3.1 Introduction 3.1.1 Many general investors are confused about the stock market prices in the market.

The investors main dilemma is that whether or not to invest in the particular asset/ assets, so that they can get better sustainable and fair return of their investment with bearing minimum/zero risk. In this point of view, many people have been studying the way security price fluctuate for over a century. In 1841, Charles Mackay assembled a book of readings about Tulip-mania and some equally famous market bubbles which had a self-explanatory title: Extraordinary Popular Delusions and the Madness of Crowds.1 In contrast to Mackeys astonishing stories, in 1900 a French mathematician named Louis Bachelier set a forth formal models in which security prices were random outcomes that had probabilities attached to them.2 The mathematician Bachelier was one of the first who studied security price movement mathematically. 3.1.2 After that, in 1936 the famous economist John Maynard Keynes suggested, most of these persons are, in fact, largely concerned, not with making superior long-range forecasts of the probable yield of an investment over its valuation a short time ahead of the general public. They are concerned , not with what an investment is really worth to a man who buys it for keeps, but with what the market will value it at, under the influence of mass psychology, three month or a year hence Thus the professional investors are forced to concern him with the anticipation of impending changes, in the atmosphere, of the kind by which experience shows that the mass psychology of the market is most influenced.3 On the other hand, during the 1950s when an econometrician named Holboork Working and his colleagues articulated the notion that security prices fluctuated around their intrinsic values.4

Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowd, Richard Bentley, London, UK, 1841. Reprinted by Harmony Books, a division of Crown Books, New York, USA, 1980. 2 Paul H. Cootner , The Random Character of Stock Market Prices, Cambridge, Mass: M.I.T. Press, 1964. 3 John Maynard Keyness, The General Theory of Employment, Interest and Money, Harcourt Brace Jovanovich, New York, USA, 1936, pp. 154-155 4 Holbrook Working, A Theory of Anticipatory Prices, American Economic Review, May 1958, pp. 188-199

3.1.3 The main concern of this study primarily is to focus on what are the out of sight motivating factors behind stock market price, investors risk-return analysis and their value of the investment in common stock. The stock market price, their return and linked risk has the remarkable deliberation in modern economics and financial management. This chapter highlights on the literature that is available in this area. The first section of this chapter explains about the meaning of the securities and stock market prices. The second section is confined to review of those literature carried out previously.

3.2 Conceptual Framework While touching into the main subject mater of the stock market price, the study has also dealt with investors risk-return analysis and their value of investment in the common stock market. It is imperative to be familiar with the general concepts of the securities and related areas under study as well. Following sub section to this section would be explaining the conceptual matters of the common stock in the capital market under study.

3.3 Securities The oxford dictionary defines security as documents providing that some body is the owner of shares, etc. in a particular company.5 Securities can be defined as financial instruments which give the owner specific rights of ownership. In board sense William
F. Sharpe, Gordon J Alexander and Jeffery V Baily have defined that, in general, only

piece of paper represents the investors rights to certain prospects of property and the conditions under which he or she may exercise those rights. The piece of paper, serving as evidence of property rights has called a security. It may be transferred to another investor, and with it will go all its rights and conditions.6 The term securities are
A. S. Hornby, Oxford Advanced Learners Dictionary of Current English, 7th ed., Oxford University Press, New Delhi, India, 2005, p.1372 6 William F. Sharpe, Gordon J Alexander and Jeffery V Baily, Investments,5th ed., Prentice Hall of India, New Delhi, India, June, 2000, p. 3
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generally, stand for instruments of ownership like common stock, preference shares, bonds, treasury bills, debenture etc., which have publicly issued.

3.3.1 Common Stock The common stock investment stands for ownership of a company with full involvement in its gain or losses of return on investment. The William F. Sharpe et al. clearly elaborates that, Common stock represents equity, or an ownership position in a corporation. It is a residual claim, in the sense that creditors and preferred stockholders must be paid as scheduled before common stockholders can receive any payments. In bankruptcy, common stockholders are in principle entitled to any value remaining after all other claimants have been satisfied. (However, in practice, courts sometimes violate this principle) The great advantage of the corporate form of organization is the limited liability of its owners. Common stockholders are generally fully paid and nonassessable, meaning that common stockholders may lose their initial investment, but not more. That is, if the corporation fails to meet its obligations, the stockholders will not force to give the corporation the funds that have needed to pay off the obligation. However, as a result of such a failure, it is possible that the value of corporations shares will be negligible. This will result in the stockholders is having lost and amount equal to the price previously paid to buy the shares.7

3.3.2 Stock Certificate Share certificate is a documentary evidence of the ownership of number of companys shares. Dr. Avtar Singh has defined in the legal point of view that an allottee of shares is entitled to have from the company a document, called share certificate, certifying that he is the holder of the specified number of shares in the company.8 Similarly, William F. Sharpe et al. has stated that, The ownership of a firms stock has typically been represented by a single certificate, with number of shares held by the particular investor noted on it. Such a stock certificate is usually registered, with the name, address, and
7 8

ibid., p. 501 Avtar Singh, Company Law, 13th ed., Eastern Book Company, Lucknow, India, 2003, p.133

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holding of the investor included on the corporations books. Dividend payments, voting material, annual and quarterly reports and other mailings are then sent directly to the investor, taking into account the size of his or holdings. Shares of stock held by an investor may be transferred to a new owner with the assistance of either the issuing corporation or, more commonly, its designed transfer agent. This agent will cancel the old stock certificate and issue a new one in its place, made out to the new owner. Subsequently, registrar will make sure that this canceling and issuing of certificate has been done properly.9

3.4 Initial Public Offering 3.4.1 Initial Public Offering (IPO) means that the initial public offer of securities by a company in the primary market to raise funds from the general investors. In brief,
Tadashi Endo has defined that, Shares are first issued to promoters (founders) of a

company. Subsequently, the companys securities, including shares, may be privately issued to promoters relatives, friends, business associates, including directors and employees of the company, the companys vendors and customers, banks and financial institution, mutual, pension or investment funds, and so on. Such investors are specific and limited in number. As a company grows further, it may need to publicly raise additional capital from investors beyond the original specific and limited number of investors. A public issue or an issue to the public is an issue of new securities to unspecific and many investors, or the public. It is followed by listing of the companys shares on a stock exchange for secondary trading. The first issue to the public by an unlisted company is specifically called and initial public offering (IPO).10 3.4.2 Section 20(1) of the Nepals Companies Act 1997, states that a public company should publish prospectus approved by the Company Registrars Office before issuing the securities. Section 21 of the Act mentions that the contents of the prospectus while section 23 states that the directors who sign the prospectus are accountable to its
9

10

ibid., p.502 Tadashi Endo, The Indian Securities Market, Vision Books Pvt. Ltd., New Delhi, India, 1998, pp. 222223

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contents.11 Furthermore, Companies Act clearly states that the provisions regarding the restrictions of issuing securities at discount and allowing the issuance of securities at premium, prerequisite to issue different securities instruments, holding of AGM and reporting requirements. As per the SEBO/Ns provision of section 2(10) Securities Registration and Issue Approval Guideline, 2000, evidently defines that the disclosure of economic, physical, managerial and trading aspects of the issuer company to be based on fact and the financial forecasting of the company should be realistic. Similarly, Section 6.2(f) states that the prospectus should contain the forecast figures of net worth, profit and loss account and balance sheet for the following three year. 3.4.3 In the Indian context, normally IPO are issued higher price than the par/face value. Recently JHS Sevendgaard Laboratories Ltd has issued IPO with price band: Rs.49 to Rs.58 per equity share of face value Rs.10 each which has the floor price 4.9 times at lower end of the price band and 5.8 times at higher end of the price band.12 While as per the present legal system and practices in Nepal, most of companys initial public offering are made at par value, they ask fifty per cent initially and remaining balance the investor have to pay, whenever they ask to pay (calls in arrear) in future. In such a situation, it has been found that there is some complication to calculate the annual rate of return of the common stock, which has not written in the standard books and the other standard journal for the risk return purpose in case of calls in arrear. 3.4.4 Further, it has been observed the fact that many researchers had ignored to adjust the market price of common stock when the investor has to invest additional capital at the time the company ask call in arrears. If the investor will not pay the balance demanded by the company, the investor will lose the number of the share in equivalent to the ratio of non-paid balance of fund. The general investor may not like to lose his holding as well as present and future market returns. In such a situation, investor may

SEBO, Performance Analysis of Issue Manager, SEBO Journal, vol. 2, Securities Board Nepal, Kathmandu, Nepal, October 2005, p. 65 12 Advertisement issued by JHS Sevendgaard Laboratories Ltd, Times Business/ Economy, Times of India, Mumbai, India, 4, October, 2006, p. 23

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prefer to pay remaining balance of payment in case of call in arrears, so that his holding remains the same.

3.5 Right Share Issue, Cash Dividend and Stock Dividend 3.5.1 Right share issue is the issue of shares at par or at a premium by an existing company to its shareholders in a certain proportion to their holdings. As per law, they have right to receive preferential treatment. In the international context, A company that uses a rights offering generally issues one right for each outstanding common share, allowing each stockholders to use his or her rights to buy additional shares in the company at a subscribed price that is generally much lower than the market price. Rational stockholders will either exercise the right or sell it.13 Equity offerings have made either as rights offers or as firm-commitment underwritten offers where the entire issue has sold directly to an underwriter. In Europe, Canada, Australia, New Zealand and Asia, a large part of equity issues are sold all the way through rights issues.14 3.5.2 Similarly, in the context of Nepal, right share issue practice is the existing shareholder can buy for himself when the company announces the right share. And also most of the cases in Nepal, all the companies had right share issued at par but only one company i.e. the Everest bank Limited which had issued at premium till the date. At the same time, as per present law and practices there is no such a system to sell their right to other party or buyer before buying himself.

Aswath Damodaran, Corporate Finance: Theory and Practice, 1st ed., John Wiley & Sons, Inc., New York, USA, 1997, p. 414 14 P. Marsh, Valuation of Underwriting Agreements for UK Rights Issues, Journal of Finance vol. 35, 1980, pp. 693-716; C. Loderer and H. Zimmerman, Stock Offerings in a Different Institutional Setting: The Swiss Case, Journal of Banking and Finance, vol.12, 1988, pp. 353-378 ; E. Eckbo and R. Masulis, Adverse Selection and the Rights Offer Paradox, Journal of Financial Economics, vol. 32, 1992, pp. 293-332; R.J. MacCulloch and D. M. Emanuel, The Valuation of New Zealand Underwriting Agreements, Accounting and Finance, vol. 34, 1994, pp.21-35; Bhren . Eckbo E. and Michalsen D., Why Underwrite Rights Offerings? Some New Evidence, Journal of Finance, vol. 46, 1997, pp. 223-261 and S.P. Ferris, G. Noronha and T. McInish, New Equity Offerings in Japan: an Examination of Theory and Practice, Journal of International Financial Markets, Institutions and Money, vol. 7, 1997, pp. 185-200.

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3.5.3 As compared to public issue of the common stock for the company, rights offerings are much less expensive because the transactions cost, administrative costs and underwriting commissions are much lower than the public issue. A rights offering has little risk for selling the share to the existing shareholders if the subscription price is set far below (or at face value) than the market price. Many books and researchers have explained about the before/after market price of the common stock but they have failed to explain what happens or how to adjust while doing the risk return analysis. Some of the experts expressed their view that the accounting treatment should be same as like a stock dividend and stock split. They have explained that the market price will go proportionately down according to the rights offering but many researches have shown the mixed results. When deeply analyze the case of rights offering, it gives different results for different cases. In the case of the stock dividend and stock split, the total shareholders fund and book value per share proportionately remain same but in the case of right offering the total shareholders fund and book value per share proportionately not remain same, because company gets additional capital from the stockholders. In such a situation, it has been found that there is some complication to calculate the annual return of the common stock, which has not written in the standard books and the other standard journal for the risk return purpose in the case of the right share issue. Most of the experts have given much stress on the cash dividend or other cash inflow of investment. 3.5.4 Further, it has been observed the fact that earlier studies had ignored to adjust the market price of common stock when the investor has to invest additional capital at the time the company offers right share issue. If the investor would not invest additional capital in the case of the right share issue, they may lose from the original and future market value of the existing common stock (asset value) due to increased number of the share when right shares are issued. Therefore, it is assumed that the general investors would not like to lose his holding as well as present and future market returns instead of holding more number of shares just by paying face value or with some premium of common stock in the case of right share issue. Moreover, the investors can sell additional right shares in future when feel to get better price of the stock.

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3.5.5 Similarly, dividend means cash payment or additional stock certificate in proportion to their holdings given to the stockholders. Generally, when the company declares cash dividend, there is no problem to take the amount of dividend for calculation in the risk- return analysis. However, when the company declares the stock dividend (i.e., bonus share) to the existing shareholders in such a situation, it is quite difficult to calculate the dividend value, because the shareholders get share in the ratio of existing holding, which has been declared by the company. 3.5.6 From the point view of company, stock splits and stock dividends are similar in several aspects. Some stockholders may actually believe that these are substitutes, but it is extremely unlikely that financial markets will not see through this deception. Other firms view stock dividends as a supplement to cash dividends and use them in periods in which they have posted good results. This rationale is more defensible because the announcement of a stock dividend may convey information to financial markets about future prospects. In fact, the use of both stock dividend and stock splits as signals of better cash flows in the future may increase the firm value.15 In particular, both conditions are corporate events in which each shareholder receives a certain number of new shares free of charge whereby the stock price would reduce accordingly. However, there are also some differences between the two cases. In the case of a stock split, each old share is split into a number of new shares with a reduced par value, leaving the total equity capital remain same. 3.5.7 On the other hand, in the case of a stock dividend, a number of new shares have received for each share owned. The new shares have the same par value as the old shares, whereby the total equity capital increases proportionally with the size of the stock dividend but shareholder fund in the book remain same and at the same time, book value per share decreases proportionately. It is a well-known fact that, on an average, the announcement of a stock split or a stock dividend is associated with a positive stock market reaction. Still, very little has been identified about the exact explanation for the positive announcement effect and only a few researches have taken
15

op. cit., Aswath Damodaran, p. 606

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the difference between stock splits and stock dividends into account while examining the announcement effect. It may show different effect from the general investor point of view while analyzing the risk return of their portfolio of investment for longer period. 3.5.8 In this case, some of the western writers have defined that pervious market price can be divided accordingly like in the case of the stock split. According to John C. Hull A stock dividend involves a company issuing more shares to its existing shareholders. For example, a 20% stock dividend means that investors receive one new share for each five already owned. A stock dividend, like a stock split, has no effect on either the assets or earning power of a company. The stock price can be expected to go down as a result of a stock dividend. The 20% stock dividend referred to is essentially the same as a 6-for-5 stock split. All else being equal, it should cause the stock price to decline to 5/6 of its previous value.16Jack Clark Francis17 has also used similar method in his book Investments Analysis and Management as John C. Hull described. It may be just assumption that the stock market price may go down which is explained by the John C. Hull and Jack Clark Francis. 3.5.9 However, Daniel Bernouli in this case has clearly stated that, the determination of the value of an item must not be based on its price, but rather on the utility it yields. The price of the item is dependent only on the thing itself and is equal for everyone; the utility, however, is dependent on the particular circumstances of the person making the estimate. Thus, there is no doubt that a gain of one thousand ducats is more significant to a pauper than to a rich man though gain the same amount.18 Furthermore, the practical market research has shown the mixed results. Before or after stock dividend, stock market price may be useful for only e forecasting purpose for short-term analysis. However, stock market price solely depends on the demand and supply of particular asset in the market.

John C. Hull, Options, Futures, and Other Derivatives, 5th ed., Pearson Education (Singapore) Pte. Ltd., Indian Branch, Delhi, India, 2004, pp. 154 -155 17 Jack Clark Francis, Investments: Analysis and Management, 5th ed., McGraw Hill International, New York, USA, 1991, p. 270 18 D. Bernoulli, Exposition of a New Theory on the Measurement of Risk, Econometrica, January 1954.

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3.5.10 Moreover, demand comes thorough the positive perception of investors towards the particular asset which is effected by so many factors in the business environment, investor psychology towards particular companys stock. Therefore, when applying the stock split principle may not be scientific in the case of right share issue and stock dividend. In such a situation, it is necessary to apply different method for this purpose. In the case of the stock dividend, the investor gets dividend but at the same time, they get some proportion of market value of existing stock. In fact, the investor gets a dividend value in total in the case of the stock dividend. The legal system of the right to sell the stock dividend may be different for different country. In the context of Nepal, the system does not permit the right to sell right share and stock dividend before receiving certificate of stock from the company. As a result, in this situation to solve this problem, it is assumed that investor may like to hold his existing share until the date of the getting the stock dividend. They may sell stock dividend whenever feel that they are getting better price in future.

3.6 Stock Valuation Models 3.6.1 The cost of goods and service, which is acceptable by the buyer and seller in the certain price in the market, defined as value. The question arises in the case for the general investor how to value the common stock. For non-professional valuation, process of stock is like a chicken and egg dilemma. The investment decision process is similar to the shopping for clothes, radio, mobile or home. In each case, buyer likes to examine the item, make conclusion, and decide whether to buy. If the prices of product are equal to his estimated price or less then he will like to buy it. The determination of a common stock goes similar manner with more formal way. The concept of value is at the heart of financial management. The value of any tradable goods and services is whatever the bidder is prepared to pay. As long as the market has accepted as being reasonably efficient, then the market price can be trusted as a fair assessment of value. Conceptually, the valuation of the equity share is the most typical because of its residual

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ownership character.19 Several analytical techniques are available to assist the financial analyst for valuing common stock. The investor expects regular earnings in the form dividends and capital gains from the upward movement of the stock price. 3.6.2 According to the Frank K. Reilly and Keith C. Brown, There are two general approaches to the valuation process:(1) the top-down , three-step approach; or (2) the bottom-up, stock valuation, stock picking approach. Either fundamentalist or technicians can implement both of these approaches. The difference between the two approaches is the perceived importance of the economy and a firms industry on the valuation of a firm and its stock. Advocate of the top-down, three-step approach believe that the economy/ market and the industry effect have a significant impact on the total return for the individual stocks. In contrast, those who employ the bottom-up, stock picking approach contend that it is possible to find stocks that are undervalued relative to their market price, and these stocks will provide superior returns regardless of the market and industry out look.20 There is not a significant different between the topdown and bottom up approach for achieving the outcome. Investors can use any one approach for analysis of securities. 3.6.3 Many Psychologists suggest that the success or failure of an individual depends on as much by his or her social, economic, and family environment as by genetic gifts. Extending this idea to the valuation of securities means investors should consider a companys economic condition, industry and market environment during the valuation process. Subject to the qualities or capabilities of a company and its management, the economic and industry business environment will act as main influencing factor on the success or failure of a company and the realized rate of return on its common stock. Because of the complexity and importance of valuing common stock, various techniques for accomplishing this task have been devised over time. These techniques fall into one of two general approaches: (1) the discount cash flow (DCF) valuation
19

R. P. Rustagi, Financial Management, 3rd ed., Galgotia Publishing Company, New Delhi, India, 2006, p. 848 20 Frank K. Reilly and Keith C. Brown, Investment Analysis and Portfolio Management, 7th ed., Shroff Publishers and Distributors Pvt. Ltd., Navi Mumbai, India, 2006, p. 369

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techniques, where the value of the stock is estimated based upon the present value of some measure of cash flow, including dividends, operating cash flow, and free cash flow. And (2) the relative valuation techniques, where the value of a stock is estimated based upon its current price relative to variables considered being significant to valuation, such as earnings, cash flow, book value, or sales21. The shortcoming of the DCF valuation techniques are depends on the cost of the capital or required rate of the return. Likewise, weaknesses of the relative valuation techniques are only possible to comparative study between the similar types and size of the companies and industry only. 3.6.4 Apart from these two approaches, the Gerald I. White Ashwinpaul C. Sondhi and
Dov Fried have defined another third approach: (3) the abnormal earnings or Edward-

Bell-Ohlson (EBO) model which determines value as a combination of the stock of assets representing the normal flow that assets generate and the discounted value of abnormal earnings generated by the assets.22 An important point is that these approaches and all of these valuation techniques have several common factors. First, all of them have significantly affected by the investors required rate of return on the stock because this rate becomes the discount rate or is a major component of the discount rate. Second, all valuation approaches are affected by the estimated growth rate of the variable used in the valuation technique- for example, dividends, earnings, cash flow, or sales.23 As a result, different analyst using the same valuation techniques will derive different estimates of value for a stock because they have different estimates for these critical variable inputs.24 3.6.5 According to Gerald I. White et al, the various approaches are equivalent in a highly stylized and perfect world. Such a world has no need for financial analysis as all is known. Analysis is challenging and rewarding, however, in real-world settings, with
21

R. P. Rustagi, Financial Management, 2nd ed., Galgotia Publishing Company, New Delhi, India, 2001, p. 377 22 Gerald I White, Ashwinpaul C.Sondhi and Dov Fried, The Analysis and Use of Financial Statements, 3rd ed., John and Sons(ASIA) Pte Ltd, Singapore, 2005, p. 683 23 op. cit., Frank K. Reilly et al., p. 377 24 ibid., p. 377

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finite knowledge and horizons and costly information. In the real world, there is uncertainty with respect to both the definition and measurement of the model parameters and their actual outcomes. The equivalence of asset-based, DCF, and EBO models breaks down, and different valuations result. The uncertainties in these models include: Difficulties in forecasting over a finite horizon, let alone to infinity The random nature of cash flows and earnings, and the difficulty in assessing whether reported amounts are permanent (will persist in the future) or transitory (nonrecurring). The measurement of assets, earnings, and cash flows, which can be influenced by the selection of accounting policies and by discretionary management policies.25 3.6.6 Similarly, in addition to the discounted cash flow and relative valuation technique, there has been growing interest in a set of performance measures referred to as value added. There are two measures of value added: economic value added (EVA) and market value added (MVA) pioneered by Stern and Stewart,26 These value-added measures the management performance based on the ability to add value to the company. These two measures have extensively used, based on the idea that security analyst, as possible indicator of the future returns should reflect superior management performance in a companys common stock returns. Generally, EVA measures the internal performance and MVA measures the external performance of a company. Several studies have attempted to determine the relationship between the two variables (EVA and MVA), and the results have not been encouraging. Although the stock of firms with positive EVA has tended to outperform the stocks of negative EVA firms, the differences are typically insignificant and the relationship does not occur every year.27
op cit., Gerald I White et al., p. 684 These concepts have described in detail in G. Bennett Stewart III, The Quest for Value: A Guide for Senior Manager, Harper Business: A Division of HarperCollins Publishers, Inc., New York, USA, 1991. 27 op. cit., Frank K. Reilly et al. p. 591
26 25

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3.6.7 These two value models have some shortcomings that it only shows the increased or decreased value of EVA and MVA, when analyst compares more than one years value. The method is very useful for comparative study for evaluation of the company and only defines about the management performance. Therefore, while using these tools, it is important to compare these changes in EVA and MVA each year to measure impact on stocks from other variables like changes in interest rates, inflation and general economic conditions. The shortcoming of these analyses is that it will not determine the actual return and risk of particular asset or stock and needs lot of care and expertise to analyze the variables that may not be possible to do every type of investors.

3.7 Approaches of Security Price Analysis There are two main approaches of security price analysis and that are technical analysis and fundamental analysis. Technical Analysis is a method of prediction of price movements based on the study of charts on the assumption that stock price trend are repetitive, because it believes that investor psychology follows a certain pattern, that is seen to have happened before is likely to be repeated. They are not bothered with the fundamental strength or weaknesses of an organization or an industry. They study about the investor and stock market price behavior. Alternatively, fundamental analysis is scientific study of the basic factors, which determines a stock price. This analysis studies the market, industry and companys performance, evaluates company management, and compares the company with its competitors and market. It considers more effective in fulfilling long-term growth of wealth, rather than their short-term price fluctuations.

3.7.1 Technical Analysis 3.7.1.1 Technical analysis can be defined as a method of identifying the past trend reversal at a very early stage and to take right decision at the right time in the movement of the reversal to ride the trend until there are evidences enough to give an idea that there will again going to be a change in trend. Through the trend analysis, prices can be

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evaluated on a yearly, quarterly, monthly, and daily basis. Technical analysis does not believe the fundamental facts about the issuing company about the companys earnings, its products, forthcoming legislation which may affect the company; and see no need to study the number of economic, industry, and company variables to arrive at an estimate of future value because they believe that past price movement will signal future price movement. A Richard McDermott, Editor and Reviser of Technical Analysis of Stock trend, in his editorial defines that, through his technical work, John Magee emphasized these three principles: 1. Stock prices tend to move in trends; 2. Volume goes with the trends and 3. A trend, once established, tends to continue in force. 28 3.7.1.2 They believe that these innumerable fundamental facts have summarized and represented on market prices of security. Most of them focus their attention on charts of security prices and on related summary of statistics about security transactions. Frank K.
Reilly and Keith C. Brown have defined that, many investors using these techniques

claim to have experienced superior rates of return on many investments. In addition, many newsletter writers base their recommendations on technical analysis. Finally, even the major investment firms that employ many fundamental analysts also employ technical analysts to provide investment advice. Numerous investment professionals and individual investors believe in and use technical trading rules to make their investment decisions. Therefore, weather you are a fan of technical analyst or an advocate of the efficient hypothesis, you should still have an understanding of the basic philosophy and reasoning behind technical approaches.29 3.7.1.3 Technical analyst base trading decisions on examinations of prior price and volume data to determine past market trends from, which they predict future behavior

R. D. Edwards and John Magee, J., Technical Analysis of Stock Trends, 7th ed., American Management Association, USA, 1997 29 op. cit., Frank K. Reilly et al., p. 626

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for the market as a whole and for the individual securities.30 Basic assumptions leading to technical analysis are as follows: 31 1. Market value of stock is determined by the interaction of supply and demand. 2. Supply and demand are governed by various rational and irrational factors. The market adjusts all these factors automatically and continuously. 3. Series of stock price and overall value of market movements contain trends that persist for appreciable duration of time. 4. Based on analysis of past price, and volume data, the changes of trends caused by the shift of demand and supply are detectable. 3.7.1.4 Generally, the technician record historical financial data on charts, study these charts in pattern of movement if they found meaningful and gives some results that they use for future security pricing. These charts are used to movement and price of different types of securities like stocks, assets, commodity market, and foreign exchange, rate of interest and rate of market return. The technician usually attempts to predict short-term price movements and thus makes recommendations concerning the timing of purchases and sales of either specific security or group of stocks. Their philosophy and assumption is that history repeat itself. However, there is no answer when it would repeat same pattern or trend in future. If a certain pattern of activity has in the past produced, certain result ninety per cent out of hundred percent can assume a strong likelihood of the same outcome whenever this pattern appears in the future. It may be taken consideration to some extent. 3.7.1.5 Correspondingly, the large part of the methodology of technical analysis lacks a strictly logical explanation. Again, most of the technical analysts rely on trading volume and charts of stock prices. Early studies found little evidence showing technical analysis to be useful in enabling investors to beat the market.32 Many technical analysts have
30 31

ibid., p. 626 Robert A Levy, Conceptual Foundation of Technical Analysis, Financial Analysis Journal, JulyAugust 1966, vol. 22, no. 4, p. 348 32 Eugene F. Fama, Efficient Capital Markets: A Review of Theory and Empirical Work, Journal of Finance, May 1970,vol. 25, no. 2, pp. 383-417

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offered the proof of ability to beat the market, but most of them committed at least one of the errors, which have described earlier. However, several recent studies have indicated that technical analysis may be useful to investors.33 William F Sharpe et al. have divided technical analysis in the two groups that the first group, consisting of momentum and contrarians strategies, simply examines the returns on stocks over a time period that just ended in order to identify candidates for purchase and sale. The second group, consisting of moving average and trading range breakout strategies, makes such an identification based on the relationship of a securitys price over a relatively short time period that just ended to its price over a relatively longer time period.34 All These strategies explained have rigorously tested, avoiding the associated pitfalls. The hundred per cent certainty of technical analysis is questionable in the practical application, because the history may not repeat same manner, even it repeat may not at same level of prediction, which is not able to describe the technical analyst. 3.7.1.6 However, usefulness of these technical strategies remains an open debate to many questions. By supporting the idea, it has been urged that the commonplace usage of modern computerized trading programs designed to implement technical strategies will ultimately eliminate any potential. Such strategies have been adopted for generating abnormal profits. The results of empirical test of the efficient market hypothesis (EMH) are the major challenges of technical analysis. The two sets of tests of the weak form are35: (1) the statistical analysis of prices to determine if prices moved in trends or were a random walk, and (2) the analysis of specific trading rules to determine if their use could beat a buy- and- hold policy after considering transactions cost risk. Almost all the studies testing the weak form EMH using statistical analysis have found that prices do not move in trends based on statistical tests of autocorrelation and runs.36 Regarding the analysis of specific trading rules, numerous technical trading rules exist that have not been or cannot be tested. Still, the vast majority of the results for the trading rules

33

______________, Efficient Capital Markets: II, Journal of Finance, December 1991, vol.46 no. 5, pp. 1575-1617 34 op. cit., William F. Sharpe et al., pp. 844-849 35 op. cit., Frank K. Reilly et al., p. 629 36 ibid., p. 629

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tested support the EMH.37 That means the technical analysis have given little support to the stock market price analysis and EMH of the study.

3.7.2 Fundamental Analysis 3.7.2.1 Fundamental analysis can be defined as a scientific study of the basic variables that determines assets or stocks value. In addition, it studies the companys sales, assets, liabilities, structure of debt, earnings, products, market share, evaluates the companys management performance, estimates the value of stock and it compares company with its competitors, industry and market. Fundamental analysis is related to objective of long-term growth and development of company, rather than short-term price fluctuations. Fundamental analyst believes that there is a basic intrinsic value for the stock market as a whole, various industries, or individual stocks and that these values depend on underlying economic variables. Therefore, investors should find out the intrinsic value of securities at the time of investment by analyzing the variables such as current and future earnings, cash flows, interest rates, and risk of investment that determines the value of securities and assets; and compare whether predominant market price significantly different from the intrinsic value by enough to cover transaction costs. 3.7.2.2 Investors who have engaged in fundamental analysis believe that, occasionally, market price and intrinsic value differ but, eventually; investors recognize the discrepancy and correct it.38 Moreover, fundamental analysis involves aggregate market analysis, industry analysis, and company analysis and portfolio management.39 Fundamental analysis use different model like top down verses bottom up forecasting, probabilistic forecasting, statistical analysis, econometric models etc. to estimate the value of security. Although many investors use technical analysis, fundamental analysis is far more predominant. Technical analysis is frequently used as a supplement to fundamental analysis than as an alternative method of analysis. Moreover, unlike

37 38

ibid., p. 629 ibid., p. 198 39 op. cit., Frank K. Reilly et al., p.199

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technical analysis, in the capital market efficiency, it is essential part of the capital market and securities and asset analysis. 3.8 Return and Risk of Investment 3.8.1 Investment can be defined simply to be the sacrifice of current cash for future cash whose objective is to increase future wealth. The sacrifice of current rupees takes place at present with certainty and the investor expects desired level of wealth at the end of his investment horizon, which is uncertain. The general principle is that the investment can be retired when cash has been needed for other purposes. The decision to investment now is the most crucial decision as the future level of wealth is not certain. Time and risk are the two major factors involved in the investment decision. Broadly, investment alternatives fall into two categories: real assets and financial assets. Real assets are tangible while financial assets involve contracts written on pieces of papers such as common stocks, bonds and debentures. It is possible to buy and sale financial assets in organized security markets. The return of common stock can be defined as the return from holding an investment over some time period is simply any cash payments received due to ownership, plus the change in market price, which has derived by the beginning price. The return is income received on an investment, which has expressed as dividend including any change in market price of the common stock (i.e. capital gain/loss), usually expressed in per cent. 3.8.2 The question may arise in the investors mind that why invest in the common stocks and why not in the other types securities and assets. In this case, Mukesh Dedhia, a certified financial planner (CFP) says that, it is always better to go for equity when it comes to retirement planning. It is especially good for youngsters. They should try to invest in systematic investment plan method. Stocks offer superior returns. This along with compounding over a long term would help to build a large corpus. It also brings down the risk element in equity investment. He offers an example of someone saving Rs.1, 000 every month for 30 years. If you take the historical returns of 25% in a mutual fund, the person would have Rs.4 core (i.e., 40 millions) plus at the

63

end of 30 years. If he earns 6% in another avenue, he would only have Rs 7 Lakhs (i.e., Rs.0.7 million) Plus.40 3.8.3 The common stockholders are the owners of the company and have the ultimate control of the companys affairs. In reality, the control is limited to a voting right either in person or by proxy, on appointment to the board of directors. Collectively, shareholders are the owners of the company and it has assumed that ultimate risk is associated with ownership. The common stock has known as the most risky securities as compared to other securities. The risk is in reality, the uncertainty associated with the end of the period expected to receive total value of an investment. Generally, the investors invest their savings in the securities on expectation of future higher return. Nevertheless, their expected return on investment may or may not happen in reality. The actual return on investment of common stock may differ significantly from the expected return. Actually, the variability between the expected and actual return has defined as risk. The greater the variability of return on security, higher the risk would be in the investment. The stock market price of a company is driven by fundamental business values, market sentiment and business environment. More specifically, systematic investment is actually trade-off between the risk and return. 3.8.4 There are several types of source of risk, which is associated to the return on the investment. However, as specified by the Prasanna Chandra, the three major ones are business risk, interest risk, and market risk41. He is more specific just segmenting as a three types of risk. In the same way, as defined by the Frank R. Reilly et al., risk components has considered a securitys fundamental risk because it deals with the intrinsic factors that should affect a securitys standard deviation of returns over time.42 Subsequently, he emphasized that the standard deviation of returns has referred to as a measure of the securitys total risk, which considers the individual stock by itself-that has not been considered as part of a portfolio.
40 41

Madhu T., Future Proofing, Times Business/ Investing, Times of India, December 7, 2006, p. 18 Prasanna Chandra, Investment Analysis and Portfolio Management, 2nd ed., Tata McGaraw-Hill Publishing Company Ltd, New Delhi, India, 2005, p.128 42 op. cit., Frank K. Reilly et al., p. 21

64

Risk Premium = f (Business Risk, Financial Risk, Liquidity Risk, Exchange Rate Risk, Country Risk)43 Jack Clark Francis defines similar view in more detail as defined by the Frank R. Reilly et al. He has presented number of probable risk factors, which has been presented in Table 3.1. Table 3.1 Some Risk Factors that May Affect an Asset44 Plus: Interest rate risk (if present) Plus: Purchasing power risk (if present) Plus: Bull-bear market risk (if present) Plus: Management risk (if present) Plus: Default risk (if present) Plus: Liquidity risk (if present) Plus: Callability risk (if present) Plus: Convertibility risk (if present) Plus: Taxability risk (if present) Plus: Political risk (if present) Plus: Industry risk (if present) Plus: The first additional risk (if present) Plus: Other additional risk factors (if present) ___________________________________________________________ Equals: Total risk, Var(r ) ____________________________________________________________ 3.8.5 The relationship between the expected future state of the economy and the performance of individual company enables a relationship to set forth between different levels of returns and their relative frequency has called a probability distribution. It would be possible to formulate a probability distribution for the relative frequency of a
43 44

ibid., p. 21 op. cit., J. C. Francis, Investments: Analysis and Management, p. 10

65

companys annual returns by analyzing its historical returns over the previous years. Nevertheless, it is well known that history never repeats itself exactly the similar way as happened in the past. Hence, after analyzing relative frequencies of historical returns of the individual company, it is possible to form a probability distribution based on historical data plus analysis of the out look for the economy, the outlook for the company and its industry and any other factors, it has deemed to be relevant as inputs for judgments. The state of the economy has a major impact on return on the investment. 3.8.6 Jack Clark Francis makes it clear that, investment decisions are based on expectations about the future. The expected rate of return for any asset is the weighted average rate of return, using the probability of each rate of return as the weight. The expected rate of return has been calculated by summing up the products of the rates of return and their respective probabilities.

E( r) =

Pr
t =1

t t

= P1r1 + P2r2 +.+ PT rT

(1-5)

The subscripts in the formula for the expected return are event counters that are appended to each possible rate of return and probabilities (denoted P) for that event T different event are perceived as probabilities45 3.8.7 Weston and Brigham point out that, Risk defined most generally, is the probability of the occurrence of unfavorable outcomes. But, risk has different meanings in different context. 46 In our context, two measures developed from the probability distribution have used as initial measures of return and risk. There are the mean and the standard deviation of the probability distribution.47 Likewise, William Sharpe et al have given more emphasis on the measurement of risk of investment. In their words, Instead of measuring the probability of a number of different possible outcomes, the measure of risk should some how estimate the extent to which the actual outcome is likely to
45 46

ibid, pp. 11-12 Freed J. Weston and Eugene F Brigham, Managerial Finance 7th ed., Hold Saunders International Editions, 1981, pp. 93 47 ibid, p. 95

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diverge from the expected out-come. Standard deviation is a measure that does this since it is an estimate of the likely divergence of actual return from an expected return.48 3.8.8 However, James C. Van Horne et al writes about the result of standard deviation that, The standard deviation can some times be misleading in comparing the risk on uncertainty , surrounding alternatives of they differ in size .. To adjust the size, or scale problem, and the standard deviation can be divided by the expected return to compute the coefficient of variation (CV). Thus, the coefficient of variation is a measure of relative dispersion (risk) - a measure of risk per unit of expected return. The larger the CV the larger the relative risk of the investment.49 Many experts and statisticians have not given idea of negative returns and outcome of the negative CV. This may be due to the illusion of expected return or out come should be always positive. However, in practical economic events there is possibility to face both the situation, either positive or negative expected return. 3.8.9 In this regard, Philip G Enns has clearly defined that, the coefficient of variation has normally computed for nonnegative data only.50 Per unit of risk can be measured by the CV, which is used to measure the per unit risk of an asset in the financial analysis. It is very easy to measure and it removes the size and scale problems, but when there is negative expected return in that case CV could be negative value. Negative value of CV could not measure per unit of risk in the financial analysis. Some statisticians have defend that the negative value of CV should be made positive value by ignoring negative sign to see the variability of data but this logic would not satisfy the purpose of financial analysis and interpretation of data that means this is the shortcoming of the coefficient of variation for the field of financial management and economics. This shows that standard deviation and CV may not give the true vision of risk of the

op. cit., William F. Sharpe et al., p. 177 James C Van Horne and Jr. John M. Wachowicz, Fundamentals of Financial Management, 8th ed., Prentice Hall Inc., USA, 1993, p.101 50 Philip G Enns, Business Statistics: Method and Applications, Richard D. Irwin Inc, USA, 1985, p. 121
49

48

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company in every type of situation. In such a situation, it shows that other types of analysis are necessary for better result. 3.8.10 The portfolio theory, originally proposed by Harry Markowitz in the 1950s, was the first formal attempt to quantify the risk of a portfolio and develop a methodology for determining the optimal portfolio.51 In his classic article, Portfolio Selection, he submitted that investors should not choose portfolios that maximize expected return, because this criterion by itself ignores the principle of diversification.52 He suggested that investors should instead consider variances of return, along with expected returns, and select portfolio that offer the highest expected return for a given level of variance. Markowitz diversification may be defined as combining assets which are less than effectively positively correlated in order to reduce portfolio risk without sacrificing portfolio return. It can sometimes reduce below the undiversifiable level. Markowitz diversification is more analytical than simple diversification and considers assets correlations (or covariance). The lower the correlation between assets, the more that Markowitz diversification will be able to reduce the portfolios risk.53 3.8.11 Similarly, James Tobin, the 1981 winner of the Nobel Prize in economics, demonstrated that the investment process could be separated into two distinct steps- (1) the construction of efficient portfolio, as described by Markowitz, and (2) the decision to combine this efficient portfolio with a risk less investment. This two-step process is the famed separation theorem.54 Again, Sharpe extended Markowitzs and James Tobins insights to develop a theory of market equilibrium under conditions of risk.55 At first Sharpe has indicated that there is besides the efficient frontier a unique portfolio, when combined with lending or borrowing at the risk free interest rate (or Treasury bill rate), controls all other combinations of efficient portfolios and lending or borrowing. He made two assumptions the first one is that there exists a single risk free at which
op cit., Prasanna Chandra, p. 243 Harry Markowitz, Portfolio Selection, Journal of Finance, vol.7 no.1, Mach 1952, pp.77-91 53 op cit: J. C. Francis, Investments: Analysis and Management, p. 234 54 James Tobin, Liquidity Preferences as Behavior Towards Risk, Review of Economic Studies, February 1958, vol. 26, no. 1, pp. 65-86 55 W. Sharpe, Capital Asset Prices: A theory of Market Equilibrium under Conditions of Uncertainty, Journal of Finance, September 1964, pp. 425-552
52 51

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investors can borrow and lend in unlimited amounts, and second is that investors have same kind of expectations regarding their expected returns, variances and correlations. The efficient frontier represents a set of portfolio that has the maximum rate of return for every given level of risk, or the minimum risk for every level of return.56 Under these assumptions, he went forward to logically prove that risk could be partitioned into two sources, the first source is caused by changes in the value of the market (or external) factors, which cannot be diversified away, and second source is caused by internal factor, which is diversified away in the market portfolio. He assigned this risk in two category non-diversifiable risk as a systematic risk and diversifiable risk as an unsystematic risk. 3.8.12 This analysis shows that undiversifiable risk should not play a role in the process of deciding factor of stock market prices that means the investors has to make portfolio with the more than two assets with negative correlation between them. However, there is problem of getting negatively correlated two assets or portfolio of stocks because the evidence has shown that most of stock moves same directions in the market. Moreover, the negative correlation happens only when the two assets price moves opposite directions (i.e., series of one asset price goes up and another assets price goes down). That means negatively correlated two assets expected return are also proportionately goes down simultaneously as per their proportion, which may not be beneficial for the aggressive investors to get optimum expected return from the portfolio of investment. 3.8.13 At the same period publication of Markowitzs theory of portfolio selection and Sharpes equilibrium theory of asset pricing, Franco Modigliani and Merton Miller have published two related articles where in they interpreted the present famous unchangeable proposition. The first one, The Cost of Capital, Corporation Finance, and the Theory of Investment, published in 1958.57 It challenged the traditional view that a firms value depends on its capital structure. The substitutability of individual debt guarantees that company is in the same risk class will be valued the same,
56 57

op. cit., Frank K. Reilly et al., p. 228 F. Modigliani and M. Miller, The Cost of Capital, Corporation Finance, and the Theory of Investment, American Review, June 1958.

69

regardless of their respective capital structure. They indicated in support of the law of one price. Subsequently their second article, Dividend Policy, Growth, and the Valuation of shares, Modigliani and Miller suggested that firms value is invariant; not only to its capital structure, but also to its dividend policy by assuming the firms investment decision is set independently.58 According to them, under a perfect market condition, the dividend policy of a firm is irrelevant, as it does not affect the firm. However in the real world , where investors would not borrow and lend at the risk less rate of interest, where both individual investors and company pay taxes, and where investors do not share equal access with management to relevant information, their is small evidence to support the Modigliani and Millers unchangeable propositions. 3.8.14 These portfolio theories are ideas from the foundation for the capital asset pricing model (CAPM) which is a major component of modern financial theory.59 The CAPM theory is concerned with deriving the expected or required rate of return on risky assets based on the assets level of undiversifiable risk. Moreover, it determines the security is undervalued, overvalued, or properly valued. There were mixed support for a positive linear relationship between rates of return and systematic risk for portfolio of stock. Some recent evidences have indicated that there is a necessity to consider additional risk variables for analysis. Furthermore, many empirical tests support the validity and relevance of the CAPM. Several papers have criticized the tests of the model and the usefulness of the model in portfolio evaluation, because it is dependent on a market portfolio risk, which is not easily available to all investors. Specially, academician have tried to find out for an alternative asset pricing theory to the CAPM that was moderately intuitive, needed only limited assumption, and provide for multiple aspect of investment risk. 3.8.15 The Arbitrage Pricing Theory (APT) developed by Stephen Ross in response to criticisms of the CAPM, suggests a linear relationship between a stocks expected

58

______________, Dividend Policy, Growth, and the Valuation of Shares, Journal of Business, October 1961. 59 op. cit., J. C. Francis, Investments: Analysis and Management, p. 266

70

return and many systematic risk factors.60 The APT is based on the law of one price, which states that the same good cannot be sold for two different prices. If the same good they sell at different prices, anyone could engage to arbitrage by simultaneously buy at low price, sell same good at high price, and make risk free profit. Remarkably, though the APT model requires less assumption and considers multiple factors to make clear the risk of a security, the CAPM has a more beneficial in its single risk factor, is well described. But some other researcher found that the inability to identify the risk factors is major limitation to the usefulness of the APT.61 Results of the initial researches are moderately favorable, it tends to propose that the APT might have more empirical explanatory than the CAPM.62 3.8.16 There are so many arguments in support and against CAPM and APT models by the different researchers, but it is probably reliable to attribute that the both models will continue to be used for pricing the capital asset. Several other researchers have recommended an alternative approach that is statistical techniques for testing the APT model. Some of them are Stephen J. Brown and Mark I. Weinstein, John Geweke and J.D. Jobson. Guofu Zhou and Stephen J. Brown and Mark I. Weinstein who have suggested an approach for estimating and testing asset-pricing models by using the bilinear paradigm.63 John Geweke and Guofu Zhou have prepared an exact Bayesian framework for testing the APT model and recommended that there is little degree of reduction in pricing error from including additional factors outside the scope of the first one.64 In the same way, J.D. Jobson has proposed the APT model, to be analyzed by using a multivariate linear regression model.65 The APT model is difficult to apply in practice in a theoretically exact fashion.
60

Stephen Ross, The Arbitrage Theory of Capital Asset Pricing, Journal of Economic Theory, vol.13, no. 2, December 1976, pp. 341-360. 61 Jay Shanken, The Arbitrage Pricing Theory: Is It Testable, Journal of Finance, vol. 37, no. 5, December 1982, pp.1129-1140. 62 Edwin Burmeister and Marjorie B. McElory, Joint Estimation of Factor Sensitivities and Risk Premia for the Arbitrage Pricing Theory, Journal of Finance, July 1988, pp. 721-733 63 Stephen Brown and Mark I. Weinstein, A New Approach to Testing Asset Pricing Models: The Bilinear Paradigm, Journal of Finance, vol. 38, no. 3, June 1983, pp. 711-743. 64 John Geweke and Guofu Zhou, Measuring the Price of the Arbitrage Pricing Theory, Review of Financial Studies, vol. 9, no. 2, summer 1996, pp. 557-587. 65 J. D. Jobson, Multivariate Linear Regression Test for the Arbitrage Pricing Theory, Journal of Finance, vol. 37, no. 4, September 1982, pp. 1037-1042

71

3.8.17 Multifactor models of risk-return analysis attempt to reduce this gap between theory and practice by specifying a set of variables, which are believe to capture the fundamental nature of the systematic risk exposure, which has occurred in the capital market. S.P. Bansal66 used multiple correlation and regression analysis in his article by using Indian equity price as dependent variable and book value per share(BP), dividend per share(DPS), earning per share( EPS), price earning (PE) ratio, dividend pay out ratio (C ), dividend yield (Y) and sales growth (G) as an independent variable for the analysis. He has concluded from the correlation and regression analysis that book value, dividend per share, earning per share and dividend coverage ratio were the variables that contributed most in determining share prices followed by price earning ratio and dividend yield and effect of growth in sales insignificant. Likewise, Monica Singhania67 also used similar variable and same method multiple correlation and regression analysis in her article as S.P. Banasal has done. After the analysis, she has remarked on her conclusion that price-earning ratio, earning per share, book value, and dividend cover were the variables, which contributed most in determining share prices followed by dividend per share and yield. In the context of Nepal, Sadakar Timilsina has used the pooled data of the sample companies to analyze the multivariate and other regression model and discovered that there is positive relationship between dividend and stock prices in addition to this; dividend has a leading control on stock market prices.68 The researches look nice analyses have been done. However, they ignored the fundamental factor of the multicollinearity effect in the multiple regression analysis. Multicollinearity arises whenever, either in the population or in the sample, several of the explanatory variables stand in an exact or almost linear relation to each other.69 In multiple-regression analysis, the regression coefficients often become less reliable as

66

L. N. Bansal, Behavior and Determinant of Equity Prices in India, Editors P. P. Arya and Yesh Pal, Research Methodology in Management, Deep and Deep Publications Pvt. Ltd, 2004, New Delhi, India, pp. 276-284. 67 Monica Singhania, Determinants of Equity Prices: A study of Select Indian Companies, The ICFAI Journal of Applied Finance, vol.12, no. 9, 2006, pp. 39-51 68 Sadakar Timilsina, Dividend and Stock Prices: An Empirical Study, MBA Thesis, T.U., Kritipur, Kathamndu, Nepal, 1997, p. 56 69 Edward J. Kane, Economic Statistics and Econometrics: An Introduction to Quantitative Economics, International edition, Harper and Row, Publishers, New York, USA, 1968, p. 278

72

the degree of correlation between the independent variables increases.70 Therefore, chances of getting multicollinearity effect in this type of analysis is very high because there is linear relationship between these variables (i.e. between the BP, DPS, EPS, PE ratio, C, Y and G variables) are very high and that may not give the better results for the analysis. The greater the degree of multicollinearity least squares allocate the sum of explained variations among the individual explanatory variables are more arbitrarily and unreliably.71 3.8.18 Van Horn James C and Jr. John M. Wachowicz have outlined that, in generally accepted view, investors are by and large, risk averse. This implies that risk investment must offer higher expected returns than less risky investments in order for people to buy and hold them.72 It may not possible to make zero risk; it may be reduced to some extent or averted. In this case, Professor I.M. Pandey clarifies that, diversification reduces risk when the returns of securities do not exactly vary in the same direction. Can diversification reduce all risk of securities? Risk has two parts. A part of the risk arises from the uncertainties which are unique to individual securities, and which is diversifiable if large numbers of securities are combined to form well-diversified portfolio. The unique risk of individual securities in a portfolio cancels out each other. This part of the risk can be totally reduced through diversification, and it is called unsystematic or unique risk. The examples of unsystematic risk are: workers declare strike in a company the R&D expert of the company leaves a formidable competitor enters the market the company loses a big contract in a bid the company makes breakthrough in process innovation the government increases custom duty on the material used by the company the company is not able to obtain adequate quantity of raw material from the suppliers
Richard I. Levin and David S. Rubin, Statistics for Management, 7th ed., Prentice-Hall of India, New Delhi, India, 1999, p. 745 71 ibid., p. 278 72 op cit., James C, Van Horn et al., p. 106
70

73

The other part of the risk arises because of the economy-wide uncertainties and the tendency of individual securities to move together with changes in the market. This part of risk cannot be reduced through diversification, and it is called systematic, or markets risk. Investors are exposed to market risk even when they hold well-diversified portfolios of securities. The examples of systematic risk are: the government changes the interest rate policy the corporate tax rate is increased the government resorts to massive deficit financing inflation rate increases the reserve bank of India (i.e., Central Bank) promulgates a restrictive credit policy Total risk, which in the case of an individual security is the variance (or standard deviation) of its return, can be divided into two parts: Total risk = Systematic risk + Unsystematic risk73 3.8.19 Francis Jack Clark has given clear vision to segregate the diversifiable riskreturn and undiversifiable riskreturn by applying the least square regression analysis of statistical tools. That can be defined as, diversifiable risk is that portion of total risk which is unique to the firm that issued the securities. Events such as labor strike, management errors, inventions, advertising campaigns, shifts in consumer taste, and lawsuits cause un-systematic variability in the value of a market asset. Since unsystematic risk changes affect one firm, or at most a few firms, they must be forecasted separately for each firm and each individual incident. Unsystematic security price movements are statistically independent from each other, and so they may be averaged to zero when different assets are combined to form a diversified portfolio. Therefore, unsystematic risk is also called diversifiable risk. To be more concrete, the rate of return from the ith securities in the tth period can be represented as the sum two components:

73

I.M. Pandey, Financial Management, 8th ed., Vikas Publishing House Pvt.Ltd, New Delhi, India, 1999, p. 350

74

ri,,t = E(ri) + ei,t

(10-1)

Total Return = Expected rate of return + diversifiable return The part of the ith assets total return that fluctuates around its expected return is denoted by ei,t
.

The diversifiable return can make either a positive or a negative

contribution to an assets total return in any particular period; it has an expected value of zero E(ei,t) = 0. This portion of the assets return is unique to asset i and may be diversified to zero in a portfolio of different securities.74 3.8.20 Likewise, undiversifiable risk is that portion of total variability in return caused by market factors that at the same time affects the prices of all securities.75 Francis Jack Clark clearly defines the statistical methods of calculation of the undiversifiable portion of the risk. In his words he defines, The systematic nature of these price changes make them immune to much of the risk reduction effects of diversification. Thus, systematic risk is also called undiversifiable risk. Changes in the economic, political, and sociological environment that affect securities markets are main sources of systematic risk. Systematic variability of return is found in nearly all securities to varying degree because most securities tend to move together in a systematic manner. .. The systematic nature of the undiversifiable portion of a securitys return is stated formally as follows: E(ri,t) = ai + bi E(rm) (10-2)

Equation (10-2) states that the ith assets expected return is a simple linear function of E(rm), the expected return from a highly diversified market portfolio. The ai term is a constant that is called the assets alpha; the alpha has value near zero for most assets. The bi term is called beta. The betas of most assets have values near positive unity.76

74 75

op. cit., J. C. Francis, Investments: Analysis and Management, pp. 264-265 J. C. Francis, Intertemporal Differences in Systematic Stock Price Movements, Journal of Financial and Quantitative Analysis, June 1975, pp. 205-219, also see G. A. Hawawini and A. Vora, Evidence of Intertemporal Systematic Risks in the Daily Price Movement of NYSE and AMEX Common Stocks, Journal of Financial and Quantitative Analysis,1979 76 op. cit., J. C. Francis, Investments: Analysis and Management, pp. 265- 266

75

Alpha is an estimate of the ith assets when the market is stationary, rm,t, = 0 The alpha intercept statistic is defined in Equation (10-5)77 ai = r - bi rm = E(ri) - bi E(rm) (10-5)

3.8.21 Similarly, the beta coefficient is defined by Equations (10-6) and (10-6a) 78

bi = bi =

Cov ( ri , rm ) Var ( rm )
units..of ..rise units..of ..run
= Slope of characteristic line

(10-6) (10-6a)

The term Var(rm) represents the variance of returns for the market portfolio, and Cov(ri,rm) denotes the covariance of returns of the ith asset with the market. The beta coefficient is an index of systematic risk. Beta coefficient may be used for ranking the systematic risk of different assets. If the beta is larger than 1, b>1.0, then the asset is more volatile than the market and is called an aggressive asset. If the beta is less than 1, b<1.0, the asset is a defensive asset; its price fluctuations are less markets.79 3.8.22 Jack Clark Francis has suggested that, total risk can be measured by the variance of return, denoted Var(r ) . This measure of total risk is partitioned into its systematic and unsystematic components in Equation (10-8)80 Var(ri) = total risk of ith asset = Var(ai + birm,t + ei.t) by substituting (ai + birm,t + ei.t) for ri.t = 0+ Var(birm,t) + Var(ei.t) since Var(ai) = 0 Var(ri) = bi2 Var(rm) + Var(e) since Var(birm) = bi2 Var(rm) = Systematic risk + Unsystematic Risk
77 78

volatile than the

(10-8)

(10-8a)

ibid., p. 272 ibid., p. 272 79 ibid., p. 273 80 ibid., p. 273

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Again, he clarified the partition of the risk in the statistical terms. In his word, in this context, partition is a technical statistical term that means to divide the total variance into mutually exclusive and exhaustive pieces. This partition is only possible if the returns from the market are statistically independent from the residual error terms that occur simultaneously, Cov(rm,t, ei,t) = 0. The mathematics of regression analysis will orthogonalize the residuals and thus ensure that the needed statistical independence exists.81 3.8.23 The percentage of total risk that is systematic can be measured by the coefficient of determination 2 (that is, the characteristic lines squared correlation coefficient).82

bi2Var (rm ) Systematic..risk = = 2 Total..risk Var (ri ) Similarly, the percentage of unsystematic risk equals (1.0- 2)83
unsystematic..risk Var (e) = = (1.0 - 2) Total..risk Var (ri )

(10-9)

(10-10)

Studies of the characteristic lines of hundreds of stocks listed on the New York Securities Exchange (NYSE) indicate that the average correlation coefficient is approximately p = 0.584. This means that the movements in the market explain 25 percent of the total variability of return in most NYSE securities. A primary use of the characteristic line (or market model, or the single index model, as it is also called) is to assess the risk characteristics of one asset.85 New risk measurements must be made periodically, however, because the risk and return of an asset may change with the

81

82 83
84

ibid., p. 273

ibid., p.274 ibid., p.274

Marshall Blume, On the Assessment of Risk, Journal of Finance, March 1971, p. 4. For similar estimates, see J.C.Francis, Statistical Analysis of Risk Surrogates for NYSE Stocks, Journal of Financial and Quantitative Analysis, December 1979. 85 M. C. Jensen, The Performance of Mutual Funds in the Period 1945 through 1964, Journal of Finance, May 1968, pp. 389-416

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passage of time.86 The undiversified investors must have to consider the proportion of systematic and unsystematic risk of total risk on the expected return. For example investors who have their entire net worth invested in one business can be bankrupted by a piece of bad luck that could be easily averaged away to zero in a diversifiable portfolio. Investors have to remember that the poorly diversified portfolio should not treat diversifiable risk lightly. Only well-diversified investors can able to minimize /make zero diversifiable risk. 3.8.24 Compared to other valuation models, risk-return analysis has a better alternative for investors, analysts and managers for valuation of the stocks. Because other models have certain shortcomings, mostly they consider the required rate of return or cost of capital. At the same time, they do not consider the risk of investment in the market, which is most important part of the investment. Investment without managing a risk is like a jumping out from the plane without having a parachute that may be deadly decision for every type of investors. Therefore, investors have to remember that the risks need to be identified and monitored on an ongoing basis. Risk-return analysis does not consider the directly investors required rate of return. However, it considers market risk-return and compares with different alternative of investments, so that investor can make their choice of investment in the different types of securities. 3.8.25 By separation of proportion of systematic and unsystematic risk, it is possible to know particular assets undiversifiable and diversifiable risk. The percentage of the undiversifiable or market risk is unavoidable risk. It is derived by the external factor of the business environment, which is not in the hands of the management. The percentage of diversifiable risk or company risk is avoidable through portfolio management. It is also very useful for analyst and manager of the company. Through this, analyst and manager can identify companys weakness in the area of information and other management system of the company so that they can make correction of their management system that will ultimately give positive response in the stock market
86

Marshall Blume, Betas and their Regression Tendencies, Journal of Finance, June 1975, pp. 785795, See also J.C. Francis, Statistical Analysis of Risk Coefficients for NYSE Stocks, Journal of Financial and Quantitative Analysis, December 1979,vol.14, no. 5, pp. 981-997

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prices. It is very useful analytical technique for every type of investors (i.e., speculator, aggressive, defensive, organized and unorganized investors). Furthermore, it is possible to choose different types of assets and portfolio according to their needs so that they can make optimum profit from investment.

3.9 Capital Market Efficiency

3.9.1 Capital market efficiency refers to the ability of security price and other assets value quickly adjusts and reflects all information, which is relevant value in its price. Although the first tests of market efficiency were formally found out as long ago as 19th century87, the classification of market efficiency into three levels did not become known until 1959.88 The majority of researchers earlier work related to efficient capital markets was based on the random walk hypothesis, which argued that changes in stock market prices occurred randomly. Richard Pike and Bill Neale defined very short and specific form that market efficiency evolved the notion of perfect competition, which assumes free and instantly available information rational investors, with no taxes or transaction costs.89 Kendall has found that chances in security prices behaved nearly as if a suitably designed roulette wheel for which each outcome was statistically independent of its previous history had generated them and frequencies were reasonably stable through time.90 3.9.2 After 1960, there were some very interesting and important academic researches have been done in favor of capital market efficiency. However, at the same time so may controversies came against the efficient capital market. Because of its importance and controversy, has given a significant thought to researchers to research in this area. Though notable available facts shows that security market in the most of the developed
L. Bachelier, Theory la speculation, Gauthiers-Villars, 1900 H.V. Roberts, Stock market Patterns and Financial Analysis: Methodological Suggestions, Journal of Finance, March 1959 89 Richard Pike and Bill Neale, Corporate Finance and Investment: Decisions and Strategies, 2nd ed., Prentice-Hall of India Private Limited, New Delhi, India, 1998, p. 41 90 Harry V. Roberts (1959), Stock-Market Patterns and Financial Analysis: Methodological Suggestions, Empirical Research in Capital Markets, edited by G. William Schwert and Clifford W. Smith, international edition, McGraw-Hill Inc, USA, 1992, p.148
88 87

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economy are highly efficient, a considerable number of people have seriously argued that they had as a fact attained perfect efficient market so that the market price of every asset always equal to its intrinsic value. 3.9.3 In an efficient market, the stock market prices that prevail at any time should be an unbiased reflection of all currently available information, including the risk involved in owing the security.91 Scientific evidence point out that market efficiencies create favorable chances for security analysts to profit from undervalued and overvalued securities.92 One notable interesting thing is that efficient markets research has made investors such passive management practices a respectable choices for calculating values, comparing them with market prices.93 Efficient market hypothesis states that stock market prices fully reflect all the relevant information that is available and usable, and that reflect the fair economic value of stocks. In his original article, Fama divided the overall efficient market hypothesis (EMH) and the information set involved: (1) weak-form EMH, (2) semistrong-form EMH, and (3) strong-form EMH.94 1. The weak-form EMH states that the current shares prices fully reflect all information contained in past price movements.95 2. The semistrong form EMH states that current market prices reflect not only all past price movement, but also past all publicly available information.96 3. The strong-form EMH goes beyond the previous two by stating that current market prices reflect all relevant information- evenly if privately held.97 3.9.4 These three sub hypotheses are based on the alternative information sets and these hypotheses are actually a subset of the efficient market hypothesis. Moreover, at the
91 92

op. cit., Frank K. Reilly et al., pp. 177-178 Robert J. Shiller, Do Stock Prices Move Too Much to Be Justified by Subsequent Changes in Dividends? American Economic Review , vol. 71, June 1981, pp. 421-436, and Bruce I. Jacob and Kenneth N.Levy, Disentangling Equity Return Regularities: New Insights and Investment Opportunities, Financial Analysis Journal, May-June 1988, pp. 18-43 93 Peter C. Aldrich , Active Versus Passive: A New Look, Journal of Portfolio Management, vol. 14 no. 1, 1987, pp. 9-11 94 op. cit., Frank K. Reilly et al., p. 178 95 op. cit., Richard Pike et al., p. 41 96 ibid., p. 41 97 ibid., p. 41

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same time, these are not mutually exclusive; they vary only in the information required.98 N.P.Paudel defended that, the most of developed countries stock market appear in the semistrong-form EMH, while the developing countries stock market appears to be a weak form EMH.99 This may not be the same result come in all and every type of the study because different researchers have found different results in the different time and area of sampling. Therefore, when time will change event and environment of business will change, and at the same time, area of sampling will give big difference of the outcome; and subsequently the research will give different results.

3.10 Anomalies of Efficient Capital Market Hypothesis

3.10.1 Some of the research has supported the hypothesis and shown the presence of the capital market efficient and other investigation of study shown some anomalies related to these hypotheses, indicating results, which is against the favor of the EMH. According to the existing literature, researchers have found some calendar anomalies observed in many developed and emerging markets.100 The anomalies mostly based on the time and size. Calendar anomalies include the calendar or seasonal regularities such as the month-of-the year effect, day-of-the week effect, holiday effect, half-month effect, turn-of-the month effect and time-of-the month effect.101 There is a small but significant weekend effect in stock market prices movements.102 Rozeff and Kenney has done first formal study on the phenomenon, and found that returns on an equally weighted index of NYSE stocks were much higher in January than the other months of the year.103 Keim has examined that the interaction of the seasonal and size effects and

Jack Clark Francis, Management of Investments,3rd ed., McGraw-Hill, Inc., Singapore, 1993, p. 421 Narayan Prasad Paudel, Investing in Shares of Commercial Banks in Nepal: An Assessment of Return and Risk Elements, Economic Review: Occasional Paper, no.14, Research Department, Nepal Rastra Bank, Kathmandu, Nepal, April 2002, p. 4 100 Dr. Fatta Bahadur K.C. and Nayan K. Joshi, The Nepalese Stock Market: Efficient and Calendar Anomalies, Economic Review: Occasional Paper, no.17, Research Department, Nepal Rastra Bank, Kathmandu, Nepal, April 2005, p.43. 101 ibid., p. 45 102 Franck Cross, The behavior of stock Prices on Fridays and Mondays, Financial Analyst Journal, November-December 1973, pp. 67-69 and R. A. Connolly, An Examination of the Robustness of the Weekend Effect, Journal of Financial and Quantitative Analysis, June 1989, pp. 133-169 103 M.S. Rozeff and Kenney Jr., Capital Market Seasonality: The Case of Stock Returns, Journal of Financial Economics, vol. 3, 1976, pp. 379-402
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finds that approximately half of the annual difference between the rates of return on small and large firms occurs in the month of January.104 3.10.2 Blume and Stambaught applied a correction for the return measurement prejudice that results from using reported closing stock market prices and indicates virtually that all of the size effect occurs in the month of January.105 Balban described the January effect for turkey although it does not have any capital gain tax.106 Pandey indicated the existence of the January effect for India although January is not the first month of fiscal year.107 He has used the daily returns for the period of January 1975 to November 1987, found that six out of eight emerging Asian Pacific stock markets exhibit importantly higher daily returns in January than in other months.108 Similarly, Fatta Bahadur K.C. and N. K. Joshi have found October effect for Nepalese Stock Market, in anticipation to the tax loss-selling hypothesis.109 Researchers have reported a leaning for stock market prices, particularly the stock market prices of small companies, to fall insignificantly late in December and then rise during the first three weeks of January.110 3.10.3 The Monday Effect also called as weekend effect or day of week effect, which describes that the average daily return of the market is not the same for every day. The Mondays average returns will be higher than the other days; the reason is that Mondays average return is calculated from the closing market price on Friday. Therefore, Mondays average return will be three times higher than the average returns
D. B. Keim, Size-Related Anomalies and Stock Returns Seasonality: Further Empirical Evidence, Journal of Financial Economics vol. 12, June 1983, pp. 13-32. 105 M.E. Blume and R.F. Stambaugh , Bias in Computed Returns: An Applications to the size Effect, Journal of Financial Economics, vol. 12, 1983, pp. 387-404 106 E. Balban, January Effect, Yes! What About Mark Twain Effect, Discussion Paper, The Central Bank of the Republic of Turkey, 1995. 107 I. M. Pandey, Is there Seasonality in the Sensex Monthly Returns?, Working Paper of Indian Institute of Management, 2002, pp.1-19 108 Y. Ho, Stock Return Seasonalities in Asia Pacific Markets, Journal of International Financial Management and Accounting, vol.2, 1999, pp.47-77 109 Fatta Bahadur K.C. and N.K.Joshi, Seasonal Anomalies in the Nepalese Stock Market, Journal of Management and Development Review, vol. 1, (2 and 3) 2004, pp.13-27 110 E. Dyl, Capital Gains Taxation and Year End Stock Market Behavior, Journal of Finance, March 1977, pp. 165-175, and W. DeBondt and R. Thaler, Further Evidence of Investor Overreaction and Stock Market Seasonality, Journal of Finance, July 1987, pp. 557-581
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of the other working days.111 Similarly, the trading time hypothesis is that the average returns of common stock are estimated during the transaction period, which means average will be the same for all the weekdays. Cross and French had found earliest evidence of weekend effect on US stock market.112 Empirical researches have indicated that the day-of-the-week effect exists in other market: Istanbul Stock Exchange113, Shanghai Composite Index114, and Amsterdam Stock Exchange.115 Similarly, emerging Asian stock market (India, Thailand, Indonesia, Malaysia, Philippines, Taiwan and South Korea) has also reported day-of-the-week effect.116 3.10.4 Effect of the average returns due to the holiday effects. Empirical researches have shown that USA and other developed countries have high rates of return before holidays. Ariel and Liano et al. are among the first researchers who have tried to define the holiday effect by appealing to other calendar anomalies as the day-of-the-week, the monthly effect and the turn-of-the year effect and their results shown that the high returns observed on pre-holidays, are not an appearance of other calendar anomalies.117 3.10.5 Pettenngill (1989) has indicated that small firms outperform than the large ones on the both January and non-January pre-holidays, however KIM and Park (1994) on the other hand have found that after controlling for the day-of-the-week effect and the pre-New-Years-Day effect, the size effect does not exhibit in average return on pre-

K. French, Stock Returns and the Weekend Effect, Journal of Financial Economics, vol. 8, 1980, pp. 55-69 and J. Lakonishok and E.Maberly, The week-end Effect Trading Patterns of Individual and Institutional Investors, Journal of Finance, vol.45, 1990, pp. 231-243 112 F. Cross, The Behavior of Stock Prices on Friday and Mondays, Financial Analyst Journal, vol.29 no.6, 1973, pp. 67-95 113 E. Balban, Day-of-the-Week Effect: New evidence from an Emerging Stock Market, Discussion Paper, the Central Bank of Republic of Turkey, 1994. 114 S. Zhou, Investigation of the Weekend Effect in Chinas Stock Market, 2003, See, http://www.ssc.uwo.ca, 115 V .D. Sar, Calendar Effects on the Amsterdam Stock Exchange, De Economists, vol.15, no. 3, 2003, pp. 271-292 116 T. Chaudhary, Day of the Week Effect in Emerging Asian Stock Market: Evidence from the GARCH Model, Applied Financial Economics, vol. 10, no. 3, 2000, pp. 235-243 117 R.A.Arial, A Monthly Effect in Stock Returns, Journal of Financial Economics, vol.18, March 1990, pp.161-174, and K.Liano, H. Manakkyan and P. H. Marchand, Economic Cycles and the Monthly Effect in the OTC Market, Quarterly Journal of Business and Economics, vol. 31, 1992, pp. 41-50

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holidays.118 Keim has suggested that the pre-holiday average return might be, in part, due to movements from the bid-ask price.119 Similarly, other researches have also indicated the evidence of holiday effects in countries like Italy, Canada, Japan, Australia and Hong Kong.120 3.10.6 The difference between first half-month and second half month on common stock rate of return of calendar month is called as a half month effect. Jaffe and Westerfield found that half-month effect for Australia and inverted half-month-effect for Japan but no existence of effect for Canada and the UK.121 Wong has studied in the five Developing stock markets of Hong Kong, Thailand, Malaysia, Singapore and Taiwan and found that there is no significant effect in Hong Kong, Malaysia, Singapore and Taiwan; alternatively, while Thailand indicated a reverse half-month effect in the second period but no half-month effect in the first and third periods.122 Boudreaux123 has studies the half-month effect in the eight countries; they are Germany, Norway, Denmark, France, Singapore, Malaysia, Spain and Switzerland. From the data analysis, he found half-month effect in three countries namely Denmark, Germany and Norway. However, alternatively significantly reverse half-month effect is found in Singapore and Malaysia. 3.10.7 Correspondingly, turn-the-month effect has two accepted line of hypotheses. One of the hypotheses put forward to define the turn-the-month effect is liquidity trading which is the demand of individual investors rises towards the end of the month in connection with the payment of salaries. In addition, a second hypothesis is portfolio rebalancing that says the institutional investors bunch their purchases at the end of the
V. Meneu and A. Pardo, Pre-holiday Effect, Large Trades and Small Investor Behavior, Journal of Empirical Finance, 2003. 119 Op cit., D.B. Keim, pp. 13-32. 120 E.Barone, Italian Stock Market: Efficiency and Calendar Anomalies, Journal of Banking and Finance, vol. 14, 1989, pp. 483-510 and C. D. Cadsby and M. Ratner, Turn-of-Month and Pre-Holiday Effects on Stock Returns: Some International Evidence, Journal of Banking and Finance, vol.16, 1992, pp. 497-513, 121 H. F. Jaffe and R. Westerfield, Is There A Monthly Effect in Stock Market Returns? Evidence from Foreign Countries , Journal of Banking and Finance, vol.13, 1989, pp. 237-244 122 K. A. Wong, Is there An Intra-Month Effect on Stock Returns in Developing Stock Markets?, Applied Financial Economics, vol. 5, 1995, pp. 285-289 123 D. O. Boudreaux, The Monthly Effect in International Stock Markets: Evidence and Implications, Journal of Financial Strategic Decisions, vol. 8, no.1, 1995, pp. 15-20.
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month because of the improvement that prepares in the performances of end-of-the month price.124 Another calendar anomaly is the time-of-the-month (i.e., third month) effect, which was first discovered by the kohers and patel.125 They used the standard and Poors Index during the period of January 1960 to June 1995 and have indicated that the returns are highest during the first third , experience a low drop during the last third and lowest and in most cases negative during the last third month. Moreover, they pointed out that this pattern remained remarkable strikingly consistent for the two indices observed. 3.10.8 The Size Effect: Several researches had shown comparison of among common stock investments in large size companies, which tend to earn significantly lower rates of return than the small sized company does. Several different variables may ultimately be shown to cause the size effect, although now there is no clear-cut theory.126 Similarly, Price earning effect is also one of the anomalies of EMH. The well-known investment strategy supported by Value Line stocks with low P/E ratios.127 Sanjay Basu had published the most widely cited research documenting the low P/E ratio effect.128 3.10.9 Various factors, including pre-test bias, biased data, mismatch between calendars and trading time, dividend effect, announcement effect, political events, change in the business environment and other factors may be the supporting cause of the anomalies of EMH. Shortcoming of anomalies is that if investor trade according to the anomalies effects of the EMH, he/ she may not get significant return after deduction of the transaction and other costs. Even there is anomalies or some inefficiencies be found, it is very difficult to detect and get benefit from them. Therefore, investor, analyst and
E. Barone, Italian Stock Market: Efficiency and Calendar Anomalies, Journal of Banking and Finance, vol. 14, 1989, pp.483-510. 125 T. Kohers and J. B. Patel, A New Time of the Month Anomaly in Stock Index Returns, Applied Economics Letters, vol. 6, no. 2, 1999 pp. 115-120. 126 Sanjay Basu, The Relationship between Earning Yield, Market Value, and the Returns for NYSE Common Stocks: Further Evidence, Journal of Financial Economics, vol. 12, no. 1, 1983. 127 Fisher Black, Yes, Virgina, There Is Hope: Test of the Value Line Ranking System, Financial Analyst Journal, September-October 1973. and Volert S. Whitbeck and Jr. Kishor Manown, A Tool In Investment Decision-Making, Financial Analysts Journal, May-June 1973, pp. 55-62 128 Sanjay Basu, The Investment Performance of Common Stock in Relation to Their Price Earning Ratios: A Test of the Efficient Market Hypothesis, Journal of Finance, vol. 32, no. 3, June 1977, pp. 663-682.
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manager have to consider these facts before analyzing the effect of anomalies of EMH. The issue of market efficiency can be solved only by the rigorous analysis and testing of large number of investment transactions over significant period.

3.11 Evidence Supporting the Efficient Market Hypothesis

3.11.1 Even though there are so many anomalies, confusing problems and the challenge of EMH, the real importance evidence in support of the EMH should not be ignored. Considerable evidence, both direct and indirect, supports lastly that the market responds efficiently to new information, and there is no significant opportunity occur for investors not having access to advantaged information to outperform the market. In this case, J. C. Francis has made some arguments for the three alternative of EMH. According to him, Empirical test of the weakly efficient markets hypotheses (namely, filter rules, serial correlations, and runs) support the hypothesis. There have been a few minor anomalies, such as the weekend and January effects, but they are not capable of generating large trading profit after commission costs are paid and no scientific studies have overturned the weekly efficient markets hypothesis.129 3.11.2 Similarly, Some anomalies to the semi strongly efficient market hypothesis have been reported. The effects of low P/E ratio, firm size, delayed reactions to quarterly earnings announcements, and managerial ownership create regularities, which are inefficient. However, these effects may really be only proxies for some rational but more subtle economic effect that remains to be discovered. In any event, the anomalies are not capable of helping anyone get rich quickly, because of the modest size of effects.130 Although the weakly efficient and semi strongly efficient hypotheses are fairly well supported by the facts, some anomalous evidence does not support us from accepting these hypotheses without some reservation. 3.11.3 Moreover, significant evidence suggests that the strongly efficient market hypothesis is not appropriate. The strongly EMH holds that markets are perfectly

129 130

op. cit., Jack Clark Francis, Management of Investments, p.420 ibid., p.420

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efficient which can be easily denied. However, the Strong EMH is not completely supported by the evidence but it is not altogether wrong. The weekend, January, size, low P/E ratio, quarterly announcements, and the managerial ownership effect are imperfections in the semi strong hypothesis. In addition, strongly EMH suffers from more than semi strong EMH imperfection that is simply untrue.

3.12 Conclusion

3.12.1 Stock market prices are one of the interesting areas of study in the capital market. Many people have been confused to deal with the stock market price and become loser in portfolio of investment. Stock market price depends upon the companys product, market, goodwill of company, management performance, quality of quarterly and yearly earnings, governments policy, business environment and other series of information. In totality, it is possible to say that stock market price is determined by the cost of investment, their expected return and associated risk of investment after stipulated time. Every investor wanted more expected return by taking certain level of investment risk. In the case of the stock market price, the investor gets dividends after certain period and he gets capital appreciation value when he sells his stocks on his investments. It looks very simple to analyze the stock market price. 3.12.2 However, in the modern economic system, price of all the goods and services are determined by the demand and supply of the market. Same way, price of the common stock is also determined by the demand and supply of the capital market. The price of the stock goes high (low) when high (low) demand in the market. Market high (low) demand of particular security comes due to the higher (lower) expected return and low (high) risk on investment compare to other securities and assets. This statement clearly indicates that stock market price is directly related to the risk-return on investment, which is associated to the particular stocks. This shows that stock market price and associated risk-return analysis are very complicated for everyone to analyze; and this has made demanding subject in the area of the economics and finance for research. Because of that, many researches have been done in this area around the world.

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3.12.3 While analyzing the stock market price analysis many researchers have confused in the case of the valuation of the right share and stock dividend in the risk return analysis. They had adapted rigorous calculation and same treatment for the stock split, right share issue and stock dividend, and no differentiation between them. Nevertheless, all the cases are very different from each other because stock split will be done when the price is extremely high and very difficult to trade everyone in the market, while right share is offered when company business is expanding and investor has to pay additional capital to keep his holding remain same. In the same way, instead of paying cash dividend, stock dividend is offered to the shareholders when companys business is expanding. They speak about value of stock before/ after right share issue and stock dividend but they are not very clear about how to treat in the case of series of year riskreturn analysis. This is one of the main shortcoming of the previous researches. 3.12 4 Correspondingly, in the case of the Nepal many researchers have made mistake in the case of the dividend payment. They are not clear about the percentage of dividend on the per share basis or per share paid up capital basis. Another mistake is that the dividend paid in cash or stock or capitalized by increasing the paid up capital which companys share has less capital than the face value of common stock. Those people who have used web site down loaded data have done this type of mistake for risk-return analysis. Therefore, in this present analysis sincere efforts have been made for not committing such mistake by using data, which are published by the listed company of the Nepal Stock Exchange Ltd. Hence, in this research the dilemma of stock market price analysis imperfection of dividend adjustment may not arise. 3.12.5 Moreover, large numbers of research have been done in favor and disfavor of the EMH. However, those researchers who have argued in support of the anomalies of the EMH are unable to give the non-existence of the EMH and they are only critics of the EMH. Notable evidence, both indirect and direct, encourages the judgment reached by reasoning that the market responds efficiently to new information, and that no significant opportunity exists for investors without access to take advantage information to outperform the market. The large size of the evidence relating to the stock market price behavior is relevant with the developed stock market, and the evidence relating to 88

smaller and less developed market like Nepal may be considerably thinner. It will no doubt provide a great opportunity and time to analyze the market relevance of EMH, which will provide enormous value for the investor, managers, and concerned people in this area. 3.12.6 Different analysts have analyzed the stock market prices (Risk-return analysis, EMH, and anomalies of EMH) from different point of view and they have concluded typically and differently by using different approaches towards the controlled variable of research. Most of them used the secondary data, which is down loaded from the internet and even they have not tried to verify, whether these data are correct. Because of that, there are so many flaws in the previous researches and analysis. Therefore, in this research work earnest efforts have been made to minimize such type of flaws by using the secondary data published by the companies, security exchange and government agencies. Further, in order to support and substantiate the secondary data interviews of different listed company management, intermediary, investors, professors, businessperson, students etc were conducted with the help of well-designed questionnaire. In addition, this primary study has also been supported by using relevant financial and statistical tools and technique for better analysis and conclusion. However, the result of the analysis largely depends on the size and the methodology used. 3.12.7 Finally, in the past so many analyses have been undertaken in the context of Nepals capital market by different brilliant researchers in the pursuit of academic meaning; moreover, little of such findings were given insignificant useful value in the capital market. Therefore, to remove such imperfection in the capital market, through this research, efforts have been made sincerely to bring out a professional exposure in the centre of conflict for people of capital market. In doing so this research study would not only be able to meet the academic requirement, but also contribute in the practical aspect of the capital market and stock market prices.

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