Thursday, November 1, 2018

Correlation between the returns of two different securities in Portfolio

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We should not ignore the relationship or correlation between the returns of two different securities in Portfolio. This correlation however has no impact on the portfolios expected return.

The portfolio expected return is a straightforward weighted average of returns on the individual securities; the portfolio standard deviation is not the weighted average of individual security standard deviations.

Let's understand correlation between securities in Portfolio:

Suppose we have two stocks A and B in our portfolio. During a given period the return of A increases say by 1% while that of B increases by 0.5% in the same period.

This means that both are moving positively in the direction of increasing returns. This is described as positive correlation. However the quantum of increase is not the same in both the cases.

Hence this is imperfect but positive correlation. In case the quantum of increase is 1% in both the cases, then the correlation is said to be positive and perfect correlation.

If the returns move in the opposite direction, say one increasing and the other decreasing, then the correlation is negative. Still the relationship could be perfect in the sense that the quantum of increase in return say in the case of A is the same in the case of B but in the opposite direction. This means that while stock A has increased its return, stock B has lost its return by the same percent.

Let us try to put these in the form of equations.
“Δ” represents the increase in return and (“Δ”) (within brackets-indicate that the return is decreasing).

Keeping these in mind let us attempt the following:
Δ of stock A = 1% for a given period = Δ of stock B = perfect and positive correlation

Δ of stock A = 1% for a given period; Δ of stock B = greater than or less than 1% but the return has increased and not decreased = positive but imperfect correlation

Δ of stock A = 1% for a given period; (“Δ”) of stock B = 1%. Then stock A and stock B are said to have perfect but negative correlation.

Δ of stock A = 1% for a given period; (“Δ”) of stock B less than or more than 1%. Then stock A and stock B are said to have imperfect and negative correlation.

We have consciously omitted the fifth possibility of both the stocks A and B losing to the same percent during a given period.

Any portfolio would avoid such stocks unless the future is going to be completely different in which case the past is not the basis on which stock selection is being made.

We have also tried to present these concepts in as simple a manner as possible. You are advised to go through these repeatedly to grasp the essence of the underlying concept in correlation between one stock and another. This is required because the concept of correlation is the fundamental based on which the selection of stocks for a portfolio is done. You will appreciate that positive correlation between two stocks would mean increased risk especially if the relationship is perfect. Negative correlation stocks are not desirable.

What is then left is positive but imperfect correlation. The risk-averse investors would invariably choose such stocks as show positive relationship between them (or among them in view of the number of stocks in a portfolio being more than 2, which is usually the case) but not perfect relationship. Then only the risk in a portfolio is reduced. For a given period, same degree of movement in return on different stocks in the same direction only increases the risk in a portfolio.

Now going back to the standard deviation of a portfolio, we will appreciate that it is not merely the weighted average of the standard deviation numbers for each stock in the portfolio. Suppose there are five stocks in a portfolio. We can appreciate that there are quite a few possible combinations of these five stocks depending upon the proportion of investment in each of them; for each combination, the weighted average of the standard deviation numbers has to be etermined first and then the ultimate average standard deviation should be found out for all possible combinations.

This involves a very complicated calculation and hence not presented here. However before we end this topic it should be mentioned that the complicated calculation is worth the time invested in, as the ultimate result is reduction in the total risk of the portfolio. This is the very objective of a portfolio.

Kinds of risk - diversifiable and non-diversifiable

Diversifiable or non-systemic risks

A portfolio aims at minimising the risk and optimising the returns. Any portfolio chooses the constituent stocks based on certain parameters and one of the important parameters is the correlation among the various stocks. A portfolio diversifies the risk by choosing stocks of:
  • Different sectors
  • Different units in the same sector
  • Different aturities and different instruments including money market.
Are there different kinds of risk associated with securities? Yes. Diversifiable and non-diversifiable risks. By choosing different sectors etc. we are diversifying the risks. This means that sector specific or industry specific or instrument specific or maturity specific risks are diversifiable.

Let's explain this through examples.

Your portfolio could contain stocks of Cement, Textiles, Software and Pharmaceuticals. This is called sector diversification. You will choose such sectors as are not having perfect correlation.

Your portfolio could contain stocks of ACC, Larsen & Toubro and Dalmia Cements. This is called unit diversification in the same sector. You will choose again such units as are not having perfect correlation.

Your portfolio could contain one-year investment (bond or debenture), more than one-year investment and long-term investment too. This is called maturity diversification. Here the relationship will rarely be perfect.

Your portfolio could contain investment into equity shares, debt instruments and money market instruments. This is called instruments diversification. Here too the relationship will not be perfect as these relate to different segments of the Financial Markets.

All the above are examples of diversifiable risks. One can use detailed analytical study of the past trends and knowledge about the various sectors and specific units for true diversification of stocks in a portfolio. Such diversifiable risks are often referred to as non-systemic risks or specific risks as such risks are not thrown in by the system.

Non-diversifiable or systemic risks
Suppose we do all the above and arrive at a very good portfolio. The US and their allies decide to bomb IRAQ. All hell breaks loose. All the markets internationally are nervous.

Can you and I do something about it besides feeling helpless about the whole thing? Such kind of risks could be specific to a country or economy or universal in its impact.

The universality of market risks depends upon the degree of integration of different countries into the global system. The more they are integrated the higher will be the degree of uniformity of impact due to US bombing IRAQ. We cannot diversify this kind of risk at least within a country or system, although global investors are in a better position to diversify the country specific risk by pulling out of the country and reinvesting the amount in less risky markets.

Typical example of a market risk in India Sensex crashing from 6000 odd points in early 2000 to less than 3000 points in 2002. The markets becoming nervous on news of Indo-Pak war is another example.

Total risk of a portfolio = market risk of the portfolio + specific risk of the portfolio
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What is Cash Budget and its Purpose,Objectives and Need

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What is Cash Budget and its Purpose,Objectives and Need : The net cash position of a firm as it moves from one budgeting sub period to another is highlighted by the cash budget. Cash budget is a statement showing the estimated cash inflows and cash outflows over the planning horizon.

The various purpose of cash budget are:

  • To coordinate the timing of cash need.
  • It pinpoints the period when there is likely to be excess cash.
  • It enables the firm which has sufficient cash to take the advantage of cash discount on its account payable to pay the obligations when due to formulate the dividend policy.
  • It help to arrange needed funds so that the most favourable terms and prevents the accumulation of excess funds.
The principle aim of cash budget as a tool to predict cash flows over a given period of time is to ascertain whether at any point of time there is likely to be an excess or shortage of cash.

The preparation of cash budgets involves various steps and is called the element of cash budgeting system. The first element is selection of period of time to be covered by the entire budget. It is referred to as the planning horizon which mean the time span and the sub period within that time span and the sub period within that time span over which the cash flows are to be protected.

The second element of cash budget is the selection of the factors that have a bearing on cash flows. The items included in the cash budget are only cash items. The factors that generate cash flows are generally divided for the purposes of preparing cash budget into two broad categories: (a) operating (b) financial.

While the former category includes cash flows generated by the operations of the firms and are known as operating cash flows.

Cash Budget And Cash Flows Statement

Cash budget is a statement showing the estimated cash inflows and cash outflows over the planning horizon. In other words, The net cash position of a firm as it moves from one budgeting sub period to another is highlighted by the cash budget.
Cash Flow Statement generally prepared annually, which shows the sources and the uses of cash during that period. It measures the changes in the financial position on each basis.

Cash Budget Objectives

  • To coordinate the timing of cash need.
  • It pinpoints the period when there is likely to be excess cash.
  • It enables the firm which has sufficient cash to take the advantage of cash discount on its account payable to pay the obligations when due to formulate the dividend policy.
  • It help to arrange needed funds so that the most favourable terms and prevents the accumulation of excess funds.
Cash Flow Statement Objectives
  • Cash Flow Statement is useful for the management to assess its ability to meet the obligation to trade creditors and to pay bank loan to pay interest to debenture holders and dividend to its shareholders.
  • Cash Flow Statement can also be prepared month wise which is useful in presenting the information of excess cash in some months and shortage of cash in other months.

Need For Preparing A Cash Budget

The principle aim of preparing a cash budget, as a tool to predict cash flows over a period of time is to ascertain whether at any point of time there is likely to be an express or shortage of cash.

The preparation of cash budget involved various steps. They may be described as the elements of the cash budgeting system.

Cost of Capital
The cost of capital is the rate of return the company has to pay to various suppliers of funds in the company. There are variations in the costs of capital due to the fact that different kinds of investment carry different levels risk which is compensated for by different levels of return on the investment.

Opportunity Cost of Capital
When an organization faces shortage of capital and it has to invest capital in more than one project, then the company will meet the problem by rationing the capital to projects whose returns are estimated to be more. The firm might decide to estimate the opportunity cost of capital in other projects.

Financial Leverage
This ratio indicates the effects on earnings by rise of fixed cost funds. It refers to the use of debt in the capital structure. Financial leverage arises when a firm deploys debt funds with fixed charge.

Operating Leverage
Operating leverage is concerned with the operation of any firm. The cost structure of any firm gives rise to operating leverage because of the existence of fixed nature of costs. This leverage relates to the sales and profit variations. Sometimes a small fluctuation in sales would have a great impact on profitability. This is because of the existence of fixed cost elements in the cost structure of a product.

Combined Leverage
The operating leverage has its effects on operating risk and is measured by the
percentage change in EBIT due to percentage change in sales. The financial
leverage has its effects on financial risk and is measured by the percentage change in EPS due to percentage change in EBIT. Since both these leverages are closely concerned with ascertaining the ability to cover fixed charges, if they are combined, the result is total leverage and the risk associated with combined leverage is known as total risk.
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Ratio Analysis : Advantages and Limitations in Financial Management

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Ratio Analysis : Advantages and Limitations in Financial Management

What is Ratio Analysis :

Ratio analysis is the method or process by which the relationship of items or groups of items in the financial statements are computed, determined and presented.

Ratio analysis is an attempt to derive quantitative measures or guides concerning the financial health and profitability of the business enterprise. Ratio analysis can be used both in trend and static analysis.

There are several ratios at the disposal of the analyst but the group of ratios he would prefer depends on the purpose and the objectives of the analysis.

Accounting ratios are effective tools of analysis. They are indicators of managerial and overall operational efficiency. Ratios, when properly used are capable of providing useful information.
Ratio analysis is defined as the systematic use of ratios to interpret the financial statements so that the strengths and weaknesses of a firm as well as its historical performance and current financial condition can be determined the term ratio refers to the numerical or quantitative relationship between items/ variables.

This relationship can be expressed as:

1) Fraction

2) Percentages

3) Proportion of numbers
These alternative methods of expressing items which are related to each other are, for purposes of financial analysis, referred to as ratio analysis. It should be noted that computing the ratio does not add any information in the figures of profit or sales.
What the ratios do is that they reveal the relationship in a more meaningful way so as to enable us to draw conclusions from them.


  • Ratios simplify and summarize numerous accounting data in a systematic manner so that the simplified data can be used effectively for analytical studies.
  • Ratios avoid distortions that may result the study of absolute data or figures.
  • Ratios analyze the financial health, operating efficiency and future prospects by inter-relating the various financial data found in the financial statement.
  • Ratios are invaluable guides to management. They assist the management to discharge their functions of planning, forecasting, etc. efficiently.
  • Ratios study the past and relate the findings to the present. Thus useful inferences are drawn which are used to project the future.
  • Ratios are increasingly used in trend analysis.
  • Ratios being measures of efficiency can be used to control efficiency and profitability of a business entity.
  • Ratio analysis makes inter-firm comparisons possible. i.e. evaluation of interdepartmental performances.
  • Ratios are yard stick increasingly used by bankers and financial institutions in evaluating the credit standing of their borrowers and customers.


An investor should caution that ratio analysis has its own limitations. Ratios should be used with extreme care and judgment as they suffer from certain serious drawbacks.

Some of them are listed below:

1. Rations can sometimes be misleading if an analyst does not know the reliability andsoundness of the figures from which they are computed and the financial position of the business at other times of the year.
A business enterprise for example may have an acceptable current ratio of 3:1 but a larger part of accounts receivables comprising a great portion of the current assets may be uncollectible and of no value. When these are deducted the ratio might be 2:1.

2. It is difficult to decide on the proper basis for comparison. Ratios of companies have meaning only when they are compared with some standards. Normally, it is suggested that ratios should be compared with industry averages. In India, for example, no systematic and comprehensive industry ratios are complied.

3. The comparison is rendered difficult because of differences in situations of 2 companies are never the same. Similarly the factors influencing the performance of a company in one year may change in another year.
Thus, the comparison of the ratios of two companies becomes difficult and meaningless when they are operation in different situations.

4. Changes in the price level make the interpretations of the ratios Invalid.

The interpretation and comparison of ratios are also rendered invalid by the changing value of money.

The accounting figures presented in the financial statements are expressed in monetary unit which is assumed to remain constant. In fact, prices change over years and as a result.

Assets acquired at different dates will be expressed at different values in the balance sheet. This makes comparison meaningless.

For e.g. two firms may be similar in every respect except the age of the plant and machinery. If one firm purchased its plant and machinery at a time when prices were very low and the other purchased when prices were high, the equal rates of return on investment of the two firms cannot be interpreted to mean that the firms are equally profitable.

The return of the first firm is overstated because its plant and machinery have a low book value.

5. The differences in the definitions of items, accounting, policies in the balance sheet and the income statement make the interpretation of ratios difficult.

In practice difference exists as to the meanings and accounting policies with reference to stock valuation, depreciation, operation profit,current assets etc.

Should intangible assets be excluded to calculate the rate of return on investment? If intangible assets have to be included, how will they be valued? Similarly, profit means different things to different people.

6. Ratios are not reliable in some cases as they many be influenced by window/ dressing in the balance sheet.

7. The ratios calculated at a point of time are less informative and defective as they suffer from short-term changes. The trend analysis is static to an extent.

The balance sheet prepared at different points of time is static in nature. They do not reveal the changes which have taken place between dates of two balance sheets. The statements of changes in financial position reveal this information, bur these statements are not available to outside analysts.

8. The ratios are generally calculated from past financial statements and thus are no indicator of future. The basis to calculate ratios are historical financial statements. The financial analyst is more interested in what happens in future.

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Friday, May 11, 2018

Types of Capital Market

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Capital market involve two parties on either end of a financial transaction. On one side, there are investors with capital who want to earn a return on their money. On the other, there are the companies, governments, or individuals who need to raise money. Capital market The capital market allow these two groups to come together so that both can meet their goals. Capital market is an essential part of many countries’ economies,making it possible for businesses to grow, for governments to provide essential services, and for individuals to invest and build their assets.

The bigger and more robust a country’s capital markets are, the more investment vehicles there typically are and the larger the potential investment capital that is available to fuel growth. At the same time, most capital market is regulated, by the government, the markets themselves, or by both.

The goal is to increase investor confidence, and, by extension, investor participation. Achieving it often depends on the perception that everyone has equal access to good information and the best prices.

What is capital market?

Capital market is the mechanism that allows the exchange of money between companies and investors, companies and banks, and investors and banks as each party seeks to raise capital or put capital to work.

While companies generally rely on their sales to keep their businesses going and on profits to underwrite new growth, there are times when a company might need a large amount of capital, perhaps to expand operations or cover operating losses. The capital market is a place to raise that money, letting companies offer ownership or promise repayment to investors in exchange for capital.

The capital market also enable individuals to buy a home, pay for college, or start a business. They can take a loan from a bank that lends its depositors’ money to borrowers in exchange for the promise of future repayment and interest.

It might help to think of the bank in this case as the investor, providing an individual with capital. In both cases, the availability of capital can contribute to economic growth. Expanding businesses typically create new jobs, putting more money into circulation.

Home buyers spend money to remodel and furnish their properties, creating or sustaining jobs. Of course, in any economy there are periods when investment capital dries up and the economy slows down — or when too much capital encourages inflation. Left unchecked by government or industry oversight, either situation could create serious problems.
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The capital market offer companies many different ways to raise funds from many different investors, including individuals and large institutions. Usually, the first options an entrepreneur explores are private sources of funds. This part of the capital market may provide limited amounts of money, but allows companies to remain privately held and founders to retain control over their operations.

One private option is a corporate loan or line of credit from a bank. The process of qualifying is similar to what you might be familiar with if you’ve arranged a mortgage or large loan.
Based on a company’s financial history and prospects, a bank may determine that the company is likely to repay the loan plus interest and advances the company the money.

Another private option is to tap friends and family — private individuals who have some affiliation with the company or its officers and are willing to take investment risk for a share of future profits.
A third choice is venture capital, or the assets of private investors channeled through a professional investment firm that may add funds to a start-up or maturing company in exchange for a piece of ownership, some say over operations, and a share in the profits.

Public sources of funds
When companies need a greater amount of capital than their earnings or private sources can provide, they may turn to the public capital markets. In the U.S., that means going to Wall Street — shorthand for the financial markets. Issuing stock and bonds are the primary public ways of raising capital.

A company that issues stock sells shares of ownership in the company and becomes publicly held. That means the company has a fiscal responsibility to its shareholders, who have a vote in how the company is run and a right to benefit from the company’s success.

Once a company is publicly held it can also issue bonds to borrow money from investors, taking on the responsibility to repay the capital at some point in the future and pay interest for its use. Public sources of funds in the capital markets generally involve far greater sums than private sources. But using this money means that a company takes on a number of new responsibilities in exchange for the cash infusion.

When companies are raising funds:
There are benefits to using a combination of methods. A company might take a loan when starting up, or work with venture capitalists that invest in the company. Several years later they may go public by issuing stock to expand into new markets, and then issue bonds at some time after that to cover the cost of upgrading equipment.

The availability of several methods to raise funds is appealing to companies because it means they can continue to tap new sources of money over time. And by choosing several ways to raise funds, it’s possible to balance the advantages and disadvantages of each method.

For example, a publicly held company may issue bonds to raise additional funds because issuing more stock would dilute the value of existing stock, upsetting current shareholders.

Companies can also look to international capital market. Some countries may offer better opportunities for raising capital than others, since there may be more potential investors in one country than in another.

For example, a companies in a small or developing nation might face a limited domestic capital market, so it could choose to offer shares to the much larger pool of investors through American Depositary Receipts (ADRs) traded in the United States, or Global Depositary Receipts (GDRs) traded in markets around the world.

On the other hand, a European company might raise capital internationally by issuing bonds in a country with lower interest rates than it might have to pay at home, reducing the cost of raising the capital.
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Thursday, May 10, 2018

Relevance of time value of money in financial decision making

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The recognition of the time value of money and risk is extremely vital in financial decision making. If the timing and risk of cash flows are not considered, the firm may make decisions which may allow it to miss its objectives of maximizing the owners welfare.

We prefer todays money to that of tomorrow due to our pressing needs for consumption and cost of abstinence form the present consumption, fall in the value of money tomorrow due to inflation and possible use of money when exchanged  for tomorrows money.

Thus, when we lend money, we forego all the advantages of liquidity, ready usability, safety etc. we abstain from present consumption when lent to somebody or invested. All these will lead to what is called the time preference for money. To compensate for that, future money will have to be discounted to the present time.
Tomorrows money or money a year hence has to be discounted to the present day by discount rate suitable as a reward for the above sacrifices. This is called discounting, used for cash flows or dividends to be received in future and to be calculated for the present.
Similarly an investment of today, if it is to be returned after a year or so, todays money has to be compounded by a discount rate to equate to the future funds likely to be available in return. This is called compounding. Compounding and discounting are thus tow major methods of analyzing the time value of money.

Time preference rate:  the time preference for money is generally expressed by an internal rate. It is a risk free rate.

Required Rate of Return = Risk free rate + Risk premium

 The risk free rate compensates for time while risk premium compensates for Risk.
Read Also :
  • Functions of Financial Officer
  • Financial Statement Analysis
  • Financial Ratios relevant in Decision Making
    Compound value and compound interest:  investments involve more than one period. The interest that is paid on the principal as well as on any interest earned but not withdrawn during the earlier periods is called compound interest. The process of finding the future value of a payment or series of payments when applying the concept of compound interest is known as compounding.

    Compound value of a lump sum:

            Future sum     =      principal + interest

    A finance manager is required to make decisions on investment, financing and dividend in view of the company's objectives.

    The decisions as purchase of assets or procurement of funds i.e. the investment/financing decisions affect the cash flow in different time periods. Cash outflows would be at one point of time and inflow at some other point of time, hence, they are not comparable due to the change in rupee value of money. They can be made comparable by introducing the interest factor.

    In the theory of finance, the interest factor is one of the crucial and exclusive concept, known as the time value of money.

    Time value of money means that worth of a rupee received today is different from the same received in future. The preference for money now as compared to future is known as time preference of money. The concept is applicable to both individuals and business houses.

    Reasons of time preference of money :

    1) Risk :
    There is uncertainty about the receipt of money in future.

    2) Preference for present consumption :
    Most of the persons and companies have a preference for present consumption may be due to urgency of need.

    3) Investment opportunities :
    Most of the persons and companies have preference for present money because of availabilities of opportunities of investment for earning additional cash flows.

    Importance of time value of money :

    The concept of time value of money helps in arriving at the comparable value of the different rupee amount arising at different points of time into equivalent values of a particular point of time, present or future.

    The cash flows arising at different points of time can be made comparable by using any one of the following :
    • by compounding the present money to a future date i.e. by finding out the value of present money.
    • by discounting the future money to present date i.e. by finding out the present value(PV) of future money.

    1) Techniques of compounding :

    i) Future value (FV) of a single cash flow :
    The future value of a single cash flow is defined as :


    Where, FV = future value
    PV = Present value
    r = rate of interest per annum
    n = number of years for which compounding is done.

    If, any variable i.e. PV, r, n varies, then FV also varies. It is very tedious to calculate the value of (1 + r)^n, so different combinations are published in the form of tables.

    These may be referred for computation, otherwise one should use the knowledge of logarithms.

    ii) Future value of an annuity :

    An annuity is a series of periodic cash flows, payments or receipts, of equal amount. The premium payments of a life insurance policy, for instance are an annuity.

    In general terms the future value of an annuity is given as :


    FVAn = Future value of an annuity which has duration of n years.
    A = Constant periodic flow
    r = Interest rate per period
    n = Duration of the annuity

    Thus, future value of an annuity is dependent on 3 variables, they being, the annual amount, rate of interest and the time period, if any of these variable changes it will change the future value of the annuity.

    A published table is available for various combination of the rate of interest 'r' and the time period 'n'.

    2) Techniques of discounting :

    i) Present value of a single cash flow :
    The present value of a single cash flow is given as :

    Present value of single cash flow

    FVn = Future value n years hence
    r = rate of interest per annum
    n = number of years for which discounting is done.

    From above, it is clear that present value of a future money depends upon 3 variables i.e. FV, the rate of interest and time period. The published tables for various combinations of  are available.

    ii) Present value of an annuity :
    Sometimes instead of a single cash flow, cash flows of same amount is received for a number of years. The present value of an annuity may be expressed as below :

    Present value of an annuity

    PVAn = Present value of annuity which has duration of n years
    A = Constant periodic flow
    r = Discount rate.
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