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Module-1
Session-2
Markets for Investment and Construction of Indexes
Source: Bhole, L.M., and Mahakud, J. (2009), Financial institutions and markets.5th Edition, Tata McGraw Hill (India)
Bhole, L.M., and Mahakud, J. (2009), Financial institutions and markets.5th Edition, Tata McGraw Hill (India).
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Mohan Rakesh, (2007), Development of Financial Markets in India, RBI Monthly Bulletin
Reilly, Frank. and Brown, Keith, Investment Analysis & Portfolio Management, 7th Edition, Thomson Soth-Western.
adjust to new information; thus, the prevailing price is fair because it reflects all available
information regarding the asset.
Financial markets are said to be perfect when, (i) a large number of savers and
investors operate in markets, (ii) the savers and investors are rational, (iii) all operations
in the markets are well informed and information is freely available to all of them, (iv)
there are no transaction costs, (v) the financial assets are infinitely divisible, (vi) the
participants in markets have homogeneous expectations, and (vii) there are no taxes. The
equilibrium in financial markets is usually determined by assuming that there would be
perfect competition, and by using the well known tool of supply and demand. Following
the above mentioned ideal conditions, the financial market equilibrium position when the
expected demand for funds (credit) for short-term and long-term investments matches
with the planned supply of funds generated out of savings and credit creation. 5
Equilibrium is established when the expected demand for funds (credit) for short-term &
long-term investment matches with the planned supply of funds generated out of savings
and credit creation (Figure A,B &C ). Interest rate can also be fixed irrespective of the
equilibrium rate of interest i.e. Administered Interest rate (Figure D) in order to
match/adjust supply and demand for funds as per economic policy requirement.
Source: Bhole, L.M., and Mahakud, J. (2009), Financial institutions and markets.5th Edition, Tata McGraw Hill (India)
Bhole, L.M., and Mahakud, J. (2009), Financial institutions and markets.5th Edition, Tata McGraw Hill (India).
The broad range of financial markets that offer such financial assets can be
categorised under the following four categories:
In order to have a risk return trade-off Investors follow calculate the expected rate
of return and evaluate the uncertainty, or risk, of an investment by identifying the range
of possible returns from that investment and assigning each possible return a weight
based on the probability that it will occur. Most investors demand a higher rate of return
on investments if they perceive that there is any uncertainty about the expected rate of
return. The increase in the required rate of return over the zero risk return is called as the
risk premium. Investors want a rate of return investors required or expected rate of
return that compensates them for the time, the expected rate of inflation, and the
uncertainty of the return. In a more formal way this risk is the uncertainty that an
investment will earn its expected rate of return. Although the required risk premium for
investing in a asset class represents a composite of all uncertainty, it is possible to
consider several fundamental sources of uncertainty including: (a) business risk, (b)
liquidity risk, (c) financial risk or leverage risk, (d) exchange rate risk, and (e) country
(political) risk.
Source: Bhole, L.M., and Mahakud, J. (2009), Financial institutions and markets.5th Edition, Tata McGraw Hill (India)
The objective of maximising return can be pursued only at the cost of incurring
higher risk. The financial markets offer a wide range of assets from very safe to very
risky, with corresponding low to high returns. The above figure shows the risk return
trade-off in a capital market line example. It shows the expected return risk spectrum
such that the representative asset classes are arrayed over a range of risk on it. The figure
shows a positive linear relationship between expected return and risk for different set of
asset classes. The rational risk averse investor will chose the appropriate investment
opportunity by considering the desired level of risk.
7. Badla and Undha badla: When a bull buys in the anticipation of an immediate rise in
price, but finds at the end of the accounting period that the price has not risen, he may
either pay for the shares and take delivery, or he may carry over his transaction to the
next accounting period by paying carry over charges or Seedha badla to the seller. When
a bear sells in anticipation of a fall in prices in the immediate future (so that he can pick
up shares later for delivery and make a profit), but the fall does not happen within the
accounting period, he has the option to borrow or buy the shares for delivery, or have his
sales carried over to the next accounting period on payment of Undha badla or
backwardation charges to the buyer.
8. Short Selling: In a normal transaction a security is bought and owned because the
investor believes the price is likely to rise. Eventually the security is sold and the position
is closed out. First you buy then you sell. A short-sell involves selling a security because
of belief that the price will decline and buying back the security later to close the position.
First you sell and then buy.
9. Actual selling and buying procedure: Procedure for Buying - Locating the broker----Placement of order (De-mat account in a depository) then - execution of order
(Contract note for tax and other legal purposes). Order may be Limit Order (upper limit
of the price has been given by the investor) or Market Order (to prevail the best market
price).Procedure for selling- Placement of order-- sale order----- execution of order
(same as buying)
10. Important abbreviations used in stock exchange quotations: Con-Convertible, Xd- ex
(excluding) dividend, Cd- cum (with) dividend, Xr- ex(excluding) right.
Quantity
Beta
Price
60,000
30
45
20,000
25
80
90,000
65
85
Solution:
Equally weighted series--1/3 (45/30 + 80/ 25 + 85 / 65) = 2.0033
Price weighted series--(45 + 80 + 85)/ )(30 + 25 + 65) = 1.75
Market value weighted series = (60 000*45 + 20 000*80 + 90 000* 85) / (60 000*30 +
20 000*25 + 90 000* 65) = 1.46
Popular Stock Market Indexes in India
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Additional Readings:
Fisher D.E. and Jordan R.J., Security Analysis and Portfolio Management, 4th
Edition., Prentice-Hall.
Jones, Charles, P., Investment Analysis and Management, 9th Edition, John
Wiley and Sons.
Prasanna, C., Investment Analysis and Portfolio Management, 3rd Edition, Tata
McGraw-Hill.
Reilly, Frank. and Brown, Keith, Investment Analysis & Portfolio Management,
7th Edition, Thomson Soth-Western.
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Additional Questions with Answers
Session 2: Markets for Investment and Construction of Indexes
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1. What are the different investment alternatives provided by different financial
markets?
Ans.
Marketable and Non-Marketable Assets:
Marketable: Investor can manage and control, Less Liquid in Nature: All the
Market Traded Securities
Non-Marketable: No management but has Right, Highly Liquid: Bank Deposits,
Post office Deposits, NSC etc.
4. Why stock market index is importance and what are the factors affecting
construction of stock market index?
Ans.
A good Stock Index captures the movement of the well diversified and highly liquid
stocks. It is the pulse rate of the economy. Index movements reflect the changing
expectations of the stock market about future dividends of the corporate sector.
Importance of Stock Market Index
To judge the performance of individual investor
To measure the market rates of return
To predict the market movements
Factors affecting the construction of stock market index
Sample: It should be representative of total population
Base year: It should be a normal year
Weighting criteria
Equally Weighted Series
Price Weighted Series
Market value Weighted Series
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