ASSIGNMENT

Ques1. What is beta? Answer: 1. The beta coefficient is the relative measure of sensitivity of an assets return to change in return on the market portfolio. 2. It can be viewed as an index of the degree of the responsiveness of the securitys returns with the market return. 3. The beta coefficient, , is calculated by relating the returns of a security with the returns for the market 4. When >1 =the security is more risky. 5. When <1=the security is less risky. 6. It can be calculated as: 7. = COV(S,M) 2m Ques1. (a) Difference between geared and ungeared beta. Geared beta An indication of the systematic risk attaching to the returns on ordinary shares. It equates to the asset Beta for an ungeared firm, or is adjusted upwards to reflect the extra riskiness of shares in a geared firm. i.e. the Geared Beta. In the Capital asset pricing model (CAPM), it is the relevant measure of total equity risk. Also known as Geared beta. It is very well related to the debt concept.

Ungeared beta The asset beta, or corporate beta, or business beta, is a measure of the business risk in a sector; that is the business risk alone, unaffected by any financial risk that would be introduced by debt financing on the balance sheet (i.e. gearing). Each business sector has its own unique risks and so each business sector will have its own asset beta. It is not possible to convert an asset beta from one sector into an asset beta for another sector; each sectors asset beta has to be derived from statistical analysis (using least squares linear regression techniques). Since the asset beta reflects purely business risk, a company with only equity finance on its balance sheet will find that its equity beta is the same as the sectors asset beta. This is because the company has no debt finance and so does not expose its shareholders to the

financial risk associated with debt finance; hence the asset beta is also called an ungeared equity beta. Ques2. Write short note on CML & SML. CML Capital market line (CML) is the tangent line drawn from the point of the risk-free asset to the feasible region for risky assets. The tangency point M represents the market portfolio, so named since all rational investors (minimum variance criterion) should hold their risky assets in the same proportions as their weights in the market portfolio.

Formula

The CML results from the combination of the market portfolio and the risk-free asset (the point L). All points along the CML have superior risk-return profiles to any portfolio on the efficient frontier, with the exception of the Market Portfolio, the point on the efficient frontier to which the CML is the tangent. From a CML perspective, this portfolio is composed entirely of the risky asset, the market, and has no holding of the risk free asset, i.e., money is neither invested in, nor borrowed from the money market account. Addition of leverage (the point R) creates levered portfolios that are also on the CML.

SML The SML essentially graphs the results from the capital asset pricing model (CAPM) formula. The x-axis represents the risk (beta), and the y-axis represents the expected return. The market risk premium is determined from the slope of the SML. The security market line is a useful tool in determining whether an asset being considered for a portfolio offers a reasonable expected return for risk. Individual securities are plotted on the SML graph. If the security's risk versus expected return is plotted above the SML, it is undervalued because the investor can expect a greater return for the inherent risk. A security plotted below the SML is overvalued because the investor would be accepting less return for the amount of risk assumed.

Ques3. Write short note on Yield to maturity. Answer: The Yield to maturity (YTM) or redemption yield of a bond or other fixed-interest security, such as gilts, is the internal rate of return (IRR, overall interest rate) earned by an investor who buys the bond today at the market price, assuming that the bond will be held until maturity, and that all coupon and principal payments will be made on schedule. Yield to maturity is actually an estimation of future return, as the rate at which coupon payments can be reinvested when received is unknown. It enables investors to compare the merits of different financial instruments. The YTM is often given in terms of Annual Percentage Rate (A.P.R.), but more usually market convention is followed: in a number of major markets the convention is to quote yields semi-annually (compound interest: thus, for example, an annual effective yield of 10.25% would be quoted as 5.00%, because 1.05 x 1.05 = 1.1025).

The yield is usually quoted without making any allowance for tax paid by the investor on the return, and is then known as "gross redemption yield". It also does not make any allowance for the dealing costs incurred by the purchaser (or seller).

If the yield to maturity for a bond is less than the bond's coupon rate, then the (clean) market value of the bond is greater than the par value (and vice versa). If a bond's coupon rate is less than its YTM, then the bond is selling at a discount. If a bond's coupon rate is more than its YTM, then the bond is selling at a premium. If a bond's coupon rate is equal to its YTM, then the bond is selling at par.

Formula c(1 + r)-1 + c(1 + r)-2 + . . . + c(1 + r)-Y + B(1 + r)-Y = P where c = annual coupon payment (in rupees, not a percent) Y = number of years to maturity B = par value P = purchase price Ques4. Write short note on yield curve. Answer: A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The most frequently reported yield curve compares the three-month, two-year, five-year and 30-year U.S. Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growth.

The shape of the yield curve is closely scrutinized because it helps to give an idea of future interest rate change and economic activity. There are three main types of yield curve shapes: 1. Normal 2. Inverted and 3. Flat (or humped). A normal yield curve (pictured here) is one in which longer maturity bonds have a higher yield compared to shorter-term bonds due to the risks associated with time. An inverted yield curve is one in which the shorter-term yields are higher than the longer-term yields, which can be a sign of upcoming recession. A flat (or humped) yield curve is one in which the shorter- and longerterm yields are very close to each other, which is also a predictor of an economic transition. The slope of the yield curve is also seen as important: the greater the slope, the greater the gap between short- and long-term rates. Ques4. Write short note on short selling. Answer: short selling is the selling of the stock that the seller doesnt own. More specifically, a short sell is a sell of the security which is not owned by the seller, but that is promised to be delivered. When one short sells a stock, the broker will lend the stock. The stock will come from the brokerage's own inventory, from another one of the firm's customers, or from another brokerage firm. The shares are sold and the proceeds are credited to persons account. Sooner or later, the person must "close" the short by buying back the same number of shares (called covering) and returning them to the broker. If the price drops, the person can buy back the stock at the lower price and make a profit on the difference. If the price of the stock rises, the person has to buy it back at the higher price, and the person loses money. Most of the time, a person can hold the stock for as long as he wants, although interest is charged on the margin account. So keeping a short sale open for a long time will cost more.