The Preamble of the Securities and Exchange Board of India describes the basic functions of the Securities and Exchange Board of India as to protect the interests of investors in securities and to promote the development of, and to regulate the securities market and for matters connected therewith or incidental thereto. SEBI has to be responsive to the needs of three groups, which constitute the market: a) the issuers of securities b) the investors c) the market intermediaries. SEBI has three functions rolled into one body: quasi-legislative, quasi-judicial and quasi- executive. It drafts regulations in its legislative capacity, it conducts investigation and enforcement action in its executive function and it passes rulings and orders in its judicial capacity. Though this makes it very powerful, there is an appeal process to create accountability. There is a Securities Appellate Tribunal which is a three-member tribunal and is presently headed by Mr. Justice J P Devadhar, a former judge of the Bombay High Court. A second appeal lies directly to the Supreme Court. SEBI has taken a very proactive role in streamlining disclosure requirements to international standards. For the discharge of its functions efficiently, SEBI has been vested with the following powers: 1. To approve by−laws of stock exchanges. 2. To require the stock exchange to amend their by−laws. 3. Inspect the books of accounts and call for periodical returns from recognized stock exchanges. 4. Inspect the books of accounts of financial intermediaries. 5. Compel certain companies to list their shares in one or more stock exchanges. 6. Registration brokers. 5.1.3. Securities Contract Regulation (SCR) Act-1956 The Securities Contracts (Regulation) Act, 1956 ―Act‖ was enacted in order to prevent undesirable transactions in securities and to regulate the working of stock exchanges in the country. The provision of the Act came into force with effect from 20th February, 1957 vide Notification No. SRO 528 dated 16th February, 1957. Definitions: Stock exchange [Section 2(j)] a) a body of individuals, whether incorporated or not, constituted before corporatisation and demutualisation under sections 4A and 4B, or b) a body corporate incorporated under the Companies Act, 1956 whether under a scheme of corporatisation and demutualisation or otherwise, for the purpose of assisting, regulating or controlling the business of buying, selling or dealing in securities. 341
Recognised Stock Exchange [Section 2(f)] means a stock exchange which is for the time being recognized by the Central Government under Section 4 of the Act. Corporatisation [Section 2(aa)] means the succession of a recognised stock exchange, being a body of individuals or a society registered under the Societies Registration Act, 1860 (21 of 1860), by another stock exchange, being a company incorporated for the purpose of assisting, regulating or controlling the business of buying, selling or dealing in securities carried on by such individuals or society. Demutualisation [Section 2(ab)] means the segregation of ownership and management from the trading rights of the members of a recognised stock exchange in accordance with a scheme approved by the Securities and Exchange Board of India (SEBI). Brief Description of Important Sections of the Act: (A) Recognised Stock Exchanges (i) Application for recognition of stock exchanges (Section 3) 3(1): Every stock exchange which desirous of being recognized for the purposes of this Act, may make an application in the prescribed manner to the Central Government (the powers of Central Government with regard to this Act are exercisable by SEBI) 3(2): Every such application shall contain required particulars and be accompanied by a copy of the bye-laws of the stock exchange for the regulation and control of contracts and also a copy of the rules relating in general to the constitution of the stock exchange (ii) Grant of recognition to stock exchanges (Section 4) 4(1): If the Central Government is satisfied, after making such inquiry as may be necessary may grant recognition to the stock exchange subject to some conditions. (iii) Corporatisation and demutualisation of stock exchanges (Section 4A) On and from the appointed date, all recognised stock exchanges (if not corporatised and demutualised before the appointed date) shall be corporatised and demutualised in accordance with the provisions contained in section 4B. (iv) Procedure for corporatisation and demutualisation (Section 4B) 4B(1):All recognised stock exchanges referred to in section 4A shall, within such time as may be specified by the SEBI, submit a scheme for corporatisation and demutualisation for its approval 4B(2): On receipt of the scheme, the SEBI after making such enquiry as may be necessary and if it is satisfied that it may approve the scheme with or without modification. Note: “appointed date” means the date which the SEBI may, by notification in the Official Gazette, appoint and different appointed dates may be appointed for different recognised stock exchanges. (v) Power of Central Government to call for periodical returns or direct inquiries to be made (Section 6) 342
Every recognised stock exchange shall furnish to SEBI periodical returns relating to its affairs as may be prescribed. Every recognised stock exchange and every member thereof shall preserve such books of accounts and other documents for period of not exceeding five years. (vi) Annual reports to be furnished to Central Government by stock exchanges (Section 7) Every recognised stock exchange shall furnish the Central Government a copy of the annual report. (vii) Power of recognised stock exchanges to make bye-laws (Section 9) 9(1) Any recognised stock exchange may, subject to the previous approval of the SEBI, make bye-laws for the regulation and control of contracts. (viii) Power of SEBI to make or amend bye-laws of recognised stock exchanges (Section 10) 10(1) The SEBI may either on a request from the governing body of a recognised stock exchange or on its own motion make bye-laws for all or any of the matters specified in section 9 or amend any bye-laws made by such stock exchange under that section. (ix) Power to suspend business of recognised stock exchanges (Section 12) The Central Government is empowered to suspend the business of recognised stock exchange on an emergency situation by giving notification in the Official Gazette stating the reasons therein, for a period of not exceeding seven days and subject to such conditions as may be specified in the notification. However, in the interest of the trade or the public the said period can be extended from time to time, provided that no such period of suspension can be extended, unless the governing body of the recognised stock exchange has been given an opportunity of being heard in the matter. (x) Conditions for listing (Section 21) Where securities are listed on the application of any person in any recognised stock exchange, such person shall comply with the conditions of the listing agreement with that stock exchange. (xi) Delisting of securities (Section 21A) 21A(1): A recognised stock exchange may delist the securities, after recording the reasons therefor, on any of the ground or grounds as may be prescribed under this Act, provided that the securities of a company shall not be delisted unless the company concerned has been given a reasonable opportunity of being heard. 21A(2): A listed company or an aggrieved investor may file an appeal before the Securities Appellate Tribunal (SAT) against the decision of the recognised stock exchange within fifteen days from the date of the decision of the recognised stock exchange, provided that SAT may, if it is satisfied that the company was prevented by sufficient cause from filing the appeal within the said period, allow it to be filed within a further period not exceeding one month. 343
(xii) Section 22 – Right of appeal against refusal of stock exchanges to list securities of public companies Where a recognised stock exchange refuses to list the securities of any public company or collective investment scheme, the company or scheme may appeal to the Central Government against such refusal, omission or failure, as the case may be: a) within fifteen days from the date on which the reasons for such refusal are furnished to it, or b) where the stock exchange has omitted or failed to dispose of, within the time specified in sub-section (1) of section 73 of the Companies Act, 1956 (1 of 1956) (hereafter in this section referred to as the ―specified time‖), the application for permission for the shares or debentures to be dealt with on the stock exchange, within fifteen days from the date of expiry of the specified time or within such further period, not exceeding one month, as the Central Government may, on sufficient cause being shown, allow. (xiii) Section 22A – Right of appeal to Securities Appellate Tribunal against refusal of stock exchange to list securities of public companies Where a recognised stock exchange refuses to list the securities of any public company or collective investment scheme, the company or scheme may appeal to the SAT against such refusal, omission or failure, as the case may be: a)within fifteen days from the date on which the reasons for such refusal are furnished to it, or b) where the stock exchange has omitted or failed to dispose of, within the time specified in sub-section (1A) of section 73 of the Companies Act, 1956 (1 of 1956), (hereafter in this section referred to as the ―specified time‖), the application for permission for the shares or debentures to be dealt with on the stock exchange, within fifteen days from the date of expiry of the specified time or within such further period, not exceeding one month, as the Securities Appellate Tribunal may, on sufficient cause being shown, allow. 5.1.4. Foreign Exchange Management Act-1999 The Foreign Exchange Management Act, 1999 (FEMA) is an Act of the Parliament of India \"to consolidate and amend the law relating to foreign exchange with the objective of facilitating external trade and payments and for promoting the orderly development and maintenance of foreign exchange market in India\". It was passed in the winter session of Parliament in 1999, replacing the Foreign Exchange Regulation Act (FERA). This act makes offences related to foreign exchange civil offenses. It extends to the whole of India, replacing FERA, which had become incompatible with the proliberalisation policies of the Government of India. It enabled a new foreign exchange management regime consistent with the emerging framework of the World Trade Organisation (WTO). It also paved the way for the introduction of the Prevention of Money Laundering Act 2002, which came into effect from 1 July 2005. Unlike other laws where everything is permitted unless specifically prohibited, under this act everything was prohibited unless specifically permitted. Hence the tenor and tone of the Act was very drastic. It required imprisonment even for minor offences. Under FERA a 344
person was presumed guilty unless he proved himself innocent, whereas under other laws a person is presumed innocent unless he is proven guilty. FEMA is a regulatory mechanism that enables the Reserve Bank of India and the Central Government to pass regulations and rules relating to foreign exchange in tune with the Foreign Trade policy of India. The buying and selling of foreign currency and other debt instruments by businesses, individuals and governments happens in the foreign exchange market. Apart from being very competitive, this market is also the largest and most liquid market in the world as well as in India. It constantly undergoes changes and innovations, which can either be beneficial to a country or expose them to greater risks. The management of foreign exchange market becomes necessary in order to mitigate and avoid the risks. Central banks would work towards an orderly functioning of the transactions which can also develop their foreign exchange market. Whether under FERA or FEMA‘s control, the need for the management of foreign exchange is important. It is necessary to keep adequate amount of foreign exchange from Import Substitution to Export Promotion. Activities such as payments made to any person outside India or receipts from them, along with the deals in foreign exchange and foreign security is restricted. It is FEMA that gives the central government the power to impose the restrictions. Restrictions are imposed on residents of India who carry out transactions in foreign exchange, foreign security or who own or hold immovable property abroad. Without general or specific permission of the MA restricts the transactions involving foreign exchange or foreign security and payments from outside the country to India – the transactions should be made only through an authorised person. Deals in foreign exchange under the current account by an authorised person can be restricted by the Central Government, based on public interest generally. Although selling or drawing of foreign exchange is done through an authorized person, the RBI is empowered by this Act to subject the capital account transactions to a number of restrictions. Residents of India will be permitted to carry out transactions in foreign exchange, foreign security or to own or hold immovable property abroad if the currency, security or property was owned or acquired when he/she was living outside India, or when it was inherited by him/her from someone living outside India. Exporters are needed to furnish their export details to RBI. To ensure that the transactions are carried out properly, RBI may ask the exporters to comply to its necessary requirements. 5.1.5. Disclosure and Investor Protection Guideline Issued by SEBI The Primary function of Securities and Exchange Board of India under the SEBI Act, 1992 is the protection of the investors‘ interest and the healthy development of Indian financial markets. No doubt, it is very difficult and herculean task for the regulators to prevent the scams in the markets considering the great difficulty in regulating and monitoring each and every segment of the financial markets and the same is true for the Indian regulator also. But what are the responsibilities of the regulators to set the system right once the scam has taken place, especially the responsibility of redressing the grievances of the investors so that their confidence is restored? The redressal of investors‘ grievances, after the scam, is the most challenging task before the regulators all over the world and the Indian regulator is not an 345
exception. One of the weapons in the hand of the regulators is the collection and distribution of disgorged money to the aggrieved investors. SEBI had issued guidelines for the protection of the investors through the Securities and Exchange Board of India (Disclosure and Investor Protection) Guidelines, 2000. These Guidelines have been issued by the Securities and Exchange Board of India under Section 11 of the Securities and Exchange Board of India Act, 1992. Before proceeding further we need to be well informed about few important definitions as stated under the guidelines, to start with is; Issuer Company- means a company which has filed offer documents with the Board for making issue of securities in terms of these guidelines , Listed Company- means a company which has any of its securities offered through an offer document listed on a recognised stock exchange and also includes Public Sector Undertakings whose securities are listed on a recognised stock exchange , Merchant Banker- means an entity registered under Securities and Exchange Board of India (Merchant Bankers) Regulations, 1992, Offer Document- means Prospectus in case of a public issue or offer for sale and Letter of Offer in case of a rights issue , Offer for Sale- means offer of securities by existing shareholder(s) of a company to the public for subscription, through an offer document. Eligibility Norms for Companies Issuing Securities: Provisions regarding this are enshrined in Chapter-II of the said guidelines. No company shall make any issue of a public issue of securities, unless a draft prospectus has been filed with the Board, through an eligible Merchant Banker, at least 21 days prior to the filing of Prospectus with the Registrar of Companies (ROCs). Provided that if, within 21 days from the date of submission of draft Prospectus, the Board specifies changes, if any, in the draft Prospectus (without being under any obligation to do so), the issuer or the Lead Merchant banker shall carry out such changes in the draft prospectus before filing the prospectus with ROCs. No listed company shall make any issue of security through a rights issue where the aggregate value of securities, including premium, if any, exceeds ₹50 lacs, unless the letter of offer is filed with the Board, through an eligible Merchant Banker, at least 21 days prior to the filing of the Letter of Offer with RSE. Provided that if, within 21 days from the date of filing of draft letter of offer, the Board specifies changes, if any, in the draft letter of offer, (without being under any obligation to do so), the issuer or the Lead Merchant banker shall carry out such changes before filing the draft letter of offer. No company shall make an issue of securities if the company has been prohibited from accessing the capital market under any order or direction passed by the Board. Pricing by Companies Issuing Securities: These provisions are being dealt in the Chapter-III of the guidelines. A listed company whose equity shares are listed on a stock exchange, may freely price its equity shares and any security convertible into equity at a later date, offered through a public or rights issue. An unlisted company eligible to make a public issue and desirous of getting its securities listed on a recognised stock exchange pursuant to a public issue, may freely price its equity shares or any securities convertible at a later date into equity shares. An eligible company shall be free to make public or rights issue of equity shares in any denomination determined by it in accordance with Sub-section (4) of Section 13 of the Companies Act, 1956 and in 346
compliance with the following and other norms as may be specified by SEBI from time to time: In case of initial public offer by an unlisted company, if the issue price is ₹500/- or more, the issuer company shall have a discretion to fix the face value below ₹10/- per share subject to the condition that the face value shall in no case be less than ₹1 per share; and, if issue price is less than ₹500 per share, the face value shall be ₹10/- per share; The disclosure about the face value of shares (including the statement about the issue price being ―X‖ times of the face value) shall be made in the advertisement, offer documents and in application forms in identical font size as that of issue price or price band.) Pre- Issue Obligations: The pre issue obligations are provided in Chapter-V, they are as follows:- • The lead merchant banker shall exercise due diligence. • The standard of due diligence shall be such that the merchant banker shall satisfy himself about all the aspects of offering, veracity and adequacy of disclosure in the offer documents. • The liability of the merchant banker shall continue even after the completion of issue process. No company shall make an issue of security through a public or rights issue unless a Memorandum of Understanding has been entered into between a lead merchant banker and the issuer company specifying their mutual rights, liabilities and obligations relating to the issue. Contents of Offer Document: In addition to the disclosures specified in Schedule II of the Companies Act, 1956, the prospectus shall also contain all material information which shall be true and adequate so as to enable the investors to make informed decision on the investments in the issue. The prospectus shall also contain the information and statements specified in this chapter and shall as far as possible follow the order in which the requirements are listed in this chapter and summarised in Schedule VIIA. Consequence of Non-Observance of the Guidelines SEBI in case of non-observance of these guidelines (Section 11B) as it seems to be a bar from doing such things which may prejudice the interest of the investors the board can give the following directions:- Direct the persons concerned to refund any money collected under an issue to the investors with or without requisite interest, as the case may be, direct the persons concerned not to access the capital market for a particular period, direct the stock exchange concerned not to list or permit trading in the securities, direct the stock exchange concerned to forfeit the security deposit deposited by the issuer company, any other direction which the Board may deem fit and proper in the circumstances of the case. Provided that before issuing any directions the Board may give a reasonable opportunity to the person concerned. Provided further that if any interim direction is sought to be passed, the Board may give post decisional hearing to such person. 347
SEBI being a premiere institution for dealing with the problems relating to securities has advanced a long way towards protecting the investors from the hazards of the predators existing in the market. As already stated before it has compiled a great bunch of guidelines dedicated to this cause. But the real scenario which came as a consequence was that only the big fishes could escape the net and the small ones were still striving to uphold their existence. In this matter, according to a daily newspaper it has become clear that SEBI had already received suggestion and advice regarding the need for a separate enactment concerning the small investors. As far as it is concerned, the Government has thought of introducing an independent legislation on investor protection to safeguard the interests of small investors. A separate legislation had also been recommended in the report prepared by Mr. Mitra, who was commissioned by the Finance Ministry to draw up the terms of reference for a new Bill. A debate has been on over the need for a separate legislation for protecting the interests of small investors, considering that there are multiple agencies involved in policing companies that raise funds from the public be it public listed companies, or NBFCs (Non-Banking Financial Companies). These include the capital markets regulator, SEBI, the banking regulator, RBI, and the Department of Company Affairs (DCA) which is responsible for regulating unlisted companies. SEBI has been in favour of a separate regulatory agency for the protection of small investors. The regulator had earlier submitted a proposal to the Finance Ministry, outlining the need for a new Act. The setting up of a comprehensive fund for the protection of investors has also been recommended by Mr. Mitra which we see in reality to have been already existing today. In fact, the report has suggested that the existing Investor Protection Fund, the corpus of which is to come from unclaimed dividends, should be merged with the new fund. 5.1.6. Grievance Mechanisms, SEBI Ombudsman Regulations-2003 Powers and Functions of Ombudsman General The Ombudsman shall have the following powers and functions: (a) to receive complaints specified in regulation 13 against any intermediary or a listed company or both; (b) to consider such complaints and facilitate resolution thereof by amicable settlement; (c) to approve a friendly or amicable settlement of the dispute between the parties; (d) to adjudicate such complaints in the event of failure of settlement thereof by friendly or amicable settlement. Other Powers and Functions The Ombudsman shall: a) draw up an annual budget for his office in consultation with the Board and shall incur expenditure within and in accordance with the provisions of the approved budget; b) submit an annual report to the Board within three months of the close of each financial year containing general review of activities of his office; and c) furnish from time to time such information to the Board as may be required by the Board. 348
(2) Every financial year of the Ombudsman shall end on 31st March of each year and the annual report shall be given in such form and manner as may be specified by the Board. Procedure for Redressal of Grievance Grounds of Complaint A person may lodge a complaint on any one or more of the following grounds either to the Board or to the Ombudsman concerned: (i) Non-receipt of refund orders, allotment letters in respect of a public issue of securities of companies or units of mutual funds or collective investments schemes; (ii) Non-receipt of share certificates, unit certificates, debenture certificates, bonus shares; (iii) Non-receipt of dividend by shareholders or unit-holders; (iv) Non-receipt of interest on debentures, redemption amount of debentures or interest on delayed payment of interest on debentures; (v) Non-receipt of interest on delayed refund of application monies; (vi) Non-receipt of annual reports or statements pertaining to the portfolios; (vii) Non-receipt of redemption amount from a mutual fund or returns from collective investment scheme; (viii) Non-transfer of securities by an issuer company, mutual fund, Collective Investment Management Company or depository within the stipulated time; (ix) Non-receipt of letter of offer or consideration in takeover or buy-back offer or delisting; (x) Non-receipt of statement of holding corporate benefits or any grievances in respect of corporate benefits, etc; (xi) Any grievance in respect of public, rights or bonus issue of a listed company; (xii) Any of the matters covered under section 55A of the Companies Act, 1956; (xiii) Any grievance in respect of issue or dealing in securities against an intermediary or a listed company. 5.1.7. Right to Information (RTI) Act-2005 The Right to Information Act (RTI) is an Act of the Parliament of India \"to provide for setting out the practical regime of right to information for citizens\" and replaces the erstwhile Freedom of information Act, 2002. The Act applies to all States and Union Territories of India except Jammu & Kashmir. Under the provisions of the Act, any citizen may request information from a \"public authority\" (a body of Government or \"instrumentality of State\") which is required to reply expeditiously or within thirty days. The Act also requires every public authority to computerise their records for wide dissemination and to proactively certain categories of information so that the citizens need minimum recourse to request for information formally. This law was passed by Parliament on 15 June 2005 and came fully into force on 12 October 2005. The first application was given to a Pune police station. Information disclosure in India was restricted by the Official Secrets Act 1923 and various other special laws, which the new RTI Act relaxes. It codifies a fundamental right of citizens. 349
The Act covers the whole of India except Jammu and Kashmir, where J&K Right to Information Act is in force. It cover all constitutional authorities, including the executive, legislature and judiciary; any institution or body established or constituted by an act of Parliament or a state legislature. It is also defined in the Act that bodies or authorities established or constituted by order or notification of appropriate government including bodies \"owned, controlled or substantially financed\" by government, or non-Government organizations \"substantially financed, directly or indirectly by funds\" provided by the government are also covered in the Act. Private bodies are not within the Act's ambit directly. In a decision of Sarbajit Roy versus Delhi Electricity Regulatory Commission, the Central Information Commission also reaffirmed that privatised public utility companies continue to be within the RTI Act- their privatisation notwithstanding. The Central Information Commission (CIC), consisting of Satyanand Mishra, M.L. Sharma and Annapurna Dixit, has held that the political parties are public authorities and are answerable to citizens under the RTI Act. The CIC, a quasi-judicial body, has said that six national parties - Congress, BJP, NCP, CPI(M), CPI and BSP and BJD - have been substantially funded indirectly by the Central Government and have the character of public authorities under the RTI Act as they perform public functions In August 2013 the government introduced a Right To Information (Amendment) Bill which would remove political parties from the scope of the law. In September 2013 the Bill was deferred to the Winter Session of Parliament. In December 2013 the Standing Committee on Law and Personnel said in its report tabled in Parliament. The RTI process involves reactive (as opposed to proactive) disclosure of information by the authorities. An RTI request initiates the process. Each authority covered by the RTI Act must appoint their Public Information Officer (PIO). Any person may submit a written request to the PIO for information. It is the PIO's obligation to provide information to citizens of India who request information under the Act. If the request pertains to another public authority (in whole or part), it is the PIO's responsibility to transfer/forward the concerned portions of the request to a PIO of the other authority within 5 working days. In addition, every public authority is required to designate Assistant Public Information Officers (APIOs) to receive RTI requests and appeals for forwarding to the PIOs of their public authority. The applicant is required to disclose his name and contact particulars but not any other reasons or justification for seeking information. The Central Information Commission (CIC) acts upon complaints from those individuals who have not been able to submit information requests to a Central Public Information Officer or State Public Information Officer due to either the officer not having been appointed, or because the respective Central Assistant Public Information Officer or State Assistant Public Information Officer refused to receive the application for information. The Act specifies time limits for replying to the request. If the request has been made to the PIO, the reply is to be given within 30 days of receipt. If the request has been made to an APIO, the reply is to be given within 35 days of receipt. 350
If the PIO transfers the request to another public authority (better concerned with the information requested), the time allowed to reply is 30 days but computed from the day after it is received by the PIO of the transferee authority. Information concerning corruption and Human Rights violations by scheduled Security agencies (those listed in the Second Schedule to the Act) is to be provided within 45 days but with the prior approval of the Central Information Commission. However, if life or liberty of any person is involved, the PIO is expected to reply within 48 hours. Since the information is to be paid for, the reply of the PIO is necessarily limited to either denying the request (in whole or part) and/or providing a computation of \"further fees\". The time between the reply of the PIO and the time taken to deposit the further fees for information is excluded from the time allowed. If information is not provided within this period, it is treated as deemed refusal. Refusal with or without reasons may be ground for appeal or complaint. Further, information not provided in the times prescribed is to be provided free of charge. Appeal processes are also defined. 5.1.8. Forward Contacts (Regulation) Act-1952 An act to provide for the regulation of certain matters relating to forward contracts, the prohibition of options in goods and for matters connected therewith. Establishment and Constitution of the Forward Markets Commission (1) The Central Government may, by notification in the official Gazette, establish a Commission to be called the Forward Markets Commission for the purpose of exercising such functions and discharging such duties as may be assigned to the Commission by or under this Act. (2) The Commission shall consist of not less than two, [but not exceeding four] members appointed by the Central Government [one of them being nominated by the Central Government to be the Chairman thereof; and the Chairman and the other member or members shall be either whole-time or part- time as the Central Government may direct]: [Provided that the members to be so appointed shall be persons of ability, integrity and standing who have shown capacity in dealing with problems relating to commerce or commodity markets, or in administration or who have special knowledge or practical experience in any matter which renders them suitable for appointment on the Commission.] (3) No person shall be qualified for appointment as, or for continuing to be, a member of the Commission if he has, directly or indirectly, any such financial or other interest as is likely to affect prejudicially his functions as a member of the Commission, and every member shall, whenever required by the Central Government so to do, furnish to it such information as it may require for the purpose of securing compliance with the provisions of this sub-section. (4) No member of the Commission shall hold office for a period of more than three years from the date of his appointment, and a member relinquishing his office on the expiry of his term shall be eligible for re-appointment. 351
(5) The other terms and conditions of service of members of the Commission shall be such as may be prescribed. Functions of the Commission The functions of the Commission shall be: (a) to advise the Central Government in respect of the recognition of or the withdrawal of recognition from any association or in respect of any other matter arising out of the administration of this Act; (b) to keep forward markets under observation and to take such action in relation to them as it may consider necessary, in exercise of the powers assigned to it by or under this Act;] (c) to collect and whenever the Commission thinks it necessary publish information regarding the trading conditions in respect of goods to which any of the provisions of this Act is made applicable, including information regarding supply, demand and prices, and to submit to the Central Government periodical reports on the operation of this Act and on the working of forward markets relating to such goods; (d) to make recommendations generally with a view to improving the organisation and working of forward markets; (e) to undertake the inspection of the accounts and other documents of [any recognised association or registered association or any member of such association] whenever it considers it necessary; and (f) to perform such other duties and exercise such other powers as may be assigned to the Commission by or under this Act, or as may be prescribed. Powers of the Commission (1) The Commission shall, in the performance of its functions, have all the powers of a civil court under the Code of Civil Procedure, 1908 (5 of 1908), while trying a suit in respect of the following matters, namely: a) Summoning and enforcing the attendance of any person and examining him on oath; b) requiring the discovery and production of any document; c) receiving evidence on affidavits; d) requisitioning any public record or copy thereof from any office; e) any other matters which may be prescribed. (2) The Commission shall have the power to require any person, subject to any privilege which may be claimed by that person under any law for the time being in force, to furnish information on such points or matters as in the opinion of the Commission may be useful for, or relevant to any matter under the consideration of the Commission and any person so required shall be deemed to be legally bound to furnish such information within the meaning of Sec. 176 of the Indian Penal code, 1860 (45 of 1860). (3) The Commission shall be deemed to be a civil court and when any offence described in Sections. 175, 178, 179, 180 or Sec. 228 of the Indian Penal Code, 1860 (45 of 1860), is 352
committed in the view or presence of the Commission, the Commission may, after recording the facts constituting the offence and the statement of the accused as provided for in the Code of Criminal Procedure, 1898 (5 of 1898) forward the case to a Magistrate having jurisdiction to try the same and the Magistrate to whom any such case is forwarded shall proceed to hear the complaint against the accused as if the case had been forwarded to him under Section 482 of the said Code. (4) Any proceeding before the Commission shall be deemed to be a judicial proceeding within the meaning of Sections. 193 and 228 of the Indian Penal Code, 1860 (45 of 1860). 5.1.9. SEBI Investment Advisers Regulations, 2013 The SEBI (Investment Advisers) Regulations, 2013 (―IA Regulations‖) have been notified on January 21, 2013. The IA Regulations came into effect from April 21, 2013. The regulations specify conditions for registration, certification, capital adequacy, risk profiling and suitability, disclosures to made, code of conduct, records to be maintained, manner of conducting inspection, etc. In terms of the IA Regulations, no person shall act as an investment adviser or hold itself out as an investment adviser unless he has obtained a certificate of registration from SEBI on and from the commencement of IA Regulations unless an exemption specifically applies. The IA Regulations are available on the SEBI website www.sebi.gov.in. [Ref. Regulation 3(1)] If any person found to be engaged in providing investment advisory services without getting registered with SEBI, appropriate action as deemed fit, under SEBI Act, 1992 may be initiated. [Ref. Regulation 3(1)]. ―Investment advice‖ is an advice relating to investing in, purchasing, selling or otherwise dealing in securities or investment products, and advice on investment portfolio containing securities or investment products, whether written, oral or through any other means of communication for the benefit of the client and shall include financial planning. Provided that the investment advice given through newspaper, magazines, any electronic or broadcasting or telecommunications medium, which is widely available to the public shall not be considered as investment advice for the purpose of IA regulations. However, investment advisers who make public appearance or make recommendations or offer an opinion concerning securities or public offers through public media while making recommendations through public media, are required to comply with the relevant provisions of SEBI (Research Analysts) Regulations, 2014. Any person, who for consideration, is engaged or willing to engage in the business of providing investment advice to clients or other persons or group of persons is required to make an application to get registration under IA Regulations unless specifically exempted under IA Regulations. A sole proprietor can also make an application for registration as an Investment Adviser, which will be processed as in the case of individual applicant. The regulations provide exemptions to certain persons such as insurance agents, pension advisers, mutual fund distributors, stock broker or sub-broker, portfolio managers, fund manager, advocate, solicitor or law firm, etc., from obtaining registration under regulation 4 353
of IA Regulations subject to the fulfillment of the conditions stipulated. [Ref. Regulation 2(1)(m) and Regulation 4]. In case of a body corporate, which proposes to undertake investment advisory services in addition to its existing activities including but not limited to distribution or execution services, the application for grant of registration as an investment adviser has to be made through a separately identifiable department or division. A body corporate which proposes to undertake only investment advisory services has to make the registration application directly and not through a separately identifiable department or division. Insurance Agents or Insurance Brokers registered with IRDA who provide advice in various insurance products across manufacturers shall be regulated by IRDA only. If such Insurance Agents or Insurance Brokers expand their activities to include investment advice on other financial products, then they may be registered and regulated under IA Regulations for such other financial products other than insurance products. The PFRDA Act envisages registration of pension Advisors by PFRDA. Such Pension Advisors will be registered and regulated by PFRDA. If such advisors advice on other financial products, then they may be subjected to regulation under IA Regulations for their conduct relating to advice of financial products other than pension products. Mutual Fund Distributors registered with Association of Mutual Funds in India (AMFI) can only provide basic advice to its mutual funds clients incidental to its distribution activity. Incidental activities with respect to distribution of mutual funds means providing basic advice pertaining to investment in mutual fund schemes limited to such schemes / products being distributed by him to his clients/ investors or any other MF product. However, if a distributor of mutual fund is engaged in providing investment advice to general investors other than or in addition to mutual fund clients, and in securities (such as shares, debentures, bonds, derivatives, securitised instruments, structured products, units of AIF, REIT, InvIT, etc.) other than or in addition to Mutual Fund Schemes distributed by him, then such distributor is required to get registration as an investment adviser. An investment adviser has fiduciary obligations. A person acting in multiple capacities such as insurance agent, pension advisor, mutual fund distributor, etc. and expand his scope of activities to include investment advice on other financial products or engaged in the financial planning of the clients, then he may be registered and regulated under IA Regulations for advising on such other financial products or financial planning of the clients. In terms of Regulation 4(i) of IA Regulations, persons providing investment advice exclusively to clients based outside India are exempted from obtaining registration under IA Regulations. Persons providing investment advice to Non-Resident Indians or Persons of Indian Origin shall fall within the purview of IA regulations. An investment adviser shall act in a fiduciary capacity towards its clients and shall disclose all conflicts of interests as and when they arise. He shall act honestly, fairly and in the best interests of its clients and in the integrity of the market. He shall maintain an arms-length relationship between his activities as an investment adviser and other activities. He shall also act with due skill, care and diligence in the best interests of its clients and shall ensure 354
that its advice is offered after thorough analysis and taking into account available alternatives based on risk profiling and suitability of the client An investment adviser required to comply with general obligations & responsibilities such as general responsibility, disclosures to clients, maintenance of records, etc, as specified under chapter III of IA Regulations as well as the code of conduct as specified under third schedule of IA regulations. Investment advisers which are banks, NBFCs and body corporate providing distribution or execution services also to their clients shall keep such activities segregated from investment advisory activities. The investment advisory service has to provided by a separately identifiable department or division (SIDD) or a subsidiary, as the case may be and such SIDD or subsidiary shall include the words ‗investment adviser‘ in its name. Further, such distribution or execution services can only be offered subject to the following conditions: The client shall not be under any obligation to avail the distribution or execution services offered by the investment adviser or its affiliates. The investment adviser shall maintain arm‘s length relationship between its activities as investment adviser and distribution or execution services. All fees and charges paid to distribution or execution service providers by the client shall be paid directly to the service providers and not through the investment adviser. An investment adviser shall disclose to its client, any consideration by way of remuneration or compensation or in any other form whatsoever, received or receivable by it or any of its associates or subsidiaries for any distribution or execution services in respect of the products or securities for which the investment advice is provided to the client. If the client desires to avail the execution services, an investment adviser shall, before recommending such services of a stock broker or other intermediary to a client, disclose any consideration by way of remuneration or compensation or in any other form whatsoever, if any, received or receivable by the investment adviser from such intermediary. An investment adviser shall disclose to the client its holding or position, if any, in the financial products or securities which are subject matter of advice. He shall disclose to the client any actual or potential conflicts of interest arising from any connection to or association with any issuer of products/securities, including any material information or facts that might compromise its objectivity or independence in the carrying on of investment advisory services. Further, investment adviser shall, while making an investment advice, make adequate disclosure to the client of all material facts relating to the key features of the products or securities, particularly, performance track record, etc. An investment adviser which is a body corporate or a partnership firm is required to appoint a compliance officer who shall be responsible for monitoring the compliance by the investment adviser in respect of the requirements of the Act, regulations, notifications, guidelines, instructions issued by SEBI. In case of an individual he himself is responsible for such compliance. 355
SEBI (Investment Advisers) Regulations have not prescribed any scale of fee to be charged by the Investment Adviser to its clients. It is as per the agreement between the client and the investment adviser. An investment adviser advising a client may charge fees, subject to any ceiling as may be specified by SEBI, if any. Further, an investment adviser shall ensure that fees charged to the clients are fair and reasonable. SEBI has launched a new web based centralized grievance redress system called SEBI Complaint Redress System (SCORES). Investors can lodge their complaints at http://scores.gov.in. On receipt of complaints, SEBI takes up the matter with the concerned investment adviser and follows up with them for redressal. 356
FINANCIAL DERIVATIVES GLOSSARY A Accrued interest The accrued interest is the amount of interest that has been accumulated from the last coupon date to the date when a bond is bought or sold. Annual coupon A coupon that is paid once a year. Ask price Price a seller is asking. Advisor The organization employed by a mutual fund to give professional advice on the fund‘s investments and to supervise the management of its assets. Asked or Offering Price The price at which a mutual fund‘s shares can be purchased. The asked or offering price means the current net asset value (NAV) per share plus sales charge, if any. For a no-load fund, the asked price is the same as the NAV. Asset Allocation Fund A fund that spreads its portfolio among a wide variety of investments, including domestic and foreign stocks and bonds, government securities, gold bullion and real estate stocks. This gives small investors far more diversification than they could get allocating money on their own. Some of these funds keep the proportions allocated between different sectors relatively constant, while others alter the mix as market conditions change. Automatic Reinvestment A service offered by most mutual funds whereby income dividends and capital gain distributions are automatically invested into the fund by buying additional shares and thus building up holdings through the effects of compounding. American-style option (cf European option) An option that may be exercised any time up until expiry. Arbitrage Exploiting price anomalies in markets to make a riskless profit. At-the-money option When the current share price is the same as the exercise price of the option. B Bid price Price a buyer is offering. 357
Bond A bond is a long-term promise to pay a specific amount on return; thus a fixed interest security generally paying a coupon as well as principal on maturity. Book value Same as face value. Balanced Fund A mutual fund that maintains a balanced portfolio, generally 60% bonds or preferred stocks and 40% common stocks. Bid or Sell Price The price at which a mutual fund‘s shares are redeemed (bought back) by the fund. The bid or redemption price means the current net asset value per share, less any redemption fee or back- end load. Bond Fund A mutual fund whose portfolio consists primarily of corporate or Government bonds. These funds generally emphasize income rather than growth. Bond Rating System of evaluating the probability of whether a bond issuer will default. Various firms analyze the financial stability of both corporate and government bond issuers. Ratings range from AAA or Aaa (extremely unlikely to default) to D (currently in default). Bonds rated BBB or below are not considered to be of investment grade. Mutual funds generally restrict their bond purchases to issues of certain quality ratings, which are specified in their prospectuses. Backwardation (cf contango) When the forwards or futures price is less than the spot price. Basis point risk Risk premium expressed as of one-hundredth part of one percent. Beta A measure of the degree to which an individual share price moves in concert with the market. C Corporate bonds Bonds issued by companies. Coupon The interest rate paid on the specified date to an investor in a bond. Coupon date The date on which the coupon is paid to an investor of a bond. Call option 358
An option where the taker can ‗call‘ the underlying share away from the writer of the option (cf put option). Capital Growth A rise in market value of a mutual fund‘s securities, reflected in its net asset value per share. This is a specific long-term objective of many mutual funds. Closed-Ended Funds A mutual fund with limited capital and fixed number of units issued. Unlike open-end schemes, closed-end funds do not repurchase their units. Commercial Paper Short-term, unsecured promissory notes with maturities. They are issued by corporations, to fund short-term credit needs. Common Stock Fund A mutual fund scheme whose holdings consist mainly of equity shares and usually emphasize growth. Custodian The bank or trust company that maintains a mutual fund‘s assets, including its portfolio of securities or some record of them. Provides safekeeping of securities but has no role in portfolio management. CME Acronym for Chicago Mercantile Exchange (where options and futures were first traded). Contango The normal relationship between forwards or futures prices and spot prices (cf backwardation). Cost of carry The total cost of carrying an asset (commodity or financial) to meet a future contractual obligation. Covered (or scrip-covered) call option writing Occurs when the writer of a call option owns the underlying share (cf naked call writing). D Debenture A fixed interest security issued by a corporation. Default When an issuer cannot meet their payment obligations. Discount Face value is greater than the market value of a bond. 359
Diversification The policy of spreading investments among a range of different securities to reduce the risks inherent in investing. Discount/ Premium The difference between the unit price and the NAV. If there is positive difference, the units are traded at premium whereas the negative difference indicate that the units are traded at a discount. Delta A measure of how much the option price changes for a given change in the share price. Derivative Any asset whose price depends on the price of another (underlying) asset; usually applied to forwards, futures and options contracts. E Exchange traded A security traded on an exchange. Exchange Privilege (Or switching privilege) The right to transfer investments from one fund into another, generally within the same fund group, at nominal cost. Ex-Dividend Date The date on which a fund‘s Net Asset Value (NAV) will fall by an amount equal to the dividend and/or capital gains distribution (although market movements may alter the fund‘s closing NAV somewhat). Most publications which list closing NAVs place an ―EX‖ after a fund‘ name on its ex-dividend date. Expense Ratio The ratio of total expenses to net assets of the fund. This ratio is listed in a fund‘s prospectus. European option An option which can only be exercised at expiry but not before (cf American-style option). Exchange traded option (ETO) An option traded on a recognised exchange; Exercise (or strike) price The price agreed upon for the exchange of an option when the option contract is opened. Expiry date The date at which the option agreement lapses. 360
F Face value Stated value of a security. The maturity value or the amount paid at maturity. Also known as book value and par value. Fund of Funds A mutual fund which invests in the schemes of other mutual funds. Futures Contracts A futures contract is an agreement between two parties to buy / sell an asset at a future date at a certain price. Financial engineering The process of repackaging basic derivatives to form new (usually custom-built) derivative instruments. Forward contract Any contract that creates an obligation in the future. Fungibility The degree to which one asset can legitimately be substituted for another contract. Futures contract A standardised exchange-traded forwards contract. G Government bonds Bonds issued by government. Gross price The price an investor pays to buy the bond. Gilt or G-sec Funds A mutual fund makes investments only in government securities, offering a default free, safe investment option. Global Fund A fund that invests in both Indian. and foreign securities. Growth Fund A mutual fund whose primary investment objective is long-term growth of capital. It invests principally in common stocks with significant growth potential. Going long Buying an asset in the expectation of a rise in the price of the asset, so that it can be resold later at a profit (cf going short). 361
Going short Selling an asset in the expectation of a fall in the price of the asset, so that it can be re-acquired later at a profit (cf going long). H Hedging (or immunisation) Protecting the value of an asset (or portfolio of assets) against price fluctuations. Hybrid derivative security A financially engineered instrument composed of an underlying asset and a derivative over that asset. I Immunisation See hedging. Income Payment of interest and dividends earned on the fund‘s portfolio securities after operating expenses are deducted. Income Fund A mutual fund that primarily seeks current income rather than growth of capital. It will tend to invest in stocks and bonds that normally pay high dividends and interest. Index Fund A mutual fund that seeks to mirror general stock-market performance by matching its portfolio to a broad-based index, such as the S&P CNX Nifty index. International Fund A fund that invests in securities traded in markets outside India. Investment Objective The financial goal (long-term growth, current income, etc.) that an investor or a mutual fund pursues. In-the-money option When the exercise price of a call option is exceeded by the current price of the underlying asset, or the exercise price of a put option is greater than the current price of the underlying asset. Index futures contract A financial futures contract over the value of a basket of shares traded on the Exchange. Index option An option over a basket of shares, such as the Nifty Index (cf share option). Intrinsic value 362
The absolute difference between the exercise price and the price of the underlying asset for in- the-money options. J Junk Bond A speculative bond rated BB or below.‖Junk bonds‖ are generally issued by corporations of questionable financial strength or without proven track records. They tend to be more volatile and higher yielding than bonds with superior quality ratings. ―Junk bond funds‖ emphasize diversified investments in these low-rated, high-yielding debt issues. L Long-term In the fixed interest market, long-term generally means greater than one year. Load A sales charge or commission assessed by certain mutual funds (―load funds,‖) to cover their selling costs. The commission is generally stated as a portion of the fund‘s offering price. Load Fund A mutual fund that levies a sales charge up to 6%, which is included in the offer of its units. A front-end load is the fee charged when buying into a fund; a back-end load is the fee charged when getting out of a fund. M Market value The price a bond sells for in the marketplace. Maturity date The date at which a bond matures. Maturity value Same as face value. Management Fee The amount a mutual fund pays to its investment adviser for services rendered, including management of the fund‘s portfolio. Money Market Fund A mutual fund that aims to pay money market interest rates. This is accomplished by investing in safe, highly liquid securities, including bank certificates of deposit, commercial paper, government securities and repurchase agreements. Money Market funds make these high interest securities available to the average investor seeking immediate income and high investment safety. Margins (initial, variation) The amounts required to be paid to the futures exchange to ensure contracts are honoured at expiry. 363
Mark-to-market The variation margin payments required to square accounts in derivative exchanges. N Net Asset Value Per Share The current market worth of a mutual fund share. Calculated daily by taking the funds total assets securities, cash and any accrued earnings deducting liabilities, and dividing the remainder by the number of shares outstanding. No-Load Fund A commission-free mutual fund that sells its shares at net asset value, either directly to the public or through an affiliated distributor, without the addition of a sales charge. Naked call option writing Occurs when the writer of an option does not own the underlying asset (cf covered writing). Normal curve A bell-shaped probability distribution, commonly used to assess probabilities of events or states of nature needed to calculate the value of options in certain option pricing models (e.g. the Black-Scholes Option Pricing Model). Novation The process of transferring ownership rights of a derivative from an individual who owns the underlying asset to the clearing house. O Over the counter A security that is not traded on an exchange, but transacted over the phone between professional investors and brokers. Open end Fund A mutual fund that buys back or redeems its shares at current net asset value. Most mutual funds continuously offer new shares to investors. Option contract A right, but not an obligation, to perform an agreed-upon action (e.g. to buy or sell a share) sometime in the future. Out-of-the money option The opposite of in-the-money option. Over the counter option An option not traded on a recognised options exchange (cf exchange-traded-option). P Par value Same as face value 364
Point (or basis point) 1/100 of a per cent. Premium When a bond‘s price exceeds face value. Purchase price The amount paid at the time of purchase of bonds. Portfolio Turnover Rate The rate at which the fund‘s portfolio securities are changed each year. If a fund‘s assets total ₹100mn and the fund bought and sold ₹100mn worth of securities that year, its portfolio turnover rate would be 100%. Aggressively managed funds generally have higher portfolio turnover rates than do conservative funds that invest for the long term. High portfolio turnover rates generally add to the expenses of a fund. Prospectus An official document that each mutual fund must publish, describing the mutual fund and offering its shares for sale. It contains information required by the Securities and Exchange Commission. Payoff diagram A payoff diagram which shows the intrinsic value of an option against share price. Premium The full price of the put or call option. Put option An option that enables the taker to ‗place‘ the option to buy an underlying asset from the writer of the option at a predetermined price. Put–call parity The relationship between the price of a put option and the price of a call option. R Record Date The date the fund determines who its shareholders are; ―unit holders of record‖ who will receive the fund‘s income dividend and/or net capital gains distribution. Frequently the business day immediately prior to the dividend distribution date . Redemption Fee A fee charged by a limited number of funds for redeeming, or buying back, fund shares. Redemption Price The price at which a mutual fund‘s shares are redeemed (bought back) by the less expensive fund. The redemption price is usually equal to the current net asset value per share. 365
Reinvestment Date (Payable Date) The date on which a share‘s dividend and/or capital gains will be reinvested (if requested) in additional fund shares. Reinvestment Privilege A service that most mutual funds offer whereby a shareholder‘s income dividends and capital gains distributions are automatically reinvested in additional shares. Rupee-Cost Averaging The technique of investing a fixed sum at regular intervals regardless of stock market movements. This reduces average share costs to the investor, who acquires more shares in periods of lower securities prices and fewer shares in periods of high prices. In this way, investing risk is spread over time. S Security Security is an investment instrument which can be traded by the investor or lender. Short-term In the fixed interest market, short-term generally means one year or less. Specialty Fund A mutual fund specializing in the securities of a particular industry or group of industries or special types of securities. Systematic Investment Plans In case of Systematic Investment Plans, instead of a lump sum amount, investor invests a pre- specified amount in a scheme at pre-specified intervals at the then prevailing NAV. Systematic Withdrawal Plans Many mutual funds offer withdrawal programs whereby shareholders receive payments from their investments. These payments are usually drawn from the fund‘s dividend income and capital gain distributions, if any, and from principal only when necessary. Sector Fund A fund that operates several specialized industry sector portfolios under one umbrella. Transfers between the various portfolios can usually be executed by telephone at little or no cost. Short Selling The sale of a security which is not owned by the seller. The ―short seller‖ borrows stock for delivery to the buyer, and must eventually purchase the security for return to the lender. Spot price The current price of an asset. Standard deviation The most commonly used statistical measure of spread in a sample or population. It is given 366
by application of a formula. Straddle A strategic options position of selling both a put and call on the same underlying security, in the hope that the price of the security will remain stable during the life of the position (this is a short straddle). Strike price See exercise price. T Tender system A system of issuing bond for sale whereby the particular issue is tendered for sale at the price/yield bid. Taker The buyer of a call or put option. Time decay of an option The decline in the time value of an option as time to expiry approaches. Time value The value of an option left over after intrinsic value is deducted from the price of the option. U Underwriter The organization that acts as the distributor of a mutual fund‘s shares to broker/dealers and the public. V Voluntary Plan A flexible plan for capital accumulation, involving no specified time frame or total sum to be invested. Vega The Greek letter denoting a measure of the sensitivity of option price to change in volatility. Volatility The degree of variability exhibited by an asset over time. When denoted by , it usually means the standard deviation of the yield on a non-dividend paying stock which underlies an option. W Wasting asset Any asset whose value declines with time (e.g. an option, whose value declines as time to expiry approaches). Writer The seller of a call or put option. 367
Y Yield Income or return received from an investment, usually expressed as a percentage of market price, over a designated period. For a mutual fund, yield is interest or dividend before any gain or loss in the price per share. Z Zero Coupon Bond Bond sold at a fraction of its face value. It appreciates gradually, but no periodic interest payments are made. Earnings accumulate until maturity, when the bond is redeemable at full face value. Nonetheless, interest is taxable as it accrues. 368
REVIEW QUESTIONS 1. Your client purchased a piece of land on 1.1.2002 for ₹100 000. He sold it on 31.12.2002 for ₹105 000 and received the money on that day. His income from the property during the year was ₹13 000. What was his return (ignoring costs, taxation and inflation)? (a) 5 per cent (b) 11.4 per cent (c) 12 per cent (d) 18 per cent Ans: (d) The rate of return is (105000+13000)/100000 =1.18 that is 18% 2. Risk that is not removed by holding a portfolio of investments is: (a) non-diversifiable risk (b) diversifiable risk (c) risk specific to certain securities (d) business risk Ans: (a) 3. Movement in the capital value of investments is called: (a) market risk (b) flexibility (c) volatility (d) economic risk Ans: (c) 4. Changing government legislation is an example of: (a) financial risk (b) market risk (c) business risk (d) diversifiable risk Ans: (c) 5. Industrial disputes are an example of: (b) diversifiable risk (a) market risk (d) information risk (c) financial risk Ans: (b) 6. Which of the following is an example of diversifiable risk? (a) management styles (b) fluctuating exchange rates (c) interest rates (d) macro economic policies Ans: (a) 7. The following four portfolios are expected to provide a range of returns as shown below. Which portfolio is the riskiest? Portfolio A: -5.6 per cent to 20.5 per cent Portfolio B: -2.8 per cent to 16.4 per cent Portfolio C: 3.6 per cent to 10.2 per cent Portfolio D: 0.7 per cent to 12.5 per cent (a) Portfolio A (b) Portfolio B (c) Portfolio C (d) Portfolio D 369
Ans: (a) Portfolio Range A 26.1% B 19.2% C 6.6% D 11.8% The riskiness is measured by the width of the gap between the upper limit and the lower limit: e.g. for portfolio A this is 20.5–(–5.6) = 26.1%. Thus, portfolio A is the riskiest. It is also the potentially highest yielding portfolio, highlighting the relationship between risk and return. 8. In general terms, the most appropriate investment classes for a client concerned with achieving capital growth from his or her portfolio are: (a) shares and property (b) shares and fixed interest (c) property and fixed interest (d) fixed interest only Ans: (a) 9. In general terms, the most appropriate investment classes for a client concerned about his or her capital value not changing are: (a) shares and property (b) shares and fixed interest (c) property and fixed interest (d) fixed interest only Ans: (d) 10. A client‘s risk tolerance: (a) does not change over time (b) is unlikely to change from one general category to another (c) is based on how much money they have (d) can change with events or with education and experience Ans: (d) 11. Beta is a measure of (b) Specific risk (a) Market Risk (d) Return (c) Overall risk Ans: (a) 370
Following information is used for problems 12, 13 & 14. Assume that the amount invested is ₹40000. Security Expected Return Correlation AB A 20 —— C B 10 0.5 — — C 12 0.6 -0.2 — Variance 0.04 0.16 — 0.02 12. What is the expected return on the portfolio ‗Use equal weights in the portfolio‘?. (a) 15% (b) 14% (c) 20% (d) 13% Ans: (b) 13. What is the covariance between securities A& C? (a) 0.017 (b) -0.169 (c) 0.0169 (d) 0.130 Ans: (c) 14. Assuming no correlation between stocks, and an equal amount of investing in all three stocks what is the risk on portfolio? (a) 0.004 (b) 0.024 (c) 0.080 (d) 3.067 Ans: (b) 371
RISK & RETURN - PRACTICE QUESTIONS AND ANSWERS Q1. You are thinking of acquiring some shares of ABC Ltd. The rates of return expectations are as follows: Possible rate of return Probability 0.05 0.20 0.10 0.40 0.08 0.10 0.11 0.30 Compute the expected return on the investment Solution: Expected return = (0.20) (0.05) + (0.40) (0.10) + (0.10) (0.08) + (0.30) (0.11) = 0.091 = 9.1% Q2. During the past five years, the returns of a stock were as follows: Year Return 1 0.07 2 0.03 3 -0.09 4 0.06 5 0.10 Compute the following: (b) Arithmetic mean (a) Cumulative wealth index (d) Variance (c) Geometric mean (e) Standard deviation Solution: (a) Cumulative wealth index CWI5 = 1 (1.07) (1.03) (0.91) (1.06) (1.10) = 1.169 (b) Arithmetic mean (c) Geometric mean Figure 1 = 0.032 or 3.2% 372
(d) Variance Return in % Deviation Square of Deviation Period Ri (Ri- R ) (Ri- R )2 3.6 12.96 1 7 -0.4 0.16 2 3 -12.4 153.76 3 -9 2.6 6.76 4 6 6.6 43.56 5 10 Variance = = = 54.3 Steps Stat 1 2 By Calculator 3 1-var:exe 4 5 x Freq. 6 71 31 -9 1 61 10 1 AC+Shift+Stat Var5 X n-1 4 7.36 Q3. The expected returns and standard deviations of stocks A and B are: Stock Expected Standard A Return Deviation B 13% 10% 5 18 Rahul buys ₹20,000 of stock A and sells short ₹10,000 of stock B, using all the proceeds to buy more of stock A. The correlation between the two securities is .25. What are the expected return and standard deviation of Rahul‘s portfolio ? Solution: N The expected return on a portfolio is given by: rp (xixri) i1 Rahul has invested ₹30,000 in stock A and – ₹10,000 in stock B. Thus XA = 1.5 and XB = -.5. Therefore, rp = (1.5x13.0%) + (-0.5x5.0%) = 17% The standard deviation of a two-security portfolio is: 373
In Rahul case: (σ p)2 = X2σ2 + X2σ2 + 2X X (σ p) 2 =(1.5)2 (10)2 + (-0.5)2 (18)2 + (2) (1.5) (-0.5) (.25) (10) (18) (σ p) = = 15.4% Q4. Manoj Kumar owns three stocks and has estimated the following joint probability distribution of returns: Out come Stock A Stock B Stock C Probability 1 -10 10 0 .30 2 0 10 10 .20 3 10 5 15 .30 4 20 -10 5 .20 Calculate the portfolio‘s expected return and standard deviation if Manoj invests 20% in stock A, 50% in stock B and 30% in stock C. Assume that each security‘s return is completely uncorrelated, with the returns of the other securities. Solution: The expected returns on the three securities in Manoj‘s portfolio are: rA = (.30 x -10%) + (.20 x 0%) + (.30 x 10%) + (.20 x 20%) = 4.0% rB = (.30 - 10%) + (.20 x 10%) + (.30 x 5%) + (.20 x -10%) = 4.5% rC = (.30 - 0%) + (.20 x 10%) + (.30 x 15%) + (.20 x -5%) = 7.5% The expected return on Manoj portfolio is therefore: rP = (.20 - 4.0%) + (.50 x 4.5%) + (.30 x 7.5%) = 5.3% The standard deviations of the portfolio‘s three securities are: 1 A .30x(10 4.0)2 .20x(0 4.0)2 (.30x(10 4.0)2 (.20x(20 4.0)2 2 58.8 3.2 10.8 51.22 11.1% 1 B .30x(10 4.5)2 .20x(10 4.5)2 (.30x(5 4.5)2 (.20x(10 4.5)2 2 9.1 6.1 0.1 42.22 7.6% 1 C .30x(0 7.5)2 .20x(10 7.5)2 (.30x(15 7.5)2 (.20x(5 7.5)2 2 16.9 1.3 163.9 1.32 6.0% 374
Alternatively, using STAT fuction: Standard Deviation of stock A Set up: STAT : ON STAT I – Var Exe X Freq -10 .3 0 .2 10 .3 20 .2 AC+Shift+Stat Var xσn = 11.13 Std. Deviation of other two stocks B & C can be find out in the same way by changing the value of ‗X‘ The fact that the three securities are uncorrelated with each other simplifies the calculation of the portfolio‘s standard deviation. Specially, P (.20)2 x(11.1)2 (.50)2 x(7.6)2 (.30)2 x(6.0)2 4.9 14.4 3.2 4.7% Q5. Ramesh Sharma owns a portfolio whose market model is expressed as: rp = 1.5% + 0.90ri + epi If the expected return on the market index is 12%, what is the expected return on Ramesh‘s portfolio? Solution: With 12% expected return on the market index, the market model would imply that the expected return on Ramesh‘s portfolio would be: rp = 1.5% + .90 x 12.0% = 12.3% Q6. M.P. Singh owns a portfolio composed of three securities with the following characteristics: Security Beta Standard Deviation Proportion A 1.20 Random Error term .30 5% 375
B 1.05 8 .50 C 0.90 2 .20 If the standard deviation of the market index is 18%, what is the total risk of Singh‘s portfolio? The beta of a portfolio is defined as the weighted average of the component securities betas. In the case of Singh‘s portfolio: 3 p XiBi i1 = (.30 x 1.20) + (.50 x 1.05) + (.20 x 0.90) = 1.07 Further, the standard deviation of a portfolio can be expressed as: 1 P P2 12 e2p 2 In the case of Singh‘s portfolio: 2 1 1 [ =N xi ]2 N X 12 e2i 2 i1 i1 1 = (1.07)2 (18)2 (.30)2(5.0)2 (.50)2(8.0)2 (.20)2(2.0)2 2 1 = 370.9 2.3 16.0 0.22 1 = 389.42 19.7% Q7. Rohan Gupta own a risky portfolio with a 20% standard deviation. If Rohan invests the following proportions in the risk free asset and the remainder in the risky portfolio, what is the standard deviation of Rohan‘s total portfolio? (a) -30% (b) 10% (c) 30% Solution: The standard deviation of a portfolio composed of a risky portfolio and a risk free asset is given by: P Xi a (a) P 1.3 20% 26% (b) P .90 20% 18% (c) P .70 20% 14% Q8. Assume that two securities constitute the market portfolio. Those securities have the following expected returns, standard deviations, and proportions: Security Expected Return Standard deviation Proportion 376
A 10% 20% .40 B 15% 28% .60 Based on this information, and given a correlation of .30 between the two securities and a risk free rate of 5%, specify the equation for the capital market line. Solution: The equation of the CML is: r p = rf + (Rm - Rf) / σm σP In this case, the market portfolio is composed of two securities, A and B. Thus the expected return of the market portfolio is: r m = (XA x rA) + (XB x rB) = (.40 x 10%) + (.60 x 15%) = 13.0% The standard deviation of the market portfolio is: 2 2 1 M X 2 A 2 A X BB 2XAXBABrAB 2 (.40)2 x(20)2 (.60)2 x(28)2 1 2x(.40)x(.60)x(.30)x(20)x(28)2 1 64 282.2 80.62 20.7% Q9. Consider two stocks, P & Q S Expected Return Standard deviation P 16% 25% Q 18% 30% The returns on the two stocks are perfectly negatively correlated. What is the expected return of a portfolio constructed to derive the standard of portfolio return to zero? Solution: The weights that derive the standard deviation of portfolio to zero, when the returns are perfectly negatively correlated, are: Wq = 1 - 0.545 = 0.455 The expected return of the portfolio is: 0.545x16% + 0.455x18% = 16.91%. 377
Q10. Expected return Stock A Stock B Standard deviation 16% s12% Co-efficient of correlation 15% 8% 0.60 (a) What is the covariance between stock A and B? (b) What is the expected return and risk of a portfolio in which A and B hae weights of 0.6 and 0.4 Solution: (a) Covariance (A, B) = 0.60 x 15 x 8 = 72 (b) Expected return = 0.6x16+0.4x12 = 14.4% Risk (standard deviation) = 11.21% Q11. Consider the following information for three mutual funds, A, B and C and the Market. A 12 18 1.1 B 10 15 0.9 C 13 20 1.2 Market Index 11 17 1.00 The mean risk-free rate was 6 percent. Calculate the treynor measure, sharp measure, and Jensen measure for the three mutual funds and the market index. Solution: Trynor measure: Rp Rf p Fund A: 12 6 5.45 1.1 Fund B: 10 6 4.44 0.9 Fund C: 13 6 5.83 1.2 Market Index: 11 6 5.00 1.0 Sharpe Measure: Rp Rf p 378
Fund A: 12 6 0.333 18 Fund B: 10 6 0.267 15 Fund C: 13 6 0.350 20 Market Index: 11 6 0.294 17 Jensen Measure: Rp Rf p(RM Rf) Fund A: 12 6 1.1(5) 0.5 Fund B: 10 6 0.9(5) 0.5 Fund C: 13 6 1.2(5) 1.0 Market Index: 0 (By definition) Q12. Vipul Ahaju‘s worth of the portfolio in the beginning of the year was ₹39,000. At year-end, Vipul received a gift of ₹4,000, which was invested in the portfolio. The portfolio‘s value at year-end was ₹42,000. What was the return on the Vipul‘s portfolio during the year? Solution: For A portfolio that receives å contribution at the end of the measurement period, the rate of return is: R0R = (End value – Beg value – Cont.) / Beg value In Rahul‘s case: RoR = (₹42,000 – ₹39,000 – ₹4000) / ₹39.00 = -.026 = - 2.6% Q13. All stock market indexes are most accurately characterised by which of the following statements about the degree to which they covary together? (a) They are perfectly positively correlated. (b) They are highly positively correlated. (c) They are uncorrelated. (d) They are negatively correlated. (e) It is impossible to generalize, some are highly positively correlated and some are negatively correlated. Ans: (b) Q14. Assume the correlation coefficient r between the rates of return from these two cement sector shares, say, A and G was +0.9. If you took a long position in G and a short position in A (or vice versa) of exactly equal value you would be perfectly hedged. Ans: False 379
Q15. Calculate the (1) expected rate of return, E(r), from the probability distribution of returns below for the ABC common share. FIVE POSSIBILITIES RATES OF RETURN PROBABILITY i=5 -0.5 = -50% 0.1 i=4 -0.1 = -10% 0.25 i=3 0.2 = 20% 0.3 i=2 0.5 = 50% 0.25 i=1 0.9 = 90% 0.1 Total 1.0 The expected rate of return for ABC is which one of the following? (a) The E(r) is 5 percent. (b) The E(r) is 20 percent. (c) The E(r) is 5 percent. (d) The E(r) is 10 percent. (e) The E(r) is 12 percent. Ans: (b) Q16. Which one of the following statements describes the phrase ‗risk‘? (a) The phrase total risk is synonymous with the variability of return from an asset. (b) Bond quality ratings essentially measure the probability that an issue of bonds falls into default. (c) Although Treasury bonds are free from default risk they nevertheless contain substantial amounts of interest-rate risk. (d) Both a and b are true. (e) All the above are true. Ans: (e) Q17. With two assets, as the correlation coefficient between the two assets is reduced, the portfolio‘s risk is reduced. Ans: True Q18. A 50-asset portfolio has —— unique covariance terms. (a) 2499 (b) 1449 (c) 1225 (d) None of the above Ans: (c) Q19. In the two-asset case, the portfolio risk-return possibilities are nonlinear when the correlation between the asset returns is less than + 1. Ans: True 380
The ex post returns of 2 shares are: YEAR RETURN A (%) RETURN B (%) 1991 20 30 1992 -10 -20 1993 15 18 1994 17 10 1995 19 5 Q20. Calculate the covariance of returns. (a) 220.32 (c) 202.38 (b) -420.11 (e) 162.08 (d) 270.36 Ans: (C) Q21. Calculate the correlation coefficient from the above information. (a) .540 Step 1 Stat Step 4 AC+Shift+Stat (b) .869 Step 1 A+BX:EXE Step 5 Reg(7) (c) .923 Step 1 Put Values Step 6 r(3) (d) .758 (Return) = .868 (e) .697 Ans: (b) Two companies, M and N have the following risk and return statistics: Standard deviation (M) = 18%; Standard deviation (N) = 30% Expected Return (M) = 14%; Expected Return (N) = 19% Correlation coefficient =0.28 Q22. Determine the risk of a portfolio of 25 percent M and 75 percent N. (a) 18.25 percent (b) 30.15 percent (c) 24.15 percent (d) 21.75 percent (e) 27.13 percent Ans: (c) Q23. Determine risk of a portfolio of 50 % M and 50 % N from the information given in problem 79. (a) 19.5 percent (b) 21.7 percent (c) 17.8 percent (d) 23.0 percent (e) 25.4 percent Ans: (a) 381
For Questions No. 24 to 27 Risk free rate of return 8% Expected rate of return on market portfolio 16% B of Security A 0.7 B of Security P 1.4 Q24. The expected rate of return of Security A will be (a) 8% (b) 16% 19.2% (c) 13.6% (d) (e) None of above Ans: (c) Q25. The expected rate return of Security P will be (a) 8% (b) 16% None of above (c) 19.2% (d) Ans: (c) Q26. If a security has expected return of 20%, its beta will be (a) 1 (b) 0.5 (c) 1.5 (d) 2 (e) None of above Ans: (c) Q27. If the risk free return is 6% and the expected return is 20%, beta will be (a) 1 (b) 0.4 (c) 1.4 (d) None of above Ans: (c) For Questions No. 28 and 29. Standard deviation of an asset 2.5% Market standard deviation 2.0% Risk- free rate of return 13.0% Expected return on market portfolio 15.0% Correlation co-efficient of portfolio with market 0.8 Q28. Expected rate of return on the portfolio will be (a) 13% (b) 15% 16% (c) 14% (d) (e) None of the above 382
Ans: (b) Q29. If the portfolio beta is 0.5 and risk free return 10%, expected return on the portfolio will be (a) 10% (b) 15% (c) 12.5% (d) 11.25% Ans: (c) Q30. Mrs. Saradha Menon has made investments in the following five securities on 1.1.2004. The number of shares bought, purchase price and the expected price on 31.12.2004 are shown in the table below: Securities No.of shares Cost price Expected year end 65price A 100 50 B 150 30 40 C 75 20 25 D 100 25 E 125 40 32 47 (i) What is the weight of Security D in the above portfolio now? (a) 27% (b) 22% (c) 13.5% (d) 8% Ans: (c) (ii) What is the expected rate of return on security A? (a) 25% (b) 28% (c) 18% (d) 30% Ans: (d) (iii) What is the return on security E? (b) 28% (a) 25% (d) 33.3% (c) 17.5% Ans: (c) (iv) Which of the following figures is approximately equals the return on the portfolio? (a) 15% (b) 17.25% (c) 18.5% (d) 26.76% Ans: (d) Q31. (i) Mrs. Ramana has a portfolio comprising equities, bonds and real estate. The standard deviations are 0.1689, 0.0716 and 0.0345 respectively. (i) The correlations are: (a) 0.45 for equity and bonds (b) 0.35 for equity and real estate (c) 0.2 for bonds and real estate (d) insufficient information Ans: (d) 383
(ii) Find out standard deviation of the portfolio, if the weights are 25%, 50% and 25% respectively. (assuming assets are not correlated) (a) 6.5% (b) 3.25% (c) 5.602 % (d) 8% Ans: (c) (iii) Assume that the proportions of investments are 20% 35% and 40% what is the risk of the portfolio. [use correction as per question (i)] (a) 9.5% (b) 9% (c) 8% (d) 6% Ans: (d) Q32. During the last five years, Mr. Saxena owned securities that had the following annual rates of return: Year Security A Security B 1 0.16 0.12 2 -0.18 -0.21 3 -0.09 0.04 4 -0.07 -0.09 5 0.19 0.15 Which is the preferable security by each of the following measure? i) Arithmetic mean annual rate of return (a) security A (b) security B (c) Both are equally preferable Ans: (c) ii) Geometric mean annual rate of return (a) security A (b) security B (c) Both are equally preferable Ans: (b) iii.) Assume that the average inflation during the holding period of investment is 4%. Real rate of return (a) security A (b) Security B (c) Both are equally preferable Ans: (b) 384
Q33. The following are the assessment of the probabilities of each of the five economic scenarios: Economic Scenario Probability Holding Bonds Cash Shares Period Return (%) Growth with low inflation 0.05 Growth with high inflation 0.2 74 4 6 Normal growth 0.5 20 -10 6 Recession with low inflation 0.2 14 9 6 Recession with high inflation 0.05 0 35 6 -30 0 6 (i) What is the expected return on Shares? (a) 20% (b) 25% (c) 15.8% (d) 13.2% Ans: (d) (ii) What is the expected return on bonds? (a) 9.7% (b) 10% (c) 1.9% (d) 3.0% Ans: (a) (iii) What is the standard deviation of stocks? (a) 29.44% (b) 17.96% 33.93% (c) 25.44% (d) Ans: (b) (iv) What is the standard deviation of bonds? (a) 17.96% (b) 14.57% 15.71% (c) 9.7% (d) Ans: (b) (v) What is the correlation coefficient between stocks and bonds? (a) -0.34 Stat (b) –0.43 (c) +0.43 X (d) –14.52 Ans: (a) Q34. Assume that you own two securities with the following expected returns and standard deviations. The proportion of holding is also indicated. Security Expected return % Standard deviation % Proportions % A 12 15 40 B 15 20 60 385
(i) what is the risk of the portfolio when the correlation between securities is +1.0? (a) 12% (b) 18% (c) 15% (d) 6% Ans: (b) (ii) What is the risk of the portfolio when the correlation between securities is -1? (a) 12% (b) 18% (c) 15% (d) 6% Ans: (d) Q35. Suppose you invest in 4 securities. Company A has an expected return of 20%, Company B 10%, Company C 12% and Company D 9%. You have invested ₹, 40000. (i) What more information is needed to find out the possible return on the portfolio? (a) market value of the investment (b) beta of the shares (c) proportion of investment (d) none of the above Ans: (c) (ii) Assuming that the portfolio is equally weighted, what is the return on the portfolio? (a) 12% (b) 10% (c) 12.75% (d) 11.5% Ans: (c) Q36. A share pays nil dividends and its current market price is 100. The possible selling prices at the end of a year and the probabilities are: Year end price Probability 90 .1 100 .2 110 .4 120 .2 130 .1 (i) What is the expected rate of return at the end of the year? (a) 8% (b) 12% (c) 10% (d) 11% Ans: (c) (ii) What is the standard deviation of expected returns? (a) 10.55% (b) 10.6% (c) 10.9% (d) 10.95% Ans: (d) 386
Q37. Radha Owns the following portfolio. Share Weightages Beta Exp. Return 1 0.35 1.20 15 2 0.25 0.75 11 3 0.4 1.0 12 (i) What is expected return on the portfolio? (a) 8 (b) 10 (c) 12.8 (d) 15 Ans: (c) (ii) What is the portfolio Beta? (b) 0.820 (a) 0.1775 (d) 1.01 (c) 0.5795 Ans: (d) Q38. At the beginning of the year Ray decided to take ₹50,000 in savings out of the bank and invest it in a portfolio of stocks and bonds; ₹20,000 was placed into common stocks and ₹30,000 into corporate bonds. A year later, Ray‘s stock and bond holdings were worth ₹25,000 and ₹23,000 respectively. During the year ₹1,000 cash dividends was received on the stocks and ₹3,000 in coupon payments was received on the bonds. The stock and bond income was not reinvested in Ray‘s portfolio. (i) Find out the return on Ray‘s stock portfolio during the year. Ans: 30% (ii) What was the return on Ray‘s bond portfolio during the year. Ans: 13.3% (iii) Find out the return on Ray‘s total portfolio during the year. Ans: 4% Solution: Ray’s Investment Stock Bond Total Beginning ₹20,000 ₹30,000 ₹50,000 ₹25,000 ₹23,000 ₹48,000 Value One year later ₹1,000 ₹3,000 ₹4,000 Dividend / Receipts (i) The return on Ray‘s stock portfolio during the year: Appreciation of the stock – ₹25,000 – ₹20,000 = ₹5,000 Dividend receipt = ₹1,000 Total return after one year = ₹6,000. i.e. ₹6,000 for ₹.20,000 which works out to 30%. (ii) The return on Ray‘s bond portfolio during the year Depreciation of the bond– ₹30,000 – ₹23,000 = ₹7,000 Coupon receipt = ₹3,000 387
Total return after one year = ₹-4,000. i.e. ₹-4,000 for R.30,000 which works out to - 13.33%. iii) The return on Ray‘s total portfolio during the year. Depreciation of the portfolio – ₹50,000 – ₹48,000 = ₹2,000 Dividend /Coupon receipts = ₹4,000 Total return after one year = ₹2,000. i.e. ₹2,000 for ₹50,000 which works out to 4%. Q39. Determine the expected return on the following portfolio: Securities No. of shares Cost Price Expected A 200 100 Year-End Price B 150 75 C 300 125 140 D 100 65 78 140 95 (i) What is the weight of Security B a) 20% b) 17.21% c) 15% d) 13.51% d) 13% Ans. (c) d) 20% d) 10.96% (ii) The expected return on Security C is. a) 10.71% b) 12% c) 11.32% Ans. (b) (iii) Determine the return on Security A a) 28.57% b) 33.33% c) 40% Ans. (c) (iv) What is the return on the portfolio: a) 21.19% b) 17.48% c) 19.16% Ans. (a) Solution: (i) The weight of Security B: (150x75) (200x100) + (150x75) + (300x125) + (100x65) =15% (ii) The expected return on Security C. The ratio between appreciation and the cost price determines the rate of return. i.e. ₹15 per share on the cost price of ₹125 per share – works out to 12 % (iii) The return on Security A Similar to (ii) above, the ratio between cost price and expected price – i.e. 40 / 100 = 40% 388
(iv) The figure of return on the portfolio that is approx. equals in the following: Similar to (ii) & (iii) above, the total return of Securities No. of Cost Expected Total initial Total shares Price ₹ Year-End investment expected return ₹ A 200 100 Price ₹ ₹ B 150 75 140 28000 C 300 125 78 20000 11700 D 100 65 140 11250 42000 Total 95 37500 9500 Appreciation 6500 91200 75250 21.19% 15950 Q40. With the following data shown in the table below, compute the risk on the portfolio. Security Std.Deviation Proportion 0.91 A 14.5 % 60% d. 14.78 B 18.5 % 40% Corr. Coeff. b. 15.74 c. 16.31 a. 14.5 Ans. (b) Solution: The risk on the portfolio takes into consideration the standard deviations of individual securities and the interactive risk between the pair of securities. Formula: XA = 60% XB = 40% σA= 14.5% σB =18.5% rAB = 0.91 (correlation coefficient) σxy = X2 σ2 + X2 σ2 + 2X X σσ r = square root of → 0.62 * 14.52 + 0.42 * 18.52 + 2* 0.6* 0.4*14.5 * 18.5 * 0.91 = sq. root of 75.69 + 54.76 + 17.17 = sq root of 247.62 = 15.74 Q41. Calculate for securities A and B based on the data given below: Probability Security A - % Security B - % 0.1 40 40 0.2 20 30 0.4 0 15 0.2 -5 0 0.1 -10 -20 389
(i) What is the rate of return and standard deviations on portfolio A and B (ii) Calculate the CoVariance? (iii) Standard Deviation of the Portfolio for equal investment. Solution: (i) Calculate expected rate of return on the portfolio: Expected return on Security A = (0.1*40) + (0.2*20) +(0.4*0) + (0.2*-5) + (0.1*-10) = 6% Expected return on Security B = (0.1*40) + (0.2*30) +(0.4*15) + (0.2*0) + (0.1*-20) = 14% Then, Calculate the standard deviation for both securities Security A = v((0.1*(40-6)2) + (0.2*(20-6)2) +(0.4*(0-6)2) + (0.2*(-5-6)2) + (0.1*(-10-6)2)) = v((0.1*1156) + (0.2*196) +(0.4*36) + (0.2*121) + (0.1*256) )= v219 = 14.8% Security B= v((0.1*(40-14)2) + (0.2*(30-14)2) +(0.4*(15-14)2) + (0.2*(0-14)2) + (0.1*(-20- 14)2)) = v((0.1*676) + (0.2*256) +(0.4*1) + (0.2*196) + (0.1*1156)) = v274 = 16.55% (ii) Further, calculate the covariance between the two securities: Assumption: Equal amount invested in both securities since so proportion is assigned. Covariance: = (0.1*(40-6)(40-14)) + (0.2*(20-6)(30-14)) +(0.4*(0-6)(15-14)) + (0.2*(5-6)(0- 14)) + (0.1*(-10-6)(-20-14))=216 (iii) Further calculate the standard deviation for the portfolio risk: Std. Deviation: = (0.5*14.82 + 0.5*16.552) + (2*0.5*0.5*216) = sq. root of 75.69 + 54.76 + 17.17 = sq root of 247.62 = 15.74 Q42. NPV is calculated in the case of a series of ———————— cash flows. (a) Zero (b) Single (c) Uneven (d) Even Ans: (c) Uneven Q43. The effective interest rate earned per rupee as the periods of compounding increase. (a) Increases (b) Decreases (c) Remains same (d) Decreases for some time and then increases (e) Data insufficient Ans: (a) Increases Q44. The term ie Efficient Frontier ln is contained in. (a) Technical Analysis (b) Modern Portfolio Theory 390
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