Financial Market Part 1.pdf

7/30/2019 Financial Market Part 1.pdf

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To understand what is finacial market, we will first try to understand what is

a market?

Economists define market as 'a cental place where sale and purchase of goods

and services takes place.'

Financial Markets refer to the set of all Financial Instutions (Fis) in an

economy which helps in the smooth flow of capital from places where it is

surplus to the areas where it is required or consumed. These Financial

Institutions may be banking or non banking financial corporations (NBFCs). A

more appropriate definition of financial markets has been given by Eugene F

Brigham1

Financial Markets is the place where people and organizations wanting to

borrow money are brought together with those having surplus of funds.

Thus the Financial Markets play a larger role in the smooth distribution and

availability of capital so that industrial development can happen in a nation.

In short, Financial Markets helps in the overall devlopment of a nation.

Note that financial markets is plural as there are a great many different

financial markets in a developmed economy like ours. Each sub market of

financial markets deals with a somewhat different type of instruments in terms

of the instrument's maturity and the assets backing it. Also, different

markets serve different types of customers, or operate in different parts of

the country. For these reasons it is often useful to classify markets along

various dimensions :

Physical assets

markets are real markets or tangible markets where industrial produce

(Computers, Machinery, Electronics goods etc) or agriculutural commodities

(Wheat, Corn, Cloves etc) or physical commodities (Gold, Silver, Crude etc)

are traded. In Financial asset markets financial assets like shares, bonds,

debentures are traded.


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Spot markets are those markets wherein

the assets are bought or sold on-the-spot. It means the assets are available

and transaction gets completed immediately. In the Futures markets the parties

agree to enter into a contract wherein the assets will be change hands on a

future date.

1 As per the definition given by Brigham and Houston in their book

'Fundamentals of Financial Management.2 Brigham and Houston in their book 'Fundamentals of Financial Management' has

given this classification.

Money markets are those markets

wherein the funds are traded for a short period of time not exceeding a year.

Few such instruments are Certificate of Deposits (CD), Commercial Paper (CP),Treasury Bills (T-bills) etc. Capital markets are those markes wherein funds

are traded for a period of over one year. Few such instruments are Debentures,

Corporate bonds, Treasury Bonds etc.

Primary markets are those markets

in which new capital is raised by the companies. The companies create new

capital (say equity capital) and issue it for the first time to investors,

this would qualify as primary market transaction. However, when the buyers of

these capital (say equity capital as previously mentioned) comes back for re-

sale of this capital, the market in which it would be sold is called as

secondary market. Stock exchange are the places where this re-sale

transactions are carried out. In short, Bombay Stock Exchange may be the

secondary market for the equity capital issued by a company.

Private markets are those markets in

which the issuer of the capital directly enters into a deal with the investor.

Thus the company gives shares to the investors while the investor put in money

in the company. This is essentially a two party transaction. However, when the

company goes ahead with issuance of shares to public it is known as public

market transaction. Under this transaction, there are large number of persons

holding the shares of the company or shares are issued to large number of

investors.


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The genesis of the Indian financial markets since the independence is marked

by four distinct phases as given below:

This period can be termed as phase of

Transitionas banking system were getting strengthened by a process of merger

& acquistions of small and weak banks. The other major activity of this period

is the efforts that were made to strengthen the co-operative financial

institutions.

This phase can be termed as phase of Growth

and Diversification. In this phase, a lot of financial institutions were

established and Indian financial market diversified into development banking,

mutural funds etc.

: Thisphase is marked byConsolidation of

various banking and non-banking financial institutions. The major thrust was

provided by the nationalization of banks. Government also started the lead

banking schemes.

This phase can ideally be called as phase of

Innovationwhich was a sequel of the policy followed by the central government

generally called as Liberalization-Privatization-Globalization (LPG). New

financial instruments viz Reverse Repo, Derivatives, Securitization, Reverse

Mortgages etc were introduced into the Indian financial markets. Sweeping

reforms were carried out in the Indian financial markets.3 Different researchers have furnished different views on the genesis of the Indian

financial markets, thus these four phases mentioned below are only indicative in

nature.

The most important role of financial markets is to transfer funds from those

who have excess of it to those who need it. Thus financial markets helps

individual in buying housing and other real estate assets, it also helps

students in getting educational loans so that they can pursue higher

education, it helps the companies to get capital which helps in their growth.

The governments also uses the financial markets to borrow the funds for

financing the infrastructural public utility projects. The important

functions of the financial markets are given below:

Liquidity refers to cash or money and other

financial assets , which can be readily converted into cash without any

significant loss of time and value.

By transferring the small and large savings of


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individuals as well as corporations, financial markets speeds up consumption

and investment.

In contributes to national growth by ensuring an

unaffected flow of surplus funds to deficit units.

By providing capital to set up the

new projects of ventures through venture capital, the financial markets

supports the budding entrepreneurs.

Financial markets helps in accelerated growth of

Industrial and economic development.

By investing in financial instruments like Term

Deposits, interest can be earned on otherwise idle surplus cash. Similarly, by

investing in shares, dividends can be earned. Thus financial markets provides

an opportunity for enhancement of income

The twin act of savings and investment clubbed

together is known as capital formation. Since financial markets helps in

transfer of funds from surplus areas to consumption (investment) areas, it

helps in capital formation

The price of traded funds is decided by the

financial markets

The financial markets lays down clearly the code of

conduct under which the funds would be traded thus it devises the sale

mechanism

One of the functions of financial markets is

proper dissemination of information so that the prospective investors may make

an information decisions.

Financial markets indeed supply funds to those who are in need for these funds

from those who are having surplus of it. However, for this process to get

completed an effective medium or channel is required. Financial Instruments


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are those tools through which or by the use of which the transfer of funds

takes place. For example, the customers at various branches of any bank would

keep their surplus funds with the bank in the form of various financial

instruments like savings bank account, term deposits, recurring deposits etc.

In turn the bank pays interest on these instruments which acts as a motivators

for the investors. The bank pools these small deposits into a big corpus which

may be given to any person or firm for purchase of any assets. An individual

may approach the bank for getting housing loan or automobile loan or possibly

personal loan. Thus, the bank will disburse this funds through separate

instruments. In short the vehicles through which funds are transferred or

traded in the financial markets are known as financial market instruments.

Financial markets can be broadly be classified into the following categories:

Apart from the above four sub-markets of financial markets, we do have

But the same has not been included in the aboveclassification because the commodity markets deals in commodities (lke Crude

Oil, Gold, Silver, Wheat etc) and their trade cannot be directly called as

financial transactions. Hence, we have included only those sub-markets of

financial markets in the classification wherin transactions carried out are

purely financial transactions


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4 Different researchers have classified financial markets differently. Here an

attempt has been made to classify the financial markets in a manner which is very

simple and easy to understand.

Money markets are those places where funds are traded for short period of time

not exceeding an year. Money markets helps in meeting the requirements of

funds on short term basis. The other important functions of money markets are:

a. Smooth functioning of commercial banks (banks can meet any shortfall in

temporary liquidity)

b. Effective Central Bank Control for tiding up the excess liquidity through

changes in credit rates

c. Development of Trade and Industry

d. Helps the Capital markets development

The chief characteristics of the developed money markets are as given under:

a. Highly organized Banking system

b. Presence of Central Banker (The regulator of the Money Markets)

c. Availability of proper credit instruments

d. Existence of Sub-markets

e. Demand and Supply of Funds

The market which trades the funds for long term is known as capital markets.

The word long term means that the maturity date of the investment shall be in

excess of one year. A business enterprise can raise capital from various

sources. Generally the companies raises long term funds from capital markets

either through borrowing from financial institutions or through issue ofsecurities on their own. Capital markets can broadly be classified into two

parts:


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It is the market of government securities thus both principal and interest

both are guaranteed. Since both the principal as well as the interest is

guaranteed thus this market has an edge over other markets and hence the name

Gilt Edged market. The G-sec market has the following features:

a. No Uncertainty w. r. t. Yield or Repayment

b. Dominant players are LIC, GIC, PF funds and select other FIs

c. Size of transaction : the value of transactions are very high (runs into

several crores of rupees)

d. RBI is the major actor on behalf of Government.

e. OTC market : it is primarily and Over the Counter (OTC) market.

f. Liquidity : the instruments traded are most liquid debt instruments

It is the market where securities viz shares, debentures and bonds issued by

the companies (corporates) are bough and sold. It consists of the new issue

market (the primary market) and the stock exchanges (the secondary market)

a. Mobilization of savings and accelerated capital formation

b. Promotion of industrial growth

c. Raising of long term loans

d. Ready and continuous market

e. Financing the Five Year Plans of Government of India

f. Development of variety of services like Broking Houses, R & T activities,

Underwriting services, Credit rating services, Custodial services, PMS etc.

Derivative markets are investment markets that are geared toward the buying

and selling of derivatives. Derivatives are securities, or financial

instruments, that get their value, or at least part of their value, from the

value of another security, which is called the underlier . The underlier can


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come in many forms including, commodities, mortgages, stocks, bonds, or

currency. The reason investors may invest in a derivative instrument is to

hedge their bet.

An is a commodity or some form of security that provides the

backing for the trading of shares. Sometimes referred to as an underlying

security, the underlier is the security that may be called for delivery in the

event that an option associated with the transaction is called or exercised.

Generally, the underlier can also be a security that cannot be delivered, but

will be settled with cash.

The use of underliers in most forms of investments is essential in order fortrades to take place. Because the underlier involves securities and

commodities that will in effect guarantee the current base trading value of

the investment, the stability of the instrument used as an underlier must be

affirmed. Without a stable underlying security, shares of stock become

worthless and the investor will quickly lose money on the investment.

Derivative market and Underlier definition taken from the websitewww.wisegeek.com/what-is-a-derivative-market.htm (October 08, 2010)

The word forex in Forex Markets stands for eign change; it's also known

as FX. In a forex trade, you buy one currency while simultaneously selling

another - that is, you're exchanging the sold currency for the one you're

buying. The foreign exchange market is an over-the-counter market.

Currencies trade in pairs, like the Euro-US Dollar (EUR/USD) or US Dollar /Japanese Yen (USD/JPY). Unlike stocks or futures, there's no centralized

exchange for forex. All transactions happen via phone or electronic network.


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Daily turnover in the world's currencies comes from two sources:

Companies buy and sell products in foreign

countries, plus convert profits from foreign sales into domestic

currency.

for profit

Most traders focus on the biggest, most liquid currency pairs. " "

include US Dollar, Japanese Yen, Euro, British Pound, Swiss Franc, Canadian

Dollar and Australian Dollar. In fact, more than 85% of daily forex trading

happens in the major currency pairs.

The world's most traded market, trading 24 hours a day

With average daily turnover of US$3.2 trillion, forex is the most traded

market in the world.

A true 24-hour market from Sunday 5 PM ET to Friday 5 PM ET, forex trading

begins in Sydney, and moves around the globe as the business day begins, first

to Tokyo, London, and New York.

Unlike other financial markets, investors can respond immediately to currency

fluctuations, whenever they occur - day or night.

Forex markets definition taken from the website www.forex.com/intro-forex-

market.html (October 08, 2010)

Following Instruments are generally traded in the money markets

2.3.1 Call Money

2.3.2 Certificate of Deposits (CD)

2.3.3 Commercial Papers (CP)


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2.3.4 Treasury Bills (T-bills)

2.3.5 MMMF

It refers to the market where funds are traded for extremely short period of

time. It consists of Overnight markets and money at short notices up to the

period of 14 days.

Certificate of Deposits are the negotiable money market instrument and is

issued in dematerialized form or as a promissory note for fund deposits at a

bank or other eligible financial institutions for a specified time period.

Generally they are short term deposit instrument issued by financial

institutions to raise large sums of money. Main features of CDs are

a. Time deposits

b. Transferable

c. Issued at discount to face value

d. Repayable on fixed date

e. Subject to Stamp duty.

In USA, the commercial paper was started by Consumer finance companies in

1920s while in India, Vaghul working group gave recommendations to government

and as per the recommendations, RBI introduced commercial papers in Indian

Money Markets from 1989.

Commercial paper is a short term unsecured instrument issued by a company in

the form of promissory notes with fixed maturities.

A Treasury bill is a kind of Promissory Note issued by the Government or any

other entity under the discount for a specified period stated therein. The

issuer promises to pay the specified mentioned amount to the bearer of the

instrument at the time of maturity (due date). The period does exceed one

year.


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In India T-bills are short liability of government. Theoretically, T-bills

should be issued for meeting temporary deficits of the government arising due

to excess expenditure over revenue at some point of time.

It is a variety of Mutual Fund which invests its corpus into money market

instruments. These type of mutual fund schemes are also known as liquid funds.

MMMF deposit account scheme can be operated either by issuing a deposit

receipt or through the issue of passbook. Some liquid schemes of mutual funds

have started offering 'cheque writing' facility. Such facility provides more

liquidity to unit holders.

2.4.1 Bonds Government bonds, Corporate bonds, PSU bonds, FI bonds etc.

2.4.2 Debentures

2.4.3 Equities

2.4.1 Bonds

Bonds are simple debt (borrowing) instruments. They are also known as fixed incomesecurities because most bonds pay regular income to the investor a rate of interest onthe bond. Some of the examples of bonds floated in the market are Government bonds,Corporate bonds, PSU bonds, FI bonds etc. The important concepts related to thebonds are:

It is the principal or face value of the bond

Coupon is the interest rate the bond pays. Generally the coupon rate does not

change in the life of the bond.


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Maturity refers to date on which the principal and coupon (if any) due on the

bonds has to be repaid to the investor. After this payment by the bond issue,

the claim of investor stands extinguished.

The safest type of a security in a company is known as debentures. A debenture

is an instrument of credit , a bond of indebtness or a mere acknowledgement of

debt issued by a company or any legal entity under its commond seal. Some of

the types of debentures floated into the capital markets are:

a. Secured debentures

b. Simple Debentures

c. Redeemable debentures

d. Perpectual debentures

e. Registered debentures

f. Bearer debenturesg. Convetible debentures

It is an evidence of partial ownership interest in an organization. They have

two chief characteristics:

a. they are anticedant

b. All claims are residual


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Detailed account of equity has been given in the sections 3.0 and 4.0

Equity / ordinary share capital, as a long term source of finance, represents

ownership capital / securities and its owners equity holders / ordinary

shareholders share the reward and risk associated with the ownership of

companies. At the time of floating the company the promotors pool in their

money and accordingly they get the shares of the company. Thus, the initialequity holders of the company are mostly the promotors. Later on the stake of

promotors are diluted and fresh capital is issued by way of further isssue of

equity shares.

It is an ownership interest in any organization. Accordingly, the equity

exists even before the company is flaoted in the form of wealth of persons,

who after the floating of the company becomes its owners or promotors.

Equity Capital is the most primitive source of capital because it existed even

before the company came into existence.


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Equity share capital is owned capital because it is the money of the shareholders who areactually the owners of the company.

Every share has fixed value or a nominal value. For example, the price of a share is Rs.10/- which indicates a fixed value or a nominal value.

The shareholders of equity capital have a residuary claim on the earnings i.e.

dividends and also in the case of winding up or dissolution of the company

they are paid in the end.

The equity shareholders receive dividend as a form of income or returns from

their investments made in the company. Though their returns are not fixed,

they vary in accordance with the profits earned by the company.

The equity shareholders enjoy voting rights for taking certain decision for

the running of the company.

The equity shares can be traded in the secondary market, so they are liquid as

they can be transferred from one person to another easily.

Preferred stock, also called preferred shares, preference shares, is a special equitysecurity that has properties of both equity and a debt instrument and is generally

considered a hybrid instrument. It is a capital stock which provides a specific dividendthat is paid before any dividends are paid to common stock holders, and which takesprecedence over common stock in the event of a liquidation.

The term bonus means an extra dividend paid to shareholders in a joint stock companyfrom surplus profits. When a company has accumulated a large fund out of profits - muchbeyond its needs, the directors may decide to distribute a part of it amongst theshareholders in the form of bonus.

A bonus share is a free share of stock given to current/existing shareholders in acompany, based upon the number of shares that the shareholder already owns at the

time of announcement of the bonus. While the issue of bonus shares increases the totalnumber of shares issued and owned, it does not increase the value of the company.

Although the total number of issued shares increases, the ratio of number of sharesheld by each shareholder remains constant.

A rights issue an option that a company opts for to raise capital under a secondarymarket offering or seasoned equity offering of shares to raise money. The rights issue isa special form of shelf offering or shelf registration. With the issued rights, existing


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shareholders have the privilege to buy a specified number of new shares from the firmat a specified price within a specified time. A rights issue is in contrast to an initial publicoffering (primary market offering), where shares are issued to the general public throughmarket exchanges.

A callable bond (also called redeemable bond) is a type of bond (debt security) thatallows the issuer of the bond to retain the privilege of redeeming the bond at some pointbefore the bond reaches the date of maturity. In other words, on the call date(s), theissuer has the right, but not the obligation, to buy back the bonds from the bond holdersat a defined call price. Technically speaking, the bonds are not really bought and held bythe issuer but are instead canceled immediately

a. Authorized Capital

It is the nominal or registered capital mentioned in the Memorandum and it acts as themaximum amount of capital which a company is authorized to issue under the terms ofmemorandum.b. Issued CapitalIt is the amount offered for sale or subscription by the company through a prospectus. c. Subscribed CapitalIt is the amount of share issued capital for which the company has receivedsubscription.d. Called up CapitalThe amount of the share capital called up the company from the subscribed capital.e. Paid up Capital

The amount of capital that the company has at its disposal which is the amount paid bythe shareholders on the capital subscribed by them.

4.0 Equity Terminologies

Equity terminologies covers a wide range of topics starting from the inception

of funds in an organization to the terms used till the dissolution of a

company. Some of the terms used in the general parlance are given in the next

section.

4.1 Understanding of various Jargons of equity markets

a. Share/StockThe stock or capital stock of a business entity represents the original capital paid into orinvested in the business by its founders or investors.b. Dividend


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Dividends are payments made by a corporation to its shareholder members. It is theportion of corporate profits paid out to stockholders. When a corporation earns a profitor surplus, that money can be put to two uses: it can either be re-invested in thebusiness (called retained earnings), or it can be paid to the shareholders as a dividend.Many corporations retain a portion of their earnings and pay the remainder as a

dividend.c. Rights IssueA rights issue an option that a company opts for to raise capital under a secondarymarket offering or seasoned equity offering of shares to raise money. The rights issue isa special form of shelf offering or shelf registration. With the issued rights, existingshareholders have the privilege to buy a specified number of new shares from the firmat a specified price within a specified time. A rights issue is in contrast to an initial publicoffering (primary market offering), where shares are issued to the general public throughmarket exchanges.d. Bonus IssueThe term bonus means an extra dividend paid to shareholders in a joint stock company

from surplus profits. When a company has accumulated a large fund out of profits - muchbeyond its needs, the directors may decide to distribute a part of it amongst theshareholders in the form of bonus.

A bonus share is a free share of stock given to current/existing shareholders in acompany, based upon the number of shares that the shareholder already owns at thetime of announcement of the bonus. While the issue of bonus shares increases the totalnumber of shares issued and owned, it does not increase the value of the company.

Although the total number of issued shares increases, the ratio of number of sharesheld by each shareholder remains constant.e. Initial Public Offer

An initial public offering (IPO), referred to simply as an "offering" or "flotation", is when acompany (called the issuer) issues common stock or shares to the public for the first time.They are often issued by smaller, younger companies seeking capital to expand, but canalso be done by large privately-owned companies looking to become publicly traded.f. Follow on Public Offer

A follow-on offering (often called secondary offering) is an issuance of stock subsequentto the company's initial public offering. A secondary offering is an offering of securities bya shareholder of the company (as opposed to the company itself, which is a primaryoffering). A follow on offering is preceded by release of prospectus similar to IPO.g. Private PlacementPrivate placement (or non-public offering) is a funding round of securities which are soldwithout an initial public offering, usually to a small number of chosen private investors. h. Qualified Institutional PlacementQualified institutional placement (QIP) is a capital raising tool, primarily used in India,whereby a listed company can issue equity shares, fully and partly convertibledebentures, or any securities other than warrants which are convertible to equity sharesto a Qualified Institutional Buyer (QIB).i. Qualified Institutional Buyer

A Qualified Institutional Buyer (QIB), in law and finance, is a purchaser of securities thatis deemed financially sophisticated and is legally recognized by security market


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regulators to need less protection from issuers than most public investors.j. Private EquityPrivate equity, in finance, is an asset class consisting of equity securities in operatingcompanies that are not publicly traded on a stock exchange

4.2 Understanding of Systematic and Unsystematic risk

First we need to understand what is a risk, then only understanding of Systematic andUnsystematic risk is possible.

4.2.1 Understanding of Risk

The chance that an investment's actual return will be different than expected.

Risk includes the possibility of losing some or all of the original

investment.

Sources of Risk

It is the variability in a security? return from changes in the level of

interest rates.

Market risk refers to the variability of returns due to fluctuations in the

securities market.

With the rise in inflation there is reduction of purchasing power, hence this

is also referred to as purchasing power risk and affects all securities.

This refers to the risk of doing business in a particular industry or

environment and it gets transferred to the investors who invest in the

business or company. It may be caused by a variety of factors like heightened

competition, emergence of new technologies, development of substitute

products, shifts in consumer preferences etc.

Financial risk arises when companies resort to financial leverage or the use

of debt financing. The more the company resorts to debt financing, the greater

is the financial risk as it creates fixed interest payments due to debt or

fixed dividend payments on preference stock thereby causing the amount of

residual earning available for common stock dividends to be more variable than

if no interest payments were required. It is avoidable to the extent that

management has the freedom to decide to borrow or not to borrow funds.

This is the risk associated with the secondary market which the particular


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security is traded in. A security which can be bought or sold quickly without

significant price concession is considered liquid. The greater the uncertainty

about the true element and the price concession, the greater the liquidity

risk. Securities that have ready markets like treasury bills have lesser

liquidity risk.

4.2.2 Classification of Risk

The risk that a security is exposed to can be broadly classified into two categories. The

first type of risk is known as Diversifiable risk because, it can be diversified or reduced bythe decision maker or it is under the control of the investor while the other type of risk is

known as non-diversified risk becuase it is beyond the control of the investor and thus

cannot be reduced.

4.2.2.1 Unsystematic or Diversifiable Risk

It is the risk specific to the security (company risk) and investor by holding a portfolio

which is well diversified can completely eliminate the unsystematic risk. The different

types of unsystematic risks are:

iBusiness Risk

iiFinancial Risk

iiiDefault Risk

4.2.2.2 Systematic or Non-diversifiable Risk

It is associated with the general market movement and it cannot be diversified. All

securities do not have the same degree if systematic risk because the impact of economy

wide factors could differ from company to company and industry to industry.


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i Market Risk

ii Interest Rate Risk

iiiPurchasing Power Risk

4.3 Understanding of Risk and Return and Calculation of Beta

Risk and return go hand in hand in investments and finance. One cannot talk about

returns without talking about risk, because, investment decisions always involve trade off

between risk and return. Risk can be defined as the chance that the actual outcome from

an investment will differ from the expected return. This means that, the more variable the

possible outcomes that can occur (i.e. the broader the range of possible outcomes), the

greater the risk.

4.3.1 Risk and Expected Rate of Return

The width of a probability distribution of rates of return is a measure of risk. The wider the

probability distribution, the greater the risk or the greater the variability of return or greater

the variance. An investor cannot expect greater returns without being willing to assume


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greater risks.

4.3.2 Return from Equity Capital.

The return from equity capital can be calculated with Capital Asset Pricing Model (CAPM).

The CAPM was developed by William F. Sharpe, John Linter and Jan Mossin is one of

the major developments in financial theory. The CAPM establishes a linear relationship

between required rate of return of a security and its systematic or undiversifiable risk or

beta. This relationship as defined by CAPM can be used to value an equity share.

Mathematically, the relationship between the share market return and the market return

can be depicted by the following formula

Rs= Rf+ (Rm - Rf)

Where, Rs= Return on stock

Rf= Risk free rate of return

Rm= Market rate of return

= Systematic risk

This relationship means that if the market price goes up by 10% and the security price

also goes up by 10%, and vice versa, the beta is said to 1, i.e., there is a perfect

correlation between return from the security and return from the market. If beta is 2, the

security price would go up twice the percentage of change of the market. If beta is 0, then

no correlation exists between the market movement and the security price movement.

4.3.3 Assumptions of CAPM

Investors are risk averse and use the expected rate of return and standard

deviation of return as appropriate measures of risk and return for their portfolio.

Investors make their investment decisions based on a single period horizon, i.e.,

the next immediate time period.

Transaction costs in financial markets are low enough to ignore and assets can

be bought and sold in any unit desired. The investor is limited only by his wealth

and the price of the asset.


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Taxes do not affect the choice of buying assets.

All individuals assume that they can buy assets at the going market price and

they all agree on the nature of the return and risk associated with each investment.

4.3.4 Measurement of (Beta)

Beta measures the relative risk associated with any individual portfolio as measured in

relation to the risk of market portfolio. The market portfolio represents the most diversified

portfolio of risky assets an investor could buy since it includes all risky assets.

The relative risk can be expressed as:

Non-diversifiable risk of asset or portfolio

= ---------------------------------------------------------

Risk of material portfolio

Thus, the beta coefficient is a measure of the non diversifiable or systematic risk of an

asset relative to that of the market portfolio.

A beta of 1 indicates an asset of average risk.

A beta coefficient greater than 1 indicates above average risk, stocks whose

returns tend to be more risky than the market.A beta coefficient less than 1 indicates below average risk, i.e., less riskier than

market portfolio.

In case of market portfolio all the diversification possible has been done, thus, the risk of

market is all non diversifiable which an investor cannot avoid. Similarly, as long as the

assets returns are not perfectly positively with returns from other assets, there will be

some way to diversify away its unsystematic risk. As a result, beta depends only on non

diversifiable risks.

4.3.5 Mathematical Calculation of Beta

The systematic relationship between the return on the security or a portfolio and the


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return on the market can be described using a simple linear regression, identifying the

return on a security or portfolio as the dependent variable Kj and the return on market

portfolio as the independent variable Km, in the single index model or market model

developed by William Sharpe.

This can be expressed as:

Kj=j+jKm+ej

Rs=+Rm

The beta parameter in the model represents the slope of the above regression

relationship and measures the responsiveness of the security or portfolio to the general

market and indicates how extensively the return of the portfolio or security will vary with

changes in the market return. The beta coefficient of a security is defined as the ratio of

the security? covariance of return with the market to the variance of the market. This can

be calculated as follows:

Cov. (Rs,Rm)

= ------------------------

Var. Rm

4.4 Stock Market Terminologies

The terminologies used in stock markets are like an ocean where the ends are seemingly

not easy to estabhlish. Thus, the terminologies used in stock market parlance are

practically innumerable. Few such examples are given below:

a. Bullish Market

A financial market of a group of securities in which prices are rising or are expected to

rise. The term "bull market" is most often used to refer to the stock market, but can be

applied to anything that is traded, such as bonds, currencies and commodities.

Bull markets are characterized by optimism, investor confidence and expectations that

strong results will continue. It's difficult to predict consistently when the trends in the


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market will change. Part of the difficulty is that psychological effects and speculation may

sometimes play a large role in the markets.

b. Bearish Market

A market condition in which the prices of securities are falling, and widespread pessimism

causes the negative sentiment to be self-sustaining. As investors anticipate losses in a

bear market and selling continues, pessimism only grows.

A bear market should not be confused with a correction, which is a short-term trend that

has duration of less than two months. While corrections are often a great place for a value

investor to find an entry point, bear markets rarely provide great entry points, as timing

the bottom is very difficult to do.

Documents

Financial Market Part 1.pdf