Professional Documents
Culture Documents
Raman Chugh
PGDBM (Finance)
Enr. No. 11105
IIMT, Greater Noida.
DECLARATION
Risk and Return in Securities market are two sides of one coin. Securities market is
totally based on this concept of risk and return, without risk returns can not be there,
because the share market is a type of speculation and speculation always carry risk with
it. It depends upon investors how they diversify the risk, how they minimize the risk by
process is to maximize earnings in the context of an acceptable level of risk. With risk
defined as uncertainty, a key component of this process is delineating the possible range
of outcomes and their root causes. As new circumstances arise, a securities lender is
The risks inherent in any securities lending program — including market, credit,
liquidity, operational, legal, and regulatory — are all relevant to the principal common
principal. Of these, market and credit risk most readily lend themselves to quantification
and modeling due to the greater frequency and depth of the data available. The following
participants who accept non-cash collateral will be addressed in a later article that will
the current market rate of interest for an investment with a similar maturity structure and
credit quality will be valued in excess of par, while a security with a yield lower than the
current market rate of interest for a similar investment will be valued below par. In the
latter scenario, an investment might have seemed attractive at the inception of the
transaction, but with an increase in interest rates, the original investment is now trading
In effect, if the security is not sold prior to maturity, it will only incur an opportunity cost
or a foregone opportunity to earn the current yield. As such, NAV is an indicator of how
the portfolio will perform relative to the market going forward, and increased volatility of
A. Company Profile
Background of ShareKhan
4Ps in Sharekhan:
• Product
• Price
• Place
• Promotion
Competitors of Sharekhan:
• History of Company
• Financial Summary
• Balance Sheet
• Shareholding of company
• Top 5 mutual funds that own the company
• Management of the company
• Product of the company
Government policy
Taxation Aspect
Major Problems
Achievements
Future Prospects
B. Project Work
Chapter 2 Risk and Returns in Securities Market
Risk in Securities Market
Chapter 5
Recommendation
Bibliography
Annexure
CHAPTER. 1
SHAREKHAN DEMAT
Dematerialisation and trading in the demat mode is the safer and faster alternative to the
delays,thefts, forgeries, settlement risks and paper work. This system works through
depository participants (DPs) who offer demat services and the securities are held in the
national networkof franchisee, making our services quick, convenient and efficient.At
Safe andsecure. Demat as a parallel solution offers freedom from delays, thefts,
forgeries,settlement risks and paper work. This system works through depository
participants (DPs) who offer demat services and the securities are held in the electronic
form. As per the guidelines of SEBI the trading through different stock exchanges can
bedone only when the shares are in DMat form. DMAT shares means the shares are notin
material form they are converted into electronic form. The transfer of shares in trading by
stock exchanges is done with the help of only DMAT accounts of the clients where the
shares of the clients are entered as in DMAT form. So with so much relevance of
The product offered by sharekhan ltd. is its DMAT Account and its services.
These are:
1. Speed Trade
2. Classic.
SPEED TRADE
The speed trade account is DMAT account which is mainly for the large scale share
trading Those persons whose main business is only of share trading, who are the dealers
in the share market and the the share trading is not for investments instead of that it is for
Speed trade customers are different customers, so the services provided to them also
different as they are large clients for the company they are also provided many facilities,
they purchase and sell their shares in bulk and hence pay big amounts of brokerage to the
The company also take margin money cheques from these clients.Speed Trade clients are
different as per their sale and purchase of securities in market in bulk. The company
provide special research reports and assistance to the speed trade clients.
Speed trade clients can also access the relevant information regarding the trading from
They can ask for the minimum brokerage charges, transaction charges to the company.
The major services available to them with the d mat account are as follows
Depositary services
Exposure
Portfolio services
Back up services
Derivatives investments.
Company information
Market inquiry
Price quoting
IPO Services
Technichal Services
Newsletters
Discussions
Fundamentals
Alerts
Commodities
Commodities Futures
Credit etc.
CLASSIC ACCOUNT
Classic is one of the major product offering by Sharekhan ltd. The company’s main
clients are of Classic DMAT account. These clients are mainly Individuals, HUFs ,
Corporates and others trade in shares just for investment and speculation apart from their
operating activities, i.e. whose main business and area of operations are not share trading.
The persons who want to open Classic Account in the share khan requires the following :
1. Two passport size photographs.
4. An agreement book containing agreement with Sharekhan, NSE, BSE and other
The companies mainly clients are classic account holders, the company provide best
services to them. The company also take margin money cheques from these clients.The
brokerage etc. are charged by the company from the client are according to agreement
done with the client and hence it depends upon negotiating with the clients, the company
often charges minimum brokerage from the clients who trade in bulk.
The main services available to the cutomers of the classic account are
Depositary services
Exposure
Portfolio services
Back up services
Derivatives investments.
Market inquiry
Price quoting
IPO Services
Technichal Services
Newsletters
Discussions
Fundamentals
Alerts
Commodities
Commodities Futures
Credit etc.
Sharekhan ltd. does its business mainly with the help of the online and so it does its
business mainy through the its website. www. Sharekhan.com . The company provide all
above services through the links available in the website the main links available there
are:
My sharekhan
Services
Trade now
Research
News
Market Corner
Derivatives
Knowledge centre
All above links have further links explaining one by one as:
MY SHAREKHAN
Under the link my sharekhan different links are abailable there these links are mainly
My portfolio
Discussion board
My alerts
My preferences
My newsletters
Sharekhan Seminars
My portfolio
services, share khan provide the main services of portfolio and under that share khan
provide the information to the respective clients about the securities in therir portfolio,
their services, their prices, their reports about future position in market, their up an low of
purchased by the company in behalf of the client of a specific amount given by the client
for such portfolio and the link contains the main information of
price of purchasing,
Balance
Broketage charges
All these informations are available to the client of the company by inserting a user name
My alerts
My alert link is provided to the customer for the alerts to customer from time to time so
that customer can never remain uninformed regarding any thing before its occurrence,
under the link my alerts customers are informed about their requirements of
documentation for the clearance of trading, their securities buy and sale information,
expectation of the shares held by them in the market, any fees or charges due by them
like
Brokerage charges
Cheques dishonoured
My Newsletters
My newsletters link contains the newsletters abailable to the clients about their
information necessary and impotant to them regarding the market positions of their
shares held by them and other important news, new guidelines , necessary documents
Changes in the brokerage charges, annual maintainance charges and other important and
relevant information.
ShareKhan Seminars
Sharekhan organizes seminars across the country from time to time in order to educate
investors in various subjects related to the stock, derivatives and commodities market.
This exclusive Seminars are organized by Sharekhan for its Online Trading Customers
for FREE.
These Seminar will equip and help you take an informed investment decision. If you
wish
to built a healthy investment portfolio, ensure that you do attend our Seminar, which are
designed keeping in mind your requirements and organized by porfessionals.
All these Seminars are held by sharekhan from time to time as this is the part of its
services apart from one of its services, by seminars sharekhan can attract more new
Customers and can hold the existing customers, this is also the marketing strategy
SERVICES
The another major link available in the website of the company is services.
Online services
PMS
Commodity
DEMAT
Share shops
Mutual Funds
Online services
The major work by Sharekhan is done online. The online services are the reason of the
fast, fair and transperant services by the company, the online services mainly is online
The client is provided with a unique customer id and a password made by himself and
after registering with the id and password he can get anytime access to the trading link of
the site, aby entering the password and id. After that he can take market watch BSE,
NSE, can place order for sale , purchase, modify the order for sale, purchase of shares
and can trade in any security listed on the stock exchange whether in Equity and whether
in futures and options of shares equity. The funds transfer take place from the saving
This was regarding online trading of shares only but sharekhan also provide
online trading of commodities, in the same manner the clients can trade through different
commodity exchanges like national commodity exchange etc. They can place order
according to pre defined lot of commodity in the market through the exchange.
Apart from online trading services other online services are also available in sharekhan as
the IPO service are done online, research reports are provided online to the clients.
PMS
PMS is Portfolio management services as this is also one of the main services provided
by the sharekhan .The company charges different fees from the client for the PMS. As
many people are not able to decide which shares, equities are beneficial and they don’t
want to take risk so they hire the PMS of the company under that the experts employed
by the company make a portfolio of the securities of the amount given by the investor
and risk preference. My potfplio contains the information regarding the pms ie portfolio
management services, share khan provide the main services of portfolio and under that
share khan provide the information to the respective clients about the securities in therir
portfolio, their services, their prices, their reports about future position in market, their up
The information abailable in the potfolio link is regarding the combination of securities
purchased by the company in behalf of the client of a specific amount given by the client
for such portfolio and the link contains the main information of
price of purchasing,
Balance
Brokerage charges
All these informations are available to the client of the company by inserting a user
name.
DMAT:
As per the guidelines of SEBI the trading through different stock exchanges can be done
only when the shares are in DMat form. DMAT shares means the shares are not in
material form they are converted into electronic form. The transfer of shares in trading by
stock exchanges is done with the help of only DMAT accounts of the clients where the
So with so much relevance of DMAT accounts sharekhan also provide DMAT services
to the clients .Dematerialisation and trading in the demat mode is the safer and faster
freedom from delays, thefts, forgeries, settlement risks and paper work. This system
works through depository participants (DPs) who offer demat services and the securities
are held in the electronic form for the investor directly by the Depository.
corporate investors. Sharekhan have a team of professionals and the latest technological
expertise dedicated exclusively to our demat department, apart from a national network
and secure. Demat as a parallel solution offers freedom from delays, thefts, forgeries,
settlement risks and paper work. This system works through depository participants
(DPs) who offer demat services and the securities are held in the electronic form .
Commodity:
Commodity market in India is today developing very fast, the commodity market deals
with the actual commodity sale purchase through different stock exchanges available for
only commodity exchange, the system of commodity market is almost the same as to the
stock market.
Sharekhan securities provide the services to commodity as its different market segment
In commodity also the same types of services like portfolio, research reports, futures,
Mutual Funds
Share khan also provide the services of mutual funds to the client on the payment of
prescribed fees, Mutual funds are the most selling securities today in the share market
A mutual fund pools together sums from individual investors and invests it in various
financial instruments. Each mutual fund has its own investment objective, which broadly
Suppose a mutual fund sells one million units or shares (used as synonyms in this
context) at Rs 10 a share and collects a total Rs 10 million. If the fund objective stated
investment in blue-chip stocks, the fund manager would invest the entire proceeds (less
any commissions and management fee) of that sale in buying equity shares of companies
like Hindustan Lever, Reliance Industries, Hero Honda and so on. And each individual
who bought shares of the fund would own a percentage of the total portfolio only to the
extent of money invested. The value of the fund's portfolio would depend on how the
shares of these companies perform on the stock market (given their financial prospects).
If the total market value of these companies (as reflected in the fund) increases to Rs 12
million, then each original share of the fund would be worth Rs 12 (Rs 12 million
divided by one million shares). This per share value is what is known as the net asset
value (NAV) of the mutual fund. It equals the market value of all its assets (after
adjusting for commissions, expenses, and liabilities, if any) by the number of such units
or shares outstanding.
Mutual funds over direct investment in equities
As financial intermediaries, they do not come without risk. Also when defined in terms
of our chances of losing money, the risk in mutual funds is no different than that present
in other financial instruments. Still they are relatively safer and a more convenient way
on investing. They offer quick liquidity. Most private mutual funds can be redeemed in
three to four working days, unlike a fixed deposit that is more likely to be received a
month after its maturity, or an equity share after the end of its settlement period (or
depending up on our broker). This too cuts the overall risk associated with investing,
often not so visible and hence not accounted by many investors. But the market risk or
the risk that exists due to economy-wide factors remains. And there is always the
possibility that a fund fails to stick to its pre-determined objectives or invests in securities
that alter its risk profile. In which case, the blame goes straight to the fund manager and
the Asset Management Company (AMC), which manages the mutual fund. All said and
done mutual funds still have following advantage over direct investment in equities.
• Affordable
Almost everyone can buy mutual funds. Even for a sum of Rs 1,000 an investor can
• Professional Management
This is the biggest advantage mutual fund have over direct investment over equity. For an
average investor, it is a difficult task to decide what securities to buy, how much to buy
and when to sell. By buying a mutual fund, we acquire a professional fund manager who
manages our money. This is the person who decides what to buy for us, when to buy it
and when to sell. The fund manager takes these decisions after doing adequate research
on the economy, industries and companies, before buying stocks or bonds. Most mutual
fund companies charge a small fee for providing this service which is called the
management fee.
• Diversification
According to finance theory, when our investments are spread across several
securities, our risk reduces substantially. A mutual fund is able to diversify more
easily than an average investor across several companies, which an ordinary investor
may not be able to do. With an investment of Rs 5000, you can buy stocks in some of
the top Indian companies through a mutual fund, which may not be possible to do as
an individual investor.
• Liquidity
Unlike several other forms of savings like the public provident fund or National Savings
Scheme or real assets, you can withdraw your money from a mutual fund on immediate
basis.
• Transparency
Regulations for mutual funds have made the industry very transparent. We can track the
investments that have been made on our behalf and the specific investments made by the
mutual fund scheme to see where our money is going. In addition to this, we get regular
• Tax Benefits
Mutual funds have historically been more efficient from the tax point of view. A debt
fund pays a dividend distribution tax of 12.5 per cent before distributing dividend to an
individual investor or an HUF, whereas it is 20 per cent for all other entities. There is no
Having understood the basics of mutual funds the next step is to build a successful
investment portfolio. Before we can begin to build a portfolio, one should understand
some other elements of mutual fund investing and how they can affect the potential value
of our investments over the years. The first thing that has to be kept in mind is that when
we invest in mutual funds, there is no guarantee that we will end up with more money
when we withdraw our investment than what we started out with. That is the potential of
loss is always there. The loss of value in our investment is what is considered risk in
investing.
Even so, the opportunity for investment growth that is possible through investments in
mutual funds far exceeds that concern for most investors. Here’s why.
At the cornerstone of investing is the basic principal that the greater the risk we take, the
greater the potential reward. Or stated in another way, we get what we pay for and we get
paid a higher return only when we're willing to accept more volatility.
Risk then, refers to the volatility -- the up and down activity in the markets and individual
issues that occurs constantly over time. This volatility can be caused by a number of
variability, uncertainty and potential for loss, that causes investors to worry. We all fear
the possibility that a stock we invest in will fall substantially. But it is this very volatility
that is the exact reason that we can expect to earn a higher long-term return from these
Different types of mutual funds have different levels of volatility or potential price
change, and those with the greater chance of losing value are also the funds that can
produce the greater returns for we over time. So risk has two sides: it causes the value of
our investments to fluctuate, but it is precisely the reason we can expect to earn higher
returns.
We might find it helpful to remember that all financial investments will fluctuate. There
are very few perfectly safe havens and those simply don't pay enough to beat inflation
Choosing a mutual fund is not an easy task with so many funds. Rarely do investors-
things that they should evaluate about a fund, which they are considering buying. Here's
my blueprint for a structured approach to fund selection. There are four basic areas that
Performance:
Performance comparisons must be used only to compare the same type of fund. They are
meaningless otherwise. Only when used within the same category of funds performance
Risk:
Almost all investing is risky, at least those investments that get any meaningful returns.
In general it is said that the riskier a fund, the more its potential for earning high returns,
at least most of the time. However, this is a simplified view that implies that a given
amount of risk always gets the same returns. This is simply not true because not all funds
The true measure of risk is whether a fund is able to give the kind of returns that justify
the kind of risk it is taking. Evidently, this is not as easy to measure as returns. There are
a wide variety of statistical techniques that can be used to measure this. When someone
says that a fund has a good performance, it means that the fund, compared to similar
Portfolio:
Unlike performance and risk, portfolio is one of the 'internals' of a fund. It is internal in
the sense that the result of good, bad or ugly portfolios is already reflected in the first two
measures and it's perfectly OK to choose funds on the basis of those two measures alone
without actually bothering about what they own. My basic analysis of portfolios
measures whether a fund (I am talking about equity funds here) holds mostly large,
medium or small companies. It also looks at whether a fund prefers companies that may
be overpriced but which are growing fast or whether it prefers low-priced stocks
belonging to companies that are growing at a more gentle pace. For fixed income funds,
an analogous analysis tells one whether a fund prefers volatile but potentially high return
long-duration securities or stable and low return short-duration securities. Also, one can
analyze whether a fund prefers safer (lower returns) securities or riskier (higher returns)
securities.
Management:
Fund management is a fairly creative and personality-oriented activity. This may not be
true of some types of funds like shorter-term fixed-income funds and, of course, index
funds, but equity investment is more of an art than a science. When we are buying a fund
because we like its track record (and unless we can foresee the future, that's the only way
to buy a fund), what we are actually buying is a fund manager's (or sometimes a fund
management team's) track record. What we need to make sure is that the fund manager
who was responsible for the part of the fund's track record that we are buying into is still
there. A high-performance equity fund with a new manager is a like a new fund.
Cost:
Funds are not run for free and nor are they run at an identical cost. While the difference
in different funds' cost is not large, these can compound to significant variations,
especially for fixed income funds where the performance differential between funds is
quite small to begin with. Even for equity funds, it may not be worth buying a higher cost
fund that appears to be only slightly better than a lower cost one. There is no reason for
one AMC to have much higher costs than others, apart from the fact that it wants to have
a higher margin, or that it wants to spend more on things like marketing, which are of no
relevance to you. If an AMC wants higher returns from its business, then it must justify it
In addition to loads a mutual fund also charges asset management fees, and certain other
expenses. These charges imposed by mutual funds are meant to compensate the fund for
the expenses it incurs in managing assets, processing transactions and paying brokerages.
For instance every redemption request involves not only administrative processing costs
but also other costs associated with raising money to pay off the outgoing investor.
Mutual Funds cannot, however, be arbitrary in the imposition of these charges. For
instance, regulations stipulate that the difference between the repurchase and the resale
price cannot exceed 7 per cent of sale price, and that recurring expenses cannot exceed
Loads:
investor has to pay for the value of the units plus an additional charge. This additional
It is the charge imposed on the investor at the time of his exit from the scheme.
Operationally, therefore, the mutual fund will pay back to the investor the value of the
A mutual fund may not want to charge an exit load in all the cases. In such a case the
mutual fund may impose charges based on the time of withdrawal. Thus, a fund desirous
of long-term investors may stipulate that the exit charge will keep reducing with duration
of investment. Such a charge is called Contingent Deferred Sales Charge. The asset
redemption during the first four years after purchase, not exceeding 4% of the
redemption proceeds in the first year, 3% in the second year, 2% in the third year and 1%
in the fourth year. In order to charge a CDSC the scheme has to be a no load scheme as
per the regulation laid down by SEBI. The idea behind charging CDSC is the recovery of
• Switchover/Exchange Fee
It is the fees charged by a fund when the investor decides to switch his investment from
one scheme of the fund to another scheme from the same fund family.
• Recurring Expenses:
Apart from loads, mutual funds also charge some other expenses. Even here regulations
stipulate the ceiling on each head. Some of the fees charged by the fund are:
investor's money.
o Trustee Fees - is the fees payable to the trustees for managing the trust.
o Custodian Fees - is the fees paid by the fund to its custodians, the
the fund.
o Registrar and Transfer Agents Charges - is the fees payable to the registrar
and the transfer agents for handling the formalities related to the transfer
TRADE NOW
Trade now is one of major and important link in the website of the sharekhan. By this
link the customer who have a genuine ID and password can sale and purchase their
securities through online.
1. Fast Trade
2. Classic
RESEARCH
Sharekhan ltd. also provide research reports to its clients about the postion of market
For example which securities can fall and which can be up in the market , at what time
Which security should sale or purchase etc.Sharekhan understand that every investors
needs and goals are different. Hence it provide a comprehensive set of research reports,
so that customers can make the right investment decisions regardless of their investing
1. Fundamental
2. Technichal
3. Mutual funds
NEWS
This is the important service of Sharekhan limited , as when the customer logon to the
website of the company he don’t require to go another site for the news section,
Sharekhan’s experts edit the whole day news update the section for the whole day and
Present in simpler form in front of the investors. The major sections of news link are as
follows:
Top Stories
Sectoral news
Economy
Finance
Press Digest
Mutual Fund
IPO
Market Today
MARKET CORNER
Commodity Futures
KNOWLEDGE CENTRE
The link knowledge centre includes the following further links which are provided for
Increase in knowledge of the clients and prospective clients of the organsiation. The
School
Stock Trivia
Opinion polls
Book Reviews
FAQs
PRICE
The price is very important for any organization specially which there is tough
competition in the market. The prices charged by sharekhan are not so low so that
thebrand image in mind of customers and potential clients do not fall , and it is not so
The maximum charges under this are Rs. 750 [including the fees payable to NSE, BSE
and other regulatory bodies]The minimum charges under this are Rs. 375 [including the
fees payable to NSE, BSE and other regulatory bodies] this is in case of corporate deal.
With the cheque of Rs. 5000 as margin money the fees for this is charged as Rs. 500.
For the offline services only the charges are cheque of Rs. 460. These are for life time.
BROKERAGE CHARGES
MAINTENANCE CHARGES
No maintenance charges for first year, from 2nd year it is Rs. 300 p.a.
PLACE
Share Shops
Get everything you need at a Sharekhan
outlet!
Customers have to do is walk into any of Sharekhan 588 share shops across 213 cities in
India to get a host of trading related services – the friendly customer service staff will
also help them with any account related queries they have.
Share Khan ltd. has many branches all over the India through where the company
operates in different areas and The company has a long chain of frenchisee also so the
network of sharekhan ltd has spread across all over the country. Share khan shops are
available many places in India and customer can take assistance from any of these for the
Online BSE and NSE executions (through BOLT and NEAT terminals)
Daily research reports and market review (High Noon, Eagle Eye)
Cool trading products (Daring Derivatives, Trading Ring and Market Strategy)
Personalised advice
Live market information
Agra
Ahmedabad
Allahbad
Ambala
Amritsar
Anand
Banda
Bangalore
Baroda
Belgaum
Bhopal
Bhubneshvar
Bijapur
Bhopal
Bhubnshvar
Calcutta
Chennai
Coimbtore
Cuttack
Dadri
Dehradun
Dispur
Faridabad
Gandhinagar
Gangtok
Gurgaon
Gwalior
Habra
Hubli
Hyderabad
Indore
Itarsi
Jaipur
Jammu
Jalandhar
Kanpur
Kochi
Lucknow
Ludhiana
Mumbai
Mysore
Nagpur
Nasik
New Delhi
Noida
Pathankot
Patna
Pondicherry
Pune
Sagar
Solapur
Surat
Thiruvanantpuram
Ujjain
PROMOTION
Sharekhan limited is one of the leading broketage house in India , as it is 85 years old it
is has become a brand name in India. For attracting more customers sharekhan also do
some
other activities for its promotion. The punchline of the company in it advertisement is “
YOUR GUIDE TO FINANCIAL JUNGLE” as the logo of the company is the lion so
this combination itself suggest Sharekhan to be a king of the financial jungle or share
market.Company advertise itself through print media most, The ECONOMIC TIMES,
BUSNESS WORLD etc. mostly contain its advertisement. Apart from the print
Advertisements, company also advertise itself by way of Canopies etc. Other than way of
advertisement the company promote itself by presales and post sale services as by
arranging first step seminars and by customer care department. The company provide
free of cost research repots 3 times a day to the clients for which mostly other companies
charges heavy fees. The company provide yearly magazines to the clients named Value
line. Thus by the adoption of the different means the company is promoting itself.
MARKETING STRATEGIES
PRODUCT STRATEGY
The product strategy of the company is very good to compete with competitors the
company operate in different field of the financial services which provide the different
Equity Trading
Commodity
Futures in Commodity
Mutual Funds
IPO
Depository
PRICE STRATEGY
The price strategy of the Sharekhan is also better. The following are its features:
It have a different range of prices for different type of customersIt have very less
maintenance charges.It have different range of brokerage charges that depends upon the
order of the client.It do not charge any hidden charges like many other competitors which
PLACE STRATEGY
Share khan have 588 share shops in 213 cities across the India. That provide a large
PROMOTIONAL STRATEGY
Sharekhan adopt different promotional activities for the growth of the organization. The
Advertising:
Awareness:
Sharekhan also promote itself by awaring people about itself and share market, its
Seminars
Canopies.
Surveys.
TIE UP
As its strategies Sharekhan have also tie up with the following Banks. These banks are
HDFC Bank.
Indiabulls Financial Services Ltd (Indiabulls) is one of the leading integrated retail
financial services company in India which was incorporated in the year 2000. It offers a
full range of financial services and products ranging from Equities to Insurance.
Indiabulls provides full access to all the products and services through multi-channels. As
on 31st March 2005,the company operates through its head office in New Delhi and 148
offices in 76 cities. The company completed its Initial Public Offering in September 2004
by issuing 27,187,519 equity shares of par value of Rs.2 per share at a premium of Rs.17
per share. The company has raised Rs.51.6 crores and has used the proceeds to
consoildate its market leadership and enter new businesses. Indiabulls Securities Ltd,
Indiabulls Insurance Advisors Pvt Ltd, Indiabulls Commodities Pvt Ltd, Indiabulls Credit
Services Ltd and Indiabulls Finance Company Pvt Ltd are the subisidiaries of the
prices, detailed data and news, intelligent analytics and electronic trading capabilities.
Management of the Company
Director
Commission Rs. 0 0 0 0
Profit on sale of
Rs. 0 0 0 0
Investment
Financial Summary
Shareholding Top 3
AdditionalCompanyProfileDetails
Chairman/BoardMembers:
Whole-timeDirector : SameerGehlaut
FaceValue:2
MarketLot:1
in Mar.'94. FFSL, together with its associates, have acquired 16.52 lac fully paid-up
48.75 per share, representing 43.95% of the voting capital of EFCL, later in Jul' 95 it was
amalgamated with the company. The company is engaged in the business of leasing, hire
purchase and other related financial services. FFSL went public in Feb.'95 to augment
resources to meet the needs of its planned growth. The company obtained its category-I
merchant banking registration from SEBI in Apr.'95. The company has been trying hard
to recover money from various clients through legal procedures and various other
measures and accordingly written off Rs 37.14 cr during the year 1999-2000 in cases
Name
Installed Production
Product Name Unit Sales Quantity Sales Value
Capacity Quantity
Shareholding Top 3
Total Promoters 78.71
Total Public & Others 13.49
Total Foreign 4.16
Price status of the company as on july 3, 2006
Chairman/BoardMembers:
Chairman : HarpalSingh
FaceValue:10
MarketLot:1
Industry:Finance&investments
History of the company
The KVB had commenced its banking business in 1916 at Karur Town (Tamilnadu).
Over the years the bank has graduated to become one of the top banks in the private
sector with strong and healthy fundamentals. The Bank has been changing its style of
functioning to fit into the constantly changing and dynamic technology age. Apart from
regular banking business, the bank also focuses on merchant banking, leasing and other
fee-based business. Merchant banking activities have been beefed up by creating separate
cells in Mumbai, New Delhi, Chennai and Secunderbad to cash in on the growing
potential in the capital market following the growth impulses in the economy. In 1995 the
bank issued 20,00,000 bonus shares in the ratio of 1:1 which was followed by rights issue
in the ratio of 1:2 at a premium of Rs 25 per share in 1996. Thus equity share capital
stood increased to Rs.6 crore. KVB and I-Flex Solutions have announced that I-Flex's
flagship product Flexcube was deployed across 183 branches of the bank. The
deployment of the flexcube Universal Banking system will enhance bank's corporate and
Retail banking business, and offer its customers anytime, anywhere access to its services.
This software would help to offer customers services through multiple delivery channels
including internet, phone, ATM etc. With a view to strengthening its capital base and
offering attractive returns to shareholders,the bank has awarded its shareholders bonus
shares in the ratio of 1:1. Subsequent to this bonus issue the Equity capital stood
increased at Rs.16.40 crores from Rs.6 crores. The bank has also made rights issue on
December,2002 to January,2003 and the issue was oversubscribed. The bank has tied up
for bancassurance with Bajaj Allianz General Insurance to hawk their non-life insurance
products through their branches. The total branches as at March,2005 were 231 and the
ATMs at 156. During 2004-05 the company introduced 6 new loan products i.e KVB
Special Home Loan, IPO Funding Scheme, KVB Kisan Mithra Scheme, Easy Trade Fin
Scheme, KVB Happy Kisan Scheme and Gold Card Scheme for Export Constituents of
the Bank. Further the company has launched a new product 'Cash Passport' which is
similar to ATM/Debit card and this product is offered in pursuance of the agreement
entered into with 'Travelex' which is engaged in travel related services all over the world.
Travellers going abroad can use this card preloaded with the required foreign exchange.
In 2004-05 the bank has entered into an agreement with MITR consortium because of
which ATMs of Punjab National Bank, Oriental Bank of Commerce, Indian Bank and
UTI Bank are at the services of KVB customers. Further the bank has implemented
RTGS facility for instant funds transfer across the country in 26 centres. In 2005-06 the
bank has launched Mobile Top-up facility to re-charge the cell phone of all service
LIABILITIES
ASSETS
Short Notice
Investments + 2298.13 2219.03 2173.01 1845.08 1538.91
Advances + 5555.45 4619.8 4023.24 3344.4 2460.03
Fixed Assets + 98.43 102.16 92.18 85.53 73.7
Other Assets + 273.53 288.69 221.21 209.65 178.43
Contingent Liabilities
2552.92 2003.48 1958.66 1999.1 1907.03
+
Bills for collection 520.23 381.67 432.87 234.44 213.49
Chairman/BoarMembers:
Chairman&CEO : PTKuppuswamy
FaceValue:10
MarketLot:50
ICICI Bank (ICICIBK) is a commercial bank promoted by ICICI Ltd, an Indian Financial
Institution. It was incorporated in Jan.'94 and received its banking licence from Reserve
Bank of India in May.'94. It is the 2nd largest bank in India. The bank has 562 branches
& extension counters across India and 1910 ATMs. The Bank offers a wide spectrum of
,Insurance, Venture Captial, asset management, cross border business & treasury and
foreign exchange services besides providing a full range of deposit and ancillary services
for both individuals and corporates through various delivery Channels and specialized
subsidiaries. All the branches are fully computerised with the state-of-the-art technology
and systems, networked through VSAT technology. The bank is connected to the SWIFT
International network. The bank has 14 subsidiaries across India and other countries like
Uk, Canada and Russia. To maintain the leadership status bank foray into internet
banking by web- enable its existing products and services. It has gained favourable
acceptance from its customer for its initiatives in business to business and business to
customer solution. To efficiently distribute its products and services, the bank has
developed multiple access channels comprising lean brick and mortar branches, ATMs,
call centers and Internet banking. The Bank has introduced the concept of mobile ATMs
in the remote/rural areas. It has also extended its mobile banking services to all cellular
Singapore. In 2000-01 the Bank of Madura (BOM) got merged with ICICIBK. With this
merger ICICIBK has become one of the largest private sector banks in India. The Board
2001. The two subsidiaries of ICICI Ltd viz ICICI Personal Financial Serivces and ICICI
Capital Services was also merged with the ICICI Bank with effective from 28th March
2002. During May,2003 the bank has acquired Transamerica Appple Distribution
Finance Private Ltd which is primarily engaged in financing in the two-wheeler segment.
After acquisition the name of the company was changed to ICICI Distribution Finance
Private Limited. The Banks subordinated long-term foreign currency debt was upgraded
to Baa3 to Ba1 by Moody's Investor Service. In the Wholesale Banking segment,the bank
has achieved a significant milestone in the market making activity by expanding the
product suite to include foreign exchange options against Indian Rupee as RBI allowed
them to be traded w.e.f.07.07.2003.The bank has emerged as one of the largest market-
Chairman N Vaghul
Managing Director & CEO K V Kamath
Director Somesh R Sathe
Director Lakshmi N Mittal
Director Anupam Puri
Director Marti G Subrahmanyam
Deputy Managing Director Nachiket Mor
Joint Managing Director Kalpana Morparia
Deputy Managing Director Chanda D Kochhar
Director P M Sinha
Nominee (Govt) Vinod Rai
Director M K Sharma
General Manager & CS Jyotin Mehta
Joint Managing Director Lalita D Gupte
Addtnl Non-Executive Director V Prem Watsa
Director Sridhar Iyengar
Director T S Vijayan
Additional Director R K Joshi
Additional Director Narendra Murkumbi
LIABILITIES
ASSETS
Notice
Investments + 50487.3 42742.9 35462.3 35891.1 8186.86
Advances + 91405.1 62647.6 53279.4 47034.9 7031.46
Fixed Assets + 4038.04 4056.41 4060.73 4239.34 384.75
Other Assets + 9574.82 8232.02 8468.83 5007.82 539.83
Contingent
268154 202942 89438.5 39446.6 13848
Liabilities +
Bills for collection 2392.09 1510.93 1336.78 1323.42 1229.8
Total Shareholding of the Company
Chairman/BoardMembers:
Chairman : NVaghul
FaceValue:10
MarketLot:1
Industry:Banks-PvtSector
Karvy
Karur Vysya Bank Ltd. The KVB had commenced its banking business in 1916 at
Karur Town (Tamilnadu). Over the years the bank has graduated to become one of the
top banks in the private sector with strong and healthy fund.
Financial Summary
ASSETS
Contingent Liabilities
2552.92 2003.48 1958.66 1999.1 1907.03
+
Bills for collection 520.23 381.67 432.87 234.44 213.49
Financial Analysis of the company
Shareholding Top 3
Total Public & Others 55.10
Total Foreign 20.93
Total Institutions 10.56
in any organization for the management of that organization. These principles are about:
Division of work
Work Specialization
Equity
Organizational hierarchy
Unity of command
Unity of direction
Scalar chain
Spain of control
Communication
Equity
Motivation
Team Work
Employees’ participation.
In Sharekhan I observed most of these principles are outdated or are present in the
organization in some different or modified form these principles are discussed with
Division of work ;
Work division is done in Sharekhan securities ltd. but the employees working there are
not restricted to do other jobs which are not assigned to them in case of necessity the
employees cooperate each other and handle the other jobs also.
Work specialization
This principle is followed in Sharekhan, the employees are placed according to their
area of specialization, like marketing people for marketing of product of company and
people from finance for research analyst jobs and technicians are people from
Technology background.
Organizational hierarchy
the organization , this is not exactly same in the Sharekhan however the relationship of
the people in Sharekhan have been pre defined but the employees work together as team
work. There are no formalities an executive can directly meet to the branch manager
The organizational chart in the Sharekhan is as follows mainly concerned for a single
branch
Chief executive
officer
Branch Manager
Territory Manager
Assistant Relation
Manager manager
Executives
Thus this is the hierarchy of the management in the Sharekhan ltd, but the relations for
accountability, communication etc. are not so much formal as provided in management
theories.
GOVERNMENT POLICY
Sharekhan limited is a brokerage house. The company follows all the rules and
regulations as prescribed by companies law, and other guidelines issued by the SEBI for
a company. Morever SEBI also regulates the brokers of the share market. As being a
brokerage company Sharekhan always follow the prescribed guidelines issued by the
SEBI and other laws. That is the reason that ShareKhan was not listed in the black
Share khan always comply with legal formalities. It functions very transperantly, It
Registration norms
Thus Sharekhan is a clean and transperant organization which follows all the rules and
years old in this field. The original name of co. is S.S. Kantilal Ishwar lal Securties pvt.
Ltd. but the company advertise it with the name of Sharekhan ltd.
Customers have to do is walk into any of Sharekhan 588 share shops across 213 cities in
India to get a host of trading related services – the friendly customer service staff will
also help them with any account related queries they have.Share Khan ltd. has many
branches all over the India through where the company operates in different areas and
The company has a long chain of frenchisee also so the network of sharekhan ltd has
spread across all over the country. Share khan shops are available many places in India
and customer can take assistance from any of these for the product and service availing.
Regarding international image company deals in share market in India, so the other
countries people mostly through their own country stock exchanges and Sharekhan is
registered with Indian stock exchanges, however as it functions through online system so
the NRIs who invest in Indian share market mainly invest through Sharekhan so the
About the taxation of the company Sharekhan ltd always pay its taxes timely and
honestly.
1. Income Tax
2. Sales Tax
3. Service Tax
However the company don’t reveal the amount of the taxes paid by it as it is not
necessary for it to do so because the company operate its business under the name of
“S.S. Kantilal ishwar lal securities pvt. Ltd, which is not a public company and hence
Morever Sharekhan ltd. as being public company have not issued its capital to the
general public so it also need not to show its accounts reports like P&l and Balance
Sheets publicly.
A company’ s share market postion refers its prices position of shares in the securities
maeket. Those companies which are listed on the stock exchanges have already issued
But Sharekhan limited has not issued its capital in the general public till now,
consequently it is not listed on the stock exchanges and hence the question for the share
• The company is the winner of Best Research publisher awards for 2005 for its
The future prospects of the company are bright of course, because of its fair and
transparent operations in the business, it has never been black listed by any legal body
The company in coming years will left its all competitors a far back and will be the only
image in the financial market services. In coming month company is also issuing its First
IPO for the general public and hence its shares will also be traded in the securities
market.
acceptable level of risk. With risk defined as uncertainty, a key component of this
process is delineating the possible rangeof outcomes and their root causes. As new
The risks inherent in any securities lending program — including market, credit,
liquidity, operational,legal, and regulatory — are all relevant to the principal common
principal. Of these, market and credit risk most readily lendthemselves to quantification
and modeling due to the greater frequency and depth of the data available.The following
participants who accept non-cash collateral will be addressed in a later article that will
MARKET RISK
Market risk potentially impacts both the future market value of a portfolio of assets
and/or liabilities andspread income associated with the portfolio. The market risk
associated with securities lending containstwo components: interest rate risk and spread
rate risk.
the value of theintegrated portfolio (i.e., both the collateral reinvestment and the funding
portfolios). This type of riskarises from maturity/reset timing mismatches between the
asset and liability positions. As noted in theDigest’s first article, the liability is the cash
collateral received from a borrower that has a certain costwhile the asset is the
investment purchased using that cash collateral that generates a certain yield.
To illustrate, consider an agent lender who has the opportunity to invest the cash received
from anovernight loan for which the agent lender will have to pay a 3.00% rebate into a
security that matures inthree months and yields 3.50%. There is a risk that over the
course of the three months the loan supporting this investment will become more
expensive (the rebate will rise), and thus spread incomewill decrease or potentially turn
negative. Had overnight rates actually increased more than anticipatedduring this period,
the three-month investment may not have been the optimal alternative.In this case,an
investment with a shorter maturity, albeit possibly initially at a lower spread, might have
been thebetter alternative since it would have matured more quickly and been reinvested
into an instrument reflecting current interest rates. In fact, as part of the interest rate risk
management process, a numberof alternative interest rate “paths” are modeled, in which
the timing and magnitude of potential ratechanges are examined.In addition to having an
effect on spread income, changes in interest rates also have an impact on themarket value
of the portfolio. The relationship of market value to purchase price is captured by its net
asset value (NAV). The first Digest article noted that a security with a yield exceeding
the current market rate of interest for an investment with a similar maturity structure and
credit quality will be valued inexcess of par, while a security with a yield lower than the
current market rate of interest for a similarinvestment will be valued below par. In the
latter scenario, an investment might have seemed attractiveat the inception of the
transaction, but with an increase in interest rates, the original investment is now trading
In effect, if the security is not sold prior tomaturity, it willonly incur an opportunity cost
or a foregone opportunity to earn the current yield. As such, NAV is anindicator of how
the portfolio will perform relative to the market going forward, and increased volatilityof
Spread rate risk can be viewed as either market- or credit-related, but is best summarized
as the marketrisk associated with the macro-economic credit outlook. This risk affects
floating rate securities, whose return is impacted by the following elements: the index
rate and the spread over this rate, and an elementnof risk associated with each. The index
rate, or reference rate, is a designated interest rate to which the coupon of a floating rate
security changes (e.g., Prime, LIBOR). For example, consider a security that pays
LIBOR + 5 basis points and resets on the 15th of every month. The interest rate risk
component is a function of the time to reset for the index rate, which in this case would
be between the 16th of the current month and the 14th of the following month. Spread
rate risk would be the risk that the 5-basis-point spread to the index is no longer at a level
appropriate to the
security.
The effect of such a change in market spreads has significant market value implications
for floating rate securities, which generally have longer expected maturities than the
widening and tightening of such spreads, which generally occurs in response to changes
securities of which this issue is a part (e.g., AA Finance), will typically vary within a
narrow band. Over the longer term, it is the potential for changes in interest rate levels —
and not spreads — that poses the greater risk to earnings. Clearly, this is what makes
CREDIT RISK
The second primary risk factor is credit risk. This risk takes two forms — reinvestment
Reinvestment credit risk is the risk that a change in the creditworthiness of an issuer will
result in achange in the market value of the issue. Whereas spread rate risk measures the
risk of a change in valuedue to changes in broad market credit concerns, credit risk, in
this context, measures the risk to value for a specific issue/issuer. In the extreme case, it
is the risk that default, or the inability of the issuer tomeet payment obligations, will
result in a substantial erosion in value. Changes in credit quality that do not result in
default will not have a realized monetary consequence unless the issue is sold prior to
maturity. However, there is an opportunity cost to the extent that the yield available to
current purchasers of the security is higher. A defaulted issue can impair the value of the
reinvestment portfolio to the extent most or all of its value is not recoverable.
All securities purchased for the collateral reinvestment vehicles must meet strict credit
quality standards. State Street devotes significant resources to analyzing the ongoing
creditworthiness of both its approved issuers and any prospective issuers under
Borrower credit risk arises from the potential inability of a borrower to return the loaned
securities. Losses can arise when the collateral on hand is insufficient to purchase
replacement securities at the time at which a borrower defaults. Borrower credit risk is
alow probability, but potentially high impact, event.This risk can be mitigated by
entering into lending agreements with highly rated counterparties and by ensuring that
the loans are properly collateralized on a daily basis. State Street conducts a rigorous
analysis of both prospective and current borrowers to ensure clients’ financial protection.
This analysis is performed on a regular basis — monthly, quarterly and annually —and
developed that combines the potential residual (or unsecured) risk in a portfolio of loans
and collateral to an individual borrower with an assessment of the likelihood that the
borrower will default over a defined time horizon. Residual risk is defined as the level of
price risk that may be unsupported by the collateral margin held.The beneficial effect of
the analysis.
SL PERFORMANCEANALYZER®
The monitoring and management of risk within the portfolio is a key part of the return
track portfolio market and credit risk through time, view program earnings within this
context, and view an internally derived combined estimate of this risk going forward.
The RiskReturn Trend Analyzer enables a securities lending participant to view spread
return relative to aggregate portfolio risk (market and credit) over time. These risks will
vary in response to both changes in the risk profile of the portfolio and the volatility of
underlying market rates and spreads. The light bluebars represent spread, dark blue bars
represent risk and the grey line represents risk-return ratio. By having
access to such a metric, a participant can easily identify changes to the risk-return
dynamic.
THE NAV TREND ANALYZER
The NAV Trend Analyzer provides a view of the current NAV of a given collateral
fluctuate over the coming month. This estimate combines the risk profile of the collateral
reinvestment portfolio with State Street’s expectationfor the volatility of underlying rates
is expected to fall. The preceding table details the current NAV projected one month
forward and the level at which the NAV actually settled. Widened bands signal periods
investors alike. The Optionetics approach to the markets prioritizes this topic and
provides individuals with a foundation for success. This three-part series will focus on
InflationRisk
The existence of inflation risk is the main reason individuals accept market risk. If
current dollars had the same purchasing power any number of years going forward, a
compounded rate of return from liquid US Treasury Bills would certainly satisfy a
conservative investor and may even compete for the aggressive investor’s attention.
So if the next 72.4 years exactly duplicates the period evaluated, you have less than a
penny to spare if your expenses remain the same and you choose to invest solely in T-
Bills. However, if you use a more realistic three month holding period for T-bill assets
with a 100% return of principal, you are left with an amount that is slightly under $1.00
(0.9924). Without inflation the picture is much rosier; an initial investment in T-Bills that
is left to compound monthly (rather than a quarterly compounding) will provide the
investor with an account valued at more than 15 times the initial amount.
Bond Risk
Perhaps a conservative investor decides that by simply replacing the T-Bill investment
with a longer maturity Treasury Note, all will be fine regardless of inflation. Although T-
Note yields are usually higher than T-Bills, periods where the yield curve becomes flat or
inverted highlight a different issue. The timing of the purchase for the longer term
security will impact investment returns. This brings us the next investor risk—interest
rate risk.
Interest rate risk is the risk of having your money locked into a lower rate of return while
interest rates rise. Assuming the asset is held to maturity to benefit from the 100% return
of principal, the longer the term to maturity for the fixed income investment, the more
opportunity there is to receive sub-standard interest rates on the money. As a result, the
10-year note is deemed to have more interest rate risk than the 90-day bill, while the 30-
year bond is deemed to have more interest rate risk than both
Using 10-year note returns starting in April 1953 and assuming 10-year holding periods
with inflation, a $1.00 initial investment will be valued at $2.65 after 639 months (53
years). A conservative investor may feel a 265% return is acceptable; however, we have
yet to account for taxes. Incorporating a 20% tax applied semi-annually results in a final
value of $2.21.
An investor who seeks even better fixed income returns by entering the municipal or
corporate bond world encounters yet another type of investment risk: credit risk.
Although defaults are less likely in the municipal bond market (reflected by lower
yields), they can occur. This type of investment does benefit from favorable tax treatment
In terms of corporate bonds, credit risk increases (reflected by higher yields) as the credit
rating decreases. AAA corporate bonds are deemed less risky from a return of principal
standpoint and, therefore, offer lower yields. Interest is taxable and there’s no guarantee
that the credit rating and safety of the bond downgraded during the holding
period.
At this time, historical municipal and corporate bond returns will not be analyzed. Those
interested may want to pursue this analysis using a bond fund or exchange traded fund
(ETF) proxy such as a Nuveen Municipal Fund or the iSharesâ Corporate Bond Fund.
The biggest challenges include obtaining sufficient return histories and incorporating
Investors generally turn to the stock market to realize returns that will outpace inflation
after accounting for taxes. Modern Portfolio Theory (MPT) serves as one basis for
portfolio construction aimed at maximizing reward while minimizing risk. This approach
1) Capital Market Line Represents optimal portfolios for a given level of risk.
Capital Asset Pricing ModelAssesses the risk-return impact of adding a security
2)
(CAPM) into a well diversified portfolio.
A linear asset price model based on risk versus
3) Security Market Line
returns.
A linear model of asset return versus market
security risk.
Inflation risk represents the risk associated with insufficient returns (not keeping pace
with increasing costs), while credit risk and stock market risk highlight represent the risk
associated with seeking higher returns (losses). Investors generally seek maximize
returns for a given level of risk by diversifying their portfolios (see previous articles on
portfolios.
A two-part personal finance article series from May & June this year examined the
impact of inflation and investment returns on retirement savings when income was
removed from the account on a monthly basis. A thirty year period was examined starting
with January 1962 and investment returns were based upon actual S&P 500
Using the same monthly inflation, return and dividend data, a $1 initial investment and a
20% tax rate on gains applied quarterly, the ending balance after 30 years was
approximately $1.26, or 126%. Remove the dividend returns and the account is valued at
$1.11 after thirty years. This represent a nice difference from compounded fixed income
returns over a 70 year period, particularly since the return of 0.12% excluded taxes.
Although the 10-year note return of 221% over 53 years seems to be an argument for T-
Note investments, when using thirty year results from initiation of the strategy, $0.96
remained in the account. Again, due to interest rate risk, the month of initiation will
impact the results with different thirty year periods yielding different returns.
Investment Risk
Investment risk includes credit risk and market risk which are both taken to combat
another risk—that due to inflation. Investors and traders need to assess the actual historic
results of the strategies they employ for their investments. In this manner, the individual
can better understand the true financial risks in which they are exposing themselves. Two
such risks may include under-investing in bonds & equities or over-investing in assets
with limited returns (i.e. an SPY Leap only strategy that misses
dividends).
In order to manage necessary market risk, the investor must take steps to understand
those risks and minimize them through diversification. Numerous articles on the topic of
asset allocation and diversification are available in the Optionetics.com article archives
by completing an author keyword search for 2004 and 2005. Traders, who often self-
investments versus the performance of trading given the goals for each, and re-evaluate
those allocations.
RETURNS IN SECURITIES MARKET
HISTORY
How to Calculate ReturnsThe Relationship between Inflation and Returns The Historical
common stocks - Average annual returns What’s the difference between Returns and
- relative to a benchmark
- inflation
- discount rate
- risk: dispersion
RETURN
STD 30%
DRAWS
• price change - loosely, capital gain or lossThe return calculation is unaffected by the
dollars.
• Real Returns - returns that have been adjusted for inflation;percentage change in
purchasing power.
the expected inflation rate. Let r be the nominal rate, R be the real
hence r = R + if + (R x if)).
2. A definition whereby the real rate can be found by deflating the
R = (1 + r) / (1 + if) - 1.
• AAR =
• GAR =
GAR/Holding-Period Returns
The holding period return is the return that aninvestor would get when holding an
()1(
2 1 - + ??+ ?+ =
nrrrm
Note the GAR is annualized version of theholding period return.Risk and Return - 8
Holding Period Return: ExampleSuppose your investment provides the following returns
1 10%
2 -5%
3 20%
4 15% % 21 . 44 4421 .
1 ) 15 . 1 ( ) 20 . 1 ( ) 95 (. ) 10 . 1 (
1)1()1()1()1(
4321
==
- ???=
- + ?+ ?+ ?+ =
rrrr
Holding Period Return (GAR): ExampleAn investor who held this investment would
Year Return
1 10%
2 -5%
3 20%
4 15% % 58 . 9 095844 .
1 ) 15 . 1 ( ) 20 . 1 ( ) 95 (. ) 10 . 1 (
)1()1()1()1()1(
4321
==
- ???=
+ ?+ ?+ ?+ = +
rrrrr
• So, our investor made 9.58% on his money for fouryears, realizing a holding period
Year Return
1 10%
2 -5%
3 20%
4 15%
% 10
% 15 % 20 % 5 % 10
=++-=
+++=rrrr
A famous set of studies dealing with the rates of returns oncommon stocks, bonds, and
Treasury bills was conductedby Roger Ibbotson and Rex Sinquefield.They present year-
1926 for the following five important types of financial instruments in the United States:
10
1000
Common Stocks
Long T-Bonds
T-Bills
$40.22
$15.64
Source: © Stocks, Bonds, Bills, and Inflation 2000 Yearbook™, Ibbotson Associates,
– 90% + 90% 0%
Average Standard
5.0 RISK
• The portion of variability present in a typical single security that isnot present in a large
group of assets held together (portfolio of assets) is termed diversifiable risk or unique
risk.
DRAWS
• price change - loosely, capital gain or lossThe return calculation is unaffected by the
dollars.
• Real Returns - returns that have been adjusted for inflation;percentage change in
purchasing power.
the expected inflation rate. Let r be the nominal rate, R be the real
rate, and if be the expected inflation rate,
hence r = R + if + (R x if)).
R = (1 + r) / (1 + if) - 1.
• AAR =
• GAR =
GAR/Holding-Period Returns
The holding period return is the return that aninvestor would get when holding an
()1(
2 1 - + ??+ ?+ =
nrrrm
Note the GAR is annualized version of theholding period return.Risk and Return - 8
Holding Period Return: ExampleSuppose your investment provides the following returns
Year Return
1 10%
2 -5%
3 20%
4 15% % 21 . 44 4421 .
1 ) 15 . 1 ( ) 20 . 1 ( ) 95 (. ) 10 . 1 (
1)1()1()1()1(
4321
==
- ???=
- + ?+ ?+ ?+ =
rrrr
Holding Period Return (GAR): ExampleAn investor who held this investment would
Year Return
1 10%
2 -5%
3 20%
4 15% % 58 . 9 095844 .
1 ) 15 . 1 ( ) 20 . 1 ( ) 95 (. ) 10 . 1 (
)1()1()1()1()1(
4321
==
- ???=
+ ?+ ?+ ?+ = +
rrrrr
• So, our investor made 9.58% on his money for fouryears, realizing a holding period
1 10%
2 -5%
3 20%
4 15%
% 10
% 15 % 20 % 5 % 10
=++-=
+++=rrrr
A famous set of studies dealing with the rates of returns oncommon stocks, bonds, and
Treasury bills was conductedby Roger Ibbotson and Rex Sinquefield.They present year-
1926 for the following five important types of financial instruments in the United States:
0.1
10
1000
Common Stocks
Long T-Bonds
T-Bills
$40.22
$15.64
Source: © Stocks, Bonds, Bills, and Inflation 2000 Yearbook™, Ibbotson Associates,
– 90% + 90% 0%
Average Standard
Series Annual Return Deviation Distribution
5.0 RISK
• The portion of variability present in a typical single security that isnot present in a large
group of assets held together (portfolio of assets) is termed diversifiable risk or unique
risk.
To derive implications for systematic risk compensation and selectivity biases, we model
returns are available for a given market. We discuss the details of this in the data section
are not available and the market is inaccessible to international investors. We view the
regime 1 to regime 2 and the ex-ante probability with which thistransition can happen are
to payoffs of a defaultable bond which has not defaulted.As with the defaultable bond,
the likelihood of transition from regime 1to regime 2 affects measured mean returns
obtained solely from data sampled fromregime 1. Hence, one would expect that observed
mean returns, particularly for anemerging market, to be higher than the ex-ante risk
premium. This bias measures the compensation for expropriation and helps us understand
compensation from sample selectivity biasesin expected returns. Let yit+1 represent an
indicator for the regime in market i att + 1 being 1 or 2. The indicator yit+1 is equal to
one if the regime at t + 1 is 1 (open to international investors), and zero otherwise. The
where E(Rit+1|It) is the ex-ante conditional mean of the gross return, et+1 is the
innovation in the systematic risk component, and hi1t+1 and hi2t+1 are diversifiable risk
determined by bi1 and bi2.Let rit+1 denote the excess return on market i, that is, rit+1 =
Rit+1 - Rf t.
Assuming that yit = 1, the valuation condition (1) then implies thatE (rit+1|It) = ls2et
where pit is the probability of the regime where market i is accessible to international
investors at time t. In other words, pit is the conditional probability that yit+1 = 1,and (1 -
pit) is the probability of a switch to regime 2. The risk premium is determinedby the
aggregate market price of risk, ls2et, and an overall beta which is aprobability-weighted
average of the betas in the two regimes. Next, we describe thedetermination of regimes 1
and 2.
Let y_it be a latent process that determines the opening and closing for market i. Thatis,
it determines if the regime is 1 or 2. In particular, if y_it >0 then the regime is 1and if
assume
(1995) argue that the survival of a market (the analogue of our regime 1) is
determinedsolely by the price process itself. However, this seems restrictive, as many
emerging markets, such as Thailand, Indonesia, and Malaysia, have had comparable
international investor. These other influences are captured by xit and #it+1. Further, the
premia and country risk ratings.Let f(.) denote the standard normal probability density
where the third equality follows from the symmetry of the normal distribution. As#it+1
and the innovation in the return of asset i may be correlated, consider the
where gi1 and gi1 are the projection coefficients between bijet+1 +hit+1 and #it+1
andbijet+1 + hit+1 and #it+1, respectively, and vi1t+1 and vi2t+1 are projection errors.
The above equations then imply that the excess return process can be written as
We consider the case where data are missing as an outcome of an attrition process.That
is, we consider the sample selectivity effects of only observing the regimewhere the
markets are accessible to international investors. In this case, the restrictionon the
where we have conditioned on the fact that the market is in regime 1 today (yit = 1)and
tomorrow (yit+1 = 1). This captures our view that an econometrician only
observesinvestable dollar return sample from regime 1. Note that E_#it+1|#it+1 >
-d0ixit_ is the same as E(#it+1|yit+1 = 1). Moreover, this quantity satisfies the relation
This is typically referred to as a hazard rate, or the inverse Mill’s ratio. We denotethis by
hit, that is, hit = f(d0ixit)/F(d0ixit). Based on the above results, it follows thatthe
This restriction shows that there are two biases in measuring the ex-ante risk
premium.The first bias stems from the fact that the econometrician does not
observeregime 2 (the regime when investable dollar returns are not available). This is re-
flected in the first term of (14). bi1 can obviously be identified in the time series
fromobservations when the market is open. bi2 is the beta at transition from regime 1 to2.
Identification of bi2 and the transition probability of going to regime 2 (that is,81 - pit)
can not be measured without additional restrictions. Note that the resultingbias is on the
The second bias is due to sample selectivity, and the effects of this can be seenin the
second term of (14). This is an adjustment to the ex-post mean to correctly estimate the
tomorrow, the risk premium is biased upwards. Put differently, investors require, on
average, a higher return when the market offers dollar returns, muchlike a defaultable
bond.
Brown, Goetzmann, and Ross (1995) focus on the second effect. It seems that the
measured risk premium will also be affected by the beta associated with the market shut-
down regime. If this beta is higher that in the regime for which datais available, then the
ex-ante mean asset will be higher, and in standard time-series regression this will show
effects implies that the ex-ante means lie on thesecurity market line.
In the special case of the world CAPM, equation (14) can be stated asE (rit+1|It, yit = 1,
betas are the world CAPM betas for the two regimes. As discussed above,taking account
of the peso problem requires measurement of bi2 and pit. In practise, estimating bi2 from
returns during a regime-switch is infeasible as there are very few, if any, in available
where lMt = E (rMt+1|It). In the empirical work we also consider time-variation inbetas.
Allowing for this time-variation is straightforward and does not affect any of the
derivations above.
Finally, note that for high survival probabilities, the hazard rate in equation (13)is almost
linear in the probabilities. Under the assumption that the probabilitiesabout expropriation
in equity markets and sovereign debt markets are highly re-lated, it is straightforward to
show that pit can essentially be backed out from observed sovereign bond spreads (see
Appendix A). The premise that probabilitiesof bond default and expropriation in equity
markets are related is supported bythe events in Malaysia in 1998 and the more recent
events in Argentina. Note thatfor small default probabilities, the hazard rate is almost
linear in sovereign bondspreads. As discussed and documented later, at least for the few
sovereign spreads that we observe, the spreads are highly correlated with observed
measures of country ratings. Hence, we can use the more extensively available data on
3. Data
We collect monthly return data on 46 developed and emerging markets from
fordeveloped markets and IFC for emerging markets. The returns from IFC are the
also consider the return on the MSCI world market portfolio. All returns are in U.S.
dollars,
and excess returns are calculated by subtracting the one-month Eurodollar rate =pp for
each month.The sample period is January 1984 to November 2000. It is, however, well
known that many emerging markets only were accessible for international investors
beginning in the late 1980s and the early 1990s. This is reflected in our data base. Data
for emerging markets are included as and when they open up. We let the opening date of
an emerging market be the date when IFC begins to record investable returns. The
inclusion date for each market is shown in Table 1. The inclusion dates are similar to
what other studies have considered to be the financial market liberalization dates (see, for
instance, Kim and Singal, 2000, Bekaert and Harvey, 2000, and Henry,2000). Our
empirical results are not sensitive to using alternative choices of liberalizationdates. The
total number of observations for developed markets is 203 and for emerging markets the
statistics of the monthly dollar returns. The averagereturns across developed and
emerging markets are about the same, 1.32%and 1.34% per month, respectively.
However, the average standard deviation ofemerging markets is about twice as high as
for developed markets. It also seemsto be greater dispersion in returns and return
volatilities of emerging economies.The correlation with the world market return is much
the countries. Theseattributes are used in our cross-sectional analysis of risk premia. The
Real GDP perCapita attribute is the real GDP per capita in constant dollars in 1990
(expressed ininternational prices, base 1985). The Trading Activity attribute is the sum of
exportsand imports divided by GDP in 1990. The real GDP per capita and trading
activityattributes are collected from the World Penn Tables. The Economic Rating and
theFinancial Rating attributes refer to the average country ratings from inclusion dateto
November 2000, and is provided by the International Country Risk Guide (ICRG).
indicators.In the empirical work our measure of reputation is the financial rating, whichis
between 0 (low) and 100 (high). A rating of 0 to 49 then indicates a very high risk;50 to
59 high risk; 60 to 69 moderate risk; 70 to 79 low risk; and 80 or more verylow risk. The
country rating are used by Erb, Harvey, and Viskanta (1996) in theirstudy of the time-
(1998) use these ratings to study investor protection and ownership structure across
Finally, we report betas versus the MSCI world market portfolio. The betas are,on
average, about the same for developed and emerging markets. However, thedispersion in
betas is much larger across emerging markets ranging from 0.07 to1.80, whereas they are
It is evident from Table 2 that the emerging economies are economies with relativelylow
GDP per capita. Further, emerging economies have a much lower countryratings than
developed economies. In fact, the correlation between the real GDP percapita and the
ratings are 70% (economic rating) and 80% (financial rating). Thetrading activity
attribute has a lower correlation with the real GDP per capita (about20%). The
correlations between trading activity and the ratings are about 20% and40%. There are a
few outliers (notably Hong Kong and Singapore), but excludingthem does not affect the
correlation between trading activity and credit rating significantly.We also collect
sovereign spreads for nine emerging economies from J.P. Morgan.2 These are economies
ratings contain much of the cross-sectional information in the spreads. For each month,
we computed the correlation between the sovereign spreads and the composite country
ratings. The correlations variedfrom -95% to -46% with an average of -72%. That is,
sovereign nations with a highspread on their dollar-denominated debt tend to have a low
country rating. This isalso highlighted in Figure 1, which shows the spreads versus
country ratings afterthe averages of the variables for each month have been subtracted.
That is, the variablesare measured as deviation from month averages to sweep out time
effects. Thecorrelation is about -58% and is highly significant (a p-value close to zero).
Similar results are obtained with either financial or economic country ratings.Our sample
begins in 1984 for developed markets, and in the late 1980s andearly 1990s for emerging
markets. Consequently, only brief data histories are available,particularly for emerging
economies. This makes it difficulty to solely rely ontime-series methods for measurement
and statistical inference. For this reason, weextensively use pooled cross-sectional
methods in the estimation. Importantly, therelative rankings of the attributes do not vary
a lot over time, indicating that mostof the information is in the cross-section. We
2The nine economies are Argentina, Brazil, Colombia, Korea, Mexico, Peru, Poland,
Turkey, andVenezuela.estimate exposures to risk sources, but evaluates the asset pricing
implications inthe cross-section. Increasing the sample for developed markets (going
back to 1976)does not change our results qualitatively and are therefore not reported.In
some specifications we allow the beta of a market versus the world market portfolio to
vary according a conditional information variable, namely the world excess dividend
yield (i.e., the dividend yield on the world market portfolio in excess of the one-month
In this section we present the estimation approach and discuss testable implications in the
time series as well as in the cross-section. We employ the generalized methodof moments
(2001), and similar to Bansal and Dahlquist (2000) and Jagannathan andWang (2002). In
this framework, specific distributional assumptions of the asset returnsare not required,
and wedo not need to work in a normally independently and identically distributed
errors. The approach is different from traditional approaches as we avoid the problem of
with missing data as the dollar return series for emerging markets
handle the missing data as in Bansal and Dahlquist (2000). The idea is to balance the data
set, and then apply the asymptotic results in the standard GMM framework. This is
further discussed below. We are interested in estimating the risk exposures and risk
describe the
estimation approach for the world CAPM with time-varying betas.As in Jagannathan and
the implications of the model in the cross-section as their is considerable cross- sectional
variation in the mean returns. Consider the cross-sectional risk premium implications in
equation (16). In addition, allow for the market beta of an asset to be time-varying
according to biM + biMzzt, where zt is a variable known at time t capturing time
where lM = E (lMt) and lMz = E (lMtzt). The biMs and biMzs are the standard
time series projection coefficients. Hence, our first sets of moment conditions, for
These moment conditions are exactly identified. We have 3N moment conditionsand the
same number of parameters. The point estimates from these moment conditions
correspond to the usual least squares estimates. We follow the literature and add
constants, or alphas. In the world CAPM, the aiMs should be equal to zero.Indeed, we
will evaluate the CAPM by checking whether the alphas are all equal tozero in the time
series. Our focus, however, is on the ability of the various modelsh and without sample
Note that we use the regime indicator variable to make our unbalanced panel abalanced
panel as in Bansal and Dahlquist (2000). That is, the moment conditions are multiplied
with the product of the regime indicators at time t and t + 1, yityit+1. The product
yityit+1 selects returns when markets are open both at time t and t + 1. In essence, this
procedure treats missing observations as zeros. This has a practical advantage since the
usual moment conditions which contain missing data can be filled with zeros, and then
The sample selectivity part in equation (17) is gihi. As noted in the discussion of
equation (14), under simplifying assumptions, the probability of default can be recovered
from the sovereign bond spread. Further, this spread can be used to 3Hayashi (2000)
14
completely characterize the hazard rate at time t. However, the data on sovereign interest
rate spreads are not available for many economies in our sample period. As shown
earlier, there is a high negative correlation between the country ratings and the spreads in
the cross-section (for economies where sovereign spread data are available). That is, a
country with a low rating tends to have a high spread (a high probability of default).
where Ai proxies for hi in the cross-section. For example, we let Ai equal the countryis
economic rating which then captures the cross-sectional variation in the hazardrate.
The cross-sectional parameters (i.e., the risk premium parameters and the g00and g01
parameters) are then identified in the last set of moment conditions for each asset i
E [(rit+1 - lMbiM - lMzbiMz - g00Ai - g01AiCi) yityit+1] = 0. (22)
The constant term l0 should be zero according to theory, and a non-zero constant
indicates that a model cannot price the assets on average. Alternatively, a non-zero
constant can be interpreted as a zero-beta rate different from the riskfree rate thatis
imposed. Note that all parameters including the betas and the cross-sectional parameters
l0, lM, lMz, g00, and g01 are jointly estimated using GMM. Details of the estimation are
given in Appendix B.
Results
This section presents the empirical results. Recall, that we earlier reported that the cross-
sectional dispersion in the average returns is fairly large for emerging markets and small
for developed markets. This cross-sectional dispersion poses a serious challenge to asset
pricing models. Variables that characterize the selectivity bias, such as country ratings,
the effects of selectivity are primarily identifiable in the cross-section. Given the large
cross-sectional dispersion in the data along with the short data histories for many
emerging markets, we, as in Black, Jensen, and Scholes (1972), Fama and MacBeth
(1973), and Jagannathan and Wang (1996), focusprimarily on the explaining the cross-
We first discuss the ability of the various models to capture the cross-section of average
returns through only systematic risk. We then include sample selectivity in the cross-
In Table 3, we provide evidence from the cross-section of asset returns. The estimated
risk premium for the market portfolio is negative, as can be seen in row 2 of Panel A.
This is a standard finding (see, for instance, Jagannathan and Wang, 1996). The ability of
the CAPM with constant betas to explain the cross-section of average returns is basically
zero as indicated by the adjusted R-square. In Panel B, we consider the CAPM where the
market betas are allowed to be time-varying. The model fails to capture the cross-
sectional dispersion in average returns in this specification as well The adjusted R-square
is only about 8%. The theoretical restriction that l0 = 0 can be rejected at the 5%
significance level. However, the constant term, as discussed below, is not particularly
the model. For completeness, we have conducted the time-series tests for both the
constant beta and timevaryingbeta versions of the CAPM (not reported in a table). We
find that the joint test of zero alphasis rejected in both cases. The rejections seem to be
(1995) who also shows that CAPM implications are rejectedin emerging markets data.
The failure of the CAPM can also be seen in Figure 2 where we plot the averagereturns
against the predicted expected returns from the model. A true model would,ignoring
estimation errors, produce observations along the 45-degree line. The figure reveals that
there is almost no dispersion in predicted expected returns. Hence, the model does not
specifications the selectivity is modelled as (g00 + g01si)Ai, where si is the annual return
volatility for market i, and Ai is defined as the economic rating for country i less the
economic rating for the U.S. The expression (g00 + g01si) is the gi for country i. The
proxy for the hazard rate for country i is Ai, based on thereasoning provided earlier. Note
that Ai is negative for emerging economies and close to zero for developed economies.
This specification captures the intuition that as economies improve their economic rating
they become akin to developed marketsand the sample selectivity term would fall.When
sample selectivity is incorporated in the standard CAPM (in Panel A), thecross-sectional
R-square rises to 41% and the parameters associated with the selectivityterm are
significant (a p-value of 3%). The time-varying beta based CAPMwith sample selectivity
included is reported in Panel B. This specification does quitewell in capturing the cross-
of the parameters that govern the selectivity bias(that is, g00 andg01) are similar across
levels (see the column labelled “Test ofJointSignificance”). The last two rows of Panel B
highlights the relevance, or the lackthereof, of the constant term l0. The empirical results
across thetwo cases (includingl0, or not) are comparable. Hence, as suggested by theory,
with poor economic rating have alarger andpositive selectivity bias. For developed
economies the variable Ai is essentiallyzero and hence the effect of selectivity on their
both emerging and developed economies. However, the selectivity premium is0.50% per
month for emerging markets and close to zero for developed markets. Inthe model with
the selectivity bias is somewhat higher, and now stands at 0.58%per month. For
emergingmarkets more than 1/2 of the ex-post risk premium can beattributed to
selectivity. That is, sample selectivity seems to be the dominant influenceon the
explanatory ability of the world CAPM with time-varying betas andsample selectivity
can be seen in Figure 3which displays the average returns againstpredicted expected
returns. The improvement in fit is visible and the model is ableto produce the
rating of an economy i lessthe comparable rating for the U.S. The ability of this
adjusted R-square) is about30%. This R-square is quite high relative the specifications
economies) on the Brady bonds to measure the hazard rates directly.The approach is as
zero recovery as in Appendix A) for allemerging markets. Recall that we are making the
assumption that the probabilityof default indebt markets coincides with the probability of
expropriation. Fromthe probabilities we can then compute the hazard rates (i.e., the his).
For developedmarkets we assume a zero default probability (and hence a zero hazard
rate). Withthis measure of the hazard rate, and the same specificationforthe gi as before,
selectivity18term, that is gihi, is about the 0.63% per month. The average probability of
the defaultis about half a percent per month. Hence, the bias in the mean return of about
0.63% per month can be supported by rather small probability of default (risk of
expropriation).Note that the empirical evidence for this specification is quite similarto
therelative economic rating is the proxy for thehazard rate. This specification was
reportedin Table 3. The reputational variable (the financial rating of country i lessthe
comparable rating for theU.S.)is able to explain about 32% of the dispersion inthe
selectivity premium. This regression also shows that the selectivity premiumrises as
thecountry’s financial rating falls. Similarly, when we use the tradingactivity variable,
larger trading activity have a smaller selectivity premium.In essence our evidence
and Ross (1995). Ourevidence indicates that this attribute is notuniquely important to
capture the crosssectionaldifferences in risk premia. Indeed, the trade activity and
explaining the cross-sectional differences in the risk premia. Thus, it seems to us that this
is dueto the fact that the volatility of returns are related to these variables.Thisis shownin
reputation. These variables, based on the work of Eaton and Gersovitz(1981), and Bulow
and Rogoff (1989a, 1989b) should matter to the compensationthat emerging markets
have toadditionallypay, due to risks of expropriation. Wefind that this indeed is the case.
In this paper we show that the cross-sectional differences in the equity returns
selectivitypremium. We show that the selectivity premium captures more than 1/2 of
implicationof this result is that after taking account ofselectivity premium all
work also shows that sovereigns thathave better financial marketreputations and trade
more actively have to pay a smaller selectivity premium. Thisempirical evidence lends
support to theview that both reputations and fear of tradesanctions are important in
This Appendix shows how the hazard rate can be measured from sovereign bondspreads.
equal to one if there is no default, and µb + bbet+1 +hbt+1 if the countrydefaults. The
payoff process can thus be written as qbt+1= ybt+1 + (1 - ybt+1) (µb + bbet+1 + hbt+1) .
(24)
For simplicity, we assume that bb = 0. That is, we assume that the recovery valueof the
bond is not related to the systematic risk in the world economy.Further, theexpected
payoff on this bond in default is less than one (i.e., µb < 1). Valuing thispayoff using the
Assume that the probabilities of default for the bond correspond to the probabilityof a
market shut-down, that is, pbt = pit. Under the further assumptionthat therecovery rate is
zero, we can directly recover the probability of default. Further,given the normal
expression can also be used to compute the ex-ante beta on market i.We denote this with
bit =pitbi1 + (1 - pit) bi2. If we assume that the ratio of thebetas across the two regimes is
Note that Rf t and Rbt can be observed directly from U.S. Treasuries and
rating.Hence, conditional on c, one can estimate the model with both a peso problem
andsample selectivity. In the special case with c = 1,there is no peso problem and wehave
that bit = bi1 = bi2.21B. Estimation DetailsThis Appendix shows the estimation in more
detail. Let q0 denote thetrue parametervector that we want to estimate. The typical
elements in q0 are aiM, biM, and biMz that are specific to each market, and the common
parameters l0, lM, lMz, g00and g01. By stacking the sample counterparts of the moment
where Xt summarizes the data used to form the moments conditions. The vectorgT (q)
has the dimension 4N. The moment conditions, given by (18) to (20), exactlyidentify the
aiM, biM, and biMz parameters. However, the moment conditions, givenby (23), is
overidentified. We have N moment conditions, but only 5 parameters (l0,lM, lMz, g00
and g01).We estimate the parameters by setting linear combinations of gT equal to zero.
ATgT = 0, (29)
that the point estimates are the ones given by ordinary least squares.
Let AT
be the product of two matrices denoted by A1T and A2T (that is, AT = A1TA2T).
where I3N is the identity matrix with dimension 3N, 03N is a 3N vector of zeros,0N is an
N vector of zeros, and A2T is a diagonal matrix with typical element equalto 1/ åTt=1
yit+1. The ˆ biMs and ˆ biMzs are estimates of biMs and biMzs, and they are
given in the estimation. The ˆ biMs and ˆ biMzs are exactly the least square
returnand scaled market excess returns as in (18) to (20). Further, the estimates of l0,
lM,lMz, g00, and g01 coincide with the least square estimates obtained in a regressionof
average returns on the betas and the proxies for sample selectivity. Our choice ofAT
Based on Hansen (1982) we know that when linear combinations of gT are setequal to
by
pT (qT - q0) d
where D0 is the gradient of the moment conditions in (28), and where S0 is the
S0 =¥åj=-¥E hf (Xt, q0) f _Xt-j, q0_0i. (32) The sample counterpart ST is estimated
using the procedure in Newey and West(1987) with four lags. D0 and A0 can be
estimated by their sample counterparts DTand AT. Note that the standard errors based on
Panel C. World
This table presents summary statistics of monthly dollar returns in global equity markets
from nclusion date to November 2000. Panels A, B and C show statistics for developed
markets, emrging markets and theWorld, respectively. The labels Average in Panels A
Correlation with World refers to thecorrelation coefficient with the world market
PRICING MODELS
that would be relatively risky if held inisolation may have little, or even no risk if held in
a welldiversifiedportfolio.
b. The feasible, or attainable, set represents all portfolios that canbe constructed from a
given set of stocks. This set is onlyefficient for part of its combinations.
c. An efficient portfolio is that portfolio which provides the highestexpected return for
any degree of risk. Alternatively, the efficient portfolio is that which provides the lowest
d. The efficient frontier is the set of efficient portfolios out of thefull set of potential
portfolios. On a graph, the efficientfrontier constitutes the boundary line of the set of
potentialportfolios.
e. An indifference curve is the risk/return trade-off function for aparticular investor and
reflects that investor's attitude towardrisk. The indifference curve specifies an investor's
required rate of return for a given level of risk. The greater the slope of theindifference
f. The optimal portfolio for an investor is the point at which theefficient set of
portfolios--the efficient frontier--is just tangentto the investor's indifference curve. This
point marks the highest level of satisfaction an investor can attain given the set
ofpotential portfolios.
developed to analyze the relationship between risk andrequired rates of return on assets
when they are held in welldiversifiedportfolios. The SML is part of the CAPM.
h. The Capital Market Line (CML) specifies the efficient set of portfolios an investor can
attain by combining a risk-free asset and the risky market portfolio M. The CML states
that the expected return on any efficient portfolio is equal to the riskless rate plusa risk
premium, and thus describes a linear relationship between expected return and risk.
i. The characteristic line for a particular stock is obtained byregressing the historical
returns on that stock against thehistorical returns on the general stock market. The slope
of thecharacteristic line is the stock's beta, which measures the amountby which the
stock's expected return increases for a given increasein the expected return on the market.
j. The beta coefficient (b) is a measure of a stock's market risk. Itmeasures the stock's
risk/return relationship for a given stock as a functionof multiple factors, rather than the
single factor (the market return) used by the CAPM. The APT is based on complex
mathematicaland statistical theory, but can account for several factors (such asGNP and
l. The Fama-French 3-factor model has one factor for the excess marketreturn (the
for size (defined as the return on a portfolio of small firms minusthe return on a portfolio
of big firms), and a third factor for thebook-to-market effect (defined as the return on a
portfolio of firmswith a high book-to-market ratio minus the return on a portfolio offirms
m. Most people don’t behave rationally in all aspects of their personallives, and
Security A is less risky if held in a diversified portfolio because ofits lower beta and
single-asset portfolio, Security A would be more risky because sA > sBand CVA >
CVB.The intercept, a, seems to be about 3.5. Using a calculator with atleast squares
%. 6 . 10
2 . 18 ... 0 . 23 0 . 14 (
kAvg =
+++-
12.1%.
.6
Several points should be noted: (1) sM over this particular periodis higher than the
historic average sM of about 15 percent,indicating that the stock market was relatively
volatile during thisperiod; (2) Stock X, with sX = 13.1%, has much less total risk thanan
average stock, with sAvg = 22.6%; and (3) this example demonstrates that it is possible
for a very low-risk single stock to have lessrisk than a portfolio of average stocks, since
sX < sM.
c. Since Stock X is in equilibrium and plots on the Security MarketLine (SML), and
M M k kˆ = --and this assumption often does not hold--then this equationmust hold:
Since sp is only 62 percent of sM, the probability distribution for Condition 2 is clearly
more peaked than that for Condition 3; thus,we can be reasonably confident of the
relevant locations of the distributions for Conditions 2 and 3.With regard to Condition 1,
the single-asset portfolio, we can besure that its probability distribution is less peaked
than that forthe 100-stock portfolio. Analytically, since b = 0.62 both for thesingle stock
. 0 ) 62 . 0 ( ) 62 . 0 ( 2
p
Ys»+s>s+s=s
We can also say on the basis of the available information that sY is smaller than sM;
Stock Y's market risk is only 62 percent of the"market," but it does have company-
specific risk, while the market portfolio does not. However, we know from the given data
thatsY = 13.8%, while sM = 19.6%. Thus, we have drawn the distribution or the single
stock portfolio more peaked than that of the market.The relative rates of return are not
stock should be
Stock Y has b = 0.62, while the average stock (M) has b = 1.0;
therefore,
however, the data simply reflect the fact thatpast returns are not an exact basis for
what are the expected return and standard deviation for a portfolio
σ p = WA2σ A2 + (1 − WA ) 2 σ B2 + 2WA (1 − WA ) ρ AB σ A σ B
= 0.32 ( 0.22 ) + 0.7 2 ( 0.4 2 ) + 2( 0.3)( 0.7 )( 0.4)( 0.2)( 0.4 )
= 0.309
Attainable Portfolios = 0.4
AB
Attainable Portfolios: rAB = +1
Attainable Portfolios: rAB = -1
Attainable Portfolios with Risk-Free Asset (Expected risk-free return = 5%)
Expe
Port
The feasible set of portfolios represents all portfolios that can be constructed from a
The collection of efficient portfolios is called the efficient set or efficient frontier.
Expected
Return, rp
An investor’s optimal portfolio is defined by the tangency point between the
The
All investors are price takers, that is, investors’ buying and selling won’t
When a risk-free asset is added to the feasible set, investors can create
The straight line connecting rRF with M, the tangency point between the line
and the old efficient set, becomes the new efficient frontier.
What is the Capital Market Line?
Ef
The Capital Market Line (CML) is all linear combinations of the risk-free
Expe
The m
is the
H
Run
Illu
_
r
20
Inte
Anal
The re
m
2
Tw
co
Betas
The dif
good
R
W
The A
world
F
the
hig
R
under
ri = rRF
Requir
rRF =6.8
6.3%, c i=
Markowitz Portfolio Theory
•
CAP
Combining stocks into portfolios can reduce standard deviation below the level
• The various weighted combinations of stocks that create this standard deviations
CAPM:
FIXED INCOME – AN EVOLUTION IN RISK AND
RETURN
Declining bond yields and a flat yield curve, driven by fallinginflation, have dominated
returns from traditional fixed income over the last few years. At the same time, the
growth of thecorporate bond market has meant a greater focus on credit. Nolonger are the
returns from taking on credit risk seen as secondary.Instead credit has become a
legitimate asset class in its own right.These developments have opened up opportunities
for clientsto receive alternative sources of return by accepting different types of risk from
In the past, investors’ fixed income return was mainly from government
premiumas compensation for this exposure. In recent years, new fixed income securities
rewardinvestors with returns from other types of risks. For example, corporate bonds
generatereturns by taking on credit risk; convertible bonds produce returns from credit
and equityrisk; and hybrid securities can source returns from credit risk, correlation,
liquidity risk,and equity risk. The chart below shows the different risks associated with
income securities and how interest rate risk has diminished as a prime contributor to
riskand return. Some securities comprise an aggregate of risks, whereas others have only
corporate bonds or synthetic credit positions using credit default swaps or a combination
of both. This poolof credit assets is then securitised, similar to a mortgage pool and made
into tranches.
Risk
Each tranche is given an S&P rating ranging from AAA to sub-investment grade
(BBB-).Investors can buy into one or more of these tranches, thereby customising their
creditrisk. The riskiest or sub-investment grade tranche is exposed to the first losses if
thereis a default, while the AAA tranche is subject to the last default. Investors in the
riskier tranches are compensated by a higher income than investors in the highly rated
above cash forholding investment grade credit, 2% for sub-investment grade, for
example, anything lessthan BBB- and 3% above cash for emerging market debt.
While the advent of new investment risks has generated return opportunities forinvestors,
allow more effective investment strategies. A credit default swap (CDS) is a newtype of
credit derivative contract between two parties that separates and transfers thecredit risk of
an asset such as a corporate bond from one party to another. For example,
investors may previously have purchased a corporate bond and consequently
beenexposed to interest rate risk and credit risk. Now instruments such CDSs allow
investment managers to extract and hedge the unwanted risks such as the interest rate risk
givinginvestors exposure to only credit risk. CDSs are commonly used to leverage a
Analysis of credit risks and returns (excluding traditional bond interest rate risk)
fromemerging market debt, corporate bonds and high yield securities reveals that there
correlations.These correlations are unlike those from traditional bond risks, in that the
investor is notbenefiting from different interest rates but from varying credit risks.
However, portfoliosof credit risk may reduce the diversification benefit between bonds
and equities as creditrisks are modestly correlated to equity performance, posing new
As risks within fixed income markets evolve, the skills and methods managers use
managersnot only aim to add value from credit through relative value sector and stock
Because default costs are real, issuers are forced by the market to a pay a higher spread to
compensate for the chance of a default over and above the risk free rate. There is
called the default cost, is the percentage of the amount that can erode an investor’s excess
return. As the quality of credit securities fall, the value of active stock selection and
A greater focus on credit has seen an evolution in the way investors source their return
fromfixed income as well as the type of securities they invest in.Risks have also changed
alongwith the development of techniques to manage these risks. With complex new
securitiessuch as hybrids, floating ratenotes and more recently CDOs and CDSs, the need
for activemanagement and experienced resources is key, with the aim of adding value for
investors.
Portfolio Theory
Efficient frontier
Beta calculation
Markets
So if the next 72.4 years exactly duplicates the period evaluated, you have less than a
penny to spare if your expenses remain the same and you choose to invest solely in T-
Bills. However, if you use a more realistic three month holding period for T-bill assets
with a 100% return of principal, you are left with an amount that is slightly under $1.00
(0.9924). Without inflation the picture is much rosier; an initial investment in T-Bills that
is left to compound monthly (rather than a quarterly compounding) will provide the
investor with an account valued at more than 15 times the initial amount
BondRisk
Perhaps a conservative investor decides that by simply replacing the T-Bill investment
with a longer maturity Treasury Note, all will be fine regardless of inflation. Although T-
Note yields are usually higher than T-Bills, periods where the yield curve becomes flat or
inverted highlight a different issue. The timing of the purchase for the longer term
security will impact investment returns. This brings us the next investor risk—interest
raterisk.
Interest rate risk is the risk of having your money locked into a lower rate of return while
interest rates rise. Assuming the asset is held to maturity to benefit from the 100% return
of principal, the longer the term to maturity for the fixed income investment, the more
opportunity there is to receive sub-standard interest rates on the money. As a result, the
10-year note is deemed to have more interest rate risk than the 90-day bill, while the 30-
year bond is deemedto have more interest rate risk than both the note
andthebill.
Using 10-year note returns starting in April 1953 and assuming 10-year holding periods
with inflation, a $1.00 initial investment will be valued at $2.65 after 639 months (53
years). A conservative investor may feel a 265% return is acceptable; however, we have
yet to account for taxes. Incorporating a 20% tax applied semi-annually results in a final
valueof$2.21.
An investor who seeks even better fixed income returns by entering the municipal or
corporate bond world encounters yet another type of investment risk: credit risk.
Although defaults are less likely in the municipal bond market (reflected by lower
yields), they can occur. This type of investment does benefit from favorable tax treatment
whichwillboostreturns.
In terms of corporate bonds, credit risk increases (reflected by higher yields) as the credit
rating decreases. AAA corporate bonds are deemed less risky from a return of principal
standpoint and, therefore, offer lower yields. Interest is taxable and there’s no guarantee
that the credit rating and safety of the bond downgraded during the holding
period.
At this time, historical municipal and corporate bond returns will not be analyzed. Those
interested may want to pursue this analysis using a bond fund or exchange traded fund
(ETF) proxy such as a Nuveen Municipal Fund or the iSharesâ Corporate Bond Fund.
The biggest challenges include obtaining sufficient return histories and incorporating
Investors generally turn to the stock market to realize returns that will outpace inflation
after accounting for taxes. Modern Portfolio Theory (MPT) serves as one basis for
portfolio construction aimed at maximizing reward while minimizing risk. This approach
1) Capital Market Line Represents optimal portfolios for a given level of risk.
Capital Asset Pricing ModelAssesses the risk-return impact of adding a security
2)
(CAPM) into a well diversified portfolio.
A linear asset price model based on risk versus
3) Security Market Line
returns.
A linear model of asset return versus market
security risk.
Inflation risk represents the risk associated with insufficient returns (not keeping pace
with increasing costs), while credit risk and stock market risk highlight represent the risk
associated with seeking higher returns (losses). Investors generally seek maximize
returns for a given level of risk by diversifying their portfolios (see previous articles on
impact of inflation and investment returns on retirement savings when income was
removed from the account on a monthly basis. A thirty year period was examined starting
with January 1962 and investment returns were based upon actual S&P 500
Using the same monthly inflation, return and dividend data, a $1 initial investment and a
20% tax rate on gains applied quarterly, the ending balance after 30 years was
approximately $1.26, or 126%. Remove the dividend returns and the account is valued at
$1.11 after thirty years. This represent a nice difference from compounded fixed income
returns over a 70 year period, particularly since the return of 0.12% excluded taxes.
Although the 10-year note return of 221% over 53 years seems to be an argument for T-
Note investments, when using thirty year results from initiation of the strategy, $0.96
remained in the account. Again, due to interest rate risk, the month of initiation will
impact the results with different thirty year periods yielding different returns.
InvestmentRisk
Investment risk includes credit risk and market risk which are both taken to combat
another risk—that due to inflation. Investors and traders need to assess the actual historic
results of the strategies they employ for their investments. In this manner, the individual
can better understand the true financial risks in which they are exposing themselves.
In order to manage necessary market risk, the investor must take steps to understand
those risks and minimize them through diversification. Numerous articles on the topic of
asset allocation and diversification are available in the Optionetics.com article archives
by completing an author keyword search for 2004 and 2005. Traders, who often self-
investments versus the performance of trading given the goals for each, and re-evaluate
those allocations.
To derive implications for systematic risk compensation and selectivity biases, we model
returns are available for a given market. We discuss the details of this in the data section
are not available and the market is inaccessible to international investors. We view the
regime 1 to regime 2 and the ex-ante probability with which thistransition can happen are
to regime 2 affects measured mean returns obtained solely from data sampled from
regime 1. Hence, one would expect that observed mean returns, particularly for an
emerging market, to be higher than the ex-ante risk premium. This bias measures the
allowus to derive separate systematic risk compensation from sample selectivity biasesin
expected returns. Let yit+1 represent an indicator for the regime in market i att + 1 being
investors), and zero otherwise. The return process, expressed indollars, is specified as
where E(Rit+1|It) is the ex-ante conditional mean of the gross return, et+1 is the
innovation in the systematic risk component, and hi1t+1 and hi2t+1 are diversifiable risk
determined by bi1 and bi2.Let rit+1 denote the excess return on market i, that is, rit+1 =
Rit+1 - Rf t.
Assuming that yit = 1, the valuation condition (1) then implies thatE (rit+1|It) = ls2et
where pit is the probability of the regime where market i is accessible to international
investors at time t. In other words, pit is the conditional probability that yit+1 = 1,and (1 -
pit) is the probability of a switch to regime 2. The risk premium is determinedby the
aggregate market price of risk, ls2et, and an overall beta which is aprobability-weighted
average of the betas in the two regimes. Next, we describe thedetermination of regimes 1
and 2.
Let y_it be a latent process that determines the opening and closing for market i. Thatis,
it determines if the regime is 1 or 2. In particular, if y_it >0 then the regime is 1and if
Following Heckman (1976, 1979), we assume that the conditional mean of the
assume
(1995) argue that the survival of a market (the analogue of our regime 1) is
determinedsolely by the price process itself. However, this seems restrictive, as many
emerging markets, such as Thailand, Indonesia, and Malaysia, have had comparable
international investor. These other influences are captured by xit and #it+1. Further, the
where the third equality follows from the symmetry of the normal distribution. As#it+1
and the innovation in the return of asset i may be correlated, consider the
where gi1 and gi1 are the projection coefficients between bijet+1 +hit+1 and #it+1
andbijet+1 + hit+1 and #it+1, respectively, and vi1t+1 and vi2t+1 are projection errors.
The above equations then imply that the excess return process can be written as
We consider the case where data are missing as an outcome of an attrition process.That
is, we consider the sample selectivity effects of only observing the regimewhere the
markets are accessible to international investors. In this case, the restrictionon the
where we have conditioned on the fact that the market is in regime 1 today (yit = 1)and
tomorrow (yit+1 = 1). This captures our view that an econometrician only
observesinvestable dollar return sample from regime 1. Note that E_#it+1|#it+1 >
-d0ixit_ is the same as E(#it+1|yit+1 = 1). Moreover, this quantity satisfies the relation
This is typically referred to as a hazard rate, or the inverse Mill’s ratio. We denotethis by
hit, that is, hit = f(d0ixit)/F(d0ixit). Based on the above results, it follows thatthe
This restriction shows that there are two biases in measuring the ex-ante risk
premium.The first bias stems from the fact that the econometrician does not
observeregime 2 (the regime when investable dollar returns are not available). This is re-
flected in the first term of (14). bi1 can obviously be identified in the time series
fromobservations when the market is open. bi2 is the beta at transition from regime 1 to2.
Identification of bi2 and the transition probability of going to regime 2 (that is,81 - pit)
can not be measured without additional restrictions. Note that the resultingbias is on the
The second bias is due to sample selectivity, and the effects of this can be seenin the
second term of (14). This is an adjustment to the ex-post mean to correctly estimate the
tomorrow, the risk premium is biased upwards. Put differently, investors require, on
average, a higher return when the market offers dollar returns, muchlike a defaultable
bond.
Brown, Goetzmann, and Ross (1995) focus on the second effect. It seems that the
measured risk premium will also be affected by the beta associated with the market shut-
down regime. If this beta is higher that in the regime for which datais available, then the
ex-ante mean asset will be higher, and in standard time-series regression this will show
effects implies that the ex-ante means lie on thesecurity market line.
In the special case of the world CAPM, equation (14) can be stated asE (rit+1|It, yit = 1,
where E (rMt+1|It) is the conditional risk premium on the world market portfolio,and the
betas are the world CAPM betas for the two regimes. As discussed above,taking account
of the peso problem requires measurement of bi2 and pit. In practise, estimating bi2 from
returns during a regime-switch is infeasible as there are very few, if any, in available
where lMt = E (rMt+1|It). In the empirical work we also consider time-variation inbetas.
Allowing for this time-variation is straightforward and does not affect any of the
derivations above.
Finally, note that for high survival probabilities, the hazard rate in equation (13)is almost
linear in the probabilities. Under the assumption that the probabilitiesabout expropriation
in equity markets and sovereign debt markets are highly re-lated, it is straightforward to
show that pit can essentially be backed out from observed sovereign bond spreads (see
Appendix A). The premise that probabilitiesof bond default and expropriation in equity
markets are related is supported bythe events in Malaysia in 1998 and the more recent
events in Argentina. Note thatfor small default probabilities, the hazard rate is almost
linear in sovereign bondspreads. As discussed and documented later, at least for the few
sovereign spreads that we observe, the spreads are highly correlated with observed
measures of country ratings. Hence, we can use the more extensively available data on
3. Data
fordeveloped markets and IFC for emerging markets. The returns from IFC are the
also consider the return on the MSCI world market portfolio. All returns are in U.S.
dollars,
and excess returns are calculated by subtracting the one-month Eurodollar rate =pp for
each month.The sample period is January 1984 to November 2000. It is, however, well
known that many emerging markets only were accessible for international investors
beginning in the late 1980s and the early 1990s. This is reflected in our data base. Data
for emerging markets are included as and when they open up. We let the opening date of
an emerging market be the date when IFC begins to record investable returns. The
inclusion date for each market is shown in Table 1. The inclusion dates are similar to
what other studies have considered to be the financial market liberalization dates (see, for
instance, Kim and Singal, 2000, Bekaert and Harvey, 2000, and Henry,2000). Our
empirical results are not sensitive to using alternative choices of liberalizationdates. The
total number of observations for developed markets is 203 and for emerging markets the
statistics of the monthly dollar returns. The averagereturns across developed and
emerging markets are about the same, 1.32%and 1.34% per month, respectively.
However, the average standard deviation ofemerging markets is about twice as high as
for developed markets. It also seemsto be greater dispersion in returns and return
volatilities of emerging economies.The correlation with the world market return is much
the countries. Theseattributes are used in our cross-sectional analysis of risk premia. The
Real GDP perCapita attribute is the real GDP per capita in constant dollars in 1990
(expressed ininternational prices, base 1985). The Trading Activity attribute is the sum of
exportsand imports divided by GDP in 1990. The real GDP per capita and trading
activityattributes are collected from the World Penn Tables. The Economic Rating and
theFinancial Rating attributes refer to the average country ratings from inclusion dateto
November 2000, and is provided by the International Country Risk Guide (ICRG).
The economic risk rating is meant to measure an economy’s current strengths
indicators.In the empirical work our measure of reputation is the financial rating, whichis
investment. The country ratings are published on a scale from 0 to 50 where a higher
between 0 (low) and 100 (high). A rating of 0 to 49 then indicates a very high risk;50 to
59 high risk; 60 to 69 moderate risk; 70 to 79 low risk; and 80 or more verylow risk. The
country rating are used by Erb, Harvey, and Viskanta (1996) in theirstudy of the time-
(1998) use these ratings to study investor protection and ownership structure across
Finally, we report betas versus the MSCI world market portfolio. The betas are,on
average, about the same for developed and emerging markets. However, thedispersion in
betas is much larger across emerging markets ranging from 0.07 to1.80, whereas they are
It is evident from Table 2 that the emerging economies are economies with relativelylow
GDP per capita. Further, emerging economies have a much lower countryratings than
developed economies. In fact, the correlation between the real GDP percapita and the
ratings are 70% (economic rating) and 80% (financial rating). Thetrading activity
attribute has a lower correlation with the real GDP per capita (about20%). The
correlations between trading activity and the ratings are about 20% and40%. There are a
few outliers (notably Hong Kong and Singapore), but excludingthem does not affect the
correlation between trading activity and credit rating significantly.We also collect
sovereign spreads for nine emerging economies from J.P. Morgan.2 These are economies
ratings contain much of the cross-sectional information in the spreads. For each month,
we computed the correlation between the sovereign spreads and the composite country
ratings. The correlations variedfrom -95% to -46% with an average of -72%. That is,
sovereign nations with a highspread on their dollar-denominated debt tend to have a low
country rating. This isalso highlighted in Figure 1, which shows the spreads versus
country ratings afterthe averages of the variables for each month have been subtracted.
That is, the variablesare measured as deviation from month averages to sweep out time
effects. Thecorrelation is about -58% and is highly significant (a p-value close to zero).
Similar results are obtained with either financial or economic country ratings.Our sample
begins in 1984 for developed markets, and in the late 1980s andearly 1990s for emerging
markets. Consequently, only brief data histories are available,particularly for emerging
economies. This makes it difficulty to solely rely ontime-series methods for measurement
and statistical inference. For this reason, weextensively use pooled cross-sectional
methods in the estimation. Importantly, therelative rankings of the attributes do not vary
a lot over time, indicating that mostof the information is in the cross-section. We
2The nine economies are Argentina, Brazil, Colombia, Korea, Mexico, Peru, Poland,
Turkey, andVenezuela.estimate exposures to risk sources, but evaluates the asset pricing
implications inthe cross-section. Increasing the sample for developed markets (going
back to 1976)does not change our results qualitatively and are therefore not reported.In
some specifications we allow the beta of a market versus the world market portfolio to
vary according a conditional information variable, namely the world excess dividend
yield (i.e., the dividend yield on the world market portfolio in excess of the one-month
In this section we present the estimation approach and discuss testable implications in the
time series as well as in the cross-section. We employ the generalized methodof moments
(2001), and similar to Bansal and Dahlquist (2000) and Jagannathan andWang (2002). In
this framework, specific distributional assumptions of the asset returnsare not required,
and wedo not need to work in a normally independently and identically distributed
errors. The approach is different from traditional approaches as we avoid the problem of
with missing data as the dollar return series for emerging markets
handle the missing data as in Bansal and Dahlquist (2000). The idea is to balance the data
set, and then apply the asymptotic results in the standard GMM framework. This is
further discussed below. We are interested in estimating the risk exposures and risk
describe the
estimation approach for the world CAPM with time-varying betas.As in Jagannathan and
the implications of the model in the cross-section as their is considerable cross- sectional
variation in the mean returns. Consider the cross-sectional risk premium implications in
equation (16). In addition, allow for the market beta of an asset to be time-varying
where lM = E (lMt) and lMz = E (lMtzt). The biMs and biMzs are the standard
time series projection coefficients. Hence, our first sets of moment conditions, for
These moment conditions are exactly identified. We have 3N moment conditionsand the
same number of parameters. The point estimates from these moment conditions
correspond to the usual least squares estimates. We follow the literature and add
constants, or alphas. In the world CAPM, the aiMs should be equal to zero.Indeed, we
will evaluate the CAPM by checking whether the alphas are all equal tozero in the time
series. Our focus, however, is on the ability of the various modelsh and without sample
Note that we use the regime indicator variable to make our unbalanced panel abalanced
panel as in Bansal and Dahlquist (2000). That is, the moment conditions are multiplied
with the product of the regime indicators at time t and t + 1, yityit+1. The product
yityit+1 selects returns when markets are open both at time t and t + 1. In essence, this
procedure treats missing observations as zeros. This has a practical advantage since the
usual moment conditions which contain missing data can be filled with zeros, and then
The sample selectivity part in equation (17) is gihi. As noted in the discussion of
equation (14), under simplifying assumptions, the probability of default can be recovered
from the sovereign bond spread. Further, this spread can be used to 3Hayashi (2000)
14
completely characterize the hazard rate at time t. However, the data on sovereign interest
rate spreads are not available for many economies in our sample period. As shown
earlier, there is a high negative correlation between the country ratings and the spreads in
the cross-section (for economies where sovereign spread data are available). That is, a
country with a low rating tends to have a high spread (a high probability of default).
Consequently, to characterize the cross-section of hazardrates, we model the hazard rate
where Ai proxies for hi in the cross-section. For example, we let Ai equal the countryis
economic rating which then captures the cross-sectional variation in the hazardrate.
The cross-sectional parameters (i.e., the risk premium parameters and the g00and g01
parameters) are then identified in the last set of moment conditions for each asset i
The constant term l0 should be zero according to theory, and a non-zero constant
indicates that a model cannot price the assets on average. Alternatively, a non-zero
constant can be interpreted as a zero-beta rate different from the riskfree rate thatis
imposed. Note that all parameters including the betas and the cross-sectional parameters
l0, lM, lMz, g00, and g01 are jointly estimated using GMM. Details of the estimation are
given in Appendix B.
Results
This section presents the empirical results. Recall, that we earlier reported that the cross-
sectional dispersion in the average returns is fairly large for emerging markets and small
for developed markets. This cross-sectional dispersion poses a serious challenge to asset
pricing models. Variables that characterize the selectivity bias, such as country ratings,
the effects of selectivity are primarily identifiable in the cross-section. Given the large
cross-sectional dispersion in the data along with the short data histories for many
emerging markets, we, as in Black, Jensen, and Scholes (1972), Fama and MacBeth
(1973), and Jagannathan and Wang (1996), focusprimarily on the explaining the cross-
We first discuss the ability of the various models to capture the cross-section of average
returns through only systematic risk. We then include sample selectivity in the cross-
of the results.
In Table 3, we provide evidence from the cross-section of asset returns. The estimated
risk premium for the market portfolio is negative, as can be seen in row 2 of Panel A.
This is a standard finding (see, for instance, Jagannathan and Wang, 1996). The ability of
the CAPM with constant betas to explain the cross-section of average returns is basically
zero as indicated by the adjusted R-square. In Panel B, we consider the CAPM where the
market betas are allowed to be time-varying. The model fails to capture the cross-
sectional dispersion in average returns in this specification as well The adjusted R-square
is only about 8%. The theoretical restriction that l0 = 0 can be rejected at the 5%
significance level. However, the constant term, as discussed below, is not particularly
constant beta and timevaryingbeta versions of the CAPM (not reported in a table). We
find that the joint test of zero alphasis rejected in both cases. The rejections seem to be
(1995) who also shows that CAPM implications are rejectedin emerging markets data.
The failure of the CAPM can also be seen in Figure 2 where we plot the averagereturns
against the predicted expected returns from the model. A true model would,ignoring
estimation errors, produce observations along the 45-degree line. The figure reveals that
there is almost no dispersion in predicted expected returns. Hence, the model does not
The model specifications with sample selectivity are also reported in Table 3. Inthese
specifications the selectivity is modelled as (g00 + g01si)Ai, where si is the annual return
volatility for market i, and Ai is defined as the economic rating for country i less the
economic rating for the U.S. The expression (g00 + g01si) is the gi for country i. The
proxy for the hazard rate for country i is Ai, based on thereasoning provided earlier. Note
that Ai is negative for emerging economies and close to zero for developed economies.
This specification captures the intuition that as economies improve their economic rating
they become akin to developed marketsand the sample selectivity term would fall.When
sample selectivity is incorporated in the standard CAPM (in Panel A), thecross-sectional
R-square rises to 41% and the parameters associated with the selectivityterm are
significant (a p-value of 3%). The time-varying beta based CAPMwith sample selectivity
included is reported in Panel B. This specification does quitewell in capturing the cross-
sectionalvariation in risk premia, and has an adjustedR-square of 61%. The magnitudes
of the parameters that govern the selectivity bias(that is, g00 andg01) are similar across
levels (see the column labelled “Test ofJointSignificance”). The last two rows of Panel B
highlights the relevance, or the lackthereof, of the constant term l0. The empirical results
across thetwo cases (includingl0, or not) are comparable. Hence, as suggested by theory,
with poor economic rating have alarger andpositive selectivity bias. For developed
economies the variable Ai is essentiallyzero and hence the effect of selectivity on their
the constant beta CAPM, the systematic risk contribution is about 0.45% per month for
both emerging and developed economies. However, the selectivity premium is0.50% per
month for emerging markets and close to zero for developed markets. Inthe model with
the selectivity bias is somewhat higher, and now stands at 0.58%per month. For
emergingmarkets more than 1/2 of the ex-post risk premium can beattributed to
selectivity. That is, sample selectivity seems to be the dominant influenceon the
explanatory ability of the world CAPM with time-varying betas andsample selectivity
can be seen in Figure 3which displays the average returns againstpredicted expected
returns. The improvement in fit is visible and the model is ableto produce the
highdispersion in average returns.We also considered alternative specifications for the
rating of an economy i lessthe comparable rating for the U.S. The ability of this
adjusted R-square) is about30%. This R-square is quite high relative the specifications
economies) on the Brady bonds to measure the hazard rates directly.The approach is as
zero recovery as in Appendix A) for allemerging markets. Recall that we are making the
assumption that the probabilityof default indebt markets coincides with the probability of
expropriation. Fromthe probabilities we can then compute the hazard rates (i.e., the his).
For developedmarkets we assume a zero default probability (and hence a zero hazard
rate). Withthis measure of the hazard rate, and the same specificationforthe gi as before,
selectivity18term, that is gihi, is about the 0.63% per month. The average probability of
the defaultis about half a percent per month. Hence, the bias in the mean return of about
0.63% per month can be supported by rather small probability of default (risk of
expropriation).Note that the empirical evidence for this specification is quite similarto
therelative economic rating is the proxy for thehazard rate. This specification was
reportedin Table 3. The reputational variable (the financial rating of country i lessthe
comparable rating for theU.S.)is able to explain about 32% of the dispersion inthe
selectivity premium. This regression also shows that the selectivity premiumrises as
thecountry’s financial rating falls. Similarly, when we use the tradingactivity variable,
larger trading activity have a smaller selectivity premium.In essence our evidence
and Ross (1995). Ourevidence indicates that this attribute is notuniquely important to
capture the crosssectionaldifferences in risk premia. Indeed, the trade activity and
explaining the cross-sectional differences in the risk premia. Thus, it seems to us that this
is dueto the fact that the volatility of returns are related to these variables.Thisis shownin
Panel B of Table 5: return volatility is decreasing in both trading activity andfinancial
reputation. These variables, based on the work of Eaton and Gersovitz(1981), and Bulow
and Rogoff (1989a, 1989b) should matter to the compensationthat emerging markets
have toadditionallypay, due to risks of expropriation. Wefind that this indeed is the case.
Conclusion
In this paper we show that the cross-sectional differences in the equity returns
selectivitypremium. We show that the selectivity premium captures more than 1/2 of
implicationof this result is that after taking account ofselectivity premium all
work also shows that sovereigns thathave better financial marketreputations and trade
more actively have to pay a smaller selectivity premium. Thisempirical evidence lends
support to theview that both reputations and fear of tradesanctions are important in
This Appendix shows how the hazard rate can be measured from sovereign bondspreads.
equal to one if there is no default, and µb + bbet+1 +hbt+1 if the countrydefaults. The
payoff process can thus be written as qbt+1= ybt+1 + (1 - ybt+1) (µb + bbet+1 + hbt+1) .
(24)
For simplicity, we assume that bb = 0. That is, we assume that the recovery valueof the
bond is not related to the systematic risk in the world economy.Further, theexpected
payoff on this bond in default is less than one (i.e., µb < 1). Valuing thispayoff using the
Assume that the probabilities of default for the bond correspond to the probabilityof a
market shut-down, that is, pbt = pit. Under the further assumptionthat therecovery rate is
zero, we can directly recover the probability of default. Further,given the normal
expression can also be used to compute the ex-ante beta on market i.We denote this with
bit =pitbi1 + (1 - pit) bi2. If we assume that the ratio of thebetas across the two regimes is
Note that Rf t and Rbt can be observed directly from U.S. Treasuries and
rating.Hence, conditional on c, one can estimate the model with both a peso problem
andsample selectivity. In the special case with c = 1,there is no peso problem and wehave
that bit = bi1 = bi2.21B. Estimation DetailsThis Appendix shows the estimation in more
detail. Let q0 denote thetrue parametervector that we want to estimate. The typical
elements in q0 are aiM, biM, and biMz that are specific to each market, and the common
parameters l0, lM, lMz, g00and g01. By stacking the sample counterparts of the moment
where Xt summarizes the data used to form the moments conditions. The vectorgT (q)
has the dimension 4N. The moment conditions, given by (18) to (20), exactlyidentify the
aiM, biM, and biMz parameters. However, the moment conditions, givenby (23), is
overidentified. We have N moment conditions, but only 5 parameters (l0,lM, lMz, g00
and g01).We estimate the parameters by setting linear combinations of gT equal to zero.
ATgT = 0, (29)
that the point estimates are the ones given by ordinary least squares.
Let AT
be the product of two matrices denoted by A1T and A2T (that is, AT = A1TA2T).
where I3N is the identity matrix with dimension 3N, 03N is a 3N vector of zeros,0N is an
N vector of zeros, and A2T is a diagonal matrix with typical element equalto 1/ åTt=1
yit+1. The ˆ biMs and ˆ biMzs are estimates of biMs and biMzs, and they are
given in the estimation. The ˆ biMs and ˆ biMzs are exactly the least square
returnand scaled market excess returns as in (18) to (20). Further, the estimates of l0,
lM,lMz, g00, and g01 coincide with the least square estimates obtained in a regressionof
average returns on the betas and the proxies for sample selectivity. Our choice ofAT
Based on Hansen (1982) we know that when linear combinations of gT are setequal to
by
pT (qT - q0) d
where D0 is the gradient of the moment conditions in (28), and where S0 is the
S0 =¥åj=-¥E hf (Xt, q0) f _Xt-j, q0_0i. (32) The sample counterpart ST is estimated
using the procedure in Newey and West(1987) with four lags. D0 and A0 can be
estimated by their sample counterparts DTand AT. Note that the standard errors based on
Investment Risk
Investment risk includes credit risk and market risk which are both taken to combat
another risk—that due to inflation. Investors and traders need to assess the actual historic
results of the strategies they employ for their investments. In this manner, the individual
can better understand the true financial risks in which they are exposing themselves. Two
such risks may include under-investing in bonds & equities or over-investing in assets).
In order to manage necessary market risk, the investor must take steps to understand
those risks and minimize them through diversification. Numerous articles on the topic of
asset allocation and diversification are available in the Optionetics.com article archives
by completing an author keyword search for 2004 and 2005. Traders, who often self-
investments versus the performance of trading given the goals for each, and re-evaluate
those allocations.
To derive implications for systematic risk compensation and selectivity biases, we model
returns are available for a given market. We discuss the details of this in the data section
are not available and the market is inaccessible to international investors. We view the
regime 1 to regime 2 and the ex-ante probability with which thistransition can happen are
to regime 2 affects measured mean returns obtained solely from data sampled from
regime 1. Hence, one would expect that observed mean returns, particularly for an
emerging market, to be higher than the ex-ante risk premium. This bias measures the
allowus to derive separate systematic risk compensation from sample selectivity biasesin
expected returns. Let yit+1 represent an indicator for the regime in market i att + 1 being
investors), and zero otherwise. The return process, expressed indollars, is specified as
where E(Rit+1|It) is the ex-ante conditional mean of the gross return, et+1 is the
innovation in the systematic risk component, and hi1t+1 and hi2t+1 are diversifiable risk
determined by bi1 and bi2.Let rit+1 denote the excess return on market i, that is, rit+1 =
Rit+1 - Rf t.
Assuming that yit = 1, the valuation condition (1) then implies thatE (rit+1|It) = ls2et
where pit is the probability of the regime where market i is accessible to international
investors at time t. In other words, pit is the conditional probability that yit+1 = 1,and (1 -
pit) is the probability of a switch to regime 2. The risk premium is determinedby the
aggregate market price of risk, ls2et, and an overall beta which is aprobability-weighted
average of the betas in the two regimes. Next, we describe thedetermination of regimes 1
and 2.
Let y_it be a latent process that determines the opening and closing for market i. Thatis,
it determines if the regime is 1 or 2. In particular, if y_it >0 then the regime is 1and if
Following Heckman (1976, 1979), we assume that the conditional mean of the
assume
(1995) argue that the survival of a market (the analogue of our regime 1) is
determinedsolely by the price process itself. However, this seems restrictive, as many
emerging markets, such as Thailand, Indonesia, and Malaysia, have had comparable
international investor. These other influences are captured by xit and #it+1. Further, the
where the third equality follows from the symmetry of the normal distribution. As#it+1
and the innovation in the return of asset i may be correlated, consider the
where gi1 and gi1 are the projection coefficients between bijet+1 +hit+1 and #it+1
andbijet+1 + hit+1 and #it+1, respectively, and vi1t+1 and vi2t+1 are projection errors.
The above equations then imply that the excess return process can be written as
We consider the case where data are missing as an outcome of an attrition process.That
is, we consider the sample selectivity effects of only observing the regimewhere the
markets are accessible to international investors. In this case, the restrictionon the
where we have conditioned on the fact that the market is in regime 1 today (yit = 1)and
tomorrow (yit+1 = 1). This captures our view that an econometrician only
observesinvestable dollar return sample from regime 1. Note that E_#it+1|#it+1 >
-d0ixit_ is the same as E(#it+1|yit+1 = 1). Moreover, this quantity satisfies the relation
This is typically referred to as a hazard rate, or the inverse Mill’s ratio. We denotethis by
hit, that is, hit = f(d0ixit)/F(d0ixit). Based on the above results, it follows thatthe
This restriction shows that there are two biases in measuring the ex-ante risk
premium.The first bias stems from the fact that the econometrician does not
observeregime 2 (the regime when investable dollar returns are not available). This is re-
flected in the first term of (14). bi1 can obviously be identified in the time series
fromobservations when the market is open. bi2 is the beta at transition from regime 1 to2.
Identification of bi2 and the transition probability of going to regime 2 (that is,81 - pit)
can not be measured without additional restrictions. Note that the resultingbias is on the
The second bias is due to sample selectivity, and the effects of this can be seenin the
second term of (14). This is an adjustment to the ex-post mean to correctly estimate the
tomorrow, the risk premium is biased upwards. Put differently, investors require, on
average, a higher return when the market offers dollar returns, muchlike a defaultable
bond.
Brown, Goetzmann, and Ross (1995) focus on the second effect. It seems that the
measured risk premium will also be affected by the beta associated with the market shut-
down regime. If this beta is higher that in the regime for which datais available, then the
ex-ante mean asset will be higher, and in standard time-series regression this will show
effects implies that the ex-ante means lie on thesecurity market line.
In the special case of the world CAPM, equation (14) can be stated asE (rit+1|It, yit = 1,
where E (rMt+1|It) is the conditional risk premium on the world market portfolio,and the
betas are the world CAPM betas for the two regimes. As discussed above,taking account
of the peso problem requires measurement of bi2 and pit. In practise, estimating bi2 from
returns during a regime-switch is infeasible as there are very few, if any, in available
where lMt = E (rMt+1|It). In the empirical work we also consider time-variation inbetas.
Allowing for this time-variation is straightforward and does not affect any of the
derivations above.
Finally, note that for high survival probabilities, the hazard rate in equation (13)is almost
linear in the probabilities. Under the assumption that the probabilitiesabout expropriation
in equity markets and sovereign debt markets are highly re-lated, it is straightforward to
show that pit can essentially be backed out from observed sovereign bond spreads (see
Appendix A). The premise that probabilitiesof bond default and expropriation in equity
markets are related is supported bythe events in Malaysia in 1998 and the more recent
events in Argentina. Note thatfor small default probabilities, the hazard rate is almost
linear in sovereign bondspreads. As discussed and documented later, at least for the few
sovereign spreads that we observe, the spreads are highly correlated with observed
measures of country ratings. Hence, we can use the more extensively available data on
3. Data
fordeveloped markets and IFC for emerging markets. The returns from IFC are the
also consider the return on the MSCI world market portfolio. All returns are in U.S.
dollars,
and excess returns are calculated by subtracting the one-month Eurodollar rate =pp for
each month.The sample period is January 1984 to November 2000. It is, however, well
known that many emerging markets only were accessible for international investors
beginning in the late 1980s and the early 1990s. This is reflected in our data base. Data
for emerging markets are included as and when they open up. We let the opening date of
an emerging market be the date when IFC begins to record investable returns. The
inclusion date for each market is shown in Table 1. The inclusion dates are similar to
what other studies have considered to be the financial market liberalization dates (see, for
instance, Kim and Singal, 2000, Bekaert and Harvey, 2000, and Henry,2000). Our
empirical results are not sensitive to using alternative choices of liberalizationdates. The
total number of observations for developed markets is 203 and for emerging markets the
statistics of the monthly dollar returns. The averagereturns across developed and
emerging markets are about the same, 1.32%and 1.34% per month, respectively.
However, the average standard deviation ofemerging markets is about twice as high as
for developed markets. It also seemsto be greater dispersion in returns and return
volatilities of emerging economies.The correlation with the world market return is much
the countries. Theseattributes are used in our cross-sectional analysis of risk premia. The
Real GDP perCapita attribute is the real GDP per capita in constant dollars in 1990
(expressed ininternational prices, base 1985). The Trading Activity attribute is the sum of
exportsand imports divided by GDP in 1990. The real GDP per capita and trading
activityattributes are collected from the World Penn Tables. The Economic Rating and
theFinancial Rating attributes refer to the average country ratings from inclusion dateto
November 2000, and is provided by the International Country Risk Guide (ICRG).
The economic risk rating is meant to measure an economy’s current strengths
indicators.In the empirical work our measure of reputation is the financial rating, whichis
investment. The country ratings are published on a scale from 0 to 50 where a higher
between 0 (low) and 100 (high). A rating of 0 to 49 then indicates a very high risk;50 to
59 high risk; 60 to 69 moderate risk; 70 to 79 low risk; and 80 or more verylow risk. The
country rating are used by Erb, Harvey, and Viskanta (1996) in theirstudy of the time-
(1998) use these ratings to study investor protection and ownership structure across
Finally, we report betas versus the MSCI world market portfolio. The betas are,on
average, about the same for developed and emerging markets. However, thedispersion in
betas is much larger across emerging markets ranging from 0.07 to1.80, whereas they are
It is evident from Table 2 that the emerging economies are economies with relativelylow
GDP per capita. Further, emerging economies have a much lower countryratings than
developed economies. In fact, the correlation between the real GDP percapita and the
ratings are 70% (economic rating) and 80% (financial rating). Thetrading activity
attribute has a lower correlation with the real GDP per capita (about20%). The
correlations between trading activity and the ratings are about 20% and40%. There are a
few outliers (notably Hong Kong and Singapore), but excludingthem does not affect the
correlation between trading activity and credit rating significantly.We also collect
sovereign spreads for nine emerging economies from J.P. Morgan.2 These are economies
ratings contain much of the cross-sectional information in the spreads. For each month,
we computed the correlation between the sovereign spreads and the composite country
ratings. The correlations variedfrom -95% to -46% with an average of -72%. That is,
sovereign nations with a highspread on their dollar-denominated debt tend to have a low
country rating. This isalso highlighted in Figure 1, which shows the spreads versus
country ratings afterthe averages of the variables for each month have been subtracted.
That is, the variablesare measured as deviation from month averages to sweep out time
effects. Thecorrelation is about -58% and is highly significant (a p-value close to zero).
Similar results are obtained with either financial or economic country ratings.Our sample
begins in 1984 for developed markets, and in the late 1980s andearly 1990s for emerging
markets. Consequently, only brief data histories are available,particularly for emerging
economies. This makes it difficulty to solely rely ontime-series methods for measurement
and statistical inference. For this reason, weextensively use pooled cross-sectional
methods in the estimation. Importantly, therelative rankings of the attributes do not vary
a lot over time, indicating that mostof the information is in the cross-section. We
2The nine economies are Argentina, Brazil, Colombia, Korea, Mexico, Peru, Poland,
Turkey, andVenezuela.estimate exposures to risk sources, but evaluates the asset pricing
implications inthe cross-section. Increasing the sample for developed markets (going
back to 1976)does not change our results qualitatively and are therefore not reported.In
some specifications we allow the beta of a market versus the world market portfolio to
vary according a conditional information variable, namely the world excess dividend
yield (i.e., the dividend yield on the world market portfolio in excess of the one-month
In this section we present the estimation approach and discuss testable implications in the
time series as well as in the cross-section. We employ the generalized methodof moments
(2001), and similar to Bansal and Dahlquist (2000) and Jagannathan andWang (2002). In
this framework, specific distributional assumptions of the asset returnsare not required,
and wedo not need to work in a normally independently and identically distributed
errors. The approach is different from traditional approaches as we avoid the problem of
with missing data as the dollar return series for emerging markets
handle the missing data as in Bansal and Dahlquist (2000). The idea is to balance the data
set, and then apply the asymptotic results in the standard GMM framework. This is
further discussed below. We are interested in estimating the risk exposures and risk
describe the
estimation approach for the world CAPM with time-varying betas.As in Jagannathan and
the implications of the model in the cross-section as their is considerable cross- sectional
variation in the mean returns. Consider the cross-sectional risk premium implications in
equation (16). In addition, allow for the market beta of an asset to be time-varying
where lM = E (lMt) and lMz = E (lMtzt). The biMs and biMzs are the standard
time series projection coefficients. Hence, our first sets of moment conditions, for
These moment conditions are exactly identified. We have 3N moment conditionsand the
same number of parameters. The point estimates from these moment conditions
correspond to the usual least squares estimates. We follow the literature and add
constants, or alphas. In the world CAPM, the aiMs should be equal to zero.Indeed, we
will evaluate the CAPM by checking whether the alphas are all equal tozero in the time
series. Our focus, however, is on the ability of the various modelsh and without sample
Note that we use the regime indicator variable to make our unbalanced panel abalanced
panel as in Bansal and Dahlquist (2000). That is, the moment conditions are multiplied
with the product of the regime indicators at time t and t + 1, yityit+1. The product
yityit+1 selects returns when markets are open both at time t and t + 1. In essence, this
procedure treats missing observations as zeros. This has a practical advantage since the
usual moment conditions which contain missing data can be filled with zeros, and then
The sample selectivity part in equation (17) is gihi. As noted in the discussion of
equation (14), under simplifying assumptions, the probability of default can be recovered
from the sovereign bond spread. Further, this spread can be used to 3Hayashi (2000)
14
completely characterize the hazard rate at time t. However, the data on sovereign interest
rate spreads are not available for many economies in our sample period. As shown
earlier, there is a high negative correlation between the country ratings and the spreads in
the cross-section (for economies where sovereign spread data are available). That is, a
country with a low rating tends to have a high spread (a high probability of default).
Consequently, to characterize the cross-section of hazardrates, we model the hazard rate
where Ai proxies for hi in the cross-section. For example, we let Ai equal the countryis
economic rating which then captures the cross-sectional variation in the hazardrate.
The cross-sectional parameters (i.e., the risk premium parameters and the g00and g01
parameters) are then identified in the last set of moment conditions for each asset i
The constant term l0 should be zero according to theory, and a non-zero constant
indicates that a model cannot price the assets on average. Alternatively, a non-zero
constant can be interpreted as a zero-beta rate different from the riskfree rate thatis
imposed. Note that all parameters including the betas and the cross-sectional parameters
l0, lM, lMz, g00, and g01 are jointly estimated using GMM. Details of the estimation are
given in Appendix B.
Results
This section presents the empirical results. Recall, that we earlier reported that the cross-
sectional dispersion in the average returns is fairly large for emerging markets and small
for developed markets. This cross-sectional dispersion poses a serious challenge to asset
pricing models. Variables that characterize the selectivity bias, such as country ratings,
the effects of selectivity are primarily identifiable in the cross-section. Given the large
cross-sectional dispersion in the data along with the short data histories for many
emerging markets, we, as in Black, Jensen, and Scholes (1972), Fama and MacBeth
(1973), and Jagannathan and Wang (1996), focusprimarily on the explaining the cross-
We first discuss the ability of the various models to capture the cross-section of average
returns through only systematic risk. We then include sample selectivity in the cross-
of the results.
In Table 3, we provide evidence from the cross-section of asset returns. The estimated
risk premium for the market portfolio is negative, as can be seen in row 2 of Panel A.
This is a standard finding (see, for instance, Jagannathan and Wang, 1996). The ability of
the CAPM with constant betas to explain the cross-section of average returns is basically
zero as indicated by the adjusted R-square. In Panel B, we consider the CAPM where the
market betas are allowed to be time-varying. The model fails to capture the cross-
sectional dispersion in average returns in this specification as well The adjusted R-square
is only about 8%. The theoretical restriction that l0 = 0 can be rejected at the 5%
significance level. However, the constant term, as discussed below, is not particularly
constant beta and timevaryingbeta versions of the CAPM (not reported in a table). We
find that the joint test of zero alphasis rejected in both cases. The rejections seem to be
(1995) who also shows that CAPM implications are rejectedin emerging markets data.
The failure of the CAPM can also be seen in Figure 2 where we plot the averagereturns
against the predicted expected returns from the model. A true model would,ignoring
estimation errors, produce observations along the 45-degree line. The figure reveals that
there is almost no dispersion in predicted expected returns. Hence, the model does not
The model specifications with sample selectivity are also reported in Table 3. Inthese
specifications the selectivity is modelled as (g00 + g01si)Ai, where si is the annual return
volatility for market i, and Ai is defined as the economic rating for country i less the
economic rating for the U.S. The expression (g00 + g01si) is the gi for country i. The
proxy for the hazard rate for country i is Ai, based on thereasoning provided earlier. Note
that Ai is negative for emerging economies and close to zero for developed economies.
This specification captures the intuition that as economies improve their economic rating
they become akin to developed marketsand the sample selectivity term would fall.When
sample selectivity is incorporated in the standard CAPM (in Panel A), thecross-sectional
R-square rises to 41% and the parameters associated with the selectivityterm are
significant (a p-value of 3%). The time-varying beta based CAPMwith sample selectivity
included is reported in Panel B. This specification does quitewell in capturing the cross-
sectionalvariation in risk premia, and has an adjustedR-square of 61%. The magnitudes
of the parameters that govern the selectivity bias(that is, g00 andg01) are similar across
levels (see the column labelled “Test ofJointSignificance”). The last two rows of Panel B
highlights the relevance, or the lackthereof, of the constant term l0. The empirical results
across thetwo cases (includingl0, or not) are comparable. Hence, as suggested by theory,
with poor economic rating have alarger andpositive selectivity bias. For developed
economies the variable Ai is essentiallyzero and hence the effect of selectivity on their
the constant beta CAPM, the systematic risk contribution is about 0.45% per month for
both emerging and developed economies. However, the selectivity premium is0.50% per
month for emerging markets and close to zero for developed markets. Inthe model with
the selectivity bias is somewhat higher, and now stands at 0.58%per month. For
emergingmarkets more than 1/2 of the ex-post risk premium can beattributed to
selectivity. That is, sample selectivity seems to be the dominant influenceon the
explanatory ability of the world CAPM with time-varying betas andsample selectivity
can be seen in Figure 3which displays the average returns againstpredicted expected
returns. The improvement in fit is visible and the model is ableto produce the
highdispersion in average returns.We also considered alternative specifications for the
rating of an economy i lessthe comparable rating for the U.S. The ability of this
adjusted R-square) is about30%. This R-square is quite high relative the specifications
economies) on the Brady bonds to measure the hazard rates directly.The approach is as
zero recovery as in Appendix A) for allemerging markets. Recall that we are making the
assumption that the probabilityof default indebt markets coincides with the probability of
expropriation. Fromthe probabilities we can then compute the hazard rates (i.e., the his).
For developedmarkets we assume a zero default probability (and hence a zero hazard
rate). Withthis measure of the hazard rate, and the same specificationforthe gi as before,
selectivity18term, that is gihi, is about the 0.63% per month. The average probability of
the defaultis about half a percent per month. Hence, the bias in the mean return of about
0.63% per month can be supported by rather small probability of default (risk of
expropriation).Note that the empirical evidence for this specification is quite similarto
therelative economic rating is the proxy for thehazard rate. This specification was
reportedin Table 3. The reputational variable (the financial rating of country i lessthe
comparable rating for theU.S.)is able to explain about 32% of the dispersion inthe
selectivity premium. This regression also shows that the selectivity premiumrises as
thecountry’s financial rating falls. Similarly, when we use the tradingactivity variable,
larger trading activity have a smaller selectivity premium.In essence our evidence
and Ross (1995). Ourevidence indicates that this attribute is notuniquely important to
capture the crosssectionaldifferences in risk premia. Indeed, the trade activity and
explaining the cross-sectional differences in the risk premia. Thus, it seems to us that this
is dueto the fact that the volatility of returns are related to these variables.Thisis shownin
Panel B of Table 5: return volatility is decreasing in both trading activity andfinancial
reputation. These variables, based on the work of Eaton and Gersovitz(1981), and Bulow
and Rogoff (1989a, 1989b) should matter to the compensationthat emerging markets
have toadditionallypay, due to risks of expropriation. Wefind that this indeed is the case.
Conclusion
In this paper we show that the cross-sectional differences in the equity returns
selectivitypremium. We show that the selectivity premium captures more than 1/2 of
implicationof this result is that after taking account ofselectivity premium all
work also shows that sovereigns thathave better financial marketreputations and trade
more actively have to pay a smaller selectivity premium. Thisempirical evidence lends
support to theview that both reputations and fear of tradesanctions are important in
This Appendix shows how the hazard rate can be measured from sovereign bondspreads.
equal to one if there is no default, and µb + bbet+1 +hbt+1 if the countrydefaults. The
payoff process can thus be written as qbt+1= ybt+1 + (1 - ybt+1) (µb + bbet+1 + hbt+1) .
(24)
For simplicity, we assume that bb = 0. That is, we assume that the recovery valueof the
bond is not related to the systematic risk in the world economy.Further, theexpected
payoff on this bond in default is less than one (i.e., µb < 1). Valuing thispayoff using the
Assume that the probabilities of default for the bond correspond to the probabilityof a
market shut-down, that is, pbt = pit. Under the further assumptionthat therecovery rate is
zero, we can directly recover the probability of default. Further,given the normal
expression can also be used to compute the ex-ante beta on market i.We denote this with
bit =pitbi1 + (1 - pit) bi2. If we assume that the ratio of thebetas across the two regimes is
Note that Rf t and Rbt can be observed directly from U.S. Treasuries and
rating.Hence, conditional on c, one can estimate the model with both a peso problem
andsample selectivity. In the special case with c = 1,there is no peso problem and wehave
that bit = bi1 = bi2.21B. Estimation DetailsThis Appendix shows the estimation in more
detail. Let q0 denote thetrue parametervector that we want to estimate. The typical
elements in q0 are aiM, biM, and biMz that are specific to each market, and the common
parameters l0, lM, lMz, g00and g01. By stacking the sample counterparts of the moment
where Xt summarizes the data used to form the moments conditions. The vectorgT (q)
has the dimension 4N. The moment conditions, given by (18) to (20), exactlyidentify the
aiM, biM, and biMz parameters. However, the moment conditions, givenby (23), is
overidentified. We have N moment conditions, but only 5 parameters (l0,lM, lMz, g00
and g01).We estimate the parameters by setting linear combinations of gT equal to zero.
ATgT = 0, (29)
that the point estimates are the ones given by ordinary least squares.
Let AT
be the product of two matrices denoted by A1T and A2T (that is, AT = A1TA2T).
where I3N is the identity matrix with dimension 3N, 03N is a 3N vector of zeros,0N is an
N vector of zeros, and A2T is a diagonal matrix with typical element equalto 1/ åTt=1
yit+1. The ˆ biMs and ˆ biMzs are estimates of biMs and biMzs, and they are
given in the estimation. The ˆ biMs and ˆ biMzs are exactly the least square
returnand scaled market excess returns as in (18) to (20). Further, the estimates of l0,
lM,lMz, g00, and g01 coincide with the least square estimates obtained in a regressionof
average returns on the betas and the proxies for sample selectivity. Our choice ofAT
Based on Hansen (1982) we know that when linear combinations of gT are setequal to
by
pT (qT - q0) d
where D0 is the gradient of the moment conditions in (28), and where S0 is the
S0 =¥åj=-¥E hf (Xt, q0) f _Xt-j, q0_0i. (32) The sample counterpart ST is estimated
using the procedure in Newey and West(1987) with four lags. D0 and A0 can be
estimated by their sample counterparts DTand AT. Note that the standard errors based on
Panel C. World
from nclusion date to November 2000. Panels A, B and C show statistics for developed
markets, emrging markets and theWorld, respectively. The labels Average in Panels A
Correlation with World refers to thecorrelation coefficient with the world market
Trading
Activity
Economic
Rating
Financial
Rating Beta
This table lists country attributes. Panels A and B show the attributes for developed
markets andemerging markets, respectively. The labels Average in Panels A and B refer
to the average (equallyweighted)across developed and emerging markets, respectively.
Real GDP per capita refers to RealGDP per capita in constant dollars (expressed in
international prices, base 1985). Trading Activityrefers to exports plus imports over
nominal GDP. Real GDP per capita and trading activity aretaken from the Penn World
Table for the year of 1990. Economic and Financial Ratings refer tothe average financial
amarket’s excess return versus the excess return on the MSCI world market portfolio.
R-square
Economic Rating
Volatility × Relative
Economic Rating
World
Market
Sample
Selectivity All
(0.49)
1.08 -0.26 0.01 [0.69] [0.69]
(0.61) (0.65)
(0.46) (0.66)
This table presents results from estimations of the asset pricing models. All markets are
estimated in one common system which includes both a timeseries estimation of betas as
well as a cross-sectional estimation of risk premia and sample selectivity premia. PaneA
and B show the results for the worldCAPM with constant and time-varying betas,
actual realized returns on the assets. Average pricing errorrefers to the cross-sectional
average (equally-weighted) ofthe pricing errors, and is reported for Developed and
significant riskpremia associated with the market, sample selectivity, andall premia.
Average Systematic
Risk
Sample
Selectivity
Pricing
Error
Volatility Attribute
Volatility Attribute
This table presents the decomposition of the measured excess returns for developed and
models with sample selectivity. Panel A and B show the decomposition for the world
The specification with the volatility attribute is as reported in Table 3 (withno constant
use these attributes instead of the volatility attribute. The decompositions are expressed
Constant Economic
Rating
Financial
Rating
Trading
R-square
Test of Joint
Significance
(0.14) (1.43)
(0.17) (1.57)
(0.29) (0.10)
(0.27) (0.02)
(0.98) (6.99)
parentheses.Panel A and B show the results for sample selectivity and volatility,
with time-varying betas using relativeeconomic rating, and volatility × relative economic
rating as in Table 3 (with no constant term).Theattributes are the economic rating, the
financial rating, and the relative trading activity. Allattributes are relative the U.S. The
coefficients.
Securities and Exchange Board of India Group
1 Background
derivatives inIndia
to beintroduced
• The road map for research in fixed income analytics and the
system.In line with the Group’s view that its conclusions on these
issues be put up for public comments, the Group has prepared this
consultative document.
has stated the need for exchange traded interest rate derivatives
admirably well:
“While OTC derivatives market has traditionally played a dominant role
(Paragraph 3.2) “The Group felt that there is a need for exchange-
risk management. The Group considered that India has already set up
in the equity markets which could be harnessed for the debt market. It,
It must also be added that interest rate risk is one of the most
amount of housing loans on the liabilities side makes interest rate risk
for many households interest rate risk is vastly more important than
The Group is well aware that the publicly available fixed income
Group is of the view that the development of this field has been held
the best way to solve the “chicken and egg”problem of whether the
the Group has arrived at April 21 as the most feasible launch date. As
discussed later, the Group desires and expects that the Exchanges
over the next three months. Allowing for a month for regulatory review
and two months for software changes, the Group desires and expects
implications:
over-marginingin the initial six month period until more refined models
over-margining.
2. Another implication is that to the extent that the zero coupon yield
would be a basis risk inhedging interest rate risk using products based
on this curve. Since all hedgesInvolve e some degree of basis risk, the
Group does not regard this as a showstopper if there is complete
month of launch. It must also be pointed out that one paisa is a small
The Group discussed three issues in connexion with product design for
year maturity and that this should be the maturity of the underlying
long bond for interest rate futures. Regarding maturity of the futures
three months, and whether the quarters should be fixed months of the
There was some discussion regarding the choice between whether the
decided that the exchanges should have the freedom to offer either or
both of these products and also to choose the coupon rate in case of
the coupon bond. Exchanges indicated that the coupon rates could be
in therange of 6-8%.
settlement:
risk.
also noted:
relatively small. This means that the entire issued amount of even a
means that a large player couldeasily corner the entire floating stock
that was allegedlysqueezed in that case had an issue size of over _6b,
much larger than the issuesizes in the Indian market, but this issue
Group decided that the ten yearlong bond futures should initially be
the bond is simply the presentalue of the principal payment (at the
yield. For example, suppose that on 18/1/2003, the ten year zero
has a coupon, the present value of the bond is obtained as the sum
discounting each coupon payment for thetime period remaining till the
coupon payment at the zero coupon yield for that maturity.The Group
a third party):
the source
the entiresource code for its algorithm available on the web site under
web site aset of at least 25 trading days (i.e. one month) of data suites
for the input data.Each day’s data suite would include the traded
algorithm. The data suite would also include thesample output from
the algorithm on this data suite. Similar data suites andsample outputs
rate and a contract on a risk free interest rate.It was generally agreed
that the liquidity in the inter-bank market (MIBOR and MIFOR)is much
theSCRA. Since the Group does not profess any expertise in legal
issues hereare similar to that for long bond futures and the
2. The settlement price would be based on the risk free zero coupon
Mkt. Stock
Sensex price Mkt.return ret. xy x2 y2
july,2006 x y
4 10520.11 1029.95
5 10410.49 1066.4 3.53 -1.04 -3.67 1.08 12.46
6 10436.84 1091.3 2.33 0.253 0.59 0.06 5.42
7 10509.53 1106.9 1.43 0.7 1 0.49 2.05
10 10684.3 1108.05 0.14 1.66 0.23 2.75 0.01
Sh. Cements
Mkt. Stock
Sensex price Mkt.return ret. xy x2 y2
x y
10520.11 720.25
10410.49 755.1 3.53 35.15 124 1.08 1235.5
10436.84 775.85 2.33 20.75 48.34 0.06 430.56
10509.53 800.2 1.43 24.35 34.82 0.49 593
10684.3 840.2 0.14 40 5.6 2.75 1600
Investors want to maximize expected return subject to their tolerance for risk. Such
returns take the form of dividend and /or interest income and appreciation in the price for
The risk associated with holding common stock is really the likelihood that expected
returns will not materialize. If dividends or price appreciation fall swhort of expectations,
the investor is disappointed. The principle sources behind dividend and price
appreciation uncertainties are forces and factors that are either controllable or not subject
Uncontrollable forces, called sources of systematic risk, include market, interest rate and
purchasing power risks. Market risk reflects changes in investor attitudes toward equities
in general that stem from tangible and intangible events. Tangible events might include
expectations of lower expected profits and the resultant panic selling. Interest rate risk
and purchasing power risk are associated with changes in the price of money and other
goods and services. Increase in interest rates (the price of money) cause the prices of all
types of securities to be marked down. Rising prices of goods and services ( inflation or
purchasing power changes) have an adverse effect on security prices because the
postponement of consumption through any form of investment means less “real” buying
The principal sources of unsystematic risk affecting the holding of common stocks are
business risk and financial risk. Business risk refers to changes in the operating
environment of the firm and how the firm adapts to them. Financial risk is associated
with the debt debt and equity mix of financing the firm. Operating profits can be
magnified up or down, depending upon the extent to which debt financing is employed
diversifiable and non diversifiable risk . the former risk can be almost entirely by holding
The only risk an investor is compensated for taking is thus non diversifiable risk. Beta
measures this risk and can be used to determine the appropriate required return on a
security.
SUGESSTIONS
1. Sharekhan ltd. should also issue an IPO so that the company can be promoted
3. It should lessen the brokerage charges so that it can cut the competitors easily.
Phones.
BIBLIOGRAPHY
Websites:
www.sharekhan.com /companyinfo
dates of site visited: 1st july,2006 , 2nd july 2006, 5th july 2006,
dates of site visited: 1st july,2006 , 2nd july 2006, 5th july 2006
Book:
Magazine:
Valueline
Publisher: ShareKhan
Newspaper
Market Intelligence.
Annexure 1
Closing Prices
July,2006 Rs.
4 1029.95
5 1066.4
6 1091.3
7 1106.9
10 1108.5
Annexure2
Market information of Jindal Steel
ltd
Closing Prices
July,2006
4 1409.15
5 1448.15
6 1467.15
7 1500.25
10 1523.25