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Capital market

Capital markets are place where investor buy and sell company and government securities with their trading decision reflecting information on company performance insight provided by financial analyst, dividend announcement by companies expectation on the future levels of interest rate and inflation the investment decision of financial managers and so on.

At both levels, companies and investor will want the capital markets to assign fair prices to the financial securities being traded.

In the language of corporate finance. Companies and investor want the capital markets to be efficient. It is possible to describe the characteristics of an efficient capital market by considering the relationship between market prices and the information available to the market.

Whether capital market are infact efficient has been studied extensively for many years.

Capital markets bring investor lender and firms (borrowing) together. Hence the financial manager has to deal with capital markets. He or she should fully understand the operations of capital market and the way in which the market value securities. He or she should also know-how risk is measured and how to cope with it in investment and financing decision.

For example, if a firm uses excessive debt to finance its growth investor many perceive it as risky. The value of the firm’s share may therefore decline. Similarly investor may not like the decision of a highly profitable growing firm to distribute dividend.

They may like the firm to reinvest profits in attractive opportunities that would enhance their prospects for making high capital gains in the future.

Investments also involve risk and return. It is through their operations in capital markets that investor continuously evaluate the actions of the financial manager.

Investor financial managers and capital market obtain a great deal of information about companies from their financial statements from financial database from the financial press, and so on.Through the application of ratio analysis financial statements can be made to yield useful information concerning the profitability, solvency performance, efficiency of operation and risk of individual companies.

This information will be used for example by investor when reaching decision about whether, and at what price to offer finance to companies by financial manager in making decisions in the key area of investment financing and dividend and by share holders making decision on which securities to add or remove from their portfolio.

The capital markets are markets for trading in long-term financial instrument or securities , but the most important ones for companies are ordinary shares or ordinary equity preference share and debt securities such as debenture, unsecured loan stock and convertible loan stock.

For companies capital market have two main function.

1) They act as a means whereby long-term funds can be raise by companies from those with fund to invest such as financial institutions and private investment.

In the fulfilling this function they act as primary market for new issue of equity or debt.

2) Second function  capital provide a ready means for investor to sell their existing holdings of share and bonds or to increase their portfolios by buying additional ones.

Here, they act as secondary market for dealing in exciting securities. The secondary market plays an important role in corporate financial management, because by facilitating the ready buying and selling of securities it increase their liquidity and hence their value.

Investor would pay less for security that was difficult to dispose of.

The secondary market is also a source  of pricing information for the primary market, increasing the efficiency with which new funds are allocated.

 

 

LAF(Liquidity Adjustment Facility

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.

 

Monetary policy

The monetary policy stance of the reserve bank continued to be the provision of adequate liquidity to meet credit growth. Support investment demand in the economy while continuing a vigil on movement in the price level.

Liquidity management in India is a subject that is not widely discounted  but is the bread and butter of daily monetary management.

Conduct of monetary policy and management in the context of large and volatile capital flows has proved to be difficult for many countries.

The evolving policy mix involved careful calibration that book into account diverse objective of central banking changes in the monetary policy framework and operating procedures and widening of the set of instrument for liquidity management.

Liquidity management and management of capital flows

While in the macroeconomics context, liquidity management refers to overall monetary, conditions, reflecting the extent of mismatch between demand and supply of overall monetary resources.

For central bank, the concept of liquidity management typically refers to the framework and set of instruments that the central bank follows insuring the amount policy.

What is the price of bank reserves?

The price of bank reserve is fixed in terms of short-term interest rate. This is set in terms of overnight inter-bank borrowing and lending rates either secured or unsecured which affect the reserves do not clear offer an their own the central bank itself steps in by influencing the short-term repurchase obligation with banks.

Supply of monetary base depends on.

1) The public demand for currency as determined by the size of monetary transactions and the opportunity cost of holding money.

2) The banking system ‘s need for reserve to settle or discharge payment obligation control banks also attempt to contract and varying the supply of bank reserve to settle meet its are therefore influenced through reserve requirements or open market operation.

Role of central bank

1) The importance of central bank liquidity management lies in its ability to exercise considerable influence and control over short-term interest rate by small money market operation.

2) Central bank typically aim at a target overnight interest rate which at as a powerful economy wide signal.

3) The liquidity management function of a central bank involves a larger economy-wide perspective.

4) Central bank liquidity management has short-term effects in financial market.

5) Central bank attempt to influence money market liquidity in order to exercise control over the short-term interest rate.

6) The central bank may directly set at one of the short term interest rate that acts as its policy rate.

Money market instrument

1)  Repo rate– Repo is a collateralized short term borrowing and lending through sale/purchase operation in debt instrument. It is a temporary sale of debt. Transfer of ownership of the securities that is the assignment of voting and financial rights. The term of the contract is in terms of a repo rate, representing the money market borrowing lending rate. Repos are usually of 1-14 days .

The collateral security in the form of SGL is transferred from  the seller to the buyer. Generally ,repos transaction take place in market lots of Rs. 5 core. Repo transaction have very low credit risk due to the SGL mechanism and the existence of collateral in the form of the underlying security.

2) Reverse repo rate– A reverse repo ready forward repurchase (buy back) is a transaction in which two parties agree to sell and repurchase the same security. The seller sells specified securities with an agreement to repurchase the same at a mutually decided future date and price.

Likewise, the buyer purchases the securities with an agreement to resell the same to the seller on an agreed date and at a predetermined price.

Reverse repo are used to

1) Meet a shortfall in the cash position

2)  Increase return on fund held

3) Borrow securities to meet regulatory (SLR) requirements

4) By the RBI adjust liquidity in the financial system under the LAF

3) Statutory Liquidity Ratio(SLR)– While the CRR enables the RBI to impose primary reserve requirements. The SLR enables it to impose secondary and supplementary reserve requirements on the banking system.

The  objective of the SLR are three-fold i) To restrict the expansion of bank credit.ii) To augment a bank’s investment in Government securities and iii) To ensure solvency of banks.

The SLR is the ratio of cash in hand (excluding CRR) balances in current account with banks and RBI gold and unencumbered approved securities to the total demand and time liabilities of the banks. The SLR defaults result in restrictions on the access of refinance.

An increase in the SLR does not, however, restrain total expenditure in the economy it would restrict only private sector expenditure but it would also help increase the government sector expenditure. A decrease in the SLR would have the opposite effect. SLR is not a technique of monetary control it only distributes bank reserve in favour of the Government public sector.

4) Bank rate– The bank rate is the standard rate at which the RBI buys rediscounts Bill’s of exchange other eligible commercial paper.It is also the rate that the RBI charges on advances on specified collaterals to banks. An increase in the B/R would decrease /increase in the lending rate of banks.Thus the B/R technique regulate the cost/availability of finance and to that extent, the volume of funds available to banks and financial institutions.

5) Cash Reserve Ratio– The CRR refers to the cash which banks have to maintain with the RBI as a percentage of their demand and time liabilities. The objective is to ensure the safety and liquidity of bank deposits.The RBI is empowered to impose penal interest on banks in respect of their shortfall in the prescribed CRR.

The penal interest is a specified percentage above the bank rate.RBI can disallow fresh access to its refinance facility to defaulting banks and charge additional interest over and above the basic refinance rate on any accommodation availed of and which is equal to the shortfall in the CRR.

The RBI pays interest equal to the bank rate on all eligible cash balances. The CRR, as an instrument of monetary policy has been very actively used by the RBI recently in the downward direction. It is at its lowest level now.

6) Open market operation(OMOs)– The OMOs refer to the sale and purchase of securities of the central and state Government and treasury-bills (T-bills). The multiple objective of OMOs, i) To control the amount of and changes in bank credit and money supply through controlling the reserve base of banks.(ii) To make the bank rate policy more effective (iii) To maintain stability in the Government securities T-bills market(iv) To support the Government’s borrowing programme (v)To smoothen the seasonal flow of funds in the bank credit market.

Through the OMOs, the RBI can affect the reserve position of banks,yields on Government securities T-bills the volume and cost of credit.

In spite of the wide power to the RBI,the OMOs is not a widely-used technique of monetary control in India. There is no restriction on the quantity maturity of the Government securities which the RBI can buy/sell/hold.

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}

 

 

Foreign exchange market

The foreign exchange market where the currency of one country is exchanged for the currency of another country. Most currency transactions are channelled through the world wide. Interbank market is the whole sale market in which major banks trade with each other.

Forex market is a world wide market of an informed network of telephone, taler,satellite facsimile and computer, communication as between the forex market participants.

Which include banks, foreign exchange, dealers , arbitrageurs and speculators. The foreign market operates are guided by different motives when they deal in the foreign exchange market.

Understanding of forex market

The foreign exchange markets in view of their critical role in overall growth and development of the economy. Particular in the transmission mechanism of  monetary policy.

The pace of reforms was contingent upon putting in place appropriate system and procedures, technologies and market practice. Initiatives taken by the Reserve bank have brought about a significant transformation of various segment of the financial markets. These developments by improving the depth and liquidity in domestic financial markets. Its contributed to better price discovery of interest rates and exchange rates.

The increase in size and depth and liquidity and freedom to market participants have also strengthened the integration of various segments of the financial market.

Increased integration not only leads to more efficient dispersal of risks across the spectrum but also increases the efficacy of monetary policy impulses.

Financial market reforms in India have enabled a greater integration of various segments of the financial market, reducing arbitrage opportunities, achieving higher level of efficiency of monetary policy in the economy.

Integration of the foreign exchange market

The degree of integration of the foreign exchange market with other markets is largely determined the degree of openness.

In the Indian context the forward price of the rupee is not essentially determined by the interest rate differentials but is also significantly influence by

a) Supply and demand of forward US dollars

b)Interest differentials and expectation of future interest rates.

C) Expectations of future us-dollar rupee exchange rate.

Participants of foreign exchange market

1)Arbitrageurs- Arbitrageurs seek to earn risk less profit by taking advantage of differences in exchange rates among countries.

2)Traders- Traders engage in the export or import of goods to a number of countries. They operate in the foreign exchange market because exporters receive foreign currencies which they have to convert into local currencies .They purchase by exchanging the local currency. They also operate in the foreign exchange market to hedge their risk.

3)Hedgers- Multinational firms have their operation in a number of countries and their assets and liabilities are designed in foreign currencies. The foreign exchange rates fluctuations can cause diminution in the home currency value of their assets and liabilities.

They operate in the foreign exchange market as hedges to protect themselves against the risk of fluctuation in the foreign exchange rates.

4)Speculators- Speculators are guided purely by the profit motive.They trade in foreign currencies to benefit from the exchange rate fluctuations. They take risks in the hope of making profits.

Foreign exchange rates

A foreign exchange rate of two currencies ,we can find the exchange rate for the third currency.

1) Cross rate -Cross rate is an exchange rate between the currencies of two countries that not quoted against each other.

Currencies of many countries are not truly traded in the forex market. Therefore all currencies are not quoted against each other . Most currencies are quoted against the US dollar. The cross rates of currencies that are not quoted against each other can be quoted in terms of the US dollar.

2) Spot exchange rate- The spot exchange rate is the rate at which a currency can be bought a sold for immediately delivery. Delivery can be within two business days after the day of the trade. In the spot market, currencies are traded for immediate delivery within two days. Financial news papers generally provide information an exchange rates.

3) Bid-ask spread- The foreign exchange dealers are always ready to buy or sell foreign currencies.  The quotations are given as a bid-ask price.

The difference between the buying(bid) and selling(ask) rates is the forex operator’s,(say,bank) spread.

Bid ask spread is the difference between the bid and ask rates of a currency.It is based on the breadth and depth of the market for that currency and its volatility. This spread is a cost transaction in the foreign exchange market.It is computed as a given below.

Spread =\frac{Ask price-Bid price}{Ask price}

4)Forward exchange rates- The forward exchange rate is the rate that is currency paid for the directory of a currency some future. In the forward market currencies are traded for the future delivery. In terms of the volume of currency transaction. The spot exchange market is much larger than the forward exchange market.

Forward rates (30 day,90 day or 180 day forward rates) for a few currencies are quoted in forex market. Most banks will however,quote currency forward rates to the traders.

 

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.

15) Ensure that the senior management, particular decision makers have access to all relevant information about the business on a timely basis.

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

Traditional view

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

 

 

 

 

 

 

Systematic risk

Systematic risk arises an account of the economy-wide uncertainties and the tendency of individual securities to move together with changes in the market. Also known as market risk.This is the risk can not be reduced through diversification.

Investor are exposed to market risk. Even when they hold well-diversified portfolio of securities systematic risk of the security.It can not be diversified because like other securities it also moves with the market.

As mention in paragraph systematic risk is not diversifiable. Investor do not pay any premium for diversifying total risk via reduction in non-systematic risk.They can do on their own, cheaply and quickly.

Add in the last of part example of systematic risk.

->The government changes the interest rate policy. The corporate tax rate increased.

->The government result to massive deficit financing.

->The RBI promulgates a restrictive credit policy.

->The government relaxes the foreign exchange contracts and announces full convertibility of the Indian rupee.

->The government withdrawal tax on dividends payment by companies.

->The government eliminates reduces the capital gain tax rate.

All securities have some systematic risk, whether bonds or stocks.I have systematic risk directly compasses interest rate risk, market risk,and inflation risk. In this discussion, however the emphasis will be on the systematic risk of common stock.

In this case, systematic risk is that part of the variability correlated with the variability of the stock market as a whole.

Measuring systematic risk.

A measure needed of this unavoidable systematic or nondiversifiable based on modern portfolio theory. The beta has emerged as such a measure. Beta’s usefulness as a measure of risk is briefly discussed here.

Beta is a relative measure of risk of an individual stock in relation to the overall market, as measure by the volatility of its returns by statistically relating the return for a security to the returns.

By statistically relating the returns for the stock market as whole (using a regression equation) it is possible to determine how the security’s returns move in relation to the market’s returns move  more( less) then the markets returns.

If the security’s returns move more(less) than the market’s returns. As  the latter changes, the security is said to be more (less) volatile than the market for example. A security whose returns rise or fall an average 15% when the market return rise or falls 10% is said to be volatile security.

Beta is the slope of the regression line relating a securities returns to those of the market. If the slope of this relationship for a particular security is a 45- degree angle. This means that for every 1% change in the market return, on average this security’s returns change 1%  if the line is higher, beta is higher,managing that the volatility( market risk) is greater

For Example, security A’s beta of 1.5 indicate that, on average security returns are 1.5 as volatile as market returns Both up and down. If the line is less steep than the 45 degree line beta is less than 1.0. This indicate that, on average, a stock’s returns have less volatility than the market as a whole. For example security c’s beta of 0.6 indicate that stock returns move up or down generally only 60% as much as the market as a whole.

The aggregate market has beta of 1.0. More volatile (risky) stock have betas small than 1.0 as a relative measure of risk, beta is very convenient if an investor is considering a particular stock and is informed that is beta 1.0,this investor can recognize immediately that the stock is very risky.

In relation to the average beta for all stock is 1.0 many brokerage houses and investment advisory services report betas as part of the total information given for individual stocks.

Estimating systematic risk

Betas are estimated from historical data, regressing for the individual security against the for some market index. As result, the usefulness of betas will depend on, among other factors, the volatility of the regression equation. Regardless of how good the fit it, however beta is an estimate subject to errors.

It is important to note that most calculated betas are ex post betas. What is actually needed in investment decision is an ex ante beta measuring expected volatility.

The common practice of many investor is simply to calculate the beta for a security and assume it will remain constant in the future . A risky assumption in the case of individual securities similar to standard deviations portfolio betas often are quite stable across time whereas individual security betas often are notoriously unstable.

However, this is not an unfavorable outcome for investors because the basic premise of portfolio theory is the necessity of holding a portfolio of securities rather than only on or a few securities.

Substantive evidence has been presented that betas tend to move toward 1.0 overtime. Betas substantially larger( smaller) than 1.0 should tend to be followed by betas that are lower, and closer to 1.0 .

Thus, forecasted betas should be closer to 1.0 thus, forecasted betas should be closer 1.0 than the estimates based solely on historical data would suggest. Several models have been advocated for adjusting betas for this tendency to ” regress toward the mean. As a result it is not unused to find ” adjusted ” betas rather than historical betas.

 

 

 

 

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 (R_{x})][R_{y}-\varepsilon(R_{y})]\timesP_{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).