CHAPTER – 1
INTRODUCTION
1.1 INTRODUCTION
Investment is the employment of funds with the aim of achieving additional income or growth in value. The essential quality of an investment is that it involves ‘waiting’ for a reward. It involves the commitment of resources which have been saved or put away from current consumption in the hope that some benefits will accrue in future. The term ‘investment’ does not appear to be as simple as it has been defined. Investment has been future categorized by financial experts and economists. It has also often been confused with the term speculation. the following discussions will give an explanation of the various ways in which investment is related or differentiated from the financial and economic sense and how speculation differ from investment. However, it must be clearly established that investment involves long-term commitment.
RISK:
In the investing world, the dictionary definition of risk is the chance that an investment’s actual return will be different than expected. Technically, this is measured in statistics by standard deviation. Risk means you have the possibility of losing some, or even all, of our original investment.
Risk consists of 2 components:
- Systematic risk (uncontrollable risk) non – diversifiable risk
- Unsystematic risk (controllable risk) diversifiable risk
1. Systematic Risk
The risk that affects the entire market and the factors are beyond the control of the corporate and the investor. They cannot be avoided by the investor. It is sub-divided into.
- Market risk
- Interest rate risk
- Purchase power risk
a.Market risk
Within the context of the capital asset pricing model (CAPM), the economy wide uncertainty that all assets are to and cannot be diversified away are often referred to as systematic risk, non –diversifiable risk or the risk of the market portfolio. This type of the risk is discussed extensively in investment courses.
b. Interest rate risk
The uncertainty associated with the effects of changes in market interest rates. There are two types of interest rate risk identified: price risk and reinvestment rate risk. The price risk is sometimes referred to as maturity risk since the greater the maturity of an investment, the greater the change in price for a given change in interest rates. Both type of interest rate risks are important in banking and are addressed extensively in banking management classes.
c.Purchase power risk (inflation risk)
The loss of purchasing power due to the effects of inflation is Purchase power risk. When inflation is present, the currency losses it’s value due to the rising price level in the economy. The higher the inflation rate the faster the money loses its value.
2. Unsystematic risk or diversifiable risk
It is unique to the firm or industry. It is caused from managerial inefficiency, technological changes, consumer preferences, labour problems etc. The magnitude and nature differ from firm to firm and industry to industry.
It can be classified into 2 types
a. Business risk
b. Financial risk
a. Business Risk:
The uncertainty associated with a business firm’s operating environment and reflected in the variability of earnings before interest and taxes (EBIT). Since this earnings measure has not had financing expenses removed, it reflects the risk associated with business operations rather than methods of debt financing. This risk is often discussed in general business management courses.
- Internal risk
- Fluctuations in sales
- Research and development
- Personal management
- External risk
b. Financial Risk:
The uncertainty brought about by the choice of a firm’s financing methods and reflected in the variability of earnings before taxes (EBT), a measure of earnings that has been adjusted for and is influenced by the cost of debt financing. This risk is often discussed within the context of the capital structure topics.
RETURNS
A major purpose of investment is to set a return of income on the funds invested. On a bond an investor expects to receive interest. On a stock, dividends may be anticipated. The investor may expect capital gains from some investments and rental incomes from house property. Return may take several forms.
Measurements of Returns
The purpose of investment is to get return or income on the funds invested in different financial assets. The most important characteristics of financial assets are the size and variability of their future returns. Since the return on income varies, various statistical techniques are used to measure it. Over the years, May methods were adopted for quantifying returns. These are now categorized as traditional and modern techniques of measurement.
Traditional method of measurement
Computation of yield to measure a financial asset is the simplest and oldest techniques of measurement. Yield can be both expected or estimated and actual for a particular period. The formula used to find yield is:
Expected cash income
Estimated yield = ------
Current price of asset
Cash income
Actual yield = ------
Amount invested
The yield that is calculated for a particular period to find out the return on the amount that is invested, for example, the annual yield on the Unit Trust Certificate is the dividend income divided by the amount invested.
Measuring Returns – Improved Technique: The ‘holding period yield’ is one of the new techniques in measuring returns. The traditional methods did not provide a satisfactory returns measure. Some of the gaps that were identified were: (a) that the traditional method does not distinguish between divided and earnings portion that the traditional method does not distinguish between divided and earnings portion that the company retains (Earnings Yield Method); (b) Dividend Yield Method ignores the possibility of price appreciation on retained earnings. It is useful only for those shareholders who wish to retain shares always and are not interested in selling and anticipate that dividends are not going to change; (c) the yield to maturity is useful only to those bond holders who will hold it to maturity. All investors may not hold bonds till maturity for obvious reasons. These methods are thus known to serve a limited purpose only. The better method measures return through the holding period yield. This measure appears more rational and clearly defined. It serves two purposes: (a) It measures that total return per rupee of the original investment, and (b) through this method, comparisons can be drawn of any asset’s expected return. An asset can be compared with other both historically and for future periods. The holding period yield can be used for any asset. For example, returns from savings accounts, stocks money, real estate and bonds can be compared through this measure. The formula for the holding period yield is:
Income payments received during the year in Rs. + Capital change for the period in Rs.
Price in rupees of original investment at the beginning of period
Dividend + (Pt-Po)
= ______
Po
A look at this formula shows that the Holding Period Yield (HPY) considers everything the investor receives over the specified period during which the asset is held relative to what was originally invested in the assets. It also considers all income payments; and positive and negative capital changes during the period. These are then measured relative to the original investment in rupees. The HPY also measures past receipts of payments as well as for an unknown future. It is useful for comparing any time period; it can be used on both Bond and Stocks.
Measure of Dispersion:
Dispersion methods help to assess risk in receiving a reward or return on investment. The greater the potential dispersion, the greater is the risk. One of the simplest methods in calculating dispersion is range. The range, however, has limited importance. It is useful when there are small samples. It loses its effectiveness when the number of values in a sample increases. The best and most effective method to find out how the data scattered around a frequency distribution is to use the standard deviation method. This method is related to the mean deviation and implies in this case the means as a point of reference from which deviation occurs. The standard deviation is based on mean and it cannot show any result without first finding out the mean. The standard deviation is recognized by the following symbol . The standard deviation is also related to variance. Variance is the square of standard deviation. In other words, standard deviation is the square root of the variance. This relationship shows that they have similar statistical characteristics. Therefore, standard deviation and variance are considered equivalent to each other as measures of risk. For a security analyst they help in depicting dispersion of HPYs around HPY.
1.2 OBJECTIVES:-
- To Study and understand the working of a brokerage firm.
- To understand the various risks involved in the brokerage firm.
- To study how risk on return of investment evaluated.
- To calculate the risk return of equities to estimate weather the company is reliable for the investor to invest in the shares of the company.
- To study and advice the investor in making effective investment.
1.3 NEED OF THE STUDY
In Indian financial environment investors are facing a lot risk to invest in various financial instruments. The investment risk can be either reduced or can be transferred. Most of the times investors try to maximize returns but want minimum risk in their investment. The present study enables us to identify the different types of risks and how to minimize them. In investment avenues it is very important to know about Risk and Returns so that one can have hassle free investment.
1.4 SCOPE OF THE STUDY
The present study has been undertaken to observe the risk and returns associated with few selected stocks. The scope of the study consists of 5 Company stocks from both private and publicsector which includes IT, Banking, Electronics, Cement and Infrastructure Sector. The scope of the study is confined to 5 Companies.
Sample size- 5 Companies
Duration- 3 months
1.5 RESEARCH METHODLOGY
During my project, I collected data through various sources like primary & secondary sources of data.
Primary source includes:-
1) Interview with branch manager.
2) Interview with investors of the firm.
3) Live trading in the market.
Secondary source includes:-
1) Various books related to stock market.
2) Books related to Financial Management.
3) Web sites were used as the vital information source.
TOOLS USED:
1: Standard Deviation
2: Variance
3. Mean
4. Line Graph
CHAPTER-2
REVIEW OF LITERATURE
THEORITICAL ASPECT
2.1 REVIEW OF LITERATURE
Review 1: Stock market risk and return: an equilibrium approach.
Author: RF Whitelaw
Source: Review of Financial Studies(2000)13(3):521-547.doi:10.1093/rfs/13.3.521
Abstract
Empirical evidence that expected stock returns are weakly related to volatility at the market Level appears to contradict the intuition that risk and return are positively related. We investigate this issue in a general equilibrium exchange economy characterized by a Regime-switching consumption process with time-varying transition probabilities between Regimes. When estimated using consumption data, the model generates a complex, non-Linear and time-varying relation between expected returns and volatility, duplicating the Salient features of the risk/return trade-off in the data. The results emphasize the Importance of time-varying investment opportunities and highlight the perils of relying on intuition from static models.
Review 2: Components of Market Risk and Return.
Author: John M. MaheuandThomas H. McCurdy
Source: journal of financial econometrics(2007)5(4):560-590.doi:10.1093/jjfinec/nbm012first published online:august 31, 2007
Abstract
This article proposes a flexible but parsimonious specification of the joint dynamics of market risk and return to produce forecasts of a time-varying market equity premium. Our parsimonious volatility model allows components to decay at different rates, generates mean-reverting forecasts, and allows variance targeting. These features contribute to realistic equity premium forecasts for the U.S. market over the 1840–2006 periods. For example, the premium forecast was low in the mid-1990s but has recently increased. Although the market's total conditional variance has a positive effect on returns, the smooth long-run component of volatility is more important for capturing the dynamics of the premium. This result is robust to univariate specifications that condition on either levels or logs of past realized volatility (RV), as well as to a new bivariate model of returns and RV.
Review 3: TheRiskandPredictabilityofInternational EquityReturns.
Author: Wayne E. Ferson
Source: Review of Financial Studies(1993)6(3):527-566.doi:10.1093/rfs/6.3.527
Abstract
We investigate predictability in national equity marketreturns,andits relationto global economicrisks. We show how to consistently estimate the fractionofthe predictable variationthat is captured by an asset pricing model for the expectedreturns. We use a model in which conditional betasofthe national equity markets dependonlocal informationvariables, while globalriskpremium dependonglobal variables. We examine single-andmultiple-beta models, using monthly data for 1970 to 1989. The models capture muchofthe predictability for many countries. Mostofthis is related to time variationin the globalriskpremium.
Review 4: Growth or Glamour? Fundamentals and Systematic Risk in Stock Returns.
Author: John Y. Campbell, Christopher Polk and TuomoVuolteenaho
Source: Review of Financial Studies (2010)23(1):305-344.doi:10.1093/rfs/hhp029First published online:April 22, 2009
Abstract
The cash flows of growth stocks are particularly sensitive to temporary movements in aggregate stock prices, driven by shocks to market discount rates, while the cash flows of value stocks are particularly sensitive to permanent movements, driven by shocks to aggregate cash flows. Thus, the high betas of growth (value) stocks with the market's discount-rate (cash-flow) shocks are determined by the cash-flow fundamentals of growth and value companies. Growth stocks are not merely “glamour stocks” whose systematic risks are purely driven by investor sentiment. More generally, the systematic risks of individual stocks with similar accounting characteristics are primarily driven by the systematic risks of their fundamentals.
Review 5: Is Default Risk Negatively Related to Stock Returns?
Author: SudheerChava andAmiyatoshPurnanandam
Source: Review of Financial Studies (2010)23(6):2523-2559.doi:10.1093/rfs/hhp107First published online:January 5, 2010
Abstract
We find a positive cross-sectional relationship between expected stock returns and default risk, contrary to the negative relationship estimated by prior studies. Whereas prior studies use noisy ex post realized returns to estimate expected returns, we use ex ante estimates based on the implied cost of capital. The results suggest that investors expected higher returns for bearing default risk, but they were negatively surprised by lower-than-expected returns on high default risk stocks in the 1980s. We also extend the sample compared with prior studies and find that the evidence based on realized returns is considerably weaker in the 1952–1980 period.
Review 6:Does Systemic Risk in the Financial Sector Predict FutureEconomicDownturns?
Author: Linda Allen, Turan G. Baliand Yi Tang
Source: Review of Financial Studies(2012)25(10):3000-3036.doi:10.1093/rfs/hhs094.
Abstract
We derive a measureofaggregate systemic risk, designatedCATFIN that complements bank-specific systemic risk measures by forecasting macroeconomicdownturns six months into the future using out-of-sample tests conducted with U.S., European, and Asian bank data. Consistent with bank “specialness,” theCATFINofboth large and small banks forecasts macroeconomicdeclines, whereas a similarly defined measure for both nonfinancial firms and simulated “fake banks” has no marginal predictive ability. High levelsofsystemic risk in the banking sector impact the macro economy through aggregate lending activity. A conditional asset pricing model shows thatCATFINis priced for financial and nonfinancial firms.
2.2 INTRODUCTION-WORKING OF A BROKING FIRM
Stock broker
According to SEBI stock broker is a member of a recognized stock exchange(s) and is engaged in buying, selling and dealing in securities. In other words broker is an Intermediary who arranges to buy and sell securities on behalf of clients i.e. the buyer and the seller. A broker can deal in securities only after getting registered with SEBI. Through stock exchanges the constitution of a broking firm may be a Proprietary concern, a partnership firm or a corporate.
Compliance department
The functions carried out by compliance department are as follows.
1. Client registration application form.
2. Broker client agreement on stamp paper of value as applicable in the respective state.
3. Identity Proof Like
- Copy of passport
- Copy of ration card
- Copy of driving license
- Copy of voters’ identity card
- Copy of pan card
- Letter from bank certifying account number and period from which the same is in operation.
4. Letter of running account
- Client registration application form.
- Broker client agreement on stamp paper.
- Certified copy of memorandum and articles of association.
- Certified copy of resolution authorizing the company to open account with HDFC and appointing persons authorized to operate upon said account on behalf of company.
5. Proof of identity in respect of authorized director.
6. Letter from the bank certifying account number and period from which the
Same is in operation.
Dealing department
Dealing department is a very important department in the broking firm as it carries out most important activities of buying and selling of securities. The people doing dealing are called as dealers. He is the person dealing on behalf of the Investor, therefore when the investor wants to trade in some scrip’s he must inform the dealer first and then the dealer deals in the market. The following are the activities carried out in a dealing department.
Entering order
The trading member can enter orders in the normal market and auction market. When
An order enters the trading system it is an active order, it tries to find out on the other
Side of the books if it finds the match, trade is generated. If it does not find a match,
The order becomes a passive order and goes and sits in the order book.