Time: 3 Hours Maximum Marks: 100
Note: Attempt questions from each section as per instructions given.
SECTION – A
Note: Answer the following questions:
Q. 1. What are the main components of a financial system? Whar are the functions of a financial system in the process of economic development?
Ans. A financial system can be defined as a set of complex, and inter-connected institutions, agents, practices, markets, transactions and claims and liabilities in the economy. It is concerned about credit, money and finance. It plays a significant role in economy’s development. Its different components are:
(a) Financial Institutions
(b) Financial Markets
(c) Financial Instruments
(d) Financial Services
FUNCTIONS OF THE FINANCIAL SYSTEM IN THE PROCESS OF ECONOMIC DEVELOPMENT
To understand the relevance of financial system let us analyze an economic system in which there is absence of sound financial system.
Lack of Financial System and Vicious Circles
- Lack of sound financial system results into low level of investment due to lack of investment. It retards the rate of economic growth.
- In such an economy, rate of savings will be low. It will, in turn, lower the rate of investment and hence the rate of economic growth slows down further.
- When there is absence of sound financial system, the cost of information is high making investments less profitable and more risky.
- Lower savings and high information costs together aggravate the problem of low capital formation. It gives birth to a vicious circle. In such situation, economy falls into a poverty trap.
Functions of the Financial System
It is very much clear from that it is a must to have a sound financial system for a rapid economic growth. It can contribute to economic development via three routes:
(a) Technical progress which is endogenous calls for higher savings and higher investments. It is provided by financial sector.
(b) No production can take place without capital. Capital formation depends upon timely availability of financé in right amount and on proper terms.
(c) It expands the size of market over space and time. It improves efficiency of function of exchange.
Functions of Financial System for playing its role in economic development:
1. Financial System acts as a link between savers and investors. In this way it improves efficiency in allocation of resources.
2. It provides a mechanism where investors can monitor the performance of their investment.
3. An efficient financial system minimizes the risk of investment. It also helps reducing the cost of collecting information.
4. It provides updated information on price and returns that helps to take right decisions.
5. It reduces the instances of cheating and fraud.
6. It provides insurance services, pension funds and portfolio adjustment facilities.
7. It creates an impulse to save more.
8. It reduces cost of transactions.
9. It helps in increasing financial assets as a percentage of GDP.
10.It also increases variety of participants and instruments in the financial market.
Q. 2. Explain the Capital Asset Pricing Model. How does the Arbitrage Pricing Theory build upon the CAPM?
Ans.
Capital Asset Pricing Model
When all individual investors attain their equilibrium as given by Markowitz, there must be an overall economic level equilibrium. The works of Sharpe, Lerner and Mossin is concerned with this equilibrium. CAPM is an equilibrium model of asset pricing which provides an understanding of the behavior of prices of securities, the risk return relationship, and the appropriate measure of risk for securities.
All Markowitz’s assumptions apply to this model as well but there are some additional assumptions too.
These are:
(a) Unrestricted borrowing and lending can occur at risk free rate of interest.
(b) There are no imperfections in the capital market such as transaction costs.
(c) There are no taxes.
It is to be noted that there are some risk free assets in the market which Markowitz did not talk about. When risk free assets enter the market scene and it is known that investor can lend or borrow any amount at risk free rate then it can be shown that the investor’s equilibrium will be attained at a level higher than what it was under Markowitz theory. The investor will select a portfolio on an upward sloping line in the curve were expected return is taken on X-axis and risk on Y-axis. It starts from origin showing that there are some assets which are risk free. It is upward sloping and is tangent to Markowitz efficiency curve at some point. This line is called capital market line. If we move on to the left of capital market line, to the Markowitz efficiency portfolio curve, one can find points on the line vertically above on the Markov Efficiency Frontier. In such a case, twofund separation theorem will work. It says that all riskaverse investors will hold a combination of the risk free asset and market portfolio.
The Arbitrage Pricing Model
The CAPM has been criticized for its restrictive assumptions. In 1976, Arbitrage Asset Pricing theory was given by Stephen Ross to overcome the limitations of CAPM. The CAPM assumes that investment decisions are taken within the framework of meanvariance. APT assumes that asset prices can be influenced by many factors other than mean and variance.
Assumption of APT model:
(i) Investors are risk averse utility maximizers.
(ii) There are no imperfections in the capital market such as transaction costs.
(iii) Their expectations are identical about expected returns, variances and covariance for all risky assets.
(iv) Security returns are generated according to Factor model. It means that there are some underlying factors that give rise to return on stocks. These may include inflation rate, rate of growth of GNP, Capital Structure and Dividends.
(v) Return on any stock is a linear function of these above mentioned factors. They are also called systematic factors or risk factors.
It does not assume:
(i) Single Period Investment horizon.
(ii) There are no taxes.
(iii) Investors can borrow or lend freely at risk free interest.
(iv) Investors select portfolio on the basis of mean or variance. We are not discussing detailed model here which involves a lot of mathematical applications. We are giving the basic equation of the model.
The equation depicts return on stock as a linear function of the underlying factors:
Ans.
Options
According to Securities Contract (Regulations) Act, 1956 option on securities has been defined as a contract for purchase or sale of a right to buy or sell, or a right to buy and sell, securities in future, and includes a teji, a mandi, a teji mandi, a galli, a put and call in securities.
Options are a kind of derivative contract in which the buyer or holder of the contact has a right but not an obligation to buy/sell the underlying asset at a pre determined price within or at the end of the specified period. The underlying asset can include securities, an index of prices of securities etc.
Types of options:
(a) An option to buy is called Call option and option to sell is called Put option.
(b) An option that can be exercised anytime on or before the expiry date is called American option while an option that can be exercised only on expiry date is called European option.
The price at which option is decided to be exercised is called Strike Price or Exercise Price. However, there is no cost for entering into forward contract but there is a cost for the contract of option. The buyer or holder of the option purchases the right from the seller or writer for a consideration which is called premium.
For example, suppose you go to market and like a mobile. It is costing Rs. 25,000. But you do not have enough money. You may give 400-500 as security money for reserving the mobile phone for you with a promise that you will come and buy that product within 7 days. In case you do not turn up in seven days the shopkeeper is free to sell it to anyone and you will lose the amount paid for reservation.
Take more formal example. Suppose European exercise, a three month, Strike US $ 80 put option on 5 kg gold. In this case,
–Underlier is gold;
–Notional amount is 5 kg
–Expiration is three months
–Strike Price US $ 80
In case of American options, the right for exercise is submitted to exchange, which randomly assigns the exercise request to the sellers of the option who are obligated to fulfil the terms of the contract within specified period. Option contacts can be settled by delivery of the underlying asset or cash.
The option contracts based on some index are called Index option. The buyer of Index option contracts has only the right but no obligation to buy or sell the underlying asset on expiry date. Index options have an advantage of lower cost and greater efficiency than a package of options because of diversifying effects of operating with a sort of portfolio which an index represents.
Initially, only S & P Nifty and BSE Sensex were permitted to deal in futures and options but later sectoral indices also permitted for derivatives trading subject to eligibility criteria. Derivative contracts can be allowed on a sectoral index if 80% of the index constituents are individually eligible for derivative trading.
By its very nature, index cannot be delivered on the maturity of Index futures or Index option contracts. Hence, these contracts are essentially settled on expiry.
Let us look at some important terms:
(a) The price at which the option holder can buy or sell the underlying asset is called strike price or exercise price.
(b) If the current price of the underlying asset exceeds the exercise price of the option, the call is said to be in the money.
(c) If the current price of the underlying asset is less than the exercise price of the option, the call is said to be out of the money.
(d) If the current price of the underlying asset is slightly greater than the exercise price of the option, the call is said to be near the money.
(e) The price paid by the buyer to the seller of the option is called premium.
(f) If a call option is written against the asset owner by the option writer, it is known as covered option and the one which is written without owing the asset is known as naked option.
In market there are many kinds of options like commodity options, stock options, currency options, stock index options, and options on futures like swaptions flortions and captions and synthetic options that combine the features of futures and options.
Option Position
Every contract has two sides. On one side there is investor who has bought the option and hence is in long position; on the other hand there is investor who has sold option and has taken a short position. The writer of the contract receives cash OTC while has the potential liabilities later. The writer’s profit or loss is the opposite of the purchaser of the option.
There are four types of option positions:
(a) Long position in a put option
(b) Long position in a call option
(c) Short position in a put option
(d) Short position in a call option
The Black-Scholes Formula
The Black Scholes Model is one of the most important concepts in modern financial theory. It was developed in 1973 by Fisher Black, Robert Merton and Myron Scholes and is still widely used today, and regarded as one of the best ways of determining fair prices of options.
The original formula for calculating the theoretical option price (OP) is as follows:
The variables are:
S = stock price
X = strike price
t = time remaining until expiration, expressed as a percent of a year
r = current continuously compounded riskfree interest rate
v = annual volatility of stock price (the standard deviation of the short-term returns over one year). See below for how to estimate volatility.
ln = natural logarithm
N(X) = standard normal cumulative distribution function
e = the exponential function.
Advantages and Limitations of the Model
Advantage:
The main advantage of the BlackScholes model is speed – it lets you calculate a very large number of option prices in a very short time.
Limitations:
The main disadvantage of the BlackScholes model is that it makes several assumptions that are not necessarily true in reality. This includes the fact that even so-called risk-free investments, such as government bonds, still carry a slim possibility of default. Moreover, it cannot be used to accurately price options with an American-style exercise as it only calculates the option price at one point in time -- at expiration. Another factor is that the pricing doesn’t take account of transaction costs or taxes. The formula also fails to take account of any dividends the holder of the underlying asset may receive.
In deriving Black Scholes Equation we have assumed the following:
(a) No Arbitrage Opportunities;
(b) Possibility of short selling of shares all the times;
(c) Zero transaction cost;
(d) Perfect divisibility of securities;
(e) Continuity in trading;
(f) Shares are not paying any dividends;
(g) Risk free r and share volatility i are known.
Q. 4. Explain the supply of money through the money multiplier process. What would be the effect of an increase in money supply on the equilibrium in money market?
Ans. Process of credit/money creation
Assumptions:
Initial deposit in the bank = Rs.100
LRR = 25% i.e. banks keep only Rs.25 as cash reserve.
Maximum amount that a bank can lend = Rs.75.
All the transactions are routed through bank
If there is an increase in money supply demand remaining same, rate of interest will decrease. As a result of this fall in rate of interest, there will be rise in speculative demand for money. It will keep happening until this excess supply is absorbed. And if there is decrease in money supply, rate of interest will increase.
SECTION-B
Note: Answer any five questions from this section:
Q. 5. Explain the concept of a derivative. List the various functions of derivative markets.
Ans.
DERIVATIVE: BASIC CONCEPTS
Derivative means any value which is not independent. It has been derived from the value of underlying asset. These values can be derived from assets like securities, commodities, bullion, currency, live stock etc. Derivative means a hybrid contract of predetermined fixed duration, linked for the purpose of contract fulfilment to the value of a specified real or financial asset or index of securities.
With Securities Laws (Second Amendment) Act, 1999, Derivative has been defined by Securities. The term Derivative has been defined in Securities Contracts (Regulation) Act as given below.
A derivative includes.
(a) a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instruments or contract for differences or any other form of security;
(b) A contract which derives its value from the prices, or index of prices of underlying securities. Derivatives Markets A derivative contract’s price can be dependent on anything. Many a times, farmers agree to sell their crops to agriculture traders at a pre determined price. In that case they get free from the uncertainty of fluctuations in prices. Different types of derivative contracts have been discussed below:
When the underlying asset of the derivative contract is coffee, wheat, pepper, cotton, gold, silver etc. it is called commodity derivative.
When underlying asset of derivative contract is some financial instruments like debentures, currency, shares etc., it is called financial derivative.
When derivative contracts are standardized and they are traded on the stock exchange, they are called exchange-traded derivatives.
When derivative contracts are customized as per the needs of the customer and price is determined through negotiation, they are called OTC (over-thecounter) derivatives.
National Commodity and Derivatives Exchange Limited helps as a mediocre for a standard derivative contract. He can enter into such contract either for entire production or part production.
Derivative markets perform following functions:
- Help in transferring risk from risk averse people to risk loving people.
- Catalyze entrepreneurial ability.
- Stimulate level of savings and investments.
- Help in discovery of future as well as current prices.
- Increase volume of trade in the market.
- Increase in number of risk averse people in market.
Q. 6. Distinguish among Markov expectations, adaptive expectations and relational expectations.
Ans. (i) Marcov Expectations:
Marcov expectations claim that immediate past will repeat in future. In other words, we can say that most recent value of a variable is used to predict its future value. If price of an asset is Rs. 100 in period t, we can expect its price for period t+1 to be Rs. 100. To put it symbolically,
It is suitable in a stable environment. For example, when there is no inflation, no fluctuations otherwise, it can be used.
(ii) Adaptive Expectations:
It claims that people keep on revising their expectations i.e. keep on adapting expectations as per the latest information or in the light of forecast errors. It can formally be written as follows:
A is speed of adjustment. It means how fast investors change their expectations on the basis of past experience. Therefore, above equation can be rewritten as:
The value of alpha lies between 0 and 1. 0 indicates that adjustment never takes place and 1 indicates that adjustment is instantaneous. It means more is the value of alpha, faster is the adaptation in expectations.
(iii) Rational Expectations:
It was introduced by John Muth in 1961. It is very complicated method of forming expectations. It claims that the subjective expectations formed by anyone say an investor about returns on an investment, will be exactly equal to the mathematical conditional expectation suggested by economic theory. It says that economic agents are not illiterate and are well aware of probability methods and quantitative techniques. They may not know actual values of the variables but they do know their probability values.
It states that a person takes into account all available information in the process of forming expectations. It will involve all relevant variables in the context.
Q. 7. Explain what on optimum currency area means. How does it work?
Ans. An optimum currency area is an economic unit composed of regions affected symmetrically by disturbances and between which labor and other factors of production flow freely. The symmetrical nature of disturbances and the high degree of factor mobility make it optimal to forsake nominal exchange rate changes as an instrument of adjustment and to reap the reduction in transactions costs associated with a common currency. The theory of the optimal currency area was pioneered by economist Robert Mundell.
The two main characteristics of an optimum currency area are as follows:
1. Perfect mobility of labour is required across the region. It means
(a) Physical ability to move which includes visas, worker's rights, etc.;
(b) Lack of cultural barriers so that free movement can take place;
(c) Institutional arrangement like transfer of savings, acceptance of educational degrees etc.
2. Across the region, there should be complete capital mobility, price and wage flexibility. Practically, there can never be perfect wage flexibility. But it wants a system is such that money and capital reach where they are needed the most as per forces of demand and supply.
Q. 8. Critically assess the suitability of the Linear Probability Model in the analysis of credit risk.
Ans. Linear probability models are econometric models in which the dependent variable is a probability between zero and one. These are easier to estimate than probit or logit models but usually have the problem that some predictions will not be in the range of zero to one. The probability of observing a 0 or 1 in any one case is treated as depending on one or more explanatory variables. For the “linear probability model”, this relationship is a particularly simple one, and allows the model to be fitted by simple linear regression. The model assumes that, for a binary outcome (Bernoulli trial), Y, and its associated vector of explanatory variables, X,
and hence the vector of parameters beta can be estimated using least squares. This method of fitting would be inefficient This method of fitting can be improved by adopting an iterative scheme based on weighted least squares, in which the model from the previous iteration is used to supply estimates of the conditional variances, var (Y|X=x), which would vary between observations. This approach can be related to fitting the model by maximum likelihood.
A drawback of this model for the parameter of the Bernoulli distribution is that, unless restrictions are placed on beta, the estimated coefficients can imply probabilities outside the unit interval.: [0, 1] For this reason, models such as the logit model or the probit model are more commonly used. The assumption that a probability model is linear in the independent variables is unrealistic in most cases. Further, if we incorrectly specify the model as linear, the statistical properties derived under the linearity assumption will not, in general, hold. (Indeed, the parameters being estimated may not even be relevant.)
Q. 9. Explain decision-making under uncertainty. What are the features of a utility function under uncertainty?
Ans.
DECISION-MAKING UNDER UNCERTAINITY
Economists used to differentiate between risk and uncertainty. Risk is used for such situations the outcomes of which can be listed and one can assign probabilities to these outcomes. For situations of uncertainty, one cannot list outcomes nor can any probabilities be assigned. But recently such a distinction has become obsolete. Now situations of risk and uncertainty are used as interchangeably.
In this section the theory of individual decisionmaking has been extended to situations of uncertainty. Rationality is basic assumption of microeconomics. It means that a rational decision-maker wishes to maximize a variable that gives positive utility and minimize a variable that gives negative utility in the presence of some constraints. For example, a producer aims at maximum profit with cost constraint. Here also investors wish to maximize their returns with minimum costs. In case of consumers, preferences are monotonic that is more is preferred to less but in uncertain situations, utility function is quite complex. It is explained below.
However, decision-making under uncertainty was talked about in mean-variance portfolio analysis, now we are going to discuss decision-making by individual under uncertainty with keeping utility maximization as his basic aim.
We can think of different outcomes of some random event and a contingent consumption plan as being a listing of what the consumer will opt for in different outcomes of random event. Investors have preferences over different plans of contingent consumption like they have over actual consumption.
A utility function can be drawn to express the preferences of the consumer. Therefore, decisionmaking under uncertainty is based not on actual utility but on expected utility. Therefore, it is important to understand properties of expected utility, axioms that it should satisfy and finding if the individual is risk averse, risk lover or risk neutral on the basis of shape of expected utility function. To understand the concept of expected utility, let us assume two mutually independent
A strong assumption is made about the utility function. It is of independent utilities which means that the choice individuals make in one state of nature do not depend on the choices that they make in other state of nature.
Properties of Expected Utility Function
(a) Utility function is directly related to wealth i.e. more is always preferred to less. It is true for things that give positive utility. Mathematically, it means that first derivative of utility function is positive.
(b) An Investor can be risk averse, risk neutral or risk lover. It can be understood by understanding a fair gamble. A fair gamble is one in which expected returns are equal to the cost of undertaking gamble. For example, if the cost of playing a gamble is Rs. 100. Chances of winning and losing are equal. Then he must be getting Rs. 200 on winning to be willing to participate because cost of winning has to be equal to winning amount multiplied by probability of winning. Then it is a fair gamble. Risk aversion means that an investor will not participate in a fair gamble because the disutility of loss is higher to him than the utility of gain. Those utility functions which exhibit risk aversion have negative second derivative. It means that these curves are upward sloping but concave to the origin.
(c) The third property indicates the behaviour of investor with changes in wealth. There are three possible behaviours:
(i) If total amount of risky assets increases with increase in wealth, investor is showing decreasing absolute risk aversion.
(ii) If this total amount decreases with increase in wealth, he is exhibiting increasing absolute risk aversion.
(iii) If it remains same, he is exhibiting, constant absolute risk aversion.
If Wealth is shown by W and U’ and U” indicate first and second derivatives of utility then a measure of absolute risk aversion will be given by:
A(W) = –U”(W)/U’(W)
(d) The final property of the utility function is to see how the % or proportion of wealth invested in risky assets changes as wealth increases. If this percentage of risky assets increases with increase in wealth, investor is showing decreasing relative risk aversion. If this % decreases with increase in wealth, he is exhibiting increasing relative risk aversion. If it remains same, he is exhibiting, constant relative risk aversion. The measure of relative risk aversion is
R (W) = –WU’ (W)/U’ (W) = W A (W)
If R(W) is negative then investor is showing decreasing relative risk aversion.
If R(W) is positive then investor is showing increasing relative risk aversion.
If R (W) is zero then investor is showing Constant risk aversion.
To conclude our discussion let us consider the role of stock market in diversification of investment and risk spreading. The role of stock market is similar to that of an insurance company. The primary stock market allows the investors to convert their stream of returns into a lump sum over a time. The original owners can spread their risks by issuing shares to a very large number of people. Once they convert it into a lump sum they can invest it in diversified asset portfolio.
Q. 10. How does initial public offering mean? What are its costs?
Ans.
INITIAL PUBLIC OFFERING
When a company sells its stock in the security market for the first time, it is called Initial Public Offering (IPO). Prospectus provides information on these securities. Whenever a company wishes to invite general public for the subscription of its shares, it needs to issue a prospectus. New securities can be issued either by public issue or by private issue. There are two types of public issue: the general issue and the right issue. In the former, shares are offered to all interested investors and in the latter, shares are first offered to existing shareholders to maintain the proportionate interest in the company. IPOs are always general offers because if they would have been purchased by existing shareholders, there is no need to sell them publicly. Two types of securities are involved in public offering: Seasoned and unseasoned. In the former, those securities are included which are not being introduced for the first time. These types of securities already exist in the market. For example, if a company wants to expand and issues shares, its shares are already in the market. On the other hand, unseasoned securities are those which are being issued for the very first time. These are initial public offerings. There is no pre-existing price for them. It is negotiated between issuing company and investment bank.
IPOs may fail or earn huge first day gains. But generally these securities are accessible to institutional investors and therefore, individual investors hardly get an opportunity to make first day gains.
If a private limited company wants to get funds, it has two options one to take loans or issue debentures or sell partial ownership. If it chooses to sell ownership, it will become a public limited company, and it would prefer to “go public” to taking debt due to many reasons. Most important of it is that if it raises a loan through an IPO, it is not required to be repaid. On the contrary, if it issues debt securities, it needs to be repaid with interest.
How will be the price of an IPO comes into the picture once the security is available for dealing in secondary market. It is almost impossible for a small investor to make first day gains which are huge in many cases. It is so because it is almost impossible for a small investor to get an opportunity to buy these securities as it is too small to get into the IPO market before jump. By the time he gets to know about these profits, these are already purchased by institutional investors and market price has already gone up.
It is also possible that a firm is not able to raise capital through primary markets. In that case, it can also raise funds through other channels. It can get funds from a bank or some other financial institutions that may finance it; it is also possible to enter into joint venture or sale of some assets of the company. We also have adoption of private placement of securities. It can be either to angel investor or in appropriate circumstances to venture capitalists. Venture capitalists refer to those investors who are not outside, successful and old enough to raise capital in public equity markets, and hence they are forced to raise funds through private equity market. Venture capital is generally invested in enterprises which are extremely risky for public capital markets.
Private placement has a great advantage over IPO in terms of cost. There is a wide gap in cost of completing an IPO and cost of private placement. There are many costs in terms of documents to be published, persons to be hired, legal formalities and disclosure and obligations after the issue to be followed. It is easier if we have lesser stakeholders who are more educated and easily convincible. It makes decision-making easier and effective.
(b) Delay in Decision-Making:
So many stakeholders will make decision-making more time consuming and less effective.
(c) Lack of Monopoly Power:
When shares will be divided in so many investors, none will have a monopoly power.
THE COSTS OF PUBLIC OFFERING
IPOs are an important way of raising funds but it is not an unmixed blessing. It has its own limitations.
(a) When a company goes public, it loses its ownership.
(b) The most obvious cost of having an IPO is cost involved in monetary terms. For an IPO, many expenses need to be incurred which include legal fees, printing costs, accounting fee, commissions, etc. most important part of the cost comes from the facts that experts need to be hired for all paper and legal work.
(c) Once a company goes public, it is not more in a position to take independent decisions. Those who have purchased shares of the company have a say in the company even if they own a small share holding.
(d) Company has to make a lot of effort to satisfy its investors else they will sell the securities which will harm the repute of the company.
(e) Once a public offering is made, the company becomes liable to many legal formalities. Its annual financial report, internal transactions, and many other documents are open to inspection.
(f) Underwriting is a big headache in IPO. Sometimes as much as 9% or more but typically 6-7% is to be paid as underwriting commission. Lawyers, accountants and financial analysts will also take their share in the cake.
We need to do a cost-benefit analysis of all options of raising funds before we go for an IPO. Size of the company, stability, product lines, markets and management determines if IPO is advisable and successful or not. Investors consider ROI, ROE, DebtEquity ratio of the company before investing. An IPO is taken more favourably by the investors as compared to debt.
Q. 11. Discuss the role of stock markets in an economy.
Ans. Finance is the life blood of an economy. Capital is a basic factor of production. Stock markets are indispensible part of capital markets. We cannot imagine that an economy can sustain or develop without a well developed stock market:
(a) It mobilizes the savings of the small investors.
(b) It provides liquidity to the assets of investors.
(c) It provides funds to the companies to undertake productive activities.
(d) It increases inflow of foreign capital.
(e) It increases entrepreneurial ability in an economy by providing funds for investment.
(f) There are indirect benefits also in form of increased employment opportunities, share in GDP and increase in reputation of a country worldwide.
(a) Secondary markets are markets where equities that have already been issued are sold to new buyers by the original buyers of the shares. It consists of recognized stock exchanges which operate under rules and bye-laws duly approved by the government and authority body (SEBI).
(b) Some specific securities are allowed to be traded on a particular stock exchange. These are called listed securities.
(c) Only members can participate in trading. Investors are not allowed to trade directly. They need to place their orders with the members who are called brokers of the exchange.
(d) There are two systems of trading in stock exchanges: open outcry system and screen based system.
(e) In open out cry system, traders shout and use signals on the floor of the exchange, which has got many notional trading posts for different securities. Buyers make their bids and sellers their offers and deals are struck at a price where both agree.
(f) In the screen based system, the computer screen replaces the trading ring, and bidders are placed at a distance and bidding through networking. Through this, a large number of geographically separated participants can directly trade with each other.
Q. 12. Write short notes on the following:
(a) Value-at-risk
Ans.
VALUE AT RISK
Value at Risk is a measure of how the market value of an asset or portfolio of an asset is likely to decrease over time in normal situations. It is a type of risk metrics that explains the market risks of a trading portfolio probabilistically.
It was explained in third Chapter that there are some widely used measures of risks. VAR is such a measure that can be applied in a large number of cases like firms, banks, individuals etc. The variance or standard deviation gives the degree of deviation but not the direction from the mean. Volatility can be in both directions. VAR helps when banks are specifically interested in analyzing the worst case scenario about their portfolio.
Merits of VAR:
(a) It is general;
(b) It is based on probability distribution of a security’s portfolio market value;
(c) It is an all encompassing measure of the risk at least theoretically;
(d) It is applicable to all liquid assets.
VAR has two parameters. First is the time horizon for which it is held and second is the confidence level at which the estimate is made. If holding period is n days and confidence level is c %, VAR defines the likelihood that a given portfolio’s losses will exceed a certain amount on a normal market conditions over a given period. It gives a measure of maximum loss expected given the level of confidence on a given portfolio.
VAR metric is a real value function of the distribution of p1 condition upon information available at 0 and p0. VAR cannot anticipate changes in the composition of the portfolio during a day. Rather, it reflects the riskiness of the portfolio based on the portfolio’s current position.
If current time period is denoted by 0 and price of security by p0 we aim at assigning p1 a probability distribution where p1 is value at the end of trading day. Often we use time series analysis to study value of securities.
Another approach is to model portfolio’s behaviour in terms of specific risk factors. Risk factors may include exchange rates, interest rates, commodity prices, spreads and implied volatilities etc. the modelled risk factors are termed as key factors. These factors are listed into a vector and a valuation function is devised which expresses price of these assets as a function of key factors. This vector of prices is random. There are three methods of calculating VAR: The historical method; the variance-covariance method and monte-carlo simulation. Historical method reorganizes actual historical returns in an order of worst to best. It assumes that things will repeat in similar fashion again. The variance-covariance method is based on an assumption that stock returns are normally distributed. A montecarlo simulation refers to any method that randomly generates trials but it does not tell anything about underlying assumptions by itself.
VAR has some limitations which are as follows:
(a) If a large loss occurs, VAR does not tell us actual loss;
(b) Assumption of normal market condition may not hold good;
(c) It does not say anything about which of the portfolio component is responsible for the largest risk exposure;
(d) VAR of a combination of two positions may be more than the sum of VAR of the individual positions. It is against diversification principle.
(b) Functions of a merchant bank
Ans.
Responsibilities and Obligations of Merchant Bankers
Responsibilities of a Merchant Banker:
(i) Making a contract with the issuing company specifying their mutual rights, obligations and liabilities.
(ii) Submitting a copy of such contract to SEBI at least one month before the date of opening of the issue.
(iii) Refusing to accept to act as merchant banker if the issuing company is an associate.
(iv) Submitting a “due diligence certificate” to SEBI at least two weeks before the opening of the issue for subscription after verification of the contents of the prospectus or letter of offer regarding the issue and reasonableness of the content of views expressed therein.
(v) Submitting to SEBI documents like particulars of the issue, draft prospectus, other documents to be circulated to investors at least two weeks before the date of filing them with ROC and Regional Stock exchange.
(vi) Ensuring that modifications and suggestions made by SEBI regarding above documents have been incorporated.
(vii) Doing all duties until the subscribers have received share certificates.
(viii) Submitting complete particulars with SEBI within 15 days of the acquisition of securities of the company.
(ix) Making following disclosures to SEBI:
(a) Its responsibilities regarding the management of the issue.
(b) Any change in the information or particulars furnished with SEBI having bearing on certificate of registration issued to it.
(c) Details relating to the breach of capital adequacy norms.
(d) Details of the companies whose issues it has managed or has been associated with.
(e) Information about its activities as manager, underwriter, consultant or advisor to the issue.
It is obligatory for a merchant banker to abide by the rules and regulations of SEBI. A merchant banker who fails to comply with the conditions of SEBI is liable for
(a) Suspension of registration or
(b) Cancellation of registration. It cannot undertake any activity from the date of suspension till it is restored by SEBI.
No comments:
Post a Comment