Fundamentals of Investment

Real Assets vs. Financial Assets

• Real Assets: Tangible and intangible physical assets utilized directly by an enterprise to produce goods and services (e.g., industrial machinery, factories, real estate land, patents).
• Financial Assets: Claims to the cash flows or income generated by real assets (or claims on other financial entities) that allocate wealth across investors (e.g., ordinary common stock of a commercial bank, corporate debentures, government Treasury bills).

Primary vs. Secondary Securities Market

1. Primary Market: The market where corporations and governments issue brand new securities directly to the investing public to raise fresh investment capital (e.g., Initial Public Offerings / IPOs via C-ASBA).
2. Secondary Market: The market where existing, previously issued securities are transferred and traded among public investors without generating new capital for the issuer (e.g., continuous daily equity trading on the Nepal Stock Exchange / NEPSE).

Net Asset Value (NAV)

Net Asset Value (NAV) represents the per-share intrinsic economic market value of an open-end or closed-end mutual fund scheme after satisfying all fund liabilities.

$$\text{NAV} = \frac{\text{Market Value of Assets} - \text{Total Fund Liabilities}}{\text{Total Number of Mutual Fund Units Outstanding}}$$

Concept of Short Sale

A short sale is an investment transaction where an investor borrows shares of a stock from a broker and sells them on the open market, intending to repurchase (cover) identical shares later at a lower price to return them to the lender.

Investor Objective: Investors execute short sales when they hold a strong bearish expectation, seeking to generate trading profits from declining asset prices.

Capital Allocation Line (CAL)

The Capital Allocation Line (CAL) is a graph displaying all feasible risk-return combinations formed by mixing a risk-free asset (Treasury bill) with a specific risky portfolio.

Slope Representation: The slope of the CAL represents the Sharpe Ratio (reward-to-volatility ratio) of the risky portfolio:

$$\text{Slope of CAL} = \frac{E(R_p) - R_f}{\sigma_p}$$

It measures excess return earned per unit of total portfolio risk.

Systematic vs. Unsystematic Risk

• Systematic (Market) Risk: Undiversifiable macroeconomic risk stemming from economy-wide factors (inflation, interest rate shifts, recessions, geopolitical crises) measured by Beta ($\beta$).
• Unsystematic (Unique) Risk: Company- or industry-specific risk (labor strikes, product recalls, management fraud) that can be completely eliminated through broad asset diversification.

Four Key Assumptions of CAPM

1. Perfect Capital Markets: All securities are perfectly divisible, there are no transaction fees, and no individual investor can influence market prices.
2. Homogeneous Expectations: All market participants share identical forecasts regarding expected returns, variances, and covariances of all assets.
3. Mean-Variance Optimizers: Investors evaluate portfolios strictly based on expected return and standard deviation over a single identical investment horizon.
4. Risk-Free Borrowing and Lending: Investors can borrow and lend unlimited sums at a common, constant risk-free rate ($R_f$).

Step-by-Step Calculation:

$$\text{CAPM Formula: } E(R_i) = R_f + \beta_i [E(R_m) - R_f]$$

$$\text{Given: } R_f = 6\%, \quad E(R_m) = 14\%, \quad \beta_i = 1.25$$

$$E(R_i) = 6\% + 1.25 \times (14\% - 6\%) = 6\% + 1.25 \times 8\% = 6\% + 10\% = \mathbf{16.0\%}$$

Conclusion: The required rate of return for the stock is 16.0%.

Step-by-Step Calculation:

$$P = \frac{M}{(1 + y)^n}$$

$$\text{Given: } M = \text{Rs } 1,000, \quad y = 0.08, \quad n = 5$$

$$P = \frac{1,000}{(1.08)^5} = \frac{1,000}{1.469328} = \mathbf{Rs\ 680.58}$$

Conclusion: The current market price of the zero-coupon bond is Rs 680.58.

Step-by-Step Calculation:

$$\text{Next Year Dividend } (D_1) = D_0 \times (1 + g) = 20 \times (1 + 0.06) = \text{Rs } 21.20$$

$$\text{Intrinsic Value } (P_0) = \frac{D_1}{k - g} = \frac{21.20}{0.12 - 0.06} = \frac{21.20}{0.06} = \mathbf{Rs\ 353.33}$$

Conclusion: The intrinsic economic value per share is Rs 353.33.

Major Types of Securities Trading Orders

1. Market Orders: Instructions to buy or sell a security immediately at the best available prevailing market price; prioritizes execution speed over price certainty.
2. Limit Orders: Instructions to buy at or below a specified maximum limit price, or sell at or above a specified minimum limit price.
3. Stop Orders (Stop-Loss): Conditional orders that activate into market orders once a threshold trigger price is breached, designed to limit downside capital loss.
4. Stop-Limit Orders: Converts to a limit order once the stop price is touched, preventing execution at unexpectedly adverse slippage prices.

Mutual Funds in Nepal: Advantages & Fee Structure

1. Core Advantages:

• Professional Fund Management: Managed by licensed merchant banking investment professionals with dedicated research desks.
• Instant Risk Diversification: Small retail capital is spread across dozens of equity, debenture, and fixed-deposit instruments.
• High Liquidity: Units can be liquidated on NEPSE or repurchased directly in open-end schemes.

2. Fee Structure:

• Management Fees: Annual statutory fee (capped by SEBON at 1.5% to 2.0% of Net Asset Value).
• Depository & Fund Supervisor Fees: Regulatory custody and oversight charges (~0.2% to 0.5%).
• Front-End / Back-End Loads: Sales charges deducted upon entry or exit in open-ended schemes.

Step-by-Step Calculation:

1. Expected Portfolio Return:

$$E(R_p) = w_X E(R_X) + w_Y E(R_Y) = (0.60 \times 15\%) + (0.40 \times 10\%) = 9.0\% + 4.0\% = \mathbf{13.0\%}$$

2. Portfolio Variance ($\sigma_p^2$):

$$\sigma_p^2 = w_X^2 \sigma_X^2 + w_Y^2 \sigma_Y^2 + 2 w_X w_Y \rho_{XY} \sigma_X \sigma_Y$$

$$\sigma_p^2 = (0.60)^2(0.20)^2 + (0.40)^2(0.12)^2 + 2(0.60)(0.40)(0.30)(0.20)(0.12)$$

$$\sigma_p^2 = (0.36)(0.04) + (0.16)(0.0144) + (0.144)(0.024) = 0.0144 + 0.002304 + 0.003456 = \mathbf{0.02016}$$

$$\text{Portfolio Standard Deviation (}\sigma_p) = \sqrt{0.02016} = 0.141986 = \mathbf{14.20\%}$$

Conclusion: Expected return is 13.0% and portfolio risk (standard deviation) is 14.20%.

Role and Responsibilities of SEBON

Established under the Securities Act, 2063, SEBON operates as the statutory apex capital market regulator in Nepal:

1. Licensing & Supervision: Licenses stock exchanges (NEPSE), clearing houses (CDSC), merchant bankers, stock brokers, and credit rating agencies.
2. Public Issue Approvals: Reviews and approves corporate prospectuses for IPOs, FPOs, rights issues, and corporate debentures.
3. Market Surveillance & Insider Trading Prevention: Monitors trading operations to prevent price manipulation, fraudulent practices, and illegal insider trading.
4. Investor Protection: Enforces disclosure standards and resolves investor grievances to preserve capital market trust.

Bond Duration and Interest Rate Risk

1. Concept of Macaulay Duration: Duration is the weighted average maturity of a bond’s cash flows, where the weights equal the present value of each cash flow divided by total bond price.
2. Modified Duration as Interest Rate Sensitivity:
   $$\text{Modified Duration } (D^*) = \frac{D_{\text{Mac}}}{1 + y}$$
   $$\% \Delta P \approx -D^* \times \Delta y$$
3. Key Properties:
   • Longer maturity bonds exhibit higher duration and greater price volatility.
   • Higher coupon rates reduce duration because more cash flows are received earlier.

Constant Growth DDM vs. Multi-Stage DDM

• Constant Growth (Gordon) DDM: Assumes dividends grow at a constant perpetual rate ($g$) forever ($P_0 = \frac{D_1}{k - g}$). Best suited for mature, stable utility and banking firms with steady cash flows.
• Multi-Stage Growth DDM: Accommodates high temporary supernormal growth during early corporate expansion stages, transitioning over time into sustainable long-term perpetual growth. Best suited for high-growth enterprises.

Ethical Standards in Investment Management

1. Fiduciary Duty: Putting client interests ahead of firm and personal interests at all times.
2. Integrity of Capital Markets: Prohibiting material non-public (insider) information trading and market manipulation.
3. Full & Fair Disclosure: Disclosing all real and potential conflicts of interest, fee arrangements, and commissions.
4. Suitability & Due Diligence: Ensuring investment recommendations match client risk tolerance, liquidity needs, and investment horizons.

Comprehensive Analysis of Markowitz Modern Portfolio Theory (MPT)

1. Theoretical Foundation:

Introduced by Harry Markowitz (1952), MPT proves that an asset’s risk should not be assessed in isolation, but by how it contributes to an overall portfolio’s risk through covariance.

2. The Efficient Frontier:

• By varying asset weights across all investable risky assets, we map the Minimum-Variance Frontier.
• The upper portion of this curve—offering maximum expected return for each level of standard deviation—constitutes the Efficient Frontier.

3. Introducing the Risk-Free Asset (CAL & Tangency Portfolio):

• Introducing risk-free lending and borrowing extends the Efficient Frontier into a straight line: the Capital Allocation Line (CAL).
• The point of tangency between the CAL and the Efficient Frontier identifies the Optimal Risky Portfolio ($P^*$), which maximizes the Sharpe Ratio.

4. Investor Optimal Choice:

Each individual investor then chooses their final allocation along the CAL where their personal indifference curve is tangent to the line, matching their specific risk aversion coefficient ($A$).

Theories of Term Structure of Interest Rates & Yield Curve Dynamics

1. Three Core Term Structure Theories:

1. Pure Expectations Theory: Long-term interest rates equal the geometric average of current and expected future short-term rates; an upward-sloping yield curve implies expectations of rising future short-term rates.
2. Liquidity Preference Theory: Investors demand an extra risk premium (liquidity premium) to hold longer-maturity debt due to higher interest rate risk.
3. Market Segmentation Theory: Long-term and short-term debt markets operate independently with distinct institutional supply and demand forces.

2. Yield Curve Determinants in Nepal:

• Dominance of commercial bank liquidity and regulatory Cash Reserve Ratio (CRR) / Statutory Liquidity Ratio (SLR) mandates.
• Low volume of long-term corporate debt versus dominant short-term Treasury bill auctions.
• Nepal Rastra Bank monetary corridor operations (SLF and SDF rates).

FCFF vs. FCFE Valuation and DCF vs. P/E Multiples

1. Conceptual Distinction:

• FCFF (Enterprise Approach): Cash flow available to all capital providers (equity and debt) after operational expenses and capital expenditures. Discounted at the Weighted Average Cost of Capital (WACC).
  $$\text{FCFF} = \text{EBIT}(1 - t) + \text{Depreciation} - \text{CapEx} - \Delta\text{NWC}$$
• FCFE (Equity Approach): Cash flow available solely to common shareholders after servicing debt obligations. Discounted at the Cost of Equity ($k_e$).
  $$\text{FCFE} = \text{FCFF} - \text{Interest}(1 - t) + \text{Net Borrowing}$$

2. DCF vs. P/E Multiples:

• DCF Advantages: Captures multi-year project lifecycles, working capital intensity, and capital expenditure needs without accounting earnings distortion.
• P/E Multiples: Quick and market-based, but heavily distorted by one-off accounting gains/losses, non-cash charges, and differing capital structures.