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SECURITY ANALYSIS: The term investment is a word of many meanings. The investment refers to net additions to the capital stock of the community. Investment decision is a part of our economic life. Everybody takes such decisions in different context and at different times. The investor deploys money in specific investment channels with the objective of better returns. The investor has various alternative investment avenues. Savings are invested in assets depending on their risky. An intelligent investor with skills of management can reduce the risk and maximize returns.

CONCEPT OF SECURITY ANALYSIS: Security analysis refers to the analysis of trading securities. It analyses the share price returns and the risk involved in the investment. Every investment involves the risk and the expected return is related to risk. The security analysis will help in understanding the behavior of security prices, market and decision making for investment. If the analysis includes scrip the analysis of a market with various securities it is known as macro picture of the behavior of the market. The entire process of estimating return and risk of a security is known as security analysis. This traditional investment analysis when applied to securities emphasizes the projection of prices ad dividends are known as security analysis. It involves the potential price of a share and future dividend stream is forecast, then discounted back to the present value. Such value is called as intrinsic value. Then the intrinsic value is compared with the securities market price, If the current market price is lower than the intrinsic value, then purchase is recommended. Further, the security analysis is

built around the idea that investors are concerned with two principal properties inherent in securities, the return that can be expected from holding a security, and risk that is achieved will be less than the return that was expected. Generally, the investors are interested primarily in selling a security for more than they pay for it. The investor hopes to achieve a higher reward than simply placing the money in a saving account. An investor who seeks reward that exceeds those available on savings account forces the real risk. There is no return without risk. The process of estimating return and risk for individual securities is known as security analysis. Security analysis is the essence of valuation of financial instruments. The value of financial asset depends upon their return and risk. The universal fact is that everyone must recognize the risk component in risk situation OBJECTIVES OF SECURITY ANALYSIS: The following are the objectives of security analysis: 1. To estimate the risk and return related to a particular security. 2. To find out the intrinsic value of the security with a view to make a buy/sell decision 3. To identify the under valued securities to buy or over value securities to sell. 4. To analyze the stock market trends to understand the stock market pattern and behavior. 5. To forecast the future earning and dividends along with the price of the securities. 6. To find out the key determinants of the intrinsic value. 7. To analyse and point out the position of economy industry and the company with a view to select the possible company for investment.

APPROACHES TO SECURITY ANALYSIS: The security analysis aimed at identifying under securities to buy and over valued securities to sell. It involves the entire process of estimating return and risk for an individual security. It is deeply rooted in fundamental concepts to measure the risk and return of security. It emphasizes on the return and risk estimates rather than mere price and dividend estimates. However, the return and risk estimates are dependent on share prices and accompanying dividend stream. Any forecast of security must necessarily consider the prospects of the economy. The economic sets greatly influence the prospects of certain industries as well as the psychological aspect of investing public. The approaches for security analysis are broadly grouped into the following categories. 1) Fundamental analysis 2) Technical analysis 3) Efficient market hypothesis.

1) FUNDAMENTAL ANALYSIS: The first major analysis of securities analysis is the fundamental analysis. A Fundamental analysis is a time honored value based approach depending. Upon a careful assessment of the fundamental of an economy, industry and the company. The fundamental analysis studies the general economic situation makes an evaluation of an industry and finally does an in-depth analysis of both financial and the non financials of the company of choice. The fundamental analysis is aimed at analyzing the various

fundamentals or basic factors that effect the risk return of the securities. The fundamental analysis involves the analysis of the following: A) THE ECONOMIC ANALYSIS B) THE INDUSTRY ANALYSIS C) THE COMPANY ANALYSIS A) THE ECONOMIC ANALYSIS: In the economic analysis the investor has to analyse the economic factor to forecast of the economy in order to identify the growth of the economy and its trend. Further based on the economic analysis the investor will identify the industry groups which are promising in the coming years in order to choose the best company in such industry group. The economic analysis provides the investor to develop a sound economic understand and be able to interpret the impact of important economic indicators on the markets. B) INDUSTRY ANALYSIS: The object of the industry analysis is to assess the prospects of various industrial groupings. The industry analysis helps to identify the industries with a potential for future growth and to select companies from such industry to invest in its securities. The industry analysis involves industry life cycle analysis, investment implication, structure and characteristics of an industry. C) THE COMPANY ANALYSIS: Company analysis is the last leg in the economy, industry and company analysis sequence. The company analysis is a study of variable that influence the future of a firm both qualitatively and quantitatively. The purpose of company analysis is to know the intrinsic value of a share of a company.

2) THE TECHNICAL ANALYSIS: As an approach to investment analysis, technical analysis is radically different from fundamental analysis. The technical analysis is frequently used as a supplement to fundamental analysis is, concerned with a critical study of the daily or weekly price volume data of index comprising several shares. The technical analysis analyses the buying and selling pressure, which govern the price trend. It helps the investors to buy cheap and sell high, regardless of the type of company the investor choose. The technical analysis complies a study of the market itself and not of the various external factors which effect the market. According to technical analyst, all relevant factors get gets reflected in the volume of the stock exchange transaction and the level of the share prices 3) EFFICIENT MARKET HYPOTHSIS: The efficient market hypothesis is also called as RANDOM WALK THEORY. It is the extension of fundamental and technical analysis to equity investment decisions. Efficient market theory says that no investors can out perform the market for the simple reason that there are numerous knowledgeable analysts and investors who would not allow the market price to deviate from the intrinsic value due to their active buying and selling. Therefore the current market price incorporates all fundamental information. According to WILLIAM SHARPE A perfectly efficient market is one in which every security price equalizes market value at all times. EUGEN FAMA expressed that An efficient capital market is a market that is efficient in processing in information. The prices of securities observed at any time are based on correct evaluation of all information available at that time. In an efficient market, prices fully reflect all available information. The efficient market theory has the following three forms of efficiency:

1. Weak form of efficiency: 2. Prices reflect in all information found in the record of past prices and volumes. 3. Semi-strong- form of efficiency: 4. Prices reflect not only all information found in the records of past and volumes but also other publicity available information. 5. Strong form of efficiency: 6. Prices reflect all available information, public as well as private. CONCEPT OF PORTFOLIO MANAGEMENT: Portfolio is the collection of financial or real assets such as equity shares, debentures, bonds, treasury, bills and property etc. in a more general sense the term portfolio may be used synonymous with the expression collection of assets which can even include physical assets (gold, silver, real estate, etc). Portfolio means a collection of combination of financial assets (securities) such as shares, debentures, government securities. Portfolios are a combination of assets. Portfolio will consist of collection of securities. What is to be borne in mind is that, in portfolio context, assets are held for investment purposes and not for consumption purposes. These holding are the result of individual preferences and decisions of the holders regarding risk and return an a host of other considerations. Portfolio is the investment of funds in different securities in which the total risk of the portfolio is minimized while expecting maximum return from it. Portfolio management takes the ingredients of risk and returns for individual securities and considers the mixing of these securities. The portfolio management in total includes the planning, super vision, forming rationalism and conservatism involved in the collection of securities to meet investors objectives. In entails choosing the one best portfolio to suit the risk-return preferences of the investors. It also encompasses the

evaluation and revising the portfolio in view of changing risk, return and investors risk preferences


It is a service activity which is associated with providing quantitative information primarily financial in nature and that which may needed for making economic decisions regarding reasoned choice among different alternative course of action. Financial management is a process of identifying management, accumulation analysis, preparation, interpretation and communication of financial information to plan evaluate and control. Financial management is that specialized function of general management which is related to the procurement of finance and its effective utilization for the achievement of the common goal of the organization. Security Analysis refers to the analysis of trading securities. It analysis the share price returns and the risk involved in the statement. The security analysis aimed at identifying under valued securities to buy and over valued securities to sell. With the reasonable review of the literature a thorough work in studying the effective functioning of the Security analysis and Portfolio management in Interconnected Stock Exchange, is felt a necessary in the explained circumstances, it is chosen for the studying in Inter-connected Stock Exchange, Hyderabad.

NEED FOR THE STUDY: The investor today is looking at investing in securities, which would give him better returns that an ordinary savings bank account or fixed deposits though at a certain amount of risk. Every person save money by post poning consumption because future is uncertain. So, they have to search out for efficient opportunities. Due to fast changing development in economic and industries scenario improving the performance of the organization is essential. As a result undertaking an academic study on Security Analysis and Portfolio Management will be a welcome step. This study will be defiantly help full in achieving the organization effectiveness. OBJECTIVES: 1) To study the investment pattern and its related risks and returns. 2) To understand, analyze and select the best Portfolio. 3) To find out the intrinsic value of security with a view to make a buy/ sell decision. HYPOTHESIS: 1) Effective Security Analysis and Portfolio Management have a bearing on company. 2) Effective Security Analysis and Portfolio Management contribute to increase the efficiency of the company. SCOPE: Even though there are number of techniques for Portfolio analysis, Markowitz Model has been choosing for the analysis. The scope of study has been restricted to Hyderabad Stock Exchange. SEBI role and guidelines has been covered study, at large Indian stock market tendencies also has been considered in the study.

METHODOLOGY In attempting to pursue this research study topic qualitative as well as quantitative approaches are undertaken. Sources of Information:Both primary and secondary data were gathered and utilized for the study of Security Analysis and Portfolio Management. The statements cover the aspects of Security Analysis and Portfolio Management the and associated issues. Personal interviews are taken with respondents to strengthen the information. Data collection tools, to obtain the data for the purpose of present study the following tools used; a) The data has been collected through HSE staff, the project guide and stock brokers. b) The data has been collected through journals, news papers and internet. Data analysis are analyzed using basic parametric techniques such as percentages and averages etc, where ever they are required.

LIMITATIONS OF THE STUDY: 1) Limited access to company information. 2) Detailed study of the topic was not possible due to limited size of the project.


The securities available to an investor for investment are numerous and of various types. The shares of over 7000 companies are listed in the stock exchanges of the country. Traditionally, the securities were classified into ownership securities such as equity shares and preference shares and creditorship security such as debentures and Bonbs.Recently a number of new securities with innovative features are being issued by companies to raise funds for their projects. Securities analysis is the initial phase of the portfolio management process. This step consists of examining the risk-return characteristics of individual securities. A basic strategy in securities investment is to buy under priced securities and sell over priced securities. There are two alternative approaches to security analysis, namely, fundamental analysis and technical analysis. They are based on different premises and follow different techniques fundamental analysis, the order of the two approaches, concentrates on the fundamental factors affecting the company such as the EPS of the company the dividend pay-out ratio, the competition faced by the company, the market share, quality of management,etc According to this approach, the share price of a company is determined by these fundamental factors. The fundamental analyst works out the true worth or intrinsic value of a security based on its fundamentals: if the current market price is higher than the intrinsic value, the share is set to be over priced and vice versa. Fundamental analysis helps to identify fundamentally strong companies whose share are worthy to be included in the investors portfolio. The alternative approach to security analysis is Technical analysis. The technical analyst believes that share price movements are systematic and exhibit


certain consistent patterns. He there fore studies past movements in the prices of shares to identify trends and patterns. He then tries to predict the future piece movements. Technical analysis is an approach which concentrates on price movements and ignores the fundamentals of the shares. A more recent approach to security analysis is the efficient market hypothesis according to the school of thought; the financial market is efficient in pricing securities. The efficient market hypothesis holds the market prices instantaneously and fully reflect all relevant available information. It means that the market prices of securities will always equal its intrinsic value. Efficient market hypothesis is a direct repudiation of both fundamental analysis and technical analysis. An investor cannot consistently earn abnormal returns by undertaking fundamental analysis or technical analysis. According to efficient market hypothesis it is possible for an investor to earn normal returns by normally choosing securities of a given risk level. In literature Beinhocker say that evaluation provide a powerful and effective recipe for salving problems and creating strategies in an predictable environment. Fitness landscapes demonstrates how evolutionary search creates robustness and adaptability through constant experimentation, parallel search , and mix of adaptive walks and long jumps .by creating and cultivating evolving portfolios of strategies, managers can make it more likely that there company will stay out of the strategy wilderness and enjoy the high fitness peaks. In view of Korczak adopts a different approach in the portfolio optimization problem. He identified problems trading rules in stock market using genetic algorithms. Technical analysis assumes that future trends can be identified as a more or less complicated function of past prices. Using a trade rule is a practical way of identifying


trends, which, in terms generate buying, and selling signals. on the basis of past prices, each rule generates a signal: to sell, to hold, or to buy. To ensure simplicity in the computing these decision. In literature of Vieire, he is present a method for finding the optimal portfolio using genetic algorithm matching the parameters defined by the analyst and the desired beta of the portfolio. The analysis done by using functions that provides the most important information on the financial health of a company. In this work, the parameter used for the analysis is the following indices: current ration, quick ratio and market value/ patrimony value. Binary codification is used to represent the portfolio. The representation not only includes the share held in the portfolio, but also it is proportion. The implementation was run for more than 4000 generations and the fitness the value reached very close to the maximum. In view of M.Sitaram Venugopal, S.Subramanian and U.S.Rao the dynamic portfolio consisting of both debt and equity that has been selected for each month for out performed the Sensex throughout the testing period. In addition, it also

dynamically switches from debt to equity during bull phase and vice versa in bear phase automatically. thus the model is able to identify the portfolio of equity and debt securities mix dynamically without human intervention and obtain consistently good results in both phases. It could used by investors-both individual and institutional for decision making.




INTRODUCTION Inter-connected stock exchange of India limited [ISE] has been promoted by 14 Regional stock exchanges to provide cost-effective trading linkage/connectivity to all the members of the participating Exchanges, with the objective of widening the market for the securities listed on these Exchanges. ISE aims to address the needs of small companies and retail investors with the guiding principle of optimizing the existing infrastructure and harnessing the potential of regional markets, so as to transform these into a liquid and vibrant market through the use of state-of-the-art technology and networking. The participating Exchanges of ISE in all about 4500 stock brokers, out of which more than 200 have been currently registered as traders on ISE. In order to leverage its infrastructure and to expand its nationwide reach, ISE has also appointed around 450 Dealers across 70 cities other than the participating Exchange centers. These dealers are administratively supported through the regional offices of ISE at Delhi [north], kolkata [east], Coimbatore, Hyderabad [south] and Nagpur [central], besides Mumbai. ISE has also floated a wholly-owned subsidiary, ISE securities and services limited [ISS], which has taken up corporate membership of the National Stock Exchange of India Ltd. [NSE] in both the Capital Market and Futures and Options segments and The Stock Exchange, Mumbai In the Equities segment, so that the traders and dealers of ISE can access other markets in addition to the ISE markets and their local market. ISE thus provides the investors in smaller cities a one-stop solution for cost-effective and efficient trading and settlement in securities. With the objective of broad basing the range of its services, ISE has started offering the full suite of DP facilities to its Traders, Dealers and their clients. 14

OBJECTIVES: 1. Create a single integrated national level solution with access to multiple markets for providing high cost-effective service to millions of investors across the country. 2. Create a liquid and vibrant national level market for all listed companies in general and small capital companies in particular. 3. Optimally utilize the existing infrastructure and other resources of participating Stock Exchanges, which are under-utilized now. 4. Provide a level playing field to small Traders and Dealers by offering an opportunity to participate in a national markets having investment-oriented business. 5. Reduce transaction cost. 6. Provide clearing and settlement facilities to the Traders and Dealers across the Country at their doorstep in a decentralized mode. 7. Spread demat trading across the country METHODOLOGY OF THE STUDY OBJECTIVES OF THE STUDY: The objectives of the study are as follows: To know the on-line screen based trading system adopted by ISE and about its communication facilities for the appropriate configuration to set network. This would link the ISE to individual brokers/members. To study about the back up measures with respect to primary communication facilities, in order to achieve network availability and connectivity back-up options. Study about Clearing & Settlements in the stock exchanges for easy transfer and error prone system. Also study about computerization demand process. To know about the settlement procedure involved in ISE and also NSDL operations. Clearing defining each and every term of the stock exchange trading procedures.



The scope of the project is to study and know about Online Trading and Clearing & Settlements dealt in Inter-Connected Stock Exchange. By studying the Online Trading and Clearing & Settlements, a clear option of dealing in stock exchange is been Understood. Unlike olden days the concept of trading manually is been replaced for fast interaction of shares of shareholder. By this we can access anywhere and know the present dealings in shares. DATA COLLECTION METHODS The data collection methods include both the primary and secondary collection methods.

Primary collection methods: This method includes the data collection from the
personal discussion with the authorized clerks and members of the exchange.

Secondary collection methods: The secondary collection methods includes the

lectures of the superintend of the department of market operations and so on., also the data collected from the news, magazines of the ISE and different books issues of this study LIMITATIONS OF THE STUDY The study confines to the past 2-3 years and present system of the trading procedure in the ISE and the study is confined to the coverage of all the related issues in brief. The data is collected from the primary and secondary sources and thus is subject to slight variation than what the study includes in reality. Hence accuracy and correctness can be measured only to the extend of what the sample group has furnished.

SAILENT FEATURES Network of intermediaries:


As at the beginning of the financial year 2003-04, 548 intermediaries (207 Traders and 341 Dealers) are registered on ISE. A broad of members forms the bedrock for any Exchange, and in this respect, ISE has a large pool of registered intermediaries who can be tapped for any new line of business. Robust Operational Systems: The trading, settlement and funds transfer operations of ISE and ISS are completely automated and state-of-the-art systems have been deployed. The communication network of ISE, which has connectivity with over 400 trading members and is spread across46 cities, is also used for supporting the operations of ISS. The trading software and settlement software, as well as the electronic funds transfer arrangement established with HDFC Bank and ICICI Bank, gives ISE and ISS the required operational efficiency and flexibility to not only handle the secondary market functions effectively, but also by leveraging them for new ventures. Skilled and experienced manpower: ISE and ISS have experienced and professional staff, who have wide experience in Stock Exchanges/ capital market institutions, with in some cases, the experience going up to nearly twenty years in this industry. The staff has the skill-set required to perform a wide range of functions, depending upon the requirements from time to time. Aggressive pricing policy The philosophy of ISE is to have an aggressive pricing policy for the various products and services offered by it. The aim is to penetrate the retail market and strengthen the position, so that a wide variety of products and services having appeal for the retail market can be offered using a common distribution channel. The aggressive pricing policy also ensures that the intermediaries have sufficient financial incentives for offering these products and services to the end-clients.

Trading, Risk Management and Settlement Software Systems:


The ORBIT (Online Regional Bourses Inter-connected Trading) and AXIS (Automated Exchange Integrated Settlement) software developed on the Microsoft NT platform, with consultancy assistance from Microsoft, are the most contemporary of the trading and settlement software introduced in the country. The applications have been built on a technology platform, which offers low cost of ownership, facilitates simple maintenance and supports easy up gradation and enhancement. The soft wares are so designed that the transaction processing capacity depends on the hardware used; capacity can be added by just adding inexpensive hardware, without any additional software work.

Vibrant Subsidiary Operations: ISS, the wholly owned subsidiary of ISE, is one of the biggest Exchange subsidiaries in the country. On any given day, more than 250 registered intermediaries of ISS traded from 46 cities across the length and breadth of the country. 1. Prof. P. V. Narasimham 2. Shri V. Shankar 3. Dr. S. D. Israni 4. Dr. M. Y. Khan 5. Mr. P. J. Mathew 6. M. C. Rodrigues 7. Mr. M. K. Ananda Kumar 8. Mr. T.N.T Nayar 9. Mr. K. D. Gupta 10. Mr. V. R. Bhaskar Reddy 11. Mr. Jambu Kumar Jain Public Interest Director Managing Director Public Interest Director Public Interest Director Shareholder Director Shareholder Director Shareholder Director Shareholder Director Shareholder Director Shareholder Director Trading Member Director



This study has been conducted purely to understand Portfolio Management for investors. Construction of Portfolio is restricted to two companies based on Markowitz model. Very few and randomly selected scripts / companies are analysed from BSE listings. Data collection was strictly confined to secondary source. No primary data is associated with the project. Detailed study of the topic was not possible due to limited size of the project. There was a constraint with regard to time allocation for the research study i.e. for a period of two months.



Portfolio management is a complex activity which may be broken down into following steps; 1) Specification of investment objectives and constraints; The typical objectives sought by investors are current income, capital appreciation, and safety of principal. The relative importance of these objectives should be specified. Further, the constraints arising from liquidity, tome horizon, tax, and special circumstances must be identified. 2) choice of asset mix: The most important decision in portfolio management is the asset mix Decision. Very broadly, this is concerned with the proportions of stocks (equity shares and units / shares of equity // oriented mutual funds) and bonds (fixed income investment vechiles in general) in the portfolio. The appropriate stock bond mix depends mainly on the risk tolerance and investment tolerance horizon of the investor. 3) Formulation of portfolio strategy: Once a certain asset mix is chosen, an appropriate portfolio strategy has to be hammered out. Two broad choices are available: an active portfolio strategy or a passive portfolio strategy. An active portfolio strategy strives to earn superior risk-adjusted returns by resorting to market timing, or sector rotation, or security selection, or some combination of these. A passive portfolio strategy, on the


other hand involves holding a broadly diversified portfolio and maintaining a predetermined level of risk exposure.

4) Selection of securities Generally, investors pursue an active stance with respect to security selection. For stock selection, investors commonly go by fundamental analysis and / or technical analysis. The factors that are considered in selecting bonds (or fixed income instruments) are yield to maturity, credit rating, term to maturity, tax shelter, and liquidity. 5) Portfolio execution: This is the phase of portfolio management which is concerned with implementing the portfolio plan by buying and/ or selling specified securities in given amounts. Though often glossed over in portfolio management discussions, this is an important practices step that has a bearing on investment results. 6) Portfolio revision: The value of a portfolio as well as its composition the relative proportions of stock and bond components may change as stocks and bonds fluctuate. Of course the fluctutations of stocks is often the dominant factor underlying this change. In response to such changes, periodic rebalancing of the portfolio is required. This primarily involves a shift from stocks to bonds or vice versa. In addition, it may call for sector rotation as well as security switches. 7) Performance evaluation: The performance of a portfolio should be evaluated periodically. The key dimensions of portfolio performance return are commensurate with its risk exposure.


Such a review may provide useful feedback to improve the quality of the portfolio management process on a continuing basis.

Sources of investment risk: As an investor you are exposed to may variety of risks. Among these there are three major ones: business risk, interest rate risk. While a detailed discussion of these is woven in the entire book, at this juncture a brief idea may be given. 1) Business risk: As a holder of corporate securities (equity shares or debentures), you are exposed to the risk of poor business performance. This may be caused by a variety of factors like heightened competition, emergence of new technologies, development of substitute products, shifts in consumer preferences. Inadequate supply of essential inputs, changes in government policies, and so on. Often, of course, the principal factor may be inept and in component management. The poor business performance definitely affects the interest of share holders, who have a residual claim on the income and wealth of the firm. It can also affect the interest of debenture holders if the ability of the firm to meet its interest and principal interest payment obligation is impaired. In such a case, debenture holders face the prospect of default risk. 2) Interest rate risk: The changes in interest have a bearing on the welfare of the investors. As the interest rate goes up., the market price of existing fixed income securities falls, and vice versa. This happens because the buyer of a fixed income security would not buy it at its par value of share value if its fixed interest rate ids lower than the prevailing rate interest rate on a similar security. For example, a debenture that has a face value


of Rs 100anda fixed rate of 12% will sell at discount if the interest rate moves up, say, 12% to 14%. While changes in interest rate will have a direct bearing on the prices of fixed income securities, they affect equity prices too, albeit some what indirectly. The changes in the relative yields of debentures and equity shares influence equity prices. 3) Market risk: Even if the power of the corporate sector and the interest rate structure remain more or less unchanged, prices of securities, equity shares in particular, tend to fluctuates. While there can be several reasons for fluctuation, the main cause appears to be the changing psychology of the investors. There are periods when investors become bullish and their investments horizons lengthen. Investor optimism, which may border on euphoria, during such periods drives share prices to great heights. The buoyancy created in the wake of this development is pervasive, affecting all most ass the shares. On the others hand, when a wave of pessimism (which often is an exaggerated response to some unfavorable political or economic development) sweeps the market, investors turn bearish and myopic prices of all most all equity shares register as decline as fear and uncertainly pervade the market. The market tends to move in cycles. As john says: you need to get deeply in to your bones the sense that any market, and certainly the stock market, moves in cycles, so that you will infallibly wonderful bargains every few years, and have a chance to sell again at ridiculously high prices a few years later. The cycles are caused by mass psychology. As john train explains: the ebb and flow of mass emotion quite regular: panic is followed by relief, and relief by optimism; then comes enthusiasm, then euphoria and rapture, then the bubble bursts, and public feeling slides off again into concern, desperation ,and finally a new panic. One would expect large participation of institutions to dampen the price


fluctuations in the market. After all institutional investors have core professional expertise to de fundamental analysis and greater financial resources to act on fundamental analysis. However nothing of this kind has happened. On the contrary, price fluctuation seen to have become wider after the arrival of the institutional investors in larger numbers. Why? Perhaps the institutions and their analysis have not displayed more presence and rationality than the general investing public and have succumbed in equal measure to the temptation to the speculation. As john Maynard Kenyes has argued, factors that contribute to the volatility of the market are not likely to diminish when expert professionals possessing best judgement and knowledge compete in the market place. Why? According to Kenyes, even these people are concerned with speculation (the activity of forecasting the psychology of the market) and not the enterprise (the activity of forecasting the prospective yield of assets over their whole life).

PORTFOLIO THEORY THE BUSINESS OF DIVERSIFICATION: Very broadly speaking the investment process consists of two types. The first task is security analysis which focuses on assessing the risk and risk returns characteristic of the available investment vehicles. The second task is portfolio selection, which involves portfolio selection, which involves choosing the best portfolio from the set of feasible portfolios. We begin our discussion with the second task with the help of portfolio theory. Portfolio theory, originally proposed by HARRY MARKOEITZ in the 1950s, was the first formal attempt to quantify the risk of aportfolio and develop a methodology for determining the optimal portfolio. Prior to the development of portfolio theory, investors dealt with the concepts of return and risk somewhat loosely. Intuitively


smart investors knew the benefit of diversification which is reflected in the traditional adage: do not put all your eggs in one basket. HARRY MARKOWITY was the first person to show quantitively why and how diversification reduces risk. In recongnition of his seminal contribution in the field was awarded the Nobel prize in Economic in 1990.

PORTFOLIO RETURNS: Measuring actual portfolio return The actual (or realized) return of a portfolio of assets over some specific time period is calculated as follows: Rp = W1R1+W2R2+.......Wn Rn Where Rp = rate on return on portfolio Ri = rate on return of assest I (I = 1,.n) Wi = weight of assest i in the portfolio ( I =1,.n) N = number of assests in the portfolio Equation can be expressed succinctly as follows: n Rp =

Wi Ri


Equation (2) says that return on a portfolio of assests is equal to the weighted average of the returns on various assests on the portfolio.

For example consider a portfolio consisting of five assests:


ASSET 1 2 3 4 5

MARKET VALUE RS 4million RS 6million RS 8million RS 10million RS 12million 40million

RATE OF RETURN 15% 12% -6% 9% 10%

The weight of various assets are: W1 = 4/40 =0.10 , W2 = 6/40 =0.15, W3 = 8/40 = 0.20 ,W4 =10/40 =0.25 ,and W5 = 12/40 =o.30 The portfolio return is: R = 0.10 ( 15%) + 0.15 ( 12%) +0.20 (-6%) =0.25 (9%) =0.30(10%) R = 7.35% THE EXPECTED RETURN ON A PORTFOLIO OF RISKY ASSETS In portfolio analysis we often want to know the expected ( or anticipated) return on a portfolio of risky assets. The expected return on portfolio is: E(Rp) = W1E( R1) + W2 E (R2) + .. +WnE (Rn) Where E(Rp) = Expected return on portfolio Wi = weigh of assest I in the portfolio (I =1,.n) E(Ri) = expected return on asset I ( i= 1,.n)



. Risk of a two asset portfolio: Recall that the variance of an individual asset s risk is defined as : n Var( Ri ) =



E( Ri)]2 Ps

The variance of the return on a portfolio consisting of two assets is slightly more difficult to calculate. It depends not only on the variance of the returns of the two assests but also on the covariance of the returns of the two assests Var(Rp) = w12 var(R1) + w22 Var(R2) + 2W1W2 Cov (R1R2) Where Var (Rp) = Variance of the Port polio return, W1W2 = Weights of assets 1 & 2 in the Port polio, var(R1),Var(R2) = Variance of the returns on assets 1 and 2, Cov (R1, R2)= Covariance of the returns on the assets 1 and 2,

In the words the above equation says that the variance of the return on a 2asset portfolio is the sum of the weighted variances of the two assets plus the weighted covariance between the two assets.

Covariance: The covariance term in the above equation term reflects the degree to which the returns of the two assets vary or change together. A positive covariance means that the returns of the two assets move in the same direction where as a negative covariance implies that the returns of the two assets move on the opposite direction. The covariance between any two assets I and j is calculated as follows.


Cov (Ri, Rj) = P1 [Ri1 E (Ri)] [R E(R j)] + P2 [Ri2 E (Ri)] [R E(R j)] + . + Pn [Rin E (Ri)] [R E(R j)]. Where P1, P2, P3, Pn = Probabilities associated with states 1,n, Ri1, Ri2 Rin = Return on asset I in state 1,n, R j1, R j2 R jn = Return on assets J in states 1n E (Ri), E (Rj) = Expected returns on assets I and J,

Example: the returns on assets 1 and 2 under the five possible states nature are given below State of Nature Probability Return on asset 1 Return on assets 2

1 2 3 4 5

0.10 0.30 0.30 0.20 0.10

-10 15 18 22 27

5 12 19 15 12

The expected return on asset 1 is: E(R1) = 0.10 (-10%) + 0.30 (18%) + 0.20 (22%) + 0.10( 27%) = 16% The expected return on assets 2 is:
E(R2) = 0.10 (15%) + 0.30 ( 12%) + 0.30 (19%) + 0.20 (15%) + 0.10 (12%) = 14%

The covariance between the returns on assets 1 and 2 calculated below:

State of Nature Probability Return on asset 1 Deviation of the return on Return on asset 2 Deviation of the return on Product of the deviations


times asset 1 from its mean 1 2 3 4 5 asset 2 from probability its mean 6 (2)(4)(6)

0.10 1 0.30 2 0.30 3 0.20 4 0.10 5

-10% 15% 18% 22% 27%

-26% -1% 2% 6% 11%

5% 12% 19% 15% 12%

-9% -2% 5% 1% -2%

23.4 0.6 3.0 1.2 -2.2 sum=26.0

Thus the covariance between the returns on the two assets is 26.0

Relation between covariance and correlation: Covariance correlation are conceptually analogous in the sense that both of them reflect the degree of comovement between two variables. Mathematically , they are related as follows: Cov (Ri, Rj)
(Ri) (Rj)

Where cor(Ri, Ri) =correlation coefficient between the returns on assets I and j

Cov (Ri,Rj) = covariance between the returns on assets I and j (Ri), (Rj) = standard deviation of the returns Thus the correlation coefficient can vary between -1.0 and +1.10. A value of -1.0 mean perfect negative correlation or perfect comovement in the opposite direction; a value of 0 means no correlations of comovement whatsoever; a value of -1.0 means perfect correlation or perfect comovement in the same direction. The exhibit portrays graphically various types of correlation relationships.






Notice that in the table there are n variance terms (the diagonal terms) and n(n-1) covariance terms (the non-diagonal terms). If n is just two, there are two variance terms. However , as n increases, the number of covariance terms is much larger than the number of variance terms. For example, when n is 10, there are 10 (that is n)variance terms. Hence the variance of a well-diversified portfolio is largely determined by the covariance terms. If covariance terms are likely to be negative, it may be possible to grid of risk almost wholly by restoring to diversification. Unfortunately, securities prices tend to move together. This means that most covariance terms are positive. Hence, irrespective of how widely diversified a portfolio is, its risk does not fall below a certain level. Dominance of covariance: As the number of securities included in a portfolio increases, the important of risk of each individual security decreases where as the significance of the covariance relation ship increases, to understand this, let us look at the equation for the variance of the portfolio return: n n Var(Rp) = n


Wi2 var(Ri) +

Wi Wj cov(RiRj)


If a valve diversification strategy is followed w = 1/n under such a strategy n Var(Rp) = 1/n



1/n var(Ri) + 1/n2 cov(Ri Rj)


The range variation term and the average covariance term may be expressed as follows: n Var = 1/n var(Ri)

n Cov = 1/n(n-1)

Cov (Ri, Rj)


Hence Var (R) = 1/n Var + n-1/n cov As n increases, the first term tends to become zero and the second term looms large. Put differently, the importance of the variance term diminishes where as the importance of the covariance term increases. Optimal portfolio: Before we discuss the procedure prescribed by Markowiz for selecting the optimal portfolio, let us review the key assumptions made by markowitz about asset selection behaviour. Investors decisions are based on only two parameters, viz . the expected return and variance. Investors are risk averse. This means that investors when investors are faced with two investments with the same expected return but with different risks, they will prefer the one with the lower risk. Investors seek to achieve the higest expected return at a given level of risk.


Investors have identical expectations about expected return, variances, and covariances for all risky assets.

Investors have a common one-period investment horizon. The procedure developed by markowitz for choosing the optimal portfolio of risky assets consists of three steps: 1) delineate the set of efficient portfolio. 2) specify the risk return indifference curves. 3) choose the optimal portfolio.

Efficient portfolios: Suppose an investor is evaluating two stocks A and B for investment stock A has an expected return of 15 percent and a standard deviation of 10 percent. Stock B has an expected return of 20 percent and a standard of 25 percent. The coefficient of correlation in the returns of A and B is 0.4 He can combine stocks A and B in a portfolio in a number of ways by simply changing the proportions of his funds allocates to them. Some of the options available to him are shown below.

Proportion ofA Port polio WA 1 2 3 4 5 1.00 0.75 0.50 0.25 0.00

Proportion of BWB 0.00 0.25 0.50 0.75 1.00

Expectedreturn E(Rp) % 15 16.25 17.50 18.75 20.00

StandardDeviation p 10 11.25 15.21 19.88 25.00


The five options described above are plotted graphically as shown. If just two stocks offer the investor with so many options, imagine the range of possibilities open to him


when he invests in a number of different securities. Exhibits shows the innumerable portfolio options available to the investor. The collection of all possible portfolio options represented by the broken egg shaped region is referred to as the feasible region.

Expected Returns, E(Rp) Risk, p 20% 15% 10% 05% 20% 15% 10%


The investor need not, however feel unduly overwhelmed by the belwildering range of possibilities shown in the exhibit because what really matters to him is the north west of the feasible range defined by the thick darkline. Referred to as the efficient frontier, this boundary contains all the efficient portfolio options available to him. It may be useful to clarify here what exactly a portfolio is. A portfolio is efficient if (and only if) there is no alternative with


i. the same E(Rp) and a lower p , or ii. the same p and a higher E(Rp), or iii. a higher E(Rp) and a lower p.

Thus in exhibit while all the available portfolio are contained in the region AFXMNO, only the portfolio which lie along the boundary AFX are efficient. AFX represents the efficient frontier. All the other portfolios are inefficient. A portfolio like z is inefficient because portfolio like B and D, among others, dominate it. The efficient frontier is the same for all the investors because portfolio theory is based on the assumption that investors have homogenous expectations We have merely defined what is meant by set of efficient portfolios. How can this actually obtained from the innumerable from the innumerable portfolio possibilities that lie before the investors ? the set of efficient portfolios may be determined with the help of graphical analysis, or calculus analysis, or quadratics programming analysis, the major advantage of graphical analysis is that it is easier to grasp. Its advantage is hat it cannot handle Portfolios containing more than three securities. Mathematical analysis can grapple with the n- dimensional space. However, the calculus method is not capable of handling constraints in the form of inequalities Quadratic programming analysis is the most versatile of all the three approaches. It can handle any number of securities and cope with inequalities as well. For all practical, the quadratic programming approach is the most useful approach. Expected Return, E(Rp)


Expected returns

RISK RETURN INDIFFERENCE CURVES: Once the efficient frontier is delineated, the next question is: What is the optimal portfolio for the investor? To determine the optimal portfolio on the efficient portfolio on the efficient frontier, the investors risk returns trade off must be known. Exhibit represents the to illustrative indifference curves which reflect risk and return tradeoff functions note that all points lying on an indifference curve provide the same level of satisfaction. The indifference curves Ip and Iq represents the risk return tradeoffs of two hypothetical investors, P and Q both P and Q like most investors are risk averse. They want higher returns to bear more risk. Q is how ever more risk averse than P Q wants a higher expected return for bearing a given amount of risk as compared to P. In general, the steeper the slope of the indifference curve the greater the degree of risk aversion.


Each person has a map of indifference curves. Exhibit shows the indifference map for P .in this figure, four risk-return indifference curves, Ip1,Ip2,Ip and Ip4 are shown. All the points lying on a given indifference curve offer the same level of satisfaction. For example, points A and B, which lie on the indifference curve Ip1 offer the same level of satisfaction; likewise, points R and S, which lie on the indifference curve Ip2 represents a higher level of satisfaction as compared to the indifference curve Ip1,the indifference curve Ip3 represents a higher level of satisfaction when compared to the indifference curve Ip4 and so on. Optimal portfolio: Given the efficient frontier and the risk-return indifference curves, the optimal portfolio is found at the point of tangency between the efficient frontier and a utility indifference curve. In exhibit two investors P and Q, confronted the same efficient frontier, but having having different utility indifferences curves (Ip1,Ip2,and Ip3 for P and Iq1,Iq2, and Iq3 for Q )are shown to achieve their highest utility indifference curves ( Ip1,Ip2, and Ip3 for P and Iq1,Iq2, and Iq3 for Q ) are shown to achieve their highest utility at points P* and Q* respectively. Expected return


Optimal portfolio with lending and borrowing: Let us introduce yet another opportunity. Suppose that the investor can also lend and borrow money at a risk free rate of R percent as shown in the exhibit. If he lends a portion of his funds at Rf and invests the balance in S (S is the point of the efficient frontier of risky portfolios where the straight line emanating from R is tangential to the efficient frontier of risky portfolios), he can obtain any combination of risk and return along the line that connects Rf and S further, if he borrows some more money and invests it along with his own funds, he can reach a point G, beyond S, as shown in the exhibit. Thus, with the opportunity of lending and borrowing, the efficient frontier changes. It is no longer AFX. Rather, it becomes Rf SG because


RfSG which is superior to the point on AGX> For example, compared to C on AFX, D on RfSG offers a higher expected return for the same standard deviation, likewise, compared to Y on AFX, Z on RfSG offers the same expected return with a lower standard deviation: and so on. Since RfSG dominates AFX, every investor would do well to choose some combination of R and S a conservative investor may choose a point like u, where as an aggressive investor may choose a point like V. However, note that both investors choose some combination of Rf and S. While the

Conservative investor weighs R more in his portfolio, the aggressive investor weighs S more in his portfolio (in fact, in his portfolio, the weight assigned to Rf is negative and that assigned to S is more than 1).


Thus, the task of portfolio selection can be separated in to two steps: a) identification of, the optimal portfolio of risky securities. b) Choice of combination of R and S depending ones risk attitude. This is the import of the celebrated separation theorem, first enunciated by James Tobin, a Nobel laureate in Economics.

Portfolio management frame work

Selection of asset mix: In your scheme of investments, you should accord top priority to a residential cover. In addition, you must maintain a comfortable liquid balance in a convenient form to


meet expected and unexpected expenses in the short run. Once these are adequately provided for, your asset mix decision in concerned mainly with financial assets which may be divided into broad categories, via stocks and bonds. stocks include equity shares (which in turn may be classified into income shares, growth shares, blue chip shares, cyclical shares, speculative shares, and so on) and units / shares of equityoriented schemes of mutual funds (like Master shares,Birla advantage, and so on). Bonds, defined very broadly, consist of non convertible-debentures of private companies, public sector bonds, gilt-edged securities, RBI relief bonds, units / shares of debt-oriented schemes, deposits in the national savings shame, and so on. The basic characteristics of this investment are that they earn a fixed or near-fixed return. Should the long-term stock-bond mix be 50:50 or 75:25 or any other? Referred to as the strategic-asset mix decision (policy asset maxi decision), this is by far the most important decision to be made by the investor. Empirical studies have shown that nearly 90percent of the variance of the portfolio return is explained by its asset mix. Put differently, only 10 percent of the variance of the portfolio return is explained by the other elements like sector rotation and security selection. Given the significance of the asset-mix decision, you should hammer it out carefully. Conventional wisdom on asset mix: The conventional wisdom on asset mix is embodies in two propositions: Other things being equal, an investor with greater tolerance for risk should tilt the portfolio in favors of stocks; where as an investor with lesser tolerance for frisk should tilt the portfolio in favour of bonds. This is because in general, stocks are riskier than bonds and hence raen higher returns than bonds. JAMES H.LORE summed up the long view well when he stated: the most enduring relation in all


finance perhaps is the relation ship between returns on equities or stocks and returns on bonds. a similar observation can be made when we look at the returns on stocks and bonds in India for the last two decades. Other things being equal, an investor with a long investment horizon should tilt his portfolio in favor of stocks where as investor with a shorter investor horizon tilts his portfolio in favour of bonds. This is because while the expected return from stocks is not sensitive to the length of the investment period, the risk from stocks diminishes as the investment period over the period 1950-1980 in the U.S capital market. One can reasonably expect a similar pattern in other capital markets as well. Why does the risk of stocks diminish as the investment period lengthens? As the investment period lengthens, the average yearly return over the period is subject to lesser volatility because low returns in some years may be Offset by high returns in other years and vice versa. Put differently there is benefit of time diversification. As period, they invest through many periods. Hence they are more comfortable investing in riskly assets over long run that over the short run. The implication of the above proposition are captures in exhibit which shoes how the appropriate percentage allocate to the stock component of the portfolio is influenced by the two basic factors, viz risk tolerance and investment horizon. To obtain the corresponding percentage allocation for the bond component of the portfolio, simply subtract the number given in the exhibit from will find this matrix, helpful in resolving in your asset-mix decision.(of course, before using this matrix, you should define your risk tolerance / short time horizon may be raised to 10 percent or so. In a similar manner, the 100 percent, given for the cell high risk tolerance / long time horizon the benefit of diversification across stocks and bonds. Appropriate percentage allocation in the stock component of the portfolio


Time horizon short Medium Long

Risk Low 0 25 50

Tolerance moderate 25 50 75

High 50 75 100

For the sake of simplicity, we assumed there is a single investment horizon. In reality, an investor may have multiple investment horizons corresponding to varied needs. For example, the investment horizons corresponding to various goals sought by an investor may be as follows:

Investment goal Buying a car Constructing a house Achieving financial independence Establishing a charitable institution

investment horizon two years ten years twenty years thirty years

Obviously, the appropriate asset mix corresponding to these investment goals would be different.

Formulation of portfolio strategy: After you have chosen a certain asset mix, you have to formulate the appropriate portfolio strategy. Two broad choices are available in this respect, an active portfolio strategy or a passive portfolio strategy. Active portfolio strategy An active portfolio strategy is followed by most investment professional and aggressive investors who strive to earn superior returns, after adjustment for risk. The four principal vectors of an active strategy, as shown in the exhibit are: 47

Market timing Sector rotation Security selection Use a specialized concept

Vectors of active portfolio management Highly active Market timing Sector rotation Security selection Use a specialized concept highly passive

.. .. ..

Market timing: This involves departing from the normal or strategy or long run asset mix to reflect ones assessment of the prospects of various assets in the near future. Suppose your investible resources for financial assets are 100 and your normal or strategic stock bond mix is 50:50. in the short hand and intermediate run however you may be inclined to deviate from your long-term asset mix. If you expect stocks to out perform bonds, on a risk-adjusted basis , in the near future, you may perhaps set up the stock component of of your portfolio to say 60 or 70 percent. Such an action, of course, would raise the beta of your portfolio. On the other hand, if you expect bonds to outperform stocks, on a risk adjusted basis, in the near future, you may set up the bond component of your portfolio to 60 percent or 70 percent. This will naturally lower the beta of your portfolio.


Marketing timing is based on an explicit or implicit of general market movements. The advocate of market timing employs a variety of tools like business cycle analysis, moving average analysis, advance-decline analysis, and econometric models. The forecast of the general market movement derived with the help of one or more of these tools is tempered by the subjective judgment of the investors. Often, of course, the investor may go largely by his market sense. Anyone who reviews the fluctuation in the market may be tempered to play the play of marketing timing. Yet very few seem to succeed in this game. A careful study on market timing argues that a investment manager must forecast the market correctly 75 percent of the time to break-even, after taking into account the cost of errors and the cost of transactions. As FISHER BLACK said: the market does just as well, on average, when the investor is out of the market as it does when he is in. so he loses money, relative to a simple buy-and-hold strategy, by being out of the market part of the time. Echoing a similar view JOHN BOGLE, chairman of the vanguard group of investment companies said: in 30 years in this business, I do not know any one who has done it successfully and consistently, nor any body who knows any body who has done it successfully and consistently. Indeed, my impression is that trying to do market timing is likely to be counter productive. JOHN MAYNARD KEYNES rendered a similar verdict decades ago: we have not proved able to take much advantage of a general systematic out of and into ordinary shares as a whole at different phases of the trade cycle. As a result of these experiences I am clear that the idea of whole sale shifts is for various reasons impracticable and indeed undesirable. Sector rotation: The concept of sector rotation can be applied to stocks as well as bonds. It is, however, used more commonly with respect to the stock component of the portfolio


where it essentially involves shifting the weightings for various industrial sector based on their assessed outlook. For example, if you believe that cement and pharmaceutical sector would do well compared to other sector in the forthcoming period (one year, two years, or whatever,) you may overweight these sectors, relative to their position in the market portfolio. With respect to binds, sector rotation implies a shift in the composition of the bond portfolio in terms of quality (as reflected in credit rating ), coupon rate, term to maturity, and so on. For example. If you anticipate a rise in interest rates you may shift from long-term bonds to medium-term or even short-term bonds. Remember that a long-term is sensitive to interest rate variation compared to short-term bond. Security selection:

Perhaps the most commonly used vector by those who follow an active portfolio strategy, security selection involves a search for under-priced securities. If you resort to active stock selection, you amyl employ fundamental and or technical analysis to identify stocks which seem to promise superior returns and concentrate the stock component of your portfolio on them. Put differently, in your portfolio such will be over weighted relative to their position to their market portfolio. Like-wise, stocks which are perceived to be unattractive will be underweighted relative to position in their market portfolio. As far bonds are concerned, security selection calls for choosing bonds which offer the highest yield to maturity at a given level of risk. Use of a specialized investment concept: A fourth possible approach to achieve superior returns is to employ a specialized concept or philosophy, particularly with respect to investment in stocks. As CHARLES D.ELLIS put it, a possible way to enhance returns is to develop


profound and valid insight into the forces that drive a particular centre of the market or a particular group accompanies or industries and systematically exploit that investment insight or concept. Some of the concepts that have been exploited successfully by investment practitioners are

1. Growth stocks: 2. Neglected or out of favour stocks: 3. Asset-ridge stocks: 4. Technology stocks: 5. Cyclical stocks:

The advantage of cultivating a specialized investment concept or philosophy is that it will help you to: A) Focus your efforts on a certain kind of investment that reflect your abilities and talents, B) Avoid the distraction of pursuing other alternatives, and C) Master an approach or style though sustain practice and continual selfcritique. As against these merits, the great disadvantage of focusing exclusively on a specialized concept or philosophy is that it may become obsolete. The changes in market place may cast a shadow over the validity of the basic premise underlying the investment philosophy. Give your profound condition and long-term commitment to your specialized investment concept or philosophy, you may not detect the need for change till it becomes rather late.


Passive strategy: The active strategy is based on the premise that the capital market is characterized by inefficiencies which can be exploited by resorting to market timing or sector rotation or security selection or use of a specialized concept or some combination of these vectors. The passive strategy, on the other hand, rests on the tenant that he capital market is fairly efficient with respect to the available information. Hence, the search for superior returns through an active strategy is considered futile. Operationally, how is the passive strategy implemented? Basically, it involves adhering to the following two guide lines: 1. Create a well-diversified portfolio at a pre-determined level of risk. 2. Hold the portfolio relatively unchanged over time, unless it becomes in adequately 3. Diversified or inconsistent with the investors risk-return preferences. Selection of securities: Selection of bonds (fixed income avenues) You should carefully evaluate the following factors in selecting fixed income avenues 1. yield to maturity: 2. the yield to maturity for a fixed income avenue reoresents the rate of retun earned by the investor if he invests in the fixed income avenue and holds it till its maturity. 3. risk of default: 4. to asses the risk of default on a bond, you may look at the credit rating of the band. If no credit ratin is available, examine relevant financial ratios (like debt-to-equity ratio, times interest earned ratio, and earning power) of the firm and asses the general prospects of the industry to which the firm belongs.


a. in yester years, several fixed income avenues offered tax shield; now very few do so. b. Liquidity: If the fixed income avenue can be converted wholly or substantially into cash at a fairly short notice, it possesses liquidity of a high order. Selection of stocks (equity shares) Three broad approaches are employed for the selection of equity shares: technical analysis looks at price behavior and volume data to determine whether the share will move up or down or remain trend less. Fundamental analysis focuses on fundamental factors like the earnings level the growth prospects, and risk exposure to establish the intrinsic value and the prevailing market price. The random selection approach is based on the premise that the market is efficient and securities are properly priced. Portfolio execution: By the time the portfolio management is reached , several keys issues have been sorted out. Investment objectives and constraints have been specified, asset mix has been chosen, portfolio strategy has been developed, and specific securities to be included in the portfolio have been identified. The next step is to implement the portfolio plan by buying and or selling specified securities in given amounts. this is the phase of portfolio execution which is often glossed over in the portfolio management literature. However it is an important practical step that has an significant bearing on investment results. Further, it is neither simple nor costless as is sometimes naively felt. For effectively handling the portfolio execution phase, you should understand what the trading game is like, what is the nature of key players


(transactors) in this game, who are the likely winners and the losers in the game, and what guidelines should be borne in mind while trading. Trading game: Security transactions tend to differ from normal business transactions in two fundamental ways: 1) a business man entering in to a transaction does so with a reasonable understanding of the motives of the party on the other side of the transaction. For example, when you are buying a piece of machinery, you are well aware of the motives of the seller. In constrast, in a typical securities transaction, the motive , and even the identity, of the other party is not known. 2) While both parties generally gain from a business transaction, a security transaction tends to be a zero sum game. A security offers the same future cash flow stream to the buyer as well as the seller. So, apart from considerations of taxes and differential risk-bearing abilities, the value of security is the same to the buyer as well as the seller. Hence constructive motives which guide business transaction are not present in most security transactions. This means that if a security transaction benefits a party it hurts the other. Put differently, if one wins the other loses. Motives for trade: Why do people trade? One motivation is cognitive. People trade because they think they have superior information or better methods for analyzing information. However, most traders tend to confuse noise or randomness for information. As MEIRSTATMON says:


traders are patterns in stock prices that are random, and they relay on intuitive judgement even when systematic analysis would have demonstrated that their judgement in incorrect. Another motivation is emotional. Trading ca be a source of pride. As MEIRSTATMAN says; specifically people trade because trading brings with it the joy of pride. When someone decides to buy a stock he assumes responsibility for the decision. A stock that goes up brings not only profits, but also pride. Of course, if the trading decision turns out to be wrong it can inflict losses and cause embarrassment. Key players: Securities market appears to be thronged by four types of players or transactions: value-based transactors, information-based transactors, liquidity based transactors, and pseudo-information based transactors. Generally, the dealer or the market maker intermediates between these transactors. Value based transactors: A value based transactor (VBT, here after) carrier out extensive analysis of publicly available information to establish values. He trades when the difference between the value assessed by him and the prevailing market prices so warrants. Typically, he places limit orders to buy and sell with a spread that is large enough to provide a cushion against errors of judgement and informational lacunae. For example, a VBT who establishes an intrinsic value of RS 50 for some equity share may place an order to buy if the net price is RS 40 or less. VBT s generally serve as the anchor for the trading system and establish the framework for the operations for the dealers. VBT s typically dont place much important on time. Information based transactors:


An information based transactor ( IBT here after) transacts on the basis of information which is not in public domain and, therefore, not reflected in security prices. Since he expects this information to have a significant impact on prices, he is keen to transact soon. To him, time is a great value. While the VBT is concerned about how much the market will move towards the justified price. (the price established in him based on fundamental analysis ), the IBT is bothered about how soon the market price will move up or down in response to new information. The IBT generally employs incremental fundamental analysis (as he is concered about price movements in response to new information). In addition, he uses technical analysis because timing is crucial to his operations. Unlike the VBT, he rarely tries to establish the absolute value of a security. Instead, he tries to assess the likely impact of marginal fundamental and technical developments. Liquidity based transators: A VBT, like an IBT, trades to reap investment advantage. A liquidity based transactor (lbt, hereafter) however, trades primarily due to liquidity considerations. He trades to deploy surplus funds or to obtain funds or to rebalances the portfolio. His trades are not based on a detailed valuation exercise ( as is the case of VBT) or access to some information that is not already reflected in market price ( as is the case of an IBT) . Hence he may be regarded as an information less trader who is driven mainly by liquidity considerations. Pseudo-information Based transactors: A pseudo-information based transactor IPIBT, hereafter) believes that he possesses information that can be a source of gain, even though yhat information is already captured or impounded in the price of the security. Or, he exaggerates the value of new information that he may come across and forms unrealistic expectations.


Essentially, the PIBT, like the LBT, is an information less trader. Yet, he mistakenly believes that the possesses information which will generate investment advantage to him. Dealers: A dealer intermediates between buyers and sellers gager to transact. The dealer is ready to buy or sell with a spread which is failly small for an certain security may be 80-82. this means that the dealer is willing to buy at 80 and sell at 82. the dealers quotations may move swiftly in response to changes in demand and supply forces in the market. Typically the dealers bid-ask price band lies well with in the bid-ask price band set by the VBT. This means that the bid price of the dealer is higher than the bid price of the VBT and the ask price of the dealer is lower than the ask price of VBT. The dealers function is such that he is not required totake a view on whether a security is worth buying or worth selling.he simply plays the role of the intermediary and he does not plan to hold the position he acquires in accommodating a transaction. Hence the dealer is a remarkably innocuous person. Lurking behind the dealer, of the cource , is the transistors real trading adversary, whose identify and motive are often unknown. Exhibit summaries the trading trading motivations, time horizons, and time Transactor VBT IBT LBT PIBT Motivation Time horizon Time vs price

Discrepancy between Weeks to months value and price New information Hours to days release or absorb cash Apparently new Hours to days information 57

preference Price Time Time



Mutes to hours


Summary of trading Motivations, Time horizons, and Time vs price preferences Who wins, who loses Who wins and who loses in the trading game which is essentially a zero sum game. It appear that the IBTS odds of winning are the highest, assuming that his information is substantiated by the market he is followed by the VBT, LBT, and PIBT in the that order. Put differently, the, the above question may be answered as follows: The IBT seems to have a distinct edge over others. The VBT tends to lose against the IBT but gains against the LBT and PIBT. The LBT may have some advantage over the PIBT.

Scripts Which I Have Selected



R SHARE DATE PRICE 6/1/2006 6/2/2006 6/3/2006 6/5/2006 6/6/2006 6/7/2006 292.2000 289.3000 290.7500 289.5000 289.8500 289.8000 AVARAGE 297.1196 297.1196 297.1196 297.1196 297.1196 297.1196 DEVIATIONS -4.9196 -7.8196 -6.3696 -7.6196 -7.2696 -7.3196 DEVIATIONS 24.2025 61.1461 40.5718 58.0583 52.8471 53.5756 R R-R [R-R} SQUARE


6/8/2006 6/9/2006 6/10/2006 6/13/2006 6/14/2006 6/15/2006 6/16/2006 6/17/2006 6/19/2006 6/20/2006 6/21/2006 6/22/2006 6/23/2006 6/24/2006 6/26/2006 6/27/2006 6/28/2006 TOTAL

295.4000 293.6000 291.4500 290.1000 290.4000 288.2000 285.9500 284.9500 284.7500 304.8500 312.4560 310.7000 314.3000 310.7000 310.9000 310.0000 313.6500 6833.7500

297.1196 297.1196 297.1196 297.1196 297.1196 297.1196 297.1196 297.1196 297.1196 297.1196 297.1196 297.1196 297.1196 297.1196 297.1196 297.1196 297.1196

-1.7196 -3.5196 -5.6696 -7.0196 -6.7196 -8.9196 -11.1696 -12.1696 -12.3696 7.7304 15.3304 13.5804 17.1804 13.5804 13.7804 12.8804 16.5304

2.957 12.3876 32.1444 49.2748 45.153 79.5593 124.76 148.0992 153.007 59.7591 235.0211 184.4273 295.1661 184.4273 189.8994 165.9047 273.2541 2525.6037

Average (R) = 6833.7500/23 =297.1196 Variane = 1/23-1(2525.6037) Variance =114.8002 Standard Deviation = Variance Standard Deviation = 114.8002 Standard Deviation = 10.7145


R SHARE DATE 6/1/2006 6/2/2006 6/3/2006 6/5/2006 6/6/2006 PRICE 463.6500 461.5000 461.6000 459.5500 459.0500 R AVARAGE 445.6374 445.6374 445.6374 445.6374 445.6374 R-R DEVIATIONS 18.0126 15.8626 15.39626 13.9126 13.4126 [R-R]2SQUARE DEVIATIONS 251.622 254.8045 193.5604 179.8978 174.5728


6/7/2006 6/8/2006 6/9/2006 6/10/2006 6/13/2006 6/14/2006 6/15/2006 6/16/2006 6/17/2006 6/19/2006 6/20/2006 6/21/2006 6/22/2006 6/23/2006 6/24/2006 6/26/2006 6/27/2006 6/28/2006 TOTAL

458.8500 458.0000 457.2500 453.5500 453.2500 450.9000 450.1000 444.2000 440.3500 437.2500 431.2500 430.1000 429.3500 432.0500 433.1000 431.0000 429.7500 423.4000 10249.6500

445.6374 445.6374 445.6374 445.6374 445.6374 445.6374 445.6374 445.6374 445.6374 445.6374 445.6374 445.6374 445.6374 445.6374 445.6374 445.6374 445.6374 445.6374

13.2126 12.9626 11.6126 7.6126 7.6126 5.2626 4.4626 -1.4374 -5.2874 -8.33874 -14.3874 -15.2374 -16.2874 13.5874 -12.5374 -14.6374 -15.8874 -22.2374

168.029 134.8524 62.6092 57.9517 27.9649 19.9148 2.0661 27.9566 70.3485 206.9973 232.1784 232.1784 265.2794 184.6174 157.1864 214.2535 252.4095 494.502 3958.0283

Average (R) = 10249.6500/23 =445.6374 Variane = 1/23-1(3958.0283 Variance = 179.8981 Standard Deviation = Variance Standard Deviation = 179.8981 Standard Deviation = 13.4126



R SHARE DATE 6/1/2006 6/2/2006 6/3/2006 6/5/2006 6/6/2006 6/7/2006 6/8/2006 6/9/2006 6/10/2006 6/13/2006 6/14/2006 6/15/2006 6/16/2006 6/17/2006 6/19/2006 6/20/2006 6/21/2006 6/22/2006 6/23/2006 6/24/2006 6/26/2006 6/27/2006 6/28/2006 TOTAL PRICE 541.0000 529.8500 533.1500 555.2000 552.3000 547.8500 558.4500 559.0500 566.5500 569.6000 574.0500 574.9500 590.2500 600.2500 630.5000 646.1500 654.5500 650.6000 654.6500 648.6500 629.5500 641.8500 642.5500 13651.5500 R AVARAGE 593.5456 593.5456 593.5456 593.5456 593.5456 593.5456 593.5456 593.5456 593.5456 593.5456 593.5456 593.5456 593.5456 593.5456 593.5456 593.5456 593.5456 593.5456 593.5456 593.5456 593.5456 593.5456 593.5456 R-R DEVIATIONS -52.5456 -63.6956 -60.6956 -38.3456 -41.2456 -45.6956 -35.0956 -34.4956 -26.9956 -23.9456 -19.4956 -26.9956 -3.2956 6.7044 36.9544 52.6044 61.0044 57.0544 61.1044 55.1044 36.0044 48.3044 49.0044 [R-R]2SQUARE DEVIATIONS 2761.0401 4057.1294 3647.6285 1470.385 1701.1995 2088.0879 1231.7011 1189.9464 726.6044 573.3918 380.0784 345.7963 10.8609 44.9489 1365.6276 2767.2228 3721.5368 3255.2045 3733.4948 3036.4948 1296.3168 2333.315 2401.4312 44139.6957


Average (R) = 13651.55/23 = 593.5456 Variane = 1/23-1(44139.6957) Variance = 2006.3498 Standard Deviation = Variance Standard Deviation = 2006.3498 Standard Deciation = 44.7922


R R SHARE PRICE AVARAGE DATE 6/1/2006 6/2/2006 6/3/2006 6/5/2006 6/6/2006 6/7/2006 6/8/2006 6/9/2006 6/10/2006 6/13/2006 6/14/2006 6/15/2006 6/16/2006 6/17/2006 6/19/2006 6/20/2006 6/21/2006 6/22/2006 6/23/2006 6/24/2006 6/26/2006 6/27/2006 6/28/2006 TOTAL 905.6000 898.6500 900.6000 903.0500 905.0500 901.9000 899.5500 900.0000 900.0500 900.0000 886.5500 899.3000 879.5500 886.0000 895.3000 897.8500 914.0000 920.3000 922.4000 922.7500 897.8500 888.6000 830.0000 20654.9000 898.0435 898.0435 898.0435 898.0435 898.0435 898.0435 898.0435 898.0435 898.0435 898.0435 898.0435 898.0435 898.0435 898.0435 898.0435 898.0435 898.0435 898.0435 898.0435 898.0435 898.0435 898.0435 898.0435 DEVIATIONS 7.5565 0.6065 2.5565 5.0065 7.0065 3.8565 1.5065 1.9565 2.0065 1.9565 -11.4935 1.2565 -18.4935 -12.0435 -2.7435 -0.1935 -15.9565 22.2565 24.7065 24.3565 -0.1935 -9.4435 -68.0435 DEVIATIONS 57.1006 0.3678 6.5357 25.065 49.091 14.8726 2.2695 3.8279 4.026 3.8279 132.1005 1.5788 342.0095 145.0459 7.5267 0.0374 254.6099 495.3518 593.23914 610.4111 0.0374 89.1797 4626.9179 7468.0298 R-R [R-R]2SQUARE

Average (R) = 20654.9000/23 =898.0435 Variane = 1/23-1(7468.0298)


Variance =339.4559 Standard Deviation = Variance Standard Deviation = 339.4559 Standard Deviation = 18.4243 STANDARD

Indian Oil Cipla Jindal Steel 445.6374 297.1196 898.0435

44.7922 13.4126 10.7145 18.4243





DATE 6/1/2006 6/2/2006 6/3/2006 6/5/2006

RA-RA -4.9196 -7.8196 -6.3696 -7.6196

RB-RB 10.5848 0.7848 -0.1152 -3.7152

(RA-RA)(RB-RB) -52.0729 -6.1368 0.7338 28.3083


6/6/2006 6/7/2006 6/8/2006 6/9/2006 6/10/2006 6/13/2006 6/14/2006 6/15/2006 6/16/2006 6/17/2006 6/19/2006 6/20/2006 6/21/2006 6/22/2006 6/23/2006 6/24/2006 6/26/2006 6/27/2006 6/28/2006 TOTAL

-7.2696 -7.3196 -1.7196 -3.5196 -5.6696 -7.0196 -6.7196 -8.9196 -11.1696 -12.1696 -12.3696 7.7304 15.3304 13.5804 17.1804 13.5804 13.7804 12.8804 16.5304

0.7348 3.1848 10.8348 18.6348 6.7348 11.4348 13.5348 11.5348 10.1348 5.1848 3.4348 -2.8152 -16.0152 -19.0152 -20.4152 -3.9652 -21.6152 -17.4652 -1.6152

-5.3417 -23.3115 -18.6315 -65.5870 -38.1836 -80.2677 -90.9484 -102.8858 -113.2017 -63.0969 -42.4871 -21.7626 -245.5519 -258.2340 -350.7413 -53.849 -284.0857 -224.9588 -26.6999 -2138.9937

CO-Variance (COVAB)=1/23 (-2138.9937) -92.9997 COVAB Correlation Coefficient (PAB)= (Std.A) (Std.B) -99.9997 -0.7349 (10.7145)(11.81)




P =

X 2 1

12 + X22 22 + 2(X1) (X2) (12) 12 = Proportion of Investment in Security 2. X2 = Proportion of Investment in Security 1.

Where X1


1 2
X 12

= Standard Deviation of Security 1. = Standard Deviation of Security 2. = Correlation Co-Efficient between Security 1 and 2. = Portfolio Risk.

1. CIPLA & RELIANCE X1 = 0.83 1 = 11.81 X12 = -0.6442 X2 = 0.17 P =

X 2 1

2 = 44.7922

12 + X22 22 + 2(X1) (X2) (12) 12

2 2 2 2 (0.83) (11.81) + (0.17) (44.7922) +2(0.83)(0.17)


0.6889 139.4761 + 0.0289 2006.3412 + 96.1679

96.0851 + 154.1516



P =

X 2 1

12 + X22 22 + 2(X1) (X2) (12) 12 = Proportion of Investment in Security 2. X2 1 = Proportion of Investment in Security 1. = Standard Deviation of Security 1. 66

Where X1

X 12

= Standard Deviation of Security 2. = Correlation Co-Efficient between Security 1 and 2.

= Portfolio Risk.


X1 = 0.68

1 = 13.4126 X12 = -0.9343

X2 = 0.32 P =
X 2 1

2 = 44.7922

12 + X22 22 + 2(X1) (X2) (12) 1

2 2 2 2 (0.68) (13.4126) + (0.32) (44.7922) +2(0.68)(0.32) (-0.9343) (13.4126)(44.7922)

83.1847 + 205.4493 244.2815 6.66

PORTFOLIO WEIGHTS CIPLA & RELIANC FORMULA: 2b Pab a b Xa = 2a + 2b -2Pab a b Xb = 1 Xa Xa = CIPLA Xb = RELIANCE 67

a = 11.81

b = 44.7922

Pab = -0.64422

2 (44.7922) (-0.6442) (11.81) (44.7922)

Xa =

(11.81)2 + (44.7922)2 2(-0.6442) (11.81 ) (44.7922) 2006.3412 + 340.7791 = 139.4761 + 2006.3411 + 681. 2347.1203 = 2827.3754

= 0.83

Xb = 1 Xa

Xb = 1 0.83

= 0.17

RELIANCE & IOC FORMULA: 2b Pab a b Xa = 2a + 2b -2Pab a b Xb = 1 Xa Xa = IOC Xb = RELIANCE a = 13.4126 b = 44.7922 Pab = -0.9343


2 (44.7922) (-0.9343) (13.4126) (44.7922)

Xa =

(13.4126)2 + (44.7922)2 2(-0.9343) (13.4126 ) (44.7922)

2006.3412 + 561.3086 = 179.8978 + 2479.2639 + 1122.6172

2567.6498 = 3781.7782

= 0.68 Xb = 1 Xa Xb = 1 0.68 = 0.32



In this combination, as per calculations and study CIPLA bears a proportion of 0.83 and where as RELIANCE bears a proportion of 0.17, which is less compared CIPLAproportion, the deviation of two companies are 11.8100 for CIPLA and 44.7922 for RELIANCE


Here risk of CIPLA is lesser than the RELIANCE i.e. 11.8100<44.7922. So investors can invest their money or fund in CIPLA, which has less standard deviation means less risk. Where as, the portfolio risk of two companies are reduced to 15.8189.


As per this combination portfolio weights are 0.68 and 0.32 for Indian Oil and Reliance respectively and standard deviation of Indian Oil is 13.4126 which is less compare to the standard deviation of Reliance i.e. 44.7922, which means less risk involved in Indian Oil compare to Reliance. So, to any investor wants to invest his money or fund in this portfolio, it is suggested that he can invest some portion of fund in Indian Oil and rest of part in Reliance. The portfolio risk of the companies Reliance and Indian Oil 6.6600, which is less than the individual companies risk


V A avadhani, Security Analysis and Portfolio Management, Himalaya publishing house,Pp 1-18, Ibid. 436-450. Donald E fisher and Ronald j jardan, Security Analysis and Portfolio Management, 6th edition, Pearson education, Pp 2-5.


Ibid. 285. S.Kevin, Portfolio Management, Prentic, hall India pvt ltd.2003, Pp 1-18. Prasanna Chandra, Investment Analysis Portfolio Management, Tata Mc Graw-hill Publishing Company ltd, Pp 218-220. V k Bhalla, Investment management, 10th edition, S chand and company Ltd, Pp 701710.

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