CHAPTER – I

INTRODUCTION

1.1 Background

Common stock is a form of corporate equity ownership, a type of security. It is a

security that represents ownership in a corporation. They are on the bottom of the
priority ladder for ownership structure; in the event of liquidation. They have rights to
a company's assets only after bondholders, preferred shareholders and other debt
holders are paid in full.

If a company goes bankrupt, the common stockholders do not receive their money
until the creditors and preferred shareholders have received their respective share of
the leftover assets. This makes common stock riskier than debt or preferred shares.
The upside to common shares is they usually outperform bonds and preferred shares
in the long run.

The term "risk and return" refers to the potential financial loss or gain experienced
through investments in securities. An investor who has registered a profit is said to
have seen a "return" on his or her investment. The "risk" of the investment,
meanwhile, denotes the possibility or likelihood that the investor could lose money. If
an investor decides to invest in a security that has a relatively low risk, the potential
return on that investment is typically fairly small. Conversely, an investment in a
security that has a high risk factor also has the potential to gain higher returns. Return
on investment can be measured by nominal rate or real rate (money earned after the
impact of inflation has been figured into the value of the investment).

Return is the reward received from investment for waiting and compensation for risk
bearing. Return is the major factor behind any investment but it involves risk. It can

1
be said that risk and return play the dominant role in investment. Researchers have
shown that most of investors are risk averter. So, it can be concluded that people
invest their belongings in those opportunities where they can get higher return with
bearing low level of risk.

The concept of risk and return are the determinant for the valuation of securities.
However, risk means that we do not know what is going to happen even though we
occasionally have a good idea of the range of possibilities that we face. In general
sense, risk can be defined as the change of loss. Assets having greater changes of loss
are viewed as more risky than those with lesser changes of loss. More formally, the
term risk is used interchangeably with uncertainty to refer to the variability of returns
associated with a given asset.

Out of the various types of the securities, this study deals with common stock
investment. It is a risky investment than both bonds and preferred stock but it has also
benefit like voting right in participation in profit. And also, common stock may be
purchased and sold immediately. There is the uncertainty of future return whose main
source is the price fluctuation of the common stock. The stock price may be decreased
due to the economic factor such as inflation, interest rates, strength of dollar,
economic growth of the nation etc. The stock price is also affected by political and
legal environment of the nation. The dividend received by the investor directly
contributes to the return received by the investors but at the same time reduces the
amount of earning re-invested by the firm resulting limited potential growth. So,
primarily the risk of a stock investment can be measured by its price volatility and
degree of uncertainty of dividend fluctuation.

Most of the investors are risk averse. Investors must seek to identify the stocks having
low risk which results high returns. A rational investor wants to maximize his/her
return at minimum risk. Even the Investors can’t increase the return; substantially
they can reduce the risk by diversification of investment in different securities making
a portfolio. Making a portfolio of common stock, an investor can’t eliminate all the
risk. Risk is of two types, i.e. systematic risk and unsystematic risk. Unsystematic risk
can be eliminated by diversification. Business risk & financial risk is the component

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of unsystematic risk. But, the systematic risk can’t be avoided through portfolio of
stock.

1.1.1 Profile of the Selected Banks

Nepal SBI Bank Limited (NSBL)

Nepal SBI Bank Ltd. (NSBL) is a subsidiary of State Bank of India (SBI) having 55
percent of ownership. The local partner viz. Employee Provident Fund holds 15%
equity and General Public 30%. In terms of the Technical Services Agreement
between SBI and the NSBL, the former provides management support to the bank
through its expatriate officers including Managing Director who is also the CEO of
the Bank. Central Management Committee (CENMAC), consisting of the Managing
Director & CEO, Chief Operating Officer (COO) & Dy. CEO, Chief Financial
Officer, Chief Risk Officer and Chief Credit Officer, exercises overall control
functions with the help of 3 Regional Offices, and oversee the overall operations of
the Bank.

NSBL was established in July 1993 and has emerged as one of the leading banks of
Nepal, with 679 skilled and dedicated Nepalese employees working in 62 branches,
7 extension counters, and 3 Regional Offices and Corporate Office. With presence in
32 districts in Nepal, the Bank is providing value added services to its customers
through its wide network of 85 ATMs, internet banking, mobile wallet, SMS
banking, IRCTC Ticket Online Booking facility, etc. NSBL is one of the fastest
growing Commercial Banks of Nepal with more than 6.22 lakhs satisfied deposit
customers and over 4.80 lakhs ATM/Debit cardholders. The Bank enjoys leading
position in the country in terms of penetration of technology products, viz. Mobile
Banking, Internet Banking and Card Services. The Bank is moving ahead in the
Nepalese Banking Industry with significant growth in Net Profit with very nominal
NPA. As of 31st Ashad, 2073, the Bank has deposits of Rs. 65.21 billion and
advances (net) of Rs. 47.54 billion, besides investment portfolio of Rs.19.29billion.

State Bank of India (SBI), with a 210 year history, is the largest commercial Bank in

3
India in terms of assets, deposits, profits, branches, customers and employees. The
Government of India is the majority stakeholder and has controlling stake in SBI, a
“Fortune 500” entity.

The SBI group consists of SBI and five associate banks. The group has an extensive
network, with over 22,000 branches in India and another 198 foreign offices in 37
countries across the world.

SBI's non- banking subsidiaries / Joint ventures are market leaders in their respective
areas and provide wide ranging services, which include life insurance, merchant
banking, mutual funds, credit cards, factoring services, security trading and primary
dealership, making the SBI Group a truly large financial supermarket and India's
financial icon. SBI has arrangements with over 1,600 various international / local
banks to exchange financial messages through SWIFT in all business centers of the
world to facilitate trade related banking business, reinforced by dedicated and highly
skilled teams of professionals.

1.2 Problem Statement

In the context of Nepal, there are no any separate institutions, which may provide
information required to make rational decisions that can accelerate the stock
investment and market efficiency. Government policy is less encouraging in
promoting common stock investment. Most of the Nepalese investors invest their fund
in single security rather than investing in portfolio of security through diversification
of risk. Not only general public but even most of educate people related on such
subject can’t prominently analyze the risk and return in stock market investment.

Investors feel more risk in stock investment than its real risk. To set up their
confidence, unbiased analysis and information about it, is a must. Risk and return of
individual stock and portfolio is therefore being a major requirement to increase stock
investment and stock market efficiency as well. Brokers, issue manager, stock broker
and all the related persons in those domains must be responsible to set the policies, &
evaluate relative riskiness of their decision. Securities market and other institutional

4
set up are yet to work towards providing knowledge and skill to investors. Hence,
this present study seeks to explore the answers of the following questions:

 What is the risk & return of investment in common stock of commercial

banks?
 Is the common stock of commercial banks are overpriced, underpriced or at
equilibrium price?

1.3 Objectives

In Nepal, many investors are facing various problems in setting their investment
policies, evaluating financial assets, constructing portfolio and revising and analyzing
their portfolio performances. The key objective of this study is to evaluate the risk &
return on common stock investment of the selected Nepalese commercial banks. In
connection with the main objectives, the specific objectives of the study are as
follows:

 To evaluate the risk & return associated with the common stock investment of
commercial banks.

 To evaluate common stock’s price under CAPM method.

1.4 Rationale

The study will be more significant for exploring and increasing stock investment.

The main significance of this study is:

 This study will be beneficial for the entire person who is directly related to the
Nepalese stock market.

 The study helps to find out whether the shares of commercial banks in Nepal
are overpriced or underpriced by analyzing the risk and return of the
individual shares.

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  The study will act as guidelines, suggestions and recommendations to
Nepalese investors & financial institutions.

1.5 Report Structure

This study has been organized in five chapters starting from Introduction, Review of
Literature, Research Methodology, and Presentation & Analysis of data to Summary,
Conclusion & Recommendations, each devoted to analysis of risk & return on
investment in commercial banks. The titles of each of these chapters are summarized
and the contents of each of these chapters are briefly mentioned below:

Chapter – I: Introduction

This chapter is introductory which includes background of the study, profile of selected
banks, focus of the study, statement of the problem, objectives of the study, significance
of the study & limitations of the study.

Chapter – II: Related Literature Review

The second chapter deals with the review of available literature which includes
conceptual/theoretical review, review of journals/articles, review of other independence
studies in Nepal, review of thesis & research gap.

Chapter- III: Methods

The third chapter explains the research methodology used in the study. Research
methodology is the systematic method of finding facts/results of the given problem
more specifically & adopted to meet the objectives of this study. It includes research
design, population & sample, nature &sources of data, data collection procedures &
data analysis tools.

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Chapter IV: Results and Findings

The fourth chapter is the main body of the research. In this chapter, the data required
for the study are presented, analyzed and interpreted by using different statistical tools
and techniques. Tables, charts, bar-graphs, etc. will be used accordingly.

Chapter V: Discussion and Conclusion

The last chapter of the study covers the summary of the study, the main conclusion
that results from the study & offer recommendations on the basis of findings &
provides guideline for the further study.

Besides these, the bibliography and appendices are incorporated at the end of the
thesis. Similarly, acknowledgement, table of contents, list of tables, list of figures,
abbreviations are included in the front part of the thesis report.

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 CHAPTER - II

RELATED LITERATURE REVIEW

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 suitable topic and continues throughout the volumes of similar or
limited subjects. It is very rare to find out completely new problem. In literature
review, researcher takes hints from past dissertation but he/she should take need of
replication. Literature review means reviewing research place. It is a vital and
mandatory process in research works. During the review of this research, in depth
study and theoretical investigation regarding risk and return on Nepalese commercial
banks is made. For the study, different related study with this topic has been
reviewed.

2.1 Conceptual Review

It is the conceptual framework on which the entire thesis will be based. This study
explores the theoretical aspects of the risk and return on investment from various
books. Analyzing the risk and return imparts knowledge about the relationship
between risk and associated return on any type of investment. It also incorporates the
review as well as background of commercial banks in Nepal.

2.1.1 Common Stock

Common stock represents equity or an ownership position in a corporation. It is

residual claim in the sense that creditors and preference shareholders must be paid as
scheduled before common stock holders can receive any payments. In bankruptcy,
common stock holders are in the principal entitled only to any value remaining after
all other claims having been satisfied (Sharpe et al., 1999:457).

The common stockholders of a corporation are its residual owners; their claim to
income and assets comes after creditors and preferred stockholders have been paid in

8
full. As a result, a stockholder’s return on investment is less certain than the return to
a lender or to a preferred stockholder. On the other hand, the return to a common
stockholder is not bounded on the upside as are returns to the others. A share of a
common stock can be authorized with or without par value. The par value of stock is
merely a stated figure in the corporate charter and is of little economic significance. A
company should not issue stock at a price less than par value because stockholders
who bought stock for less than par value would be liable to creditors for the
differences between the below par price they paid and the par value(Van Horne,
2002:27).

2.1.2 Security Market

Security markets exist in order to bring together buyers and sellers of securities,
meaning that they are mechanisms created to facilitate the exchange of financial as-
sets. There are many ways in which security markets can be distinguished. One way
has already been mentioned: primary and secondary markets. Here the key distinction
is whether the securities are being offered for sale by the issuer. Interestingly, the
primary market itself can be subdivided into seasoned and unseasoned new issues. A
seasoned new issue refers to the offering of an additional amount of an already
existing security, whereas an unseasoned new issue involves the initial offering of a
security to the public. Unseasoned new equity issues are often referred to as initial
public offerings, or IPO'S

Another way of distinguishing between security markets considers the life span of
financial assets. Money markets typically involve financial assets that expire in one
year or less, whereas capital markets typically involve financial assets with life spans
of greater than one year. Thus Treasury bills are traded in a money market, and
Treasury bonds are traded in a capital market (Sharpe et al., 1999:9-10).

2.1.3 Market Price of the Share

The market price of a firm's stock represents the value that market participants place
on the company (VanHorne, 2002:4). The market prices reflect the true or intrinsic
value of the share based on the underlying future cash flows. The implications of such

9
a level of market efficiency are clear and no one can consistently beat the market i.e.
earns abnormal returns (Paudel, 2002:4).

2.1.4 Stock Valuation

Many corporations don’t issue preferred stock, so the bulk of equity issues are called
common stock. Common stock also has a nominal par value, but it is mostly an
accounting/legal relic and has no bearing on the dividends or price of the stock. Since
dividends on common stock are determined by the board, their cash flows are the
most uncertain of the financial instruments discussed so far. Shareholders have a
residual claim on the firm’s assets, which is the value leftover after all other claims
have been paid. Thus, any earnings remaining after all other obligations are met, are
either paid out in dividends or retained by the firm, ostensibly to be used as capital for
the firm’s growth. These retained earnings increase the residual claim, potentially
increasing the value of stock shares (Schmitz, 2012: 148).

2.1.5 Concept of Investment on Common Stock

Some investment alternatives are preferred over others since the risk and return
characteristics on such underlying investment alternatives satisfy the individual
investor's expectations. Return expected on share investment can be partitioned into
dividend and capital gain components. Both these two components of the total return
on share investment are not certain with investors having to make decisions in an
uncertain environment. Fixed deposits, National Saving Bonds and the other saving
products/ schemes offered by non-bank financial institutions are the other investment
alternatives available in the market producing a fixed rate of return over the investor's
investment horizon. Investments in shares are risky in relation to investments in other
fixed income securities. Despite the risk element inherent to investment in shares,
most investors desire to invest in shares in anticipation that the future price of the
stock will increase. The intrinsic, or theoretical, price of the stock today can be
ascertained by analyzing publicly disclosed financial investment. Investors, in most
cases, do not analyze published financial statement before they make the investment
in shares of a given company. The actual market price of the stock striving towards

10
equilibrium must reflect the theoretical value of the stock determined by using some
valuation models. Determining the intrinsic value of the stock today and comparing it
with the actual market price however, are rare in practice (Paudel, 2002:2-3).

2.1.6 The Expected Rate of Return on Common Stock

How much return should be earned from an investment is a puzzle for investors in an
increasingly competitive market. Therefore, investing in a stock market is getting an
additional risk to the funds of individuals or firms, since stock market volatility arises
from different aspects. In other words, when determining an investment, individuals
or firms must choose the investment in such a way that the return of the investment
exceeds its cost. However, in determining the capitalized value of an investment, the
investor must be able to estimate the cash inflows and cash outflows over the
investment period. Not only that, other factors also have to be considered in
determining the investment since various risks and uncertainties are associated with
an investment within a rapidly changing market. The market risk premium, systematic
risk, firm size, and PE ratio are key factors in determining the expected rate of return
on common stock (Gunarathna, 2014:1)

2.1.7 Risk on Common Stock

In a word of uncertainty, the return may not be realized. Risk can be thought of as the
possibility that the actual return from holding a security will deviate from the
expected return. The greater the magnitude of deviation and greater the probability of
its occurrence, the greater is said to be the risk of the security (VanHorne, 2002:37).

The risk of an investment often depends on how long you plan to hold the investment.
Common stocks, for example, can be extremely risky for short term investors.
However, over the long haul the bumps tend to even out, and thus, stocks are less
risky when held as part of a long-term portfolio. (Brigham & Houston, 2007:279)

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2.1.8 Relationship between Risk & Return

The return on an investment and the risk of an investment are basic concepts in
finance. Return on an investment is the financial outcome for the investor. Risk is
present whenever investors are not certain about the outcomes an investment will
produce. Suppose, however, that investors can attach a probability to each possible
dollar return that may occur. Investors can then draw up a probability distribution for
the dollar returns from the investment. A probability distribution is a list of the
possible dollar returns from the investment together with the probability of each
return. It is often assumed that an investment’s distribution of returns follows a
normal distribution. This is a convenient assumption because a normal distribution
can be fully described by its expected value and standard deviation. Therefore, an
investment’s distribution of returns can be fully described by its expected return and
risk. (Piersonet al.2012:169-171).

For the business, the position is the opposite of that of the investors: sources of
finance that are relatively risky (from the business’s point of view) tend to be cheap in
terms of servicing cost; safe sources tend to be expensive. The level of returns
required by secured lenders is relatively low but the existence of such loans
represents, as we shall see a potential threat to the welfare of the shareholders. Equity
investors expect high returns, but issuing additional ordinary shares does not tend
greatly to increase the risk borne by the original shareholders (Mclaney, 2009:219).

2.1.9 Systematic and Unsystematic Risks

Systematic risk is due to risk factors that affect the overall market – such as changes
in the nation’s economy, tax reform by Congress, or a change in the world energy
situation. These are risks that affect securities overall and, consequently, cannot be
diversified away. In other words, even an investor who holds a well-diversified
portfolio will be exposed to this type of risk. Unsystematic risk is risk unique to a
particular company or industry; it is independent of economic, political, and other
factors that affect all securities in a systematic manner. A wildcat strike may affect
only one company; a new competitor may begin to produce essentially the same

12
product; or a technological breakthrough may make an existing product obsolete. For
most stocks, unsystematic risk accounts for around 50 percent of the stock’s total risk
or standard deviation. However, by diversification this kind of risk can be reduced
and even eliminated if diversification is efficient. Therefore not all of the risk
involved in holding a stock is relevant, because part of this risk can be diversified
away. The important risk of a stock is its unavoidable or systematic risk. Investors can
expect to be compensated for bearing this systematic risk. They should not, however,
expect the market to provide any extra compensation for bearing avoidable risk. It is
this logic that lies behind the capital-asset pricing model.

Total risk ( j ) = Systematic Risk (non diversifiable or unavoidable) + Unsystematic

Risk (diversifiable or avoidable). (Van Horne &Wachowicz, 2008:105-106)

Diversifiable risk (sometimes called unsystematic risk) represents the portion of an

asset’s risk that is associated with random causes that can be eliminated through
diversification. It is attributable to firm-specific events, such as strikes, lawsuits,
regulatory actions, or the loss of a key account. Non diversifiable risk (also called
systematic risk) is attributable to market factors that affect all firms; it cannot be
eliminated through diversification. Factors such as war, inflation, the overall state of
the economy, international incidents, and political events account for non diversifiable
risk. Because any investor can easily create a portfolio of assets that will eliminate
virtually all diversifiable risk, the only relevant risk is non diversifiable risk. Any
investor or firm therefore must be concerned solely with non diversifiable risk. The
measurement of non diversifiable risk is thus of primary importance in selecting
assets with the most desired risk–return characteristics (Gitman&Zutter, 2012:329-
330).

2.1.10 Capital Assets Pricing Model (CAPM)

Capital market theory represented a major step forward in how investors should think
about the investment process. The formula for the CML offers a precise way of
calculating the return that investors can expect for (1) providing their financial capital
(RFR), and(2) bearing σ port units of risk ([E(RM) − RFR]/σM). This last term is

13
especially significant because it expresses the expected risk premium prevailing in the
marketplace. Unfortunately, capital market theory is an incomplete explanation for the
relationship that exists between risk and return. To understand why, recall that the
CML defined the risk an investor bears by the total volatility (σ) of the investment.
However, since investors cannot expect to be compensated for any portion of risk that
they could have diversified away (i.e., unsystematic risk), the CML must be based on
the assumption that investors only hold fully diversified portfolios, for which total
risk and systematic risk are the same thing. The limitation is thus that the CML cannot
provide an explanation for the risk-return trade-off for individual risky assets because
the standard deviation for these securities will contain a substantial amount of unique
risk. The capital asset pricing model (CAPM) extends capital market theory in a way
that allows investors to evaluate the risk-return trade-off for both diversified
portfolios and individual securities. To do this, the CAPM redefines the relevant
measure of risk from total volatility to just the non diversifiable portion of that total
volatility (i.e., systematic risk). This new risk measure is called the beta coefficient,
and it calculates the level of a security’s systematic risk compared to that of the
market portfolio. Using beta as the relevant measure of risk, the CAPM then redefines
the expected risk premium per unit of risk in a commensurate fashion. This in turn
leads once again to an expression of the expected return that can be decomposed into
(1) the risk-free rate and (2) the expected risk premium. (Reily and Brown, 2012: 216-
217)

2.1.11 the Systematic Risk as Measured by Beta

The second measure with which we are concerned, and most important for our
purposes, is the beta. The beta is simply the slope of the characteristic line. The
relationship between excess returns for the stock and excess returns for the market
portfolio is known as the characteristic line, and it is used as a proxy for the expected
relationship between the two sets of excess returns.

Beta depicts the sensitivity of the security's excess return to that of the market
portfolio. If the slope is 1, it means that excess returns for the stock vary
proportionally with between returns for the excess returns for the market portfolio. In

14
other words, the stock has the same stock avoidable or systematic risk as the market
as a whole. A slope steeper than 1 market means that the stock's excess return varies
more than proportionally with the excess return of the market portfolio. Put another
way, it has more systematic risk than the market as a whole. This type of stock is
often called an "aggressive" investment. A slope less than 1,means that the stock has
less unavoidable or systematic risk than does the market as a whole. This type of
stock is often called a "defensive" investment (Van Horne, 2002:64).

2.1.12 Capital Market Line (CML)

The CML is a model of the risk–return trade-off that only applies to portfolios that
have diversified away all unsystematic risk. The CML’s main contribution is the
relationship it specifies between the risk and expected return of a well-diversified
portfolio. The CML makes it clear that the market portfolio is the single collection of
risky assets that maximizes the ratio of expected risk premium to portfolio volatility.
The investment prescription of the CML is that investors cannot do better, on average,
than when they divide their investment funds between (1) the riskless asset and (2) the
market portfolio.(Reily and Brown, 2012:234)

2.1.13Security Market Line (SML)

When the capital asset pricing model is depicted graphically, it is called the security
market line (SML).The SML will, in fact, be a straight line. It reflects the required
return in the marketplace for each level of non diversifiable risk (beta). In the graph,
risk as measured by beta, b, is plotted on the x axis, and required returns, r, are plotted
on the y axis. The risk–return trade-off is clearly represented by the SML.

In other words Security Market Line (SML) is the depiction of the capital asset
pricing model (CAPM) as a graph that reflects the required return in the marketplace
for each level of non diversifiable risk (beta). (Gitman & Zutter, 2012:334)

In market equilibrium, the relationship between an individual security's expected rate

of return and its systematic risk, as measured by beta, will be linear. The relationship
is known as the security market line. Under the assumptions of the CAPM, all

15
securities lie along this line. It shows that the expected return on a risky security is a
combination of the risk-free rate plus a premium for risk. This risk premium is
necessary to induce risk-averse investors to buy a risky security. The unsystematic
risk of a security can be eliminated by the well-diversified investor, investors overall
are not compensated for bearing such risk according to the CAPM. The investor in
only a single security will be exposed to both systematic and unsystematic risk but
will be rewarded for only the systematic risk that is borne (Vanhorne, 2002:70)

2.1.14 Differences between Capital Market Line (CML) and Security Market
Line (SML)

It is important to recognize the difference between the capital market line and the
security market line. The CML shows expected returns plotted against risk, where risk
is measured in terms of standard deviation of returns. This is appropriate because the
CML represents the risk/return trade-off for efficient portfolios, that is, the risk is all
systematic risk. The SML, on the other hand, shows the risk/return trade-off where
risk is measured by beta, that is, only by the systematic risk element of the individual
security. No individual security’s risk/return profile is shown by the CML because all
individual securities have an element of specific risk, that is, they are all inefficient.
Thus all individual securities (and indeed all inefficient portfolios) lie to the bottom-
right of the efficient frontier (Mclaney, 2009:199).

2.1.15Limitations of the CAPM

 The model makes unrealistic assumptions

 The parameters of the model cannot be estimated precisely
 The market index used can be wrong.
 The firm may have changed during the 'estimation' period
 The model does not work well
 If the model is right, there should be:
 A linear relationship between returns and betas
 The only variable that should explain returns is betas
 The reality is that

16
  The relationship between betas and returns is weak
 Other variables (size, price/book value) seem to explain differences in
returns better. (Damodaran, 2013: 18)

2.1.16 Assumptions of CAPM

In developing CAPM several assumptions need to be made. These are as follows:

 Investors are risk-averse, and maximize expected utility of wealth.
 The capital market is not dominated by any individual investors.
 Investors are interested in only two features of a security, its expected returns
and its variance (or standard deviation).
 There exists a risk-free rate at which all investors may borrow or lend without
limit at the same rate.
 There is an absence of dealing charges, taxes, and other imperfections.
 All investors have identical perceptions of each security.
A glance at these assumptions indicates that some are likely to be valid in the real
world, whereas others clearly are not. For example, Assumption 1 seems to be
true; certainly most people seem to prefer more wealth to less (all things being
equal) and most of us are risk-averse. Assumption 5, on the other hand, is clearly
invalid in reality. Whether or not the invalidity of certain of these assumptions
seriously weakens the model is probably discernible only by looking at how well
CAPM works in practice (Mclaney, 2009:202).

2.2 Review of Previous Work

However, risk & return is not a new concept for financial analysis, in context of Nepal
and its very slow growing capital market, few studies are made regarding this topic.
Some studies related to the topic of risk and return has been conducted in the partial
fulfillment of the requirements of Master degree in Business Studies. In this study,
only relevant subject matters are reviewed which are as follows:

17
Mishra S.K (2002) analyzed “Risk and Return on Common Stock Investment of
Commercial Banks in Nepal; with special reference to five listed commercial banks”.
The major objective of this study was to promote and protect the interest of the
investor by regulation the issuance sales and distribution of securities and purchases,
sale or exchange of securities. The study also intends to supervise and monitor the
activities of the stock exchange and of other related firms carrying on securities
business. In addition, he tried to render contribution to the development of capital
market by making securities transactions fair, healthy, efficient and responsible.

Followings are the finding of the study; it was noticed that there was a positive
correlation between risk and return character of the company. Nepalese capital market
being inefficient, the price index itself was not sufficient to give the information about
the prevailing market. Situation and the company proper regulation should be
introduced so that there is more transparency in issuance, sales and distribution of the
securities. Investors do not have any idea about the procedures of the securities
issuance. Neither company nor the stock brokers transmit any information to the
investors about the current market situation and hence, it becomes difficult for
common investors to invest in the securities.

Both government authorities and the stock exchange regulator body should try to
promote healthy practices so that the stock brokers do not give false information to
the investors for their personal benefit which is a common practice in Nepal. Investors
should get regular information about the systematic risk (Beta), Return on Equity and
P/E Ratio of various listed companies in some way; it is given in economic times for
the companies listed in Nepal Stock Exchange. Security exchange Board of Nepal
should make this mandates easier for the investors to calculate risk and return of
portfolio.

Budhathoki S. (2009) has conducted the study “Risk & Return Analysis on Common
Stock Investment: Analysis of Listed Commercial Banks”. The study concluded that
majority of the stock investment has been taking place without base the logical
financial evaluation, for most of the investors it is the blind game. Many people have
unrealistically optimistic or pessimistic expectations about stock market investments

18
or perhaps the fear of the unknown. The study enables investors to put the return they
can expect & the risks they may take into better prospective.

Khadka R. H (2006) in his study “Analysis of Risk and Return on Selected Nepalese
Commercial Banks Listed in NEPSE” with special reference to 7 listed commercial
banks is also relevant to this study. The main objective of the study is to analyze the
risk, return and other relevant variables that help in making decision about investment
on securities of the listed commercial banks. This study will also target to determine
whether the share of commercial banks are correctly priced or not by analyzing the
required rate of return using the CAPM. The study addressed the following findings in
risk return behavior from the analysis of different stock.

The share of Bangladesh Bank offered highest realized rate or return. Amongst them,
NABIL bank is the lowest having 5.23% which is less than required rate or return.
NBL, which is hard hit by the events (Return = -0.8809), the ranking of the bank is
placed as the highest return earner. The study showed that the realized rate or returns
of the samples banks do not have the same features being within the range of 5.23%
to 16.12%.

2.3 Research Gap

There are number of research works performed by various researchers on the topic of
“Risk & Return Analysis of Nepalese Commercial Banks”. Some researchers used
very few sample size which may not cover the whole population & other researchers
used nominal fiscal period which may not provide the whole scenario of market.

In the study of few thesis on the similar topic by past researchers, there has been
found a poor analysis of risk & return. The previous researchers used the NEPSE
Index, but this study finds out the conclusions using industry index i.e. banking index
which is a sub-index. Banking index is computed on the basis of listed commercial
banks. The main gap of this thesis is that it provides an idea about how to analyze the
risk and return and conclude the under or overvaluation of common stock. The
previous researchers only analyzed about the risk and return. They didn’t give any

19
suggestions about undervalued or overvalued stock. Thus, the present study provides
more reliable & accurate conclusion than previous research works.

20
 CHAPTER - III

METHODS

The research method is the systematic way of solving research problems. Research
methodology refers to the overall research processes, which a researcher conducts
during his/her study. It includes all the procedures from theoretical foundation to the
collection and analysis of data. As most of the data are quantitative, the research is
based on the scientific models. It is composed of both parts of technical aspect and
logical aspect on the basis of historical data.

In it, the various steps are studied that are generally adopted by studying research
problem along with the logic behind them. This section focuses on the method of
research used in this study. Research methodology includes research design,
population and sample of data, data collection procedures, nature of sources of data,
data analysis tools & technique used. In this study, all the data are secondary and
these data are analyzed using appropriate financial as well as statistical tools.
Outcomes are presented in a simple way.

3.1 Types of Research

The study includes an outline of what the investigator will do from writing the
hypotheses and their operational implications to the final analysis of data. The
structure of the research is more specific, it is the outline, the scheme, and the
standard of the operation of the variables. This study is mainly related to
quantitative aspects such as various accounting statement, functional budgets and
the actual results of the budgets. As per the requirements of the study, both
descriptive and analytical approaches are used.

21
3.2 Population and Sample

3.2.1 Population

Population or universe refers to the entire group of people, events or things of interest
that the researcher wishes to investigate. The population of this study is 29 companies
listed in NEPSE under commercial banks group during the FY 2071/72.

3.2.2 Sample

A sample is a collection of items or elements from a population or universe. Hence, a

sample is only a portion or subset of the universe or population. It comprises some
observations selected from the population. Here, researcher has used random
sampling to select the sample. The sample consists of 1 selected banks. Thus, these
banks are chosen as sample for the study. The selected sample banks for the analysis
are:

 Nepal SBI Bank (SBI)

3.3 Types of data and its collection procedure

It shows the sources of data & how they are collected. Most of the data necessary for
the research is collected from the secondary sources. Data related to the market prices
of stocks, NEPSE index etc. is taken from the trading report published by NEPSE.
Financial statements of commercial banks and their annual reports are also collected.
The collection procedure is summarized below:

 Financial documents provided by the related banks on their website.

 Trading Report published by Nepal Stock Exchange.
 Related websites of finance.
 Other related books and booklets.

22
3.4 Instrument

For the accomplishment of the envisaged objectives of this research study, various
financial and statistical tools and instrument have been employed in the course of the
analysis of data. These tools are;

3.4.1 Standard Deviation and Variance

Investment in shares or stocks is always associated with risks. The extent of such risk
has, therefore, been measured in terms of Harry Markowitz's "mean-variance" concept
which states that returns were measured by mean return and the risk by the standard
deviation or its square, variance. Standard deviation is a measure of the variability of
the distribution of returns around its mean value, and hence shows the total risk
involved in a single stock. In the symbolic form, standard deviation is;

∑(𝑅𝑗 −𝑅̅𝑗 )
σj = √ 𝑛−1

Where,

σj = Standard deviation of the returns on the stock 'j'

Rj = Annual rate of return of stock ‘j’

̅j = Average (Expected) rate of return of stock ‘j’

R

n = number of observations.

Apart from the standard deviation, variance has also been used to measure the extent
of risk in a stock. Variance is the square of the standard deviation, and as "mean-
variance" concept states, higher the value, higher is the risk associated with the
individual stock. In the symbolic form, variance is;

Variance (σj2)= Variance of stock 'j'

23
3.4.2 Coefficient of Variation (C.V)

The standard deviation can sometimes be misleading in comparing the risk, or

uncertainty, surrounding alternatives if they differ in size. In this case, the coefficient
of variation is used to measure risk .It is the measure of relative dispersion (risk). It
measures the risk per unit of return. Higher the coefficient of variation, greater is the
risk.

Mathematically,
𝜎𝑗
C.V = ̅̅̅𝑗
𝑅

Where,
C.V= Coefficient of Variation
σj= Standard deviations of returns of stock ‘j’
R j = Expected return on stock ‘j’.

3.4.3 Covariance (COVjm)

Covariance is a statistical measure of the degree to which two variables, such as 'Rj'
and 'Rm' move together. The covariance between two variables, in this case is;

 
COV(Rj, Rm) = 
(R j  R j )( Rm  Rm )
n 1

Where,

COV(Rj, Rm) = covariance between the individual stock 'j' and the market 'm'

Rj= Annual rate of return of individual asset 'j'

Rm = Annual rate of market return

𝑅̅ j = Expected rate of return of asset 'j' &

̅m = Expected rate of return of the market

R

n = number of observations

24
3.4.4 Correlation Coefficient (r jm )

The other measure for the extent of relationship and its direction between the single
stock return and the market rate of return is the correlation coefficient. It can be
directly derived from the covariance as;

COV jm
r jm 
 j m
Where,
r jm  Correlation coefficient between stock ‘j’ & market ‘m’
COVjm = Covariance between stock ‘j’ & market ‘m’
 j  Risk of the stock ‘j’
 m  Risk of the market ‘m’

The covariance may have any positive or negative value whereas the value of the
correlation coefficient ranges from +1 to -1.

In the case of the covariance, if it is positive, 'j' and 'm' move together. Conversely, if
it is negative, the two variables, 'j' and 'm', tends to move the opposite direction. The
covariance, however, does not affect the portfolio’s expected return.Unlike the
covariance, correlation coefficient reveals the degree or strength of relationship
between the returns two variables i.e. 'j' and 'm'. A positive correlation coefficient
indicates that the returns from two variables generally move in the same direction,
whereas a negative correlation coefficient implies that they generally move in
opposite directions. The stronger the relationship, the higher the correlation
coefficient is to one of the two extreme values. A zero correlation coefficient implies
that the returns from two variables are uncorrelated; they show no tendency to vary
together in either a positive or negative linear fashion.

25
3.5 Technique of analysis

Data are collected for analysis. The data can be analyzed by using financial and
statistical tools. A brief description of the terms used in this study is as follows:

3.5.1 Market Price of Stock (P)

The major data of this study is market price of stock. The market price of a firm's
stock represents the value that market participants place on the company. It is taken
from the annual reports of all four sample banks used in analysis of this study.

3.5.2 Dividend (D)

Dividend is return to the shareholders for their investment. It can be given in the form
of cash or shares or both. Apart from cash dividend, if company offers dividend in the
form of shares, its monetary valuation is hardly possible and creates difficulties.
However the formula for the valuation of the total dividend has been specified as:

TDt= CDt+ SDt%×MPS (t+1)

Where,

TD = Total Dividend

CD = Cash Dividend

SD = Stock Dividend

MPS= Market Price per Share

t = Time period

26
3.5.3 Annual return on Common Stock Investment (R)

Annual return on common stock is also known as single period rate of return. It has
been calculated as the ratio of received on investment plus any the market price of the
proceeding period. Mathematically,

𝐷𝑡 +(𝑃𝑡 −𝑃𝑡−1 )
Rt = 𝑃𝑡−1

Where,

Rt=Actual Rate of Return of common stock at time ‘t’

D= Cash dividend at time‘t’

Pt= MPS at time 't'

Pt-1 = MPS at time't-1'

27
3.6 Limitations

The researcher has segregated the annual dividend in quarters as the observed data is
on quarterly basis. In this fast changing world, it is difficult to manage with the pace
of change due to the arrival of unexpected difficulties. As no study can be free from
its own limitations, this study has also some limitations, which are mentioned below:

 The study is primarily based on secondary sources of data such as annual

reports of concerned banks, annual reports of Nepal Rastra Bank, Nepal stock
exchange, related books, magazines, journal and other concerned materials.
Therefore, the consistency of findings & conclusions is strictly dependent
upon the reliability of secondary data.

 The study concentrates only on those factors which are related with common
stock & available in the form required for analyzing the different issues.

 This study is not sufficient for depth analysis as only the selected tools and
techniques such as tables, pie-chart, trend lines and bar-diagrams are used.

28
 CHAPTER - IV

RESULTS AND FINDINGS

This chapter is the main body of the study. The chapter includes analysis of collected
data and their presentation. In this chapter, secondary data are analyzed in table,
figure, chart and diagram form. Detail data of market price of stock, earning per share,
dividend of each bank and relevant data of NEPSE index are presented and their
interpretation and analysis is done. With reference to various readings and literature
review in the proceeding chapter, effort is made to analyze and establish the
relationship between risk and return of stock investment with a special reference to
listed commercial banks. This chapter also analyzes the systematic and unsystematic
risk of each commercial Bank. The main objective of the study is to present data &
analyze them with the help of various financial & statistical tools.

4.1 Presentation of data in Tables, figures and their analysis

4.1.1 Analysis of Market Movement

Index is one of the most important indicators of secondary market which is regarded
as mirror of the economy of the country. NEPSE index group consists of different
indices & they are computed as per market capitalization. Among them, overall
NEPSE index is the oldest one which is being calculated from the initial days of
NEPSE. There is only stock market in Nepal, known as Nepal Stock Exchange,
shortly NEPSE. In the context of Nepalese financial market, average market
movement is represented by the NEPSE index and average return or market return can
be found by using NEPSE index. NEPSE index is calculated by considering all listed
shares including that of promoter share of all listed companies at NEPSE. The NEPSE
index is adjusted and changed continuously.

29
 Figure: 4.1

NEPSE Index Movement

1200
1036.11
1000
961.23

800
Index in points

749.1

600
518.33
400
362.85 389.74

200

0
2066/067 2067/068 2068/069 2069/070 2070/071 2071/072
Fiscal Year

Figure 4.1 shows that the NEPSE index is 749.10 in the initial year which sharply
decreases to 362.85 in the F/Y 2067/068. Thereafter, it shows the increasing trend
until the F/Y 2070/071 and again decreased in F/Y 2071/072. The maximum index is
1036.11 points in the fiscal year 2070/071& that of minimum is 362.85 in the F/Y
2067/068.

4.1.2 Analysis of Banking Industry Index Movement

Commercial Banking index is a sub-index of NEPSE, which is computed only on the

basis of commercial banking sector. The number of listed companies under
commercial banks group by NEPSE is 29 at the end of FY 2071/72. The study takes
sample of one commercial bank (Nepal SBI Bank) for the analysis. Banking index is
the mirror of the growth & development of the banking field.

30
 Table: 4.1

Commercial Banking Industry Index Movement

Commercial Bank Index

Annual return
Fiscal Year Index (Rm) (𝑅𝑚 − 𝑅̅𝑚 ) (𝑅𝑚 − 𝑅̅𝑚 )2
2067/68 328.7 -0.2806 -0.3194 0.1020
2068/69 358.57 0.0909 0.0521 0.0027
2069/70 505.48 0.4097 0.3709 0.1376
2070/71 945 0.8695 0.8307 0.6901
2071/72 831.35 -0.1203 -0.1590 0.0253
∑𝑅𝑚 = 0.1938 ∑(𝑅𝑚 − 𝑅̅𝑚 )2 = 0.9578
̅ 𝒎)
Expected Return ( 𝑹 0.0388
Risk (𝝈𝒎 ) 48.93%
Variance(𝝈𝟐𝒎 ) 0.2395

Source: Annual report of NEPSE from 2067 to 2072& Appendix I

Table 4.1 shows the commercial banking industry movement in different years. The
highest point of Banking index is 945 in the year 2070/071& that of the lowest was
328.7 in the year 2067/068. Thereafter, it shows the increasing trend until the F/Y
2070/071& later shows the decreasing trend till 2071/072.

Similarly, table 4.1 also shows that the expected rate of return, standard deviation &
variance are 3.88%, 48.93% % & 23.95 % respectively.

Table 4.1 also shows the annual rate of return of banking sector. In the initial F/Y
2067/068, it had negative return of 28.06%.The annual return is in increasing trend
up to F/Y 2070/071. This means, the investor has earned the profit from the common
stock investment in commercial banks in the particular year. But, In the F/Y
2071/072, the annual rate of return of the banking sector is negative. The highest
negative return is 12.03%. Here, the investor suffers loss from banking investment.

31
4.1.3 Year wise MPS, EPS & P/E Ratio of SBI Bank

The year wise MPS, EPS, P/E Ratio, total dividend & annual return are given below:

Table: 4.2

MPS, EPS, Total Dividend & P/E Ratio of SBI Bank

Fiscal Cash Dividend Stock Total PE

Year MPS (RS) Dividend (%) Dividend (Rs) EPS Ratio
2067/68 565 5 17.5 116.125 24.85 22.73
2068/69 635 5 17.5 153.75 22.93 27.69
2069/70 850 7.5 20 263.5 32.75 25.95
2070/71 1280 7.0237 22.0745 202.8245 34.83 36.75
2071/72 887 1.42 28.42 534.295 34.84 25.46

Source: Annual Report of SBI from 2067-72 & Appendix II

Table 4.2 reveals that the SBI pays cash dividend & stock dividend in each F/Y. The
cash dividend is Rs. 5 in the F/Y 2067/068 & 2068/069. Thereafter it increases
&reaches to Rs. 7.50 by the F/Y 2069/070. Then again decreases to Rs. 7.0237 and
Rs.1.42 in the F/Y 2070/71 & 2071/072 respectively. The P/E ratio of SBI is
maximum (36.75 times) in the F/Y 2070/071 & the minimum (22.73 times) in the F/Y
2067/068. The EPS is the highest in the F/Y 2071/072(i.e. Rs. 34.84) & that of the
lowest of Rs. 22.93 in the F/Y 2068/069.

Similarly, Table 4.2 reflects that the market price of stock of SBI is the highest
(Rs.1280) in the F/Y 2070/071 & the lowest (Rs. 565) in the F/Y 2067/068. From
the F/Y 2068/069, it is in rising trend until F/Y 2071/071 & thereafter decreases &
reaches to Rs. 887 in the F/Y 2071/072.

32
 Figure: 4.2

Annual Return on Stock of SBI

0.7535 0.7445
0.8

0.6
Annual Return in %

0.396
0.4

0.2 -0.0808 0.1104

0
2067/068 2068/069 2069/070 2070/071 2071/072
-0.2
Fiscal Year

Source: Appendix II

Figure 4.2 shows the annual return on stock of SBI. It is negative in the initial F/Y
2067/068 (i.e. -0.0808). Thereafter, the return is positive (0.3960, 0.7535, 0.7445 &
0.1104) in the F/Y 2068/069, 2069/070, 2070/071 & 2071/072 respectively. From
the analysis, it concludes that the negative return may be the reason of heavy decline
in share price of the company’s stock.

33
4.1.4 Overall Risk & Return Results of SBI Bank

The overall risk & return of SBI is tabulated below:

Table: 4.3

Overall Risk & Return Results of SBI

Variables Value
Expected Return ( R SBI ) 38.47%

Risk (  SBI ) 37.34%

Variance (  SBI )2 13.94%

Coefficient of Variation (CV) 0.9704

Covariance between return on Banking industry & return of SBI ( 0.1571
COVSBI , BI )

Correlation between return of SBI& return of Banking industry ( rSBI , BI ) 0.8602

Beta Coefficient (  SBI ) 0.6563

Systematic Risk (SR) 32.12%

Unsystematic Risk (USR) 5.22%
Proportion of systematic risk in total risk 86.02%
Proportion of unsystematic risk in total risk 19.98%

Source: Appendix III

Table 4.3 shows that the expected return of SBI is positive (i.e. 38.47%) with the S.D
of 37.34% & CV of 0.9704. This indicates that to achieve per unit return, 0.9704 unit
of risk must be beared.

The beta coefficient of SBI is 0.6563 which is lower than 1 & therefore, it is a
defensive asset & considered to be less risky. The correlation coefficient between
Banking industry & SBI is positive (i.e. 0.8602) which shows the positive relation

34
between banking industry & stock of SBI. Out of total risks, SBI’s stock has 32.12%
systematic risks & 5.22% unsystematic risks.

Figure: 4.3

Proportion of Systematic Risk & Unsystematic Risk of SBI

19.98%

Systematic Risk
Unsystematic Risk
86.02%

Source: Appendix V

Figure 4.3 shows that the systematic risk of SBI is 86.02% which can’t be
diversifiable. Since the systematic risk is very high in the company, it cannot be
reduced through diversification. All equity investors have to bear this risk .However,
the unsystematic risk is 19.98% that can be diversifiable. The management of the
company focuses to minimize the type of risk.

35
 Table: 4.4

Tabulation of Major Findings

Banks SBI
Expected Rate of Return (R ) 38.47%

Standard Deviation ( ) 37.34%

Coefficient of Variation (C.V) 0.9704
Covariance (Covjm) 0.1571
Correlation Coefficient (r jm ) 0.8602

Beta Coefficient (β) 0.6563

Proportion of SR in total risk (%) 86.02%
Proportion of USR in total risk (%) 13.98%

Source: Appendix IV

4.2 Major Findings

The major findings from the study of risk & return of selected commercial banks can
be summarized below:

 The covariance and correlation coefficient SBI is positive which shows that
they move the same direction of commercial banking index.
 SBI has the highest proportion of systematic risk (i.e. 86.02%) which can’t be
minimized by the internal management.
 The common stocks of all the sample commercial bank are overpriced. In this
circumstance, investors can gain from the sale of overpriced stocks.

36
 CHAPTER– V

DISCUSSION AND CONCLUSION

5.1 Discussion

The study has been primarily focused on the risk and return analysis of common stock
investment of Nepalese commercial banks among other securities. Investors of
common stock are ultimate owners of the company, who are ultimately associated
with risk and return. Risk and return is an updated concept for modern investment
decision & acts as basic foundation of safer investment. Risk and return analysis
should always be addressed before investment. So as to maximize the share price, the
financial manager must learn to assess two key determinants i.e. risk and return. It
becomes easier when there is existence of developed and healthy stock market.

Common stock is the most risky security and life blood of stock market and
investment in common stock of company can’t ensure the annual return and the return
on principal. Therefore, investment in the common stock is very sensitive on the
ground of risk. Dividend to common stockholder is paid only if the firm makes on
operative profit after tax preference dividend. Common stock has attracted more
investors in Nepal. Rush in the primary market during the primary issue is one of the
examples. But private investor plays a vital role in economic development of the
nation by mobilizing the disposed capital in different from the society.

The relationship between risk and return is described by investor’s perceptions about
risk and their demand for compensation. No investors will like to invest in risky assets
unless she/he is assured of adequate compensation for the acceptance of risk. Hence,
risk plays a central role in the analysis of investment process, identification of
overpriced & underpriced securities, making appropriate investment strategies as well
as construction of efficient portfolio. Risk, return & time are the elements of
investment. It is the investor required risk premium that establishes a link between
risk and return in a market dominated by rational investors. The higher risk will

37
command by rational premium and the tradeoff between the two assumes a liner
relationship between risk and risk premium.

The fundamental objective of the study is to evaluate the risk & return of selected
commercial banks. Among the 29 companies listed in NEPSE under commercial
banks group during the FY 2071/72, only commercial banks namely SBI are taken as
reference to analyze the risk & return. Data of last five years are taken for the study.
Market price per share & dividend per share of the concerned banks are used to
analyze the risk & return of the common stock of the banks. Secondary data are
collected from the NEPSE, NRB, SEBON, related banks and their websites. Other
subjective types of information are collected through the officials of NRB, SEBON
and NEPSE. While analyzing the risk & return, various financial & statistical tools
such as expected return, standard deviation, coefficient of variance, coefficient of
correlation & required rate of return have been used for the analysis & interpretation
of the data.

5.2 Conclusion

 In terms of C.V, the SBI’s security is the best as it has the lowest unit of risk
per 1 unit of return (i.e. 0.9704).
 The study reflects that the stock of SBI has the highest systematic risk & such
risk can’t be diversified or minimized.

 It indicates that SBI banks have stock with good income opportunity. The
price may decrease in near future which leads to lower the return of investors.
So it is better to sell these stocks instead of holding them for longer period of
time. Here investors can gain by selling the stocks which are being
overvalued.

5.3 Implications

The findings of the study might be important for those who are interested in the
investment in common stock of commercial banks directly or indirectly. Basically, the
study has been focused on the individual investors who are going to invest their funds

38
on the banking sector. Based on the major findings of the study, the following
recommendations have been developed:.

 The coefficient of variation of SBI is low therefore risk per unit return is least
of SBI bank is less. Hence, it is prescribed to select the common stock of SBI
for individual stock investment due to its lowest C.V.
 Investment on common stock is a risky job. Investors have to focus not only
on return but also on risk. Higher the return, higher will be the risk definitely.
However, it does not guarantee return and principal both. Hence, it is risk in
the short term investment and therefore, the investors need to be prepared for
it. The financial institutions and companies should provide the real financial
statements. The data provided by NEPSE and the company itself is different in
certain cases. It creates confusion to the possible investor about the actual
financial condition of the company. The value of assets and liabilities should
not be manipulated by the company to show the under profitability or over
profitability.
 The development of stock market is also dependent on political stability of the
country. So, the government should be stable for the growth & development of
stock market.

39
REFERENCE

40
APPENDICES

41
42