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Q1 Describe the investment process.

Ans    The Investment Process It is rare to find investors investing their entire savings in a single security. Instead, they tend to invest in a group of securities. Such a group of securities is called a portfolio. Financial experts stress that in order tominimise risk an investor should hold a well-balanced investment portfolio. The investment process describes how an investor should decide the securities to invest in while constructing a portfolio, how he should spread the investments, and when he should sell them. This is a procedure involving the following five steps: 1Setting investment policy This initial step determines the investor’s objectives and the investible amount. Since there is a definite relationship between risk and return, the objectives should be stated in terms of both risk and return. This step concludes with the asset allocation decision, which is identification of the potential categories of financial assets for consideration in the portfolio that the investor is going to construct. Time horizon – The time horizon is the expected number of months, years, or decades for which the money will be invested. Risk appetite – Risk appetite is an investor’s ability and willingness to lose some or all of his original investment in exchange for greater potential returns Active management is the process of managing investment portfolios by attempting to time the market and/or select undervalued stocks to buy and overvalued stocks to sell, based upon research, investigation and analysis. 2. Performing security analysis The second step is security selection. Security analysis involves examining a number of individual securities and identifying those securities that currently appear to be mispriced. Fundamental analysis is a method used to evaluate the worth of a security by studying the financial data of the issuer. Technical analysis is a method used to evaluate the worth of a security by studying market statistics. 3. Portfolio construction The third step identifies the specific assets in which to invest, and determines the amounts to put into each asset. Asset Allocation 	Security Selection Active investor 	Market timing 	Stock picking Passive investor 	Maintain pre-determined selections 	Try to track a well-known market index like Nifty, Sensex

4. Portfolio revision This step is the periodic revision of the portfolio using the three previous steps. A portfolio might not be the optimal one forever and needs constant modifications. 5. Portfolio performance evaluation This step involves determining periodically how the portfolio has performed over the review period (returns earned compared to targeted returns).

Q2Write about the secondary markets? Explain the role of financial intermediaries. A  Secondary market is the place where original purchases of securities trade those securities. These securities may trade repeatedly in the secondary market, but the original issuers will be unaffected. This means that they would not receive any additional cash from those transactions. Cash is received by the person who sells the security and not the issuer.

Financial Intermediaries Financial intermediaries channel the savings of individuals, businesses, and governments into loans or investments. This means individuals are net suppliers of funds, whereas governments and organisations are net users of funds. The major intermediaries are commercial banks, mutual funds, life insurance companies, and finance companies. Financial intermediaries facilitate interface between providers and users of capital. They build funds by accepting deposits and/or issuing securities (and, in the process, they incur liabilities). These funds are used for acquiring financial assets by making loans and/or buying securities. This set of activity is known as financial intermediation

The main role of financial intermediaries is to invest the savings collected from various investors to buy securities of companies. Using the services of the intermediary saves time and cost for the company in terms of search collecting and screening investors. For the investor it avoids the situation of asymmetric information. • Financial intermediaries allow individual small savers to access large investment projects through the mechanism of fund pooling. Individual investors are usually too small to benefit individually from large projects. Pooling done by financial intermediaries allow the small investors to do so. • An household investor has constraints for investing in large investment projects. Through fund pooling the intermediaries permit household investors to invest in these projects. • Financial intermediaries reduce the risk of poor returns by spreading the savings across various securities or investments. Mutual funds are one such example.

Small investors are interested in short term investments, whereas most of the projects undertaken are long term in nature. In order to bridge the gap, financial intermediaries use liquidity management strategies which enables the investors to invest in long term projects.

Q3Explain the meaning of risk. Describe the factors that affect risk

Meaning of Risk Risk is the likelihood that your investment will either earn money or lose money. It is the degree of uncertainty regarding your expected returns from your investments, including the possibility of losing some or all of your investment. Risk includes not only adverse outcomes (lower returns than expected) but good outcomes (higher returns). Both downside and upside risks are considered while measuring risk. Factors that affect Risk The common risk factors are: • Business risk: As a security holder you get dividends, interest or principal (on maturity in case of securities like bonds) from the firm. But there is a possibility that the firm may not be able to pay you due to poor financial performance. This possibility is termed as business risk. The poor financial performance could be due to economic slowdown, poor demand for the firm’s goods and services and large operating expenses. Such a performance affects the equity and the debt holder. The equity holder may not get dividends and residual claim on the income and wealth of the firm. Similarly a debt holder may not get interest and principal payments. • Inflation risk: It is the possibility that the money you invested will have less purchasing power when your financial goal is met. This means, the rupee you get when you sell your asset buys lesser than the rupee you originally invested in the asset.

Interest rate risk: The variability in a security’s return resulting from changes in the level of interest rates is referred to as interest rate risk. For example the value of a bond may reduce due to rising interest rates. When the interest rate rises, the market price of existing fixed income securities fall, and vice versa. This happens because the buyer of a fixed income security would not buy it at its par value or face value if its fixed interest rate is lower than the prevailing interest rate on a similar security. This occurs due to interest fixed rate lower being lower than the present rate on a similar security. Hence as a buyer you would pay less than the face or par value for such a security. The changes in interest also have an indirect effect on effect equity prices. That means the prices are affected by changes in the relative yields of debentures.

Market risk: Market risk is the changes in returns from a security resulting from ups and downs in the aggregate market (like stock market). This type of risk arises when unit price or value of investment decreases due to market decline. The market tends have a cyclic pattern. John Train says “You need to get deeply into your bones the sense that any market, and certainly the stock market, moves in cycles, so that you will infallibly get wonderful bargains every few years, and have a chance to sell again at ridiculously high prices a few years later”. The market risk represents a part of the total risk of a security that can be attributed to economic factors like government spending, GDP growth rate money supply, inflation and interest rate structure. Market risk is unavoidable as the economic factors have an effect on all firms to some degree. Market risk is therefore known as systematic risk or non-diversifiable risk.

Q4Introduction to economic analysis Explanation on variables Ans. Economy Analysis Economic analysis is done for two reasons: • A company’s growth prospects are dependent on the economy in which it operates. • Most companies’ shares and stocks generally perform well when the economy is in boom.

4.3.1 Factors to be considered in economy analysis The economic variables that are considered include: • gross domestic product (GDP) growth rate • exchange rates • balance of payments (BOP)

•current account deficit • government policy (fiscal and monetary policy) • domestic legislation (laws and regulations) • unemployment rates • public attitude (consumer confidence) • inflation • interest rates • productivity (output per worker) • capacity utilisation (output by the firm). GDP is the total income earned by a country and GDP growth rate is comparison of GDP year-on-year. Inflation is important for investors, as excessive inflation undermines consumer spending power (prices increase) and so can cause economic stagnation. However, deflation (negative inflation) can also hurt the economy, as it encourages consumers to postpone spending (as they wait for cheaper prices). Exchange rate changes affect exports and imports. If excha nge rate strengthens, exports are hit. If the exchange rate weakens, imports are affected. BOP influences exchange rate movements, through supply and demand for foreign currency. BOP reflects a country’s international monetary transactions for a specific time period. It consists of current account and capital account. The current account is an account of the trade in goods and services. The capital account is an account of the cross-border transactions in financial assets.

Business cycle and leading coincidental and lagging indicators All economies experience recurrent periods of expansion and contraction. This recurring pattern of recession and recovery is called business cycle. The business cycle consists of expansionary and recessionary periods. When business activity reaches a high point, it peaks. A low point on the cycle is called trough. Troughs represent the end of a recession and the beginning of an expansion. Peaks represent the end of an expansion and the beginning of a recession. In the expansion phase, business activity grows, production and demand increases, and employment expands. Businesses and consumers borrow more for investment and consumption purposes. As the cycle moves into the peak, demand for goods overtakes supply and prices rise. This creates inflation. During inflationary times, there is too much money chasing a limited amount of goods.