Mbs final thesis

Portfolio Management of Listed Commercial
Banks in Nepal
Submitted By:
Asha Jaiswal
T.U. Regd. No.: 7-2-329-34-2004
Exam Roll No.: 3290015
Campus Roll. No.: 16/2064
Submitted To:
Office of the Dean
Faculty of Management
Siddhanath Multiple Campus
Tribhuvan University
Mahendranagar, Kanchanpur
IN THE PARTIAL FULFILLMENT OF REQUIREMENTS OF THE DEGREE OF MASTER
OF BUSINESS STUDIES (M.B.S)

January, 2012
Letter of Recommendation
Mrs. Asha Jaiswal has completed this thesis entitled, Portfolio Management of Listed
Commercial Banks in Nepal under my supervision. She carried out this research from
June 2011 to January 2012. I here by recommend her thesis be submitted for viva voice.
------------------------
Mr. Hari Shankar Pant
Lecturer
Date:-…/…./
……...

Tribhuvan University
Letter of Approval
This thesis entitled, Portfolio Management of Listed Commercial Banks in
Nepal by Asha Jaiswal submitted to Faculty of Management, Siddhanath Multiple
Campus, Tribhuvan University, has been approved by the undersigned members
of research committee:
Members of Research Committee:
------------------------
Internal Examiner
-----------------------
External Examiner
------------------------
Head
Date: …../…. /…..

Acknowledgements
I am heartily indebted to my supervisor Mr. Hari Shankar Pant whose inspiration
and constant guidance helped me prepare this dissertation a success. I am grateful for his
incessant support and friendly care. Likewise, I express my gratitude and great sense of
respect to Mr. Dammar Ayer, head of the Faculty of management for the approval of
thesis. I would like to thank my dear husband, Dammar Singh Saud for his invaluable
suggestion and typing this thesis, without his vigilance this would not be possible in time.
I would like to thank my dear sisters and brother for their kind help during this research.
The credit of success of the thesis goes to my loving parents Mr. Ramdulare
Jaiswal and Mrs.Dipa Jaiswal.
March 2011 Asha Jaiswal

Abstract
This research seeks to present the solution of the inability of investors to invest their
investment in more profitable sectors and the problem of capital formation and its proper utilization
(because of their unorganized investment policy formation and lack of consideration of portfolio
optimization) by the portfolio management of listed commercial banks named Nepal SBI Bank Ltd.,
NABIL Bank Ltd. and Nepal industrial and Commercial bank Ltd. The main objective of the study is
portfolio analysis of the common stock of different listed commercial banks of Nepal in terms of risk
and return. Expected return, required rate of return, CAPM model and statistical models like mean,
standard deviation, coefficient of variation, covariance, correlation and beta are calculated and
analyzed. The study is focus on the portfolio analysis of the three Commercial banks of Nepal. All
the data used in the study are secondary & primary data published by and collected from the
NEPSE and SEBON and their respective websites. Financial tools, statistical tools and personal
judgment are used. The data gathered for this purpose are presented in table and graphs. This
study has been analyzed with the help of risk diversification which helps to minimize risk in
common stock investment and maximize return through portfolio analysis.

Table of Contents
Portfolio Management of Listed Commercial.....................................................................1
Faculty of Management.......................................................................................................1
This thesis entitled, Portfolio Management of Listed Commercial Banks in Nepal by
Asha Jaiswal submitted to Faculty of Management, Siddhanath Multiple Campus,
Tribhuvan University, has been approved by the undersigned members of research
committee:............................................................................................................................3
CHAPTER I – INTRODUCTION.......................................................................................1
1.1 Background of the Study...............................................................................................1
1.2. Objectives of the Portfolio Management......................................................................3
1.3. Meaning of the Commercial Banks..............................................................................3
1.4. Securities Market..........................................................................................................4
Historical background of securities market.....................................................................4
1.5. Statement of the Problem..............................................................................................6
1.6. Objectives of the Study.................................................................................................6
1.7. Scope of the Study........................................................................................................7
1.8. Limitation of the Study.................................................................................................7
1.9. Organization of the Study.............................................................................................8
Chapter First:...................................................................................................................8
Introduction: ................................................................................................................8
Chapter Second:...............................................................................................................8
Reviews of literature: ..................................................................................................8
Chapter Third:..................................................................................................................8
Research methodology: ...............................................................................................8
Chapter Four:...................................................................................................................8
Data presentation and analysis: ...................................................................................8
Chapter Five:....................................................................................................................8
Summary, Conclusion and Recommendation: ............................................................8
Bibliography and appendices: .....................................................................................9
CHAPTER II - REVIEW OF LITERATURE.................................................................9
2.1. Conceptual Review.......................................................................................................9
2.1.1 Investment.............................................................................................................10
2.1.2 Return....................................................................................................................11
2.1.3 Risk.......................................................................................................................12
2.1.4 Diversification of Risk.........................................................................................13
Risk diversification through portfolio construction...................................................13
Simple diversification................................................................................................15
Superfluous diversification........................................................................................15
Diversification across industries................................................................................15
Simple diversification across quality rating categories.............................................16
Mean-Variance indifference curves...........................................................................16
Security market line (SML).......................................................................................16
Efficient frontier.........................................................................................................18
Capital market line (CML).........................................................................................18
Investment performance evaluation...........................................................................18

2.2 Review of Popular Models of Portfolio.......................................................................19
2.2.1 Markowitz portfolio selection model....................................................................19
2.2.2 Capital Assets Pricing Model (CAPM).................................................................20
Assumptions of Capital Assets Pricing Theory Model..................................................21
2.2.3. Arbitrage Pricing Theory Model (APT)..............................................................21
2.3. Review of Articles......................................................................................................22
2.4. Review from Journal...............................................................................................27
2.5 Reviews from Thesis....................................................................................................31
CHAPTER III - RESEARCH METHODOLOGY............................................................35
3.1 Research Design.......................................................................................................35
3.2 Sources of Data........................................................................................................35
3.3 Population and Sample............................................................................................36
3.4 Data Collection Procedure.......................................................................................36
3.5 Data Analysis Tools.................................................................................................36
3.5.1 Financial Tools..................................................................................................36
Portfolio Expected Return..........................................................................................37
Portfolio Risk.............................................................................................................37
Minimum Risk Portfolio............................................................................................38
Portfolio Beta.............................................................................................................38
3.5.2 Statistical Tools.....................................................................................................38
Expected Return (Arithmetic Mean)..........................................................................38
Standard Deviation.........................................................................................................38
Variance.....................................................................................................................40
Co-efficient of variance (CV)....................................................................................40
Total Risk...................................................................................................................40
Diversifiable Risk / Unsystematic Risk.....................................................................40
Un-diversifiable Risk / Systematic Risk....................................................................41
Covariance.................................................................................................................41
Correlation.................................................................................................................41
Beta Coefficient.........................................................................................................42
CHAPTER IV - .................................................................................................................42
PRESENTATION AND ANALYSIS OF DATA.............................................................42
4.1 Presentation of data..................................................................................................43
4.2 Analysis of Individual Bank: ..................................................................................44
NABIL Bank Limited................................................................................................46
4.3 Overall Market (NEPSE).........................................................................................49
4.4. Inter Bank Comparison ..........................................................................................50
4.4.2 Comparison of beta and correlation of different banks:...................................50
4.4.3 Analysis of systematic Risk and unsystematic risk:.........................................51
4.5 Portfolio Analysis ...................................................................................................51
4.5.1 Portfolio analysis of stocks between SBI and NIC Bank.................................51
4.5.2 Portfolio Analysis of stocks between NIC and NABIL....................................52
4.5.3 Portfolio analysis of stock between NABIL & SBI..........................................53
Chapter-5............................................................................................................................55
5.1 Summary, Conclusion and Recommendation .........................................................55
5.2 Conclusion...............................................................................................................56

5.3 Recommendation.....................................................................................................57
BIBILOGRAPHY..........................................................................................................58
Websites:...................................................................................................................60
ANNEX..........................................................................................................................61
Annex-1 .................................................................61
Annex-2..........................................................................................................................63
ANNEX-3......................................................................................................................64
ANNEX-4......................................................................................................................65
ANNEX - 5....................................................................................................................66

CHAPTER I – INTRODUCTION
1.1 Background of the Study
A bank is an institution, which deals in money, receiving it on deposit from customers,
honoring customers drawing against such deposits on demand, collecting cheques for customers
and lending or investing surplus deposits until they are required for payment. In the resent days,
various types of banks are established for instance industrial bank, commercial bank, agriculture
bank, joint stock bank, cooperative bank and development bank. Modern banks are more
advanced than the ancient ones. This is because of the growth in population, changes occurred in
the industrial filed and trade, the beginning of the competitive age and changes in the peoples
ideology and due to the dependence on each other, (Bhandari, 2003:1)
A portfolio is a combination of investment assets. The portfolio is the holding of securities and
Investment in financial assets i.e. bonds, stock portfolio management is related to the efficient
portfolio investment in financial assets. The portfolio analysis is reformed to develop a portfolio that
has the maximum return at whatever level of risk and an investor thinks appropriate. If portfolio is
being constructed they can reduce unsystematic risk without loosing considerable return, therefore
we need to extend our analysis of risk and return of portfolio context.
Portfolio management is concerned with efficient management of portfolio investment in
financial assets, including shares and debentures of companies. The management may be by
professionals, by others, or by individuals themselves. A portfolio of an individual or a corporate
unit is the holding of securities and investment in financial assets. These holdings are the result of
individual preferences and decisions regarding risk and return. The process of portfolio
management is closely and directly linked with process of decision-making the correctness of
which cannot be ensured in all cases.
A portfolio is the collection of investment securities. Portfolio theory deals with the
selection of optimal portfolios; that is, portfolios that provide risk for any specified degree of risk for
any specified rate of return.
According to the Weston and Brigham (1982), “A portfolio simply represents the practice
among the investors of having their funds in more than one asset. The combination of the
investment assets is called a portfolio.”
According to Cohen, Zinbarg and Zeikel (1978), “Portfolio management is the art of
handling a pool of funds so that it not only preserves its original worth but also over time
appreciates in value and yields an adequate return consistent with the level of risks assumed.”
According to Keith Ambachtscheer, “Portfolio management concerns itself with selecting
‘good’ stocks or bonds are fading.” Portfolio management of bank assets basically means
allocation of funds to different components of banking assets having different degree of risk and
varying rates of return in such a way that balance the conflicting goal of maximum yield and
minimum risk.
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Investment is the employment of the funds with the aim to achieving addition income of
growth in value. It involves the commitment of the resources that have been saved or put away
from consumption, for the future. Investment involves long-term commitment and waiting for the
reward. An investor involves in the sacrifice of current rupees for the future rupees. The sacrifice
takes place in the present and is certain, while the reward comes later and is uncertain. The
investor can invest the fund in the two types of assets. They are real assets and financial assets.
Real assets investment involves some kind of tangible assets such as building, machinery,
automobiles etc. financial investment is pieces representing and indirect claim to real assets held
by someone else. These pieces of paper are common stock, bond, debenture etc. which
represents as the liquid assets.
Frank and Reilly defines, “An investment is the current commitment of funds for a period of
time to derive a future flow of funds that will compensate the investing units for the time funds are
committed, for the expected rate of inflation and also for the uncertainty involves in the future flow
of the funds.”
Every investor has a wide area of Investment Avenue such as common stock, preferred
stock, debt, securities, derivative securities, hybrid securities, real assets; mutual fund etc.
common stock represents ownership position in a corporation. It has a residual claim, means after
the payment of the creditors and preference shareholders and all the other claims only when the
common stockholder gets the value. In bankruptcy, common stockholders are, in principle, entitled
to the assets remaining after all prior claimants have been satisfied. The risk is the highest with
common stock investment. When the investors buy the common stock they receive certificate of
ownership in the company. The certificate states the number of shares purchased and their paid
value. In Nepal, as per the provision of Nepal company act 2053 no common stocks are allowed to
issue without par value. Its par value must be either Rs. 10 or Rs. 100. Common stock has one
important characteristic. Their investment value and average market price then to increase
regularly but persistently over the decades as their net worth builds through the reinvestment of
undistributed earning. However, most of the time, common stocks are subject of irritations and
excessive price fluctuation in either direction as most people are speculative or gamblers.
Every investment involves uncertainties that make future investment return risky. Some
sources of uncertainty that contribute to the investment risk are interest rate risk, market risk,
default risk, call ability risk, convertibility risk, political risk and industry risk.
The Nepalese investor is constrained by a large number of environment influences, which
he must consider before making a choice of investment. The Nepalese investment scene has
many schemes; it appears that he investor has a wide choice. Nepalese investor does not have
complete information about the different investment. Many investors have made instantaneous
investment and regretted latter.
A portfolio is a bundle of combination of individual assets or securities. If investor holds a
well diversified portfolio, then his concern should be the expected return and risk of the portfolio
return theory provides the normative approach to the investors’ decision to investment in assets or
securities under risk. The objective of the portfolio analysis is to develop a portfolio that has the
maximum return at whatever level of risk, the investor seems appropriate.
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1.2. Objectives of the Portfolio Management
The portfolio management is a complex task. Investment matrix is one of the many
approaches, which may be used in this connection. The various considerations involved in
investment decisions liquidity, safety and yield of the investment. Image of the organization is also
to be taken in account. These considerations may be taken into account and an overall view
obtained through a matrix approach by allotting marks for each consideration totaling them. The
investors would like to have the following objectives of portfolio management.
(a) Capital
(b) Safety or security of an investment
(c) Income by way of dividends and interests
(d) Marketability
(e) Liquidity
(f) Tax planning- capital gains tax, income tax and wealth tax
(g) Risk avoidance or minimization of risk.
1.3. Meaning of the Commercial Banks
Commercial banks are those financial institutions deal with accepting deposits of the
person and institutions and giving loan against securities. They provide working capital needs of
trade industries and even to agricultural sectors. Moreover, commercial bank also provides
technical and administrative assistance to industries trade and business enterprises. Commercial
banks pool together the savings of the community and arrange them for the productive use. They
transfer monetary sources from savers to users. In addition to above, the main purpose is to uplift
the backward sector of economy.
Commercial bank is a corporation, which accepts demand deposit subject to check and makes
short term loans to business enterprises, regardless of the scope of its other services. Commercial
banks are the heart of the financial system. They make fund available through their lending and
investing activities to borrowers, individuals, business and services for producer to customers and
financial activities of the government. So, commercial banks are those financial institutions, which
collects loan against proper securities for their productive purpose.
After the announcement of liberal and free market economic based policy, Nepalese banks
and financial sectors having greater network had access to the national and international market.
They have to go with their portfolio management very seriously and superiority. They are fighting
with various challenges in order to increase their regular basis of income as well as to enrich the
quality base of service for the attraction of good clients. In this competitive and market oriented
open economy, each and every commercial banks and financial institution has a determining role
by evidencing various opportunity for the sake of expanding provision of best service to their
customers and by making themselves as a strong and potential financial intermediaries as per
country’s need of present scenario to obtain the desired level of economic development of nation.
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No doubt, if commercial banks and financial institutions has to gain prosperity without
delay, they should immediately start to improve customer service quality of high standards to
reflect tremendous opportunities in the market for their customer benefit like managing their risk,
giving them the advantage of global strength, insights and philosophy because this can make the
customer take full confidence to expands their transaction further more with best approach and full
secured for each investment made to earn superior returns over time.
Nepal being listed among least developed countries the commercial banks have play a
catalytic role in the economic growth. Its investments range from small-scale cottage industries to
all types of social and commercial loans and large industries. Generally the investment of the CBs
include the investment on government securities like Treasury bills, Development bonds, National
saving bank, foreign government securities, and shares of government owned companies,
investment on debentures and similarly the CBs used their funds as loan and advances.
The guidelines given by Nepal Rastra Bank play a significant role in the composition of the
bank portfolio. Portfolio management activities of Nepalese bank are in developing stage, however
on the other hand most of the joint venture banks are not doing such activities so far.
1.4. Securities Market
Capital plays a vital role in the economic development of the country. Nepal being one of
the least developed countries in the world to make every possible attempt to efficiently mobilize the
available capital. The need of securities market development in Nepal has been an accepted
reality; however, it has not been develop at desired rate. The growth of the economy very much
depends on the strength and efficiency of its securities markets.
Security market is the place where securities are brought and sold through intermediary
networks. It acts as the mechanism for bringing together buyers and sellers of financial assets in
order to facilitate trading.
Security market helps in proper mobilization of fund by facilitating the fund transfer
between those who have and those who uses hence contribute greatly in economic growth.
The securities markets help to channel public savings to industries and business
enterprises. Securities market help liquidation, which increases corporate sector productivity.
Securities markets also accelerate growth indirectly by reducing risk, which encourage firm
investment.
Historical background of securities market
The history of securities market began with the flotation of shares to the general public by
Biratnagar jute mills and Nepal bank limited in 1937.Introduction of the company Act in 1964, the
4

first issue of Government Bond in 1964 and the establishment of Securities Exchange Center Ltd.
In 1976 were other significant developments resulting to capital markets.
Securities Exchange Center was established with an objective of facilitating and promoting
the growth of capital markets. The SEC was the only institution at that time managing and
operating primary and secondary of long-term government and corporate securities.
A need to develop different institutional mechanism relating to securities market was
strongly felt to avoid potential conflict of interest between the services provided. Therefore in 1993,
with a mandate to regulate and develop the securities market, securities board of Nepal (SEBO)
was established.
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1.5. Statement of the Problem
Investment is the exchange of financial claim-stocks and bonds etc. investment is the
employment of funds with the aim of achieving additional income growth in value. It involves the
commitment of resources that have been saved or put away from current consumption in the hope
that some benefits will accrue in future. Investment involves long-term commitment and waiting for
reward.
There are many individual and institutional investors to assist the process of economic
development of country. The main problem of most under developed countries like Nepal is capital
formation and proper utilization. In such countries institutional as well as individual investors have
more responsibilities to avoid above problem and they have to contribute to the national economy.
In the present situation, Nepalese investors are found to be more interested in investment in less
risky and liquid sectors only. Nepalese investors have formulated their investment policy in an
unorganized manner. They do not consider portfolio optimization. Nepalese investors do not have
complete information about the different investment. Many investors have made instantaneous
investment and regretted later.
-
The research seeks to analyze investment of investors, portfolio management of investors
and return on various types of investment.
•How does the portfolio investment manage by the investors?
•Is the portfolio investment management efficient?
•How do investors analyze the risk and return using portfolio diversification?
•What is the trend of investment of different assets?
1.6. Objectives of the Study
In the existing competitive environment, the investors face many problems to mobilize their
deposit on profit making investment. The main objectives of the study are to analyze, examine and
interpret technique followed by the investors on their investment. The specific objectives of the
study are as follows:
•T o evaluate common stock investment in terms of risks and return.
•To analyze deposit and government securities in terms of risk and return.
•To analyze portfolio risk and return.
•To provide suggestive package based on the analysis of the data.
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1.7. Scope of the Study
This study will be concise, practical, usable and valuable to the major parties intended in
portfolio management of investors. This will be useful to the management students, researches
and even to the experts. Nepalese investors or institution do not have clear view towards effective
investment. They follow traditional and ineffective investment policy. They are found to be
interested in investment in less risky assets. Hence, the significance of this study will be minimize
risk in common stock investment and maximize return through portfolio analysis, the study will fulfill
the need in this aspect. It will help also as a literature for the further study about the related topics
of financial performance and portfolio management. Similarly, the firms would follow the suggestion
of this to make their policy and strategy more practical and scientific.
1.8. Limitation of the Study
In the context of Nepal, data problem is major problem for the study. There is a considerable
place for arguing about its accuracy and reliability. There are many limitations, which weaken the
generalization e.g. inadequate coverage financial sector; time periods taken, and other variables.
Besides these following specific limitations also mentioned.
♦ This study has employed secondary & primary data published by and
collected from selected banks.
♦ Only financial aspects are analyzed, other performance of bank is
neglected while providing suggestion.
♦ This study concentrates only on those factors which are related with
portfolio mgmt and available in the form required for analyzing the different
issues.
♦ This study is focused on the listed commercial bank namely Nepal SBI
Bank Ltd., NABIL Bank Ltd., and NIC Bank Ltd.
♦ This study is focused on the data and information from 2006 to 2010.
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1.9. Organization of the Study
Chapter First:
Introduction:
The introduction chapter included general background, statement of problem, objectives of the
study, scope of the study and limitation of the study.
Chapter Second:
Reviews of literature:
The review of literature include review of theories of the concerned topic, review of
supportive text, review of books, review of various experimental studies conducted inside and out
side of the country, review of related article and review of legislation related to commercial banks.
Chapter Third:
Research methodology:
It includes the research methodology to conduct the study and tools and techniques used
in the analysis of the data as well. This includes, research design, sources of data, population and
sample, method of data analysis, various financial and statistical tools.
Chapter Four:
Data presentation and analysis:
It explains the data presentation and analysis, scoring the empirical findings out of the
study through definite source of research methodology. Investment operation of bank, risk and
return on investment are mentioned. It also contains major findings of the study.
Chapter Five:
Summary, Conclusion and Recommendation:
It includes the summary of the study, conclusion of the main findings and recommendation for
further investment.
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Bibliography and appendices:
Besides this bibliography and appendices will also present at the end of the thesis. Similarly,
acknowledgement, table of contents, list of tables, list of diagram, abbreviations are also included.
CHAPTER II - REVIEW OF LITERATURE
This chapter deals with the reviewing to “Portfolio Management” in more detail and
descriptive Manner. For the study, various books, journals and articles as well as few past
dissertations are also reviewed. This research has been based on different books for an accurate
study due to lack of sufficient materials related to portfolio management. Investment is not a
gamble; it is a systematic and scientific way of using excess fund to get maximum return with
lowest level of risk. The most common definition of investment is the sacrifice of certain present
value for future value. To make investment decision, it needs lots of information related to assets
situation of market, risk and return factor involved to the stocks, other opportunity available in the
market, interest rate of bank, government current policies, expected change in policies, tax, laws
and regulation as well as attitude of investors.
2.1. Conceptual Review
Portfolio management is the process of selecting a bundle of securities that provides the
investing organization a maximum yield for a given level of risk or alternatively ensuring minimum
level of risk for a given level of return. It can be also taken as risk and return management. Its aims
to determine an appropriate asset mix which attains optimum level of risk and return. Portfolio
management of the bank assets basically means allocation of fund to different components of
banking assets having degrees of risk and varying rates of returns in such a way that balance
conflicting goal of maximum yield and minimum risk. When the process of portfolio management of
bank assets are done various factor such as, availability of fund, liquidity requirement, central
banks policy etc. should be considered. As the task of portfolio management of the bank assets is
to be carried out within the given macro economic environment the manager should carefully watch
related macro economic indicators such as; interest rate, inflation rate, national income, savings
ratio etc. assets of the bank can be broadly classified into:
•Investment
•Loans and advances
.
Portfolio theory was originally proposed by Harry Markowitz in 1952 A.D. the theory is
concerned with selection of an optimal portfolio by risk averse investors. Risk averse investors is
an investors who selects a portfolio that maximizes expected return for any given level of risk or
minimizes risk for any given level of expected returns. Risk adverse investors will select only
efficient portfolios. Portfolio theory can be used to determine the combination of these securities
that will create the set of efficient portfolios. The selection of the optimal portfolio depends upon the
investor’s performance for risk and return.
9

Portfolio investment refers to the investment that combines several assets. The modern
portfolio theory explains the relationship between assets risk and return. The theory is founded on
the mechanics of measuring the effect of an asset on risk and return of portfolio. Portfolio
investment assumes that the mean and variance of returns are the only two factors that the
investor cares. Based on this assumption, we can say that rational investor always prefers the
highest possible mean return for a given level of risk or the lowest possible level of risk for a given
amount of return. Portfolio, technically known as efficient portfolios, is a superior portfolio. The
efficient portfolios is a function of not only risk and return of individual asset included, but also the
effect of the relationship among the assets on the sum total of portfolio risk and return. The
portfolio return is straight weight average of the individual asset. But the portfolio risk is not
weighted average of the variances of return of individual assets. The portfolio risk is affected by the
variance of return as well as the covariance between the return of individual assets included in the
portfolio and their respective weights.
Portfolio analysis considers the determination of future risk and return in holding various
blends of individual securities. Portfolio expected return is a weighted average of the expected
return of individual securities but portfolio variance is sharp contrast, can be something less than a
weighted average of security variance. As a result investor can reduce portfolio risk by adding
another security with greater individual risk then other security in the portfolio. The seemingly
curious result occurs because risk greatly on the covariance among return of individuals securities.
The aim of portfolio management is to achieve the maximum return from a portfolio which has been
delegated to be managed by an individual or financial institution. The manager has to balance the
parameters which define a good investment i.e. security, liquidity and return. The goal is to obtain
the highest return for the client of managed portfolio.
2.1.1 Investment
Sharpe et al (2003) define investment as sacrifice of current dollars for future dollars. They have
attributed the involvement of time and risk during investment. Sacrifice takes place in the present
and is certain. The reward comes later, if at all, and the magnitude is generally uncertain. Shrestha
et al (2002) write investment as utilization of savings for something that is expected to produce
profits benefits. In the words of Cheney and Moses (1992) investment brings forth visions of profit,
risk, speculation, and wealth. They have briefly described the categories and types of investment
alternatives objectives, the expected rate of return, the expected risk, taxes, the investment horizon
and investment strategies are the factor to be considered in choosing among investment
alternatives.
Sharpe et al (2003) makes the distinction between real investment and financial
investment. “Real investments involve some kind of tangible asset, such as land, machinery, or
factories. Financial investments involve contracts written on pieces of paper, such as common
stocks and bonds.”
10

They further discussed about the globalization of the investment business and write the
growth in foreign security markets significantly increase international opportunities for U.S.
investors. They have conducted the comparative study of distribution of the total market value of
common stock Markets around the world in 1970 and in 1996, which reveal that the total proportion
of the world’s common stocks represented by the United States has declined over the last 25 years
from almost two-thirds to roughly 45% in 1996.
2.1.2 Return
Return is reward for investment. Historical returns allow the investor to assess the future or
unknown returns, which is also called expected return. Expected returns are the ex-ante returns
and such predicted return may or may no occur. Fisher and Jordan (2000) have discussed about
components of return. They have identified returns is the composition of periodic cash receipts and
change in price of assets. Return can be positive or negative. Cheney and Moses (1992) explain
return in terms of single period. They have defined it as holding period return and calculated by
comparing the return to the amount initially invested. Brealey and Myers (2000) have written it as
summation of the cash payment received due to ownership plus price appreciation divided by the
beginning price. This is also a measurement of return for a single period. Cheney and Mosses
(1992) further described the calculation of expected return from arithmetic and geometric mean
approach. Geometric mean return is consistent with assumption of reinvesting income when it is
received. Due to inherent bias in the arithmetic mean, the geometric mean will always be equal or
less than arithmetic mean. The arithmetic mean and geometric mean will only be equal when the
holding period returns are constant over the investment horizon. However, Van Horne and
Wachowicz (2002) have also agreed and have further defined it is a tool for the return of
investment horizon of one year or less. They have suggested for longer periods, it is better to
calculate rate of return as an investment yield. The yield calculation is present value based and this
considers the time value of money. Further, return for the future can be determined from the
probabilities of different phases of the economy, viz., prosperity, recession, depression and
recovery. Weston and Copeland (1992) illustrated the use of probability from the normal
distribution concepts. They have defined expected return as summation of the product of
probabilities of different stages in an economy and rate of return.
Sapkota (1999) has calculated the expected return from the average of holding of period
return on stocks of eight different banks for each year using data of B.S. 2050/51 to B.S2055/56.
He ha s identified the common stock of Nepal bank limited to be fetching the maximum of return,
i.e., 66.99%. He further writes Nepal’s state bank of India (SBI) bank as the low yielding security. In
addition, his study has revealed that the expected return of banking industry is 60.83%. The
portfolio across the industries constructed during the study has identified the combination of the
securities of Nepal Grindlays Bank and Bishal Bazar Company the best portfolio with the return of
0.2666(26.66%). He concluded his study by identifying any significant differences in the portfolio
return of banking industry and overall market. Shrestha (2003) finds the return of the Nepal
Bangladesh bank limited (NRB) to be the highest. But Nepal bank limited is out of the purview of
this research. Manandhar (2003) finds out the Bank of Kathmandu limited (BOK) the high yielding
security.
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2.1.3 Risk
Risk is the feeling of the negative returns. In the words of Cheney and Moses (1992) is
uncertainty of whether the money investors lend will be returned. They have regarded such risk as
bankruptcy risk. According to them, stockholder of the firm should not only consider bankruptcy risk
but also the risk that the firm will yield a rate of return below some targeted rate. They have given
range, variance, standard deviation, coefficient of variance (CV) and beta as a parameter for the
measurement o frisk. However, the variance may have been suggested as a measure of economic
risk by Fisher (1906). Cheney and Moses further describe beta as a parameter for the
measurement of the systematic risk. Systematic risk has been defined as un-diversifiable risk,
which is beyond the control of the organization. Apart from this, they describe unsystematic risk as
a diversifiable risk, which can be reduced through the portfolio effect. Further, beta values for
assets generally rang between +0.5 and 2.0. Fisher and Jordan (2000), however, write nearly all
betas are positive and most beta lie between +0.4 and 1.9. Weston and Copeland (1992) writ e if
the return on the individual investment fluctuates by exactly the same degree as the returns on the
returns of the market as a whole, the beta for the security is one. Cheney and Moses further
describe that standard deviation contains two parts diversifiable and non-diversifiable risk. Sys
thematic risk can be diversified away by combining the assets with a portfolio of other assets.
Further, they have explained that systematic risk is the ratio between covariance (j, m) and
standard deviation of the market. Unsystematic risk has been defined as product of standard
deviation of assets and the (1-Pjm). But Weston and Copeland (1992) has defined that systematic
risk is the product of b and Var (Rm, t) and unsystematic risk Var ( ). Fisher and Jordan (2000)
define systematic risk as portion of total variability in return caused economic, political and social
changes.
Weston and Copeland described that if that if the un-diversifiable( or systematic) risk in
return of an investment is greater than for the market portfolio, then the beta of the individual
investment is greater than one, and its risk adjustment factor is greater than the risk adjustment
factor for the market as a whole. The beta for individual security reflects industry characteristics
and management policies that determine how returns fluctuate in relation to variations in overall
market returns. If the general economic environment is stable, if industry characteristics remain
unchanged and management policies have continuity, the measure of beta will be relatively stable
when calculated for different time periods. However, if these conditions of stability do not exit, the
value of beta will vary.
Sharpe et al (2003) define risk as the divergence of an actual return from an expected
return and identified standard deviation as a measurement of such divergence. Clarke’s (n.d.)
explains standard deviation and variance are equally acceptable and conceptually equivalent
quantitative measures of asset’s total risk.
Sapkota (2000) measured systematic risk fro beta. He concluded SBI stocks,NRB stocks
and Everest Bank limited (EBL) stocks with negative beta. He has identified the portfolio beta to be
0.5573, calculated from product of individual beta and weights of the market capitalization. This
portfolio beta has been used for the hypothesis test regarding the significance difference between
the portfolio beta and market beta, which has revealed average beta of the banking portfolio, is
equal to 1 at 5%, 2% and 1% level of significance. On the contrary, at 10% level of significance the
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case is opposite. Pradhan (2002) has analyzed the stocks of six finance companies, six insurance
companies including Soaltee Hotel and Necon Air in terms of the risk measured through standard
deviation, CV and beta. His study has revealed the least CV of Kathmandu finance company and
has identified this stock has least volatile. Manandhar (2003) has used the standard deviation,
coefficient of variance and the beta tools for the measurement of the risk associated in the stocks
of five different stocks of commercial banks. She has identified the BOK stocks as the most risky
stocks with its standard deviation and CV of returns 1.3949 and 1.2380 respectively. Further her
research has shown that the BOK possesses the highest value of beta as 2.3020. Shrestha (2003)
carried out risk return analysis of the eight commercial banks where he has computed highest
standard deviation for the stocks of BOK and least standard deviation of Himalayan bank limited
(HBL). A part from this, his study has identified the negative beta for the stocks of SBI.
Weston and Copeland (1992) describe about the three possible attitudes towards risk, a
desire for risk, an aversion to risk and indifference to risk. They further described the utility theory
where he has mad e explanations to the diminishing marginal utility for wealth. According to him,
someone with a diminishing marginal utility fir wealth will get more pain from a dollar lost than
pleasure from a dollar gained. Most investor (as opposed to people who habitually gamble)
appears to have diminishing marginal utility for wealth and this directly affects their attitude towards
risk. He has written about the indifference curve describing that each points of the indifference
curve shows the combination of mean and standard deviation of returns which give a risk averse
investor the same total utility.
2.1.4 Diversification of Risk
Risk diversification through portfolio construction
Elton and Gruber (2001) described the effect of diversification. They write portfolio with 1
to infinity of assets will have decreasing pattern of the expected portfolio variance. They have
supported this interpretation through an artificial example and concluded as more and more
securities are added, the average variance on portfolio declines until it approaches the average
covariance.
They further write effectiveness of diversification in reducing the risk of a portfolio varies
from country to country. The average covariance relative to the variance varies from country to
country. Thus in Switzerland and Italy securities have relatively high covariance indicating that
stocks tend to move together. On the other hand, the security market in Belgium and in the
Netherlands tends to have stocks with relatively low covariance. For these latter security markets,
much more of the risk of holding individual securities can be diversified away. Diversification is
especially useful in reducing the risk on the portfolio in these markets.
Pradhan (2002) constructed the portfolio of three assets, viz., Paschimanchal finance
company (PFC), Nepal state bank of India ltd (NSBIBL) and Citizen Investment Trust (CIT) where
he has constructed nine portfolios at different weights and identified the portfolio with weights PFC-
0.33, NSBIBL-0.34 and CIT-0.33 to be the optimal. The weights he identified are purely on the
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random sampling basis. Apart from this he has also made the portfolio of two assets taking the
stocks of the Paschimanchal finance company and citizen investment trust with weights
0.55(PFC)and 0.45(CIT). Manandhar (2003) has also constructed portfolio of NBB-HBL and NLL-
HBL.
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Simple diversification
Simple diversification is the random selection of securities that are to be added to a
portfolio. Simple diversification reduces a portfolio’s total diversifiable risk to zero and only un-
diversifiable risk remains.
Clarkes, defines simple diversification as “not putting all eggs in one basket” or “spreading
the risks”. Evans and Archer (1968) made sixty different portfolio of each size from randomly
selected New York Stock Exchange (NYSE) stocks and proved the decrease in the un-diversifiable
risk with increase in the number of securities in the portfolio. They made the portfolio from the
randomly selected securities and allocated equal weights. “Spreading the portfolio’s assets
randomly over two or three times as many stocks cannot be expected risk any further.”
Superfluous diversification
“It refers to the investors spreading himself in so many investments on his portfolio. The
investor finds it is impossible to manage the assets on his portfolio because the management of a
large number of assets requires knowledge of the liquidity of each investment return, tax liability
and thus becomes impossible without specialized knowledge”.
In this context, Clarkes adds that superfluous diversification usually result in the following portfolio
management problems.
•Impossibility of good portfolio management
•Purchase of lackluster performers
•High search costs
•High transaction costs
He describe that although more money is spent to manage superfluously diversified
portfolio; there will most likely to be no concurrent improvement in the portfolio’s performance.
Thus, superfluous diversification may lower the net return to the portfolio’s owners after the
portfolio’s management expenses are deducted.
Diversification across industries
Another diversification can be experienced from the combination of the stocks from
different industries. The basic principle of diversifying assets across the industries is the losses
incurred in one stock can be compensated through the gain realized from the profitable stocks.
Fisher and Lorie(1970) have made an empirical research on random and across industry
diversification of portfolio containing 8,16,32,and 128 NYSE listed common stocks where they have
concluded that diversifying across industries is not better than simple diversification and increasing
the number of different assets held in the portfolio above eight does not significantly reduce the
portfolio’s risk.
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Simple diversification across quality rating categories
Study of Wagner and Lau (1971) explains the effect of simple diversification across stocks
that have the same standard and Poor’s quality ratings. Their study consists of six diversified
portfolio each containing 20 equally weighted common stocks that all have identical quality ratings.
Their empirical study supported the economic theory, which suggest that risk- adverse investors
should require higher average rates of return in order to induce them to assume higher levels of
risk s. further their study revealed simple diversification yields significant risk reductions within
homogenous quality rating categories against the risk reductions within the heterogeneous
samples used by Evans and Archer (1968). They concluded their study, as the highest quality
portfolio of randomly diversified stocks was able to achieve lower levels of risk than the simply
diversified portfolios of lower quality stocks. This result reflected the fact that default risk (as
measured by the quality ratings) is part of total risk. Their findings suggested that portfolio
managers could reduce portfolio risk to levels lower than those attainable with simple diversification
by not diversifying across lower-quality assets.
Mean-Variance indifference curves
Indifference curves represent the investor’s risk preferences. Through indifferences
curves, it is possible for an investor to determine the various combinations of expected returns and
risks that provide a constant utility. Joshi (2002) writes that the curves can be drawn on a two
dimensional figure, where the horizontal axis indicates risk as measured by standard deviation
(denoted by σρ) and the vertical axis indicates reward as measured by expected return (denoted
by rp).
The sets of mean variance indifference curves are literally a theory of choice. The only
assumptions necessary to draw the indifference curves for risk-averse investors are
•People prefer more wealth to less
•They have diminishing marginal utility of wealth
These assumptions, if valid, imply that all decision makers are risk averse and will require higher
return to accept greater risk.
Indifference curves cannot intersect. “A risk adverse investor will find any portfolio that is lying on
an indifference curve that is “father north-west” to be more desirable (that is, to provide greater
utility) than any portfolio lying on an indifference curve that is “not as far northwest”. Last, he further
describes that an investor has an infinite number of indifference curves.”
Security market line (SML)
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Sharpe, Treynor, Mossin and linter originally developed security market line or the capital
assets pricing model (CAPM) equation. SML shows the picture of market equilibrium. Weston and
Copeland (1992) explain SML provides a unique relationship between un-diversifiable risk
(measured by beta) and expected return. Capital asses pricing model is an equilibrium theory of
how to price and measure risk. Logic of the security market line is that the required return on any
investment is the risk-free return plus a risk-adjusted factor. They have given the model for the risk
adjustment factor as the product of risk premium required for the market return and the risk of the
individual investment.
Brigham and Aweston (n.d.) have defined that if the rate of change in the risk free rate and
market rate of return is the same, then the slope of the SML remains the constant, and however,
the slope of the security market line. Rather they cause parallel shifts in the SML.
It assumes equilibrium where required rate of return is equal to the expected rate of return.
Further the model defines disequilibrium condition appears when:
•Expected rate of return > Required rate of return= Under priced
•Expected rate of return < Required rate of return = Over priced
Bhatta (2003) evaluates stocks of the companies, viz., National Finance Company, Citizen
Investment Trust, Himalaya Finance Company, Kathmandu Finance Company, Universal Finance
Company, Capital Market limited and People’s Finance limited are under priced. Shrestha (2003)
has also made research to identify whether the stocks of Nepal state bank of India limited(SBI),
Nepal Bangladesh bank limited(NBB), standard chartered bank Nepal (SCB), Everest bank limited
(EBL), bank of kathmandu limited(BOK), and Nepal Arab Bank limited(NABIL) are correctly priced
or not. He concludes all the stocks are under priced.
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Efficient frontier
Collections of possible portfolios are the attainable sets. Cheney and Moses (1992) define
at any given level of risk or return, however there is no one portfolio that provides the highest
(lowest) level of expected return or risk. This set of portfolio that dominates all other portfolio in the
attainable set is referred to as the efficient frontier. They further add once the investor has
determined the expected returns and standard deviations for each of the assets and correlation
coefficients between the assets, then the portfolios on the efficient frontier can be identified.
Estimation of the efficient frontier requires quadratic programming that will simultaneously estimate
the minimum portfolio risk at each level of expected return.
Olsen (1983) writes when only common stocks are considered as components of portfolio
on the efficient frontier, a sample size of several hundred randomly selected securities will provide
an estimate of the efficient frontier not significantly different from the frontier obtained by using the
entire universe of common stocks.
Elton and Gruber (2001), in this context, write for the convex figure of efficient frontier
infinite number of possibilities must be considered.
Capital market line (CML)
“The efficient frontier that can be constructed without borrowing or lending is convex
towards the E(r) axis in risk-return space. However, if borrowing and lending opportunities are
concluded in the analysis, linear set of investment opportunities called the capital market line
emerges”.
Sharpe’s (1964) writes the CML is the locus of the portfolio that wealth-seeking risks-
averse investor will fond more desirable than any other portfolios. Fisher and Jordan (2000)
describe that all investor will end up with portfolios somewhere along CML and all efficient
portfolios would lie along CML. However, not all securities or portfolios lie along the CML. From the
derivation of the efficient frontier we know that all portfolios, except those that are efficient, lay
below the CML. Observing the CML tells us something about the market price of risk.
Investment performance evaluation
Sharpe (1963) devised an index of portfolio performance. His model is generally accepted
as single parameter portfolio performance index and can be calculated from the both risk and
return statistics. This technique ranks the stocks from its excess return-to-beta ratio. Of stocks are
ranked by excess return to beta (from its highest to lowest), the ranking represents the desirability
of any stock’s inclusion in a portfolio. Treynor (1965) conceived an index of portfolio performance
that is based on systematic risk, as measured by portfolios’ beta coefficients. Jansen (1968) has
developed another performance measure by modifying the characteristic regression line. His
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performance is a one parameter investment performance measure. The basic random variables in
Jansen’s model are risk premiums.
2.2 Review of Popular Models of Portfolio
2.2.1 Markowitz portfolio selection model
Markowitz developed the basic model, which defines the expected return of a portfolio as a
weighted average of the expected returns of the individual assets in the portfolio. The weights are
defined as the portion of the investor’s wealth invested in particular assets.
Markowitz used the variance of return as the measure of risk. The risk of the portfolio is
not the weighted average of the variance of the expected returns of the individual assets in the
portfolio however. Estimating portfolio risk in this way would obscure the effect of combining assets
with different returns patterns in a portfolio. Portfolio expected return and risk will be explained and
illustrate in the next sections.
The portfolio model developed by Markowitz is base on the following reasonable
assumptions:
1. The expected return form an assets is the mean value of a probability distribution of
future returns over some holding period.
2. The risk of an individual assets or portfolio is based on the variability of returns. (i.e., the
standard deviation or variance)
3. Investors depend solely on there estimates of return and risk in making their investment
decisions. This means that an investor utility (indifference) curves are only the function of expected
return and risk.
4. Investors adhere to the dominance principle. That is, for any given level of risk, investor prefer
assets with a higher expected return for assets with same expected return investors prefer lower to
higher risk.
According to Markowitz, the expected return of the portfolio is the weighted average of the
expected returns of the individual assets in the portfolio. The weights are proportion of the investor
wealth invested in each asset, and sum of the weights must be equal one.
RP = WA RA + WB RB +-------------+ WN RN
Where,
Rp = portfolio expected returns
WA = weight of investment invested in stock ‘A’
WB = weight of investment invested in stock ‘B’
RA = expected return for stock ‘A’
RB = expected return for stock ‘B’
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According to Markowitz, the portfolio risk is measured by either variance or the standard
deviation of returns. “The portfolio risk is affected by the variance of return as well as the
covariance between the return of individual assets included in the portfolio and respective weights”
The variance of returns from the portfolio made up an asset is defined by following
equation:
Variance (σp²) = B)rA(rCOV2WAWBWB²sB²WA²s²A ++
σp = WA² σA² + WB² σB² +2 WA WB COV ( r A r B )
Where,
σp = standard deviation of portfolio rate of return
COV (r A r B) = covariance of return between assets A & B
The covariance is related to correlation as shown in equation
COV (r A r B) = PAB σ A σ B
PAB = correlation coefficient between variable A & B.
2.2.2 Capital Assets Pricing Model (CAPM)
A model that describe the relationship between risk and expected( required) return; in this
model a securities expected(required) return is the risk free rate plus a premium based on the
systematic risk of the securities.
This model was developed in 1960 A.D. it has important implications for finance ever
since, while other models also attempt to capture market behavior. The CAPM is simple in the
concept and has real world applicability. It allows us to draw certain implications about risk and the
size of the risk premium necessary to compensate for bearing a risk.
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Assumptions of Capital Assets Pricing Theory Model
Capital market theory (CMT) uses portfolio theory as its starting point: thus, the
assumption underling portfolio theory also pertains to the CAPM and the CAPM appear less
realistic than the portfolio theory assumptions.
1. All the investors are risk-averse. Thus all the investors seek to be on the efficient frontier.
2. There are no constraints on the amount of money that can be borrowed. Borrowing and lending
occurs at the identical risks-free rate.
3. All investors have identical belief about the expected returns and risk of assets and portfolios;
that is, all investors have homogeneous expectations.
4. All investors have a common investment horizon, whether it is on month, three month, one year
or whatever.
5. All investors are infinitely divisible and marketable; that is it possible to buy or sell any portion of
an asset or portfolio.
6. Taxes and transaction costs do not exist. That is there are no tax effects, costs of acquiring
information or transecting costs associated with buying or selling securities. These are often
referred to as perfect market assumptions. Market assumed to be competitive therefore the same
investment opportunities are available to all investors.
7. There are no unanticipated changes in inflation or interest rates.
8. The capital markets are in a same state equilibrium or striving toward equilibrium, there are no
under pricing or overpricing exists, the prices will move to correct this disequilibrium situation.
Using beta as our index of Un-diversifiable risk, the CAPM model is given in the equation below:
R j = R f + (R m – R f) b j
Where,
R j = the required or expected rate of return of stock j
R f = risk free rate of return.
R m = the required rate of return on the market portfolio.
B j = the beta coefficient of assets j
2.2.3. Arbitrage Pricing Theory Model (APT)
CAPM is based on only single factor of the average market performance, and it is based
on some unrealistic assumptions. Such a reservation on the part of the user called for a new
model. Stephen A Ross’s multifactor model (1976), called arbitrage pricing theory (APT), is the
answer to this call.
The APT is said to superior on the ground that it is more general than CAPM. The CAPM
assumes that the rate of return on a security is influenced by only one factor that is the average
market performance. Unlike CAPM the APT assumes that the rate of return on a marketable
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security is a linear function of the movement of a set of economic factors (Fk) common to all
securities. The random of return under ATP model is a linear function of k factors as follows:
R j = R j + bj1F1+ bj2F2 +………+bjk Fk + ej
Where,
R j = random rate of return on stock j
R j = expected rate of return on stock j
Bjk = sensitivity of stock j return to kth factor
Fk = mean zero factor common to the returns of assets under consideration
Ej = random error term indicating the unique effect of return.
The Fk is the mean zero random of k factor and it is the deviation of realized value from
the expected value. (I.e. Fk=Fk-Fk). The error term ej is the unique or systematic risk which can be
eliminated through diversification and does not affect the stock rate of return. Therefore, the ATP
model is rewritten as follows:
R j = R j + bj1 (F1-F1) + bj2 (F2-F2) +…………+ bjk (Fk-Fk)
The name arbitrage refers to the market condition where two or more securities of identical
factor sensitive are priced differently, providing opportunities to make profit by selling over-priced
securities shot and buying under priced securities long. Such transactions are called arbitrage and
they allow market participants to make profit without investment and without assuming any risk
through short selling and buying long for the amount equivalent to the short selling. Such
opportunities rarely exist in an efficient market and no one can benefit from arbitrage transactions.
Otherwise, prices will continue to change until the expected return from such transactions is zero.
Therefore the expected arbitrage profit is zero the long if the market functions efficiently. The ATP
is based on this very principle of “no investment, no risk, and no return”.
The ATP states that if no arbitrage opportunity exists in the market, the asset pricing is a
function of risk free rate and a set of relevant factor to risk premium. It is, therefore, true that ATP is
not different from CAPM which also states that return on security is equal to risk free and risk
premium for the market related factor. The ATP model can be expressed through some
mathematical manipulation in CAPM format as follows:
R j = R f + bj1 [E (F1) - R f] + bj2 [E (f2) – R f] +…………+ bjk [E (Fk)-R f]
Thus, we can see that the ATP logic is not much different from the logic used in the CAPM.
Similar to CAPM, only the set of systematic risk is priced in he above model, and no price is
assigned for the diversifiable risk. The risk premium for systematic risk of each factor is determined
as the market price per unit of risk multiplied by the degree of factors systematic risk.
2.3. Review of Articles
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There are not many articles published relating to portfolio management of commercial
banks of Nepal. However there are some of the articles related to portfolio management which
have been summarized below
Mr. Yogendra Timilsina, has published an article on “Managing Investment portfolio”. He is
however, confronted with problems of managing investment portfolio particularly in times of
economic slowdown like ours. A rational investor would like to diversify his investments in different
classes of assets so as to minimize risks and earn a reasonable rate of return.
Commercial banks have continuously been reducing interest rates on deposits. Many
depositors are exposed to the increasing risk of non-refund of their deposits because of the
mismanagement in some of the banks and financial institutions and accumulation of huge non
performing assets with them
Few depositors of cooperative societies lost their deposits because some of these
cooperatives were closed down because of their inability to refund public deposits. An investor in
days of crisis has to make an effort to minimize the risk and at least earn a reasonable rate of
return on his aggregate investment.
An investment in equity share an earn dividend income as well as capital gain in the form
of bonus share and right share until an investor holds it and capital profit when he sells it in stock
market. As returns from equity investments have fluctuated within a very wide range, investor feels
it much difficult to balance risk and reward in their equity portfolio. As a matter of fact, investors in
equity shares should invest for a reasonable long time frame in order to manage the risk.
Making investment in fixed deposits with commercial banks is a normal practice among the
common people. Normally fixed deposits with banks are considered risk less but they also are not
hundred percent of free of risk. You should select the bank to put your deposits therein, which has
sound financial health and high credibility in banking business. In times of crisis if you select a sick
bank to deposit your money there is high probability that your money could not be returned back.
An investor may have the option of making investment in Government bonds or
debentures. In history we have examples that government can nationalize the private property of
its citizens, cancel out currency notes, can covert the new investment into some conditional
instrument. But in democracy there is no probability that the government would default to repay
money back. This is comparatively risk free investment, but yields low return.
An investor has to evaluate the risk and rerun of each of the investment, alternatives and
select an alternative, which ahs lower degree of risk and offer at least reasonable rate of return.
One can draw a safe side conclusion to invest all the money he has only in government securities
but this is not a rational decision. An investor who does not try to maximize return by minimizing
the possible risk is not a rational investor. On the other hand one can lace over confidence on
equity investment and assume high risk by investing the whole money in equity shares. Stock
market these days is much dwindling and notoriously unpredictable therefore this too is not a wise
decision. Therefore portfolio, which consists of only one class of financial assets, is not a good
portfolio.
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Mr. Shiva Raj Shrestha (2059) has given a short glimpse on article entitled “Portfolio
Management in Commercial Banks,Theory and Practices”.
Mr. Shrestha in his article has highlighted the following issues:
•The portfolio management becomes very important both for individuals and institutional investor.
• Investor would like to select better mix of investment assets subject on these aspects like, higher
return that is comparable with alternatives according to the risk class of investor.
• Good quality with adequate safety on investment, maximum tax concession, economic
efficient mixes.
For fulfilling those aspects, the following strategies will be adopted.
•Do not hold any signal i.e. try to have a portfolio of different securities.
• Choose such portfolio of securities, which ensure maximum return with minimum risk or less
return for wealth maximizing objectives.
He has mentioned short transitory view on portfolio management in Nepalese commercial
banks. Now a days number of banks and financial institution are operating in this sector are having
greater network and access to national and international markets. They have to go with their
portfolio management very seriously and superiority, to get success to increase their regular
income as well as to enrich the quality service to their clients. In this competitive and market
oriented open economy, each commercial banks and financial institution has to play a determining
role by widening various opportunities for the sake of expanding of best service to their customers.
In this context he has presented two types of investment analysis techniques i.e.
fundamental analysis to consider any securities such as equity, debenture or bond and other
money and capital market instrument. He has suggested that the banks having international joint
venture network can also offer admittance to global financial markets. He has pointed out the
requirements of skilled labors, proper management information system (MIS) in joint venture banks
and financial institution to get success in portfolio management and customer assurance.
According to Mr. Shrestha, the portfolio management activities of Nepalese commercial
banks at present is in nascent stage. However, on the other hand most of banks are not doing such
activities so far because of following reasons. Such as unawareness of the client about the service
available, hesitation of taking risk by the client to use such facilities, lack of proper techniques to
run such activities in the best and successful manner, less development of capital market and
availability of few financial investment in the financial market.
He has given the following conclusion for smooth running and operation of commercial
banks and financial institution.
•For surviving of commercial banks should depend upon their own financial health.
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• In order to develop and expand the portfolio management activities successfully, the investment
management methodology of portfolio manager should reflect high standards and give their clients
the benefits of global strengths, local insights and product philosophy.
• With the discipline and systematic approval to the selection of appropriate countries, financial
assets and management of various risks the portfolio manager could enhance the opportunity for
each investor to earn superior return over time.
• The Nepalese banks having greater network and access to national and international capital
market have to go for portfolio management activities for the increment of their fee based income
as well as enrich the client base and contribute to the national economy.
An article published on the Kathmandu post daily of 9th march 2003 entitled “Managing a
Banking Risk” by Chandra Thapa, in his article has accomplished the subsequent issues.
Banking and financial service are among the fastest growing industries in developed world
and are also emerging as cornerstones for other developing and underdeveloped nations as well.
Bank primary function is to trade risk. Risk cannot be avoided by the bank but can only be
managed. There exist two types of risk. The first is the diversifiable risk or the firm specific risk
which can be mitigated by maintaining an optimum and diversified portfolio. This is due to the fact
that when one sector does optimum and diversified portfolio. This is due to the fact that when one
sector does no do well the growth in another might offset the risk. Thus depositor must have the
knowledge of the sectors in which there banks have make the lending. The second is un-
diversifiable risk and it is correlated across borrower, countries, and industries. Such risk is not
under control of the firm and bank.
According to Mr.Thapa risk management of the banks is not only crucial for optimum trade
off between risk and profitability but is also one of the deciding factors for overall business
investment lending to growth of economy. Managing risk not only needs sheer professionalism at
the organization level but appropriate environments also need to develop. Some of the major
environment problems Nepalese banking sector is under government intervention, relatively weak
regulatory fame, if we consider the international standard, meager corporate governance and the
biggest of all is lack of professionalism. The only solution to mitigate the banking risk is to develop
the badly needed commitment eradication of corrupt environment especially in the disbursement of
lending, and formulate prudent and conducive regulatory frame work.
Another article published on the Kathmandu post daily 28th April entitled “Efficient
Banking” by L.D. Mahat, in his article he has accomplished, the efficiency of banks can be
measured using different parameters. The concept of productivity and profitability can be applied
while evaluating efficiency of banks. The term productivity refers to the relationship between the
quantity of inputs employed and the quantity of outputs produced. An increase in productivity
means that more output can be produced from the same inputs or the same outputs can be
produced from fewer inputs. Interest expense to interest income ratio shows the efficiency of banks
in mobilizing resource at lower cost and investing in high yielding assets. In other words, it reflects
the efficiency in use of funds.
According to Mr. Mahat, the analysis of operational efficiency of banks will help one in
understanding the extant of vulnerability of banks under the changed scenario and deciding whom to bank
25

upon. This may also help the inefficient banks to upgrade their efficiency and be winner in the situations
developing due to slowdown in the economy. The regulators should also be concerned on the fact that the
banks with unfavorable ratio may bring catastrophe in the banking industry.
Shree Prasad Poudel, deputy director, NRB in his article “Government Security Markets Rationale
and Development in Nepal” has concluded that the security markets are the centre of the financial
system. Debt securities market in the Nepal is highly dominated by government debt securities.
Debt statistics evident that Nepal remained debt free nation till 1950’s. From the beginning of
1960’s foreign loans and domestic bonds been alternative means of debt financing in Nepal as a
result total debt as a percentage of GDP widened from 1% in 65.3% in 2000.
According to Mr. Poudel, government debt consist Treasury Bills, National Savings Certificates,
Development Bonds, Special Bonds, and Citizen Savings Certificates.
He further added that NRB and Commercial Banks are the main holders of government bonds. In
this article he suggested following improving area in debt securities market in Nepal:
• To make government securities active instruments of open market operation coupon rate on
government securities has to be fixed closely to the market rate of interest.
•Exchange of government securities at the market price have to be encouraged.
•Products of government debt securities need to be diversified to meet investor’s demands.
• Like equity shares the marketable government securities needs to be exchange in the floor of
Nepal stock exchange at competitive price.
Dr. Govinda Bahadur Thapa has expressed his view that the commercial banks including
foreign joint venture banks seem to be doing pretty well in mobilizing deposits. Likewise loans and
advances of banks are also increasing. But compared to high credit needs particularly by the newly
emerging industries, the banks still to lack adequate funds.
Out of the commercial banks, Nepal bank ltd. and Rastriya Banijya Bank are operating with
the normal profit the later turning towards negative form time to time. Because of non-recovery of
the accrued interest, the margin between interest, income and interest expenses is declining.
There banks have not been able to increase their income from commission and discount. On the
contrary, they have got heavy burden of personal and administrative overheads. Similarly due to
accumulated over due and defaulting loans, profit position of three banks has been seriously
affected on the other banks have been functioning in venture banks have been functioning in an
extremely efficient way. They are making huge profit year and have been disturbing large amount
of bonus and dividends to employees and shareholders.
According to him, the joint venture banks concentrate to modern off balance sheets
operations and efficient personal management has to add to the maximization of their profits.
Dr Sunity Shrestha(1995) in her study “Portfolio Behavior of Commercial Banks in Nepal”
has made Remarkable efforts to examine various portfolio behavior of commercial bank in Nepal
such as investment portfolio liability portfolio, assets portfolio etc. According to her, investment of
commercial banks when analyzed individually, were observed that Nepalese domestic banks invest
26

in government securities, national saving bond, debenture and company’s shares. On the basics of
this study she found that the supply of the bank credit was expected to depend on total deposit,
lending rate, bank rate, lagged variables and the dummy variables, similarly demand of bank credit
was assumed to be effected by national income, lending rate, treasury bill rate and other variables.
The resources of commercial banks were expected to be related with variables like total deposit,
cash reserves requirement, and bank rate and lending rate. On the basics of her finding
conclusions:
• Τηε ρελατιονσηιπ οφ βανκσ πορτφολιο ϖαριαβλεσ ασ φουνδ το βε βεστ
εξπλαινεδ βψ λονγ−λινεαρ εθυατιονσ.
• Demand of deposit of commercial banks in Nepal is positively affected by the GDP from
nonagricultural and the deposit rate and lending rate of interest.
• The investment of commercial banks on government securities has been observed to be affected
by total deposits; cash reserves requirements, Treasury bill rates and lending rates.
• The investment of commercial banks in shares and securities are normal and not found to have
strategic decisions towards investment in shares and securities.
•The loan loss ratio has been found to increase with low recovery of loan.
2.4. Review from Journal
Some related journals to our study have been taken into account. Bill Ausura in his article
entitled “Current Issues in Technology Management” shows portfolio management has become
one of the hot topic industries over the last three to five years. Portfolio management must be
interwoven into multitudes of other business activities, processes and discipline in order to really be
effective. Some key items must connect with and precede portfolio management include
formulation n of company mission, goals/objectives and strategy, and establishment of solid work
and organizational structures. One final item to consider in context for portfolio management is the
nature of corporate culture and its people. This people element is the one many companies fail to
consider or understand fully, but it is often the one, which presents the greatest implementation
barrier when companies attempt to start doing portfolio management.
Portfolio management has been studied, documented and discussed for decades. Some
companies have done an excellent job of establishing and maintaining core competencies in this
key business function. But today more then ever, companies are challenged to learn and apply the
full discipline of life cycle portfolio management. As market and competitive pressures continue to
increase especially in times of economic uncertainty the needs for good portfolio management
becomes more pressing. However, these same market and competitive pressures often cause
companies to miss the critical role of portfolio management as they cut corners in budgets and
people, putting their emphasis and their hopes more and more on individual new projects instead
of taking a more holistic approach to overall business management.
Lewellene and Shaken in their journals entitled “learning, Assets Pricing Test and Market
Efficiency” studies the assets-pricing implication of parameter experimental test can find patterns in
the data that differ from those perceived by the rational inventor. Returns might appear predictable
27

to an econometrician or appear to depart from capital assets pricing model. But saver can neither
perceive nor exploits this certainty. Returns appear excessively volatile even though prices react
efficiently to cash flows news. They conclude the parameter uncertainty can be important for
characterizing and testing market efficiency.
Financial economists generally assume that, unlike themselves, investor knows the mean,
variance, and the covariance of the cash flow process. Practitioners do not have this luxury. To
apply the elegant frame work of modern portfolio theory, they must estimate the process using
whatever information is available. However, Black (1986) so memorably observe, the world is a
noisy place, their observations are necessarily imprecise. The literatures an estimation risk
formalize this problem, but it seems to have had little impact on mainstream thinking about Assets
Pricing and Market Efficiency. They believe that this is due, in part, to its focus on the subjective
believes of investor rather than the empirical properties of returns. They show that learning can
significantly affect assets pricing tests. Prices in their model satisfy that commonly accepted
nations of market efficiency and rational expectation, investor use all available information when
making decision and, in equilibrium, the perceived pricing functions equals the true pricing function,
in spite of this, the empirical properties of returns differ significantly from the properties perceived
by investor. Excess returns can appear to be predictable even though investor perceive a constant
risk premium; prices can appear to be too volatile even though investor attempt to hold mean
variance efficient portfolios. Put simply, empirical test can find patterns in returns the rational
investor can neither perceive nor exploit. It is important to note that predictability is but to some
spurious estimation problem. Rather, it is a feature of true data generation process. This means
that parameter uncertainty can affect empirical test in surprising ways. We find, for example, that
an implement able replicating the strategy in real time is expected to generate abnormal profits. An
econometrician replicating the strategy in real time is to find in a frequenters sense, risk-adjusted
profits. Again, however a rational investor dies not gain anything from following strategy, the
investor’s perceived zero profit. A similar phenomenon explains why investor can not use cross
sectional predictability to beta the market. The puzzle highlights the distinction betweens the
repeated sampling perspective of empirical test and conditionally perspective of investment
decision. It also shows how difficult or might be to construct valid Assets Pricing Test in the
presence of parameter uncertainty.
The fact parameter uncertainty might explain observed assets pricing anomalies does not
of course, mean that it dais. Their simulations suggest that learning might be important, but
empirical tests are necessary to draw strong conclusion. The assets market efficiency, the
researcher may, in effect, need to copy the Bayesian-updating process of rational investor to
determine whether the patterns observed due to the data could no exploited, this is not an easy
task; it would necessarily require some judgment about the learning process and what up a
reasonable past. This observation is suggestive of fames (1970) critique of assets Pricing Test. He
emphasis that empirical test always entail a joint hypothesis of market efficiency and model of
perceived expected returns. Their study suggests that empirical test may also require an
assumption about prior beliefs. The role of prior beliefs and learning is typically ignored, but it might
be critical for understanding anomalies.
Another journal published in journal of finance entitled, “Local Return Factor and
Emerging Stock Market” by Rouwenhorst: 1999 is relevant to our study. This article examines the
28

source of return variation in emerging stock markets. Compared to developed market the
correlation between most emerging market and stock market has been historically low and until
recently many emerging country restricted investment by foreign investor.
He attempts two sets of question to answer by this solution. Many emerging stock market
have firms with multiple shares are treated as single value weighted portfolio of the outstanding
equity securities. He concludes that the return factors in emerging market are quantitatively similar
to those in developed markets. The low correlation between the country returns factor suggest that
the premiums have a strong local character. Furthermore, global exposure cannot explain the
average factors returns of emerging market. There is little evidence that correlation between the
local factor portfolios have increased which suggests that factors responsible for increase of
emerging market country relation are separated from those that derive the difference between
expected return with in these market. A Bayesian analysis of premiums in developed and emerging
market shows that unless on e has stronger prior believes to the contrary, the empirical evidence
favors the hypothesis that the size, momentum and value strategic are compensated for expected
returns around the world. At last, the paper documents the relationship between expected return
and share turnover examine the turnover characteristic of local return factor portfolio. There is no
evidence of a relation between expected return and turnover in emerging market. However, beta,
size and momentum and value are positively cross section ally correlated with turnover in emerging
markets. This suggests that the returns premiums do not simply reflect compensation for liquidity.
The journal of finance published bimonthly by American Finance Association for many
decades is taken out into account. In its recent volume of august 1999, an article “local Return
Factors and Turnover in Emerging Stock Market” by K. Greet Rouwenhorst has been received
here. There is growing empirical that multiple factors are cross sectional correlated with average
return in the United States. Measured over long time, small stock earns higher average return than
large stock (Bank 1981). It showed that value of stock with high book-to-market earning to price
(E/P), on cash flow to price(C/P) out performed growth stock with low B/M, E/P or C/P. more over
stock, with high return over the past 3 month to one year continue to out performed stocks with
work poor prior performance.. The evidence that beta is also compensated for in average return is
weaker.
The interpretation of the evidence is strongly debated. Some believe that premiums are
compensation pervasive risk factors. Other attributes them to form characteristics of insufficiency in
the way market incorporated information into prices. Yet other averages that survivorship or data
snooping may bias the premiums. The paper examines the source of return variation in emerging
stock markets. From the perspective of collecting independents samples, emerging market
countries are particularly interesting because of their relative isolations from the capital market of
other countries. Compared to developed markets as historically been low (Harvey, 1995) and until
recently many emerging countries restricted investment by foreign investors. Interestingly, Bekaert
and Harvey (1995) find that despite the recent trend toward abolition of these restriction and
substantial inflows of foreign capital. Some emerging equity markets have actually become more
segmented from world capital markets. A large portion of the equity capital o f emerging economics
is held by local investors who are likely to evaluate their portfolios in the light of local economic and
market condition.
29

On the above background Rouwenhorst attempts to answer two sets of questions. The first
set of three questions concerns the existence of expected return premiums,
• Do the factors that explain expected return difference in developed equity market also describe
the cross section of expected return of emerging firm?
•Are the return factors in emerging markets primarily local or having global components as well?
• How does the emerging market evidence contribute to the international evidence from developed
markets that similar return factors are present markets around the world?
•The second sets of question of the paper include:
• Is there a cross sectional relationship between liquidity and average returns in emerging
markets?
•Are the return factors in emerging markets cross sectional correlated with liquidity?
About the data Rouwenhorst stated that as of April, 1997 the emerging market. Database
(EMDB) of the IFC contains data more in the sample. Eleven countries are excluded because of
insufficient return histories, which leave 1705 firms in 20 countries that the IFC tracks for at least
seven years.
For some month closing process and dividends is available dating back to 1975. starting at
various points during 1980s the IFC expand its reporting to include monthly time series for price-
bond ratios, price-earning ratios, market capitalization trading volume and the number of days per
month that a stock is traded total returns are calculated as the sum of the divided returns and price
appreciation, using prices scaled by a capital adjustment factor which the IFC computes to correct
for the price effects associated with stock split stock dividend and right uses. Many emerging
markets have firms with multiple classes of shares carrying different ownership restriction. Forms
with multiple shares classes are treated as single value weighted portfolio of the outstanding equity
securities.
The first conclusion is that the return factors in emerging markets are qualitatively similar
to those in developed market small stock outperform growth stocks and emerging markets stock
exhibit momentum. There is no evidence that the local markets betas are associated with the
average returns. The low correlation between the country return factors suggests that the
premiums have a strong local character. Furthermore global exposures cannot explain the average
factor returns of emerging markets. There is little evidence that the correlation between the local
portfolios have increased which suggests that the factor responsible for the increase of emerging
market country correlation and separate from those that drive the difference between expected
returns within these markets. A Bayesian analysis of premiums in developed and emerging
markets show that unless one has strong prior beliefs to the contrary the empirical evidence favor
the hypothesis that size momentum and value strategies are compensated for in expected returns
and share turnover and examines the turnover characteristics of the local returns factor portfolios.
There is no evidence of a relation between expected returns and turnover in emerging markets
however beta size momentum and value is positively in emerging markets. This suggests that the
return premiums do not simply reflect a compensation for liquidity. This study by Rowe horst does
not consider the analyzed the returns factors in worldwide stock markets. However it concentrates
in the various emerging stock markets. Hence the article contributes in the article contributes in the
area of risk and return analysis in common stock investment.
30

“A Monte Carlo Method for Optimal Portfolios” by Jerome B. Detemple, Rene Garcia and
Marcel Rindisbacher. In this study “A Monte Carlo method of Optimal Portfolios” they have
developed a comprehensive approach for the calculation of the optimal portfolios in assets
allocations problems with complete markets.
The major benefit of this method, which relies on Monte Carlo simulation, is its flexibility. Indeed,
the approach permits (i) any finite number of state variables (ii) any diffusions process for the state
variables (iii) any number of risky assets. It is also valid for any preference relation in the Von
Neumann – Morgenstern class. This flexibility provides a distinct advantage over alternative
approaches to the problem.
This study concludes that a number of economics results that can be used as guidelines
for the sound assets allocation rules. The performance of these rules will also depend on the
empirical sophistication of the underlying model of financial markets. Clearly, they do not suggest
that the models investigated here are adequate in that respect although they appear more realistic
that the specifications examine in the prior literature. But the important point here is that the
approach they have proposed offers great generality. It can be easily adopted to address the asset
allocation problem for a large class of financial market model.
“Portfolio Choice in the Presence of Personal Illiquid Projects” by Miquel Faig and Pauline
Shun. This study covers the data from 1995SCF. These data shows those households that are
savings to invest in their own homes or in their own business have significantly safer portfolios. The
data also suggest that it is the younger households that tend to invest in these personal projects.
This research helps to explain why young investors and entrepreneurs have larger than expected
holdings of safe financial assets.
Conclusions of this research are as follows:
• When individuals save to invest in their own business or in their own homes, they hold a portfolio
of financial assets that is safer than we would expect given their characteristics.
• Individuals engaged in multi stage personal projects in which there is a penalty for discounting
them due to lack of liquidity.
• Individuals do not rely on large holdings of financial assets to insure the continuation of their
projects; instead they rely on the safety of their holdings.
2.5 Reviews from Thesis
Several thesis works have been conducted by various students regarding the various
aspects of commercial banks such as financial performance, leading policy, investment policy,
interest rate structure, resources mobilization, capital structure etc. However some relevant thesis
works have been reviewed here. They are presented below.
The study performed by Mr. Gopal Prasad Bhatta (2003) is based on 10 listed companies’
data, using five years data from 1990 to 1995. Among different objectives, the one is “to analyze
the performance of listed companies in terms of risk and return i.e. expected rate of return and
31

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