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INTERNATIONAL SCHOOL OF CORPORATE MANAGEMENT, PUNE1
A PROJECT REPORT
ONRISK AND RETURN ON EQUITY IN INDIA
Submitted as partial fulfillment towards the two years post graduationcourseof Post Graduate Programme In Corporate Studies.
SUBMITTED BY:YOGESH KUMAR AGRAWAL
ISCOM /PGPCS-V
BATCH 2009-2011
INTERNAL GUIDE
PROF. MANOJ RAWAL
INTERNATIONAL SCHOOL OF CORPORATE
MANAGEMENT,
PUNE
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PREFACE
For a long time, there was a wind of recession blowing all over the business world andwealth liberalization policy in the Indian Economy. So, now a days market is becoming moreand more competitive, company demands more and more professional and accomplishedemployees.
Students have to get practical training along with the theoretical knowledge of thebusiness condition. There are many advantages of making these kinds of reports , the studentcan become aware of the particular knowledge about marketing of capital goods. Readinggives only the theoretical knowledge and visits give practical knowledge.
It is true that technical studies cant be perfect without practical training and perfection
is basic necessity of management student.
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ACKNOWLEDEMENT
Feelings of gratefulness to anyones help directly arise from bottom of the heart. Thesmall but an important can prove to be a milestone in ones life. Every human being has suchkind of experience. Being human being, I also have the same feelings of gratefulness as todayI have achieved important milestone in own life, the completion of this project.
The project dedicated to all the people whom I met, took guidance, interviewed andlearnt something from them. It would be my misfortune if I dont take this opportunity tothank all who helped me in this report making.
I also thanks to Mr. Keshav Rae (Director- ISCOM) And Mr. Lt. Col. Vijay Niar( Deputy Director-ISCOM) for their help and constant inspiration with a keen interest inprogress of project.
I would like to thankMr. MANOJ RAWAL (Lecturer of ISCOM) for being myInternal Project Guide and helping me throughout the project time by providing informationrequired for my project. He was the main source of guidance for my project.
YOGESH KUMAR AGRAWAL
ISCOM
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DECLARATION
I hereby declare that this Project Report titled RISK AND RETURN ON EQUITY ININDIA submitted to INTERNATIONAL SCHOOL OF CORPORATEMANAGEMENT,PUNE as a part of the curriculum for the POST GRADUATEPROGRAMME IN CORPORATE STUDIES .
YOGESH KUMAR AGRAWAL
ISCOM
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TABLE OF CONTENT
SERIAL NO. TITLE PAGE NO.
1 INTRODUCTION TO INVESTMENT 6
2 EQUITY SHARES 8
3 PREFERENCE SHARES 9
4 DEBENTUES 11
5 DERIVATIVES 136 STOCK EXCHANGE 16
7 PORTFOLIO 17
8 PHASES OF PORTFOLIO MANAGEMENT 18
9 RISK 19
10 PHASES OF PORTFOLIO MANAGEMENT 21
11 CONCEPT OF RISK AND RETURN 23
12 CONCEPT OF ROI AND RISK 24
13
IMPACT OF FINANCIAL LEVERAGES ON RISK $
RETURN 26
14 CAPM 27
15 SHORTCOMINGS OF CAPM 28
16 MARKET RISK PREMIUM 32
17 EQUITY PREMIUM IN INDIA 33
18 Asset-specific required return 39
19 Arbitrage pricing theory 41
20 METHODOLOGY OF THE STUDY 42
21 COMPANY PROFILE 44
22 CONCLUSION 53
23 BIBLIOGRAPHY 54
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INTRODUCTION TO INVESTMENT
Investment may be defined as an activity that commits funds in any financial form in the
present with an expectation of receiving additional return in the future. The expectations bring
with it a probability that the quantum of return may vary from a minimum to a maximum. This
possibility of variation in the actual return is known as investment risk. Thus every investment
involves a return and risk.
Investment is an activity that is undertaken by those who have savings. Savings can bedefined as the excess of income over expenditure. An investor earns/expects to earn additional
monetary value from the mode of investment that could be in the form of financial assets.
The three important characteristics of any financial asset are:
y Return-the potential return possible from an asset.
y Risk-the variability in returns of the asset form the chances of its value going down/up.
y Liquidity-the ease with which an asset can be converted into cash.
Investors tend to look at these three characteristics while deciding on their individual
preference pattern of investments. Each financial asset will have a certain level of each of
these characteristics.
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Investment avenues
There are a large number of investment avenues for savers in India. Some of them are
marketable and liquid, while others are non-marketable. Some of them are highly risky while
some others are almost risk less.
Investment avenues can be broadly categorized under the following heads:
Corporate securities
y Equity shares.
y Preference shares.
y Debentures/Bonds.y Derivatives.
y Others.
Corporate Securities
Joint stock companies in the private sector issue corporate securities. These include equity
shares, preference shares, and debentures. Equity shares have variable dividend and hence
belong to the high risk-high return category; preference shares and debentures have fixedreturns with lower risk.
The classification of corporate securities that can be chosen as investment avenues can be
depicted as shown below:
EquityShares
Preference
sharesBonds Warrants Derivatives
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Equity shares
By investing in shares, investors basically buy the ownership right to the company.
When the company makes profits, shareholders receive their share of the profits in the form of
dividends. In addition, when company performs well and the future expectation from the
company is very high, the price of the companys shares goes up in the market. This allows
shareholders to sell shares at a profit, leading to capital gains.
Investors can invest in shares either through primary market offerings or in the
secondary market.The primary market has shown abnormal returns to investors who subscribed for the
public issue and were allotted shares.
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Preference shares
Preference shares are legally shares, but they are very different from ordinary shares.The economic effect of prefs is more like that of bonds. Like convertibles, they are regardedashybrids of debt and equity.
Dividends on preference shares have to be paid before dividends on ordinary shares.Dividends on ordinary shares may not be paid unless the fixed dividends on preference
shares is paid first.Dividends are fixed like bond coupons, although there are usually provisions to not pay,
or delay payments. Preference shareholdershave a higher priority if a company is liquidated than ordinary shareholders, although a lowerpriority than debt holders.
In the case of cumulative Preference shares, if the dividend is not paid in full, the unpaidamount is added to the next dividend due.
Preference dividends are fixed, so they do not participate in increases (or decreases) inprofits as ordinary shareholders do.
Types of Preference Shares
Preference share can be defined as those shares that carry preferential right with regard to
dividend as well as repayment of capital in case of winding up of the company. There are
many types of preference shares which company can issue; here are some of them
1. Cumulative and Non cumulative Preference shares Cumulative preference shares give the
right to the preference shareholders to receive arrears of dividend which were not paid in
previous years due to company making loss. While Non- cumulative Preference shareholders
do not have right like Cumulative preference shareholders and therefore they cannot demand
any arrears of dividend which were not paid during previous years by the company.
2. Participating and Non Participating Preference shares Participating Preference
shareholders have the right to receive any remaining profit which is left after payment of
dividend to the equity shareholders, while Non Participating Preference shareholders do nothave such rights.
3. Convertible and Non Convertible Preference shares Convertible Preference shares can be
converted into equity shares if preference shareholder decides to do so while Non Convertible
Preference shares does not have any such right
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4. Redeemable and Non Redeemable Preference shares Redeemable Preference shares are
those shares which have to be repaid by the company after a fixed period of time from the date
of issue of such shares while Non Redeemable Preference shares cannot be redeemed repaid
by the company except on winding up of the company.
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Debentures
Debentureis a document that either creates a debt or acknowledges it. In corporate finance,
the term is used for a medium- to long-term debt instrument used by large companies to
borrow money. In some countries the term is used interchangeably with bond, loan
stockornote.
Debentures are generally freely transferable by the debenture holder. Debenture holders have
no rights to vote in the company's general meetings of shareholders, but they may have
separate meetings or votes e.g. on changes to the rights attached to the debentures. The interest
paid to them is a charge against profit in the company's financial statements.
Types Of Debentures
1.Secured Debentures2.Unsecured debentures3.Redeemable Debentures4.Irredeemable Debentures5.Convertible Debentures
6.Non-Convertible Debentures7.Registered Debentures8.Bearer Debentures
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Difference Between Debt and Equity
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Derivatives
Derivative is a contract whose payoff depends on the behavior of some benchmark, which is
known as the "underlying". The underlying is typically a tradable asset, for example,
a stock or commodity, but can be a non-tradable such as the weather (in the case of weather
derivatives). The most common derivatives are futures, options, and swaps.
The most common derivatives have a market value and are traded on exchanges. Among the
oldest of these are rice futures, which have been traded on the Dojima Rice Exchange since the
eighteenth century.
Derivatives are usually broadly categorized by:
the relationship between the underlying asset and the derivative
(e.g., forward, option, swap);
the type of underlying asset (e.g., equity derivatives, foreign exchange derivatives, interest
rate derivatives, commodity derivatives or credit derivatives);
the market in which they trade (e.g., exchange-traded or over-the-counter); and
their pay-off profile.
Derivatives can be used for speculating purposes ("bets") or to hedge ("insurance"). For
example, a speculator may sell deep in-the-money naked calls on a stock, expecting the stock
price to plummet, but exposing himself to potentially unlimited losses. Very commonly,
companies buy currency forwards in order to limit losses due to fluctuations in the exchange
rate of two currencies.
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Types of derivatives
Over-the-counter: (OTC) derivatives are contracts that are traded (and privately
negotiated) directly between two parties, without going through an exchange or other
intermediary. Products such as swaps, forward rate agreements, and exotic options are almost
always traded in this way. The OTC derivative market is the largest market for derivatives,
and is largely unregulated with respect to disclosure of information between the parties, since
the OTC market is made up of banks and other highly sophisticated parties, such as hedge
funds. Reporting of OTC amounts are difficult because trades can occur in private, without
activity being visible on any exchange.
Exchange-traded derivative contracts:(ETD) are those derivatives instruments
that are traded via specialized derivatives exchanges or other exchanges. A derivatives
exchange is a market where individuals trade standardized contracts that have been defined by
the exchange.A derivatives exchange acts as an intermediary to all related transactions, and
takesInitial margin from both sides of the trade to act as a guarantee. The world's largest
derivatives exchanges (by number of transactions) are the Korea Exchange (which
lists KOSPI Index Futures & Options).
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Common derivative contract types
1. Futures/Forwards are contracts to buy or sell an asset on or before a future date at a
price specified today. A futures contract differs from a forward contract in that the
futures contract is a standardized contract written by a clearing house that operates an
exchange where the contract can be bought and sold, whereas a forward contract is a
non-standardized contract written by the parties themselves.
2. Options are contracts that give the owner the right, but not the obligation, to buy (in
the case of a call option) or sell (in the case of a put option) an asset. The price at
which the sale takes place is known as the strike price, and is specified at the time the
parties enter into the option. The option contract also specifies a maturity date. In the
case of a European option, the owner has the right to require the sale to take place on
(but not before) the maturity date; in the case of an American option, the owner can
require the sale to take place at any time up to the maturity date. If the owner of the
contract exercises this right, the counter-party has the obligation to carry out the
transaction.
3. Swaps are contracts to exchange cash (flows) on or before a specified future date
based on the underlying value of currencies/exchange rates, bonds/interest rates,
commodities, stocks or other assets.
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Stock Exchange
In a stock exchange a person who wishes to sell his security is called a seller, and a person
who is willing to buy the particular stock is called as the buyer. The rate ofstock depends on
the simple law of demand and supply. If the demand of shares of company x is greater than its
supply then its price of its security increases.
In Online Exchange the trading is done on a computer network. The sellers and buyers log on
to the network and propose their bids. The system is designed in such ways that at any given
instance, the buyers/sellers are bidding at the best prices.
The transaction cycle for purchasing and selling shares online is depicted below:
Client
Member/
Broking
firm. Stock Exchange
(BSE / NSE)
Member/
Broking
firm.
Client
Transaction Cycle
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PORTFOLIO
A portfolio is an appropriate mix of or collection of investments held by an institution or a
private individual. It is a collection of securities, since it is rarely desirable to invest the entire
funds of an individual or an institution in a single security.
y Portfolio analysis considers the determination of future risk and return in holding
various blends of individual securities.
y Portfolio expected return is a weighted average of the expected return of individual
securities but portfolio variance, in short contrast, can be something less than a
weighted average of security variances.
y As a result an investor can sometimes reduce portfolio risk by adding security with
greater individual risk than any other security in the portfolio. This is because risk
depends greatly on the co-variance among return of individual securities.
y Since portfolios expected return is a weighted average of the expected return of its
securities, the contribution of each security to the portfolios expected returns depends
on its expected returns and its proportionate share of the initial portfolios market
value.
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PHASES OF PORTFOLIO MANAGEMENT
Five phases can be identified in this process:
1. Security analysis
2. Portfolio analysis
3. Portfolio selection
4. Portfolio revision
5. Portfolio evaluation
SECURITY ANALYSIS
An examination and evaluation of the various factors affecting the value of a security. Security
Analysis stands for the proposition that a well-disciplined investor can determine a rough value
for a company from all of its financial statements, make purchases when the market inevitably
under-prices some of them, earn a satisfactory return, and never be in real danger of permanent
loss.
PORTFOLIO ANALYSIS
Analysis phase of portfolio management consists of identifying the range of possible
portfolios that can be constituted from a given set of securities and calculating their return and
risk for further analysis.
PORTFOLIO SELECTION
The proper goal of portfolio construction is to generate a portfolio that provides the highest
returns at a given level of risk. A portfolio having this characteristic is known as an efficient
portfolio. The inputs from portfolio analysis can be used to identify the set of efficient
portfolios. From this set of efficient portfolios, the optimal portfolio has to be selected for
investment. Harry Markowitz portfolio theory provides both the conceptual framework and
analytical tools for determining the optimal portfolio in a disciplined and objective way.
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PORTFOLIO REVISION
Having constructed the optimal portfolio, the investor has to constantly monitor the portfolio
to ensure that it continues to be optimal. Portfolio revision is as important as portfolio analysis
and selection.
PORTFOLIO EVALUATION
It is the process, which is concerned with assessing the performance of the portfolio over a
selected period of time in terms of returns and risk. This involves quantitative measurement of
actual return realized and the risk born by the portfolio over the period of investment. It
provides a feedback mechanism for improving the entire portfolio management process.
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RISK
Risk is a concept that denotes a potential negative impact to an asset or some characteristic of
value that may arise from some present process or future event. In everyday usage, risk is
often used synonymously with the probability of a known loss. Risk is uncertainty of the
income / capital appreciation or loss of the both.
The total risk of an individual security comprises two components, the market related risk
called systematic riskalso known as undiversifiable risk and the unique risk of that particular
security called unsystematic riskor diversifiable risk.
Types of risk
Systematic risk (market) Unsystematic risk (company risk)
Examples:
y Interest rate risk
y Market risk
y Inflation risky Demand
y Government policy
y International factors
Examples:
y Labor troubles
y Liquidity problems
y Raw materials risksy Financial risks
y Management problems
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The Risk/Return Tradeoff
The risk/return tradeoff could easily be called the "ability-to-sleep-at-night test." While somepeople can handle the equivalent of financial skydiving without batting an eye, others areterrified to climb the financial ladder without a secure harness. Deciding what amount of riskyou can take while remaining comfortable with your investments is very important.
In the investing world, the dictionary definition of risk is the chance that an investment's actualreturn will be different than expected. Technically, this is measured in statistics by standarddeviation. Risk means you have the possibility of losing some, or even all, of our originalinvestment.
Low levels of uncertainty (low risk) are associated with low potential returns. High levels ofuncertainty (high risk) are associated with high potential returns. The risk/return tradeoff is thebalance between the desire for the lowest possible risk and the highest possible return. This isdemonstrated graphically in the chart below. A higher standard deviation means a higher riskand higher possible return.
A common misconception is that higher risk equals greater return. The risk/return tradeofftells us that the higher risk gives us thepossibility of higher returns. There are no guarantees.Just as risk means higher potential returns, it also means higher potential losses.
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On the lower end of the scale, the risk-free rate of return is represented by the return on U.S.Government Securities because their chance of default is next to nothing. If the risk-free rate is
currently 6%, this means, with virtually no risk, we can earn 6% per year on our money.
The common question arises: who wants to earn 6% when index funds average 12% per yearover the long run? The answer to this is that even the entire market (represented by the indexfund) carries risk. The return on index funds is not 12% every year, but rather -5% one year,25% the next year, and so on. An investor still faces substantially greater risk and volatility toget an overall return that is higher than a predictable government security. We call thisadditional return the risk premium, which in this case is 6% (12% - 6%).
Determining what risk level is most appropriate for you isn't an easy question to answer. Risktolerance differs from person to person. Your decision will depend on your goals, income and
personal situation, among other factors.
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Concept of Risk vs. Return
Anyone who has invested in anything is familiar with the trade-off between risk and returnwhether youve consciously weighed the options and thought about it or not. Before youvebought into an investment, youve decided that youre able to stomach the risk is hopes ofcertain returns. And in order to make long term financial progress you need to decide whatlevel of risk you can handle while at the same time remaining comfortable with yourinvestments.
Investment risk can be defined as the chance that an investments actual return will bedifferent than expected. Risk also means that there is the possibility of losing some, if not all,or your investment. Where there are low levels of uncertainty, there are low potential returns.The opposite is true for high levels of uncertainty.
It is important however, to remember that higher risk does not equal higher returns. Higherrisk only gives us the possibility for higher returns. There are also greater potential losses.
While were on this subject, I think its also important to bring up the concept of the riskpremium. Too many try to balance their risk against the wrong return. If theyre going to takea risk in the stock market, theyre looking for a return of about %11 percent or so. Now, wouldyou be willing to take the same risk for only 6%? Because this is what youre doingessentially.
Take a look at U.S. Government bonds and what they are paying. Lets say that theyre
offering a 5% return. Because these types of bonds are virtually risk free, they represent a riskfree rate of return. Mutual funds may have losses of -6% one year and gains of 20% the nextfor an average of around 11%. The difference between the 11% and the 5% is called the riskpremium. The risk you take by investing in mutual funds is for the additional 6% return.
Not everyone goes through this type of analysis when theyre investing, but the concept isimportant to understand. You dont want to take on a large amount of risk if there isnt asignificant risk premium.
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Concepts of Return on Investment & Risk
Investment return and risk are fundamental to understanding market behavior. Return oninvestment is essentially profit made by an investor. Profits and losses must be analyzedcarefully, as simple percentage comparisons give misleading answers. Risk refers to theprobability of depreciation as well as its potential magnitude, which can exceed originalinvested amount. Risk and return on investment are directly correlated; higher risk begets asmaller chance of high return and vice versa.
Return on Investment (ROI)
y The term refers to how much money is gained or lost after an investment. If you invest$1,000 and get back $1,080, you have an $80 (8 percent) return on the investment.
A negative return looks like this: You invest $1,000 and a year later only $900remains. Return in this case was negative $100, or negative 10 percent. The percentageis in relation to original amount invested.
Unbalanced Percentages
y Gains and losses do not balance out with percentages. For example, $1,000 investedhas a -10 percent annual return. So a year later, $1,000 is reduced to $900. Now, if that$900 had a 10 percent positive annual return the year after that, 10 pecent of $900 is$90. Therefore, the total after two years is $990, less than the starting $1,000. Thenumbers work slightly against the investor even though percentages even out.
Risk: Depreciation Probability
y Risk is a comprehensive term. It encompasses probability and magnitude of a loss.Buying stock allows a possibility that amount invested disappears from your accountas the company goes out ofbusiness. That is bigger risk than buying a well-rated bondin terms of depreciation probability. A well-rated bond is less likely to give negativereturn on investment than stocks. Therefore, as a general rule, stocks have a higherdepreciation probability.
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Impact Of Financial Leverage On Return And Risk
Financial Leverage:
Financial Leverage in the extent or degree to which the company's total capital is composed of
Debt.
Financial leverage of Debt Financing increase overall risk and return of the company. Debt
financing impact on returns of a change in the extent to which the firm's assets are financed
with borrowed money. Financial Leverage magnifies risk and adds volatility to returns. The
higher the leverage, the more risky the company becomes. This is because a company having
higher leverage will have to pay interests which is an extra expense going from the operatingcash flows Increase in Returns:
Financial leverage increase in Returns or ROE (Return on Equity) of the firm. EBIT is
greater then Interest cost for financial leverage then it is good for the firm. Because its mean
firm is generating profits by the use of Debt it takes resulting in positive cash flows.
When debt is introduced in capital structure of firm then the number of share holders is less
and if company makes profit form this debt then this debt is distributed in lesser number of
peoples. This increase in per share resulting in Increased ROE.
Increase in Risk:
Debt contain fixed interest regardless of company is making any profit or not this increase
chance of Losses. Can cause bankruptcy.
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Shortcomings of CAPM
y The model assumes that either asset returns are (jointly) normally distributed randomvariables or that investors employ a quadratic form of utility. It is however frequentlyobserved that returns in equity and other markets are not normally distributed. As aresult, large swings (3 to 6 standard deviations from the mean) occur in the marketmore frequently than the normal distribution assumption would expect.
y The model assumes that the variance of returns is an adequate measurement of risk.This might be justified under the assumption of normally distributed returns, but for
general return distributions other risk measures (like coherent risk measures) will likelyreflect the investors' preferences more adequately. Indeed risk in financial investmentsis not variance in itself, rather it is the probability of losing: it is asymmetric in nature.
y The model assumes that all investors have access to the same information and agreeabout the risk and expected return of all assets (homogeneous expectationsassumption).
y The model assumes that the probability beliefs of investors match the true distributionof returns. A different possibility is that investors' expectations are biased, causingmarket prices to be informationally inefficient. This possibility is studied in the field ofbehavioral finance, which uses psychological assumptions to provide alternatives to theCAPM such as the overconfidence-based asset pricing model of Kent Daniel, DavidHirshleifer, and Avanidhar Subrahmanyam (2001).
y The model does not appear to adequately explain the variation in stock returns.Empirical studies show that low beta stocks may offer higher returns than the modelwould predict. Some data to this effect was presented as early as a 1969 conference inBuffalo, New York in a paper by Fischer Black, Michael Jensen, and Myron Scholes.Either that fact is itself rational (which saves the efficient-market hypothesis but makesCAPM wrong), or it is irrational (which saves CAPM, but makes the EMH wrong indeed, this possibility makes volatility arbitrage a strategy for reliably beating themarket).
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y The model assumes that given a certain expected return investors will prefer lower risk
(lower variance) to higher risk and conversely given a certain level of risk will preferhigher returns to lower ones. It does not allow for investors who will accept lowerreturns for higher risk. Casino gamblers clearly pay for risk, and it is possible thatsome stock traders will pay for risk as well.
y The model assumes that there are no taxes or transaction costs, although thisassumption may be relaxed with more complicated versions of the model.
y The market portfolio consists of all assets in all markets, where each asset is weightedby its market capitalization. This assumes no preference between markets and assetsfor individual investors, and that investors choose assets solely as a function of theirrisk-return profile. It also assumes that all assets are infinitely divisible as to theamount which may be held or transacted.
y The market portfolio should in theory include all types of assets that are held byanyone as an investment (including works of art, real estate, human capital...) In
practice, such a market portfolio is unobservable and people usually substitute a stockindex as a proxy for the true market portfolio. Unfortunately, it has been shown thatthis substitution is not innocuous and can lead to false inferences as to the validity ofthe CAPM, and it has been said that due to the inobservability of the true marketportfolio, the CAPM might not be empirically testable. This was presented in greaterdepth in a paper by Richard Roll in 1977, and is generally referred to as Roll's critique.
y The model assumes just two dates, so that there is no opportunity to consume andrebalance portfolios repeatedly over time. The basic insights of the model are extendedand generalized in the intertemporal CAPM (ICAPM) of Robert Merton, and theconsumption CAPM (CCAPM) of Douglas Breeden and Mark Rubinstein.
y CAPM assumes that all investors will consider all of their assets and optimize oneportfolio. This is in sharp contradiction with portfolios that are held by individualinvestors: humans tend to have fragmented portfolios or, rather, multiple portfolios: for
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each goal one portfolio see behavioral portfolio theory and Maslowian PortfolioTheory.
The CAPM is a model for pricing an individual security or a portfolio. For individualsecurities, we make use of the security market line (SML) and its relation to expected returnand systematic risk (beta) to show how the market must price individual securities in relationto their security risk class. The SML enables us to calculate the reward-to-risk ratio for anysecurity in relation to that of the overall market. Therefore, when the expected rate of returnfor any security is deflated by its beta coefficient, the reward-to-risk ratio for any individualsecurity in the market is equal to the market reward-to-risk ratio, thus:
The market reward-to-risk ratio is effectively the market risk premium and by rearranging theabove equation and solving for E(Ri), we obtain the Capital Asset Pricing Model (CAPM).
where:
y is the expected return on the capital asset
y is the risk-free rate of interest such as interest arising from government bonds
y (the beta) is the sensitivity of the expected excess asset returns to the expected
excess market returns, or also ,
y is the expected return of the market
y is sometimes known as the market premium orrisk premium (thedifference between the expected market rate of return and the risk-free rate of return).
Restated, in terms of risk premium, we find that:
which states that the individualrisk premium equals the market premium times.
Note 1: the expected market rate of return is usually estimated by measuring the GeometricAverage of the historical returns on a market portfolio (e.g. S&P 500).
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Note 2: the risk free rate of return used for determining the risk premium is usually thearithmetic average of historical risk free rates of return and not the current risk free rate ofreturn.
Security Market Line
The SML essentially graphs the results from the capital asset pricing model (CAPM) formula.The x-axis represents the risk (beta), and they-axis represents the expected return. The marketrisk premium is determined from the slope of the SML.
The relationship between and required return is plotted on thesecurities market line (SML)which shows expected return as a function of . The intercept is the nominal risk-free rateavailable for the market, while the slope is the market premium, E(Rm)Rf. The securitiesmarket line can be regarded as representing a single-factor model of the asset price, where
Beta is exposure to changes in value of the Market. The equation of the SML is thus:
It is a useful tool in determining if an asset being considered for a portfolio offers a reasonableexpected return for risk. Individual securities are plotted on the SML graph. If the security'sexpected return versus risk is plotted above the SML, it is undervalued since the investor canexpect a greater return for the inherent risk. And a security plotted below the SML isovervalued since the investor would be accepting less return for the amount of risk assumed.
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Market Risk Premium
Arisk premiumis the minimum amount of money by which the expected return on a risky
asset must exceed the known return on a risk-free asset, in order to induce an individual to
hold the risky asset rather than the risk-free asset. Thus it is the minimum willingness to
accept compensation for the risk.
Thecertainty equivalent, a related concept, is the guaranteed amount of money that an
individual would view as equally desirable as a risky asset.
Premium for Bearing Risk
Why has the rate of return on stocks in India and other countries been significantly
higher than the rate of return on relatively risk free assets? An intuitive answer is that
stocks are riskier than bonds and investors require a premium for bearing this
additional risk. Indeed, the standard deviation of the returns to stocks in India (about
30 percent a year historically) is larger than that of the returns to T-bills (about 2percent a year), so obviously, stocks are considerably riskier than bills.
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Equity Premium in India
The equity premium is the return earned by a risky security, such as a stock, in
excess of that earned by a risk free security, such as a Treasury Bill. It is a crucial input
into financial decisions such as asset allocation, capital budgeting and planning for
retirement.
Historical data provide a wealth of evidence documenting that over long periods
of time, stock returns have been considerably higher than returns for T-bills. As Table 1
shows, the average annual real return (that is, the inflation-adjusted return) on the U.S.
stock market for the past 115 years has been about 7.5 percent. In the same period, the
real return on a relatively riskless security was a paltry 1.0 percent.
Returns for Selected Developed Countries
(Mean Real Return)
Country Period
Market
Index
Relatively Riskless
Security Risk Premium
United Kingdom 19471999 5.70% 1.10% 4.60%
Japan 19701999 4.7 1.4 3.3Germany 19781997 9.8 3.2 6.6
France 19731998 9 2.7 6.3
The annual return on the U.K. stock market, for example, was 5.7 percent in the
post-WWII period, an impressive 4.6% premium over the average bond return of 1.1
percent. Similar statistical differences have been documented for France, Germany, and
Japan. And together, the United States, the United Kingdom, Japan, Germany, and
France account for more than 85 percent of capitalized global equity value.
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The equity premium for India for the post liberalization period,
using both the BSE 100 and the Sensex index as a proxy for the return on equity. Since4participation in the T-bill market was highly regulated before 2000, we report the equity
premium relative to the Bank Deposit Rate, using the later as a proxy for the return on
a risk free security.
India Returns, 1991-2004
Relatively
Riskless
Security BSE 100
Equity
Premium
(BSE 100) Sensex
Equity
Premium(Sensex)
MEAN REAL
RETURN% 1.28 12.6 11.3 11 9.7
STANDARD
DEVIATION% 1.73 37.2 37.7 32.6 33.2
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Real Terminal Value of Rs 1 Invested
Investment Period Stocks (BSE 100)
Bank
Deposit Ratio
19842004 Rs 19.25 Rs 1.28 15.04
19912004 4.68 1.18 3.97
One can gain additional insights by examining what these differential rates imply
for the time it takes to double ones money. Using rates in India over the 1991-2004
period, the doubling period for investments in stocks is about 6 years compared to about
55 years for investments in a risk free asset. This kind of long-term perspective
underscores the remarkable wealth-building potential of the equity premium and
highlights why it is of central importance in portfolio allocation decisions, in making
estimates of the cost of capital, and in the current debate about the advantages of
investing Social Security Trust or retirement funds in the stock market.
To enhance and deepen our understanding of the risk-return trade-off in the
pricing of financial assets, we make a detour into modern asset pricing theory and look
at why different assets yield different rates of return. The deux ex machina of this
theory is that assets are priced such that, ex-ante, the loss in marginal utility incurred
by sacrificing current consumption and buying an asset at a certain price is equal to the
expected gain in marginal utility contingent on the anticipated increase in consumption
when the asset pays off in the future.
The operative emphasis here is the incremental loss or gain in well being due to
incremental consumption, which must be differentiated from the incremental
consumption itself. This is because the same amount of incremental consumption may
result in different degrees of well-being at different times. A five-course dinner after a
heavy lunch, for example, yields considerably less satisfaction than a similar dinner
when one is hungry!
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As a consequence, assets that pay off when times are good and consumption levels are high,
i.e. when the incremental value of additional consumption is low, are less desirable than those
that pay off an equivalent amount when times are bad and additional consumption is bothdesirable and more highly valued.
This principle in the context of the standard, popular paradigm, the Capital Asset Pricing
Model (CAPM). This model postulates a linear relationship between an assets beta, a
measure of systematic risk, and expected return. Thus, high beta stocks yield a high-expected
rate of return. That is so because in the CAPM, good times and bad times are captured by the
return on the market. The performance of the market as captured by a broad based index acts
as a surrogate indicator for the relevant state of the economy. A high beta security tends to pay
off more when the market return is high, that is, when times are good and consumption is
plentiful; as discussed earlier, such a security provides less incremental utility than a security
that pays off when consumption is low, is less valuable to investors and consequently sells for
less.
Thus assets that pay off in states of low marginal utility will sell for a lower price than
similar assets that pay off in states of high marginal utility. Since rates of return are
inversely proportional to asset prices, the latter class of assets will, on average, give a
lower rate of return than the former.
Another perspective on asset pricing emphasizes that economic agents prefer to
smooth patterns of consumption over time. Assets that pay off a relatively larger
amount at times when consumption is already high, destabilize these patterns of
consumption, whereas assets that pay off when consumption levels are low, smooth
out consumption. Naturally, the latter are more valuable and thus require a lower rate
of return to induce investors to hold these assets. (Insurance policies are a classic
example of assets that smooth consumption. Individuals willingly purchase and hold
them, in spite of their very low rates of return.)
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To return to the original question: are stocks so much more riskier than bills so
as to justify a 7% differential in their rates of return as observed in the U.S?
What came as a surprise to many economists and researchers in finance was theconclusion of a research paper that Edward Prescott and I wrote in 1979. Stocks and
bonds pay off in approximately the same states of nature or economic scenarios and
hence, as argued earlier, they should command approximately the same rate of return.
In fact, using standard theory to estimate risk-adjusted returns, we found that stocks in
the U.S on average should command, at most, a 1% return premium over bills. Since,
for as long as we had reliable data, (about a hundred years), the mean premium on
stocks over bills was considerably and consistently higher, we realized that we had a
puzzle on our hands. It took us six more years to convince a skeptical profession and for
our paper The Equity Premium: A Puzzle to be published. (Mehra and Prescott
(1985)).
For the purpose of this article, I have done a similar analysis for India using thedata in Table 6, which contains the sample statistics for the Indian economy for the19912004 period.
Indian Economy Sample Statistics, 19912004
Statistic ValueRisk-free rate, Rf 1.0128Mean return on equity, E(Re) 1.126Mean growth rate of consumption, E(x) 1.0227Standard deviation of growth rate of
consumption, (x) 0.0224Mean equity premium, E(Re) Rf 0.113
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Asset pricing
Once the expected/required rate of return, E(Ri), is calculated using CAPM, we can comparethis required rate of return to the asset's estimated rate of return over a specific investmenthorizon to determine whether it would be an appropriate investment. To make thiscomparison, you need an independent estimate of the return outlook for the security based oneitherfundamental or technical analysis techniques, including P/E, M/B etc.
Assuming that the CAPM is correct, an asset is correctly priced when its estimated price is thesame as the present value of future cash flows of the asset, discounted at the rate suggested byCAPM. If the observed price is higher than the CAPM valuation, then the asset is overvalued(and undervalued when the estimated price is below the CAPM valuation). When the asset
does not lie on the SML, this could also suggest mis-pricing. Since the expected return of the
asset at time tis , a higher expected return than what CAPMsuggests indicates thatPtis too low (the asset is currently undervalued), assuming that at time t+ 1 the asset returns to the CAPM suggested price.
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Asset-specific required return
The CAPM returns the asset-appropriate required return or discount ratei.e. the rate at whichfuture cash flows produced by the asset should be discounted given that asset's relativeriskiness. Betas exceeding one signify more than average "riskiness"; betas below one indicatelower than average. Thus, a more risky stock will have a higher beta and will be discounted ata higher rate; less sensitive stocks will have lower betas and be discounted at a lower rate.Given the accepted concave utility function, the CAPM is consistent with intuitioninvestors(should) require a higher return for holding a more risky asset.
Since beta reflects asset-specific sensitivity to non-diversifiable, i.e. market risk, the market asa whole, by definition, has a beta of one. Stock market indices are frequently used as local
proxies for the marketand in that case (by definition) have a beta of one. An investor in alarge, diversified portfolio (such as a mutual fund), therefore, expects performance in line withthe market.
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Risk and diversification
The risk of a portfolio comprises systematic risk, also known as undiversifiable risk, and
unsystematic risk which is also known as idiosyncratic risk or diversifiable risk. Systematicrisk refers to the risk common to all securitiesi.e. market risk. Unsystematic risk is the riskassociated with individual assets. Unsystematic risk can be diversified away to smaller levelsby including a greater number of assets in the portfolio (specific risks "average out"). Thesame is not possible for systematic risk within one market. Depending on the market, aportfolio of approximately 30-40 securities in developed markets such as UK or US willrender the portfolio sufficiently diversified such that risk exposure is limited to systematic riskonly. In developing markets a larger number is required, due to the higher asset volatilities.
A rational investor should not take on any diversifiable risk, as only non-diversifiable risks arerewarded within the scope of this model. Therefore, the required return on an asset, that is, the
return that compensates for risk taken, must be linked to its riskiness in a portfolio context -i.e. its contribution to overall portfolio riskiness - as opposed to its "stand alone riskiness." Inthe CAPM context, portfolio risk is represented by higher variance i.e. less predictability. Inother words the beta of the portfolio is the defining factor in rewarding the systematicexposure taken by an investor.
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Arbitrage pricing theory
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METHODOLOGY OF THE STUDY
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Primary Data:
The data provided by the firm was been analyzes by using Markowitz model
determines an efficient asset of portfolio return i.e.,1. Return
2. Standard deviation
3. Coefficient of correlation
Secondary Data:
The data that is used in this project is of secondary nature. The data is to be
collected from secondary sources such as various websites, journals, newspapers, books, etc.,
the analysis used in this project has been done using selective technical tools. In Equity
market, risk is analyzed and trading decisions are taken on basis of technical analysis.It is
collecting share prices of selected companies for a period of five years.
PERIOD OF THE STUDY:
The study of Equity value and portfolio management for a period of five years (2003-
2007).
LIMITATIONS:
y The companies are selected on the basis of the performance
y Expand or contract the size of the portfolio reflect the changes in investor risk
disposition.
SOURCE :
NCE, The standards set by NSE in terms of market practices and technologies have become
industry benchmarks and are being emulated by other market participants. NSE is more than amere market facilitator. It's that force which is guiding the industry towards new horizons and
greater opportunities.
TOOLS & TECHNIQUES:
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The following statistical techniques were used for measuring the performance of the
companys funds.
1. Rate of Return (ROR)N2-N1
ROR =N1
Where, N1 is Close period at period1
N2 is Close period at period
2. Standard Deviation (SD)SD =
Where,
N is total number of months
3. Betan xy x * y
Beta =n x2 (x)2
4. Alpha
Alpha = Avg (y) (beta*Avg (x))
5. Coefficient of Correlation
n xy x * yCoefficient of Correlation =
[(n y2 (y) 2) (n x2 (x) 2)]
6. Coefficient of Correlation
Coefficient of determination = (Coefficient of Correlation) 2
COMPANY PROFILE
Ericsson
2
1
1( )
n
ii
Xn
W Q!
!
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Ericsson is a Swedish telecommunications equipment manufacturer, founded in 1876 as a
telegraph equipment repair shop by Lars Magnus Ericsson. In the early 20th century, Ericsson
dominated the world market for manual telephone exchanges but was late to introduce
automatic equipment. The world's largest ever manual telephone exchange, serving 60,000
lines, was installed by Ericsson in Moscow in 1916. In the 1990s, Ericsson held a 35-40
percent market share of installed cellular telephone systems. Headquartered in Stockholm,
Sweden, Ericsson is considered to be part of the so-called Wireless Valley.
Like most of the telecommunications equipment industry, Ericsson suffered heavy losses after
the telecommunications crash in the early years of the 2000s. The company had to lay off tens
of thousands of staff worldwide in an attempt to staunch the losses
As of 2004, Ericsson is making an operational profit again. The loss making handsets division
was divested into a joint venture with Sony, called Sony Ericsson. Ericsson now concentrates
on its core systems: supplying infrastructure for all major wireless technologies and
modernizing existing copper lines for broadband services. In addition, it has one of the largest
services divisions in the telecom industry and is steadily growing in new areas such as
managed services.
JM
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JM is one of the Nordic regions leading developers of housing and residential areas.
Operations focus on new production of homes in attractive locations, with the main focus on
expanding metropolitan areas and university towns in Sweden, Norway, Denmark andBelgium. We are also involved in project development of commercial premises and contract
work, primarily in the Greater Stockholm area.
JM seeks to promote long-term quality and environmental consideration in all its operations.
Annual sales total approximately SEK 8.5 billion and the company has some 2,200
employees. JM is a public limited company and is listed on the Stockholm Stock Exchange A
list.
Volvo
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Volvo is a world-leading Swedish manufacturer of commercial vehicles, buses and
construction equipment, drive systems for marine and industrial applications, aerospace
components and services. It was founded in April 14, 1927 in the city of Gothenburg, as aspin-off from roller ball bearing maker SKF. Volvo Cars, the automobile manufacturer, has
since 1999 been owned by the Ford Motor Company.
The Volvo Group today has more than 81,000 employees, with manufacturing in 25 countries
and sales in more than 185 markets. The group provides complete solutions for financing and
service. The Volvo Group's net sales 2004 amounted to 22 billion. Renault owns 20% of the
Volvo Group.
Comparison between Ericsson, Volvo and JM
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Before starting with the comparison, we will explain what we did to get the regression curve.First we calculated with the given Stock prices the weekly returns. Than we calculated fromthe annually risk free interest rate the weekly interest rates too. After that we calculated from
the given data for OMXSPI the weekly market return. Than we built the differences betweenstock return and risk free interest rate and the differences between the market return and the
risk free interest rate. So with this differences we could use the following-formula: ( ) i f m frr= + r r, where i requal to stock return, m requal to market return, frequal tothe risk free interest rate and , where the values which we will calculate. First we plottedthe stock return over the market risk premium. Than followed the real regression. We plotteda trend line in the points. With the help of this trend line one can see the correlation betweenthe stock return and the market return. Additionally excel plots information about the
regression like the R , the values for and , their standard errors and the t-valuesrespectively the p-values. In our research we used the 5%- interval to see if the values arestatistically significant or not, that means if we could reject the zero-hypothesis or not.
Ericsson:-
Regression Statistics
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Multiple R 0,809347632R Square 0,655043589
Adjusted RSquare 0,653674715
Standard Error 0,054974601Observations 254
df SS MS F Significance FRegression 1 1,446207804 1,446207804 478,5270819 3,5487E-60Residual 252 0,761596115 0,003022207Total 253 2,207803919
Coefficients Standard Error t Stat P-value Lower 95% Upper 95%
Intercept -0,0014 0,003451 -0,40707 0,684301 -0,0082 0,005391
weeklymarket return(rm) 2,252417 0,102985 21,87124 3,66E-60 2,049595 2,455239
We can see that the value for R is 0.65 so about 65% of the risk from Ericsson can beexplained by the market risk and the reminder 35% is unique risk. The value for is thecoefficient for the Interception. states how much on average the stock price changed whenthe market index was unchanged. A positive coefficient means that the stock performs better
than the market if the -value is constant. But from the t-value one can see, that thiscoefficient is not significant, because the t-value has to be smaller than -1.96 or bigger than
1.96 for our 5% interval. The value for , the sensitivity of the stock to the market, is 2.25with a t-value of 21.87, what is very significant or the possibility that we are wrong, expressedin the p-value is very small. In the graphic the value for is expressed in the slope of theregression trend line. The larger the value the steeper the trend line. If there would beperfect correlation between the stock value and the market value, we would have equals to1. If one could ad a stock to his portfolio one should choose one with a low correlation orbetter a negative correlation. The best correlation would be minus one. In this case one wouldbalance the stocks with each other and the risk of the portfolio would be much less than the
individual risk of the stocks. If one looks at the value, one can see that it is negative, butvery small. So the stock would perform worse than the market. But the value is notsignificant, because the value for t is smaller than 1.96. So it is not possible to reject the
zerohypothesis.
Volvo:-
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Now we will compare the stock from Ericsson with the Volvo stock. Therefore we will look
at the alpha and beta values too, as well as their significances and R . From the first view one
can see some differences. First the spreading of the points is less compact, compared to
Ericsson. Of course one can see a lot of points around zero and one can recognize a positive
trend but there are a lot of points far away from the other points too. In spite of everything
there is a positive correlation between the stock return of Volvo and the market return. But we
can see not only the spreading and therefore the trend are not so explicit like in Ericsson,
although the scatter of the points is in the Volvo example wider.
Regression StatisticsMultiple R 0,67941895R Square 0,46161011
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Adjusted RSquare 0,45947364Standard Error 0,03045344
Observations 254
df SS MS F Significance F
Regression 1 0, 200378765 0,200379 216,0623 9, 65847E-36Residual 252 0,233707841 0,000927Total 253 0,434086606
Coefficients Standard Error t Stat P-value Lower 95% Upper 95%Intercept 0,00373281 0,001910969 1,953358 0,051884 -3,06982E-05 0,00749631
rm-rf 0,83797557 0,057008797 14,69906 9,66E-36 0,725701169 0,95024996
First we will concentrate on the value for R . It is 0.46. So 46% of the variation in the Volvo
stock can be explained by the market variation and the reminder or 54% of the variation are
unique risk. Continuing the comparison we will look at and values. The value is 0.83
so it is less than one. This means that the risk of Volvo is less than market risk. The t-value
for the value is 14.69. This means that we are very save with the value and can trust it.
The value for is very small, only 0.0037. But the t-value is only 1.95, so the result for isstatistically not significant. We can not reject our zero-hypothesis and make no proposition
about . Comparing these two stocks one can say that Ericsson is more risky than Volvo and
the bigger part o f the risk is explained by the market.
JM
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Here one can see two things on the first view. The first thing concerns the spreading of the
points in the whole graphic. One can see that the frequency of the points in the bottom left and
upside right quadrant is less than in the cases before. There are a lot of points in the bottomright and upside left part too. This means that it is harder to make a trend line and that this
trend it less strong than in the other cases before. But of course there is still a trend.
The second point applies to the scatter of the points around the trend line. One can see directly
that the average distance is much more than in the cases before. This means that it is hard to
explain the stock risk of JM from the market risk. The biggest part of the risk will be unique
risk. Lets see if we can prove our presumptions with facts. Therefore we will look again at
the Datasheet for JM.
Regression Statistics
Multiple R 0,33290017
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R Square 0,11082252Adjusted RSquare 0,10729404Standard Error 0,03892112
Observations 254
df SS MS F Significance F
Regression 1 0, 047579 0,047579 31,40799 5,47342E-08Residual 252 0,381743 0,001515Total 253 0,429322
Coefficients Standard Error t Stat P-value Lower 95% Upper 95%
Intercept 0,00269212 0,002442 1,10243 0,271326 -0,002117182 0,007501Rm weeklymarket return 0,40674829 0,072882 5,580881 6,17E-08 0,263211969 0,550285
Lets first look at the value for the scatter of the points R . It is 0.11. So about 11% of thevariations for JM can be explained through market variations. This proves our speculationsand shows that JM has a very high unique risk, about 89% and very low market risk. Nowlets have a look to the value. It is 0.41. This testifies our earlier assumptions about thespreading of the points too. The JM stock has a much lower risk than the market risk. Thetvalue
is lower than in the other cases before but it is still higher than 1.96 and so it isstatistically significant. The interception with the y- axis or the -value is still very small,about 0.002 and like in the cases before it is not statistically significant, because the t-value isonly 0.96.
Conclusion
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INTERNATIONAL SCHOOL OF CORPORATE MANAGEMENT, PUNE53
We made regressions for the beta and alpha values for different kind of companies and try to
find out if the reflect our expectations for these types of industries. We could prove our
expectation for Ericsson, which is a high tech company in a risky industry. It has a high beta
value which mirrors the high risk and high return. Than we concentrated on Volvo, an
automobile company which has a beta value little bit less than one. It is more in a traditional
safe industry but not so safe like our last company, JM which represents the real estate
industry with a very low beta, very safe compared to high tech industry our even to the
market. In the last point we looked if the risk free rate does matter or not and found out that in
our research, where it is very low, it makes no difference if one include it or neglect it.
BIBLIOGRAPHY
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WWW.EQUITY.COM
WWW.INVESTMENT.COM
WWW.BSE.COM
WWW.ERICSSON.COM
WWW.VOLVO.COM
WWW.JM.COM