TERMS AND CONCEPTS

Financial Concepts:

The Risk/Return TradThe risk/return tradeoff could easily be called the "ability-to-sleep-at-night test." While some people can handle the equivalent of financial skydiving without batting an eye, others are terrified to climb the financial ladder without a secure harness. Deciding what amount of risk you can take while remaining comfortable with your investments is very important.

In the investing world, the dictionary definition of risk is the chance that an investment's actual return will be different than expected. Technically, this is measured in statistics by standard deviation. Risk means you have the possibility of losing some, or even all, of our original investment.

Low levels of uncertainty (low risk) are associated with low potential returns. High levels of uncertainty (high risk) are associated with high potential returns. The risk/return tradeoff is the balance between the desire for the lowest possible risk and the highest possible return. This is demonstrated graphically in the chart below. A higher standard deviation means a higher risk and higher possible return.

A common misconception is that higher risk equals greater return. The risk/return tradeoff tells us that the higher risk gives us the possibility of higher returns. There are no guarantees. Just as risk means higher potential returns, it also means higher potential losses.

On the lower end of the scale, the risk-free rate of return is represented by the return on U.S. Government Securities because their chance of default is next to nothing. If the risk-free rate is currently 6%, this means, with virtually no risk, we can earn 6% per year on our money.

The common question arises: who wants to earn 6% when index funds average 12% per year over the long run? The answer to this is that even the entire market (represented by the index fund) carries risk. The return on index funds is not 12% every year, but rather -5% one year, 25% the next year, and so on. An investor still faces substantially greater risk and volatility to get an overall return that is higher than a predictable government security. We call this additional return the risk premium, which in this case is 6% (12% - 6%). 

Determining what risk level is most appropriate for you isn't an easy question to answer. Risk tolerance differs from person to person. Your decision will depend on your goals, income and personal situation, Financial Concepts: Capital Asset Pricing Model (CAPM)

among other factors. Financial Concepts: Capital Asset Pricing Model (CAPM)

Pronounced as though it were spelled "cap-m", this model was originally developed in 1952 by Harry Markowitz and fine-tuned over a decade later by others, including William Sharpe. The capital asset pricing model (CAPM) describes the relationship between risk and expected return, and it serves as a model for the pricing of risky securities.

CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat our required return, the investment should not be undertaken.


The commonly used formula to describe the CAPM relationship is as follows:

For example, let's say that the current risk free-rate is 5%, and the S&P 500  is expected to return to 12% next year. You are interested in determining the return that Joe's Oyster Bar Inc (JOB) will have next year. You have determined that its beta value is 1.9. The overall stock market has a beta of 1.0, so JOB's beta of 1.9 tells us that it carries more risk than the overall market; this extra risk means that we should expect a higher potential return than the 12% of the S&P 500. We can calculate this as the following:

What CAPM tells us is that Joe's Oyster Bar has a required rate of return of 18.3%. So, if you invest in JOB, you should be getting at least 18.3% return on your investment. If you don't think that JOB will produce those kinds of returns for you, then you should consider investing in a different company.

It is important to remember that high-beta shares usually give the highest returns. Over a long period of time, however, high beta shares are the worst performers during market declines (bear markets). While you might receive high returns from high beta shares, there is no guarantee that the CAPM return is realized.

Investment in India - Banking System

Introduction

The Reserve Bank of India (RBI) is India's central bank. Though the banking industry is currently dominated by public sector banks, numerous private and foreign banks exist. India's government-owned banks dominate the market. Their performance has been mixed, with a few being consistently profitable. Several public sector banks are being restructured, and in some the government either already has or will reduce its ownership.

Private and foreign banks
The RBI has granted operating approval to a few privately owned domestic banks; of these many commenced banking business. Foreign banks operate more than 150 branches in India. The entry of foreign banks is based on reciprocity, economic and political bilateral relations. An inter-departmental committee approves applications for entry and expansion.

Capital adequacy norm
Foreign banks were required to achieve an 8 percent capital adequacy norm by March 1993, while Indian banks with overseas branches had until March 1995 to meet that target. All other banks had to do so by March 1996. The banking sector is to be used as a model for opening up of India's insurance sector to private domestic and foreign participants, while keeping the national insurance companies in operation.

Banking
India has an extensive banking network, in both urban and rural areas. All large Indian banks are nationalized, and all Indian financial institutions are in the public sector.

RBI banking
The Reserve Bank of India is the central banking institution. It is the sole authority for issuing bank notes and the supervisory body for banking operations in India . It supervises and administers exchange control and banking regulations, and administers the government's monetary policy. It is also responsible for granting licenses for new bank branches. 25 foreign banks operate in India with full banking licenses. Several licenses for private banks have been approved. Despite fairly broad banking coverage nationwide, the financial system remains inaccessible to the poorest people in India.

Indian banking system
The banking system has three tiers. These are the scheduled commercial banks; the regional rural banks which operate in rural areas not covered by the scheduled banks; and the cooperative and special purpose rural banks.

Scheduled and non scheduled banks
There are approximately 80 scheduled commercial banks, Indian and foreign; almost 200 regional rural banks; more than 350 central cooperative banks, 20 land development banks; and a number of primary agricultural credit societies. In terms of business, the public sector banks, namely the State Bank of India and the nationalized banks, dominate the banking sector.

Local financing
All sources of local financing are available to foreign-participation companies incorporated in India, regardless of the extent of foreign participation. Under foreign exchange regulations, foreigners and non-residents, including foreign companies, require the permission of the Reserve Bank of India to borrow from a person or company resident in India.

Regulations on foreign banks
Foreign banks in India are subject to the same regulations as scheduled banks. They are permitted to accept deposits and provide credit in accordance with the banking laws and RBI regulations. Currently about 25 foreign banks are licensed to operate in India. Foreign bank branches in India finance trade through their global networks.

RBI restrictions
The Reserve Bank of India lays down restrictions on bank lending and other activities with large companies. These restrictions, popularly known as "consortium guidelines" seem to have outlived their usefulness, because they hinder the availability of credit to the non-food sector and at the same time do not foster competition between banks.

Indian vs. Foreign banks
Most Indian banks are well behind foreign banks in the areas of customer funds transfer and clearing systems. They are hugely over-staffed and are unlikely to be able to compete with the new private banks that are now entering the market. While these new banks and foreign banks still face restrictions in their activities, they are well-capitalized, use modern equipment and attract high-caliber employees.

Government and RBI regulations
All commercial banks face stiff restrictions on the use of both their assets and liabilities. Forty percent of loans must be directed to "priority sectors" and the high liquidity ratio and cash reserve requirements severely limit the availability of deposits for lending. The RBI requires that domestic Indian banks make 40 percent of their loans at concessional rates to priority sectors' selected by the government. These sectors consist largely of agriculture, exporters, and small businesses. Since July 1993, foreign banks have been required to make 32 percent of their loans to these priority sector. Within the target of 32 percent, two sub-targets for loans to the small scale sector (minimum of 10 percent) and exports (minimum of 12 percent) have been fixed.

Foreign banks, however, are not required to open branches in rural areas, or to make loans to the agricultural sector. Commercial banks lent dols 8 billion in the Indian financial year (IFY, April-March) 1997/98, up sharply from dols 4.4 billion in the previous year.

The deployment of gross loans was as follows:

Sampling methods

Before an organisation conducts primary research it has to be clear which respondents it wishes to interview. A company cannot possibly interview the whole population to get their opinions and views. This simply would be to costly and unfeasible. A sample of the population is taken to help them conduct this research. To select this sample there are again different methods of choosing your respondents, a mathematical approach called 'probability sampling' and a non- mathematical approach, simply called 'non-probability sampling'. Lets look at these in a little more detail.

Probability Sampling Methods - A mathematical chance of selecting the respondent.

Simple Random Samples

With this method of sampling the potential people you want to interview are listed e.g. a group of 100 are listed and a group of 20 may be selected from this list at random. The selection may be done by computer.

Systematic samples

Out of the 100 people we talked about above, systematic sampling suggests that if we select the 5th person from the above list, then we would select every 5th, 10th, 15th, 20th etc. The pattern is the every consecutive 5th. If the 6th person was selected then it would be every consecutive 6th.

Multi-Stage Samples

With this sampling process the respondents are chosen through a process of defined stages. For example residents within Islington (London) may have been chosen for a survey through the following process:

Throughout the UK the south east may have been selected at random, ( stage 1), within the UK London is selected again at random (stage 2), Islington is selected as the borough (stage 3), then polling districts from Islington (stage 4) and then individuals from the electoral register (stage 5).

As demonstrated five stages were gone through before the final selection of respondents were selected from the electoral register.

Non Probability Samples

Convenience Sampling

Where the researcher questions anyone who is available. This method is quick and cheap. However we do not know how representative the sample is and how reliable the result.

Quota Sampling

Using this method the sample audience is made up of potential purchasers of your product. For example if you feel that your typical customers will be male between 18-23, female between 26-30, then some of the respondents you interview should be made up of this group, i.e. a quota is given.

Dimensional Sampling

An extension to quota sampling. The researcher takes into account several characteristics e.g. gender, age income, residence education and ensures there is at least one person in the study that represents that population. E.g. out of 10 people you may want to make sure that 2 people are within a certain gender, two a certain age group who have an income rate between £25000 and £30000, this will again ensure the accuracy of the sample frame again.