FINANCE SERIES-2

Prem Kumar

2nd year Student (finance)

IBS Hyderabad


Dear Friends!

We had discussed the Basics of Risk and Return in our last Paper.Having discussed the basics, we now come to some deeper concepts of CAPM.

CAPM (Capital Asset Pricing Model):

The CAPM is a model that relates Risk & Required Rate of Return (RRR) for assets in a well diversified portfolio.

Assumptions of CAPM:

• Single holding period
• Identical expectations for all investors
• Unlimited funds can be borrowed or lent at the risk free rate.
• Assets are perfectly divisible
• No taxes
• No transactions costs
• Price takers: Individual investor would not be able to influence market
• Fixed quantities of all assets

CAPM helps us to construct a portfolio of securities based on our specific Risk-Return Profile (What is your Risk – Return Profile?).We can make a variety of portfolios consisting of distinct weightage of stocks from a given set of stocks. All these portfolios make a feasible set of portfolio.

An Efficient portfolio is a portfolio of stocks chosen from the Feasible set of portfolios, which satisfies any one of these two conditions:

a)Maximum return for a given risk

b) Minimum risk for a given amount of return.

As can be understood with little mind boggling that within the frame of feasible set, one can have a collection of efficient portfolios. The collection of all these efficient portfolios is called the Efficient set /Efficient Frontier.

fig.1

Now, lets discuss one basic logic: If you are given a specific return A and are ready to face a risk X for expecting this risk. If there is an alternative return B for which you are ready to bear a risk Y and you have your own analysis of various such Risk –return tradeoffs ( Your Risk-Return Profile),then we take all such points on Risk-Return graph and connect them. This curve is your Indifference curve (Similar to one in Microeconomics).

An Indifference curve reflects an investor’s attitude towards risk/return trade off. Now your trade would definitely be different from mine. So all of us have our distinct Indifference curves based on our respective Risk averseness.

Now the point of intersection of your Indifference curve with efficient portfolio (efficient set) is called your optimal portfolio.

fig.2

Now, if we introduce an asset like Treasury bill (Risk free) in our so called optimum portfolio, what should happen?

We know, if Krf is the return of any such asset,then this will represent a point somewhere on Y axis( because risk representing X dimension is 0).This asset is included in our optimum portfolio,so this point should be added in new efficient frontier.

Hence draw a straight line from Krf , a tangent on old efficient frontier.

fig.3

The line MZ is called Capital Market Line and is defined as a locus of all possible combinations of Risk free asset and portfolio M.

Portfolios below CML are Inferior and all investors will choose a portfolio on CML.

fig.4

_{Now, what is your New optimum portfolio?}

Now, what is your New optimum portfolio?

It is the Point of intersection of Your Indifference Curve and CML.

Now let me make something clear because for beginners there is a very big confusion between two terms.

Capital Market Line (CML) is NOT Security Market Line (SML).

What is SML (Security Market Line)?

SML gives risk/return relationship for an individual stock whereas CML gives the same for efficient portfolios. We have already discussed SML in our last article.

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Finance Series-1

The Sub Prime Issue!!!!!!!!!

Article from:
Manish Tewari
2nd year student
ICFAI Business School Hyd.

Today whenever you read newspaper one thing that will definitely be there is the “subprime” issue. This article has been prepared for the understanding of what exactly subprime is and why is it that our stock exchange is getting effected by it.

What is Prime Loan????

The prime home loan market essentially refers to individuals who have good credit ratings and to whom the banks lend directly. The rate of interest charged is lower than that of subprime as the element of risk is less.

What is sub prime???

Let us first start with what exactly is sub prime. For simplicity consider a case wherein an American is in need of a home loan. But there is a slight problem the concerned person doesn't have a great credit rating. So a bank will not give him a home loan. Now what happens is that a second American who has a good credit rating and is willing to take on some amount of risk will apply for loan. Given his good credit rating the bank is willing to give him a loan. The bank gives the second American a loan at a certain rate of interest. This person will now divide the total loan into small lots and lend it to people having poor credit ratings. The person will charge a premium for bearing the higher risk. Thus the rate of interest for subprime borrowers is higher than that of primary borrowers.

Securitization of the subprime loans

Securitization essentially involves, converting these home loans (sub prime) into financial securities, which promise to pay a certain rate of interest. Thus the individual is able to pay the money back to the bank by selling these securities to institutional investors. The interest and the principal that is repaid by the subprime borrowers through equated monthly installments is passed onto these institutional investors.

When did the problem started???

The subprime home loans are given out as floating rate home loans. A floating rate home loan as the name suggests is not fixed. As interest rates go up, the interest rate on floating rate home loans also go up. As interest rates to be paid on floating rate home loans go up, the Equated Monthly Installments (EMIs) that need to be paid to service these loans go up as well. Now what happened is that since the subprime loans were given to people with lower credit worthiness, these people were hit harder by the rise in the EMIs. A lot of the borrowers defaulted. Once, more and more subprime borrowers started defaulting, payments to the institutional investors who had bought the financial securities stopped, leading to huge losses.

Why is then the Indian Stock Market affected????

Institutional investors, who had invested in securitized paper from the subprime home loan market, saw their investments turning into losses. Most big investors have a certain fixed proportion of their total investments invested in various parts of the world. These were basically the Hedge Fund Investors. Since the borrowers were defaulting a lot hence there was a need for these institutional investors to pool in money into the U.S. market from somewhere else part of the world. This money came in from emerging markets like India, where their investments have been doing well. So these big institutional investors, to make good of their losses on the subprime market, sold their investments in India and other emerging markets. This is the reason that there has been a fall in the stock market of India.