The CAPM draws conclusions from a variety of assumptions.

Some are vital to its premise, others cause only minor changes if they are untrue. Since the early 1970s much research into the plausibility and effects of weakness in these assumptions has been conducted by academia. The assumptions that form the basis for the CAPM are:

Investors measure asset risk by the variance of its return over future periods. All other measures of risk are unimportant.

Investors always desire more return to less, and they are risk averse; that is, they will avoid risk if all else is equal. There are no restrictions on the borrowing and lending of money at the risk-free rate of interest. All possible investments are traded in the market and are available to everyone, the assets are infinitely devisable, and there are no restrictions on short selling. The market is perfectly efficient. That is, every investor receives and understands the same information, processes it accurately, and trades without cost. There is no consideration of the effects of taxation. Aim to maximize economic utilities. Are rational and risk-averse. Are broadly diversified across a range of investments. Are price takers, i.e., they cannot influence prices. Can lend and borrow unlimited amounts under the risk free rate of interest. Trade without transaction or taxation costs. Deal with securities that are all highly divisible into small parcels. Assume all information is available at the same time to all investors. (http://en.wikipedia.org/wiki/Capital_asset_pricing_model#Assumptions_of_CAPM)

Further, the model assumes that standard deviation of past returns is a perfect proxy for the future risk associated with a given security.

APPLYING THE CAPM

Despite limitations, the Capital Asset Pricing Model remains the best illustration of long-term tradeoffs between risk and return in the financial markets. Although very few investors actually

use the CAPM without modification, its principles are very valuable, and may function as a sufficient guide for the average long-term investor. These principles may be stated as: 1. Diversifythere is no compensation for unsystematic risk. 2. Hold long termdo not worry about timing when to get in or out of the market. 3. To earn a higher return, take on more systematic risk. The more stocks one holds that are sensitive to the business cycle the more average return the portfolio will receive. For shorter term, or more sophisticated investing, other models have been developed. However, unless the model is based on market inefficiencies, or obtaining superior information, it will still have the CAPM basic tenets at its center.

Read more: Capital Asset Pricing Model (CAPM) http://www.referenceforbusiness.com/encyclopedia/Bre-Cap/Capital-Asset-Pricing-ModelCAPM.html#ixzz1tp8EJNJq Read more: Capital Asset Pricing Model (CAPM) http://www.referenceforbusiness.com/encyclopedia/Bre-Cap/Capital-Asset-Pricing-ModelCAPM.html#ixzz1tp87aIgw

QUESTION 2

Treynor Index

Definition
A measure of a portfolio's excess return per unit of risk, equal to the portfolio's rate of return minus the risk-free rate of return, divided by the portfolio's beta. This is a similar ratio to the Sharpe ratio, except that the portfolio's beta is considered the measure of risk as opposed to the variance of portfolio returns. This is useful for assessing the excess return from each unit of systematic risk, enabling investors to evaluate how structuring the portfolio to different levels of systematic risk will affect returns.

Read more: http://www.investorwords.com/5071/Treynor_Index.html#ixzz1tpH5wBeR

Sharpe ratio

Definition
A risk-adjusted measure developed by William F. Sharpe, calculated using standard deviation and excess return to determine reward per unit of risk. The higher the Sharpe ratio, the better the fund's historical risk-adjusted performance.

Use in finance
The Sharpe ratio is used to characterize how well the return of an asset compensates the investor for the risk taken, the higher the Sharpe ratio number the better. When comparing two assets each with the expected return against the same benchmark with return , the asset with the higher Sharpe ratio gives more return for the same risk. Investors are often advised to pick investments with high Sharpe ratios. However like any mathematical model it relies on the data being correct. Pyramid schemes with a long duration of operation would typically provide a high Sharpe ratio when derived from reported returns, but the inputs are false. When examining the investment performance of assets with smoothing of returns (such as with-profits funds) the Sharpe ratio should be derived from the performance of the underlying assets rather than the fund returns.

Read more: http://www.investorwords.com/4536/Sharpe_ratio.html#ixzz1tpHBdDBh

QUESTION 3

The benefits of rupee cost averaging Pallavi rao in New Delhi | February 22, 2005 12:46 IST

There are many investors who like to park their money as a lumpsum into an asset class and
forget about it. They don't want to worry about what's happening to it on a daily basis as long as the investment earns them some returns in the long haul. That's not a bad idea at all and the safer the instrument, the lesser are your worries about returns. But there is another way this lumpsum can be used -- by investing a fixed sum at regular intervals. This method eliminates the need to time the market (making an entry or an exit) -- an area where most investors are prone to go wrong. This method is commonly known as the rupee cost averaging.

Under this system, one need not worry about when and how much to invest. A fixed sum of money can be invested regularly and over time it averages out the costs. For instance, if one were to buy units of a mutual fund -- by following rupee cost averaging, the fixed amount of money will fetch more units when the net asset value of the units are down, and vice versa. What one must remember here is that what price you pay for a single unit does not matter but the average price at the end of purchase is what holds and the returns are based on this average cost. This automatically falls in line with the age-old principle of buy low and sell high. Rupee cost averaging, of course, does not inculcate the selling aspect. It only helps one average the cost of an asset purchase. What is it? Equity market investors always want to buy low and sell high but timing the market rarely works. If you are a long-term investor who buys shares based on fundamental attributes, a strategy that eliminates the need to time the market is rupee-cost averaging. Under this strategy, you invest a fixed amount at predetermined intervals over a period of time. So if the price of a share is high you will get fewer units and if it is low you will get more units. In the long run, the average price of shares is lowered and there is no need to time the market. How does it work? Say, you bought 10 shares of a company at Rs. 100 apiece. The next tranche of investment is due in a month. Subsequently, the price of the stock went down to Rs. 80 apiece. Now you buy another 10 shares of the company which pulls down the average cost of per share to Rs. 90 (100*10+80*10/20=90). Alternatively, after a month prices may escalate to Rs. 120, pulling up your average price to Rs. 110 (100*10+120*10/20). But since the recommended strategy of investing is buy-andhold, in the long run after the market experiences crests and troughs, this strategy works well. How can you do it? Many brokerages give you the option to set a predetermined amount or number of stocks to be triggered on a given date. For example, you can earmark Rs. 500 to be invested in the shares of a particular company on a given date every month for a year. This will mean that through the various ups and downs of the market during the 12 months, you will be able to buy the share at high and low prices. You can also give standing instruction to the brokerage house with which

you have a trading account irrespective of the fact whether it provides the above-mentioned facility. You can even open a systematic investment plan with a mutual fund for a fixed period of time. Is it useful? Rupee-cost averaging does not guarantee a profit or any kind of protection in volatile markets. However, it has been seen in the past that this strategy generally works in favour of investors over the long run. Also, this strategy instils investing discipline. However, like any other equity investment, you may not be able to bank on this money during an emergency if the markets are low. You must continue averaging price for a long period (at least 12 months or more) and hold on to your position for even longer.

Question 4
When we purchase the shares of the company it is important to compare the market price of the shares with the current and future expected performance of the company. Shares of a company that is currently earning good profit are more valuable. But the current performance or profit of a company is not sufficient indicator of the value of company's share. The future expected performance of a company, in terms of its profit margin and total profit, are important determinants of true value of its shares. Understanding the competitive position of a company enables an investor to make a better assessment of the future performance of the company and therefore value of its share. Therefore, it is important to understand the competitive position of a product of a company before purchasing its shares. ( http://www.enotes.com/business/q-and-a/why-important-understand-competitive-position182207)

ASSIGNMENT B

QUESTION 3

Markowitz diversification

A strategy that seeks to combine in a portfolio assets with returns that are less than perfectly positively correlated, in an effort to lower portfolio risk (variance) without sacrificing return. Related: Naive diversification. Copyright 2012, Campbell R. Harvey. All Rights Reserved.

Markowitz Diversification Diversification of a portfolio with appropriate regard for the mathematical formulas in Markowitz portfolio theory. That is, Markowitz diversification occurs when one uses mathematical models to find the securities to place in a portfolio such that the portfolio has the highest possible return for its level of risk. One may engage in Markowitz diversification when one wishes to increase or decrease one's portfolio's risk, or when the portfolio was previously not diversified. See also: Markowitz portfolio theory.