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1.

0 Introduction to the Financial Markets


To understand what is finacial market, we will first try to understand what is a market? Economists define market as 'a cental place where sale and purchase of goods and services takes place.' Financial Markets refer to the set of all Financial Instutions (Fis) in an economy which helps in the smooth flow of capital from places where it is surplus to the areas where it is required or consumed. These Financial Institutions may be banking or non banking financial corporations (NBFCs). A more appropriate definition of financial markets has been given by Eugene F Brigham1 Financial Markets is the place where people and organizations wanting to borrow money are brought together with those having surplus of funds. Thus the Financial Markets play a larger role in the smooth distribution and availability of capital so that industrial development can happen in a nation. In short, Financial Markets helps in the overall devlopment of a nation. Note that financial markets is plural as there are a great many different financial markets in a developmed economy like ours. Each sub market of financial markets deals with a somewhat different type of instruments in terms of the instrument's maturity and the assets backing it. Also, different markets serve different types of customers, or operate in different parts of the country. For these reasons it is often useful to classify markets along various dimensions : 1.1 Different Types of Markets2 a. Physical asset markets and Financial asset markets : Physical assets markets are real markets or tangible markets where industrial produce (Computers, Machinery, Electronics goods etc) or agriculutural commodities (Wheat, Corn, Cloves etc) or physical commodities (Gold, Silver, Crude etc) are traded. In Financial asset markets financial assets like shares, bonds, debentures are traded.

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b. Spot markets and Futures markets : Spot markets are those markets wherein the assets are bought or sold on-the-spot. It means the assets are available and transaction gets completed immediately. In the Futures markets the parties agree to enter into a contract wherein the assets will be change hands on a future date.

As per the definition given by Brigham and Houston in their book 'Fundamentals of Financial Management. 2 Brigham and Houston in their book 'Fundamentals of Financial Management' has given this classification. c. Money markets and Capital markets : Money markets are those markets wherein the funds are traded for a short period of time not exceeding a year. Few such instruments are Certificate of Deposits (CD), Commercial Paper (CP), Treasury Bills (T-bills) etc. Capital markets are those markes wherein funds are traded for a period of over one year. Few such instruments are Debentures, Corporate bonds, Treasury Bonds etc. d. Primary markets and Secondary markets : Primary markets are those markets in which new capital is raised by the companies. The companies create new capital (say equity capital) and issue it for the first time to investors, this would qualify as primary market transaction. However, when the buyers of these capital (say equity capital as previously mentioned) comes back for resale of this capital, the market in which it would be sold is called as secondary market. Stock exchange are the places where this re-sale transactions are carried out. In short, Bombay Stock Exchange may be the secondary market for the equity capital issued by a company. e. Private markets and Public markets : Private markets are those markets in which the issuer of the capital directly enters into a deal with the investor. Thus the company gives shares to the investors while the investor put in money in the company. This is essentially a two party transaction. However, when the company goes ahead with issuance of shares to public it is known as public market transaction. Under this transaction, there are large number of persons holding the shares of the company or shares are issued to large number of investors. 1.3 Genesis and Development of Financial Markets 3 :

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The genesis of the Indian financial markets since the independence is marked by four distinct phases as given below: The period between 1950 to 1960 : This period can be termed as phase of Transition as banking system were getting strengthened by a process of merger & acquistions of small and weak banks. The other major activity of this period is the efforts that were made to strengthen the co-operative financial institutions. The period between 1960 to 1969 : This phase can be termed as phase of Growth and Diversification. In this phase, a lot of financial institutions were established and Indian financial market diversified into development banking, mutural funds etc. The period between 1969 to 1990 : This phase is marked by Consolidation of various banking and non-banking financial institutions. The major thrust was provided by the nationalization of banks. Government also started the lead banking schemes. The period from 1991 onwards : This phase can ideally be called as phase of Innovation which was a sequel of the policy followed by the central government generally called as Liberalization-Privatization-Globalization (LPG). New financial instruments viz Reverse Repo, Derivatives, Securitization, Reverse Mortgages etc were introduced into the Indian financial markets. Sweeping reforms were carried out in the Indian financial markets.
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Different researchers have furnished different views on the genesis of the Indian financial markets, thus these four phases mentioned below are only indicative in nature.

1.4 Role of Financial Markets The most important role of financial markets is to transfer funds from those who have excess of it to those who need it. Thus financial markets helps individual in buying housing and other real estate assets, it also helps students in getting educational loans so that they can pursue higher education, it helps the companies to get capital which helps in their growth. The governments also uses the financial markets to borrow the funds for financing the infrastructural public utility projects. The important functions of the financial markets are given below: a. Provision of Liquidity : Liquidity refers to cash or money and other financial assets , which can be readily converted into cash without any significant loss of time and value. b. Mobilization of savings : By transferring the small and large savings of

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individuals as well as corporations, financial markets speeds up consumption and investment. c. National growth : In contributes to national growth by ensuring an unaffected flow of surplus funds to deficit units. d. Financial Support to Entrepreneurs : By providing capital to set up the new projects of ventures through venture capital, the financial markets supports the budding entrepreneurs. e. Industrial development : Financial markets helps in accelerated growth of Industrial and economic development. Other functions of Financial Markets a. Enhancement of income : By investing in financial instruments like Term Deposits, interest can be earned on otherwise idle surplus cash. Similarly, by investing in shares, dividends can be earned. Thus financial markets provides an opportunity for enhancement of income b. Capital formation : The twin act of savings and investment clubbed together is known as capital formation. Since financial markets helps in transfer of funds from surplus areas to consumption (investment) areas, it helps in capital formation c. Price determination : The price of traded funds is decided by the financial markets d. Sale Mechanism : The financial markets lays down clearly the code of conduct under which the funds would be traded thus it devises the sale mechanism e. Information dissemination : One of the functions of financial markets is proper dissemination of information so that the prospective investors may make an information decisions.

2.0 Financial Markets and Instruments


Financial markets indeed supply funds to those who are in need for these funds from those who are having surplus of it. However, for this process to get completed an effective medium or channel is required. Financial Instruments

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are those tools through which or by the use of which the transfer of funds takes place. For example, the customers at various branches of any bank would keep their surplus funds with the bank in the form of various financial instruments like savings bank account, term deposits, recurring deposits etc. In turn the bank pays interest on these instruments which acts as a motivators for the investors. The bank pools these small deposits into a big corpus which may be given to any person or firm for purchase of any assets. An individual may approach the bank for getting housing loan or automobile loan or possibly personal loan. Thus, the bank will disburse this funds through separate instruments. In short the vehicles through which funds are transferred or traded in the financial markets are known as financial market instruments.

2.1 Classification of financial markets4 Financial markets can be broadly be classified into the following categories: a. b. c. d. Money Markets Capital Markets Derivative Markets Forex Markets

Apart from the above four sub-markets of financial markets, we do have Commodity markets. But the same has not been included in the above classification because the commodity markets deals in commodities (lke Crude Oil, Gold, Silver, Wheat etc) and their trade cannot be directly called as financial transactions. Hence, we have included only those sub-markets of financial markets in the classification wherin transactions carried out are purely financial transactions

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Different researchers have classified financial markets differently. Here an attempt has been made to classify the financial markets in a manner which is very simple and easy to understand.

2.2 Brief description of Money, Capital, Derivative and Forex markets 2.2.1 Money Markets Money markets are those places where funds are traded for short period of time not exceeding an year. Money markets helps in meeting the requirements of funds on short term basis. The other important functions of money markets are: a. Smooth functioning of commercial banks (banks can meet any shortfall in temporary liquidity) b. Effective Central Bank Control for tiding up the excess liquidity through changes in credit rates c. Development of Trade and Industry d. Helps the Capital markets development The chief characteristics of the developed money markets are as given under: a. b. c. d. e. Highly organized Banking system Presence of Central Banker (The regulator of the Money Markets) Availability of proper credit instruments Existence of Sub-markets Demand and Supply of Funds Capital Markets

2.2.2

The market which trades the funds for long term is known as capital markets. The word long term means that the maturity date of the investment shall be in excess of one year. A business enterprise can raise capital from various sources. Generally the companies raises long term funds from capital markets either through borrowing from financial institutions or through issue of securities on their own. Capital markets can broadly be classified into two parts:

2.2.2.1

Gilt Edged Market or G-secs.

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It is the market of government securities thus both principal and interest both are guaranteed. Since both the principal as well as the interest is guaranteed thus this market has an edge over other markets and hence the name Gilt Edged market. The G-sec market has the following features: a. No Uncertainty w. r. t. Yield or Repayment b. Dominant players are LIC, GIC, PF funds and select other FIs c. Size of transaction : the value of transactions are very high (runs into several crores of rupees) d. RBI is the major actor on behalf of Government. e. OTC market : it is primarily and Over the Counter (OTC) market. f. Liquidity : the instruments traded are most liquid debt instruments

2.2.2.2 Corporate Securities market It is the market where securities viz shares, debentures and bonds issued by the companies (corporates) are bough and sold. It consists of the new issue market (the primary market) and the stock exchanges (the secondary market)

2.2.3 Role of Capital Markets in India a. Mobilization of savings and accelerated capital formation b. Promotion of industrial growth c. Raising of long term loans d. Ready and continuous market e. Financing the Five Year Plans of Government of India f. Development of variety of services like Broking Houses, R & T activities, Underwriting services, Credit rating services, Custodial services, PMS etc.

2.2.3

Derivative Markets5

Derivative markets are investment markets that are geared toward the buying and selling of derivatives. Derivatives are securities, or financial instruments, that get their value, or at least part of their value, from the value of another security, which is called the underlier**. The underlier can

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come in many forms including, commodities, mortgages, stocks, bonds, or currency. The reason investors may invest in a derivative instrument is to hedge their bet.

** An underlier6 is a commodity or some form of security that provides the


backing for the trading of shares. Sometimes referred to as an underlying security, the underlier is the security that may be called for delivery in the event that an option associated with the transaction is called or exercised. Generally, the underlier can also be a security that cannot be delivered, but will be settled with cash. The use of underliers in most forms of investments is essential in order for trades to take place. Because the underlier involves securities and commodities that will in effect guarantee the current base trading value of the investment, the stability of the instrument used as an underlier must be affirmed. Without a stable underlying security, shares of stock become worthless and the investor will quickly lose money on the investment.
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Derivative market and Underlier definition taken from the website

www.wisegeek.com/what-is-a-derivative-market.htm (October 08, 2010)

2.2.4 Forex Markets7 The word forex in Forex Markets stands for foreign exchange; it's also known as FX. In a forex trade, you buy one currency while simultaneously selling another - that is, you're exchanging the sold currency for the one you're buying. The foreign exchange market is an over-the-counter market. Currencies trade in pairs, like the Euro-US Dollar (EUR/USD) or US Dollar / Japanese Yen (USD/JPY). Unlike stocks or futures, there's no centralized exchange for forex. All transactions happen via phone or electronic network.

Who trades currencies, and why?

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Daily turnover in the world's currencies comes from two sources:

--> Foreign trade (5%). Companies buy and sell products in foreign countries, plus convert profits from foreign sales into domestic currency. --> Speculation for profit (95%). Most traders focus on the biggest, most liquid currency pairs. "The Majors" include US Dollar, Japanese Yen, Euro, British Pound, Swiss Franc, Canadian Dollar and Australian Dollar. In fact, more than 85% of daily forex trading happens in the major currency pairs. The world's most traded market, trading 24 hours a day With average daily turnover of US$3.2 trillion, forex is the most traded market in the world. A true 24-hour market from Sunday 5 PM ET to Friday 5 PM ET, forex trading begins in Sydney, and moves around the globe as the business day begins, first to Tokyo, London, and New York.

Unlike other financial markets, investors can respond immediately to currency fluctuations, whenever they occur - day or night.

Forex markets definition taken from the website www.forex.com/intro-forexmarket.html (October 08, 2010)

2.3 Money Market Instruments Following Instruments are generally traded in the money markets 2.3.1 2.3.2 2.3.3 Call Money Certificate of Deposits (CD) Commercial Papers (CP)

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2.3.4 2.3.5

Treasury Bills (T-bills) MMMF

2.3.1 Call Money Market It refers to the market where funds are traded for extremely short period of time. It consists of Overnight markets and money at short notices up to the period of 14 days. 2.3.2 Certificate of Deposits (CDs) Certificate of Deposits are the negotiable money market instrument and is issued in dematerialized form or as a promissory note for fund deposits at a bank or other eligible financial institutions for a specified time period. Generally they are short term deposit instrument issued by institutions to raise large sums of money. Main features of CDs are a. b. c. d. e. Time deposits Transferable Issued at discount to face value Repayable on fixed date Subject to Stamp duty. financial

2.3.3 Commercial Papers (CPs) In USA, the commercial paper was started by Consumer finance companies in 1920s while in India, Vaghul working group gave recommendations to government and as per the recommendations, RBI introduced commercial papers in Indian Money Markets from 1989. Commercial paper is a short term unsecured instrument issued by a company in the form of promissory notes with fixed maturities. 2.3.4 T- bills A Treasury bill is a kind of Promissory Note issued by the Government or other entity under the discount for a specified period stated therein. issuer promises to pay the specified mentioned amount to the bearer of instrument at the time of maturity (due date). The period does exceed year. any The the one

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In India T-bills are short liability of government. Theoretically, T-bills should be issued for meeting temporary deficits of the government arising due to excess expenditure over revenue at some point of time.

2.3.5 Money Market Mutual Fund It is a variety of Mutual Fund which invests its corpus into money market instruments. These type of mutual fund schemes are also known as liquid funds. MMMF deposit account scheme can be operated either by issuing a deposit receipt or through the issue of passbook. Some liquid schemes of mutual funds have started offering 'cheque writing' facility. Such facility provides more liquidity to unit holders. 2.4 Capital Market Instruments 2.4.1 2.4.2 2.4.3 Bonds Government bonds, Corporate bonds, PSU bonds, FI bonds etc. Debentures Equities

2.4.1 Bonds Bonds are simple debt (borrowing) instruments. They are also known as fixed income securities because most bonds pay regular income to the investor a rate of interest on the bond. Some of the examples of bonds floated in the market are Government bonds, Corporate bonds, PSU bonds, FI bonds etc. The important concepts related to the bonds are:

2.4.1.1 Par Value It is the principal or face value of the bond 2.4.1.2 Coupon Coupon is the interest rate the bond pays. Generally the coupon rate does not change in the life of the bond.

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2.4.1.3 Maturity Maturity refers to date on which the principal and coupon (if any) due on the bonds has to be repaid to the investor. After this payment by the bond issue, the claim of investor stands extinguished.

2.4.2

Debentures

The safest type of a security in a company is known as debentures. A debenture is an instrument of credit , a bond of indebtness or a mere acknowledgement of debt issued by a company or any legal entity under its commond seal. Some of the types of debentures floated into the capital markets are: a. b. c. d. e. f. g. Secured debentures Simple Debentures Redeemable debentures Perpectual debentures Registered debentures Bearer debentures Convetible debentures

2.4.3

Equities

It is an evidence of partial ownership interest in an organization. They have two chief characteristics: a. they are anticedant b. All claims are residual

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Detailed

account of equity has been given in the sections 3.0 and 4.0

3.0 Introduction to equity Equity / ordinary share capital, as a long term source of finance, represents ownership capital / securities and its owners equity holders / ordinary shareholders share the reward and risk associated with the ownership of companies. At the time of floating the company the promotors pool in their money and accordingly they get the shares of the company. Thus, the initial equity holders of the company are mostly the promotors. Later on the stake of promotors are diluted and fresh capital is issued by way of further isssue of equity shares. 3.1 Equity Simplified It is an ownership interest in any organization. Accordingly, the equity exists even before the company is flaoted in the form of wealth of persons, who after the floating of the company becomes its owners or promotors. 3.2 Salient features of equity capital a. Primitive Source of Capital Equity Capital is the most primitive source of capital because it existed even before the company came into existence. b. Owner's Capital

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Equity share capital is owned capital because it is the money of the shareholders who are actually the owners of the company. c. Fixed Value or Nominal Value Every share has fixed value or a nominal value. For example, the price of a share is Rs. 10/- which indicates a fixed value or a nominal value. d. Residuary Claim The shareholders of equity capital have a residuary claim on the earnings i.e. dividends and also in the case of winding up or dissolution of the company they are paid in the end. e. Dividends The equity shareholders receive dividend as a form of income or returns from their investments made in the company. Though their returns are not fixed, they vary in accordance with the profits earned by the company. f. Voting Rights The equity shareholders enjoy voting rights for taking certain decision for the running of the company. g. Liquidity The equity shares can be traded in the secondary market, so they are liquid as they can be transferred from one person to another easily. 3.3 Types of equity capital a. Preference Share Capital Preferred stock, also called preferred shares, preference shares, is a special equity security that has properties of both equity and a debt instrument and is generally considered a hybrid instrument. It is a capital stock which provides a specific dividend that is paid before any dividends are paid to common stock holders, and which takes precedence over common stock in the event of a liquidation. b. Bonus Shares The term bonus means an extra dividend paid to shareholders in a joint stock company from surplus profits. When a company has accumulated a large fund out of profits - much beyond its needs, the directors may decide to distribute a part of it amongst the shareholders in the form of bonus. A bonus share is a free share of stock given to current/existing shareholders in a company, based upon the number of shares that the shareholder already owns at the time of announcement of the bonus. While the issue of bonus shares increases the total number of shares issued and owned, it does not increase the value of the company. Although the total number of issued shares increases, the ratio of number of shares held by each shareholder remains constant. c. Rights Issue A rights issue an option that a company opts for to raise capital under a secondary market offering or seasoned equity offering of shares to raise money. The rights issue is a special form of shelf offering or shelf registration. With the issued rights, existing For Copy rights please mail: sanjay_mail999@rediffmail.com or Call : 9819217565

shareholders have the privilege to buy a specified number of new shares from the firm at a specified price within a specified time. A rights issue is in contrast to an initial public offering (primary market offering), where shares are issued to the general public through market exchanges. d. Redeemable Bond/Debenture A callable bond (also called redeemable bond) is a type of bond (debt security) that allows the issuer of the bond to retain the privilege of redeeming the bond at some point before the bond reaches the date of maturity. In other words, on the call date(s), the issuer has the right, but not the obligation, to buy back the bonds from the bond holders at a defined call price. Technically speaking, the bonds are not really bought and held by the issuer but are instead canceled immediately 3.4 Components of equity capital a. Authorized Capital It is the nominal or registered capital mentioned in the Memorandum and it acts as the maximum amount of capital which a company is authorized to issue under the terms of memorandum. b. Issued Capital It is the amount offered for sale or subscription by the company through a prospectus. c. Subscribed Capital It is the amount of share issued capital for which the company has received subscription. d. Called up Capital The amount of the share capital called up the company from the subscribed capital. e. Paid up Capital The amount of capital that the company has at its disposal which is the amount paid by the shareholders on the capital subscribed by them. 4.0 Equity Terminologies Equity terminologies covers a wide range of topics starting from the inception of funds in an organization to the terms used till the dissolution of a company. Some of the terms used in the general parlance are given in the next section.

4.1 Understanding of various Jargons of equity markets a. Share/Stock The stock or capital stock of a business entity represents the original capital paid into or invested in the business by its founders or investors. b. Dividend

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Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business (called retained earnings), or it can be paid to the shareholders as a dividend. Many corporations retain a portion of their earnings and pay the remainder as a dividend. c. Rights Issue A rights issue an option that a company opts for to raise capital under a secondary market offering or seasoned equity offering of shares to raise money. The rights issue is a special form of shelf offering or shelf registration. With the issued rights, existing shareholders have the privilege to buy a specified number of new shares from the firm at a specified price within a specified time. A rights issue is in contrast to an initial public offering (primary market offering), where shares are issued to the general public through market exchanges. d. Bonus Issue The term bonus means an extra dividend paid to shareholders in a joint stock company from surplus profits. When a company has accumulated a large fund out of profits - much beyond its needs, the directors may decide to distribute a part of it amongst the shareholders in the form of bonus. A bonus share is a free share of stock given to current/existing shareholders in a company, based upon the number of shares that the shareholder already owns at the time of announcement of the bonus. While the issue of bonus shares increases the total number of shares issued and owned, it does not increase the value of the company. Although the total number of issued shares increases, the ratio of number of shares held by each shareholder remains constant. e. Initial Public Offer An initial public offering (IPO), referred to simply as an "offering" or "flotation", is when a company (called the issuer) issues common stock or shares to the public for the first time. They are often issued by smaller, younger companies seeking capital to expand, but can also be done by large privately-owned companies looking to become publicly traded. f. Follow on Public Offer A follow-on offering (often called secondary offering) is an issuance of stock subsequent to the company's initial public offering. A secondary offering is an offering of securities by a shareholder of the company (as opposed to the company itself, which is a primary offering). A follow on offering is preceded by release of prospectus similar to IPO. g. Private Placement Private placement (or non-public offering) is a funding round of securities which are sold without an initial public offering, usually to a small number of chosen private investors. h. Qualified Institutional Placement Qualified institutional placement (QIP) is a capital raising tool, primarily used in India, whereby a listed company can issue equity shares, fully and partly convertible debentures, or any securities other than warrants which are convertible to equity shares to a Qualified Institutional Buyer (QIB). i. Qualified Institutional Buyer A Qualified Institutional Buyer (QIB), in law and finance, is a purchaser of securities that is deemed financially sophisticated and is legally recognized by security market

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regulators to need less protection from issuers than most public investors. j. Private Equity Private equity, in finance, is an asset class consisting of equity securities in operating companies that are not publicly traded on a stock exchange 4.2 Understanding of Systematic and Unsystematic risk First we need to understand what is a risk, then only understanding of Systematic and Unsystematic risk is possible. 4.2.1 Understanding of Risk The chance that an investment's actual return will be different than expected. Risk includes the possibility of losing some or all of the original investment. Sources of Risk a. Interest Rate Risk It is the variability in a security? return from changes in the level of interest rates. b.Market Risk Market risk refers to the variability of returns due to fluctuations in the securities market. c. Inflation Risk With the rise in inflation there is reduction of purchasing power, hence this is also referred to as purchasing power risk and affects all securities. d. Business Risk This refers to the risk of doing business in a particular industry or environment and it gets transferred to the investors who invest in the business or company. It may be caused by a variety of factors like heightened competition, emergence of new technologies, development of substitute products, shifts in consumer preferences etc. e. Financial Risk Financial risk arises when companies resort to financial leverage or the use of debt financing. The more the company resorts to debt financing, the greater is the financial risk as it creates fixed interest payments due to debt or fixed dividend payments on preference stock thereby causing the amount of residual earning available for common stock dividends to be more variable than if no interest payments were required. It is avoidable to the extent that management has the freedom to decide to borrow or not to borrow funds. f. Liquidity Risk This is the risk associated with the secondary market which the particular For Copy rights please mail: sanjay_mail999@rediffmail.com or Call : 9819217565

security is traded in. A security which can be bought or sold quickly without significant price concession is considered liquid. The greater the uncertainty about the true element and the price concession, the greater the liquidity risk. Securities that have ready markets like treasury bills have lesser liquidity risk.

4.2.2 Classification of Risk

The risk that a security is exposed to can be broadly classified into two categories. The first type of risk is known as Diversifiable risk because, it can be diversified or reduced by the decision maker or it is under the control of the investor while the other type of risk is known as non-diversified risk becuase it is beyond the control of the investor and thus cannot be reduced. 4.2.2.1 Unsystematic or Diversifiable Risk It is the risk specific to the security (company risk) and investor by holding a portfolio which is well diversified can completely eliminate the unsystematic risk. The different types of unsystematic risks are: iBusiness Risk iiFinancial Risk iiiDefault Risk 4.2.2.2 Systematic or Non-diversifiable Risk It is associated with the general market movement and it cannot be diversified. All securities do not have the same degree if systematic risk because the impact of economy wide factors could differ from company to company and industry to industry.

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i Market Risk ii Interest Rate Risk iiiPurchasing Power Risk

4.3 Understanding of Risk and Return and Calculation of Beta Risk and return go hand in hand in investments and finance. One cannot talk about returns without talking about risk, because, investment decisions always involve trade off between risk and return. Risk can be defined as the chance that the actual outcome from an investment will differ from the expected return. This means that, the more variable the possible outcomes that can occur (i.e. the broader the range of possible outcomes), the greater the risk.

4.3.1 Risk and Expected Rate of Return The width of a probability distribution of rates of return is a measure of risk. The wider the probability distribution, the greater the risk or the greater the variability of return or greater the variance. An investor cannot expect greater returns without being willing to assume

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greater risks.

4.3.2 Return from Equity Capital. The return from equity capital can be calculated with Capital Asset Pricing Model (CAPM). The CAPM was developed by William F. Sharpe, John Linter and Jan Mossin is one of the major developments in financial theory. The CAPM establishes a linear relationship between required rate of return of a security and its systematic or undiversifiable risk or beta. This relationship as defined by CAPM can be used to value an equity share. Mathematically, the relationship between the share market return and the market return can be depicted by the following formula Rs= Rf + (Rm - Rf) Where, Rs= Return on stock Rf= Risk free rate of return Rm= Market rate of return = Systematic risk

This relationship means that if the market price goes up by 10% and the security price also goes up by 10%, and vice versa, the beta is said to 1, i.e., there is a perfect correlation between return from the security and return from the market. If beta is 2, the security price would go up twice the percentage of change of the market. If beta is 0, then no correlation exists between the market movement and the security price movement.

4.3.3 Assumptions of CAPM Investors are risk averse and use the expected rate of return and standard deviation of return as appropriate measures of risk and return for their portfolio. Investors make their investment decisions based on a single period horizon, i.e., the next immediate time period. Transaction costs in financial markets are low enough to ignore and assets can be bought and sold in any unit desired. The investor is limited only by his wealth and the price of the asset.

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Taxes do not affect the choice of buying assets. individuals assume that they can buy assets at the going market price and All they all agree on the nature of the return and risk associated with each investment. 4.3.4 Measurement of (Beta)

Beta measures the relative risk associated with any individual portfolio as measured in relation to the risk of market portfolio. The market portfolio represents the most diversified portfolio of risky assets an investor could buy since it includes all risky assets. The relative risk can be expressed as: Non-diversifiable risk of asset or portfolio = --------------------------------------------------------Risk of material portfolio

Thus, the beta coefficient is a measure of the non diversifiable or systematic risk of an asset relative to that of the market portfolio. beta of 1 indicates an asset of average risk. A beta coefficient greater than 1 indicates above average risk, stocks whose A returns tend to be more risky than the market. beta coefficient less than 1 indicates below average risk, i.e., less riskier than A market portfolio.

In case of market portfolio all the diversification possible has been done, thus, the risk of market is all non diversifiable which an investor cannot avoid. Similarly, as long as the assets returns are not perfectly positively with returns from other assets, there will be some way to diversify away its unsystematic risk. As a result, beta depends only on non diversifiable risks.

4.3.5 Mathematical Calculation of Beta

The systematic relationship between the return on the security or a portfolio and the

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return on the market can be described using a simple linear regression, identifying the return on a security or portfolio as the dependent variable Kj and the return on market portfolio as the independent variable Km, in the single index model or market model developed by William Sharpe. This can be expressed as: Kj=j+jKm+ej Rs=+Rm The beta parameter in the model represents the slope of the above regression relationship and measures the responsiveness of the security or portfolio to the general market and indicates how extensively the return of the portfolio or security will vary with changes in the market return. The beta coefficient of a security is defined as the ratio of the security? covariance of return with the market to the variance of the market. This can be calculated as follows: Cov. (Rs,Rm) = -----------------------Var. Rm

4.4 Stock Market Terminologies The terminologies used in stock markets are like an ocean where the ends are seemingly not easy to estabhlish. Thus, the terminologies used in stock market parlance are practically innumerable. Few such examples are given below: a. Bullish Market A financial market of a group of securities in which prices are rising or are expected to rise. The term "bull market" is most often used to refer to the stock market, but can be applied to anything that is traded, such as bonds, currencies and commodities. Bull markets are characterized by optimism, investor confidence and expectations that strong results will continue. It's difficult to predict consistently when the trends in the

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market will change. Part of the difficulty is that psychological effects and speculation may sometimes play a large role in the markets. b. Bearish Market A market condition in which the prices of securities are falling, and widespread pessimism causes the negative sentiment to be self-sustaining. As investors anticipate losses in a bear market and selling continues, pessimism only grows. A bear market should not be confused with a correction, which is a short-term trend that has duration of less than two months. While corrections are often a great place for a value investor to find an entry point, bear markets rarely provide great entry points, as timing the bottom is very difficult to do.

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