The Three Little Investors

I watched as the minute hand of my clock raced
endlessly around the face. The prospect of choosing a
stock the next morning to invest my college savings in
was keeping me awake. I had decided to invest my money
in a stock because there was still a long time before I
went to college, and I knew that in the long run,
stocks could provide the greatest return on my money.


Eventually, I fell asleep. Suddenly, I was strolling
through a town, next to a stockbroker and the three
little pigs from my favorite children’s storybook.


“Where are we going?” I asked.


“Today we are going stock shopping to find the perfect
stock to invest our college savings in, just like you!”
explained the first little pig enthusiastically.


As we approached the first stock, I realized that the
stock was in the shape of a straw hut. “Pick me!” it
wailed. “I’m the least expensive, so you can buy more
shares of me than the more expensive stocks.”


“Say no more,” interjected the first little pig. “I
choose to invest in you.” I could tell this was a
mistake by the stockbroker’s irritated expression.


The other two little pigs, the stockbroker, and I
continued on our search. Along the way, I decided to
ask the stockbroker why he was upset.


“That stock was not a cheap stock,” he explained. “You
cannot tell how inexpensive a stock is by just looking
at its price. You must consider the price/earnings
ratio, which tells you how much you must spend to get a
dollar’s worth of the company’s earnings.”


We arrived at the second stock, which was also in the
shape of a house; however, this house was made of
sticks.


“Invest in me!” it begged. “My company is marketing a
new medicine to cure cancer.”


“Say no more,” interrupted the second pig, confidently.
“I choose to invest in you.”


The last little pig, the stockbroker and I resumed our
journey for the perfect stock. I had thought that the
second pig had made a wise decision, but immediately
after beginning on our journey, the stockbroker
elucidated why he was so upset by the second pig’s
choice.


“The second pig did not invest—he speculated. Investing
is for long-term profit, whereas speculating is for
short-term profit (not for investing for the future).
He didn’t know anything about that company or the
product. By speculating, the second pig took the risk
of the new medicine being a scam and losing all his
money. ”


The third stock, just as the last two, was in the shape
of a house. It looked much better than the other two
stocks. It was made out of brick and it looked strong
and sturdy. Immediately, I could tell the stockbroker
also agreed by the approving smile on his face.


“I am the Nationwide Insurance stock,” it informed.
Finally a stock whose company I was familiar with.
“Invest in me! Clothes, cell phones, and furniture go
in and out of style; however, insurance never goes out
of style. Everyone needs insurance if they want to own
a house, a car, or a business. Insurance protects from
tornadoes, fires, and even big bad wolves!”


I used my new knowledge to question the stock. “What is
your P/E ratio?”


“My P/E ratio is extremely low, which is extremely good
for investors.”


“I’m investing my future in the future of your company,
so how do I know that your future will be successful?”
I asked.


“Natural and man-made disasters are always occurring,
so people will always need insurance. Insurance is a
priority, not a luxury. When money is tight, people
stop buying clothes, computers, and other luxuries.
However, they always keep their insurance.”


Finally, I felt confident in investing in a stock. “Say
no more,” I said. “I would be happy to invest in you.”
The stockbroker smiled, and I knew I had made a wise
decision. The third little pig also invested in
Nationwide because it had a low price/earnings ratio,
and a bright future.


The next morning, I awoke knowing exactly what stock to
invest in: Nationwide because it’s a brick-strong
investment.

Olivia Goldberg’s winning First Place Investwrite Essay – Spring 2007, 6-8 Grade Division.

Contributed by Debashis Chand

Exchange Traded Funds

I guess most of you must have heard about Index funds, which are generally floated by Mutual funds. Index funds has sole objective of providing same return to its investor as a benchmark index (like S&P CNX Nifty or Sensex). To do so they bundle up security in same proportion as in the benchmark index which they are tracking. Thus value of portfolio fluctuates with the market resulting in almost same return with market. Exchange traded funds are just like Index fund when it comes to formation of portfolio. But they differ on some important aspects. They first came into existence in the USA in 1993.

Definition: A fund that tracks an index, but can be traded like a stock. ETFs always bundle together the securities that are in an index. So we can say ETF are Index fund that trades on stock exchanges.

How it’s different from Index funds:
Trading: Investors has advantage to do anything with ETF that they do with normal stock. Short selling, margin trading etc. is allowed which is rare in case of Mutual funds.
Intra-day trading: ETFs are traded on stock exchanges so they can be bought and sold at any time during the day (unlike most mutual funds). Their price will fluctuate from moment to moment, just like any other stock's price. In case of Mutual fund they are generally traded on their last day’s Net Asset Value (NAV).
Operating and transaction costs: ETF is purchased through brokers so they attract brokerage fee unlike Mutual funds.

Next Post: ETF in India

Recent CRR hike by RBI and its implication

What is CRR?

This is the amount of money that the banks have to necessarily park with the RBI. The base of this is the total of the deposits that a bank has.

CRR is one of the best ways to remove excess liquidity from the market, thus cooling of the money supply.
As the money is not available with the banks, banks are forced to lend at higher prices and also push for deposits with higher interest rate. Higher interest on loans will drive people away from loans and higher interest on deposits will incline people towards depositing the money in the bank, rather than consuming it. The reserve ratio is sometimes used as a tool in monetary policy, influencing the country's economy, borrowing, and interest rates.

Recent Hike:

Dr. Y. Venugopal Reddy, Governor, RBI, presented the Mid-term Review of Annual Policy for the Year 2007-08 on 30^th Oct 2007, in a meeting with Chief Executives of major commercial banks. RBI hiked CRR by 50 basis point from 7% to 7.5%. Bank Rate, Repo Rate and Reverse Repo Rate kept unchanged. This is aimed to suck out Rs. 16,000 cr. from the system effective from 10^th November. The measure has been taken to manage capital inflow and suck out huge liquidity in system. RBI has aired it concern over huge inflow in real estate and equity market.

Was it expected?

No, it was not. Last time US Fed cut interest rate thus easing monetary policy. So even RBI was expected to follow this and take liberal policy decision.

Reason behind CRR hike

According to RBI governor Y. Venugopal Reddy the step has been taken to stabilize the economy from unwarranted excessive liquidity in system. He said in the bank’s mid-term review of annual monetary policy statement: “Financial markets continue to experience conditions of surplus liquidity, warranting an appropriate response in order to ensure orderly market conditions.”

Reddy also recognized the risks from “the rapid escalation in asset prices—equity and real estate—driven by capital inflows”, saying: “...the biggest challenge for monetary policy is the management of capital inflows and the attendant implications for liquidity and overall stability.” we have seen USD 8.9 billion flow into the Indian market in past one month and apparently Dr. Reddy is concerned about that and he thinks that the asset prices have risen to elevated levels

Sensex in recent past has climbed to new levels. During this month Sensex has gained more than 14%.

Implications

CRR hike generally triggers increase in interest rate. But at this point of time when Repo, Reverse Repo and other key policy rate has remained same, there is no chance of immediate increase in interest rate. In short run equity market will suffer a bit. Investors who find India a long-term attractive story will continue to put in money through various routes through portfolio, private equity, FDI. So in long run this decision has no impact on equity market.

Some public sector banks, like Bank of Baroda chairman A.K. Khandelwal and Punjab National Bank chairman K.C. Chakraborty said they would not hike their lending rates following the CRR hike but deposit rates would certainly go down.

Overall we can see this decision more as liquidity management tool rather than an attempt to increase interest rate.

To get a copy of Mid-term Review of Annual Policy for 2007-08 visit http://www.rbi.org.in/scripts/NotificationUser.aspx?Id=3908&Mode=0#p1

Loan Syndication

Suppose you need 100 crore Rupees for an investment project. You go to a bank, they tells you that they can not finance more than 10 crore Rupees and so you move to a new lender. Here again you find same difficulty. So now you have an option to take loan from multiple lenders. In this case you have to deal with multiple lenders for single investment project.

Here borrower can use loan syndication facility. He needs to appoint one Arranger or lead manager. This Bank place the syndicated loan to other banks and makes sure that syndication is fully subscribed. A syndicated facility is a lending facility, defined by a single loan agreement, in which several or many banks can participate.

A borrower wants to raise a relatively large amount of money quickly and conveniently. The amount exceeds the exposure limits or appetite of any one lender. The borrower does not want to deal with a large number of lenders. So what should he do? Even lender doesn’t want to miss this opportunity. They can simply use loan syndication facility.

By this approach borrower gets desired amount without dealing with multiple lenders while lenders do not miss a profitable loan proposal due to low exposure limit and minimize their risk.

The market for syndicated loans is huge. In 2003 banks extended close to USD 2 trillion in syndicated loans. The standard theory for why banks join forces in a syndicate is risk diversification. The banks in the syndicate share the risk of large, indivisible investment projects. Syndicates may also arise because additional syndicate members provide informative opinions of investment projects or additional expertise after the funding has been extended

ROLES WITHIN THE SYNDICATION PROCESS

1. ARRANGER / LEAD MANAGER: this is the bank that has been awarded mandate by prospective borrower and he is responsible for placing the syndicated loan to other banks. Arranger has to ensure that issue is fully subscribed.

2. UNDERWRITING BANK: The bank that commits to supplying the funds to the borrwoer -if necessary from its own resources if the loan is not fully subscribed. Underwriter may be the arranging bank or another bank. This should be noted that not all syndicated loans are fully underwritten. Risk is that the loan may not be fully subscribed and underwriter has to supply funds committed.

3. PARTICIPATING BANK: The bank that participates in the syndication by lending a portion of the total amount required.

4. FACILITY MANAGER / AGENT: The one that takes care of the administrative arrangements over the term of the loan (e.g. disbursements, repayments, compliance). He acts for the banks.

BENEFITS TO THE BORROWER

•Deals with a single bank: As stated earlier borrower in case of syndicated loan facility doesn’t need to deal with each and every lender. Borrower has to deal with Lead manager only. This saves time and administrative expense of borrower.

•quicker and simpler than other ways of raising capital: Borrower can alternatively raise capital through other sources. He can issue share, debenture etc. But this entire route involves substantial cost and time. Syndication is a better option in this regard.

BENEFITS TO THE LEAD BANKS

•Good arrangement and other fees can be earned without committing capital: Lead manager earns fees because of his services to borrower. This can be done without committing any capital.

•Enhancement of bank’s relationship with the client: Because Lead banker deals with client his relationship with client enhances that can bring business for bank in long term.

BENEFITS TO THE PARTICIPATING BANKS

•Access to lending opportunities with low marketing costs.

•Opportunities to participate in future syndications.

•in case the borrower runs into difficulties, participant banks have equal treatment.

STAGES

1. PRE-MANDATE PHASE

The prospective borrower may liaise with a single bank or it may invite competitive bids from a number of banks.

THE LEAD BANK NEEDS TO: identify the needs of the borrower and designs an appropriate loan structure. Then develop a persuasive credit proposal to obtain internal approval.

2. PLACING THE LOAN

The lead bank can start to sell the loan in the marketplace. He needs to prepare an information memorandum, term sheet, legal documentation and then approach selected bank and invite participation. Lead manager need to negotiate with borrower at this stage to satisfy participant’s concern if any.

3. POST-CLOSURE PHASE

The agent now handles the day-to-day running of the loan facility.

Benefits of loan syndications for borrowers Syndicated loans provide borrowers with a more complete menu of financing options. In effect, the syndication market completes a continuum between traditional private bilateral bank loans and publicly traded bond markets. This has resulted in a more competitive corporate finance market, which has permitted issuers to achieve more market-oriented and cost-effective financing.

Example of Loan syndication Deals:

In 2005 Reliance Port and Terminal, a subsidiary of Reliance Industries, has raised loan for expanding its port facility (Rs 42 billion) to increase imports of crude oil by Reliance Petrochemicals, from 33 million tones to around 66 million tones. A total of 20 banks syndicated the loan with the security trustee being the UTI Bank.

Similarly, Indian Rayon raised Rs 750 crore to acquire 50 per cent of AT&T's stake in Idea Cellular. The balance of the AT&T stake, valued at Rs 1,500 crore (Rs 15 billion), will be picked up by the Tatas.

The same applied for a loan syndication of Rs 5,000 crore (Rs 50 billion) for Hindalco a few years back and for Rs 1,000 crore (Rs 10 billion) for Bhushan Steel.

SBI Caps has been a leading player in the Indian loan syndication market. It has been ranked first in Asia-Pacific for project finance syndication by Thomson Project Finance International. Realizing the huge potential in the loan syndication market, the investment bank tied with IDFC for syndication of debt financing of infrastructure projects in 2006.

Mutual Fund Series-I

There are number of investment options available in market today, mostly they all confuse investors instead of helping them. Right from traditional insurance to risky and volatile stocks, fixed deposit, post office savings deposit schemes, debentures (this alone has so many forms) and so on and so forth.

So how one can decide where to put his hard earned money?

Investment decision of individual depends on many factors. One should have fair knowledge of product beforehand he has decided to invest in that one. In this post we are going to discuss one popular form of investment that is Mutual funds.

What is a Mutual fund:

In simple terms mutual fund is an investment vehicle where many investors with similar interest come together and pool their money for a common investment objective. Then this fund is managed by professionals on their behalf. But this definition is very general and over-simplified in nature. Next one is a bit technical.

A mutual fund is a company that brings together money from many people and invests it in stocks, bonds, or other securities. (The combined holdings of stocks, bonds, or other securities and assets the fund owns are known as its portfolio.) Each investor owns units, which represent a part of these holdings.

Advantages of Mutual Fund investing-

Portfolio Diversification: Mutual funds invest in different kind of instruments viz. stocks, bonds, money market instrument etc. investment in such a wide variety of instruments provides diversification which may not be case in a normal investment.

Suppose as an investor you think ONGC, ACC, Infosys, Wipro or RIL share quite rewarding. These shares are currently trading between 1000 Rs. to 2500 Rs. So how many retail investors can buy these shares and what happens if prices go down after investing in them?

Suppose one is willing to invest 5000 Rs. in that case he will not able to invest in blue-chip companies share without taking high risk. Mutual fund comes handy at this time. You invest in any scheme that invests in large cap and your money will be invested in these large cap companies.

Professional Management: one of the main reasons behind existence of Mutual fund is lack of time and expertise which is not available for common investors. In a mutual fund, your money is managed by professionals who have good understanding of market. This professionally managed fund hence provides better return to investors.

Reduction of Risk: Diversification is a key characteristic of mutual funds. Diversification reduces risk.

Transaction Costs and Taxes: Investing in stock market have transaction cost. Whenever you buy or sell some stock you have to primarily pay brokerage charges. In case of mutual funds generally you are required to pay two kind of fee; entry and exit load. Mutual fund also provides tax benefit for some particular schemes.

Liquidity and Convenience: Mutual funds are highly liquid and marketable. Open ended funds can be redeemed right back to issuing AMC. Close ended funds are traded in secondary market.

Disadvantage of mutual fund investing:

Cost: There are two types of cost which is associated with mutual funds; one is usual entry and exit charges other is charges to cover expenses of fund. Sometime times these cost overweight returns.

Fluctuating returns: Over the time mutual funds have started to build portfolio in such a way that there returns are highly correlated with market. This results in returns that largely vary with market. Returns of mutual funds so fluctuates some times like market.

No guaranteed return: there is no guarantee that a scheme will provide you your expected return.

In next post: History, how mutual funds works, Structure, Types of Scheme

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.

Related Articles:
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.

Basics of Finance series 1- Risk and Return

Finance Series: 1: Risk & Return Analysis:

“It’s always better to be in unison”. It was well said in Geeta by Lord Krsna: Aho Parth! Sanghe sakthi kaliyuge.O Arjun! For unity is the strength in Darkness.

So, as part of this series, I will be discussing, on a regular basis, about basics of Finance then contouring Investment Banking and Security Analysis along with latest happenings in the financial sectors.

As this paper is the very first in the series, I am discussing the very first topic in the financial parlance i.e. Risk and Return Analysis.

In this series we will discuss following:

1. Basic Risk/Return Concepts
2. Portfolio Risk
3. CAPM/SML
4. Portfolio Theory
5. Asset Pricing Model

This topic may seem very primitive in nature and scope but as a start up it might turn up little fruitful and for beginners, it is a must.

I promise to bring you every possible thing in Finance in due course of time as a regular series and we are also committed to deeper and more complex topics as well.

The 1st Year students may take it as an additional rapid go through for their examination preparation and my 2nd year friends may find it useful for their placement brush-ups


So here we go………….

Risk and Return Analysis

There are two kinds of returns in finance
a) Historical returns b) Anticipated returns (future prospective).

We must remember that calculations of risk differ with these two returns. Historical returns are based on the previously recorded data whereas anticipated returns are future projections about “would be realized returns” based on certain assumptions, trends or expectations.

Risk, as it stands, is the quantified value of the uncertainty in the returns (Anticipated return).It pertains to the probability of earning a return less than that expected. So greater is the chance of a return far below the expected return, greater is the risk.

A second school of thought defines risk as the variance (fluctuation, deviation) in the return from a mean, stated, expected or most likely return. Hence, as long as your returns in future (anticipated) are distant from your measurement, you are in a more risky zone.


In the above figure, the Y AXIS SHOWS THE PROBABILITY OF RETURN.

We can see that the stock X represented by red line is more bent towards mean and the height (probability) of return is higher compared to Stock Y with less height. Hence Y is more risky than X even though the return for both is same.

So how do we measure this risk component?

Risk is simply the Standard deviation( square root of variance) of returns.
The formula goes as such:




Here Ki= Return from stock,
= Mean (average) of all such returns

Now this risk can be broken into two halves
a) Part which is company specific (or asset specific)
b) Part which is market specific.

Now the company specific risk is called Diversifiable risk (Unsystematic risk) because this risk can be eliminated by taking a good number of assets (securities) that offsets the effect of one risk by another negatively correlated security (asset).If we take n number of securities or asset that show some kind of negative correlation, than we can have a bucket of securities in which we shall still have optimum profit, even if few of the securities are giving negative return.
This concept is the backbone of Portfolio theory and the bucket of securities from diverse industry or nature that we are talking about is the portfolio.

The second kind of risk is the market related risk which is called Non Diversifiable or Systematic risk. This is the risk associated with the entire market and can not be done away with.


Now Beta (β): β is the alternate measure of Company risk (diversifiable, unsystematic).This is the relationship between a company and the market. It shows how a company performs relative to market.

If market (say, BSE 500) gives a return of 15% and my stock (say RIL) gives a return of 19%, then we relate the returns of RIL with market (BSE 500) as follows:

Ri= α + β(Rm)+ error

This equation means that Return on RIL is β times the return on BSE 500 with a constant term added with some negligible error(negligible because my equation will revert to mean in a little stretched period and this mean error will be zero).
This α = A return realized by the security (RIL) even when market gives zero return.(Remember, this is not the Rf i.e Risk free return.).

This beta can also be termed as such: β = covariance (i,m)/variance(i) i.e. covariance of security with market divided by variance of security.

Security Market Line:

Ki=K(rf)+ β(Km- K(rf))

Here Ki is the return on security (RIL)
K(rf) is the Risk free return(Govt.Security,T bills)(Remember this is not the α of last equation).
Km- K(rf) = Risk Premium .This signifies the extra return(incentive) that investors would ask for investing in a riskier security. Had they invested in T bills, they would not have been into risk. As they are facing risk here, they want an extra incentive for that.

CAPM (Capital Asset Pricing Model):

This model is the mother of portfolio theory and the SML, we just discussed.
Before discussing CAPM, lets first discuss the difference between Expected return and Required return.

Required Rate of return:the return needed by investors for investing in a particular security based on its relative risk profile. In a more explicit term, it is this return which is obtained by SML equation.i.e one obtained with Km, β and K(rf).You simply put values in the right hand side of equation Ki=K(rf)+ β(Km- K(rf)) and obtain Ki.This Ki is your Required rate of return.i.e market forces believe that based on your comparative risk profile ,you would be generating this much return.

But practically, it never so happens that a firm generates this much returns for its shareholders. Because, as we know the return is generated out of profit, that a firm makes based on its hard core business and the return is seldom a captive of market forces(at least financial markets).
Let us assume that investors expect RIL to generate a profit of 19% and the current share prices of RIL say that based on the risk profile and market conditions, after calculating by the equation of CAPM (SML), RIL is supposed to generate a profit of X rupees and hence the return would be A. This A is required rate of return.

Now ,due to his acumen, operational efficiency and better market condition(may be abroad),Mr Mukesh Ambani earned Y rupees as profit and hence gave his shareholders B % return instead of A%.
So,B% is the Expected rate of return.

Now, ideally, in an efficient market, Market forces should have seen this before and the required rate of return should have been B% instead of A%. But it never happen that way.hence, now we are faced with three conditions:

a)Expected ROR> Required ROR: RIL is UNDERVALUED
b) Expected ROR = Required ROR: RIL is FAIRLY VALUED
c) Expected ROR< Required ROR: RIL is OVERVALUED

In first case, the company is better than market perceives it to be. Hence market has undervalued it and placed a lesser price for it. This company is a good investment and in due course of time, market will realize that this is a premium company and hence its share prices would go up.

In second case, the market knows that true worth of company hence no long term correction in prices.

In third case, market has thought that the company is a very good one and demands a premium. But market was wrong. It has actually overvalued the company and the company could not generate enough profit and return as was expected from it. Hence, the prices of its share would go down. . .

All securities above blue line (SML) are UNDERVALUED and all securities below SML are OVERVALUED.
Now at the end of this first session, I would like to discuss two very interesting things which are often neglected in CAPM.The one is effect of inflation and another one is that of Risk profile change.

Impact of Inflation: As we know,SML is the line which originates with Rf(Risk free return) with a slope equal to β.Now, in the linear equation Ki=K(rf)+ β(Km- K(rf)),we observe: K(rf) is the intercept with Y axis i.e Return axis X axis represents Km- K(rf), i.e Risk premium β is the slope. Now if inflation changes (increases),K(rf) i.e Risk free return will be adjusted to new inflation. It means RBI will increase the interest rate to cool off inflation and the yield on T Bills will also increase. In short Interest rate increases. Now as K(rf) increases, the entire SML shifts upward without any change of slope(β).This is justified because β symbolizes security’s relative performance with the market and the impact of higher interest rates will be same both for the RIL and BSE 500( i.e market as well as company).

Impact of change of Risk Appetite: Suppose, the relative appetite of market forces, investors change.i.e the entire market has become more bullish for the economic growth, and the so called India Story has spelt its magic. So what shall happen now? Now , β will change( decrease).This is so because, now market is ready to take bigger risk and is ready to accept Mr Mukesh Ambani with more vigor. The relative performance and riskiness of RIL has gone up compared to rest of the market. A reverse would be expected in a bearish market where β i.e slope becomes more steeper and market starts expecting less to RIL than it used to before.

In a bearish phase, the Risk premium would increase and market would now demand more return for the same risk profile.

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In next issue, I will discuss following:

1. CAPM in detail
2. Efficient frontier Theory
3. Capital Market Line (CML)
4. Security Market Line (SML) in little deeper
5. Arbitrage Pricing Theory
6. Fama French 3 Factor model.

Thank You

Prem Kumar