Financial Economics 6th Sem Compiled by Aasif-Ur-Rahman

COMPILED BY: AASIF-UR-RAHMAN
FINANCIAL MARKETS AND

CASH FLOW STREAMS
UNIT 1
CONCEPT:
The financial market is a very broad term that primarily refers to
a marketplace where buyers and sellers participate in the trade,
i.e., buying and selling of assets. Simply saying, it is a
platform that facilitates traders to buy and sell financial
instruments and securities. These instruments and securities
can be shares, stocks, bonds, commercial papers,
bills, debentures, cheques and more.
Financial markets are known for transparent pricing, strict
regulations, costs and fees and clear guidelines. One big
characteristic of such markets is that the market forces
determine the price of the assets. Also, a financial market may
or may not have a physical location, meaning investors can buy
and sell assets over the Internet or phone.
CLASSIFICATION OF THE FINANCIAL MARKET

As we mentioned before that financial is a very broad term, so
just mentioning their types will not give readers a good idea of
the financial markets. That is why we are mentioning
classification and giving type under each category.

BY NATURE OF ASSETS
Stock market: This is the market where shares of the company
are listed and traded after their IPO.
Bond market: This market allows companies and the government
to raise money for a project or investment. Investors buy bonds
from a company, which later returns the amount of bond with
agreed interest.
Commodities market: In this market, investors buy and sell
natural resources or commodities, like corn, oil, meat, and gold.
Derivatives market: This market deals in derivatives or contracts,
whose value is based on the underlying asset being traded.
BY NATURE OF CLAIM
Equity Market: It is a market where investors deal in stocks
or other equity instruments. It is basically the market for
residual claims.
Debt Market: In this market, investors buy and sell fixed claims
or debt instruments, like debentures or bonds.
BY MATURITY OF CLAIM
Money Market: The markets where investors buy and sell
securities that mature within a year are the money market.
Assets that investors buy and sell in this market are commercial
paper, certificate of deposits, treasury bills, and more.
Capital Market: Markets, where investors buy and sell medium
and long term financial assets, is a capital market. There are two
types of capital market: Primary Market (where a company
issues its shares for the first time (IPO), or already listed
company issues fresh shares) and Secondary Market or Stock
Market (where buyers and sellers trade already issued
securities in the primary market).
BY TIMING OF DELIVERY
Cash Market: It is the market where transactions are
settled in real time.
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Futures Market: In this market, settlement and delivery take
place at a future specified date.
BY ORGANIZATIONAL STRUCTURE
Exchange Traded Market: A market with centralized authority
and set regulations are Exchange Traded Market, like NYSE,
NASDAQ.
Over-the-Counter Market (OTC): Markets with customized
procedures and decentralized organization is an OTC market. It is
a type of secondary market. Smaller organizations prefer this
market as it has fewer regulations and is less expensive.
Functions of Financial Market

Mentioned below are the important functions of the financial market.
 It mobilizes savings by trading it in the most productive methods.

 It assists in deciding the securities price by interaction with the
investors and depending on the demand and supply in the market.
 It gives liquidity to bartered assets.
 Less time-consuming and cost-effective as parties don’t have to
spend extra time and money to find potential clients to deal with
securities. It also decreases cost by giving valuable information
about the securities traded in the financial market
INSTRUMENTS OF DEVELOPED MONEY

CAPITAL MARKETS:
There are two types of financial market
1. Money Market
2. Capital Market
Money Market
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It is one part of financial market where instruments like
securities ,bonds having short term maturities usually
less than one year are traded is known as Money market
.Organization or Financial institutions having short term
money requirement less than one year to meet immediate
needs like buying inventories, raw material ,paying loans
come to Money Market. It involves lending and borrowing
of short term funds. Money market instruments like
treasury bills, certificate of deposit and bills of exchange
are traded their having maturity less than one year
.Investment in money market is safe but it gives low rate
of return.
Money Market is regulated by R.B.I in India and

instrument having maturity less than one year usually
traded in money markets
Major Players in Money Market:-

1. RBI
2. Central Government
3. State Governments
4. Banks
5. Financial Institutions
6. Micro Finance Institutions
7. Foreign Institutional Investors (FII)
8. Mutual Funds
Money Market Instruments

1. Treasury Bills
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2. Commercial Papers
3. Certificate of Deposit
4. Bankers Acceptance
5. Repurchase Agreement
1. Treasury Bills
Treasury Bills are also known as T-Bills. This is one of
safest instrument to invest .T-bills are issued by
RBI backed by government security. RBI issue treasury
bills on the behalf of central government to meet the
short term liquidity needs of central government bills are
issued at a discount to face value, on maturity face value
is paid to holder.
At present, the Government of India issues three types of
treasury bills through auctions, for 91-day, 182-day and
364-day. Treasury bills are available for a minimum
amount of Rs.25,000 and in multiples of Rs. 25,000.
Treasury bills are also issued under the Market
Stabilization Scheme (MSS).In this if RBI want to absorb
excess liquidity it can issue T-bills.
2. Commercial Papers (CP)

Commercial papers are issue by private organizations or
financial institutions having strong credit rating to meet
short term liquidity requirements. These are unsecured
instruments as these are not backed by any security. The
return on commercial papers is usually higher than T-
bills. Different rating agencies,rate the commercial paper
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before issue by any organization .If commercial paper
carrying good rating means it is safe to invest and
carrying lower risk of default .
All corporate are not eligible to issue CP, only who met
certain defined criteria by RBI are eligible to issue CP.
CP can be issued for maturities between a minimum of 7

days and a maximum of up to one year from the date of
issue and can be issued not less than 5 lakhs and
multiples thereafter.
3. Certificate Of Deposit
Certificate of Deposit (CD) is a money market instrument.
CDs can be issued by scheduled commercial banks and
select All-India Financial Institutions (FIs) that have been
permitted by RBI to raise short-term resources. Minimum
amount of a CD should be Rs.1lakh, i.e., the minimum
deposit that could be accepted from a single subscriber
should not be less than Rs. 1lakh, and in multiples of Rs.
1lakh thereafter. The maturity period of CDs issued by
banks should not be less than 7 days and not more than
one year, from the date of issue. CDs may be issued at a
discount on face value.
In this a person invest his money in COD and after the

end of maturity period he receives money along with
interest.

4. Bankers Acceptance
Bankers Acceptance is also a money market instrument
to meet short term liquidity requirement .In this company
provides bank guarantee to seller to pay amount of good
purchased at agreed future date. In case buyer failed to
pay on agreed date, seller can invoke bank guarantee. It
is usually used to finance export and import.
5. Repurchase Agreement
Repurchase agreement is also known as Repo .It is
money market instrument .In this one party sell his asset
usually government securities to other party and agreed
to buy this asset on future agreed date. The seller pays an
interest rate, called the repo rate, when buying back the
securities. This is like a short term loan given by buyer of
security to seller of security to meet immediate financial
needs.
Major Players in Money Market:-

1. S.E.B.I
2. Central and State Government
3. Financial Institutions like L.I.C.
4. Financial intermediaries like stock brokers
5. Individuals
6. Corporate houses
7. Insurance companies

Capital Market
Capital market is also very important part of Indian
financial system .This segment of financial market meant
to meet long term financial needs usually more than one
year or more .Companies like manufacturing,
infrastructure power generation and governments which
need funds for longer duration period raise money from
capital market. Individuals and financial institutions who
have surplus fund and want to earn higher rate of interest
usually invest in capital market.
S.E.B.I. regulate the capital market in India .It set the
transparent mechanism rules and regulations for
investors and borrowers. It task is to protect the interest
of investors and promote the growth of capital market.
Capital market can be primary market and secondary

market. In primary market new securities are issued
where as in secondary market already issue securities
are traded.
Capital market is divided into two
1. Equity
2. Bond
Capital Market Instruments

1. Shares
2. Debentures
3. Bonds
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Equities
Equity market generally know as stock .In this company
want to raise money issue shares in share market like
B.S.E. or N.S.E.to individual or financial institutions who
want to invest their surplus money
Shares can be issued in two ways:

If company issuing share for first time that it is known as
I.P.O.(Initial Public Offering ).IPO of any company issued
in primary market and if company issuing shares for
second or third time than it is known as FPO(Follow on
Public Offering ) and trading of already issued shares
take place in secondary market.
Share gives ownership right to individuals who subscribe
to it, in this way company has to dilute his ownership
right same way public sector undertakings dilute up to 49
percent of their ownership and keep remaining 51 percent
with them so that they have majority control.
A person earns from shares is company make profit
which is distributed among share holders know as
dividend and if company make loss value of share also
falls so shares are high risk instruments
Bond or Debt
Bond market is also known as Debt market. A debt
instrument is used by government or organization to
generate funds for longer duration. The relation between
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person who invest in debt instrument is of lender and
borrower .This gives no ownership right .A person
receives fixed rate of interest on debt instrument.
If any company or organization want to raise money for
long term purpose without diluting his ownership that it is
known as Debentures. These are backed by security so
there is no risk involves but return on these instrument is
low as compared to shares .Company pay fixed rate of
interest on debentures.
If government want to generate funds to meet long term

needs like infrastructure it issue bonds know as
sovereign bonds which are backed by government
security so there is no risk
CHARACTERISTICS OF FINANCIAL INSTRUMENTS:

Financial Instruments are intangible assets, which are
expected to provide future benefits in the form of a claim
to future cash. It is a tradable asset representing a legal
agreement or a contractual right to evidence monetary
value / ownership interest of an entity.
Under the subject of Finance Management, Financial

Instruments can be classified as cash instruments and
derivative instruments. Financial Instruments are
typically traded in financial markets where price of a
security is arrived at based on market forces.
Cash Instruments:
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Cash Instruments are tradable and derive their value
from financial markets. Cash Instruments can be further
classified into equity instruments and debt instruments.
Equity Instruments refer to instruments which represent

ownership of the asset. Types of Equity Instruments are
as follows:
 Common Shares: Common (ordinary) shares represent

partial ownership of the company and provide their
holders claims to future streams of income, paid out of
company profits and commonly referred to as
dividends.
 Preferred shares is a financial instrument, which
represents an equity interest in a firm and which
usually does not allow for voting rights of its owners.
Typically the investor into it is only entitled to receive a
fixed contractual amount of dividends and this make
this instrument similar to debt. Preferred shares can
also be non-cumulative, redeemable, convertible,
participating etc.
 Private Equity: When companies are organized as
partnerships and private limited companies, their
shares are not traded publicly. The form of equity
investments, which is made through private
placements, is called private equity. The most important
sources of private equity investments come from
venture capital funds, private equity funds and in the
form of leveraged buyouts.
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 ADRs, GDRs: Investors may invest into foreign shares
by purchasing shares directly, purchasing American
Depository Receipts (ADRs), Global Depository Receipts
(GDRs).
 Exchange traded funds (ETFs) are passive funds, that
track specific index. Thus investor can invest into a
specific index, representing a country’s (e.g. foreign)
stock market.
Debt Instruments represent debt/ loan given by a
financial investor to the owner of the asset. The types of
bonds issued in debt capital markets include Callable and
Potable bonds, Convertible bonds, Eurobonds, Floating
rate notes, foreign bonds, Index linked bonds, Junk bonds,
Strips etc.
Derivative Instruments:
Investments based on some underlying assets are known

as derivatives. In general derivatives contracts promise
to deliver underlying products at some time in the future
or give the right to buy or sell them in the future. Types of
derivative instruments are as follows:
 Forward Contract: A forward contract gives the holder

the obligation to buy or sell a certain underlying
instrument at a certain date in the future at a specified
price.
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 Futures Contract: Futures contracts are forward
contracts traded on organized exchanges. A futures
contract is a legally binding commitment to buy or sell a
standard quantity at a price determined in the present
(the futures price) on a specified future date.
 Swaps: A swap is an agreement whereby two parties
(called counterparties) agree to exchange periodic
payments. The cash amount of the payments exchanged
is based on some predetermined principal amount.
 Options: An option is a contract in which the option
seller grants the option buyer the right to enter into a
transaction with the seller to either buy or sell an
underlying asset at a specified price on or before a
specified date.
Financial Markets:
 A financial market is a market where financial

instruments are exchanged or traded. Financial
markets provide three major economic functions i.e.
Price discovery, Liquidity and Reduction of transaction
costs
 Price Discovery refers to transactions between buyers
and sellers of financial instruments in a financial
market determine the price of the traded asset. It is
these functions of financial markets that signal how the
funds available from those who want to lend or invest
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funds will be allocated among those needing funds and
raise those funds by issuing financial instruments.
 Liquidity function provides an opportunity for investors
to sell a financial instrument, since it is referred to as a
measure of the ability to sell an asset at its fair market
value at any time. Without liquidity, an investor would be
forced to hold a financial instrument until conditions
arise to sell it or the issuer is contractually obligated to
pay it off.
 The function of reduction of transaction costs is
performed, when financial market participants are
charged and/or bear the costs of trading a financial
instrument. In market economies the economic
rationale for the existence of institutions and
instruments is related to transaction costs, thus the
surviving institutions and instruments are those that
have the lowest transaction costs.
what are financial derivative?

Financial derivatives, as mentioned above, are contracts
that base their value on an underlying asset. In them, the
seller of the contract does not necessarily have to own
the asset, but can give the necessary money to the buyer
for it to acquire it or give the buyer another derivative
contract.
These financial derivatives are used to hedge investments
and to speculate. Thus, if a trader wishes to speculate on
a derivative, they can make profit if the price of their
purchase is lower than the price of the underlying asset.
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For example: if you want to buy a futures contract (which
we will talk about later) for any asset that has a price of
$1,000, and the price of it at the end of the contract
increased to $1,100, you will be earning $100. In addition,
you could also benefit from the fall in the sale price of the
asset you have selected.
They can also be used as a hedge, or to minimize the
risks of a short term trade where you could be affected
by fluctuations in the price of the asset.
Now, there is no single type of financial derivative, there
are many. However, the three most used are: Options,
Futures and Swaps.
Trading Derivatives
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The derivatives market is very large, it is said that it has

around $ 1.2 million due to the large number of
derivatives available for assets such as: currencies,
stocks , bonds, or commodities. Even in 2016, a figure was
announced that pointed to the 25 billion contracts of
derivatives traded, where Asia led the way with 36% of
the volume, North America with 34%, and 20% for Europe.
Today the derivative market is divided into two.
OTC: Over The Counter
Also known as non-exchange derivatives, these are
contracts that are made directly and privately, that is,
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they are not listed on any stock exchange. They are
usually used by investment banks.
Exchanged-Traded
They are quoted on the stock exchanges and are used
mostly by small investors. They are public and the terms
of the contract are predetermined.
Types of Financial Derivatives
Financial derivatives have marked important milestones
throughout the global economy. Among the most popular
are:
 CDO's
 Swaps and CDS
 Forwards
The CDO's (Collateralized Debt Obligation) are financial
instruments that are considered the main cause of the
economic crisis that occurred in 2008 and which based
their value on the repayment of the loans offered.
The swaps offer investors the possibility of exchanging
assets or debts for another of similar value, managing to
reduce the risks for the parties involved. The swaps
resulted in the CDS (Credit Defaul Swap), which was sold
as insurance against the default of the municipal bonds
and which contributed to the 2008 financial crisis.
Forwards are another type of OTC financial derivative and
are used to buy or sell an asset at a previously agreed
upon value on a specific date in the future.
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In addition, there are financial derivatives that are used to
trade in the network in a decentralized manner, that is,
without an intermediary. The three most popular are the
following.
CFD's
The CFDs contracts for difference) allow you to buy or
sell a certain number of units of a particular asset,
depending on of the decrease or rise in its value and
thanks to the leverage. The gains (or losses) will depend
on the fluctuation of the price of the asset. With CFDs you
can open long positions, if you think the price will
increase or short positions, if you think it will decrease.
For example, suppose that the price of an action is $100
and you decide to buy a thousand shares of it for a total of
$100,000. If the price increases to $105, you will be
earning $5000, since for each share you bought you will
earn an additional $5, your total profit being $105,000.
Futures
They are used to exchange an underlying asset at a future
date and at a predetermined price, which protects buyers
from drastic changes in asset prices. They are used
mostly to trade commodities.
For example, a cookie maker could buy sugar futures at a
set price. In this way, if the price of sugar increases
considerably, the manufacturer can afford to buy the
necessary quantity a few months later.
Options
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Options are contracts that are made between two parties
and allows the owner to buy (call) or sell (put) assets at a
specific price and at a specific date or before. They are
used most frequently in stock trading.
In the options, the buyer has the right to buy or sell the
underlying asset. While the seller is obliged to buy or sell
it at the agreed price, as long as the buyer has exercised
their right.
For example: suppose that the shares of a telephone
company are valued at $95 today, but next month the
company is launching a new device that will most likely
increase the value of the shares. So we acquire call
options at $100 for three months, which in the market
have a value of $5 for each one. In three months, as
buyers we can exercise our right, so the seller must sell
the shares at $100.
BASIC THEORY OF INTEREST:
What Is Discounting?
Discounting is the process of determining the present
value of a payment or a stream of payments that is to be
received in the future. Given the time value of money, a
dollar is worth more today than it would be worth
tomorrow. Discounting is the primary factor used in
pricing a stream of tomorrow's cash flows
How Discounting Works

For example, the coupon payments found in a regular
bond are discounted by a certain interest rate and added
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together with the discounted par value to determine the
bond's current value.
From a business perspective, an asset has no value
unless it can produce cash flows in the future. Stocks pay
dividends. Bonds pay interest, and projects provide
investors with incremental future cash flows. The value of
those future cash flows in today's terms is calculated by
applying a discount factor to future cash flows.
KEY TAKEAWAYS
 Discounting is the process of determining the
present value of a future payment or stream of
payments.
 A dollar is always worth more today than it would be
worth tomorrow, according to the concept of the time
value of money.
 A higher discount indicates a greater the level of risk
associated with an investment and its future cash
flows.
Time Value of Money and Discounting
When a car is on sale for 10% off, it represents a discount
to the price of the car. The same concept of discounting is
used to value and price financial assets. For example, the
discounted, or present value, is the value of the bond
today. The future value is the value of the bond at some
time in the future. The difference in value between the
future and the present is created by discounting the
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future back to the present using a discount factor, which
is a function of time and interest rates.
For example, a bond can have a par value of $1,000 and
be priced at a 20% discount, which is $800. In other
words, the investor can purchase the bond today for a
discount and receive the full face value of the bond at
maturity. The difference is the investor's return.
What Is Present Value (PV)?

Present value (PV) is the current value of a future sum of
money or stream of cash flows given a specified rate of
return. Future cash flows are discounted at the discount
rate, and the higher the discount rate, the lower the
present value of the future cash flows. Determining the
appropriate discount rate is the key to properly valuing
future cash flows, whether they be earnings or debt
obligations.
KEY TAKEAWAYS
 Present value states that an amount of money today
is worth more than the same amount in the future.
 In other words, present value shows that money
received in the future is not worth as much as an
equal amount received today.
 Unspent money today could lose value in the future
by an implied annual rate due to inflation or the rate
of return if the money was invested.
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 Calculating present value involves assuming that a
rate of return could be earned on the funds over the
period.
Understanding Present Value (PV)
Present value is the concept that states an amount of
money today is worth more than that same amount in the
future. In other words, money received in the future is not
worth as much as an equal amount received today.
Receiving $1,000 today is worth more than $1,000 five
years from now. Why? An investor can invest the $1,000
today and presumably earn a rate of return over the next
five years. Present value takes into account any interest
rate an investment might earn.
For example, if an investor receives $1,000 today and can
earn a rate of return 5% per year, the $1,000 today is
certainly worth more than receiving $1,000 five years
from now. If an investor waited five years for $1,000,
there would be opportunity cost or the investor would
lose out on the rate of return for the five years.
Internal Rate of Return (IRR):

What Is Internal Rate of Return (IRR)?
The internal rate of return is a metric used in financial
analysis to estimate the profitability of potential
investments. The internal rate of return is a discount
rate that makes the net present value (NPV) of all cash
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flows equal to zero in a discounted cash flow analysis.
IRR calculations rely on the same formula as NPV does.
KEY TAKEAWAYS
 IRR is the annual rate of growth an investment is
expected to generate.
 IRR is calculated using the same concept as NPV,
except it sets the NPV equal to zero.
 IRR is ideal for analyzing capital budgeting projects
to understand and compare potential rates of annual
return over time.
Formula and Calculation for IRR
The formula and calculation used to determine this figure
is as follows.
The formula and calculation used to determine this figure
is as follows.
0=NPV=t=1∑T(1+IRR)tCt−C0where:Ct
=Net cash inflow during the period tC0
=Total initial investment costsIRR=The internal r
ate of returnt=The number of time periods
To calculate IRR using the formula, one would
set NPV equal to zero and solve for the discount rate,
which is the IRR. However, because of the nature of the
formula, IRR cannot be easily calculated analytically and
therefore must instead be calculated either through trial-
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and-error or by using software programmed to calculate
IRR. This can be done in Excel.
Generally speaking, the higher an internal rate of return,
the more desirable an investment is to undertake. IRR is
uniform for investments of varying types and, as such,
IRR can be used to rank multiple prospective investments
or projects on a relatively even basis. In general, when
comparing investment options, the investment with the
highest IRR would probably be considered the best.
How to Calculate IRR in Excel

Using the IRR function in Excel makes calculating the IRR
easy. Excel does all the necessary work for you, arriving
at the discount rate you are seeking to find. All you need
to do is combine your cash flows, including the initial
outlay as well as subsequent inflows, with the IRR
function. The IRR function can be found by clicking on the
Insert Function (fx) icon.
Here is a simple example of an IRR analysis with cash
flows that are known and annually periodic (one year
apart). Assume a company is assessing the profitability of
Project X. Project X requires $250,000 in funding and is
expected to generate $100,000 in after-tax cash flows the
first year and grow by $50,000 for each of the next four
years.
The initial investment is always negative because it
represents an outflow. Each subsequent cash flow could
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be positive or negative, depending on the estimates of
what the project delivers in the future. In this case, the
IRR is 56.72%, which is quite high.
Keep in mind that the IRR is not the actual dollar value of
the project. It is the annual return that makes the net
present value equal to zero.
Excel also offers two other functions that can be used in
IRR calculations, the XIRR and the MIRR. XIRR is used
when the cash flow model does not exactly have annual
periodic cash flows. The MIRR is a rate of return measure
that also includes the integration of a cost of capital as
well as the risk-free rate.
What is Bond Yield?

Bond yield is the return an investor realizes on a bond.
The bond yield can be defined in different ways. Setting
the bond yield equal to its coupon rate is the simplest
definition. The current yield is a function of the bond's
price and its coupon or interest payment, which will be
more accurate than the coupon yield if the price of the
bond is different than its face value. More complex
calculations of a bond's yield will account for the time
value of money and compounding interest payments.
These calculations include yield to maturity (YTM), bond
equivalent yield (BEY) and effective annual yield (EAY).
(Discover the difference between Bond Yield Rate vs.
Coupon Rate).
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Bond Yields: Current Yield And YTM
Overview of Bond Yield
When investors buy bonds, they essentially lend
bond issuers money. In return, bond issuers agree to pay
investors interest on bonds through the life of the bond
and to repay the face value of bonds upon maturity. The
simplest way to calculate a bond yield is to divide its
coupon payment by the face value of the bond. This is
called the coupon rate.
Coupon Rate=Bond Face Value/Annual Coupon Payment

If a bond has a face value of $1,000 and made interest or
coupon payments of $100 per year, then its coupon rate is
10% ($100 / $1,000 = 10%). However, sometimes a bond is
purchased for more than its face value (premium) or less
than its face value (discount), which will change the yield
an investor earns on the bond.
Bond Yield Vs. Price

As bond prices increase, bond yields fall. For example,
assume an investor purchases a bond that matures in
five years with a 10% annual coupon rate and a face value
of $1,000. Each year, the bond pays 10%, or $100, in
interest. Its coupon rate is the interest divided by its par
value.
If interest rates rise above 10%, the bond's price will fall if
the investor decides to sell it. For example, imagine
interest rates for similar investments rise to 12.5%. The
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original bond still only makes a coupon payment of $100,
which would be unattractive to investors who can buy
bonds that pay $125 now that interest rates are higher.
If the original bond owner wants to sell her bond, the
price can be lowered so that the coupon payments and
maturity value equal yield of 12%. In this case, that means
the investor would drop the price of the bond to $927.90.
In order to fully understand why that is the value of the
bond, you need to understand a little more about how the
time value of money is used in bond pricing, which is
discussed later in this article.
If interest rates were to fall in value, the bond's price
would rise because its coupon payment is more
attractive. For example, if interest rates fell to 7.5% for
similar investments, the bond seller could sell the bond
for $1,101.15. The further rates fall, the higher the bond's
price will rise, and the same is true in reverse when
interest rates rise.
In either scenario, the coupon rate no longer has any
meaning for a new investor. However, if the annual
coupon payment is divided by the bond's price, the
investor can calculate the current yield and get a rough
estimate of the bond's true yield.
Current Yield=Bond PriceAnnual /Coupon Payment

The current yield and the coupon rate are incomplete
calculations for a bond's yield because they do not
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account for the time value of money, maturity value or
payment frequency. More complex calculations are
needed to see the full picture of a bond's yield.
Capital Asset pricing Model

(CAPM)
unit 2
Capital Market Line (CML)
What Is the Capital Market Line (CML)?
The capital market line (CML) represents portfolios that
optimally combine risk and return. Capital asset pricing
model (CAPM), depicts the trade-off between risk and
return for efficient portfolios. It is a theoretical concept
that represents all the portfolios that optimally combine
the risk-free rate of return and the market portfolio of
risky assets. Under CAPM, all investors will choose a
position on the capital market line, in equilibrium, by
borrowing or lending at the risk-free rate, since this
maximizes return for a given level of risk.
KEY TAKEAWAYS
 The capital market line (CML) represents portfolios that
optimally combine risk and return.
28

 CML is a special case of the CAL where the risk portfolio is
the market portfolio. Thus, the slope of the CML is the
sharpe ratio of the market portfolio.
 The intercept point of CML and efficient frontier would
result in the most efficient portfolio called the tangency
portfolio.
 As a generalization, buy assets if sharpe ratio is above CML
and sell if sharpe ratio is below CML.
Understanding the Capital Market Line
(CML)
Portfolios that fall on the capital market line (CML), in
theory, optimize the risk/return relationship, thereby
maximizing performance. The capital allocation line (CAL)
makes up the allotment of risk-free assets and risky
portfolio for an investor. CML is a special case of the CAL
where the risk portfolio is the market portfolio. Thus, the
slope of the CML is the sharpe ratio of the market
portfolio. As a generalization, buy assets if the sharpe
ratio is above the CML and sell if the sharpe ratio is
below the CML.
CML differs from the more popular efficient frontier in
that it includes risk-free investments. The intercept point
of CML and efficient frontier would result in the most
efficient portfolio, called the tangency portfolio.
The CAPM, is the line that connects the risk-free rate of
return with the tangency point on the efficient frontier of
optimal portfolios that offer the highest expected return
for a defined level of risk, or the lowest risk for a given
29

level of expected return. The portfolios with the best
trade-off between expected returns and variance (risk)
lie on this line. The tangency point is the optimal portfolio
of risky assets, known as the market portfolio. Under the
assumptions of mean-variance analysis + that investors
seek to maximize their expected return for a given
amount of variance risk, and that there is a risk-free rate
of return + all investors will select portfolios which lie on
the CML.
According to Tobin's separation theorem, finding the
market portfolio and the best combination of that market
portfolio and the risk-free asset are separate problems.
Individual investors will either hold just the risk-free
asset or some combination of the risk-free asset and the
market portfolio, depending on their risk-aversion. As an
investor moves up the CML, the overall portfolio risk and
return increases. Risk averse investors will select
portfolios close to the risk-free asset, preferring low
variance to higher returns. Less risk averse investors
will prefer portfolios higher up on the CML, with a higher
expected return, but more variance. By borrowing funds
at the risk-free rate, they can also invest more than 100%
of their investable funds in the risky market portfolio,
increasing both the expected return and the risk beyond
that offered by the market portfolio.
The Capital Market Line Equation

Rp=rf+σ/TRT−rfσp
30

Where :Rp=portfolio returnrf=risk free rateRT

=market returnσT
=standard deviation of market returnsσp
=standard deviation of portfolio returns
Capital Asset Pricing Model (CAPM)

What Is the Capital Asset Pricing Model?
The Capital Asset Pricing Model (CAPM) describes the
relationship between systematic risk and expected
return for assets, particularly stocks. CAPM is widely
used throughout finance for pricing risky securities and
generating expected returns for assets given the risk of
those assets and cost of
Capital Asset Pricing Model - CAPM

Understanding the Capital Asset Pricing
Model (CAPM)
The formula for calculating the expected return of an
asset given its risk is as follows:
Investors expect to be compensated for risk and the time
value of money. The risk-free rate in the CAPM formula
accounts for the time value of money. The other
components of the CAPM formula account for the investor
taking on additional risk.
The beta of a potential investment is a measure of how
much risk the investment will add to a portfolio that looks
31

like the market. If a stock is riskier than the market, it will
have a beta greater than one. If a stock has a beta of less
than one, the formula assumes it will reduce the risk of a
portfolio.
A stock’s beta is then multiplied by the market risk
premium, which is the return expected from the market
above the risk-free rate. The risk-free rate is then added
to the product of the stock’s beta and the market risk
premium. The result should give an investor the required
return or discount rate they can use to find the value of
an asset.
The goal of the CAPM formula is to evaluate whether a
stock is fairly valued when its risk and the time value of
money are compared to its expected return.
For example, imagine an investor is contemplating a
stock worth $100 per share today that pays a 3% annual
dividend. The stock has a beta compared to the market of
1.3, which means it is riskier than a market portfolio. Also,
assume that the risk-free rate is 3% and this investor
expects the market to rise in value by 8% per year.
The expected return of the stock based on the CAPM
formula is 9.5%:
The expected return of the CAPM formula is used to

discount the expected dividends and capital appreciation
32

of the stock over the expected holding period. If the
discounted value of those future cash flows is equal to
$100 then the CAPM formula indicates the stock is fairly
valued relative to risk.
Problems With the CAPM

There are several assumptions behind the CAPM formula
that have been shown not to hold in reality. Modern
financial theory rests on two assumptions: (1) securities
markets are very competitive and efficient (that is,
relevant information about the companies is quickly and
universally distributed and absorbed); (2) these markets
are dominated by rational, risk-averse investors, who
seek to maximize satisfaction from returns on their
investments.
Despite these issues, the CAPM formula is still widely
used because it is simple and allows for easy
comparisons of investment alternatives.
Including beta in the formula assumes that risk can be
measured by a stock’s price volatility. However, price
movements in both directions are not equally risky. The
look-back period to determine a stock’s volatility is not
standard because stock returns (and risk) are
not normally distributed.
The CAPM also assumes that the risk-free rate will
remain constant over the discounting period. Assume in
the previous example that the interest rate on U.S.
33

Treasury bonds rose to 5% or 6% during the 10-year
holding period. An increase in the risk-free rate also
increases the cost of the capital used in the investment
and could make the stock look overvalued.
The market portfolio that is used to find the market risk
premium is only a theoretical value and is not an asset
that can be purchased or invested in as an alternative to
the stock. Most of the time, investors will use a major
stock index, like the S&P 500, to substitute for the market,
which is an imperfect comparison.
The most serious critique of the CAPM is the assumption
that future cash flows can be estimated for the
discounting process. If an investor could estimate the
future return of a stock with a high level of accuracy, the
CAPM would not be necessary
The beta of an asset and of a Portfolio: is a

measure of the overall systematic risk of a portfolio of
investments. It equals the weighted-average of the beta
coefficient of all the individual stocks in a portfolio.
While variance and standard deviation of a portfolio are
calculated using a complex formula which includes
mutual correlations of returns on individual
investments, beta coefficient of a portfolio is the straight
weighted-average of individual beta coefficients. This is
because beta coefficient represents the systematic risk
which cannot be diversified away and hence less than
34

perfect correlation between returns on individual
investments does not reduce overall systematic risk.
Since the broad market has a beta coefficient of 1, a
portfolio beta of less than 1 means that the portfolio has
lower systematic risk than the market and vice versa.
Portfolio beta is an important input in calculation
of Treynor's measure of a portfolio.
Formula
Portfolio beta equals the sum of products of individual
investment weights and beta coefficient of those
investments. It is a measure of the systematic risk of the
portfolio.
β = w × β + w × β + ... + w × β
p A A B B N N
Where β is the portfolio beta coefficient, w is the weight

p A
of the first investment, β is the beta coefficient of first

A
investment; w is the weight of the second investment,

B
β is the beta coefficient of second investment; w is the

B n
weight of the nth investment, β is the beta coefficient of

n
n investment and so on.

th
Example
Let us say we have a 2-asset portfolio. Their weights are
35% and 65%, their standard deviations are 2.3% and 3.5%
35

and their betas are 0.9 and 1.2, respectively. Their mutual
correlation coefficient is 0.5.
The portfolio beta in this case is 1.095:
Portfolio Beta = 35% ×: 0.9 + 65% ×: 1.2 = 1.095
The standard deviation of the portfolio in this case is
2.77% which is lower than the weighted-average of the
individual standard deviations which works out to 3.08%.
Security Market Line (SML):

What Is the Security Market Line?
The security market line (SML) is a line drawn on a chart
that serves as a graphical representation of the capital
asset pricing model (CAPM)*which shows different
levels of systematic, or market risk, of
various marketable securities, plotted against
the expected return of the entire market at any given
time.
Also known as the "characteristic line," the SML is a
visualization of the CAPM, where the x-axis of the chart
represents risk (in terms of beta), and the y-axis of the
chart represents expected return. The market risk
premium of a given security is determined by where it is
plotted on the chart relative to the SML.
36

Security Market Line
Understanding the Security Market Line
The security market line is an investment evaluation tool
derived from the CAPM*a model that describes risk-
return relationship for securities*and is based on the
assumption that investors need to be compensated for
both the time value of money (TVM) and the
corresponding level of risk associated with any
investment, referred to as the risk premium.
KEY TAKEAWAYS
The security market line (SML) is a line drawn on a

chart that serves as a graphical representation of the

capital asset pricing model (CAPM).
 The SML can help to determine whether an
investment product would offer a favorable expected

return compared to its level of risk.
 The formula for plotting the SML is required return =
risk-free rate of return + beta (market return - risk-

free rate of return).
The concept of beta is central to the CAPM and the SML.
The beta of a security is a measure of its systematic risk,
which cannot be eliminated by diversification. A beta
value of one is considered as the overall market average.
A beta value that's greater than one represents a risk
level greater than the market average, and a beta value of
less than one represents a risk level that is less than the
market average.
37

The formula for plotting the SML is:
 Required return = risk-free rate of return + beta
(market return - risk-free rate of return)
Although the SML can be a valuable tool for evaluating

and comparing securities, it should not be used in
isolation, as the expected return of an investment over
the risk-free rate of return is not the only thing to
consider when choosing investments.
Using the Security Market Line

The security market line is commonly used by money
managers and investors to evaluate an investment
product that they're thinking of including in a portfolio.
The SML is useful in determining whether the security
offers a favorable expected return compared to its level
of risk.
When a security is plotted on the SML chart, if it appears
above the SML, it is considered undervalued because the
position on the chart indicates that the security offers a
greater return against its inherent risk.
Conversely, if the security plots below the SML, it is
considered overvalued in price because the expected
return does not overcome the inherent risk.
The SML is frequently used in comparing two similar
securities that offer approximately the same return, in
38

order to determine which of them involves the least
amount of inherent market risk relative to the expected
return. The SML can also be used to compare securities
of equal risk to see which one offers the highest expected
return against that level of risk.
Use of the Capital Asset Pricing Model

(CAPM) in investment analysis and as a
pricing formula:
What Is the Capital Asset Pricing Model?
The Capital Asset Pricing Model (CAPM) describes the
relationship between systematic risk and expected
return for assets, particularly stocks. CAPM is widely
used throughout finance for pricing risky securities and
generating expected returns for assets given the risk of
those assets and cost of capital.
Capital Asset Pricing Model - CAPM
Understanding the Capital Asset Pricing
Model (CAPM)
The formula for calculating the expected return of an
asset given its risk is as follows:
Investors expect to be compensated for risk and the time

value of money. The risk-free rate in the CAPM formula
accounts for the time value of money. The other
39

components of the CAPM formula account for the investor
taking on additional risk.
The beta of a potential investment is a measure of how
much risk the investment will add to a portfolio that looks
like the market. If a stock is riskier than the market, it will
have a beta greater than one. If a stock has a beta of less
than one, the formula assumes it will reduce the risk of a
portfolio.
A stock’s beta is then multiplied by the market risk
premium, which is the return expected from the market
above the risk-free rate. The risk-free rate is then added
to the product of the stock’s beta and the market risk
premium. The result should give an investor the required
return or discount rate they can use to find the value of
an asset.
The goal of the CAPM formula is to evaluate whether a
stock is fairly valued when its risk and the time value of
money are compared to its expected return.
For example, imagine an investor is contemplating a
stock worth $100 per share today that pays a 3% annual
dividend. The stock has a beta compared to the market of
1.3, which means it is riskier than a market portfolio. Also,
assume that the risk-free rate is 3% and this investor
expects the market to rise in value by 8% per year.
The expected return of the stock based on the CAPM
formula is 9.5%:
40

The expected return of the CAPM formula is used to

discount the expected dividends and capital appreciation
of the stock over the expected holding period. If the
discounted value of those future cash flows is equal to
$100 then the CAPM formula indicates the stock is fairly
valued relative to risk.
Problems With the CAPM

There are several assumptions behind the CAPM formula
that have been shown not to hold in reality. Modern
financial theory rests on two assumptions: (1) securities
markets are very competitive and efficient (that is,
relevant information about the companies is quickly and
universally distributed and absorbed); (2) these markets
are dominated by rational, risk-averse investors, who
seek to maximize satisfaction from returns on their
investments.
Despite these issues, the CAPM formula is still widely
used because it is simple and allows for easy
comparisons of investment alternatives.
Including beta in the formula assumes that risk can be
measured by a stock’s price volatility. However, price
movements in both directions are not equally risky. The
look-back period to determine a stock’s volatility is not
standard because stock returns (and risk) are
not normally distributed.
41

The CAPM also assumes that the risk-free rate will
remain constant over the discounting period. Assume in
the previous example that the interest rate on U.S.
Treasury bonds rose to 5% or 6% during the 10-year
holding period. An increase in the risk-free rate also
increases the cost of the capital used in the investment
and could make the stock look overvalued.
The market portfolio that is used to find the market risk
premium is only a theoretical value and is not an asset
that can be purchased or invested in as an alternative to
the stock. Most of the time, investors will use a major
stock index, like the S&P 500, to substitute for the market,
which is an imperfect comparison.
The most serious critique of the CAPM is the assumption
that future cash flows can be estimated for the
discounting process. If an investor could estimate the
future return of a stock with a high level of accuracy, the
CAPM would not be necessary.
The CAPM and the Efficient Frontier

Using the CAPM to build a portfolio is supposed to help an
investor manage their risk. If an investor were able to use
the CAPM to perfectly optimize a portfolio’s return
relative to risk, it would exist on a curve called
the efficient frontier, as shown on the following graph.
The graph shows how greater expected returns (y-axis)
require greater expected risk (x-axis). Modern Portfolio
42

Theory suggests that starting with the risk-free rate, the
expected return of a portfolio increases as the risk
increases. Any portfolio that fits on the Capital Market
Line (CML) is better than any possible portfolio to the
right of that line, but at some point, a theoretical portfolio
can be constructed on the CML with the best return for
the amount of risk being taken.
The CML and efficient frontier may be difficult to define,
but it illustrates an important concept for investors: there
is a trade-off between increased return and increased
risk. Because it isn’t possible to perfectly build a portfolio
that fits on the CML, it is more common for investors to
take on too much risk as they seek additional return.
In the following chart, you can see two portfolios that
have been constructed to fit along the efficient frontier.
Portfolio A is expected to return 8% per year and has a
10% standard deviation or risk level. Portfolio B is
expected to return 10% per year but has a 16% standard
deviation. The risk of portfolio B rose faster than its
expected returns
The efficient frontier assumes the same things as the
CAPM and can only be calculated in theory. If a portfolio
existed on the efficient frontier it would be providing the
maximal return for its level of risk. However, it is
impossible to know whether a portfolio exists on the
efficient frontier or not because future returns cannot be
predicted.
43

This trade-off between risk and return applies to the
CAPM and the efficient frontier graph can be rearranged
to illustrate the trade-off for individual assets. In the
following chart, you can see that the CML is now called
the Security Market Line (SML). Instead of expected risk
on the x-axis, the stock’s beta is used. As you can see in
the illustration, as beta increases from one to two, the
expected return is also rising.
The CAPM and SML make a connection between a stock’s
beta and its expected risk. A higher beta means more risk
but a portfolio of high beta stocks could exist somewhere
on the CML where the trade-off is acceptable, if not the
theoretical ideal.
The value of these two models is diminished by
assumptions about beta and market participants that
aren’t true in the real markets. For example, beta does
not account for the relative riskiness of a stock that is
more volatile than the market with a high frequency of
downside shocks compared to another stock with an
equally high beta that does not experience the same kind
of price movements to the downside.
44

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FINANCIAL MARKETS AND

CLASSIFICATION OF THE FINANCIAL MARKET

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Functions of Financial Market

 It mobilizes savings by trading it in the most productive methods.

INSTRUMENTS OF DEVELOPED MONEY

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Money Market is regulated by R.B.I in India and

Major Players in Money Market:-

Money Market Instruments

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2. Commercial Papers (CP)

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CP can be issued for maturities between a minimum of 7

In this a person invest his money in COD and after the

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Major Players in Money Market:-

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Capital market can be primary market and secondary

Capital Market Instruments

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Shares can be issued in two ways:

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If government want to generate funds to meet long term

CHARACTERISTICS OF FINANCIAL INSTRUMENTS:

Under the subject of Finance Management, Financial

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Equity Instruments refer to instruments which represent

 Common Shares: Common (ordinary) shares represent

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Investments based on some underlying assets are known

 Forward Contract: A forward contract gives the holder

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 A financial market is a market where financial

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what are financial derivative?

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The derivatives market is very large, it is said that it has

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How Discounting Works

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What Is Present Value (PV)?

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Internal Rate of Return (IRR):

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How to Calculate IRR in Excel

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What is Bond Yield?

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Coupon Rate=Bond Face Value/Annual Coupon Payment

Bond Yield Vs. Price

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Current Yield=Bond PriceAnnual /Coupon Payment

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Capital Asset pricing Model