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Investment Planning
CFP – Module IV
Copyright © 2003 Accenture. All rights reserved.

Accenture, its logo, and Accenture Innovation Delivered are trademarks of Accenture.
Session I
© 2003 Accenture. All Rights Reserved. 2

Syllabus overview
• Risk
– Definition
– Measurement – standard deviation, beta
– Management – diversification, hedging
– Portfolio risk and effect of diversification – CAPM, Treynor / Jensen’s measure
• Financial instruments
– Pricing of equity shares, bonds
– NSC, PPF, mutual funds, government securities
– Futures and options
– Case studies on applicability to various categories of individuals
• Investment strategies
– Active and passive strategies
– Asset allocation and revision
• Regulatory environment
– AMFI code for MFs, SEBI guidelines, etc.
Readings
• Exam perspective
– Security analysis and portfolio management by Punithavathy Pandian
– Security analysis and portfolio management by Prasanna Chandra
– Mock tests
• Knowledge perspective – In addition to the above,

– In the wonderland of investments by A N Shanbag
– Outlook Money
– http://mutualfundsindia.com/
– www.valueresearchonline.com
– www.moneycontrol.com
– www.investopedia.com
• Self development
– Rich Dad, Poor Dad
– The millionaire next door
– …

Pedagogy
• Concepts + practical knowledge in every session
• Validating understanding of concepts through quantitative problems
• MS Excel v/s Financial Calculators
• Interactive sessions & two way learning

Risk
• Possibility of a loss or injury
• Types of risk
Systematic Unsystematic
Controllable / avoidable / diversifiable No To some extent
Example 9/11 attacks Product launch fails
Types Market risk Business risk
Interest rate risk Financial risk
Purchasing power risk
• Conceptually useful categories although in reality, there are overlaps

Risk measurement
• Standard deviation
– Measure of volatility based on returns over a period of time
– Excel Formulae
• STDEVP – Standard deviation of the population
• STDEV – Standard deviation of a sample
– No ready formulae in MS Excel if probabilities are given

Risk measurement (contd.)
• Beta
– Measure of volatility of a fund in comparison to an index / benchmark
– Measure of systematic risk
– Beta = 1  Stock return moves exactly in tandem with the market return
– 1 > Beta > 0  Stock less volatile than the market
– Beta < 0  Stock return moves in the opposite direction as compared to market
– Derives its utility from the benchmark
• R Squared
– Advises investors if beta of a fund / security is measured against an appropriate
benchmark
– Describes the degree to which a fund’s volatility is a result of day to day fluctuations
experienced by the overall market
– R squared = square of the correlation co-efficient
– Value ranges between 0 and 1
– Do not trust beta if value of R squared is closer to 0

Risk measurement (contd.)
• Alpha
– Measures extra return over market risk adjusted return i.e. return for taking on risk
posed by factors other than market volatility
– Alpha of 1 , fund outperformed the benchmark by 1%.
– Negative alphas indicate that it would have been better off to invest in the market
index than in this fund
– Alpha = Average return on investment less (Beta * Average return on the market
index)

Session II

Risk management through diversification – Markowitz’s
model
• Portfolio risk can be reduced by diversification
• Diversification can be across asset classes or within the same asset class
• By definition, only “unsystematic” risk can be diversified
• Diversification is subject to the laws of diminishing marginal utility and hence should be
done intelligently
Uniqu
Risk
e risk
Total Risk
Market
risk
Number of stocks

Risk management through diversification - Markowitz’s
model
• Diversification reduces risk due to the interplay of covariance between two or more
assets
• Covariance is a measure of the degree to which returns on two risky assets move in
tandem.
• A positive covariance means that asset returns move together. A negative covariance
means returns vary inversely.
• Diversification
• Effect of co-efficient of correlation (r) on portfolio risk

– If r = 1  return on securities move in the same direction and hence, no change in
the portfolio risk due to diversification
– If r = -1  return on securities move in the reverse direction and offset each others’
risk to zero

Risk management through diversification - Markowitz’s
model
• Portfolio balancing
– Correlation co-efficient is one of the measures to reduce risk
– Share of various securities in a portfolio is the other key measure to reduce risk
• To zeroise portfolio risk where r = -1, % to be invested in asset 1 =

– SD of asset 2 / (SD of asset 1 + SD of asset 2)
• If r <> -1, % to be invested in asset 1 =

– Variance of asset 2 – (covariance of asset 1,2) / Variance of asset 1 + Variance of
asset 2 – (2 covariance of asset 1,2)
• If correlation is less than the ratio of smaller SD to larger SD, then, combination of
securities provides a lesser standard deviation than when either of them is taken alone

Formulae to remember - Markowitz’s model
Value Formula
Portfolio return (2 asset portfolio)
Portfolio risk (2 asset portfolio)
Portfolio risk (3 asset portfolio)
Co-variance Correlation between two assets times the standard deviation of each
Key legends
Wa = Proportion of investment in asset A
Wb = Proportion of investment in asset B
E(Ra) = Expected return on investment A
E(Rb) = Expected return on investment B
= Portfolio variance
= Covariance between security A and B

Session III

Capital Asset Pricing Model
• Describes relationship between risk and expected return
– Used in the pricing of risky securities
• Premise – investors need to be compensated in two ways
Dimension Denoted by
Time value of money Risk free interest rate (rf)
Risk premium Beta * market premium (rm – rf )
• Return on a security = rf + β * (rm – rf )

Shortcomings of CAPM
• Stock prices in reality do not follow any specific pattern and often go contrary to what
the CAPM suggests
Unrealistic assumptions
• Uniform understanding of risk and expected return of all assets.
• Existence of a risk-free rate
• Non existence of taxes or transaction costs
• Non existence of a “market portfolio”
• Normal distribution of asset returns

Portfolio evaluation
• Sharpe Index
– Measure a portfolio’s excess return per unit of risk i.e. risk adjusted performance
– Risk = Standard deviation
– Implicit assumption - portfolio is not a diversified portfolio
– Sharpe = (Portfolio Return - Risk-Free Return) / Standard Deviation
• Treynor Index
– Similar to Sharpe index except that risk in this case = Beta
– Useful to assess excess return from each unit of systematic risk
– Enables investors to evaluate how structuring the portfolio to different levels of
systematic risk will affect returns.
– Treynor = (Portfolio Return - Risk-Free Return) / Beta

Portfolio evaluation
• Jensen’s measure
– Represents average return on a portfolio over and above that predicted by CAPM
– Also referred to as "Jensen's alpha”
– Jensen’s measure = Expected portfolio return – (Portfolio return as per CAPM)
– i.e. Expected portfolio return – [rf + Beta * (rm – rf)]

Next Steps
• Bond pricing
• Pricing of equity shares
• Portfolio management
• Futures and options
• Tax implications
• Practice, practice, practice

Session IV

Bonds
Parameters Bonds Equity
Nature of funding (for the issuer) Loan Capital
Ownership pattern Non existent / borrower Exists

relationship
Variability in returns Relatively limited Relatively higher
Legal right to returns Exists Does not exist
Security of capital Relatively higher (take Relatively lower

precedence over equity holders)
Returns vary primarily due to Interest rate movements Corporate earnings, stock
market behavior, dividend policy,
etc.
Dependence of returns on No Yes
corporate earnings

Types of bonds
• Government bonds - Gilts / G-Secs
– Issuers - Central / state government
– Medium to long term
– Issued by RBI on behalf of the government
– Semi annual interest payments
– Includes bonds issued by governmental agencies guaranteed by central / state
government
• Corporate bonds
– Secured / unsecured
– Plain vanilla
– Zero coupon
– Floating rate
– Bonds with embedded options – convertible, callable, puttable
– Commodity linked bonds

Risks
• Interest rate risk
• Inflation risk
• Default risk
• Call risk
• Liquidity risk
• Reinvestment risk
• Foreign exchange risk (for foreign currency denominated bonds)

Rating of bonds
• Standard and Poor’s
• Moody’s
• Crisil
– AAA – Highest safety of timely interest and principal payment
– AA – High safety of timely interest and principal payment
– A – Adequate safety …
– BBB – Sufficient safety …
– BB – Inadequate safety …
– B – Greater susceptibility to default
– C – Vulnerable to default
– D – in default

Factors affecting bond pricing
• Coupon rate
• Tenure
• Frequency of interest payments
• Investor expectations of interest rates

– Credit rating
– Yield on competing options
– Inflation expectations
– …

Bond pricing
• Pricing of zero coupon bonds
– Relatively simplistic due to single cash flow model
• Pricing of periodic interest bonds

– Present value of future cash flows
– Amenable to annuity formulae due to constancy of interest cash flows

Session V

Yield to maturity
• Yield to maturity
– Discount rate that equates the present value of cash flows receivable from owning a
bond to the price of the bond
– Rate of return that an investor can expect to earn from a bond IF held till maturity
– Similar to Internal rate of return (IRR)
• YTM assumptions
– Interest and principal payments as per schedule; no default
– Bond held till maturity
– Coupon payments reinvested immediately at the same interest rate as the YTM of
the bond

Bonds – Golden rules
• Market price of a bond and its yield are inversely related
• If yield remains the same over a bond’s life, the discount / premium depends on the
maturity period / tenor
• If yield remains the same over a bond’s life, discount / premium amount decreases at
an increasing rate as its life gets shorter
• A fall in bond yield has a greater impact on bond prices than a rise in yield
• Higher the coupon rate, lesser is the sensitivity of bond price to changes in yield

Term structure of interest rates
• Measures the market’s expectations of future interest rate movements
• Constructed by graphing the YTMs of G-secs (in the Y axis) and their respective
maturities (in the X axis)
• Yield curve shapes

Term structure of interest rates (contd.)
– Normal yield curve
• Market expects long term securities to offer a higher yield as uncertainty is
greater
– Flat yield curve

• Mixed signals being given and it is difficult to determine movement of interest
rates.
• Slope of the curve becomes flatter than usual.
• Investors can maximize risk/return tradeoff by choosing fixed-income securities
with the least risk, or highest credit quality.
– Inverted yield curve

• Form during extra-ordinary or abnormal market conditions. Reverse of normal
yield curve.
• Some investors take this to mean a signal that the economy will experience a
slowdown and hence lock money in long term securities although yield is lower
than short term securities

Term structure of interest rates (contd.)
– Corporate bonds will yield a better return than G-secs due to higher credit risk. The
difference in yields is referred to as credit spread.
– Forecasting using yield curve:

• Downward sloping yield curve indicates a coming recession
• Sharp upward sloping yield curve indicates a coming boom

Session VI

Duration
• The time, in years, it takes a bond's cash flows to repay the investor the total price of
the bond
– For a zero coupon bond, duration = time to maturity
– For a coupon bond, duration < time to maturity
• Duration decreases as coupons are paid to a bondholder i.e. it moves closer to time to
maturity
• Types of duration
– Macaulay duration – Basic duration. Use “Duration” formula in excel
– Modified duration –It shows how much duration changes for each % change in
yield. Appropriate for investors who want to measure the volatility of a particular
bond. Use “MDuration” formula in excel. It will always be < basic duration
– Effective duration – applicable for securities with embedded options

Duration rules
• Larger the coupon rate, lower the duration and less volatile the bond price
• Longer the term to maturity, longer the duration and more volatile the bond price
• Higher the YTM, lower the duration and less volatile the bond price

Immunisation
• Optimum investment outflow = Xa * Duration of Bond A + Xb * Duration of Bond B
where Xa and Xb = % of investment in Bonds A and B
• Assumptions
– Change in interest rates would occur before payments are received from both the
bonds
– Bonds have the same yield
– Shift in interest rates affects all bonds equally
– No call or default risk

Stock return and valuation
• Commonly used terms
– Face value
– Book value
– Share premium
– Dividends
– Capital gains
– Earnings per share (EPS)
– Price / Equity (P/E) ratio
– Dividend payout ratio (DPS)
– Growth rate (g)
• Stock returns
– Capital gains / losses
– Dividend receipts

Session VII

Equity valuation
• Balance sheet valuation
– Book value
– Liquidation value
– Replacement cost
• Dividend discount model

– Single period valuation model
– Multi period valuation model
• Zero growth
• Constant growth
– Two stage growth model
• Earnings multiplier approach
• Present value of growth opportunities (PVGO)

Session VIII

Derivatives
• Key characteristics
– “Derive” their value based on an underlying asset (“underlying”)
– Underlying may or may not be a tradable product – e.g. stocks, commodities,
currencies, weather, wind speed …
– Anything which may have, to a certain degree, an unpredictable effect on any
business activity can qualify to being an underlying of a derivative
• Types
– Forwards
– Futures
– Swaps
– Options

Forwards
• A contract between two parties
– Where, at a certain time in the future,
– One party will deliver a pre-specified quantity of an asset
– And the other party will pay a pre-agreed amount of money for it (Forward price)
• Parties legally bound by the contract and its conditions
• Forward price derived based on principles of time value of money and arbitrage
• Example
– Spot price – Rs. 100
– Duration – 6 months
– Risk-free interest rate – 6% pa
– Forward price = 100*(1+(0.06/2))^1 = Rs. 103/-

Futures
• Standardised forwards traded on the exchange
• Marked to market at the end of every working day

Forwards and futures – common usage
• Risk reduction through greater certainty about financial position
• Speculation
– E.g. Selling uncovered futures without owning the asset / having a long position in it
• Definitions
– Long positions
– Short positions

Swaps
• Financial instruments, which allow investors to change the nature of their cash flows
(e.g. fixed / variable) by exchanging it with other investors with the desire
– Interest rate swaps
– Currency swaps

Options
• Most flexible of all derivatives
• Gives the buyer an “option” to buy the underlying asset at an agreed price on or before
a specified date
• Parties
– Option buyer / holder
• Has a right but no obligation
• Pays a premium
– Option seller / writer
• Obligated to deliver if option exercised by the option buyer
• Receives a premium

Types of options
Buyer Seller
Call Right to buy an asset Obligation to sell the asset
Put Right to sell an asset Obligation to buy the asset
• European
– Can be exercised only ON maturity date
• Bermudan
– Can be exercised prior to maturity dates, which are pre-determined
• American
– Can be exercised anytime on or before maturity date

Terminologies
• Exercise price / strike price

– Fixed price at which the option holder / buyer can buy / sell the underlying asset
• Premium
– Price paid by an option buyer to the option writer / seller
• Expiration date
– Date when the option contract expires / matures
– After expiration date, the contract is worthless
• Exercising the option

– Act of buying / selling the underlying asset as per the option contract
• Exchange traded options

– Options traded on an exchange
• Over the counter options

– Options not traded on an exchange

Terminologies (contd.)
Call option Put option
In the money Market price > Strike price Market price < Strike price
Out of the money Market price < Strike price Market price > Strike price
At the money Market price = Strike price Market price = Strike price
• Intrinsic value
– Value of the option if it were to expire immediately
• Time value
– Excess of market price of the call option over intrinsic value

Option Payoffs
Option buyer / holder
Strike Price > Market price Nil Strike Price – Market Price
Strike Price <= Market price Market Price – Strike Price Nil
Summary Max (MP-SP, Nil) Max (SP-MP, Nil)
Payoff of a call option Payoff of a put option
Payoff Payoff
Strike price
Strike Price
Market price Market price

Option Payoffs
Option seller / writer
Strike Price > Market price Nil Market price – Strike price
Strike Price <= Market price Strike Price – Market price Nil
Summary Min (SP-MP, Nil) Min (MP-SP, Nil)
Payoff of a call option Payoff of a put option
Payoff Payoff
Strike Price Strike price

Market price Market price

Option strategies
Strategy When Action
Desire to invest in a stock Buy a stock

Protective Put
Need for protection in event of a fall Simultaneously buy a put option
Stock Put
Payoff Payoff
Payoff
Profit
Payoff

Option strategies
Desire to earn premium Buy a stock

Covered call
Have a threshold sale price in mind Simultaneously sell a call option
Stock Sell a call
Payoff Payoff
Profit
Payoff
Payoff

Option strategies
Investor believes that stock price will Buy a call and a put at the
Straddle
move but not sure about direction same exercise price
Payoff
A. Call B. Put
Profit
Payoff Payoff
Profit
Payoff
Note: Straddle is profitable only if the stock price deviates from the exercise price by an amount >=
cost of buying the straddle (P+C)

Option strategies
Intent to limit value of a portfolio Buy a put option (if stock held)
Collar
between two bounds Write a call option
• A collar is a trade that establishes both a maximum profit (the ceiling) and minimum
loss (the floor) when holding the underlying asset.
• The premium received from the sale of the ceiling reduces that due from the purchase
of the floor.
• Strike prices are often chosen at the level at which the premiums net out.

Factors determining option values
Variables Impact on call option

Exercise price Higher the exercise price, lower the value of call option
Expiration date Longer the time to expiration, more valuable the call option
Stock price Higher the stock price, higher the value of call option
Variability of stock price Higher the variability, higher the value of call option
Risk free rate Higher the risk free rate, higher the value of call option

Binomial model for option valuation
Assumptions
• Stock currently selling for S can take two possible values next year – uS or dS (uS>dS)
• An amount of B can be borrowed or lent at a rate of r the risk free rate. The interest
rate factor (1+r) = R
• d<R<u
• Exercise price = E

Binomial model for option valuation (contd.)
• Value of call option, just before expiration, if stock price goes up to uS is
– Cu = Max (uS – E,0)
• Value of call option, just before expiration, if stock price goes down to uD is
– Cu = Max (dS – E,0)
• Assuming a portfolio consisting of shares of the stock and B rupees of borrowing,

the following equations hold good:
• = Cu – Cd / S (u - d)
• B = (d*Cu – u*Cd) / (u – d) * R
• Value of call option (C) = S-B

Option strategies
Vertical / money Purchase and sale of options at

spread different exercise prices
Horizontal / time Purchase and sale of options at
spread differing expiration dates

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Investment Planning

Copyright © 2003 Accenture. All rights reserved.

© 2003 Accenture. All Rights Reserved. 2

• Knowledge perspective – In addition to the above,

© 2003 Accenture. All Rights Reserved. 4

• Validating understanding of concepts through quantitative problems

• MS Excel v/s Financial Calculators

• Interactive sessions & two way learning

© 2003 Accenture. All Rights Reserved. 5

• Conceptually useful categories although in reality, there are overlaps

© 2003 Accenture. All Rights Reserved. 6

© 2003 Accenture. All Rights Reserved. 7

© 2003 Accenture. All Rights Reserved. 8

© 2003 Accenture. All Rights Reserved. 9

© 2003 Accenture. All Rights Reserved. 10

• By definition, only “unsystematic” risk can be diversified

© 2003 Accenture. All Rights Reserved. 11

• Effect of co-efficient of correlation (r) on portfolio risk

© 2003 Accenture. All Rights Reserved. 12

• To zeroise portfolio risk where r = -1, % to be invested in asset 1 =

• If r <> -1, % to be invested in asset 1 =

© 2003 Accenture. All Rights Reserved. 13

Portfolio return (2 asset portfolio)

Portfolio risk (2 asset portfolio)

Portfolio risk (3 asset portfolio)

© 2003 Accenture. All Rights Reserved. 14

© 2003 Accenture. All Rights Reserved. 15

• Premise – investors need to be compensated in two ways

Time value of money Risk free interest rate (rf)

Risk premium Beta * market premium (rm – rf )

• Return on a security = rf + β * (rm – rf )

© 2003 Accenture. All Rights Reserved. 16

• Uniform understanding of risk and expected return of all assets.

• Existence of a risk-free rate

• Non existence of taxes or transaction costs

• Non existence of a “market portfolio”

• Normal distribution of asset returns

© 2003 Accenture. All Rights Reserved. 17

© 2003 Accenture. All Rights Reserved. 18

© 2003 Accenture. All Rights Reserved. 19

• Pricing of equity shares

• Futures and options

• Practice, practice, practice

© 2003 Accenture. All Rights Reserved. 20

© 2003 Accenture. All Rights Reserved. 21

Nature of funding (for the issuer) Loan Capital

Ownership pattern Non existent / borrower Exists

Variability in returns Relatively limited Relatively higher

Legal right to returns Exists Does not exist

Security of capital Relatively higher (take Relatively lower

© 2003 Accenture. All Rights Reserved. 22

© 2003 Accenture. All Rights Reserved. 23

• Foreign exchange risk (for foreign currency denominated bonds)

© 2003 Accenture. All Rights Reserved. 24

© 2003 Accenture. All Rights Reserved. 25

• Frequency of interest payments

• Investor expectations of interest rates

© 2003 Accenture. All Rights Reserved. 26

• Pricing of periodic interest bonds

© 2003 Accenture. All Rights Reserved. 27

© 2003 Accenture. All Rights Reserved. 28

© 2003 Accenture. All Rights Reserved. 29

© 2003 Accenture. All Rights Reserved. 30