Volatility smiles

A plot of the implied volatility of an option as a function  of its strike price is known as a volatility smile.

Describe volatility smiles in different way.

Put call parity

Put-call parity provides a good starting point for understanding volatility smiles. It is an important relationship between the price,c, of a European call and the price,p,of a European put .

$P+Soe^{-qt}$ = $C+k^{-rt}$

The call and the put have the same strike price ,k, time to maturity,T,

So= The variable is the price of the underlying assets today

r= Risk free interest rate

q= the yield on the assets

A key feature of the put-call parity relationship is that it is based on a relatively simple no-arbitrage argument. It does not require any assumptions about the future probability distribution of the assets price. It is true the when the assets price distribution is log normal and when it is not log normal.

Suppose that for a particular value of the volatility, PBs and CBs are the value of European put and call option calculate using the Black-Schloes model suppose further that Pmkt and Cmkt are the market values of these option.Because put-call parity holds for the market value of these option.Because put-call parity holds for the Black-Schloes model, we must have.

$P^{_{Bs}^{}$+$Soe^{-qt}=C^{_{Bs}$+$Ke^{-rt}$

Because it also holds  for the market prices we have

$P^{_{mkt}}$+$Soe^{-qt}$ =$C^{_{mkt}}+Ke^{-rt}$

Substracting these two equation gives

$P^{_{Bs}}$$P^{_{mkt}}$ = $C^{_{Bs}}$$C^{_{mkt}}$

Foreign currency option

The volatility smile used by traders to price foreign currency options. The volatility is relatively low for at-the-money options.It becomes progressively higher as an option moves either in the money or out of the money.

We show how to determine the risk-neutral probability distribution for an assets price at future time from the volatility smile given by options maturing at that time. We refer to this as the implied distribution.

A log normal distribution with the same mean and standard deviation as the implied distribution has heavier tails than the log normal distribution.

Consistent with each other consider first a drop-out of the money call option with a higher strike price of K2. This option pays off only if the exchange rate proves to be above K2.

The probability of this is higher for the implied probability distribution than for the implied probability distribution. We therefore expect the implied distributed to give a relatively high price for the option. A relatively high price leads to a relatively high implied volatility.

Equity options

The volatility smile used by traders to price equity options (both those an individual stocks indices) This is some times referred to as a volatility skew. The volatility decrease as the price increase. The volatility used to price increase.

The volatility use in  price a low strike price option.(deep-out-of the money put on a drop-in-the money call) is significantly higher strike price option (deep-in-the-money put on a deep-out- of -the money call.

The volatility smile for the equity option corresponds to the implied probability distribution given by the solid  line. A log normal distribution with same mean and standard rather than as the relationship between the implied volatility and K. The smile is then usually much less dependent on the time to maturity.

Cost of debt

A company may raise debt in a variety of ways. It may borrow funds from financial institutions or public either in the form of public deposit or debentures (bonds) for a specified period of time at a certain rate of interest.

A debenture or bond may be issued at par or at a discount or premium as compared to its face value. The contractual rate of interest or the coupon rate from that basis for calculating the cost of debt.

Debt issued at par

The before-tax cost of debt is the rate of return required by lenders. It is easy to compute before-tax cost of debt issued and to be redeemed at par;  It is simply equal to the contractual or coupan rate of interest.

For example, a company decides to sell a new issue of 7  years 15 percent bonds of Rs. 100 bonds and will pay Rs. two each at par. If the company realises to bond holders at maturity, the before-tax cost of debt will simply be equal to the rate of interest of 15 percent.

Kd =i= $\frac{INT}{Bo}$

Where

Kd= before-tax cost of debt

i= the coupan rate of interest

Bo= the issue price of the bond(debt)

INT= Amount of interest

The before tax cost of bond in the example

Kd = $\frac{15}{100}$= 0.15 or 15%

Debt issued at discount and premium

When debt is issued at par and redeemed at par. This equation can be rewritten as follows to compute the before-tax cost of debt.

Bo = $\frac{\sum_{}^{n}}{t=1}$ $\frac{INTt}{(1+kd)t}+\frac{Bn}{(1+kd)}n$

Bn= The repayment of debt on maturity

If the discount or premium is adjusted for computing taxes, following short-cut method can also be used to calculate the before-tax cost debt.

Cost of the existing debt

Sometime a firm may like to compute the current cost of the existing debt. In such a case the cost of debt should be approximate by the current market yield of the debt.

Firm has 11 percent debenture of Rs. 100000(rs.100 face value l) out standing at 31 December.19×1 matured on December 31. 19×6 ). If a new issue of debentures could be sold at net reliable price Rs.80 in the beginning of 19×2.

The interest paid on debt is tax deductible. The higher the interest charges the lower will be the amount of tax payable by the firm. This implies that the government indirectly pays a part of the lender’s required rate of return. As a result of the interest tax shield, the after tax cost of debt to the firm will be substantially less than the investor required rate of return.

The before-tax cost of debt kd should therefore, be adjusted for the tax effect as follows.

After tax cost of debt

Kd(I-T), where T= the corporate tax

Kd(1-T)=0.1650(1-0.35)=0.1073 or 10.73%

It should be noted that the tax benefit of interest deductibility would be available only  when the firm is profitable and is paying taxes.

An unprofitable firm is not required to pay any taxes. It would not gain any tax benefit associated with the payment of interest and it’s true  cost of debt is the before-tax cost.

It is important to remember that in the calculation of the average cost of capital. The after-tax cost of debt must be used, not the before-tax cost of debt.

The LAF has emerged as one of the most important instruments of monetary policy in recent years. The RBI, as the lender of the last resort, was providing various general and sector-specific refinance facilities to the banks.

In keeping with the recent policy objective of shifting from direct to indirect techniques of monetary control. It became a general refinance facility.

The LAF operates through repo auctions,that is, the sale of Government securities from the RBI portfolio for absorption of liquidity, and reserve repo auctions, that is,  buying of Government securities for injection of liquidity on a daily basis, thereby creating a  corridor for the call money rates and other short-term interest rates.

The funds under LAF are expected to be used by banks for their day-to-day mismatches in liquidity. The maturity of repos is form one day to fourteen days. All scheduled banks are eligible to participate in the repo and reverse repo auctions.

The minimum bid size for LAF is rs.5 crore and in multiples of Rs. 5 crore thereafter. All transferable Government of India dated securities/T-bills (expect 14-day T-bills) can be traded in the repo and reverse repo markets.

The DL is the sum of the RBI balance sheet flows that arise out of its money market operation.It represent a change in the total liquidity in the system which occurs due to monetary policy action. It comprise policy-induced flows from the RBI to banks. It is the sum of the following i) net repos and OMOs  of the RBI and ii) RBI credit to banks.

The LAF technique is based on the view that the RBI balance sheet can be partitioned into autonomous and discretionary components.The Autonomous liquudity(AL) and DL bear an inverse relationship with the change in the change in the inter-bank call money rate.

The AL is the sum of RBI’s net incremental claims on the following.

i) the Government adjusted for OMOs and repo operation.

ii) Banks(other than credit to schedule banks)

iii) Commercial sector.

iv) Foreign assets net of liabilities (Other than schedule bank deposit with RBI.

Under LAF  the RBI periodically daily if necessary, sets/rests its repos and reverse repo rate.It uses 3-day repos to siphon of liquidity from the market. The repos are used for absorbing liquidity at a given rate (floor) ,and for infusing liquidity through reverse repos, at a given rate( ceiling).

Merits of LAF

i) The LAF is a new short-term liquidity management technique.

ii)It is a flexible instrument in the hands of the RBI to modulate, even out, adjust or manage short-term market.

iii) Liquidity fluctuation on a daily basis and to help create stable or orderly conditions in the overnight/call money markets.

iv)It is meant to help monetary authorities to transmit short-term interest rate signals to other money markets, financial markets, and the long-end of the yield curve.

V) The repos operations also provide liquidity and breadth to the underlying treasury securities markets.

The LAF operations combined with OMOs and B/R changes, have become the major technique (operating procedure) of the monetary policy in INDIA.

Swap

Swap are similar to future and forward contracts in providing hedge against financial risk. A swap is an agreement between two parties called counter parties to trade cash flows cash flows over a period of time. Swaps arrangements are quite flexible and are useful in many financial situation.

Two most popular swap and interest rate swap. These two swaps can be combined when interest on loan in two currencies are swapped. The interest rate and currency swap market enable firms to arbitrage the differences between capital markets.

Currency Swap

Currency swap involves an exchange of cash payments in one currency for cash payments in another currency. Most international companies require foreign currency for making investment abroad.

These firm find difficulties in entering new market and raising capital at convenient terms.Currency swap is an easy alternative for these companies to overcome this problem.

Use of currency swap to transform loan and assets.

A swap such as the one considered can be used to transform borrowing in one currency to borrowing in another.

For example IBM an issue \$15 million of U.S. dollar denominated bonds at 8% interest. It has the effect of transforming this transaction into one where IBM has borrowed £10 million pounds at 11% interest.

It has the effect of transforming this transaction into one where IBM has borrowed £10 million  pounds at 11%.The initial exchange of principal converts the proceeds of the bond issue from U.S. dollar to sterling.

It can also be used to transform the nature of assets. Suppose that IBM can invest £10 million pounds in the UK to yield 11% per annum for the next the five years. But feels that the U.S. dollar will strengthen against sterling and prefers a U.S. dollar will strengthen against sterling and prefer a U.S. denominated investment.

Valuation of currency swaps

In the absence of default risk. A currency swap can be decomposed into a position in two bonds. As is the case with an interest rate swap.It is short GBP bonds that pays interest at 11% per annum and long a USD bond that pays interest at 8% per annum.

In general, if we define $V{_{swap}}$ as the value in U.S.dollar of a swap where dollar are received and a foreign currency is paid them.

$V{_{swap}}=B{_{D}}-S{_{o}}B{_{F}^{}}$

Where,

$B{_{F}}$ = value

$B{_{D}}$ = U.S. dollar

$S{_{o}}$ = spot exchange

Interest rate swap

The interest rate swap allows a company to borrow capital at fixed (or floating rate) and exchange its interest payments at floating rate or fixed rate. This is the most common type of swap is a plain vanilla interest swap. In this a company agree to pay cash flows equal to interest at a predetermined fixed rate.

On a notional principal for a number of years. In return, it receives interest at a floating rate on the same notional principal for the same period  of time.

The floating rate in many interest rate swap agreement is the London interbank offer rate(LIBOR). LIBOR is the rate offered on one-month deposit.

LIBOR rates are determined by trading between bank and change frequently so that the supply of the reference rate of interest for floating rate loans in the domestic financial market. LIBOR rates are determined by trading between banks and change frequently so that the supply of the reference rate of the interest for loans in international financial markets.

To understand how it is used consider a five year loan with a rate of interest specified as six-month LIBOR  plus 0.5% per annum.

The life of the loan is divided into ten periods. Each six months in length. For each periods the rate of interest is set 0.5% per annum above the six month LIBOR rate at the beginning of the period interest is paid at the end of the period.

Valuation of interest rate swaps

An interest rate swap is worth zero or close to zero, when it is first initiated. After it has been in existence for sometime its value may become positive or negative.

To calculate the value we can regard the swap either as a long position in one bond combined with a short position in another bond or as a portfolio of forward rate agreements.

Valuation in terms of bond prices.

$V_{swap}$ = $B_{n}$$B_{fix}$

Underwriting

Underwriting entails an agreement whereby a person or organisation agrees to take a specified number of share or debenture. Specified amount of stocks offered to the public in the event of the public not subscribing to it. In underwriters to issues of capital who agree to take up.

Securities which are not fully subscribed either by others or by themselves .

Following are the features of underwriting

1) Make all efforts to protect the interests of its client.

2) Maintain high standard of integrity of and fairness in the conduct of its business .

3)Ensure that it and it’s personal will act in an ethical manner in all its dealings with a body corporate making an issue of securities .

4)Endeavour to ensure all professional dealings are effected in a prompt , efficient and effective manner.

5) At all times render high standard of service, exercise due diligence , ensure proper care and exercise independent profession.

6) Avoid conflict of interest and make adequate disclosure of his interest.

7) Not discriminate amongst it’s v client ,save and except on ethical and commercial considerations.

8)Not discriminate amongst it’s clients, save and except on ethical and commercial considerations.

9 Not either through its account or their respective accounts or through their associate or family members relatives or friends indulge in any insider trading.

10) Provide adequate freedom and power to its compliance officer for the  effective discharge of his duties.

11)Ensure that good corporate policies and corporate governance is in place.

12)Ensure that it has adequate resources to supervise diligently. Does supervise diligently persons employed or appointed by it to conduct business on its behalf.

13)Be responsible for the acts or omissions of its employees and agents in respect to the conduct of its business.

Capital structure

The mixed of debt and equity is known as the firm’s capital structure. The financial manager must strive to obtain the best financing mix or the option of capital structure. The firm’s  is considered optimum when the market value of share is maximised.

The assets of a Company can be financed either by increasing the owner’s claim or the creditors claims. The owner’s claims increase when the firm raise funds by issuing ordening share or by relating the earning. Creditors claims increased by borrowing.

1) The various means of financing represent the financial structure of a company. Short term borrowing an excluded from the list of methods of financing the firm’s capital structure of the enterprise.

2) It is used to represent the proportionate relationship between debt and equity. Equity includes paid-up share capital, share premium and reserve and surplus (retained earning).

3) Capital structure decision is a significant management decision. It influences the shareholder’s return and risk.The market value of the share may be affected by the capital structure decision.

The company will have to plan it’s capital structure initially at the time of its promotion.Whenever funds have to be raised to finance investments , a decision is involved.

4) A demand for raising funds generator a new structure since a decision has to be made as to the quantity and forms of financing.

5) The decision will involve an analysis of the existing capital structure and the factor, which will govern the decision at present.

6) The company’s policy to retain or distribute earning affects the owners claims. Shareholders’ equity position is strength and by retention of earnings. Thus , the dividend decision has a learning of the company. The new financing decision of the company may affect its debt equity mix.

The debt equity mix has implication for the shareholders’ earning and risk, which in turn will affect the cost of capital and the market value of the firm.

Understanding of capital structure.

This  decision should be examined from the point of its impact on the value of the firm. If capital structure decision can affect a firm’s value then it would like to have a capital structure, which maximizes.

it’s market value however those exist conflicting theories on the relationship between capital structure and the value of a firm.

Theory of capital structure

Capital structure is relevant is the net income (NI) approach.

1) Modigliani and Miller(mm) theory-The traditionalists believe that its affects the firm’s value modigliani and miller (mm), under the assumption of perfect capital markets and no taxes.

2) Theory of  capital structure is relevant is the net income (NI) approach. The net income approach a firm that finance its assets by equity and debt is called a levered firm. On the other hand,a firm that uses no debt and finances its assets entirely by equity is called an uncovered firm.

3) The firm’s overall cost capital is the weighted average cost of capital(WACC). There is an alternative way of calculating wacc($K{_{o}}$),wacc is the weighted average of costs of call of the firm’s securities.

WACC= cost of equity×equity weight+cost of debt × debt weight

The traditional view has emerged as a compromise to the extreme position taken by NI approach. Like the NI approach it does not assume constant cost of equity with financial leverage and continuously declining WACC.

A judicious mix of debt and equity capital on increase the value of the firm by reducing the weight average cost of capital up to certain level of debt.

Optimum capital structure

A firm has an optimum capital structure that occurs when WACC is minimum as thereby maximising the value of the firm.

WACC declines with moderate level of leverage since low-cost debt is replaced for expensive equity capital. Financial leverage. Resulting in risk to shareholder will cause the cost of equity to increase.

Traditional theory assume that at moderate level of leverage, the increase in the cost of equity is more than affect by the lower cost of debt funds are cheaper than equity funds Carries the clear implication that the cost of debt plus the increased cost of equity is more than offset of debt plus to increased cost of equity to increase.

The uncertain that debt fund are cheaper then equity funds carries  the clear implication that cost of debt plus the increased cost of equity before debt financing.

WACC= cost of equity×weight of equity +cost of debt ×weight of debt

Covariance

Covariance of returns on two assets measures their co-movenenent.

The risk of a portfolio could be measured in terms of its variance or standard deviation.

Three steps are involved in the calculation of covariance.

1)Determine the expected return on assets.

2)Determine the deviation of possible returns from the expected return for cash asset.

3)Determine the sum of the product of each deviation of returns of two assets and respective probability.

Formula of calculating covariance of x and y

$Cov_{xy}$ =$\sum_{i=1}^{n}$$[R_{x}-\varepsilon&space;(R_{x})]$$[R_{y}-\varepsilon(R_{y})]$$\times$$P_{i}$

$Cov_{xy}$=the return on securities x and y

Y,$R_{x}$ and $R_{y}$= returns on securities X and Y

$E(R_{x})$ and $E(R_{y})$=expected return of x and y

$P_{i}$ = probability of occurrence of the state of economy

Following possibilities between the return of securities x and y

->Positive covariance- x’s and y’s return could be above their average returns at the same time. Alternative x’s and y’s return below their average returns at the same time, In either situation this implies positive relation between two returns. It would be positive.

->Negative covariance-X’s return could be above its average return while y’s return could be below its average return and vice versa. This denotes a negative relationship between returns of x and y. It would be negative.

->Zero covariance-Returns on x and y could show no pattern that is, there is no relationship. In this situation, it would be zero. In reality, covariance may be non-zero due to randomness and negative and positive terms may not cancel out each other.

Correlation

The degree of association or strength of relationship between two variable is represented by a number called a correlation coefficient. The person product moment correlation coefficient is a measure of the linear relationship between two variable X and Y, and is denoted by $r_{xy}$ or simply r, The population correlation coefficient is denoted by the Greek letter r(rho).

The value of a correlation coefficient can range from -1 to 1. A value of +1 denotes a perfect positive relationship. All the data points fall on straight line such that high scores on one variable are paired with high scores on the other, and low scores are paired with low scores.

A coefficient of -1 denotes a perfect negative or inverse relationship. For this case all the data points on a straight line such that high scores on one variable are paired with high scores on the other, and low scores are paired with low scores.

A coefficient of -1 denotes a perfect negative or inverse relationship. For this case, the data points also fall on a straight line,but high scores on one variable are paired with low scores on the other and vice versa resulting in a line that slopes down instead of up, If these is no linear association between the variables, r is equal to 0. In this case the data points tend to fall in a circle.

Intermediate degree of association are represented by coefficient less then 0 (-1<r<0)  or by coefficient greater then 0 (0<r<1).

USA bank risk and return

The ability of commercial bank in the united states to engage in securities activities. It either directly or indirectly through affiliates of parent holding companies. It has been restricted through much of U.S. history but the boundaries of the restrictions have varied both through time and according to regulatory jurisdiction.

Restriction were imposed by some reasons.

->Fears of potential conflict of interest.

->Fear that commercial banks would have excessive economic power.

->Assume adverse effect on bank safety.

->A desire to protect non bank dealers.

Commercial bank or commercial bank holding companies or their risk and return moderate increase in private securities activities have not increased either the riskiness or the failure rate of commercial bank in the past, nor do, they promise to do so in the future.

The area of discussion.

The Nature of bank risks

Financial risk may be defined as the probability(uncertainty) of realizing a (outcome) an investment. It is lower than the investor expected at the time the investment was made. As losses net of gains must be charged against an institution’s capital (net worth). Sufficiently large losses can drive it into economic insolvency.Thus excessively risk activities relative to an institution’s capital to assets ratio can have an adverse impact on its safety and soundness.

The riskiness of a bank’s  activities depends both on the riskiness of all of the individual activities conducted in its asset, liability and off-balance sheet.

Portfolio and on the interaction or covariance of the returns on these activities through time.That is the riskiness of the over all bank can not be determine by simply summing the risk of its individual activities.

Bank would never want to eliminate all risks

They could do so only at the expense of lower return rather, well managed bank seek to control their risk exposure through risk management.

Risk management involves selecting individual activities with know risk and return portfolio. Combining them through diversification so as to obtain the highest overall net income gains.

Possible while exposing the bank to an aggregate risk exposure  that is consistent with the banks capital position.

The risk that banks generally assume are follows.

1)Credit risk

2)Interest risk

3)Liquidity risk

4)Foreign risk

5)Operation risk

6)Regulatory risk

7)Legal risk

8)Black box risk

Evaluation of the riskiness of securities activities

In theory,securities activities can increase,decrease,or not change the risk exposure of commercial banks. Bank holding companies.The potential impact be measured in two basic ways.

Change in volatility and return

A number of studies seek to measures the impact risk if banks were permitted to engage. In addition securities activities.Either through hypothetical acquisitions of existing investment firms or through expansion of the same activities as under taken by existing securities dealer.

Basically, these studies  the change in measures of volatility and return. It would occur if banks generally would hypothetically acquire different percentage of investment banking activities.

Most of the studies estimate the total risk by calculating the covariance of returns.Banking and other activities that might be combined with banking.Some studies also estimate the additional revenue earned by summing the revenue from the activities.

Several of the papers that use market return on the share of commercial  banks and securities companies do not include measures of capital available to absorb losses.They provide useful information only if the correlation of return implies smaller risk.Other studies relate risk to capital by calculating “Z” score,which measures the probability that a reduction in return might exceed a firm’s capital.

All the studies suffer from an additional serious shortcoming.They fail account for the fact that both commercial banks and investment bank hold, underwriter and trade U.S. government and municipal general obligation bond.

Change in the failure puts of banks engaging in securities

Thought history,few if any U.S. commercial bank  have failed because their involvement in securities activities before or after glass-stegall.J.F.I.O connor.Connor is the comptroller of the currency from 1933 to 1938 cut to  give the reason for the failure of call 2955 national banks that failed from 1865 through 1936, including the depression years 1929 to 1933.

Securities were not a sufficiently frequent reason to be classified separately the among the seven categories of the reason listed for the reason listed for these failure.

->It was strongly asserted at the time that banks involvement in securities understanding and trading was an important case of the great number of banks failures, experienced during the great depression.

->Securities purchased by smaller banks from banks that dealt in securities was a cause of the smaller banks’failures.

->Major cause of bank failures of commercial bank in easy 1930 had been the extensive investment of bank assets in long-term securities.

Three risk need to be considered

>Underwriting risk-Securities underwriting is riskless when the issue is underwritten on a “best offers”basis.In these situation, the underwriter contracts to market the issue and is not liable if the amount obtained is less than the amount expected.

When underwriters purchase and then sell the issue they may incurr risk.

->Dealing risk-Securities hold for trade could pose additional risk to the extent that the market values of the securities might decline.These potential costs are offset by gains in these values.

Both stock  and bond price are volatile and dealers at times have experienced large losses an net.

Banks already can assume as much interest risk as they wish through dealing and investing in government securities and colaterlized mortgage obligation.

->Brokerage risk– Securities brokerage activity at banks is likely to increase were commercial banks permitted to underwrite and sell securities without limit however, this activity involves to price risk.

Fundamental analysis

The objective of fundamental security analysis is to appraise the intrinsic value of a security.The intrinsic value is the true economic worth of a financial asset.The fundamentalist maintain that at any point of time every share has an intrinsic value which should in principle be equal to the present value of the future stream of income from that share discounted at an appropriate risk related rate of interest.

The fundamentalist attempt to estimate the real worth of a security by considering.The real worth of a security by considering the earning potential of a firm which in turn will depend on investment environment factor such as state and growth of national economy,monetary policies of the reserve bank of India corporate laws environment and the factor relating to the specific Industry such as state of product and the growth potential of the industry.

It will depend to a large extent,on the firm’s competitiveness,its quality of management operational efficiency profitability,capital structure and dividend policy.

Fundamental analysis has consist with three factor.

1)Economy analysis

2)Industry analysis

3)Company analysis

First we consider economy analysis.

1)Economy analysis-An investment in the equity of any company is likely to be more profitable if the economy is strong and prosperous,so the expectation of the growth of the economy is favorable for the stock market.

Not all industries grow at the same rate,do all companies. The growth of a company or an industry depend basically on its ability to satisfy human wants through production of goods or performance of service.

Investment climate in an economy can be observed from the GNP and its components.GNP stand for gross national product,the broadest measure of economic activity used to determine where the national economy is where it has been and where it has been and where it is going.

Monetary and financial conditions are reflecting these demand supply gaps as well as the onset of a durable pick-up in aggregate spending.Banks non-food credit is beginning to dip after expanding abuse 30 percent for three years in succession.Driving up money supply and squeezing overall liquidity.The growth of bank.Credit has favored retail lending particular housing real estate trade,transport and professional service and non-banking financial companies sector which were not significant in the credit market.

The economic indicator are grouped into leading indexes to help in analysis and for casting.The coincidal indicator include GNP in constant or “real” terms,corporate profits,industrial production unemployment and the producer price index.There are many coincidental indexes,but these are the most common.The indicator tell us what is happening in the economy,but they do forecast the future.

The leading indicator tell us what to expect in the future.Some of the popular leading indexes are fiscal policy.Monetary policy,GNP deflator productivity,consumer spending, residential construction and stock prices as measured by the RBI etc.

The lagging indicators turn after the movement in the coincidental indicators.The best-know lagging indicator is the prime rate,which usually turns down a few months or quarters after a turn down in the economy.

Commercial paper rates, capital,expenditure the inventory sales,ratio retail sales and the consumer price index are other important lagging indicator.

Significance and Interpretation of the economic Indicators.

The investor makes an analysis of the economy primarily to determine an investment strategy,It is not necessary to make their own economic forecasts.The primary responsibility is to identity the trends in the economy and adjust the investment position accordingly many of the published forecasts are excellent and provide the necessary perspective.

The variance for analysis have their own significance.The GNP is nominal and real terms is a useful economic indicator.

2) Industry analysis

The industries that contribute to the output of the major segment of the economy vary in their growth rate and in their overall contribution to economic activity some have growth more rapidly than GNP and offer the expectation of continued growth other have maintained a growth comparable to that of the GNP.A flow have been unable to expand and have declined in economic.

Significance seeking industries that are expected to grow at faster than the “real rate of GNP for the future seems to be a logical starting position.

In a broad sense an industry might be considered a community of interests.This concept would reflect the idea of a group of people coming together because they do a certain type of work or produce a similar type of production.Such group would include agriculture as well as manufacturing,mining and merchandising.

The classification of an industry is important when we analyze its growth.Each industry takes the share of the GNP with every other industry .Thus,the manufacturing industry compete with agriculture, transaction and public utilities.

This inter industry competition is important and within each major industry classification.The product or service-oriented segments compete for share GNP.

A second reason for a domination in the industry growth rate is the nature of the technological change itself.The basic types of major technological changes help to produce an old product more cheaply or a completely new product on mass basis.

A high priced commodity or service is changed a low priced one making it available to a large market.

A third factor that tend to limit the growth of an industry is competitive pressure from other industries.The industry that first experienced a technological change may be restrained by the development of a new industry,competing directly for raw material and thus tending to raise costs for the original industry and limit its expansion potential.Sometime ,new industries are directly competitive with the old product or original product.

Fourth and final factor that might reduce the rate of growth of an industry is a decrease decreased population growth.In order for a product to expand its output at an increasing rate,per capita output would have to grow at an increasing rate.For this to occur,consumers would have to spend more of their income.

The consumer’s income does not increase as fast as the growth of the product,because the economy grows more slowly than an industry experiencing rapid growth, and so it is unlikely that the industry’s growth rate can be sustained.

Investment classification of industries

• The discussion upto this point has been about the economic classification of industries.Investment services provide basic industry information more closely related to our needs and concentrate more on companies within the industry.If an industry appears yo offer attractive future benefit,we can easily translate this into the probability that a company’s equity will allow us to share in the industry’s prosperity.

Selecting an Expanding Industry

An understanding of the growth pattern of an industry and of the stages of growth pioneering,expansion and stagnation as well as the sign of obsolescence, should help us reach a solution to the problem of where to invest.the investor should select industries that are in the expansion stage of the growth cycle and should concentrate on these areas.Except for special circumstances brought about by individual portfolio needs,an investor should not invest in industries in the pioneering stage unless he or she is prepared to accept a great deal of speculative risk,comparable to that assumed by the innovator or speculator

3)Company Analysis

The specific market and economic environment may enhance the performance of a company for a period of time,it is ultimately the firm’s own capabilities that will judge its performance over a long period of time .

A)Marketing first variable that influences future earning in terms of both quality and quantity is the marketing results of the firm in comparison to industry.This in turn is determined by the share of the company in the industry,growth of its sales and stability of sales.A company in a strong competitive position will provide greater earning with more certainty.

1.Sales:The rupee amount of annual sales and its share market help to determine a company’s relative competitive position within the industry and how successful it has been RI meeting competition.Here to rank the company, the companies should be comparable in like product groups

2.Growth in sales:The annual growth in sales is equally if not more important than the amount of sale in determining the competitive position of the company.Expanding annual sales and adequate financing firm will be in a better position to earn money.

3.Stability of sales:Stability of sales will provide stable earning for a firm,other things of plant .Aggregate sales of various industries vary in their degree of stability and company’s sales should have same pattern as that of the industry.

B)Accounting policies:There is a risk of faulty Interpretation of corporate earnings and consequent bad judgement in purchasing,keeping or selling stock.

1)Inventory pricing:i)Cost or market value methods in which case inventory is priced at lower of average cost of inventory or the market price.

ii)First in first out,method in which the inventory is priced at the cost of last purchase and the cost of goods first acquired are adjusted in cost of sales.

iii)Last in first out method is just opposite of the FIFO method.Here cost of inventory is on basis of first purchase and last purchase and last purchase cost is adjusted in cost of sales.

2)Depreciation methods:The depreciation for wear and tear of the machinery and so reduction in value of assets is provided as fixed expenses.The change providing provision for depreciation will thus affect net income and also affect net income and also affect the valuation of the assets.

3)Non-operating Income:Non-operating income such as dividend income,interest,etc,generally occur to the firms.To avoid error of judgement these incomes should be studied.In certain accounting period the non-operating income for reason such as gains or losses due to sale of fixed asset of the comoany.

C)Profitability-We are interested in income amount stability a growth of these earning particularly the amount and when they will be recieved.This rest on the assumptions that the profitability the relationship between the sales and earning,will remain constant to study the relationship if expenses and sales,one needs to study the trends of the profitability ratios, namely, gross profit margin,net profit margin,earning power return on equity and earning per share.

D)Dividend policy:In most of the cases it is observed that the management tries to have a stable dividend policy and increase the dividend only when they expect they will be able to maintain the higher rate of dividend in future.