Risk and return

Risk and Return Analysis of Listed Commercial
Banks of Nepal
Submitted By:
Asha Jaiswal
T.U. Regd. No.: 7-2-329-34-2004
Exam Roll No.: 3290029
Campus Roll. No: 16
Submitted To:
Office of the Dean
Faculty of Management
Tribhuvan University
IN THE PARTIAL FULFILLMENT OF REQUIREMENTS
OF THE DEGREE OF MASTER OF BUSINESS STUDIES
(M.B.S)
2012

Acknowledgements
I am heartily indebted to my supervisor Mr. Yagya Raj Pathak 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 study.
The credit of success of the thesis goes to my loving parents Mr. Ramdulare Jaiswal
and Mrs.Dipa Jaiswal.
2012 Asha Jaiswal

Abstract
This study 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 risk and return analysis 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 in terms
of risk and return. All the data used in the study are secondary 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. On the basis of
expected return of NABIL bank is better for investment because it has expected
return of 22.9% greater than other banks. Moreover, in terms of the analysis of
deposit and government securities bank with the better risk premium is considered
beneficial for investment. So NABIL Bank Ltd. is the best option for investment
for the investors. But the combination of SBI and NIC is less risky because its
standard deviation is 0.4182 i.e. 41.82% less than other banks. So if the investor
wants to take risk then s/he can invest NABIL and SBI otherwise SBI and NIC is
the best option for the investment.

Table of Contents
Risk and Return Analysis of Listed Commercial...........................................................1
Faculty of Management..................................................................................................1
CHAPTER - I ................................................................................................................1
INTRODUCTION..........................................................................................................1
1.1 Background of the Study..........................................................................................1
Meaning of the Commercial Banks...............................................................................4
Securities Market...........................................................................................................6
Historical background of securities market................................................................6
1.2. Statement of the Problem........................................................................................7
1.3. Objectives of the Study...........................................................................................8
1.4. Scope of the Study...................................................................................................8
1.5. Limitation of the Study...........................................................................................8
1.6. Organization of the Study........................................................................................9
Chapter I:....................................................................................................................9
Introduction: ..........................................................................................................9
Chapter II:...................................................................................................................9
Reviews of literature: ............................................................................................9
Chapter III:...............................................................................................................10
Research methodology: .......................................................................................10
Chapter IV:...........................................................................................................10
Data presentation and analysis: ...........................................................................10
Chapter V:................................................................................................................10
Summary, Conclusion and Recommendations: ...................................................10
CHAPTER - II..........................................................................................................11
REVIEW OF LITERATURE...................................................................................11
2.1. Review of Theoretical Framework........................................................................12
2.1.1 Investment.......................................................................................................14
2.1.2 Return..............................................................................................................15
2.1.3 Risk..................................................................................................................16
2.1.4 Diversification of Risk...................................................................................19
Risk diversification through portfolio construction.............................................19
Simple diversification...........................................................................................20
Superfluous diversification...................................................................................20
Diversification across industries..........................................................................21
Simple diversification across quality rating categories........................................21
Mean-Variance indifference curves.....................................................................22
Security Market Line (SML)................................................................................22
Efficient Frontier..................................................................................................23
Capital Market Line (CML).................................................................................24
Investment Performance Evaluation....................................................................24
2.2 Review of Popular Models of Portfolio.................................................................25
2.2.1 Markowitz Portfolio Selection Model.............................................................25
2.2.2 Capital Assets Pricing Model (CAPM)...........................................................27
Assumptions of Capital Assets Pricing Theory Model............................................27
2.2.3. Arbitrage Pricing Theory Model (APT).........................................................28
2.3. Review of Articles.................................................................................................30
2.4. Review from Journal.........................................................................................37
2.5 Reviews of Thesis Related to This Study...............................................................44

RESEARCH METHODOLOGY.................................................................................51
3.1 Research Design.................................................................................................51
3.2 Sources of Data..................................................................................................52
3.3 Population and Sample.......................................................................................52
3.4 Data Collection Procedure..................................................................................53
3.5 Data Analysis Tools...........................................................................................53
3.5.1 Financial Tools............................................................................................53
Portfolio Expected Return....................................................................................54
Portfolio Risk.......................................................................................................54
Minimum Risk Portfolio......................................................................................55
Portfolio Beta ......................................................................................................55
3.5.2 Statistical Tools...............................................................................................55
Expected Return (Arithmetic Mean)....................................................................56
Standard Deviation...................................................................................................56
Variance................................................................................................................56
Co-efficient of variance (CV)...............................................................................57
Total Risk.............................................................................................................57
Diversifiable Risk / Unsystematic Risk................................................................58
Un-diversifiable Risk / Systematic Risk..............................................................58
Covariance............................................................................................................59
Correlation............................................................................................................59
Beta Coefficient....................................................................................................60
CHAPTER - IV ..........................................................................................................61
PRESENTATION AND ANALYSIS OF DATA.......................................................61
4.1 Data Analysis of Risk & Return of Individual Bank..........................................62
4.1.1. Nepal SBI Bank Limited................................................................................62
4.4 Overall Market (NEPSE)....................................................................................68
4.5. Inter Bank Comparison ....................................................................................69
4.5.2 Comparison of beta and correlation of different banks:..............................70
4.5.3 Analysis of systematic Risk and unsystematic risk:....................................70
4.6 Portfolio Analysis ..............................................................................................71
4.6.1 Portfolio analysis of stocks between SBI and NIC Bank............................71
4.6.3 Portfolio analysis of stock between NABIL & SBI....................................74
CHAPTER - IV............................................................................................................75
5.1 Summary............................................................................................................75
5.2 Conclusion..........................................................................................................76
5.3 Recommendations..............................................................................................78
BIBILOGRAPHY....................................................................................................81
Websites:.............................................................................................................83
ANNEX....................................................................................................................84
Annex-1....................................................................................................................84
Annex-2....................................................................................................................85
ANNEX-3.................................................................................................................85
ANNEX-4.................................................................................................................87
ANNEX - 5...............................................................................................................88

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 recent 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)
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 of risk. 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. 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. Risk, meanwhile, has devolved into the financial
equivalence of dark matter, evident solely by its effects.
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
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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. 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.
Risk and Return are the most two important attributes of an investment. They are linked
in the capital markets and that generally, higher returns can only be achieved by taking on
greater risk. Risk isn’t just potential loss of return; it is the potential loss of the entire
investment itself (loss of both principle and interest). Consequently, taking on additional
risk in search of higher returns is a decision that should not be taking lightly.
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.
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 Keith Ambachtscheer, “Portfolio management concerns itself with selecting
‘good’ stocks or bonds are fading.” Portfolio management of bank assets basically means
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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.
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
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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.
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.
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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.
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
5

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.
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
6

in 1964, the 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 (SEBON) was established.
1.2. 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.
7

The study seeks to analyze investment of investors, risk and return on various types of
investment.
• What happens to risk and return when securities are combined in a portfolio?
• 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?
• How to estimate expected returns and risk for individual securities?
1.3. Objectives of the Study
The main objective of the study is to analyze and interpret the risk and return of selected
banks. The specific objectives of the study are as follows:
• To evaluate common stock investment in terms of risks and return.
• To analyze portfolio risk and return of commercial banks.
• To provide suggestive package based on the analysis of the data.
1.4. 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,
researchers and even to the experts. The significance of this study will be to minimize
risk in common stock investment and maximize return through portfolio analysis in terms
of risk and return; the study will fulfill the need in this aspect. It will also help as a
literature for the further study about the related topics of financial performance and
portfolio management. Similarly, the investors would follow the suggestion of this to
make their policy and strategy more practical and scientific.
1.5. 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;
8

time periods taken, and other variables. Besides these following specific limitations also
mentioned.
• This study has employed secondary data published by and collected from selected
banks.
• Only financial aspects are analyzed, other performance of bank is neglected while
providing suggestion.
• This study is only focused on the three listed commercial banks namely Nepal SBI
Bank Ltd., NABIL Bank Ltd., and NIC Bank Ltd. So the findings can not be
generalized.
• There are too many literatures available in the area of risk and return analysis. This
study is based only on few of them.
• This study is focused on the data and information from 2006 to 2010.
1.6. Organization of the Study
Chapter I:
Introduction:
The introduction chapter includes general background, statement of problem, objectives
of the study, scope of the study and limitation of the study.
Chapter II:
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.
9

Chapter III:
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 IV:
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 V:
Summary, Conclusion and Recommendations:
It includes the summary of the study, conclusion of the main findings and
recommendation for further investment as well as bibliography and annex.
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CHAPTER - II
REVIEW OF LITERATURE
Review of literature is the study of past research studies and relevant materials. It is an
advancement of existing knowledge and in-depth study of subject matter. It starts with a
search of a suitable topic and continues throughout the volumes of similar or related
subjects. It is very rare to find out completely new problem. In literature review,
researcher takes hints from past dissertation but he or she should take heed of replication.
Literature review means reviewing research studies and other pertinent prepositions in
the related area of the study so that all the past studies their conclusions and deficiencies
and further research take place. It is a vital and mandatory process in research works.
During the review of this research, in depth study and theoretical investigation regarding
portfolio’s aspects and their present application and potentialities made. Investment
“Range of investment held by an investor, company etc.”(Oxford Dictionary; 2010:272)
A portfolio simply represents the having their funds in more than one assets. The
combination of investment assets is portfolio. Hence, in this chapter, the focus has been
made on the review of literature relevant to the investment portfolio analysis of
commercial banks in Nepal. 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.
11

2.1. Review of Theoretical Framework
variance (CV) and beta as a parameter for the measurement of risk. However, the
beyond the control of the organization. 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. Risk, meanwhile, has devolved into the financial
equivalence of dark matter, evident solely by its effects.
the amount initially invested. 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.
Risk and Return are the most two important attributes of an investment. They are linked
in the capital markets and that generally, higher returns can only be achieved by taking on
greater risk. Risk isn’t just potential loss of return; it is the potential loss of the entire
investment itself (loss of both principle and interest). Consequently, taking on additional
risk in search of higher returns is a decision that should not be taking lightly.
12

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.
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
13

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.
14

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.”
“Investment is the current commitment of funds for a period of time to derive a future
flow of funds that will compensate the investing unit for the time funds are committed,
for the expected rate of inflation and also for uncertainty involved in the future flow of
the funds.”(Frank and Reilly; 2004:298-299)
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
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
15

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.
2.1.3 Risk
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variance (CV) and beta as a parameter for the measurement o frisk. However, the
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.
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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 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 (2008) 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
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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 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
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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.
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.
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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)
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
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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.
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
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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)
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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 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.
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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’
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.
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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.
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
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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 security is a linear function of the movement of a set of economic factors (Fk)
common to all securities. The random of return under APT model is a linear function of k
factors as follows:
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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. 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 APT 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 APT is
based on this very principle of “no investment, no risk, and no return”.
The APT 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 APT 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 APT model can be
expressed through some mathematical manipulation in CAPM format as follows:
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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 APT 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
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
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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, and 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.
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:
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• 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.
Mr. Shrestha 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.
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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.
• 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
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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.
34

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 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
35

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 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:
36

• The relationship of banks portfolio variables as found to be best explained by
long-linear equations.
• 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 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
37

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 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
38

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.
Thapa, C. (2009) has published an article on The Kathmandu Post daily of 9th march
2009 entitled “Managing Banking Risk”, in his article he has accomplished the
subsequent issues. Banking and financial service are among the fastest growing industries
in developed world and are also emerging as cornerstones in other developing and
undeveloped 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
39

optimum and diversified portfolio. This is due to the fact that when one sector does not
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
undiversifiable risk and it is correlated across borrower, countries, and industries. Such
risk is not under control of the firm and bank. On the basis of his article 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 organizational level
but appropriate environments also need to develop. Some of the major environmental
problems of Nepalese banking sector are 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 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 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
40

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
41

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.
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
42

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