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Chapter 1 Executive Summary

The last 15 years have seen a revolution in the way financial economists understand the investment world. It was once thought that stock and bonds returns were essentially unpredictable. But it is discovered that stock and bond returns have a substantial predictable component at long horizons. once thought that the Capital asset pricing model provided a good description of why average returns on some stocks, portfolios, funds or strategies were higher than others. Now it is recognized that the average returns of many investment opportunities cannot be explained by the CAPM. Portfolio theories were developed by Markowitz (1952) and Tobin (1958) in the early 1950s and 1960s, which suggested that the risk of an individual security is the standard Deviation of its returns a measure of return volatility. Thus, the larger the standard deviation of security returns the greater the risk. Markowitz observed that (i) (ii) When two risky assets are combined their standard deviations are not additive, provided the returns from the two assets are not perfectly positively correlated and When a portfolio of risky assets is formed, the standard deviation of the portfolio is less than the sum of standard deviations of its constituents. Best portfolios are constructed when two securities are perfectly negatively correlated. Markowitz was the first to develop a specific measure of portfolio risk and to derive the expected return and risk of a portfolio. The Markowitz model generates the efficient frontier of portfolios and the investors are expected to select a portfolio, which is most appropriate for them, from the efficient set of portfolios available to them. The application of Markowitz is very complicated as the number of correlations required to calculate are huge. But Markowitz contribution to portfolio Theory cannot be ignored. Ever since Markowitz introduced the concept of portfolio theory in 1952 one of the questions predominant in the minds of financial theorists has been the consistency of the investors optimal portfolio. Research into this area, which become known as capital market theory attempted to
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analyze the equilibrium relationships between assets. One of the products of this research was widely accepted Capital asset pricing model of Sharpe and lintner. Sharpe (1964) developed a computationally efficient method, the single index model, where return on an individual security is related to the return on a common index. The common index may be any variable thought to be the dominant influence on stock returns. Ri = + Rm Where Ri = Security Return =Relationship of security with Common Index Generally Market Index Rm =Market Index =Risk free return The single index model can be extended to portfolios as well. This is possible because the expected return on a portfolio is a weighted average of the expected returns on individual securities. When analyzing the risk of an individual security, however, the individual security risk must be considered in relation to other securities in the portfolio. In particular, the risk of an individual security must be measured in terms of the extent to which it adds risk to the investors portfolio. Thus, a securitys contribution to portfolio risk is different from the risk of the individual security. Investors face two kinds of risks, Diversifiable (Unsystematic risk) is unique risk which is specific to security and which can be eliminated by increasing the number of securities and nondiversifiable (Systematic risk) is related with the market as a whole. It affect the entire economy therefore is often referred to as the market risk. The market risk is the component of the total risk that cannot be eliminated through portfolio diversification. (1)

Chapter 2 Introduction
Investors and financial researchers, in order to test the relationship between Risk and Return, have done numerous researches in the past. In order to assess the risk exposure to different assets, practitioners all over the world use a plethora of models in their portfolio selection process. A stocks contribution to the risk of a fully diversified portfolio depends on its sensitivity to market changes. This sensitivity is generally known as beta. A security with a beta of 1.0 has average market riska well-diversified portfolio of such securities has the same standard deviation as the market index. A security with a beta of .5 has below-average market riska well-diversified portfolio of these securities tends to move half as far as the market moves and has half the markets standard deviation.

Basis on which Investments is made Risk: Risk can be defined as the uncertainty in achieving the expected return. It is the chance that an investment's actual return will be different than expected. This includes the possibility of losing some or all of the original investment. Risk is usually measured by calculating the standard deviation of the historical returns or average returns of a specific investment

Return: Return can be defined as the percentage annual accretion to the net wealth employed in an investment avenue. In simple terms, it is the gain or loss of a security in a particular

period. The return consists of the income and the capital gains relative on an investment. It is usually quoted as a percentage.

Return(y)= P1-P0+D1 P0

Timing: Timing involves at what time the investment avenue is being purchased or sold. There are different investment styles that are present for making the investments at different intervals. Portfolio Management involves time element and time horizon. The present value of future returns /cash flows by discounting is useful for share valuation and bond valuation.

Early Developments 2.1


The Capital Asset Pricing Model (CAPM) of Sharpe (1964), Lintner (1965), and Black (1972) provides predictions for equilibrium expected returns on risky assets. More specifically, it states that the expected excess return over the risk-free interest rate of an asset equals a coefficient, times the (mean-variance efficient) market portfolios expected excess return over the risk-free interest rate (equation 3). This relatively straightforward relationship between various rates of return is difficult to implement empirically because expected returns and the efficient market portfolio are unobservable. Despite this formidable difficulty, a substantial number of tests have never the less been performed, using a variety of ex-post values and proxies for the unobservable ex-ante variables. Recognizing the seriousness of this situation quite early, Roll (1977) emphasized that tests following such an approach provide no evidence about the validity of the CAPM. The obvious reason is that ex-post values and proxies are only approximations and therefore not the variables one should actually be using to test the CAPM. Fama and MacBeth provided evidence (i) (ii) (iii) Of a larger intercept term than the risk-free rate, That the linear relationship between the average return and the beta holds and That the linear relationship holds well when the data covers a long time period.

So CAPM passed the early scares and accepted as a useful tool. 2.1.1 CAPM

The Capital Asset Pricing Model is based on the two parameter portfolio analysis model developed by Markowitz (1952). Markowitz drew attention to the common practice of portfolio diversification and showed exactly how an investor can reduce the standard deviation of portfolio returns by choosing stocks that do not move exactly together. This model was simultaneously and independently developed by John Linter (1965), Jan Mossin (1966). In equation form the model can be expressed as follows:

Where

is expected return on the asset i,

is the risk free rate of return,

is

expected return on market proxy and

is a measure of risk specific to asset i, and expected

return on market portfolio is also called the security market line. If CAPM is valid, all securities will lie in a straight line called the security market line in the , frontier. The security

market line implies that return is a linearly increasing function of risk. Moreover only the market risk affects the return and the investor receive no extra return for bearing diversifiable (residual) risk. The assumptions employed in the CAPM can be summarized as follows [Brealey-Meyers (2003)]: 1. Investment in U.S. Treasury bills is risk free. It is true that there is little chance of default, but they dont guarantee a real return. There is still some uncertainty about inflation. 2. Investors can borrow money at the same rate of interest at which they can lend. Generally borrowing rates are higher than lending rates. CAPM also makes the following assumptions:

3. Investors are risk averse individuals who maximize the expected utility of their end of period wealth. Implication: The model is a one period model. 4. Investors have homogenous expectations (beliefs) about asset returns. Implication: all investors perceive identical opportunity sets. This is, everyone have the same information at the same time.

5. Asset returns are distributed by the normal distribution.

6. There exists a risk free asset and investors may borrow or lend unlimited amounts of this asset at a constant rate: the risk free rate (kf).

7. There is a definite number of assets and their quantities are fixed within the one period world.

8. All assets are perfectly divisible and priced in a perfectly competitive marked Implication. e.g. human capital is non-existing (it is not divisible and it cant be owned as an asset).

9. Asset markets are frictionless and information is costless and simultaneously available to all investors. Implication: the borrowing rate equals the lending rate.

10. There are no market imperfections such as taxes, regulations, or restrictions on short selling.

2.1.2 According to CAPM, a market portfolio includes riskless securities as well as risky securities. It can also be written as:

Where,

Portfolio Theory ANY individual investors optimal selection of portfolio ( partial equilibrium)

CAPM equilibrium of ALL individual investors (and asset suppliers) (general equilibrium)

E(return) = Risk-free rate of return + Risk premium specific to asset i = Rf + (Market price of risk)x(quantity of risk of asset i) CAPM tells us 1) what is the price of risk? 2) what is the risk of asset i?

2.1.3 Example
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Expected Return Asset i Asset j 10.9% 5.4%

Standard Deviation 4.45% 7.25%

E(return) = Risk-free rate of return + Risk premium specific to asset i = Rf + (Market price of risk)x(quantity of risk of asset i) Question: According to the above equation, given that asset j has higher risk relative to asset i, why wouldnt asset j has higher expected return as well? Possible Answers: (1) the equation, as intuitive as it is, is completely wrong. (2) the equation is right. But market price of risk is different for different assets. (3) the equation is right. But quantity of risk of any risky asset is not equal to the standard deviation of its return.

E(return) = Risk-free rate of return + Risk premium specific to asset i

= Rf + (Market price of risk)x(quantity of risk of asset i) The intuitive equation is right. The equilibrium price of risk is the same across all marketable assets

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In the equation, the quantity of risk of any asset, however, is only PART of the total risk (s.d) of the asset. Specifically:

Total risk = systematic risk + unsystematic risk

Risk and Return


Expected Return 15%
Standard Deviation

4.0%

Risk

65.8%

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Average annual standard deviation (%) 49% -

Variability of Returns Compared with Size of Portfolio


Unsystematic or diversifiable risk (related to company-unique events) 24% 19% Total Risk Systematic or nondiversifiable risk (result of general market influences) 10 20 25 Number of stocks in portfolio

Risk and Return


Expected Return
2

=-1
1

= 1

Risk

Standard Deviation

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Risk & Return


Expected Return

X X
RF --

X X

X Efficient frontier X X X X

Risk

Std dev

Risk & Return


Expected Return

RM -X RF -Risk

X Efficient frontier X X X X X X X X

Std dev

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Portfolio Choice
Expected Return

Risk

Standard Deviation

CAPM says:
(1)Unsystematic risk can be diversified away. Since there is no free lunch, if there is something you bear but can be avoided by diversifying at NO cost, the market will not reward the holder of unsystematic risk at all. (2)Systematic risk cannot be diversified away without cost. In other words, investors need to be compensated by a certain risk premium for bearing systematic risk.

E(return) = Risk-free rate of return + Risk premium specific to asset i = Rf + (Market price of risk)x(quantity of risk of asset i)

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Precisely: [1] Expected Return on asset i = E(Ri) [2] Equilibrium Risk-free rate of return = Rf [3] Quantity of risk of asset i = COV(Ri, RM)/Var(RM) [4] Market Price of risk = [E(RM)-Rf] Thus, the equation known as the Capital Asset Pricing Model: E(Ri) = Rf + [E(RM)-Rf] x [COV(Ri, RM)/Var(RM)] Where [COV(Ri, RM)/Var(RM)] is also known as BETA of asset I Or E(Ri) = Rf + [E(RM)-Rf] x i

Pictorial Result of CAPM


E(Ri) Security Market Line E(RM) Rf
slope = [E(RM) - Rf] = Eqm. Price of risk

= 1.0

[COV(Ri, RM)/Var(RM)]

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Example
Assume that the annual riskfree return is 5%. You made the following estimates for Coca-Cola and the S&P500:

1. Suppose that you use the S&P500 as a proxy for the market portfolio. Using the CAPM, what is the expected return on Coca-Cola? Using the SML equation, we have Hence, the expected return on Coca-Cola is 13%.

2. What is the standard deviation of Coca-Cola? We need to use the following equation:

Hence, the standard deviation of Coca-Cola is 25%. 3. How can you explain that

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4. According to estimates, what is the equation of the CML? The equation of the CML is

5. The Sharpe ratio of the market portfolio is What is the interpretation of the Sharpe ratio? The Sharpe ratio is the market premium per additional unit of risk (as measured by standard deviation).

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6. According to estimates, what is the equation of the beta version of the SML? The equation of the beta version of the SML is

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7. Suppose that your investment goal is to have an expected return on your portfolio equal to 16%. According to the CAPM, what is the most efficient portfolio with that level of expected return? We need to solve the following equation: with

Hence,

8. Suppose that your investment is $1,000,000. Specify the amount you invested in the market portfolio. Since the weight in the market portfolio is 137.5%, you need to invest $1,375,000 [=$1,000,000*1.375] in the market portfolio. Therefore, you must borrow $375,000 [=$1,375,000-$1,000,000]. 9. What is the standard deviation of your portfolio? We need to use the following formula:

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Therefore, the standard deviation of your portfolio is 27.5%. [=0.275=1.375*0.2]. 10. What is the beta of your portfolio? We need to the use the following formula: What is the beta of the riskfree security? 0! What is the beta of the market portfolio? 1! Hence, the beta of your portfolio is 1.375 [=1*1.375 ].

11. How can we determine the amount invested in CocaCola? Since we are using the S&P500 as proxy for the market portfolio, the amount you invested in Coca-Cola is equal to: the weight of Coca-Cola in the S&P500*$1,375,000.

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12. Is it efficient to invest only in Coca-Cola? According to the CAPM, the expected return on Coca-Cola is equal to the expected return on the S&P500. However, the standard deviation of Coca-Cola is larger than the standard deviation of the S&P500. Hence, investing only in Coca-Cola is not efficient!

Chapter 3
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What is an equilibrium 3.1CONDITION 1:Individual investors equilibrium: Max U


Assume: [1] Market is frictionless => borrowing rate = lending rate => linear efficient set in the return-risk space [2] Anyone can borrow or lend unlimited amount at risk-free rate [3] All investors have homogenous beliefs => they perceive identical distribution of expected returns on ALL assets

=> thus, they all perceive the SAME linear efficient set (we called the line : CAPITAL MARKET LINE => the tangency point is the MARKET PORTFOLIO

E(Rp)
B Q Market Portfolio A Rf
M

Capital Market Line

E(RM)

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3.2 CONDITION 2: Demand = Supply for ALL risky assets Remember expected return is a function of price. Market price of any asset is such that its expected return is just enough to compensate its investors to rationally hold it.

3.3 CONDITION 3: Equilibrium weight of any risky assets The Market portfolio consists of all risky assets. Market value of any asset i (Vi) = PixQi Market portfolio has a value of iVi Market portfolio has N risky assets, each with a weight of wi Such that wi = Vi / iVi for all i

3.4 CONDITION 4: Aggregate borrowing = Aggregate lending Risk-free rate is not exogenously given, but is determined by equating aggregate borrowing and aggregate lending.

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Chapter 4

Two-Fund Separation:
Given the assumptions of frictionless market, unlimited lending and borrowing, homogenous beliefs, and if the above 4 equilibrium conditions are satisfied, we then have the 2fund separation. TWO-FUND SEPARATION: Each investor will have a utility-maximizing portfolio that is a combination of the riskfree asset and a portfolio (or fund) of risky assets that is determined by the Capital market line tangent to the investors efficient set of risky assets Analogy of Two-fund separation Fisher Separation Theorem in a world of certainty

Two-fund separation

E(Rp)
B Q Market Portfolio A Rf
M

Capital Market Line

E(RM)

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Derivation of CAPM Using equilibrium condition 3

wi = Vi / iVi for all i market value of individual assets (asset i) wi = -----------------------------------------------market value of all assets (market portfolio)

Consider the following portfolio: hold and a% in asset i (1-a%) in the market portfolio

The expected return and standard deviation of such a portfolio can be written as: E(Rp) = aE(Ri) + (1-a)E(Rm) (Rp) = [ a2i2 + (1-a)2m2 + 2a (1-a) im ] 1/2

Since the market portfolio already contains asset i and, most importantly, the equilibrium value weight is wi

therefore, the percent a in the above equations represent excess demands for a risky asset We know from equilibrium condition 2 that in equilibrium, Demand = Supply for all asset.

Therefore, a = 0 has to be true in equilibrium.

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Chapter 5 Beta
Beta is a measure of a stock's volatility in relation to the market. By definition, the market has a beta of 1.0, and individual stocks are ranked according to how much they deviate from the market. A stock that swings more than the market over time has a beta above 1.0. If a stock moves less than the market, the stock's beta is less than 1.0. High-beta stocks are supposed to be riskier but provide a potential for higher returns; low-beta stocks pose less risk but also lower returns. Beta is a key component for the capital asset pricing model (CAPM), which is used to calculate cost of equity. Beta is a useful measure. A stock's price variability is important to consider when assessing risk. Indeed, if you think about risk as the possibility of a stock losing its value, beta has appeal as a proxy for risk.

Return on Stock i,
Stock H, High Risk: = 1.5 30 -20 -10 -| -20 | -10 0 -10 --20 -| 10 | 20 Stock L, Low Risk: = 0.5 | 30 Stock A, Average Risk: = 1.0

Return on the market

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5.1 Is Beta Dead


The Fama and French (1992) study has itself been challenged. The studys claims most attacked are these: That the beta has no role for explaining cross-sectional variation in returns, That the size has an important role, That the book to-market equity ratio has an important role. The studies responding to the Fama and French challenge generally take a closer look at the data used in that study. Kothari, Shanken, and Sloan (1995) argue that Fama and Frenchs (1992) findings depend critically on how one interprets their statistical tests. Kothari, Shanken, and Sloan focus on Fama and Frenchs estimates for the coefficient on beta, which have high standard errors and therefore imply that a wide range of economically plausible risk premiums cannot be rejected statistically. The view, that the data are too noisy to invalidate the CAPM, is supported by Amihud, Christensen, and Mendelson (1992) and Black (1993). In fact, Amihud, Christensen, and Mendelson (1992) find that when a more efficient statistical method is used, the estimated relation between average return and beta is positive and significant. Black (1993) suggested that the size effect noted by Banz (1981) could simply be a sample period effect: the size effect is observed in some periods and not in others.

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5.2 Is Beta Alive


The general reaction to the Fama and French (1992) findings, despite these challenges, has been to focus on alternative asset pricing models. Jagannathan and Wang (1993) think that this may not be necessary. Instead they show that the lack of empirical support for the CAPM may be due to the inappropriateness of some assumptions made to facilitate the empirical analysis of the model. Such an analysis must include a measure of the return on the aggregate wealth portfolio of all agents in the economy, and Jagannathan and Wang say most CAPM studies do not do that. Most empirical studies of the CAPM assume, instead, that the return on broad stock market indexes, like the NYSE composite index, is a reasonable proxy for the return on the true market portfolio of all assets in the economy. However, in the United States, only one-third of nongovernmental tangible assets are owned by the corporate sector, and only one-third of corporate assets are financed by equity. Furthermore, intangible assets, like human capital, are not captured by stock market indexes. Jagannathan and Wang (1993) abandon the assumption that the broad stock market indexes are adequate. Following Mayers (1972), they include human capital in their measure of wealth. Since human capital is, of course, not directly observable, Jagannathan and Wang choose the growth of labor income, and build human capital into the CAPM this way: Then Jagannathan and Wangs version of the CAPM is show that the CAPM is able to explain 28 percent of the cross-sectional variation in average returns in the 100 portfolios studied by Fama and French (1992). Thus, Jagannathan and Wang (1993) directly respond to the challenge of Fama and French (1992).

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Chapter -6 Indian Stock Market


6.1 WHAT IS STOCK
Share or stock is a document issued by a company, which entitles its holder to be one of the owners of the company. A share is issued by a company or can be purchased from the stock market.

6.2 What is stock market


A market where dealing of securities is done is known as share market. There are basically two types of share market in India: 1. Bombay Stock Exchange (BSE) 2. National Stock Exchange (NSE)

6.3 DIFFERENCE BETWEEN PRIMARY AND SECONDARY MARKETIn the primary market securities are issued to the public and the proceeds go to the issuing company. Secondary market is a term used for stock exchanges, where stocks are bought and

Individuals apply to get shares of the company Company IPO

Companies share ownership by issuing shares


sold after they are issued to the public.
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Company

Owners

Companies allocate shares to individuals and those who get the shares become part owners of the company.

SECONDARY MARKET

Company

Stock Exchange

Broker Individual Investors

Companies get themselves listed on popular stock exchanges like BSE and NSE

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6.4 DYNAMICS OF THE SHARE MARKET

Buyer
He pays the money to his broker

Broker
His broker pays it to the exchange

Stock Exchange
The exchange pays it to the sellers broker

Broker
Sellers broker finally pays the money to the seller

Seller

Similar process happens for the transfer of shares from the sellers end.

Capital markets in India have considerable depth. There are 22 stock exchanges in India. Ahmadabad, Delhi, Calcutta, Madras and Bangalore are major ones amongst the other stock exchanges. These stock exchanges are served by 3,000 brokers and 20,000 sub-brokers. A number of providers for merchant banking services exist. The market capitalization of the Bombay Stock Exchange (BSE) alone was around Rs.5 trillion in December 1994.This makes it one of the largest emerging stock markets in the world. A number of other cities also have stock markets. There are two other exchanges in Bombay: National Stock Exchange (NSE) Over The Counter Exchange of India (OTCEI) The regulatory agency which oversees the functioning of stock markets is the Securities and Exchange Board of India (SEBI), which is also located in Bombay. India has one of the most active primary markets in the world, with roughly 130 public issues taking place each month. The National Stock Exchange (NSE), Bombay Stock Exchange (BSE) and OTCEI have already
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introduced screen-based trading. All other exchanges (except Guwahati, Magadh and Bhubaneswar) are to introduce full computerization and screen-based trading by 30 June 1996. This will bring about greater transparency for investors, reduce spreads, allow for more effective monitoring of prices and volumes and speed up settlement.

6.4.1 TRANSACTION CYCLE

IN SHARE MARKET

6..5 Major Stock Market In India

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There are two major capital markets in India in terms of liquidity, volume of trades and the volume if companies listed. These are:
1) NSE ( National Stock Exchange) 2) BSE (Bombay Stock Exchange)

6.5.1 Bombay Stock Exchange: Bombay Stock Exchange is the oldest stock exchange in Asia with a rich heritage, now spanning three centuries in its 133 years of existence. What is now popularly known as BSE was established as "The Native Share & Stock Brokers' Association" in 1875. BSE is the first stock exchange in the country which obtained permanent recognition (in 1956) from the Government of India under the Securities Contracts (Regulation) Act 1956. BSE's pivotal and pre-eminent role in the development of the Indian capital market is widely recognized. It migrated from the open outcry system to an online screen-based order driven trading system in 1995. Earlier an Association Of Persons (AOP), BSE is now a corporatised and demutualised entity incorporated under the provisions of the Companies Act, 1956, pursuant to the BSE (Corporatisation and Demutualisation) Scheme, 2005 notified by the Securities and Exchange Board of India (SEBI). With demutualisation, BSE has two of world's best exchanges, Deutsche Brse and Singapore Exchange, as its strategic partners. Over the past 133 years, BSE has facilitated the growth of the Indian corporate sector by providing it with an efficient access to resources. There is perhaps no major corporate in India which has not sourced BSE's services in raising resources from the capital market. Today, BSE is the world's number 1 exchange in terms of the number of listed companies and the world's 5th in transaction numbers. The market capitalization as on December 31, 2007 stood at USD 1.79 trillion. The BSE Index, SENSEX, is India's first stock market index that enjoys an iconic stature, and is tracked worldwide. It is an index of 30 stocks representing 12 major sectors. The SENSEX is constructed on a 'free-float' methodology, and is sensitive to market sentiments and market realities. 6.5.2 National Stock Exchange:
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The NSE, located in Bombay, was set up in 1993 to encourage stock exchange reform through system modernization and competition. NSE's reach has been extended to 21 cities, of which 6 cities do not have their own stock exchanges. NSE plans to cover 40 cities by end-1996. The NSE has a very modern implementation of trading using contemporary technology in computers and communication. It is an electronic screen based system where members have equal opportunity and access for trading irrespective of their location, since they are connected by a satellite network. The number of members trading on the exchange has increased from the 227 at commencement to 600 members as of November 1995. NSE, thus, helps to integrate the national market and provides a modern system with a complete audit trail of all transactions. In a further effort to improve the settlement system and minimize the risks associated therein, NSE has set up a subsidiary - National Securities Clearing Corporation (NSCC). On par with clearing corporations the world over, NSCC will shortly guarantee settlement of trades executed and settled through it. The instruments traded are treasury bills, government security, and bonds issued by public sector companies. Currently, 200 large companies are traded on the NSE; that list is expected to gradually expand as the exchange stabilizes. The NSE is a computerized market for debt and equity instruments. The government of India issues around Rs.70 billion of debt instruments per year. The market is still nascent; but, trading volumes are steadily rising. Average daily turnover in stocks have increased from Rs.70 million in November 1994 to Rs.990 million during July 1995.

6.5.2.1 Objectives:
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To establish a nationwide trading facility for equities, debt instruments and hybrids. To ensure equal access to investors all over the country through appropriate communication network. To provide a fair, efficient and transparent securities market to investors using an electronic communication network. To enable shorter settlement cycle and book entry settlement system. To meet current international standards of securities market. NSE-NIFTY: The national Stock Exchange on April 22, 1996 launched a new Equity Index The NSE-50. The new Index which replaces the existing NSE-100 Index is expected to serve as an appropriate Index for the new segment of futures and options. Nifty means National Index for Fifty Stock. The NSE-50 comprises 50 companies that represent 20 broad Industry groups with an aggregate market capitalization of around Rs.170000crores. All companies included in the index have a market capitalization in excess of Rs.500crores each and should have traded for 85% of trading days at an impact cost of less than 1.5%. The base period for the index is the close of prices on Nov 3,1995 which makes one year of completion of operation of NSEs capital market segment. The base value of the Index has been set at 1000.

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Table 1

50 Companies of NIFTY as on 1st March, 2009 A B B Ltd. N T P C Ltd. A C C Ltd. National Aluminium Co. Ltd. Ambuja Cements Ltd. Oil & Natural Gas Corpn. Ltd. Bharat Heavy Electricals Ltd. Power Grid Corpn. Of India Ltd. Bharat Petroleum Corpn. Ltd. Punjab National Bank Bharti Airtel Ltd. Ranbaxy Laboratories Ltd. Cairn India Ltd. Reliance Capital Ltd. Cipla Ltd. Reliance Communications Ltd. D L F Ltd. Reliance Industries Ltd. G A I L (India) Ltd. Reliance Infrastructure Ltd. Grasim Industries Ltd. Reliance Petroleum Ltd. H C L Technologies Ltd. Reliance Power Ltd. H D F C Bank Ltd. Siemens Ltd. Hero Honda Motors Ltd. State Bank Of India Hindalco Industries Ltd. Steel Authority Of India Ltd. Hindustan Unilever Ltd. Sterlite Industries (India) Ltd. Housing Development Finance Corpn. Ltd. Sun Pharmaceutical Inds. Ltd. I C I C I Bank Ltd. Suzlon Energy Ltd. I T C Ltd. Tata Communications Ltd. Idea Cellular Ltd. Tata Consultancy Services Ltd. Infosys Technologies Ltd. Tata Motors Ltd. Larsen & Toubro Ltd. Tata Power Co. Ltd. Mahindra & Mahindra Ltd. Tata Steel Ltd. Maruti Suzuki India Ltd. Unitech Ltd. Satyam Wipro Ltd. Zee Entertainment Enterprises Ltd.

Chapter 7 Review of Literature


The process of selecting a portfolio may be divided into two stages. The first stage starts with observation and experience and ends with beliefs about the future performances of available
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securities. The second stage starts with the relevant beliefs about future performances and ends with the choice of portfolio. This has been written by Markowitz (1952) in his research paper. He has given as E-V rule, E-V rule states that that the investor would (or should) want to select one of those portfolios which give rise to the (E, V) combinations indicated as efficient in the figure; i.e., those with minimum V for given E or more and maximum E for given V or less. The article presents a very comprehensive view to calculate highest expected return for a given level of risk. The Markowitz approach only takes into account risky assets and there is no provision for the risk free assets. Also the portfolio to be constructed must be based on the covariances between different securities and the securities which have minimum covariance must be selected. CAPM has been extensively used in various stocks markets and Portfolios. Michailidis, Tsopoglou, Papanastasiou and Mariola(2006) in their study deals with 100 stocks listed on Athens stock exchange for the period of January 1998 to December 2002. Regression analysis is performed for the monthly return for the ten years. The findings of the study were not in favor of the theorys basic hypothesis that higher risk (beta) is associated with a higher level of return. Klemkosky and Martin (1975), found the practical importance of beta effect on portfolio diversification by comparing the residual risk of high and low beta stock portfolios containing from two to twenty-five securities. These comparisons indicated that the levels of diversification achieved for high versus low beta portfolios for a given portfolio size were significantly different with high beta portfolios requiring a substantially larger number of securities to achieve the same level of diversification as a low beta portfolio. This information should be of particular benefit to the portfolio manager who seeks maximum diversification with a limited number of securities.

7.1 Literature on CAPM:


Jack Clark Francis and Frank Fabozzi (1979) conducted a study over a period of 73 months between December 1965 and December 1971 on 694 stocks listed in NYSE. The study looked into the stability of the single index market model (SIMM). The result of the study supports the
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hypothesis that SIMM is affected by macroeconomic conditions. The inter-temporal instability in the betas frequently observed could be due to this business cycle economics. Richard Roll (1981) found the trading infrequency to be an important cause of bias in short interval data. As the small firms are traded less frequently the risk measures for these firms are downward biased. The bias is very large in daily data and is also present in returns from monthly data. According to the author this bias can possibly explain effects like the small firm effect, low P/E ratio effect and high dividend yield firm effects, present in the market. Jeffrey F. Jaffe, Randolph Westerfield, M. A Christopher (1989) studied two sets of indices from the US and one set each from Canada, Australia, England and Japan. The authors find that Monday return for common stocks is negative only when market has declined in the previous week. The findings are inconsistent with market efficiency. The inconsistency cannot be explained by serial correlation arising from infrequent trading or higher risk on those particular Mondays.

7.2 CAPM Tests in Indian Context


There are many studies has already been done on Capital Asset Pricing Model on the Indian Capital Market. Vaidyanathan (1995) in his study found that Indian Capital market is not
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efficient enough, and it is not having historical data on tapes and data has not been adjusted for bonus/right etc over a long period of time which leads to market inefficiency. He also recommended that in order to compete in twenty first century, we need to strengthen the infrastructure, improve liquidity, minimize insider trading and enhance transparency. Manjunatha and Mallikarjunappaa(2007) in their study deals with 66 stocks listed on the BSE exchange. The stock was selected on based on two criteria: 1) the companies selected should have been constituents of BSE Sensex 2) traded for the minimum time period of six months in a year during the study period. The daily adjusted share prices and index from January 1990 to June 2005 were used to study. The study revealed that the alpha of the CAPM was equal to the risk-free rate of the returns, beta held the percentage returns when portfolios were formed with market value weights, neither beta nor size variables explained the variation in portfolio returns. A study conducted by Obaidullah (1994) used monthly stock price data for a period of sixteen years (1976-91) for a sample of thirty stocks. The results from the exercise, however, do not lend themselves to any supportive or contradictory interpretation. The coefficients of 2p are, in general, not statistically significant. This is in conformity with the CAPM. However, in the multiple regression model, the coefficients of p also in most cases become statistically insignificant which is contrary to what the CAPM predicts. Hence he suggests that CAPM as a description of asset pricing in Indian markets does not seem to rest on solid grounds. Vaidyanathan & Gali (1994 a) studied the variation in various indices (Sensex, ET index and Natex) and found that one scrip (Reliance) explained more than half of the variation in the indices during 1989 and 1990. In case Hindustan Lever is also considered then the two scrips explain around 70% of the variation in Sensex and Natex. Vaidyanathan & Gali (1994 b) studied the efficiency of the stock market (weak form) using runs, serial correlation and filter tests at four different points for the period 1980 to 1990 for ten scrips. The evidence from all the three tests support the weak form of efficiency.

Chapter 8 Need of the Study


39

Over the years, there has been many significant studies has been done in order to know the relation between Risk and Return. One of the most important contributions by researchers is in the field of security market is the establishment of the relationship between Risk and Return by the way of Capital Asset Pricing Model. After Markowitz (1952), Linter (1965) and Mossin (1966) has given this concept, a large number of studies have been conducted to test CAPM. A recent study on the same has been done by Michailidis, Tsopoglou, Papanastasiou, and Mariola (2006) in the Greek Securities Market, whereas Vaidyanathan (1995) applied the CAP Model in 1995. Recently Manjunatha and Mallikarjunappa (2007) conducted a study on 66 stocks of BSE. The Indian Stock Market is changing its dimensions in terms of liquidity and number of trades on the stock market. Earlier derivatives and short selling was not allowed in the Indian Stock Market but since 2001 it has been traded on the National Stock Exchange (India). The cost of transaction has reduced. There have not been many studies found of Applicability of CAPM on National Stock Market which is said to be more efficient than any other in terms of number of transactions and the liquidity. So it is endeavored to conduct such a study from Indian perspective.

Chapter 9 Research Objectives

40

The main objectives of the study are as follows: 1. 2. To test the relation between risk (systematic risk) and return. To study the effect on Portfolio Return with the diversification of risk.

Chapter 10 Research Methodology

41

Capital Asset Pricing Model is used in order measure the relationship among risk, return, and effect of diversification on the portfolio risk in the Indian Stock Market. The first step is focused to estimate a beta coefficient for each stock using monthly adjusted returns. For this, weekly opening and closing prices, after adjusting with the bonus issue, right issue, and other factors, of composite portfolio of 42 companies stocks of NSE representing all sectors of economy (index), is taken as the sample for the study. 10.1 Data Collection: The study used monthly stock returns from 42 Index companies listed on the NSE for the period of July 2005 to June 2008. The data is obtained from the PROWESS, a data base maintained by the CMIE Ltd. and from the websites of NSE and moneycontrol. All stock returns have been adjusted for the dividends as required by the CAPM. The stock prices are basically adjusted for the bonus and stock split. For example, if stock prices got a bonus of 1:1 that means for every one stock you are getting one stock as bonus, the previous stock prices that stock has been divided by two when the bonus credited to the shareholders and like the same way if each stock has been splitted up into five parts then the previous prices of that stock has been divided by five. 10.2 Beta Calculation

CAPM tells that return on security i, in time period t is a linear function of market return

Where, alpha is indicating the minimum level of return

42

The weekly return for the stocks from the stock prices was first calculated using the following formula.

P1:- Opening price of the stock in Current Week i.e. on Monday P0:- Opening Price of the stock in the Last Week i.e. on Monday Further for the calculation of Beta covariance of stock return to market return has been calculated by using the following equation. Covariance = The Data was arranged in the excel sheet and the covariance of the Nifty Index with Stock was calculated using excel function i.e. =COVAR (array1, array2) Variance = The Variance of the Stock is also calculated by arranging the data in the excel sheet and using excel function i.e. =VARP (number1, number2) Beta is estimated by regressing the weekly security return to the return of index. = Cov Ri.Rm/m2 The Beta is also calculated using Excel Sheet functions. The beta can be estimated by regressing each stocks monthly return against the market index according to the following equation:

43

10.3 Calculation of Various Risks: In the next stage, total market risk of the stock is calculated for each stock which is the sum of total market risk and total non-market risk. For calculating the total market risk, the variance of the stock is calculated, which is equal to the total market risk. The variance of the stock has been calculated using the formula Variance = The Variance of the Stock is also calculated by arranging the data in the excel sheet and using excel function i.e. =VARP (number1, number2). Total risk of the security is the sum of the total market risk and total non-market risk.

Where

variance of stock i representing the total risk is,

is total market risk, and

is non-market risk. 10.4 Calculation of alpha: Further alpha of each stock is calculated for calculating the minimum return expected from the stock. Alpha is a constant intercept indicating a minimum level of return that is expected from the security I, if market remains flat is calculated in this way: Alpha () =

Where is a constant intercept of security I, return of index, and is slope of the security i.

is a mean return of security I,

is mean market

10.5 Calculation of Coefficient of Determination:

44

The Coefficient of determination in stock return is explained by the Index return, coefficient of determination (R2) is calculated by dividing the systematic risk of the stock with the total market risk of that stock.

10.6 Calculation of Expected return of securities and portfolio: The expected return of the stocks has been calculated by using the following formula:

Where is the minimum level of return from the stock is the stock beta is the average mean of the Index return.

Weighted average return of each stock will be taken in order to make the portfolio return. Here, we will assume that equal weights to be given to each security in the portfolio. Symbolically, portfolio return can be obtained as:

Where

45

Total risk of a portfolio will be the weighted average of total risk of individual securities, which is composite of market and non-market risk. For better comparability of the market risk and return, all securities will be arranged in the ascending order on the basis of the beta value and then five portfolios will be made. The portfolio with the least beta (consisting of six securities) will be the portfolio number one. Second portfolio will be the next six securities on the basis of the beta and so on. The portfolio consisting with least beta will be the least responsive to the market index. The portfolio with the highest six betas will be more responsive to the market index.

The following equation will be used in order to estimate the portfolio betas:

Where,

The main objective is to test the relationship between risk (Systematic risk) and return, and effect of diversification on the portfolio risk. To calculate the expected return of the securities and portfolios here, the study has taken the average market return as market return which gave 0.46% weekly return to the market, and weekly interest on fixed deposit (0.11) has been taken as risk free return.

46

Chapter 11 The Relation between Risk and Return


Our first objective is to find the relation between the risk and the expected return of the securities. For this NIFTY-50 companies was taken as the sample size. Out of 50 companies, data for 42 companies is available, as some of the companies were listed after July, 2005. Pearson correlation coefficient between the stock beta and expected return (0.499) with high degree of linear relationship between these two, and the total market risk and expected return (0.527) signifies the high degree of relationship between risk and stock return. The proposition of CAPM seems to be right here. Diversification has been carried out on the basis of the arranging of securities according to the beta value. Stocks, which come in the first ranking, can be categorized as less volatile as their respected beta is low. They remain less responsive to the market up and downswings. On the other hand, stocks in the second end of ranking are of high risk as their respected beta are highest, which shows the high degree of market volatile, showing the high degree of market sensitivity in terms of upswings and downswings. The beta value explains the proportional change in the security return due to the effective change in the market
47

return. The ups and downswings in the security return depended to the market return. To determine the variation is the stock return is explained by the index return, coefficient of determination (R2) is calculated for this purpose. So 1- R 2 explains the variation in the stock return that is not due to the index movement or index return. Coefficient of Determination is the indication of the movement of the stock return due to the index return. If value of R 2 is 0.71 then it means that there is a 71% variation in the stock return due to the index return.

Table 2

Individual Stock return and Risk Variance Stock HEROHONDA SUNPHARMA CIPLA TCS RANBAXY SATYAMCOMP INFOSYSTCH HINDUNILVR AMBUJACEM ZEEL ITC GAIL NTPC BHARTIARTL HCLTECH WIPRO BPCL Beta 0.46 0.46 0.56 0.58 0.59 0.62 0.65 0.72 0.73 0.77 0.77 0.78 0.78 0.81 0.82 0.84 0.85 Stock 16.50 16.92 29.35 15.64 24.72 18.05 16.46 19.04 18.76 42.06 19.50 24.61 17.26 19.03 24.34 20.80 39.01 Alpha Stock -0.03 0.40 -0.10 -0.03 -0.17 0.16 0.02 -0.08 -0.04 0.07 0.06 0.04 0.09 0.44 -0.09 -0.18 -0.46 Systemati c Risk 2.45 2.49 3.64 3.86 4.06 4.50 4.88 5.97 6.12 6.86 6.93 7.08 7.08 7.69 7.87 8.18 8.35 Unsystematic Risk 14.06 14.44 25.71 11.78 20.67 13.55 11.58 13.08 12.65 35.20 12.57 17.53 10.18 11.34 16.47 12.62 30.67 R2 0.15 0.15 0.12 0.25 0.16 0.25 0.30 0.31 0.33 0.16 0.36 0.29 0.41 0.40 0.32 0.39 0.21 E(R) 0.18 0.61 0.16 0.24 0.11 0.45 0.32 0.25 0.29 0.42 0.42 0.40 0.45 0.81 0.29 0.21 -0.07

48

ACC ABB TATAMOTORS SIEMENS MARUTI GRASIM NATIONALUM RELIANCE M&M ONGC HDFC PNB TATAPOWER HDFCBANK HINDALCO TATASTEEL ICICIBANK TATACOMM LT SAIL BHEL UNITECH RELINFRA SBIN STER

0.87 0.90 0.92 0.93 0.94 0.95 0.95 0.96 0.99 1.00 1.06 1.15 1.15 1.16 1.17 1.18 1.27 1.32 1.33 1.34 1.37 1.40 1.41 1.41 1.51

27.36 31.50 21.92 33.99 27.45 22.57 45.67 21.04 26.25 24.42 30.18 30.07 32.16 26.93 37.37 36.59 34.87 48.51 33.74 45.84 38.86 129.13 47.64 47.64 58.05

0.00 0.50 -0.29 0.22 -0.10 0.07 0.35 0.45 0.05 -0.18 0.21 -0.35 0.28 -0.08 -0.25 0.12 -0.13 -0.11 0.42 0.31 0.32 2.44 -0.22 -0.22 0.71

8.68 9.46 9.73 9.94 10.30 10.43 10.56 10.79 11.40 11.49 13.09 15.32 15.35 15.63 15.82 16.04 18.71 20.28 20.40 20.81 21.65 22.82 23.14 23.14 26.27

18.68 22.04 12.18 24.05 17.15 12.14 35.11 10.25 14.84 12.93 17.09 14.75 16.82 11.30 21.55 20.55 16.15 28.23 13.34 25.03 17.21 106.31 24.49 24.49 31.78

0.32 0.30 0.44 0.29 0.38 0.46 0.23 0.51 0.43 0.47 0.43 0.51 0.48 0.58 0.42 0.44 0.54 0.42 0.60 0.45 0.56 0.18 0.49 0.49 0.45

0.40 0.91 0.13 0.64 0.34 0.50 0.79 0.90 0.51 0.27 0.70 0.18 0.81 0.46 0.29 0.66 0.46 0.50 1.03 0.93 0.95 3.09 0.43 0.43 1.40

The table explains the weekly expected return on the stocks. Whereas R2 is explaining the coefficient of determination i.e. the proportion of stocks returns that came from the index value.

49

11.1 Correlation Analysis


Correlation Analysis of Beta and Expected Return: 11.1.1 Table of Correlation between Beta and Expected Return Correlations
Table 3

Beta Expected Return Pearson Correlation 1 .499(**) Sig. (2-tailed) .001 N 42 42 Expected Return Pearson Correlation .499(**) 1 Sig. (2-tailed) .001 N 42 42 ** Correlation is significant at the 0.01 level (2-tailed). Beta Interpretation: The correlation between the Beta and Expected return is 0.499 which signifies the high level of correlation between the two and there exist a linear relation between the two as its significance level is 0.001 which is very high. The standard error term should be less than 0.05 but our standard is very low i.e. 0.001 which shows that there is very less chance of the error in the calculation of the correlation of the Beta and return from the stocks. The correlation value varies between -1 to +1 and our analysis is showing that the relation between. Although the Correlation is not that high but still it shows a good correlation between the two. Beta is the slope of Systematic risk. The correlation is showing that with the increase in the slope of Systematic Risk, the shareholders are getting moderate level of return. The proposition of CAPM says that with the increase in the slope of Beta value, the expected return should also be higher.

50

11.1..2 Correlation Analysis of Total Market Risk and Expected Return: Table of Correlation between Total Market Risk and Expected Return

Correlations Expected_ Return Expected_Return Pearson Correlation Sig. (2-tailed) N Systematic_Risk Pearson Correlation Sig. (2-tailed) N
Table 4

Systematic_ Risk 1 .527** .000 42 42 .527** 1 .000 42 42

**. Correlation is significant at the 0.01 level (2-tailed).

Interpretation: Pearson Coefficient of Correlation between the Total market Risk and the Expected Return is showing a significant high level of relation which means, with the increase in the risk related to stock the Return also increase. This relation shows that shareholder demands higher return to face higher risk. The proposition of CAPM seems to be right here. High risk yield high return to the stock. The proposition of CAPM is that if you invest in a risky security you should get higher return for taking extra risk.

51

11.2 Regression Analysis

b Variables Entered/Removed

Model 1

Variables Entered Betaa

Variables Removed .

Method Enter

a. All requested variables entered. b. Dependent Variable: Expected_Return

Model Summary Model 1 R R Square a .499 .249 Adjusted R Square .230 Std. Error of the Estimate .43775

a. Predictors: (Constant), Beta


Table 5

52

a Coefficients

Model 1

(Constant) Beta

Unstandardized Coefficients B Std. Error -.295 .242 .881 .242

Standardized Coefficients Beta .499

t -1.216 3.644

Sig. .231 .001

a. Dependent Variable: Expected_Return

Interpretation: The correlation coefficient r, is the correlation between the observed and predicted value of the dependent variable. The values of r for models produced but the regression procedure range from 0 to 1. Larger value of r indicates stronger relationships. The coefficient of determination, r2, indicates the proportions of variation in the dependent variable explained by the regression model. The value of r2 ranges from 0 to 1. The value of r2 0.249 explains that only 24.9% of the dependent variable is explained by independent variable. The regression is Y = -0.295 + 0.881X There is high degree of significance exist between the Expected Return of the stock and its beta, as the value of standard error is very low i.e. 0.001. This shows that there is high degree of linear relationship exist between the stock beta and its expected return which signifies that with the increase in the stock beta, its return also increases that means higher the risk higher the return of the stock. Our first objective to find the applicability of the CAPM in Indian Stock Market satisfies as it shows the relationship between the Risk and Return.

53

Chapter 12 The Effect on Portfolio Return with the Diversification of Risk


In order to obtain the result of our second objective the beta of the stocks has been arranged in the ascending order. A Stocks which come in the first end of ranking, can be categorized as less volatile to the market, has been put in the first portfolio. On the other hand stock with highest value of beta, showing high degree of volatility, is included in the last portfolio. With this, eight portfolios have been constructed with 40 securities on the basis of beta value. The Excess two securities has been included in the first and last portfolio that means first and last portfolio consist of six securities and rest of the portfolio consist of five securities. Beta of the stock integrates the stock to the market developments. The ups and downswing in the market rate of return bring less or more proportional change in the return of security depending upon beta value. The List of portfolios and its securities are as follows:
Table 6

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Variance Stock Beta Stock HEROHONDA 0.46 16.50 SUNPHARMA 0.46 16.92 CIPLA 0.56 29.35 TCS 0.58 15.64 RANBAXY 0.59 24.72 SATYAMCOMP 0.62 18.05

Portfolio 1 Alpha Systematic Stock -0.03 0.40 -0.10 -0.03 -0.17 0.16 Risk 2.45 2.49 3.64 3.86 4.06 4.50

Unsystematic Risk 14.06 14.44 25.71 11.78 20.67 13.55 R2 E(R) 0.15 0.18 0.15 0.61 0.12 0.16 0.25 0.24 0.16 0.11 0.25 0.45

Variance Stock INFOSYSTCH HINDUNILVR AMBUJACEM ZEEL ITC Beta Stock 0.65 16.46 0.72 19.04 0.73 18.76 0.77 42.06 0.77 19.50

Portfolio 2 Alpha Systematic Stock 0.02 -0.08 -0.04 0.07 0.06 Risk 4.88 5.97 6.12 6.86 6.93

Unsystematic Risk 11.58 13.08 12.65 35.20 12.57 R2 E(R) 0.30 0.32 0.31 0.25 0.33 0.29 0.16 0.42 0.36 0.42

Variance Stock GAIL NTPC BHARTIARTL HCLTECH WIPRO Beta Stock 0.78 24.61 0.78 17.26 0.81 19.03 0.82 24.34 0.84 20.80

Portfolio 3 Alpha Systematic Stock 0.04 0.09 0.44 -0.09 -0.18 Risk 7.08 7.08 7.69 7.87 8.18

Unsystematic Risk 17.53 10.18 11.34 16.47 12.62 R2 E(R) 0.29 0.40 0.41 0.45 0.40 0.81 0.32 0.29 0.39 0.21

Variance Stock BPCL ACC ABB Beta Stock 0.85 39.01 0.87 27.36 0.90 31.50

Portfolio 4 Alpha Systematic Stock -0.46 0.00 0.50 Risk 8.35 8.68 9.46

Unsystematic Risk 30.67 18.68 22.04 R2 E(R) 0.21 -0.07 0.32 0.40 0.30 0.91
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TATAMOTORS SIEMENS

0.92 0.93

21.92 33.99

-0.29 0.22

9.73 9.94

12.18 24.05

0.44 0.29

0.13 0.64

Portfolio 5 Variance Alpha Systematic Stock Beta Stock MARUTI 0.94 27.45 GRASIM 0.95 22.57 NATIONALUM 0.95 45.67 RELIANCE 0.96 21.04 M&M 0.99 26.25 Stock -0.10 0.07 0.35 0.45 0.05 Risk 10.30 10.43 10.56 10.79 11.40

Unsystematic Risk 17.15 12.14 35.11 10.25 14.84 R2 E(R) 0.38 0.34 0.46 0.50 0.23 0.79 0.51 0.90 0.43 0.51

Portfolio 6 Variance Alpha Systematic Stock Beta Stock ONGC 1.00 24.42 HDFC 1.06 30.18 PNB 1.15 30.07 TATAPOWER 1.15 32.16 HDFCBANK 1.16 26.93 Stock -0.18 0.21 -0.35 0.28 -0.08 Risk 11.49 13.09 15.32 15.35 15.63

Unsystematic Risk 12.93 17.09 14.75 16.82 11.30 R2 E(R) 0.47 0.27 0.43 0.70 0.51 0.18 0.48 0.81 0.58 0.46

Variance Stock Beta Stock HINDALCO 1.17 37.37 TATASTEEL 1.18 36.59 ICICIBANK 1.27 34.87 TATACOMM 1.32 48.51 LT 1.33 33.74

Portfolio 7 Alpha Systematic Stock -0.25 0.12 -0.13 -0.11 0.42 Risk 15.82 16.04 18.71 20.28 20.40

Unsystematic Risk 21.55 20.55 16.15 28.23 13.34 R2 E(R) 0.42 0.29 0.44 0.66 0.54 0.46 0.42 0.50 0.60 1.03

Portfolio 8
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Variance Stock Beta Stock SAIL 1.34 45.84 BHEL 1.37 38.86 UNITECH 1.40 129.13 RELINFRA 1.41 47.64 SBIN 1.41 47.64 STER 1.51 58.05

Alpha Stock 0.31 0.32 2.44 -0.22 -0.22 0.71

Systematic Risk 20.81 21.65 22.82 23.14 23.14 26.27

Unsystematic Risk 25.03 17.21 106.31 24.49 24.49 31.78 R2 E(R) 0.45 0.93 0.56 0.95 0.18 3.09 0.49 0.43 0.49 0.43 0.45 1.40

Testing of Portfolio Risk and Return: Eight portfolios have been constructed in order to test the relation between portfolio risk and return.
Table 7

Beta P1 P2 P3 P4 P5 P6 P7 P8 0.55 0.73 0.81 0.89 0.96 1.10 1.25 1.41

Variance Stock 23.03 25.45 23.00 31.87 29.04 27.38 34.49 54.54

Testing of Portfolio Risk and Return Alpha Systematic Unsystematic R2 Stock 0.04 0.00 0.06 -0.01 0.16 -0.02 0.01 0.56 Risk 6.33 8.43 9.37 10.34 11.14 12.80 14.53 16.32 Risk 16.70 17.01 13.63 21.52 17.90 14.58 19.96 38.22 0.27 0.33 0.41 0.32 0.38 0.47 0.42 0.30

E( R ) 0.29 0.34 0.43 0.41 0.61 0.48 0.59 1.21

It can be observed from the table that with the increase in the portfolio beta, the return of respected portfolio is also increasing. As first portfolio has beta value of 0.55 its expected return is 0.29 and portfolio eight whose beta value is high among all portfolios is also giving high return to the investors.

12.1 Correlation Analysis


12.1.1 Correlation between Portfolio Beta and Portfolio Return:

57

It can be said from the table that correlation coefficient between portfolios beta and portfolio expected return, and between portfolios market risk and portfolio return, is very which are supposed to be positive according to CAPM.

Correlations P_Beta 1 P_Expected_ Return .841** .009 8 8 .841** 1 .009 8 8

P_Beta

Pearson Correlation Sig. (2-tailed) N P_Expected_Return Pearson Correlation Sig. (2-tailed) N

**. Correlation is significant at the 0.01 level (2-tailed).


Table 8

Interpretation:

The Pearson Correlation Coefficient is the correlation between Portfolio

Return and Portfolio Beta. The values of Correlation range from 0 to 1. Larger value of correlation indicates stronger relationships. Here we can see that there exist stronger relation between the Portfolio Beta and Portfolio Return. The value of correlation is very high i.e. 0.841 and the significance level is also very high. The significance value should be low and should be less than 0.05. Here the value of significance is 0.009 that is very high and which is showing a very high degree of relation between the Portfolio Beta and Portfolio Return. The correlation between the two showing the applicability of the Capital Asset Pricing Model applies Indian Stock Market. It shows that with the increase in the Systematic Risk attach to a certain security, the investors demands higher return.

12.1.2 Correlation between Portfolio Return and Portfolio Systematic Risk: The Systematic Risk is the market risk which we cannot control and is affected by the market factor.

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Correlations P_Expected_ Return 1 Systematic_ Risk .837** .010 8 8 .837** 1 .010 8 8

P_Expected_Return Pearson Correlation Sig. (2-tailed) N Systematic_Risk Pearson Correlation Sig. (2-tailed) N

**. Correlation is significant at the 0.01 level (2-tailed).


Table 9

Interpretation:

The Pearson Correlation Coefficient between Portfolio Systematic and

Portfolio Return shows the relation between these two. The values of Correlation range from 0 to 1. Larger value of Correlation indicates stronger relationships if the correlation between two is negative, it shows that if the one variable is increasing the other variable will decrease and vice versa. Here we can see that there is high degree of correlation between portfolio return and portfolio systematic risk. The value of correlation is 0.837 which is significant also. The value of Significance is 0.01 which should not be higher than 0.05. The relation shows that with the increase in the return of the portfolio with beta, the systematic risk is also increasing. The proposition of Capital Asset Pricing Model is that with the increase in the risk, the return of that security should also increase. With the relation we find, we can say that this propositions fits to Indian Stock Market. We can interpret that the diversification helps in reducing the risk. If we invest in diversified portfolio, we can increase our return with given level of risk.

12.2 Regression Analysis


4.3.1 Regression Analysis of Portfolio Beta and Portfolio Return:

59

Model Summary Model 1 R R Square .841 a .707 Adjusted R Square .659 Std. Error of the Estimate .16978

a. Predictors: (Constant), P_Beta


a Coefficients

Model 1

(Constant) P_Beta

Unstandardized Coefficients B Std. Error -.291 .228 .868 .228

Standardized Coefficients Beta .841

t -1.279 3.809

Sig. .248 .009

a. Dependent Variable: P_Expected_Return


Table 10

Interpretation: The correlation coefficient r, is the correlation between the observed and predicted value of the dependent variable. The values of r for models produced but the regression procedure range from 0 to 1. Larger value of r indicates stronger relationships. The coefficient of determination, r2, indicates the proportions of variation in the dependent variable explained by the regression model. The value of r2 ranges from 0 to 1. The value of r2 0.707 explains that only 70.7% of the dependent variable is explained by independent variable which is showing that there is high degree of effect of portfolio beta on portfolio return. The regression is Y = -0.291 + 0.868X The significant level is very high between the Expected Return of the stock and its beta, as the value of standard error is very low i.e. 0.009. This shows that there is high degree of linear relationship exist between the portfolio beta and its portfolio return which signifies that with the increase in the portfolio beta, its portfolio return also increases that means higher the risk higher the return of the portfolio. It also conclude that if we invest in diversified securities then we can maximize our return with given level of risk

Chapter 13 Security Market Line:

60

When Capital Asset Pricing Model is depicted graphically, it is called Security Market Line. It shows the relation between the portfolios beta and expected return. It also suggests the expected return that an investor should earn in the market for any level of market sensitivity (Beta). We can obtain SML by joining the portfolios beta to the corresponding portfolios expected return. Figure 1, provides the empirical SML representing various combinations of portfolios return, and the portfolios beta, and is observed to be very close to theoretical SML, asserting the positive and linear relationship.

Figure 1

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The security market line (SML) expresses the return an individual investor can expect in terms of a risk-free rate and the relative risk of a security or portfolio. The SML with respect to security i can be written as: E (Ri) = Rf + i (E (Rm-Rf)) Where i i Rm/ m or Cov (Ri, Rm)/ 2 m Equation (3) is a version of the CAPM. The set of assumptions sufficient to derive the CAPM version of (3) are the following: (i) The investors utility functions are either quadratic or normal, (ii) All diversifiable risks are eliminated and (iii) The market portfolio and the risk-free asset dominate the opportunity set of risky assets. The SML is applicable to portfolios as well. Therefore, SML can be used in portfolio analysis to test whether securities are fairly priced, or not.

62

Chapter -13 Capital Market Line


To test the closeness to theoretical CML, the empirical capital market line is made hat signifies the positive and linear relationship between total market risk of the portfolio and portfolio expected return. Diversification, generally, involves holding more than one stock in the portfolio, which differs from each other on some common attributes. But for the sale of convenience, here diversification was carried on the basis of beta value each stock

Figure 2

63

The capital market line (CML) specifies the return an individual investor expects to receive on a portfolio. This is a linear relationship between risk and return on efficient portfolios that can be written as: E (RP) = Rf + p (E (Rm)-Rf))/ m Where, RP = portfolio return Rf = risk-free return Rm = market portfolio return, p = standard deviation of portfolio returns, and m = standard deviation of market portfolio returns. The CML is valid only for efficient portfolios and expresses investors behavior regarding the market portfolio and their own investment portfolios.

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Chapter-15

Problems with the CAPM


Subsequent studies, however, provided weak empirical evidence on these relationships. Issue in the CAPM is whether investors face only one risk arising from uncertainty about the future values of assets. In all likelihood, investors face many sources of risk, as shown by Mertons (1973) inter-temporal asset pricing model. As we have discussed capital asset pricing model was developed 40 years ago by Sharpe (1964) and Lintner (1965) and was the first apparently successful attempt to show how to assess the risk of the cash flow from a potential investment project and to estimate the projects cost of capital , the expected rate of return that investors will demand if they are to invest in the project. In a major development (1992), tests by Fama and French, said, in effect, that the CAPM is useless for precisely what it was developed to do. Since then, researchers have been scrambling to figure out just whats going on. Whats wrong with the CAPM? Are the Fama and French results being interpreted too broadly? Must the CAPM be abandoned and a new model developed? Can the CAPM be modified in some way to make it still a useful tool? The mixed empirical findings on the return-beta relationship prompted a number of responses: (i) The single-factor CAPM is rejected when the portfolio used as a market proxy is inefficient. For example, Roll (1977) and Ross (1977). Even very small deviations from efficiency can produce an insignificant relationship between risk and expected returns (Roll and Ross, 1994; Kandel and Stambaugh, 1995). (ii) Kothari, Shanken and Sloan (1995) highlighted the survivorship bias in the data used to test the validity of the asset pricing model specifications. Fama concluded after his studies in (1992) beta as a sole valuable in explaining return on stock is dead. Though the three-factor models have better empirical explanatory power than

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the original CAPM to explain cross sectional returns the economic reason for why size and BV/MV to be priced is not known. In their later articles, Fama and French, The CAPM is Wanted, Dead or Alive (1996) give reasoning that the small stocks with high BV/MV ratio are firms that have performed poorly and are vulnerable to financial distress and hence command a premium, which they call as 'distress premium'. Banz (1981) tested CAPM by checking whether the size of the firms involved can explain the residual variation in average returns across assets that are not explained by the CAPMs beta. Banz challenges the CAPM by showing that size does explain the cross-sectional variation in average returns on a particular collection of assets better than beta. He found that during the 193675 period, the average return to stocks of small firms (those with low values of market equity) was substantially higher than the average return to stocks of large firms after adjusting for risk using the CAPM. This observation becomes known as the size effect.

Challenge

The CAPM was quite successful until 1981. In 1981, however, empirical studies suggested that it might be missing something. A decade later, in 1992 another study suggested that it might be missing everything, and the debate about the CAPMs value is on.

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Chapter 16 Findings and Recommendations


Findings
1. A positive relationship exists between portfolios beta and portfolios return, i.e. the coefficient of correlation between the two is statistically significant. Study shows that as the value of beta attached to the respected security keeps on increasing, its return expectation among the investors also increases. Thus it proves that the higher beta gives higher return. 2. The results of the study found that Capital Asset Pricing Model does applicable to Indian Stock Market so all the assumptions that Capital Asset Pricing Model takes apply to Indian Market. 3. The study found that the investors are Risk averse individuals who maximize the expected utility of their end of period wealth. 4. The investors have homogenous expectations about asset returns. 5. The non-market risk of the portfolio will go on declining as portfolio is diversified. 6. The study also proves that in Indian Capital Market, as the systematic risk attached to a security increase the return also increases so there is statistically significant relations exist between the two.

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Recommendations
1. The financial engineer should use this study to develop such instruments where the higher risk is accompanied with the higher returns. This will help the investors to diversify their risk attached to the security and will lead them to higher return at given level of risk. 2. For calculating the risk adjusted rate CAPM is advisable. 3. The study has been carefully conducted under certain assumptions and between the periods July 2005 to June 2008, and should not be blindly applied.

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Chapter -17 Conclusion


The study aims to find the relation between risk and reward. The study used weekly stocks return from the 42 companies listed in the National Stock Exchange from July 2005 to June 2008. The finding of the study is in support of the theorys basic hypothesis that the higher risk (beta) is associated with the higher level of return. The model does explain, however, excess returns. The results obtained lend support to the linear structure of the CAPM equation being a good explanation of security returns. The high value of the estimated correlation coefficient between the risk and the slope indicates that the model used, explains excess returns. The objective of the study was to find the linear relation between the risk and the return on the Indian Stock Market and study is very much successful in finding the relation between these two. The study indicates that as the risk attached to a certain security increases, the expected return to that security should also be in linear relation to that. The theory thus applies to Indian Stock market, but it needs to be tested time to time and its applicability to other stock market in India should also be tested. The investors should not blindly believe on this model, they should take care of the assumption taken by the Capital Asset Pricing Model.

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Chapter-18 Bibliography
Brealey-Meyers(2003), Principles of Corporate Finance, The McGraw-Hill Companies, Delhi pp. 152-203 Francis, Jack Clark and Frank J. Fabozzi, (1979),The Effects of Changing Macroeconomic Conditions on the Parameters of the Single Index Market Model, Journal of Financial and Quantitative Analysis, June, Vol. 14, No.2, pp. 351-360.

Jaffe, Jeffrey F., Randolph Westerfield and MA Christopher, 1989, A Twist on the Monday Effect in Stock Prices: Evidence from the U.S. and Foreign Stock Markets, Journal of Banking and Finance, September, Vol. /3, No.4/5, pp. 641-50. Klemkosky R.C. and Martin J.D. (1975),The Effect of Market Risk on the Portfolio Diversification, the Journal of Finance, March 1975 Linter J (1965), Security Prices, Risk and Maximum Gains from the Diversification , Journal of Finance, December 1965 Manjunatha T. and Mallikarjunappa T. (2007),Capital Asset Pricing Model: Beta and Size Tests, AIMS International, January 2007. Markowitz H (1952), Portfolio Selection, the Journal of Finance, March 1952

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Michailidis G, Tsopoglou S, Papanastasiou D and Mariola E (2006), Testing the Capital Asset Pricing Model (CAPM): The Case of the Emerging Greek Securities Market , International Research Journal of Finance and Economics, Issue 4, 2006

Obaidulllah, M., 1994, Indian Stock Market: Theories and Evidence , Hyderabad: ICFAI. Palaha, Satinder, 1991, Cost of Capital and Corporate Policy, Anmol Publications. Roll, Richard, 1981,A Possible Explanation of the Small Firm Effect , Journal of Finance, September, Vol.36, No.4, pp. 879-88. Vaidyanathan R, (1995), Capital Asset Pricing Model: The Indian Context , The ICFAI Journal of APPLIED FINANCE, July 1995 Zikmund.(2003). Business Research Methods, Akash Press, Delhi, pp. 102-105.

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Chapter-19 Annexure
List of 42 Companies included in NIFTY as on 30th June, 2008 HERO HONDA LTD. SUN PHARMACEUTICAL LTD. CIPLA TATA CONSULATNCY SERVICES RANBAXY SATYAM COMPUTER SERVICES INFOSYS TECHNOLOGIES HINDUSTAN UNILEVER LTD AMBUJA CEMENT ZEE LTD. ITC LTD. GAIL NTPC BHARTI AIRTEL HCL TECHNOLOGIES WIPRO BHART PETROLEUM CORPORATION LTD SIEMENS MARUTI UDYOG LTD. GRASIM INDUSTRIES NATIONAL ALUMINIUM COMPANY RELIANCE INDUSTRIES MAHINDRA AND MAHINDRA ONGC HOUSING DEVELOPMENT FINANCE CORPORATION PUNJAB AND NATIONAL LTD. TATA POWER LTD. HDFC BANK LTD. HINDALCO INDUCTRIES TATA STEEL LTD. ICICI BANK LTD. TATA COMMUNICATIONS LARSEN AND TURBO STEEL AUTHORITY OF INDIA LTD 72

ACC ABB TATA MOTORS LTD. STERLITE INDUSTRIES LTD

BHART HEAVY ELECTRICALS LTD. UNITECH RELIANCE INFRASTRUCTURE LTD. STATE BANK OF INDIA

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