UNIT I - Market Organization and Structure

BMP Hypothesis : What matters is how far you can think and
how creative you are!

- Capital market has an original maturity greater than one year (bonds, stocks and
mortgages).

Functions of financial system

1. Saving
- The financial system facilitates saving for people with excess funds whose
incomes exceed expenditures and the excess funds don’t have use in current
time.
- No of loan account in Nepal : 16 lakhs - 20 lakhs (estimated)
- No of savings account in Nepal: 3-4 crore
- In Nepal people enter the financial system to save while in general they enter
to invest and trade.
2. Borrowing
- Borrowing is done by people who don’t have funds in current time but will
generate funds in the future with a earning capacity.
- Financial system helps in time travel of money, you borrow the money today
that is yet to be earned in the future.
3. Risk Management
-
4. Investing and Information oriented traders
- In general most people enter the financial system for investment and trading.
There is a fundamental difference between investor and trader and it is not
the amount of risk and return each individual has. The main difference is
motive.
- Investing : Investors transform/pull current wealth to future wealth where
future wealth should be greater than current wealth and the return is “fair”.
- Information oriented traders : Their motive is to use the information about
the financial market and securities available to generate high returns. The
return in IOT is more than fair, known as “excess return” or “abnormal
return”.
- Abnormal return is not consistent. If someone is consistently generating
abnormal returns then?
- Both investing and information oriented traders can be both long term and
short term.
- Example of short term investor : Interbank lending to maintain CRR sheet.
(In this case bank lending is not a trader but an investor).
 - Information Oriented Traders are also called “Active Portfolio
Managers”. Their performance appraisal is done through α, which is the
excess return over market return.

In developed economies:
- Investment and business generate profit which is reinvested to create capital.
- Capital accumulation in the economy depends on the profit you can generate.
- This is the organic way of creating capital but this is not the reality in today’s
developed world.
- “Creditism” - You are not dependent on profit to generate capital. You can depend on
credit to generate capital.
- Today’s economy is not profit driven but credit driven.

Money Supply
- Increase in money supply is the increase in size of the balance sheet (liabilities) of
Central Bank while decrease in money supply (contractionary policies) is decrease in
the size of balance sheet.
- The increase in money supply of the U.S. is not sustainable but to counteract inflation
which is a result of haphazard increase in money supply, the U.S. imports goods and
services at relatively lower cost.

Assets
1. Securities
2. Currencies
3. Contracts ( Risk Management for Forex Risk)
4. Commodities
5. Real Estate

Securities
- In layman terms, a security is an agreement between the lender and borrower of the
fund.
- Securities are fungible1 and tradable financial instruments used to raise capital in public
and private markets.
1. Fixed income securities: Securities in which the current income/ future payments are
fixed, predetermined and in the case where payments are defaulted by securities
issuer, security holders can go through bankruptcy to get their money. Examples:
i. Bonds
ii. T-bills
iii. Repo
iv. Reverse-repo
2. Equity securities
3. Pooled investments:
- In simple terms pooled investment is the pooling of funds and issuing of
security to those investors from which funds are pooled.

1
Fungible : being something (such as money or a commodity) of such a nature that one part or
quantity may be replaced by another equal part or quality in paying a debt or settling an account.
Examples:
a. Mutual funds : Mutual funds pools funds and issues units to provide ownership
of the pooled funds. This money is invested in different places (diversification)/
different types of market.
- The value of a mutual fund is derived from the assets that the pooled
funds are invested in. Its value is not self-determined.
- Diversification of securities and risk minimization is the major benefit of
mutual funds.
- You get the advices and services of portfolio managers in a mutual fund,
but this is useful only when said portfolio managers can generate α .
- Examples : Growth fund, Balance fund, Exchange fund.
1. Open end mutual fund
- If the units bought can be redeemed by selling mutual funds to the
investment bank/ issuer.
- Additional securities can be issued in open end mutual funds.
2. Closed end mutual fund
- If the units bought can’t be redeemed by selling mutual funds to
the investment bank.
- But it can be sold in the secondary market at a price of Net Asset
Value (NAV).
- Additional securities can’t be issued in close end mutual funds.
b. Hedge funds
- It is a pooled investment fund that holds liquid assets and that makes use
of complex trading and risk management techniques to improve
investment performance and insulate returns from market risk.
- It is an extremely private fund with negligible regulations.
- Hedge fund manager : General Partner
- The General Partner’s task is to invest the money of the Limited Partner.
- GP comes with knowledge.
- Qualified Investor : Limited Partner
- QP comes with money, people with excess funds.
- Investment decisions need not be made public as they don’t issue
securities to the public and are not liable to the public.
- Their issued security is known as “Limited Partner Interest”.
- Financial leverage - It is when one uses borrowed funds (debt) for
funding the acquisition of assets in the hopes that the income of the new
asset or capital gain would surpass the cost of borrowing.
- How hedge funds use leverage.2
Mutual funds and hedge funds are the worst performing financial institutions and hence
prove that active portfolio management doesn’t work as per research.
c. Exchange traded funds3
- If a receipt received by transferring shares to an ETF is traded in the
secondary market, it is called Exchange traded funds.

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Hedge%20funds%20use%20leverage%20in,gains%2C%20but%20also%20the%20losses.
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 - ETF only asks for those portfolios that mimic the market dynamics. E.g. if
the market increases by 2% your portfolio also increases by 2%.
- An ETF mainly mimics a particular stock exchange market.
- Issuer receives hurdle rate if there is no profit and some amount of
commission if there is profit through the market movement.
- The ETF is open ended. (you can get your refund).
- Cash transactions don't happen in an ETF. Transaction of share portfolio
happens.
4. Asset backed securities:
- It is the assets of financial assets (derived securities).
- Loans are grouped into different categories and equity securities are issued
against those categories which is transfer of ownership.
a. Tranche (t1) , (t2), (t3)
- So, the interests earned through those types of loans
- Asset backed securities are hence a liability to the bank.
- This process is called “Securitization” - Originate and distribute : Loan
originates and securities are distributed.
- Asset backed securities is done generally in Mortgage loans and hence it
is also called MBS (Mortgage Backed Security)
- Benefits : Mortgage market is more liquid. It increases the loaning
capacity/ loanable funds of banks.
- Special purpose entity/ Special purpose vehicle : Tranche is sold to a
Special purpose entity and then Tranche sits in the asset of a Special
purpose entity. Thus tranche is not seen in the balance sheet of a bank.

The Big Short - Movie

Asset Management Company
- Asset Management Companies are government backed, have higher holding capacity
and buy bad loans at discounted prices.
- It takes the benefit of the cyclical character of an economy.

Currencies
- It is a form of asset where investment can be done.
- Primary Currency : USD
- Secondary Currency : GBP, Euro, Japanese Yen

Contracts
- As a risk management for Forex Risk.
- Contracts are either American or European. American contracts are flexible and can
be redeemed before maturity. American contracts are usually used for the purpose of
speculation.
- However, European contracts are less flexible and hence can’t be redeemed before
maturity.
Eg. We are to buy a contract for 100M € at 1.25/€ for 3 months.
Here, 1.25/Euro is Forward Price decided 3 months ago but to be paid after 3
months/after the termination of the contract.
 - Settlement:
- Physical : Settlement through the exchange of commodities (oil barrel in case
of forward contract in oil) and cash.
- Cash Basis : The cash equivalent of change in price of commodities in
contract is transferred on cash settlement. For example in the following
forward contract example, 200M is transferred to our account.
- Types of contracts:
1. Forward Contract
- Forward contracts are usually carried out in oil trade.
- For e.g. 100 M oil barrels forward contract with a forward price of
$12/barrel.
- If the price of oil after 3 months is $14/barrel, we get a profit of
$2/barrel.
2. Future Contract
3. Option Contract
- Option contracts are not present in Nepal.
4. SWAP Contract
- We can also invest in these types of contracts. Nepalese commercial banks invest in
Forward Contract, Future Contract and SWAP contract.
- Complex Contracts are the derivatives of the above types of contracts.

Commodities
- One of the mediums of investing in commodities is Contract for Difference (CFD).
CFD is an agreement sold by banks to customers where customers are in the long
position. If price increases you profit the difference in increase of price multiplied by
quantity bought. If price decreases you have to pay the difference in decrease of price
of the given commodity to the bank.
- CFD helps increase liquidity in the market and also helps in faster flow of information
in the market.
- For e.g. 100 M oil barrels forward contract with a forward price of $12/barrel.
- If the price of oil after 3 months is $14/barrel, we get a profit of $2/barrel.

Real Estate4
In the context of world, there are two types of real estate:
1. REIT - Real Estate Investment Trust
- To diversify real estate investment.
- It also makes the real estate market more liquid.
- REIT issue units and the increase in price of real estate is reflected in the price
of the units.
2. MLP - Master limited Partnership

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REIT Vs MLP
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Financial Intermediaries Involved
1. Brokers
- A broker is an individual or firm that charges a fee or commission for
executing buy and sell orders submitted by an investor.
- They bring buyers and sellers together in the same market at the same time.
- Brokers don’t trade in their own account.
- Brokers are order driven.
2. Dealers
- They bring buyers and sellers together in the same market at different times.
- Dealers do trade in their own account.
- Dealers are quote driven.
3. Arbitrageur
- They bring buyers and sellers to different markets at the same time.
- Arbitrageur helps in making the price of stocks/ securities in different
markets similar/same.
4. Brokers - Dealers
5. Exchanges
- NEPSE is an exchange i.e. a common house (online or physical) where market
operations take place.
- In a physical common house far cry out system is used.
6. Alternative trading system
- Investors with significant positions in the market including institutional
investors trade in alternative trading systems.
- The order from those investors is matched by brokers in the exchange
platform without significantly affecting the market price fluctuations.
7. Depository participants
- Brokers take the help of depository participants to settle the trade.
- Depository participants are Banks and Financial Institutions. (BFIs)
8. Insurance Companies
- Used for risk management in the financial market.
- Insurance companies collect funds from share owners of the company.
- Insurance companies sell insurance products with high diversity
(diversification) at a price called premium.
- The risk from insurance products is being transferred to the shareholders of
insurance companies and this risk is mitigated through diversification
strategy.
- Insurance companies also sell insurance products such as CDS - Credit
Default Swap. Popularised by AIG.
- Major assumption for diversification strategy : Not all events take place
simultaneously.
Nick Leeson : Rogue Trader

Position
1. Long
- Long position : Buy and Hold
- Investors maintain “long” security positions in the expectation that the stock
will rise in value in the future.
2. Short
 - Borrowing/Lending of stock/share.
- Borrow share (for 6 months) → sell in the market → certain amount from the
cash accumulated from selling is given to that party from which share is
borrowed as a collateral → Payment in Lieu (payment of dividend of the
borrowed share when dividend is issued) → After 6 months if share price
decreases (profit) / if share price increases (loss) → Collateral money earns
you interest
- Brokers facilitate such transactions and hence take commission on such
transactions.

Leveraged Position
- Margin trading
- Leverage Ratio : Decided by the government of Nepal.

Order
- In order to take the positions we must take orders from the broker.
i. Buy order - tries to go for the lowest price
ii. Sell order - tries to go for the highest price

Orders based on type:

1. Market order :
- Buy or sell based on the best price in the market.
- Lowest price for buy and highest price for sell.
2. Limit order
-
3. Marketable limit order
-
4. AON order
- All or None
-
Orders based on validity:
5. IOC order (Immediate or cancel) FOK (Fill or Kill)
6. Day order
7. GTC order
8. Stop loss order :
- Stop 400, GTC, Sell, Limit 250 : Sells until cancelled if price below 400 up
until 250.
9. GTD order

- In order to take the positions we must take orders from the broker.
i. Buy order - tries to go for the lowest price
ii. Sell order - tries to go for the highest price

Market
1. Primary Market
- IPO (Initial Public Offering) - Unseasoned : Underwriting/ Best effort
 -Two methods:
1. Underwriting
2. Best effort
- Under best effort, the investment bank tries to sell the
shares (IPO) at a lower price to avoid under subscripion
(this is bad to the brand image of the company).
- Thus this undervalued share through market
operations of buying and selling is built in value (book
building) to its actual value.
- This is the reason for the continuous circuit of newly
listed companies and reaches a somewhat stable level
reflecting its true book value.
- First time share distribution to the public.
- Face value : At Rs. 100
- Book building : A measure to reflect the true price/ value of the issued
share. But, not in countries like Nepal dwindled in corruption.
- Road show5
- Following the law of a particular country and around the price
through road show, an IPO is issued.
- Accelerated book building6 : Not in Nepal Fast book building
process (1-2 days), but at a slightly discounted price.
- FPO (Seasosned)
- Following public offering.
- Redistribution of shares to the public to generate further capital.
- Private placement (PIPE)
- PIPE : Private Investment in Public Enterprise
- Issue shares to Qualified Institute Buyers (QIB)
- Disadvantage : Lower liquidity because these shares are not traded in
the secondary market.
- Advantage : Easier to run the Board with qualified and less number of
shareholders.
- Right shares
- DRP
- Dividend reinvestment plan
- Offer to buy shares after dividend payment.
- Share at discounted price
- Not practiced in Nepal.
- Shelf registration
- For companies with big market cap - FPO issuing large shares -
Increases supply of shares - Dramatically decreases the share price -
Downside to both investors and companies.
- To avoid this selling pressure piecemeal placement is followed.
2. Secondary Market
- Main aim : To provide liquidity to the primary market.
1. Call market
- The 10:30 t0 11:00 market in Nepal is called market.

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 - Call market is more liquid than the continuous market.
- Both buyer and seller must be ready to buy and sell to enter the
call market.
2. Continuous market
- TMS platform is a continuous market.
- In our case, pre-opening, opening and post closing.
- Post-closing is the market after 3:00 PM where brokers work on settlement.
- Settlements left today are done pre-opening (10:30-11:00) tomorrow.
- Secondary market are:
1. Order driven : Continuous market
2. Quote driven : Call market
3. Brokered : In which both quote and order are not possible. E.g. real
estate.

UNIT II - Security Market Index

- Index is the average.
- Each index represents the target market.
- Stock index represents the equity market.
- Fixed income index represents the bond market.
- Index is either price dependent/equal-weighted/ market cap dependent/
fundamental value weighted.
- In price weighted index, small movement of those whose price is higher causes major
changes. Influence of each actor is not reflected.
- Disadvantage of equal-weighted index - A fundamentally good company can be
misrepresented, and a bad company is more represented.
- Market capitalization : Total value of firm in market. The firm whose share value is
higher is represented with greater weights.
- Fundamental value : Any fundamental value such as EPS (earnings per share) or
book value dependent index. The firms whose fundamentals are great are better
represented in the market index. This is beneficial to shareholders because the
health of the firm represents the market index.
- Theoretically good/ practically possible/ information generating - Market cap
weighted market index.
- CPI is weighted.
- Measurement
- Application of statistics

1. Price weighted index

 Year Security Beginning No. of End of Return Beginning BPW x R
of year price shares year of year
price price
weight
(BPW)

1 CIT 5000 1 5530 10.6% 0.25 2.70%

2 SCB 500 1 520 4% 0.025 0.10%

3 MEN 200 1 170 -15% 0.0102 -0.15%

4 SKBBL 900 1 840 -6.6% 0.046 -0.30%

5 RBCL 13000 1 13300 2.3% 0.0663 1.53%

19,600 20,360 Total = 1 3.88%

20,360
Also, BPW x R = 19,600
𝑥 100
- Divisor to calculate the beginning Index : Say suppose the divisor is in 100s i.e. for
our example 196.
- Using the divisor our beginning index is 100 then our end index must be 103.88.
- The return and weight don’t match. The one with the highest return doesn’t get the
highest weight in the calculation of the index. The security with higher price impacts
the index highest.
- E.g. Dow Jones

2. Equal weighted index

Securi Beginn No. of Value Return End of Weigh WxR Value

ty ing of share (Initial) year t (W) (Final(
year s (A) price( AxB)
price B)

1 CIT 5000 5.2 26000 10.6% 5530 0.2 2.12% 28756

2 SCB 500 52 26000 4% 520 0.2 0.8% 27040

3 MEN 200 130 26000 -15% 170 0.2 -3% 22100

4 SKBB 900 28.88 26000 -6.6% 840 0.2 -1.33% 24259.

L 2

5 RBCL 13000 2 26000 2.3% 13300 0.2 0.46% 26600

19,600 1,30,00 20,36 -0.95% 12875

0 0 5.2

- To make the value same for all of the securities we change the number of
shares in calculation of the index.
- Assumption : Shares are divisible.
 - Misrepresentation : Overrepresentation of security with higher market cap
and underrepresentation of security with lower market cap. Because of this,
- Divisor : 1300
- Beginning index : 100
- Ending index : 99.05 (100- 0.95)

3. Market Cap weighted index

Yea Securi Beginnin No. of Value Retur End of Weight WxR AxB
r ty g of year shares n period (W)
price outsta price
nding (B)
(A)

1 CIT 5000 10000 5x108 10.6% 5530 0.667 7.076

0 %

2 SCB 500 2000 1x108 4% 520 0.133 0.534

00 %

3 MEN 200 5000 1x106 -15% 170 0.0013 -0.02

%

4 SKBB 900 2000 18x106 -6.6% 840 0.024 -0.16%

L 0

5 RBCL 13000 10000 13x107 2.3% 13300 0.173 0.40%

19,600 20,36 20,36 Total = 7.83% 8076500

0 0 1 00

- Increment from total initial value to total final value (A x B) is equal to W x R

a. Float Market Cap weighted index
- The no. of shares outstanding includes promoter shares also which is
not traded in the market. Thus, to calculate float market cap weighted
index only ordinary shares are taken into account so that promoter
shares and its proportion doesn’t affect the market index.
b. Free Float Market Cap weighted index
- Excluding those shares traded by mutual funds.

4. Fundamental weighted index

 Year Securi Begin No. of EPS Retur End Weig WxR AxB
ty ning share n of ht
of s perio
year outsta d
price nding price

- Weight is decided/ determined through EPS (EPS weighted market index).

Comparing W x R of all indexes

Security Price weighted Equal weight Market cap Fundamental

index index weighted index weighted index

CIT 2.70% 2.12% 7.076%

SCB 0.10% 0.8% 0.534%

MEN -0.15% -3% -0.02%

SKBBL -0.30% -1.33% -0.16%

RBCL 1.53% 0.46% 0.40%

3.88% -0.95% 7.83%

Indices Construction
i. Broad Index : Include every security in the market. E.g. NEPSE, Shanghai Stock
Exchange . Russell 5000, Russell 2000
ii. Narrow Index : S&P 500, selection through different criterias.

Bond Index
- Barclays Bloomberg US Bond Aggregate Index

30th April, 2024

UNIT - III Risk and Return

Return
𝐸𝑛𝑑𝑖𝑛𝑔 𝑤𝑒𝑎𝑙𝑡ℎ − 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑤𝑒𝑎𝑙𝑡ℎ
𝑅𝑒𝑡𝑢𝑟𝑛 = 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑤𝑒𝑎𝑙𝑡ℎ
𝑥 100%
(𝑁 𝑥 𝑃1) + (𝑁 𝑥 𝐷1) − (𝑁𝑥𝑃𝑜)
= (𝑁 𝑥 𝑃𝑜)
𝑁 (𝑃1+𝐷1−𝑃𝑜)
= 𝑁 𝑃𝑜
𝑃1+𝐷1−𝑃𝑜
= 𝑃𝑜
𝑃1−𝑃𝑜 𝐷1
= 𝑃𝑜
+ 𝑃𝑜
𝑃1−𝑃𝑜
where, 𝑃𝑜
is capital gain
𝐷1
𝑃𝑜
is current income/ gain
N → Number of security
P1 → Price after one period
Po→ Beginning price
D1 → Dividend per security
This is similar to:
𝐷1
𝑃𝑜 = 𝐾𝑒−𝑔
𝐷1
𝐾𝑒 − 𝑔 = 𝑃𝑜
𝐷1
𝐾𝑒 = 𝑔 + 𝑃𝑜

- Growth drives the price. If your company has the capacity to grow, theoretically,
only then its share price increases.
- 𝑔 = 𝑅𝑅 𝑥 𝑅𝑂𝐸
RR → Retention ratio (retention ratio of profit)
𝑅𝑅 = 1 − 𝐷𝑃𝑂 where, DPO → Dividend payout ratio
RR is also written as (b).
ROE → Return on equity

Portfolio Return
𝑅𝑃 = 𝑤1𝑅1 + 𝑤2𝑅2 + 𝑤3𝑅3 + 𝑤4𝑅4
Risk
- Risk is the uncertainty of return.
- It is measured by the standard deviation of return.
- The volatility of return is risk.
-
Suppose:

Suppose Return Risk

CBIL 15 30

SCB 10 20
 - Risk per unit of return:
For CBIL : 30/15 = 2
For SCB : 20/10 = 2
- According to risk per unit return, both securities are equally risky and hence equally
favourable by investors.
- Risk/ Return is:
σ
𝐶. 𝑉. (𝐶𝑜𝑒𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑡 𝑜𝑓 𝑣𝑎𝑟𝑖𝑎𝑡𝑖𝑜𝑛) =
𝑋
where, σ is the standard deviation.
𝑋 is the mean.
- Historically, returns follow normal distribution.

Confidence interval and level of significance (ADD)

Risk (table Method)

S1 S2 S3 ………..Sn

S1 𝑤1 σ1
2 2 Cov2,1 𝑤2𝑤1 Cov1,3 𝑤1𝑤3

S2 Cov1,2 𝑤1𝑤2 𝑤2 σ2
2 2 Cov2,3 𝑤2𝑤3

S3 Cov1,3 𝑤1𝑤3 Cov2,3 𝑤2𝑤3 𝑤3 σ3

2 2

.
.
.
Sn 2 2
𝑤𝑛 σ𝑛

Risk of Portfolio
2 2 2 2
σ𝑃 = 𝑤1 σ1 + 𝑤2 σ2 + 2 𝑤1 𝑤2 𝐶𝑜𝑣1, 2

When 2 securities are in a portfolio:

2 2 2 2 2 2
σ𝑃 = 𝑤1 σ1 + 𝑤2 σ2 + 𝑤3 σ3 + 2 * 𝐶𝑜𝑣1, 2 𝑤1𝑤2 + 2 * 𝐶𝑜𝑣2, 3 𝑤2𝑤3 + 2 * 𝐶𝑜𝑣1, 3 𝑤1𝑤3
Weights on the basis of value of shares.
If risk had been weighted average as return is, the benefits of forming a portfolio wouldn’t
exist. If that were the case, diversification wouldn’t yield any benefits.
This is because Standard Deviation can’t be added or subtracted but Variance can be.
Suppose,
1. If two stocks are perfectly positively correlated:
No benefit of making a portfolio.
2 2 2 2
σ𝑃 = 𝑤1 σ1 + 𝑤2 σ2 + 2 𝑤1 𝑤2 𝑟1,2 𝑥 σ2 𝑥 σ1
Since, 𝑟1,2 𝑥 σ1 𝑥 σ2 = 𝐶𝑜𝑉1,2
Here, 𝑟1,2 = 1
So,
2 2
σ𝑃 = (𝑤1 σ1) + (𝑤2 σ2) + 2 𝑤1 𝑤2 σ2 σ1

σ𝑃 = (𝑤1
2. If two stocks are perfectly negatively correlated:
Risk is minimised by diversification.
3. If two stocks have zero correlation:
Risk is minimised by diversification.
Conclusion : When making a portfolio, choose those kinds of securities that are unrelated to
each other i.e. correlation between -1 and +1.
Diversification makes sense in this case because it decreases the risk.

Portfolio
Question no. 1
Consider the following historical prices of the commercial banks.
Including only price appreciation and not dividend payout. This is a good assumption,
because people invest in stock mainly for price appreciation and not current income gain.
Current income gain can also be from bonds and such.

Year End Nabil Citizen HPRNBL (𝑅𝑁 − 𝑅𝑁)

2 HPRCIT (𝑅 − 𝑅 )2 (𝑅𝑁 − 𝑅𝑁)*
Price Bank Investme 𝐶 𝐶
(𝑅𝐶 − 𝑅𝐶)
Ltd. nt Trust

2006 2126 265 - - - -

2007 4020 200 89.09 6445.04 -24.53 3456.26 -4719.72

2008 5200 230 29.35 421.93 15 370.95 -395.62

2009 4185 500 -19.52 802.53 117.39 6910.60 -2354.99

2010 2090 770 -50.06 3465.56 54 389.67 -1162.07

2011 1140 1000 -45.45 2944.04 29.87 19.27 238.20

2012 1267 900 11.14 5.43 -10 1958.95 -103.17

2013 1750 1000 38.12 859.13 10 588.55 -711.08

2014 1650 2000 -5.714 210.92 100 4321.75 -954.74

2015 1909 3000 15.69 47.35 50 247.75 108.31

 2016 2410 3000 26.24 303.84 0 1173.75 -597.19

ARITHMETIC MEAN 15505.78

𝑅𝑁 𝑅𝐶
=8.809 =34.2
6 19437.49 -10652.08

STANDARD DEVIATION 15505.78 19437.49

10−1 10−1
41.5 46.47

COEFFICIENT OF 41.5 46.47

8.809 34.26
VARIATION
4.71 1.35

COVARIANCE −10652.08
9
-1183.56

CORRELATION −1183.56
41.5 𝑥 46.47
-0.6137

For Banks : Market value is lower than its book value because of the preconceived
assumptions in investors that the net worth of a bank will keep on decreasing in the coming
years.
Net worth is the remaining asset given that it pays out all of its liabilities.

a. Calculate the HPR (Holding Period Return) for each year.

𝑃1−𝑃0+𝐷1
𝐻𝑃𝑅 = 𝑃0

Since dividend payout is not given, in our case

𝑃1−𝑃0
𝐻𝑃𝑅 = 𝑃0

b. Calculate the arithmetic mean.

c. Calculate the risk of each share.
2
Risk = (𝑅𝑥 − 𝑅𝑋)
d. Calculate the coefficient of variation for both shares:
σ
𝐶. 𝑉. (𝐶𝑜𝑒𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑡 𝑜𝑓 𝑣𝑎𝑟𝑖𝑎𝑡𝑖𝑜𝑛) =
𝑋
e. Calculate the covariance and correlation between the shares.
∑(𝑅𝑁−𝑅𝑁)(𝑅𝐶 −𝑅𝐶)
𝐶𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = 𝑁−1
𝑟𝐴,𝐵 𝑥 σ𝐴 𝑥 σ𝐵 = 𝐶𝑜𝑉𝐴,𝐵
𝐶𝑜𝑉𝐴,𝐵
𝑟𝐴,𝐵 = σ𝐴 𝑥 σ𝐵

where, 𝑟𝐴,𝐵 is the correlation between A and B.

For (f) and (g) assume that the investor decided to invest equally the
total wealth in the NABIL and CIT stock.
f. Calculate the average return on the portfolio.
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑒𝑡𝑢𝑟𝑛 = 𝑤1𝑅1 + 𝑤2𝑅2
 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑒𝑡𝑢𝑟𝑛 = 0. 5 𝑥 8. 809 + 0. 5 𝑥 34. 26
Hence,
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑒𝑡𝑢𝑟𝑛 = 21. 53
g. Calculate the risk of the portfolio.
2 2 2 2
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑖𝑠𝑘 = 0. 5 * 41. 5 + 0. 5 * 46. 47 + 2 * 0. 5 * 0. 5 * (− 1183. 56)

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑖𝑠𝑘 = 19. 45

h. You decided to form 5 portfolios with the following weight:

Portfolio Weight on Weight on Risk (σ ) Return (RP) CV

𝑃
Nabil CIT

P1 1 0 41.5 8.809 4.7

P2 0.75 0.25 25.69 15.17 1.69

P3 0.5 0.5 19.45 21.53 0.903

P4 0.25 0.75 29.63 27.89 1.0623

P5 0 1 46.47 34.26 1.35

i. Calculate the return and return on each portfolio.
ii. Plot the risk and return of the portfolio in graph (Risk in the X-axis, Return in
the Y-axis)

- Decrease risk increase return happens only on a certain portion of the

graph.
- You can decrease risk and increase return up to the minimum variance
portfolio point.
- Minimum variance portfolio is the point tangent to the curve.
iii. Calculate the minimum variance portfolio.
2
σ𝐵 −𝐶𝑜𝑉𝐴,𝐵
𝑤𝐴 = 2 2
σ𝐴 +σ𝐵 −2𝐶𝑜𝑉𝐴,𝐵
2
46.47 −(−1183.56)
𝑤1 = 2 2
41.5 +46.46 −2𝑥(−1183.56)

w1 = 0.535 (for NABIL)

w2 = 0.465 (for CIT)
 Equation of a line perpendicular to X-axis: 𝑥 = 𝑎
The formula to calculate minimum variance portfolio is calculated by solving
the equation of line perpendicular to X-axis and the quadratic equation of the
curve.
The graph given above is called Feasible Set because it is the only graph
possible through the combination of securities of NABIL and CIT.
Our goal as a portfolio manager is to move Northwest.

Assume that the correlation between the NABIL bank stock and CIT stock
and CIT stock were perfectly negative.
i. You decided to form 5 portfolios with the following weight:

Portfolio Weight on Weight on Risk (σ ) Return (RP) CV

𝑃
Nabil CIT

P1 1 0 41.5 8.809 4.7

P2 0.75 0.25 19.5 15.17 1.29

P3 0.5 0.5 2.485 21.53 0.115

P4 0.25 0.75 24.47 27.89 0.878

P5 0 1 46.45 34.26 1.355

i. Calculate the return and risk on each portfolio.
2 2 2 2
σ𝑃 = 𝑤1 σ1 + 𝑤2 σ2 + 2 𝑤1 𝑤2 𝐶𝑜𝑣1, 2
Cov1,2 = -1
Since,
𝑟𝐴,𝐵 𝑥 σ𝐴 𝑥 σ𝐵 = 𝐶𝑜𝑉𝐴,𝐵
And 𝑟𝐴,𝐵= -1
2 2 2 2
σ𝑃 = 𝑤1 σ1 + 𝑤2 σ2 − 2 𝑤1 𝑤2σ1 σ2
i.e.
σ𝑃 = 𝑤1σ1 − 𝑤2σ2
We also have,
σ1 = 41. 5 (for NABIL)
σ2 = 46. 47(for CIT)
So, using weights and standard deviations.
Since Risk is non-negative, using only positive values.

ii. Plot the risk and return of the portfolio in graph (Risk in X-axis, Return in the
Y-axis)
 iii. Calculate the minimum variance portfolio.
2
σ𝐵 −𝐶𝑜𝑉𝐴,𝐵
𝑤𝐴 = 2 2
σ𝐴 +σ𝐵 −2𝐶𝑜𝑉𝐴,𝐵
2
46.47 −(−1928.5)
𝑤1 = 2 2
41.5 +46.46 −2𝑥(−1928.505)

Hence w1 = 0.528 (For Nabil)

w2 = 0.472 (For CIT)
Assume the correlation between the NABIL bank stock and CIT stock
were perfectly positive.
j. You decided to form 5 portfolios with the following weight:

Portfolio Weight on Weight on Risk (σ ) Return (RP) CV

𝑃
Nabil CIT

P1 1 0 41.5 8.809 4.7

P2 0.75 0.25 42.74 15.17

P3 0.5 0.5 43.98 21.53

P4 0.25 0.75 45.22 27.89

P5 0 1 46.47 34.26
i. Calculate the risk and return on each portfolio.
Cov1,2 = 1
Since,
𝑟𝐴,𝐵 𝑥 σ𝐴 𝑥 σ𝐵 = 𝐶𝑜𝑉𝐴,𝐵
And 𝑟𝐴,𝐵= -1
2 2 2 2
σ𝑃 = 𝑤1 σ1 + 𝑤2 σ2 + 2 𝑤1 𝑤2σ1 σ2
i.e.
σ𝑃 = 𝑤1σ1 + 𝑤2σ2
 We also have,
σ1 = 41. 5 (for NABIL)
σ2 = 46. 47(for CIT)
So, using weights and standard deviations.

ii. Plot the risk and return of the portfolio in graph (Risk in the X-axis, Return in
the Y-axis).

iii. Calculate the minimum variance portfolio.

2
σ𝐵 −𝐶𝑜𝑉𝐴,𝐵
𝑤𝐴 = 2 2
σ𝐴 +σ𝐵 −2𝐶𝑜𝑉𝐴,𝐵
2
46.47 +1928.5
𝑤1 = 2 2
41.5 +46.47 +2𝑥1928.505

Hence w1 = 0.6565 (For Nabil)

w2 = 0.3435 (For CIT)

Conclusion:
1. If two securities or stocks are perfectly positively correlated, there is no benefit of
making a portfolio of them. E..g. when correlation is +1.

2. But, if the correlation is less than 1, the graph curves further and further towards the
Y-axis, making diversification and portfolio advantageous. (See 0.68 correlation)
 3. When correlation is perfectly negatively correlated, we can reduce the risk to nearly
zero. This means that the return on one security compensates the loss on another
security keeping the return nearly constant.

4. Thus, make a portfolio of those kinds of securities that are unrelated i.e. have less
correlation.

Efficient Portfolio:

Assume our Portfolio contains three securities of NABIL,CIT and HDL which gives the above
graph of Risk Vs. Return.
Efficient Portfolio Set should fulfil the two criterias:
1. Maximum return for the same level of risk.
2. Minimum risk for the same level of return.
Efficient Portfolio lies northeast of Minimum Variance Portfolio and is known as Efficient
Portfolio Set.
Thus, the allocation of wealth should be done in certain proportions/ weights in order to stay
in an Efficient Portfolio.
MVP is also efficient because each proportion in below has a reflection in the northeast
direction i.e. Efficient Portfolio Set except MVP.

1. We now add Treasury Bills that have the equation of x=0 (because it entails zero risks
and minimum returns).
 2. When we change the weights of T-bills and our portfolio and again plot their Risk and
Return, it gives rise to a straight line from the intercept to the point of MVP.
This line is also efficient and this gives us reasons to add risk free assets to our portfolio. CB

13th May, 2024

Optimal risky portfolio

Question no. 4
CIT and Nabil are introduced in the portfolio in the weight 0.5 and 0.5 respectively.
Then with the introduction of T-bills, the Risk and return of the portfolio at different
weights is calculated.

𝑅𝑇𝑃 = 𝑤𝑇𝑅𝑇 + 𝑤𝑃𝑅𝑃

RP = 21.5
σ𝑃 = 19. 5
RT = 1
σ𝑇 = 0
2 2 2 2
σ𝑇𝑃 = 𝑤𝑇 σ𝑇 + 𝑤𝑃 σ𝑃 + 2 𝑟𝑇1𝑃 𝑤𝑇 𝑤𝑃σ𝑇 σ𝑃
2 2
= 0 + 𝑤𝑃 σ𝑃 + 0
2 2
= 𝑤𝑃 σ𝑃

= 𝑤𝑃 σ𝑃

Portfolio Weight of Weight of Risk (σ ) Return CV

𝑇𝑃
T-bills (wT) Other Risky (RTP)
portfolio
i.e. ORP
(wP)

T1 1 0 0 1

T2 0.75 0.25 4.875 6.125

T3 0.5 0.5 9.75 11.25

T4 0.25 0.75 14.625 16.375

T5 0 1 19.5 21.5

a. Calculate the return and risk on each portfolio.

b. Plot the risk and return of the portfolio in graph (Risk in the X-axis, Return in the
Y-axis).

Plot :
Here, Nabil and CIT are in constant proportion (50/50).

Portfolio Weight of Weight of Risk (σ ) Return CV

𝑇𝑃
T-bills (wT) Other Risky (RTP)
portfolio
i.e. ORP
(wP)

T1 1 0 0 1

T2 0.75 0.25 4.875 6.125

T3 0.5 0.5 9.75 11.25

T4 0.25 0.75 14.625 16.375

T5 0 1 19.5 21.5

T6 -0.25 1.25 24.375 25.625

T7 -0.5 1.5 29.25 31.75

T8 -1 2 39 42

The negative weight signifies a short position.

Overlap this graph plot with the previous graph plot.

- A portfolio with Risky assets and risk free assets only falls on the capital allocation
line if it is to be efficient.
- The Capital Allocation line extends depending upon your leverage (the amount of
funds you can borrow).
UNIT IV - Capital Asset Pricing Model
- Each point in the Capital Allocation Line has the coordinates of (σ𝑃, 𝑅𝑃).
- Taking points (0, RP) and (σ𝑃, 𝑅𝑃)
- The equation of a line with two points is given by:
𝑦2 − 𝑦1 = 𝑚(𝑥2 − 𝑥1)
Or,
𝑦 = 𝑚𝑥 + 𝐶
Or,
𝑦2−𝑦1
𝑦= 𝑥2−𝑥1
. 𝑥 + 𝑦 − 𝑖𝑛𝑡𝑒𝑟𝑐𝑒𝑝𝑡
𝑅𝑃−𝑅𝑓𝑟
𝑅 =( σ𝑃−0
) σ + 𝑅𝑓𝑟
𝑅𝑃−𝑅𝑓𝑟
𝑅 =( σ𝑃
) σ + 𝑅𝑓𝑟…………………..(i)
Eqn (i) is the Capital Allocation Line.
- Capital Market Line:
- If all the securities/stock in market are taken in the portfolio and their
weights is determined by their market cap (market weight) and then T-bills
are introduced to this package and the weights are changed as above then, the
plot of Risk and Return again gives a straight line, which is called Capital
Market Line.
- The Capital Market line is the most efficient any portfolio can be.
- The equation of Capital Market Line is:
𝑅𝑀−𝑅𝑓𝑟
𝑅 =( σ𝑀
) σ + 𝑅𝑓𝑟
𝑃1−𝑃0
- 𝑅= 𝑃0

- The portfolio plot of average risk and average return, to be efficient should fall
exactly at the Capital Market Line, if it falls below CML it is overvalued
(because it gives less than optimal return, in present time we need to pay more
price) and if it falls above CML it is undervalued (because it gives more than
optimal return, in present time we need to pay less price i.e. since ).
- The return of market package (RM) can be calculated by taking market cap weights of
individual stock/security (using individual components). Since the market index is
also a market cap weighted index, we can also calculate RM as:
𝑅1−𝑅0
𝑅𝑀 = 𝑅0

where, R1 is the market index today.

R0 was the market index yesterday.

16th May, 2024

Security Characteristics Line
- Security characteristic line (SCL) is a regression line, plotting performance of a
particular security or portfolio against that of the market portfolio at every point in
time.
𝑁1−𝑁0
𝑅𝑀 = 𝑁0
𝑃1𝑖−𝑃0𝑖
𝑅𝑖 = 𝑃0𝑖

- Return of scrip Ri v.s. RM plot gives SCL.

- Slope of SCL is β : If market return changes by 1%, the return on our portfolio
changes by β%.
- If β is less than 1, it is less volatile/ less risky than market e.g. in case of
commercial banks.
- If β is higher than 1, it is more volatile/more risky than market e.g. in case of
microfinances, hydropower.
- β is also a measure of Systematic Risk.
- It is also called non-diversifiable risk or market risk.
- It is that part of total risk that is caused by factors beyond the control of a
specific company, such as economic, political and social factors.
- It is captured by the sensitivity of a security’s return with respect to the overall
market return.

Security Market Line:

- Every scrip will have one SCL, since it is for individual scrips. Every individual stock
will also have it’s own slope and hence its own beta β.
- The graph of return as a function of beta is plotted which gives a straight line called
- Beta is slope and has smaller
𝑅𝑖 = 𝑓(β𝑖)
- Y = mx + c
- Eqn of SML is:
𝑅𝑖 = ( 𝑅𝑚 − 𝑅𝑓𝑟 ) βi +𝑅𝑓𝑟
Return of scrip = Market Risk premium * Beta of scrip + Risk free rate of
return
- Cornering:7

7
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 -
- Bullish
- Bearish

22nd May, 2024

Question no. 1

Nepal Arbitrageurs employs many analysts who devise and implement trading strategies.
You are one of the board members of the Nepal Arbitrageur. You are trying to evaluate three
trading strategies that have been used for different periods of time.
a. Ramesh believes that he can predict share movements based on earnings
announcements. In the last 100 days he has earned a return of 6.2 percent
b. Sunil has been very successful in predicting daily movements of the Australian dollar
and the Japanese Yen based on the carry trade. In the last 4 weeks, he has earned 2
percent after accounting for all transaction costs.
c. Lisa follows the fashion industry and luxury retailers. She has been investing in these
companies for the last three months. Her return is 5 percent.
You as a board member are planning to promote one of your employees, however you are
confused by the returns earned over different periods. Annualize returns in all three cases
and make your decision.

Try all the questions given.

30th May, 2024

- Systematic risk is the risk that can’t be diversified away whereas unsystematic risk is
the risk that can be diversified away (firm specific risk)
- Systematic risk impacts the entire market and can’t be diversified whereas
unsystematic risk impacts a specific firm and hence can be diversified.
- In general maximum benefit of diversification can be achieved when there are
approximately 30 scrips in your portfolio. With more than 30 scrips in your portfolio
 the risk becomes asymptotic to increase in the number of scrips. Why n=30,
search ?
𝑅𝑖 = 𝑅𝑓 + (𝑅𝑚 − 𝑅𝑓)β
- Here, β is the systematic risk.
- Explain all of the variables in the equation above.

Performance Evaluation (CAPM)8

1. Sharpe Ratio9
- Sharpe and Treynor’s Ratio should be compared for analytical purposes
whereas M&M Risk Adjusted Measure and Jensen’s Alpha quantify the
differences.
𝑅𝑃−𝑅𝑓 𝑅𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚
𝑆ℎ𝑎𝑟𝑝𝑒 𝑅𝑎𝑡𝑖𝑜 = σ𝑃
= 𝑅𝑖𝑠𝑘

- The sharpe ratio is also the slope of CAL (Capital Allocation Line).
- Sharpe ratio is the risk premium per unit of total market risk that includes
both systematic and unsystematic risk.
2. Treynor’s Ratio
𝑅𝑃−𝑅𝑓 𝑅𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚
𝑇𝑟𝑒𝑦𝑛𝑜𝑟'𝑠 𝑅𝑎𝑡𝑖𝑜 = β𝑃
= 𝑆𝑦𝑠𝑡𝑒𝑚𝑎𝑡𝑖𝑐 𝑅𝑖𝑠𝑘

- Logic : we are able to diversify the unsystematic risk and manage it so taking
unsystematic risk into analysis is not logical.
- Thus, Treynor’s Ratio is the risk premium per unit of systematic risk only.

3. M&M Risk Adjusted Measure

𝑀&𝑀 = 𝑆. 𝑅. 𝑥 σ𝑚 + 𝑅𝑓𝑟
𝑅𝑃−𝑅𝑓
𝑀&𝑀 = σ𝑝
𝑥σ𝑚 + 𝑅𝑓𝑟
- M&M risk adjusted measure is comparable to the market and helps in relative
analysis of your portfolio with respect to the market.
4. Jensen’s Alpha
𝐽𝑒𝑛𝑠𝑒𝑛'𝑠 𝐴𝑙𝑝ℎ𝑎 = 𝑅𝑃 − [(𝑅𝑖 − 𝑅𝑓𝑟)β𝑖 + 𝑅𝑓𝑟]
- When alpha is +ve, the portfolio manager is beating the market by that much
positive number.
- When alpha is -ve, the portfolio manager is losing to the market by that much
negative number.
- In reality, in most cases of portfolio managers, the alpha of portfolio managers is
statistically not different from zero.
- Survivorship bias in mutual fund :10

8
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9
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10

[Link]
0risk%20is%20the%20risk%20that%20the%20reported%20returns,of%20particular%20interest%20
to%20investors.
 - A well developed and well regulated market isn’t easily beatable and only some people
are able to do this consistently such as Warren Buffet and Charlie Monger.

UNIT V - Market Efficiency

Definition11
- “How much does the price of scrip reflect the information?”
- “How quickly the information gets incorporated in prices?”
- “Unanticipated information”
- If a market moves due to anticipated information, that market is not efficient.
- For a market to be highly efficient the information should be incorporated into prices
in the time it takes for an individual investor to complete a trade.
- Market efficiency refers to how well prices of the scrip reflect all available
information.
- The correct value of a scrip is insider information known only to the organization and
any other price is estimated price.
- All the information including insider information will never be reflected in the stock’s
price, hence a market is not fully efficient.
- The value of an asset is the present value of future cash flow from those assets.
- To know that value you need to have all the information there is of the target
company which only happens when you own that company.
- Efficiency is measured on a scale.

4th June, 2024

Factors affecting market efficiency

1. Market participants:
- Some stocks are more followed while some are less followed. The stocks that
are more followed quickly reflect change in information whereas such is not in
the case of less followed stocks.
- The chances of generating abnormal profit is greater in the case of less
followed stocks. Market reaction to the updates in such stocks/companies is
slower.
- Stocks with low market caps whose ownership belongs to a limited number of
market participants are also slow or sometimes work in reverse when
incorporating new information into the stock price. i.e. negative news might
even cause the stock price to rise.
- In case of stocks that are more followed, the gap between market value and
intrinsic value is small because all of the information is quickly reflected
through their price. E.g. bank scrips in Nepal.
- Only with a larger number of market participants can a market be efficient.
2. Information availability and disclosure:
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 - In a market where adequate regulations are not put in place to strictly disclose
all relevant information of companies registered in the stock exchange to the
public such as in Nepal, market efficiency is a farfetched concept.
- Management discussion and analysis (MDA) : A section of annual report that
consists of future plans of a company. This information should also, in theory,
be made public to keep the market efficient.
3. Limit on trading:
- Restrictions on available trading instruments also restrict quick flow and
reflection of information on scrip prices.
- For example, the restriction on short sell restricts bad scrips from decreasing
in value as much as it should have in the absence of any such restrictions.
- E.g. there is a trading limit and restrictions on buying scrip with low market
cap/ bad scrips by mutual funds. When institutional investors such as mutual
funds are restricted from a portion of the market, that portion becomes less
followed.
4. Information acquisition and taxation cost:
- Cost required (manpower cost/technology cost) to acquire information -
information acquisition cost
- Cost associated with buying/selling of scrip - broker commission and charge,
capital appreciation tax - taxation cost.
- Higher the information acquisition and taxation cost, higher is the price vs.
cost differential of a scrip and lower is the market efficiency.

Efficient-market theory12
The efficient-market hypothesis says that financial markets are effective in processing and
reflecting all available information with little or no waste, making it impossible for investors
to consistently outperform the market based on information already known to the public. In
1970, Fama wrote another paper that explored the idea of market efficiency in more depth,
noting that it seemed to take three forms:
1. Weak form efficiency
- In this form, market prices reflect all past trading information, such as
historical prices and trading volumes.
- According to weak-form efficiency, technical analysis (the study of past price
and volume data) cannot consistently generate excess returns because this
information is already reflected in stock prices.
- Excess return/ Abnormal return = Actual return - Expected return
2. Semi-strong form efficiency
- This idea says that all publicly available information, including news and past
trading data, is fully reflected in stock prices.
- As a result, neither technical analysis nor fundamental analysis (the study of
financial statements and economic factors) can consistently beat the market,
because all available information is already incorporated into prices.
3. Strong form
- There is no information that is left to be incorporated in the stock price.
- No market can be strong-form efficient because of the probability of insider
trading and also because insider information is rarely known to the public.

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 - However, developed capital markets might be strong- form efficiency.

Efficient market hypothesis further says that stock’s future movement follows Random walk
- Random walk theory.
i.e. You can’t predict the future movement of a stock by studying its past movement.

Anomalies in Random walk theory

- Serial correlation in the price of stock, in each quarter of past years, the stock’s price
has consistently increased for unknown reasons.
- Behavioural financial economists tried explaining the anomalies citing that human
beings are innately irrational but these theories also have criticisms.

6th June, 2024

Lists of Anomalies

1. Year End
1. Window dressing
- It is seen through evidence that returns increase at the turn of the year. (start
of new fiscal year)
- This is because a company (institutional investor) throws bad scripts and
retains good scripts - phenomenon known as window dressing.
- They however buy back those scripts as we move on with the rest of the fiscal
year.
2. Loser stock selling at the end of the year, so that you book loss and decrease your
taxation amount. The institutional investor however buys back the loser stocks in
later months when the price of those stocks has significantly decreased due to mass
selling at the end of the year.

2. Weekend
1. Buy at the end of the week (Thursday) before the stock market closes and sell at the
start of the week (Sunday) immediately after the stock market reopens.
- This phenomenon leads to an increase in returns at the start of the week and
decrease in returns at the end of the week.

3. Holiday Effect : Public Holiday

- mixed reaction : Increase/ decrease before/after public holiday
- Explanation : When people are in a positive mood before holiday they buy shares and
if they are in a negative mood they don’t. Thus holiday mood/ sentiment determines
whether buying/ selling increases.
- Further, allocation of funds/resources from stocks to holiday spending will also have
an impact.
4. Size
- Stocks with low cap are seen to have high return and stocks with high cap are seen to
have low return.

5. Value
- P|E ratio i.e. Price to earnings ratio (How valuable is $1 earned by the company to
you?)
- Value stock has low P|E whereas Growth stock has high P|E
- Value stocks outperform growth stocks in an underdeveloped market, but such
anomaly decreases as the market moves towards greater efficiency.

6. Momentum
- Stock prices gain momentum when a company releases “unanticipated news”.
- “Earnings surprise” when EPS is significantly different from the expected EPS. Such
news caused an increase in share price for several consecutive days - momentum.
- Reasoning : To understand the reason for earning surprise takes a certain time, up
until which the share gains momentum in market price.
- “Buy on rumour, sell on facts”
- Momentum can be both positive and negative.
- One of the reasons for momentum is “overreaction”.

7. IPOs
- Share price increases immediately after a company releases IPO.
- Companies usually underprice their shares due to the fear of under subscription
(book building) and even in our case where every IPO is priced at Rs. 100.
- Since IPOs are underpriced, they are a safe investment whose actual value is surely to
be increased once shares reach the secondary market. Thus the reason for circuit
upon circuit of IPOs.

Adaptive market hypothesis

Data snooping/mining
- Conventionally : Develop a hypothesis - collect data to test that hypothesis.
- Collect data and develop a hypothesis based on the extensive data you have collected.
- “If you torture data long enough it will confess to any crime.”
The education of a value investor.

UNIT VI - Security Analysis

- Securities are divided into:
1. Fixed income securities
- With fixed income securities coupon/ interest is fixed and you have a
legal claim to the company if the company fails in routine coupon
payment and take the company to the route of “liquidation”.
- Fixed income securities suffer from interest rate risk.
a. Bond
- When interest increases the price of bond decreases whereas
reinvestment opportunity decreases (the coupon that we get
from bond that is to be reinvested decreases).
- When
- We can equalise the increment and decrement magnitude of
price of bond and reinvestment opportunity in order to hedge
the interest rate risk of bond : Immunisation
b. Loans
- When interest rate increases the price of loan also decreases.
- Say suppose, a bank provides a loan at 5% interest rate and the
market interest rate has increased to 10%. This causes the bank
 to try and sell the 5% interest rate loan to others so that their
funds can be invested into loans with a current market interest
rate of 10%. This increases supply and decreases price of loan
with a 5% interest rate.
2. Equity securities

Duration & Calculation of change in bond price

∆𝑃 ∆𝑖
𝑃
=− 𝐷𝑥 (1+𝑖)
where,
∆𝑃
𝑃
= Percentage change in price of bond
D = Duration
∆𝑖 = Change in interest rate
i = Beginning interest rate

- This equation gives the change in bond price when the interest rate changes.
- Duration13:
- Duration is always calculated in years and the duration is always lower than
the maturity of the bond.
- At the point of duration, the weighted average cash flow before that point and
the weighted average cash flow after that point is equal.
- The weighted average cash flow is also known as discounted payback period.

Sample:

13
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Calculation of duration
[Question no. 1]
Calculate the duration of the bond with following properties.
YTM = 5%
Coupon = 5%
F.V. = 1000
Maturity = 5 years

|............|...........|...........|.............|..............|
50 50 50 50 50+1000

Year C.f. PVIF5%,n PV PV x Year

1 50 0.9524 47.62 47.62

2 50 0.9070 45.35 90.7

3 50 0.8638 43.19 129.6

4 50 0.8227 41.135 164.52

5 1050 0.7835 822.675 4113.35

4545.8

Value of Bond = I (PVIFAr,n) + M (PVIFr,n)

= 50(PVIFAr,n) +1000(PVIFr,n)
= 1000
(When yield to maturity and coupon are same, the value of bond is equal to its face value)

Then,
∑𝑃𝑉 𝑥 𝑌𝑒𝑎𝑟
𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 = 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑏𝑜𝑛𝑑
4545.8
𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 = 1000
= 4. 5 𝑦𝑒𝑎𝑟𝑠

Immunisation
- For immunisation, the increment and decrement due to price change and
reinvestment opportunity of fixed income securities must be equalised.

Price ↓
Interest rate ↑ Equalise
Reinvestment (R) ↑
 Price ↑
Interest rate ↓ Equalise
Reinvestment (R) ↓

- For immunisation, we must set our investment horizon exactly equal to the duration
of the fixed income securities.

[Question no. 1]
You want to have Rs. 1607000 Rs. after four years. Currently you have Rs.
1000000. Rs. 1607000 is going to fund your child’s MBBS dream.

1 2 3 4
|.........|..........|.............|...........|
10 lakhs 16.07 lakhs
PV FV

FV = PV (1+r)n
Thus,
r = 12.59%

Your rate of return must be 12.6%. So, you decided to invest in a bond with the
following features.

Bond (A) Bond (B)

F.V. 1000 1000

Maturity 5 years 4 years

Coupon 12.6% 12.6%

YTM 12.6% 12.6%

Which bond should you choose? Use calculation to show that you will be certain
to make your fund 160700 at the end of year 4. Assume that the interest rate in
the market will decrease to 10% from year 2.

Answer:
We choose that bond which has its investment horizon equal to duration.

∑𝑃𝑉 𝑥 𝑌𝑒𝑎𝑟
𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 = 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑏𝑜𝑛𝑑
Bond (B) has a maturity of 4 years and hence can’t have duration of 4 years (it will have a
duration less than maturity).

Thus, calculating only for Bond A.

For Bond (A)
 Year C.f. PVIF5%,n PV PV x Year

1 126 0.880 110.88 110.88

2 126 0.788 99.288 198.58

3 126 0.700 88.2 264.6

4 126 0.622 78.372 313.488

5 1126 (126 + 1000) 0.5524 622.0024 3110.012

3997.56

∑𝑃𝑉 𝑥 𝑌𝑒𝑎𝑟
𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 = 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑏𝑜𝑛𝑑
Value of a bond is equal to its Face Value because the yield to maturity (YTM) and Coupon
rate are equal.
3997.56
𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 = 1000
= 3. 997 𝑦𝑒𝑎𝑟𝑠
If you are lucky and the interest rate doesn’t change.
Year C.f. Reinvestment At end

1 126 12.6% 126(1.126)3= 179.88

2 126 12.6% 126(1.126)2= 159.75

3 126 12.6% 126(1.126)1= 141.87

4 126 12.6% You get a coupon of

126.

You sell here at Rs.

1000.
126+1000
(1+0.0126)
=Rs. 1000
1000 + 126 = 1126

1607.5
(From 1 bond)
From 1000 bonds
Total = 1607500

5 1126 12.6%

If the interest rate decreases to 10%

Year C.f. Reinvestment At end

1 126 12.6% 126(1.1)3=167.706

2 126 10% 126(1.1)2=152.46

3 126 10% 126(1.1)1=138.6

 4 126 10% You get a coupon of
126.

You sell here at Rs.

1000.
126+1000
(1+0.01)
=Rs.
1023.63
1023.63 + 126 =
1149.63

From 1 bond
1608.396
From 1000 bonds
1608396

5 1126

If mistakenly you had purchased bond (B), what would have happened? Show all the
calculations.
When the interest rate remains the same i.e. 12.6%.
Year C.f. Reinvestment At end

1 126 12.6% 126(1.126)3= 179.88

2 126 12.6% 126(1.126)2= 159.75

3 126 12.6% 126(1.126)1= 141.87

4 126 12.6% 1126

Total = 1607.5

When interest rate falls to 10%

Year C.f. Reinvestment At end

1 126 12.6% 126(1.1)3=167.706

2 126 10% 126(1.1)2=152.46

3 126 10% 126(1.1)1=138.6

4 126 10% 1126

Total = 1584.766
 BMP Hypothesis : Education is about minimising your risk, not
maximising your return/value.

Equity Analysis
- Equity analysis is generally done by professionals rather than academicians because
according to academicians (Efficient market hypothesis), the only way to consistently
gain abnormal returns is either through illegal activities or through exceptional luck.
- Professionals however argue that we can generate value by analysing businesses.
- Benjamin Graham14
- According to Warren Buffet stock is similar to bond if an investor is able to make an
educated guess of the return of stock similar to coupon.
For accounting : Introduction to Financial Accounting : Porter Norton

1. Leverage Ratio15
𝐷𝑒𝑏𝑡 𝐷𝑒𝑏𝑡 𝐸𝑞𝑢𝑖𝑡𝑦
𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 𝑅𝑎𝑡𝑖𝑜 = 𝐸𝑞𝑢𝑖𝑡𝑦
/ 𝐴𝑠𝑠𝑒𝑡𝑠
/ 𝐴𝑠𝑠𝑒𝑡𝑠
- Balance sheet represents the financial position of a company at a particular
point of time (source of funds and use of funds).
- Income statement is the financial status of a company in a particular period of
time.
- Debt is further divided as:
1. Interest bearing : Loans that bear interest
2. Non-interest bearing : Accounts payable
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐵𝑒𝑎𝑟𝑖𝑛𝑔 𝐷𝑒𝑏𝑡
𝐼𝑓 𝐸𝑞𝑢𝑖𝑡𝑦
≥ 0. 5 - According to Warren Buffet, don’t invest in those
companies.
And,
𝐷𝑒𝑏𝑡
𝐸𝑞𝑢𝑖𝑡𝑦
≤ 0. 8

- This is because when the interest rate is high, the company loses its flexibility/
robustness. This is because a large portion of the company’s income goes
towards paying interest, decreasing its flexibility of investment.
- By nature, banks are for financial intermediation, and thus they mobilise debt
to equity at a ratio of 9:1. Thus, in many cases where the nature of business
requires using a higher leverage, we need to compare the debt to equity with
industry average.

14
[Link]
15

[Link]
e%20ratio%20is%20any%20one%20of%20several%20financial%20measurements,output%20will%2
0affect%20operating%20income.
 - In lack of flexibility, a company is unable to grab opportunities or minimise
risks.

2. Liquidity Ratio
- For liquidity Current Assets (CA) and Current Liabilities (CL) are of concern.
- Assets
1. Current Assets (CA) - Can liquidate and convert to cash within 1 year.
a. Accounts receivable
b. Prepaid expenses
c. Marketable securities
d. Cash
e. Inventory
2. Future Assets (FA)
- Liability
1. Short-term liabilities (STL) : Is liable to be settled within 1 year.
2. Long-term liabilities (LTL)
𝐶𝐴
𝐿𝑖𝑞𝑢𝑖𝑑𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 = 𝐶𝐿
> 1. 5
- Interpretation : The assets that are to be liquidated within 1 year should be at
least 1.5 times the liabilities to be settled within a year.
- Higher liquidity ratio is also not good because of the opportunity cost?

3. Profitability Ratio
- Formula:
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝑅𝑂𝐸 = 𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦
- ROE 10% meaning : Each Rs. 1000 injected into a company gives a return of
Rs. 100.
- Acc. to WB 𝑅𝑂𝐸 ≥ 8% for the business to be investable.
- Net income is EATS (Earnings available to shareholders)
𝑅𝑂𝐸
𝐸𝑃𝑆 = 𝑁𝑜. 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠
- The profit is accounting profit i.e. might not be realised as cash (some sales
are not realised in cash).

4. Management
- A corporation consists of millions of shareholders and thus makes it difficult
for decision-making. Decision-making responsibility is thus vested upon the
management of a corporation.
- Thus, management plays an integral role in the progress/downfall of a
corporation.
- Further, moral hazard and adverse selection problems between agent
(management) and principle (shareholders) exist in the case of management.
- Prioritise corporations that disclose upper management salary and bonuses,
BOD salary and bonuses, with the intuition that management that makes such
information public, is working for the corporation and not just for self-centred
goals.

5. Product (Future Potential)

 - Do you believe that the product you are investing in will stay relevant for 30
years? If so, move ahead with investment in that business.

6. Tax (Capital Gain)

- In general an investor pays 18% capital gain tax whereas a trade pays 39%
capital gain tax.
- Say suppose you start your investment with Rs. 5000
Also, suppose the following are the same profits earned by a short term
investor/trader.
Price of stock For a value For a trader
(Assuming 10% investor
increment each
year)

1st year Rs. 5000 500 x 40% = 200 tax

Remaining 5300
10% increase each
year 7320 - 5000
= 2320 x 0.18
2nd year Rs. 5500 Assuming 18% 530 x 40% = 212 tax
tax Remaining Rs. 5618
= Rs. 417.6 (5300 + (530-212)

3rd year Rs. 6050 561.8 x 40% =

224.72
Remaining 5955.08

4th year Rs. 6655 595.5 x 40% =

238.032

5th year Rs. 7320.5 Remaining =

6312.548

Total capital gain Total capital gain:

= 2320 = Rs. 6312.548 -
Total tax = Rs. 5000
417.6 = 1312.548

Total tax = 874.752

- Compounding is a friend of the value investor.

- An investor pays lower tax than a trader.
- Invest for a minimum period of 10 years (because in America 10 year bonds
are highly popular).

7. Stable books, earnings etc.

- Profit of a company is divided into:
- Dividend (D)
- Retained earnings (R/E) - This is reinvested into other investments
that further increases the value of equity (E) for the shareholders.
- A shareholder receives:
 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 (𝐷) + ∆𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒

Ao Do
E0

A1 D1
E1

- Change in book value should be equal to difference in retained earnings

(E1 -Eo).
- But this does not translate into practicality because certain money is allocated
to various other stuff such as maintenance of fixed assets to stay in existing
position.
- If the growth of book value of a company is stable, a trend/pattern of growth
is predictable which makes it a safe and stable investment.
In the example discussed in class (Siddhartha Bank)
𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑡𝑜𝑡𝑎𝑙
𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 = 𝑇𝑜𝑡𝑎𝑙 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠

FY 2018-19 2019-20 2020-21 2021-22 2022-23

Book 170 163 186 172 179

value per
share

-7 23 -14 7

Dividend 15 3 1 1 4
per share

Earnings 23 19 22 20 22
per share D (15) D (3) D (1) D (1) D(4)
Reinvest Reinvest Reinvest Reinvest Reinvest
(8) (16) (21) (19) (18)

ROE 13% 10% 12% 11.95% 12.51%

Total reinvested = 8+16+21+19= 64 (Last year’s reinvestment is not added
because the book value after that is unknown)
Total change in book value = 9
Thus, in the span of 5 years Rs. 55 per share is used in maintenance.
This is an example of unstable books.
𝐸𝑃𝑆 𝑥 𝑇𝑜𝑡𝑎𝑙 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠
𝑅𝑂𝐸 = 𝑇𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦
- ROE might not be realised and still might have receivables left. However, net
cash flow from operating activities shows the total cash inflow into the bank.
Net cash flow from operating activities = 6,416,332,242
Then,
𝑁𝑒𝑡 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑓𝑟𝑜𝑚 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑖𝑒𝑠 6416332242
𝑇𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦
= 25000000000
= 25%
- This value 25% might be higher than ROE because the receivables from
previous fiscal year might increase Net cash ROE.
𝑁𝑒𝑡 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑓𝑟𝑜𝑚 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑖𝑒𝑠 6416332242
𝑇𝑜𝑡𝑎𝑙 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
= 140899802
= 𝑅𝑠. 45
 -Net Rs. 45 per share earned in that F/Y.
-All of the above are fundamental analysis of a company.
-With companies showing a stable pattern of EPS, Book value, ROE
(fundamentals) we can use prediction models such as Dividend Discount
Model (Discounted cash flow model) to gauge the value of share of those
companies and thus can make an educated guess/ prediction of intrinsic value
of the share.
- If we are unable to use Discounted cash flow model we can use multiple
models including multiple ratios:
a. P/E Ratio
b. P/S.R Ratio
c. P/Cf Ratio
The above ratios must be nearly constant on an average.
We can calculate the average market valuation of the company using such
ratios since calculation of book value is redundant (the book values don’t show
a stable pattern).
- Each company has a unique nature and unique business model according to
which suitable fundamental analysis figures and ratios should be used.
8. Competitive advantage
- MOAT
- The term “economic moat” popularised by Warren Buffett, refers to a
business’ ability to maintain competitive advantages over its competitors in
order to protect its long-term profits and market share.
- Competitive advantages can come from:
a. Brand
b. Product differentiation
c. Cost
- For retail giants such as Walmart, Bhatbhateni, the competitive
advantages come from economies of scale i.e. low cost.
- Their Cash Conversion Cycle is negative.
|............|..........|..........|..............|................|
Cash RM WIP FG Sales (Cr.) Cash
RM - Raw materials
WIP - Work in progres
FG - Finished goods
- The above is an operating cycle. A company's operating cycle of
30 days means the cash invested in raw materials is returned in
30 days.
- Suppose you buy raw materials on loan for 10 days, then after
10 days you take a loan for 20 days to repay the loan of the
supplier.
- The 20 day period, or the period of time for which you have to
take a loan is called Cash Conversion Cycle (CCC).
- For retail giants, they sell products (whose price to suppliers is
to be paid in x days) and earn cash in less than x days, making
their Cash Conversion Cycle (CCC) negative.
d. Loyal (switching cost)
 - Standard Chartered Bank earns less through interest on loans as compared to
other sources of income and the chances of default on existing loans are also
minimal, hence decreasing risk & discount factor thus increasing the intrinsic
value.
9. Margin of safety
- Margin of safety = Intrinsic value - Current market price
- Using margin of safety to invest in a company is called value investing.
10. Intrinsic value
- Intrinsic value is the discounted value of the cash that can be taken out of a
business during its remaining life.
- Stock valuation is done as that of bond (Warren Buffet) assuming n as 10
years (10 year government bond considered as risk free investment).
- For that, C and M can be calculated.
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 = 𝐶(𝑃𝑉𝐼𝐹𝐴𝑟,𝑛) + 𝑀(𝑃𝑉𝐼𝐹𝑟,𝑛)
- C = D (Dividend) At minimum this is the dividend to be earned in the coming
10 years.
- Among the aggressive and defensive approach to estimation of
dividend, we usually take the defensive approach as we are risk averse.
- The geometric average of change in book value for the past five years is
calculated which is M.
10
179 (1. 0115) (𝑃𝑉𝐼𝐹𝑟,𝑛)
- Our average long-run average interest rate is 6%, however for bonds issued by
the government it is 1-2%, an aggressive approach thus estimates interest rate
of 3%.
10
- 5(𝑃𝑉𝐼𝐹𝐴3,10) + 179 (1. 0115) (𝑃𝑉𝐼𝐹3,10)
- Margin of safety = Intrinsic value - Current market price
- This calculation is usable only when a company has stable books, earnings etc.

25th June, 2024

UNIT VII - Investment Companies
Services provided
1. Underwriting
2. Portfolio Management Service
- By paying a certain fee i.e. hurdle rate you can employ investment companies
to manage your investment portfolio.
- IPS : Investment Policy Statement - to understand the investment preferences
of investors.
3. Corporate Advisory Services
4. Consultancy
5. Mutual Fund
- This is one of the major objectives of an investment company.
- Mutual fund is issued by Asset Management Company to the public.
- The issue is called UNIT.
- When you are buying a unit you are not buying part of a business but a fund of
a fund.
 - The capital accumulated through issuance of public units is then invested into
other investments following the Capital Market Line (CML).
- Benefits of a mutual fund:
1. Professional service
2. Liquidity
- Mutual funds cater to investors with common interest for e.g.
those who want to invest in low cap businesses. E.g. Laxmi Low
Cap Fund.
- When you buy a mutual fund unit instead of shares of a low cap
business, you get the return of directly investing in the
business and liquidity (ease of selling units in secondary
market).
- Mutual fund units have high liquidity in the secondary market.
3. Diversification & Reach
- Balanced Fund : Balanced investment in all financial
instruments such as equity, debt, bonds etc.
- You get the benefits of diversification on low investment.
- You get to benefit from investing in an expensive share (e.g.
Unilever Nepal Ltd.) through the buy of units.
Shares with small caps have higher prices because of lack of liquidity.

Some Terminologies
1. Net Asset Value:
- Each mutual fund has a NAV.
- NAV is the total market value of assets in the said mutual fund + Other assets
- Liabilities
𝑀.𝑉. 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡𝑠 +𝑂𝑡ℎ𝑒𝑟 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝑁𝐴𝑉 = 𝑇𝑜𝑡𝑎𝑙 𝑢𝑛𝑖𝑡𝑠
- Units can be traded in the market at a price near the NAV, it doesn’t however
surpass NAV.
2. Load
- Fee to be paid to the mutual fund company while buying units or while
exiting.
a. Front-end
b. Back-end
- Higher the fees, lesser the NAV because a unit sold in the secondary market
(for back-end load) has a price as (NAV-load).
- Equity growth fund : 1.5-2.5% (internationally)
- Higher the risk, higher the load.
3. Expense Ratio
- Expenses incurred while operating the fund.
𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠
𝐸𝑥𝑝𝑒𝑛𝑠𝑒 𝑅𝑎𝑡𝑖𝑜 = 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
4. Asset Under Management (AUM)
- 𝐴𝑈𝑀 = 𝑇𝑜𝑡𝑎𝑙 𝑢𝑛𝑖𝑡𝑠 * 𝑁𝐴𝑉
- AUM gives the size of the mutual fund/ how big the mutual fund is.

Types of Mutual Fund

1. Open end
 - Units are redeemable at the issuer at NAV or certain price as per conditions
pre-agreed upon.
- Open end funds lack maturity.
2. Close end
- They are not redeemable and are traded in the secondary market.
3. Interval?
- Mix of open and close ended.
- If certain criteria are fulfilled, the units are redeemable at the issuer.

Portfolio
1. Income fund
- For the purpose of getting a coupon/fixed payment instead of capital
appreciation.
- Income funds pursue current income over capital appreciation by investing in
stocks that pay dividends, bonds, and other income-generating securities.
- For a fixed income.
2. Growth fund
- Invest in companies that are in initial stages and have high growth potential
such as IT companies.
- They entail a lot of risk and hence are appropriate for a risk taker investor.
3. Value fund
- Look at the book value, growth, intrinsic value and buy shares if they are
undervalued in the market.
4. Equity fund
- Only invest in shares.
5. Debt fund
6. Real estate fund
- Invest in REITs.
- You get the benefits of real estate appreciation without buying real estate.

SIP - Systematic Investment Plan

- If you purchase an asset at Regular interval for a Fixed period of time, at high prices
you will buy less units and at low prices you will be able to buy more units. Hence, on
average you will end up buying at low prices and make profit. This is SIP in a single
sentence. You don’t need to worry about the direction and timing of the market.

4th July, 2024

UNIT VIII - Dividend
Net Income

Sales (S)
- Variable Cost (VC) =
Contribution Margin (CM)
- Fixed Cost (FC) =
Earnings before Interest and Taxes (EBIT)
- Interest (I) =
Earnings before taxes (EBT)
- Tax (T) =
Earnings after taxes (EAT)
- Preferred dividend (DP) =
Earnings available to shareholders’ (EATS)
- Dividend (D) =
Retained Earnings (R/E)

- EATS is also known as Net Income. It can be used to pay out dividend (D) or reinvest
(R/E).
i.e.
𝐷 + 𝑅/𝐸 = 𝑁𝐼
𝐷 𝑅/𝐸
𝑁𝐼
+ 𝑁𝐼
=1
where,
𝐷
𝑁𝐼
is the DPO (Dividend Payout Ratio)
𝑅/𝐸
𝑁𝐼
is the RR (Retention Ratio). It is denoted by b.

Dividend Types :

1. Cash Dividend
a. Regular constant
i. Absolute
ii. Constant DPO
b. Regular + Additional
- In periods of extraordinary profit, the company provides additional
cash dividends on top of regular constant cash dividends.
- Pros : If a company distributes dividend on regular constant and
regular+additional basis:
- Long term prospects is stable
- Investors are attracted due to which marketability is increased.
- Cons:
- Investor expectation is heightened and a slight decrease in
regular cash dividend results in negative sentiment from
 investors (this is because of loss-aversive sentiment of
investors).
c. Residual Policy
- Residual dividends is a dividend policy adopted by certain companies,
wherein the amount of dividends paid to shareholders is equal to the
profit amount left after the company has paid its capital expenditure
(CapEx) and its operating costs (working capital).
- The profit of the current year is forecasted to manage the expenditure
of the coming year → Additional Fund Needed (AFN). AFN is fulfilled
through either debt or equity.
- D/E Ratio is kept constant because changing D/E makes EPS and ROE
volatile. It is also because if debt is taken from banks (Consortium
financing), banks don’t allow changing D/E ratio until the maturity of
the loan.
- Thus, financing is done through:
1. Internal financing (b)
2. External financing
- The Internal financing (b) is subtracted from the profit of this F/Y.
Further, it is checked whether there are any regulatory provisions or
not, and these regulatory provisions are also subtracted from profit.
The remaining amount is distributed as a dividend to stakeholders.
- The policy of distributing this remaining amount is called residual
policy.

[Question]
You are the CFO of Sahas Urja. You are planning to estimate the amount of Dividend
to be distributed to your shareholders. Your firm has 1.5 Crore shares outstanding.
Currently your firm made a profit of 30 crores. The budget estimate from your
Account Department shows that you will need around 10 crores investment to replace
a turbine in Next year. Your Debt to equity ratio currently is 1:1. You are under a strict
debt covenant of a bank from which you have a loan commitment. So, considering
the situation, how much dividend per share (DPS) will you be able to maintain at max
considering there are no any regulatory provisions to be made, since you are working
currently in a deprived location of Nepal.

Answer:
The debt to equity ratio must be maintained at 1:1. To increase assets next year by 10
crores, we need 5 crores from debt financing and 5 crores from equity financing.
Thus,
Profit - AFN = 30 - 5 crores = 25 crores
Hence,
25
𝐷𝑃𝑆 = 1.5
= 𝑅𝑠. 16. 67
 2. Stock Dividend :
- Bonus Shares.
- Extra shares given to existing shareholders, instead of cash.
- Cash Dividend reduces balance sheet size, but not stock dividend.
- Simply the rearrangement in shareholders equity account takes place without
any impact on shareholders’ value and balance sheet size.
- Shareholders Equity A/C

Common Stock (Rs….., par,.......

Shares outstanding)

Additional Paid in
(Premium, Paid in)

Retained Earnings

Total Shareholders’ equity

Numerical no. 1
Currently Sana Kisan Laghubitta is trading at Rs. 800 per share, its shareholder equity
account appears as below:

Common stock (Rs 100 par, 50,00,000 Rs. 50,00,00,000

shares)

FoAdditional paid in Rs. 1,00,00,000

Retained earnings Rs. 90,00,00,000

Total Shareholders’ equity Rs. 141,00,00,000

Here, Rs. 61,00,00,000 is the book value.

61,00,00,000/ 50,00,000 = Book value per share

The microfinance declared a 20% stock dividend. What will happen after the stock dividend
to:
a. No. of shares outstanding
The microfinance declares a 20% stock dividend on total shares outstanding
Hence,
New number of shares outstanding is equal to:
50,00,000 + 0.2 ×1 50,00,000 = 60,00,000
New shares (additional shares) = 20% of 50,00,000 = 10,00,000

b. Market price of share?

Total value should remain the same before and after the stock dividend, as stock
dividend doesn’t increase wealth.
 No. of shares before stock dividend × Market price of share before stock
dividend = No. of shares after stock dividend × Market price of share after
stock dividend
𝑜𝑟, 50, 00, 000 × 𝑀𝑃𝑆𝐵 = 𝑁𝐴 × 𝑀𝑃𝑆𝐴
50, 00, 000 × 800 = 60, 00, 000 × 𝑀𝑃𝑆𝐴
Hence,
MPSA = Rs. 666.67

c. The Shareholders’ Equity Account

For the stock dividend of 10,00,000 shares, Rs. 100 (par value) and Rs. 700
(Premium) amounting to present day market price of Rs. 800.

100 Par = 1000,00,000

10,00,000
700 Premium = 7000,00,000

Common stock (Rs 100 par, 60,00,000 Rs. 60,00,00,000

shares)

Additional paid in Rs. 71,00,00,000

(Previous additional paid in + Premium
form stock dividend)

Retained earnings Rs. 10,00,00,000

(Previous retained earnings - value of
stock dividend)

Total Shareholders’ equity Rs. 141,00,00,000

3. Split/ Reverse split

- Split (Break)
- Example:
- 2 for 1 split : Split a stock into two stocks/shares.
- Par value decreases by half.
- No. of share outstanding increases by twice.
- Split is done to make expensive shares affordable so that there are
more market participants following that particular share, hence
increasing efficiency (Refer to → Efficient market hypothesis).
- It makes the shares marketable.
- It increases the liquidity of the shares.
- Reverse Split (Combine)
- Example:
- 1 for 2 reverse split : Combine 2 stocks into 1.
- Par value increases.
- No. of share outstanding decreases.
 - Reverse split is done to regain market confidence and decrease
elasticity in case of rapid price decline.
- When the price of a share declines rapidly, it loses
market confidence.
- It also increases elasticity of the share i.e. a slight shock
or slight information might cause a huge effect in
market prices.
- Reverse split is a rare phenomenon due to negative signalling effects
and connotations in the market.
4. Repurchase (Treasury stock)
- Buy back

7/11/2024
Stock Repurchase

Assume earning after tax of 2 crores and [Link] shares outstanding 50 lakhs. The market price
of share is 630 Rs per share and the company is planning to distribute Rs 1.5 crore dividend.
For shareholders, getting dividend or stock repurchase is similar.

When company is providing dividend

Here ,
EPS = 2 Crore / 50 lakhs = Rs 4
DPS = 1.5 Crore / 50 lakhs = Rs 3
MPS = 630 Rs
MPS after dividend = 630-3
= 627 Rs

If Repurchase is done,
MPSB * NB = MPSA* NA
630 * 50,000 = MPS * NA
Here, NA = 5,000,000- 1.5 Crore / 630
= 5000000 - 23810
= 4976190

MPSA=( 630 * 5000000 ) / 4976190

MPSA= 633

So stock repurchase is same as cash dividend for shareholders.

(While we get cash dividend, the price has decreased to 627 but outstanding share remains
same; but while repurchase, the price has increased to 633 but outstanding share has
decreased)

(If we get cash dividend, we need to deduct tax; but stock repurchase has tax advantage)
Reverse split vs Stock Repurchase/ Buy Back
- Reverse split gives negative sentiment
- Stock Repurchase is done when organization thinks the company is undervalued.

When some shareholder creates problem to the organization, the organization buys their
share (permanent retirement of the shareholder)
Acquisition could also be the motive.
The buy back share can later be distributed to managers later (without increasing
outstanding share; first outstanding share decreases after buy back but after giving to
managers, it can return to original number)
Buy back is also done when we want to convert public company into private.
Benefit of stock repurchase - Tax advantage

Suppose you are CFO

Given conditions …..

As a CFO which one do you prefer?

Cash Dividend
Stock Repurchase
Stock Dividend
Split

AGM - Declaration Date and Record Date

Where, Record date is July 28 (if today is July 11)- which means in July 28 we check our
register
In order to become shareholder ones name must be there in company’s registrar (RTA).

Put/Call Ratio(PCR) :

If Put/Call Ratio(PCR) < 1 investors are bullish towards the stock.

If PCR > 1 investors are bearish towards the stock.