Financial Markets & Institutions

(Course Code: FIN-)

Introduction

An investor can invest his surplus funds in different investment alternatives like shares, stocks, bonds,
debentures depending upon the investment environment, availability of fund, expected rate of return
considering the risk factors involve therein. The ultimate objective of an investor is to learn how to
construct an optimal portfolio of investments. In order to accomplish, an investor will have to be aware
of the various investment alternatives available and be able to make estimates of the returns he expects to
get from the individual securities in the portfolio as well as their risk. Securities are marketable financial
instruments that bestow on their owners the right to make specific claims on particular assets. An
individual security provides evident of either creditor ship or ownership depending on whether it is a
bond or stock respectively.
Investment Categories
Basically investments involve two categories viz., real assets and financial assets. Real assets include
those assets which are tangible, material things like furnitures, land, building, ornaments, automobiles
etc. Financial assets, on the other hand, include pieces of paper representing an indirect claim to real
assets held by individuals or firms or any corporate body. Being pieces of paper, financial assets
represent debt or equity commitments in the form of I owe you (IOU) or stock certificates.
Liquidity being one of the special interest to investors distinguishes real assets from financial assets.
Obviously, real assets are less liquid than financial assets as because the former are more heterogeneous
and yield benefits only in cooperation with other productive factors. Moreover, returns on real assets are
frequently more difficult to measure accurately. However, our principal concern in analyzing investment
is more concern with financial assets rather than real assets. Investors in securities always have an
alternative to direct investing. Indirect investing refers to buying and selling of shares of investment
companies that, in turn, hold portfolios of securities. Investors purchasing shares of a particular portfolio
managed by an investment company are purchasing an ownership interest in that portfolio of securities
and are entitled to a prorate share of the dividends, interest, and capital gains generated by the portfolio.
A direct investor, however, have the following investment categories:
i.
Government securities,
ii.
Corporate bonds,
iii.
Corporate common stocks,
iv.
Preferred stocks and
v.
Derived securities
Investments in the above assets may, further, be categorized according to their source of issuance and the
nature of the buyers commitment as debt instruments and equities. To this end, investments in securities
can also be classified on the basis of income or return they earn each year of their life as fixed income
securities and variable income securities. Fixed income securities are those which have a defined limited
money claim. The money received from those investments will never exceed this promised claim,
although they can fall short of promise in the case of default. Variable income securities, on the other
hand, have a residual claim to the earnings of a company. These claimants are entitled to whatever is left
after all the other security holders have exercised their claims to the firms earnings. While the
stockholders claim to the earnings is residual, it is also unlimited in amount. If the firm proves to be a
huge success, the stockholders may reap huge gains, while the bondholders receive only their fixed
claim.

Organizing Financial Assets

Investment covers a wide range of activities. It refers to investing money in common stocks, bonds,
certificates of deposits, or mutual funds. Some rationale investors choose others paper assets such as

warrants, puts and calls, futures contracts, and convertible securities. Our main concern is to focus on the
financial assets, financial claims on the issuers of the securities. There are two apathies in investing
individuals fund which is the commitment of the same to one or more assets that will be held over some
future time period as the desires of the fund holders. One of the investment avenues is the direct
investment. It is defined as the investors would buy or sell securities themselves with the help given by
the brokerage houses. The other avenue of investing called indirect investment refers to the buying and
selling of shares of investment companies. Investors can invest in a portfolio of securities through buying
the shares of a financial intermediary that invest in various types of securities on behalf of its
shareholders. Indirect investment, therefore, is a very important alternative for all categories of investors.
Investors, on the other hand, can invest in financial markets choosing the best alternative from a wide
variety of assets. Major types of financial assets can be categorized as:
Financial Assets
Direct investing
Money market
instruments

Indirect investing
(Mutual funds)
Capital market
instruments

Fixed income
Instruments

Derivative
instruments

Equity
instruments
Direct investing

Money market

Treasury bills
Treasury notes
Treasury bonds
Commercial papers
Eurodollars deposit
Commercial papers
Bankers acceptances
Repurchase agreements
Eurodollar certificates of deposit
Negotiable certificates of deposits
Treasuries
Debentures
Income bond
Call futures
Potable bond
Corporate bond
Mortgage bond
Convertible bond
Sinking fund
Preferred stock
Common stock
Money market deposits
Savings deposits
Certificates of deposits
Government savings bonds
Options (puts and calls)
Warrants

Fixed income
Capital market

Equities
Nonmarketable

Derivatives market

Futures contracts
Indirect investing
Annuities
Insurance policies
Unit investment trusts
Open-end investment companies
Closed-end investment companies

Equities

Debt Instruments
Debt instruments include all types of fixed-income securities promising the investors that they will
receive specific cash flows at specific times in the future. Securities generating one cash flow are known
as pre-discount securities or zero-coupon securities. On the other hand, it may involve multiple cash
flows. If all the cash flows are of the same size, they are generally referred to as coupon payments. The
date beyond which the investors will no longer receive cash flows known as maturity date. On this date
investors will receive the principal along with the last coupon payment. Although these cash flows are
promised, they may not be received due to the risk associated with such investments. Financial assets
issued by government, firms, and individuals often take the form of IOUs calling for fixed periodic
payments, termed as interest and the repayment of the amount borrowed, termed as principal. Debt
instruments represent money loaned rather than ownership to the investors.
Deposits and Contracts
Currency, in real sense, is a government IOU. Money and savings accounts referred to as demand and
time deposits are loans to banks and other like financial institutions. Demand and savings and other time
deposits cannot e withdrawn without notice, although financial institutions provide this advantage to the
deposit holders. Savings accounts draw interest, and some forms like certificates of deposits (CDs) have
specific maturities. CDs pay higher interest than normal saving accounts do.
Government Securities
Government securities are those securities which are issued by the government to finance deficit in
budget when revenues fall short of expenditures. Government securities are all most invariably bond
issues of various types. These bonds are issued by the government at all levels. Because it can print
money, the securities of the government are not subject to default. The government securities are riskless,
default free and earn a fixed rate of interest income. Being issued by the government debt securities differ
in quality, yield, and maturity. In the national and international financial market, we usually find the
following governments securities:
Treasury Bills: Treasury bills are short-term notes that mature in three months, six months, nine months
and maximum one year from the date of issue. These securities can be redeemed only at maturity.
Treasury bills can be easily sold in the money market at prices that reflect prevailing interest rate and on
a discount basis before maturity. The discount to the investors is the difference between the less-thanface-value price they pay and face value they receive at the bills maturity.
Certificate of Indebtness or Treasury Certificate: Certificate of indebtness differs from Treasury bills
because they are issued at par value and pay fixed interest rates. These fixed interest rates are called
coupon rates. Every bond issue of this type promises to pay a coupon rate of interest that is printed on the
bond and never changes. The bond investor collects this interest income by tearing perforated coupon slip
off the edge of the certificate and cashing the coupons at the banks and post offices or other government
approved authorities. Treasury certificate matures within one year from the date of issue.
Treasury Notes: Treasury notes are similar to the treasury certificate accept with regard to time of
maturity. Notes typically have a maturity of one to ten years when they are newly issued. Like treasury
certificate, however, they are sold at face value in the money market and pay fixed coupon interest
payments each year of their life.
Treasury Bonds: Treasury bonds make up the smallest segment of the government debts. Bonds differ
from notes and certificates with respect to maturity; bonds mature and repay their face value within a
period from ten to thirty years from the date of issue. Some bond issues are callable or redeemable prior
to maturity.
Private Issues

Private debt securities are issued by corporations and/or both financial and nonfinancial institutions
which run the spectrum in quality and yield. The categories of these types of securities are furnished
below:
Corporate Bonds: When corporations go to the capital markets to obtain money for all corporate
purposes, the single most important sources of funds is through the sale of debt securities. It is a longterm written promise to pay under seal a certain sum of money at a certain time for specific rate of
interest. Bondholders have the right to receive fixed rate of interest payment before any dividends may be
distributed to the equity owners. In addition, the bondholders have what is termed a fixed claim on the
assets of the firm. This means that when the bonds mature, , or in the event of liquidation of the firm, the
bondholders are entitled to receive a stated amount and this claim has priority over any of the claim of
the equity owners.
Corporate bond is long-term debt securities issued by corporations help to finance their operations. It is
similar to other kinds of fixed-income securities in that it promises to make specific payments at
specified times and provides legal remedies in the event of default. Different names are often used for the
same type of bond, and occasionally the same name will be used for different bonds. However, the
following types of bonds are available in the financial market:
Debentures: Debentures are general obligations of the issuing corporation and thus represent unsecured
credit. Their claim is fixed but based only on the firms ability to generate cash flow. To protect the
holders of such bonds, the indenture will usually limit the future issuance of secured debt as well as any
additional unsecured debt.
Income bond: All interest on bonds must be paid before any dividends are distributed to the
shareholders. Income bond is a security on which interest is paid only if earnings are sufficient. These are
infrequently sold to raise new capital because of the residual nature of interest payments. In some income
bonds, the interest payment must be approved and declared by the board of directors as much the same
way as dividends are paid on preferred stocks. If the interest on bond is not paid, it may be cumulative
and payable at a later time. Income bonds are still debt instruments but they are closely related to stock in
the essential characteristic of interest payment.
Mortgage bond: Mortgage bond represents debt which is secured by the pledge of subject security. In
case of default, the bondholder is entitled to obtain the property and to sell it to offset his claims on the
firm.
Equipment trust certificate/bond: Any way in which the principal of a bond issue is secured through the
pledge of equipment. The title to the property or machinery usually remains in the hands of the trustee
until the debt is repaid. The corporation receives the title to the equipment only when all scheduled
payments are made. Each six month after the purchase of equipment, a principal and interest payment
would be paid to the trustee. The trustee in turn would retire some of the equipment trust certificates and
pay the interest on the outstanding debts.
Convertible bond: The convertible bond provides the holder with an option to exchange his bond for a
predetermined number of common shares at any time period to maturity. The convertible bonds offer the
promise of sharing the capital growth. If the stocks increase in value, the bonds also will increase. If the
stock remains at the same price, the bonds will still provide a good yield.
Callable bond: The callable bond gives the issuing firm to retire the bonds at a stated call price. The call
option usually becomes operative after a stated period of call protection which is usually either five or ten
years after originally issuance. The call price usually begins at a value close to the sum of the principal
plus one annual interest payment and steadily declines to the value of the principal at maturity. The
promise to redeem bonds at maturity can be altered or modified by what is called call future providing
the benefit for the issuer.
Potable bond: A potable bond gives holder the option to exchange his bond for cash equal to the face
value of the same.
Registered bond: One other safeguard might be indicated in the indenture which assures the basic
security of the bond. A bond may be registered to protect the owners from loss. When the bond principal
is registered the name and address of the bondholders are recorded with the issuing company. The
registration of the principal does not guarantee that the bondholder will receive principal repayment at
maturity, but it does provide him with protection from loss should the bond certificate be lost or
destroyed.

Collateral trust bond: Some bond issues pledge stocks or bonds as additional security for the money
borrowed. This type of bond is referred to as collateral trust bond. The collateral is usually the personal
property of the corporation that is issuing the bond.
Sinking fund: A sinking fund is a specific type of security issued for the benefit of the investors. A part
of the principal of debt is paid each year reducing the amount outstanding at maturity. Sinking fund
operates by having the corporation transmit cash to the trustee who can then purchase bonds in the open
market.
Receivers certificates: Receivers certificates are debt instruments that arise out of reorganization. When
a corporation in reorganization needs capital, the receivers or the trustees have the power to raise
additional funds. The securities issued are known as receivers certificates and the principal value of
these claims takes precedence over any other debt outstanding. This priority places them in a superior
position with respect to other debt.
Bond indenture: The special promises that are made to the bondholder are set forth in the bond
indenture. It is an agreement between corporation issuing the bonds and a corporate trustee, usually a
commercial bank or trust company who represents the bondholder. The usual items that are found in the
bond indenture are: the authorization of the issue, the exact wording of the bond, the interest or coupon
rate, the trustees certificate, the registration and endorsement, the property pledged as security if any,
and the agreements, restrictions and remedies of the trustee.
Commercial Papers: Commercial paper is an unsecured short-term promissory note issued by both
financial and nonfinancial companies. These securities are issued to supplement bank credit and are sold
by companies of prime credit standing.
Bankers Acceptance: Bankers acceptance are time draft drawn on and accepted by a bank which has
agreed to do so for an importer or a holder of merchandise, thus substituting bank credit for commercial
credit. Such instruments are widely used in foreign trade. The buyer of the goods may issue a written
promise to the seller to pay a certain amount within a short period of time the maturity of which is less
than one year. This written promise offering liability to both the bank and the buyer of the goods is
termed as bankers acceptance.
Certificates of Deposits: Certificates of deposit (CDs) are special type of interest-bearing deposit at
commercial banks or savings and loan associations. Large corporate time deposits in commercial banks
are often of certain minimum amounts for a specified time period. Unlike time deposits, these certificates
of deposit are negotiable.
Eurodollar Certificates of Deposits: In the world of international trade and finance, large short-term
certificates of deposit denominated in dollars and issued by banks outside the United States are known as
Eurodollar certificates of deposit (henceforth Euro CDs). Euro CDs are negotiable.
Eurodollar Deposits: Dollar-denominated time deposits in commercial banks outside United States are
commonly known as Eurodollar deposits. Eurodollar deposits cannot be traded and thus they are not
negotiable.
Repurchase Agreements: A money market instrument may be traded between two investors. The seller
of such instrument may agree to repurchase it for a agreed-on price at a later date. This agreement is like
a collateralized loan from buyer to seller.
Equity Instruments
Investment media representing an ownership position is the equity investment in which the investor is an
owner of the firm and is thus entitled to a residual share of profits. Equity instruments differ from fixed
income securities in that their returns are not contractual. Returns can be much better or much worse than
those from a bond. The equity ownership, however, arises out of the indirect equity investment and direct
equity investment. Before going to describe the direct and indirect equity investment, we need to identify
the components of equities.
Components of Equities
Capital structure refers to long-term sources of financing for a firm. It is consisted of long-tern debt and
equities. Shareholders equity is a residual item that is not fixed. It is the difference between the assets
and all other liabilities of a firm which is found as:
Assets Liabilities = Equity
However, the equities of a firm are comprised of the following components:

i.
ii.
iii.
iv.
v.
vi.
vii.
viii.

Common stock: The amount of money paid by the owners of the organization measured as the
product of par value (face value) and number of shares outstanding.
Preferred stock: The amount which is measured by the par value of any shares outstanding
promising to pay a fixed rate of return in the form of fixed dividend.
Surplus: The excess amount above each share of stocks par value paid by the shareholders.
Equity reserves: Representing any fund for contingencies, providing a reserve for dividend
expected, and a sinking fund to retire stock or debt in the future.
Undistributed profit: The net earnings after tax that is retained in the business rather than
distributing to the shareholders as dividends
Subordinated debentures: Long-term debt carrying a convertible feature. The holders of them
have the right to exchange their debt for shares of stock.
Equity commitment notes: Debt security repayable only from the sale of stock.
Minority interest in consolidated debentures: The holdings of ownership shares of other
business enterprises.

Direct Equity Investment

Two major direct equity investments are common stocks and preferred stocks. When investing directly,
investors can choose money market securities, capital market securities or the securities in the derivatives
market that include options and financial futures contracts. However, the followings are major direct
equity investments:
Common stock: Common stock may be defined as the residual ownership of a corporation, which is
entitled to all assets and earnings after the other limited claims have been paid and which has the basic
voting control. In short, common stock is the fundamental ownership equity. The investor in common
stock thus occupies a position directly comparable to that of the owner of a firm or a factory. Common
stock bears the main burden of the risk of the enterprise and also receives the lions share of the
advantages of success. Common stock has no maturity date rather its life is limited by the length of time
stated in the corporate charter.
Common stock represents the ownership interest of corporations. Among other things, the holders of
common stock elect the board of directors, have a right to the earnings of the firm after all expenses and
obligations have been paid, also run the risk of receiving nothing if earnings are insufficient to cover all
obligations. Holders of common stock receive a return in the form of the distribution of corporate
income like dividends and capital appreciation. Common stockholders have only a residual claim against
the income and assets of the firm. Thus, the potential for gain is greater for holders of common stock than
that for debt holders whose gain is fixed. In contrary, the risk for the equity owners is correspondingly
greater since they have last claim to the firms income and assets. However, the characteristics of
common stock can be summarized as the following manner:
It normally has control of the corporation and will exercise that control in its own interest.
It has unlimited ownership rights to the remaining gains from the business after other security
holders have received their contractual payments.
It bears the principal hazards of the business.
Common stock may be sold by its holder to any willing buyer.
The earnings on the common stockholders equity may be unstable.
Dividends may fluctuate. It must depend on earnings, cash position, surplus position, expansion
needs, debt situation and management policy.
Common stock prices fluctuate extensively.
Common stocks in general are a price-level hedge. That is, they tend to earn, pay dividends and
bring market prices at levels which are vaguely related to the general commodity price level.
Dividends are normally less than the earnings on the common stockholders equity.
Common stockholders have voting power to vote for the board of directors and for against major
issues of the corporation.
Common stockholders have pre-emptive right to subscribe to any new issue of stock so that they
can maintain their previous fraction of the total number of shares sold.
Par value common stock just like preferred stock can be par or no par.

The market value of common stock is the variable of concern to investors. The aggregate market value of
a corporation which is calculated by multiplying the market price per share of the stock by the number of
shares outstanding determines the total value of the firm as estimated in the market place. Dividends are
the cash payments which are distributed to the common shareholders by the corporation. However, the
followings are the types of dividend concerned:
Dividend yield: It is the amount of dividend per share divided by market price of the same. This
income component of a stocks return is stated on a percentage basis.
Dividend payout ratio (D/P ratio): It refers to the ratio of dividends to earnings. It indicates the
percentage of a firms earnings paid out in cash to its shareholders.
Retention ratio: It is the complement of payout ratio indicating the percentage of firms current
earnings retained by it for reinvestment purposes.
Preferred stock: Preferred stock is a hybrid sorts between a fixed and variable income security. It is an
equity security with an intermediate claim between bondholders and stockholders on a firms assets and
earnings. In the event of liquidation, preferred stockholders have a claim on available assets before the
common stockholders. In addition preferred stockholders get their stated dividends before common
stockholders receive any dividends. Many issues of preferred stock are callable at a stated redemption
price. Preferred stocks are usually perpetual securities having no maturity date, although there are
exceptions to the general rule. However, following are the special features of preferred stock:
Some preferred stockholders have voting rights and some preferred stockholders do not have this
right and voice in the management.
Preferred stockholders have pre-emptive right to subscribe to additional issues of common stock
but non-voting preferred stock have no pre-emptive right.
Most preferred stock have par value. In this case, the shares cash dividend rights are usually
stated at a percentage of par values.
Cash dividends are the most significant aspect of preferred stock in which the stockholders
should get more gain from dividends than from capital appreciation.
Preferred stocks can be categorized as follows:
Cumulative preferred stock: Holders of cumulative preferred stocks are entitled to a dividend
whether the firm earn profit or not. If the corporation misses a preferred dividend or any part of
the ones, it is not lost but must be made up in a later year before any cash dividends can be paid
the common stockholders.
Non-cumulative preferred stock: Holders of non-cumulative preferred stocks are entitled to a
dividend if firm earn profit. If the corporation does not earn any profit, the dividend is lost to the
preferred stockholders.
Participating preferred stocks: Participating preferred stock is somewhat uncommon which is
entitled to a stated rate dividend/ interest and a share of earnings available to be paid to the
common stock holders. The holders of participating preferred stocks are entitled to receive extra
dividends when earnings permit.
Convertible preferred stocks: At the option of the holders, convertible preferred stocks may be
converted into another security (generally firms common stock) on stated terms.
Trust preferred stocks: These types of stocks are structured so that their dividend payments are
treated as tax-deductible interest by the issuer.
Adjustable-rate preferred stocks: Adjustable-rate preferred stocks have the cash dividends that
fluctuate from quarter to quarter in accordance with the current market interest rates. These
stocks are created to make cash dividend yield on preferred stock fluctuate with market
conditions and thus be more competitive with bond investments.
Money market preferred stocks: Money market preferred stocks have finite life that expires
very soon after they are used- some issues mature even after seven weeks. They typically offer a
large denomination because they are targeted at large corporate investors.
Stock Dividends: Instead of and sometimes in addition to cash dividends, investors can receive dividend
in the form of stock. Often firms pay stock dividends as a replacement for or a supplement to the
payment of cash dividends. A stock dividend is a payment of stock to existing owners.

Stock Splits: Stock splits have similar effect upon a firms share price as do stock dividends. Stock splits
are commonly used to lower the market price of the firms stock. To enhance the trading activity highpriced firms often believe to lower the price of the same.
Stock Repurchases: Stock repurchases refer to the firm buying its own stock. Repurchased stock is
called treasury stock. A corporation can repurchase its shares in one of the following ways: open market
purchase, private negotiated transactions or a tender offer.
From the above discussion, we may conclude that preferred stock possesses some characteristics similar
to bonds and some to common stock. However, the different characteristics of common stock, preferred
stock and bond are summarized in the following Table.
Table: Features and Characteristics of Different Securities.
Aspects
Common stock
Preferred stock
Bonds
Claim on income:
Priority
Last
Second
First
Amount
Residual
Fixed
Fixed
Claim on assets:
Priority
Last
Second
First
Amount
Residual
Fixed
Fixed
Claim:
Discretionary
Discretionary
Mandatory
Maturity
Perpetual
Perpetual
Fixed

Derived Securities

Securities deriving part or all of their value from an underlying asset are termed as derivative securities.
In addition to common stock investments, it is also possible to invest in equity-derivative securities,
which are securities that have a claim on the common stock of a firm. The securities we term derived
securities include such financial assets as options, warrants, and futures contracts. All or part of their
value is derived from the value of another security. As for example, the value of a call option is derived
from the value of the common stock against which the call option is written; the value of a commodity
futures contract is derived from the value of the commodity which must be delivered in the future.
Option: An option is the right to buy or sell common stock at a specified price for a stated period of time.
Option instruments include warrants and puts and calls.
A warrant is an option issued by a corporation giving the holder the right to acquire a firms
common stock from the company at a specified price within a designated time period. The
warrant does not constitute ownership of the stock only the option to buy the stock.
A call option is similar to a warrant because it is an option to buy the common stock of a
company within a certain period at a specified price called the striking price. Unlike warrant it is
not issued by the company rather than by another investor willing to assume the other side of the
transaction.
A put option is the right to sell a given stock at a specified price during a designated time period.
Futures contract: A futures contract is an agreement providing for the future exchange of a particular
asset at a currently determined market price. The seller contracts to deliver the asset at a specified
delivery date in exchange for a specified amount of cash from the buyer.

Indirect Equity Investment

Indirect equity investment requires less supervision than does a direct investment. These investments
involve a commitment of funds to an institution of some sort that in return manages the investment for
the investor. Special types of indirect investments are given below:
Annuities
Under some circumstances, employees are permitted to have certain portions of their salaries withheld by
their employers for investment in variable annuities. The amount invested in the variable annuities is not
taxable until it is withdrawn. Investor of such scheme may withdraw during retirement when he is in a
lower tax bracket. It is also a device for deferring the payment of income taxes. The organization
managing the annuity invests the proceeds of all participants in the plan of a portfolio.

Insurance policies
Like insurance policy is another name of indirect investment when the policy is purchased from a mutual
insurance company, the insured becomes an owner of the company.
Mutual funds
Mutual funds, the popular name for open-end-investment companies sell and redeem their own shares.
Owners of funds shares can sell them back to the company any time they choose. The mutual fund is
legally obligated to redeem them .Investors purchase new shares and redeem their existing shares at the
net asset value (NAV). The NAV of an investment company share is computed by calculating the total
market value of the securities in the portfolio minus any trade payables and dividing by the number of the
funds shares currently outstanding.
Unit investment trusts
It is an investment company that owns a fixed set of securities for the life of the company referring that
the investment company rarely alters the composition of its portfolio during the life of the company.
Open-end investment companies
An investment company which is ready to purchase its own shares at or near their net asset value is
called an open-end investment company. Commonly known as mutual funds, these companies also
continuously offer new shares to the public for a price at or near their net asset value. The number of
share outstanding of these types of companys changes on a daily basis as their capitalization is open.
Close-end investment companies
A closeend investment company does not stand ready to purchase its own shares if one of its
shareholders sells them. Its shares are traded on an organized stock exchange through the presence of
broker.
Investors Return through Direct Investment
Investor
Holds

Portfolio of Assets

Dividends and/or
interest

Income

Capital gain or

loss

Investors Return through Indirect Investment

Investor
holds shares in
Investment companys funds

which is a
Portfolio of Assets

Dividends and/or
interest

Income

Capital gain or
loss

Financial Markets
In the economic sense, investment means the commitment of funds to capital assets. Accordingly the
investors are users of funds which they own or acquire in the market. Investors supply the funds by
acquiring debt and equity instruments with their savings and they also transfer these instruments among
each other. In this connection investment market includes the markets for funds both short and long term.
A market is a mechanism that brings buyer and seller together to aid in the transfer of goods and services.
It is not a physical location where physical commodities are found ready to be bought and sold. Rather it
is a process by which buyer and seller can communicate regarding the relevant aspects of the transaction.
So financial market is a mechanism that brings buyer and seller of financial assets together for fixing the
price of a particular security. Under such mechanism, those who establish and administer the market do
not own the assets. They provide a physical location or an electronic system allowing potential buyers
and sellers to interact. They provide necessary information and logistic support to transfer the ownership
of the securities being traded.
Characteristic of a market
Individuals enter into the securities markets to buy or sell their securities at a price justified by the
prevailing supply and demand. An efficient market is that where the participants must have timely and
accurate information on the volume and prices of past transactions and on all currently outstanding bids
and offers. A good security market possesses the following characteristic:
Investors will be able to get accurate and quick information necessary for the security
transactions.
A market should operate in a position where the ability to buy or sell an asset at fixed price is
not substantially different from the price for prior transaction, assuming no new information is available.
A market should ensure the price continuity meaning that prices do not change much from one
transaction to the next unless substantial new information becomes available. A continuous market
without large price changes between trades is a characteristic of a liquid market.
The buyers and sellers trade at prices above and below the current market price.
An efficient or good market is one in which the transaction cost is minimum i.e., the market
should be internally efficient.
A market should reflect all the information available regarding the supply and demand factors
in the market. This condition is refers to as external or informational efficiency.
Nature of Securities Markets
The prime objective of a firm is to achieve the highest value for the shareholders. The firms management
should examine sufficiently the process by which a firms market value is determined, in particular, the
important role of financial markets in the process. The determination of share price is a combination of

10

firms actions and reactions in the capital markets under the securities markets. Hence the securities
markets make the flow of funds through the financial system. The borrowers of funds seek to augment
their current income in order to acquire assets, and their refinancing to do so. Lenders have excess funds
on which they wish to earn a return. The role of the securities markets is to facilitate the transfer of funds
in the quickest and efficient manner. Capital markets are often referred to as the markets for long term
and medium term funds. Capital market thus can be broadly classified into securities markets and nonsecurities markets. Securities market have in turn two segments; the market for primary issue, where the
initial transactions between the users of funds and the suppliers of funds take place and the markets
wherein secondary trading of issued securities take place in the secondary market. No member of the
stock exchange, in this respect, is supposed to violate the provisions of Securities and Exchange
Commission by manipulation of the securities prices.
Probably the most essential function performed by exchange is the creation of continuous market- the
opportunity to buy or sell securities immediately at a price that varies a little from the previous selling
price. Thus, a continuous market allows investors to be liquid. That is, they are not obligated to hold their
securities until maturity, or if they have common stocks indefinitely. An exchange also helps to fix the
prices. Buy and sell order (or demand or supplies) determine the prices. The exchange brings together
buyers and sellers from all over the nation and even from foreign countries. The stock exchange also
provides a service to industry by directly aiding new financing. The ease with which the investors can
trade issues makes them more willing to invest in new issues. One way in which the securities market
may be classified is by the types of securities bought and sold there. The broadest classification is based
upon whether the securities are new issues or are already outstanding and owned by investors. New
issues are made available in the primary markets; securities that are already outstanding and owned by
investors are usually bought and sold through the secondary market. Another classification is by
maturity; securities with maturity of one year or less are normally traded in the money market; those with
maturities of more than one year are bought and sold in the capital market. However, highly liquid debt
securities that have short terms until they mature and involve little or no risk of default are call money
market securities. All money market securities are debts that mature within 270 days or less. Money
market securities are frequently issued instead of long-term debt securities in order to avoid
administrative cost. Money market securities pay continuously fluctuating rates of interest that exceed the
rate of inflation only slightly.
Investors also benefit from the market mechanisms. They would hesitant to acquire the securities that are
not readily marketable and such reluctance would reduce the total quantity of funds available to finance
industry and government. Those who own securities must be assured of a fast, fair, orderly and open
system of purchase and sell at known prices. The classification of market we are most interested in is the
one that differentiates between old and new securities- the primary and secondary markets. It Is obvious
found that the investors who bought stock at the offering price enjoyed a profit. In recent years the
secondary markets have been further fragmented, creating third and fourth markets- where the third
market represents over-the-counter trading of shares which are listed on an organized exchange and the
fourth market represents direct trading of a huge number of shares between two investors viz., large
institutional investors without intermediary. Once the investors have purchased the new issues, they
change hands in the secondary markets: the organized exchanges and over-the-counter (OTC) market.
Organized exchanges are physical market places where the agents of buyers and the sellers operate
through the auction process. Unlike the organized exchange, the over-the-counter market has no central
location where the securities are traded. Being traded over-the-counter market implies that the trade takes
place by telephone or electronic device and that dealers stand ready to buy or sell specific securities for
their own accounts. They will buy at a bid price and sell at an asked price that reflects the competitive
market conditions. The organized exchange being a self-policy organization of dealers requires at least
two market makers (dealers) for each security, but often there are five or ten or even twenty for
government securities. So, the multiple dealer function in the OTC market is an attractive feature for
many countries in comparison to the single specialist arrangement on the organized exchange. In an
organized exchange the majority of the securities consist of equities, in terms of both volume and value.
The opposite dimension of the market is for the debt securities. It is safe to say that most long-term bond
trading takes place in the OTC market, while all the trading in the short-term government securities takes
place in the OTC market. However, debt securities can be categorized by the issuers of securities.
Corporate bonds, the most popular debt securities, are traded both on the exchange and over-the-counter,
although most of the trading takes place OTC .

11

Role of Securities Markets

For rapid economic development both direct and indirect financing should be considered complementary.
Efficient and effective operation of securities market is required to meet at least two basic requirements.
First one is to support industrialization through savings mobilization, investment fund allocation and
maturity transformation. Second one is to be safety and efficiency in discharging the above role. In a
developing country like Bangladesh such conditions do not prevail due to the prevalence of informal
credit markets. The recent development towards privatization seeks the need of efficient capital markets.
It performs various functions in the process of economic development. The securities markets provide
both savers and users with a broad spectrum of investment choices that can increase the level of both
savings and investment. Securities markets can attract the investors as it offers higher return to the
investment portfolio. This investment portfolio easily can draw more savers in the investment process
that in turn involves institutions like brokerage house, investment banking, money investing firms etc.
Under the scheme of Foreign Direct Investment (FDI), securities markets attract external sources in the
capital market. Entrepreneurs are supposed to be provided capital procuring other factors of production
that would ensure full-employment and create more productive capacity in the economy. A securities
market can achieve this type of objective. Securities markets can augment the growth; development and
stability of a countrys financial structure increase the allocation of savings, allocation of existing real
wealth and ensure the distribution of income. In economic development of a country the problem is
mainly two-fold viz., increase or creation of domestic savings and transformation of more funds to
investment. Securities markets can ensure efficient allocation of savings to productive investment by the
creation/development of money and capital market.
In the economic sense, capital formation is the change in the stock of the capital goods represented by
producers durable equipment, and business inventories. In modern capitalistic economy, capital
formation would be impossible without a market or group of markets for the transfer of savings to those
seeking funds for investment in economic goods and services. In this connection, a variety of instruments
representing money and claims to money are employed. Savers provide the funds and in return expect to
receive dividends, interest, or rent and the investors offer the hope of income and price appreciation. In
the financial sense, a securities market is the market for instruments representing longer-term funds. It is
consisted of institutions and mechanism whereby intermediate-term funds and long-term funds are
pooled and made available to business, government, and individuals, and where outstanding instruments
are transferred. On the other hand, money market focuses on debt instruments only with maturities
ranging from one day to one year. It is engage in purchasing and selling of new instruments rather than
trading in outstanding claims. In financial terminology, the investment market includes the markets for
funds both short and long term. Both long term and short term segment of investment market includes the
primary sale and purchase of and secondary transactions in instruments. Business firms invest capital in
amounts that are beyond their capacity to save in any reasonable period of time.
Securities market plays a crucial role for the proper functioning of capitalistic economy. They serve to
channel funds from savers to borrowers. Another important function that the securities market does is the
allocative function by channeling funds to those who can make best use of them. The existence of the
secondary market ensures the purchasers of the primary securities that they can quickly sell their
securities. Since there are no guarantees in the financial market, sales may involve losses. Such a loss
may be much preferred to having no cash at all if the securities cannot be sold readily.
Classification of Securities
Before analyzing securities, it is essential for financial analysts, economists, business policymakers,
security investors, academicians to study and develop an understanding of different classes of securities.
Depending upon a wide variety of considerations, securities can be categorized into four broad groups
viz;
i. Bond,
ii. Common stock,
iii. Preferred stock and
iv. Derivative securities.
Bonds are fixed income securities with a fixed maturity. There is a specified date at which time the firm
must pay all liabilities it owes to the bondholders who do typically have the fixed claim on the income of

12

the firm. In addition, bondholders have fixed claim on the assets of the firm. More specifically, when the
bonds mature or in the event of liquidation of the firm, the bondholders are entitled to receive their
principal having a priority over any of the claims of the equity owners.
Equity shares or common stocks called to be perpetual lie on the other side of the securities spectrum.
Common stocks or equities have no maturity period. They exist as long as the corporation exists.
Common stockholders have the residual claim against the income and assets of the firm.
Preferred stock basically called the hybrid security lies somewhere between those of common stock and
bonds. Like bondholders, the holders of preferred stock have a fixed claim on the income of the
corporation. On the other hand, like common stock preferred stock is a perpetual liability of the firm.
Derivative securities include warrants, options, futures contracts. Part, if not all, of their value is derived
from the value of another security.
Securities Markets Distinguished
Investment defined as the changes in capital stocks. In the economic sense, capital formation is the
change in the stock of the capital goods. According to the views of capitalistic economy, capital
formation or accumulation of capital for investment and industrial development of an economy would, no
doubt, be meaningless without an organized market or group of markets. In this connection, it is sinequa-non to transfer the savings from surplus unit to those seeking funds for investment in economic
goods and services for the rapid economic development and emancipation. To make effective this
transfer, a variety of instruments representing money and claims to money are employed. Savers provide
the funds and expect to get a reasonable return. Users of the funds are supposed to get income, price
appreciation, or both.
Capital Market
In the financial sense, the capital market is the market for the instruments representing long-term funds
requirement of the corporation. It consists of a sprawling complex of institutions and mechanism
whereby intermediate-term funds and long-term funds are pooled and made available to business,
government, and individuals. In this mechanism outstanding instruments collecting the funds are
transferable.
Characteristics of Capital Market
The characteristics of the capital market and its elements may be classified and measured in varieties of
ways. There are a number of submarkets having distinguished features and independent rates of yield.
However, the capital markets assume the following characteristics:
Debt and equities instruments traded in the capital markets are intermediate or longer-term in
maturity.
The scope of the market is very wide.
The supply of the new funds comes from the same sectors although it is funneled within the
markets through financial institutions.
The demand for the capital market instruments comes from five categories like individuals and
households, business and financial corporation, central government, local government, and foreign
government.
Under the auspice of capital markets, both negotiated and open markets are widely used.
Transactions in open markets influence the prices and yields of longer-term instruments
immediately.
Lon-term instruments in the open market are transferred among the investors in the over-thecounter market and organized exchanges rather than the raising of new funds in the primary markets.
Capital Market Instruments
The major instruments traded in the capital markets are medium and longer-term in maturity are
discussed below:
Government securities with maturity of more than one year. They are marketable and their
yields vary with changing credit and capital market conditions
Longer-term debt owned by the government.
Privately owned longer-term debt that is sponsored by the government.
Long-term debt of local government.
Long-term corporate bonds including corporate mortgage debt.
Common stock, preferred stock
Mortgage including residential, commercial, and industrial lien.

13

Money market
It focuses on debt instruments only the maturities of which range from one day to one year. It also
involves a complex of instruments dominated by the central bank as agent of the government and
commercial banks. It purchases and sells new instruments rather than trading in outstanding claims.
Characteristics of Money Market
Money market is not the unique place or mechanism where short term debt instruments are traded among
the investors rather there are several locations where direct transactions take place between borrowers
and lenders. Under an efficient system to handle any amount and volume of transactions at any time,
regional submarkets are also linked together with the centrally organized market. However, the basic
characteristics of money markets are given below:
Short-term securities with maturity of less than one year are traded in the money market
Central and regional short-term markets create a national short-tern interest rate structure.
They also create a national short-term credit.
Idle funds are transferred through the intermediaries from all over the country to the central open
market.
Funds are largely transferred on a wholesale basis, although the large institutions deal directly
with each other.
The whole role of the institutions involved in the money market is controlled by the monetary
and credit system of the country.
The major participants in the money markets are the central banks and commercial banks.
Money Market Instruments
Money market instruments are summarized below:
Treasury bills
Bankers acceptance
Commercial paper
Certificates of deposits-CDs
Negotiable CDs
Any firm distinction between money and capital markets is some what arbitrary. Suppliers of funds may
direct them to one or both the market and users of fund may draw funds from either market. Furthermore,
funds flow back and forth between two. Any institution serves both the market. Rates of interest or fund
acquisition costs are interrelated with changes in the general demand and supply of funds.
Primary Market
Primary market is a security market where new securities are being sold for the first time. It is a market
where new issues of common stock, preferred stock or bonds are sold by government or firms to acquire
new capital. A primary market is one in which a borrower issues new securities in exchange for cash
from an investor. When securities are initially offered to the public, they are said to be to be sold in the
primary market. Primary markets are those in which the sellers of the securities are also the issuers of the
securities i.e. the issuing firms are the sellers of the securities. If the existing corporations issue additional
shares, these would be sold in what is called the primary market. A primary issue occurs when the issuer
gets the proceeds from an initial public offering (IPO) of stocks or bonds. An intermediary that finds out
the buyers for IPOs is termed as investment banker.
New treasury bills, stocks, or bonds all take place in the primary markets. The issuers of these securities
receive cash from the buyers of these new securities, who in turn receive financial claims that previously
did not exist.
Functions of Investment Banker
An investment banker is defined as firm or a financial intermediary specializing in the sale of new
securities to the public investors. For doing so an investment banker performs a wide variety of functions.
The typical functions done by an investment banker are, however, summarized below:
Advisory Functions: An investment banker serves a potential security issuer in an advisory capacity. It
helps the issuing firm analyze its financing needs and suggests different ways of raising funds. Being an
underwriter, an investment banker may function as an adviser in mergers, acquisitions, and financing
operations. The investment banker reaching an agreement with the issuer is called originator or managing
underwriter who subsequently coordinates two temporary groups. An number of investment bankers
being the members of underwriting syndicate, the first group, pool their money and share the
underwriting risk. The second group known as selling group is generally made up of brokerage firms
agreed to sell the primary issues to the investors.

14

Administration Functions: The investment banker shares with the issuer the responsibility of
conforming to the securities laws involving preparing the registration statement and prospectus. The
Securities and Exchange Commission (SEC) requires that most primary issues should be accompanied by
a registration statement disclosing information that should allow potential investors to assess the quality
of the new issue. The information that must be published in registration statements is set by law. After
filing the registration statement with the Securities and Exchange Commission, there is usually only a
brief waiting period until the new issue may be offered for sale.
Underwriting Functions: Underwriting refers to the guarantee by investment banker that the issuer of
the new securities will receive s certain amount cash for them. The managing underwriter forms an
underwriting syndicate the members of which literally buy the securities from the issuing firm on the day
of the offering. When the securities are actually sold to the public, they are sold either by members of the
underwriting syndicate or by members of the selling group. The members of the selling group are brokerdealer firms buying the securities from the underwriters and in turn resell them to their customers.
Distribution Functions: Investment bankers distribute the new issues to investors in several ways viz.,
i)
Underwriting-by which they buy the issues and then sell them to the public investors. They
also bring together issuer and investors as an intermediary.
ii)
Private placement- meaning that investment banker finds one buy (typically large institution)
for an entire issue and arrange for direct sale from the issuer to this large investor.
iii)
Best-efforts basis- where the investment banker may agree to distribute new issues assuming
no financial responsibility if all the securities can not be sold. The commission or
compensation for the investment banker for best-efforts offerings are typically more than for a
direct placement but less than for a fully underwriting public offering.
Pricing Functions: The investment bankers must stabilize the pricing of a new issue during the
distribution period to prevent it from drifting downward. The underwriting manager supports the price by
placing orders to buy the newly issued security at a specified price in a secondary market where the new
securities are trading.
Floatation Costs
The underwriter offering the highest net cash proceeds for the IPOs gets the deal. Investment bankers
make profits by selling IPOs at price above what they paid for them. The difference between the buying
and selling prices is called the spread. The spread in a security issue is typically divided into three parts:
The management fee, the underwriting fee, and the selling concession. These are explained below:
The originator or the managing underwriter keeps a certain point for originating and managing
the syndicate.
The entire underwriting group earns a specific percentage of the total profit.
The members of the selling group earn the remaining portion of the total profit.
The precise composition of these fees may vary from offering to offering but the general rule of thumb is
20 percent, 20 percent and 60 percent respectively to originator, investment bankers and selling group. In
case where the originator sells to the ultimate buyers without the involvement of other parties, he
receives the total spread.
New Issue Underwriting Process/ Primary Offering of Securities
After giving advice investment bankers purchase initial public offerings from the issuer to resell them to
the investing public as quickly as possible by making an underwriting syndicate comprised of brokerage
houses commonly known as investment bankers. At their capacity investment bankers help create new
issues, advise IPO clients, handle administrative tasks, under write the new issues, and distribute the
securities to the investing public.
Isuuer

Investmen
t
Banker

Originating investment
banker

Investmen Investmen Investmen

t
t
t
Banker
Banker
Banker
Underwriting Syndicate

15

Investmen
t
Banker

Selling Group

Investing Public
Figure: IPO floatation
Issuer
Sells securities to the underwriters
Originating investment banker
Advises issuer
Forms syndicate
Buys securities from issuer
Resells securities to public or selling group
Investment banker
Buys securities from issuer
Resells securities to public or selling group
Selling group
Sells securities to the investors
Seasoned and Unseasoned Public Offering
Primary issues of securities commonly known as initial public offerings (IPOs) are sold by the firm
known as issuer to the investors through the investment bankers. When the issuer is selling the securities
in the primary market, these are known as initial public offerings. Such type of securities can be
categorized into two groups viz., seasoned issues and unseasoned issues.
Seasoned Issues: Sales of common stocks of a publicly traded company are called seasoned issues.
Broadly speaking an offering of seasoned issues would involve the issuance of additional shares of
existing companies having common stocks outstanding. A seasoned public offering is a new offering of
securities by a firm that has already issued securities to the public. Three types of seasoned issues are
available in the field of IPOs as follows:
i.

Primary seasoned offering: It refers to the offering of new issues of securities by a firm that has
already done an initial public offering. The principal object of such offering is to raise new
capital for the firm.
ii.
Secondary seasoned offering: Also known as secondary placement, a secondary public offering
refers to the purchase of the securities by the underwriters directly from the firms founder,
other prepublic owners, and other post-public holders of the securities not from the firm. The
principal objective of secondary seasoned offering is to cash out the firm.
iii.
Combined seasoned offering: It is partly primary and partly secondary seasoned issue which is
generally used to both raise new capital for the firm and to cash out some of the prepublic
owners.
Unseasoned Issues: Initial public offerings which are being offered to the public for the first time are
known as unseasoned issues. There is no established market price for them rather is negotiated between
the investment bankers and the issuing firm.
Secondary Markets
Primary issues of securities occur relatively infrequently. When an investor buys a security, the seller is
another investor. Such trade occurs in what are called secondary markets. When investment bankers
underwrite IPOs in the primary markets, the issuers receive the cash proceeds. In the secondary markets
one investor sell securities to another investor and the issuing firm is not involved. The secondary market
is an effective mechanism existing for the resale of the new issues. The secondary market gives investors
the means to trade existing securities. The securities continue to trade between investors in a market
called secondary market. In secondary markets issuer no longer receive any cash proceeds. The
secondary markets perform a wide variety of activities like:
A secondary market brings the investors together so that transaction can be made immediately at
a price that varies little from transaction to transaction.

16

A secondary market gives investors he means to trade existing securities.

A secondary market continues to maintain the marketability of the tradable assets.
Market fixes the price of the security by the transaction that flow from the investors demand and
supply preferences.
A secondary market makes the transaction price public which helps investors making better
decisions.
A secondary market stimulates new financing encouraging the investors to invest in IPOs.
Being a self-regulatory organization, a secondary market regulate and monitor the activities of
members, employees, listed firms. A secondary market also exists for trading of common stock,
preferred stock, bonds, debentures, warrants, options, and futures contracts. However, the
structure of the secondary market is given below:
Secondary Markets
Type of securities

Bonds

Markets
Organized stock exchanges
Over-the-counter market
Third market
Fourth market
Organized exchanges (a relatively small amount)
Over-the-counter market

Puts and calls

Organized stock exchange

Equities

Pattern of Secondary Market

Secondary markets may be categorized into four groups as i) first market called organized stock
exchanges, ii) second market termed as over-the-counter (OTC) market, iii) third market and iv) fourth
market. There position and status are given in the following manner:
Secondary Markets

1st Market

2nd Market

3rd Market

4th Market

Organized Exchanges
In the secondary markets individual investor can sell securities to another investor without the presence
and involvement of the firm that issued the securities. Such type of secondary trading takes place on the
organized stock exchanges.
The OTC Market
In past times securities were traded over-the-counter of banks or in the offices of security dealers. Today
over-the-counter trades occur in brokers offices, dealers offices, homes, over the phone, electrically, and
any place or even any transport whole over the country and in foreign countries. The over-the-counter
(OTC) market includes trading in all securities not listed on one of the exchanges. It also includes trading
in listed stocks referring to as third market. Though unlisted securities trading market, OTC is one the
most modern and efficient securities market in the world. OTC market is not physically located market in
any one place. It consists of a number of broker-dealers throughout the country who are linked together
through an e-mail or electronic communications network. Any security can be traded on the OTC market
as long as a registered dealer is willing to make a market in the security. The OTC market competes with
investment bankers and organized exchanges as OTC dealers can operate as both a primary and a
secondary market.

17

Risk-free securities, government and corporate bonds, common stocks etc. are traded in over-the-counter
market. Corporate bonds are preferably traded in the OTC market because organized exchanges prefer to
trade stocks of corporations instead of their bonds as the commissions of common stock are higher. The
OTC broker-dealers are organized as sole proprietorships, some as partnerships, and many as
corporations. However, the broker-dealers in the OTC market can be categorized as follows:
OTC house- An OTC house is specialized in OTC issues and rarely belongs to an exchange.
Investment banking house- An investment banking house is specialized in IPOs and may
diversify by acting as dealer in both listed and OTC securities.
Commercial bank- A commercial bank may be an OTC dealer or broker when it trades securities.
Stock exchange member house- It can work as OTC broker or dealer having a separate
department specifically formed to carry on trading in OTC market.
Bond house- A bond house may deal in government and autonomous bond issues trading in OTC.
Third and Fourth Markets
The secondary markets can occasionally be categorized into four parts. The first market represents
organized exchanges where listed securities are traded. Second market is the over-the-counter market
where the unlisted securities are traded. The third market represents over-the-counter trading of securities
which are listed on an exchange while the fourth market represents direct trading between two investors
bypassing the activities usually done by the brokerage firms.
The Third Market: The third market is an OTC marketing stocks associated with an exchange. Although
most transactions in listed stocks take place on an exchange, a brokerage firm without being a member of
an exchange can make a market in a listed stock. A number of broker-dealers who are not members of
Dhaka Stock Exchange (DSE) can make markets in stocks of DSE listed firms. The OTC dealers making
up the third market provide minimal services for their clients-only execution of buy-sell orders and
record keeping. They are always ready to execute large trades at much lower commissions. The success
or failure of the third market depends on whether the OTC market in these stocks is as good as the
exchange market and whether the relative cost of the OTC transaction compares favorably with the cost
on the exchange.
The Fourth Market: The method of reducing commission costs in the security transactions sometimes
would be the complete elimination of broker-dealer firm as a middleman. When one investor sells
security directly to another investor without a broker-dealer as middleman, they are said to be trading in
the fourth market. In all most all cases, both parties involved in each transaction of fourth market are
institutions. Direct investor-to-investor trades occur through a communications network between block
traders. A block is a single transaction involving 10,000 or more shares. The participants of fourth market
bypass the normal dealer system. However, the organizer of the fourth market collects only a small
commission for helping to arrange block transaction.
Third
market
Organized
exchange

The OTC
market
Fourth
market

Figure: Diagram of the organized exchange, OTC market, and the third and fourth market.
Liquidity in the Secondary Market
Liquidity is the ability or power of an asset to be converted into cash or near cash at the time needed
without loss. Liquid asset is a readily marketable asset with a relatively stable price that is reversible.
Perfectly marketable assets are called perfectly liquid assets. Whenever sold they suffer no price decline.
Most securities have more moneyness than real asset but are not perfectly liquid assets like cash. That is,

18

securities are more liquid than real asset but less liquid than cash and demand deposits at a bank.
Investors pay a slightly higher price, called a liquidity premium for assets that are more liquid. Illiquid
asset, on the other hand, are the assets that con not be sold quickly unless the seller incurs significant
execution costs that include the following components:
Price concession the seller must grant to the buyer to execute a quick sale.
The bid-asked spread, the size of which varies inversely with the liquidity of the subject security.
The compensation required to find the other party of the transaction.
Commissions of the brokerage firms.
Taxes.
In fine, liquidity of an asset is the ability to buy or sell the same quickly without causing any significant
change in its price. Liquidity varies inversely with the costs incurred when buying and selling. Liquidity
of a security increases as the volume of trading in it increases.
Features of a liquid market
Dealer and broker work together to create a liquid market as their work is easier and their cost of doing
business is less in liquid markets. However, the followings are the qualities that a liquid market must
possess:
Depth- being the position where buy and sell orders exist both above and below the price at
which the security is trading. A market without depth is called a shallow market.
Breadth-being a position where buy and sell orders exist in volume. Markets lacking the volume
of orders needed to provide liquidity are called thin markets.
Resiliency-where new orders pour in immediately in response to price changes caused by
temporary order imbalances. A speedy price discovery process is essential for resilient.
Brokers and Dealers
The trading activities done by the investors are executed by a security firm acting either a broker or a
dealer. A firm acting in a brokerage capacity serves as an agent for investors by finding anther investor to
take the other side of the transaction. For doing this job, the broker is compensated by a commission. A
broker in the securities markets is an intermediary representing buyers and sellers in securities
transactions.
A dealer, on the other hand, may take positions in various securities. A dealer may buy or/and sell
securities for its own account. If the dealer has a long position i. e., owns the stock and the stock declines
in price, the dealer losses money. On the other hand, if the dealer has a short position in a stock, he has
temporarily sold more stocks than it owns. Under this circumstance, if the stock increases in price, the
dealer will loss money if covers its short position through purchasing stock in the market prices higher
than the dealer originally sold the stock for. The difference between bid price and ask price is the
compensation (profit/loss) for the dealer. Bid price refers to the price that dealer wishes to pay to the
seller of the securities and ask prices is the price at which he will sell a security. Dealers are called
market makers as they will sell or buy the securities for their own account in order to balance customers
orders. If a party of the transaction is not available, the dealer will become the second party to constitute
the transaction. A vast majority of the securities firms act as both brokers and dealers.
Types of Broker
Membership in the organized stock exchange are frequently referred to as seats, though tradingis
conducted without chairs. Being an investor an individual will fill out a form disclosing information
about his personal income and finances. An investor will deal with a broker who will probably be his
connection with the market for the same time. The broker will provide the investor with information
about the company he is interested in, about general economic trends, and about other investments of
interest. However, the brokers are categorized as under:
Commission Broker: The vast majority of the seats of an organized stock exchange are owned by the
commission brokers. They are he agents on the exchange floor who buy and sell securities for the clients
of brokerage houses. They act like employees of a brokerage house. They communicate via telephone

19

with brokerage, receive transactions from the brokerages that employ their services and they send back
confirmation messages. They may also act dealers and seek profits by trading for their own account.
Floor Broker: Floor broker execute orders for commission brokers having more orders than they can
handle. From the brokerage house, orders of the clients will be phoned to floor of the exchange to a
person called a floor broker. Floor brokers basically buy an sell securities on the floor of the exchange.
They are free-lance members of the exchange and help prevent backlogs of orders, and allow many firms
to operate with fewer exchange memberships than would be needed without their services.
Floor Trader: Floor traders are sometime called as registered traders. They differ from floor brokers as
they trade primarily for their own accounts. They are speculators searching the exchange floor for
profitable buying and selling opportunities. They trade free of commission as they deal for their own
accounts. They can buy and sell the same security on the same day in order to profit from price
movements.
Specialists: The floor brokers purchase securities from a person called a specialist. Specialists are
assigned to posts on the trading floor where they make a market in one or more stocks assigned to them
by the exchange. These market makers act as both a dealer and a broker in the stocks assigned to them.
As a broker, they execute orders for other brokers for commission and as a dealer, they buy and sell
shares of their assigned stock for their own accounts. The specialists keep an investor in one or more
stocks and buy and sell out of that inventory. They publicize prices at which they are willing to buy a
stock and prices at which they are willing to sell. Specialists must accept the obligation to maintain a fair
and orderly market for their assigned stocks.
Distinction between primary market and secondary market:
Primary market
i. Seller of the securities is the issuer
of the securities
ii. Primary securities are typically call
initial public offerings (IPOs)
iii. Primary issues of securities occur
relative infrequently
iv. Primary securities previously did
not exist in the market
v. Gain from secondary transaction is
not possible in the primary market
vi. Original issuer remains unaffected
due to the price the changes

Subject
Holder/
issuer
Name
Frequency
Existences
Gains
Effects

Secondary market
i. Seller of the securities is the
holder of the security
ii.
Secondary securities
are
outstanding securities
iii. Secondary securities occur
frequently
iv. Secondary securities are
outstanding
v. Investor can gain from the
secondary market
vi. Investors will be affected by the
price changes

According to their operation, the securities markets are categorized as primary market and secondary
market. Each of these markets can further be divided into money market and capital market on the basis
of economic unit issuing the securities. The following Table considers each of the major segments of the
securities markets and the functions they perform.
Capital
Money
market
market
Primary
A
B
market

A Primary capital market

Secondary
market

instruments say IPOs of shares,

stocks etc.
B Primary money market instruments say IPOs of T-bills,
Figure - Segment of securities market
C Secondary capital market instruments say shares and stocks outstanding

20

DSecondary money market instruments like dentures and bonds outstanding with the maturity of less
than one year.
Money market
Capital market
debt instruments only
Equity instruments
It purchases and sells new instruments rather
Old instruments are traded
than trading in outstanding claims.
near money instruments like short-term
government debt ,commercial papers

longer term instruments

subject to very slight price risk

shows considerable price variation

Stock Exchanges
When securities are traded between investors, issuers no longer receive any cash proceeds. Investors
usually initiate securities purchases in the secondary markets by calling a security brokerage house. After
an account has been opened, a broker relays the clients order to a dealer making a market in the
securities the investors want. Since the secondary market involves the trading of securities initially sold
in the primary market, it provides liquidity to the individuals who acquired these securities. The primary
market benefits greatly from the liquidity provided by the secondary market because investors would
hesitate to purchase securities in the primary market if they could not subsequently sell them in the
secondary market. However, the basic functions of the secondary market may be summarized below:
Providing a market placing: A stock exchange provides a market place for purchasing and selling
securities in the secondary markets. Investors would be able to buy and sell securities at any
time, as stock exchange provides the facility for continuous trading in securities like shares,
bonds, debentures etc.
Continuous/active trading: Secondary markets maintain active trading so that investors can buy
or sell immediately at a price that varies little from transaction to transaction. A continuous
trading increasing liquidity of the assets traded in the secondary markets.
Providing liquidity: An organized stock exchange provides the investors with a place to liquidate
their holdings meaning that securities can be sold in the stock exchanges at any time.
Media of asset pricing: Security price is determined by the transaction that flow from investor
demand and supply preferences. A secondary market usually makes their transactions prices
public that helps investors make better decisions.
Stimulate new financing: If the investors can trade their securities in a liquid secondary market,
they will be encouraged to invest in IPOs that will directly help the issuing authority to collect
new finance.
Monitoring activities: Being self-regulatory organization a secondary market can monitor the
integrity of members, employees, listed firms, clients, and other related bodies/persons.
Provide risk premium: Without an active secondary market, the issuers would have to provide a
much higher rate of return to compensate investors for the substantial liquidity risk.
An indicator of the economy: An organized stock plays the role as an indicator of the state of
health of the economy of a nation as a whole.
Savings-investment linkage: Providing the linkage between savings and investment, stock
exchanges help in mobilizing savings and channelizing them into the corporate sector as
securities.
Furthermore, the prevailing market price of the securities is being determined by transactions made in the
secondary market. New issues of outstanding securities to be sold in the primary market are based on the
prices and yields in the secondary market. Hence, the capital costs of the corporations are determined by
investor expectations and perceptions that are reflected in market price prevailing in the secondary
market. In addition to that, nonpublic IPOs may also be priced based on the prices and values of
comparable stocks or bonds in the public secondary market.

21

Trading Systems in Stock Exchanges/Trading Arrangement

Investors give orders to the broker or dealer to execute their transactions in the securities markets with a
view to managing their portfolios. When an investor places an order with a broker/dealer, there are a
number of arrangements from which he can choose. These arrangements include the type of orders
placed, the cost of executing the trade, and the method of paying for the transaction. It is important to
understand the different types of orders placed and executed in the securities markets.
Trading System
Trading system in the organized stock exchange is the floor trading under which trading took place
through an open outcry system on the trading floor. In floor trading buyers and sellers transact business
face to face using a variety of signals. Now-a-days this trading system is abolished by a new one called
screen-based trading system introducing a fully automated computerized mode of trading. The screenbased trading systems are of two types:
i. Quote driven system: Being the market maker, dealer in a particular security inputs two-way
quotes. One is for buying (bid price) and the other is for selling (offer/ask price). Investors then place
their orders on the basis of the bid-ask quotes.
ii. Order driven system: Under this system investors can place their buy orders or sell orders
which are then fed into the system.
Several orders are discussed below:
Market Order: The market order being the most frequent types of order is an order to buy or sell a stock
at the best current market price. It indicates that the investor is willing to buy or sell at the best price
currently prevails in the stock exchanges. Hence, a market buy order is what the investor wills to pay the
lowest price available, a market sell order, on the other hand, indicates that the investor is willing to sell
the security at the highest bid price currently available. A market order provides immediate liquidity for
investor willing to accept the prevailing market price. Market orders are used if the investors want to
trade a small quantity of stock quickly in the hope that the price of whose will not change the current
market price substantially.
Limit Order: A limit order indicates that the investor specifies the price at which he will buy or sell
securities. So, a limit buy order specifies the maximum price the investor wants to pay for some expected
securities. A limit sell order, on the other hand, stipulates the minimum price at which an investor wants
to sell some quantity of securities. The order shall be executed only if the broker obtains the desired
price. A limit order may either be day order or open order. A limit day order exists until the end of the
current trading day. A limit open order is good until cancelled.
Stop Order: Stop order is an order that specifies a certain price at which a market order takes effect.
Sometimes called stop loss order is executed to protect an investors existing profit or to limit losses.
More specifically, a stop-loss-order is an order by which an investor instructs his broker to sell certain
number of securities if the price goes down to whatever level the former specifies.
Stop Limit Order: It is an order specifying both the stop price and the limit price at which the investor
wants to buy or sell securities. The investor will take the risk of no trade if the security price will not
reach the limit price. A stop limit order to buy is the reverse of a stop limit order to sell. As soon as the
stock price reaches the stop level, the order to buy will be executed at the limit level or better indicating
that below the limit price the order will not be executed.
Day Order: It is an order that remains effective only for a day it is brought to the floor. The majority of
orders are day orders. If not executed it is cancelled.
Good-till-cancelled Order: It is an order that remains effective indefinitely. It is known as open order
since the investors are willing to wait until the price reaches some limit the set.
Fill or kill Order: It is an order that must be executed immediately. Being unexecuted such an order is
cancelled.
An order is round lot that indicates 100 shares or multiple of 100 shares. On the other hand, an odd lot is
any number of shares between 1 and 99.
Clearing Procedures
Securities are traded on the daily basis. But the settlement dare includes three business or working days
after the trade day. Purchaser becomes the legal owner of the securities he bought on the settlement date
on which the seller gives them up. At that day both the buyer and seller settle with the brokerage firm.

22

Most of the customers allow their brokerage firm to keep their securities in the name of the brokerage
firm. The client receives a monthly statement showing his cash position, securities held, any funds
borrowed from the brokerage and so on.
Cash flows between the firm and financial markets
To raise capital a firm sells debt and equity to investors in the financial markets through
financing decisions.
The funds raised by the firm is invested in the investment activities of the firm called investment
decision or capital budgeting.
The invested funds generate cash for the firm through its operation.
Cash is paid to the debtors for using external funds as the cost of debt like interest if any.
Cash is paid to the government as taxes.
Cash is paid to the equity holders as dividends.
Retained cash flows are invested in the firm sometimes by distributing stock dividend or bonus
shares to the existing equity holders that also increases capital.

Appendix
Regulations of Stock Exchanges/ Securities and Exchange Commission
In mixed economies like Bangladesh, the major part of domestic savings takes place in the private sector.
The domestic saving rate is positively related to the level of income and its growth rate. To raise the
saving rate one must understand the savings preferences and motives of the non- corporate sector of the
country. Economic history of some developing countries suggests that, in the evolution of the financial
structure, the non-corporate sector prefers to hold more than fifty per cent of its financial saving in the
form of saving and fixed deposits.
Securities markets in Bangladesh were established in 1954 while the formal trading began in 1956. Their
activities are being controlled and regulated by their Article of Association along with other government
regulations subject to amendment from time to time. The Capital Issue Act, 1954, however, is one of the
pieces of legislation governing the stock exchange in the country. Consequently upon, with the spirit of
the nationalization and socialization motive of the government, the then only securities market in
Bangladesh, the Dhaka Stock Exchange Ltd. suspended its trading and other administrative activities in
1971 after the independence of the country. Later on in 1976 it resumed its activities with nine listed
companies after the changes of the government policies. Activities of the securities markets improved
since 1985 and gained momentum from early 1991
Efficient and effective operation of securities market is required to meet at least two basic requirements.
First one is to support industrialization through savings mobilization, investment fund allocation and
maturity transformation. Second one is to be safety and efficiency in discharging the above role. In a
developing country like Bangladesh such conditions do not prevail due to the prevalence of informal
credit markets. The recent development towards privatization seeks the need of efficient capital markets.
It performs various functions in the process of economic development. In economic development of a
country like Bangladesh, the practices, and the supervision of issuers, market and intermediaries are
vested upon regulatory authority. The Board of SEC is the policymaking and overseeing body and the
regulatory functions are taken care of by Chairman and members.
All the components of securities markets should be concerned with the investor protection. It is essential
to say that the legal protection of investors in a country is an important determinant of the development
of its financial markets. Where laws are protective of outside investors and enforced, investors are
willing to finance firms, and financial markets are both boarder and more valuable. Keeping this view in
mind, the government of Bangladesh has set up Securities and Exchange Commission (henceforth SEC)
on June 8, 1993 under the Securities and Exchange Commission Act, 1993. Securities and Exchange
Commission is an independent, quasi-judicial agency of the government, the mission of which is to
administer laws in the securities field and to protect investors and the public in securities transactions.
Consistent with the over all policies, SEC is supposed to act as a central regulatory agency performing

23

wide range of functions covering the entire capital market including the proper issue of capital, the
establishment of fair trading.
Scenario of Securities Markets in Bangladesh
The securities market of Bangladesh started functioning with the reactivation of Dhaka Stock Exchange
and Investment Corporation of Bangladesh ICB, the largest investment banker and underwriter, in 1976.
Subsequently, in 1980s, National Credit Limited and Bangladesh Commerce and Investment Ltd. also
started functioning in securities market activities in Bangladesh.DSE is the largest organized exchange at
present in Bangladesh. After her independence in 1971, the then existing securities market (The Dhaka
Stock Exchange) was abolished by the decision of the government. All the listed companies were
converted into sector corporations. The controls were vested with government. New industrial policy was
formulated that deterred the growth of new companies. But subsequently, it was found that the publicly
owned enterprises increasingly became losing concerns. Private enterprises became to grow in 1976 and
they started functioning side by side with the public sector enterprises. As a result of the revamping of the
private sector, Dhaka Stock Exchange resumed in 1976 with 9 listed companies. Under denationalization
policy in 1982, the government returned some of the jute and cotton mills to their previous owners. The
dimension of privatization spirit results in the development of stock exchange. In 1980s, two private
investment companies viz., National Credit Ltd. and Bangladesh Commerce and Investment Ltd. were
permitted to function in the securities market activities along with Dhaka Stock Exchange and Investment
Corporation of Bangladesh. At present National Credit Ltd. and Bangladesh Commerce and Investment
Ltd. do not function in the capital market. However, the securities markets in the country are developing
its operation in all respect and the second securities market in Chittagong started operation in 1995. Other
individual firms came forward to help investors to take part in the stock exchange activities. However, in
the context of Dhaka Stock Exchange, and Chittagong Stock Exchange are involved in bringing together
the buyers and sellers of securities as per provisions of the Securities and Exchange Commission (SEC
for short), Bangladesh. These two secondary markets take the responsibilities to meet the demands of
buyers and sellers of the market by setting transactions. They have no authority to fix the price of the
securities; rather they confirm the transactions in the market. Both the exchanges are conducted by
Computerized Automated Trading System and are self-regulated.
Each stock exchange establishes listing requirements, approves, suspends or removes listing privileges of
companies, monitors listed companies in compliance with regulatory provisions and permits dual listing.
In order to protect the interest of the investors government has established Securities and Exchange
Commission on 8th June 1993 the main functions of which are to develop and regulate markets and
ensure proper issuance of securities. This Commission acts as a Central Regulatory Agency that guides
the entire capital market. Thus, a lot of policies and regulations were framed by the government through
the Commission to protect and enhance the securities markets helping channelize savings of different
investment opportunities. But now-a-days the dual authority of Bangladesh Bank and Securities and
Exchange Commission could jeopardize the development and function of Merchant Banking policy.
Trends of Securities Markets in Bangladesh
Securities markets in Bangladesh were established about 48 years back in 1954. But formal trading began
in 1956. Their activities are controlled and regulated by their Article of Association along with other
government regulation subject to amendment from time to time. The Capital Issue Act, 1954, however, is
one of the pieces of legislation governing the stock exchange in the country. The then only securities
market in Bangladesh, the Dhaka Stock Exchange Ltd. suspended its trading and other administrative
activities in 1971 after the independence of the country. Later on in 1976 it resumed its activities with the
changes of government policies. Activities of the securities markets improved since 1985 and gained
momentum from early 1991, which would be shown in the findings of the study in a later section. As on
30th June, 2000 there were 239 listed securities with Dhaka Stock Exchange while there were only 138
securities in 1991. Listed securities comprised shares of 219 companies, 10 mutual funds and 10
debentures. During FY 1999-2000, 11 securities got listed with DSE, the issued capital of which was Tk.
2,046.5 million. At the same date the total number of tradable securities in DSE was Tk. 685.69 million
with total issued capital of Tk. 30,517 million. In this year the number of tradable securities was
increased by 25.52% and the total issued capital increased by 6.39%. Total market capitalization as on
30th June 2000 of all listed securities in DSE amounted to Tk. 54,004 million as compared to Tk.
50,748.41 million as on 30th June 1999 with an increase in market capitalization of 6.425%[Annual

24

Report of SEC, 1999-2000]. The present market capitalization is roughly 2% of Gross Domestic Product
(GDP) of the country. In 1999-2000 turnover of shares and debentures recorded a decrease of 47% to Tk.
27.60 billion as against Tk. 51.90 billion of 1998-1999. The turnover volume registered 51% decline
from comparing period of 1998-1999; 651.4 million from 1331.2 million. The DSE all share price index
stood up to 561 points on 29 th June from 484 points of 31 st January 2000. This is undoubtedly the sign of
reviving confidence from the investors.
Role of Securities Market in Economic Development
For rapid economic development both direct and indirect financing should be considered complementary.
Efficient and effective operation of securities market is required to meet at least two basic requirements.
First one is to support industrialization through savings mobilization, investment fund allocation and
maturity transformation. Second one is to be safety and efficiency in discharging the above role. In a
developing country like Bangladesh such conditions do not prevail due to the prevalence of informal
credit markets. The recent development towards privatization seeks the need of efficient capital markets.
It performs various functions in the process of economic development. The securities markets provide
both savers and users with a broad spectrum of investment choices that can increase the level of both
savings and investment. Securities markets can attract the investors as it offers higher return to the
investment portfolio. This investment portfolio easily can draw more savers in the investment process
that in turn involves institutions like brokerage house, investment banking, money investing firms etc.
Under the scheme of Foreign Direct Investment (FDI), securities markets attract external sources in the
capital market. Entrepreneurs are supposed to be provided capital procuring other factors of production
that would ensure full-employment and create more productive capacity in the economy [Ahmed, 1994].
Prof. Drake [1988] in this regard, strongly argues that a securities market can achieve this type of
objective. Securities markets can augment the growth; development and stability of a countrys financial
structure increase the allocation of savings, allocation of existing real wealth and ensure the distribution
of income. In economic development of a country the problem is mainly two-fold viz., increase or
creation of domestic savings and transformation of more funds to investment. Securities markets can
ensure efficient allocation of savings to productive investment by the creation/development of money and
capital market.
Status of Legal Authority
Securities and Exchange Commission was set up on June 8, 1993 under the Securities and Exchange
Commission Act, 1993 with a view to protecting the interest of the investors and regulating securities
markets in Bangladesh. For the development of securities markets and for the matter concerned therewith
or incidental thereto, Securities and Exchange Commission is an independent, quasi-judicial agency of
the government, the mission of which is to administer laws in the securities field and to protect investors
and the public in securities transactions. Being a corporate body Securities and Exchange Commission
has a perpetual succession and a common seal. The Commission consists of five members including
chairman, the Chief Executive as follows: i) Chairman, ii) two full time members, iii) one member
nominated by the Ministry of Finance not below the rank of Joint Secretary and iv) one member
(amongst the Deputy Governor, B-Bank) nominated by Bangladesh Bank. One full times member will be
the Vice-Chairman of the Commission. The Chairman and full time members shall be appointed for three
years from the date of appointment. They shall be appointed amongst the persons having capability of
dealing with the problems relating to the company matters and securities markets or have special
knowledge and experience of law, finance, economics, accountancy, administration, discipline etc. Its
staff consists of Executive Director, Director and Deputy Director of different Divisions, lawyers,
accountants, security analysts, librarian and others.
In our country two organized exchanges, viz., Dhaka Stock Exchange (DSE for short) and Chittagong
Stock Exchange (CSE for short) are involved in doing the secondary activities of securities markets as
the provision of the Securities and Exchange Commission. These two securities markets take the
responsibilities to bring the rules and regulations into effect in any of the transactions in the securities
markets except fixing the prices of the securities. No members of the exchanges, in this respect, can
isolate the provisions of Securities and Exchange Commission by manipulating the security prices. The
Acts, Ordinances, Rules and Regulations are devoted to achieve the objectives of the same guide
regulatory functions of the SEC. As per the provision of the Act the Head Office of the Commission shall
be located in Dhaka and with the prior approval of the government, the Commission may set-up offices at
any other places in Bangladesh.

25

Areas of Legal Coverage

The Securities and Exchange Commission was established under the Securities and Exchange
Commission Act, 1993 to protect the interest of the investors in securities markets. Under the Act, Rules
and Regulation there under, the Commission is supposed to perform the following functions:
i)
to ensure the issuance of securities properly.
ii)
to promote and regulate the Bangladesh capital markets.
iii)
to regulate the activities of the stock exchanges.
iv)
to register and regulate the activities of intermediaries like stock brokers/dealers, underwriters
who are associated with the securities markets.
v)
to monitor the activities of any collective scheme like mutual funds.
vi)
to monitor the functions of all authorized self-regulatory organizations in the securities
markets.
vii)
to prohibit fraudulent and unfair activities in the securities markets.
viii)
to prohibit insider trading in securities.
ix)
to introduce and promote investor education and training regarding to the securities markets.
x)
to conduct research and publication focusing different aspects of securities markets.
xi)
to regulate substantial acquisition of shares or stocks and take-over the companies.
Beside the above functions, the Commission is assigned to call for information, undertake investigation
and inspection, conduct inquiries and audit of any issuer or dealer of securities, the exchange and
intermediaries and self-regulatory organizations in the securities markets. Thus, the work and strategies
of the Commission are to protect investors, facilitate capital formation and inhibit fraud in the public
offerings of securities. There are different Departments of SEC to perform the above functions. Being
one of the Departments, Corporate Finance performs specific functions as:
a)
raising of capital through initial public offerings (IPOs) and other form of equity
debts.
b)
supervising the functions of the stock exchanges.
c)
regulating the listed companies and corporate disclosure.
d)
regulating and disclosing the interest of directors, officers and major
shareholders.
e)
monitoring and supervising the utilization of fund procured through public
issues and right issues.
f)
making policies for share-repurchase and stock-splits.
Legal Services Department of the Commission performs the following functions:
a) to interpret laws, rules, orders and regulations.
b) to prosecute against the violators of the provisions Acts, Rules and Regulations.
c) to file cases against the accused persons and firms listed with the exchanges.
Problems leading to Regulation
After the commencement of the Securities and Exchange Commission, various laws, rules, regulations
and numerous policies implication become sine-qua-non to govern the securities markets and the
investment industries in the country. The followings are major abuses regarding the securities trading:
Fraud: It is deliberate deception performed with a view to obtaining unfair or illegal gains from the
securities markets. By applying any fraudulent activity, a dishonest player in the securities markets earns
abnormal gain that hampers the interest of the investors.
Illegal solicitation: It occurs when a broker or dealer sells securities without first giving the investors the
issuers prospectus that reveals all the relevant facts.
Wash sale: With a view to creating a record of a sale the seller of securities repurchases the same. A
deceptive transaction in which the seller of the securities repurchases the same is called a wash sale. This
is done to deceive someone into believing that the market price has changed. It also indicates the sales
between members of the same group to record artificial transaction prices.
Churning: Churning involves an abuse of the customers confidence by a securities broker by the
transactions disproportionating the size and nature of the clients account with a view to generating
commission for the broker.

26

Cornering: A securities market becomes corner when a price manipulator owns the total supply through
buying all the available securities and controls over the price.
Matched order: A matched order involves illusory transactions in which two individuals act the same
task. The co-conspirators create a record of a trade and give the impression that delivery was made
without a true change in ownership occurring.
Insider trading: Corporate directors, executives, accountants and other concerned persons being the
insiders have access to material nonpublic information about the corporation. Insider trading occurs when
securities transactions are made based on material nonpublic information that was obtained in breach of a
fiduciary trust. Temporary insiders like auditors, consultants, financial analysts, and bankers also shall be
liable for breaching of a fiduciary trust if they make profit from information to which they had temporary
access.
Illegal pools: Association of two or more persons the objective of which is to make profit through price
manipulation is called illegal pools. Under this scheme a large amount of money are being used to buy or
sell stocks to artificially affect security prices. After obtaining the objective the pool is dissolved. Pool
members provide capital, inside information and manage the pool operations.
Unauthorized trading: It occurs when a clients account shows securities trades that were not authorized
verbally and/ or in writing by the client before the transaction occurred.
Participants in the Securities Markets
People of different categories do engage in share trading on DSE. Share ownership in DSE has increased
significantly during the last couple of years. The motivation of all the participants is presumed to be the
same: to earn a return at least commensurate with the level of risk assumed.
In the securities markets, there are many different groups of potential buyers viz., people who buy stocks
because they want to have capital gain; people who buy stocks because of some interesting news
captured their interest; people who buy stocks to take advantage of arbitrage plays; and people who buy
stocks to obtain dividends. Each group can be lured into the marketing of stocks at different entry points
in the cycle. These people with diverse interest can be further broken down into two categories: capital
gain players and return on investment players. However, the participants in the securities markets are
named as follows:
Securities and Exchange Commission: The Securities and Exchange Commission is the federal
regulatory agency that oversees the issuance and trading of securities. Its mission is to administer laws in
the securities field and to protect investors and the public in the securities transactions.
Stock Exchange: It provides a market place or facilities for bringing together buyers and sellers of
securities or for otherwise performing with respect to securities the functions commonly performed by a
stock exchange and includes such market place and facilities. Regulations for the admission of securities
for trading on the stock exchanges are very stringent.
Issuer: Its an either existing or a newly established firm offering or already offered bonds, notes or
securities for public sale or private placement.
Underwriter: The individual or firm finding the investors for the initial public offerings of securities are
called underwriters. It is also called investment banker. It purchases new issues from the issuers and
arranges for their resale to the investors. The investment-banking firm that first reaches an agreement
with the issuer is called the originator. The originator ultimately manages the flotation and coordinate two
temporary groups called underwriting syndicate and the selling group.
Commercial Bank: Commercial banks participate in the securities markets by making portfolio
management with the equity shares for their own and for the customers also. In recent days commercial
banks have been found to be entering the securities markets in the form of being underwriters of public
issue of shares, and then managing portfolio with small amount of shares for their own profit. In addition
to the commercial operations, commercial banks keep a serious thought to participatory role in the
securities markets.
Pension Funds:
Insurance Companies:
Mutual Funds:

27

Investment Company: Its a company engaged in buying and selling securities of other companies and
includes a company, the investment of which in share capital of other companies at any one time is of
enlargement equivalent to eighty per cent of the aggregate of its own paid up capital and free reserves.
Broker: It means any person engaged in the business of effecting transactions in securities for the
accounts of others. Brokers are commission sales people who need not invest their own funds in the
securities they sell. Dealers employ many brokers.
Dealer: A dealer is an individual or a firm that puts its own capital at risk by investing in a security in
order to carry an inventory of the security and makes a market in it. Typically a dealer buys for his or her
own account and sells to the customers from the dealers inventory. Dealers profit or loss is the
difference between the prices he pays and the price he receives for the same security. The same
individual or firm may function at different times, as broker and dealer.
Speculator: Its an individual who is willing to assume a relatively large risk in the hope of a large gain
in shorter period of time. Its principal concern is to increase capital rather than dividend income.
Speculator may buy and sell the same day or may invest in enterprises they do not expect to be profitable
for years.
Broker-dealer (B/D): Its a firm that retails mutual fund shares and other securities to the public.
Jobber: He is the person engaged in the business of effecting transactions in securities for his own
account but does not include any person trading securities either individually or in some fiduciary
capacity otherwise than as a part of a regular business.
Investor: Its an individual whose principal concerns in the purchase of a security are regular dividend
income, safety of the original investment and if possible, capital appreciation.
Bear: Its a person who thinks security prices will fall. It denotes the description given to the stock
market when share prices are falling and when the economic outlook is pessimistic.
Bull: Its a person who believes security prices will rise. It denotes the description given to the stock
market when share prices are rising and when the economic outlook is optimistic.
Stag: This is the description given to the share market when an investor buys shares offered in a new
issue and sells them shortly afterward. These investors have no intention to hold the shares as a medium
or long-term investment.
Commission Broker: An agent who executes the publics orders for the purchase or sale of securities. He
is the employee of a member firm who buys or sells for the customers of the firms.
Floor Broker: A member of a stock exchange who executes orders on the floor of the exchange to buy or
sell listed securities. Sometimes he acts on floor for the other members.
Registered Trader: An exchange member who utilizes his floor trading privileges primarily to purchase
and sell for his own account and others that he has an interest. He is allowed to use his membership to
buy or sell for his own account.
Specialist: It refers to as the center of the auction market. He has two functions; viz., to serve as broker
who handles the limit order or special orders placed with member brokers and to act as dealer in the
stocks assigned to him in order to maintain a fair and orderly market. He is expected to buy or sell for
his own account when there is insufficient public supply or demand to provide a continuous, liquid
market.
Short seller: A short sale occurs when one person sells a second person security borrowed from a third
person. A short seller is the speculator who expects the price of that security to fall, enabling him to
purchase the security at a lower price later and then delivers it at the higher price at which he had
previously arranged to sell it.
Government Regulations
the government has enacted a varieties of laws applicable to the securities markets. These laws were the
result of certain abuses that took place during the last decade. The collapse of the stock market of
Bangladesh in 1996 provides an impetus for the regulation of securities trading. Securities market s
regulating authority of Bangladesh along with the investors recognize that the regulation of the securities
markets is necessary in order to restore the confidence of the investors in the markets and ensure a
continuous flow of capital in business. The basic laws under which the transfer of stocks and bonds are
being regulated are the Securities and Exchange Ordinance, 1969, and Securities and Exchange
Commission Act, 1993. The principal objectives of these laws are to protect the suppliers of capital from
fraud and to ensure that information received by investors is truthful, accurate, complete, and reliable.

28

Laws launched and imposed by the regulating authority-SEC attempt to achieve these goals by way of
disclosing all material information affecting the price of a security, controlling the insider activities, and
controlling the issuance of new stocks and the trade of outstanding stocks. Laws permitted the
corporations not to hide neither favorable nor unfavorable information from the public. The actual
implementations of full disclosure sometimes present problems, which must be turned over to corporate
counsel. Corporate directors, officers, and major shareholders (who are called insiders) are not permitted
to profit from inside information. Transactions made by such insiders must be reported to the Securities
and Exchange Commission. The SEC publishes reports of insider trading showing the names of insiders
involved in trades. Corporate insiders are permitted to trade in the stock of their corporation if the comply
with the reporting requirements although they are not permitted to make short-term abnormal profit by
selling short. Laws have been established to ensure that information provided to investors in prospectuses
for new stocks is accurate and complete. For the sake of the investors protection in the securities
markets, government has enacted various regulations as needed time to time. Various Act, Rules,
Regulations, Orders, and Amendments promulgated time to time are presented in table-2, 3 and 4 in the
appendix. Many of the regulations were enacted after the market crash in 1996. Organized securities
markets, of course, being regulated by different regulations under the purview of Securities and
Exchange Commission Act. The primary objective of these legislations is to protect unwary and new
investors from fraud and manipulation and to make the market more competitive and efficient by
exercising sound policy regime set-up by the government.
Government Legislation
Many fraudulent and undesirable practices occur in the securities markets-both in primary and secondary
markets. To improve the stability and validity of the securities markets, more acts, rules and regulations
have been legislated by the government after establishment of Securities and Exchange Commission in
1993. A tremendous development in the securities markets is possible if the legislation come into effect.
Table -1 in the appendix contains a brief description of the major legislations regulated in the securities
markets that are liable to give protection to the investors in the securities markets. The followings are the
regulations regarding the legislation to protect the interest of investors.

Investment Companies
Investment companies are financial institutions obtaining money from individual investors and use it to
purchase financial assets like stocks, bonds etc. from the financial markets. In turn investors receive
certain rights regarding the financial assets that the investment company has bought and the earnings that
the company may generate. Investment companies act like financial intermediaries. Unlike any company,
an investment company issues shares of stock to the investors who are stockholders. The stockholders
own the investment companies directly and thus own the financial assets indirectly that the company
itself owns.
Types
Investment companies are classified as:
i. Unit investment trusts
ii. Managed investment companies.
Managed investment companies can further be categorizes as:
a) Closed-end investment companies
b) Open-end investment companies.
Unit investment trusts
Unit investment trust is an investment company that owns a fixed set of securities for the life of the
company meaning that it rarely alters the composition of the portfolio during the life of the company.
Unit investment trust has no board of directors and portfolio manager.
Managed investment companies

29

Managed investment companies are the companies having both board of directors and portfolio manager.
It may be an independent firm, an investment adviser, a firm associated with brokerage, or an insurance
company.
Closed-end investment company: A closed-end investment company issues a fixed number of shares
which may be listed with a stock exchange and bought and sold like any companys shares. It does not
stand ready to purchase its own shares when ever one of its owners decides to sell them.
Open-end investment companies: Commonly known as mutual funds an open-end investment company
stands ready to purchase its own shares at or near net asset value. It can also offer new shares to the
public for a price at or near their net asset value.
Net asset value (NAV):
The share price of mutual fund is based on its net asset value per share, which is found by subtracting
from the market value of the portfolio of mutual funds liabilities and then dividing by number of mutual
fund shares issued. The mathematical expression of net asset value (NAV) is given below:
NAVt = [MPt LIABt]/MFt
and
NAVt = [MPt LIABt]/NOSt
Where, NAVt, MPt, LIABt, MFt and NOSt denote the net asset value of the investment company, market
value of the investment companys assets, liabilities of the investment company, mutual funds and the
number of shares outstanding of the investment company respectively at the end of day t.

Risk and Return

Concept of Investment Risk
Risk analysis of investment is one of the most complex, controversial and slippery areas in finance.
Business decisions are generally made under conditions of uncertainty rather than under conditions
approaching certainty. In fact, both risk and uncertainty are the extreme end of the same spectrum. The
word risk shall be used to connote the idea of the twofold possibility of loss or gain. Some people
things that investments are inclined to give emphasis to possibilities of loss but it is a negative
pessimistic and depressing approach. But some people things that investments are inclined to give
emphasis to possibilities of gain which is optimistic.
In formal term, risk associated with a project o investment may be defined as the variability that is likely
to occur in the future returns or investment. Therefore, we relate risk to variability of return i.e., the
degree to which the return on an investment varies unpredictably.

Categories of Risk
Shortly speaking risk is the variability of return from an investment. Returns on investment may vary
from the expectation of the investors. So risk may be defined as the likelihood that the actual return from
an investment will be less than the expected return. Depending upon the elements of risk, it may be
broadly divided into two categories like systematic risk and unsystematic risk. Some elements of risk that
are external to the firm cannot be controlled and effect large numbers of securities are the sources of
systematic risk. On the other hand, controllable, internal factors somewhat peculiar to industries and/or
firms are referred to as elements of unsystematic risk. The risk associated with macro, pervasive factor
such as a national economy is called systematic risk. On the other hand, the micro risks associated with
factors particular to a company are called unsystematic or unique risk. Investment manager can do little
about systematic risk, although they can do much about unsystematic or unique risk.
Pervasive Risk
Some risks are pervasive and applicable to all investments.
Purchasing power risk: Purchasing power risk is the uncertainty of purchasing power of the
amount to be received. It refers to the impact of inflation or deflation on an investment. Rising prices on
goods and services are normally associated with what is referred to as inflation. On the other hand,
falling prices on goods and services are termed deflation. Purchasing power risk or inflation risk has
received considerable publicity in recent years. When investor holds his surplus funds in the safety
deposit box, he suffers from purchasing power risk. The risk of loss of income or principal because of
decreased purchasing power of money is also known as purchasing power risk. For some investors,

30

purchasing power risk is very important. Individuals or institutions using their income to buy goods and
services are greatly concerned over any changes in the purchasing power of their income. Investors who
fear inflation usually invest partially in common stocks and real estate with the hope that will rise in
value. Rationale investors should include in their estimate of expected return, an allowance for
purchasing power risk, in the form of an expected annual percentage change in prices.
Default risk: Another form of systematic risk is default risk. This type of risk arises because firms may
eventually go bankrupt. Default risk undiversifiable or uncontrollable as it is systematically related to the
business cycle affecting all most all investment even though some default risk may be diversified away in
a portfolio of independent investments.
Exchange rate risk: The chance that return will be affected by changes in rates of exchange
because investments have been made in international markets whose promise to pay dividends, interest,
or principal is not denominated in domestic currency risk or exchange risk. Exchange rate risk is the
uncertainty due to the determination of an investment in a country other than that of the investors own
country. The likelihood of incurring this risk is becoming greater as investor buy and sell assets around
the world, as opposed to only assets within their own countries.
Political risk: Also called country risk, political risk is the uncertainty due to the possibility of
major political change in the country where an investment is located. The chance that returns will be
affected by the policies and stability of nations is termed political risk. The dander of debt repudiation or
failure to meet debt service, expropriation of assets, differences in taxes, restrictions on repatriating
funds, and the prohibition against exchanging foreign currency into domestic currency are typical
political risks.
Systematic risk
Systematic risk refers to that portion of total variability in return on investment caused by factors
affecting the prices of all securities in the portfolio. Economical, political, sociological changes are the
sources of systematic risk. Their effect is to cause prices of nearly all individual common stocks, bonds,
and other securities in the market to move together in the same manner. Systematic risk affects the
economic or financial system. Systematic risk may be categorized under the following means:
Market risk: The price of common stock changes frequently in the process of bought and sold
by the investor or speculator in the market place. The price of a stock may fluctuate daily and cyclically
even though earnings maintain unchanged and some common stocks have a seasonal pattern. Because of
the changes in the market prices of the stock the investors can lose money. Variability in return on most
common stocks that is due to basic sweeping changes in investor expectations is referred to as market
risk. Expectations of lower corporate profits in general may cause the larger body of common stocks to
fall in price.
Investment prices vary because investors vacillate in their preference for different forms of investments
or simply because they sometimes have money to invest and sometimes do not have. The extensive
vagaries of the stock market, the uncertainty and stowness of real estate markets and the irregular
markets for mortgages and second-grand bond issues all illustrate in the presence of market risk.
Interest-rate-risk: Interest-rate-risk may be defined as the fluctuation in market price of fixed
income securities owing to changes in levels of interest rate. Fixed income securities mean notes and
bonds, mortgage-loan and preferred stock paying a definite amount of interest or dividends annually to
investors. Interest is the price paid for the use of money and like other prices fluctuates with demand and
supply forces operating in the market. The degree of fluctuation in the market prices of fixed income
securities resulting from interest-rate-risk depends firstly on the amount of change in interest rates. With
any change in the market rate of return on a bond, the market price changes inversely. The second factor
affecting the degree of fluctuation is the length of period of maturity. Every business or price of property
is subject to the possibility that its earning power or usefulness may wane because of competition, change
in demand, uncontrollable costs, managerial error, government action or some similar circumstances.
Liquidity risk: Liquidity risk is the possibility of not being able to sell an asset for fair market
value. When an investor acquires an asset, he expects that the investment will mature or hat it could be
sold to someone else. In either case, the investor expects to be able to convert the security into cash and
use the proceeds for current consumption or other investment. The more difficult it is to make this
conversion, the greater the liquidity risk.
Default risk: Another risk of systematic risk is default risk. This type of risk arises because of
firms may eventually go bankrupt. Default risk is undiversifiable or uncontrollable as it is systematically
related to the business cycle affecting almost all investment even though some default risk may be
diversified away in a portfolio of independent investments.
Real estate risk: Such type of systematic risks is unique and generally not found in most
investments rather than real estate. The specific risk inherited in real estate investments are given below:

31

As there is no continuous auction trading market, quoted price may not represent intrinsic value
of the property.
It is more difficult to find a buyer and seller raising the cost of transacting.
Real estate markets are inefficient as they are likely to be segmented.
The cost of acquiring information is greater.
Property value is more influenced by changes in the rates of interest than other equities.
Returns on real estate assets are determined by the going rates on default-free assets.
Real estate is less liquid than financial instruments.

Unsystematic risk
A portion of total risk that is unique or peculiar to a firm or an industry above and beyond that affecting
securities market in general may be termed as unsystematic risk. Management capability, consumer
preference, labor strikes are the elements of unsystematic risk. However, the unsystematic risk of an
investment consists of two major components: credit risk and sector risk:
Credit risk: Credit risk sometimes called company risk consists of business risk and financial risk.
Business risk is the risk inherent in the nature of the business. On the other hand, financial risk is the risk
in addition to business risk arising from using financial leverage. Credit risk is associated with the ability
of the firm that issues securities to meet its promise on those securities. The fundament promise of every
investment is a return commensurate with its risk. So the credit risk analyzed is the ability to deliver
returns that are consistent with the risk assumed. However, business risk and financial risk are discussed
below:
Business risk: The loss or income on capital associated with the ability of some companies to maintain
their competitive position and to maintain their earnings growth is sometimes refers to as the business
risk. Common stock and to some extent preferred stock and bond posses this risk. The risk that results is
either temporary or permanent. The business risk is not only associated with the weaker companies that
have suffered a total loss but also happened in the case of some quality companies when a deficit
earnings or a sharp drop earnings sustained which have resulted in substantial losses to investors.
In other words business risk is defined as the change that the firm will not have the ability to compete
successfully with the assets that it purchases. As for example, the firm may acquire a machine that may
not operate properly that may not produce salable products or that may face other operating or market
difficulties that cause losses. Any operational problems are classed as business risk.
Business risk can be divided into two categories: external and internal. Internal business risk is largely
associated with the efficiency with which a firm conducts its operations within the broader operating
environment imposed upon it. On the other hand, external business risk is the result of operating
conditions imposed upon the firms by circumstances beyond its control. Each firm faces its own set of
external risk, depending upon the specific operating environment factors that it must deal with.
Financial risk: Financial risk is associated with the way in which a company finances its investment
activities. It may be defined as the change that an investment will not generate sufficient cash flows to
cover interest payments on money borrowed to finance it or principal payments on the debt or to provide
profits to the firm. We usually gauge financial risk by looking at the capital structure of a firm. The
presence of borrowed money in the capital structure creates fixed payments in the form of interest that
must be sustained by the firm. The financial risk is avoidable risk to the extent that managements have
the freedom to decide to borrow or not to borrow funds. A firm with no debt financing has no financial
risk.
Sector risk: Sector or industry risk refers to the risk of doing better or worse than expected as a result of
investing in one sector of the economy instead of another. Sector investing implicitly acknowledges that
the impact of individual investment decisions is les critical, certainly to large portfolios, than investing in
the proper sector at the proper time. Sector rotation is a portfolio management style shifting resources to
sectors that are expected to be more promising and are overweighted in a portfolio in contrast to other
sectors which are underweighted.
As the number of stocks in the portfolio is increased, the unsystematic or residual risk of the individual
securities is diversified away leaving only the systematic or market-related risk.
We assume that all rationale profit maximizing investors want to hold a completely diversified market
portfolio of the risky assets and they borrow or lend to arrive at a risk level that is consistent with their
risk preferences. Under such conditions, the relevant risk measure for an individual asset is its

32

comovement with the market portfolio. This comovement measured by an assets covariance with the
market portfolio is its systematic risk.
Finally, we may draw conclusion as- we can divide total risk into two components viz., a general or
market component and a specific or issuer component. An investor can construct a diversified portfolio
and eliminate part of the total risk called diversifiable or nonmarket risk. The systematic risk known as
nondiversifiable or market risk is directly associated with overall movements in the general market or
economy.
Categories of risk
Sources of risk
Purchasing power risk
Pervasive risk
Exchange rate risk
Political
Market risk
Interest rate risk
Systematic risk
Liquidity risk
Default risk
Real estate risk
Credit risk
Business risk
Unsystematic risk
Financial risk
Sector risk
Different connotation of risk can be shown as under:
Total risk = General risk + Specific risk
= Systematic risk + Nonsystematic risk
= Nondiversifiable risk + Diversifiable risk
= Market risk + Issuer risk

Systematic risk and Unsystematic risk Distinguished

Before identifying the differences between systematic risk and unsystematic we should have clear
understanding about the terminologies. However, they are defined as below:
Systematic risk: Nondiversifiable risk is call systematic risk. It is the portion of total risk which can not
be eliminated, controlled through diversification of assets.
Unsystematic risk: Diversifiable risk is called unsystematic risk. It is that portion of total risk which can
be eliminated, controlled through diversification of assets.
The major differences between them can be summarized below:
Systematic risk
Unsystematic risk
i.
It relates to market risk affecting all the i.
It does relate to market risk.
securities in the market.
ii.
It can not be diversified away through ii. It can be diversified through making
making portfolio of assts.
portfolio of assets.
iii. It is related to market-wide factors.
iii. It is related to business specific factors.
iv.
It arises due to economic uncertainty
iv. It arises due to business phenomenon.
v.
It is termed as common risk.
v.
It is termed as unique risk.
vi.
It is measured by the movement of vi. Unique risk of the individual securities
individual securities with the changes
can totally be eliminated by putting
in the market.
them in a group.
vii. Securitys beta is the standardized vii Unsystematic risk is total risk minus
measure of systematic risk.
.
systematic risk.
Business risk and Financial risk Distinguished
i.
ii.
iii.

Business risk
Business risk is uncertainty of expected
return on asset if the company does not
use debt.
It is calculated from the overall asset
invested in the business.
It is related to the total profit if the
business.

33

i.
ii.
iii
.

Financial risk
Financial risk is the uncertainty of
return if the company takes debt.
It arises if the total debt of the firm
is more in the capital structure.
It is related to the financial profit of
the business.

iv.
v.
vi.
vii.
viii
.
ix.

It is related to the investment policy of the

firm.
It relates operating leverage.
Owners and creditors are concerned with
this risk.
Owners as well as creditors can control
this risk.
This is unavoidable risk.

iv.
v.
vi.
vi.
vii
i.
ix.

It is related to both investment

policy and capital structure of the firm.
It relates financial leverage.
Owners of the business are
concerned with this risk.
Only the owners of the business
can control this risk.
This is avoidable risk.

Capital structure is not considered in

Capital structure is considered in
analyzing business risk.
analyzing financial risk.
The concluding characteristics of risk can be summarized as below:
Risk measures the changes in product price.
The more debt in the business, the riskier the investment.
The larger the margin of safety, the lower the risk.
The more variable the return, the more risky the investment.
E(rp )

Total risk

Unsystematic risk

Systematic risk

p
Number of securities in the portfolio
Figure: Reduction of risk through diversification of assets.
Return
Investment implies that investor defers current consumption in order to add to his/her wealth so that
he/she can consume more in future. So, the return on investment is concerned with change in wealth
resulting from the investment. Such change in wealth can either be due to cash inflows in the form of
interest or dividends, or caused by a change in the price of the asset. The period during which an investor
deploys funds (wealth) is termed as its holding period and the return for that period is called holding
period return (HPR). HPR is calculated as:
Ending value of the investment
HPR = ----------------------------------------Beginning value of the investment
An investor can convert HPR to an annual percentage rate to derive a percentage return commonly
known as holding period yield (HPY). HPY is further be calculated as:
HPY = HPR1
Again, annual holding period return can be calculated as:
Annual HPR = [HPR] 1/N
Where, N is the number of years an investment holds. Suppose an investment is made by Tk. 200 the
value of which would become art Tk.250 after 2 years. The holding period return from the investment is:
HPR = [Ending value/ Beginning value]
= Tk.250/Tk.200 = 1.25
Annual HPR = [1.25]1/N = [1.25]1/2 = 1.1180
Therefore,
Annual HPY = 1.11801= 0.1180 =11.80%
If the investment is held for a period of 3 years, the holding period yield then would become:
Annual HPR = [1.25]1/N = [1.25]1/3 = 1.08
Therefore,

34

Annual HPY = 1.08 1= 0.08 = 8%.

Alternatively, holding period return can be defined as the capital gains plus dividend per taka invested in
the stock like:
HPR = [Capital gains + Dividend]/Investments
HPR = [(Ending price Beginning price) + Cash dividends]/Beginning price
The ending value of the investment can be the result of a change in the price for the investment. Annual
holding period yield assumes a constant annual yield for each year.
Another calculation of return is called geometric mean which is the nth root of the product of the holding
period returns for n years. Geometric mean, therefore, is:
GM = [HPR]1/N 1
Where,
= the product of the annual holding period return calculated as:
[HPR1] [HPR2] ------- [HPRn]
Suppose holding period returns for three consecutive years from an investment are 1.10, 1.15 and 1.20
respectively. The geometric mean return from the investment can be calculated as:
GM = [(1.10) (1.15) (1.20)] 1/3 1
= [1.518] 1/3 1 = 1.14931= 0.1493 = 14.93%.

Historical vs. Expected Returns

Returns from security consist of income in the form of dividend or interest plus change in capital. Total
returns consist of all price changes and income received during a specific interval. Future returns are the
meaningful ones for decision made today. An important use of expected return is to compare value across
asset classes and across time. Some asset allocation decisions are based on the risk premium differential,
which is the difference between the expected return on assets such as stocks, bonds, or real estate and the
expected return on a risk-free asset such as a Treasury bill. An important way to assess return is to
compare historical (ex post) and expected (ex ante) returns. Historical returns are generated by the history
of the performance of an investment over a specified time period. Expected returns, on the other hand,
are the best estimates of what returns might be over some future time period. Historical returns are
known with certainty whereas expected returns are fraught with uncertainty i.e., they are probabilistic in
nature.

Measures of Expected Return

Investments are made to generate income, to appreciate capital and to preserve capital. An investment
periodically generates cash for the investor in the form of interest, dividends, or rent. The market price or
the value of an investment may rise or fall over time. A capital gain arises when the market value of an
asset is above the price what is paid to acquire the asset. Capital loss arises when the market price fall
below what is paid for the asset. In order to measure the return generated by an investment, one should
account for both the income generated by the investment during the period the asset was held and the
change in the price. Investors in common stock consider the change in price and the amount of dividends
declared by the company during the holding period of the asset. For bonds, the holding period return is
equal to the price change and interest received. Investors are concerned to measure the return and choose
among alternative investment assets. To meet this, the investors are likely to measure both historical (ex
post) and expected (ex ante) rates of return. Historical returns are often used by the investors with a view
to estimating the expected rates of return. The first measure of return from an individual investment is the
historical rate of return during the period the investment is held. The second measure of return is the
measure of expected rate of return for an investment.
The period during which an investor owns an asset is termed as its holding period and the percentage
return from the investment and price changes during this period is called holding period return. For a
perpetual security like stock, the holding period return for a particular period of time is equal to the sum
of the price change plus dividends received for that period divided by the price at the beginning of the
time period. For fixed income security like bond, the holding period return is equal to the price change
plus interest received divided by the beginning price. However, in general, the holding period return is
calculated as follows:
rit = [(Pit Pi,t1) + Dit]/ Pi,t1

35

where,
rit = Return for stock i at time t,
Pit = Price of the stock i at time t,
Pi,t1 = Price of the stock i at time t1 and
Dit = Dividends declared for stock i at time t
To measure the return generated by an investment, the price change and the cash flow derived from the
investment during the period must be taken into account. To illustrate such return, consider the following
data for stock i.
Beginning price
Ending price
Dividends

Tk.120
Tk.150
Tk. 15

Thus, the return for stock i for a particular period would be:
ri = [(150-120) + 15] / 120
= .375 = 37.5%
The ex post or historical average return for stock i may be calculated as follows:
N

ri = 1/n (ri1 + ri2 + .............. + rin)

or

ri = 1/n rit
t=1

where, n denotes the number of time periods. The following Table illustrates data relating to the above
formula:
Time
1
2
3
4
5
6
7
8
9
10
Retur
.12
.10
.15
.04
.09
.03 .04 .14 .02
.05
n
The historical mean return for stock i is computed as:
ri = 1/10[(.09) +.12+(.03)+.04+.14+(.02)+.10+.15+.04+(.05)]
= 1/10 (.40) = .04 = 4 %
After calculating the historical rate of return of a security is essential to calculate its expected (ex ante)
return. The expected rate of return is the ex ante return that an investor expects to earn over some future
holding period. An investor determines how certain the expected rate of return on an investment is by
analyzing estimates of expected returns. In this connection, an investor assigns probability values to all
possible returns. These probability values range from zero (zero per cent) indicating no change of the
return to one (hundred per cent) indicating complete certainty that the investment will generate the
specific rate of return. For sure, for a fruitful estimation, these probabilities are based on the historical
performance of the investment or similar investments modified by the investors expectations for the
future. To describe the outcome from a particular probability distribution, it is essential for an investor to
estimate its expected value. The expected value is the average of all possible return outcomes, where
each outcome is weighted by its respective probability of occurrence. The expected rate of return from an
investment is defined as:
N

E(r) = h iri
i=1

where,
E(r) = the expected return on security in subject,
ri = the ith possible return,
hi = the probability of ith return (ri) and
n = the number of possible returns
Probability
.10
.10
.10
.10
.10 .10
.10 .10 .10
Possible return .09 .12
.14 .02 .10 .15 .04
.03 .04
From the above ex ante data the expected rate of return for stock i may be computed as:
E(ri) = .10(.09)+.10(.12)+.10(.03)+.10(.04)+.10(.14)+.10(.02).10(.10)+

36

.10
.05

.10(.15) +.10(.04)+.10(.05)
= .059 .019 =.040 = 4%
Measures of Risk
Risk arises from the expected volatility in assets return over time caused by one or more of the following
sources of returns on investment:
fluctuations in expected income
fluctuations in the expected future price of the asset
fluctuations in the amount an investor can reinvest and fluctuations in returns earned from
reinvestment
In this section we examine the measures of risk arising from an investment. There are two methods of
measuring risk viz., i) absolute measure and ii) relative measure of risk. The absolute measures of risk for
an investment are:
Variance of rates of return (2i)
Standard deviation of rates of return (i)
Covariance (im)
These measures of risk can be influenced by the magnitude of original numbers. Hence, to compare
series with greatly different values, we need a relative measure of dispersion. The relative/standardize
measures of risk for investments are:
Coefficient of variation (CV) of rates of return which is calculated as:
CV = i/E(ri)
Correlation coefficient (ij), being a statistical measure of the extent to which two variables are
associated which is calculate as:
ij = ij/i j
Covariance of returns with the market portfolio called beta (i) which is calculated as:
i = i m/ 2m
Statistical measures allow an investor to compare the return and risk measures for alternative investments
directly. Variance and standard deviation of the estimated distribution of expected returns are, however,
two possible measures of uncertainty. Calculation of the expected return of the probability distribution is
essential to calculate the variance and standard deviation.
Standard deviation is a measure of the dispersion of forecast returns when such returns approximate a
normal probability distribution. It is a statistical concept and is widely used to measure risk from holding
a single asset. The standard deviation is derived so that a high standard deviation represents a large
dispersion of return and is a high risk; a low deviation is a small dispersion and represents a low risk.
Standard deviation of the rates of return is simply the square root of the variance of the rates of return
which tells us about the potential for deviation of the return from its expected values. Variance is directly
related to the standard deviation and is of considerable importance in finance. However, the variance is
simply the standard deviation squared (or the standard deviation is the root of the variance). The
following is the formula for calculating the variance of historical returns (using ex post data):
N

r = 1/(N 1) (rit ri)2

2

t=1

Dividing by N1 gives us an unbiased estimate for the variance when the sample is relatively a small
size. In the case of the example of historical data the computation of the variance would be as follows:
(.09 .04)2 = (.13)2 = .0169
(.12 .04)2 = (.08)2 = .0064
(.03 .04)2 = (.07)2 = .0049
(.04 .04)2 = (00)2 = 0000
(.14 .04)2 = (.10)2 = .0100
(.02 .04)2 = (.06)2 = .0036
(.10 .04)2 = (.06)2 = .0036
(.15 .04)2 = (.11)2 = .0121

37

(.04 .04)2 = (00)2 = 0000

(.05 .04)2 = (.09)2 = .0081
=====================
Total
= .0656
2r = 1/9 (.0656)
= .0073
Standard deviation is the positive square root of the variance.
r = 2r = .0073 = .085 = 8.5 %
The variance of expected rates of return by using ax ante data could be found as follows:
N

2(r) = ht[rit E(ri)]2

t=1

In case of our example of probability distribution of possible return, the variance of the population by
using ex ante data is computed as follows:
.10(.09 .04)2 = .10(.13)2 = .00169
.10(.12 .04)2 = .10(.08)2 = .00064
.10(.03 .04)2 = .10(.07)2 = .00049
.10(.04 .04)2 = .10(00)2 = 00000
.10(.14 .04)2 = .10(.10)2 = .00100
.10(.02 .04)2 = .10(.06)2 = .00036
.10(.10 .04)2 = .10(.06)2 = .00036
.10(.15 .04)2 = .10(.11)2 = .00121
.10(.04 .04)2 = .10(00)2 = 00000
.10(.05 .04)2 = .10(.09)2 = .00081
=====================
Total
= .00656
2r = .00656
Also,
= .00656 = .081 = 8.1%
Thus, the ex ante standard deviation is considered as a weighted average of the potential deviations from
the expected returns and a reasonable measure of risk.
Covariance: The expected rates of return and the variance provide the information about the natures of
the probability distribution of a single stock or a portfolio of stocks indicating nothing about the returns
on securities interrelated. Certainly a stock may generate a rate of return above its expected value. If it is
known in advance, will it impact on the expected rate of return on other stock? If one stock generates a
rate of return above its expected value, will other stock produce the same? A statistical measure giving
answer to these questions is the variance between two stocks. Covariance refers to the measure of the
degree of association between the returns of a pair of securities. It is defined as the extent to which two
random variables covary over time. However, the properties of covariance are given below:
A positive covariance: The returns on two securities tend to move in the same direction at the
same time indicating that if one increases (decreases), the other does the same.
A negative covariance: The returns on two securities tend to move inversely at the same time
indicating that if one increases (decreases), the other decreases (increases).
Zero covariance: The returns on two securities are independent having no tendency to move in
the same or opposite directions together.
To understand the concept of covariance, let us assume that we have two stocks called stock A and stock
B. In a period of six months the stocks produce the following rates of return:
Month
Jan
Feb
Mar
Apl
May
Jun
Mean
Stock-A
.12
.14
.08
.04
.04
.10
.04
Stock-B
.09
.12
.06
.10
.08
.06
.09
We like to estimate the covariance from the sample of the six monthly returns. As the data given above
are historical returns, the sample covariance may be computed by using the following formula:
N

38

A,B = 1/ (N1) [(rA,t rA)( rB,t rB)]

t=1

Using the data in our example, we can estimate the covariance of the returns from stock A and stock B as
follows:
(.12 .04)(.09 .06) = (.08)(.03) = .0024
(.14 .04)(.12 .06) = (.10)(.06) = .0060
(.10 .04)(.06 .06) = (.14)(00) = 0000
(.08 .04)(.10 .06) = (.04)(.04) = .0016
(.04 .04)( .09 .06) = (.08)(.15) = .0120
(.04 .04)(.08 .06) = (00)(.02) = 0000
=============================
Total
= .0220
AB = 1/5 (.022)
=.0044
The above equation is used to calculate the covariance from a sample of paired returns. Now the question
arises when the actual probabilities of getting various pairs of returns at the same time. The probabilities
of getting various pairs of returns on two investments at the same time could be presented in the joint
probability distribution. If we have the actual probability distribution rather than a sample estimate, the
population covariance of underlying joint distribution may be estimated by applying the following
formula:
N

AB = ht [rAt E(rA)][ rBt E(rB)]

t=1

Suppose we have the following observation about the expected rates of return from two stocks:
Probability .20
.25
.30
.15
.10
E (r)
Stock-A
.02
.07
.10
.11
.21
.09
Stock-B
.24
.18
.10
.10
.01
.12
Covariance describes the relationship between the returns on stock A and B. We compute the population
covariance as follows:
.20(.02 .09)(.24 .10) = .20 (.07)(.14) = .00196
.25 (.07 .09)(.18 .10) = .25(.02)(.08) = .0004
.30(.10 .09)(.10 .10) = .30(.01)(00) = 0000
.15(.13 .09)(.01 .10) = .15(.04)( .11) = .00066
.10(.21 .09)( .12 .10) = .10(.12)(.22) = .00264
=====================================
Total = .00566
AB = .00566
The calculation of covariance is very important since it is a critical input in determining the variance of a
portfolio of stocks. However, it doesnt accurately describe the nature of the relationship between two
investments. Furthermore, we can standardize the covariance obtaining a better descriptor called the
correlation coefficient.
Correlation coefficient: Correlation coefficient is a statistical measure of the relative comovements
between returns on securities. It measures the extent to which the returns on any two securities are
related. As the covariance number is unbounded, we can bound it by dividing it by the product of the
standard deviations for the two investments as follows:
rA,B = AB / (rA)(rB)
The resulting number of the above equation is called the coefficient correlation falling within the range 1
to + 1. With perfect positive correlation, the returns on securities have a perfect direct linear relationship
indicating that the return on one security allows an investor to forecast perfectly what the other security
will result. With perfect negative correlation, the returns on securities have a perfect inverse linear
relationship to each other indicating that the return on one security provides knowledge about the return
on the other security i.e. when return on one security is high, the other is low. With zero correlation, there
exists no relationship between the returns on two securities indicating that the return on one security

39

provides no value in predicting the return on the other security. However, we can rewrite the covariance
as the product of the correlation coefficient and the standard deviations of the two stocks as:
AB = rA,B [(rA)(rB)]
If we square the correlation coefficient we obtain a number called the coefficient of determination.
Coefficient of determination (CD) tells the fraction of the variability in the returns on the one investment
that can be associated with the variability in the returns on the other.
CD (R 2) = (rij)2
Table: Different Aspects of Statistical Measures of Returns on Securities.
Ex post (historical)
Ex ante (expected)
Mean return:
Expected return:
N
N
E(r) = hiri
ri = 1/ n rit
i=1

t=1

Variance:

Variance:

2 = 1/(n 1) (rit ri)2

t=1

2(r) = hi [ri E(r)]2

i=1

Standard deviation:

Standard deviation:

= 1/(n 1) (rit ri)2

(r) = hi [ri E(r)]2

t=1

i=1

Covariance(sample):

Covariance (population):

AB =1/(N1) [(rAt rA)( rBt rB)]

AB =hi [rAi E(rA)][ rBi E(rB)]

t=1

i=1

Calculating a standard deviation using probability distributions involves making subjective estimates of
the probabilities and the likely returns. We cannot avoid such estimates as future returns are uncertain.
The prices of the securities are based on investors expectations about the future. The relevant standard
deviation in this situation is the ex ante standard deviation rather than ex post based on the realized
returns. Although standard deviations based on realized returns could be used as proxies for ex ante
standard deviations, it should be remembered that past may not always be extrapolated into the future
without modifications. Though ex post standard deviations are convenient, they are subject to error.
Individual Stock and Market Portfolio
We have discussed the relationship between the returns on two individual stocks in the preceding
discussion. At this stage we like to discuss about the relationship between the returns on a individual
stock and the market portfolio.
Characteristic Line
The pairs of returns can be plotted in figure. The line passing through the observations is the line of best
fit. This line helps in describing the relationship between the return from individual stock and that of
market portfolio or market return. If we relate the return from an individual stock to the market return in
this way, the line of best fit refers to as the stocks characteristic line. The characteristic line shows the
return an investor expects the stock to produce, given that a particular rate of return appears for the
market.
Ri

rf

40

Rm

The straight line in the figure represents the line of best fit between the return on stock i and market
return. In the regression analysis, the term it in the Equation is a random-error term which will have a
mean value of zero and is assumed to be uncorrelated with the market returns, the error terms of other
securities, and error terms of the same security over time. The most interesting parameters in the line are
the intercept and beta coefficient.
Beta factor: Beta picks up the risk that cannot be diversified away. As the effective diversification
eliminates almost all of an assets unique risk, the relative measure of a single assets risk is not its
standard deviation, but its beta. Beta indicates an assets contribution to the total risk of a portfolio. Since
the characteristic line is a straight line, it can be fully described by its slope and the point where it passes
through the vertical axis. The slope of the characteristic line is commonly known as the stocks beta
factor. The beta factor of an individual stock is an indicator of the degree to which the stock responds to
changes in the return produced by the market. That is, beta measures the covariance of return on stock i
with market divided by the variance of market return. Since beta indicates the manner in which the
returns on security change systematically with changes in the returns on market, it is frequently referred
to as the measure of a securitys systematic o market risk. If the markets return increased by 10%, then a
stock with beta of .75 is expected to increase its return by 7.5% (.75 x 10%). The formula for an assets
beta factor and the intercept are as follows:
i = i,m / 2 rm
Ai = ri i rm
where,
i = beta factor of stock i,
i,m = the covariance of return on the stock i with the return on the market,
2 rm = the variance of return on market,
Ai = intercept and
ri , rm = mean return on stock i and market respectively.
Another method of estimating historical beta is to use the fact that;
ri,m = i,m / i m

i,m = ri,m i m
Again,
i = ri,m i m / 2 m
= rim (i/ m)
The beta of stock i is equal to the correlation coefficient for stock i and market portfolio, multiplied by
the ratio of the standard deviation of stock i to the standard deviation of the market return. In another
way, the beta of stock i is a function of the correlation of the returns on stock i with those of the market
(rim) and the variability of the returns on stock i relative to the variability of the market returns (i/ m).
The covariance of market return with itself is the variance of market return:
mm = 2m
Thus, the beta for the market index would be:
m = mm / 2m
= 2m / 2m = 1
We can, now, classify the systematic or market risk of securities by using the beta of market index into
two categories. A stock having a beta of greater than 1 has above-average market-related or systematic
risk and a stock having beta of less than 1 has below-average market-related or systematic risk. Hence;
1: stock holds systematic risk more than average
1: stock holds systematic risk less than average
= 1: Stock holds systematic risk equal to average
= 0: Stock holds no systematic risk
Estimating Beta
Beta is a mathematical value that measures the risk of one asset in terms of its effects on the risk of a
group of assets called portfolio. It is concerned solely with market related risk, as would be concern for
an investor holding stocks and bonds. It is derived mathematically so that a high beta indicates a high
level of risk, a low beta represents low level of risk. There are different methods of estimating beta like
historical beta using ex post return, ex ante beta using ex ante return, and ex ante beta using adjusted
historical betas.
The following Table represents historical returns on stock i and market.

41

Return on
ri
rM
.03
.09
.12
.04
.08
.14

.02
.04
.08
.03
.02
.13

ri
= .07

rM =
.04

(rit ri)2

( rM t rM)2

(rit ri)( rM t rM)

(.03.07) =(.04)2=.0016
(.09 .07) = (.02)2=.0004
(.12 .07) =(.05)2=.0025
(.04.07)=(.11)2=.0121
(.08 .07) =(.01)2=.0001
(.14 .07) = (.07)2=.0049
(rit ri) = .0216

(.02.04)2=(.02)2= .0004

(.04)(.02)= .0008
(.02)(00) = 0000
(.05)(.04) = .0020
(.1)(.01) = .0011
(.01)(.02)=.0002
(.07)(.09)=.0063

(.04 .04)2 =(.08)2=. 0064

(.08.04)2 =(.04)2= .0016

(.03.04)2 =(.01)2=.0001
(.02.04)2=(.02)2=.0004
(.13.04)2 =(.09)2=.0081
( rM t rM)2 = .017

(ritri)(rM t rM)=.01

The covariance between return on stock i and market portfolio and variance of the return on market are,
therefore:
N

i,m = 1/(N1) (rit ri)(rmt rm) = 1/4(.01) = .0025

t=1
N

2m = 1/ (N1) ( rm t rm)2 =1/4(.017) = .00425

t= 1

m = .065 = 6.5 %
N

2i = 1/ (N1) (ri,t ri) = 1/4 (.0216) = .0054

t=1

i = .073 = 7.3 %
The correlation coefficient between return on stock i and market portfolio is:
rim = im /i m
= .0025/(.065)(.073) = .53
Thus, the beta factor and intercept using ex post return can be estimated as:
i = i m / 2 m
= .0025 /.00425 = .59
Again,
i = rim (i/ m)
= .53 (.073/.065)
= .53 1.1231 = .59
The intercept is:
Ai = rit i rm = .07 .59 (.04) =.07 .0236 =.0464
In the above case, the beta factor for stock i is .59 which indicates that if the market return goes to be
higher by 1 per cent, the return for stock i tends to increase by .59 per cent.
The ex ante or expected beta can be estimated from probability distribution. The following information
are given to find beta.
Probability
.20
.25
.30
.25
Return on stock-i
.16
.12
.40
.18
Return on market portfolio
.08
.16
.20
.09
From the above information the following estimations are made:
Pro
b.
.20
.25
.30
.25

Return
ri
Rm
-.18
-.09
.16
.08
.12
.16
.40
.20

ht ri t

ht rmt

ht [ rit E(ri)]2

ht [ rmt E(rm)]2

-.036
.040
.036
.100

-.018
.020
.048
.050

.20(.32)2 =.0205
.25(.02)2=.0001
.30(.02)2=.00012
.25(.26)2=.0169

.20(.188)2=.0071
.25(.018)2=..00008
.30(.062)2=.0012
.25(.102)2=.0026

.20(.32) (.188)=.0120
.25(.02) (.018)= .00009
.30(.02) (.062)= .00037
.25(.26) (.102)=.0066

.140

.098

=.03762

=.01098

= .01814

Expected return:
N

42

ht [ rit E(ri)] [ rmt E(rm)]

E(ri) = ht rm,t = .140

t=1
N

E(rM) = ht rm,t = .098

t=1

Variance:

2(ri) = ht [rit E(ri)]2 = .03762

t= 1
N

2(rm) = ht [rmt E(rm)]2 = .01098

t=1

Standard deviation:

(ri) = ht [rit E(ri)]2 = .03762= .1940

t= 1

(rm) = ht [rmt E(rm)]2 = .01098 = .1048

t=1

Covariance:

i,m = ht [ri t E (ri)][ rm t E (rm)] = .01814

t=1

Correlation coefficient:
rA,B = i,m / (ri)(rm)
= .01814/ [(.1940)(.1048)] = .89
Beta coefficient:
i = i,m / 2 m
= .01814 /.01098 = 1.65
Again,
i = rim (i/ m)
= .89 (.1940/.1048) = 1.65
Problem Set
A. Suppose you are given the following observation:
Return on
Jan
Feb
Mar
Apl
May
Jun
Stock-A
.02
.04
-.02
.08
-.04
.04
Stock-B
.02
.03
.06
.03
-.04
.08
You are required toi.
find out the sample mean return for each of the stock
ii.
find out the variance and standard deviation for the stocks
iii.
compute the covariance and correlation coefficient between the return on the stocks
iv.
find out the coefficient of determination and comment on the result
Solution:
(rAt
( rBt
( rBt
rAt rA)2
(rAt rA)
Mont
Return on
2

r
)

r
)

r
)

A
B
B
h
StockStock(
r
Bt rB)
A
B
Jan
.02
.02
00
0000
-.01
.0001
0000
Feb
.04
.03
.02
.0004
00
0000
0000
Mar
-.02
.06
-.04
.0016
.03
.0009
-.0012
Apl
.08
.03
.06
.0036
00
0000
0000
May
-.04
-.04
-.06
.0036
-.07
.0049
.0042
Jun
.04
.08
.02
.0004
.05
.0025
.0010
Toal
.12
.18
.0096
.0084
.0040
Sample mean:
Stock-A
N
rA = 1/ N rAt = 1/6 .12 = .02
t=1

Stock-B

43

 rB = 1/ N rBt = 1/6 .18 = .03

t=1

Sample variance:
Stock-A
N
2(rA) = 1/N1(rAt rA)2 = 1/5 x .0096 = .00192
t =1

Stock-B

2(rB) = 1/N1(rBt rB)2 = 1/5 x .0084 = .00168

t =1

Standard deviation:
Stock-A
N
(rA) = 1/N1(rAt rA)2
t =1

= 1/5 .0096 = .00196 =.044 = 4.40%

Stock-B

(rB) = 1/N1(rBt rB)2

t =1

= 1/5 .0084 = .00168 =.042 = 4.20%

Covariance:

rA, rB = 1/ (N1) [(rA,t rA)( rB,t rB)]

t=1

= 1/5 .0040 = .0008

Correlation coefficient:

rA,B = (rA, rB) / (rA)(rB)

= .0008/ (.044)(.041) = .44

Again,

rA, rB = rA,B (rA)(rB)

= (.44) (.044) (.041) = .0008
Coefficient od determination:
CD = (.44) 2
= .20
B. Suppose following information are the information about ex ante data:
Probability .20
.25
.30
.15
.10
Stock-A
.16
.12
.08
.04
.02
Stock-B
.02
.07
.10
.13
.21
You are required toi.
find out the expected rate of return for each of the stocks
ii.
compute the variance and standard deviation for the stocks
iii.
compute the covariance and correlation coefficient between the return on the stocks
iv.
find out the coefficient of determination of the stocks and comment on the result
Solution:
Prob.
Return
ht rAt
ht rBt
ht [rAtE(rA)]2 ht[rBtE(rB)]2
ht [ rAt E(rA)]
rA
rB
[ rBtE(rB)]
.20
.16 .02
.032
.004
.00087
.0011
-.00096
.25
.12 .07
.030
.018
.00017
.00013
-.00015
.30
.08 .10
.024
.030
.000059
.000015
-.00003
.15
.04 .13
.006
.020
.00044
.00021
-.0003
.10
.02 .21
.002
.021
.00055
.0014
-.00087
1.00
.094
.093
.0021
.0029
-.0023
Expected rate of return:
Stock-A
N
E(rA) = ht rA t = .094 = 9.4%
t=1

Stock-B

44

E(rB) = ht rB t = .093 = 9.3%

t=1

Variance:
Stock-A

2(rA) = ht [rAt E(rA)]2 = .0021

t= 1

Stock-B
N

2(rB) = ht [rBt E(rB)]2 = .0029

t=1

Standard deviation:
Stock-A

(rA) = ht [rAt E(rA)]2 = .0021= .046 = 4.6%

t= 1

Stock-B

(rB) = ht [rBt E(rB)]2 = .0029 = .054 = 5.4%

t=1

Covariance:

(rA,rB) = ht [rA t E (rA)][ rB t E (rB)] = . 0023

t=1

Correlation coefficient:
rA,B = (rA, rB) / (rA)(rB)
= . 0023/ [(.046)(.054)] = . 93
Again,
(rA, rB) = rA,B (rA)(rB)
= . 93 [(.046)(.054)] = . 0023
Coefficient of determination:
CD = (.93)2 = .86
Problem:
Suppose you are given the following information:
Probability
.20
.25
.30
.15
Return on Stock-i
.16
.12
.08
.04
Return on market portfolio-M
.02
.07
.10
.13
You are required tofind out the beta factor for stock i and comment on the result.
Solution:
Prob.
Return
ht rit
ht rmt
ht [ rit E(ri)]2
ht [rmtE(rm)]2
Ri RM
.20
.16 .02 .032
.004
.00087
.0011
.25
.12 .07 .030
.018
.00017
.00013
.30
.08 .10 .024
.030
.000059
.000015
.15
.04 .13 .006
.020
.00044
.00021
.10
.02 .21 .002
.021
.00055
.0014
1.00
.094
.093
.0021
.0029
Solution:
For stock i:
N
E(ri) = ht ri t = .094 = 9.4%
t=1

For market:

E(rM) = ht rM t = .093 = 9.3%

t=1

For beta factor:

45

.10
.02
.21

ht [ rit E(ri)]
[ rit E(rm)]
-.00096
-.00015
-.00003
-.0003
-.00087
-.0023

i = (ri,rM) / 2 rM
Again,

(ri,rM) = ht [ri t E (ri)][ rM t E (rM)] = . 0023

t=1
N

and

2(rM) = ht [rM t E(rM)]2 = .0029

t=1

therefore,
i = . 0023/.0029 = .79
The beta factor for stock i is .79. This indicates that if the market return goes to be higher by 1 per cent,
the return for stock i is expected to decrease by .79 per cent for the next time period.

Valuation of Firm
Determinants of Stock Prices
Literature hypothesizes that the fluctuations in earnings are much more pronounced than the fluctuations
in dividends. A downturn in earnings is not followed by a downturn in dividends, unless the downturn in
earnings persists for a long period. As a result management knows that the market reacts negatively to
dividend downturns, hence they are supposed to try to avoid this decline. By paying dividends in years
with negative earnings, management signals to the investors that the decline in earnings is temporary, and
that positive earnings are expected to prevail in the future.
Investors may or may not prefer dividends to capital gains and at the same time prefer predictable to
unpredictable dividends. However, there are many factors influencing a companys dividend policy in
practice. But all the factors are not identical for every company. The company management may adopt
such a policy in order that it may retain control of the companys operations. A companys dividend
policy is, therefore, influenced by its investment and financing decisions and by some influencing factors
as well. To gain an understanding of what determines the prices of a stock, I like to consider in this
section of the chapter, what determines the price of individual stock. The prices of stock will be
determined by trading among individuals. Even if these stocks themselves are not directly traded, we can
merely infer their prices in a competitive market from the prices of the stocks that are traded. To
understand the stock market accurately, an investor will find the following determinants that affect the
prices of the stocks. It is logical to expect a relationship between corporate profits and securities prices.
So, expected earnings and interest rats are the ultimate determinants of securities prices. The transfer of
capital between markets would raise the interest rates that affect the securities prices in two ways: i) high
rate of interest lessens the firms profits ii) interest rates affect the economic activities that affect the
corporate profits. Interest rates obviously affect the securities prices because of their effects on profits.
They have also an effect due to the competition in the stocks and bonds markets. The higher rate of
interest causes the investors to sell stocks and transfer funds to bond market. Thus, higher rate of interest
depresses securities prices. Inflationary pressures are strongest during business boom, and that also exerts
upward pressure on rates. Slack business reduces the demand for credit; rate of inflation falls and the
result is a drop in interest rates. However, this section of this paper will strive at explaining the factors
determining firms dividend and the stock price as well.
Expectation of future earning: Market price of a share equates the present value of expected future
returns. The shareholders expectation of dividends is generally guided by the future earnings of the
company. It may be assumed that shareholders prefer dividends if companies use retained earnings
inefficiently although transaction costs and taxation considerations generally favor retentions rather than
dividend payments.
Pattern of past dividends: While making dividend decision of a year, firms give emphasis on the last
years dividend.
Availability of cash: Cash flow is the most important determinant of dividends. Cash dividends can only
be paid with cash. Thus, a shortage of cash in the bank may restrict dividend payments.

46

Corporate earnings: Corporate earnings are considered as the primary determinant of dividends as they
provide the cash flow necessary for payment of dividends. If management increases the proportion of
earnings per share paid out as dividends, shareholders would become wealthier, suggesting that dividend
decision is a very important one. Dividends payments usually may not exceed retained earnings.
Matter increases stock prices: An increase in payout ratio provide signals to investors a potential growth
in future that increases the value of the firm. A firm would suffer the impact of negative signal when it
decreases dividend payout. Information of changes in earnings with existing dividend rates is also the
most important determinant of firms dividend policy.
Interest rates: Existing interest rates affect the profits of the company. Investors always compare the
existing interest rate with dividend income. Comparatively, high rate of interest influences the investors
to invest in fixed income securities like bonds etc. rather than stocks. Therefore, high rate of interest
depresses securities prices.
Transactions costs: Transaction costs incur when the company pays dividends and issue new shares to
finance its investment opportunities. This thing can be considered while making dividend decision. On
the other hand, retentions do not incur transaction costs. Thus the presence of issuing costs suggests that
shareholders should favor retention rather than dividends. But a shareholder being forced to sell shares
for income through lack of dividend must incur selling costs.
Business expansion: Firms investment needs and financing opportunities can influence its dividend
policy. Firms having profitable investment opportunities may prefer to retain a large fraction of its
earnings that causes the payout to be relatively low. According to the theme of financial analysts, growth
companies with abundant investment opportunities should reinvest their earnings hampering dividend
payments. Financial analysts pointed out a number of factors like shareholders expectation, past pattern
of dividend payments, cash needs for the company, current earnings of the company, expectation of
future earnings, tax consideration, legal constraints, and owners and capital market consideration
affecting a forms dividend policy.
Managers have access to the information about the expected cash flows of the firm not possessed by
outsiders and thus, changes in dividend payout may provide signals about the future cash flows of the
firm that can not be communicated credibly by other means. Empirical studies indicate that dividend
changes convey some unanticipated information to the market. Another theoretical issue concerns the
extent to which the investors with different dividend preferences is the clientele effect. Possible reasons
for the formation of clienteles are different perceptions of the relative riskiness of dividends and retained
earnings and different investor tax brackets. Being insiders sometimes the financial managers and
analysts have access to the information about expected cash flows of the firm not possessed by the
outsiders. On the other hand, changes in dividend payout providing signals about the firms future cash
flows cannot be communicated by other means.
However, it may be noted here that the apparently significant industry effect may exist from the fact that
variables are often similar within a given industry. These similarities are the fundament reasons why
firms in the same industry have similar dividend payouts.
Corporate
ratevaluation model, dividends, required rate of returns, earnings per share, price earning
According
totaxthe
ratio ultimately determine the prices of the stocks.
Although a firms industry does not help to explain its dividend payout ratio, economic analysis can
innovate
some effect
of industry on the dividend policy and the value of the stock as well. However, it
Changes
in government
spending
may be noted here that the apparently significant industry effect may exist from the fact that variables are
often similar within Changes
a giveninindustry.
These corporate
similarities
are
fundament
reasons
whyearnings
firms in the same
total spending
Nominal
earnings
Realthe
corporate
earnings
Expected
real corporate
industry have similar dividend payouts.
According
to themoney
valuation model, dividends, required rate of returns, earnings per share, price earning
Changes in nominal
ratio ultimately determine the prices ofChanges
the stocks.
Furthermore, a complete model of economic variables
in real money
is desired to understand the stock market more accurately. A classical model to determine the stock prices
Stock price
identifying exogenous and endogenous variables determining Interest
the stock
rate of a company can be shown by
Potential output
Changes exhibited
in price level in the following Figure.
the following
flow diagram

Changes in real money

47

Above Figure shows that the potential output of the economy being the nonpolicy variable along with
three active policy variables- fiscal policy, monetary policy and corporate tax rate ultimately affect the
prices of the stocks. Two independent variables like government spending (fiscal policy) and money
supply (monetary policy) affect the stock prices in two way: i) by affecting total spending that along with
corporate tax rate affects corporate earnings which is positively related to changes in stock prices, ii) by
affecting total spending which along with the potential output and past changes in prices determine
current changes in prices which ultimately determine current changes in real output. Output and changes
in prices cause inflation and real growth influencing the current interest rate. Interest rates possess a
negative influence on the stock prices. Potential output, government spending, money supply, and
corporate tax rate cause the changes in total spending, price level and real money which ultimate affect
corporate earnings and interest rates. Interest rate is negatively related to price earning ratio and, in turn,
corporate earnings and price earning ratio determine the stock prices.
The ultimate determinants of stock prices are present and expected earnings of the corporation and
prevailing interest rates. There exists a strong positive relationship between corporate net earnings and
stock prices. The expected value of the stock and the market as well should be a function of the expected
streams of benefits to be received and the investors required rate of return. Investors will expect
corporate net earnings and dividends to rise and as a result stock price will tend to rise if the economy is
prospering. However, the relationship between the stock price and its determinants are summarized
below:
Notion of the determinants
Impact on stock price
Interest rates rise (fall).
Stock prices fall (rise).
An increase (decrease) in expected Stock prices tend to increase (decrease).
corporate earnings.
A change in government spending.
Affects the corporate earnings.
An increase in tax rate.
Reduces the corporate net earnings.
An increase in money supply.
Increases the prices of stocks.
An increase in output.
Increases the prices of stocks.
An increase in risk factor (discount Reduces stock prices.
rate).
An increase (decrease) in growth of Causes an increase (decrease) in stock
dividend.
prices.

Econometric Analysis of the Variables

48

Corporate dividend policy is concerned with how much of its earnings a firm should pay to the
shareholders. Alternatively, retaining portion may be reinvested for the future earnings prospects of the
firm. Retained earnings imply no concurrent tax liabilities. On the other hand, dividends are taxed at a
flexible rate as applicable for individual shareholders. In spite of the tax treatment imposed by the
government, corporations distribute a fraction of their earnings as dividends. By reducing their dividends,
firms may raise the level of investment and therefore depress the rate of return on investment. The return
on investment is made up of cash dividends, capital gains (or losses) and capital distributions. It is
assumed that the dividends and capital gains are equally valuable to the investors though this may not
always be the case as tax treatments sometimes favor capital growth over dividends. But a firm may
increase its retained earnings without having return on capital to partly or wholly replace debt finance. A
general question may arise in the mind of the shareholders that the corporate dividend policy affects their
wealth. If an increase in dividends increases the value of the firm, the shareholders will prefer to take
earnings as dividends and new investments should be financed through the sale of new securities. But
financial theorists find that dividend policy does not impact on share value although it affects the firms
willingness to undertake its investment opportunities and thus impacts the firms value. However, the
corporate owners want a share of the profits their firm earns. Considering the shareholders demand a
firm may take dividend decision recognizing the impact of the same on the shareholders wealth. For
sure, theoretically, shareholders are indifferent between receiving corporate earnings as dividends and
having a capital appreciation. Hence, the corporate dividend policy should have a relatively direct
bearing on cyclical fluctuations and longer term growth trends in the economy.
The appropriate ex-post measure of the return on equities is unambiguously total past income, i.e.,
dividends plus capital gains or losses on a stock over the market value of the same. But dividends plus
recent capital gains or losses on a stock are not necessarily the best measure of ex-ante return. This is
why capital gains and losses embody the capitalized value of any change in expected income and so are
ordinarily larger than the change in expected income itself, which is the relevant quantity for the
measurement of future return. Presumably for this reason, investors more frequently use dividends plus
retained earnings than dividends plus capital gains approximating future expected income for portfolio
selection. Since corporate earnings paid out to common shareholders are not available for financing new
investments, the corporate dividend decision is intertwined with corporate financial policy. Earnings per
share measure the shareholders return. Shareholders return in turn implies payment of dividends and/or
capital gains. Employment of profits will enhance the shareholders equity and the shareholders earnings
are return on equity called net worth. Retention ratio multiplied by return on equity (ROE) measures the
growth of a firm.
Retention ratio is a percentage of net profit undistributed or retained by a firm. A firm retaining more
may command higher share price because of high growth in earnings. Shareholders of higher growth
firms may obtain their return in the form of capital gains. But there is uncertainty regarding capital gains.
Payment of dividends helps to resolve this uncertainty. Market price of slower growth firms shares, on
he other hand, may be lower. However, dividends are to be paid because it is the direct and most
objective way of communicating to shareholders that their company is doing well although this does not
make much sense in terms of growth. In this connection, a firm should accept all profitable projects
implying that shareholders will reinvest their dividends in the share of the firm. However, firms dividend
policies should be applied by considering some specific rules viz., net profit rule implying that dividends
must be paid from past and current earnings, the capital impairment rule prohibiting payment of
dividends from the capital account so that the shareholders and creditors are protected and the insolvency
rule stating that the corporation may not pay dividends when insolvent.
The efficiency of capital markets depends on the extent to which capital asset prices fully reflect
information that affects their value. In a world of rational expectations, the firms dividend
announcements provide just enough pieces of the firms sources and uses statement for the market to
deduce the unobserved piece, to wit, the firms current earnings. Management of the firm should regard
their shareholders as having a proprietary interest in earnings and urge the shareholders special interest
in getting earnings in dividends, subject to their interest in regularity of payment. Unless there are other
compelling reasons to the contrary, fiduciary responsibilities of the management require them to
distribute part of any substantial increase in earnings to the shareholders in dividends. Similarly,

49

management believes that it is both fair and prudent for dividends to the shareholders to reflect any part
of substantial or continuous decline in earnings and that under these circumstances shareholders should
understand and accept the cut. Firms tend to increase dividends only when there is a high probability that
cash flows in the future would be sufficient to support the higher rate of payment and dividends are
decreased only when management is assumed that cash flows are insufficient to support the present
dividend rate. It is obvious to argue that there should be a positive relation between dividend payments
and share prices. Investors may have a preferred consumption pattern and the existence of transaction
costs makes a particular dividend pattern a more desirable way to achieve their preferences than by
selling securities. The markets estimate of current earnings contributes in turn to the estimate of the
expected future earnings on which the firms market value largely hinges.
The impact of dividend policy on the market value of a firm is a subject of long-standing controversy.
The major changes in earnings with existing dividend rates are the post important determinant of the
firms dividend decisions. As the management beliefs that the shareholders prefer a steady stream of
dividends, firms tend to make periodic partial adjustments toward a target payout ratio rather than
dramatic changes in payout. To gain an understanding of what determines the prices of a stock in addition
to the dividends, this paper strives at considering and analyzing the factors affecting the price of
individual stock. The prices of stock will be determined by trading among individuals. Even if these
stocks themselves are not directly traded, we can merely infer their prices in a competitive market from
the prices of the stocks that are traded. To understand the stock market accurately, any one will find some
determinants that affect the securities prices. It is logical to expect a relationship between corporate
profits and securities prices. So, expected earnings and interest rates are the ultimate determinants of
securities prices. The transfer of capital between markets would raise the interest rate that affects the
securities prices in two ways: i) high rate of interest lessens the firms profits ii) interest rates affect the
economic activities that affect the corporate profits. Interest rates obviously affect the securities prices
because of their effects on profits.
On Stock Return
Stock price behavior of the companies and its relation with explanatory variables like dividend payout
ratio, stock dividends, right, retained earnings, earnings price ratio, size of company i.e. asset size,
corporate governance like number of directors, ownership pattern represented by sponsors
shareholdings. The relationship between stock return and explanatory variables is given by the following
random-effect generalized least square (GLS) regression model:
rij = + 1ageij + 2EPSij +3 dpratioij + 4 assetij + 5 stdivij +6 rightij +
7 sprsij +8 ndij +9 gdivij
Pooled data for the estimation can be used for the study purpose. These pooled data take care of the
short-term influences of transitory effects of the dependent and independent variables. Therefore, the
combination of cross-section and time-series data is conducted to provide the effective coefficient
estimates.
On Price Earning ratio
Price earning ratio is the more widely used method of estimating stock price. A stock is said to be worth
some multiple of its future earnings indicating that an investor determines price of a stock by deciding
how much he is willing to pay for each unit of estimated earnings. However, the price earning ratio has
been determined by dividend payout ratio, required rate of return, growth rate of dividend, stock
dividend, and other variables which has been explained by the following regression model:
P/E ratio ij = +1ageij +2dpratioij +3 assetij + 4 stdivij + 5 rightij +
6 sprsij + 7 ndij
Analysis of the Variables
Stock price behavior of the companies and its relation with dividends, stock dividends, right, retained
earnings, earnings price ratio, earnings per share (EPS), dividend payout ratio, firm size, sponsor

50

shareholding, age of the company, are analyzed in this section of the study. Dividend payout (D/P) ratio
is related with earnings. General observation in the securities market indicates the notion that earnings
are important determinant of stock prices. Stock return is the outcome of price changes and dividend
thereon. Changes in stock prices experience changes in EPS over the same time period indicating that a
large increase in stock price over the time period experience large increase in EPS and the stock suffering
large decline in price tends to have experienced large decreases in EPS. Price earning ratio is the more
widely used method of estimating stock price. A stock is said to be worth some multiple of its future
earnings indicating that an investor determines price of a stock by deciding how much he is willing to
pay for each unit of estimated earnings.

Valuation Concepts
Valuation is based on economic factors, industry variables, and an analysis of the financial statements
and the out look for the individual firm. The purpose of valuation is to determine the long-run
fundamental economic value of a specific companys common stock. When a firm is considering the
purchase of marketable securities- debt, preferred stock or common stock- it must have some knowledge
of investment value. If the firm is evaluating an acquisition it must have techniques to determine how
much to pay for the stock to be acquired. When a firm is considering a public offering to sell its own
stock in order to raise additional equity capital, it must establish a price for the issue and the time the
offering to achieve a maximum benefit to existing shareholders. These are all issues related to the
valuation of the firm and its securities.
The valuation of a security is defined as its worth in money or other securities at a given moment in time.
The value is expressed either in terms of a market for the security or in terms of the laws or accounting
procedures applicable to the security. In this regard, five major concepts of valuation may be discussed in
the following manner.
1. Going Concern Value: The value of the securities of a profitable operating firm with prospects for
indefinite future business might be expressed as a going concern value. The worth of the firm would be
expressed in terms of the future profits, dividends, or expected growth of the business.
2. Liquidation Value: If the analyst is dealing with the securities of a firm that is about to go out of
business, the net value of its assets, or liquidation value, would be of primary concern
3. Market Value: If the analyst is examining a firm whose stock or debt is traded in a security market, he
can determine the market value of the security. This is the value of the debt and equity securities as
reflected in the bond or stock markets perception of the firm.
4. Book Value: This is determined by the use of standardized accounting techniques and is calculated
from the financial reports, particularly the balance sheet, prepared by the firm. The book of the debt is
usually fairly close to its par or face value. The book value of common stock is calculated by dividing the
firms equity on the balance sheet by number of shares outstanding.
5. Intrinsic Value: A securitys intrinsic value is the price that is justified for it when the primary factors
of value are considered. In other words, it is the real worth of the debt or equity instrument as
distinguished from the current market price. The financial analyst estimated intrinsic value by carefully
appraising the following fundamental factors affecting security value:
a) Value of the firms assets: The physical assets held by the firm have some market. They can
be liquidated if need be to provide funds to repay debt and distribute to shareholders. In technique of
going concern valuation, asset values are usually omitted.
b) Likely future interest and dividends: For debt the firm is committed to pay future interest and
repay principal. For preferred and common stock, the firm makes attempts to declare and pay dividends.
The likelihood of these payments affects present value.
c) Likely future earnings: The expected future earnings of the firm are generally viewed as the
most important single factor affecting security value. Without a reasonable level of earnings, interest and
dividend payments may be in jeopardy.
d) Likely future growth rate: A firms prospects for future growth are carefully evaluated by
investors and creditors as a factor influencing the intrinsic value.
Analysis of Intrinsic Value

51

Analysis of intrinsic value is the process of comparing the real worth of a security with the current
market price or proposed purchase price. The fundamental factors affecting value usually change less
rapidly than the market price of a security. In imperfect market, the analyst can hope to locate variance
between intrinsic value and the asking price for a security. The primary goal of analyzing intrinsic value
is to locate clearly undervalues or clearly overvalued firms or stocks. In the case of an undervalued
security, the market has not discovered that fundamental factors justify a higher market price. That is, the
security is worth more than its selling price. For overvalued stock, the reverse situation is true.

Purpose of Valuation
The purpose of valuation may be summarized as under:
i. For return on investment: Purchase of a business return on investment is an important
consideration.
ii. Purchasing the controlling interest in a business: This serves the same purpose as the
purchase of an active business. However, the part purchased should have a higher value than its strict
proportion to the whole.
iii. Marketing a companys share: A sufficient number of people should be interested in buying
shares.
iv. Buying a share in a business: The likely pattern of income receivable in terms of income and
capital gain is an important consideration.
v. Acquiring assets: The purpose here is to acquire a business or a part thereof in order to obtain
the assets which it holds.
vi. For estate duty purpose: An unquoted business requires a value to be placed upon its shares
for estate duty purpose, since in this case no market price is available.
vii. For insurance cover: This is largely concerned with the costs of replacing the relevant
assets.
viii. Security against loan: The lender is concerned with the realizable value of the assets of a
firm.
Factors Influencing the Valuation Process
Generally speaking the value of the firm should depend upon the expected return, measured in terms of
net cash inflows generated by the firms assets and the future returns. Specifically the following factors
influence the value of a firm:
The comparative position
The first important factor influencing the valuation of an enterprise both interms of quantity and quality
is the competitive position of the same, or simply the enterprises past growth of sales, its future expected
growth and its position within the enterprise. An enterprise in a strong competitive position will provide
greater earning with more certainty than an enterprise in a poor competitive position.
Profitability
The second important factor that influences the valuation of an enterprise is the profitability of the same.
The expenses and the profitability ratios can determine the future earnings of an enterprise. The higher
and more stable the earnings of a company, the greater and more stable its value. Profit margins have a
strong impact on future earnings. Since dividends are directly influenced by earnings, the higher the
earnings and the more stable they are, the greater the dividends also the greater the future value.
The operating efficiency
The third important factor that influences the valuation of an enterprise is the operating efficiency of the
same. This factor has an influence in determining the quality and ability of an enterprise to earn money in
future. Operating efficiency attempts to relate real input to real output. The operating efficiency of an
enterprise is measured by its operating ratio and its break-event-point. The lower the operating ration, the
higher the earnings and also the greater the future value.
The current financial position
The current financial position is the fourth important factor that influences the valuation of an enterprise.
An enterprise should be in a good financial position to maintain its profitability and earnings for the
common stockholders. The basic financial problem of the corporate management is to maintain a balance
between liquidity and profitability. Too much cash or liquidity on the other hand does not help the profit
of the enterprise. Idle funds are not productive funds. The ideal current financial position is the balance

52

between excess liquidity and illiquidity. If there is ideal current financial position in the enterprise, this
ideal current financial position will increase the value of the enterprise.
Capital structure characteristics
The capital structure characteristics being the fifth important factor influence the valuation of an
enterprise. The method that the management uses in financing the companys growth will have the
influence upon the stability of earnings. As long as the earnings of the enterprise are above the costs of
borrowed funds, the earnings per share of common stock are increased. The use of large amount of debt
in the capital structure tends to make earnings unstable. Hence, if the proportion of owners equity in the
capital structure is higher than that of debt, the earnings will be higher and at the same time the higher the
earnings, the higher the value of the firm.
Management
The sixth and the last important factor that influences the valuation of an enterprise is the efficiency or
inefficiency of the management. The quality and the depth of management is essential to the future
profitability of a business enterprise. Many analysts consider the quality of corporate management as the
single most important factor influencing the future earnings and overall success of the enterprise. Without
efficient management an enterprise could not maintain its comparative position or introduce new
products. Hence, efficient or inefficient management has a great influence on the valuation of an
enterprise.

Valuation Techniques
The methods of security valuation can be considered under three main heads viz., i) those that are based
on physical assets, ii) those that emphasize earning power, and iii) those that stress actual or imputed
market prices. There is no single reliable method of determining the value of an enterprise or its
securities that can be applied to all situations. Often several methods or various combinations of methods
are useful in a particular situation. It is worth noting that the purpose of the particular valuation and the
point of view of the evaluator strongly influence the selection of approach to or method of valuation. The
followings are the aforesaid three methods of valuation of securities, shares, stocks, and debentures
generally used by financial analysts.
A] Asset Approaches to Valuation
The valuation of securities is often determined on the basis of the value of assets. The value of assets is
determined on the basis of three approaches which are discussed below:
i. Book value or Break-up value: Book value is determined by the asset value shown on the
companys balance sheet. The excess of assets over debt represents the net worth of the business in the
accounting terminology and provide the base for the calculation of the book value. If a company has got
outstanding preference shares, a value for these shares are deducted to determine the net worth
application to ordinary shares. The net worth available to ordinary shares divided by the number of
outstanding ordinary shares give book value per share. The major weaknesses of this method of valuation
are given below:
First, figures for book value are influenced by the accounting practices and policies of an
enterprise.
Secondly, there is lack of standardization of accounting practices in the treatment of intangibles
like goodwill and patents.
Thirdly, analysts face the difficult job of reconstructing reported figures in valuing the security of
one company against that of another in order to get them on comparable basis.
Fourthly, a concern following financial accounting practices will arrive at the value by reference
to conventions rather than sheer logic of value.
Finally, book value approach does give proper consideration to the earning power of the assets
which may be the real test of their worth.
ii. Realizable or liquidation value: The value of individual assets which can be had by selling
them. Such value is known as the realizable or liquidation value. The liquidation value can be estimated
for the company as a whole means the estimated net amounts that will be received by sale of assets less
any liabilities. The liquidation value of a company is usually less than its economic value as a going
concern. It has significance in bargaining on valuation because it represents a minimum price. A
company should not be sold as a unit for less than its liquidation value. When earnings in a company are
nonexistent, liquidation value may become significant.

53

iii. Replacement or reproduction value: To avoid the problem of changing price levels it is
often suggested that assets should be valued on the basis of replacement cost rather than historical cost.
Replacement cost is estimated by competent engineering authorities by breaking down property into its
various component units for purpose of detailed examination. Such a valuation has much significance as
expert opinion, but the conclusions are not universally accepted. The major problems arising in this
method of valuation are mentioned below:
First, it is often difficult to estimate costs of replacement.
Secondly, there remains the problem of determining depreciation on the replacement costs.
Thirdly, While costs of replacing physical assets can be calculated by painstaking appraisal, the
cost of duplicating the business organization, its experience, know-how, and reputation-apart
from the physical assets is the most difficult to determine.
Finally, estimate of replacement cost do not measure the value of assets in use.
B] Capitalization of Earnings Approach
The capitalization of earnings approach for the valuation of ordinary shares is based on the philosophy
that the current value of the property depends on the income which can be had over the years. This
approach is based on the feeling that it is the earning power that provides income to the shareholders and
it income that they value rather than physical assets. The basic validity of this approach is rarely
challenged. However, problems do arise in the application of this approach to actual situations. There are
three basic steps involved in the method of valuation: determination of earnings, determination of rate of
capitalization and capitalizing the value of earnings.
i. Determination of earnings: In determining future earning power one has to consider the
corporate earnings past record and the first step to get this record as straight as possible. There are
difficulties in getting reliable data and the person making the valuation may not have access to all the
data he would like. Difficulty is also created due to the varied character of accounting practices which
may require a number of adjustments for converting earnings data to a basis appropriate for the
comparison. In practice, an estimate of future earnings is prepared over an arbitrary time horizon which
would be a period short enough to justify reasonable degree of confidence in the expected earnings. The
significant consideration is selection of a period of time which represents a normal picture of both the
good and bad years in the companys recent history. It should be a period covering the completion of
business cycle so that poor years are averaged with the good.
Thus, in assessing future earning power one has to pay due attention to the record of earnings of the
enterprise in the past, nature and context of competition in the industry, treatment of research and
development expenditures, the general economic conditions and government policies of trade, tariff,
taxation, money and banking etc. In fact one has to determine maintainable profits for future. There are
three approaches to the determination of maintainable profits: i) a simple average may be calculated in
case of established industry with no growth prospects, ii) weighted average has to be calculated in case of
established industry with no growth prospects and iii) projected average has to be calculated in case of
industries having growth potential.
ii. Rate of capitalization: After determining annual earning rate for the enterprise as a whole or
per share, the next step is to apply a capitalization rate to arrive at the prospective investment value. The
capitalization rate is no more than an earning price ratio, i.e., it is the ratio of earnings to price. In
general, the selection of this rate of capitalization is affected by the following considerations:
a) Prevailing interest rates,
b) Risk involved in the industry,
c) Time required for reaching capacity production in the enterprise,
d) Nature, magnitude and potentiality of competition.
iii. Capitalization of earnings: The process of putting a valuation on the estimated earnings is
known as the capitalization of earnings. As seen earlier, the process of estimating future earnings is an
inexact one. Similarly, the selection of appropriate rate of capitalization is mainly subjective. Some
adjustments in capitalized value of income become necessary. If some of the assets purchased have not
contributed to the operating income, they can be sold without affecting the normal operating income.
There may be excessive amounts of cash, inventories and other assets on hand. The fair market value of
these assets should be added to the capitalized value of earnings. On the other hand, it may be necessary
to put additional sums to operate the assets affectively. Future earnings of a small manufacturing concern

54

may depend upon the purchase of additional machineries or patent rights. Such payments made in order
to obtain the estimated normal net income should be subtracted from the value of assets calculated by
capitalization of income. For capitalizing the earnings or maintainable profits at the capitalization rate the
followings are the usual treatments:
Treatment-1: Capitalize maintainable profits at the capitalization rate related to the industry or
business.
Treatment-2: Maintainable profits are arrived at after deducting taxes, preference dividend and
normal plough back. After these deductions, the remaining profits are capitalized at the estimated
capitalization rate.
Treatment-3: If the enterprise has surplus funds invested in outside shares or securities or
redundant assets not helping in the normal earnings capacity of the enterprise, in that case additions will
be made to the capitalized value of earnings for the value of such redundant investments and assets.
Treatment-4: If the enterprise has a highly geared financial structure, i.e., high debt to equity
ratio, the plough back is suitably increased and the rate for capitalizing the earnings also requires suitable
adjustments. Financial leverage may add to earnings per share but it also increases volatility of these
earnings.
C] Market Price
Advocates of this approach argue that actual market prices are appraisals of knowledgeable buyers and
sellers who are willing to support their opinions with cash. Hence, the prices at which transactions take
place are practically expressions of value which should be preferred to theoretical views or valuation.
Market value of the share is in the nature of bloodless verdict of the market place. Supporters of market
price argue that it is determined by investors valuation of expected future earnings and thus reflects the
value of the security. Moreover, the market price is a definite measure that can readily be applied to a
particular situation and it minimizes the subjectivity of other approaches in favor of a known yardstick of
value. Market price is a highly fluctuating quantity. In fact, the fluctuation may be so violent and extreme
that one may question the validity of using the market price of the securities as a basis for exchange.
However, in spite of this shortcoming it is given much consideration, primarily due to its wide
acceptance. The problems in using market price can be analyzed as follows:
First, market quotations are not available for a large number of enterprises whose shares are not
listed on the exchanges.
Secondly, even for those enterprises whose shares are listed there may not be an active trading.
Thirdly, the release of a relatively small number of shares on a thin market may be enough to
depress market prices substantially.
Fourthly, the market price for a particular share on a given date may be influenced by artificial
means like cornering of shares.
Fifthly, sales of shares in a closely held enterprise may not reflect fair market price.
Finally, it is difficult to sell whether movements on the price of a share in response to rumours
cause the price to move upwards or away from its economic value.
To meet some of the objective noted above, the theory of fair market value has been developed. Fair
market value is based on the assumptions that there are willing buyers and willing sellers actually in the
market, each well-informed and prepared to act in an entirely rational manner. This approach meets to a
greater extent most of the objections against market price.

Valuation of Common Stock

A capitalization technique is merely a method of converting future cash returns into a single present or
intrinsic value for a security. Common stock offers the potential for growth of future cash flows, and this
must be reflected in the intrinsic value analysis. The value of common stock for one period and more
than one period can be estimated as follows.
1. Single-period Model:
The rate of return on an investment can be expressed solely in terms of the effects for one period,
normally a year. It is assumed that the security is purchased at point 0 i.e., the beginning period and sold

55

at point 1 to be termed as ending period. Any cash received during the year plus any increase in the value
represents the return from the investment. Such value can be calculated by using the following formula:
E(r)1 = [(P1P0) + D]/P0
where,
E(r)1 = rate of return earned in period 1.
P1= price of the security at the end of period 1.
P0 = starting value of the security at point 0 and
D = any cash received in the form of dividends between point 0 and the end of period 1.
2. Perpetual Dividends Model:
A second approach to the valuation of common stock looks at more than one period. It is useful for firms
that will perpetually pay dividends but will not grow in terms of earning or dividends. The following
formula can be used to find out the value of the stock:
PV = PMT/i
where,
PV = price of the security
PMT = the annual receipt or payment
i = the appropriate time value of money (a considerable discount factor).
The above mentioned formula can be rewritten as:
P0 = DPS1/ ke
whee,
P0 = price of the security.
DPS1= dividends per share in period 1 and every future period if the firms dividends are not
growing.
ke = required rate of return.

Valuation of Bond or Debenture

It is relatively easy to determine the intrinsic value of a bond or a debenture. If there is no risk of default,
there is no difficulty in estimating the cash flows associated with a bond. The expected cash flows consist
of the annual interest payments plus the principal amount to be recovered at maturity or sooner. The
appropriate capitalization or discount rate to be applied will depend upon the riskiness of the bond. The
risk in holding a government bond is less than that associated with a debenture issued by a company.
Consequently, a lower discount rate would be applied to the cash flows of the government bond and a
higher rate to the cash flows of the debenture.
1. Bond with Single Maturity Period:
When a bond or a debenture has a finite maturity, to determine its value we will consider the annual
interest payments plus its terminal or maturity value. Using the present value concept, the discounted
value of these flows will be calculated. By comparing the present value of a bond with its current market
value, it can be determined whether the bond is overvalued or undervalued. The following formula can be
used in determining the value of a bond:
Vd = R1/ (1 + kd) + R2/ (1 + kd)2 + . + Rn / (1 + kd)n + Mn / (1 + kd)n
n

= Rt/ (1 + kd)t + Mn/ (1 + kd)n

t=1

where,

Vd = value of bond or debenture

R = annual interest
kd = required rate of return
M = terminal or maturity value
n = number of years to maturity.
2. Bond in Perpetuity
The bond which will never mature is known as perpetual bond. This type of bond or debenture is rarely
found in practice. In case of perpetual bonds, the value of the same would simply the discounted value of
the infinite stream of interest flows. The value of a perpetual bond can be determined by using the
following formula:

56

Vd = R1/ (1 + kd) + R2/ (1 + kd)2 + + R/ (1 + kd)

= Rt/ (1 + kd)t = R/kd

t=1

where,

Vd = value of bond or debenture

R = constant annual interest
kd = required rate of return
The above equation is an infinite series of R taka per year and the value of a perpetual bond is simply the
discounted sum of the infinite series.
3. Valuation of Preferred Share
Preferred share may be issued with or without a maturity period. The holders of preference shares get
dividends at a fixed rate. Like bond, it is relatively easy to estimate the cash inflows associated with the
preference shares. The following formula is to be used in determining the value of preference share:
Vp = Dp1/ (1 + kP) + Dp2/ (1 + kP)2 + + Dpn + Mn/ (1 + kp)n
n

= Dt/ (1 + kP)t + = Mn/ (1 + kp)t

t=1

where,
Vp = value of preferred share
Dp = preferred dividends
kP = required rate on preferred share
Mn = terminal value of preference share.
The value of a preference share considered as perpetuity can be determined by dividing annual dividend
by expected return. The following formula is used to calculate the value of a preference share:
Vp = Dp/kp
4. Valuation of Equity Share
The valuation of equity share is relatively more difficult. The difficulty arises because of two factors viz.,
i.
the estimates of the amount and timing of the cash flows expected by investors are more
uncertain. In case of debentures and preference shares, the rate of interest and dividend is
known with certainty. It is, therefore, easy to make the forecasts of cash flows associated
with them.
ii.
the earnings and dividends on equity shares are generally expected to grow unlike the
interest on debentures and preference dividend. These features of equity shares make the
calculation of shares difficult.

Problems of Valuation
When a business is transferred or its assets are sold, it is necessary for the parties involved in the
transaction to agree upon the price to be paid. The decision on the price to be paid is often difficult to
arrive at. The balance sheet surplus of assets over liabilities is the generally accepted guide to the price to
be paid for the business as a going concern. However, balance values are book values and are often
unreliable. The followings are the usual problems confronting one in the valuation of a firm:
i. Balance sheet values of fixed assets may be wrong indicators, for they are generally based on a
book value consideration. Changes in the actual value of assets are not incorporated in a balance sheet.
ii. The value of current assets may be reliable. But here again the amounts of debts, accounts
receivables etc. may be unknown. Moreover, the inventory may not find a ready market.
iii. Some assets may be highly specialized and may not have a ready market.
iv. The selling or break-up value and the buying or replacement value may become difficult and
different of assessment.
v. It may be difficult for a purchaser to estimate how much the possession of the sellers assets
would add to his profitability. The inflows have to be discounted not only for interest but also for risk.
vi. The value of goodwill may be greater to the buyer than the seller
So, these are the basic problems arise while making valuation of a firm.

Bond Markets
57

Understanding of fixed income securities

Fixed income securities are the investment alternatives generating predetermined fixed income to the
investors. Bonds and debentures offer the investors the opportunity to earn stable nominal returns with
low risk of loss of principal if held to maturity. Nevertheless bonds also offer investors the chance to earn
more returns by speculating on interest rate movements. Although bonds and debentures are long-term
fixed income securities, both of them are debt securities. Generally speaking debt securities issued by
government and public sector units are commonly known as bonds. On the other hand, debt securities
issued by private sector joint stock companies are called debentures. A debenture is also called an
unsecured bond backed by general credit of a company. However, bonds and debentures are often used
interchangeably. Bonds can be defined as the long-term debt instruments which represent a contractual
obligation to pay both principal and interest thereon by the issuer to the holder. Two major categories of
bonds available in the securities markets are government bonds and corporate bonds. The holder of bonds
can sell them off any time before maturity although no maturity the issuer reimburses to the holder. If a
bond is going to be sold before maturity, the price will depend on the level of interest rates at that time.
Therefore, the buyers of the bonds are exposed to interest rate risk. So, on the part of the buyers and
sellers of bonds it is essential to understand the fundamentals of bonds how to price, analyze, and manage
them.

Theorems of Bond Pricing

Being fixed income securities bonds are issued with a fixed rate of interest known as coupon rate. The
calculation of coupon rate is based on the face value and maturity of the bond. At the time of issuance,
the coupon rate seems to be equal to the prevailing market interest rate. Based on the market condition,
interest rate may change. If the current market interest rate is higher than the coupon rate of a bond, the
bond generates a lower return and becomes less attractive to the investors. Therefore, the price of the
bond declines below its face value. On the other hand, if the market interest rate declines below the
coupon rate, bond price will increase and the bond becomes popular and being sold at a premium on its
face value. Thus, the general assumption is that the bond prices vary inversely with changes in market
interest rates.
Burton G. Malkiel identified the relationship between bond prices and changes in market interest rates.
He stated five fundamental principles to relate bond prices and market interest rates which are known as
bond pricing theorems. These are discussed as:
1. Bond prices move inversely to market interest changes.
2. The variability in bond prices and term to maturity are positively related. For a given change in
the level of market interest rates, changes in the bond prices are greater for long-term maturities.
3. The sensitivity to changes in market interest rates increases at a diminishing rate as the time
remaining until the bonds maturity increases.
4. Absolute increases in market interest rates and subsequent bond price changes are not
symmetrical. For a given maturity, a decrease in market interest rate causes a price rise that is
larger than the price decline resulting from an equal increase in market interest rate.
5. Bond price volatility is related to its coupon rate. The percentage change in a bonds price due to
a change in the market interest rate will be smaller if its coupon rate is higher.
The amount of price variation necessary to adjust to a given change in interest rates is a function of the
number of years to maturity. In the case of long-maturity bond, a change in market interest rate results in
a relatively large price change when compared to a short-maturity bond. Long-term bond is more
sensitive to interest rate changes than short-term bond. This is why short-term bonds generally possess
less exposure to interest rate risk.

Bond Risk Analysis

As compare to other financial assets or securities fixed income securities are considered to be less risky.
Though they are less risky, are not entirely risk-free securities. Therefore, the investment in bonds is a
function of various types and sources of risk. The actual return from a bond may differ from the expected
return due to defalcation or changes in market interest rate. Both systematic and unsystematic risk can
influence the return from the investments in bond. However, the major risks involved in investments in
bond are default risk and interest rate risk.

58

Default risk: Default risk refers to the failureness of the company to repay principal and/or interest
thereon on the stipulated dates. Inefficient financial performance and management inefficacy lead to
default risk. Default risk arises due the nonpayment of whole or a part of interest and principal. I n such a
situation, investors in bonds suffer losses which reduce their return from bonds. Through credit rating
such risk can be identified and measured. Credit rating is a process of qualitative analysis of the
companys business and management and quantitative analysis of the companys financial performance.
Interest rate risk:
Since the price of a bond rarely moves in financial markets, the major income from the bond represents
the coupon interest rates. An investor in bond generally receives these interests annually or semiannually. Hence, the investors can reinvest their interest amounts at the prevailing market interest rate so
that interest on principal begets interest. An investor can do so, so long as he holds the security. Investor
can sell the bond off at a price which may be equal to the face value. During the holding period, market
interest rates may change. If the interest rate increases, the investor would be able to reinvest the annual
interest earned from the bond at a higher rate which will maximize the return. In addition to that bond
price will fall below its face value as the market interest rate moves up. Therefore, investor would suffer
a loss if he sells the bond. If the lose on sale exceeds the gain on reinvestment, investor will suffer a net
lose on account of the rise in market interest rate. In contrast, if the interest rate declines, opposite
dimension will exist. The investors have to reinvest the amount of interest at a lower than what was
expected. Since the market interest declines, the bond price will move above the face value because the
demand of that bond would become high as its rate of return is higher. Under these circumstances, the
investors would incur lose in reinvesting the interest while they will gain on selling the bond. Investors in
bond experience variations in expected rate of return because of the changes in the market interest rate.
This variability in return is termed as interest rate risk. Interest rate risk is the result of two components
like reinvestment of annual interest and the capital gains or losses on the sale of the bond at the end of the
holding period. When the market interest rises, there is the possibility of making gains from
reinvestments of interest but there may exist a lose on sale of the bond and vice versa. However,
reinvestment risk and price risk are the decompositions interest rate risk. Both reinvestment risk and price
risk have an opposite effect on the return of bond. Investor can eliminate interest rate risk by holding the
bond for its duration. If the holding period significantly differs from the duration of the bond, interest rate
risk will exist for the bond.

Term Structure of Interest Rates

The term structure of interest rate refers to the relationship between time to maturity and yields for a
particular category of bonds at a particular point in time. Particular theories are developed to explain the
nature of bond yields over time. The following theories are vital in this regard.
Expectations Theory: Expectations theory of term structure of interest rates states that market
participants and the market force as well will determine the return from holding a security where the
return from holding an n-period bond equals the average return expected from holding a series of oneyear bonds over the same n-periods. The long-term rate of interest would be equal to an average of the
present yield on short-term bond plus the expected future yields on short-term bonds which are expected
to prevail over the long-term period. For each period, the total rate of return is expected to be the same on
all securities regardless of the time to maturity. The term structure of interest rate consists of a set of
forward rates and spot rate. Spot rate is the rate which is applicable today and the forward rates are
expected to prevail in the future. The rate of return an investor requires to invest is a function of three
factors as:
i. risk-free real rate of return,
ii. inflation and
iii. risk premium.
More specifically,
E(r) = risk-free rate + inflation + risk premium
The rate of return for the n th year bond can be estimated by using the following formula:
(1 + trn) = [(1 + t r 1 ) (1 + t + 1 r 1) - - - - - (1 + t + n-1 r 1)] 1/n 1
where,

59

(1 + trn) = the rate of return on a n-year bond,

(1 + t r 1 ) = current rate on a one-year bond,
(1 + t + 1 r 1) = the expected rate on a bond with one-year to maturity beginning one-year from
now,
(1 +

t + n-1

r 1) = the expected rate on a bond with one-year to maturity beginning n 1-year from

now,
n = bond maturity period.
The formula is applicable for any number of periods. Any long-term rate is geometric average of
consecutive one-period rate.
Let us consider an example. Suppose one-year bond rate is 10 per cent and two forward rates are 11 per
cent and 12 per cent. Find out the three-year bond.
This problem can be solved by using geometric average of the current one-year rate and the expected
forward rates for the subsequent two years as follows:
(1 + tr3) = [(1 + t r1 ) (1 + t + 1 r 1) (1 + t + 2 r 1)] 1/3 1.0
= [(1.10)(1.11)(1.12)] 1/3 1.0
= [1.3675] 1/3 1.0 = 1.11 1.0 = 0.11 = 11%
Liquidity Preference Theory: Liquidity preference theory assets that as in the expectations theory,
interest rates reflect the sum of current and expected short rates plus liquidity premium. Because of the
uncertainty in future, investors prefer to invest in short-term bonds. On the other hand, borrowers prefer
long-term to invest in capital assets. Under these circumstances, investors are supposed to receive a
liquidity premium to invest in long-term bonds. Therefore, this theory implies that long-term bonds
should offer higher yields.
Preferred Habital Theory: The difference between the expectations theory and liquidity preference
theory is the recognition that future interest rate expectations are uncertain. To compensate this
uncertainty, risk-averse investors would like a higher rate for long-term bonds. Being third theory of term
structure of interest rates, preferred habital theory assets that investors usually prefer maturity sectors or
habits. A financial institution with many five-year maturity deposits to pay off will not wish to take the
reinvestment rate risk that would result from investing in one-year Treasury bills. This theory means that
the borrowers and lenders can be induced to shift maturities if they are adequately compensated by an
appropriate risk premium.

Bond Yields and Prices

Bond returns can be calculated in many ways though they are prefixed. The followings are general
expressions of bond returns which are usually found in the securities markets.
Coupon Rate
It is the fixed annual interest rate affixed on the face of the bond and is calculated on the face value. It is
the fixed rate of return at which income is payable to the bondholder. Suppose a bond of face value of Tk.
500 with 15 per cent coupon rate will generate Tk. 75 to bondholder annually till maturity.
Current Yield
Since a bond can be sold before maturity, it might be performed in the prevailing market price. The
current market price of a bond in the secondary market may differ from its face value. Current yield is the
ratio of annual interest receivable on a bond and its current market price which can be shown
mathematically as:
Current yield = I n/P0
where,
In = amount of annual interest
P0 = current market price of the bond
Current yield can be expressed in percentage term by multiplying the ratio by 100 as:
Current yield (per cent) = [I n/P0] 100
In the earlier example, if the current market price of the bond is Tk. 490, the current yield would become:
Current yield = [I n/P0] 100
= [75/490] 100 = 15.31 per cent

60

The properties of current yield are: the lower the selling price of the bond the higher the current yield and
higher the market price the lower the current yield. It implies that there is an adverse relationship
between current market price of a bond and its current yield. On the other hand, if the current yield of the
bond is lower than the coupon rate, the bond is selling at a premium and vise versa. The current yield
measures the annual return to a bondholder who purchases the bond from the secondary market and sells
before maturity at the same price at which it was bought. It does not measure the entire returns from a
bond held till maturity.
Spot Interest Rate
A zero coupon bond is a bond which is sold with no coupons, no interest to be paid during the life of the
bond and is redeemed for face value at maturity. It is a special type of bond paying no annual interest.
Therefore, the return on this bond represents a discount on issue of the bond. As for example a two-year
bond with a face value of Tk. 1000 may be issued for Tk. 800 at discount. The investor purchasing the
bond at Tk. 800 will receive Tk. 1000 after two years from now. This type of bond is called pure discount
bond. The return received from a zero coupon bond expressed on an annualized basis is called spot
interest rate. Hence, spot interest rate represents the annual rate of return on a bond having only one cash
inflow. It can be expressed as the discount rate that equates the redemption value to the discounted value
at which the investor purchased it. Thus, the spot interest rate of a two-year bond of face value Tk. 1000
issued at a discount for Tk. 800 can be estimated as:
800 = 1000/(1 + k) 2
(1 + k)2 = 1000/800
(1 + k)2 = 1.25
(1 + k) = 1.25 = 1.1180
Therefore,
k = 1.1180 1 = .1180 = 11.80 per cent
A zero coupon bond with a face value of Tk. 1000 with a maturity period of three years is issued at
discount for Tk. 700. The spot interest rate can be shown as below:
700 = 1000/(1 + k) 3
(1 + k)3 = 1000/700
(1 + k)3 = 1.4286
(1 + k) = 31.4286 = 1.1263
Therefore,
k = 1.1263 1 = .1263 = 12.63 per cent
The spot interest rate depends on the life of the bond and the difference between the face value and
discounted value of the bond.
Yield to Maturity
Yield to maturity (YTM) is most widely used measure of return on bond. It is the compounded rate of
return an investor expects to receive from a bond purchased at current market price which he holds till
maturity. On the other hand, it may be termed as internal rate of return or discount rate that makes the
present value of all the futures cash inflows from the bond equal to the purchase price of the bond. The
relationship among the cash outflow, the cash inflow, and the YTM of a bond can be expressed as:
n

PM = [Ct / (1 + YTM)t + TV / (1 + YTM)n]

t=1

where,
PM = market price of the bond,
Ct = cash inflow from the bond during the whole life of the bond,
YTM = yield to maturity,
TV = terminal value of the bond,
n = total maturity period of the bond.
Hence, it is possible to estimate the YTM equating both the sides of the equation by trial and error
method. Let us consider a bond with a face value of Tk. 1000 having 15 per cent coupon rate which will
mature at par. Five years maturity bond can be purchased at Tk. 800 in the market. The YTM of the said
bond can be determined as under:
The relationship among the cash outflow, the cash inflow, and the YTM of a bond can be expressed as:
n

61

PM = [Ct / (1 + YTM)t + TV / (1 + YTM)n]

t=1
5

800 = [150 / (1 + YTM)t + 1000 / (1 + YTM)5]

t=1

Since the market price is lower than the face value, the YTM would be higher than the coupon interest
rate. This can be estimated by trial and error method. Firstly, we may consider 20 per cent as YTM. Then
the right hand side of the equation becomes[150/(1 + .20)1 +150/(1 + .20)2 +150/(1 + .20)3 +150/(1 + .20)4 +
150/(1 + .20)5] + [1000/(1 + .20)5
= [125 + 104.17 + 86.81 + 72.34 + 60.28] + [401.88]
= 448.60 + 401.88 = 850.48
Since the estimated value Tk. 850.48 is higher than the desired value Tk. 800, we should try again by a
higher discount rate. Taking 25 per cent as YTM, the right hand side of the equation would become[150/(1 + .25)1 +150/(1 + .25)2 +150/(1 + .25)3 +150/(1 + .25)4 +
150/(1 + .25)5] + [1000/(1 + .25)5
= [120 + 96 + 76.80 + 61.44 + 49.15] + [327.68]
= 403.39 + 327.68 = 731.07
This value is lower than our desired value Tk. 800. Hence, desired YTM lies between 20 per cent and 25
per cent. It can be estimated by using interpolation as shown below:
YTM = Lower YTM + [(Value at lower YTM Desired Value) / (Value at lower YTM Value
at higher YTM)] (Higher YTM Lower TYM)
= 20 + [(850.48 800)/(850.48 731.07)](2520)
= 20 + (0.4227)(5) = 20 + 2.1135 = 22.11 per cent.
Alternatively, the present values of the future cash inflows can be estimated by using present value tables
like:
Tk. 150 (present value annuity factor for 5 yrs., 20%) + Tk. 1000 (present value factor for 5
yrs., 20%)
= (150 2.9906) + (1000 0.4019) = 448.59 + 401.90 = 850.49
Again,
Tk. 150 (present value annuity factor for 5 yrs., 25%) + Tk. 1000 (present value factor for 5
yrs., 25%)
= (150 2.689) + (1000 0.328) = 403.35 + 328 = 731.35
Therefore,
YTM = 20 + [(850.49 800)/(850.49 731.35)](2520)
= 20 + (0.4238)(5) = 20 + 2.119 = 22.12 per cent.
Yield to Call
At the option of the issuer or of the investor, some bonds may be redeemable before their maturity
period. If such option is executed, the subject bond would be called for redemption at the specific call
price on the specified call date. For bonds likely to be called, the yield to maturity calculation is
unrealistic. Hence, the better calculation here is termed as yield to call (YTC). The end of the deferred
call period, when a bond can first be called, is often used for the yield-to-call calculation. This is
appropriate for the bonds selling at a premium. In case of redeemable bond, two yields are to be
calculated as:
a) Yield to maturity: It asserts that the bond will be redeemed only at the end of full maturity
period.
b) Yield to call: It implies that the bond will be redeemed at the call date before the full maturity.
Yield-to-call is the discount rate that makes the present value of cash inflows to call equal to the bonds
current market price.

62

Let us consider an example. A bond with a face value of Tk. 100 having 15 per cent coupon rate will
mature at par in 15 years. The bond is callable in 5 years at Tk. 115. It currently sells for Tk. 105 in the
market. The YTC of the said bond can be determined as under:
The relationship among the cash outflow, the cash inflow, and the YTC of a bond can be expressed as:
n

PM = [Ct / (1 + YTC)t + TV / (1 + YTC)n]

t=1

By putting the values, we have

5

105 = [15 / (1 + YTC)t + 115 / (1 + YTC)5]

t=1

We have to find the value of YTC that makes the right hand side of the equation equal to Tk. 105. This
can be done by trial and error method. Since the market price is lower than the face value, the YTC
would be higher than the coupon interest rate. Firstly, we may consider 15 per cent as YTC. Then the
right hand side of the equation becomes[15/(1+.15)1+15/(1+.15)2+15/(1+.15)3+15/(1+.15)4+15/(1+.15)5]+
[115/(1+.15)5]
= [13.04 + 11.34 + 9.86 + 8.58 + 7.46] + [57.17]
= 50.28 + 57.17 = 107.45
Since the estimated value, Tk. 107.45 is higher than the desired value, Tk. 105; we should try again by a
higher discount rate. Taking 18 per cent as YTC, the right hand side of the equation would become[15/(1+.18)1+15/(1+.18)2+15/(1+.18)3+15/(1+.18)4+15/(1+.18)5]+
[115/(1+.18)5]
= [12.71 + 10.77 + 9.13 + 7.74 + 6.56] + [50.27]
= 46.91 + 50.27 = 97.18
This value is lower than our desired value, Tk. 105. Hence, desired YTC lies between 15 per cent and 18
per cent. It can be estimated by using interpolation as shown below:
YTC = Lower YTC + [(Value at lower YTC Desired Value) / (Value at lower
YTC
Value at higher YTC)] (Higher YTC Lower TYC)
= 15 + [(107.45 105)/(107.45 97.18)](1815)
= 15 + (0.2386)(3) = 15 + 0.7157 = 15.72 per cent.

Bond Duration
A bond will face interest rate risk if holding period differs from duration. For any bond there is a holding
period at which the effect of reinvestment risk and price risk balances each other. The lose on
reinvestment of interest can be compensated by a capital gain on the sale of the bond and vice versa. For
this holding period there is no interest rate risk. The holding period at which interest rate risk disappears
is called the duration of the bond. Thus, the duration of bond is required time period at which the price
risk and the reinvestment risk of a bond are of equal magnitude but opposite in direction. Therefore, the
bond duration is the weighted average life of the bond. The various time periods at which the bond
generates returns are weighted according to the respective size of the present value of these returns. The
formula for calculating bond duration can be expressed as:
d = [1{I1/(1+k)1}+2{I2/(1+k)2}+3{I3/(1+k)3}+ - - - - - - - + n (In+MV)/(1+k)n] / P0
This equation requires discounting the series of cash flows, which are multiplied by the time period in
which they occur. The sum of these cash flows is divided by the price of the bond obtained by using
present value model. However, the above formula can be expressed in a more general format as:
n

d = [(t)(C t)/(1+k)t] / Ct/(1+k)t]

t=1

t=1

where,
d = bond duration,
Ct = annual cash flow both interest and principal amount,
k = discount rate which is the proxy of market interest rater,

63

t = time period of each cash flow and

n = number of period.
Let us consider an example. A 5-year bond having 15 per cent coupon rate was issued at a premium of 5
per cent 3 years ago. The prevailing interest rate in the market is 18 per cent. The calculation of the bond
duration can be summarized as:
Assume that the face value of the bond is Tk. 100.
Year
Cash flow PV factor Present value PV multiplied by
(Ct)
@ 18 %
(PV)
years
1
15
0.8475
12.7125
12.7125
2
15
0.7182
10.7730
21.5460
3
15
0.6086
9.1290
27.3870
4
15
0.5158
7.7370
30.9480
5
15
0.4371
6.5565
32.7825
5
105
0.4371
45.8955
229.4775
92.8035
354.8535
n

Bond duration (d) d = [(t)(Ct)/(1+k)t] / Ct/(1+k)t]

t=1

t=1

= 354.8535/92.8035 = 3.82 years

The duration of the 5-year maturity bond is 3.82 years. If the bond is held for 3.82 years, the interest rate
risk can be eliminated. The impact of reinvestment risk and price risk would offset each other to reduce
the interest rate risk to zero.

Bond Volatility
Bond volatility is the absolute value of the percentage change in the bond price for a given change in
yield to maturity. If we divide the percentage change in price by the percentage change in yield to
maturity, we simply get bond volatility. Therefore, bond volatility can be expressed by applying the
following formula:
Bond volatility = [P/P]/ r
where,
P/P = percentage change in price
r = percentage change in yield to maturity
To understand bond volatility, let us take an example. Suppose interest rate increases from 10 per cent to
12 per cent and price changes from Tk. 100 to Tk. 90. Thus, bond volatility can be expressed as:
Bond volatility = [P/P]/ r
= [100-90/100]/(12-10)
= 10 %/ 2% = 5

Equity Markets
Introduction
After discussing the fixed income securities in the preceding chapter, it is essential to evaluate and
analyze equity securities. Valuation of common stocks is easier to describe because they do not have the
many technical features like fixed income securities. Fundamental analysis asserts that the intrinsic value
of each share depends upon the returns that an investor receives in future from investing in the share in
the form of dividends and capital appreciation. The decision to buy or sell shares is based on a
comparison between the intrinsic value of a share and price currently prevails in the market. If the market
price of a share exceeds its intrinsic or investment value, the share is suggested to be sold because it is
perceived to be overpriced and vice-versa. Specialists believe that the market price of a share is the
reflection of its investment value. Though the market price of a share may differ from intrinsic value in
the short-run, the price would move along with the investment value of the share in the long-run.
Therefore, the investment value called intrinsic value and the market value of shares are the ingredients
of investment decisions making in the securities markets. The intrinsic value is determined by a process
of common stock valuation.

64

The Basic Valuation Model

The general principle of valuation also applies to share or stock valuation. The value of a share today is a
function of the cash inflows expected by the investors and the risk associated with the cash inflows. The
cash inflows expected from an equity share will consist of the dividend expected to be received by the
owner while holding the share and the price which he expected to obtain when the share is sold. The
price which the owner is expected to receive when the share is sold will include the original investment
plus a capital gain. It is normally found that a shareholder does not hold the share in perpetuity. He holds
the share for some times, receives the dividends, and finally sells it to obtain capital gains. But when he
sells the share, the buyer is also simply purchasing a stream of future dividends and liquidating price
when he sells the share. The logic can be extended further. The ultimate conclusion is that, for
shareholders in general, the expected cash inflows consist only of future dividends and, therefore, the
value of a common stock is determined by capitalizing the future dividend stream discounted by an
appropriate discount rate known as investors required rate of return. Thus, the value of a share is the
present value of its future stream of dividends. The formula for calculating the present value is given as
below:
P0 = D1/(1 + k) + P1/(1+k)
where,
P0 = price per share today,
D1= dividend per share at the end of first year,
P1= price per share at the end of first year,
k = investors required rate of return.
It a buyer wishes to hold a share for three years and then sell after purchasing it for P1 at the end of first
year, the value of the same to him today will be:
P1/(1+k) = D2/(1 + k)2 + D3/(1 + k)3 + D4/(1 + k)4 + P4/(1 + k)4
The price at the end of the fourth year and all future prices are determined in a similar manner. The
general formula for determining the value of the share at the present time can be written as follows:
P0 = D1/(1 + k) + D2/(1 + k)2 + D3/(1 + k)3 + . + Dn/(1 + k)n
n

= Dt/(1 + k)t
t=1

It is obvious from the above equation that the present value of the share is equal to the capitalized value
of an infinite stream of dividends. It should be noticed here that D t in the equation are expected
dividends. In fact investors estimate the dividends per share likely to be paid by the company in future
period if time. These estimates are based on their subjective probability distributions Thus, The D t are
expected values or means of these probability distributions. Obviously, the present value of future sums
would be lower than those future sums.
Common Stock Valuation
The fundamental concept of valuation of shares or stocks is that of present value. A study of present
value concept is a sine-qua-non for the evaluation process. Time value of money states that money today
is more desirable than those in future. Fundamental security analysis suggests two basic approaches to
the valuation of common stock as given below:
1. Present value or income capitalization approach: Commonly known as capitalization of
income method, the present value approach is similar to the discounting process. The future cash inflows
generated from holding of common stock are discounted to the present value at an appropriate discount
rate some times referred to as investors required rate of return.
2. Price-earning (P/E) ratio or multiplier approach: The price-earning (P/E) ratio approach is
termed as the earnings multiplier approach. A stock is said to be worth some multiple of its future
earnings. It implies that an investor or an analyst determines the value of a stock by deciding how much
money he is willing to pay for every unit of money of estimated earnings.
Present Value Approach

65

The fundamental analysis suggests that the classic method of estimating intrinsic value involves the
present value concept. Under this method, the value of a share can be determined by a present value
process involving the capitalization of expected future cash inflows. Therefore, the intrinsic value of a
share is equal to the sum of the discounted values of the future stream of cash inflows an investor expects
to receive from the share which can be determined as:
n

P0 = FCFt/(1 + k)t
t=1

where,
P0 = price of a share today (present value),
FCFt = free-cash-inflows at time t and
k = investors required rate of return called appropriate discount rate.
The prerequisites to use this model are:
i. Required rate of return: An appropriate discount rate is proxy of investors required rate of
return. An investor willing to purchase a share must assess the risk that commensurates the expected
return. At a given level of risk, an expected rate of return is minimum rate of return that will be required
to induce the investor to invest. It is also considered as the investors opportunity cost.
ii. Expected cash flows: Amount and the timing of the future stream of cash inflows called freecash-flows are very important in determining the value of a share. The value of a bond is the present
value of any interest payments plus the present value of the bonds face value that will be received at
maturity. Likewise the value of a share is the present value of all cash flows to be received from the
issuer. The stream of cash flows from holding a share consists of the cash dividends received and the
future price at which the share can be sold.
iii. Dividend discount model: It uses the present value model to determine the value of a share.
As cash dividends are the cash payments a shareholder receives from a firm, they constitute the
foundation of valuation for common stock. Dividend discount model (DDM) asserts that the current price
of a share is equal to the discounted value of all future dividends received by the investors. The value of a
share as asserted by DDM can be estimated by the following formula:
Pcs = D1/(1 + kcs) + D2/(1 + kcs)2 + D3/(1 + kcs)3 + . + D/(1 + kcs)

= Dt/(1 + kcs)t
t=1

where,
Pcs = intrinsic value of a common stock
kcs = discount rate, investors required rate of return or opportunity cost.
D1, D2, , D = annual dividends expected to be received each year.
To use the DDM for share valuation, the investor has to forecast the future dividends during the holding
period. It is not possible on the part of the investor to forecast the expected dividends accurately. This is
why modifications of DDM have been developed to render it useful for the valuation of share.
As in case of most of the shares, the amount of dividends grows because of the growth of earnings of a
company; this phenomenon should be taken into consideration for the valuation purpose. Therefore, the
growth rate pattern of dividends should be considered. Different assumptions regarding the growth rate
patterns should be made and incorporated into the valuation model. The assumptions which are
commonly used are:
1. Dividends will not grow at all in future, i.e. the zero growth assumption,
2. Dividends will grow at a constant rate in future, i.e. the constant growth assumption,
3. Dividends will grow at varying rate in future, i.e. the multiple growth assumption.
These assumptions regarding the growth patterns of dividends in future give rise three individual versions
of the present value model of share valuation like: a) Zero-growth model, b) Constant-growth model and
c) Multiple-growth model.
Zero-Growth Model

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Zero-growth model asserts that dividends will not grow over time. The current dividend shall be
remained unchanged. A certain amount of dividend equal to the current dividend being paid, to be paid
every year from now to infinity. This pattern of dividend payment is referred to as the no-growth rate or
zero-growth model. Under this model, the value of the share would be determined as:
P0 = D0/(1 + k)1 + D0/(1 + k)2 + D0/(1 + k)3 + . + D0/(1 + k)
In short,
P0 = D0 / kcs
where,
P0 = price of share,
D0 = constant dividend expected for all future time periods,
kcs = required rate of return or opportunity cost.
The value of share with no-growth version is easy to calculate because like a preferred stock the dividend
remains unchanged. Thus, zero-growth common stock is perpetuity and is easily valued given the
required rate of return or investors opportunity cost.
Let us take an example. An investor expects to receive Tk. 10, Tk. 12 and Tk. 15 as dividend from a share
during the next three years and hopes to sell it off at Tk. 120 at the end of third year. If his required rate
of return is 15 per cent, intrinsic value of the share can be estimated as:
P0 = D1/(1 + k)1 + D2/(1 + k)2 + D3/(1 + k)3 + S3/(1 + k)3
= 10/(1 + .15)1 + 12/(1 + .15)2 + 15/(1 + .15)3 + 120/(1 + .15)3
= 10/1.15 + 12/ 1.3225 + 15/ 1.5209 + 120/1.5209
= 8.70 + 9.07 + 9.86 + 78.90 = Tk. 106.53
Constant-Growth Model
The constant-growth model is originated by Myron J. Gordon. This is why this model is known as
Gordons share valuation model. In this model, it is assumed that dividends will grow at the same rate
upto infinite future and that the investors required rate of return would be greater than the dividend
growth rate. It is necessary to compound some beginning dividend into the future. The higher the growth
rate, the higher the value of the share; the higher the required rate of return, the lower the value of the
share; the longer the time period, the higher the value of the share and vice-versa. By applying the growth
rate (g) to the current dividend (D 0), the dividend expected to be received after one year (D 1) can be
determined as:
D1 = D0(1 + g)1
The expected dividend of any year thereafter can be determined from the current dividend as:
D2 = D0(1 + g)2 = D1(1 + g)
D3 = D0(1 + g)3 = D2(1 + g)
D4 = D0(1 + g)4 = D3(1 + g)
D10 = D0(1 + g)10 = D9(1 + g)
Dn = D0(1 + g)n = Dn1(1 + g)
The present value model for share valuation can, therefore, be written when the future dividends are
expected to grow at a constant rate over time as follows:
Pcs = [D0(1+g)/(1+kcs)] + [D0(1+g)2/(1+kcs)2] + . + [D0(1+g)n/(1+kcs)n]
When the holding period, n, approaches infinity, the above formula can be simplified as:
P0 = D1 / (kg)
= D0 (1 + g) / (kg)
Thus, the intrinsic value of a share is equal to the next years expected dividend divided by the difference
between the investors required rate of return and its expected dividend growth rate.
Let us consider some examples.
Example-01: An investor expects to get Tk. 10, Tk. 12 and Tk. 15 as dividend from a share during the
next three years. The share is expected to be sold at Tk. 100 at the end of the third year. If the investors
required rate of return is 10 per cent, the value of the share would be:
P0 = D1/(1 + k)1 + D2/(1 + k)2 + D3/(1 + k)3 + S3/(1 + k)3
= 10/(1 + .10)1 + 12/(1 + .10)2 + 15/(1 + .10)3 + 100/(1 + .10)3
= 9.09 + 9.92 + 11.27 + 75.13 = Tk. 105.41

67

Example-02: Jahan Corporation is currently paying Tk. 10 per share as cash dividends and expects it to
grow at 10 per cent a year for the foreseeable future. If the investors required rate of return is 15 per
cent, the price of Jahans share can be estimated as:

P0 = D1 / (kg)
= D0 (1 + g) / (kg)
= 10 (1 + .10) / (.15 .10) = 10(1.10)/.05 = Tk. 220
If the investors required rate of return is 12 per cent with other variables held constant, the price of
Jahans share can be estimated as:
P0 = D1 / (kg)
= D0 (1 + g) / (kg)
= 10 (1 + .10) / (.12 .10) = 10(1.10)/.02 = Tk. 550
When the required rate of return declines with other variables held constant, the price of the share
increases.
If the investors required rate of return is 18 per cent with other variables held constant, the price of
Jahans share can be estimated as:
P0 = D1 / (kg)
= D0 (1 + g) / (kg)
= 10 (1 + .10) / (.18 .10) = 10(1.10)/.08 = Tk. 137.50
When the required rate of return increases with other variables held constant, the price of the share
decreases.
If the dividend growth rate is 12 per cent with other variables held constant, the price of Jahans share can
be estimated as:
P0 = D1 / (kg)
= D0 (1 + g) / (kg)
= 10 (1 + .12) / (.15 .12) = 10(1.12)/.03 = Tk. 373.33
When the growth rate of dividend increases return increases with other variables held constant, the price
of the share increases.
If the dividend growth rate is 8 per cent with other variables held constant, the price of Jahans share can
be estimated as:
P0 = D1 / (kg)
= D0 (1 + g) / (kg)
= 10 (1 + .08) / (.15 .08) = 10(1.08)/.07 = Tk. 154.29
When the growth rate of dividend decreases with other variables held constant, the price of the share
decreases. These examples suggest that the share price constantly fluctuates depending upon the
variables. If investors use the constant-growth version of dividend discount model to estimate the value
of a share, a different price will be obtained because of the influence of the variables. However, the
constant-growth model may not become realistic in different situations. The growth of dividends may
vary depending upon the varying situation of the company and the economy as well.
Example-03: Jahan corporation is currently paying a dividend of Tk. 10 per share as dividend and it
expects dividend to grow at 8 per cent a year for the foreseeable future. If the investors required rate of
return is 15 per cent, the intrinsic value of Jahans share will be calculated by the method described
below:
P0 = D1/ (kg)
= D0(1+g)/(kg)
= 10(1.08) /(15.08)
= 10.8/.07 = Tk. 154.29
Multiple-Growth Model

68

The financial position of many companies may be that a period of extraordinary growth will prevail for a
certain number of years, after which the dividend growth rate shall become changed to a level at which it
is expected to continue indefinitely. The constant-growth model is unable to deal with these situations.
This pattern of dividend can be presented by a two-stage growth model. Such a variation of the DDM is
termed as the multiple-growth model. More specifically, a multiple-growth model can be defined as a
situation in which the expected future growth of dividends shall be shown by two or more growth rates.
The basic characteristic of multiple-growth model is that although two or more growth rates of dividends
are to be described in the multiple-growth model, at least two different growth rates are involved. Under
thus circumstances, the value of a share should be the sum of the present values of two dividend flows.
One is the dividends received from period 1 to N and the other refers to the dividends received from N+1
to infinity. Sum of the total present values represents the intrinsic value or the price of the share. For our
understanding we can divide the period into two parts called first phase and second phase. The growth
rates of dividends during the first phase may vary over time. The expected dividends for each year during
the first phase can be forecasted individually irrespecting the constant-growth or varying growth rates of
dividends during the first phase. Therefore, multiple-year holding period valuation model can be used for
the first phase, using expected dividends for each year by the following formula:
P0 = D1/(1 + k)1 + D2/(1 + k)2 + + DN/(1 + k)N
N

= Dt/(1 + k)t
t=1

Since the growth of dividends is assumed to be constant during the second phase at another growth rate,
the present value of this phase would be based on the constant-growth model of DDM. After period N,
the investor would enter into the next year at which the second phase will commence. So, after period N,
the expected stream of dividends for time periods N+1, N+2, N+3 and so on which will grow at an
another constant rate, would be considered. The expected dividends after period N can, therefore, be
calculated as:
DN+1 = DN(1 + g)1
DN+2 = DN(1 + g)2
DN+3 = DN(1 + g)3
and so on to infinity.
Gordon share valuation model, therefore, can be applied to estimate the present value of the second phase
stream of dividends at time N commencing from period N+1 to infinity as:
Pn = DN(1 + g)/(k-g)
= DN+1/(k-g)
The value of the share as estimated is assumed to be the present value at time N Not today. If this value is
to be considered at time zero, it must be discounted by the required rate of return (1+k) to estimate the
present value at time zero for the second phase of dividend streams. The discounted value of the second
phase streams of dividend can be obtained as:
P0 = DN+1/(k-g)(1+k)N
The present values of two phases estimated above may be added to provide the intrinsic value of the
share having a two-stage growth of dividends as under:
N

P0 = [Dt/(1 + k)t ] + [DN+1/(kg)(1+k)N]

t =1

From the discussion and expression given above, a well-know multiple-growth model may be assumed to
be a two-period model. This model assumes near-term growth at a rapid rate for some period followed by
a suitable steady growth rate. This can be expressed by the following equation:
N

P0 = [D0(1+ g1)t/(1 + k)t ] + [DN(1+ gc)/(kgc)(1+k)N]

t =1

where,
P0 = estimated value of share today,
D0 = current dividend,
g1 = growth rate of dividend at first phase,

69

gc = constant-growth rate of dividend at second phase,

k = investors required rate of return
DN = dividend at the end of the first phase
N = number of period after which second phase will start.
Let us consider some examples.
Example-01: A company is currently pays a dividend of Tk. 10 per share and expects to pay a dividend of
Tk. 11 per share during the next year. Also investors expect a dividend of Tk. 12 and Tk. 15 per share
respectively during the two subsequent years. After that (year of receiving dividend of Tk. 15) investors
expect that annual dividend will grow at 15 per cent a year upto infinity. If the investors required rate of
return is 20 per cent, the intrinsic value of share of that company will be calculated by the method
described below:
The expected dividends for each year during the first phase are given. Therefore, the following multipleyear holding period valuation model can be used to estimate the present value of the share for the first
phase:
V1 = D1/(1 + k)1 + D2/(1 + k)2 + D3/(1 + k)3 + D4/(1 + k)4
= 11/(1 + .20)1 + 12/(1 + .20)2 + 15/(1 + .20)3
= 9.17 + 8.33 + 8.68 = 26.18
By using the constant-growth model of DDM, the present value of second phase at time zero of dividends
receivable from fourth year to infinity can be estimated as:
V2 = DN(1+ g)/(kg)(1+k)N
= 15 (1+.15)/(.20 .15)(1 + .20)3
= 17.25/(.05)(1.728) = 17.25/.0864 = 199.65
Therefore, the intrinsic value of the share is sum of the two present values as given below:
P0 = V1 + V2
= 26.18 + 199.65 = Tk. 225.83
Example-02: Suppose a corporation currently pays a dividend of Tk. 10 per share and expects it to grow
at 12 per cent a year for next five years at the end of which the new growth rate is expected to be a
constant 8 per cent a year for the foreseeable future. If the investors required rate of return is 15 per cent,
the intrinsic value of the share will be calculated by the method described below:
Solution: The first step in the valuation process devotes to determine the amount of dividends of every
year of supernormal growth in the following way:
The compound of beginning dividend (D0) at supernormal growth rate, 12 per cent for each of the five
years as follows:
D0 = Tk. 10
D1 = D0(1 + g1)1 = Tk. 10(1 + .12)1 = Tk. 11.20
D2 = D0(1 + g1)2 = Tk. 10(1 + .12)2 = Tk. 12.54
D3 = D0(1 + g1)3 = Tk. 10(1 + .12)3 = Tk. 14.05
D4 = D0(1 + g1)4 = Tk. 10(1 + .12)4 = Tk. 15.74
D5 = D0(1 + g1)5 = Tk. 10(1 + .12)5 = Tk. 17.62
Now, the present values of the dividends are estimated by discounting with the required rate of return, 15
per cent, as:
Present value of D1 = Tk. 11.20(.869) = Tk. 9.73
D2 = Tk. 12.54(.756) = Tk. 9.48
D3 = Tk. 14.05(.658) = Tk. 9.24
D4 = Tk. 15.74(.572) = Tk. 9.00
D5 = Tk. 17.62(.497) = Tk. 8.76
=============================
Total present value of D1 to D5 = Tk. 46.21
Sum of the discounted dividends produces the value of the share for its five years only. To evaluate the
dividends from year six to infinity, the constant-growth model, therefore, can be used. After the end of

70

year five the company will enter into year six. The value of the share at the start of year six can be
estimated by using the following model:
PN = DN+1/(kgc)
where,
DN+1 = D5+1 = D6 = D5 (1+ gc) = Tk. 17.62(1.08) = Tk. 19.03
Therefore,
PN = 19.03/(.15.08) = 19.03/.08 = Tk. 271.86
Thus, Tk. 271.86 is the price of the share which would be received at the beginning of year six (the end
of year five). This value is also to be discounted to get the present value of the share using the present
value factor for five years at 15 percent as under:
Discounted value of PN = PN(PV factor for 5 yrs, 15%)
= Tk. 271.86 (.497) = Tk. 135.11
Adding together the two present values, we get the intrinsic value as:
Present value of the first years of dividends
= Tk. 46.21
Present value of the share at the end of year five = Tk. 135.11
==========
Present value of the share (P0)
= Tk. 181.32
Price-Earning (P/E) Ratio Approach
The ratio is the ratio of price per share to earning per share is commonly known as price-earning ratio.
Much of the real world discussion of stock market valuation concentrates on the firms price-earning
multiple. Earning multiplier approach states that the price of the stock is equal to the product of its
earnings and a multiplier. It implies that the price of a stock is the product of EPS and P/E multiplier of
that stock. Price-earning (P/E) ratio approach postulates that the current market price of a stock can be
determined as under:
P0 = E0P0/E0
Where E, being the estimated earnings for the next twelve months, refers to the earnings used to calculate
P/E ratio. Therefore;
P0 = Estimated earnings estimated P/E ratio
Determinants of P/E ratio
The constant-growth version of dividend discount model estimates the price of stock as follows:
P0 = D1 / (kg)
By dividing both the sides of the equation by expected earnings (E 1), we get:
P0/E1= [D1 / (kg)]/E1
P0/E1= P0/E1
P0= [P0/E1] E1
Therefore, the determinants of P/E ratio are;
i.
The dividend payout ratio, DPS/EPS
ii.
Investors required rate of return, k
iii.
The expected growth rate of dividend, g.
These can be discussed as:
The higher the payout ratio, the higher the P/E ratio
The higher the expected growth rate, the higher the P/E ratio
The higher the required rate of return, the lower the P/E ratio.
Suppose, payout ratio of a firm is .60. The required rate of return is 15 per cent with an expected growth
rate of 7 per cent. If the expected earnings of the firm for the next year is Tk.10, what would be the price
of the share of that firm.
P/E = [D1/E1]/kg
= .60/.15.07 = .60/.08 = 7.50
Therefore, the price for the stock is
P0 = [P/E] E1

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= 7.50 10 = Tk. 75
If the investors required rate of return, k, is 12 per cent and growth rate is being 7 per cent;
P/E = .60/.12.07 = .60/.05 = 12 and P0 = 1210 = Tk. 120.
If the investors required rate of return, k, is 18 per cent and growth rate is being 7 per cent;
P/E = .60/.18 .07 = .60/.11 = 5.45 and P0 = 5.45 10 = Tk. 54.50.
We can think of the value of the firm as the sum of the value of assets or the no-growth value of the firm
plus the net present value of the future investments, the firm will make. The present value is called
present value of growth opportunities, PVGO. Therefore, the value of the firm is:
P0 = No-growth value per share + PVGO
P0 = [E1/k] + PVGO
Now recall that the dividends represent the earnings which are not retained for reinvestment purpose. The
growth rate of dividends is, therefore, the ratio of earnings reinvested to book value of the firm like:
g = Reinvested earnings/ Book value
If earnings equal to the product of return on equity and book value (ROE book value), growth of
dividend would become:
g = [Reinvested earnings/ Book value] [Total earnings/ Book value]
g = [b ROE]
Hence, substituting for expected dividends (D 1) and growth of dividend (g) in the constant-growth
version of DDM, we find the value of the firm as:
P0 = E1(1b) / k (ROE b)
Implying the P/E ratio, we get
P0 / E1= (1b) / k (ROE b)
Assume that risk-free rate is 7 %, risk premium (r m rf) is also 5 %, and retention ratio is 40 %.
Therefore,
r m = rf + market risk premium = 7 % + 5% = 12%. For a company with beta () equals to 1,
the required rate of return of the firm, k, will become equal to 12%. The return on equity (ROE) of that
firm would also become equal to the expected return on the stock. Therefore, the growth of the firm
would become:
g = .12 .40 = .048 = 4.80%
P/E = (1.40) / (0.12 .048) = 8.33.
We may observe that one important implication of stock valuation model is that riskier stock will have
lower P/E multiples which can be expressed as:
P/E= (1b) / (kg).
Riskier firm will have higher required rate of return implying higher value of k, therefore, P/E multiple
will become lower.

Derivatives Markets
Introduction
Financial engineering can be defined as the development and creative application of financial techniques
for solving financial problems, exploiting investment opportunities, and to add value. Financial
transactions and investment activities particularly in securities as well involve uncertainty. Fluctuations
in the financial assets expose to risk. The investors particularly dealers are supposed to hedge risk
involved in their financial transactions. Hence, it is necessary for the investors, market makers and
financial management concerned to have basic understanding about proper risk management tools.
Financial derivatives are widely used tools in this regard. Financial derivatives can be defined as
instruments for hedging the risk involved in buying, holding, and selling different types of financial
assets like shares, stocks etc. Broadly speaking they refer to financial assets/instruments for the
management of risk arising from the uncertainty prevailing in the transactions of financial assets.
Financial derivatives are, therefore, evolved to hedge the risk while dealing in the financial assets. They
are commonly known as derivative securities since their values are derived from the underlying assets.
Finally, financial derivatives are designed help providing financial protection to participants in the
financial markets against adverse movements in the price of the underlying assets. They facilitate in
transactions of financial assets at or within a predetermined future date at the price determined today. The

72

values of the financial derivatives are derived from the performance of the financial assets, interest rates,
currency exchange rate, stock market indices, and what not.
A financial derivative can also be defined as a contract specifying the rights and obligations between the
issuer of financial derivatives and the holder thereof to receive or deliver future cash flows based on
some future events. Some derivatives are traded or transacted on organized stock exchanges which are
known as exchange-traded derivatives like options, warrants, futures. Other derivatives known as overthe-counter derivatives are not transacted in the organized stock exchange but are privately negotiated
between the parties. These types of derivatives are like the forwards.
Options
An option can be defined as the right to the holder, (but not the obligation) to buy or sell a given quantity
of an asset on or before a given date in future, at prices agreed upon today. Many corporate securities are
similar to the stock options that are traded on organized exchanges. Almost every issue of corporate
stocks and bonds has option features. In addition, capital structure and capital budgeting decisions can be
viewed in terms of options. Options are of two types: call options and put options.
Call options
Call options give the holder the right, but not the obligation, to buy a given quantity of some asset within
some time in the future called expiration date, at prices agreed upon today known striking price or
exercise price. When exercising a call option, investors call in the underlying asset.
Put options
Put options give the holder the right, but not the obligation, to sell a given quantity of an asset at some
time in the future, at prices agreed upon today. When exercising a put, investors put the asset to
someone.
There are two parties in an option contract. The investor getting the right to buy a specific number of
shares in case of call option is called buyer. On the other hand, the investor wishing to sell a specified
numbers of shares to the buyer of the option is referred to as seller. The option contract is initiated by the
seller of the option and the seller is called the writer of the option. Let us take an example: Suppose the
current market price of a share of a company is Tk. 200. A call option would give the right to buy the
share at a specified price of Tk. 210 during the next 3 months.
Some vocabularies
The will use exercise the option only if it is profitable, otherwise, the option can be thrown away.
Followings are the vocabulary associated with the option:
Strike price: The fixed price specified in the option contract at which the option holder can buy
or sell the underlying asset can be defined as strike or exercise price.
Exercising the option: The transaction regarding the buying or selling the underlying asset
according to the option contract is called the exercising the option.
Expiration date: The date on or before which the option can be exercised is called expiration
date.
American vs. European option: An option can be defined as American option if it may be
exercised anytime on or before the expiration date. A European option, on the other hand, can be defined
as one which may be exercised only on the expiration date.
Option Premium
The option premium is the amount called the value of the option paid by the buyer to by the option. Some
factors affect the premium of the option. A call option will yield profit to the option holder if the current
market price is greater than the exercise price. The following outcomes may occur:
In-the-Money
The exercise price is less than the spot price of the underlying asset i.e., the current market price is
greater than the exercise price.
At-the-Money
The exercise price is equal to the spot price of the underlying asset i.e., the current market price of the
stock is equal to the exercise of strike price.

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 Out-of-the-Money
The exercise price is more than the spot price of the underlying asset i.e., the current market price of the
stock is less than the exercise price.
Therefore, for a call option, the following terms are true:
If St > Ep, option is in the money
If St < Ep, option is out of the money
If St = Ep, option is at the money
C0 = Max [St - Ep, 0]
For put options:
If Ep > St, option is in the money
If Ep < St, option is out of the money
If Ep = St, option is at the money
Where,
St is the value of the stock at expiry (time t)
Ep is the exercise price.
C0 is the value of the call option at expiry
If a call option is in the money, it is exercised immediately and the option holder will earn profit. The
positive cash flow or the profit incurred to the option holder is known as the intrinsic value of the call.
Intrinsic Value
The difference between the exercise price of the option and the spot price of the underlying asset can
be termed as intrinsic value of the call.
Speculative Value
The difference between the option premium and the intrinsic value of the option can be termed as
speculative value of the call.
Option premium = Intrinsic value + Speculative value
Suppose, the exercise price of an option is Tk.200 and the market price of the share is Tk. 250. The call
option is in the money. If the owner of the option exercises it he/she will make a profit equivalent of Tk.
50 (Tk.250-Tk.200). If the market price of the share is Tk. 200, the call is at the money and the holder
would get no cash flow. On the other hand, if the market price of te share is less than Tk. 200, the option
is out of the money and the holder would experience a negative cash flow. Thus,
The intrinsic value of a call option = St - Ep,
if St is greater than Ep
=0
if S t is less than or equal to Ep
The above notions indicate that the intrinsic value of a call is always greater than zero or (S t > Ep).
One, who understands this, can become a financial engineer, tailoring the risk-return profile to meet the
clients needs. If we assume that the option expires at t, then the present value of the exercise price is:
Ep/(1 + rf)t
and the value of the call is:
C0 = S0 Ep/(1 + rf)t
It is obvious from the above equation that the option value depends on the following factors:
i. The stock price: The higher the stock price, the more the call is worth and vice-versa.
ii. Exercise price: The lower the exercise price, the more the call is worth and vice-versa.
iii. The time to expiration: The longer the time to expire is, the more the option is worth and viceversa.
v. The risk-free rate: The higher the risk-free rate is, the more the call is worth and vice-versa.
Call
Put
Stock price
+

Exercise price

+
Interest rate
+

Volatility in the stock price

+
+
Expiration date
+
+
The value of a call option C0 must fall within max (S0 Ep, 0) < C0 < S0.
The precise position will depend on these factors: market value, time value and intrinsic value for an
American call.
The premium of an option is the function of intrinsic value and time value. The time value of an option is
the excess of the premium over the intrinsic value. Consider an example: the premium for a call option
with strike price of Tk.200 is Tk.20. If the current market price of the share underlying the call is Tk.
215, the call option is in the money. The intrinsic value of the call is Tk. 15 (Tk. 215 Tk. 200). The

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premium quoted being Tk. 10, the excess of the premium over the intrinsic value Tk. 5 (Tk. 15Tk. 10) is
the time value of the call option. A call at the money or out of the money has no intrinsic value having
only the time value and the entire premium represents the time value.
Let us consider a case: Suppose the exercise price of an option is Tk. 200 with a premium of Tk. 10. If
the price of the share rises above Tk. 210 (Tk. 200 + Tk. 10) at any time before the expiration date, the
option holder can exercise the option to buy share at Tk. 200 and the seller is obligated to make the share
available to the option holder at the exercise price (Tk. 200). Assume that the current market price of the
share is Tk.250. The call option holder can make a profit by buying the share at Tk. 200 equal to Tk. 50
(Tk.250Tk.200) with a net profit of Tk. 40 (Tk.50Tk.10).
Other Options
Call provision on a bond: A call provision provides the issuer the right, but not the obligation to
repurchase the bond at a specified price.
Put bonds: The owner of a put bond has the right to force the issuer to repurchase the bond for a fixed
price for a fixed period of time.
Green Shoe provision: The right of the underwriter to purchase additional shares from the issuer at the
offer price in an IPO.
Insurance: Insurance obligates the insurer (option writer) to purchase the underlying asset at a
specified price for a specified period (the term of the policy).
Stocks and Bonds as Options
Levered Equity is a call option.
The underlying assets comprise the assets of the firm.
The strike price is the payoff of the bond.
If at the maturity of their debt, the assets of the firm are greater in value than the debt, the
shareholders have an in-the-money call, they will pay the bondholders and call in the assets of
the firm.
If at the maturity of the debt the shareholders have an out-of-the-money call, they will not pay
the bondholders (i.e. the shareholders will declare bankruptcy) and let the call expire.
The value of a stock option depends on the following factors:
Current price of underlying stock.
Dividend yield of the underlying stock.
Strike price specified in the option contract.
Risk-free interest rate over the life of the contract.
Time remaining until the option contract expires.
Price volatility of the underlying stock.
Much of corporate financial theory can be presented in terms of options.
Common stock in a levered firm can be viewed as a call option on the assets of the firm.
Real projects often have hidden option that enhance value.
Futures Contracts
Futures Contracts commonly known as futures are also financial derivatives constituting instrument for
hedging the risk in the financial markets due to the price fluctuation of the assets. The features of a
futures contract are the same as that of a forward contract. However, these are two different instruments
used for risk management. Futures contracts have been designed to remove the disadvantages of forward
contracts. A futures contract can be defined as an agreement between two parties for buying or selling an
asset at a certain time in future at a certain price. Like commodities, financial assets form the underlying
assets in futures contracts. So, Stocks, bonds etc. are the financial assets underlying futures contracts. A
futures contract on financial assets is known as financial future. The fundament idea regarding futures
contracts is that for hedging a portfolio with a higher volatility than the market index, more futures
contracts may be required to bring about an effective and efficient hedge. The required number of futures
contracts can be estimated by using the following formula:
F0 = [Vp/ Vf] p
Where,
F0 = Required number of futures,
Vp = Value of portfolio to be hedged,

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Vf = Value of one futures contract,

p = Portfolio beta
Forwards
Forward contracts are commitment entered into by two parties to exchange a specific amount of money
for a particular commodity at a specified future time. A forward contract can be described as an
agreement to buy or sell an asset at a predetermined fixed price at a specified future date. In a forward
contract, the agreement is initiated at one time but the execution of the contract takes place at a
subsequent date. The terms of the contract, such as price, quality and quantity of the assets, delivery date
are specified at the time of initiating the contract but the actual payment and delivery of the asset occur
later.
Under a forward contract, one of the parties of the contract agrees to buy the underlying asset on a certain
specified future date at a certain price. The other party of the contract agrees to sell the underlying asset
on the same day at the same price. The following terms are applicable in a forward contract:
Long position and short position: The buyer of such contract is said to have a long position while the
seller have a short position.
Delivery price and delivery date: The price specified in the forward contract is termed as the delivery
price and the time specified is referred to as delivery date.
Warrants
Warrants are financial assets giving the holder the right but not obligation to buy shares of common
stocks directly from the issuing authority at a fixed price for a given period of time. Each warrant
specifies the number of shares of common stock a holder can purchase at the exercise price at the
expiration date. Some features of warrants are same as those of call options. From the view point of the
holders call options and warrants like the same. But still there exists a significant difference in
contractual features of them. Say warrants have long maturity period. Some warrants are same as the
perpetuals having no expiration date at all. The basic difference between call options and warrants is that
call options are issued by individuals and warrants are issued by the firms. When a warrant is exercised, a
firm must issue new shares of stock. Each time a warrant is exercised, the number of shares outstanding
increases. In case of call options is not necessary i.e., when a call option is exercised, there is no change
in the number of shares outstanding.
Convertible Bonds
A convertible bond is same as the bond with warrants. The major difference between convertible bonds
and warrants is that warrants can be separated into distinct securities but convertible bonds are not.
Convertible bonds are the fixed income securities which would be converted into common stocks after
certain period of time. Therefore, the convertible bond givers the holder the right to exchange for it a
given number of shares of common stock any time on or before the expiration date. A preferred stock can
be converted into common stock. The convertible preferred stocks and convertible bonds are same except
a convertible preferred stock has an infinite maturity date. The following vocabularies are applicable for
convertible bonds.
Conversion premium: The difference between the conversion price and the current stock price,
divided by the current stock price.
Conversion price: The dollar amount of a bonds par value that is exchangeable for one share of
stock.
Conversion ratio: The number of shares per bond received for conversion into stock.
Conversion value: The value a convertible bond would have if it were to be immediately
converted into common stock.
Straight bond value: The value a convertible bond would have if it could not be.

Basis for Comparison

Meaning
Sections to be referred

Share
Stock
The capital of a company is
The conversion of the fully paid up
divided into small units, which are shares of a member into a single
commonly known as shares.
fund is known as stock.
Section 2 (46) of the Indian
Section 94 of the Indian companies
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Basis for Comparison

Is it possible for a
company to make
original issue?
Paid up value
Definite number
Fractional transfer
Nominal value
Denomination

Share
companies Act, 1956.

Act, 1956.

Yes

No

Shares can be partly or fully paid

up.
A share has a definite number
known as distinctive number.
Not possible.
Yes
Equal amounts

Stock

Stock can only be fully paid up.

A stock does not have such
number.
Possible
No
Unequal amounts

Key Differences between Share and Stock

The following are the major differences between share and stock
1. A share is that smallest part of the share capital of the company which highlights the
ownership of the shareholder. On the other hand, the bundle of shares of a member in a
company, are collectively known as stock.
2. Section 2 (46) defines the term share. Section 94 authorizes the limited company to
convert its fully paid up shares into stock.
3. The share is always originally issued while the original issue of Stock is not possible.
4. A share have a definite number known as distinctive number which distinguishes it from
other shares, but a stock does not have such number.
5. Shares can be partly paid or fully paid. Conversely, Stock is always fully paid.
6. A share can never be transferred infractions. As opposed to stock, can be transferred
infractions.
7. Shares have nominal value, but stock does not have any nominal value.

Comparison Chart
Basis for Comparison
Meaning
Collateral
Interest Rate
Issued by
Payment
Owners
Risk factor

Bonds
Debentures
A bond is a financial instrument
A debt instrument used to raise
showing the indebtedness of the issuing long term finance is known as
body towards its holders.
Debentures.
Yes, bonds are generally secured by
Debentures may be secured or
collateral.
unsecured.
Low
High
Government Agencies, financial
Companies
institutions, corporations, etc.
Accrued
Periodical
Bondholders
Debenture holders
Low
High
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Basis for Comparison

Priority in repayment at
First
the time of liquidation

Bonds

Debentures
Second

Key Differences between Bonds and Debentures

The following are the major differences between bonds and debentures:
1. A financial instrument issued by the government agencies, for raising capital is known as
Bonds. A financial instrument issued by the companies whether it is public or private for
raising capital is known as Debentures.
2. Bonds are backed by assets. Conversely, the Debentures may or may not be backed by
assets.
3. The interest rate on debentures is higher as compared to bonds.
4. The holder of bonds is known as bondholder whereas the holder of debentures is known
debenture holder.
5. The payment of interest on debentures is done periodically whether the company has
made profit or not while accrued interest can paid on the bonds.
6. The risk factor in bonds is low which is just opposite in case of debentures.
7. Bondholders are paid in priority over debenture holders at the time of liquidation.
A commercial bank is a financial institution that is authorized by law to receive money from
businesses and individuals and lend money to them. Commercial banks are open to the public
and serve individuals, institutions, and businesses. A commercial bank is almost certainly the
type of bank you think of when you think about a bank because it is the type of bank that most
people regularly use.
The main functions of commercial banks are accepting deposits from the public and advancing
them loans.
However, besides these functions there are many other functions which these banks perform. All
these functions can be divided under the following heads:
1. Accepting deposits
2. Giving loans
3. Overdraft
4. Discounting of Bills of Exchange
5. Investment of Funds
6. Agency Functions

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7. Miscellaneous Functions
. Accepting Deposits:
The most important function of commercial banks is to accept deposits from the public. Various
sections of society, according to their needs and economic condition, deposit their savings with
the banks.
For example, fixed and low income group people deposit their savings in small amounts from
the points of view of security, income and saving promotion. On the other hand, traders and
businessmen deposit their savings in the banks for the convenience of payment.
Therefore, keeping the needs and interests of various sections of society, banks formulate
various deposit schemes. Generally, there are three types of deposits which are as follows:
(i) Current Deposits:
The depositors of such deposits can withdraw and deposit money whenever they desire. Since
banks have to keep the deposited amount of such accounts in cash always, they carry either no
interest or very low rate of interest. These deposits are called as Demand Deposits because these
can be demanded or withdrawn by the depositors at any time they want.
Such deposit accounts are highly useful for traders and big business firms because they have to
make payments and accept payments many times in a day.
(ii) Fixed Deposits:
These are the deposits which are deposited for a definite period of time. This period is generally
not less than one year and, therefore, these are called as long term deposits. These deposits
cannot be withdrawn before the expiry of the stipulated time and, therefore, these are also called
as time deposits.
These deposits generally carry a higher rate of interest because banks can use these deposits for
a definite time without having the fear of being withdrawn.
(iii) Saving Deposits:
In such deposits, money up to a certain limit can be deposited and withdrawn once or twice in a
week. On such deposits, the rate of interest is very less. As is evident from the name of such
deposits their main objective is to mobilize small savings in the form of deposits. These deposits
are generally done by salaried people and the people who have fixed and less income.
2. Giving Loans:
The second important function of commercial banks is to advance loans to its customers. Banks
charge interest from the borrowers and this is the main source of their income.
Banks advance loans not only on the basis of the deposits of the public rather they also advance
loans on the basis of depositing the money in the accounts of borrowers. In other words, they
create loans out of deposits and deposits out of loans. This is called as credit creation by
commercial banks.
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Modern banks give mostly secured loans for productive purposes. In other words, at the time of
advancing loans, they demand proper security or collateral. Generally, the value of security or
collateral is equal to the amount of loan. This is done mainly with a view to recover the loan
money by selling the security in the event of non-refund of the loan.
At limes, banks give loan on the basis of personal security also. Therefore, such loans are called
as unsecured loan. Banks generally give following types of loans and advances:
(i) Cash Credit:
In this type of credit scheme, banks advance loans to its customers on the basis of bonds,
inventories and other approved securities. Under this scheme, banks enter into an agreement
with its customers to which money can be withdrawn many times during a year. Under this set
up banks open accounts of their customers and deposit the loan money. With this type of loan,
credit is created.
(iii) Demand loans:
These are such loans that can be recalled on demand by the banks. The entire loan amount is
paid in lump sum by crediting it to the loan account of the borrower, and thus entire loan
becomes chargeable to interest with immediate effect.
(iv) Short-term loan:
These loans may be given as personal loans, loans to finance working capital or as priority
sector advances. These are made against some security and entire loan amount is transferred to
the loan account of the borrower.
3. Over-Draft:
Banks advance loans to its customers up to a certain amount through over-drafts, if there are no
deposits in the current account. For this banks demand a security from the customers and charge
very high rate of interest.
4. Discounting of Bills of Exchange:
This is the most prevalent and important method of advancing loans to the traders for short-term
purposes. Under this system, banks advance loans to the traders and business firms by
discounting their bills. In this way, businessmen get loans on the basis of their bills of exchange
before the time of their maturity.
5. Investment of Funds:
The banks invest their surplus funds in three types of securitiesGovernment securities, other
approved securities and other securities. Government securities include both, central and state
governments, such as treasury bills, national savings certificate etc.Other securities include
securities of state associated bodies like electricity boards, housing boards, debentures of Land
Development Banks units of UTI, shares of Regional Rural banks etc.
6. Agency Functions:

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Banks function in the form of agents and representatives of their customers. Customers give
their consent for performing such functions. The important functions of these types are as
follows:
(i) Banks collect cheques, drafts, bills of exchange and dividends of the shares for their customers.
(ii) Banks make payment for their clients and at times accept the bills of exchange: of their customers for which payment is made at the fixed time.
(iii) Banks pay insurance premium of their customers. Besides this, they also deposit loan
installments, income-tax, interest etc. as per directions.
(iv) Banks purchase and sell securities, shares and debentures on behalf of their customers.
(v) Banks arrange to send money from one place to another for the convenience of their customers.
7. Miscellaneous Functions:
Besides the functions mentioned above, banks perform many other functions of general utility
which are as follows:
(i) Banks make arrangement of lockers for the safe custody of valuable assets of their customers
such as gold, silver, legal documents etc.
(ii) Banks give reference for their customers.
(iii) Banks collect necessary and useful statistics relating to trade and industry.
(iv) For facilitating foreign trade, banks undertake to sell and purchase foreign exchange.
(v) Banks advise their clients relating to investment decisions as specialist
(vi) Bank does the under-writing of shares and debentures also.
(vii) Banks issue letters of credit.
(viii) During natural calamities, banks are highly useful in mobilizing funds and donations.
(ix) Banks provide loans for consumer durables like Car, Air-conditioner, and Fridge etc.

81