Unit – 1 (Introduc on)

1. Under Indian Financial System, Financial market plays a major role –

Highlight the key features of Financial Market.
Ans. A financial market serves as a crucial pillar of the Indian financial system by facilita ng the
exchange of financial assets and fostering economic growth. Below are the key features of the
financial market:

1. Facilita on of Fund Flow:

The financial market connects en es with surplus funds (savers) to those in need of funds
(borrowers), ensuring efficient alloca on of resources.

2. Diverse Market Segments:

The Indian financial market is broadly categorized into two segments:

o Money Market (for short-term funds, e.g., treasury bills, commercial papers).

o Capital Market (for long-term funds, e.g., equity shares, bonds).

3. Wide Range of Instruments:

The market offers various financial instruments, such as equity, bonds, deriva ves, mutual
funds, and cer ficates of deposit, catering to different investment needs and risk appe tes.

4. Liquidity Provision:
Financial markets provide liquidity by enabling investors to buy or sell securi es easily,
ensuring a smooth flow of funds in the economy.

5. Price Determina on:

The interac on between buyers and sellers determines the price of financial assets. Factors
like demand, supply, and market condi ons influence these prices.

6. Risk Management:
Financial markets facilitate risk management through instruments like deriva ves (futures,
op ons, swaps), enabling investors to hedge against uncertain es.

7. Regula on and Supervision:

Regulatory bodies like the Securi es and Exchange Board of India (SEBI) and the Reserve
Bank of India (RBI) oversee the financial market to ensure transparency, stability, and
investor protec on.

8. Encouragement of Investment:
By offering a rac ve investment avenues and returns, financial markets encourage both
domes c and foreign investments, boos ng economic development.

9. Market Par cipants:

A wide array of par cipants, including retail investors, ins tu onal investors, banks, and
foreign investors, ensures diversity and dynamism in the market.

10. Economic Indicator:

The performance of financial markets o en reflects the overall economic condi on, serving
as a barometer for economic trends and policy effec veness.
Conclusion

The financial market is integral to the Indian financial system, ac ng as a bridge between surplus
and deficit sectors, fostering financial stability, and driving economic progress. Its efficiency and
development are essen al for a sustainable and vibrant economy.

2. Financial Market is key in Indian Financial System – Highlight the

importance of capital market.
Ans. The capital market plays a pivotal role in the Indian financial system by facilita ng the
efficient alloca on of financial resources, suppor ng economic growth, and fostering financial
stability. Here are the key points highligh ng its importance:

1. Mobiliza on of Savings:
The capital market channels savings from individuals and ins tu ons into produc ve
investments. It offers various instruments like shares, debentures, and bonds, encouraging
par cipa on from a broad investor base.

2. Efficient Resource Alloca on:

By providing a pla orm for trading securi es, the capital market ensures that funds flow to
projects and enterprises with the highest poten al for returns, fostering economic growth
and development.

3. Promo on of Industrial Growth:

The capital market helps industries raise long-term funds for expansion, moderniza on, and
diversifica on, contribu ng to the growth of the manufacturing and service sectors in India.

4. Liquidity Provision:
Through stock exchanges, the capital market offers liquidity, enabling investors to buy or sell
securi es easily. This feature enhances investor confidence and encourages par cipa on.

5. Encouragement of Entrepreneurship:
By facilita ng access to capital through equity financing, the capital market supports the
establishment and growth of startups and entrepreneurial ventures.

6. Economic Indicators:
The performance of the capital market reflects the overall health of the economy. It acts as a
barometer for economic condi ons, guiding policymakers and investors in their decisions.

7. Foreign Investment A rac on:

The capital market, par cularly through instruments like Foreign Por olio Investment (FPI)
and Foreign Direct Investment (FDI), a racts global capital to India, contribu ng to forex
reserves and strengthening the rupee.

8. Risk Diversifica on:

A diverse range of investment op ons allows investors to balance their por olios, minimizing
risks while maximizing returns.

9. Regulatory Support:
Ins tu ons like SEBI (Securi es and Exchange Board of India) ensure a well-regulated and
transparent capital market, promo ng investor trust and protec ng against fraud.
10. Employment Genera on:
The growth of capital markets contributes to employment opportuni es in financial services,
including brokerage, investment advisory, and fund management.

Conclusion

The capital market is a cornerstone of India's financial system, driving the na on’s economic
progress and bridging the gap between savings and investments. Its robust func oning ensures a
vibrant economy and a sustainable future.

3. Difference between Money market and Capital market.

Ans.

4. Explain in brief instruments of money market

Ans. Money Market Instruments

 Call Money – When a loan is granted for one day and is repaid on the second day, it is
called call money. No collateral securi es are required for this kind of transac on.

 No ce Money – When a loan is granted for more than a day and for less than 14 days, it is
called no ce money. No collateral securi es are required for this kind of transac on.

 Term Money – When the maturity period of a deposit is beyond 14 days, it is called term
money.

 Treasury Bills – Also known as T-Bills, these are Government bonds or debt securi es with
maturity of less than a year. Buying a T-Bill means lending money to the Government.
 Short-term government securi es issued by the Reserve Bank of India (RBI) with maturi es
of 91 days, 182 days, and 364 days.

 Cer ficates of Deposit (CD): Time deposits issued by banks with a specified maturity and
interest rate, generally for a short-term period. Bank takes loan from Corporate. It is issued
in Rs 1,00,000/- or mul ple there of.Maturity period ranges from 7 days to 1 year.

 Commercial Paper (CP): Unsecured short-term promissory notes issued by companies to

meet their working capital needs. Corporate takes loan from Bank. It is issued for Rs
5,00,000/- or mul ple there of. Maturity period ranges from 7 days to 1 year.

 Repurchase Agreements (Repos) (Bank) Short-term borrowing instruments where one

party sells securi es to another with an agreement to repurchase them at a future date at
a predetermined price.

5. Difference between Hedging, Specula on, and Arbitraging.

Ans.
Aspect Hedging Speculating Arbitraging
Objective To protect against To earn profits by To exploit price differences
potential losses from taking risks based on between markets or assets.
price movements. price changes.
Risk Level Low to moderate (risk- High (risk-taking Low (relies on price
reduction strategy). strategy). inefficiencies).
Nature Defensive; focuses on Aggressive; focuses on Neutral; aims for risk-free
minimizing losses. maximizing profits. profit opportunities.
Instrume Derivatives like futures, Stocks, derivatives, or Stocks, currencies, bonds, or
nts Used options, or forwards. any asset expected to derivatives.
fluctuate.
Example A farmer uses futures A trader buys a stock A trader buys gold in one
Scenario contracts to lock in expecting its price to market and sells it in another
crop prices. rise. at a higher price.
Market Depends on reducing Relies on market Exploits inefficiencies or
Depende exposure to market trends and price mispricing in the market.
ncy volatility. movements.
Skill/Kno Moderate; requires High; requires analysis High; requires quick
wledge understanding of risk and prediction of execution and market access.
Required mitigation. market trends.
Outcome Reduces risk, but High risk with the Minimal risk with small,
potential profits are potential for high consistent profits.
limited. returns or losses.
Unit – 2 (Security Analysis)
6. Difference between fundamental and technical analysis.
Ans.

7. Highlight the Six tenets of the Dow Theory or Principles of Dow Theory.
Ans. The Dow Theory is a financial theory that states that the market is in an upward trend if one
of its key averages, such as the Dow Jones Industrial Average (DJIA), surpasses over previous
significant high. This movement is confirmed by a similar rise in another average, like the Dow
Jones Transporta on Average (DJTA). This confirma on suggests that the upward trend is
"broad-based" and not isolated to a single sector.

For example-Say the DJIA reaches an intermediate highô To validate the bullish trend, Investors
look for the DJTA to also climb to a new high .This dual confirma on helps to dis nguish genuine
market trends from temporary fluctua ons. Also, it provides investors with a more reliable signal
of market direc on.

The market discounts everything- This tenet in the Dow theory essen ally means that the
prevailing price of any stock or security considers all relevant informa on. Price and volume
informa on, valua on, earnings and profit poten al, management strength and demand and
supply are all accounted for. So, whenever any new informa on surfaces, the prices will
incorporate those details and change accordingly. This is also known as the Efficiency Market
Hypothesis (EΜΗ).
You can iden fy three types of market trends (Uptrend [High-High, High-low], Downtrend
[Lower-low, Lower-high] and Sideway Trend [High-low, High-low]- The Dow theory iden fies
three types of price trends in the market, depending on the dura on over which they last. They
are:

 Primary trends: These are broad, long-term trends that can last for several years. They are
either over archingly bullish or bearish. If you are planning to invest with a long-term
outlook, primary trends are important for your investment decisions.

 Secondary trends: Secondary trends are smaller correc ve trends that occur within long-
term primary trends. They may last for a few weeks or a few months. For instance, in a
primary bullish market, prices may temporarily decline for 2-3 weeks before rising again.

Minor trends: Minor trends are further smaller trends within secondary price pa erns. They last
for very short periods- from a few hours to a few days. You can use this aspect of the Dow
theory in technical analysis for short-term orders like intraday or swing trades.

Primary trends have three dis nct phases- A closer look at the primary trends reveals three
main phases, where stock prices behave differently. These phases include:

Accumula on: The accumula on phase begins at the end of a prolonged bear market. Retail
investors remain afraid to take long posi ons because of the poten al for further price declines.
However, ins tu onal investors infuse smart money into the market and purchase (or
accumulate) the securi es in large volumes.

Public par cipa on: The accumula on of stocks causes a price reversal and drives it upward. By
using the Dow theory in technical analysis, short-term traders no ce this and begin to buy the
stock, leading to stronger bullish price movements. As public par cipa on grows, it causes the
market to move upward overall.

Distribu on/Panic: In this phase, retail investors con nue to remain op mis c about the price
rally, so the upward movement con nues and peaks. This is when ins tu onal investors start
distribu ng or selling off their holdings, leading to a growing supply. As a result, prices begin to
fall, leading to the start of a downward trend

The indices need to confirm each other- To recognise a bullish or bearish trend, all the indices in
the market must confirm one another. This means that all the indices must move upward for a
trend to be labelled as bullish (or downward for a trend to be labelled as bearish).

The trading volume must also confirm a trend- The volume is a secondary but equally important
indicator as the price in the Dow theory. That is why this tenet suggests that the volume must
confirm a trend to make it more reliable. Rising prices coupled with rising trading volume signals
a strong bullish trend, and falling prices with growing trading volumes mean that the bear market
is strong.

Trends con nue ll the prices show a dis nct reversal- Secondary trends are o en mistaken for
reversals of the primary trends. This tenet in Dow theory helps differen ate between the two. To
recognise a reversal in the primary trend look for confirma on in the indexes. The primary trend
is said to con nue as long as the prices do not reverse from the direc on they are moving in.
8. Write a note on Elliot wave theory.
Ans. The Ellio Wave Theory in technical Analysis describes price movements in the financial
market. Developed by Ralph Nelson Ellio , it observes recurring fractal wave pa erns iden fied
in stock price movements and consumer behaviour. Investors who profit from a market trend are
described as riding a wave.

The Ellio Wave theory was developed by Ralph Nelson Ellio in the 1930s. He studied 75
years' worth of yearly, monthly, weekly, daily, and self-made hourly and 30-minute charts
across various indexes.

Ellio defined rules to iden fy, predict, and capitalize on wave pa erns in books, ar cles, and
le ers summarized in R.N. Ellio 's Masterworks, published in 1994.

Ellio Wave Interna onal is the largest independent financial analysis and market forecas ng
firm whose market analysis and forecas ng are based on Ellio ’s model.

The basic pa ern Ellio described consists of impulsive waves (denoted by numbers) and
correc ve waves (denoted by le ers). An impulsive wave is composed of five subwaves and
moves in the same direc on as the trend of the next larger size.

A correc ve wave is composed of three subwaves and moves against the trend of the next
larger size. As Figure 1 shows, these basic pa erns link to form five- and three-wave structures
of increasingly larger size (larger "degree" in Ellio terminology).

The first small sequence is an impulsive wave ending at the peak labeled 1. This pa ern signals
that the movement of one larger degree is also upward. It also signals the start of a three-wave
correc ve sequence, labeled wave 2.
Unit – 3 (Security Valua on)
9. Consider a 5 years ZCB F.V of ₹1,000/-. It has ‘BB’ ra ng. Yield on the
similar ZCB’s are given below:
T – Bills: 7%
AAA: T + 1%
AA: AAA + 1.5%
A: AA + 2%
BBB: A + 3%
BB: BBB + 2%
Market price of ZCB today is ₹482/-, Calculate Intrinsic value and advice.
Unit – 4 (Risk and Returns)
10.Differen ate between systema c and unsystema c risk.
 11.Calculate expected returns and std.
Ans. See the class note.

Unit – 5+6+8 (PMS)

12.What do mean by por olio management. Explain the objec ve of
por olio management.
Ans. Ac vi es in Por olio Management
The following three major ac vi es are involved in the forma on of an Op mal Por olio
suitable for any given investor:
a. Selec on of securi es.
b. Construc on of all Feasible Por olios with the help of the selected securi es.
c. Deciding the weights/propor ons of the different cons tuent securi es in the por olio so
that it is an Op mal Por olio for the concerned investor.
The ac vi es are directed to achieve an Op mal Por olio of investments commensurate with
the risk appe te of the investor.
Objec ves of Por olio Management

i.Security/Safety of Principal Amount: Security not only involves keeping the principal sum intact but
also its purchasing power.
ii.Stability of Income: To facilitate planning more accurately and systema cally the reinvestment or
consump on of income.
iii.Capital Growth: It can be a ained by reinves ng in growth securi es or through purchase of growth
securi es.
Marketability i.e. the case with which a security can be bought or sold: This is essen al for
providing flexibility to investment por olio.
i.Liquidity i.e. nearness to money: It is desirable for the investor so as to take advantage of a rac ve
opportuni es upcoming in the market.
ii.Diversifica on: The basic objec ve of building a por olio is to reduce the risk of loss of capital
and/or income by inves ng in various types of securi es and over a wide range of industries.
Favourable Tax Status: The effec ve yield an investor gets from his investment depends on tax
to which it is subjected to. By minimising the tax burden, yield can be effec vely improved.
1. Security Analysis

Security analysis cons tutes the ini al phase of the por olio forma on process and consists of
examining the risk-return characteris cs of individual securi es and also the correla on among
them.
 A simple strategy in securi es investment is to buy under-priced securi es and sell overpriced
securi es. But the basic problem is how to iden fy under-priced and overpriced securi es and
this is what security analysis is all about.
There are two alterna ve approaches to analyse any security viz. Fundamental Analysis and
Technical Analysis. Fundamental analysis, concentrates on the fundamental factors affec ng the
company such as the EPS of the company, the dividend pay-out ra o, fundamental factors
affec ng the industry to which the company belongs.
It compares this intrinsic value with the current market price. If the current market price is
higher than the intrinsic value, the share is said to be overpriced and vice versa.
2. Por olio Analysis

Once the securi es for investment have been iden fied, the next step is to combine these to
form a suitable por olio. Each such por olio has its own specific risk-return characteris cs
which are not just the aggregates of the characteris cs of the individual securi es cons tu ng
it. The return and risk of each por olio can be computed mathema cally based on the Risk-
Return profiles for the cons tuent securi es and the pair-wise correla ons among them.
3. Por olio Selec on

The goal of a ra onal investor is to iden fy the Efficient Por olios out of the whole set of
Feasible Por olios men oned in point 2 and then to zero in on the Op mal Por olio sui ng his
risk appe te. An Efficient Por olio has the highest return among all Feasible Por olios having
same or lower Risk or has the lowest Risk among all Feasible Por olios having same or higher
Return. Harry Markowitz’s por olio theory (Modern Por olio Theory) outlines the
methodology for loca ng the Op mal Por olio for an investor out of efficient por olios.
4. Por olio Revision

Once an op mal por olio has been constructed, it becomes necessary for the investor to
constantly monitor the por olio to ensure that it does not lose it op mality. Since the
economy and financial markets are dynamic in nature, changes take place in these variables
almost on a daily basis and securi es which were once a rac ve may cease to be so with the
passage of me. This por olio revision may also be necessitated by some investor-related
changes such as availability of addi onal funds for investment, change in risk appe te, need of
cash for other alterna ve use, etc.
5. Por olio Evalua on

This process is concerned with assessing the performance of the por olio over a selected period
of me in terms of return and risk and it involves quan ta ve measurement of actual return
realized and the risk borne by the por olio over the period of investment.
13.Explain:
A) CAP model
Ans. The Capital Asset Pricing Model (CAPM) is a widely used finance theory that determines
the expected return on an asset, given its risk rela ve to the market. It is based on the
premise that investors need to be compensated for both the me value of money (the risk-
free rate) and the risk they take on (systema c risk, measured by beta).
Key Concepts in CAPM:
1. Risk-Free Rate Rf : The return on a risk-free asset, like a government bond. This is the
baseline return.
2. Beta beta : A measure of an asset’s sensi vity to overall market returns. A beta of 1
means the asset moves in line with the market. A beta greater than 1 means the asset is
more vola le than the market, and less than 1 means it is less vola le.
3. Market Return Rm : The expected return of the market, typically represented by a broad
market index like the S&P Sensex.
4. Expected Return Ri : The return an investor expects to earn on an asset based on its risk
rela ve to the market.
CAPM Formula:
The formula for the expected return of an asset is:
Ri = Rf + beta * (Rm - Rf)
Where:
- ( Ri ) = Expected return of the asset
- ( Rf ) = Risk-free rate
- ( beta ) = Beta of the asset
- ( Rm ) = Expected market return
- ( Rm - Rf ) = Market risk premium (the addi onal return over the risk-free rate for taking on
market risk)
Example of CAPM Analysis:

Let’s say you’re analyzing the stock of Company Y and have the following informa on:
- Risk-free rate Rf = 4% (this could be the return on a 10-year government bond).
- Beta of Company Y betaY = 1.2 (the stock is 20% more vola le than the market).
 Expected market return Rm = 8% (the return expected from the overall market).

Solu on:
Step 1: Apply the CAPM Formula
Using the CAPM formula:
RY = Rf + betaY * (Rm - Rf)
Subs tute the values:
RY = 4% + 1.2 *(8% - 4%)
RY = 4% + 1.2 *4%
RY = 4% + 4.8% = 8.8%
Interpreta on CAPM

The expected return for Company Y is 8.8% based on the CAPM.

- Risk-free rate (4%): The investor could earn 4% from a risk-free investment, like government
bonds.
- Beta (1.2): Since the stock’s beta is 1.2, it is 20% more vola le than the market. This means
the stock is expected to move in the same direc on as the market but with greater
magnitude. If the market goes up by 1%, the stock is expected to rise by 1.2%.
- Market Risk Premium (4%): The difference between the expected return of the market (8%)
and the risk-free rate (4%) is 4%, which compensates investors for the risk of inves ng in
the stock market as a whole.
Thus, based on the risk associated with Company Y (with a higher beta), investors expect an
8.8% return to compensate for the risk rela ve to a risk-free alterna ve.

Key Takeaways from the Example:

- Beta determines the stock's exposure to market movements. A beta of 1.2 means Company
Y is expected to be more vola le than the market.
- Market Risk Premium reflects the addi onal return required by investors for taking on the
risk of inves ng in the market instead of a risk-free asset.
- The expected return (8.8%) is a func on of both the me value of money (through the risk-
free rate) and the stock's risk (through its beta and the market risk premium).
Advantages of CAPM:
- Simplicity: It’s a simple and widely used model for es ma ng expected returns based on
risk.
- Systema c Risk Focus: CAPM focuses on systema c risk, which cannot be diversified away,
making it a useful tool for pricing assets with known market exposure.

Limita ons of CAPM:

- Assump ons: CAPM assumes markets are efficient, investors are ra onal, and there is a
single period investment horizon, which may not hold in real life.
- Beta: Beta is only based on historical data and may not fully capture future risk.
- Simplifica on: It assumes that only market risk ma ers, while in reality, other factors may
influence asset returns.

In summary, CAPM provides a framework for es ma ng the expected return on an asset

based on its risk rela ve to the market, with the assump on that investors are compensated
for both the me value of money and the risk they take on.

B) Arbitrage Pricing Theory

Ans. Arbitrage Pricing Theory (APT) is an asset pricing model that determines the fair price of
an asset based on its rela onship with mul ple macroeconomic factors, rather than relying
on a single market factor (like in the Capital Asset Pricing Model or CAPM). The theory
assumes that there are no arbitrage opportuni es (i.e., riskless profits) in efficient markets.

Key Concepts:
- Mul ple Factors: APT suggests that asset returns are influenced by various factors (e.g.,
interest rates, infla on, GDP growth).
- Linear Rela onship: The return on an asset is a linear func on of these factors.
- No Arbitrage Condi on: If asset prices deviate from their expected value based on these
factors, arbitrageurs will exploit the mispricing, restoring equilibrium.

Formula:
The expected return of an asset is modeled as:
Ri = Rf + b1F1 + b2F2 +…….. + bnFn

Where:
- ( Ri ) = Expected return of asset (i)
- ( Rf ) = Risk-free rate
- ( b1, b2,….., bn ) = Sensi vi es to the respec ve factors (Vola lity)
- ( F1, F2,….., Fn ) = The economic factors (e.g., interest rates, infla on)
Example:
Suppose an investor wants to determine the expected return of a stock. According to APT,
this stock's return can be influenced by factors like interest rates, GDP growth, and infla on.

Let's say:
- Risk-free rate Rf = 3%
- Factor sensi vi es b1, b2 for the stock:
- Sensi vity to interest rates b1 = 0.5
- Sensi vity to infla on b2 = 0.8
- Economic factors:
- Interest rate factor F1 = 2%
- Infla on factor F2 = 1.5%
Solu on:
The expected return of the stock would be:

Ri = 3% + (0.5 mes 2%) + (0.8 mes 1.5%) = 3% + 1% + 1.2% = 5.2%

So, the stock's expected return is 5.2%.
Advantages of APT:
- Flexibility: It allows for mul ple risk factors, making it more adaptable than single-factor
models like CAPM.
- No need for market por olio: APT doesn’t require the assump on that investors hold a
diversified market por olio.

Disadvantages:
- Iden fying the relevant factors is difficult.
- It requires good es mates of factor sensi vi es, which can be challenging in prac ce.

In summary, APT is a more generalized approach to asset pricing, based on the assump on
that returns are influenced by mul ple factors and that markets are free of arbitrage
opportuni es.

C) Mul factor theory

Ans. Mul -Factor Model is an asset pricing model that expands on the concept of CAPM
(Capital Asset Pricing Model) by considering mul ple sources of risk (factors) rather than
just one (the market risk). The theory posits that asset returns are influenced by several
systema c factors, such as macroeconomic variables or other risk factors that affect the
market as a whole, not just the overall market return.
Key Concepts:
1. Mul ple Risk Factors: Instead of relying solely on the market return, mul -factor models
incorporate several factors (e.g., interest rates, infla on, industrial produc on, etc.) that
could explain an asset’s returns.
2. Factor Sensi vi es: Each asset has different sensi vi es (also called factor loadings) to
each of the risk factors.
3. Idiosyncra c Risk: The model also accounts for risk unique to the individual asset, which is
not explained by the factors.
Mul -Factor Model Formula:
The general form of a mul -factor model is:
Ri = alphai + beta1 F1 + beta2 F2 + …. + betan Fn + epsiloni
Where:
- ( Ri ) = Return on asset (i)
- ( alphai ) = Asset-specific alpha (the return independent of the factors)
- ( beta1, beta2, ….., beta n ) = Sensi vi es of asset (i) to the factors (F1, F2, dots, Fn)
- ( F1, F2, …., F n ) = The n different risk factors (e.g., interest rates, infla on)
- ( epsiloni ) = Idiosyncra c (unique) risk of the asset

Example of a Mul -Factor Model:

Let’s assume you are analyzing the return of a stock in a mul -factor model. We will consider
two factors:
1. Factor 1 (Interest rates): The sensi vity of the stock to changes in interest rates.
2. Factor 2 (Infla on): The sensi vity of the stock to changes in infla on.
Given Data:
- Risk-free rate = 3%
- Factor sensi vi es beta1, beta2 :
- ( beta1 ) (sensi vity to interest rates) = 1.5
- ( beta2 ) (sensi vity to infla on) = -0.8
- Factor returns:
- Interest rate factor F1 = 4% (rise in interest rates)
- Infla on factor F2 = 2% (rise in infla on)
Alphai-2%.
Solu on:
Step 1: Calculate Expected Return of the Stock
Using the mul -factor model formula:
Ri = alphai + beta1 F1 + beta2 F2 + epsiloni
Let’s assume the stock alpha alphai is 2% (the stock outperforms the market by 2%
regardless of the factors).
Ri = 2% + (1.5 mes 4%) + (-0.8 mes 2%)
Ri = 2% + 6% - 1.6% = 6.4%
So, the expected return of the stock based on these two factors is 6.4%.
Advantages of Mul -Factor Models:
- More Comprehensive: By considering mul ple factors, these models capture a broader set
of risks and can more accurately explain asset returns.
- Flexibility: They allow for the inclusion of various macroeconomic and market-specific
factors that could impact asset prices.
- Improved Risk Management: By iden fying specific factors affec ng asset returns, investors
can be er manage and hedge risks.

Disadvantages:
- Complexity: Mul -factor models are more complex than single-factor models like CAPM,
requiring es ma on of mul ple factor sensi vi es.
- Data Intensive: They require detailed data on mul ple factors and their rela onships to
asset returns, which can be difficult to obtain or es mate.
- Factor Selec on: Choosing the right factors is not always straigh orward, and incorrectly
iden fied factors can lead to inaccurate predic ons.

D) Henry Theory
Unit – 7
14.Write a note on Mutual Fund.
Ans. A mutual fund is a professionally managed investment vehicle that pools money
from multiple investors to invest in a diversified portfolio of securities, such as stocks,
bonds, money market instruments, or other assets. The primary goal of a mutual fund is
to provide small or individual investors access to professionally managed, diversified
investment opportunities, which might be di icult to achieve independently.

Types of Mutual Funds

1. Equity Funds: Invest primarily in stocks, o ering higher returns but with
increased risk.
2. Debt Funds: Focus on fixed-income securities like bonds, suitable for
conservative investors.
3. Hybrid Funds: Combine equity and debt investments to balance risk and return.
4. Index Funds: Mimic the performance of a specific market index, such as the S&P
500.
5. Money Market Funds: Invest in short-term debt instruments for low-risk and
stable returns.

Advantages

1. Access to Expertise: Investors benefit from professional fund management.

2. Risk Mitigation: Diversification reduces the impact of poor performance by
individual securities.
3. Flexibility: Options to choose funds based on risk appetite, financial goals, and
investment horizon.
4. Transparency: Mutual funds are regulated by bodies like SEBI (in India) or SEC
(in the USA), ensuring investor protection.

Advantages

1. Access to Expertise: Investors benefit from professional fund management.

2. Risk Mitigation: Diversification reduces the impact of poor performance by
individual securities.
3. Flexibility: Options to choose funds based on risk appetite, financial goals, and
investment horizon.
4. Transparency: Mutual funds are regulated by bodies like SEBI (in India) or SEC
(in the USA), ensuring investor protection.
Limitations

1. Fees and Expenses: Management fees and operational costs reduce net
returns.
2. Market Risks: Returns are not guaranteed and depend on market performance.
3. Lock-in Period: Some funds, like ELSS (Equity Linked Savings Scheme), may
have a lock-in period restricting liquidity.
Documents Needed for Investing in Mutual Funds
 Iden ty Proof
 Address Proof
 Bank Account Proof
 KYC Documents
 Income Proof

15.Prac cal sums on Sharpe Ra o, Treynor and Jensen Alpha.

Ans. 1. Sharpe Ra o:
- This ra o tells us how much extra return you get for the risk taken.
- Formula: Sharpe Ra o = (Return of the investment - Risk-free rate) / Standard Devia on

Example:
- Let’s say the risk-free rate (like a government bond return) is 5%.
- If a fund earned 7% with a standard devia on of 0.5%, the Sharpe Ra o would be:
(7% - 5%) / 0.5 = 4
- A higher Sharpe Ra o (like 4) means be er performance per unit of risk.
2. Treynor Ra o:
- This also measures how much return you get for the risk taken, but it uses a different
measure of risk called Beta, which reflects how much the fund moves in rela on to the market.
- Formula: Treynor Ra o = (Return of the investment - Risk-free rate) / Beta
- Example:
- If the risk-free rate is 5% and a fund has a return of 8% with a Beta of 1.2
(8% - 5%) / 1.2 = 2.5
- A higher Treynor Ra o (like 2.5) indicates be er performance rela ve to the market risk
taken.

- Use Sharpe Ra o for general risk assessment and Treynor Ra o for diversified equity funds.
3. Jensen Alpha:
The Jensen measure, also known as Jensen's Alpha, is a risk-adjusted performance metric that
measures the excess return of an investment rela ve to the expected return based on its risk as
measured by the Capital Asset Pricing Model (CAPM). Essen ally, it helps investors understand
whether an investment has performed be er or worse than expected based on its systema c
risk (beta).
Formula
The formula for Jensen's Alpha is:
alpha = Ri - [Rf + beta (Rm - Rf)]
Where:
- ( alpha ) = Jensen's Alpha
- ( Ri ) = Actual return of the investment
- ( Rf ) = Risk-free rate of return (e.g., return on government bonds)
- ( betai ) = Beta of the investment (a measure of its vola lity compared to the market)
- ( Rm ) = Expected return of the market
Interpreta on
- If ( alpha > 0 ): The investment has outperformed the market on a risk-adjusted basis.
- If ( alpha < 0 ): The investment has underperformed the market.
- If ( alpha = 0 ): The investment has performed in line with expecta ons based on its risk.
Example Calcula on
- An investor has an investment in a stock (let's call it Stock A).
- The actual return of Stock A (( Ri )) over a certain period is 12%.
- The risk-free rate (( Rf )) is 3%.
- The expected market return (( Rm )) is 10%.
- The beta of Stock A (( betai )) is 1.2.
Step 1: Calculate the expected return using CAPM
Using the CAPM formula:
Re = Rf + beta (Rm - Rf)
Pu ng in the values:
Re = 3% + 1.2 mes (10% - 3%)
Calcula ng:
Re = 3% + 1.2 mes 7% = 3% + 8.4% = 11.4%
Step 2: Calculate Jensen's Alpha
Now we can calculate Jensen's Alpha: alpha = Ri - Re = 12% - 11.4% = 0.6%
Unit – 9
16.What are the various types of Market Efficiency.
Ans. Market efficiency refers to how well prices in a financial market reflect all available
informa on. A market is considered efficient if it quickly adjusts prices to new informa on,
making it difficult for investors to consistently achieve returns above the market average by using
that informa on.

Types of Market Efficiency

The Efficient Market Hypothesis (EMH), proposed by Eugene Fama in the 1960s, categorizes
market efficiency into three forms:

1. Weak Form Efficiency:

- In weak form efficient markets, current stock prices fully reflect all past trading informa on,
such as stock prices, volumes, and trends.
- Technical analysis, which uses historical prices and volumes to predict future price
movements, is ineffec ve because past price movements cannot predict future prices.
- Example: A stock’s price movement in the past doesn’t give any clue about its future price
trend.
2. Semi-Strong Form Efficiency:
- Semi-strong form efficiency means that stock prices not only reflect all historical trading
informa on but also incorporate all publicly available informa on, such as earnings reports,
news, and macroeconomic data.
- Fundamental analysis, which evaluates a company’s financials and prospects, is unlikely to
provide consistent excess returns.
- Example: A er a company announces a major new product, its stock price should adjust
instantly to reflect the poten al impact, making it impossible to gain an advantage by trading
based on the announcement.
3. Strong Form Efficiency:
- Strong form efficiency suggests that all informa on, both public and private (including insider
informa on), is already reflected in stock prices.
- This means that even insiders cannot earn abnormal returns because all informa on is
already incorporated into market prices.
- Example: Even a corporate insider with non-public informa on would not be able to gain an
advantage because the market has already absorbed that data.