
ii. Recession and lower rate of interest
iii. Boom and higher rate of interest
iv. Boom and lower rate of interest
The key macro-economic variables affecting the price of stock can be
summarized in Table 6.1.
Variables Effects Nature of
variables
Fiscal policy Affects corporate Independent and
earnings that affects policy variable
securities prices
Monetary policy Affects corporate Independent and
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earnings that affects policy variable
securities prices
Corporate tax Affects corporate Independent and
rate earnings that affects policy variable
securities prices
Output of the Determines changes Independent and
economy in prices policy variable
Interest rates Have a negative Dependent variable
influence on prices of
securities like
shares , stocks etc.
Inflation rate Relates interest rate Dependent variable
through purchasing
power
Savings rate Changes supply of Dependent variable
money and affects
interest rates
General price Influence current Dependent variable
level changes interest rates
Changes in real Generate inflation Dependent variable
output and real growth that
affects interest rates
Changes in Affect interest rates Dependent variable
money supply and cause inflation
Corporate Affect securities Dependent variable
earnings prices
Changes in total Determine changes Dependent variable
earnings in output
Enterprise/indus Changes in output Dependent variable
try performance and affects earnings
Table 6.1: Variables of Stock Price Movements with Their
Respective Effect on the Securities Prices.
Forecasting Methods
Forecasting is the method of predicting about the position of the
economy. This type of preassumption about the economy can
be carried out for short-term periods, medium-term periods, and
long-term periods. Whatever the term may be an investor
should be more concerned about the objectives of the economic
forecasts. Some methods of economic forecasting are discussed
below:
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Anticipatory Surveys
Anticipatory surveys are the surveys of intentions of people in
government, business, trade and industry regarding their
consumption activities, plant and machinery expenditures, level
of inventory future plans of consumers, with regard to their
spending on durables and non-durables etc. Based on the
results of these surveys, the investors as well as analysts can
form the forecast of the future state of the economy. Surveys of
the intentions of the consumers regarding the plan and budget
for expenditures in advance can provide valuable inputs to the
short-term economic forecasting.
Indicator Approach
This refers to the technique by which various types of indicators
being time series data of certain economic variables are
analyzed to find out how the economy is likely to perform in
future. These variables are categorized as under:
Leading Indicators: These are time series data
reaching their high points or their low points in advance of the
high points and low points of total economic activity like money
supply, change in sensitive materials prices, change in
manufacturers’ unfilled orders etc.
Coincidental Indicators: These are indicators reaching
their peaks and troughs at proximately the same time as the
economy like employees on non-agricultural pay rolls, personal
income less transfer payments etc.
Lagging Indicators: These are indicators reaching their
turning points after the economy has already reached its own
turning points such as average duration of unemployment,
average prime rate, change in consumer price index for services
etc.
Though all the indicators forecast the economic activities,
leading indicators are more useful for economic forecasting
since they measure something that foreshadows a change in
economic activity. However, the composition of the economic
indicators appears in Table 6.2.
Leading Indicators
i. Average weekly hours of manufacturing
production workers
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ii. Average weekly initial unemployment claims
iii. Manufacturers’ new orders
iv. Vendor performance
v. New orders for nondefense capital goods
vi. New private housing units authorized by local
building permits
vii. Yield curve slope
viii. Money supply (M2)
ix. Index of consumer expectation
x. Changes in sensitive materials prices
xi. Contracts and orders of plants and machineries
xii. Changes in manufacturers’ unfilled orders
Coincident Indicators
i. Employees on non-agricultural pay rolls
ii. Personal income less transfer payments
iii. Industrial production
iv. Manufacturing and trade sales
Lagging Indicators
i. Average duration of unemployment
ii. Ratio of trade inventories to sales
iii. Change in index of labor cost per unit of output
iv. Average prime rate changed by banks
v. Commercial and industrial loan outstanding
vi. Ratio of consumer installment credit outstanding
to personal income
vii. Change in consumer price index for services
Table-6.2: Indexes of Economic Indicators.
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including monetary and fiscal policy of the government can be
estimated.
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leads to an increase in economic activities. But an increase in
money demand leads to reduce economic activities. Finally,
investors should open their eyes on the activities of the
government as well as its agencies because of their role in
monetary policy and fiscal policy and their impact on the rates
of interest and other determinants of stock prices.
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Corporate tax rate
Stock price
Interest rate
Potential output Changes in price level
Figure 6.1 shows that the potential output of the economy being
the nonpolicy variable along with three active policy variables-
fiscal policy, monetary policy and corporate tax rate ultimately
affect the prices of the stocks. Two independent variables like
government spending (fiscal policy) and money supply
(monetary policy) affect the stock prices in two ways:
i. by affecting total spending that along with corporate
tax rate affects corporate earnings which is positively related to
changes in stock prices,
ii. by affecting total spending which along with the
potential output and past changes in prices determine current
changes in prices which ultimately determine current changes in
real output.
Output and changes in prices cause inflation and real growth
influencing the current interest rate. Interest rates possess a
negative influence on the stock prices. Potential output,
government spending, money supply, and corporate tax rate
cause the changes in total spending, price level and real money
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which ultimately affect corporate earnings and interest rates.
Interest rate is negatively related to price earning ratio and, in
turn, corporate earnings and price earning ratio determine the
stock prices.
The ultimate determinants of stock prices are present and
expected earnings of the corporation and prevailing interest
rates. There exists a strong positive relationship between
corporate net earnings and stock prices. The expected value of
the stock and the market as well should be a function of the
expected streams of benefits to be received and the investors’
required rate of return. Investors will expect corporate net
earnings and dividends to rise and as a result stock price will
tend to rise if the economy is prospering. However, the
relationship between the stock price and its determinants are
summarized below:
Notion of the Impact on stock price
determinants
♦ Interest rates rise (fall). ♦ Stock prices fall (rise).
♦ An increase (decrease) in ♦ Stock prices tend to increase
expected corporate earnings. (decrease).
♦ A change in government ♦ Affects the corporate
spending. earnings.
♦ An increase in tax rate. ♦ Reduces the corporate net
earnings.
♦ An increase in money ♦ Increases the prices of
supply. stocks.
♦ An increase in output. ♦ Increases the prices of
stocks.
♦ An increase in risk factor ♦ Reduces stock prices.
(discount rate).
♦ An increase (decrease) in ♦ Causes an increase
growth of dividend. (decrease) in stock prices.
Exercise
137
2. Define dundament analysis. Why is it important in
determining the security prices?
3. Define macroeconomic variables. What are major
macroeconomic variables? State their influences in the
determination of security prices.
4. State the composition of the economic indicators.
5. Briefly explain the basic competitive forces for economy
analysis.
6. Differentiate between independent variables and
dependent variables in determining the security price.
7. What is EIC analysis? State the process of EIC analysis.
8. What is economic forecasting? Why is it important in
investment decision making. What is the significance of
economic forecasting?
9. What is meant by the determinants of security prices?
Explain them.
Chapter- Seven
Industry Analysis
An investor can choose one or more securities for investment
purpose. Each company belongs to a particular industry. The
performance of individual companies would be influenced by the
characteristics of industry to which they belong to. So, an
analyst or an investor has to undertake an industry analysis to
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study the fundamental factors affecting the performance of the
industry. Industry analysis is the second stage of fundamental
analysis. If an investor is convinced about the performance of
the economy and market, he should proceed to consider an
industry promising the most opportunities for investment
purpose. An industry is described as a homogenous group of
companies working in a particular area of the economy or
market. Broadly speaking, an industry can, therefore, be defined
as a group of companies producing similar type of products
serving the same needs of a common set of buyers or users.
Concept of Industry
Industries are categorized on the basis of products like banking
industry, insurance industry pharmaceuticals industry, garments
industry etc. But this classification of industry becomes very
difficult when dealing with companies having a diversified
product line say, a group of companies. The basic concepts of
industry analysis are closely related to the various issues of
valuation principles. Investors can apply these concepts in
several ways. The amount and clarity of information, the degree
of rigor sought, and the specific model used are usually
considered while someone is assessing the industry
performance.
Industry Classification
Many problems are involved in the classification of industry.
While classifying industry, analysts and investors need to deal
with different models. Standard industrial classification (SIC)
system is widely used system which is based on census data to
classify industry on the basis of products the companies
produce. However, industries are classified on the basis of
products what the companies belonging to an industry produce.
Accordingly, industries are categorized as pharmaceutical
industry, garments industry, cement industry, agriculture
industry, and so forth.
Industry Analysis
Economy, industry and companies are analyzed on the basis of
a wide range of data like sales revenue, present, past and future
earnings, financing decisions including dividends, capital
budgeting and capital structure decisions, working capital
decisions, product line, rules and regulations, and so on.
Reasonably, the analysis of these indicators requires
considerable expertise and should be performed by financial
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analysts employed by brokerage firms, specialists, and
institutional large investors with the help of professionals and
academicians. Economists believe that there are four stages of
a product namely pioneering stage, expansion stage, stagnation
stage and decay stage. Industry analysts argue that the analysis
of the stages of a product includes the first step in analyzing an
industry. Such fundamental analysis assesses the general
health and current position of the industry. The second step is to
assess the position of the industry in relation to the business
cycle and macroeconomic conditions while the third step
includes a qualitative analysis of industry characteristics. All the
steps involve in an analysis is called industry life cycle.
According to the industry life cycle theory, the life of an industry
might be segregated into the aforesaid stages which are very
much essential to an investor because the profitability of an
industry depends on its stage of growth.
Years
[1] Pioneering stage [3] Stagnation
stage
[2] Expansion stage [4] Decay
stage
Figure-7.1: Industry life cycle
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Pioneering stage
Being the first stage of industry life cycle, pioneer stage
determines the stage of growth through which the industry is
passing. It is also the first stage of a new industry where the
technology as well as the product are relatively new and have
not reached a stage of perfection. In this stage, the rapid growth
in demand for the output of industry occurs. As a result, the
companies belonging to the industry enjoy a great opportunity
to make profit. Many companies come to the industry to
compete with each other vigorously and attempt to capture
their share of the market. Weak firms in the industry are
eliminated and a lesser number of firms survive the pioneering
stage. It is very difficult for the analysts and investors to identify
the companies surviving and coming out strongly later on. So,
investment in the companies in the pioneer stage is risky.
Industries in the pioneer stage are called sunrise industries.
Expansion stage
Being the second stage of an industry life cycle, an expansion
stage identifies the survivors from the pioneering stage. They
continue to grow and prosper though the rate of growth which is
moderate than that in the pioneering stage. Each company finds
a market for itself and develops its own strategies to sell and
maintain its position in the market. The competition among the
surviving companies brings about improved products at lower
prices. Companies in the expansion stage of an industry are
attractive and suitable for investment purpose. Since the
demand exceeds the supply in this stage, companies create
higher returns at lower risk. The earnings of the companies in
the expansion stage increase leaving higher profits as well as
dividends to the company owners.
Stagnation stage
In the third stage of the industry life cycle, industries evolve into
the stabilization stage at which the growth begins to moderate.
At this stage sales may still be increasing at a much slower rate
than that in the expansion stage. Products become more
standardized and less innovative, the market is full of
competitors, and costs are stable rather than decreasing
through efficiency moves. Industries in this stage continue
without significant growth. So, the industries in this stage begin
to stagnate. An investor should dispose of his holdings in an
industry passing from the expansion stage to stagnation stage
as what is to follow is the decay of the industry.
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Decay stage
The last and the final stage of the industry life cycle is the decay
stage passing from the stagnation stage. This stage starts when
the product of the industry are no longer in demand. New
products and new technologies have come to the market.
Customers have changed their habits, style, and liking. As a
result, the industry becomes obsolete and gradually ceases to
exist. Thus, the changing scenario of the habits of the
customers, technologies, and declining demands for the
products are the causes of the decay of the industry. Investors
should get out of the industry before the onset of the decay
stage.
From the above discussion, we may conclude that the industry
life cycle approach has important implications for the investors
making investment decisions. It provides the investors an
insight into the advantageous of an investment in a given
industry at a time horizon. Finally, we may conclude saying that
an industry experiences low profitability in the pioneering stage,
high profitability in the expansion stage, medium but steady
profitability in the stagnation stage and declining profitability in
the decay stage.
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industries are considered to become the example of such
industries.
Cyclical Industries
Being most volatile, cyclical industries include those doing well
when economy prospers and are likely to be hurt when it falters.
Durable goods like autos, refrigerators, stereos are the
examples of the products of cyclical industries. During the
recession, purchases of these goods are postponed.
Countercyclical industries also exist moving opposite to the
prevailing economic trend.
Interest-Sensitive Industries
Interest-sensitive industries are particularly sensitive to
expectations about changes in interest rates. Examples of such
industries include banking industries, financial service
industries, real estate industries, building industries etc.
These classifications of industries according to economic
conditions do not constitute an exhaustive set. However,
irrespecting to the conditions of the economy, other
classifications are logical as well as possible.
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determining the strength of the following basic competitive
factors:
Threat of new entrants
Bargaining power of buyers
Bargaining power of suppliers
Rivalry between existing competitors
Threat of substitute products or services
Government Effects
There are certain industrial and economic policies of the
government. Time to time government imposes rules and
regulates the economic and industrial activities of a country. So,
government regulations and actions can provide significant
effects on industries. Investors should give emphasis in
assessing the impacts of these effects on the industry.
Structural Changes
Structural changes in the economy can also provide significant
influence on industry. If the country wishes to move from an
industrial society to another one, major concerning industries
shall be affected. Under such a situation, new industries with
tremendous potential will be emerging while some traditional
industries may never recover their former position. Structural
changes may also occur within relatively new industries.
Finally, potential investors are interested in future performance
of the industry. They also realize that such analyses are difficult
but equity prices are a function of expected parameters rather
than past and known values.
Industry Characteristics
There are a large number of key indicators characterizing an
industry which should be considered a lot while analyzing by the
investors. These characteristics include operational and
structural aspects of the industry some of which are discussed
below:
Demand Supply Gap
The demand for a particular product is subject to be changed
over-time. But the capacity to produce the product tends to
change at regular intervals which depend on the installation of
additional production capacity. Therefore, an industry should
experience under-supply and over-supply of capacity at
different times. According to demand-supply rules, additional
supply will reduce the profitability and insufficient supply tends
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to improve the profitability. As a result, the gap between
demand and supply in an industry seems to become a good
indicator.
Competitive Conditions
The magnitude of the competitions among the companies in
the industry is determined by certain competitive forces which
include barriers to entry, the threat of substitution, bargaining
power of buyers and suppliers, the rivalry among competitors
etc.
Labor Conditions
The labor union in some countries like ours are very powerful
and objective oriented. The labor conditions in the industry
under analysis seem to be an important consideration in an
economy. The future prospect of an industry would not become
bright the labor of which is rebellious and is inclined to resort to
strikes frequently. It implies that labor unrest in a particular
industry will hamper the growth and development of and even it
may destroy that industry.
Permanence
Permanence is defined as a condition related to the products
and technology used by a particular industry. In an economy
where the rapid technological change is special phenomenon,
the degree of permanence of an industry is sort of vital
consideration in industry analysis. If the demand for a product of
a particular industry will vanish near future or rapid
technological changes would render the products obsolete
recently, investors should discontinue investment with this
industry.
Government Attitudes
Government encouragement, regulations, and attitudes toward
an industry carry an importance on the prospects of the same.
Government encourages some industries by making favorable
legislations that can assist toward achieving growth and
development. On the other hand, government discourages some
industries making them difficult to survive by imposing some
rules and regulation very tight.
Raw Materials
The price and availability of raw materials used in a particular
industry are considered to become important factors
determining the profitability of that industry. The industries
having heavy dependence on a very few manufacturers or on
imports for their raw material supply will suffer tremendously.
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So, industry analysis must take into consideration the price and
supply of raw materials and their impacts on the prosperity of
the industry.
Cost Structure
The cost structure being the proportion of fixed costs to variable
costs claims the importance to be considered while analyzing an
industry. The higher the portion of fixed costs, the higher is the
sales volume necessary to achieve break-even point and vice
versa. Lower break-event point, however, provides higher
margin of safety. An investor should choose an industry having
a lower break-event point for investment purpose.
While making investment decisions an investor must evaluate
the aforesaid factors. If the factors discussed above indicate
suitable future prospects, the investors might commit funds to
that industry.
Exercise
1. What is meant by industry? Differentiate between firm and
industry.
2. Why is analysis of industry essential for making investment
decisions?
3. Briefly explain the basic competitive forces for industry
analysis.
4. What is industry life cycle? State the industry life cycle.
5. What are different stages of induetry life cycle? Explain.
6. Discuss the fundament characteristics of industry analysis.
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Chapter-Eight
Company Analysis
Company analysis is the final stage of fundamental analysis
followed by economy and industry analysis. Economy analysis
guides the investors about the prospects of growth and
development of the economy while industry analysis helps the
investors to select the industry which would generate steady
and non-interrupted profits for foreseeable future.
When the economy analysis has indicated a suitable time to
invest in the shares, and stocks etc. and industry analysis has
been performed to find the industries with most promising
future, it is essential for the investors to choose profitable
companies within those industries. Company analysis deals with
the estimation of return and risk of individual companies. A sort
of information regarding the company influences the price of
the securities of that company. So, a change of security price of
a company is a function of information regarding the company.
These information are of two types namely internal information
and external information. Internal information consists of price
data and events made public like annual reports to the
shareholders, private and public statements made by the
company officers, the financial statements. These are
information made to the public by the companies regarding
operational performance. On the other hand, external
information consists of those generated independently by
outsiders of the companies for example the financial analysts.
These are prepared by investment services and financial press.
In company analysis, analysts forecast expected future earnings
of the company which seem to have a direct and powerful effect
upon share prices. The trend, stability and earnings of a
company depend upon a number of factors regarding the
operational performance of a company. This process of security
analysis is called top-down fundamental analysis. However, an
147
investor must consider two fundamental values like dividends
and required rate of return or, alternatively, earnings and the
price-earning (P/E) ratio while making investment decisions.
148
Mergers and Takeovers: Inappropriate mergers and
takeovers are likely adversely affect the value of the shares if
the management fails to deliver the promised performance. On
the other hand, acquisition favorably affects market value of
shares, when management can strengthen existing core of
business. The company may need to issue additional shares in
order to finance acquisitions. Unless there exists an unsatisfied
demand for the company’s shares, the issue of additional shares
on the market is likely to depress share price. If a company is
expected to raise additional funds, its share price is likely to be
marked down.
Dividend performance: The dividend prospects of an
individual company may be at variance with the likely payout
rates in the market. Dividend performance may over-valuate the
expected future value and performance of the company.
Cross-sectional Analysis: In times when the stock
market is rising strongly the overall market price earnings ratio
tends to rise and with it the price earnings ratios of companies
also rise. The overall level of the stock market and the market’s
view of the sector often affect a company’s price earnings
ratios. The market rating of a single company may also be
compared to similar companies in the same sector. If a
company has poor growth prospects, then the investors will
expect to be compensated by way of a higher level of income, in
order to make company’s share as attractive as those of a
company which is expected to grow quickly and whose shares
are likely to enjoy a significant increase in value.
Future Earnings Forecasts: Share price and forecast
earnings contain substantially similar information concerning
future changes in the value of the company. Hence, it is obvious
that there would be a strong correlation between expected
future earnings and share price; as anticipated future earnings
rise, the share price rises and as anticipated future earnings fall,
share price fall. Share price reacts to reported performance
when disclosure takes place. Company announcements like
anticipated profits; announcements of potential amount of
dividends, resignation of key managers/personnels may have a
profound effect on market sentiments and share prices.
To calculate total business value, the present value free cash
flow needs to be added to the residual value, which is the value
at the end of the forecast period. The residual value is
determined by the same value drivers as the free cash flow, and
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also needs to be adjusted by the cost of capital. One of the
simpliest ways of calculating the residual value is to take the
after-tax cash inflows and to capitalize them. The steps,
however, required to calculate the business value is
summarized in Figure 8.1.
After-tax cash
inflow
Business value
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specific factors are likely to be most important. Share price
performance in the short-term may be very different from long
term. Investors looking for short-term gains rather than long
term performance are likely to seek out companies whose share
price in the short term is likely to be stronger. Adversely,
investors whose holding period for the shares is intended to be
much longer would be more concerned with the longer term
performance of the company and its shares are less worried if in
the short term the company’s shares under-perform the market.
Share prices will not be constant, as random buy and sell orders
come from people who have cash to invest or who need to raise
cash. However, unless a fundamental reappraisal of a
company’s prospects takes place, shares will tend to be traded
within a relatively narrow price range. Different events might
lead to a fundamental reassessment of a company’s share
price. When new information results in the company’s prospects
being downward, the shares should be re-rated downward and
vice versa. In practice, it is particularly difficult to discern
whether any share price fluctuation will be constrained within
participated limits, or whether the trend will continue with great
amplitude for hours, days or weeks to follow. Market sentiment
being the influential factor affecting the overall assessment is
an amalgam and synthesis of all other factors depending on
whether sentiment is positive or negative. On the basis of the
judgments driving the market sentiment brokers will make
recommendations to investors. Finally, investors must exercise
judgment as to the extent to which the intrinsic value of the
share is already in the price. Having calculated the intrinsic
value of the share, investor must then compare the calculated
value for each stock with its current market price. The decision
whether to buy or sell is independent on the extent to which a
share’s intrinsic value is greater or less than its market value.
However, Figure 8.2 illustrates the dynamics of share price
changes.
151
Company
Bullish or
Bearish
Management
Product markets
Performance
Takeovers
Dividends
Market assessment
152
Buy, hold or sell
Figure-8.2: Dynamics in Assessing Share Price
Movements.
Fundamental Analysis
Company fundamental analysis includes analyzing the basic
financial variables in order to estimate the company’s
investment value commonly known as intrinsic value. The
variables determining the investment value of the company
include sales revenue, operating profit known as earnings
before interests and taxes (EBIT), earnings before taxes (EBT),
tax rate, depreciation, after-tax net profit, sources of short-term
and long-term financing, asset utilization, and other factors. In
addition to those, company’s competitive position in the
industry, management, labor relation, technological changes,
foreign competition etc should be considered efficiently and
effectively by the investors. Furthermore, company fundamental
analysis needs to analyze data to estimate the price of stocks or
shares using one of the valuation models. To this end, the
commonly used model known as dividend discount model (DDM)
is one of the valuable models.
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operations. A company’s dividend policy is, therefore, influenced
by its investment and financing decisions and by some
influencing factors as well. To gain an understanding of what
determines the prices of a stock, we like to consider in this
section of the chapter, what determines the price of individual
stocks. The prices of stocks will be determined by trading
among individuals. Even if these stocks themselves are not
directly traded, we can merely infer their prices in a competitive
market from the prices of the stocks that are traded. To
understand the stock market accurately, an investor will find the
determinants that affect the prices of the stocks. It is logical to
expect a relationship between corporate profits and securities
prices. So, expected earnings and interest rats are the ultimate
determinants of securities prices. The transfer of capital
between markets would raise the interest rates that affect the
securities prices in two ways: i) high rate of interest lessens the
firm’s profits ii) interest rates affect the economic activities that
affect the corporate profits. Interest rates obviously affect the
securities prices because of their effects on profits. They have
also an effect due to the competition in the stocks and bonds
markets. The higher rate of interest causes the investors to sell
stocks and transfer funds to bond market. Thus, higher rate of
interest depresses securities prices. Inflationary pressures are
strongest during business boom, and that also exerts upward
pressure on rates. Slack business reduces the demand for
credit; rate of inflation falls and the result is a drop in interest
rates. However, this section will strive at explaining the factors
determining firm’s dividend and the stock price as well.
Expectation of future earning: Market price of a share
equates the present value of expected future returns. The
shareholders’ expectation of dividends is generally guided by
the future earnings of the company. It may be assumed that
shareholders prefer dividends if companies use retained
earnings inefficiently although transaction costs and taxation
considerations generally favor retentions rather than dividend
payments.
Pattern of past dividends: While making dividend
decision of a year, firms give emphasis on the last years’
dividends.
Availability of cash: Cash flow is the most important
determinant of dividends. Cash dividends can only be paid with
cash. Thus, a shortage of cash in the bank may restrict dividend
payments.
154
Corporate earnings: Corporate earnings are considered
as the primary determinant of dividends as they provide the
cash flow necessary for payment of dividends. If management
increases the proportion of earnings per share paid out as
dividends, shareholders would become wealthier, suggesting
that dividend decision is a very important one. Dividends
payments usually may not exceed retained earnings.
Matter increases stock prices: An increase in payout
ratio provide signals to investors a potential growth in future
that increases the value of the firm. A firm would suffer the
impact of negative signal when it decreases dividend payout.
Information of changes in earnings with existing dividend rates
is also the most important determinant of firm’s dividend policy.
Interest rates: Existing interest rates affect the profits
of the company. Investors always compare the existing interest
rate with dividend income. Comparatively, high rate of interest
influences the investors to invest in fixed income securities like
bonds etc. rather than stocks. Therefore, high rate of interest
depresses securities prices.
Transactions costs: Transaction costs incur when the
company pays dividends and issue new shares to finance its
investment opportunities. This thing can be considered while
making dividend decision. On the other hand, retentions do not
incur transaction costs. Thus the presence of issuing costs
suggests that shareholders should favor retention rather than
dividends. But a shareholder being forced to sell shares for
income through lack of dividend must incur selling costs.
Business expansion: Firm’s investment needs and
financing opportunities can influence its dividend policy. Firms
having profitable investment opportunities may prefer to retain
a large fraction of its earnings that causes the payout to be
relatively low. According to the theme of financial analysts,
growth companies with abundant investment opportunities
should reinvest their earnings hampering dividend payments.
Financial analysts pointed out a number of factors like
shareholders’ expectation, past pattern of dividend payments,
cash needs for the company, current earnings of the company,
expectation of future earnings, tax consideration, legal
constraints, and owners’ and capital market consideration which
affect form’s dividend policy.
Managers have access to the information about the expected
cash flows of the firm not possessed by outsiders and thus,
changes in dividend payout may provide signals about the
future cash flows of the firm that can not be communicated
155
credibly by other means. Empirical studies indicate that
dividend changes convey some unanticipated information to the
market. Another theoretical issue concerns the extent to which
the investors with different dividend preferences is the clientele
effect. Possible reasons for the formation of clienteles are
different perceptions of the relative riskiness of dividends and
retained earnings and different investor tax brackets. Being
insiders sometimes the financial managers and analysts have
access to the information about expected cash flows of the firm
not possessed by the outsiders. On the other hand, changes in
dividend payout providing signals about the firm’s future cash
flows cannot be communicated by other means.
However, it may be noted here that the apparently significant
industry effect may exist from the fact that variables are often
similar within a given industry. These similarities are the
fundamental reasons why firms in the same industry have
similar dividend payouts.
According to the valuation model, dividends, required rate of
returns, earnings per share, growth of dividend, price earning
ratio ultimately determine the prices of the stocks.
156
Corporate dividend policy is concerned with how much of its
earnings a firm should pay to the shareholders. Alternatively,
retaining portion may be reinvested for the future earnings
prospects of the firm. Retained earnings imply no concurrent tax
liabilities. On the other hand, dividends are taxed at a flexible
rate as applicable for individual shareholders. In spite of the tax
treatment imposed by the government, corporations distribute a
fraction of their earnings as dividends. By reducing their
dividends, firms may raise the level of investment and therefore
depress the rate of return on investment. The return on
investment is made up of cash dividends, capital gains (or
losses) and capital distributions. It is assumed that the
dividends and capital gains are equally valuable to the investors
though this may not always be the case as tax treatments
sometimes favor capital growth over dividends. But a firm may
increase its retained earnings without having return on capital
to partly or wholly replace debt finance. A general question may
arise in the mind of the shareholders that the corporate
dividend policy affects their wealth. If an increase in dividends
increases the value of the firm, the shareholders will prefer to
take earnings as dividends and new investments should be
financed through the sale of new securities. But financial
theorists find that dividend policy does not impact on share
value although it affects the firm’s willingness to undertake its
investment opportunities and thus impacts the firm’s value.
However, the corporate owners want a share of the profits their
firm earns. Considering the shareholders’ demand a firm may
take dividend decision recognizing the impact of the same on
the shareholders’ wealth. For sure, theoretically, shareholders
are indifferent between receiving corporate earnings as
dividends and having a capital appreciation. Hence, the
corporate dividend policy should have a relatively direct bearing
on cyclical fluctuations and longer term growth trends in the
economy.
The appropriate ex-post measure of the return on equities is
unambiguously total past income, i.e., dividends plus capital
gains or losses on a stock over the market value of the same.
But dividends plus recent capital gains or losses on a stock are
not necessarily the best measure of ex-ante return. This is why
capital gains and losses embody the capitalized value of any
change in expected income and so are ordinarily larger than the
change in expected income itself, which is the relevant quantity
157
for the measurement of future return. Presumably for this
reason, investors more frequently use dividends plus retained
earnings than dividends plus capital gains approximating future
expected income for portfolio selection. Since corporate
earnings paid out to common shareholders are not available for
financing new investments, the corporate dividend decision is
intertwined with corporate financial policy. Earnings per share
measure the shareholders’ return. Shareholders’ return in turn
implies payment of dividends and/or capital gains. Employment
of profits will enhance the shareholders’ equity and the
shareholders’ earnings are return on equity called net worth.
Retention ratio multiplied by return on equity (ROE) measures
the growth of a firm.
Retention ratio is a percentage of net profit undistributed or
retained by a firm. A firm retaining more may command higher
share price because of high growth in earnings. Shareholders of
higher growth firms may obtain their return in the form of
capital gains. But there is uncertainty regarding capital gains.
Payment of dividends helps to resolve this uncertainty. Market
price of slower growth firms’ shares, on he other hand, may be
lower. However, dividends are to be paid because it is the direct
and most objective way of communicating to shareholders that
their company is doing well although this does not make much
sense in terms of growth. In this connection, a firm should
accept all profitable projects implying that shareholders will
reinvest their dividends in the share of the firm. However, firm’s
dividend policies should be applied by considering some specific
rules viz., net profit rule implying that dividends must be paid
from past and current earnings, the capital impairment rule
prohibiting payment of dividends from the capital account so
that the shareholders and creditors are protected and the
insolvency rule stating that the corporation may not pay
dividends when insolvent.
The efficiency of capital markets depends on the extent to
which capital asset prices fully reflect information that affects
their value. In a world of rational expectations, the firm’s
dividend announcements provide just enough pieces of the
firm’s sources and uses statement for the market to deduce the
unobserved piece, to wit, the firm’s current earnings.
Management of the firm should regard their shareholders as
having a proprietary interest in earnings and urge the
shareholders’ special interest in getting earnings in dividends,
subject to their interest in regularity of payment. Unless there
158
are other compelling reasons to the contrary, fiduciary
responsibilities of the management require them to distribute
part of any substantial increase in earnings to the shareholders
in dividends. Similarly, management believes that it is both fair
and prudent for dividends to the shareholders to reflect any part
of substantial or continuous decline in earnings and that under
these circumstances shareholders should understand and
accept the cut. Firms tend to increase dividends only when
there is a high probability that cash flows in the future would be
sufficient to support the higher rate of payment and dividends
are decreased only when management is assumed that cash
flows are insufficient to support the present dividend rate. It is
obvious to argue that there should be a positive relation
between dividend payments and share prices. Investors may
have a preferred consumption pattern and the existence of
transaction costs makes a particular dividend pattern a more
desirable way to achieve their preferences than by selling
securities. The market’s estimate of current earnings
contributes in turn to the estimate of the expected future
earnings on which the firm’s market value largely hinges.
The impact of dividend policy on the market value of a firm is a
subject of long-standing controversy. The major changes in
earnings with existing dividend rates are the post important
determinant of the firm’s dividend decisions. As the
management beliefs that the shareholders prefer a steady
stream of dividends, firms tend to make periodic partial
adjustments toward a target payout ratio rather than dramatic
changes in payout. To gain an understanding of what
determines the prices of a stock in addition to the dividends, we
strive at considering and analyzing the factors affecting the
price of individual stock. The prices of stocks will be determined
by trading among individuals. Even if these stocks themselves
are not directly traded, we can merely infer their prices in a
competitive market from the prices of the stocks that are
traded. To understand the stock market accurately, any one will
find some determinants that affect the security prices. It is
logical to expect a relationship between corporate profits and
security prices. So, expected earnings and interest rates are the
ultimate determinants of security prices. The transfer of capital
between markets would raise the interest rate that affects the
security prices in two ways:
i. high rate of interest lessens the firm’s profits
159
ii. interest rates affect the economic activities that affect
the corporate profits. Interest rates obviously affect the security
prices because of their effects on profits.
On Stock Return
Stock price behavior of the companies is related with
explanatory variables like dividend payout ratio, stock
dividends, rights, retained earnings, earnings price ratio, size of
company i.e. asset size, corporate governance like number of
directors, ownership pattern represented by sponsors’
shareholdings. The relationship between stock return and
explanatory variables can be given by the following random-
effect generalized least square (GLS) regression model:
ri = i + 1 agei + 2 EPSi + 3 dpratioi + 4 asseti +
5 stdivi +
6 righti + 7 sprsi + 8 ndi + 9 gdivi
Pooled data for the estimation can be used empirical tests.
These pooled data take care of the short-term influences of
transitory effects of the dependent and independent variables.
Therefore, the combination of cross-section and time-series data
is conducted to provide the effective coefficient estimates.
160
size, sponsor shareholding, age of the company can be analyzed
for study purpose or empirical tests. Dividend payout (D/P) ratio
is related with earnings. General observation in the securities
market indicates the notion that earnings are important
determinant of stock prices. Stock return is the outcome of price
changes and dividend thereon. Changes in stock prices
experience changes in EPS over the same time period indicating
that a large increase in stock price over the time period
experience large increase in EPS and the stock suffering large
decline in price tends to have experienced large decreases in
EPS. Price earning ratio is the more widely used method of
estimating stock price.
161
Interval Measures = Current asset/ Average daily
operating costs
162
ratios measure the efficiency in asset management. The major
ratios under this measure are as follows:
Cost of goods sold
Inventory turn over ratio =
Inventories
All other things remaining same, the higher the ratio is, the
more efficiently the firm is managing inventories. This measure
gives some indication of how fast a company can sell its
products. How fast a company can collect its sales is the
receivables turn-over ratio which can be calculated as:
Sales (in credit)
Receivables turn-over ratio =
Receivables
This ratio makes sense if the company can convert it to days.
So, days’ sales receivables is essential and it can be calculated
as:
365 Days
Day’s sales in receivables =
Receivables turn-over
This ratio can, subsequently, be called average collection period
(ACP) which can also be defined as Days sales outstanding. This
ratio indicates days’ worth of sales uncollected. So, lower the
ratio, the better.
Receivables
Average collection period (Days sales outstanding) =
Average
daily credit sales
Sales
Net working capital turn over ratio =
163
Net working
capital
Sales
Debtor turn over ratio =
Average debtors
D] Profitability ratio:
The profotability ratios measure the relative profits of a
company. These ratios are calculted by relating the profits
either to sales, or to investment, or to assets, or to equities. The
major profitability ratios are:
i. Ratios related to Sales:
Grofit profit
Gross profit ratio =
Sales
EBIT
Operating profit ratio =
Sales
Administrative expenses
Administrative expense ratio =
Sales
Selling expenses
Selling expenses ratio =
Sales
Administrative expenses +
Selling expenses
Operating expenses ratio =
Sales
164
ii. Ratios related to Investments:
Net income
Return on assets (ROA) =
Total assets
Net income
Return on Equity (ROE) =
Equities
EBIT
Return on capital employed =
Total capital employed
Net income
Earning per share (EPS) =
No of Shares outstanding
Equities
Book value (BV) =
No of Shares outstanding
165
Break-up of ROE
Return on asset (ROA) = After-tax net income/ Total
assets
Pretax and preinterest profit margin = EBIT/Sales
Asset turnover = Sales/Total assets
Profit margin [EBIT/Sales] × Asset turnover = [Sales/Total
assets]
= EBIT/Total assets
Leverage (L) = Total assets/ Equities
ROE = ROA × Leverage
ROE = ROA × Equity multiplier
= ROA × [1 + Debt-Equity ratio]
Alternatively,
ROE = Net income/ Equities
Multiplying this ratio by assets/assets, we have:
ROE = [Net income/ Equities] × [Assets/Assets]
= [Net income/ Asset] × [Assets/Equities]
= ROA × Leverage
Multiplying top and bottom by sales, we have:
ROE = [Net income/ Equities] × [Assets/Assets] ×
[Sales/Sales]
= [Net income/ Sales] × [Sales/Assets] ×
[Assets/Equities]
= [Profit margin] × [Asset turnover] × [Equity
multiplier]
Furthermore, Multiplying top and bottom by EBIT and EBT, we
have:
ROE = [Net income/ Equities] × [Assets/Assets] ×
[Sales/Sales] ×
[EBIT/EBIT] × [EBT/EBT]
ROE = [EBIT/ Sales] × [EBT/EBIT] × [Net income/EBT]
× [Sales/Assets] × [Assets/Equities]
ROE = [EBIT efficiency] × [Interest burden] × [After-tax
retention rate]
× [Asset turnover] × [Leverage]
Du Pont Analysis
Net Assets/Sales = Profit margin
Sales/Assets = Asset turnover
Profit margin × Asset turnover = ROA
Financing plan = Assets + Debts = 1-
[Debt/Assets]
ROE = ROA / [1- (Debt/Assets)
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Du Pont identity is the popular expression that breaks ROE into
three parts:
i. Operating efficiency measured by profit margin
ii. Asset use efficiency measured by total asset turnover
iii. Financial leverage measured by equity multiplier
Therefore,
ROE = [Profit margin] × [Asset turnover] × [Equity
multiplier]
= ROA × [Equity multiplier]
Case Study
The followings are the Balance Sheet and Income Statement of
Bigbee Ltd. [Figures in Tk. 000’]
Balance Sheet
Assets: Liabilities:
Current Assets: Current Liabilities:
Cash ----------------Tk. Accounts payable-Tk.
15,000 30,000
Short-term ivst. -- Notes payables-- ---
65,000 60,000
Receivables ----- Accruals -------------
315,000 130,000
Inventories------- Total current liabilities----Tk.
415,000 220,000
Total Current Assets -----Tk. Long-term bonds---------------
810,000 580,000
Plant & Equipments ----- Tk. Total Liabilities----------- Tk.
870,000 800,000
Total assets--------------Tk. Preferred stocks (400,000
1,680,000 shares)
==== Tk.
====== 40,000
Equity:
Comn. stock (50,000,000
shares)
Tk.
130,000
Retained earnings----------Tk.
710,000
Total Equity----------------Tk.
167
840,000
Total Tk.
1,680,000
====
======
Income Statement
[Figures in ‘000 Tk.]
Sales ---------------------------------------------------------Tk.
2,850,000
(-) Cost of goods sold --------------------------(-)
2,497,000
EBIT including dep. And amrt.---------------------------Tk.
353,000
(-) Depreciations --------------------------------------- 90,000
(-) Amortizations ---------------------------------------- 00
EBIT ---------------------------------------------------------Tk. 263,000
(-)Interest ------------------------------------------------60,000
EBT ----------------------------------------------------------Tk. 203,000
(-) Taxes @ 40 % -------------------------------------- 81,200
Net income before preferred dividends ------------------Tk.
121,800
(-) Preferred dividends
-----------------------------------4,000
Net income ---------------------------------------------------Tk.
117,800
(-) Common dividends ---------------------------------
53,000
Addition to retained earnings--------------------------------Tk.
64,800
===
======
Data per share (Absolute figures):
EPS = Net income/ Common stocks outstanding
= 117,800,000/50,000,000 = Tk.2.356
DPS = Tk. 1.06, Book value per share = Tk.16.80
Common stock price = Tk. 26
Cash flow per share = [Net income + Dep. + Amrt.]/
Common stock
= [117,800,000 +90,000 +
00]/50,000,000
= Tk. 4.16
168
From the information given above calculate the followings:
A] Short-term Solvency or Liquidity Measures:
i. Current ratio = Current assets / Current liabilities
= Tk. 810,000,000/ Tk. 220,000,000 = 3.68
Times
ii. Quick or Acid test ratio = [Current assets – Inventories]
/ Current liabilities
= Tk.[810,000,000 – 415,000,000] / Tk.
220,000,000
= 1.80 Times
iii. Cash ratio = Cash / Current liabilities
= Tk. 15,000,000 / Tk. 220,000,000
= 0.068 Times
iv. Net working capital to total assets = Net working
capital / Total assets
= [Current assets- Current liabilities]/ Total
assets
= Tk. [810,000,000 – 220,000,000] / Tk.
1,680,000,000
= 0.35 Times.
v. Interval Measures = Current assets / Average daily
operating costs
= Tk. 810,000,000 / [2,497,000,000/365]
= 118 Days.
B] Long-term Solvency or Financial Leverage Ratio:
vi. Total Debt ratio = [Total assets-Total equity]/ Total
assets
= Tk. [1,680,000,000– 840,000,000] /
Tk. 1,680,000,000
= 0.50 Times
vii. Debt-Equity ratio = Total debt / Total equity
= Tk. 580,000,000/ Tk. 840,000,000
= 0.69 Times.
viii. Equity Multiplier (Leverage) = Total assets / Total
equity
= Tk. 1,680,000,000 / Tk. 840,000,000
= 2.00 Times.
ix. Long-term debt ratio = Long-term debt / [Long-term
debt + Total equity]
=Tk. 580,000,000 /Tk. [580,000,000 +
840,000,000]
= 0.408 Times.
x. Time interest earned ratio = EBIT/ Interest
169
= Tk. 263,000,000/ Tk.
60,000,000
= 4.38 Times.
xi. Cash coverage ratio = [EBIT + Depreciation] / Interest
= Tk. [263,000,000 + 90,000,000] /
Tk. 60,000,000
= 5.88 Times.
xii. Fixed charge coverage = Income before fixed charges
and taxes / Fixed charges
= [EBIT + Lease payments] /[Lease obligation +
Int.Exps.]
= Tk.[263,000,000 + 00]/Tk. [00 + 60,000,000]
= 4.38 Times.
C] Asset Management or Asset Turn-over ratio:
xiii. Inventory turn over ratio = Cost of goods sold /
Inventory
= Tk. 2,497,000,000 /Tk. 415,000,000
= 6.02 Times.
xiv. Receivable Turn-over = Sales (credit) / Receivables
= Tk. 2,850,000,000 / Tk.
315,000,000
= 9.05 Times.
xv. Average collection period (Days sales outstanding)
= Receivables / Average daily credit
sales
= Tk. 315,000,000 /
[2,850,000,000/365]
= 40.34 Days.
xvi. Day’s sales in inventory = 365 Days/Inventory turn-
over
= 365 Days/ 6.02 = 60.63
Days.
xvii. Day’s sales in receivables = 365 Days / Receivable
turn-over
= 365 Days / 9.05
= 40.33 Days.
xviii. Fixed assets turn over ratio = Sales / Fixed assets
= Tk. 2,850,000,000/ Tk.
870,000,000
= 3.28 Times.
xiv. Total assets turn over ratio = Sales / Total assets
= Tk. 2,850,000,000/ Tk.
1,680,000,000
= 1.70 Times.
170
xx. Net working capital (NWC) turn over = Sales / NWC
= Tk. 2,850,000,000/ Tk. [810,000,000-
220,000,000]
= 4.83 Times.
D] Profitability ratio:
xxi. Profit margin = Net income/ Sales
= Tk.117,800,000 / Tk. 2,850,000,000
= .041 = 4.1 %
xxii. Return on asset (ROA) = Net income/ Total assets
= Tk. 117,800,000 / Tk.
1,680,000,000
= .070 = 7 %.
xxiii. Return on equity (ROE) = Net income/ Equity
= Tk. 117,800,000 / Tk.
840,000,000
= .14 = 14 %.
E] Market Value Measure:
xxiv. Earning per share (EPS) = Net income / Shares
outstanding
= Tk. 117,800,000 / 50,000,000
= Tk. 2.356
xxv. Price earning ratio (P/E) = Price per share / EPS
= Tk. 26/ Tk. 2.356
= 11.04 Times
xxvi. Book value per share (BV) = Equities / No. of shares
= Tk. [840,000,000 / 50,000,000]
= Tk. 16.80
xxvii. Market to Book ratio = Market value per share / Book
value per share
= Tk. 26/Tk. [840,000,000
50,000,000]
= 1.55 Times.
xxviii. Price / Cash flow ratio = Price per share / Cash flow
per share
= Tk. 26 / Tk. 4.16 = 6.25
Times.
Exercise
1. What is a company? State the basic features of a company.
2. What is the concept of company? Define company analysis.
Explain the stages of company analysis.
171
3. What is firm specific analysis? State the key indicators of
company analysis.
4. State the factors affecting the stock price of a company.
5. State the factors governing the value of a security.
6. Why is the analysis of accounting value and market value of
a firm important to the investors?
7. What are different elements of company fundamental
analysis? Explain them.
8. Expalin several measures of company fundamentals.
9. The followings are the Balance Sheet and Income Statement
of Evergreen
Ltd.
Balance Sheet
Assets:
Cash -------------------------------------Tk. 250,500
Receivables --------------------------------- 336,000
Inventories--------------------------------- 350,500
Current assets-----------------------------------Tk. 937,000
Fixed assets.------------------------------------------500,500
Total assets-------------------------------------Tk. 1437,500
=====
==
Liabilities:
Accounts payable ----------------------Tk. 250,000
Notes payable -------------------------------184,000
Other current liabilities --------------------247,000
Total current liabilities--------------------------Tk. 681,000
Long-term debt ---------------------------------------395,500
Equity---------------------------------------------------361,000
Total liabilities and equities Tk. 1437,500
======
====
Income Statement
172
i. Current ratio,
ii. Quick ratio,
iii. Inventory turn over ratio,
iv. Days sales outstanding ratio,
v. Total assets turn over ratio,
vi. Fixed assets turn over ratio,
vii. Debt ratio,
viii. Profit margin ratio,
ix. ROA,
x. ROE.
Chapter-Nine
Technical Analysis
In an organized stock market, prices of the securities fluctuate
daily on account of continuous buying and selling. Under such
circumstances, an investor wills to buy a security at a lower
price and sell at higher price to create a surplus called return on
investment (ROI). In doing so an investor tends to analyze the
movements of the prices of the securities in the markets. Two
approaches namely fundamental analysis and technical analysis
are used for this purpose. Fundamental analysis is devoted to
analyze the investment value sometimes called intrinsic value
of a security based on current and future earning capacity of the
company. On the other hand, technical analysis, being the
173
second approach to the security analysis, studies the general
movements of the prices of the securities. Technical analysis
can be defined as a method of forecasting fluctuations in the
prices of the securities, whether individual securities or the
market as a whole. This analysis uses specific market-generated
data as opposed to fundamental data such as earnings, sales,
growth and etc. for the analysis of both individual stocks and
the aggregate stock market. It is an internal analysis as it
utilizes the record of the market itself to assess the demand for
and supply of individual securities or the entire market.
Technical analysts assume that the prices of the securities are
determined on the basis of demand and supply and reflect the
optimism or pessimism of the market participants. The reason
for technical analysis is that the security price behavior repeats
itself over time and an analyst attempts to derive methods to
predict this repetition. Under technical analysis an investor
looks at past price data to see if he can establish any pattern.
Then, he looks at current price data to see if any of the
established patterns are applicable and if so extrapolation can
be made to predict future movements of the price. Some
statistical weapons such as volume of trading, stock market
indices are also utilized to some extent although past price data
are the major data used in technical analysis. The basic theme
of the technical analysis is that prices move in trends which may
either be upward or downward. It is assumed that the present
trends are influenced by the past trends and that the projection
of future trends is possibly by an analysis of past price trends.
Hence, technical analysis is an analysis of historical price and
volume movements so as to forecast the future movements of
security prices.
174
There are both rational and irrational factors surrounding
the demand and supply factors of a security.
It focuses on the timing.
In technical analysis, emphasis is given on price changes.
Technical analysis is basically designed to detect likely
price movements over a relatively short time.
Security price behave in a particular direction for some
length of time.
Security prices seem to change on the basis of the
changes in the demand and supply factors.
Technical Indicators
The essential indicators used in technical analysis of analyzing
the value of securities are analyzed below.
Breadth of the market
The advance-decline measures the net difference between the
number of stocks advancing in price and those declining in price
for a group of stocks on an organized stock exchange.
Subtracting the number of declines from the numbers of
advances produces the net advance for a given day. The
advance-decline line refers to the breadth of the market. This is
based on the daily or weekly data available in public. This
advance-decline line thus, can be compared to a stock average
175
to determine whether movements of stock price in this market
indicator have also occurred in the market as a whole. The two
normally move together. When both tend to rise (fall), the
overall market is said to be technically strong (week). If the line
is rising and average is declining, the decline in the average
should reverse itself.
Moving Average
A moving average of prices is a technique to analyze both the
overall market and individual stocks. It can detect both the
direction and the rate of change. Under this technique of
analyzing of the movements of stock price, some number of
days of closing prices is chosen to calculate a moving average.
The moving average line represents the basic trend of stock
prices. A comparison of the current market price to the moving
average produces a buy or sell signal. Buy decision is taken
when actual prices rise through the moving average on the high
volume with the opposite applying to a sell decision.
Volume
Volume of trading is a part and parcel for technical analysis of
security price movements. High as well as abnormal trading
volume is regarded as a bullish market implying that the prices
of the securities will rise within a short period of time. On the
other hand, the bearish market indicates that the prices of the
securities will fall in the near future.
New Highs and Lows
High and low prices of the securities in the stock market is also
a technique of analyzing security prices. A market is called
bullish when a significant number of stocks each day 52-week
highs. On the other hand, rising market indexes and few stocks
hitting new highs indicate a troublesome sign.
Short-interest Ratio
Short selling refers to the method of selling of stocks by
borrowing them which would be refunded at a latter date. Short
interest refers to the number of stocks which have been sold
short but not yet bought back which can be calculated as under:
Short-interest ratio (SR) = Total stocks sold short/ Average daily
trading volume.
This ratio indicates the number of days necessary to work off
the current short interest. It is considered to be a measure of
investor sentiment and many investors continue to refer to it.
Investors wish to sell short with the expectation that the price of
the security will decline. Therefore, the higher the short interest,
176
the more investors are expecting a decline. On the other hand,
a large short-interest position for an individual stock should
indicate heavy speculation by investors that the price would fall.
Therefore, the general theorem of many technical analysts
asserts that a high short-interest ratio is taken as a bullish sign
because the large number of shares sold short represents a
large number of shares that must be repurchased in order to
close out the short sales. The larger the short-interest ratio, the
larger the potential demand that is indicated. An increase in the
ratio indicates more pent-up demand for the shares that have
been shorted.
Mutual Fund Liquidity
Mutual funds sometimes called investment companies are large
institutional investors who own and manage a portfolio of
securities on behalf of their shareholders. Such portfolio
managers would vary their cash positions across time
depending on their expectations for the market. The larger the
liquidity percentage, the more bullish it is for the market. The
rationale involves the potential buying power represented by
this liquidity. On the other hand, a lower level of liquidity
indicates little available money for purchases by the mutual
funds, a bearish sign.
Contrary Opinion
Investors sometimes base on the theory of contrary opinion.
Contrary opinion is the idea of trading opposite those investors
who supposedly always lose to go against the crowd. We may
consider some of the best known traditional contrary opinion
indicators as under.
Odd-Lot Short Sell Theory: This theory asserts that
small investors buying and selling odd-lots are usually wrong in
their actions at market peaks and troughs. Such investors buy
(sell) when the market is at or close to peak (bottom).
177
on a random basis but is influenced by three distinct cyclical
trends guiding its direction. According to Dow Theory there are
three movements in the market which are simultaneous in
nature. These movements are summarized below:
1. Primary movements: Primary movement refers to
the long-range cycle carrying the entire market up or down
lasting for several years.
2. Secondary movements: Secondary movement refers
to the opposite direction occurring within the primary
movement lasting only for a short time like several weeks or
months which is commonly known as correction.
3. Minor movements: Known as third movement minor
moves refer to the day-to-day fluctuations occurring randomly
around the primary and secondary movements in the market.
However, Figure 9.1 exhibits the movements in the market
where the vertical axis represents prices of the stock and
horizontal axis represents time. The primary trend of the market
is upwards but secondary reactions are in the opposite
direction.
Secondary trend
Time
178
Bull Market
During the bull market in the first phase the prices of the
securities will advance with the revival of confidence in the
future prospect of the business. It refers to the period of time
during which measures of the stock market rise. It, however,
indicates upward primary movements and prompt investors to
buy securities. During the second phase, the prices of the
securities would advance due to the higher earnings of the
companies. In the third phase, the prices of the securities would
advance as a result of the inflation and speculation. Therefore,
during the bull market the line chart exhibits three peaks as
depicted in Figure 9.2.
Prices
Time
179
industry, company, and internal factors.
political factors which
are external to the
market.
ii. It analyzes the economic ii. It analyzes the
fundamentals, industry movements of
fundamentals, and market prices of the
company fundamentals. individual securities
or market as a whole.
iii. Fundamental analysis iii Technical analysis is
tends to have a basically designed to
substantial interest in detect price
the medium and long movements over a
time. short time.
iv. Fundamental analysis iv. It is a tedious process
tends to estimate of evaluating security
intrinsic value of a prices.
security.
v. Fundamental analysis v. Technical analysis
helps identifying helps identifying the
undervalued and best timing of an
overvalued securities. investment.
vi. It is an accurate and vi. It is not an accurate
absolute method of method of analysis.
analyzing security
prices.
vii. It can identify the vii.
It suffers to identify
reasons for the the patterns of
fluctuations of security security price
prices. movements.
viii It can easily predict the viii It can not interpret
. patterns of future . the meaning of
changes of price. patterns and their
impact on future
price movements.
Technical analysis helps investors buying and selling securities
identified as undervalued or overvalued. Therefore, technical
analysis may be used as a supplement to fundamental analysis
rather than as a substitute to it. Fundamental analysis and
technical analysis are two alternative approaches to predicting
security price behavior. Neither of them is perfect nor complete
by itself.
Exercises
180
1. Define technical analysis. Show the elements of technical
analysis.
2. What are the properties of technical analysis?
3. How does technical analysis help in predicting the future
price of any stock?
4. What do you mean by Dow Theory? State the propoerties of
Dow Theory.
5. What are the indicators of technical analysis? Explain.
6. Differentiate between bearish market and bullish market.
7. Differentiate fundamental analysis from technical analysis.
Part-Three
Security Valuation
181
Chapter Ten: Background to Valuation
of Firm
Chapter Eleven: Valuation of Fixed-
Income Securities
Chapter Twelve: Valuation of Common
Stocks
Chapter-Ten
Fundamentals of
Valuation of Firm
Valuation Concepts
Valuation is based on economic factors, industry variables,
financial position and the out look of the individual firm. The
purpose of valuation is to determine the long-run fundamental
economic value of a specific company’s common stock. When a
firm is considering the purchase of marketable securities, debt,
preferred stock or common stock, it must have some knowledge
of investment value. If the firm is evaluating an acquisition it
must have techniques to determine how much to pay for the
182
stock to be acquired. When a firm is considering a public
offering to sell its own stock in order to raise additional equity
capital, it must establish a price for the issue and the time of
offering to achieve a maximum benefit to existing shareholders.
These are all issues related to the valuation of the firm and its
securities.
The valuation of a security is defined as its worth in money or
other securities at a given moment in time. The value is
expressed either in terms of a market for the security or in
terms of the laws or accounting procedures applicable to the
security. In this regard, five major concepts of valuation may be
discussed in the following manner.
1. Going Concern Value: The value of the securities of
a profitable operating firm with prospects for indefinite future
business might be expressed as a going concern value. The
worth of the firm would be expressed in terms of the future
profits, dividends, or expected growth of the business.
2. Liquidation Value: If the analyst is dealing with the
securities of a firm that is about to go out of business, the net
value of its assets, or liquidation value, would be of primary
concern.
3. Market Value: If the analyst is examining a firm
whose stock or debt is traded in a security market, he can
determine the market value of the security. This is the value of
the debt and equity securities as reflected in the bond or stock
market’s perception of the firm.
4. Book Value: This is determined by the use of
standardized accounting techniques and is calculated from the
financial reports, particularly the balance sheet, prepared by the
firm. The book of the debt is usually fairly close to its par or face
value. The book value (BV) of common stock is calculated by
dividing the firm’s equity on the balance sheet by number of
shares outstanding as given below:
Equities
BV
= No . ofshares .
5. Intrinsic Value: A security’s intrinsic value is the
price that is justified for it when the primary factors of value are
considered. In other words, it is the real worth of the debt or
equity instrument as distinguished from the current market
price. The financial analyst estimated intrinsic value by carefully
183
appraising the following fundamental factors affecting security
value:
a) Value of the firm’s assets: The physical assets held
by the firm have some market value. They can be liquidated if
need be to provide funds to repay debt and distribute to
shareholders. In technique of going concern valuation, asset
values are usually omitted.
b) Likely future interest and dividends: For debt the
firm is committed to pay future interest and repay principal. For
preferred and common stock, the firm makes attempts to
declare and pay dividends. The likelihood of these payments
affects present value.
c) Likely future earnings: The expected future
earnings of the firm are generally viewed as the most important
single factor affecting security value. Without a reasonable level
of earnings, interest and dividend payments may be in jeopardy.
d) Likely future growth rate: A firm’s prospects for
future growth are carefully evaluated by investors and creditors
as a factor influencing the intrinsic value.
Analysis of Intrinsic Value
Analysis of intrinsic value is the process of comparing the real
worth of a security with the current market price or proposed
purchase price. The fundamental factors affecting value usually
change less rapidly than the market price of a security. In
imperfect market, the analyst can hope to locate variance
between intrinsic value and the asking price for a security. The
primary goal of analyzing intrinsic value is to locate clearly
undervalues or clearly overvalued firms or stocks. In the case of
an undervalued security, the market has not discovered that
fundamental factors justify a higher market price. That is, the
security is worth more than its selling price. For overvalued
stock, the reverse situation is true.
Purpose of Valuation
The purpose of valuation may be summarized as under:
i. For return on investment: Purchase of a business
return on investment is an important consideration.
ii. Purchasing the controlling interest in a
business: This serves the same purpose as the purchase of an
active business. However, the part purchased should have a
higher value than its strict proportion to the whole.
iii. Marketing a company’s share: A sufficient number
of people should be interested in buying shares.
184
iv. Buying a share in a business: The likely pattern of
income receivable in terms of income and capital gain is an
important consideration.
v. Acquiring assets: The purpose here is to acquire a
business or a part thereof in order to obtain the assets which it
holds.
vi. For estate duty purpose: An unquoted business
requires a value to be placed upon its shares for estate duty
purpose, since in this case no market price is available.
vii. For insurance cover: This is largely concerned with
the costs of replacing the relevant assets.
viii. Security against loan: The lender is concerned
with the realizable value of the assets of a firm.
185
attempts to relate real input to real output. The operating
efficiency of an enterprise is measured by its operating ratio and
its break-event-point. The lower the operating ration, the higher
the earnings and also the greater the future value.
The current financial position
The current financial position is the fourth important factor that
influences the valuation of an enterprise. An enterprise should
be in a good financial position to maintain its profitability and
earnings for the common stockholders. The basic financial
problem of the corporate management is to maintain a balance
between liquidity and profitability. Too much cash or liquidity,
on the other hand, does not help the profit of the enterprise.
Idle funds are not productive funds. The ideal current financial
position is the balance between excess liquidity and illiquidity. If
there is ideal current financial position in the enterprise, this
ideal current financial position will increase the value of the
enterprise.
Capital structure characteristics
The capital structure characteristics being the fifth important
factor influence the valuation of an enterprise. The method that
the management uses in financing the company’s growth will
have the influence upon the stability of earnings. As long as the
earnings of the enterprise are above the costs of borrowed
funds, the earnings per share of common stock are increased.
The use of large amount of debt in the capital structure tends to
make earnings unstable. Hence, if the proportion of owners’
equity in the capital structure is higher than that of debt, the
earnings will be higher and at the same time the higher the
earnings, the higher the value of the firm.
Management
The sixth and the last important factor that influences the
valuation of an enterprise is the efficiency or inefficiency of the
management. The quality and the depth of management is
essential to the future profitability of a business enterprise.
Many analysts consider the quality of corporate management as
the single most important factor influencing the future earnings
and overall success of the enterprise. Without efficient
management an enterprise could not maintain its comparative
position or introduce new products. Hence, efficient or
inefficient management has a great influence on the valuation
of an enterprise.
186
Valuation Techniques
The methods of security valuation can be considered under
three main heads viz., i) those that are based on physical
assets, ii) those that emphasize earning power, and iii) those
that stress actual or imputed market prices. There is no single
reliable method of determining the value of an enterprise or its
securities that can be applied to all situations. Often several
methods or various combinations of methods are useful in a
particular situation. It is worth noting that the purpose of the
particular valuation and the point of view of the evaluator
strongly influence the selection of approach to or method of
valuation. The followings are the aforesaid three methods of
valuation of securities, shares, stocks, and debentures generally
used by financial analysts.
A] Asset Approaches to Valuation
The valuation of securities is often determined on the basis of
the value of assets. The value of assets is determined on the
basis of three approaches which are discussed below:
i. Book value or Break-up value: Book value is
determined by the asset value shown on the company’s balance
sheet. The excess of assets over debt represents the net worth
of the business in the accounting terminology and provide the
base for the calculation of the book value. If a company has got
outstanding preference shares, a value for these shares are
deducted to determine the net worth application to ordinary
shares. The net worth available to ordinary shares divided by
the number of outstanding ordinary shares give book value per
share. The major weaknesses of this method of valuation are
given below:
▪ First, figures for book value are influenced by the
accounting practices and policies of an enterprise.
▪ Secondly, there is lack of standardization of accounting
practices in the treatment of intangibles like goodwill and
patents.
▪ Thirdly, analysts face the difficult job of reconstructing
reported figures in valuing the security of one company
against that of another in order to get them on
comparable basis.
▪ Fourthly, a concern following financial accounting
practices will arrive at the value by reference to
conventions rather than sheer logic of value.
187
▪ Finally, book value approach does not give proper
consideration to the future earning power of the assets
which may be the real test of their worth.
ii. Realizable or liquidation value: The value of
individual assets can be had by selling them. Such value is
known as the realizable or liquidation value. The liquidation
value can be estimated for the company as a whole means the
estimated net amounts that will be received by sale of assets
less any liabilities. The liquidation value of a company is usually
less than its economic value as a going concern. It has
significance in bargaining on valuation because it represents a
minimum price. A company should not be sold as a unit for less
than its liquidation value. When earnings in a company are
nonexistent, liquidation value may become significant.
iii. Replacement or reproduction value: To avoid the
problem of changing price levels it is often suggested that
assets should be valued on the basis of replacement cost rather
than historical cost. Replacement cost is estimated by
competent engineering authorities by breaking down property
into its various component units for purpose of detailed
examination. Such a valuation has much significance as expert
opinion, but the conclusions are not universally accepted. The
major problems arising in this method of valuation are
mentioned below:
▪ First, it is often difficult to estimate costs of replacement.
▪ Secondly, there remains the problem of determining
depreciation on the replacement costs.
▪ Thirdly, While costs of replacing physical assets can be
calculated by painstaking appraisal, the cost of
duplicating the business organization, its experience,
know-how, and reputation-apart from the physical assets
is the most difficult to determine.
▪ Finally, estimate of replacement cost does not measure
the value of assets in use.
B] Capitalization of Earnings Approach
The capitalization of earnings approach for the valuation of
ordinary shares is based on the philosophy that the current
value of the property depends on the income which can be had
over the years. This approach is based on the feeling that it is
the earning power that provides income to the shareholders and
it income that they value rather than physical assets. The basic
validity of this approach is rarely challenged. However,
188
problems do arise in the application of this approach to actual
situations. There are three basic steps involved in the method of
valuation: determination of earnings, determination of rate of
capitalization and capitalizing the value of earnings.
i. Determination of earnings: In determining future
earning power one has to consider the corporate earnings’ past
record and the first step to get this record as straight as
possible. There are difficulties in getting reliable data and the
person making the valuation may not have access to all the
data he would like. Difficulty is also created due to the varied
character of accounting practices which may require a number
of adjustments for converting earnings data to a basis
appropriate for the comparison. In practice, an estimate of
future earnings is prepared over an arbitrary time horizon which
would be a period short enough to justify reasonable degree of
confidence in the expected earnings. The significant
consideration is the selection of a period of time which
represents a normal picture of both the good and bad years in
the company’s recent history. It should be a period covering the
completion of business cycle so that poor years are averaged
with the good.
Thus, in assessing future earning power one has to pay due
attention to the record of earnings of the enterprise in the past,
nature and context of competition in the industry, treatment of
research and development expenditures, the general economic
conditions and government policies of trade, tariff, taxation,
money and banking etc. In fact, one has to determine
maintainable profits for future. There are three approaches to
the determination of maintainable profits:
a) a simple average may be calculated in case of
established industry with no growth prospects,
b) weighted average has to be calculated in case of
established industry with no growth prospects and
c) projected average has to be calculated in case of
industries having growth potential.
ii. Rate of capitalization: After determining annual
earning rate for the enterprise as a whole or per share, the next
step is to apply a capitalization rate to arrive at the prospective
investment value. The capitalization rate is no more than an
earning price ratio, i.e., it is the ratio of earnings to price. In
general, the selection of this rate of capitalization is affected by
the following considerations:
189
a) Prevailing interest rates,
b) Risk involved in the industry,
c) Time required for reaching capacity production in the
enterprise,
d) Nature, magnitude and potentiality of competition.
iii. Capitalization of earnings: The process of putting
a valuation on the estimated earnings is known as the
capitalization of earnings. As seen earlier, the process of
estimating future earnings is an inexact one. Similarly, the
selection of appropriate rate of capitalization is mainly
subjective. Some adjustments in capitalized value of income
become necessary. If some of the assets purchased have not
contributed to the operating income, they can be sold without
affecting the normal operating income. There may be excessive
amounts of cash, inventories and other assets on hand. The fair
market value of these assets should be added to the capitalized
value of earnings. On the other hand, it may be necessary to put
additional sums to operate the assets affectively. Future
earnings of a small manufacturing concern may depend upon
the purchase of additional machineries or patent rights. Such
payments made in order to obtain the estimated normal net
income should be subtracted from the value of assets calculated
by capitalization of income. For capitalizing the earnings or
maintainable profits at the capitalization rate the followings are
the usual treatments:
Treatment-1: Capitalize maintainable profits at the
capitalization rate related to the industry or business.
Treatment-2: Maintainable profits are arrived at after
deducting taxes, preference dividend and normal plough back.
After these deductions, the remaining profits are capitalized at
the estimated capitalization rate.
Treatment-3: If the enterprise has surplus funds
invested in outside shares or securities or redundant assets not
helping in the normal earnings capacity of the enterprise, in that
case additions will be made to the capitalized value of earnings
for the value of such redundant investments and assets.
Treatment-4: If the enterprise has a highly geared
financial structure, i.e., high debt to equity ratio, the plough
back is suitably increased and the rate for capitalizing the
earnings also requires suitable adjustments. Financial leverage
may add to earnings per share but it also increases volatility of
these earnings.
190
C] Market Price Approach
Advocates of this approach argue that actual market prices are
appraisals of knowledgeable buyers and sellers who are willing
to support their opinions with cash. Hence, the prices at which
transactions take place are practically expressions of value
which should be preferred to theoretical views or valuation.
Market value of the share is in the nature of “bloodless verdict
of the market place”. Supporters of market price argue that it is
determined by investors’ valuation of expected future earnings
and thus reflects the value of the security. Moreover, the market
price is a definite measure that can readily be applied to a
particular situation and it minimizes the subjectivity of other
approaches in favor of a known yardstick of value. Market price
is a highly fluctuating quantity. In fact, the fluctuation may be so
violent and extreme that one may question the validity of using
the market price of the securities as a basis for exchange.
However, in spite of this shortcoming it is given much
consideration, primarily due to its wide acceptance. The
problems in using market price can be analyzed as follows:
First, market quotations are not available for a large
number of enterprises whose shares are not listed on the
exchanges.
Secondly, even for those enterprises whose shares are
listed there may not be an active trading.
Thirdly, the release of a relatively small number of
shares on a thin market may be enough to depress market
prices substantially.
Fourthly, the market price for a particular share on a
given date may be influenced by artificial means like cornering
of shares.
Fifthly, sales of shares in a closely held enterprise may
not reflect fair market price.
Finally, it is difficult to sell whether movements on the
price of a share in response to rumours cause the price to move
upwards or away from its economic value.
To meet some of the objective noted above, the theory of fair
market value has been developed. Fair market value is based on
the assumptions that there are willing buyers and willing sellers
actually in the market, each of them are well-informed and
prepared to act in an entirely rational manner. This approach
191
meets to a greater extent most of the objections against market
price.
192
i = the appropriate time value of money (a considerable
discount factor).
The above mentioned formula can be rewritten as:
DPS 1
P0 =
ke
whee,
P0 = price of the security.
DPS1= dividends per share in period 1 and every future
period if the firm’s dividends are not growing.
ke = required rate of return.
R1 R2 Rn Mn
= + 2 +. .. . .. .+ n +
( 1+k d ) ( 1+ k d ) ( 1+ k d ) ( 1+ k d )
n
where,
Vd = value of bond or debenture
R = annual interest
193
kd = required rate of return
M = terminal or maturity value
n = number of years to maturity.
2. Bond in Perpetuity
The bond which will never mature is known as perpetual bond.
This type of bond or debenture is rarely found in practice. In
case of perpetual bonds, the value of the same would simply the
discounted value of the infinite stream of interest flows. The
value of a perpetual bond can be determined by using the
∞
following formula: Rt R
dV =∑ =
t=1 d
t
(1+k )
d k
R1 R2 R∞
= + +. .. . .. .. . .+ ∞
( 1+k d ) ( 1+ k d ) 2
(1+ k d )
where,
Vd = value of bond or debenture
R = constant annual interest
kd = required rate of return
The above equation is an infinite series of R taka per year and
the value of a perpetual bond is simply the discounted sum of
the infinite series.
3. Valuation of Preferred Share
Preferred share may be issued with or without a maturity
period. The holders of preference shares get dividends at a fixed
rate. Like bond, it is relatively easy to estimate the cash inflows
associated with the preference shares. The following formula is
N
to be used in determining the value of preference share:
Dp Mn
V p =∑ t + n
t=1 (1+k P ) (1+k P )
D1 D2 D pn Mn
= + 2
+. .. . .. .+ n
+ n
(1+k p ) (1+k p ) (1+k p ) (1+k p )
where,
Vp = value of preferred share
Dp = preferred dividends
kP = required rate on preferred share
Mn = terminal value of preference share
n = number of maturity period
194
The value of a preference share considered as perpetuity can be
determined by dividing annual dividend by expected return. The
following formula is used to calculate the value of a preference
share:
Dp
V p=
kP
4. Valuation of Equity Share
The valuation of equity share is relatively more difficult. The
difficulty arises because of two factors viz.,
i. The estimates of the amount and timing of the cash
flows expected by investors are more uncertain. In case of
debentures and preference shares, the rate of interest and
dividend is known with certainty. It is, therefore, easy to make
the forecasts of cash flows associated with them.
ii. The earnings and dividends on equity shares are
generally expected to grow unlike the interest on debentures
and preference dividend. These features of equity shares make
the calculation of shares difficult.
Problems of Valuation
When a business is transferred or its assets are sold, it is
necessary for the parties involved in the transaction to agree
upon the price to be paid. The decision on the price to be paid is
often difficult to arrive at. The balance sheet surplus of assets
over liabilities is the generally accepted guide to the price to be
paid for the business as a going concern. However, balance
values are book values and are often unreliable. The followings
are the usual problems confronting one in the valuation of a
firm:
i. Balance sheet values of fixed assets may be wrong
indicators, for they are generally based on a book value
consideration. Changes in the actual value of assets are not
incorporated in a balance sheet.
ii. The value of current assets may be reliable. But here
again the amounts of debts, accounts receivables etc. may be
unknown. Moreover, the inventory may not find a ready market.
iii. Some assets may be highly specialized and may not
have a ready market.
iv. The selling or break-up value and the buying or
replacement value may become difficult and different of
assessment.
195
v. It may be difficult for a purchaser to estimate how
much the possession of the seller’s assets would add to his
profitability. The inflows have to be discounted not only for
interest but also for risk.
vi. The value of goodwill may be greater to the buyer
than the seller
So, these are the basic problems arise while making valuation of
a firm.
196
would become zero. On the other hand, if there are no profitable
investment opportunities, the D/P ratio will range between zero
percent to 100 percent.
In fine so long as the firm is able to earn more than the equity-
capitalization rate (ke), the investors would be content with the
firm retaining the earnings. In contrast, if the return is less than
the ke, investors would prefer to receive dividends.
Relevance of Dividends
Some Models
There are some theories that consider dividend decisions to be
an active valuation in determining the value of a firm. The
dividend decision is, therefore, relevant. We categorically
examine below two theories representing this notion: a)
Walter’s Model and b) Gordon’s Model.
Walter’s Model
Professor James E. Walter argues that the choice of dividend
policy almost always affects the value of the enterprise. The
investment policy of an enterprise can not be separated from its
dividend policy and both are, according to Walter, interlinked.
The key argument in support of the relevance proposition of
Walter’s model is the relationship between the return on a firm’s
investment or its internal rate of return (r) and its cost of capital
or the required rate of return (k) in determining the dividend
policy that will maximize the wealth of the stockholders.
However, Walter’s model is based on the following assumptions:
a) All financing is done through retained earnings i.e.,
debt or new equity is not issued.
b) With additional investment undertaken, the firm’s
internal rate of return, r, and its cost of capital, k, are
considered constant.
c) All earnings are either distributed as dividends or
reinvested immediately.
d) Beginning earnings and dividends never change. The
values of the earnings per share, E, and the dividend per share,
D, may be changed in the model to determine results, but any
given values of E and D are assumed to remain constant forever
in determining a given value.
e) The firm has perpetual life.
Walter has evolved a mathematical formula to arrive at the
appropriate dividend decision. His formula is based on the share
valuation model that states:
197
D r [( E−D)/k ]
P= +
k k
where,
P = market price per share
D = dividend per share
E = earnings per share
r = internal rate of return
k = cost of capital
The above mentioned equation clearly reveals that the market
price per share is the sum of the present value of two sources of
income: i) the present value of an infinite stream of constant
dividends, D/k, ii) present value of the infinite stream of capital
gains, [r(ED)/k]/k. When the firm retains a perpetual sum of
(ED) at r rate of return, its present value will be r(ED)/k. This
quantity can be known as capital gain which occurs when
earnings are retained within the firm. If this retained earnings
occur every year, the present value of an infinite number of
capital gains, r[(ED)/k will be equal to [r(ED)/k]/k. Thus, the
value of a share is the present value of all dividends plus
present value of all capital gains. So, the equation that will give
the value of a share is as follows:
r
P0 =
[
D+ ( E−D )
k ]
k
Example:
To illustrate the effect of different dividend policies on the value
of share respectively for the growth firm, normal firm and
declining firm the following example is made.
Let us assume,
EPS = Tk. 10
Growth firm-A r = 15 % = .15
(r>k) k = 10 % = .
10
When D/P ratio is 0% i.e., D = Tk. 0, then:
P = [0 + (.15/.10) (10 0)]/ .10 = Tk. 150
When D/P ratio is 40% i.e., D = Tk. 4, then:
P = [4 + (.15/.10) (10 4)]/ .10 = Tk. 130
When D/P ratio is 80% i.e., D = Tk. 8, then:
P = [8 + (.15/.10) (10 8)]/ .10 = Tk. 110
When D/P ratio is 100% i.e., D = Tk. 10, then:
P = [10 + (.15/.10) (10 10)]/ .10 = Tk. 100
198
Now we assume that,
EPS = Tk. 10
Normal firm-B r = 10 % = .10
(r = k) k = 10 % = .
10
When D/P ratio is 0 % i.e., D = Tk. 0, then:
P = [0 + (.10/.10) (10 0)]/ .10 = Tk. 100
When D/P ratio is 40 % i.e., D = Tk. 4, then:
P = [4 + (.10/.10) (10 4)]/ .10 = Tk. 100
When D/P ratio is 80 % i.e., D = Tk. 8, then:
P = [8 + (.10/.10) (10 8)]/ .10 = Tk. 100
When D/P ratio is 100 % i.e., D = Tk. 10, then:
P = [10 + (.10/.10) (10 10)]/ .10 = Tk. 100
Again, we assume that,
EPS = Tk. 10
Decline firm-C r = 8 % = .08
(r<k) k = 10 % = .
10
When D/P ratio is 0% i.e., D = Tk. 0, then:
P = [0 + (.08/.10) (10 0)]/ .10 = Tk. 80
When D/P ratio is 40 % i.e., D = Tk. 4, then:
P = [4 + (.08/.10) (10 4)]/ .10 = Tk. 88
When D/P ratio is 80 % i.e., D = Tk. 8, then:
P = [8 + (.08/.10) (10 8)]/ .10 = Tk. 96
When D/P ratio is 100 % i.e., D = Tk. 10, then:
P = [10 + (.08/.10) (10 10)]/ .10 = Tk. 100
Summary Table:
D/P ratio 0% 40 % 80 % 100 %
Value of firm-A in Tk 150 130 110 100
Value of firm-B in Tk. 100 100 100 100
Value of firm-C in Tk. 80 88 96 100
The calculation of the value of shares according to Walter’s
formula yields following conclusions:
a) When the firm is able to earn a return on investment
exceeding the required rate of return i.e., r > k, the value of the
shares is inversely related to the D/P ratio: as the payout ratio
increases, the market value of the shares declines. Its value is
highest when the D/P ratio is zero. If, therefore, the firm retains
its entire earnings, it will maximize the market value of the
shares. When all earnings are distributed, its value is the lowest.
In other words, the optimal payout ratio is zero. The firm is
called growth firm.
199
b) When r = k, the market value of the shares is constant
irrespective of the D/P ratio i.e., the market value of the shares
is not affected by D/P. Whether the firm retains the profits or
distributes dividends is a matter of indifference. In other words,
the firm is called normal firm.
c) When r < k, the firm does not ample profitable
investment opportunities and the D/P ratio and the value of the
shares are positively correlated: as the payout ratio increases,
the market value of the shares also increases. Its value is
highest when the D/P ratio is 100 % while it is the lowest with
D/P ratio being zero. When r < k, the firm would be well-advised
to distribute the entire earnings to the shareholders. In other
words, the optimal payout ratio is 100 %. This type of firm is
called declining firm.
Gordon’s Model
Another theory which contents that dividends are relevant is the
Gordon Model. This model, which opines that dividend policy of
a firm affects its value, is based on the following assumptions:
a) The firm is an all-equity firm. No external financing is
used and investment programs are financed exclusively
by retained earnings.
b) r and k are constant.
c) The firm has perpetual life.
d) The retention ratio, once decided upon, is constant. Thus,
the growth rate, (g = br) is also constant.
e) k > br.
According to Gordon, the market value of a share is equal to the
present value of future streams of dividends. A simplified
version of Gordon’s model can be symbolically expressed as:
E (1−b )
P0 =
(k−br)
Where,
P0 = market price per share
E = earnings per share
b = retention ratio
1 b = D/P ratio
k = cost of capital
br = growth rate
The implication of dividend policy, according to Gordon model,
are shown respectively for the growth firm, normal firm and
declining firm:
For growth firm,
200
Let us assume:
EPS = Tk. 10
Growth firm-A r = 15 % = .15
(r>k) k = 10 % = .
10
When D/P ratio (1 b) = 40 % i.e., D = Tk. 4, then, b = 60 %,
So, g = br = .15×.60 = .09
Therefore, P = 10(1 .60) / (.10 .09) = Tk. 400
When D/P ratio (1 b) = 60 % i.e., D = Tk. 6, then, b = 40 %,
So, g = br = .15×.40 = .06
Therefore, P = 10(1 .40) / (.10 .06) = Tk. 150
When D/P ratio (1 b) = 90 % i.e., D = Tk. 9, then, b = 10 %,
So, g = br = .15×.10 = .015
Therefore, P = 10(1 .10) / (.10 .015) = Tk. 106
For normal firm,
We assume that,
EPS = Tk. 10
Normal firm-B r = 10 % = .10
(r = k) k = 10 % = .
10
When D/P ratio (1 b) = 40 % i.e., D = Tk. 4, then, b = 60 % =
Tk. 6
So, g = br = .10×.60 = .06
Therefore, P = 10(1.60) / (.10 .06) = Tk. 100
When D/P ratio (1 b) = 60 % i.e., D = Tk. 6, then, b = 40 % =
Tk. 4
So, g = br = .10×.40 = .04
Therefore, P = 10(1 .40) / (.10 .04) = Tk. 100
When D/P ratio (1 b) = 90 % i.e., D = Tk. 9, then, b = 10 % =
Tk. 1
So, g = br = .10 ×.10 = .01
Therefore, P = 10(1 .10) / (.10 .01) = Tk. 100
For growth firm,
We assume that,
EPS = Tk. 10
Decline firm-C r = 8 % = .08
(r<k) k = 10 % = .
10
When D/P ratio (1 b) = 40 % i.e., D = Tk. 4, then, b = 60 % =
Tk. 6
So, g = br = .08 ×.60 = .048
Therefore, P = 10(1 .60) / (.10 .048) = Tk. 77
201
When D/P ratio (1 b) = 60 % i.e., D = Tk. 6, then, b = 40 % =
Tk. 4
So, g = br = .08×.40 = .032
Therefore, P = 10(1.40) / (.10 .032) = Tk. 88
When D/P ratio (1 b) = 90 % i.e., D = Tk. 9, then, b = 10 % =
Tk. 1
So, g = br = .08 ×.10 = .008
Therefore, P = 10(1 .10) / (.10 .008) = Tk. 98
Summary Table:
D/P ratio 40 % 60 % 90 %
Value of firm-A in Tk 400 150 106
Value of firm-B in Tk. 100 100 100
Value of firm-C in Tk. 77 88 98
It is clearly revealed that under Gordon model:
a) The market value of the share, P, increases with the
retention ratio b for firms with growth opportunities (r > k).
b) The market value of the share, P, increases with the
payout ratio (1-b) for declining firms (r < k).
c) The market value of the share, P, is not affected by
dividend policy when r = k.
Therefore, Gordon’s model concludes about dividend policy are
similar to the conclusion of Walter’s model. This similarity is
done to the similarities of assumptions which underlie both the
models
Modigliani-Miller Model
MM Propositions-I:
Franco Modigliani and Merton Miller have a convincing argument
that a firm can not change the total value of its outstanding
securities by changing the proportions of its capital structure.
The market value of a firm is independent of a change in the
debt-equity ratio. That is value of the levered firm is equal to
the value of the unlevered firm:
V L = VU
202
VU = Value of the firm financed by equity only.
VL = Value of the firm financed both by debt and equity.
The value of the firm is always the same under different capital
structures. No capital structure any better or worse than any
other capital structure for the firm’s shareholders.
This pessimistic result is the famous MM Propositions-I.
According to MM Proposition;
The value of the unlevered firm:
EBIT
V U=
ke
where, ke = cost of equity of a unlevered firm.
By adding debt to the unlevered firm we get the value of the
levered firm as:
The value of the levered firm:
EBIT
V L= +D
ke
Therefore,
V L = VU + D
An increase in D/E ratio results an increase in the required rate
of return on equity.
Example:
Suppose the equity of a firm is Tk. 50 million. EBIT is Tk. 10
million with required rate of return of 10%. According to MM
Propositions-I:
The value of the firm:
EBIT
V U=
ke
Tk .10 million
= . 10 = Tk. 100 million
Suppose equity is Tk. 25 million and debt is Tk. 25 million, EBIT
is Tk. 10 million, required rate of return is 10% and the cost of
debt is 8%.
Thus, According to MM Propositions-I:
The value of the firm:
EBIT
V L= +D
ke
Tk .(10−2)
= +Tk . 25 million
. 10
= Tk. 105 million
203
Determinants of the Value of the Firm
Market factors
● Economic conditions
● Government rules and regulations
● Competitive environment- Domestic and
Foreign
204
Financing decision
Sales
Revenue
Weighted
Free
Interest rate Average
Operating Cash
Cost and
Taxes Cost of
Flows Firm risk
Capital
Required (FCF)
Investment in Market risk
(WACC)
Operations
N
Po = ∑ FCFt /(1 + WACC)t
t=1
Exercises
1. What is meant by valuation of firm?
2. Define the concept of valuation? What are different concepts
of valuation of a firm? Explain them.
3. What are different values of a security? Why is intrinsic value
of a security important for an investor? How is it calculated?
4. Discuss the purposes of security valuation.
5. Discuss the factors affecting the security valuation.
6. What is meant by security valuation? What are different
techniques of security valuation? Explain them.
7. What are different models of common stock valuation? Explain
them with example.
8. Define different problems of security valuation.
9. How is dividend related to the valuation of the security? What
are different valuation models?
10. What are different theories of dividends? State the concepts
of dividend irrelevance and relevance theories.
11. What are the determinants of the value of the firm? Explain them.
12. What is the alternative technique of valuation?
205
Chapter-Eleven
Valuation of
Fixed-Income Securities
206
the holder. If a bond is going to be sold before maturity, the
price will depend on the level of interest rates at that time.
Therefore, the buyers of the bonds are exposed to interest rate
risk. So, on the part of the buyers and sellers of bonds it is
essential to understand the fundamentals of bonds how to price,
analyze, and manage them.
Bond Features
A bond can be categorized on the basis of its:
i. Intrinsic characteristics: The annual interest rate, term
to maturity, principal value, and the type of ownership are
important intrinsic features.
ii. Types: Bond can be categorized as:
◘ Secured (senior) bonds which are backed by a legel
claims on some specific property of the issuer in case of default.
◘ Unsecured bonds which are backed only by the
promise of the issuer to pay interest and pricipal on a timely
basis.
◘ Subordinated (junior) debentures which possess a
claim on income and assets that is subordinated to other
debentures.
◘ Revenue bonds which are popular corporate sector
municipal issues.
◘ Refunding issues which provide funds to prematurely
retire another issue.
iii. Indendture provisions: It is the contract between the
issuer and bondholders specifying legal requirements.
iv. Maturity: It refers to the life of the bond.
207
being sold at a premium on its face value. Thus, the general
assumption is that the bond prices vary inversely with changes
in market interest rates.
Burton G. Malkiel identified the relationship between bond
prices and changes in market interest rates. He stated five
fundamental principles to relate bond prices to market interest
rates which are known as bond pricing theorems. These are
discussed as:
1. Bond prices move inversely to market interest changes.
2. The variability in bond prices and term to maturity are
positively related. For a given change in the level of
market interest rates, changes in the bond prices are
greater for long-term maturities.
3. The sensitivity to changes in market interest rates
increases at a diminishing rate as the time remaining
until the bond’s maturity increases.
4. Absolute increases in market interest rates and
subsequent bond price changes are not symmetrical. For
a given maturity, a decrease in market interest rate
causes a price rise that is larger than the price decline
resulting from an equal increase in market interest rate.
5. Bond price volatility is related to its coupon rate. The
percentage change in a bond’s price due to a change in
the market interest rate will be smaller if its coupon rate
is higher.
The amount of price variation necessary to adjust to a given
change in interest rates is a function of the number of years to
maturity. In the case of long-maturity bond, a change in market
interest rate results in a relatively large price change when
compared to a short-maturity bond. Long-term bond is more
sensitive to interest rate changes than short-term bond. This is
why short-term bonds generally possess less exposure to
interest rate risk.
208
influence the return from the investments in bond. However, the
major risks involved in investments in bond are default risk and
interest rate risk.
Default risk: Default risk refers to the failureness of the
company to repay principal and/or interest thereon on the
stipulated dates. Inefficient financial performance and
management inefficacy lead to default risk. Default risk arises
due the nonpayment of whole or a part of interest and principal.
In such a situation, investors in bonds suffer losses which reduce
their return from bonds. Through credit rating such risk can be
identified and measured. Credit rating is a process of qualitative
analysis of the company’s business and management and
quantitative analysis of the company’s financial performance.
Interest rate risk:
Since the price of a bond rarely moves in financial markets, the
major income from the bond represents the coupon interest
rates. An investor in bond generally receives these interests
annually or semi-annually. Hence, the investors can reinvest
their interest amounts at the prevailing market interest rate so
that interest on principal begets interest. An investor can do so,
so long as he holds the security. Investor can sell the bond off at
a price which may be equal to the face value. During the
holding period, market interest rates may change. If the interest
rate increases, the investor would be able to reinvest the annual
interest earned from the bond at a higher rate which will
maximize the return. In addition to that bond price will fall
below its face value as the market interest rate moves up.
Therefore, investor would suffer a loss if he sells the bond. If the
lose on sale exceeds the gain on reinvestment, investor will
suffer a net lose on account of the rise in market interest rate.
In contrast, if the interest rate declines, opposite dimension will
exist. The investors have to reinvest the amount of interest at a
lower rate than what was expected. Since the market interest
declines, the bond price will move above the face value because
the demand of that bond would become high as its rate of
return is higher. Under these circumstances, the investors would
incur lose in reinvesting the interest while they will gain on
selling the bond. Investors in bond experience variations in
expected rate of return because of the changes in the market
interest rate. This variability in return is termed as interest rate
risk. Interest rate risk is the result of two components like
reinvestment of annual interest and the capital gains or losses
209
on the sale of the bond at the end of the holding period. When
the market interest rises, there is the possibility of making gains
from reinvestments of interest but there may exist a lose on
sale of the bond and vice versa. However, reinvestment risk and
price risk are the decompositions interest rate risk. Both
reinvestment risk and price risk have an opposite effect on the
return of bond. Investor can eliminate interest rate risk by
holding the bond for its duration. If the holding period
significantly differs from the duration of the bond, interest rate
risk will exist for the bond.
210
where,
(1 + trn) = the rate of return on a n-year bond,
(1 + t r 1) = current rate on a one-year bond,
(1 + t + 1 r 1) = the expected rate on a bond with one-year
to maturity beginning one-year from now,
(1 + t + n –1 r 1) = the expected rate on a bond with one-
year to maturity beginning n 1-year from now,
n = bond maturity period.
The formula is applicable for any number of periods. Any long-
term rate is geometric average of consecutive one-period rate.
Let us consider an example. Suppose one-year bond rate is 10
per cent and two forward rates are 11 per cent and 12 per cent.
Find out the three-year bond.
This problem can be solved by using geometric average of the
current one-year rate and the expected forward rates for the
subsequent two years as follows:
(1 + tr3) = [(1 + t r1) (1 + t + 1 r 1) (1 + t + 2 r 1)] 1/3 1.0
= [(1.10)(1.11)(1.12)] 1/3 1.0
= [1.3675] 1/3 1.0
3
= √ 1. 3675 1.0
= 1.11 1.0 = 0.11 = 11%
Liquidity Preference Theory: Liquidity preference theory
assets that as in the expectations theory, interest rates reflect
the sum of current and expected short rates plus liquidity
premium. Because of the uncertainty in future, investors prefer
to invest in short-term bonds. On the other hand, borrowers
prefer long-term to invest in capital assets. Under these
circumstances, investors are supposed to receive a liquidity
premium to invest in long-term bonds. Therefore, this theory
implies that long-term bonds should offer higher yields.
Preferred Habital Theory: The difference between the
expectations theory and liquidity preference theory is the
recognition that future interest rate expectations are uncertain.
To compensate this uncertainty, risk-averse investors would like
a higher rate for long-term bonds. Being third theory of term
structure of interest rates, preferred habital theory assets that
investors usually prefer maturity sectors or habits. A financial
institution with many five-year maturity deposits to pay off will
not wish to take the reinvestment rate risk that would result
from investing in one-year Treasury bills. This theory means that
the borrowers and lenders can be induced to shift maturities if
211
they are adequately compensated by an appropriate risk
premium.
212
yield measures the annual return to a bondholder who
purchases the bond from the secondary market and sells before
maturity at the same price at which it was bought. It does not
measure the entire returns from a bond held till maturity.
Spot Interest Rate
A zero coupon bond is a bond which is sold with no coupons, no
interest to be paid during the life of the bond and is redeemed
for face value at maturity. It is a special type of bond paying no
annual interest. Therefore, the return on this bond represents a
discount on issue of the bond. As for example a two-year bond
with a face value of Tk. 1000 may be issued for Tk. 800 at
discount. The investor purchasing the bond at Tk. 800 will
receive Tk. 1000 after two years from now. This type of bond is
called pure discount bond. The return received from a zero
coupon bond expressed on an annualized basis is called spot
interest rate. Hence, spot interest rate represents the annual
rate of return on a bond having only one cash inflow. It can be
expressed as the discount rate that equates the redemption
value to the discounted value at which the investor purchased
it. Thus, the spot interest rate of a two-year bond of face value
Tk. 1000 issued at a discount for Tk. 800 can be estimated as:
1000
800=
(1+k )2
1000
(1+k )2=
800
(1 + k)2 = 1.25
(1 + k) = √1.25
= 1.1180
Therefore, k = 1.1180 1
= .1180 = 11.80 per cent
A zero coupon bond with a face value of Tk. 1000 with a
maturity period of three years is issued at discount for Tk. 700.
The spot interest rate can be shown as below:
1000
700=
(1+k )3
1000
(1+k )3 =
700
213
(1 + k)3 = 1.4286
3
(1 + k) = √ 1.4286
= 1.1263
Therefore, k = 1.1263 1
= .1263 = 12.63 per cent
The spot interest rate depends on the life of the bond and the
difference between the face value and discounted value of the
bond.
Yield to Maturity
Yield to maturity (YTM) is the most widely used measure of
return on bond. It is the compounded rate of return an investor
expects to receive from a bond purchased at current market
price which he holds till maturity. On the other hand, it may be
termed as internal rate of return or discount rate that makes the
present value of all the futures cash inflows from the bond equal
to the purchase price of the bond. The relationship among the
cash outflow, the cash inflow, and the YTM of a bond can be
expressed as:
N
Ct TV n
MP=∑ t
+
t =1 ( 1+ YTM ) ( 1+YTM )n
where,
MP = market price of the bond,
C t = cash inflow from the bond during the whole life
of the bond,
YTM = yield to maturity,
TV = terminal value of the bond,
n = total maturity period of the bond.
Hence, it is possible to estimate the YTM equating both the
sides of the equation by trial and error method. Let us consider
a bond with a face value of Tk. 1000 having 15 per cent coupon
rate which will mature at par. Five years maturity bond can be
purchased at Tk. 800 in the market. The YTM of the said bond
can be determined as under:
The relationship among the cash outflow, the cash inflow, and
the YTM of a bond can be expressed as:
N
Ct TV n
MP=∑ t
+
t =1 ( 1+ YTM ) ( 1+YTM )n
214
5
150 1000
∑ (1+YTM) + t
(1+YTM )
5
800 = t =1
Since the market price is lower than the face value, the YTM
would be higher than the coupon interest rate. This can be
estimated by trial and error method. Firstly, we may consider 20
per cent as YTM. Then the right hand side of the equation
becomes-
215
Tk. 150 (present value annuity factor for 5 yrs., 20%) +
Tk. 1000 (present value factor for 5 yrs., 20%)
= (150 × 2.9906) + (1000 × 0.4019) = 448.59 + 401.90
= 850.49
Again,
Tk. 150 (present value annuity factor for 5 yrs., 25%) +
Tk. 1000 (present value factor for 5 yrs., 25%)
= (150 × 2.689) + (1000 × 0.328) = 403.35 + 328 =
731.35
Therefore,
850 . 49−800
20+[ ]×(25−20 )
YTM = 850 . 49−731 . 35
= 20 + (0.4238)(5) = 20 + 2.119 = 22.12 per cent.
Concluding decision:
◘ If the puchasing price is lower than the face value, the
YTM would be higher than coupon interest rate and vice –
versa.
◘ If the terminal value is higher than the purchasing value,
YTM would be higher than coupon interest rate and vice-
versa.
216
If demonstrate the formula using the above data, we have the
AYM as:
1000−800
150+
5 190
AYM = = =0 . 21=21 %
1000+800 900
2
Yield to Call
At the option of the issuer or of the investor, some bonds may
be redeemable before their maturity period. If such option is
executed, the subject bond would be called for redemption at
the specific call price on the specified call date. For bonds likely
to be called, the yield to maturity calculation is unrealistic.
Hence, the better calculation here is termed as yield to call
(YTC). The end of the deferred call period, when a bond can first
be called, is often used for the yield-to-call calculation. This is
appropriate for the bonds selling at a premium. In case of
redeemable bond, two yields are to be calculated as:
a) Yield to maturity: It asserts that the bond will be
redeemed only at the end of full maturity period.
b) Yield to call: It implies that the bond will be redeemed
at the call date before the full maturity. Yield-to-call is the
discount rate that makes the present value of cash inflows to
call equal to the bond’s current market price.
Let us consider an example. A bond with a face value of Tk. 100
having 15 per cent coupon rate will mature at par in 15 years.
The bond is callable in 5 years at Tk. 115. It currently sells for
Tk. 105 in the market. The YTC of the said bond can be
determined as under:
The relationship among the cash outflow, the cash inflow, and
the YTC of a bond can be expressed as:
N
Ct TV n
MP=∑ t
+
t=1 (1+ YTC ) (1+ YTC)n
where,
MP = market price of the bond,
Ct = cash inflow from the bond during the whole life
of the bond,
YTC = yield to call,
TV = terminal value of the bond,
n = total maturity period of the bond.
217
By putting the values, we have;
5
15 115
105=∑ t+ 5
t =1
(1+YTC) (1+YTC )
We have to find the value of YTC that makes the right hand side
of the equation equal to Tk. 105. This can be done by trial and
error method. Since the market price is lower than the callable
price, the YTC would be higher than the coupon interest rate.
Firstly, we may consider 15 per cent as YTC. Then the right hand
side of the equation becomes-
15 15 15 15 15 115
[ + + + + + ]
( 1+. 15) ( 1+. 15 ) (1+. 15 ) (1+. 15 ) ( 1+.15 ) ( 1+.15 )5
2 3 4 5
15 15 15 15 15 115
[ + + + + + ]
( 1+. 18) ( 1+. 18 ) (1+. 18 ) (1+. 18 ) ( 1+.18 ) ( 1+.18 )5
2 3 4 5
218
Yield to maturity and yield to call are assumed to be the
effective annual rate of interest/return (EAR). Coupon rate is
contractual interest rate agrred by both bond issuer and holder.
Annual interest income is determined interms of coupon interest
which will remain unchanged. Market interst rate is available in
the market. If it is agrred by both the parties it becomes
coupon. If YTM/YTC is higher than market interest, the bond is
assumed to be overpriced and vice-versa. Because of the
excess amount of money refunded by the issuer, the bondholder
can earn more return over the interest income.
Bond Duration
A bond will face interest rate risk if holding period differs from
duration. For any bond there is a holding period at which the
effect of reinvestment risk and price risk balances each other.
The lose on reinvestment of interest can be compensated by a
capital gain on the sale of the bond and vice versa. For this
holding period there is no interest rate risk. The holding period
at which interest rate risk disappears is called the duration of
219
the bond. Thus, the duration of bond is required time period at
which the price risk and the reinvestment risk of a bond are of
equal magnitude but opposite in direction. Therefore, the bond
duration is the weighted average life of the bond. The various
time periods at which the bond generates returns are weighted
according to the respective size of the present value of these
returns. The formula for calculating bond duration can be
expressed as:
I1 I2 I n +TV n
[
d= 1×
( 1+k )
+2×
(1+ k )2
+−−−−+n×
]
( 1+k )n P0
This equation requires discounting the series of cash flows,
which are multiplied by the time period in which they occur. The
sum of these cash flows is divided by the price of the bond
obtained by using present value model. However, the above
formula can be expressed in a more general format as:
N
C
∑ t × ( 1+kt )t
t =1
d= N
Ct
∑
t =1 ( 1+ k )t
where,
d = bond duration,
C t = annual cash flow both interest and principal
amount,
k = discount rate which is the proxy of market interest
rate,
t = time period of each cash flow and
N = number of period.
Let us consider an example. A 5-year bond having 15 per cent
coupon rate was issued at a premium of 5 per cent 3 years ago.
The prevailing interest rate in the market is 18 per cent. The
calculation of the bond duration can be summarized as:
Assume that the face value of the bond is Tk. 100.
Year Cash PV Present PV multiplied
flow factor value (PV) by years
(Ct) @ 18 %
1 15 0.8475 12.7125 12.7125
2 15 0.7182 10.7730 21.5460
3 15 0.6086 9.1290 27.3870
4 15 0.5158 7.7370 30.9480
220
5 15 0.4371 6.5565 32.7825
5 105 0.4371 45.8955 229.4775
92.8035 354.8535
N
C
∑ t × ( 1+kt )t
t =1
d= N
Ct
∑
Bond duration t =1 ( 1+ k )t
354 . 8535
= =3 .82 years
92 . 8035
The duration of the 5-year maturity bond is 3.82 years. If the
bond is held for 3.82 years, the interest rate risk can be
eliminated. The impact of reinvestment risk and price risk would
offset each other to reduce the interest rate risk to zero.
Bond Volatility
Bond volatility is the absolute value of the percentage change in
the bond price for a given change in yield to maturity. If we
divide the percentage change in price by the percentage
change in yield to maturity, we simply get bond volatility.
Therefore, bond volatility can be expressed by applying the
following formula:
ΔP/ P
Bond volatility = Δr
where,
∆P/P = percentage change in price
∆r = percentage change in yield to maturity
To understand bond volatility, let us take an example. Suppose
interest rate increases from 10 per cent to 12 per cent and price
changes from Tk. 100 to Tk. 90. Thus, bond volatility can be
expressed as:
ΔP/ P
Bond volatility = Δr
(100−90 )/100
=
12−10
10 %
= =5
2%
221
Exercise
1. Define fixed income securities. State different types of fixed
income securities.
2. What is bond and debenture? State the features of bond.
3. What are different theories of bond price determination?
4. How would you differetiate bond from debenture.
5. What is bond risk? How would you determine it?
6. Contrast among the returns from different types of fixed
income securities.
7. Differentiate:
i. Current yield from spot interest rate
ii. Yield to call from yield to maturity.
8. Peopoles Insurance Ltd. has a 15 % debenture with a face
value of Tk. 100 that will mature at par in 5 years. It can be
purchased at Tk. 105 in the market. Calculate the yield to
maturity of Peopoles Insurance Ltd.
9. Define bond duration? How would you calculate it? How is
bond interest rate risk offset by capital gains?
10. Prime Insurance Ltd. has a 20 % debenture with a face
value of Tk. 100 that will mature at par in 5 years. It can be
purchased at Tk. 110 in the market. Calculate the yield to
maturity of Prime Insurance Ltd.
11. Peace Valley Ltd. has a 15 % bond with a face value of
Tk. 100 that will mature at par in 15 years. The bond is
callable in year 5 at a price of Tk. 110. It can be purchased
at Tk. 105 in the market. Calculate the followings:
i. Current Yield,
ii. Yield to call,
iii. Yield to maturity
12. What is bond volatility? How is it calculated?
13. An investor owns a bond with a face value of Tk.1000 for
a 8-year of maturity. The bond makes annual coupon
payments at 10 per cent. The bond is currently priced at Tk.
950. If the market interest is 12 per cent, should the investor
hold or sell the bond?
222
Chapter-Twelve
Valuation of
Common Stocks
223
original investment plus a capital gain. It is normally found that
a shareholder does not hold the share in perpetuity. He holds
the share for some times, receives the dividends, and finally
sells it to obtain capital gains. But when he sells the share, the
buyer is also simply purchasing a stream of future dividends and
liquidating price when he sells the share. The logic can be
extended further. The ultimate conclusion is that, for
shareholders in general, the expected cash inflows consist only
of future dividends and, therefore, the value of a common stock
is determined by capitalizing the future dividend stream
discounted by an appropriate discount rate known as investor’s
required rate of return (RRR). Thus, the value of a share is the
present value of its future stream of dividends. The formula for
calculating the present value of a share of one year holding
period is given as below:
D1 P1
P0 = +
( 1+ k ) ( 1+ k )
D1+ P 1
=
( 1+k )
where,
P0 = price per share today,
D1= dividend per share at the end of first year,
P1= price per share at the end of first year,
k = investor’s required rate of return.
If a buyer wishes to hold a share for three years and then sell
after purchasing it for P1 at the end of first year, the value of the
same to him today will be:
P1 D2 D3 D4 P4
= 2 + 3 + 4 + 4
( 1+ k ) ( 1+k ) ( 1+k ) ( 1+k ) ( 1+ k )
The price at the end of the fourth year and all future prices are
determined in a similar manner. The general formula for
determining the value of the share at the present time can be
written as follows:
D1 D2 D3 Dn
P0 = + + + .. .. . .+
( 1+ k ) ( 1+ k )
2
( 1+ k )
3
(1+ k )
n
n
Dt
=∑ t
t=1 (1+k )
It is obvious from the above equation that the present value of
the share is equal to the capitalized value of an infinite stream
224
of dividends. It should be noticed here that D t in the equation
are expected dividends. In fact, investors estimate the dividends
per share likely to be paid by the company in future period of
time. These estimates are based on their subjective probability
distributions. Thus, the Dt are expected values or means of
these probability distributions. Obviously, the present value of
future sums would be lower than those future sums
(cumulative).
225
where,
P0 = price of a share today (present value),
FCFt = free-cash-inflows at time t and
k = investor’s required rate of return called appropriate
discount rate.
The prerequisites to use this model are:
i. Required rate of return: An appropriate discount rate is
proxy of investor’s required rate of return. An investor willing to
purchase a share must assess the risk that commensurates the
expected return. At a given level of risk, an expected rate of
return is minimum rate of return that will be required to induce
the investor to invest. It is also considered as the investor’s
opportunity cost.
ii. Expected cash flows: Amount and the timing of the
future stream of cash inflows called free-cash-flows are very
important in determining the value of a share. The value of a
bond is the present value of any interest payments plus the
present value of the bond’s face value that will be received at
maturity. Likewise the value of a share is the present value of all
cash flows to be received from the issuer. The stream of cash
flows from holding a share consists of the cash dividends
received and the future price at which the share can be sold.
i. Dividend discount model: It uses the present value
model to determine the value of a share. As cash
dividends are the cash payments a shareholder
receives from a firm, they constitute the foundation of
valuation for common stock. Dividend discount model
(DDM) asserts that the current price of a share is
equal to the discounted value of all future dividends
received by the investors. The value of a share as
asserted by DDM can be estimated by the following
formula:
D1 D2 D3 D∞
P= + 2 + 3 +. .. .. .+ ∞
( 1+k ) ( 1+k ) ( 1+k ) ( 1+k )
∞ FCFt
=∑ t
t=1 (1+k )
where,
Pcs = intrinsic value of a common stock
226
k cs = discount rate, investor’s required rate of
return or opportunity cost.
D1, D2, …, D∞ = annual dividends expected to be received
each year.
To use the DDM for share valuation, the investor has to forecast
the future dividends during the holding period. It is not possible
on the part of the investor to forecast the expected dividends
accurately. This is why modifications of DDM have been
developed to render it useful for the valuation of share.
As in case of most of the shares, the amount of dividends grows
because of the growth of earnings of a company; this
phenomenon should be taken into consideration for the
valuation purpose. Therefore, the growth rate pattern of
dividends should be considered. Different assumptions
regarding the growth rate patterns should be made and
incorporated into the valuation model. The assumptions which
are commonly used are:
1. Dividends will not grow at all in future, i.e. the zero
growth assumption,
2. Dividends will grow at a constant rate in future, i.e. the
constant growth assumption,
3. Dividends will grow at varying rate in future, i.e. the
multiple growth assumption.
These assumptions regarding the growth patterns of dividends
in future give rise three individual versions of the present value
model of share valuation like:
a) Zero-growth model,
b) Constant-growth model and
c) Multiple-growth model.
Zero-Growth Model
Zero-growth model asserts that dividends will not grow over
time. The current dividend shall be remained unchanged. A
certain amount of dividend equal to the current dividend being
paid, to be paid every year from now to infinity. This pattern of
dividend payment is referred to as the no-growth rate or zero-
growth model. Under this model, the value of the share would
be determined as:
D0 D0 D0 D0
P0 = 1 + 2 + 3 +.. .. . .+ ∞
( 1+ k ) ( 1+ k ) ( 1+ k ) ( 1+ k )
227
In short,
D0
P0 =
k
where,
P0 = price of share,
D0 = constant dividend expected for all future time
periods,
k = required rate of return or opportunity cost.
The value of share with no-growth version is easy to calculate
because like a preferred dividend this dividend remains
unchanged. Thus, zero-growth common stock is perpetuity and
is easily valued given the required rate of return or investor’s
opportunity cost. Let us take an example: A company pays
constant dividend of Tk. 10 per share each year. If investor’s
required rate of return is 15 per cent, the value of the share
would be:
D0
P0 =
k
Tk . 10
P0 = =Tk . 66 . 67
.15
Let us take another example. An investor expects to receive Tk.
10, Tk. 12 and Tk. 15 as dividend from a share during the next
three years and hopes to sell it off at Tk. 120 at the end of third
year. If his required rate of return is 15 per cent, intrinsic value
of the share can be estimated as:
D1 D2 D3 P3
P0 = 1
+ 2 + 3 + 3
( 1+ k ) ( 1+ k ) ( 1+ k ) ( 1+ k )
10 12 15 120
P0 = + 2 + 3 +
( 1+. 15 )1 ( 1+. 15) ( 1+ .15 ) ( 1+.15 )
3
Constant-Growth Model
The constant-growth model is originated by Myron J. Gordon.
This is why this model is known as Gordon’s share valuation
model. In this model, it is assumed that dividends will grow at
the same rate upto infinite future and that the investor’s
228
required rate of return would be greater than the dividend
growth rate. It is necessary to compound some beginning
dividend into the future.
The higher the growth rate, the higher the value of the
share; the higher the required rate of return, the lower
the value of the share; the longer the time period, the
higher the value of the share and vice-versa.
By applying the growth rate (g) to the current dividend (D 0), the
dividend expected to be received after one year (D 1) can be
determined as:
D1 = D0(1 + g)1
The expected dividend of any year thereafter can be
determined from the current dividend as:
D2 = D0(1 + g)2 = D1(1 + g)
D3 = D0(1 + g)3 = D2(1 + g)
D4 = D0(1 + g)4 = D3(1 + g)
D10 = D0(1 + g)10 = D9(1 + g)
Dn = D0(1 + g)n = Dn1(1 + g)
The present value model for share valuation can, therefore, be
written when the future dividends are expected to grow at a
constant rate over time as follows:
2 n
D 0 (1+ g )
D 0 ( 1+ g)1 D 0 ( 1+ g)
P0 = 1 + 2 +. .. . ..+ n
( 1+k ) (1+ k ) ( 1+k )
When the holding period, n, approaches infinity, the above
formula can be simplified as:
D1
P0 =
( k −g )
D 0 (1+g )
=
( k −g )
Thus, the intrinsic value of a share is equal to the next year’s
expected dividend divided by the difference between the
investor’s required rate of return and its expected dividend
growth rate.
Let us consider some examples.
Example-01: An investor expects to get Tk. 10, Tk. 12 and Tk.
15 as dividend from a share during the next three years. The
share is expected to be sold at Tk. 100 at the end of the third
229
year. If the investor’s required rate of return is 10 per cent, the
value of the share would be:
D1 D2 D3 P3
P0 = 1 + 2 + 3 + 3
( 1+ k ) ( 1+ k ) ( 1+ k ) ( 1+ k )
10 12 15 100
= + + +
( 1+.10 )1 2 3
( 1+.10 ) ( 1+. 10) ( 1+. 10)
3
230
D1
P0 =
(k −g )
D 0 (1+g )
=
( k −g )
10( 1+.10 )
= ( .18−.10)
= 11/.08 = Tk. 137.50
When the required rate of return increases with other variables
held constant, the price of the share decreases.
If the dividend growth rate is 12 per cent with other variables
held constant, the price of Jahan’s share can be estimated as:
D1
P0 =
(k −g )
D 0 (1+g )
=
( k −g )
10( 1+.12 )
= ( .15−.12)
= 10(1.12)/.03 = Tk. 373.33
When the growth rate of dividend increases return increases
with other variables held constant, the price of the share
increases.
If the dividend growth rate is 8 per cent with other variables
held constant, the price of Jahan’s share can be estimated as:
D1
P0 =
(k −g )
D 0 (1+g )
=
( k −g )
10( 1+.08)
= ( .15−.08)
= 10(1.08)/.07 = Tk. 154.29
When the growth rate of dividend decreases with other
variables held constant, the price of the share decreases. These
examples suggest that the share price constantly fluctuates
depending upon the variables. If investors use the constant-
231
growth version of dividend discount model to estimate the value
of a share, a different price will be obtained because of the
influence of the variables. However, the constant-growth model
may not become realistic in different situations. The growth of
dividends may vary depending upon the varying situation of the
company and the economy as well.
Example-03: Jahan corporation is currently paying a dividend of
Tk. 20 per share as dividend and it expects dividend to grow at
10 per cent a year for the foreseeable future. If the investor’s
required rate of return is 15 per cent, the intrinsic value of
Jahan’s share will be calculated by the method described below:
D1
P0 =
(k −g )
D 0 (1+g )
=
( k −g )
20( 1+.10 )
= ( .15−.10)
= 20(1.10) / (15 .10)
= 22 /.05 = Tk. 440
Example-04: The market price of the share of IBM Corporation is
Tk. 250 and it paid Tk 15 per share as cash dividend.The
investor’s required rate of return is 12 % and dividends are
expected to grow per year at a constant, g. What would be the
price per share of IBM after 5 years?
Solution:
D1
P0 =
(k −g )
D (1+g)
P0 = 0
( k−g )
15 (1+g )
250=
or, (. 12−g )
or, 250 (0.12 – g) = 15 (1 + g)
or, 30 – 250g = 15 + 15g
or, 30 – 15 = 15g + 250g
or, 265g =15
or, g = 0.0566 = 5.66 %.
Therefore the share price after 5 years would be:
232
D 5+1
P5 =
(k−g )
D5 +1 = D6 = D0 (1 + g)6 = Tk. 15 (1.0566)6 = Tk. 20.87
Tk .20 . 87
P5 = =Tk . 329 .18
(.12−. 0566 )
Again,
P0 = Tk. 250 (1 + .0566)5 = Tk. 329.22
Multiple-Growth Model
The financial position of many companies may be that a period
of extraordinary growth will prevail for a certain number of
years, after which the dividend growth rate shall become
changed to a level at which it is expected to continue
indefinitely. The constant-growth model is unable to deal with
these situations. This pattern of dividend can be presented by a
two-stage growth model. Such a variation of the DDM is termed
as the multiple-growth model. More specifically, a multiple-
growth model can be defined as a situation in which the
expected future growth of dividends shall be shown by two or
more growth rates. The basic characteristic of multiple-growth
model is that although two or more growth rates of dividends
are to be described in the multiple-growth model, at least two
different growth rates are involved. Under thus circumstances,
the value of a share should be the sum of the present values of
two dividend flows. One is the dividends received from period 1
to N and the other refers to the dividends received from N+1 to
infinity. Sum of the total present values represents the intrinsic
value or the price of the share. For our understanding we can
divide the period into two parts called first phase and second
phase. The growth rates of dividends during the first phase may
vary over time. The expected dividends for each year during the
first phase can be forecasted individually irrespecting the
constant-growth or varying growth rates of dividends during the
first phase. Therefore, multiple-year holding period valuation
model can be used for the first phase, using expected dividends
for each year by the following formula:
D1 D2 DN
P0 = 1
+ 2
+.. .. .+ N
( 1+ k ) ( 1+ k ) ( 1+k )
N
Dt
=∑ t
t =1 (1+k )
233
Since the growth of dividends is assumed to be constant during
the second phase at another growth rate, the present value of
this phase would be based on the constant-growth model of
DDM. After period N, the investor would enter into the next year
at which the second phase will commence. So, after period N,
the expected stream of dividends for time periods N+1, N+2,
N+3 and so on which will grow at an another constant rate,
would be considered. The expected dividends after period N
can, therefore, be calculated as:
DN+1 = DN(1 + g)1
DN+2 = DN(1 + g)2
DN+3 = DN(1 + g)3
and so on to infinity.
Gordon share valuation model, therefore, can be applied to
estimate the present value of the second phase stream of
dividends at time N commencing from period N+1 to infinity as:
D n (1+ gc )
Pn =
( k−g c )
Dn
+1
=
(k−gc )
The value of the share as estimated under the above formulla is
assumed to be the present value at time N on today. If this
value is to be considered at time zero, it must be discounted by
the required rate of return (1+k) to estimate the present value
at time zero for the second phase of dividend streams. The
discounted value of the second phase streams of dividend can
be obtained as:
Dn+1
P0 =
(k −g c )( 1+ k )n
Pn
=
(1+k )n
The present values of two phases estimated above may be
added to provide the intrinsic value of the share having a two-
stage growth of dividends as under:
N Dt Pn
P0 = ∑
t=1 [ (1+k )t ][
+
( 1+ k )n ]
234
From the discussion and expression given above, a well-know
multiple-growth model may be assumed to be a two-period
model. This model assumes near-term growth at a rapid rate for
some period followed by a suitable steady growth rate. This can
be expressed by the following equation:
N
D0 (1+ g 1 )t Dn ( 1+ gc )
P0 = ∑
t =1
[ t
( 1+ k ) ][
+
( k −gc )( 1+ k ) n ]
where,
P0 = estimated value of share today,
D0 = current dividend,
g1 = growth rate of dividend at first phase,
gc = constant-growth rate of dividend at second phase,
k = investor’s required rate of return
Dn = dividend at the end of the first phase
N = number of period after which second phase will start.
Let us consider some examples.
Example-01: A company currently pays a dividend of Tk. 10 per
share and expects to pay a dividend of Tk. 11 per share during
the next year. Also investors expect dividends of Tk. 12 and Tk.
15 per share respectively during the two subsequent years.
After that (year of receiving dividend of Tk. 15) investors expect
that annual dividend will grow at 15 per cent a year upto
infinity. If the investor’s required rate of return is 20 per cent,
the intrinsic value of share of that company will be calculated by
the method described below:
The expected dividends for each year during the first phase are
given. Therefore, the following multiple-year holding period
valuation model can be used to estimate the present value of
the share for the first phase. The sum of the present values of
dividends received upto the year of constant growth can be
estimated as:
D1 D2 D3
V 1= 1
+
2 + 3
(1+ k ) (1+ k ) ( 1+ k )
12 15
P0 = 11 1 + 2 + 3
( 1+. 20 ) (1+. 20 ) ( 1+.20 )
= 9.17 + 8.33 + 8.68 = 26.18
By using the constant-growth model of DDM, the value of the
share at the n th year can be caculated as:
235
D n (1+ gc )
Pn =
( k−g c )
Dn
+1
=
(k−gc )
15( 1+. 15 )
= (. 20−. 15)
= 345
The present value of second phase at time zero of dividends
receivable from fourth year to infinity can be estimated as:
Pn
V 2= n
( 1+ k )
345
= ( 1+.20 )3
= 199.65
Therefore, the intrinsic value of the share is sum of the two
present values as given below:
P 0 = V1 + V2
= 26.18 + 199.65 = Tk. 225.83
Example-02: Suppose a corporation currently pays a dividend of
Tk. 10 per share and expects it to grow at 12 per cent a year for
next five years at the end of which the new growth rate is
expected to be a constant 8 per cent a year for the foreseeable
future. If the investor’s required rate of return is 15 per cent, the
intrinsic value of the share will be calculated by the method
described below:
Solution: The first step in the valuation process devotes to
determine the amount of dividends of every year of
supernormal growth period in the following way:
The compound of beginning dividend (D 0) at supernormal
growth rate, 12 per cent for each of the five years are as
follows:
D0 = Tk. 10
D1 = D0(1 + g1)1 = Tk. 10(1 + .12)1 = Tk. 11.20
D2 = D0(1 + g1)2 = Tk. 10(1 + .12)2 = Tk. 12.54
236
D3 = D0(1 + g1)3 = Tk. 10(1 + .12)3 = Tk. 14.05
D4 = D0(1 + g1)4 = Tk. 10(1 + .12)4 = Tk. 15.74
D5 = D0(1 + g1)5 = Tk. 10(1 + .12)5 = Tk. 17.62
Now, the present values of the dividends are estimated by
discounting with the required rate of return, 15 per cent, as:
Present value of D1 = Tk. 11.20(.869) = Tk. 9.73
D2 = Tk. 12.54(.756) = Tk. 9.48
D3 = Tk. 14.05(.658) = Tk. 9.24
D4 = Tk. 15.74(.572) = Tk. 9.00
D5 = Tk. 17.62(.497) = Tk. 8.76
========================
=====
Total present value of D1 to D5 = Tk. 46.21
Sum of the discounted dividends produces the value of the
share for its five years only. To evaluate the dividends from year
six to infinity, the constant-growth model, therefore, can be
used. After the end of year five the company will enter into year
six. The value of the share at the start of year six can be
estimated by using the following model:
D n+1
Pn =
(k −g c )
where,
DN+1 = D5+1
= D6
= D5 (1+ gc)
= Tk. 17.62(1.08)
= Tk. 19.03
Therefore,
D n+1
Pn =
(k −g c )
19 .03
= ( . 15−. 08 )
= Tk. 271.86
Thus, Tk. 271.86 is the price of the share which would be
received at the beginning of year six (the end of year five). This
value is also to be discounted to get the present value of the
share using the present value factor for five years at 15 percent
as under:
Discounted value of PN = PN (PV factor for 5 yrs, 15%)
237
= Tk. 271.86 (.497) = Tk. 135.11
Adding together the two present values, we get the intrinsic
value as:
Present value of the first years of dividends = Tk. 46.21
Present value of the share at the end of year five = Tk. 135.11
=========
=
Present value of the share (P0) = Tk. 181.32
238
P0
P0 =
( )E1
×E1
P0 =( PE )×E 1
= 7.50 × 10 = Tk. 75
If the investor’s required rate of return, k, is 12 per cent and
growth rate is being 7 per cent;
P . 60
E
= . 12−. 07
= 12
Therefore, the price for the stock is
P0 =( PE )×E 1
= 12 × 10 = Tk.. 120
If the investor’s required rate of return, k, is 18 per cent and
growth rate is being 7 per cent;
239
P . 60
E
= . 18−. 07
= 5.45
Therefore, the price for the stock is
P0 = ( PE )×E 1
240
For a company with beta () equals to 1, the required rate of
return of the firm, k, will become equal to 12%. The return on
equity (ROE) of that firm would also become equal to the
expected return on the stock (.12). Therefore, the growth of the
firm would become:
g = .12 × .40 = .048 = 4.80%
P (1−. 40 )
=
E (. 12−. 048)
= 8.33.
We may observe that one important implication of stock
valuation model is that riskier stock will have lower P/E multiples
which can be expressed as:
P (1−b)
=
E k−g
P/E= (1b) / (kg).
Riskier firm will have higher required rate of return implying
higher value of k, therefore, P/E multiple will become lower.
Exercise
1. What is meant by common stock? Why are common stocks
called perpetuities?
2. State the basic features of common stock.
3. Enumerate different models of common stock valuation.
4. What is dividend discount model? State the versions of
dividend discount model.
5. Define preferred stock. What are different types of
preferred stocks? Differetiate common stocks from
preferred stocks.
6. An investor expects to get Tk. 10, Tk. 12 and Tk. 15 as
dividend from a share at the end of next three years
respectively. The share is expected to be sold at Tk. 100 at
the end of the third year. If the required rate of return is 10
per cent, what would be the value of the share?
7. Alpha corporation is currently paying Tk. 15 per share as
dividend and it expects dividend to grow at 10 per cent a
year for the foreseeable future. If the investor’s required
241
rate of return is 15 per cent, find the value of Alpha’s share
and comment on the result.
8. Grameen Phone pays Tk. 20 per share and expects to grow
it at 12 per cent a year for five years at the end of which
the new growth rate is expected to be a constant 10 per
cent a year. If the required rate of return is 15 per cent,
find the value of the share of GP.
9. Westec pays Tk. 18 as dividend per share and expects to
grow it at 12 per cent a year for five years at the end of
which the new growth rate is expected to be a constant 10
per cent a year. If the required rate of return is 15 per
cent, how much an investor would pay for the share of
Westec?
10. An investor expects to get Tk. 15, Tk. 18 and Tk. 15 as
dividend from a share at the end of next three years
respectively. The share is expected to be sold at Tk. 150 at
the end of the third year. If the required rate of return is 15
per cent, what would be the value of the share?
11. An investor expects to get Tk. 10, Tk. 12 and Tk. 15 as
dividend from a share at the end of next three years
respectively. The share is expected to be sold at Tk. 100 at
the end of the third year. If the required rate of return is 10
per cent, what would be the value of the share?
12. The EPS of Jahan Mani Corporation is Tk. 30 and its fixed
D/P ratio is 50%. The expected growth rate dividends for
next five years are 12%, 15%, 20%, 10% and 12%
respectively. Thereafter a constant growth rate is
determined as 18%. How much an investor should pay to
purchase the share of Jahan Mani if expected rate of return
is 20%.
13. ABC Ltd. has just paid a dividend of Tk. 20 per share.
Investors require a 15 per cent return from investments. If
the dividend is expected to grow at a steady 10 per cent
per year, what should be the market price of the stock?
What will the stock be worth in five years?
14. A company has just paid a dividend of Tk. 20 per share
and dividend is expected to grow at a rate of 10 per cent
per year for the next 5 years and at a rate of 15 per cent
per year forever after that. What will be the market price of
the stock 10 years?
242
Appendix:
243
When dividend decision is treated as long-term financing
decision, the net earnings of the firm may be viewed as a
long-term source of financing. The declaration of cash
dividends reduces the amount of funds available to finance
growth and either restricts growth or forces the firm to find
other financing sources. Thus, the firm might accept a
guideline to retain earnings as long as either of two
conditions exists:
i. Sufficient profitable projects are available:
The acceptance of highly profitable projects represents a
worthwhile growth goal for most firms. As long as such
projects are available the firm can retain earnings to
finance them.
ii. Capital structure needs equity funds: The
firm has a variety of sources of long-term funds. To avoid
the high risk associated with excessive debt, the firm must
have a balance of debt and equity financing. Because of
the costs of floating common stock, retained earnings are
preferable as equity financing. Hence, earnings may be
retained as a part of the long-term financing decision
related to the management of capital structure.
With either of these guidelines, cash dividends will be
considered as a remainder.
b) As a wealth maximization decision
With this approach, the firm recognizes that the payment
of dividends has a strong influence on the market price of
common stock. Higher dividends increase the value of the
stock to many investors. Similarly, low dividends decrease
the perceived value of the stock. In a wealth maximization
sense, the firm declares sufficient dividends to meet the
expectations of investors and shareholders. The
management of a firm, while evolving a dividend policy,
must strike a proper balance between the aforesaid two
approaches. When the firm increases the retained portion
of the net earnings, dividends decrease and consequently
the market price may be adversely affected and vice-
versa. But according to Merton H. Miller and Franco
Modigliani dividends do not affect market price. According
to James E. Walter, on the other hand, dividend policies
have profound effects on a firm’s position in the stock
market. For the reason we do not yet have any evidence
244
on whether a maximization of wealth approach correctly
deals with the dividend decision.
245
profitability and more importantly, the expectation of
future profitability since the firm would probably conserve
its cash if the management were preparing for future
difficulties.
Need for current income: Many shareholders
require income from their investments to pay for their
current living expenses. These investors may be reluctant
to sell their shares in order to gain cash. Cash dividends
provide current income to those investors without
affecting their principal and capital.
246
par value and the number of outstanding shares, the
capitalization of the company would not be changed at all.
Stock repurchase: A repurchase of stock occurs
when a firm buys back outstanding shares of its own
common stock. A firm repurchases stock for three major
reasons as given below:
i. For stock option: A stock option is the right to
repurchase a specified number of shares of
common stock during a stated period and at a
stipulated price.
ii. For acquisitions: A firm seeking control of another
firm may be willing to offer its own common stock
for the stock of other firm.
iii. For retiring the stock: When a firm retires a
portion of its stock, the retirement increases the
firm’s earnings per share. The repurchase of sock
for the purpose of retiring it is treated a form of
cash dividend by the internal revenue services.
247
of dividend policy is the stability of dividends which
refers to the consistency or lack of variability in the
stream of dividends. In more precise terms it means
that a certain minimum amount of dividend is paid
regularly. The investors favor a stable dividend and
there are several reasons why they would prefer a
stable dividend policy and pay a higher price for a
firm’s shares which observe stability in dividend
payments. So, stability of dividend plays vital role in
dividend policy.
c) Legal, contractual, internal constraints and
restrictions: The firm’s dividend policy is also
affected by certain legal, contractual and internal
requirements and commitments. The legal factors
stem from certain statutory requirements, the
contractual restrictions arise from certain loan
covenants and the internal constraints are the
result of the firm’s liquidity position.
d) Owner’s consideration: The dividend policy is
also affected by the owner’s considerations of the
tax status of the shareholders, their opportunities of
investment and the dilution of ownership.
Undoubtedly, it is well-nigh impossible to establish a
policy that will maximize each owner’s wealth. The
firm must aim at a dividend policy which has a
beneficial effect on the wealth of the majority of the
equity shareholders.
e) Capital market consideration: Another factor
that can strongly affect dividend policy is the extent
to which the firm has access to the capital markets.
In case the firm has easy access to the capital
markets, either because it is financially strong or
large in size, it can follow a liberal dividend policy.
On the other hand, if the firm has only limited
access to the capital markets, it is likely to adopt
low dividend payout ratio. So, in this way dividend
policy is affected by capital market considerations.
f) Inflation: Finally, inflation is the another factor
which affects the firm’s dividend decision. With
rising price, funds generated from depreciation may
be adequate to replace absolute equipments. These
248
firms have to rely upon retained earnings as a
source of funds to make up the shortfall. So,
dividend payout tends to be low during the period
of inflation.
249
Part-Four
Portfolio Management
250
Chapter Seventeen: Bond Portfolio
Chapter- Thirteen
Introduction to Portfolio
251
the portfolio management is a function of dealing with the
analysis of individual securities and with the theory of
combining individual securities into the portfolios.
252
and corners were used for manipulation. As a result, American
stock market crashed in 1929, which is known as famous great
depression.
During 1930s investment management came to its
professionalism phase and ordinary investors used to come into
the market for investment. Investors began to analyze securities
while making investment decisions. Famous security analysts
like Benjamin Graham, David Dodd and Cottle (Grham, Dodd
and Cottle) began to analyze securities for investment purpose
and laid foundation work for the security analysis for
professional investors.
The third stage of investment management is the scientific
stage. Herry Markowitz is called the founder of this stage. His
historical work entitled “Portfolio Selection” published in Journal
of Finance in 1952 marked the beginning of this stage. Herry
Markowitz happened to be the father of modern portfolio theory
attempted to measure risk. He showed how the risk in
investment could be minimized though proper diversification of
investment which required the creation of a portfolio. Markowitz
was awarded Nobel price for economics in 1990 with William
Sharpe (for his contribution to the development of CAPM) and
Merton Miller for his pioneering approach to investment
management.
The investment management approach of Markowitz was
followed by William Sharpe, John Lintner and Jan Mossin through
the development of capital asset pricing model (CAPM).
253
valued properly to safeguard the investors. So security valuation
is the preliminary stage in the portfolio management process.
Security analysis involves the examining the risk-return
characteristics of individual securities. A more popular strategy
in security investment is to buy underpriced securities and sell
overpriced securities. So, proper valuation of securities is a sine-
qua-non for security investment. Two approaches, namely
fundamental analysis and technical analysis (discussed in
chapter 6, 7, 8 and 9) can be used in determining the actual
value of the securities. Fundamental analysis focuses on the
fundamental factors affecting the value of the share such as
earnings per share, profitability, price earning ratio, dividend
payout ratio etc. Technical analysis, on the other hand, asserts
that share price movements are systematic and shows certain
consistent patterns. Historical price movements will determine
the future price of a share. However, if the market is efficient,
the price of security instantaneously and fully reflects all
relevant available information. All the analyses assert that
market prices of the securities should always be equal to their
intrinsic values.
Step-2: Portfolio Anlysis
The motto of building a portfolio is to keep the investible funds
of an investor in different securities that minimizes risk without
sacrifying return because investors are risk averse. Portfolio
analysis in the management process involves the analyzing the
expected rate of return and the level of risk of the portflio
investment. A portfolio constituting of individual securites has
its own risk-return characteristics which are not the aggregrates
of the characteristics of the individual securities of the portfolio.
Step-3: Portfolio Selection
Portfolio analysis provides the input for the portfolio selection.
An investor builds a portfolio that generates higher return at a
given level of or lower risk. On the other hand, an investor also
chooses a portfolio with a lower risk at a given or higher
expected rate of return. A portfolio having these characteristics
is known as an efficient portfolio. From the efficient portfolios,
an investor can select his/her optimal portfolios for investment.
Markowitz portfolio thery provides both theoretical and
conceptual framework for determining the optimal portfolios for
investment.
Step-4: Portfolio Revision
254
After getting the selection of optimal portfolios, investors
require to monitor the portfolio to ensure that it continues to
become optimal according to the criterions of efficient
portfolios. Since the financial market is volatile, changes in the
security prices take place almost daily. A security may incurr
losses once uopn a times it generated profits and vice-versa.
New securities with higher return commensurating lower level of
risk may emerge in the market. Investors should revise their
portfolios in the light of the developments of the market. This
revision leads the investors to purchase some new securities
and sell some of the existing securities. The best performing
securities should be incorporated and bad performing should be
erezed from the portfolio.
Step-5: Portfolio Evaluation
The goal of the portfolio manager or profit seeker is to construct
portfolios that ensure maximum profits with minimum risk.
Portfolio evaluation can be defined as the process of estimating
the performance of a portfolio over a period of time in terms of
return and risk. Hence, the process requires to measure the
actual return realized and the inherent risk of the portfolio over
the period of investment. Portfolio evaluation also provides the
mechanism for identifying the weaknesses in the investment
correcting the deficiencies. This is why, this step of the portfolio
management process is called feedback mechanism for
improving the portfolio management process.
Finally, portfolio management process is a continuous
process. This process should maintain the order of the steps
involved in the whole process. It provides the investors an ideal
feedback for building a better portfolio in future.
Markowitz Portfolio
255
Investors are risk averse. All the rational investors will choose
the security with lower level of risk given a choice between two
securities with equal rates of return. On the other hand,
investors choose the security with higher expected rate of
return among the securities with equal risk or lower risk. In
finance concept, the terms risk and uncertainty are used
interchangeably. Risk is defined as the uncertainty of future
outcome or the probability of an adverse outcome.
Before the development of Markowitz portfolio theory, there was
no specific measure for the risk and the investors had no means
to quantify risk variable. He developed a basic portfolio model
deriving the expected rate of return for a portfolio of assets and
an expected risk measure. He asserts that the variance of the
rate of return is a meaningful measure for the portfolio risk
under a set of assumptions. He shows diversification of
investment can reduce the total risk of a portfolio. However, his
model is based on the following assumptions:
i. Individual investment is considered as being
represented by a probability distribution of expected return.
ii. Investor is supposed to maximize one-period expected
utility and his utility curve demonstrates diminishing marginal
utility of wealth.
iii. Risk of the portfolio is being estimated on the basis of
the variability of expected return.
iv. Investment decision is fully based on expected return
and risk.
v. Investors prefer higher expected return at a given
level of risk and similarly they prefer minimum risk at a given
level of expected return.
From the aforesaid discussion it remains clear that a rational
investor, no doubt, takes additional return and risk rather than
at a desired level. If an investor is interested only to maximize
return, he would tend to hold only the single asset which he fells
will offer the higher future return. However, investors like to
hold portfolios of securities since they are concerned with both
return and risk confirming that diversification may eliminate risk
without any loss of return. Moreover, portfolio asserts that a
single asset or portfolio of assets is considered to be efficient if
no other asset or portfolio of assets offers higher expected rate
of return with the same or lower risk, or lower risk with the
same or higher expected return.
256
Exercises
1. What does the term ‘portfolio’ mean?
2. Define portfolio management.
3. State different steps involved in portfolio management.
Elucidate the portfolio management process.
4. How does portfolio emerge? Show the evolution process of
portfolio management.
5. Why is portfolio evaluation a feedback mechanism for
improving the portfolio management?
6. Define Markowitz portfolio. State the assumptions of
Markowitz portfolio.
7. What are key assumptions underlying the selection of
portfolio by Markowitz?
8.
257
Chapter- Fourteen
Portfolio Analysis
258
proportion of total value for the individual security. It is the
percentage of the total funds invested in individual securites in
the portfolio.
Let us assume that an investor has a total sum of Tk. 1000 to
invest in securities and he likes to put Tk. 600 in security A and
Tk. 400 in security B. Security A generates 10 percent return
and security B generates a return equal to 6 percent. The total
return from Tk. 1000 would be equal to Tk. 84 [(Tk. 600 ×.10) +
(Tk. 400 × .06)]. Hence, the portfolio return would be equal to
8.4 percent (84/1000 × 100). The rate of return from the
portfolio can be estimated by the return divided by the amount
the investor has invested. In this example the portfolio rate of
return can be calculated as:
(841000 )×100=(1000
600 400
)×.10+(1000 )×. 06=8 .6 %
The portfolio return for a particular holding period using
historical data is calculated as: N
r P=∑ w i r i
i=1
where,
rp = portfolio return at time
wi = the weight of the i’th security in the portfolio
ri = rate of return of i’th security.
The term ‘w’ being the portfolio weight is the fraction of the
money the investor invests in each security. The portfolio
weight of security is calculated dividing its value at the
beginning of the period by the beginning value of the portfolio.
Portfolio weights can be estimated as the ratio of amount
invested in individual securities constituting the portfolio which
can be given by the following formula:
Amount invested in stock i
Weight for stock i (wi) =
Total investment
where, N
∑ wi=w1 + w2 +.. .. . ..+ w N =1 .00
i −1
259
0 0 0
Rate of return 8% 12% 10% 9% 14%
The portfolio rate of return can be calculated by following
calculation:
= .1113 = 11.13%
Thus, expected rate of return for a portfolio is the weighted
average of the expected rates of return for the individual
securities in the portfolio. The percentage of a portfolio’s
aggregate value investing in each portfolio asset represent as
portfolio weights. The computation of the expected rate of
return for the portfolio is being formulized
N as follow:
E(r P )=∑ wi ×E(r i )
i=1
where,
E (rp) = expected return on the portfolio at time t
wi = the weight of the i’th security in the portfolio at time
t
E (ri) = expected return on i’th security at time t
∑wi = 1.00
N = number of securities in the portfolio.
260
The information of a hypothetical portfolio using ex ante data is
given below:
Security A B C D E
Amount 2000 300 4000 350 250
invested 0 0 0
Rate of return 14% 10% 9% 12% 15%
The portfolio expected rate of return can be calculated by
following calculation:
Securi Amount Expected Weight [wi×E(ri
ty investe rate of (wi) )]
d return [E(ri)]
A 2000 .14 .13 .0182
B 3000 .10 .20 .0200
C 4000 .09 .27 .0243
E 3500 .12 .23 .0276
D 2500 .15 .17 .0255
1.00 .1156
The expected rate of return for the portfolio, therefore, is:
N
E(r P )=∑ wi ×E(r i )
i=1
= .1156 = 11.56%.
A portfolio weight can be either positive or negative. A positive
weight means that investor is buying the security which means
the long position in the security. The opposite of the long
position is called the short position which means the selling
short. In case of short position the portfolio weight is negative
because the numerator is negative. The example of short selling
can be given by the following explanation. When an investor
sells security short, he borrows the security from someone
(generally from the broker or dealer). Hence, the investor is
obliged to return the number of security he borrowed to the
supplier after a certain period. Suppose an investor borrows 100
shares of ACI from his broker to sell them at Tk. 200 and collects
Tk. 20,000 (Tk. 200×100). Afterward, the price of share of ACI
falls Tk. 180 per share. The investor then goes back into the
market and will have to purchase the 100 shares of ACI for Tk.
18,000 (Tk.180×100). Investor then returns the 100 shares of
ACI to the broker by making a profit of Tk. 2,000 (Tk. 20,000 −
Tk. 18,000). If the investor receives any dividends of ACI during
the period, the investor should pay in cash the amount of
dividends to the broker from which he borrowed the shares.
261
Eventually, investor can invest the money received from selling
short in another security. Suppose an investor has Tk. 10,000 of
his own and sells short Tk. 5,000 of shares of ACI and uses it in
addition to his own money to buy shares of AB Bank. Now what
are the portfolio weights? The investor is buying shares of AB
Bank for Tk. 15,000 which is 150 percent of the investor’s equity
investment of Tk. 10,000. Thus, the portfolio weight for shares
of AB Bank stands 1.5 (15,000/10,000). Therefore, the weight
for shares of ACI would be − 0.50 which can be estimated as:
We know that,
wAB + wACI = 1.00
therefore, w ACI = 1.00 − wAB = 1.00 − 1.5 =
0. − 50.
In this case, if the return for AB Bank is 20 percent and that of
ACI is 15 percent, the portfolio return would be:
rP = (wAB × rAB) + (wACI ×rACI)
= [1.5 × .20] + [(− 0.50) × .15]
= .225 = 22.5%.
Portfolio Risk
The variance and standard deviation of return are the
alternative measures of risk in investment. The portfolio risk is
measured by the portfolio variance and standard deviation. The
calculation of a portfolio variance is not so easy. The reason
behind is that the variance of a portfolio is not a weighted
average of the variance of the individual securities in the
portfolio. For calculating the risk of a portfolio, the riskiness of
each security within the context of the overall portfolio has to
be considered. This depends on the interactive risk of the
securities in the portfolio. The return of a security moves with
the return of the other securities in the portfolio and contributes
to the overall risk of the portfolio as well. Covariance indicates
the interactive risk of a security relative to other securities in
the portfolio. Portfolio variance is directly influenced by the
following factors which determine the riskiness of a portfolio of
two securities:
variance of each security;
covariance between the securities and
portfolio weights for each security
Portfolio risk can be diversified by using equally weighted
portfolios of several securities. An efficient diversification will be
one whereby a risky portfolio can be constructed which provides
262
the lowest possible risk for any given level of expected return.
Several portfolios of two risky assets are very easy to calculate
and analyze. They provide principles and considerations
applying to portfolios of many assets. Before going indepth
analysis, we consider a portfolio oconsisting of two securities
viz., security I and security J.
N
2 2
P
σ =∑ hi [( w A r Ai +w B r Bi )− {w A E (r A )+ w B E(r B ) }]
i=1
The right hand side of the equation can be rewritten as:
N
2 2
σ P =∑ hi [ w A {r Bi −E( r A )}+ w B {r Bi−E( r b )}]
i=1
The squared term tells us to multiply the underscored terms in
the bracket as:
2 2 N 2 N
2
σ P =w A
∑ hi [ r Ai−E ( r A )] +w ∑ hi [ r Bi−(r B )]2
B
i=1 i=1
N
+2 w A wB ∑ hi [ r Ai−E (r A ) ][ r Bi−E(r B ) ]
i=1
263
The first two terms are the variance of securities A and B,
whereas the second two terms are the covariances between
security A and B as given below:
2 2 2 2 2
P A A B B
σ =w σ +w σ + 2 w A w B σ AB
The following Table illustrates the parameters describing the
rate of return of the securities.
Security I J
Expected rate of return, 10% 12%
E (ri)
Standard deviation, σi 8% 10%
Covariance, σij 45
Correlation coefficient, ρij 0.50
A proportion invested in security i is denoted by w i and the
remainder, 1 wi denotes the amount invested in security j, w j.
The variance of the portfolio of two risky securities (security i
and j) with variance σ2i and σ2j respectively with portfolio weights
wi and wj respectively can be calculated by using the following
formulas:
σ2p= [w2iσ2i + w2jσ2j + 2 wiwj σij]
Since σij = σiσj rij
Therefore,
σ2p= [w2iσ2i + w2jσ2j + 2 wiwj σiσj rij]
where,
σ2p= portfolio variance:
wi = portfolio weight for security i;
wj = portfolio weight for security j;
σ2i = variance for security i;
σ2j = variance for security j;
σij = covariance between security i and j;
rij = correlation coefficient between the return of security
i and j;
σi = standard deviation for security i;
σj = standard deviation for security j
The above equations reveal that the portfolio variance can be
reduced if the covariance or correlation term is negative.
It reveals that if the covariance (or correlation
coefficient) term is positive, the portfolio standard
deviation (which is the root of variance) is still less
than the weighted average of the standard deviations
of individual securities, unless the two securities are
perfectly positively correlated.
264
By using the above data, the formulas for the expected return,
variance, and standard deviation of the portfolio are:
E(rp) = .10 × wi + .12 × wj
σ2p = [(.08)2 w2i + (.10)2 w2j + 2 (.08 × .10 × .50 wi
wj)]
2
σp = σ √ P
265
Security i j
w .40 .60
σ 10% 15%
rij .75
The variance of the portfolio (σ2p) consisting of security i and j
can be calculated as:
σ2p= [w2iσ2i + w2jσ2j + 2 wiwj σiσj rij]
= [(.40) 2 (.10)2 + (.60)2 (.15)2 + 2 (.40)(.60)
(.10)(.15)×.75]
= .0016 + .0081 + .0054
= .0151
The standard deviation of the portfolio is:
2
σp = √σ P
If rij = 0 .50:
σ2p= [w2iσ2i + w2jσ2j + 2 wiwjσiσj rij]
= [(.40) 2 (10)2 + (.60)2 (15)2 + 2(.40)(.60)(10)
(15) × .50]
= 16 + 81 + 36
= 133
266
2
σp = √σ P
= √ 133 = 11.53%
If rij = 00:
σ2p= [w2iσ2i + w2jσ2j + 2 wiwjσiσj rij]
= [(.40) 2 (10)2 + (.60)2 (15)2 + 2(.40)(.60)
(10)(15) × 00]
= 16 + 81
= 97
2
σp = √σ P
= √ 97 = 9.85%
If rij = 0.50:
σ2p= [w2iσ2i + w2jσ2j + 2 wiwjσiσj rij]
= [(.40) 2 (10)2 + (.60)2 (15)2 + 2(.40)(.60)(10)
(15) × (0.50]
= 16 + 81 36
= 61
2
σp = √σ P
= √ 61 = 7.81%
If rij = 1:
σ2p= [w2iσ2i + w2jσ2j + 2 wiwjσiσj rij]
= [(.40) 2 (10)2 + (.60)2 (15)2 + 2(.40)(.60)(10)
(15) (1.00]
= 16 + 81 72
= 25
2
σp = σ √= 25 = 5 %
P
√
Summary Table
Standard deviation weight
Security- Security- Security- Security rij σp
i j i -j
+
13.00
1.00%
0.50
11.53
10% 15% .40 .60 %
00 9.85%
– 0.50 7.81%
– 1.00 5.00%
The standard deviation of the portfolio will be affected by the
correlation between two securities. The standard deviation of
the portfolio is positively correlated with correlation coefficient.
267
Portfolio standard deviation will decline if the
correlation coefficient moves from +1 to
downward and will increase if the correlation
coefficient moves from 1 to upward.
Diversification
Diversification is the process by which securities are combined
in a portfolio. Diversification reduces the risk without sacrificing
portfolio return. The process of reducing investment risk
through portfolio diversification in given in Figure 14.1. In the
example given above, portfolio risk is found to lie between the
standard deviations for the securities when rij = 1 and .50 and
lower than the two standard deviations when r ij = 1 and .50.
To find out the impact of diversification, it is essential to
consider the impact of correlation coefficient on portfolio risk
more closely. To know the influence of diversification on the
portfolio risk, we can examine the following cases.
p
▪
▪
▪
▪ Total risk
▪
▪
▪ Unsystematic risk
▪
▪ Systematic risk
▪ ▪ ▪ ▪ ▪ ▪ ▪ ▪ ▪ ▪
Number of securities in the portfolio
Figure-14.1: Reduction of risk through diversification of assets.
268
the relative comovements between the returns of two securities
is referred to as correlation coefficient. It is a relative measure
of association that is bounded by + 1 to 1. When the
correlation coefficient between two securities is + 1, the
security returns are perfectly positively correlated. With perfect
positive correlation, the returns have a perfect direct linear
relationship. Let us recall the formula for portfolio variance:
σ2p= [w2iσ2i + w2jσ2j + 2 wiwj σiσj rij]
Under the regime of perfect positive correlation, the correlation
coefficient (rij) is equal to +1 and thus the portfolio variance
would become:
σ2p= [w2iσ2i + w2jσ2j + 2 wiwjσiσj]
The right hand side of the equation can be expressed like a 2 +
2ab + b2 and thus be rewritten as:
σ2p= [(wiσi)2 + 2 (wiσi)(wjσj) + (wjσj)2]
= [(wiσi) + (wjσj)]2
The standard deviation of the portfolio would become:
269
would decrease at the same time and vice versa. When the
correlation coefficient between two securities is 1, the security
returns are perfectly negatively correlated. With perfect
negative correlation, the returns have a perfect inverse linear
relationship to each other. Let us recall again the formula for
portfolio variance:
σ2p= [w2iσ2i + w2jσ2j + 2 wiwjσiσj rij]
Under the regime of perfect negative correlation, the correlation
coefficient (rij) is equal to 1 and thus the portfolio variance
would become:
σ2p= [w2iσ2i + w2jσ2j 2 wiwjσiσj]
The right hand side of the equation can be expressed like a 2
2ab + b2 and thus be rewritten as:
σ2p= [(wiσi)2 2 (wiσi)(wjσj) + (wjσj)2]
= [(wiσi) (wjσj)]2
The standard deviation of the portfolio would become:
= √[(.40)(10)−(.60)(15)] 2
= √ (4−9) 2
= √ (−5) 2
= √ 25 = 5%
The portfolio standard deviation is low. If the portfolio weights
for security i and j in the above example are changed as .60 and
.40 respectively, the portfolio standard deviation would become:
σp= [(wiσi) (wjσj)]
270
= [(.60)(10) (.40)(15)]
= [6 6] = 0
Zero portfolio standard deviation indicates that the portfolio of
the securities with perfect negative correlation may become
entirely risk-free though it contains risky assets. So,
diversification becomes effective when securities are perfectly
negatively correlated.
Zero Correlation
If the movements of returns of two securities are independent of
each other, the covariance is said to be zero. It implies that if
the return for one security increases, the return for the other
will remain constant. With zero correlation coefficient (r ij = 0),
the formula for portfolio variance would become:
σ2p= [w2iσ2i + w2jσ2j + 2 wiwj σiσj rij]
Since the correlation coefficient between the securities is zero
(rij = 0), the above formula would become:
σ2p = [w2iσ2i + w2jσ2j]
The standard deviation of the portfolio would become:
2 2 2 2
σ p= √w σ +w σi i j j
= √[(.40)2(10)2+(.60)2 (15)2 ]
= √ 16+81
= √ 97
= 9.85%
Portfolio standard deviation is lower than the standard
deviations of the individual securities in the portfolio. So,
diversification becomes effective when securities are not
correlated.
271
the better. The portfolio variance for three-security (Security i, j
and k) can be estimated by using the following formula:
2 2 2 2 2 2
2
[ i i
k j j k
σ =¿ w σ +w σ +w σ +2w i w j σ ij +2wi w k σ ik ¿ ¿ ¿¿
P
]
¿
Again,
2 2 2 2 2 2
2
[ i i j j k k
σ =¿ w σ +w σ +w σ +2w i w j σ i σ j r ij +2w i w k σ i σ k r ik ¿ ¿ ¿¿
P
]
¿
However, the variance for a portfolio of three or more securities
can also be estimated by using the following formula:
N N N
2 2 2
P i i
σ = w σ + w i w j σ ij
∑ ∑∑
i=1 i=1 j=1
where,
i≠j
σ2p= portfolio variance
wi = portfolio weight for security i
wj = portfolio weight for security j
σ2i = variance of return of security i
σ2j = variance of return of security j
σij = covariance between security i and j
∑ ∑ = N2 numbers are to be added together
For N number of securities, covariances are N(N –1) and unique
covariances are [N (N –1)]/2. The contribution of each security’s
own risk the total portfolio risk will be extremely small. The
portfolio risk consists almost entirely of the covariance risk
between the securities. The first part of the equation of σ2p is:
N
2 2 2
σ =∑ w i σ
P i
i=1
If equal amount is invested in each securities, the weight would
become 1/N. So,
N
2 1 2
σ =∑ ( N )2 σ
P i
i=1
272
N
2 1 1 2
P i
σ =∑ ( N )( N )σ
i=1
N 2
2
P 1 σi
σ =N ∑N
i=1
σ2i/N represents an average variance for the stocks in the
portfolio. The larger the number of securities in the portfolio, the
smaller the σ2p. Therefore, by ignoring the first part of the right
hand side of the equation, the risk of the portfolio is attributable
to:
N N
2
P
σ = w i w j σ ij
∑∑
i=1 j=1 [i ≠ j]
The portfolio variance and standard deviation depend on the
proportion of investment in each security in the portfolio called
portfolio weight, the variance of each security and covariance
between the securities in the portfolio. Let us consider a
portfolio with three securities namely A, B and C. The proportion
of investment in each of the securities (portfolio weights) are
25%, 35% and 40% respectively. The variance of each security
(σi×σi = σi2), and covariance of each possible pair of securities
(σij ) can be given by the following variance-covariance matrix:
Cell
Stock A B C
A 40 45 30
Row B 45 35 50
C 30 50 25
Weights .25 .35 .40
(wi)
273
securities represented by that cell. This process can be started
from the first cell in the first row and should continue till the last
cell in the last row is reached. By summing the products,
resulting figure is the portfolio variance.
From the information regarding security A, B and C, the risk of
the portfolio constituting them can be estimated by using the
following formula:
N N
2
P
σ = w i w j σ ij
∑∑
i=1 j=1
This formula can be arranged by replacing A, B and C for i and j
as follows:
σ2p= [(wAwA σAA) + (wAwB σAB) + (wAwC σAC) +
(wBwA σAB) + (wBwB σBB) + (wBwC σBC ) +
(wCwA σAC) + (wCwB σBC) + (wCwC σCC)]
= [(.25×.25×40) + (.25×.35×45) + (.25×.40×30)
+
(.35×.25×45) + (.35×.35×35) + (.35×.40×50) +
(.40×.25×30) + (.40×.35×50) + (.40×.40×25)]
= 38.67
Therefore,
2
σp = √σ p
= 38.67 = 6.22 √
An alternative method of calculating portfolio standard veriation
by using the above information can be defined as:
2 2 2 2 2 2 2
=¿ [ w ]
A
σ P
σ A +w B σ B +w C σ C ¿ ¿ ¿ ¿
¿
= [(.25)2 (40) + (.35)2 (35) + (.40)2 (25)
+ 2 × (.25)(.35)(45) + 2 × (.25)(.40)(30) + 2 × (.35)
(.40)(50)]
= 2.50 + 4.29 + 4.00 + 7.88 + 6.00 + 14.00
= 38.67
Therefore,
274
2
σ P= σ√ P
= 38.67 = 6.22
√
Since, the covariance between two securities is the product of
correlation coefficient between the two securities and the
standard deviations of the two securities, the following equation
can be given for covariance.
σij = rij σiσj
Therefore, the covariance term of the above equation can be
replaced by the product of correlation coefficient and the
standard deviations of the securities. Thus, the above formula
can be rewritten as:
N N
2
P
σ = ∑∑ w i w j σ i σ j r ij
i=1 j=1
If the correlation coefficient between the securities is given by
the following way, the portfolio variance would be calculated by
using the above formula. An illustration can be given for
calculating portfolio variance. Consider the following information
regarding security A, B and C.
Stock Std. Correlation coefficient
dev. A B C
(σi)
A 16 1.00 0.80 0.50
B 12 0.80 1.00 0.75
C 10 0.50 0.75 1.00
Weights (wi) .25 .35 .40
It can be noted here that the correlation coefficient of a security
with itself is equal to 1:
2
σ ii σ i
r ii= = =1
σ i×σ i σ 2i
Since, ij
σ =σ σ r
i j ij , the above information can be shown in
variance –covariance matrix. The following table shows the
product of rij, σi and σj which is equal to σij:
Stock A B C
σA σA rAA σA σB rAB σA σC rAC
A
= σAA = σAB = σAC
σB σA rAB σB σB rBB σB σC rBC
B
= σAB σBB σBC
C σC σA rAC σCσB rBC σC σC rCC
275
= σAC = σBC = σCC
Weights .25 .35 .40
(wi)
= [(.25×.25×256) + (.25×.35×153.6) +
(.25×.40×80) +
(.35×.25×153.6) + (.35×.35×144) +
(.35×.40×90) +
(.40×.25×80) + (.40×.35×90) +
(.40×.40×100)]
= 117.72
Therefore,
2
σp = √σ p
276
= 117.72 = 10.85
√
From a given set of ‘n’ securities, any number of portfolios can
be created. The portfolios can be set up by two securities, three
securities, four securities and so on. Another portfolio can be
built by the same securities with different weights. Hence, new
portfolios can be created either by changing the securities in the
portfolio or by changing the proportion of investment in the
existing securites constituting the portfolio.
N
2 2
P
σ =∑ hi [( w A r A +wB r B )−{ w A E(r A )+w B E ( r B ) }]
i=1
The right hand side of the equation can be rewritten as:
N
2 2
P
σ =∑ hi [ {w A (r Ai −E[ r A ])}+{wB (r Bi −E[ r B ])}]
i=1
277
Exercises
1. Define portfolio return and risk.
2. State the significance of covariance in the elimination of
portfolio risk.
3. Consider the following information:
Security A B C D E
Amount 10,00 15,00 25,00 20,00 30,00
invested 0 0 0 0 0
Expected 16% 10% 12% 9% 13%
return
Estimate the expected rate of return of the portfolio
consisting of the above securities.
4. Define portfolio weights. How can an investor estimate a
portfolio weight?
5. Define the concepts of long position and short position.
6. What is short selling? Explain the concept of short selling.
7. How can short selling increase the expected rate of return
for a portfolio?
8. Suppose an investor purchased shares of A for Tk. 10,000,
shares of B for Tk. 5,000 and borrows by borrowing Tk.
5,000. If the transactions constitute the investor’s portfolio,
find the portfolio weights.
9. Suppose you purchase security A and B for Tk. 1,000 and Tk.
500 respectively and borrow Tk. 500. If these transactions
constitute your entired portfolio, what would be the portfolio
weights for each component of the portfolio?
10.
11. Stock A and stock B have the following information:
Stock A B
Std. dev. 16% 12%
σ(r)
Weight (w) .40 .60
Estimate the portfolio standard deviations if the correlation
coefficient between the stocks (r A,B) is 1.00, 0.50, 00, -0.50,
and -1.00.
278
Chapter- Fifteen
Portfolio Selection
and Revision
Selection of assets
Determining risk-return
trade-offs
Determining the optimal
279
mix
Managing portfolio
performance
280
future implicitly presumes an infinite planning or forecasting
horizon, whereas forecasting using the appropriate economic
scenarios approach has a 3 to 5-year planning horizon.
Expected return
281
Risk (σ)
Figure-15.1: Attainable set and efficient set of portfolios
The risk averse investors should select the portfolios with the
lowest possible risk for a given level of return. A portfolio having
the minimum standard deviation is called global minimun
variance portfolio because no other minimum variance
portfolio has a smallest risk. The bottom segment of the
minimum variance frontier is dominated by portfolios of the
upper segment. The segment of the minimum variance frontier
above the minimum variance portfolio offers the investors the
best return-risk trade-offs. This segment is called efficient
frontier. No portfolio on the efficient frontier dominates any
other portfolio. All the portfolios in the line meets the objectives
of the investors.
All the portfolios in the efficient frontier have the
maximum expected rate of return for a given level
of risk or minimum risk for a given level of expected
rate of return.
More specifically, the efficient frontier represents that set of
portfolios having the maximum expected rate of return for
every given level of risk or minimum risk for every level of
return. A portfolio in the efficient frontier that has the highest
utility to the investor is called an optimal portfolio. Optimal
portfolio lies at the point of tendency between the efficient
frontier and the curve with the highest possible utility.
Therefore, an optimal portfolio occurs at the point of tendency
between the investor’s highest indifference curve and the
efficient set of portfolios.
The portfolio an investor selects from the efficient frontier
depends on the investor’s degree of risk aversion. A highly risk
averse (defensive) investor chooses a portfolio on the lower left
282
hand segment of the efficient frontier. On the other hand, an
aggressive investor will choose on the upper portion of the
efficient frontier. However, Markowitz used the technique of
quadratic programming to select the efficient portfolios. Using
the expected return and risk of individual securites and the
covariance for each pair of securities, Markowitz calculated
return and risk for all possible portfolios. For any specific
portfolio expected return, minimum portfolio risk can be
determined by using quadratic programming. With another
expected portfolio return, a similar procedure may give the
minimum risk portfolio. The minimum risk portfolios constitute
the set of efficient portfolios.
283
Single Index Model
A less restrictive form of the single index model is known as
market model. It relates the return on each stock to the return
on the market using a linear relationship with intercept (α) and
slope (β). Market model is identical to the single index model
except that the assumption of the error terms for different
securities being uncorrelated is not made. According to the
characteristic line, the systematic risk input and intercept for an
individual stock (stock i) are derived from the market model.
General understanding about the securities market is that when
the overall market is up, the market prices of most of the stocks
increase and when the market is down, most stocks in the
market experience negative returns. Therefore, the changes in
the individual security prices can be attributed to the changes in
the overall market. There are many variables affecting security
prices which are common to all assets. The overall level of
interest rates, as for example affect the pricing of all bonds. The
effect on stock prices of this type of variable is termed as
market factor affecting the prices of all securities in the market.
This market effect is due to the relationship between individual
security returns and the return on the market portfolio which is
suggested by the theory called capital asset pricing model
(CAPM). CAPM asserts that it is the sensitivity of individual
securities to changes in the return from market portfolio and
this determines the return an investor might expect for each
security. This sensitivity of individual securities to changes in
the overall market return is measured by its beta. CAPM argues
that the differences between required returns associated with
various securities are due to differences in the securities’ betas.
However, the assumptions of the market model are given below:
Returns from individual securities are related to each
other through a common relationship with an index of
the overall market.
There exists a linear relationship between individual
security and the market index.
The relationship between the return for a particular security and
the market index can be expressed as follows:
rit = i + βi (rmt)+ еit
where,
rit = return on stock i at time t,
rmt = return on market at time t,
еit = error term
284
i = alpha intercept of the regression which equals
Ri i×Rm
i = systematic risk (beta) of stock i which equals
σim /2m
If is assumed to be zero and is 1, the market model is called
zero model. The systematic risk as measured by beta (i) shows
how sensitive a stock’s return is to the return on the market
index. It measures the extent to which the return of a security
will vary with changes in the market return.
Suppose the beta parameter of a stock is 1.25. The market
return increases by 10 per cent. So, the return for the stock is
expected to increase by 12.5 per cent (10 % × 1.25). If the
market return decreases by 10 per cent, the return for the stock
is expected to decrease by 12.5 per cent. A stock with beta of .
75 increases return by 7.5 per cent if the market return
increases by 10 per cent and if the market return deceases by
10 per cent, the return for the stock would decrease by 7.5
percent (10 % × 0.75). Alpha intercept, on the other hands,
indicates the return a stock can earn when market return is
zero. As for example, a stock with an alpha of 5 per cent is
expected to earn 5 per cent return when market return is zero
and the stock is also expected to earn an additional return of 5
per cent at all levels of market return. On the other hand, a
stock with an alpha of negative (–) 2.5 per cent is expected to
lose 2.5 per cent return when market return is zero and the
stock is also expected to earn 2.5 per cent less at all levels of
market return. Therefore:
Positive alpha represents an expected return and a
desirable aspect of a security. On the other hand,
negative alpha represents a panelty to the investor
and an undesirable aspect of a security
The term еit, in the single index model represents the
unexpected return which is not identified by the market. It is the
error term that influences the return for a stock which is not
influenced by the market return. Company-wide firm specific
factors are responsible for proportion of return which is known
as error term or residual. It may take any value but over a large
number of observations it would average out to zero.
When alpha of the single index model is assumed to zero and
beta is 1 as we came to know, the market model is called zero
model which is:
285
rit = rmt + еit
Therefore, the residual term of the model becomes:
еit = rit – rmt
Positive residual represents excess return of a stock over
market return whereas negative residual represents the
magnitude of the return which less than market return.
However, William Sharpe modified the Markowitz model of
portfolio selection. He suggested that a satisfactory modification
may be achieved by abandoning the covariance of each security
with each other security and substituting in its place the
relationship of each security with a market index. The
modification is that Sharpe model requires only N beta
coefficients in stead of [N(N-1)/2] covariance terms in the
Markowitz model. This modification of market model (also
Markowitz model) is known as Sharpe index model.
where,
σ2i = variance for security i
286
σ2m = variance for market index
σ2ei = residual variance for securuty i
βi = beta coefficient for security i
287
Residual 180 290 385 110 205
variance
Weight .20 .15 .25 .30 .10
Findout the followings:
i. Portfolio alpha
ii. Portfolio beta
iii. Portfolio residual variance
iv. Average portfolio return when market return is 10%
v. Portfolio standard deviation when market variance is
100.
Calculation table:
Stoc Weig Alph Beta Residual
w i2 ×
k ht a (βi) variance wi×αi wi×βi
σ2ei
(wi) (αi) (σ2ei)
A .20 2.50 1.00 180 0.50 0.200 7.200
0
B .15 3.50 1.25 290 0.52 0.188 6.525
5
C .25 4.00 0.75 385 1.00 0.188 24.063
0
D .30 2.00 1.45 110 0.60 0.435 9.900
0
E .10 1.00 0.50 205 0.10 0.050 2.050
0
Total 2.72 1.061 49.738
5
Solution:
i. Portfolio alpha N
α P =∑ wi ×α i
i=1
= 2.725
ii. Portfolio beta N
β P=∑ wi ×β i
i=1
= 1.061
iii. Portfolio residual variance
N
2 2
eP
σ =∑ w i ×σ 2 ¿
i=1
= 49.73
iv. Average portfolio return when market return is 10%
288
r P =α P +[ β P ×(r m )]
= 2.725 + 1.061(10)
= 13.34%
v. Portfolio standard deviation when market variance is
100. N
2 2 2 2
P P m i 2¿
σ = β ×σ + ∑ w ×σ
i=1
= [(1.061)2 × (100)] + 49.738
= (1.1257)(100) + 49.738
= 162.308
Therefore,
Portfolio standard deviation
2
√
σ P= σ P
=√ 162.308 =12.74
Sharpe index model tells us to estimate the portfolio return as:
N
r P=∑ W i ( α i + β i ×r m )
i=1
where,
rP = expected portfolio return
wi = proportion of the portfolio devoted to stock i
rm = eturn for market index
αi and βi alpha and beta coefficient for stock i
Let us consider the following information:
Stock A B C D E
Alpha 2.50 3.50 4.00 2.00 1.00
Beta 1.00 1.25 0.75 1.45 0.50
Weight .20 .15 .25 .30 .10
Also assume that market index return is 8.50%. From the the
information given above calculate portfolio return.
Solution:
Stoc Weig Alph Beta
k ht a (βi) wi [αi + βi (rm)]
(wi) (αi)
A .20 2.50 1.00 .20 [2.50 + 1.00 (8.5)]
= 2.20
B .15 3.50 1.25 .15 [3.50 + 1.25 (8.5)]
= 2.12
C .25 4.00 0.75 .25 [4.00 + 0.75 (8.5)]
= 2.59
D .30 2.00 1.45 .30 [2.00 + 1.45 (8.5)]
289
= 4.30
E .10 1.00 0.50 .10 [1.00 + 0.50 (8.5)]
= 0.53
= 11.74
Therefore, portfolio return is:
N
r P =∑ W i ( α i + β i ×r m )
i=1
= 11.74%
William Sharpe called the variance explained by the index as
the systematic risk. Unexplained variance is called residual
variance or unsystematic risk. According to Sharpe index
systematic risk for an individual security can be calculated as:
Systematic risk = β2i×σ2m
Unsystematic risk ( е2i) = [Variance – Systematic
risk]
Therefore,
Total risk for individual security is:
(σ2i) = [β 2i × σ2m] + е2i
and portfolio variance is:
N 2 N
σ P=
2
[( ∑ wi ×β i σ
i=1
) 2
m
] [(
+ ∑w
i=1
2
i
×ε
2
i
)]
Markowitz Model vs. Single Index Model
Single index model is the simplified model of Markowitz model.
The covariance term in the Markowitz model is modified to
achieve single index model. This simplification reduces the
inputs required for portfolio analysis. In the single index model
only three estimates are needed for each security constituting
the portfolio. These estimates are: risk-free return (α)
systematic risk measured by beta coefficient (β) and variance of
residual return (σ2e). In addition to these, two estimates of
market index are needed. These are: return for market and
variance of the return for market index. Therefore, for N security
case, the number of estimates for the portfolio analysis is:
3N + 2
For a portfolio of 50 securities, the total estimates needed are
(3×50) + 2 = 152.
On the other hand, the number of estimates for the portfolio
analysis the Markowitz model is:
[N (N –1)/2] + 2N
290
So, for a portfolio of 50 securities, the total estimates needed
are:
[50 (50 –1)/2] + (2×50) = 1325.
By using single index model portfolio expected return and
portfolio variance can be calculated for finding efficient
portfolios and portfolio. It would be needed for analyzing and
selecting portfolios.
Pricing of Securities
You are given the following information:
Security A B C D E F Total
Estimated .32 .30 .25 .20 .18 .22
return
Beta (βi) 1.90 2.1 1.7 1.10 0.85 1.0
0 5 0
Weight (wi) .10 .30 .20 .15 .15 .10
(wi × βi) 0.1 0.6 0.3 0.16 0.127 0.1 1.56
9 3 5 5 5 0 25
Assume that the market return is 15 % and the risk-free return
is 7 %. Calculate:
i. Which of the security given above are undervalued?
ii. Estimate the expected return and risk of the portfolio
of the securities listed above by using the security market line.
Solution:
i. According to the CAPM, the expected rate of return of a
security can be calculated by the formula:
E( ri) = rf + βi(rm − rf)
Calculation Table
Given rm = 15 %, rf = 7 %
Securi beta Expected return Estimat
ty ed
return
A 1.90 E(rA) = .07 + 1.90 (.15 − .07) = .32
.222
B 2.10 E(rB) = .07 + 2.10 (.15 − .07) = .30
.238
C 1.75 E(rC) = .07 + 1.75 (.15 − .07) = .25
.21
D 1.10 E(rD) = .07 +1.10 (.15 − .07) .20
= .158
E 0.85 E(rE) = .07 + 0.85 (.15 − .07) .18
= .138
F 1.00 E(rF) = .07 + 1.00 (.15 − .07) .22
291
= .15
Comments: All the securities are overpriced since their
expected returns are lower than the estimated returns.
ii. The portfolio systematic risk (beta):
N
β P=∑ wi ×β i
i=1
= 1.5625
Portfolio expected rate of return by using security market line
(SML):
E (rp) = rf + βp (rm − rf)
= .07 + 1.5625 (.15 −.07)
= .07 + .125 = .195 = 19.5 %
Combinations Line
A combinations line can be drawn on a graph by plotting the
expected rate of returns against the standard deviation of
different portfolios. Each point on the line shows the expected
292
rate of returns and standard deviation of a portfolio of two
securities with given portfolio weights. Each point on the
combinations line represents a different set of portfolio weights
in the securities.
We know that,
For a portfolio of security A and B
W A + WB = 1
Therefore,
WB = (1 – WA)
Then,
E(rp) = [WA × E(rA)] + [(1 – WA) × E(rB)]
σ2p = [w2Aσ2A + (1– wA)2σ2B + 2 wA (1– wA) σAσB rAB]
½
σp = [w2Aσ2A + (1– wA)2σ2B + 2 wA (1– wA) σAσB rAB]
Likewise,
If wA = 1.00
Therefore wB = (1.00 − wA)
293
= (1.00 – 1.00) = 00
Portfolio return would be:
E(rp) = [1.00 × 0.12 ] + [00 × 0.10]
= 0.12 = 12 %
and portfolio standard deviation would be:
σp= [{(1.00)2 × (0.08)2} + {(00)2 × (0.12)2} ]1/2
= 0.08 = 8 %
If wA = 0.75,
Therefore wB = (1.00 − wA)
= (1.00 – .75) = .25
Portfolio return would be:
E(rp) = [.75 × 0.12] + [0.25) × 0.10]
= 0.115 =11.50 %
and portfolio standard deviation would be:
σp = [{(.75)2 × (0.08)2} + {(.25)2 × (0.12)2} ]1/2
= 0.06 = 6 %
If wA = .50,
Therefore wB = (1.00 − wA)
= (1.00 – .50) = .50
Portfolio return would be:
E(rp) = [.50 × 0.12] + [.50 × 0.10]
= 0.11 = 11 %
and portfolio standard deviation would be:
σp= [{(.50)2 × (0.08)2} + {(.50)2 × (0.12)2} ]1/2
= 0.07 = 7 %
If wA = .25
Therefore wB = (1.00 – wA)
= (1.00 −.25 ) = 00
Portfolio return would be:
E(rp) = [.25 × 0.12] + [.75 × 0.10]
= 0.105 = 10.50 %
and portfolio standard deviation would be:
σp= [{(.25)2 × (0.08)2} + {(.75)2 × (0.12)2} ]1/2
= 0.09 = 9 %
If wA = − 0.50,
Therefore wB = (1.00 – wA)
= [1.00 − (– .50) = 1.50
Portfolio return would be:
E(rp) = [− 0.50 × 0.12] + [1.50 × 0.10]
= 0.09 = 9 %
294
and portfolio standard deviation would be:
σp= [{(−.50)2 × (0.08)2} + {(1.50)2 × (0.12)2} ]1/2
= 0.18 = 18 %
The summary table:
WA 1.50 1.00 0.75 0.50 0.25 −0.
50
WB −. 00 0.25 0.50 0.75 1.50
50
E(rp) .13 .12 . .11 .1050 .09
115
0
σp . .08 .06 .07 .09 .18
134
2
E(r p)
Combinations
line
5 10 15 σp
295
R
B
RA
296
σ P =√[ w A σ A +(1−w A )σ B ]2
297
wB = (1.00 − wA)
= (1.00 – .50) = 0.50
Therefore, portfolio return would be:
E(rp) = [.50 × 0.12] + [.50 × 0.10]
= 0.11
and portfolio standard deviation would be:
σp = [(.50) × (0.08)] + [(.50) × (0.12) ]
= 0.10
If wA = .25
wB = (1.00 − wA)
= (1.00 – .25) = 0.75
Therefore, portfolio return would be:
E(rp) = [.25 × 0.12] + [.75 × 0.10]
= 0.105
and portfolio standard deviation would be:
σp= [(.25) × (0.08) + [(.75) × (0.12) ]
= 0.11
If wA = − 0.50,
wB = (1.00 − wA)
= [1.00 – (– .50)] = 1.50
Therefore, portfolio return would be:
E(rp) = [(− 0.50) × 0.12] + [1.50 × 0.10]
= 0.09
and portfolio standard deviation would be:
σp = [(−.50) × (0.08)] + [(1.50) × (0.12)]
= 0.14
The summary table:
WA 1.50 1.00 0.75 0.50 0.25 −0.
50
WB − 00 0.25 0.50 0.75 1.50
0.50
E(rp) .13 .12 .115 .11 .105 .09
σp .06 .08 .09 .10 .11 .14
The relationship between the expected return and standard
deviation of different portfolios of securities, having perfect
positive correlation, can be shown in Figure 15.3.
E(rP)
298
σP
Figure-15.3: Shows the combinations of returns and standard
deviations of portfolios of securities having perfect positive
correlation.
299
equation. Assuming the preceeding expression, we can
calculate the expected returns and standard deviations of
different portfolios having different values for w A. The following
example can be given:
If wA = 1.50
wB = (1.00 − wA)
= (1.00 – 1.50) = − 0.50.
Therefore, the portfolio return would be:
E(rp) = [1.50 × 0.12] + [(– 0.50) × 0.10]
= 0.13
and portfolio standard deviation would be:
σ P =√[ w A σ A−(1−w A )σ B ]2
σ P=√[ {(1. 50)×(. 08)}−{(−0 .50 )×(0.12 )}]2
=√ [.18]2 = .18
Likewise,
If wA = 1.00
wB = (1.00 − wA)
= (1.00 – 1.00) = 00
Therefore, portfolio return would be:
E(rp) = [1.00 × 0.12] + [00 × 0.10]
= 0.12
and portfolio standard deviation would be:
σ P =√[ w A σ A−(1−w A )σ B ]2
σ P =√[ {(1. 00 )×(. 08 )}−{( 00)×(0 .12 )}]2
=√ [.08]2 = .08
If wA = 0.75
wB = (1.00 − wA)
= (1.00 – .75) = .25
Therefore, portfolio return would be:
E(rp) = [.75 × 0.12] + [0.25 × 0.10]
= 0.115
and portfolio standard deviation would be:
σ P =√[ w A σ A−(1−w A )σ B ]2
σ P=√[ {(.75 )×(. 08 )}−{(.25 )×(0. 12)}]2
=√ [.03]2 = .03
300
If wA = .50
wB = (1.00 − wA)
= (1.00 – .50) = .50
If wA = .25
wB = (1.00 − wA)
= (1.00 – .25) = .75
Therefore, portfolio return would be:
E(rp) = [.25 × 0.12] + [.75 × 0.10]
= 0.105
and portfolio standard deviation would be:
σ P =√[ w A σ A−(1−w A )σ B ]2
σ P=√[ {(.25 )×(.08 )}−{(.75 )×(0. 12)}]2
=√ [−0.07 ]2 = .07
If wA = − 0.50
wB = (1.00 − wA)
= [1.00 – (–.50) = 1.50
Therefore, portfolio return would be:
E(rp) = [( − 0.50) × 0.12] + [1.50 × 0.10]
= 0.09
and portfolio standard deviation would be:
σ P =√[ w A σ A−(1−w A )σ B ]2
σ P=√[ {(−0. 50 )×(. 08 )}−{(1 .50 )×(0.12 )}]2
=√ [−0.22]2 = 0.22
The summary table:
WA 1.50 1.00 0.75 0.50 0.25 – 0.50
301
WB − 00 0.25 0.50 0.75 1.50
0.50
E(rp) .13 .12 .115 .11 .105 .09
σp .18 .08 .03 .02 .07 .22
The relationship between the expected return and standard
deviation of different portfolios can be shown in Figure 15.4.
E(rP)
σP
302
having different values for wA. The following example can be
given:
If wA = 1.50
wB = (1.00 − wA)
= (1.00 – 1.50) = − 0.50.
Therefore, the portfolio return would be:
E(r P )=w A ×E(r A )+w B ×E(r B )
= [1.50 × 0.10] + [(– 0.50) × 0.04]
= 0.13
and portfolio standard deviation would be:
σ P=[ w A σ A ]
= 1.50 × .05 = .075
Likewise,
If wA = 1.00
wB = (1.00 − wA)
= (1.00 – 1.00) = 00
Therefore, portfolio return would be:
E(r P )=w A ×E(r A )+w B ×E(r B )
= [1.00 × 0.10] + [00 × 0.04]
= 0.10
and portfolio standard deviation would be:
σ P=[ w A σ A ]
= 1.00 × .05 = .05
If wA = 0.75
wB = (1.00 − wA)
= (1.00 – .75) = .25
Therefore, portfolio return would be:
E(r P )=w A ×E(r A )+w B ×E(r B )
= [.75 × 0.10] + [0.25 × 0.04]
= 0.085
and portfolio standard deviation would be:
σ P=[ w A σ A ]
= .75 × .05 = .0375
If wA = .50
wB = (1.00 − wA)
= (1.00 – .50) = .50
Therefore, portfolio return would be:
E(r P )=w A ×E(r A )+w B ×E(r B )
= [.50 × 0.10] + [.50 × 0.04]
303
= 0.07
and portfolio standard deviation would be:
σ P=[ w A σ A ]
= 0.50 × .05 = .025
If wA = .25
wB = (1.00 − wA)
= (1.00 – .25) = .75
Therefore, portfolio return would be:
E(r P )=w A ×E(r A )+w B ×E(r B )
= [.25 × 0.10] + [.75 × 0.04]
= 0.055
and portfolio standard deviation would be:
σ P=[ w A σ A ]
= .25 × .05 = .0125
If wA = 2.00
wB = (1.00 − wA)
= [1.00 – 2.00) = -1.00
Therefore, portfolio return would be:
E(r P )=w A ×E(r A )+w B ×E(r B )
= [2.00 × 0.10] + [(-1.00) × 0.04]
= 0.16
and portfolio standard deviation would be:
σ P=[ w A σ A ]
=2.00 × .05 = .10
The summary table:
WA 1.50 1.00 0.75 0.50 0.25 2.00
WB − 00 0.25 0.50 0.75 -1.00
0.50
E(rp) .13 .10.085 .07 .055 .16
σp .075 .05 . .025 . .10
037 012
5 5
Investment in security A and B can be plotted in Figure 15.5. A
risky security is plotted at point A with an expected rate of
return of 10 per cent and standard deviation of 5 per cent. A
risk-free rate of return is plotted at point B, where the return is
assumed to be 4 per cent without taking any risk. When one of
304
two investments is risk-free, as it is in our example, the
combination line is straight line.
E(rP)
15
10 ♦A
♦B
0 5 10 σP
Figure- 15.5: Borrowing and Lending on Risk and Expected
Return
305
wB = weight for stock B
wA = weight for stock A
α = alpha intercept of the line
β = slope of the line
The value of wB is expressed by the value wA which will estimate
the portfolio expected rate of return. The values for α and β will
be determinied by the relative expected rates of return on the stocks constituting
the portfolio. To compute the values for α and β, we can demonstrate the
following example. The expected return of a three-stock (A, B and
C) portfolio is:
E(rP) = wA E(rA) + wB E(rB) + (1 – wA – wB) E(rC)
= wA E(rA) + wB E(rB) + E(rC) – wA E(rC) – wBE(rC)
= wA E(rA) – wA E(rC) + wB E(rB) – wBE(rC) + E(rC)
= wA [E(rA) – E(rC)] + wB [E(rB) – E(rC)] + E(rC)
Therefore,
– wB [E(rB) – E(rC)] = – E(rP) + wA [E(rA) – E(rC)] + E(rC)
wB [E(rC) – E(rB)] = [E(rC) – E(rP)] + wA [E(rA)] – E(rC)]
Solving for wB as a function of wA, we get:
E(r C )−E(r P ) E (r A )−E(r C )
Let,
w B=
[ E(r C )−E(r B ) ] [
+w A
E(r C )−E(r B ) ]
E(r C )−E(r P )
and
[ E(r C )−E(r B ) ]=α
E(r A )−E (r C )
[ E (r C )−E (r B ) ]=β
306
E(r C )−E(r P )
α=
[ E(r C )−E(r B ) ]
. 15−E (r P )
α= [ . 15−. 12 ]
The value for the intercept depends on the expected rate of
return of the portfolio. Our assumption is that different sets of
portfolio weights will give us same expected rate of return. We
assume the portfolio expected return to be 12 per cent. The
value for alpha is:
. 15−. 12
α= [ . 15−. 12 ]
=1. 00
Therefore, the formula for 12 per cent isoexpected return line is:
wB = 1.00 – 1.67wA
Hence, for any value of wA, the portfolio expected return would
be 12 per cent.
Let’s demonstrate an example. Suppose an investor invests 25
per cent of his investible funds in stock A. Accordingly;
Given = wA = .25
wB = 1.00 – 1.67wA
307
wB = 1.00 – 1.67wA
wB = 1.00 – (1.67 × .75)
= 1.00 – 1.2525 = – .2525
Therefore, wC = 1.00 – (wA + wB)
= 1.00 – (.75 – .2525) = .5025
Thus,
E(rP) = wA E(rA) + wB E(rB) + (1 – wA – wB) E(rC)
= [.75 × (.10)] + [– .2525 × (.12)] + [.5025 × (.15)]
= 0.1201 = 12 %
Summary Table
Portfolio weight (wA) .25 .50 .75
Portfolio Expected return .12 .12 .12
E(rP)
For any value of portfolio weight (w A), portfolio expected rate of
return would be 12 per cent.
Iso-variance Ellipses
At a given level of portfolio standard deviation, investors choose
a portfolio with higher expected rate of return. So, it is very
important for the investors to analyze the portfolios with the
same variance or standard deviation. Now we want to find a set
of portfolios all of which have the same variance. The portfolio
weights for this family of set are given by one of the isovariance
ellipses. Each ellipse of the family represents a given level of
variance. Thus, the variance for a three-stock (stock A stock B
and stock C) portfolio can be calculated as:
2 2 2 2 2
σ 2 r P =[ w A σ A + w B σ B +( 1−w A −w B )2 σ C +2 w A w B σ AB
+2 w A (1−w A −w B )σ AC +2 w B (1−w A −w B )σ BC ]
Suppose the variance-covariance matrix for stock A, B nad C is
given in the following Table:
Stock A B C
A 0.25 0.15 0.17
B 0.15 0.21 0.09
C 0.17 0.09 0.28
By taking the square root of the variance, the following Table
shows the standard deviation for stock A, B and C as follows:
Stock A B C
Std. dev. 0.50 0.46 0.53
Suppose we want to find ellipse of portfolio weights with a 30
per cent portfolio variance. To find two points on ellipse, let us
308
assume the weight for stock A (w A) equals to zero (00) and
substitute this into the portfolio variance formula as follows:
2 2 2 2 2
σ 2 r P =[ w A σ A + w B σ B+( 1−w A −w B )2 σ C +2 w A w B σ AB
+2 w A (1−w A −wB )σ AC +2 w B (1−w A −w B )σ BC ]
.30 = [(00)2 (.50)2] + [(w2B) (.46)2] + [(1– 00 – wB)2 (.53)2]
+
2 × [00 × wB × .15] + 2 [00 × (1– 00 – wB) × .17] +
2 [wB × (1– 00 – wB) × .09]
After simplifying the equation we get:
.30 = 0.28 – 0.38wB + 0.31w2B
After solving the quadratic equation we get the following two values for w B that
would make the right-hand side equal to the left-hand side:
wB = 1.28
and
wB = – 0.05
Therefore, the portfolios having a 30 per cent variance have the following
portfolio weights:
wA = 00, wB = 1.28
and wC = (1 – wA – wB)
= (1 – 00 – 1.28)
= – 0.28
and
wA = 00, wB = – 0.05
and wC = (1 – wA – wB)
= [1 – 00 – (– 0.05)]
= 1.05
These are two of the many portfolios on the 30 % variance ellipse. To find more,
we merely select another arbitrary value for w A say 1.00. We substitute this new
value for wA in the portfolio variance equation and solve once again for two
values for wB. However, for any value of wA, portfolio variance would become
30 per cent.
309
Exercises
1. What is meant by portfolio revision?
2. What factors do necessitate portfolio revision?
3.
4.
Chapter- Sixteen
Measuring
Portfolio Performance
310
i. a general measure of exposure to market risk i.e., beta
coefficient, m,
ii. extramarket covariance or group risk, and
iii. residual or specific risk measuring the uncertainty of
earning the specific return. Sources of different risk and returns
are given below:
Markowitz Portfolio
Investors are risk averse. All the rationale investors will choose
the security with lower level of risk given a choice between two
securities with equal rates (higher) of return. On the other hand
investors choose the security with higher expected rate of
return among the securities with equal (lower) risk. In finance
concept, the terms risk and uncertainty are used
interchangeably. Risk is defined as the uncertainty of future
outcome or the probability of an adverse outcome.
Before the development of Markowitz portfolio theory, there was
no specific measure for the risk and the investors had no means
to quantify risk variable. He developed a basic portfolio model
deriving the expected rate of return for a portfolio of assets and
an expected risk measure. He asserts that the variance of the
rate of return is a meaningful measure for the portfolio risk
under a set of assumptions. He shows that diversification of
investment can reduce the total risk of a portfolio. However, his
model is based on the following assumptions:
i. Individual investment is considered as being
represented by a probability distribution of expected return.
ii. Investor is supposed to maximize one-period expected
utility and his utility curve demonstrates diminishing marginal
utility of wealth.
iii. Risk of the portfolio is being estimated on the basis of
the variability of expected return.
iv. Investment decision is fully based on expected return
and risk.
v. Investors prefer higher expected return at a given level
of risk and similarly they prefer minimum risk at a given level of
expected return.
311
From the aforesaid assumptions it remains clear that a rationale
investor, no doubt, takes additional return and risk rather than
at a desired level. If an investor is interested only to maximize
return, he would tend to hold only the single asset which he fells
will offer the higher future return. However, investors like to
hold portfolios of securities since they are concerned with both
return and risk confirming that diversification may eliminate risk
without any loss of return. Moreover, portfolio asserts that a
single asset or portfolio of asset is considered to be efficient if
no other asset or portfolio of assets offers higher expected rate
of return with the same or lower risk, or lower risk with the
same or higher expected return.
One of the ways of calculating the portfolio return is the
portfolio holding period yield which can be estimated as:
NAV t +Dt
PHPY t = −1
NAV t−1
where,
PHPYt = portfolio holding period yield per share at time t
NAVt = per share net asset value of the porfolio at time t
NAVt–1 = per share net asset value of the portfolio at time
t–1
Dt = cash distribution per share during time t
Holding period yield per share of different portfolios can be
calculated by using the above formulla. Different yields as
calculated can be compared. The share of the portfolio with
higher one year holding period yield shows the better
performance. The well-managed portfolio could have achieved
higher returns than the market or other portfolios by taking on
considerably more risky investments.
312
commonly known as composite measures of portfolio
performance. Accordingly, the measures are also called as
Sharpe ratio, Treynor ratio, and Jensen ratio. How ever, we can
catalog the following risk-adjusted performance measures to
examine the circumstances in which each measure might be
more relevant.
313
From the information given above rank the portfolio according
to their performance.
The Sharpe index for the portfolios:
Portfolio-A:
R A −R f
SR=
σA
. 12−. 05
= =0 .875
. 08
Portfolio-B:
RB −R f
SR=
σB
. 15−. 05
= =1
. 10
Portfolio-C:
RC −R f
SR=
σC
. 10−. 05
= =1. 67
. 03
According to Sharpe measure performance of portfolio C is
better because its index is higher. Thus, the ranking of the
portfolios interms of risk-premium per unit of total risk,
therefore, is: C > B > A.
rP
SR
rf
σP
Figure-16.1: Graphical Presentation of Sharpe index
314
Treynor’s Performance Measure
The portfolio performance measure developed by Jack Treynor
is called Treynor ratio (TR). It is the ratio of the risk premium to
the volatility of return measured by portfolio systematic risk
(beta). This is why this ratio is commonly known as reward-to-
volatility ratio (RVOL). This ratio can be used as a benchmark
based on the ex post security market line. The Treynor ratio,
therefore, be estimated as:
R P −R f
TR=
βP
Where,
TR = Teynor ratio which is reward-to-volatility ratio
(RVOL) i. e. portfolio risk-adjusted return
Rp = portfolio return
Rf = portfolio risk-free return
βp = portfolio systematic risk or beta.
The Treynor index measures the relative risk premium also. The
risk premium is related to the amount of portfolio systematic
risk measured by portfolio beta coefficient which is the slope of
the characteristic line. Graphically, Treynor index measures
slope if the line emanating outward from the risk-rfee rate to the
portfolio. It is the amount of risk premium per unit of systematic
risk (βP) of the portfolio. Therefore;
Tthe higher the Treynor ratio, the better the
performance of the portfolio and vice-versa.
Unlike Sharpe index, Treynor index also shows risk and return of
a portfoilo in a single measure which cateragorizes the
performance of the portfolio on a risk adjusted basis.
rP
TR
rf
βP
315
Figure-16.2: Graphical Presentation of Treynor index
316
For Portfolio-A:
R A −R f
SR=
σA
. 12−. 07
= =0 .50
. 10
For Portfolio-B:
RB −R f
SR=
σB
. 18−. 07
= =0 . 7333
. 15
For Portfolio-C:
RC −R f
SR=
σC
. 16−. 07
= =0 . 90
. 10
For Portfolio-D:
RD −R f
SR=
σD
. 10−. 07
= =0 . 375
. 08
For Market Portfolio-M:
R M −Rf
SR=
σM
. 15−. 07
= =0 . 7273
. 11
According to Sharpe Index, Portfolio B and C are performing
better than the market index whereas Portfolio A and D are
performing worse than the market index.
Treynor ratios for the portfolios:
For Portfolio-A:
R A −Rf
TR=
βA
317
. 12−. 07
= =0 . 0556
. 90
For Portfolio-B:
R B −Rf
TR=
βB
. 18−. 07
= =0 . 092
1. 20
For Portfolio-C:
RC −R f
TR=
βC
. 16−. 07
= =0 . 086
1. 05
For Portfolio-D:
R D−R f
TR=
βD
. 10−. 07
= =0 . 04
. 75
For Market Portfolio-M:
R M −R f
TR=
βM
. 15−. 07
= =0 . 08
1. 00
According to Treynor Index, Portfolio B and C are also
performing better than the market index whereas Portfolio A
and D are performing worse than the market index.
Jensen’s Performance Measure
Another risk-adjusted portfolio performance measure has been
developed by Michael Jensen which is known as Jensen ratio
(also known as Jensen alpha). Jensen measures the absolute
performance on a risk-adjusted basis. The performance of the
portfolio is the ability of the manager to earn through successful
prediction of security prices which are higher than those which
can be achieved at a given level of riskiness of the portfolio.
318
This ratio measures the differential between the actual return of
the portfolio and the expected return of the portfolio at a given
level of risk. Therefore, the the Jensen ratio attempts to
determine if more than expected returns are being achieved for
the level of the riskiness of the portfolio. The Jensen model is,
therefore, given below:
r Pt −r PF =α P +β P (r Mt −r PF )
Where,
r Pt = average return of the portfolio at time t
r PF = risk-free rate of return (interest rate) during time
t
r Mt = average return of a market portfolio during time t
α P= alpha intercept measuring the forecasting ability
of the portfolio
β P= systematic risk
The differential return is, therefore, calculated as:
αp = rp − E( rp)
where,
αp = return differential,
rp = actual return on the portfolio and
E( rp) = expected return on the portfolio.
The graphical presentation of Jensen alpha is given in Figure
16.3.
rP – E(rP)
Posi
tive (+) alpha
Neutral alpha
319
Neg
ative (−) alpha
βP[E(rM − rf)]
320
−0.022
Portfolio -B αB = rB − E(rB) = .18 − .166 =
0.014
Portfolio -C αC = rC − E(rC) = .16 − .154 =
0.006
Portfolio -D αD = rD − E(rD) = .10 − .130 =
−0.03
Market portfolio- αM = rM − E(rM) = .15 − .150 = 0
M
Positive alphas of portfolio B and C indicate better performance
whereas negative alphas of portfolio A and D indicate worse
performance and zero alpha of market portfolio indicates
neutral performance.
Appraisal Ratio
Appraisal ratio is also known as information ratio that devides
the alpha of the portfolio by unsystematic risk of the portfolio
which is called tracking error in the industry. It measures
abnormal return per unit of risk that could be diversified away
by holding a market index portfolio. The Appraisal ratio,
therefore, be estimated as:
αp
AR=
σ (εp)
Where,
AR = Appraisal ratio,
αp = Portfolio alpha
σ(ɛp) = Portfolio residual (error)
Each measure bears significant appeal and does not provide
consistent assessment of performance
Decomposition of Performance
The performance of the investment refers to effectiveness and efficiency of the
investor in terms of the returns. Since return is the outcome of investments which
is the subject to uncertainty, the investor must consider and take into account the
level of risk. PPerformance evaluation, therefore, focuses on assessing how well
an investor or portfolio manager achieves highest returns balanced with
acceptable level of risk. Eugene Fama has provided an analytical framework that
allows a detailed breakdown of a fund’s performance into the source or
321
components of performance. This is known as the Fama decomposition of total
return. The total return, being the composition of current income and capital
gains, on a portfolio can be divided into risk free return and the excess return.
Thus,
Total return (TR) = Risk-free return (rf) + Excess return (ε)
The excess return arises from different factors or sources, such as risk bearing
and stock selection. Hence the excess return, in turn, may be decomposed into
two components, like risk premium, the price or reward for taking risk and
return from stock selection known as return from stock selectivity. Therefore,
Excess return = Risk premium + Return from stock selection.
The risk of a security can be divided into two parts viz., systematic risk and
unsystematic risk or diversifiable risk. A portfolio is created to minimize or
eliminate the unsystematic part of risk through diversification. But, in practice,
no portfolio would be fully diversified. Hence, a portfolio would have both
systematic risk and a small amount of diversifiable risk. Hence, the risk premium
can be decomposed into two components, namely return for bearing systematic
risk (market risk) and return for bearing diversifiable risk. Thus,
Risk premium = Return for bearing systematic risk + Return
for bearing diversifiable risk
Thus, the total return on a portfolio can be decomposed into four components.
Return on portfolio = Risk-free return + Return from market risk
+ Return from diversifiable risk
+ Return from pure selectivity
This breakdown of return can be presented as:
R p =R f + R1 + R2+ R3
Each component can be calculated. The risk free rate of return, R f , is the return
available on a riskless asset such as the government security.
The return from systematic (market) risk, R1, is calculated as:
R1= β p ( Rm −¿ R f )
where,
Rm = Return on the market index
( Rm− R f ) = Market risk premium.
The return from diversifiable risk, R2, is calculated as:
σp
where,
R 2=
[( ) ]
σm
−β p ( Rm − R f )
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The return from pure selectivity, R3, is the additional return obtained by a
portfolio manager for his superior stock selection ability. It actually the
difference between the return obtained by manager and the sum of the other three
components that can be estimated as:
R3=R p−¿+ R1+ R2 ¿
Mathematically, return from pure selectivity can be calculated as the difference
between the actual return the portfolio generates and the return mandated by its
total risk. This component of return is also known as Fama’s net selectivity
measure. The following formula may be used to calculating this measure.
σp
where,
[ ( )
Fama’s net Selectivity = R p − Rf +
σm
(Rm−R f )
]
R p =Actual return on portfolio .
R f =Risk free rate .
Rm =Return on market index .
σ p=Standard deviation of portfolio return
σ m=Standard deviation of market index return .
We can illustrate Fama decomposition of portfolio return using the
following data on a portfolio.
R p =15 % σ p=6 %
Rm =10 % σ m=4 %
R f =7.5 % β p=0.9
Fama’s decomposition can be exihibited using the above data as:
` R P=R f + R1 + R2 + R3
Given,
R f =7.5 %
R1=β P (Rm −R f )
¿ 0.9 ( 10 %−7.5 % ) = 2.25 %
σp
R 2=
[( )
σm ]
−β p ( R m−Rf )
6%
¿
[( ) ]
4%
−.9 (10 %−7.5 %)
¿(1.50−0.9)(2.5 %)
¿ 1.5 %
R3=R p−¿+ R1+ R2 ¿
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¿ 15 %−( 7.5 %+2.25 % +1.5 % )
¿ 3.75 %.
Therefore,
R P=R f + R1 + R2 + R3
¿ 7.5 %+ 2.25% +1.5 %+ 3.75 %
¿ 15 %
Thus
Alternatively, Fama’s net selectivity can be directly calculated as
follows
σp
Fama’s net selectivity¿ R p− Rf +
[ ( )
σm
(R m−R f )
]
[
¿ 15 %− 7.5 % + ( 64 %% )(10 %−7.5 %)]
¿ 15 %−(7.5 % +3.75) ¿ 3.75 %
Fama’s net selectivity is positive (3.75%). It indicates that the portfolio
generates the return what it expects with the commensurating level of
risk. Fama’s net selectivity may become negative if realized return on
a portfolio is less than what mandated by the total risk of the portfolio.
This seems to be the poor performance of the portfolio. A portfolio
manager attempting to earn a higher return than the market return is
supposed to assume higher risk and depends on the superior stock
selection ability.
Exercises
324
Chapter-Seventeen
Bond Portfolio
For a country’s economic development, a deep well functioning domestic bond
markets are extremely important as they facilitate long term financing for areas
such as infrastructure, housing and private sector development. But developing
deep and diversified bond market is not so easy. Due to the importance of this
market to the entire economy, it is necessary that the governments should lead
the process of developing bond market by creating a domestic securities market
and providing an adequate framework to develop corporate bond market.
The Financial sector is crucial for any economy that affects its business
environment, investment, economic prospects and social dimensions, including
poverty. The financial markets, the pivotal point of financial sector, perform a
vital function within the global economic system such as attracting and
allocating savings, setting interest rates and discovering the prices of financial
assets. A well diversified financial sector is highly dependent on the extreme
collaboration of financing from equity market, bond market, and banks. The
government bond market forms the backbone of a modern securities market in
both developing and developed countries.
The recent global bond market pays a pivotal role in the
augmentation of financial markets. It represents an important
investment opportunity also. An understanding of bonds is
helpful in an efficient market because local and international
325
bonds increase the investment opportunities for the creation of
diversified portfolios. The first consideration for an investor is to
build a bond portfolio. Undoubtedly, an efficient and strong bond
market benefits the economy. If the economy is growing slowly,
interest rates may decline and bond price may rise. A decline in
economic growth may result in fewer investment opportunities.
As a result, investors demand for bonds which increases bonds
and decreases bonds yields. There is a strong relatioship
between the income from bonds and current inflation.
The higher the rate of inflation, the
larger should be the bond interest
rate.
Interest rate reflects expected inflation not the economic
growth. For a given rise in inflation, investors demand more
income from a bond to compensate for the expected decline in
the purchasing power. Therefore;
A rise (fall) in inflation will tend to decline
(increase) bond prices leading an increase
(decrease) in bond yields.
Investors in bond always dislike inflation because of its negative
influence on fixed income securities. Rather they desire actions
which encourage economic growth and reduce inflation. Bonds
and debentures are considered fixed income securities as they
impose fixed financial obligations on the issuers. These
securities are traded in a market called bond market. The debt
market typically is devided into three segments like:
i. Short-term debt market of issues with maturity of one
year or less. This market is called money market.
ii. Inermediate-term debt market of issues with maturity
of more than one but less than ten years.
iii. Long-term debt market of issues with maturity of more
than years. This market is called bond market.
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long-term investment instruments for institutional investors,
such as pension funds and insurance companies. Finally, bond
markets help diversify a country’s financial sector and reduce
foreign currency risk which arises when local investments are
financed with foreign currency denominated loans.
ii. Beneficiaries of the Government Bond:
Parties who can directly be benefited form the government bond are outlined
below:
a) Governments: The government can use this market to smooth the path
of economic aggregates over time, fund their expenditures, and
minimize the welfare cost of financing them. It also provides a key
barometer of the markets’ reaction to government actions, and a
benchmark yield curves which helps in pricing of different assets.
b) Central Bank: Central bank gets the idea of the term structure of
interest rates that provides the paramount guide to the underlying
structure of inflationary expectations in forming the monetary policy.
c) Public Enterprises: Government securities market facilitates the
issuance facility of debt by other public institutions. Government
interest rates establish a benchmark for the borrowings of all public
institutions facilitating the timing of their borrowings.
d) Financial System: To financial institutions, the term structure of
interest provides essential information on interest rates. It offers the best
estimate of their future behavior, the primary determinants of the
demand for loanable funds. Moreover, the term structure allows
financial institutions to evaluate the relative worth of financial contracts
with very dissimilar cash flows.
e) Business: The term structure of interest rates provides the basic
criterion to evaluate business investment by having a look on the
minimum standard for fixed rate financing that allows potential
investors to judge the worth of the project.
f) Households: Government bonds are indispensable instruments to meet
the investment needs of households. These bonds entail a minimum
amount of credit risk, a source of uncertainty that households do not
assess or diversify well due to their limitations.
iii. Prerequisites for Development of Government Bond Market
Development of Government securities market must be viewed as a dynamic
process in which continued macroeconomic and financial sector stability are
essential for building an efficient market and establishing the credibility of the
government as an issuer of debt securities. Prerequisites for establishing an
efficient government securities market include:
a) credible and stable government;
b) sound fiscal and monetary policies;
c) effective legal, tax, and regulatory infrastructure;
d) smooth and secure settlement arrangements; and
327
e) a liberalized financial system with competing intermediaries.
iv. ‘Four Is’ perspective of Bond market development
The Nomura research institute, in 2004 has developed a framework (Figure-17.1)
showing the four different perspectives of bond market development namely;
issuer, investor, intermediary and infrastructure, and also articulates their intra-
relationship that contributes towards the harmonious development of bond
market.
Insufficient liquidity
Investor Intermediary
usiness Opportunities
328
In the framework, centered by issuer, the investor perspective
has been emphasized very clearly. The point is that the lack of
diverse investor with different risk appetites leads to conservative
investor behavior and accordingly insufficient liquidity in the bond
market which has bearing impacts on other three perspectives. In
essence, the figure clears that the problems in different
perspective constitute a “chicken-and-egg” vicious cycle and they
can not be resolved individually.
329
able to earn an expected retun commensurating with the level
of risk. This belief asserting that invetors do not actively seek
out trading possibilities to out perform the market is known as
passive portfolio management strategy. Passive bond
management strategies are based on the proposition that bond
prices are fairly deermined leaving risk as the portfilo variable
to control. Passive management strategies do not depend on
expectation data. Therefore, passive bond managemnt
strategies are based on inputs which are known at the time
rather than on expectations. These strategies have a lower
expected return and risk than do active strategies. The simplest
bond portfolio management strategy is to buy and hold where
invetors select a portfolio of bonds based on their objectives
with the intent to hold them to maturity. On the other hand,
indexing is the objective to construct a portfolio of bonds that
will equate the performance of a specified bond index.
330
Contingent portfolio management is a structured form of active
management with a safety net provided by classical
immunization. It allows a bond portfolio manager to pursue the
highest returns available through active strategies while relying
on classical bond immunization techniques to ensure a given
minimal return over the investment horizon.
Excercise
1. What is bond portfolio?
2. State the emergence of bond portfolio
3. What are ‘Four Is’ of bond portfolio management? Explain.
4. Define bond portfolio management strtegy.
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5. Define passive bond portfolio management and active bond
portfolio management.
******
Part-Five
Capital Market Theory
332
Chapter Eighteen: Capital Asset
Pricing Model
Chapter Nineteen: Efficient Market
Theory
Chapter Twenty: Derivative Markets
Chapter-Eighteen
333
is defined as capital market theory. Investors and concerned
wish to examine model that explains security prices under the
condition of market equilibrium. One equilibrium model known
as capital asset pricing model (CAPM) is commonly used in
determining the prices of the capital assets. CAPM was
developed in mid-1960s by famous researchers William Sharpe,
John Lintner and Jan Mossin independently and it is called
Sharpe-Lintner-Mossin CAPM. CAPM is an extension of the
portfolio theory of Markowitz which describes how rationale
investors should build efficient portfolios and select the optimal
portfolio. It allows us to measure the relevant risk of individual
security as well as to access the relationship between risk and
returns an investor expects from an investment.
Assumptions of CAPM
The capital asset pricing model is based on certain explicit
notions regarding the general behavior of the investors. The
basic assumptions of CAPM are given below:
▫ All rationale investors have unique probability
distribution for future rates of return.
▫ All investors make their investment decision on the
basis of expected rate of return and standard deviation of the
return.
▫ All the investors have the same one-period time
horizon.
▫ All investors can borrow or lend at risk-free rate of
return.
▫ There are no transaction costs but if any they are small
and hence are ignored.
▫ There are no personal income taxes on both dividend
income and capital gain as well.
▫ Investors are indifferent between capital gains and
dividends.
▫ There is no inflation.
▫ An investor can sell short any amount of any share.
▫ The market is perfect market. So no one can influence
the price of any security.
▫ Investors possess homogeneity of expectations having
identical expectations regarding to the decision period and
decisions inputs.
▫ Capital markets are in equilibrium position.
However, it is true that many of the above assumptions are
untenable. And they do not materially alter the real world.
334
Moreover, the model describes the risk return relationship and
the pricing of assets. Market equilibrium exists when prices are
fixed at levels providing no abnormal profit for the speculative
trading. The implications of the assumptions of CAPM are:
a) Rational investors will choose higher expected rate
of return at a given level or lower standard
deviation.
b) All the investors will choose the lower standard
deviation at a given level or higher expected rate
of return.
c) All investors would choose to hold the market
portfolio consisting of all the assets existed in the
market.
d) The market portfolio will lie on the efficient frontier
and will become optimal risky portfolio.
e) All efficient portfolios will plot the tradeoff
between the expected rate of return and standard
deviation for efficient portfolios.
f) All securities and all portfolios will plot the tradeoff
between expected return and systematic risk.
The market portfolio of all risky and risk-free assets with each
asset weighted by the ratio of its market value to the market
value of all assets constituting the portfolio.
E(rp)
CM
L
335
E(rM)
rf
σP
σM
[ E (r M )−r f ]
σM
The slope of the CML is the market price of risk for efficient
portfolio or the equilibrium price of risk in the market. It
estimates the additional return that the market demands for the
each percentage increase in the risk (std. dev.) of a portfolio.
Suppose expected return of a market portfolio is 15 per cent
with a standard deviation of 10 per cent. If the risk-free rate is 8
per cent, the slope of the CML would become:
[ 0 . 15−0 . 08 ]
=0 . 70
0 .10
The risk premium of 0.70 indicates that the market demands
this amount of return for each percentage increase in the risk of
a portfolio.
All the combinations of expected return and standard deviation
of efficient portfolios lie on the capital marlet line. This line is
formed by mixing the the market portfolio with the risk free
asset. The relationship between the return and risk of any
portfolio on the capital market line can be expressed by the
following equation:
336
E( r m )−r f
E( r P )=r f +
[ σm ] ×σP
E(r)
SML
rM M
rf
337
1
beta (β)
βM
Figure-17.2: The security market line and its slope
Security market line depicts that the market beta is 1 and return
is equal to risk-free rate plus market risk premium. SML has the
underlying connotations. The standardized measure of
systematic risk is commonly known as beta (). The covariance
of the subject stock (stock i) with the market portfolio (im) is the
relevant risk measure. Beta defining as im /2m is a standardized
measure of risk because it relates this covariance to the
variance of the market portfolio. As a result, the market portfolio
has a beta of 1[mm /2m = 1]. If the beta of the subject stock is
above 1, the stock has higher normalized systematic risk than
the market assuming that it is more volatile than the overall
market portfolio. The notion that individual stock prices may be
related to market returns is shown in the following chart:
Beta Description Type of
company
Greater than Stock price moves in Volatile
one the same direction,
>1 but move quickly than
market
Less than one Stock moves less Defensive
<1 quickly than market
Equal to one Stock moves with Cyclical
=1 market
Equal to zero Stock is not affected Risk-free
=0 by market
◘ When the beta of a stock is greater than one, the stock
returns for that company move in the same direction, but
to a much greater degree.
◘ A company having beta less than one means that the
company’s stock returns do not closely track changes in
market returns and vice-versa.
◘ The closer the beta to zero, the less relation there is to
market returns.
The contribution to the risk of market portfolio by the individual
securities can be attributed as:
σ im
σm
338
where σim stands for the covariance between stock i and the
market portfolio. CML equation can be expressed as follows:
E( r m )−r f
E( r P )=r f +
[ σm
This equation may be applicable for individual security as:
]
×σP
E (r m )−r f σ im
E ( r m )−r f
Since,
E( r i )=r f +
[ σ
2
m ]×σ im
σ im
β i= 2
σ m
The expected rate of return can be estimated as:
σ
E( r i )=r f + [ E( r m )−r f ]× 2im
σ m
or
339
iv. In CML, the risk is defined iv. In SML, the risk is
as total risk and is measured defined as the systematic
by standard.deviation (σ) risk and is measured by
beta (β)
v. CML is the basis of the v. SML is the basis of the
capital market theory. capital asset pricing model.
vi. CML is valid for efficient vi. SML is valid for all
portfolios only. portfolios and all individual
securities.
vii. The expression of CML is: vii. The expression of SML
E(rp) = rf + [{E(rm) − rf}/ is:
σm] × σp ri = rf + βi(rm− rf)
viii. The slope of the CML is: viii. The slope of SML is:
[ E (r m )−r f ] (r m−r f )
σm β
CAPM
The relationship between the expected return and risk as
measured by security market line is known as capital asset
pricing model. The security market line specifies the relationship
between the expected return and beta of individual securities,
efficient portfolios and inefficient portfolios. A part of the return
is a reward for bearing the risk and the other represents the
reward for waiting referring the time value of money. The
reward for bearing the risk is called risk premium. The risk
premium of a security is the product of beta and the risk
premium of the market which represents the excess of expected
market return over the risk-free return. Therefore, the expected
rate of return of a security is risk-free return plus the product of
beta and risk premium of the market, which can be expressed
as:
E(r i )=r f + βi [ E( r m )−r f ]
The first part of the right hand side of the equation is the risk-
free rate, rf, which a security earns without taking any risk. This
sort of return is viewed as the reward for waiting. The
relationship between return and risk as measured by beta
specified by the security market line is commonly known as
capital asset pricing model (CAPM). The relationship is simple
linear relationship showing the properties:
The higher the value of beta, the higher would become
340
the risk of the security and therefore, larger would be
the return and vise versa.
341
◘ Expected return (CAPM) < Estimated (realized) return
» Securities are underpriced.
◘ Expected return (CAPM) = Estimated (realized) return
» Securities are correctly priced.
Underpriced securities are attractive because they provide more
demand to the investors. These types of securities generate
more return than the level of risk assumed. Overpriced
securities, on the other hand, are undesirable because their
estimated returns are lower than the expected return.
In the context of CAPM, securities which are plotted above the
SML are undepriced because they offer higher return than the
expected with the same risk.On the other hand, securities which
are plotted below the SML are overpriced because they offer
lower return than the expected with the same risk. Even
securities plotted on the SML are correctly priced since their
estimated returns are equal to the expected returns. Let us
consider the following example:
Securit A B C D E F G H I
y
beta 1.7 1.5 1.00 0.9 0.5 0 −0. −1. −1.
5 0 0 0 0 50 00 25
Actual .22 .20 .16 .12 .10 . .02 −.0 00
return 0 2
5
Assume that market return is 15% and risk-free rate is 7%. The
expected rates of return of the above securities as per CAPM are
exhibited in the following Table:
Securit beta Expected return as per CAPM: Comparis
y E(r )=r + β E(r )−r on
i f i [ m f ]
A 1.75 E (rA) = .07 + 1.75 (.15 − .07) E (rA)> rm
= .21
B 1.50 E (rB) = .07 + 1.50 (.15 − .07) E (rB)> rm
= .19
C 1.00 E (rC) = .07 + 1.00 (.15 − .07) E (rC) =
= .15 rm
D 0.90 E (rD) = .07 + 0.90 (.15 − .07) E (rD) <
= .142 rm
E 0.50 E (rE) = .07 + 0.50 (.15 − .07) E (rE)< rm
= .11
F 00 E (rF) = .07 + 00 (.15 − .07) = . E (rF) = rf
07
342
G −0. E (rG) = .07 + (−.50)(.15 − .07) E (rG) < rf
50 = .03
H −1. E (rH) = .07 + (−1.00)(.15 − .07) E (rH) < rf
00 = −.01
I −1. E (rI) = .07 + (−1.25)(.15 − .07) E (rI) < rf
25 = −.03
If beta is negative, the return would be less than risk-free
return.
Summary Table:
Securi Actual Expected Comparison Comment
ty return return
(ri) E(ri)
A .22 .21 rA > E (rA) Underpriced
B .20 .19 rB > E (rB) Underpriced
C .16 .15 rC > E (rC) Underpriced
D .12 .142 rD < E (rD) Overpriced
E .10 .11 rE < E (rE) Overpriced
F .05 .07 rF < E (rF) Overpriced
G .02 .03 rG < E (rG) Overpriced
H −.02 −.01 rH < E (rH) Overpriced
I 00 −.03 rI > E (rI) Underpriced
Exercise
1. Define capital asset pricing model (CAPM). State the
assumptions of capital asset pricing model (CAPM).
2. Define capital market line (CML) and security market line
(SML).
3. Differentiate CML from SML.
4. Why do do risks and returns from all assets in the market lie
on the security market line?
5. Why is security market line called the basis of capital asset
pricing model?
343
6. What are key assumptions underlying the selection of portfolio
by Markowitz.
7. Describe the pricing strategy under capital asset pricing model.
8. Assume that market return is 15 % and risk-free return is 7 %.
The beta of ABC Ltd. is 0.75. What would be the expected rate
of return on the stock of ABC Ltd. based on the CAPM? If another
stock has an an expected return of 20 %, what would be its
beta?
9. How would you estimate the overvalued and undervalued
shares? Explain.
10. Using CAPM, calculate the expected rate of returns for the
following stocks assuming that market rate of return is 15% and
risk-free rate of return is 8%.
Stoc A B C D E
k
Beta 1.75 1.00 .50 .75 1.20
344
Chapter-Nineteen
345
participants. In the context of efficient market hypothesis (EMH),
the efficiency means:
i. informational efficiency
ii. operational efficiency and
iii. investment efficiency.
Researchers have attempted to test the efficient market
hypothesis in the field of stock markets and bond markets and
found mixed evidence. A rationale profit seeking investor
attempts not only to reason out the factor responsible for the
investment in the stock market but also attempts to forecast the
likely price of securities at future date. In an efficient market, all
the relevant and ascertainable information is already reflected
in the security prices and the current prices of the securities
represent unbiased estimates of the fair value of the securities
and no investor will be able to earn abnormal or supernormal
profit on their investment. A perfectly efficient market is one
where all the securities are correctly priced and there are no
under or over priced securities. In an efficient capital market,
security prices adjust rapidly to the infusion of new information
sensitive to the security prices. An efficient market requires that
a large number of competing profit-maximizing participants
analyze and fix price independently. New information affecting
security prices comes to the market in a random fashion and
each announcement affecting security prices is independent.
The competing investors attempt to adjust security prices
rapidly to reflect the effect of new information. The stock price
movements may also be occurred by the use of certain
fundamental factors like price-earning ratio, pay-out ratio, past
price sequence of securities. Therefore, in addition to efficient
market hypothesis, two distinct schools in securities price
behavior are fundamental school and technical school.
346
shareholders’ expectations of dividends and capital gains. The
fundamentalists analyze share prices on the basis of economic
influences, industry factors, and aggregated company statistics
like product demand, corporate earnings, amount of dividends
and company management. Being pioneers in this school
Fischer and Jordon believe that subject to risk-return, stock
prices are based on corporate earnings and other economic
environment. Corporate earnings and amount of dividends are
considered as key variables in determining stock prices. To
provide buy or sell decisions, the believers of this school depend
on whether the current market price is less than or greater than
the intrinsic value. To estimate the intrinsic value of a security,
they use past and historical prices. However, under these
circumstances, fundamentalists suggest purchase of under
priced share and selling of overpriced ones.
Technical School
The technical school traces its long history from Elliott wave
principle where he investigated stock price movements during
the long period and devised a unique formula defining stock
price movements based on the premise that the stock price
movements might be predicted by examining its behavioral
charts of past sequence of prices. They argue that the forces of
demand and supply fix the price and the volume of the stocks.
Past price movements of a corporate stock can merely assess
the corporate earning power, market psychology, and other
factors influencing its stock price. A wide variety of tools like Bar
Chart, Moving Average, Point Figure Charts, and Price Volume
Bar Chart are used to predict stock price movements. However,
the technical analysis of stock price behavior should only be
viewed as a supplement to the fundament analysis.
Technical Analysis
The basic proposition of stock price changes is that past trends in market
movements can be used to forecast or understand the future. The most significant
things are the assumptions that stock prices tend to move in trends that persist for
long periods and that these trends can be detected. However, technical analysis
of market efficiency is based on the following basic assumptions:
◘ Market price of the securities should be determined by the interaction
of demand and supply.
◘ Demand for and supply of the securities are governed by both rational
and irrational factors.
◘ Reversals of trends are caused by shifts in demand and supply.
347
◘ Although there are minor fluctuations in the market, security prices
tend to move in trends that persist for long period of time.
◘ Any change in demand for and supply of the securities can be detected
in charts.
◘ For developing the tools of technical analysis
(i) the use of charting and
(ii) the key indicator series to project future market movements are
essential.
There are three major movements in the security market: viz., daily fluctuations,
secondary movements and primary trends. The former two are only important to
the extent they reflect on the long-term primary trend in the market primary trend
may be either bullish or bearish in nature.
348
The expected share price at tomorrow, based on current
information, is the sum of today’s price of the same and the
expected return thereon. In securities markets, this
characteristic of stock prices is said that the same follow an
expected return model. In an efficient capital market, observed
price at tomorrow coincide with the expected price at tomorrow.
Expected return model assumes that the price of a security fully
reflects all available information at that point in time. The
expected share price in future is based on current information
set. As security prices adjust to all new information, these
security prices should reflect all publicly available at any point
in time. So, the security prices prevailing at any time should be
an unbiased reflection of all currently available information
including risk. In an efficient market, the expected returns
implicit in the current price of the security should reflect it risk.
This means that investors can be confident that current prices
fully reflect all available information and are consistent with the
risk involved. Most of the works regarding market efficiency are
purely based on the assumption that the market equilibrium can
be stated in terms of expected returns. Like two parameter
model this assumption would posit that condition on some
relevant information set, the equilibrium expected return on a
security is a function of its risk. Such expected return theory of
price formation can be described notationally as follows:
E (~
Pit+1|φ t ) =[ 1+E (~
r it+1|φ t ) ] P it
where,
E = expected value operator;
Pit = price of the stock of security i at time t;
~
Pit+1 = price of the stock of security i at time t + 1;
~r
it+1 = one-period percentage return (Pit + 1 Pit) | Pit and
φt = set of information.
Tildes (~) indicate the P it + 1 and rit + 1 are random variables at t.
The expected price of security i, given the full set of information
available at time t (t), is equal to the current price times 1 plus
the expected return on security i, given the set of available
information. The conditional expectation notation of the
equation is meant to imply that the information in t is fully
utilized in determining equilibrium expected returns of the
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security and t is fully reflected in the formation of the security
price it. However, it is also assumed that this information set
includes knowledge of all the relevant relationships among
variables like inflation, interest rates, earnings, amount of
dividends, gross domestic product. The assumptions that the
condition of market equilibrium can be stated in terms of the
trading systems based only on information having expected
returns in excess of equilibrium expected returns. Thus, let
xit+1 = pit 1 E[pit+1|t]
Where, xit+1 indicates the difference between the actual price in
t + 1 and the expected price in t + 1. The above equation shows
the excess market value of security i. In an efficient market:
E (xit+1 t) = 0
which says that the market reflects a ‘fair game’ with respect to
the information set. The ‘fair game model, in the theory of
efficient capital markets firstly recognized and studied
rigorously by Samuelson and Mandelbrot, implies the
assumptions that the conditions of market equilibrium can be
stated in terms of expected returns, and the information is fully
utilized by the market informing equilibrium expected returns
and thus current market prices of the securities. This clearly
assumes that the current prices of the securities fully reflect all
available information and are consistent with the risk involved.
Xit+1 is the return at t + 1 in excess of the equilibrium expected
return projected at t. Any trading system based on information
that tells the investors the amounts of fund available at t that
are to be invested in each of then n available securities may be
described as follows:
(t) = [1(t), 2(t), ...., n (t)]
Where i(t) denotes the amounts of fund available at time t. the
total excess market value at time t + 1 would be calculated by
the following system:
n
V t+1 =∑ α i ( φt ) [ r it+1 −E (~
r it+1|φt ) ]
i=1
According to the model prescribed by Fama which form the fair
game property has the following expectation:
n
~
E ( V t+i|φ t ) =∑ α i ( φ t ) E ( ~
x it +1|φ t )=0
i=1
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The expected return or fair game on the basic of efficient
markets model claims other testable implications.
b) Sub-martingale Model:
Based on currently available information, the expected price of
a security at tomorrow may be equal to the today’s observed
price of the same. This phenomenon in the securities market is
referred to as martingale. On the other hand, the expected price
of a security at tomorrow, also based on the current set of
information, may be greater than today’s observed price. This
position of the security in the capital market is termed as sub-
martingale. Assuming expected return theory, let
E ~
P it |φ t ≥P it
( +1 ) or
E ~
r it |φt ≥0
( )
+1
The expected value of the next period’s price of security i,
based on the information, is equal to or greater than the current
price. The price sequence for security i follows a submartingale
model. The assumption of the model is that the expected
returns conditional on information are non-negative and implies
that such trading rules based on the information cannot have
greater expected profits than a policy of buying-and-holding
security during the future period. Tests of such rules claim the
empirical investigation on the efficient markets model.
c) Random Walk Model:
The random walk hypothesis (RWH) states that successive
prices of securities are independent and successive price
changes are identically distributed. Under these assumptions it
is stipulated that past price sequence is of no use in assessing
future returns of securities. However, these two hypotheses that
the successive changes (successive one-period returns), based
on current information, are independent and successive change
returns are identically distributed constitute random walk
model. The model following-
f ( r it +1|φt )=f ( r it +1 )
says that conditional and marginal probability distributions of an
independent random variable are identical. Since that
distribution of price changes will depend on the price level, one-
period returns are independent, identically distributed, price will
follow a random walk. In the random walk literature, the
information is assumed to include only the past return history
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like rit, ri t 1, ri t – 2 and so on. However, assuming that the
expected return on security i, based on expected return model,
seems to be constant over time, we have:
E (~
r it+1|φt ) =E (~
r it+1 )
Stating that mean of the distribution of r i t + 1 is independent of
the information available at time t whereas the random walk
model says that the entire distribution is independent of
information. However, the random walk model says that the
sequence of past returns is of no consequence in determining
future returns. Thus, the empirical tests of ‘random walk’ model
strongly support the testable properties of ‘fair game’ model. It
is very much significant to state here that the tests of the
aforesaid models depend upon the available information in the
securities market. Such type of information may be classified
into three categories, viz. information on past price sequence,
publicly available information and privately held information.
Market efficiency based on the information can be categorized
into weak- form, semi-strong form and strong form. Having
presented a brief review of various testable models regarding
stock price behavior in the securities markets, the following
section of this paper turns to focus the stock price behavior in
the weak form efficient market hypothesis.
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market hypothesis, semi-stroung form efficient market hypothesis and strong
form efficient market hypothesis. Each differs from others in terms of its
assumptions and nature and characteristics about the amount and kind of
information that comes to the marketplace and the rate at which it is reflected in
price. The more quickly the information co mes to the marketplace and the more
rapidly it is reflected in the security market prices, the more highly efficient is
the market. However, market efficiency rests on the conditions such as absence
of transaction costs for trading securities, market participants have costless
access to available information, and past prices are serially uncorrelated and
future price depends upon information at future date. Capital market efficiency
can be categrized on the basis of information such as: information on past prices,
publicly available information, private information.
Weak-Form EMH
Weak-form efficient market hypothesis means that the price data is incorporated
in current market prices, i.e., yesterday’s price is the only information that
determines today’s or tomorrow’s stock prices. Weak-form market efficiency
implies that current stock price fully reflects information of historical sequence
of stock prices. If prices follow non-random trends, stock price changes are
dependent; otherwise they are independent. Random walk hypothesis asserts that
successive prices are independent and successive changes are identically
distributed. Weak-form testa, therefore, involve the question whether all the
information contained in the sequence of past prices is fully reflected in the
current price.
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are able to see through mere changes in accounting information that do not have
economic consequences.
Strong-Form EMH
The strong form of market efficiency refers to the most extreme case, market
efficiency under which both public and private information are quickly
impounded in the security price. Thus, it is hypothesized that insider information
is also immediately impounded in the valuation of a security. This implies that
no group of market participants or investors has monopolistic access to
information. In order to test the strong form market efficiency, there are three
groups of investors to be examined. These groups are corporate insiders, stock
exchange specialists and mutual funds. Holders of private information like
managers and their associates would not be able to make consistently above
normal returns using their private information. Extreme form of market
efficiency is difficult to accept because the existence of private information in
the market cannot be directly observed. But by examining the profitability of
trading strategy released by the SEC, it is merely possible to test the strong-form
market efficiency. In this connection, the official summery of insider trading is a
record of transactions in a security made by the officers, directors and major
shareholders of firm. If these insiders are able to make super- normal returns, the
market would not be no longer strong – form efficient.
354
a random walk. Large daily price changes tend to be followed by
large daily changes. The signs of the successor changes are
apparently random indication that the phenomenon represents
a denial of the random walk model but not of the market
efficiency hypothesis. Random walk hypothesis asserts that
price changes over time are independent when they follow a
random walk. When new information arrives randomly in the
market and investors react to it immediately, change in the
prices also become independent. Statistical test of
independence of stock price changes is one of the tests of weak-
form market efficiency. If such test suggests that price changes
are independent, past sequence of price information have no
influence on the current market price. Another test of weak-
form market efficiency is to test specific trading rules using past
price data. Researchers have formulated two statistical tests
viz. autocorrelation tests and sings test to verify the
independent movements of stock prices.
Autocorrelation tests: These tests of independence measure
the significance of positive or negative correlation in returns
over time. The serial correlation test involves measuring the
correlation between price changes for various lags such as one
day, four days, nine days, sixteen days and the like. Investors
believing capital markets are efficient would expect insignificant
correlations for such combination. The typical range of
correlation coefficients is usually from +1 to -1 and these
correlations are typically not statistically significant.
Sings test: Signs test being another statistical test of
independence involves classifying each price change by its sign
which means whether it is plus (+), 0 or minus (-). Increase in
price indicates plus and decrease in price refers minus sign. On
a transaction to transaction basis, positive and negative price
changes are about equally likely. Under the assumption that
price changes are random, any pair of no-zero changes should
be as like as any other, and likewise for triplets of consecutive
no-zero changes. Then the runs in the series of signs can be
counted and compared to know information about a random
series. If there are persistent price changes, the length of the
runs will indicate it. Price changes result like: + + + + +
+ + + +. A run occurs when two consecutive changes
are the same, that is, two or more consecutive positive or
negative price changes constitute one run. When the price
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changes in a different direction, like if a negative price change is
followed by a positive price change, the run ends and a new run
may begin. To test the independence, the number of runs for a
given series may be compared to the number in a table of
expected values for the number of runs that should be occurred
in a random series. The actual number of runs for the stock
price series consistently fell into the range expected for a
random series.
Tests of Trading Rules: Another test of weak-form of efficient
market hypothesis was emerged in response to the assertion
that the prior statistical tests of independence were too rigid to
identify the intricate price patterns examined by technical
analysts. The statistical tests demonstrate that trends (other
than those consistent with a random series) do not appear to
exist in stock prices. A technical trading rule based solely on
past price and volume data can outperform a simple buy-and-
hold strategy. Trading rule studies compare the risk-return
results derived from a simulation including transaction costs to
the results from a simple buy-and hold policy. Markets could be
more efficient with higher number of aggressive, profit-
maximizing investors attempting to adjust stock prices to reflect
new information; market efficiency depends on trading volume.
More trading in security could promote market efficiency. On
the other hand, securities with relatively few stockholders and
little trading activity, the market could be inefficient. Therefore,
more active and heavily traded securities in the trading rule
tests could bias the results forward finding efficiency.
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Strong Form EMH
This form of EMH argues that all information is fully reflected in fixing security
prices. Top management of firms or corporate insiders have access to
information about investment opportunities, financing alternatives, corporate
strategies and other important information that are not available to the public.
Specialists are the persons who make markets in stocks listed on the exchanges.
Strong form EMH may be divided into two types viz., (i) super-strong form that
includes insiders and exchange specialists who have pure monopolistic
information and (ii) near–strong form that includes private information such as
earnings forecasts generated from public information. The procedure to test such
type of strong-form EMH is to examine the performance of professional money
managers over time. In this regard, Mutual fund managers are the only group of
professional money managers for which return data were available. To determine
whether a manager’s performance is statistically different from average
performance, the following t statistic may be calculated:
AR i
t=
σ
√N
where,
ARi = mean abnormal return for fund i
σ = standard deviation of abnormal returns for fund i
N = number of observations.
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found that there are degrees of market efficiency, each specifying the type of
information that is reflected in security price. If the market is weak-form
efficient, then security price reflect any information pertaining to the security's
future expected return that can be obtained by examining the security's past
history. If the weak-form holds, technical analysis, or charting, will be
ineffective. But if the semi-strong form holds, both technical and fundamental
security analysis are ineffective. To beat the market, the analyst must seek out
private information. When the market is strong form, all the information that is
knowable is reflected in security prices. If this is true, no form of analysis will be
effective in discriminating profitable from unprofitable investments. It is also
true that if the securities market is efficient, insiders and large institutions should
not be able to make profits in excess of the market in general. The knowledge of
portfolio performance has shown that this king of investors does not better than
the market. Finally we can merely draw an inference that is the communications
systems advance, information gets disseminated faster and more accurately and
securities laws are forcing fuller disclosure of inside corporate data, it would
appear that the securities markets are efficient, but not perfect, in digesting
information and adjusting stock prices.
Exercises
1. What does an efficient market mean?
2. Do you think that a market should be efficient? Justify your
opinion.
3. Discuss the rationale for expecting an efficient capital
market.
4. What are different forms of efficient capital market?
5. What do is meant by efficient market hypothesis (EMH)?
State the pros and cons of different form of efficient market.
6. How would test different efficient market hypotheses?
7. “An efficient capital market is one where the security prices
fully reflect all available information”—Explain focusing on
the different forms of market efficiency.
Chapter-Twenty
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Derivative Markets
Financial engineering can be defined as the development and
creative application of financial techniques for solving financial
problems, exploiting investment opportunities, and to add
value. Financial transactions and investment activities
particularly in securities as well involve uncertainty. Fluctuations
in the financial assets expose to risk. The investors particularly
dealers are supposed to hedge risk involved in their financial
transactions. Hence, it is necessary for the investors, market
makers and financial management concerned to have basic
understanding about proper risk management tools. Financial
derivatives are widely used tools in this regard. Financial
derivatives can be defined as instruments for hedging the risk
involved in buying, holding, and selling different types of
financial assets like shares, stocks etc. Broadly speaking they
refer to financial assets/instruments for the management of risk
arising from the uncertainty prevailing in the transactions of
financial assets. Financial derivatives are, therefore, evolved to
hedge the risk while dealing in the financial assets. They are
commonly known as derivative securities since their values are
derived from the underlying assets. Finally, financial derivatives
are designed to help providing financial protection to
participants in the financial markets against adverse
movements in the price of the underlying assets. They facilitate
in transactions of financial assets at or within a predetermined
future date at the price determined today. The values of the
financial derivatives are derived from the performance of the
financial assets, interest rates, currency exchange rate, stock
market indices, and what not.
A financial derivative can also be defined as a contract
specifying the rights and obligations between the issuer of
financial derivatives and the holder thereof to receive or deliver
future cash flows based on some future events. Some
derivatives are traded or transacted on organized stock
exchanges which are known as exchange-traded derivatives like
options, warrants, futures. Other derivatives known as over-the-
counter derivatives are not transacted in the organized stock
exchange but are privately negotiated between the parties.
These types of derivatives are like the forwards.
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Options
An option can be defined as the right to the holder, (but not the
obligation) to buy or sell a given quantity of an asset on or
before a given date in future, at prices agreed upon today. Many
corporate securities are similar to the stock options that are
traded on organized exchanges. Almost every issue of corporate
stocks and bonds has option features. In addition, capital
structure and capital budgeting decisions can be viewed in
terms of options. Options are of two types: call options and put
options.
Call options
Call options give the holder the right, but not the obligation, to
buy a given quantity of some asset within some time in the
future called expiration date, at prices agreed upon today
known striking price or exercise price. When exercising a call
option, investors ‘call in’ the underlying asset.
Put options
Put options give the holder the right, but not the obligation, to
sell a given quantity of an asset at some time in the future, at
prices agreed upon today. When exercising a put, investors ‘put’
the asset to someone.
There are two parties in an option contract. The investor getting
the right to buy a specific number of shares in case of call
option is called buyer. On the other hand, the investor wishing
to sell a specified numbers of shares to the buyer of the option
is referred to as seller. The option contract is initiated by the
seller of the option and the seller is called the writer of the
option.
Let us take an example: Suppose the current market price of a
share of a company is Tk. 200. A call option would give the right
to buy the share at a specified price of Tk. 210 during the next 3
months.
Some vocabularies
The investor will exercise the option only if it is profitable,
otherwise, the option can be thrown away. Followings are the
vocabulary associated with the option:
Strike price: The fixed price specified in the option
contract at which the option holder can buy or sell the
underlying asset can be defined as strike or exercise price.
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Exercising the option: The transaction regarding the
buying or selling the underlying asset according to the option
contract is called the exercising the option.
Expiration date: The date on or before which the option
can be exercised is called expiration date.
American vs. European option: An option can be
defined as American option if it may be exercised anytime on or
before the expiration date. A European option, on the other
hand, can be defined as one which may be exercised only on
the expiration date.
Option Premium
The option premium is the amount called the value of the option
paid by the buyer to by the option. Some factors affect the
premium of the option. A call option will yield profit to the option
holder if the current market price is greater than the exercise
price. The following outcomes may occur:
■ In-the-Money
The exercise price is less than the spot price of the underlying
asset i.e., the current market price is greater than the exercise
price.
■ At-the-Money
The exercise price is equal to the spot price of the underlying
asset i.e., the current market price of the stock is equal to the
exercise of strike price.
■ Out-of-the-Money
The exercise price is more than the spot price of the underlying
asset i.e., the current market price of the stock is less than the
exercise price.
Therefore, for a call option, the following terms are true:
If St > Ep, option is in the money
If St < Ep, option is out of the money
If St = Ep, option is at the money
C0 = Max [St - Ep, 0]
For put options:
If Ep > St, option is in the money
If Ep < St, option is out of the money
If Ep = St, option is at the money
Where,
St is the value of the stock at expiry (time t)
Ep is the exercise price.
C0 is the value of the call option at expiry
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If a call option is in the money, it is exercised immediately and
the option holder will earn profit. The positive cash flow or the
profit incurred to the option holder is known as the intrinsic
value of the call.
Intrinsic Value
The difference between the exercise price of the option and the
spot price of the underlying asset can be termed as intrinsic
value of the call.
Speculative Value
The difference between the option premium and the intrinsic
value of the option can be termed as speculative value of the
call.
Option premium = Intrinsic value + Speculative
value
Suppose, the exercise price of an option is Tk.200 and the
market price of the share is Tk. 250. The call option is in the
money. If the owner of the option exercises it he/she will make a
profit equivalent of Tk. 50 (= Tk.250 –Tk.200). If the market
price of the share is Tk. 200, the call is at the money and the
holder would get no cash flow. On the other hand, if the market
price of the share is less than Tk. 200, the option is out of the
money and the holder would experience a negative cash flow.
Thus,
The intrinsic value of a call option = S t – Ep, if S t is greater
than Ep
=0 if S t is less than or
equal to Ep
The above notions indicate that the intrinsic value of a call is
always greater than zero or (St > Ep).
One, who understands this, can become a financial engineer,
tailoring the risk-return profile to meet the client’s needs. If we
assume that the option expires at t, then the present value of
the exercise price is: E P
(1+r f )t
and the value of the call is:
( S 0−E P )
C0 =
(1+r f )t
It is obvious from the above equation that the option value
depends on the following factors:
i. The stock price: The higher the stock price, the more
the call is worth and vice-versa.
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ii. Exercise price: The lower the exercise price, the more
the call is worth and vice-versa.
iii. The time to expiration: The longer the time to expire
is, the more the option is worth and vice-versa.
vi. The risk-free rate: The higher the risk-free rate is, the
more the call is worth and vice-versa.
Call
Put
Stock price + –
Exercise price –
+
Interest rate + –
Volatility in the stock price + +
Expiration date +
+
The value of a call option C0 must fall within max (S0 – Ep, 0) <
C0 < S0.
The precise position will depend on these factors: market value,
time value and intrinsic value for an American call. The premium
of an option is the function of intrinsic value and time value. The
time value of an option is the excess of the premium over the
intrinsic value. Consider an example: the premium for a call
option with strike price of Tk.200 is Tk.20. If the current market
price of the share underlying the call is Tk. 215, the call option
is in the money. The intrinsic value of the call is Tk. 15 (= Tk.
215 −Tk. 200). The premium quoted being Tk. 10, the excess of
the premium over the intrinsic value Tk. 5 (= Tk. 15 −Tk. 10) is
the time value of the call option. A call at the money or out of
the money has no intrinsic value having only the time value and
the entire premium represents the time value.
Let us consider a case: Suppose the exercise price of an option
is Tk. 200 with a premium of Tk. 10. If the price of the share
rises above Tk. 210 (= Tk. 200 + Tk. 10) at any time before the
expiration date, the option holder can exercise the option to buy
share at Tk. 200 and the seller is obligated to make the share
available to the option holder at the exercise price (Tk. 200).
Assume that the current market price of the share is Tk.250.
The call option holder can make a profit by buying the share at
Tk. 200 equal to Tk. 50 (= Tk.250 −Tk.200) with a net profit of
Tk. 40 (= Tk.50 −Tk.10).
Other Options
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◘ Call provision on a bond: A call provision provides the
issuer the right, but not the obligation to repurchase the bond at
a specified price.
◘ Put bonds: The owner of a put bond has the right to
force the issuer to repurchase the bond for a fixed price for a
fixed period of time.
◘ Green Shoe provision: The right of the underwriter to
purchase additional shares from the issuer at the offer price in
an IPO.
◘ Insurance: Insurance obligates the insurer (option
writer) to purchase the underlying asset at a specified price for
a specified period (the term of the policy).
Futures Contracts
Futures Contracts commonly known as futures are also financial
derivatives constituting instrument for hedging the risk in the
financial markets due to the price fluctuation of the assets. The
features of a futures contract are the same as that of a forward
364
contract. However, these are two different instruments used for
risk management. Futures contracts have been designed to
remove the disadvantages of forward contracts. A futures
contract can be defined as an agreement between two parties
for buying or selling an asset at a certain time in future at a
certain price. Like commodities, financial assets form the
underlying assets in futures contracts. So, Stocks, bonds etc.
are the financial assets underlying futures contracts. A futures
contract on financial assets is known as financial future. The
fundament idea regarding futures contracts is that for hedging a
portfolio with a higher volatility than the market index, more
futures contracts may be required to bring about an effective
and efficient hedge. The required number of futures contracts
can be estimated by using the following formula:
VP
F0 = ×β P
Vf
Where,
F0 = Required number of futures,
Vp = Value of portfolio to be hedged,
Vf = Value of one futures contract,
βp = Portfolio beta
Forwards
Forward contracts are commitment entered into by two parties
to exchange a specific amount of money for a particular
commodity at a specified future time. A forward contract can be
described as an agreement to buy or sell an asset at a
predetermined fixed price at a specified future date. In a
forward contract, the agreement is initiated at one time but the
execution of the contract takes place at a subsequent date. The
terms of the contract, such as price, quality and quantity of the
assets, delivery date are specified at the time of initiating the
contract but the actual payment and delivery of the asset occur
later.
Under a forward contract, one of the parties of the contract
agrees to buy the underlying asset on a certain specified future
date at a certain price. The other party of the contract agrees
to sell the underlying asset on the same day at the same price.
The following terms are applicable in a forward contract:
Long position and short position: The buyer of such
contract is said to have a long position while the seller have a
short position.
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Delivery price and delivery date: The price specified in
the forward contract is termed as the delivery price and the
time specified is referred to as delivery date.
Warrants
Warrants are financial assets giving the holder the right but not
obligation to buy shares of common stocks directly from the
issuing authority at a fixed price for a given period of time. Each
warrant specifies the number of shares of common stock a
holder can purchase at the exercise price at the expiration date.
Some features of warrants are same as those of call options.
From the view point of the holders call options and warrants like
the same. But still there exists a significant difference in
contractual features of them. As for example warrants have long
maturity period. Some warrants are same as the perpetuals
having no expiration date at all. The basic difference between
call options and warrants is that call options are issued by
individuals and warrants are issued by the firms. When a
warrant is exercised, a firm must issue new shares of stock.
Each time a warrant is exercised, the number of shares
outstanding increases. In case of call options is not necessary
i.e., when a call option is exercised, there is no change in the
number of shares outstanding. Though a warrant is similar to
the call option, the following aspects can be experienced for call
options and warrants:
i. Warrants are issued by the corporations, but call
option (and put options) are created by investors.
ii. Usually, warrants have maturity of at least several
years but calls expire within a few months only.
iii. In general each warrant is unique but calls are not.
Convertible Bonds
A convertible bond is same as the bond with warrants. The
major difference between convertible bonds and warrants is
that warrants can be separated into distinct securities but
convertible bonds are not. Convertible bonds are the fixed
income securities which would be converted into common
stocks after certain period of time. Therefore, the convertible
bond gives the holder the right to exchange for it a given
number of shares of common stock any time on or before the
expiration date. A preferred stock can be converted into
common stock. The convertible preferred stocks and convertible
bonds are same except a convertible preferred stock has an
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infinite maturity date. The following vocabularies are applicable
for convertible bonds.
◘ Conversion premium: The difference between the
conversion price and the current stock price, divided by
the current stock price.
◘ Conversion price: The dollar amount of a bond’s par
value that is exchangeable for one share of stock.
◘ Conversion ratio: The number of shares per bond
received for conversion into stock.
◘ Conversion value: The value a convertible bond would
have if it were to be immediately converted into common
stock.
◘ Straight bond value: The value a convertible bond would
have if it could not be.
Exercise
1. What are the main differences between:
a. ptions and warrant contracts
b. forward and future contracts
2. What is option premium? How is it calculated?
3. Define the following terms used with puts and calls:
i. Strike price
ii. Exercising the option
iii. Expiration date
iv. American vs. European option
v. In-the-Money
vi. At-the-Money
vii. Out-of-the-Money
4. What is convertible bond? State different aspects of
convertible bonds.
APPENDICES
367
the interest of the investors in securities markets. Under the
Act, Rules and Regulation there under, the Commission is
supposed to perform the following functions:
i) to ensure the issuance of securities properly.
ii) to promote and regulate the Bangladesh capital
markets.
iii) to regulate the activities of the stock exchanges.
iv) to register and regulate the activities of intermediaries
like stock brokers/dealers, underwriters who are
associated with the securities markets.
v) to monitor the activities of any collective scheme like
mutual funds.
vi) to monitor the functions of all authorized self-regulatory
organizations in the securities markets.
vii) to prohibit fraudulent and unfair activities in the
securities markets.
viii) to prohibit insider trading in securities.
ix) to introduce and promote investor education and
training regarding to the securities markets.
x) to conduct research and publication focusing different
aspects of securities markets.
xi) to regulate substantial acquisition of shares or stocks
and take-over the companies.
Beside the above functions, the Commission is assigned to call
for information, undertake investigation and inspection, conduct
inquiries and audit of any issuer or dealer of securities, the
exchange and intermediaries and self-regulatory organizations
in the securities markets. Thus, the work and strategies of the
Commission are to protect investors, facilitate capital formation
and inhibit fraud in the public offerings of securities. There are
different Departments of SEC to perform the above functions.
Being one of the Departments, Corporate Finance performs
specific functions as:
a) raising of capital through initial public
offerings (IPOs) and other form of equity debts.
b) supervising the functions of the stock
exchanges.
c) regulating the listed companies and
corporate disclosure.
d) regulating and disclosing the interest of
directors, officers and major shareholders.
e) monitoring and supervising the utilization
of fund procured through public issues and right issues.
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f) making policies for share-repurchase and
stock-splits.
Legal Services Department of the Commission performs the
following functions:
a) to interpret laws, rules, orders and regulations.
b) to prosecute against the violators of the provisions of
Acts, Rules and Regulations.
c) to file cases against the accused persons and firms
listed with the exchanges.
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Insider trading: Corporate directors, executives,
accountants and other concerned persons being the insiders
have access to material nonpublic information about the
corporation. Insider trading occurs when securities transactions
are made based on material nonpublic information that was
obtained in breach of a fiduciary trust. Temporary insiders like
auditors, consultants, financial analysts, and bankers also shall
be liable for breaching of a fiduciary trust if they make profit
from information to which they had temporary access.
Illegal pools: Association of two or more persons the
objective of which is to make profit through price manipulation
is called illegal pools. Under this scheme a large amount of
money are being used to buy or sell stocks to artificially affect
security prices. After obtaining the objective the pool is
dissolved. Pool members provide capital, inside information and
manage the pool operations.
Unauthorized trading: It occurs when a client’s
account shows securities trades that were not authorized
verbally and/ or in writing by the client before the transaction
occurred.
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Stock Exchange: It provides a market place or facilities
for bringing together buyers and sellers of securities or for
otherwise performing with respect to securities the functions
commonly performed by a stock exchange and includes such
market place and facilities. Regulations for the admission of
securities for trading on the stock exchanges are very stringent.
Issuer: It’s an either existing or a newly established firm
offering or already offered bonds, notes or securities for public
sale or private placement.
Underwriter: The individual or firm finding the investors
for the initial public offerings of securities are called
underwriters. It is also called investment banker. It purchases
new issues from the issuers and arranges for their resale to the
investors. The investment-banking firm that first reaches an
agreement with the issuer is called the originator. The originator
ultimately manages the flotation and coordinate two temporary
groups called underwriting syndicate and the selling group.
Commercial Bank: Commercial banks participate in the
securities markets by making portfolio management with the
equity shares for their own and for the customers also. In recent
days commercial banks have been found to be entering the
securities markets in the form of being underwriters of public
issue of shares, and then managing portfolio with small amount
of shares for their own profit. In addition to the commercial
operations, commercial banks keep a serious thought to
participatory role in the securities markets.
Investment Company: It’s a company engaged in
buying and selling securities of other companies and includes a
company, the investment of which in share capital of other
companies at any one time is of enlargement equivalent to
eighty per cent of the aggregate of its own paid up capital and
free reserves.
Broker: It means any person engaged in the business of
effecting transactions in securities for the accounts of others.
Brokers are commission sales people who need not invest their
own funds in the securities they sell. Dealers employ many
brokers.
Dealer: A dealer is an individual or a firm that puts its
own capital at risk by investing in a security in order to carry an
inventory of the security and makes a market in it. Typically a
dealer buys for his or her own account and sells to the
customers from the dealer’s inventory. Dealer’s profit or loss is
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the difference between the prices he pays and the price he
receives for the same security. The same individual or firm may
function at different times, as broker and dealer.
Speculator: It’s an individual who is willing to assume a
relatively large risk in the hope of a large gain in shorter period
of time. Its principal concern is to increase capital gains rather
than dividend income. Speculator may buy and sell the same
day or may invest in enterprises they do not expect to be
profitable for years.
Broker-dealer (B/D): It’s a firm that retails mutual fund
shares and other securities to the public.
Jobber: He is the person engaged in the business of
effecting transactions in securities for his own account but does
not include any person trading securities either individually or in
some fiduciary capacity otherwise than as a part of a regular
business.
Investor: It’s an individual whose principal concerns in
the purchase of a security are regular dividend income, safety
of the original investment and if possible, capital appreciation.
Bear: It’s a person who thinks security prices will fall. It
denotes the description given to the stock market when share
prices are falling and when the economic outlook is pessimistic.
Bull: It’s a person who believes security prices will rise. It
denotes the description given to the stock market when share
prices are rising and when the economic outlook is optimistic.
Stag: This is the description given to the share market
when an investor buys shares offered in a new issue and sells
them shortly afterward. These investors have no intention to
hold the shares as a medium or long-term investment.
Short seller: A short sale occurs when one person sells
a second person security borrowed from a third person. A short
seller is the speculator who expects the price of that security to
fall, enabling him to purchase the security at a lower price later
and delivers it at the higher price at which he had previously
arranged to sell it.
D. Cost of Investment
Understanding the cost of capital
From the standpoint of the firm using funds, the required rate of
return becomes the minimum acceptable rate of to be earned
from the new investment opportunities. Since the required rate
of return is an opportunity cost, the suppliers presumably could
earn the required rate of return from comparable alternative
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elsewhere, and they are going to demand that the firm earn at
least this much. Therefore, the firm should not accept projects
earning less. The cost of capital or the required rate of return for
a firm can be defined as the composite cost of the firm’s
financing components. One of the most important concepts
regarding investment and financing decision is that of the
weighted average cost of capital (WACC). This is the cost of
capital for the firm as a whole, and it can be interpreted as the
required return on the overall firm. A firm can raise capital in a
variety of forms and different forms of capital may have
different cost associated with them. The important uses of the
cost of capital stand out in particular:
The cost of capital is an important link in achieving the
financial goal of the firm- maximizing the stockholders’
wealth by maximizing the firm’s equity value.
Maximization of the firm’s value is closely tied to
minimization of all input costs, and capital is an
important input.
The cost of capital is used to make capital budgeting
decisions.
Required Return vs. Cost of Capital
Required return (RR) is the rate of return that the firm must
earn on the investment just to compensate its investors for the
use of the capital needed to finance the project. This why
financial practitioners always say that RR is also the cost of
capital (CC) associated with the investment. The concerns in the
financial markets generally use the term required return, cost of
capital, and appropriate discount rate (DR) more or less
interchangeably, because, they all mean essentially the same
thing. The fact is here that the CC associated with an
investment depends on the risk of that investment. This is one
of the most important lessons in corporate finaPnce:
The cost of capital depends primarily on the use of
funds, not the source of funds
Calculation of CC
Calculation of CC is a three-part process:
i. Estimating the specific CC
ii. Determining the weights or capital structure
proportions,
iii. Combining the costs and weights to obtain an
estimate of the CC.
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Specific CC means the costs of capital of each of the various
parts, or components, included in the weighted CC. Finding a
specific CC may be thought of as a two-step process:
i. Finding the investor’s required rate of return
associated with the capital source.
ii. Adjusting the investor’s required rate of return as
found into a specific CC for the firm by considering:
a) The firm’s tax situation.
b) The flotation costs the firm may incur in acquiring the
capital.
A specific CC for the firm is basically the rate of return required
by investors adjusted for the firm’s tax and flotation cost
particulars.
Investors’ Required Rate of Return (RRR):
In present value terms, investors’ required rate of return for
capital source-i, is the discount rate that satisfies the equation
below:
N
Ct
C0 =∑
t=1 (1+ k i )t
where,
C0 = cash paid by the investor at time t = 0
C t = expected cash payment from the firm to the
investors in time t
N = life of capital
ki = investors’ required rate of return for capital source
i.
Investors’ Required Rate of Return (RRR) on Equity:
The two sources of new equity capital are common stock
(external equity) and retained earnings (internal equity).
Investors’ required rate of return (RRR) on equity reflects the
opportunity cost that stockholders can earn outside the firm.
Investors’ RRR on common stock (externally provided equity)
and on retained earnings (internally provided equity) are equal.
Therefore, we may refer to both or either as the RRR on equity,
ke. A good financial analyst has several ways to estimate ke,but
two methods are particularly important.
1. Dividend Discount Model (DDM) Approach:
According to the constant growth-version of DDM, the investors’
RRR on equity is (ke):
D1
where,
ke =
[ ]
P0
+g
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D1= nest year’s expected dividend per share
P0 = market per of common stock
g = expected constant dividend growth rate.
Investors’ RRR on common stock = Investors’ RRR on
retained earnings = Investors’ RRR on equity = ke
2. The Capital Asset Pricing Model (CAPM) Approach:
The firm’s stock is a financial asset, so we can
apply CAPM to determine the RRR on equity, ke as:
ke = rf + (rmrf)
where,
rf = risk-free rate of interest
rm = expected rate of return on the market index
= beta (covariability) risk of the equity.
Cost of equity
Although common stock and retained earnings have the same
RRR , they do not have the same cost of capital. By using the
constant growth-version of DDM, cost of new common stock and
retained earnings can be estimated as follows:
i. Cost of common stock: When common stock is
issued, the firm incurs flotation costs that reduce the
cash proceeds the firm receives. The cost of new
common stock (kCS) can be estimated as:
D1
where,
k CS =
[ P0 (1−F ) ] +g
where,
k P=
[ ]
P0
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DP = expected preferred dividend
P0 = price of preferred stock
However, the cost of preferred stock (kP) is:
DP
k D= [ (1−T )
(1−F )
×k d ]
Where,
T = corporate tax rate
f = flotation costs as percentage of B0
kd = interest rate on debt.
Determining the weights or capital structure proportions
Weight is the proportion of one component of capital in the
capital structure. We can use the market value of the firm’s
equity (E) and the market value of the firm’s debt (D). So, the
total value (V) of the firm would become:
V=E+D
If we divide both sides by V, we can calculate the percentages
of the total capital represented by the debt and equity:
100% = E/V + D/V
These percentages can be interpreted just like portfolio weights,
and they are often called the capital structure weights. Weights
can be book weight and market weight.
Book weight: It is determined by dividing the book value of
each capital source by the sum of the book values of all the
long-term capital sources.
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Marker weight: It is determined by dividing the market value
of each capital source by the sum of the market values of all the
long-term capital sources.
Combining the costs and weights to obtain an estimate
of the CC
Once the various costs of capital and their weights are
determined, the overall (composite) cost of capital, commonly
known as weighted average cost of capital (WACC), can be
calculated as:
N
k WACC =∑ wi k i
i=1
where,
kWACC = the weighted average cost of capital
w i = percentage of the capital supplied by i th
source
ki = cost of capital of the i th source
N = number of the long-term capital sources in
the firm’s capital structure.
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