P. 1
Investment Analysis and Portfolio Management

Investment Analysis and Portfolio Management

|Views: 1|Likes:
Published by Himanshu Singhal

More info:

Published by: Himanshu Singhal on Mar 22, 2012
Copyright:Attribution Non-commercial

Availability:

Read on Scribd mobile: iPhone, iPad and Android.
download as PDF, TXT or read online from Scribd
See more
See less

03/22/2012

pdf

text

original

Test Det ai l s

Sr . Name of Modu l e Fees Test No. of Max i m u m Pass Cer t i f i cat e
No. ( Rs. ) Du r at i on Qu est i on s Mar k s Mar k s Val i di t y
( i n ( % ) ( i n year s)
mi n u t es)
1 Financial Market s: A Beginners' Module 1500 120 60 100 50 5
2 Mut ual Funds : A Beginners' Module 1500 120 60 100 50 5
3 Currency Derivat ives: A Beginner' s 750 60 50 100 50 5
Module # # #
4 Equit y Derivat ives: A Beginner' s 750 60 50 100 50 5
Module # # #
5 I nt erest Rat e Derivat ives: A Beginner' s 1500 120 60 100 50 5
Module
6 Securit ies Market ( Basic) Module 1500 105 60 100 60 5
7 Capit al Market ( Dealers) Module * 1500 105 60 100 50 5
8 Derivat ives Market ( Dealers) Module * * 1500 120 60 100 60 3
9 FI MMDA- NSE Debt Market ( Basic) Module 1500 120 60 100 60 5
10 I nvest ment Analysis and Port f olio 1500 120 60 100 60 5
Management Module
11 NI SM- Series- I : Currency Derivat ives 1000 120 60 100 60 3
Cert if icat ion Examinat ion
12 NI SM- Series- I I -A: Regist rars t o an I ssue 1000 120 100 100 50 3
and Share Transf er Agent s -
Corporat e Cert if icat ion Examinat ion
13 NI SM- Series- I I - B: Regist rars t o an I ssue 1000 120 100 100 50 3
and Share Transf er Agent s - Mut ual Fund
Cert if icat ion Examinat ion
14 NSDL- Deposit ory Operat ions Module 1500 75 60 100 60 # 5
15 Commodit ies Market Module 1800 120 60 100 50 3
16 AMFI - Mut ual Fund ( Basic) Module 1000 90 62 100 50 No limit
17 AMFI - Mut ual Fund ( Advisors) Module # # 1000 120 72 100 50 5
18 Surveillance in St ock Exchanges Module 1500 120 50 100 60 5
19 Corporat e Governance Module 1500 90 100 100 60 5
20 Compliance Of f icers ( Brokers) Module 1500 120 60 100 60 5
21 Compliance Of f icers ( Corporat es) Module 1500 120 60 100 60 5
22 I nf ormat ion Securit y Audit ors Module 2250 120 90 100 60 2
( Part - 1)
I nf ormat ion Securit y Audit ors Module 2250 120 90 100 60
( Part - 2)
23 FPSB I ndia Exam 1 t o 4* * * 2000 120 75 140 60 NA
per
exam
24 Opt ions Trading St rat egies Module 1500 120 60 100 60 5
* Candidat es have t he opt ion t o t ake t he CMDM t est in English, Guj arat i or Hindi language. The workbook f or t he
module is present ly available in ENGLI SH.
* * Candidat es have t he opt ion t o t ake t he DMDM t est in English, Guj arat i or Hindi language. The workbook f or t he
module is also available in ENGLI SH, GUJARATI and HI NDI languages.
# Candidat es securing 80% or more marks in NSDL- Deposit ory Operat ions Module ONLY will be cert if ied as ' Trainers' .
# # Candidat es have t he opt ion t o t ake t he AMFI ( Adv) t est in English, Guj arat i or Hindi languages. The workbook f or
t he module, which is available f or a f ee at AMFI , remains in ENGLI SH.
# # # Revision in t est f ees and t est paramet ers wit h ef f ect f rom April 01, 2010. Please ref er t o circular NSE/ NCFM/
13815 dat ed 01-Jan- 2010 f or det ails.
* * * Modules of Financial Planning St andards Board I ndia ( Cert if ied Financial Planner Cert if icat ion) i. e. ( i) Risk Analysis
& I nsurance Planning (ii) Ret irement Planning & Employee Benef it s ( iii) I nvest ment Planning and ( iv) Tax Planning
& Est at e Planning.
The curriculum f or each of t he module ( except FPSB I ndia Exam 1 t o 4) is available on our websit e: www. nseindia. com
> NCFM > Curriculum & St udy Mat erial.
PDF created with pdfFactory trial version www.pdffactory.com
1
CONTENTS
CHAPTER 1: OBJECTI VES OF I NVESTMENT DECI SI ONS ......................................... 1
1.1 I nt roduct ion ............................................................................................... 1
1.2 Types of invest ors ....................................................................................... 1
1.2.1 I ndividuals ............................................................................................. 1
1.2.2 I nst it ut ions ............................................................................................ 2
1.2.2.1 Mut ual funds ................................................................................. 2
1.2.2.2 Pension funds ................................................................................ 2
1.2.2.3 Endowment funds .......................................................................... 3
1.2.2.4 I nsurance companies ( Life and Non- life) ............................................. 3
1.2.2.5 Banks ............................................................................................. 3
1.3 Const raint s ................................................................................................. 4
1.3.1 Liquidit y ................................................................................................ 4
1.3.2 I nvest ment horizons ............................................................................... 4
1.3.3 Taxat ion ................................................................................................ 5
1.4 Goals of I nvest ors ....................................................................................... 5
CHAPTER 2: FI NANCI AL MARKETS ........................................................................ 6
2.1 I nt roduct ion ............................................................................................... 6
2.2 Primary and Secondary Market s .................................................................... 6
2.3 Trading in Secondary Market s ....................................................................... 7
2.3.1 Types of Orders ...................................................................................... 7
2.3.2 Mat ching of Orders ................................................................................. 8
2.4 The Money Market ....................................................................................... 9
2.4.1 T- Bills ................................................................................................... 9
2.4.2 Commercial Paper .................................................................................. 9
2.4.3 Cert ificat es of Deposit ........................................................................... 10
2.5 Repos and Reverses................................................................................... 10
2.6 The Bond Market ....................................................................................... 11
2.6.1 Treasury Not es ( T- Not es) and T- Bonds.................................................... 11
2.6.2 St at e and Municipal Government bonds ................................................... 11
2.6.3 Corporat e Bonds .................................................................................. 11
2.6.4 I nt ernat ional Bonds .............................................................................. 12
PDF created with pdfFactory trial version www.pdffactory.com
2
2.6.5 Ot her t ypes of bonds ............................................................................ 12
2.7 Common St ocks ........................................................................................ 13
2.7.1 Types of shares .................................................................................... 14
CHAPTER 3 FI XED I NCOME SECURI TI ES ............................................................. 15
3.1 I nt roduct ion: The Time Value of Money ........................................................ 15
3.2 Simple and Compound I nt erest Rat es .......................................................... 15
3.2.1 Simple I nt erest Rat e ............................................................................. 15
3.2.2 Compound I nt erest Rat e ....................................................................... 16
3.3 Real and Nominal I nt erest Rat es ................................................................. 18
3.4 Bond Pricing Fundament als ......................................................................... 19
3.4.1 Clean and dirt y prices and accrued int erest .............................................. 20
3.5 Bond Yields .............................................................................................. 20
3.5.1 Coupon yield ........................................................................................ 20
3.5.2 Current Yield ........................................................................................ 20
3.5.3 Yield t o mat urit y ................................................................................... 21
3.5.4 Yield t o call .......................................................................................... 23
3.6 I nt erest Rat es ........................................................................................... 24
3.6.1 Short Rat e ........................................................................................... 24
3.6.2 Spot Rat e ............................................................................................ 24
3.6.3 Forward Rat e ....................................................................................... 25
3.6.4 The t erm st ruct ure of int erest rat es ........................................................ 26
3.7 Macaulay Durat ion and Modified Durat ion ..................................................... 28
CHAPTER 4 CAPI TAL MARKET EFFI CI ENCY .......................................................... 32
4.1 I nt roduct ion ............................................................................................. 32
4.2 Market Efficiency ....................................................................................... 32
4.2.1 Weak- form Market Efficiency .................................................................. 32
4.2.2 Semi- st rong Market Efficiency ................................................................ 32
4.2.3 St rong Market Efficiency ........................................................................ 33
4.3 Depart ures from t he EMH ........................................................................... 33
CHAPTER 5: FI NANCI AL ANALYSI S AND VALUATI ON .......................................... 35
5.1 I nt roduct ion ............................................................................................. 35
5.2 The Analysis of Financial St at ement ............................................................. 35
PDF created with pdfFactory trial version www.pdffactory.com
3
5.2.1 I ncome St at ement ( Profit & Loss) ........................................................... 36
5.2.2 The Balance Sheet ................................................................................ 36
5.2.3 Cash Flow St at ement ............................................................................ 37
5.3 Financial Rat ios ( Ret urn, Operat ion and, Profit abilit y Rat ios) .......................... 38
5.3.1 Measures of Profit abilit y: RoA, RoE ......................................................... 39
5.3.2 Measures of Liquidit y ............................................................................ 39
5.3.3 Capit al St ruct ure and Solvency Rat ios ..................................................... 39
5.3.4 Operat ing Performance ......................................................................... 39
5.3.5 Asset Ut ilizat ion ................................................................................... 39
5.4 The valuat ion of common st ocks ................................................................. 40
5.4.1 Absolut e ( I nt rinsic) Valuat ion ................................................................. 40
5.4.2 Relat ive Valuat ion ................................................................................. 44
5.5 Technical Analysis ..................................................................................... 49
5.5.1 Challenges t o Technical Analysis ............................................................. 50
CHAPTER 6: MODERN PORTFOLI O THEORY ......................................................... 51
6.1 I nt roduct ion ............................................................................................. 51
6.2 Diversificat ion and Port folio Risks ................................................................ 51
6.2.1 Port folio variance - General case ............................................................ 56
6.3 Equilibrium Module: The Capit al Asset Pricing Module .................................... 57
6.3.1 Mean- Variance I nvest ors and Market Behaviour ....................................... 58
6.3.2 Est imat ion of Bet a ................................................................................ 63
6.4 Mult ifact or Modules ................................................................................... 64
CHAPTER 7: VALUATI ON OF DERI VATI VES ......................................................... 66
7.1 I nt roduct ion ............................................................................................. 66
7.2 Forwards and Fut ures ................................................................................ 66
7.3 Call and Put Opt ions .................................................................................. 68
7.4 Forward and Fut ure Pricing ......................................................................... 68
7.4.1 Cost - of carry and convenience yield ........................................................ 69
7.4.2 Backwardat ion and Cont ango ................................................................. 70
7.5 Opt ion Pricing ........................................................................................... 70
7.5.1 Payoffs from opt ion cont ract s ................................................................. 70
7.5.2 Put - call parit y relat ionship ..................................................................... 72
7.6 Black- Scholes formula...................................................................................... 73
PDF created with pdfFactory trial version www.pdffactory.com
4
CHAPTER 8: I NVESTMENT MANAGEMENT ............................................................ 75
8.1 I nt roduct ion ............................................................................................. 75
8.2 I nvest ment Companies .............................................................................. 75
8.2.1 Benefit s of invest ment s in managed funds ............................................... 76
8.3 Act ive vs. Passive Port folio Management ...................................................... 76
8.4 Cost s of Management : Ent ry/ Exit Loads and Fees .......................................... 78
8.5 Net Asset Value ......................................................................................... 78
8.6 Classificat ion of funds ................................................................................ 79
8.6.1 Open ended and closed- ended funds ....................................................... 79
8.6.2 Equit y funds ........................................................................................ 79
8.6.3 Bond funds .......................................................................................... 80
8.6.4 I ndex funds ......................................................................................... 80
8.6.5 Money market funds ............................................................................. 80
8.6.6 Fund of funds ....................................................................................... 80
8.7 Ot her I nvest ment Companies ..................................................................... 80
8.7.1 Unit I nvest ment Trust s ( UTI ) ................................................................. 80
8.7.2 REI TS ( Real Est at e I nvest ment Trust s) .................................................... 81
8.7.3 Hedge Funds ........................................................................................ 81
8.8 Performance assessment of managed funds ................................................. 81
8.8.1 Sharpe Rat io ........................................................................................ 82
8.8.2 Treynor Rat io ....................................................................................... 82
8.8.3 Jensen measure or ( Port folio Alpha) ........................................................ 82
MODEL TEST ................................................................................................. 82
PDF created with pdfFactory trial version www.pdffactory.com
5
Di st r i but i on of w ei ght s i n t he
I nvest ment Anal ysi s and Por t f ol i o Management Modul e Cur r i cul um
Chapt er Ti t l e Wei ghs ( % )
No
1 Obj ect ives of I nvest ment Decisions 9
2 Financial Market s 13
3 Fixed I ncome Securit ies 12
4 Capit al Market Efficiency 8
5 Financial Analysis and Valuat ion 23
6 Modern Port folio Theory 10
7 Valuat ion of Derivat ives 12
8 I nvest ment Management 13
Not e: Candidat es are advised t o refer t o NSE' s websit e: www.nseindia.com, click on ' NCFM'
link and t hen go t o 'Announcement s' link, regarding revisions/ updat ions in NCFM modules or
launch of new modules, if any.
Copyright © 2010 by Nat ional St ock Exchange of I ndia Lt d. ( NSE)
Exchange Plaza, Bandra Kurla Complex,
Bandra ( East ) , Mumbai 400 051 I NDI A
All cont ent included in t his book, such as t ext , graphics, logos, images, dat a compilat ion et c.
are t he propert y of NSE. This book or any part t hereof should not be copied, reproduced,
duplicat ed, sold, resold or exploit ed for any commercial purposes. Furt hermore, t he book in it s
ent iret y or any part cannot be st ored in a ret rieval syst em or t ransmit t ed in any form or by any
means, elect ronic, mechanical, phot ocopying, recording or ot herwise.
PDF created with pdfFactory trial version www.pdffactory.com
6
CHAPTER 1 : Obj ect i ves of I nvest ment Deci si ons
1.1 I nt r oduct i on
I n an economy, people indulge in economic act ivit y t o support t heir consumpt ion requirement s.
Savings arise from deferred consumpt ion, t o be invest ed, in ant icipat ion of fut ure ret urns.
I nvest ment s could be made int o financial asset s, like st ocks, bonds, and similar inst rument s
or int o real asset s, like houses, land, or commodit ies.
Our aim in t his book is t o provide a brief overview of t hree aspect s of invest ment : t he various
opt ions available t o an invest or in financial inst rument s, t he t ools used in modern finance t o
opt imally manage t he financial port folio and last ly t he professional asset management indust ry
as it exist s t oday.
Ret urns more oft en t han not differ across t heir risk profiles, generally rising wit h t he expect ed
risk, i.e., higher t he ret urns, higher t he risk. The underlying obj ect ive of port folio management
is t herefore t o creat e a balance bet ween t he t rade- off of ret urns and risk across mult iple asset
classes. Port folio management is t he art of managing t he expect ed ret urn requirement for t he
corresponding risk t olerance. Simply put , a good port folio manager ’s obj ect ive is t o maximize
t he ret urn subj ect t o t he risk- t olerance level or t o achieve a pre- specified level of ret urn wit h
minimum risk.
I n our first chapt er, we st art wit h t he various t ypes of invest ors in t he market s t oday, t heir
ret urn requirement s and t he various const raint s t hat an invest or faces.
1.2 Ty pes of i nv est or s
There is wide diversit y among invest ors, depending on t heir invest ment st yles, mandat es,
horizons, and asset s under management . Primarily, invest ors are eit her individuals, in t hat
t hey invest for t hemselves or inst it ut ions, where t hey invest on behalf of ot hers. Risk appet it es
and ret urn requirement s great ly vary across invest or classes and are key det erminant s of t he
invest ing st yles and st rat egies followed as also t he const raint s faced. A quick look at t he broad
groups of invest ors in t he market illust rat es t he point .
1.2.1 I ndi vi dual s
While in t erms of numbers, individuals comprise t he single largest group in most market s, t he
size of t he port folio of each invest or is usually quit e small. I ndividuals differ across t heir risk
appet it e and ret urn requirement s. Those averse t o risk in t heir port folios would be inclined
t owards safe invest ment s like Government securit ies and bank deposit s, while ot hers may be
risk t akers who would like t o invest and / or speculat e in t he equit y market s. Requirement s of
individuals also evolve according t o t heir life-cycle posit ioning. For example, in I ndia, an individual
PDF created with pdfFactory trial version www.pdffactory.com
7
in t he 25- 35 years age group may plan for purchase of a house and vehicle, an individual
belonging t o t he age group of 35- 45 years may plan for children’s educat ion and children’s
marriage, an individual in his or her fift ies would be planning for post - ret irement life. The
invest ment port folio t hen changes depending on t he capit al needed for t hese requirement s.
1.2.2 I nst i t ut i ons
I nst it ut ional invest ors comprise t he largest act ive group in t he financial market s. As ment ioned
earlier, inst it ut ions are represent at ive organizat ions, i.e., t hey invest capit al on behalf of ot hers,
like individuals or ot her inst it ut ions. Asset s under management are generally large and managed
professionally by fund managers. Examples of such organizat ions are mut ual funds, pension
funds, insurance companies, hedge funds, endowment funds, banks, privat e equit y and vent ure
capit al firms and ot her financial inst it ut ions. We briefly describe some of t hem here.
Box No. 1.1:
The I ndian financial market s are also wit nessing act ive part icipat ion by inst it ut ions wit h
foreign inst it ut ional invest ors, domest ic mut ual funds, and domest ic insurance companies
comprising t he t hree maj or groups, owning more t han a t hird of t he shareholding in list ed
companies, wit h t he Government and promot ers anot her 50%. Over t he years t he share of
inst it ut ions has risen in share ownership of companies.
1.2.2.1 Mut ual f unds
I ndividuals are usually const rained eit her by resources or by limit s t o t heir knowledge of t he
invest ment out look of various financial asset s (or bot h) and t he difficult y of keeping abreast of
changes t aking place in a rapidly changing economic environment . Given t he small port folio
size t o manage, it may not be opt imal for an individual t o spend his or her t ime analyzing
various possible invest ment st rat egies and devise invest ment plans and st rat egies accordingly.
I nst ead, t hey could rely on professionals who possess t he necessary expert ise t o manage t hier
funds wit hin a broad, pre-specified plan. Mut ual funds pool invest ors’ money and invest according
t o pre- specified, broad paramet ers. These funds are managed and operat ed by professionals
whose remunerat ions are linked t o t he performance of t he funds. The profit or capit al gain
from t he funds, aft er paying t he management fees and commission is dist ribut ed among t he
individual invest ors in proport ion t o t heir holdings in t he fund. Mut ual funds vary great ly,
depending on t heir invest ment obj ect ives, t he set of asset classes t hey invest in, and t he
overall st rat egy t hey adopt t owards invest ment s.
1.2.2.2 Pensi on f unds
Pension funds are creat ed ( eit her by employers or employee unions) t o manage t he ret irement
funds of t he employees of companies or t he Government . Funds are cont ribut ed by t he employers
and employees during t he working life of t he employees and t he obj ect ive is t o provide benefit s
PDF created with pdfFactory trial version www.pdffactory.com
8
t o t he employees post t heir ret irement . The management of pension funds may be in- house or
t hrough some financial int ermediary. Pension funds of large organizat ions are usually very
large and form a subst ant ial invest or group for various financial inst rument s.
1.2.2.3 Endow ment f unds
Endowment funds are generally non- profit organizat ions t hat manage funds t o generat e a
st eady ret urn t o help t hem fulfill t heir invest ment obj ect ives. Endowment funds are usually
init iat ed by a non-refundable capit al cont ribut ion. The cont ribut or generally specifies t he purpose
(specific or general) and appoint s t rust ees t o manage t he funds. Such funds are usually managed
by charit able organizat ions, educat ional organizat ion, non- Government organizat ions, et c.
The invest ment policy of endowment funds needs t o be approved by t he t rust ees of t he funds.
1.2.2.4 I nsur ance compani es ( Li f e and Non- l i f e)
I nsurance companies, bot h life and non- life, hold large port folios from premiums cont ribut ed
by policyholders t o policies t hat t hese companies underwrit e. There are many different kinds
of insurance polices and t he premiums differ accordingly. For example, unlike t erm insurance,
assurance or endowment policies ensure a ret urn of capit al t o t he policyholder on mat urit y,
along wit h t he deat h benefit s. The premium for such poliices may be higher t han t erm policies.
The invest ment st rat egy of insurance companies depends on act uarial est imat es of t iming and
amount of fut ure claims. I nsurance companies are generally conservat ive in t heir at t it ude
t owards risks and t heir asset invest ment s are geared t owards meet ing current cash flow needs
as well as meet ing perceived fut ure liabilit ies.
1.2.2.5 Bank s
Asset s of banks consist mainly of loans t o businesses and consumers and t heir liabilit ies
comprise of various forms of deposit s from consumers. Their main source of income is from
what is called as t he int erest rat e spread, which is t he difference bet ween t he lending rat e
( rat e at which banks earn) and t he deposit rat e ( rat e at which banks pay) . Banks generally do
not lend 100% of t heir deposit s. They are st at ut orily required t o maint ain a cert ain port ion of
t he deposit s as cash and anot her port ion in t he form of liquid and safe asset s ( generally
Government securit ies) , which yield a lower rat e of ret urn. These requirement s, known as t he
Cash Reserve Rat io ( CRR rat io) and St at ut ory Liquidit y Rat io ( SLR rat io) in I ndia, are st ipulat ed
by t he Reserve Bank of I ndia and banks need t o adhere t o t hem.
I n addit ion t o t he broad cat egories ment ioned above, invest ors in t he market s are also classified
based on t he obj ect ives wit h which t hey t rade. Under t his classificat ion, t here are hedgers,
speculat ors and arbit rageurs. Hedgers invest t o provide a cover for risks on a port folio t hey
already hold, speculat ors t ake addit ional risks t o earn supernormal ret urns and arbit rageurs
t ake simult aneous posit ions ( say in t wo equivalent asset s or same asset in t wo different
PDF created with pdfFactory trial version www.pdffactory.com
9
market s et c.) t o earn riskless profit s arising out of t he price different ial if t hey exist .
Anot her cat egory of invest ors include day- t raders who t rade in order t o profit from int ra- day
price changes. They generally t ake a posit ion at t he beginning of t he t rading session and
square off t heir posit ion lat er during t he day, ensuring t hat t hey do not carry any open posit ion
t o t he next t rading day. Traders in t he market s not only invest direct ly in securit ies in t he so-
called cash market s, t hey also invest in derivat ives, inst rument s t hat derive t heir value from
t he underlying securit ies.
1.3 Const r ai nt s
Port folio management is usually a const rained opt imizat ion exercise: Every invest or has some
const raint ( limit s) wit hin which she want s t he port folio t o lie, t ypical examples being t he risk
profile, t he t ime horizon, t he choice of securit ies, opt imal use of t ax rules et c. The professional
port folio advisor or manager also needs t o consider t he const raint set of t he invest ors while
designing t he port folio; besides having some const raint s of his or her own, like liquidit y, market
risk, cash levels mandat ed across cert ain asset classes et c.
We provide a quick out line of t he various const raint s and limit at ions t hat are faced by t he
broad cat egories of invest ors ment ioned above.
1.3.1 Li qui di t y
I n invest ment decisions, liquidit y refers t o t he market abilit y of t he asset , i.e., t he abilit y and
ease of an asset t o be convert ed int o cash and vice versa. I t is generally measured across t wo
different paramet ers, viz., ( i) market breadt h, which measures t he cost of t ransact ing a given
volume of t he securit y, t his is also referred t o as t he impact cost ; and ( ii) market dept h, which
measures t he unit s t hat can be t raded for a given price impact , simply put , t he size of t he
t ransact ion needed t o bring about a unit change in t he price. Adequat e liquidit y is usually
charact erized by high levels of t rading act ivit y. High demand and supply of t he securit y would
generally result in low impact cost s of t rading and reduce liquidit y risk.
1.3.2 I nvest ment hor i zons
The invest ment horizon refers t o t he lengt h of t ime for which an invest or expect s t o remain
invest ed in a part icular securit y or port folio, before realizing t he ret urns. Knowing t he invest ment
horizon helps in securit y select ion in t hat it gives an idea about invest ors’ income needs and
desired risk exposure. I n general, invest ors wit h short er invest ment horizons prefer asset s
wit h low risk, like fixed- income securit ies, whereas for longer invest ment horizons invest ors
look at riskier asset s like equit ies. Risk- adj ust ed ret urns for equit y are generally found t o be
higher for longer invest ment horizon, but lower in case of short invest ment horizons, largely
due t o t he high volat ilit y in t he equit y market s. Furt her, cert ain securit ies require commit ment
PDF created with pdfFactory trial version www.pdffactory.com
10
t o invest for a cert ain minimum invest ment period, for example in I ndia, t he Post Office savings
or Government small- saving schemes like t he Nat ional Savings Cert ificat e ( NSC) have a
minimum mat urit y of 3- 6 years.
I nvest ment horizon also facilit at es in making a decision bet ween invest ing in a liquid or relat ively
illiquid invest ment . I f an invest or want s t o invest for a longer period, liquidit y cost s may not be
a significant fact or, whereas if t he invest ment horizon is a short period ( say 1 mont h) t hen t he
impact cost ( liquidit y) becomes significant as it could form a meaningful component of t he
expect ed ret urn.
1.3.3 Tax at i on
The invest ment decision is also affect ed by t he t axat ion laws of t he land. I nvest ors are always
concerned wit h t he net and not gross ret urns and t herefore t ax-free invest ment s or invest ment s
subj ect t o lower t ax rat e may t rade at a premium as compared t o invest ment s wit h t axable
ret urns. The following example will give a bet t er underst anding of t he concept :
Tabl e 1.1:
Asset Type Ex pect ed Ret ur n Net Ret ur n
A 10% t axable bonds ( 30% t ax) 10% 10%* ( 1- 0.3) = 7%
B 8% t ax- free bonds 8% 8%
Alt hough asset A carries a higher coupon rat e, t he net ret urn for t he invest ors would be higher
for asset B and hence asset B would t rade at a premium as compared t o asset A. I n some
cases t axat ion benefit s on cert ain t ypes of income are available on specific invest ment s. Such
t axat ion benefit s should also be considered before deciding t he invest ment port folio.
1.4 Goal s of I nv est or s
There are specific needs for all t ypes of invest ors. For individual invest ors, ret irement , children’s
marriage / educat ion, housing et c. are maj or event t riggers t hat cause an increase in t he
demands for funds. An invest ment decision will depend on t he invest or ’s plans for t he above
needs. Similarly, t here are cert ain specific needs for inst it ut ional invest ors also. For example,
for a pension fund t he invest ment policy will depend on t he average age of t he plan’s part icipant s.
I n addit ion t o t he few ment ioned here, t here are ot her const raint s like t he level of requisit e
knowledge ( invest ors may not be aware of cert ain financial inst rument s and t heir pricing) ,
invest ment size ( e.g., small invest ors may not be able t o invest in Cert ificat e of Deposit s) ,
regulat ory provisions ( count ry may impose rest rict ion on invest ment s in foreign count ries)
et c. which also serve t o out line t he invest ment choices faced by invest ors.
PDF created with pdfFactory trial version www.pdffactory.com
11
CHAPTER 2: Fi nanci al Mar k et s
2.1 I nt r oduct i on
There are a wide range of financial securit ies available in t he market s t hese days. I n t his
chapt er, we t ake a look at different financial market s and t ry t o explain t he various inst rument s
where invest ors can pot ent ially park t heir funds.
Financial market s can mainly be classified int o money market s and capit al market s. I nst rument s
in t he money market s include mainly short - t erm, market able, liquid, low- risk debt securit ies.
Capit al market s, in cont rast , include longer- t erm and riskier securit ies, which include bonds
and equit ies. There is also a wide range of derivat ives inst rument s t hat are t raded in t he
capit al market s.
Bot h bond market and money market inst rument s are fixed-income securit ies but bond market
inst rument s are generally of longer mat urit y period as compared t o money market inst rument s.
Money market inst rument s are of very short mat urit y period. The equit ies market can be
furt her classified int o t he primary and t he secondary market . Derivat ive market inst rument s
are mainly fut ures, forwards and opt ions on t he underlying inst rument s, usually equit ies
and bonds.
2.2 Pr i mar y and Secondar y Mar k et s
A primary market is t hat segment of t he capit al market , which deals wit h t he raising of capit al
from invest ors via issuance of new securit ies. New st ocks/ bonds are sold by t he issuer t o t he
public in t he primary market . When a part icular securit y is offered t o t he public for t he first
t ime, it is called an I nit ial Public Offering (I PO) . When an issuer want s t o issue more securit ies
of a cat egory t hat is already in exist ence in t he market it is referred t o as Follow- up Offerings.
Example: Reliance Power Lt d.’s offer in 2008 was an I PO because it was for t he first t ime t hat
Reliance Power Lt d. offered securit ies t o t he public. Whereas, BEML’s public offer in 2007 was
a Follow- up Offering as BEML shares were already issued t o t he public before 2007 and were
available in t he secondary market .
I t is generally easier t o price a securit y during a Follow- up Offering since t he market price of
t he securit y is act ually available before t he company comes up wit h t he offer, whereas in t he
case of an I PO it is very difficult t o price t he offer since t here is no prevailing market for t he
securit y. I t is in t he int erest of t he company t o est imat e t he correct price of t he offer, since
t here is a risk of failure of t he issue in case of non- subscript ion if t he offer is overpriced. I f t he
issue is underpriced, t he company st ands t o lose not ionally since t he securit ies will be sold at
a price lower t han it s int rinsic value, result ing in lower realizat ions.
PDF created with pdfFactory trial version www.pdffactory.com
12
The secondary market ( also known as ‘aft ermarket ’) is t he financial market where securit ies,
which have been issued before are t raded. The secondary market helps in bringing pot ent ial
buyers and sellers for a part icular securit y t oget her and helps in facilit at ing t he t ransfer of t he
securit y bet ween t he part ies. Unlike in t he primary market where t he funds move from t he
hands of t he invest ors t o t he issuer ( company/ Government , et c.) , in case of t he secondary
market , funds and t he securit ies are t ransferred from t he hands of one invest or t o t he hands
of anot her. Thus t he primary market facilit at es capit al format ion in t he economy and secondary
market provides liquidit y t o t he securit ies.
There is anot her market place, which is widely referred t o as t he t hird market in t he invest ment
world. I t is called t he over- t he- count er market or OTC market . The OTC market refers t o all
t ransact ions in securit ies t hat are not undert aken on an Exchange. Securit ies t raded on an
OTC market may or may not be t raded on a recognized st ock exchange. Trading in t he OTC
market is generally open t o all regist ered broker- dealers. There may be regulat ory rest rict ions
on t rading some product s in t he OTC market s. For example, in I ndia equit y derivat ives is one
of t he product s which is regulat orily not allowed t o be t raded in t he OTC market s. I n addit ion
t o t hese t hree, direct t ransact ions bet ween inst it ut ional invest ors, undert aken primarily wit h
t ransact ion cost s in mind, are referred t o as t he fourt h market .
2.3 Tr adi ng i n Secondar y Mar k et s
Trading in secondary market happens t hrough placing of orders by t he invest ors and t heir
mat ching wit h a count er order in t he t rading syst em. Orders refer t o inst ruct ions provided by
a cust omer t o a brokerage firm, for buying or selling a securit y wit h specific condit ions. These
condit ions may be relat ed t o t he price of t he securit y ( limit order or market order or st op loss
orders) or relat ed t o t ime ( a day order or immediat e or cancel order) . Advances in t echnology
have led t o most secondary market s of t he world becoming elect ronic exchanges. Disaggregat ed
t raders across regions simply log in t he exchange, and use t heir t rading t erminals t o key in
orders for t ransact ion in securit ies. We out line some of t he most popular orders below:
2.3.1 Types of Or der s
Li mi t Pr i ce/ Or der : I n t hese orders, t he price for t he order has t o be specified while ent ering
t he order int o t he syst em. The order get s execut ed only at t he quot ed price or at a bet t er price
( a price lower t han t he limit price in case of a purchase order and a price higher t han t he limit
price in case of a sale order) .
Mar k et Pr i ce/ Or der : Here t he const raint is t he t ime of execut ion and not t he price. I t get s
execut ed at t he best price obt ainable at t he t ime of ent ering t he order. The syst em immediat ely
execut es t he order, if t here is a pending order of t he opposit e t ype against which t he order can
mat ch. The mat ching is done aut omat ically at t he best available price ( which is called as t he
PDF created with pdfFactory trial version www.pdffactory.com
13
market price) . I f it is a sale order, t he order is mat ched against t he best bid ( buy) price and if
it is a purchase order, t he order is mat ched against t he best ask ( sell) price. The best bid price
is t he order wit h t he highest buy price and t he best ask price is t he order wit h t he lowest
sell price.
St op Loss ( SL) Pr i ce/ Or der : St op- loss orders which are ent ered int o t he t rading syst em,
get act ivat ed only when t he market price of t he relevant securit y reaches a t hreshold price.
When t he market reaches t he t hreshold or pre- det ermined price, t he st op loss order is t riggered
and ent ers int o t he syst em as a market / limit order and is execut ed at t he market price / limit
order price or bet t er price. Unt il t he t hreshold price is reached in t he market t he st op loss
order does not ent er t he market and cont inues t o remain in t he order book. A sell order in t he
st op loss book get s t riggered when t he last t raded price in t he normal market reaches or falls
below t he t rigger price of t he order. A buy order in t he st op loss book get s t riggered when t he
last t raded price in t he normal market reaches or exceeds t he t rigger price of t he order. The
t rigger price should be less t han t he limit price in case of a purchase order and vice versa.
Ti me Rel at ed Condi t i ons
Day Or der ( Day) : A Day order is valid for t he day on which it is ent ered. The order, if not
mat ched, get s cancelled aut omat ically at t he end of t he t rading day. At t he Nat ional St ock
Exchange ( NSE) all orders are Day orders. That is t he orders are mat ched during t he day and
all unmat ched orders are flushed out of t he syst em at t he end of t he t rading day.
I mmedi at e or Cancel or der ( I OC) : An I OC order allows t he invest or t o buy or sell a securit y
as soon as t he order is released int o t he market , failing which t he order is removed from t he
syst em. Part ial mat ch is possible for t he order and t he unmat ched port ion of t he order is
cancelled immediat ely.
2.3.2 Mat chi ng of or der s
When t he orders are received, t hey are t ime- st amped and t hen immediat ely processed for
pot ent ial mat ch. The best buy order is t hen mat ched wit h t he best sell order. For t his purpose,
t he best buy order is t he one wit h highest price offered, also called t he highest bid, and t he
best sell order is t he one wit h lowest price also called t he lowest ask ( i.e., orders are looked at
from t he point of view of t he opposit e part y) . I f a mat ch is found t hen t he order is execut ed
and a t rade happens. An order can also be execut ed against mult iple pending orders, which
will result in more t han one t rade per order. I f an order cannot be mat ched wit h pending
orders, t he order is st ored in t he pending orders book t ill a mat ch is found or t ill t he end of t he
day whichever is earlier. The mat ching of orders at NSE is done on a price- t ime priorit y i.e., in
t he following sequence:
• Best Price
• Wit hin Price, by t ime priorit y
PDF created with pdfFactory trial version www.pdffactory.com
14
Orders lying unmat ched in t he t rading syst em are ‘passive’ orders and orders t hat come in t o
mat ch t he exist ing orders are called ‘act ive’ orders. Orders are always mat ched at t he passive
order price. Given t heir nat ure, market orders are inst ant ly execut ed, as compared t o limit
orders, which remain in t he t rading syst em unt il t heir market prices are reached. The set of
such orders across st ocks at any point in t ime in t he exchange, is called t he Limit Order Book
( LOB) of t he exchange. The t op five bids/ asks ( limit orders all) for any securit y are usually
visible t o market part icipant s and const it ut e t he Market By Price ( MBP) of t he securit y.
2.4 The Money Mar k et
The money market is a subset of t he fixed- income market . I n t he money market , part icipant s
borrow or lend for short period of t ime, usually up t o a period of one year. These inst rument s
are generally t raded by t he Government , financial inst it ut ions and large corporat e houses.
These securit ies are of very large denominat ions, very liquid, very safe but offer relat ively low
int erest rat es. The cost of t rading in t he money market ( bid- ask spread) is relat ively small due
t o t he high liquidit y and large size of t he market . Since money market inst rument s are of high
denominat ions t hey are generally beyond t he reach of individual invest ors. However, individual
invest ors can invest in t he money market s t hrough money- market mut ual funds. We t ake a
quick look at t he various product s available for t rading in t he money market s.
2.4.1 T- Bi l l s
T- Bills or t reasury bills are largely risk- free ( guarant eed by t he Government and hence carry
only sovereign risk - risk t hat t he government of a count ry or an agency backed by t he
government , will refuse t o comply wit h t he t erms of a loan agreement ) , short- t erm, very liquid
inst rument s t hat are issued by t he cent ral bank of a count ry. The mat urit y period for T- bills
ranges from 3-12 mont hs. T-bills are circulat ed bot h in primary as well as in secondary market s.
T- bills are usually issued at a discount t o t he face value and t he invest or get s t he face value
upon mat urit y. The issue price ( and t hus rat e of int erest ) of T- bills is generally decided at an
auct ion, which individuals can also access. Once issued, T- bills are also t raded in t he secondary
market s.
I n I ndia, T- bills are issued by t he Reserve Bank of I ndia for mat urit ies of 91- days, 182 days
and 364 days. They are issued weekly ( 91- days mat urit y) and fort night ly ( 182- days and 364-
days mat urit y) .
2.4.2 Commer ci al Paper
Commercial papers ( CP) are unsecured money market inst rument s issued in t he form of a
promissory not e by large corporat e houses in order t o diversify t heir sources of short - t erm
borrowings and t o provide addit ional invest ment avenues t o invest ors. I ssuing companies are
required t o obt ain invest ment - grade credit rat ings from approved rat ing agencies and in some
PDF created with pdfFactory trial version www.pdffactory.com
15
cases, t hese papers are also backed by a bank line of credit . CPs are also issued at a discount
t o t heir face value. I n I ndia, CPs can be issued by companies, primary dealers ( PDs) , sat ellit e
dealers ( SD) and ot her large financial inst it ut ions, for mat urit ies ranging from 15 days period
t o 1-year period from t he dat e of issue. CP denominat ions can be Rs. 500,000 or mult iples
t hereof. Furt her, CPs can be issued eit her in t he form of a promissory not e or in demat erialized
form t hrough any of t he approved deposit ories.
2.4.3 Cer t i f i cat es of Deposi t
A cert ificat e of deposit ( CD) , is a t erm deposit wit h a bank wit h a specified int erest rat e. The
durat ion is also pre- specified and t he deposit cannot be wit hdrawn on demand. Unlike ot her
bank t erm deposit s, CDs are freely negot iable and may be issued in demat erialized form or as
a Usance Promissory Not e. CDs are rat ed ( somet imes mandat ory) by approved credit rat ing
agencies and normally carry a higher ret urn t han t he normal t erm deposit s in banks (primarily
due t o a relat ively large principal amount and t he low cost of raising funds for banks) . Normal
t erm deposit s are of smaller t icket - sizes and t ime period, have t he flexibilit y of premat ure
wit hdrawal and carry a lower int erest rat e t han CDs. I n many count ries, t he cent ral bank
provides insurance ( e.g. Federal Deposit I nsurance Corporat ion ( FDI C) in t he U.S., and t he
Deposit I nsurance and Credit Guarant ee Corporat ion ( DI CGC) in I ndia) t o bank deposit ors up
t o a cert ain amount ( Rs. 100000 in I ndia) . CDs are also t reat ed as bank deposit for t his
purpose.
I n I ndia, scheduled banks can issue CDs wit h mat urit y ranging from 7 days – 1 year and
financial inst it ut ions can issue CDs wit h mat urit y ranging from 1 year – 3 years. CD are issued
for denominat ions of Rs. 1,00,000 and in mult iples t hereof.
2.5 Repos and Rev er se Repos
Repos ( or Repurchase agreement s) are a very popular mode of short - t erm ( usually overnight )
borrowi ng and lendi ng, used mai nly by invest ors dealing in Government securit ies. The
arrangement involves selling of a t ranche of Government securit ies by t he seller ( a borrower
of funds) t o t he buyer ( t he lender of funds) , backed by an agreement t hat t he borrower will
repurchase t he same at a fut ure dat e ( usually t he next day) at an agreed price. The difference
bet ween t he sale price and t he repurchase price represent s t he yield t o t he buyer ( lender of
funds) for t he period. Repos allow a borrower t o use a financial securit y as collat eral for a cash
loan at a fixed rat e of int erest . Since Repo arrangement s have T- bills as collat erals and are for
a short mat urit y period, t hey virt ually eliminat e t he credit risk.
Reverse repo is t he mirror image of a repo, i.e., a repo for t he borrower is a reverse repo for
t he lender. Here t he buyer ( t he lender of funds) buys Government securit ies from t he seller ( a
borrower of funds) agreeing t o sell t hem at a specified higher price at a fut ure dat e.
PDF created with pdfFactory trial version www.pdffactory.com
16
2.6 The Bond Mar k et
Bond market s consist of fixed- income securit ies of longer durat ion t han inst rument s in t he
money market . The bond market inst rument s mainly include t reasury not es and t reasury
bonds, corporat e bonds, Government bonds et c.
2.6.1 Tr easur y Not es ( T- Not es) and T- Bonds
Treasury not es and bonds are debt securit ies issued by t he Cent ral Government of a count ry.
Treasury not es mat urit y range up t o 10 years, whereas t reasury bonds are issued for mat urit y
ranging from 10 years t o 30 years. Anot her dist inct ion bet ween T-not es and T- bonds is t hat T-
bonds usually consist of a call/ put opt ion aft er a cert ain period. I n order t o make t hese
inst rument s at t ract ive, t he int erest income is usually made t ax- free.
I nt erest on bot h t hese inst rument s is usually paid semi- annually and t he payment is referred
t o as coupon payment s. Coupons are at t ached t o t he bonds and each bondholder has t o
present t he respect ive coupons on different int erest payment dat e t o receive t he int erest
amount . Similar t o T- bills, t hese bonds are also sold t hrough auct ion and once sold t hey are
t raded in t he secondary market . The securit ies are usually redeemed at face value on t he
mat urit y dat e.
2.6.2 St at e and Muni ci pal Gover nment bonds
Apart from t he cent ral Government , various St at e Government s and somet imes municipal
bodies are also empowered t o borrow by issuing bonds. They usually are also backed by
guarant ees from t he respect ive Government . These bonds may also be issued t o finance
specific proj ect s ( like road, bridge, airport s et c.) and in such cases, t he debt s are eit her repaid
from fut ure revenues generat ed from such proj ect s or by t he Government from it s own funds.
Similar t o T- not es and T- bonds, t hese bonds are also grant ed t ax- exempt st at us.
I n I ndia, t he Government securit ies ( includes t reasury bills, Cent ral Government securit ies
and St at e Government securit ies) are issued by t he Reserve Bank of I ndia on behalf of t he
Government of I ndia.
2.6.3 Cor por at e Bonds
Bonds are also issued by large corporat e houses for borrowing money from t he public for a
cert ain period. The st ruct ure of corporat e bonds is similar t o T- Not es in t erms of coupon
payment , mat urit y amount ( face value) , issue price ( discount t o face value) et c. However,
since t he default risk is higher for corporat e bonds, t hey are usually issued at a higher discount
t han equivalent Government bonds. These bonds are not exempt from t axes. Corporat e bonds
are classified as secured bonds (if backed by specific collat eral) , unsecured bonds (or debent ures
which do not have any specific collat eral but have a preference over t he equit y holders in t he
PDF created with pdfFactory trial version www.pdffactory.com
17
event of liquidat ion) or subordinat ed debent ures ( which have a lower priorit y t han bonds in
claim over a firms’ asset s) .
2.6.4 I nt er nat i onal Bonds
These bonds are issued overseas, in t he currency of a foreign count ry which represent s a large
pot ent ial market of invest ors for t he bonds. Bonds issued in a currency ot her t han t hat of t he
count ry which issues t hem are usually called Eurobonds. However, now t hey are called by
various names depending on t he currency in which t hey are issued. Eurodollar bonds are US
dol l ar- denominat ed bonds i ssued out si de t he Unit ed St at es. Eur o- yen bonds are yen-
denominat ed bonds issued out side Japan.
Some int ernat ional bonds are issued in foreign count ries in currency of t he count ry of t he
invest ors. The most popular of such bonds are Yankee bond and Samurai Bonds. Yankee
bonds are US dollar denominat ed bonds issued in U.S. by a non- U.S. issuer and Samurai
bonds are yen- denominat ed bonds issued in Japan by non-Japanese issuers.
2.6.5 Ot her t ypes of bonds
Bonds could also be classified according t o t heir st ruct ure/ charact erist ics. I n t his sect ion, we
discuss t he various clauses t hat can be associat ed wit h a bond.
Zer o Coupon Bonds
Zero coupon bonds ( also called as deep- discount bonds or discount bonds) refer t o bonds
which do not pay any int erest ( or coupons) during t he life of t he bonds. The bonds are issued
at a discount t o t he face value and t he face value is repaid at t he mat urit y. The ret urn t o t he
bondholder is t he discount at which t he bond is issued, which is t he difference bet ween t he
issue price and t he face value.
Conver t i bl e Bonds
Convert ible bonds offer a right ( but not t he obligat ion) t o t he bondholder t o get t he bond
convert ed int o predet ermined number of equit y st ock of t he issuing company, at cert ain, pre-
specified t imes during it s life. Thus, t he holder of t he bond get s an addit ional value, in t erms
of an opt ion t o convert t he bond int o st ock ( equit y shares) and t hereby part icipat e in t he
growt h of t he company’s equit y value. The invest or receives t he pot ent ial upside of conversion
int o equit y while prot ect ing downside wit h cash flow from t he coupon payment s.The issuer
company is also benefit ed since such bonds generally offer reduced int erest rat e. However, t he
value of t he equit y shares in t he market generally falls upon issue of such bonds in ant icipat ion
of t he st ock dilut ion t hat would t ake place when t he opt ion ( t o convert t he bonds int o equit y)
is exercised by t he bondholders.
PDF created with pdfFactory trial version www.pdffactory.com
18
Cal l abl e Bonds
I n case of callable bonds, t he bond issuer holds a call opt ion, which can be exercised aft er
some pre- specified period from t he dat e of t he issue. The opt ion gives t he right t o t he issuer
t o repurchase ( cancel) t he bond by paying t he st ipulat ed call price. The call price may be more
t han t he face value of t he bond. Since t he opt ion gives a right t o t he issuer t o redeem t he
bond, it carries a higher discount ( higher yield) t han normal bonds. The right is exercised if t he
coupon rat e is higher t han t he prevailing int erest rat e in t he market .
Put t abl e Bonds
A put t able bond is t he opposit e of callable bonds. These bonds have an embedded put opt ion.
The bondholder has a right ( but not t he obligat ion) t o sell back t he bond t o t he issuer aft er a
cert ain t ime at a pre- specified price. The right has a cost and hence one would expect a lower
yield in such bonds. The bondholders generally exercise t he right if t he prevailing int erest rat e
in t he market is higher t han t he coupon rat e.
Since t he call opt ion and t he put opt ion are mut ually exclusive, a bond may have bot h opt ion
embedded.
Fi x ed r at e and f l oat i ng r at e of i nt er est
I n case of fixed rat e bonds, t he int erest rat e is fixed and does not change over t ime, whereas
in t he case of float ing rat e bonds, t he int erest rat e is variable and is a fixed percent age over a
cert ain pre- specified benchmark rat e. The benchmark rat e may be any ot her int erest rat e such
as T- bill rat e, t he t hree- mont h LI BOR rat e, MI BOR rat e ( in I ndia) , bank rat e, et c. The coupon
rat e is usually reset every six mont hs ( t ime bet ween t wo int erest payment dat es) .
2.7 Common St ock s
Simply put , t he shareholders of a company are it s owners. As owners, t hey part icipat e in t he
management of t he company by appoint ing it s board of direct ors and voicing t heir opinions,
and vot ing in t he general meet ings of t he company. The board of direct ors have general
oversight of t he company, appoint s t he management t eam t o look aft er t he day- t o- day running
of t he business, set overall pol icies aimed at maximizing profit s and shareholder value.
Shareholders of a company are said t o have limit ed liabilit y. The t erm means t hat t he liabilit y
of shareholders is limit ed t o t he unpaid amount on t he shares. This implies t hat t he maximum
loss of shareholder in a company is limit ed t o her original invest ment . Being t he owners,
shareholders have t he last claim on t he asset s of t he company at t he t ime of liquidat ion, while
debt - or bondholders always have precedence over equit y shareholders.
At it s incorporat ion, every company is aut horized t o issue a fixed number of shares, each
priced at par value, or face value in I ndia. The face value of shares is usually set at nominal
PDF created with pdfFactory trial version www.pdffactory.com
19
levels ( Rs. 10 or Re. 1 in I ndia for t he most part ) . Corporat ions generally ret ain port ions of
t heir aut horized st ock as reserved st ock, for fut ure issuance at any point in t ime.
Shares are usually valued much higher t han t he face value and t his init ial invest ment in t he
company by shareholders represent s t heir paid- in capit al in t he company. The company t hen
generat es earnings from it s operat ing, invest ing and ot her act ivit ies. A port ion of t hese earnings
are dist ribut ed back t o t he shareholders as dividend, t he rest ret ained for fut ure invest ment s.
The sum t ot al of t he paid- in capit al and ret ained earnings is called t he book value of equit y of
t he company.
2.7.1 Types of shar es
I n I ndia, shares are mainly of t wo t ypes: equit y shares and preference shares. I n addit ion t o
t he most common t ype of shares, t he equit y share, each represent ing a unit of t he overall
ownership of t he company, t here is anot her cat egory, called preference shares. These preferred
shares have precedence over common st ock in t erms of dividend payment s and t he residual
claim t o it s asset s in t he event of liquidat ion. However, preference shareholders are generally
not ent it led t o equivalent vot ing right s as t he common st ockholders.
I n I ndia, preference shares are redeemable ( callable by issuing firm) and preference dividends
are cumulat ive. By cumulat ive dividends, we mean t hat in case t he preference dividend remains
unpaid in a part icular year, it get s accumulat ed and t he company has t he obligat ion t o pay t he
accrued dividend and current year ’s dividend t o preferred st ockholders before it can dist ribut e
dividends t o t he equit y shareholders. An addit ional feat ure of preferred st ock in I ndia is t hat
during such t ime as t he preference dividend remains unpaid, preference shareholders enj oy
all t he right s ( e.g. vot ing right s) enj oyed by t he common equit y shareholders. Some companies
also issue convert ible preference shares which get convert ed t o common equit y shares in
fut ure at some specified conversion rat io.
I n addit ion t o t he equit y and fixed- income market s, t he derivat ives market is one of I ndia’s
largest and most liquid. We t ake a short t our of derivat ives in t he 5t h chapt er of t his module.
PDF created with pdfFactory trial version www.pdffactory.com
20
CHAPTER 3: Fi x ed I ncome Secur i t i es
3.1 I nt r oduct i on: The Ti me Val ue of Money
Fixed- income securit ies are securit ies where t he periodic ret urns, t ime when t he ret urns fall
due and t he mat urit y amount of t he securit y are pre- specified at t he t ime of issue. Such
securit ies generally form part of t he debt capit al of t he issuing firm. Some of t he common
examples are bonds, t reasury bills and cert ificat es of deposit .
3.2 Si mpl e and Compound I nt er est Rat es
I n simple t erms, an int erest payment refers t o t he payment made by t he borrower t o t he
lender as t he price for use of t he borrowed money over a period of t ime. The int erest cost
covers t he opport unit y cost of money, i.e., t he ret urn t hat could have been generat ed had t he
lender invest ed in some ot her asset s and a compensat ion for default risk (risk t hat t he borrower
will not refund t he money on mat urit y) . The rat e of int erest may be fixed or float ing, in t hat it
may be linked t o some ot her benchmark int erest rat e or in some cases t o t he inflat ion in t he
economy.
I nt erest calculat ions are eit her simple or compound. While simple int erest is calculat ed on t he
principal amount alone, for a compound int erest rat e calculat ion we assume t hat all int erest
payment s are re- invest ed at t he end of each period. I n case of compound int erest rat e, t he
subsequent period’s int erest is calculat ed on t he original principal and all accumulat ed int erest
during past periods.
I n case of bot h simple and compound int erest rat es, t he int erest rat e st at ed is generally
annual. I n case of compound int erest rat e, we also ment ion t he frequency for which compounding
is done. For example, such compounding may be done semi- annually, quart erly, mont hly,
daily or even inst ant aneously ( cont inuously compounded) .
3.2.1 Si mpl e I nt er est Rat e
The formula for est imat ing simple int erest is :
T R P I
* *
·
Where,
P = principal amount
R = Simple I nt erest Rat e for one period ( usually 1 year)
T = Number of periods ( years)
PDF created with pdfFactory trial version www.pdffactory.com
21
Ex ampl e 3.1
What is t he amount an invest or will get on a 3-year fixed deposit of Rs. 10000 t hat pays
8% simple int erest ?
Answer: Here we have
P = 10000, R = 8% and T = 3 years
2400 3
*
% 8
*
10000
* *
· · · T R P I
Amount = Principal + I nt erest = 10000+ 2400 = 12400.
3.2.2 Compound I nt er est Rat e
I n addit ion t o t he t hree paramet ers ( Principal amount ( P) , I nt erest Rat e ( R) , Time ( T) ) used
for calculat ion of int erest in case of simple int erest rat e met hod, t here is an addit ional paramet er
t hat affect s t he t ot al int erest payment s. The fourt h paramet er is t he compounding period,
which is usually represent ed in t erms of number of t imes t he compounding is done in a year
( m) . So for semi- annual compounding t he value for m = 2; for quart erly compounding, m = 4
and so on.
Let us consider an int erest rat e of 10% compounded semi - annually and an i nvest ment
of Rs. 100 f or a peri od of 1 year. The i nvest ment wi l l become Rs. 105 i n 6 mont hs
and for t he second half, t he int erest wil l be calculat ed on Rs. 105, which will come t o
105* 5% = 5.25. The t ot al amount t he invest or will receive at t he end of 1 year will become
105 + 5. 25 = 110. 25. The equi val ent i nt er est rat e, i f compounded annual ly becomes
( ( 110.25- 100) / 100) * 100 = 10.25%. The equivalent annual int erest rat e is
1 – 1
m
m
R

,
_

¸
¸
+
.
The formula used for calculat ing t ot al amount under t his met hod is as under:
P
m
R
P A
m T
– 1
*

,
_

¸
¸
+ ·
Where
A = Amount on mat urit y
R = int erest rat e
m = number of compounding in a year
T = mat urit y in years
Ex ampl e 3.2
What is t he amount an invest or will get on a 3-year fixed deposit of Rs. 10000 t hat pay 8%
int erest compounded half yearly?
PDF created with pdfFactory trial version www.pdffactory.com
22
Answer:
Here P = 10000, R = 8% and T = 3, m = 2. The t ot al int erest income comes t o:
P
m
R
P I nt erest
m T
– 1
*
1
1
]
1

¸

,
_

¸
¸
+ ·
20 . 2653 . 10000 –
2
08 . 0
1
*
10000
3 * 2
Rs ·
1
1
]
1

¸

,
_

¸
¸
+ ·
Amount = Principal + I nt erest = 10000+ 2653.20 = 12653.20.
Ex ampl e 3.3
Consider t he same invest ment . What is t he amount if t he int erest rat e is compounded mont hly?
Answer:
Here P = 10000, R = 8% and T = 3, m = 12. The t ot al int erest income comes t o:
P
m
R
P I nt erest
m T
– 1
*
1
1
]
1

¸

,
_

¸
¸
+ ·
37 . 2702 . 10000 –
12
08 . 0
1 * 10000
3 * 12
Rs ·
1
1
]
1

¸

,
_

¸
¸
+ ·
Amount = Principal + I nt erest = 10000+ 2702.37 = 12702.37.
Cont i nuous compoundi ng
Consider a sit uat ion, where inst ead of mont hly or quart erly compounding, t he int erest rat e is
compounded cont inuously t hroughout t he year i.e. m rises indefinit ely. I f m approaches infinit y,
t he equivalent annual int erest rat e is
1 – 1

,
_

¸
¸

+
R
, which can be shown ( using t ools from
different ial calculus) , t o t end t o
] 1 – 718 . 2 [
r
or
1 –
r
e
in t he limit , ( where e= 2.71828…is t he
base for nat ural logarit hms) . Furt her, for convenience, we use ‘r ’ (in small let t ers) t o represent
cont inuously compound int erest rat e.
Thus, an invest ment of Re. 1 at 8% cont inuously compounded int erest becomes
0833 . 1
08 . 0
· e
aft er 1 year and t he equivalent annual int erest rat e becomes 0.0833 or 8.33%. I f t he invest ment
is for T years, t he mat urit y amount is simply 1*
rT
e
, where e = 2.718.
Cont inuous compounding is widely assumed in finance t heory, and used in various asset pricing
models—t he famous Black- Scholes model t o price a European opt ion is an illust rat ive example.
Ex ampl e 3.4
Consider t he same invest ment ( Rs. 10000 for 3 years) . What is t he amount received on
PDF created with pdfFactory trial version www.pdffactory.com
23
mat urit y if t he int erest rat e is 8% compounded cont inuously?
Answer:
Here P = 10000, e = 2.718, r = 8% and T = 3
The final value of t he invest ment is
rT
e P
*
.
I t comes t o
50 . 12712
*
10000
3 * 08 . 0
· e
.
3.3 Real and Nomi nal I nt er est Rat es
The relat ionship bet ween int erest rat es and inflat ion rat es is very significant . Normally, t he
cash flow from bonds and deposit s are cert ain and known in advance. However, t he value of
goods and services in an economy may change due t o changes in t he general price level
( inflat ion) . This brings an uncert aint y about t he purchasing power of t he cash flow from an
invest ment . Take a small example. I f inflat ion ( say 12%) is rising and is great er t han t he
int erest rat e ( say 10% annually) in a part icular year, t hen an invest or in a bond wit h 10%
int erest rat e annually st ands t o lose. Goods wort h Rs. 100 at t he beginning of t he year are
wort h Rs. 112 by t he end of t he year but an invest ment of Rs. 100 becomes only Rs. 110 by
end of t he year. This implies t hat an invest or who has deposit ed money in a risk- free asset will
find goods beyond his reach.
An economist would look at t his in t erms of nominal cash flow and real cash flows. Nominal
cash flow measures t he cash flow in t erms of t oday’s prices and real cash flow measures t he
cash flow in t erms of it s base year ’s purchasing power, i.e., t he year in which t he asset was
bought / invest ed. I f t he int erest rat e is 10%, an invest ment of Rs. 100 becomes Rs. 110 at t he
end of t he year. However, if inflat ion rat e is 5% t hen each Rupee will be wort h 5% less next
year. This means at t he end of t he year, Rs. 110 will be wort h only 110/ 1.05 = Rs. 104.76 in
t erms of t he purchasing power at t he beginning of t he year. The real payoff is Rs. 104.76 and
t he real int erest rat e is 4.76%. The relat ionship bet ween real and nominal int erest rat e can be
est ablished as under:
) ( 1 rat e inflat ion
Flow Cash Nominal
Flow Cash Real
+
·
And
rat e t ion la inf
rat e int erest al nomin
rat e erest int real
+
+
· +
1
1
1 (
I n our example, t he real int erest rat e can be direct ly calculat ed using t he formula:
4.76% or 0.0476 1 –
05 . 1
10 . 0 1
·
1
]
1

¸

+
+
· rat e erest int al Re
PDF created with pdfFactory trial version www.pdffactory.com
24
3.4 Bond Pr i ci ng Fundament al s
The cash inflow for an invest or in a bond includes t he coupon payment s and t he payment on
mat urit y ( which is t he face value) of t he bond. Thus t he price of t he bond should represent t he
sum t ot al of t he discount ed value of each of t hese cash flows ( such a t ot al is called t he present
value of t he bond) . The discount rat e used for valuing t he bond is generally higher t han t he
risk- free rat e t o cover addit ional risks such as default risk, liquidit y risks, et c.
Bond Price = PV ( Coupons and Face Value)
Not e t hat t he coupon payment s are at different point s of t ime in t he fut ure, usually t wice each
year. The face value is paid at t he mat urit y dat e. Therefore, t he price is calculat ed using t he
following formula:

+
·
t
t
y
t C
Price Bond
) 1 (
) (
( 1)
Where C( t ) is t he cash flow at t ime t and y is t he discount rat e. Since t he coupon rat e is
generally fixed and t he mat urit y value is known at t he t ime of issue of t he bond, t he formula
can be re- writ t en as under:

+
+
+
·
T
t
T t
y
Value Face
y
Coupon
Price Bond
) 1 ( ) 1 (
( 2)
Here t represent s t he t ime left for each coupon payment and T is t he t ime t o mat urit y. Also
not e t hat t he discount rat e may differ for cash flows across t ime periods.
Ex ampl e 3.5
Calculat e t he value of a 3-year bond wit h face value of Rs. 1000 and coupon rat e being 8%
paid annually. Assume t hat t he discount rat e is 10%.
Here:
Face value = Rs. 1000
Coupon Payment = 8% of Rs. 1000 = Rs. 80
Discount Rat e = 10%
t = 1 t o 3
T = 3
26 . 950
) 1 . 0 1 (
1000
) 1 . 0 1 (
80
) 1 . 0 1 (
80
1 . 0 1
80
3 3 2
·
+
+
+
+
+
+
+
· Pr ice Bond
Now let us see what happens if t he discount rat e is lower t han t he coupon rat e:
PDF created with pdfFactory trial version www.pdffactory.com
25
Ex ampl e 3.6
Calculat e t he bond price if t he discount rat e is 6%.
46 . 1053
) 06 . 0 1 (
80
) 06 . 0 1 (
80
06 . 0 1
80
3 2
·
+
+
+
+
+
· Pr ice Bond
Since t he discount rat e is higher t han t he coupon rat e, t he bond is t raded at a discount . I f t he
discount rat e is less t han t he coupon rat e, t he bond t rades at a premium.
3.4.1 Cl ean and di r t y pr i ces and accr ued i nt er est
Bonds are not t raded only on coupon dat es but are t raded t hroughout t he year. The market
price of t he bonds also includes t he accrued int erest on t he bond since t he most recent coupon
payment dat e. The price of t he bond including t he accrued int erest since issue or t he most
recent coupon payment dat e is called t he ‘dirt y price’ and t he price of t he bond excluding t he
accrued int erest is called t he ‘clean price’. Clean price is t he price of t he bond on t he most
recent coupon payment dat e, when t he accrued int erest is zero.
Dirt y Price = Clean price + Accrued int erest
For report ing purpose ( in press or on t rading screens) , bonds are quot ed at ‘clean price’ for
ease of comparison across bonds wit h differing int erest payment dat es ( dirt y prices ‘j ump’ on
int erest payment dat es). Changes in t he more st able clean prices are reflect ive of macroeconomic
condit ions, usually of more int erest t o t he bond market .
3.5 Bond Yi el ds
Bond yield are measured using t he following measures:
3.5.1 Coupon yi el d
I t is calculat ed using t he following formula:
Value Face
Payment Coupon
Yield Coupon ·
3.5.2 Cur r ent Yi el d
I t is calculat ed using t he following formula:
Bond t he of Price Market Current
Payment Coupon
Yield Coupon ·
The main drawback of coupon yield and current yield is t hat t hey consider only t he int erest
payment ( coupon payment s) and ignore t he capit al gains or losses from t he bonds. Since t hey
consider only coupon payment s, t hey are not measurable for bonds t hat do not pay any
int erest , such as zero coupon bonds. The ot her measures of yields are yield t o mat urit y and
PDF created with pdfFactory trial version www.pdffactory.com
26
yield t o call. These measures consider int erest payment s as well as capit al gains ( or losses)
during t he life of t he bond.
3.5.3 Yi el d t o mat ur i t y
Yield t o mat urit y ( also called YTM) is t he most popular concept used t o compare bonds. I t
refers t o t he int ernal rat e of ret urn earned from holding t he bond t ill mat urit y. Assuming a
const ant int erest rat e for various mat urit ies, t here will be only one rat e t hat equalizes t he
present value of t he cash flows t o t he observed market price in equat ion ( 2) given earlier. That
rat e is referred t o as t he yield t o mat urit y.
Ex ampl e 3.7
What is t he YTM for a 5-year, 8% bond ( int erest is paid annually) t hat is t rading in t he market
for Rs. 924.20?
Here,
t = 1 t o 5
T = 5
Face Value = 1000
Coupon payment = 8% of Rs. 1,000 = 80
Put t ing t he values in equat ion ( 1) , we have:
5
5
1
) 1 (
1000
) 1 (
80
20 . 924
y y
t
+
+
+
·

Solving for y, which is t he YTM, we get t he yield t o mat urit y for t he bond t o be 10%.
Yield and Bond Price:
There is a negat ive relat ionship bet ween yields and bond price. The bond price falls when yield
increases and vice versa.
Ex ampl e 3.8
What will be t he market price of t he above bond ( Example 3 7) if t he YTM is 12%.
t = 1 t o 5
T = 5
Face Value = 1000
Coupon payment = 8% of 1,000 = 80
Put t ing t he values in equat ion ( 1) , t he bond price comes t o:
PDF created with pdfFactory trial version www.pdffactory.com
27
20 . 901
) 12 . 0 1 (
1000
) 12 . 0 1 (
80
5
5
1
·
+
+
+
·

t
Pr ice Bond
Furt her, for a long- t erm bond, t he cash flows are more dist ant in t he fut ure and hence t he
impact of change in int erest rat e is higher for such cash flows. Alt ernat ively, for short - t erm
bonds, t he cash flows are not far and discount ing does not have much effect on t he bond price.
Thus, price of long- t erm bonds are more sensit ive t o int erest rat e changes.
Bond equivalent yield and Effect ive annual yield: This is anot her import ant concept t hat is of
import ance in case of bonds and not es t hat pay coupons at t ime int erval which is less t han 1
year ( for example, semi- annually or quart erly) . I n such cases, t he yield t o mat urit y is t he
discount rat e solved using t he following formula, wherein we assume t hat t he annual discount
rat e is t he product of t he int erest rat e for int erval bet ween t wo coupon payment s and t he
number of coupon payment s in a year:
T
T
t
t
y
Value Face
y
Coupon
Price Bond

,
_

¸
¸
+
+

,
_

¸
¸
+
·

2
1
2
1
( 3)
YTM calculat ed using t he above formula is called bond equivalent yield.
However, if we assume t hat one can reinvest t he coupon payment s at t he bond equivalent
yield ( YTM) , t he effect ive int erest rat e will be different . For example, a semi- annual int erest
rat e of 10% p.a. in effect amount s t o
% 25 . 10 1025 . 1
2
10 . 0
1
2
or ·

,
_

¸
¸
+
.
Yield rat e calculat ed using t he above formula is called effect ive annual yield.
Ex ampl e 3.9
Calculat e t he bond equivalent yield (YTM) for a 5-year, 8% bond (semi-annual coupon payment s),
t hat is t rading in t he market for Rs. 852.80? What is t he effect ive annual yield for t he bond?
Here,
t = 1 t o 10
T = 10
Face Value = 1000
Coupon payment = 4% of 1,000 = 40
Bond Price = 852.80
PDF created with pdfFactory trial version www.pdffactory.com
28
Put t ing t he values in equat ion ( 3) , we have:

,
_

¸
¸
+
+

,
_

¸
¸
+
·
10
1
10
2
1
1000
2
1
40
80 . 852
y y
t
Solving, we get t he Yield t o Mat urit y ( y) = 0.12 or 12%.
The effect ive yield rat e is
% 36 . 12 1236 . 0 1 –
2
12 . 0
1 1 –
2
1
2 2
or
y
·

,
_

¸
¸
+ ·

,
_

¸
¸
+
3.5.4 Yi el d t o cal l
Yield t o call is calculat ed for callable bond. A callable bond is a bond where t he issuer has a
right ( but not t he obligat ion) t o call/ redeem t he bond before t he act ual mat urit y. Generally t he
callable dat e or t he dat e when t he company can exercise t he right , is pre- specified at t he t ime
of issue. Furt her, in t he case of callable bonds, t he callable price ( redempt ion price) may be
different from t he face value. Yield t o call is calculat ed wit h t he same formula used for calculat ing
YTM ( Equat ion 2) , wit h an assumpt ion t hat t he issuer will exercise t he call opt ion on t he
exercise dat e.
Ex ampl e 3.10
Calculat e t he yield t o call for a 5-year, 7% callable bond ( semi- annual coupon payment s) , t hat
is t rading in t he market for Rs. 877.05. The bond is callable at t he end of 3rd year at a call
price of Rs. 1040.
Here:
t = 1 t o 6
T = 6
Coupon payment = 3.5% of 1,000 = 35
Callable Value = 1040
Bond Price = 877.05
Put t ing t he values in t he following equat ion:
T
T
t
t
y
Value Callable
y
Coupon
Price Bond

,
_

¸
¸
+
+

,
_

¸
¸
+
·

2
1
2
1
we have:
PDF created with pdfFactory trial version www.pdffactory.com
29
6
6
1
2
1
1000
2
1
35
05 . 877

,
_

¸
¸
+
+

,
_

¸
¸
+
·

y y
t
Solving for y, we get t he yield t o call = 12%
3.6 I nt er est Rat es
While comput ing t he bond prices and YTM, we assumed t hat t he int erest rat e is const ant
across different mat urit ies. However, t his may not be t rue for different reasons. For example,
invest ors may perceive longer mat urit y periods t o be riskier and hence may demand higher
int erest rat e for cash flow occurring at dist ant t ime int ervals t han t hose occurring at short t ime
int ervals. I n t his sect ion, we account for t he fact t hat t he int erest demanded by invest ors also
depends on t he t ime horizon of t he invest ment . Let us first int roduce cert ain common concept s.
3.6.1 Shor t Rat e
Short rat e for t ime t , is t he expect ed ( annualized) int erest rat e at which an ent it y can borrow
f or a gi ven t i me i nt er val st ar t i ng f r om t i me t . Shor t r at e i s usual l y denomi nat ed
as r
t
.
3.6.2 Spot Rat e
Yield t o mat urit y for a zero coupon bond is called spot rat e. Since zero coupon bonds of
varying mat urit ies are t raded in t he market simult aneously, we can get an array of spot rat es
for different mat urit ies.
Relat ionship bet ween short rat e and spot rat e:
I nvest ors discount fut ure cash flows using int erest rat e applicable for t hat period. Therefore,
t he PV of an invest ment of T years is calculat ed as under:
) 1 ...( ) 1 ( ) 1 (
) (
) (
2 1 T
r r r
I nvest ment I nit ial
I nvest ment PV
+ + +
·
Ex ampl e 3.11
I f t he short rat e for a 1-year invest ment at year 1 is 7% and year 2 is 8%, what is t he present
value of a 2-year zero coupon bond wit h face value Rs. 1000 :
35 . 865
1556 . 1
1000
08 . 1
*
07 . 1
1000
· · · P
For a 2-year zero coupon bond t rading at 865.35, t he YTM can be calculat ed by solving t he
following equat ion:
2
2
) 1 (
1000
35 . 865
y +
·
The result ing value for y is 7.4988%, which is not hing but t he 2-year spot rat e.
PDF created with pdfFactory trial version www.pdffactory.com
30
3.6.3 For w ar d Rat e
One can assume t hat all bonds wit h equal risks must offer ident ical rat es of ret urn over any
holding period, because if it is not t rue t hen t here will be an arbit rage opport unit y in t he
market . I f we assume t hat all equally risky bonds will have ident ical rat es of ret urn, we can
calculat e short rat es for a fut ure int erval by knowing t he spot rat es for t he t wo ends of t he
int erval. For example, we can calculat e 1-year short rat e at year 3, if we have t he 3-years spot
rat e and 4-years spot rat e ( or in ot her words are t here are 3-year zero coupon and a 4-year
zero coupon t reasury bonds t rading in t he market ) . This is because, t he proceeds from an
invest ment in a 3-year zero coupon bond on t he mat urit y day, reinvest ed for 1 year should
result in a cash flow equal t o t he cash flow from an invest ment in a 4-year zero coupon bond
( since t he holding period is t he same for bot h t he st rat egies) .
Ex ampl e 3.12
I f t he 3-year spot rat e and 4-year spot rat es are 8.997% and 9.371% respect ively, find t he
1-year short rat e at end of year 3.
Given t he spot rat es, proceeds from invest ment of Re. 1 in a 3-year zero coupon bond will be
1* 1.08997
3
= 1.2949.
I f we reinvest t his ( mat urit y) amount in a 1-year zero coupon bond, t he proceeds at year 4 will
be 1.2949* ( 1+ r
3
) .
This should be equal t o t he proceeds from an invest ment of Rs. 1 in a 4-year zero coupon
bond, assuming equal holding period ret urn.
Proceeds from invest ment of Re. 1 in a 4-year zero coupon bond is 1* 1.09371
4
= 1.4309
Solving,
4309 . 1 ) 1 (
*
2949 . 1
3
· + r
r
3
= 0.11 or 11%, which is not hing but t he 1 year short rat e at t he end of year 3.
Fut ure short rat es comput ed using t he market price of t he prevailing zero coupon bonds’ price
( or prevailing spot rat es) are called forward int erest rat es. We use t he not at ion f
i
t o represent
t he 1-year forward int erest rat e st art ing at year i. For example, f
2
denot es t he 1-year forward
int erest rat e st art ing from year 2.
3.6.4 The t er m st r uct ur e of i nt er est r at es
We have discussed various int erest rat es ( spot , forward, discount rat es) , and also seen t heir
behaviour, and connect ions wit h each ot her. The t erm st ruct ure of int erest rat es is t he set of
relat ionships bet ween rat es of bonds of different mat urit ies. I t is somet imes also called t he
PDF created with pdfFactory trial version www.pdffactory.com
31
yield curve. Formally put , t he t erm st ruct ure of int erest rat es defines t he array of discount
fact ors on a collect ion of default - free pure discount ( zero- coupon) bonds t hat differ only in
t heir t erm t o mat urit y. The most common approximat ion t o t he t erm st ruct ure of int erest rat es
is t he yield t o mat urit y curve, which generally is a smoot h curve and reflect s t he rat es of
ret urn on various default - free pure discount ( zero- coupon) bonds held t o mat urit y along wit h
t heir t erm t o mat urit y.
The use of forward int erest rat es has long been st andard in financial analysis such as in pricing
new financial inst rument s and in discovering arbit rage possibilit ies. Yield curves are also used
as a key t ool by cent ral banks in t he det erminat ion of t he monet ary policy t o be followed in a
count ry. The forward int erest rat e is int erpret ed as indicat ing market expect at ions of t he t ime-
pat h of fut ure int erest rat es, fut ure inflat ion rat es and fut ure currency depreciat ion rat es.
Since forward rat es helps us indicat e t he expect ed fut ure t ime pat h of t hese variables, t hey
allow a separat ion of market expect at ions for t he short , medium and long t erm more easily
t han t he st andard yield curve.
The market expect at ions hypot hesis and t he liquidit y preference t heory are t wo import ant
explanat ions of t he t erm st ruct ure of int erest in t he economy. The market expect at ion hypot hesis
assumes t hat various mat urit ies are perfect subst it ut es of each ot her and t hat t he forward
rat e equals t he market expect at ion of t he fut ure short int erest rat e i.e. ) (
i i
r E f · , where i is
a fut ure period. Assuming minimal arbit rage opport unit ies, t he expect ed int erest rat e can be
used t o const ruct a yield curve. For example, we can find t he 2-year yield if we know t he
1-year short rat e and t he fut ures short rat e for t he second year by using t he following formula:
) 1 (
*
) 1 ( ) 1 (
2 1
2
2
f r y + + · +
Since, as per t he expect at ion hypot hesis ) (
2 2
R E f · − , t he YTM can be det ermined solely by y
current and expect ed fut ure one- period int erest rat es.
Liquidit y preference t heory suggest s t hat invest ors prefer liquidit y and hence, a short - t erm
invest ment is preferred t o a long-t erm invest ment . Therefore, invest ors will be induced t o hold
a long- t erm invest ment , only by paying a premium for t he same. This premium or t he excess
of t he forward rat e over t he expect ed int erest rat e is referred t o as t he liquidit y premium.
Therefore, t he forward rat e will exceed t he expect ed short rat e, i.e. ) (
2 2
r E f > , where ) ( –
2 2
r E f
represent t he liquidit y premium. The liquidit y premium causes t he yield curve t o be upward
sloping since long- t erm yields are higher t han short - t erm yields.
Ex ampl e 3.13
Calculat e t he YTM for year 2- 5 if t he 1-year short rat e is 8% and t he fut ure rat es for years
2- 5 is 8.5% ( f
2
) , 9% ( f
3
) , 9.5% ( f
4
) and 10%( f
5
) respect ively.
PDF created with pdfFactory trial version www.pdffactory.com
32
Answer:
% 8
1 1
· · r y
0825 . 1 ) 085 . 1 * 08 . 1 ( ) ; 1 ( * ) 1 ( ) 1 (
2
2 2 1
2
2
· · + + + + y f r y
, i.e. y
2
= 8.25%
0850 . 1 ) 09 . 1 * 0825 . 1 ( ) ; 1 ( * ) 1 ( ) 1 (
3 2
3 3
2
2
3
3
· · + + + + y f y y
, i.e. y
3
= 8.50%
0875 . 1 ) 095 . 1 * 0850 . 1 ( ) ; 1 ( * ) 1 ( ) 1 (
4 3
4 4
3
3
4
4
· · + + + + y f y y
, i.e. y
4
= 8.75%
09 . 1 ) 10 . 1 * 0875 . 1 ( ) ; 1 ( * ) 1 ( ) 1 (
5 4
5 5
4
4
5
5
· · + + + + y f y y
, i.e. y
5
= 9.00%
I t can be seen t hat because of t he liquidit y premium, t he fut ure int erest rat e increases wit h
t ime and t his causes t he yield curve t o rise wit h t ime.
Box No. 3.1:
Rel at i onshi p bet w een spot , f or w ar d, and di scount r at es
Recall t hat discount fact ors are t he int erest rat es used at a given point in t ime t o discount
cash flows occurring in t he fut ure, in order t o obt ain t heir present value. So how do spot
rat es, forward rat es, and discount rat es relat e t o each ot her?
A discount funct ion ( d
t , m
) is t he collect ion of discount fact ors at t ime t for all mat urit ies
m. Spot rat es ( s
t , m
) , i.e., t he yields earned on bonds which pay no coupon, are relat ed t o
discount fact ors according t o:
m
S m
m t
e d
1
– *
,
· and
m t m t
nd
m
S
, ,
1
1
– ·
The est imat ion of a zero coupon yield curve is based on an assumed funct ional relat ionship
bet ween eit her par yields, spot rat es, forward rat es or discount fact ors on t he one hand
and mat urit ies on t he ot her. Par yield curves are t hose t hat reflect ret urn on bonds t hat
are priced at par, which j ust means t hat t he redempt ion yield is equal t o t he coupon rat e
of t he bond.
There is a different forward rat e for every pair of mat urit y dat es. The relat ion bet ween
t he yield- t o- mat urit y ( YTM) and t he implied forward rat e at mat urit y is analogous t o t he
relat ion bet ween average and marginal cost s in economics. The YTM is t he average cost
of borrowing for m periods whereas t he implied forward rat e is t he marginal cost of
ext ending t he t ime period of t he loan, i.e. it describes t he marginal one- period int erest
rat e implied by t he current t erm st ruct ure of spot int erest rat e. Because spot int erest
PDF created with pdfFactory trial version www.pdffactory.com
33
rat es depend on t he t ime horizon, it is nat ural t o define t he forward rat es f
t,m
as t he
inst ant aneous rat es which when compounded cont inuously up t o t he t ime t o mat urit y,
yield t he spot rat es ( inst ant aneous forward rat es are t hus rat es for which t he difference
bet ween set t lement t ime and mat urit y t ime approaches zero) .

, ) (
1

0
,

·
m
m t
du u f
m
S
or we can sayy

1
1
]
1

¸

·

m
m t
du u f d
0
,
) ( exp
Thus, knowing any of t he four means t hat t he ot her four can be readily comput ed.
However, t he real problem is t hat neit her of t hese curves is easily forecast able.
3.7 Macaul ay Dur at i on and Modi f i ed Dur at i on
The effect of int erest rat e risks on bond prices depends on many fact ors, but mainly on coupon
rat es, mat urit y dat e et c. Unlike in case of zero- coupon bonds, where t he cash flows are only at
t he end, in t he case of ot her bonds, t he cash flows are t hrough coupon payment s and t he
mat urit y payment . One needs t o average out t he t ime t o mat urit y and t ime t o various coupon
payment s t o find t he effect ive mat urit y for a bond. The measure is called as durat ion of a
bond. I t is t he weight ed ( cash flow weight ed) average mat urit y of t he bond.

·
·
T
t
t
w t Durat ion
1
*
The weight s ( Wt ) associat ed for each period are t he present value of t he cash flow at each
period as a proport ion t o t he bond price, i.e.
Price Bond
y
CF
Price Bond
flow cash of PV
W
t
t
t
) 1 ( +
· ·
This measure is t ermed as Macaulay’s durat ion
1
or simply, durat ion. Higher t he durat ion of t he
bond, higher will be t he sensit ivit y t owards int erest rat e fluct uat ions and hence higher t he
volat ilit y in t he bond price.
This t ool is widely used in fixed income analysis. Banks and ot her financial inst it ut ions generally
creat e a port folio of fixed income securit ies t o fund known liabilit ies. The price changes for
fixed income securit ies are dependent mainly on t he int erest rat e changes and t he average
1
The met hod was designed by Frederick Macaulay in 1856 and hence named as Macaulay Durat ion.
PDF created with pdfFactory trial version www.pdffactory.com
34
mat urit y ( durat ion) . I n order t o hedge against int erest rat e risks, it is essent ial for t hem t o
mat ch t he durat ion of t he port folio of fixed income securit ies wit h t hat of t he liabilit ies. A bank
t hus needs t o rebalance it s port folio of fixed- income securit ies periodically t o ensure t hat t he
aggregat e durat ion of t he port folio is kept equal t o t he t ime remaining t o t he t arget dat e. One
should not e t hat t he durat ion of a short - t erm bond declines fast er t han t he durat ion of t he
long- t erm bond. When int erest rat es fall, t he reinvest ment of int erest s ( unt il t he t arget dat e)
will yield a lower value but t he capit al gain arising from t he bond is higher. The increase or
decrease in t he coupon income arising from changes in t he reinvest ment rat es will offset t he
opposit e changes in t he market values of t he bonds in t he port folios. The net realized yield at
t he t arget dat e will be equal t o t he yield t o mat urit y of t he original port folio. This is also called
bond port folio immunizat ion.
Ex ampl e 3.14
What is t he durat ion for a 5-year mat urit y, 7% ( semi- annual) coupon bond wit h yield t o
mat urit y of 12%?
Here:
t = 1 t o 10
T = 10
Coupon payment = 3.5% of 1,000 = 35
YTM = 12 % or 6% for half year.
Period Time t ill Cash PV of Cash Flow ( discount Weight s ( b)* ( e)
payment Flow = 6% per period)
( a) ( b) ( c ) ( d) ( e) ( f )
( 33.02/ 816)
1 0.5 35 33.02 = 0.0405 0.0202
2 1 35 31.15 0.0382 0.0382
3 1.5 35 29.39 0.0360 0.0540
4 2 35 27.72 0.0340 0.0679
5 2.5 35 26.15 0.0321 0.0801
6 3 35 24.67 0.0302 0.0907
7 3.5 35 23.28 0.0285 0.0998
8 4 35 21.96 0.0269 0.1076
9 4.5 35 20.72 0.0254 0.1142
10 5 1035 577.94 0.7083 3.5413
Sum 816.00 1.0000 4.2142
PDF created with pdfFactory trial version www.pdffactory.com
35
The selling price of t he bond as calculat ed from column ( d) is Rs. 816.00. The durat ion of t he
bond is 4.2142 years.
Since for a zero coupon bond, t he cash flow is only on t he mat urit y dat e, t he durat ion equals
t he bond mat urit y. For coupon-paying bonds, t he durat ion will be less t han t he mat urit y period.
Since cash flows at each t ime are used as weight s, t he durat ion of a bond is inversely relat ed
t o t he coupon rat e. A bond wit h high coupon rat e will have lower durat ion as compared t o a
bond wit h low coupon rat e.
Ex ampl e 3.15
What is t he durat ion for a 5-year mat urit y zero coupon bond wit h yield t o mat urit y of 12%?
Answer: One does not need t o do any calculat ion for answering t his quest ion. All cash flows
are only on t he mat urit y dat e and hence t he durat ion for t his bond is t he mat urit y dat e.
Alt hough durat ion helps us in measuring t he effect ive mat urit y of t he bond, invest ors are
concerned more about t he bond price sensit ivit y wit h respect t o change in int erest rat es. I n
order t o measure t he price sensit ivit y of t he bond wit h respect t o t he int erest rat e movement s,
we need t o find t he so-called modified durat ion (MD) of t he bond. Modified durat ion is calculat ed
from durat ion ( D) using t he following formula:
n
y
D
MD
+
·
1
,
Where,
y = yield t o mat urit y of t he bond
n = number of coupon payment s in a year.
The price change sensit ivit y of modified durat ion is calculat ed using t he following formula:
Change Yield MD Change Price
*
( –) ( %) ·
Not e t he use of minus (- ) t erm. This is because price of a bond is negat ively relat ed t o t he yield
of t he bond.
Ex ampl e 3.16
Refer t o t he bond in Example 3 14 i.e. 5-year mat urit y, 7% ( semi- annual) coupon bond wit h
yield t o mat urit y of 12%. Calculat e t he change in bond price if t he YTM falls t o 11%.
Answer: I n Example 3 14, we calculat ed t he durat ion t o be 4.2142 and t he bond price t o be
816. The modified durat ion of t he bond is:
PDF created with pdfFactory trial version www.pdffactory.com
36
976 . 3
06 . 1
2142 . 4
2
12 .
1
2142 . 4
1
· ·
+
·
+
·
n
y
D
MD
The price change will - 3.976* 1 = 3.976% or Rs. 816 * 3.976% = 32.45
New Price = 816 + 32.45 = 848.45
Check: The act ual market price of a 5-year mat urit y, 7% ( semi- annual) coupon bond wit h YTM
= 11% would be:
25 . 849
2
11 . 0
1
1000
2
11 . 0
1
35
2
1
2
1
10
1
10
·

,
_

¸
¸
+
+

,
_

¸
¸
+
·

,
_

¸
¸
+
+

,
_

¸
¸
+
·
∑ ∑
· t
t T
T
t
t
y
Value Face
y
Coupon
Price Bond
Not e t hat t here is st ill some minor differences in t he act ual price and t he bond price calculat ed
using t he modified durat ion formula, due t o what is called ‘convexit y’. However, we would not
be covering t he concept in t his chapt er.
PDF created with pdfFactory trial version www.pdffactory.com
37
CHAPTER 4: Capi t al Mar k et Ef f i ci ency
4.1 I nt r oduct i on
The Efficient Market s Hypot hesis ( EMH) is one of t he main pillars of modern finance t heory,
and has had an impact on much of t he lit erat ure in t he subj ect since t he 1960’s when it was
first proposed and on our underst anding about pot ent ial gains from act ive port folio management .
Market s are efficient when prices of securit ies assimilat e and reflect informat ion about t hem.
While market s have been generally found t o be efficient , t he number of depart ures seen in
recent years has kept t his t opic open t o debat e.
4.2 Mar k et Ef f i ci ency
The ext ent t o which t he financial market s digest relevant informat ion int o t he prices is an
import ant issue. I f t he prices fully reflect all relevant informat ion inst ant aneously, t hen market
prices could be reliably used for various economic decisions. For inst ance, a firm can assess
t he pot ent ial impact of increased dividends by measuring t he price impact creat ed by t he
dividend increase. Similarly, a firm can assess t he value of a new invest ment t aken up by
ascert aining t he impact on it s market price on t he announcement of t he invest ment decision.
Policymakers can also j udge t he impact of various macroeconomic policy changes by assessing
t he market value impact . The need t o have an underst anding about t he abilit y of t he market t o
imbibe informat ion int o t he prices has led t o count less at t empt s t o st udy and charact erize t he
levels of efficiency of different segment s of t he financial market s.
The early evidence suggest s a high degree of efficiency of t he market in capt uring t he price
relevant informat ion. Formally, t he level of efficiency of a market is charact erized as belonging
t o one of t he following ( i) weak- form efficiency ( ii) semi- st rong form efficiency ( iii) st rong-
form efficiency.
4.2.1 Weak - f or m Mar k et Ef f i ci ency
The weak- form efficiency or random walk would be displayed by a market when t he consecut ive
price changes ( ret urns) are uncorrelat ed. This implies t hat any past pat t ern of price changes
are unlikely t o repeat by it self in t he market . Hence, t echnical analysis t hat uses past price or
volume t rends do not t o help achieve superior ret urns in t he market . The weak- form efficiency
of a market can be examined by st udying t he serial correlat ions in a ret urn t ime series.
Absence of serial correlat ion indicat es a weak- form efficient market .
4.2.2 Semi - st r ong Mar k et Ef f i ci ency
The semi- st rong form efficiency implies t hat all t he publicly available informat ion get s reflect ed
in t he prices i nst ant aneously. Hence, in such market s t he impact of posi t ive ( negat ive)
PDF created with pdfFactory trial version www.pdffactory.com
38
informat ion about t he st ock would lead t o an inst ant aneous increase ( decrease) in t he prices.
Semi- st rong form efficiency would mean t hat no invest or would be able t o out perform t he
market wit h t rading st rat egies based on publicly available informat ion.
The hypot hesis suggest s t hat only informat ion t hat is not publicly available can benefit invest ors
seeking t o earn abnormal ret urns on invest ment s. All ot her informat ion is account ed for in t he
st ocks price and regardless of t he amount of fundament al and t echnical analysis one performs,
above normal ret urns will not be had.
The semi- st rong form efficiency can be t est ed wit h event - st udies. A t ypical event st udy would
involve assessment of t he abnormal ret urns around a significant informat ion event such as
buyback announcement , st ock split s, bonus et c. Here, a t ime period close t o t he select ed
event including t he event dat e would be used t o examine t he abnormal ret urns. I f t he market
is semi-st rong form efficient , t he period aft er a favorable (unfavorable) event would not generat e
ret urns beyond ( less t han) what is suggest ed by an equilibrium pricing model ( such as CAPM,
which has been discussed lat er in t he book) .
4.2.3 St r ong Mar k et Ef f i ci ency
The level of efficiency ideally desired for any market is st rong form efficiency. Such efficiency
would imply t hat bot h publicly available informat ion and privat ely ( non- public) available
informat ion are fully reflect ed in t he prices inst ant aneously and no one can earn excess ret urns.
A t est of st rong form efficiency would be t o ascert ain whet her insiders of a firm are able t o
make superior ret urns compared t o t he market . Absence of superior ret urn by t he insiders
would imply t hat t he market is st rongly efficient . Test ing t he st rong- form efficiency direct ly is
difficult . Therefore, t he claim about st rong form efficiency of any market at t he best remains
t enuous.
I n t he years immediat ely following t he proposal of t he market efficiency, t est s of various forms
of efficiency had suggest ed t hat t he market s are reasonably efficient . Over t ime, t his led t o
t he gradual accept ance of t he efficiency of market s.
4.3 Depar t ur es f r om t he EMH
Evidence accumulat ed t hrough research over t he past t wo decades, however, suggest s t hat
during many episodes t he market s are not efficient even in t he weak form. The ret urns are
found t o be correlat ed bot h for short as well as long lags during such episodes. The downward
and upward t rending of prices is well document ed across different market s ( moment um effect ) .
Then t here is a whole host of ot her document ed deviat ions from efficiency. They include, t he
predict abilit y of fut ure ret urns based on cert ain event s and high volat ilit y of prices compared
t o volat ilit y of t he underlying fundament als. All t hese evidences have st art ed t o offer a challenge
t o t he earlier claim of efficiency of t he market . The lack of reliabilit y about t he level of efficiency
of t he market prices makes it less reliable as a guideline for decision- making.
PDF created with pdfFactory trial version www.pdffactory.com
39
Alt ernat ive prescript ions about t he behaviour of market s are widely discussed t hese days.
Most of t hese prescript ions are based on t he irrat ionalit y of t he market s in eit her processing
t he informat ion relat ed t o an event or based on biased invest or preferences. For inst ance, if
t he invest ors on an average are overconfident about t heir invest ment abilit y, t hey would not
pay close at t ent ion t o new price relevant informat ion t hat arises in t he market . This leads t o
inadequat e price response t o t he informat ion event and possibly cont inuat ion of t he t rend due
t o t he under react ion. This bias in processing informat ion is claimed t o be t he cause of price
moment um. Biased invest or preferences include aversion t o t he realizat ion of losses incurred
in a st ock. This again would lead t o under react ion.
The market efficiency claim was based on t he assumpt ion t hat irrat ional ( biased) invest ors
would be exploit ed by t he rat ional t raders, and would event ually lose out in t he market ,
leading t o t heir exit . Therefore, even in t he presence of biased t raders t he market was expect ed
t o evolve as efficient . However, more recent evidence suggest t hat t he irrat ional t raders are
not exit ing t he market as expect ed, inst ead at many inst ances t hey appear t o make profit s at
t he expense of t he rat ional t raders.
Some of t he well-known anomalies—or depart ures from market efficiency—are calendar effect s
like t he January effect and various day- of- t he- week effect s and t he so- called size effect . The
January effect was first document ed in t he US market s—st ock ret urns were found t o be higher
in January t han in any ot her mont h. Since t hen, it has been empirically t est ed in a number of
int ernat ional market s, like Tokyo, London, and Paris among ot hers. While t he evidence has
been mixed, t he fact t hat it exist s implies a persist ent deviat ion from market efficiency.
St ock ret urns are generally expect ed t o be independent across weekdays, but a number of
st udies have found ret urns on Monday t o be lower t han in t he rest of t he week. One of t he
reasons put forward t o explain t his anomaly is t hat ret urns on Monday are expect ed t o be
different , given t hat t hey are across Friday- end- t o- Monday- morning, a much longer period
t han any ot her day, and hence wit h more informat ion. This is why t his depart ure from market
efficiency is also somet imes called t he weekend effect .
The alt ernat ive prescript ions about t he behaviour of market s based on various sources and
forms of invest or irrat ionalit y are collect ively known as behavioral finance. I t implies t hat ( i)
t he est imat ion of expect ed ret urns based on met hods such as t he capit al asset pricing model
is unreliable, and ( ii) t here could be many profit able t rading st rat egies based on t he collect ive
irrat ionalit y of t he market s.
Depart ures from market efficiency, or t he delays in market s reaching equilibrium ( and t hus
efficiency) leave scope for act ive port folio managers t o exploit mispricing in securit ies t o t heir
benefit . A number of invest ment st rat egies are t ailored t o profit from such phenomena, as we
would see in lat er chapt ers.
PDF created with pdfFactory trial version www.pdffactory.com
40
CHAPTER 5: Fi nanci al Anal y si s and Val uat i on
5.1 I nt r oduct i on
I nvest ment s in capit al market s primarily involve t ransact ions in shares, bonds, debent ures,
and ot her financial product s issued by companies. The decision t o invest in t hese securit ies is
t hus linked t o t he evaluat ion of t hese companies, t heir earnings, and pot ent ial for fut ure
growt h. I n t his chapt er we look at one of t he most import ant t ools used for t his purpose,
Valuat ion. The fundament al valuat ion of any asset ( and companies are indeed asset s int o
which we invest ) is an examinat ion of fut ure ret urns, in ot her words, t he cash flows expect ed
from t he asset . The ‘value’ of t he asset is t hen simply what t hese cash flows are wort h t oday,
i.e., t heir present discount ed value. Valuat ion is all about how well we predict t hese cash flows,
t heir growt h in fut ure, t aking int o account fut ure risks involved.
5.2 The Anal y si s of Fi nanci al St at ement s
A company’s financial st at ement s provide t he most accurat e informat ion t o it s management
and shareholders about it s operat ions, efficiency in t he allocat ion of it s capit al and it s earnings
profile. Three basic account ing st at ement s form t he backbone of financial analysis of a company:
t he income st at ement ( profit & loss) , t he balance sheet , and t he st at ement of cash flows. Let
us quickly summarize each of t hese.
5.2.1 I ncome St at ement ( Pr of i t & Loss)
A profit & loss st at ement provides an account of t he t ot al revenue generat ed by a firm during
a period ( usually a financial year or a quart er) , t he expenses involved and t he money earned.
I n it s simplest form, revenue generat ion or sales accrues from selling t he product s manufact ured,
or services rendered by t he company. Operat ing expenses include t he cost s of t hese goods
and services and t he cost s incurred during t he manufact ure. Beyond operat ing expenses are
int erest cost s based on t he debt profile of t he company. Taxes payable t o t he Government are
t hen debit ed t o provide t he Profit Aft er Tax ( PAT) or t he net income t o t he shareholders of t he
company.
Act ual P&L st at ement s of companies are usually much more complicat ed t han t his, wit h so-
called ‘ot her income’ ( income from non- core act ivit ies) , ‘negat ive’ int erest expenses ( from
cash reserves wit h t he company) , preferred dividends, and non- recurring, except ional income
or expenses. The example given below is t hat of a large company in t he Pharmaceut ical sect or
over t he period 2006- 2008.
PDF created with pdfFactory trial version www.pdffactory.com
41
I l l ust r at i on 5.1
I ncome St at ement ( US$M) 2006 2007 2008
Net sales 16,380 21,340 33,565
Cost of sales ( 5,332) ( 6,584) ( 8,190)
SG&A ( 1,408) ( 1,771) ( 2,738)
Research & development ( 1,534) ( 2,440) ( 2,725)
Ot her operat ing it ems ( 3,650) ( 4,620) ( 5,369)
EBI T 4,457 5,926 14,543
Tot al ot her non- operat ing it ems 543 1,336 305
Associat es 0 0 0
Net int erest income/ expense 869 1,072 1,146
Except ional it ems 0 0 0
Pr et ax pr of i t 5,869 8,334 15,994
Taxat ion ( 239) 67 ( 485)
Minorit y int erest 3 ( 559) ( 640)
Preferred dividends 0 0 0
Net ext raordinary it ems 100 0 0
Repor t ed net i ncome 5,733 7,843 14,869
5.2.2 The Bal ance Sheet
Asset s owned by a company are financed eit her by equit y or debt and t he balance sheet of a
company is a snapshot of t his capit al st ruct ure of t he firm at a point in t ime; t he sources and
applicat ions of funds of t he company.
A company owns f i xed asset s ( machi ner y, and ot her i nf r ast r uct ur e) , cur r ent asset s
( manufact uring goods in progress, money it expect s t o receive from business part ners—
receivables, invent ory et c.) , cash and ot her financial invest ment s. I n addit ion t o t hese t hree,
a company could also own ot her asset s which carry value, but are not direct ly market able, like
pat ent s, t rademarks, and ‘goodwill’—value not linked t o asset s, but realized from acquisit ions.
These asset s are financed eit her by t he company’s equit y (invest ment s by shareholders) or by
debt . The illust rat ive example shown below is t he balance sheet of a large Pharmaceut ical
company.
PDF created with pdfFactory trial version www.pdffactory.com
42
I l l ust r at i on 5.2
Bal ance Sheet ( US$m) 2006 2007 2008
Cash and market able securit ies 15,628 14,106 17,290
Account s receivable 3,609 6,789 14,177
I nvent ory 5,117 6,645 7,728
Ot her current asset s 2,471 2,653 5,079
Cur r ent asset s 26,826 30,192 44,274
Net t angible fixed asset s 8,977 10,122 11,040
Tot al financial asset s 3,237 2,239 2,659
Net goodwill 507 697 1,729
Tot al asset s 39,547 43,250 59,701
Account s payable 2,279 2,966 3,722
Short - t erm debt 0 0 0
Tot al ot her current liabilit ies 1,236 80 2,651
Cur r ent l i abi l i t i es 3,515 3,046 6,373
Long- t erm debt 18,747 11,144 1,436
Tot al ot her non- current liabilit ies 1,053 895 92
Tot al provisions 0 0 0
Tot al l i abi l i t i es 23,314 15,085 7,901
Minorit y int erest – accumulat ed 332 438 1,886
Shareholders’ equit y 15,902 27,728 49,915
Shar ehol der s’ f unds 16,233 28,166 51,800
Li abi l i t i es and shar ehol der s’ f unds 39,547 43,250 59,701
5.2.3 Cash Fl ow St at ement
The cash flow st at ement is t he most import ant among t he t hree financial st at ement s, part icularly
from a valuat ions perspect ive. As t he name implies, such a st at ement is used t o t rack t he cash
flows in t he company over a period. Cash flows are t racked across operat ing, invest ing, and
financing act ivit ies. Cash flows from operat ions include net income generat ion adj ust ed for
changes in working capit al ( like invent ories, receivables and payables) , and non- core accruals
(like depreciat ion, et c). A firm’s invest ment act ivit ies comprise fixed, and current asset s (capit al-
and operat ing expendit ure) , somet imes int o ot her firms ( like an acquisit ion) , and generally
represent negat ive cash flows. Cash flows in financing act ivit ies are t he net result of t he firm’s
borrowing, and payment s during t he period. The sum t ot al of cash flows from t hese t hree
heads represent s t he net change in cash balances of t he firm over t he period.
PDF created with pdfFactory trial version www.pdffactory.com
43
Cash generat ion from operat ing act ivit ies of t he firm, when adj ust ed for it s capit al expendit ure
represent t he ‘free cash’ available t o it , for pot ent ial invest ment act ivit ies, acquiring ot her
firms or businesses, or dist ribut ion among it s shareholders. As we will see in lat er t opics, free
cash flows are t he key t o calculat ing t he so- called int rinsic value of an asset in any discount ed
valuat ion model. Our illust rat ive example below shows t he cash flow st at ement ( and free cash
flows) of a large pharmaceut ical company over t he period 2006- 2008.
I l l ust r at i on 5.3
Cash Fl ow ( US$M) 2006 2007 2008
Report ed net income 5,733 7,843 14,869
Preferred dividends 0 0 0
Minorit y int erest ( 3) 559 640
Depreciat ion and amort izat ion 610 813 969
Cash t ax adj ust ment 75 ( 511) ( 1,337)
Tot al ot her operat ing cash flow ( 1,365) ( 2,156) ( 753)
Net change in working capit al ( 3,177) ( 4,154) ( 9,340)
Cash f r om oper at i ons 1,872 2,394 5,048
Capit al expendit ure ( 3,387) ( 2,000) ( 1,995)
Net acquisit ions/ disposals 3,511 1,367 ( 5,242)
Tot al ot her invest ing cash flows 634 1,272 1,177
Cash f r om i nvest i ng act i vi t i es 758 639 ( 6,060)
Change in borrowings 805 ( 1,742) 768
Equit y raised/ share buybacks 0 0 0
Dividends paid ( 793) ( 2,629) ( 18)
Tot al ot her financing cash flows ( 156) ( 127) ( 88)
Cash f r om f i nanci ng act i vi t i es ( 144) ( 4,498) 661
Change i n cash 3,518 ( 1,465) ( 352)
Fr ee cash f l ow ( 1,514) 394 3,052
5.3 Fi nanci al Rat i os ( Ret ur n, Oper at i ng and, Pr of i t abi l i t y Rat i os)
Financial rat ios are meaningful links bet ween different ent ries of financial st at ement s, as by
t hemselves t he financial ent ries offer lit t le t o examine a company. I n addit ion t o providing
informat ion about t he financial healt h and prospect s of a company, financial rat ios also allow
a company t o be viewed, in a relat ive sense, in comparison wit h it s own hist orical performance,
ot hers in it s sect or of t he economy, or bet ween any t wo companies in general. I n t his sect ion
we examine a few such rat ios, grouped int o cat egories t hat allow comparison of size, solvency,
PDF created with pdfFactory trial version www.pdffactory.com
44
operat ing performance, growt h profile and risks. The list below is by no means exhaust ive,
and merely serves t o illust rat e a few of t he import ant ones.
5.3.1 Measur es of Pr of i t abi l i t y: RoA, RoE
Ret ur n on Asset s ( RoA) in it s simplest form denot es t he firm’s abilit y t o generat e profit s
given it s asset s :
RoA = ( Net I ncome + I nt erest Expenses) * ( 1- Tax Rat e) / Average Tot al Asset s
Ret ur n on Equi t y ( RoE) is t he ret urn t o t he equit y invest or :
RoE = Net I ncome / Shareholder Funds
Somet imes t his rat io is also calculat ed as RoAE, t o account for recent capit al raising by
t he firm
Ret urn on Average Equit y = Net I ncome / Average Shareholder Funds
Ret urn on Tot al Capit al = Net I ncome + Gross I nt erest Expense / Average t ot al capit al
5.3.2 Measur es of Li qui di t y
Short - t erm liquidit y is imperat ive for a company t o remain solvent . The rat ios below get
increasingly conservat ive in t erms of t he demands on a firm t o meet near- t erm payables.
Current rat io = Current Asset s / Current Liabilit ies
Quick Rat io = ( Cash + Market able Securit ies + Receivables) / Current Liabilit ies
Acid t est rat io = ( Cash + Market able Securit ies) / Current Liabilit ies
Cash Rat io = ( Cash + Market able Securit ies) / Current Liabilit ies
5.3.3. Capi t al St r uct ur e and Sol vency Rat i os
Tot al debt t o t ot al capit al = ( Current Liabilit ies + Long- t erm Liabilit ies) /
( Equit y + Tot al Liabilit ies)
Long- t erm Debt - Equit y = Long- t erm Liabilit ies / Equit y
5.3.4 Oper at i ng Per f or mance
Gross Profit Margin = Gross Profit / Net Sales
Operat ing Profit Margin = Operat ing I ncome / Net Sales
Net Profit Margin = Net I ncome / Net Sales
5.3.5 Asset Ut i l i zat i on
These rat ios look at t he effect iveness of a firm t o ut ilize it s asset s, especially it s fixed asset s.
A high t urnover implies opt imal use of asset s. I n addit ion t o t he t wo below t here are ot hers like
Sales t o invent ories, and Sales t o Working capit al.
Tot al Asset Turnover = Net Sales / Average Tot al Asset s
Fixed Asset Turnover = Net Sales / Average Net Fixed Asset s
There are many ot her cat egories, like t he ‘common size’ rat ios, which serve t o present t he
company in t erms of one of it s own denominat ors, like Net Sales, or t he market capit alizat ion;
and ot hers t hat specifically look at t he risk aspect of t hings ( business, financial, and liquidit y) .
PDF created with pdfFactory trial version www.pdffactory.com
45
We shall t ake a look at anot her t wo cat egories, t he market measures, and valuat ion rat ios,
aft er t he discussion on valuat ions.
5.4 The v al uat i on of common st ock s
I n chapt er 3, we examined a few of t he maj or valuat ion met hods for fixed income- generat ing
asset s. Using financial st at ement s and rat ios, we now examine some of t he concept s relat ing
t o share valuat ions and t o be more specific, we will deal wit h valuat ion of common st ocks.
Common shareholders are t he owners of t he firm, and as such are t he final st akeholders in it s
growt h, and risks; t hey appoint t he management t o run it s day- t o-day affairs and t he Board of
Dir ect ors t o oversee t he management ’s act i vit ies. The cash f lows ( r et ur n) t o common
shareholders from t he company are generally in t he form of current and fut ure dividends
dist ribut ed from t he profit s of t he firm. Alt ernat ively, an invest or can always sell her holdings
in t he mar ket ( secondary mar ket ) , get t he prevai ling mar ket price, and reali ze capit al
appreciat ion if t he ret urns are posit ive.
We now examine t he valuat ion of common shares in some det ail. As ment ioned above, t he
valuat ion of any asset is based on t he present value of it s fut ure cash flows. Such a met hodology
provides what is called t he ‘int rinsic’ value of t he asset —a common st ock in our case. The
problem of valuing t he st ock t hen t ranslat es int o one of predict ing t he fut ure free cash flow
profile of t he company, and t hen using t he appropriat e discount fact or t o measure what t hey
are wort h t oday. The appropriat ely named discount ed- cash flow t echnique is also referred t o
as absolut e valuat ion, part icularly when compared t o anot her widely- followed approach in
valuat ion, called relat ive valuat ion.
Relat ive valuat ion looks at pricing asset s on t he basis of t he pricing of ot her, similar asset s—
inst ead of pricing t hem independent ly—t he core assumpt ion being t hat asset s wit h similar
earnings and growt h profile, and facing t he same risks ought t o be priced comparably. Two
st ocks in t he same sect or of t he economy could t hus be compared, and t he same sect or ( and
it s st ocks) across count ries. The discussion on relat ive valuat ion follows t hat of absolut e or
int rinsic valuat ion.
5.4.1 Absol ut e ( I nt r i nsi c) Val uat i on
I nt rinsic value or t he fundament al value refers t o t he value of a securit y, which is int rinsic t o or
cont ained in t he securit y it self. I t is defined as t he present value of all expect ed cash flows t o
t he company. The est imat ion of int rinsic value is what we would be dealing wit h in det ails in
t his chapt er.
5.4.1.1 Di scount ed Cash Fl ow s
The discount ed cash flow met hod values t he share based on t he expect ed dividends from t he
PDF created with pdfFactory trial version www.pdffactory.com
46
shares. The price of a share according t o t he discount ed cash flow met hod is calculat ed as
under:


·
+
·
1
0
) 1 (
t
t
t
r
Div
P
Since t he profit s of t he firm are not cert ain, t he act ual fut ure dividends are not known in
advance. However, t he market forms an expect at ion of t he fut ure dividends and t he value of a
share is t he present value of expect ed fut ure dividends of t he company. I t can be shown t hat
t he formula can be seen as an ext ension of t he formula
) 1 (
1 1
0
r
P Div
P
+
+
·
.
As explained above, we can writ e t he share price at t he end of t he year 1 as a funct ion of t he
2nd year dividend and price of share at t he end of t he year 2. Or,
) 1 (
2 2
1
r
P Div
P
+
+
·
Similarly,
) 1 (
3 3
2
r
P Div
P
+
+
·
and so on.
Put t ing t he values of P
1
, P
2
, P
3
, P
4
, we can writ e:
N
N
N
N
r
P
r
Div
r
Div
r
Div
r
Div
r
P Div
P
) 1 ( ) 1 (
....
) 1 ( ) 1 (
1 ) 1 (
3
3
2
2
1 1 1
0
+
+
+
+ +
+
+
+
+
+
·
+
+
·
Now when N t ends t o infinit y,
N
r ) 1 ( + t ends t o infinit y and t he value of
N
N
r
P
) 1 ( +
t ends t o zero
and t herefore may be ignored. So t he current share price ( P
0
) can be writ t en as:


·
+
·
1
0
) 1 (
t
t
t
r
Div
P
5.4.1.2 Const ant Di vi dend Gr ow t h
Let us see a special case of t he above model when it is assumed t hat amount paid as dividends
grows at a const ant rat e ( say g) every year. I n t his case, t he cash flows in various years will be
as under:
Year Cash Flow
0 - P
0
1 Div
1
2 Div
2
= Div
1
* ( 1+ g)
3 Div
3
= Div
2
* ( 1+ g) = Div
1
* ( 1+ g)
2
4 Div
4
= Div
3
* ( 1+ g) = Div
2
* ( 1+ g)
2
= Div
1
* ( 1+ g)
3
I n t his circumst ance, where t he dividend amount grows at a const ant rat e, t he const ant dividend
PDF created with pdfFactory trial version www.pdffactory.com
47
growt h model st at es t hat t he share price can be obt ained using t he simple formula:
g r
Div
P

1
0
·
This formula can be used only when t he expect ed rat e of ret urn ( r) is great er t han t he growt h
rat e ( g). Ot herwise, t he present value of t he growing perpet uit y will reach infinit e. This is even
t rue in real world. I t is not possible for a st ock’s dividend t o grow at a rat e g, which is great er
t han r for infinit e period. I t can only be for a limit ed number of years. This model is not
applicable in such cases.
Example: RNL has paid a dividend of Rs. 10 per share last year ( D
0
) and it is expect ed t o grow
at 5% every year. I f an invest or ’s expect ed rat e of ret urn from RNL share is 7%, calculat e t he
market price of t he share as per t he dividend discount model.
Answer: The following are given:
Div
0
= 10; g = 5% or 0.05; r = 7% or 0.07.
50 . 10 05 . 1 * 10 ) 1 ( *
0 1
· · + + g Div Div
525
02 . 0
50 . 10
05 . 0 – 07 . 0
50 . 10

1
0
· · · ·
g r
Div
P
The market price of RNL share as per t he dividend discount model wit h const ant growt h rat e is
Rs. 525.
I f we know t he market price of t he share, t he dividend amount and t he dividend growt h rat e,
t hen we can comput e t he expect ed rat e of ret urn ( r) by using t he following formula:
g
P
Div
r + ·
0
1
5.4.1.3 Pr esent Val ue of Gr ow t h oppor t uni t i es ( PVGO)
One can split t he value of t he shares as comput ed in t he const ant growt h model int o t wo part s
– t he present value of t he share assuming level st ream of earnings (a level st ream of earnings
is simply t he current income ext rapolat ed int o t he fut ure, wit h no growt h; in which case,
t here’s no need t o ret ain any of t he earnings) and t he present value of growt h opport unit ies.
The value of growt h opport unit ies is posit ive if t he firm ( and t he market ) believes t hat t he firm
has avenues t o invest which will generat e a ret urn t hat is more t han t he market expect ed rat e
of ret urn. Now when t he firm’s income pot ent ial from addit ional invest ment is more t han t he
market expect ed rat e of ret urn, t hen for every penny re- invest ed ( plowbacked rat her t han
dist ribut ed as dividend) will generat e a ret urn t hat is higher t han t he market expect at ion. The
PDF created with pdfFactory trial version www.pdffactory.com
48
value of such excess ret urn is referred t o as present value of growt h opport unit ies.
PVGO = Share Price – Present value of level st ream of earnings
= Share price – EPS / r
The growt h in t he fut ure dividend arises because t he firms, inst ead of dist ribut ing 100% of t he
earnings as dividends, plowbacks and invest s cert ain port ion of t he current year profit on
proj ect s whose yield will be great er t han t he market expect ed rat e of ret urn.
The growt h rat e in dividend ( g) , equals, t he Plowback rat io * ROE.
5.4.1.4 Di scount ed Fr ee- cash f l ow val uat i on model s
Using t he above concept s, we are now in a posit ion t o look at valuat ion using cash flows, wit h
t he discount ed free cash flow model. We first det ermine t he value of t he ent erprise and t hen
value t he equit y by deduct ing t he debt value from t he firm value. Thus:
Market value of equit y ( V
0
) = Value of t he firm + Cash in hand – Debt Value
The price of t he share ( P
0
) is t he market value of t he equit y divided by t he number of shares
out st anding.
I t is simple t o calculat e t he debt value since t he payment s t o be made t o debt holders is
predet ermined and cert ain. However, t he real problem lies wit h det ermining t he value of t he
firm. As per t he discount ed free cash flow model, t he value of a firm is t he present value of t he
fut ure free cash flow of t he firm. The discount ing rat e is t he firms weight ed average cost of
capit al ( WACC) and not t he market expect ed rat e of ret urn on equit y invest ment . WACC is t he
cost of capit al t hat reflect s t he risk of t he overall business and not t he risk associat ed wit h t he
equit y invest ment alone. WACC is calculat ed using t he following formula:
E D
E
r
E D
D
T r WACC
E D
+
+
+
· * * ) – 1 (
where
r
D
and r
E
is t he expect ed rat e of ret urn on debt and equit y
T = I ncome Tax Rat e
D = t he market value of debt ; E = t he market value of equit y
The firm value ( V
0
) is calculat ed using t he following formula:
N
wacc
N
N
wacc
N
wacc wacc
wacc
r
e Valu minal Ter
r
FCF
r
FCF
r
FCF
r
FCF
V
) 1 (
) (
) 1 (
. . . .
) 1 ( ) 1 (
1
3
3
2
2 1
0
+
+
+
+ +
+
+
+
+
+
·
The t erminal value at year N is oft en comput ed by assuming t hat t he FCF will grow at a
const ant growt h rat e beyond year N, i.e.
PDF created with pdfFactory trial version www.pdffactory.com
49
) – ) ( (
) 1 ( *
) – ) ( (
1
FCF WACC
FCF
FCF WACC
N
N
g r
g FCF
g r
FCF
Value Terminal
+
· ·
+
where g
FCF
is t he expect ed growt h rat e of t he firms free cash flow
What is free cash flow ( FCF) ? The free cash measures t he cash generat ed by t he firm t hat can
be dist ribut ed t o t he equit y shareholders aft er budget ing for capit al expendit ure and working
capit al requirement s. While comput ing FCF, we assume t hat t he firm is a 100% equit y owned
company and hence we do not consider any payment t o debt or equit y holders while calculat ing
t he free cash flow. Thus t he formula for comput ing FCF is:
Capit al Working in I ncrease – e Expendit ur Capit al – Depn T – * EBI T VFCF Terminal + · ) ( 1
where T in t he t ax rat e.
We st art wit h EBI T since we do not consider cash out flow in t he form of int erest payment s.
Depreciat ion lowers t he EBI T but is added back since it is a non- cash expendit ure ( does not
result in cash payment s) . Since t he firm has t o incur any planned capit al expendit ure and has
t o finance any working capit al requirement before dist ribut ing t he profit s t o t he shareholders
t he same is deduct ed while calculat ing t he free cash flows.
5.4.2 Rel at i ve Val uat i on
Relat ive valuat ion models do calculat e t he share price but t hey are generally based on t he
valuat ion of comparable firms in t he indust ry. Various valuat ion mult iples such as price-earning
rat io, ent erprise value mult iples, et c. are used by t he finance professionals which depends on
t he indust ry, current economic scenario, et c. Most of t hese models are generally used for
evaluat ion purpose as t o whet her a part icular st ock is overvalued or undervalued and less for
act ual valuat ion of t he shares.
As discussed in t he first chapt er, t he face value or nominal value of a share is t he price print ed
on t he share cert ificat e. One should not confuse a share’s nominal value wit h t he price at
which t he company issues shares t o t he public. The price at which a company issues shares
may be more or less t han t he face value. The issue price is generally more t han t he face value
and t he difference bet ween t he issue price and t he face value is called as share premium.
Market price is t he price at which t he share is t raded in t he market . I t is det ermined by t he
demand and supply of t he share in t he market and depends on t he market ( buyers and sellers)
est imat ion of t he present value of all fut ure cash flows t o t he company. I n an efficient market ,
we assume t hat t he market is able t o gat her all informat ion about t he company and price
accordingly. Market capit alizat ion of a company is t he t ot al value of all shares of t he company
and is calculat ed by mult iplying t he market price per share wit h t he number of shares out st anding
in t he market .
PDF created with pdfFactory trial version www.pdffactory.com
50
The book val ue or car r yi ng val ue in account ing, is t he value of an asset according t o it s
balance sheet account balance. For asset s, t he value is based on t he original cost of t he asset
less any depreciat ion, amort izat ion or impairment cost s made against t he asset . Book value
per share is calculat ed by dividing t he net asset s of t he company wit h t he number of shares
out st anding. The net asset of t he company is t he values of all asset s less values of all liabilit ies
out st anding in t he books of account s.
5.4.2.1 Ear ni ng per Shar e ( EPS)
Earning per share is t he firms’ net income divided by t he average number of shares out st anding
during t he year.
Calculat ed as:
year t he during g out st andin shares of number Average
Shares Preference on Dividend – Proift Net
EPS ·
5.4.2.2 Di vi dend per Shar e ( DPS)
Dividends are a form of profit dist ribut ion t o t he shareholders. The firm may not dist ribut e t he
ent ire income t o t he shareholders, but decide t o ret ain some port ion of it for financing growt h
opport unit ies. Alt ernat ively, a firm may pay dividends from past years profit during years
where t here is insufficient income. I n t his case, t he dividends amount will be higher t han t he
earnings. The dividend per share is t he amount t hat t he firm pays as dividend t o t he holder of
one share i.e. t ot al dividend / number of shares in issue.
The dividend payout rat io ( DPR) measures t he percent age of income t hat t he company pays
out t o t he shareholders in t he form of dividends. The formula for calculat ing DPR is:
EPS
DPS
I ncome Net
Dividends
DPR · ·
Ret ent ion rat io is t he opposit e of dividend payout rat io and measures t he percent age of net
income not paid t o t he shareholders in t he form of dividends. I t is not hing but ( 1- DPR) .
Ex ampl e: Th e f ol l owi ng i s t he f i gu r e f or Ash a I n t er n at i on al dur i ng t he y ear
2008- 09:
Net I ncome: Rs. 1,000,000
Number of equit y shares ( 2008) : 150,000
Number of equit y shares ( 2009) : 250,000
Dividend paid: Rs. 400,000
Calculat e t he earnings per share ( EPS) , dividend per share ( DPS) , dividend payout rat io and
PDF created with pdfFactory trial version www.pdffactory.com
51
ret ent ion rat io for Asha I nt ernat ional.
Answer:
000 , 200
2
000 , 250 000 , 150
2
·
+
·
+
·
closing Opening
shar es of number Aver age
5
000 , 200
0000 , 000 , 1
· · ·
shares of Number Average
I ncome Net
EPS
2
000 , 200
000 , 00 , 4
· · ·
shares of Number Average
Dividends
DPS
% 40 4 . 0
5
2
or
EPS
DPS
DPR · · ·
Ret ent ion Rat io = 1- DPR = 0.6 or 60%
5.4.2.3 Pr i ce- ear ni ngs r at i o ( P/ E Rat i o)
Price earning rat io for a company is calculat ed by dividing t he market price per share wit h t he
earnings per share ( EPS) .
share per earning Annual
share per price Market
Rat io Earnings Price ·
The earning per share is usually calculat ed for t he last one year. Somet imes, we also calculat e
t he PE rat io using t he expect ed fut ure one-year ret urn. I n such case, we call forward PE or
est imat ed PE rat io.
Example: St ock XYZ, whose earning per share is Rs. 50 is t rading in t he market at Rs. 2000.
What is t he price t o earnings rat io for XYZ?
Answer:
40
50
2000
· · ·
share per earning Annual
share per price Market
Rat io Earnings Price
We cannot draw any conclusion as t o whet her a st ock is undervalued or overvalued in t he
market by j ust considering t he PE rat io. A higher PE rat io implies t hat t he invest ors are paying
more for each unit of net income, which implies t hat t he invest ors are opt imist ic about t he
fut ure performance ( or fut ure growt h rat e) of t he company. St ocks wit h higher PE rat io are
also called growt h firms and st ocks wit h lower PE rat io are called as income firms.
5.4.2.4 Pr i ce- Book Rat i o
The price- book rat io is widely used as a conservat ive measure of relat ive valuat ion of an asset ,
where t he asset s of t he firm are valued at book. I nvest ors also widely use t he rat io t o j udge
whet her t he st ock is undervalued or overvalued, as it ’s less suscept ible t o fluct uat ions t han t he
PDF created with pdfFactory trial version www.pdffactory.com
52
PE rat io. The formula t o calculat e t he rat io is:
Price- book rat io = Market price of t he share / Book Value per share.
5.4.2.5 Ret ur n on Equi t y
Ret urn on equit y measures profit abilit y from t he equit y shareholders point of view. I t is t he
ret urn t o t he equit y shareholders and is measured by t he following formula:
Capit al Share Preferred Excluding Equit y r Shareholde Average
Dividends Preferred – Tax aft er I ncome Net
ROE ·
Example: XYZ Company net income aft er t ax for t he financial year ending 31
st
March, 2009
was Rs. 10 million and t he equit y share capit al as on 31
st
March, 2008 and 31
st
March 2009
was Rs. 80 mi ll ion and Rs. 120 mi ll ion respect i vely. Calcul at e t he ret urn on equi t y of
XYZ company for t he year 2008- 09.
Answer:
million
Equit y Closing Equit y Opening
Equit y Aver age 100
2
120 80
2
·
+
·
+
·
% 10 10 . 0
100
10
or
Equit y Average
Tax aft er Profit Net
Equit y on Ret urn · · ·
5.4.2.6 The DuPont Model
The Du Pont model is widely used t o decide t he det erminant s of ret urn profit abilit y of a company,
or a sect or of t he economy. Ret urns on shareholder equit y are expressed in t erms of a company’s
profit margins, asset t urn, and it s financial leverage.
DuPont Model breaks t he Ret urn on equit y as under:
RoE = Ret urn on Equit y
= Net Profit s/ Equit y
= Net Profit s/ Sales * Sales/ Asset s * Asset s/ Equit y
= Profit Margin * Asset Turnover * Financial Leverage
The first component measures t he operat ional efficiency of t he firm t hrough it s net margin
rat io. The second component , called t he asset t urnover rat io, measures t he efficiency in usage
of asset s by t he firm and t he t hird component measures t he financial leverage of t he firm
t hrough t he equit y mult iplier. The analysis reflect s a firms’ efficiency in different aspect s of
business and is widely used now for cont rol purpose. I t shows t hat t he firm could improve it s
RoE by a combinat ion of profit abilit y ( higher profit margins), raising leverage ( by raising debt ) ,
by using it s asset s bet t er ( higher asset t urn) or a combinat ion of all t hree.
PDF created with pdfFactory trial version www.pdffactory.com
53
The DuPont analysis could be easily ext ended t o ascert ain a sect or ’s profit abilit y met rics for
comparabilit y, or, for t hat mat t er, an ent ire market .
5.4.2.7 Di vi dend Yi el d
Dividend yield is t he rat io bet ween t he dividend paid during t he last 1-year period and t he
current price of t he share. The rat io could also be used wit h t he forward dividend yield inst ead—
expect ed dividends, for eit her t he next 12 mont hs, or t he financial year.
Example: ABC Company paid a dividend of Rs. 5 per share in 2009 and t he market price of
ABC share at t he end of 2009 was Rs. 25. Calculat e t he dividend yield for ABC st ock.
Answer:
% 20 20 . 0
25
5
or
share per Price Current
dividend year Last
Yield Dividend · · ·
5.4.2.8 Ret ur n t o I nvest or
The ret urn what t he invest or earns during a year by holding t he share of a company is not
equal t o t he dividend per share or t he earnings per rat io. An invest or ’s earning is t he sum of
t he dividend amount t hat he received from t he company and t he change in t he market price of
t he share. The invest ment amount is equal t o t he market price of t he share at t he beginning of
t he year. An invest or ’s ret urn can be calculat ed using t he following formula:
Price Market Opening
share) t he of price ( market Dividends
Ret urn( r) Expect ed
Δ +
·
Example: The share price of PQR Company on 1st April 2008 and 31st March 2009 is Rs. 80
and Rs. 84 respect ively. The company paid a dividend of Rs. 6 for t he year 2008- 09. Calculat e
t he ret urn for a shareholder of PQR Company in t he year 2008- 09.
Answer:
% 5 . 12
80
10
80
) 80 – 84 ( 6 ) (
· ·
+
·
∆ +
·
Price Market Opening
share t he of price market Dividends
Ret urn( r) Expect ed
I f we writ e t he dividends during t he year as Div
1
, t he price of t he share at t he beginning and
at t he end of t he year as P
0
and P
1
respect ively, we can writ e t he above formula as:
0
0 1 1

P
P P Div
r
+
·
This can be re- writ t en as:
) 1 (

1 1
0
r
P Div
P
+
·
PDF created with pdfFactory trial version www.pdffactory.com
54
This implies t hat given t he expect ed rat e of ret urn for an invest or, t he price of a share can be
calculat ed based on t he invest or expect at ion of t he fut ure dividends and t he fut ure share
price. We have already learned in t he previous chapt er about t he fact ors t hat affect t he expect ed
rat e of ret urns and how one can calculat e t he expect ed rat e of ret urns ( e.g. using CAPM) . Now
t he quest ion arises what det ermines t he next year price ( P
1
) of a share.
5.5 Techni cal Anal y si s
Our final approach t o valuat ion is also considered t he most cont roversial, wit h t he numbers of
believers balancing t hose who find fault wit h t he met hodology. Technical analysis involves
making t rading decisions by st udying records or chart s of past st ock prices and volume, and in
t he case of fut ures, open int erest .
The t echnical analyst s do not at t empt t o measure a securit y’s int rinsic value but believe in
making short - t erm profit by analyzing t he volume and price pat t erns and t rends. Technical
analyst s use st at ist ical t ools like t ime series analysis ( in part icular t rend analysis) , relat ive
st rengt h index, moving averages, regressions, price correlat ions, et c. The field of t echnical
analysis is based on t he following t hree assumpt ions.
a) The market discount s everyt hing: Technical analyst s believe t hat t he market price
t akes int o considerat ion t he int rinsic value of t he st ocks along wit h broader economic
fact ors and t he market psychology. Therefore, what is import ant is an analysis of t he
price movement t hat reflect s t he demand and supply of a st ock in t he short run.
b) Price moves in t rends: Trends are of t hree t ypes, viz. upt rend, downt rend and horizont al
t rend. Technical analyst s believe t hat once t rends are est ablished in t he prices, t he
price moves in t he same direct ion as t he t rends suggest s.
c) Hist ory t ends t o repeat it self: This assumpt ion leads t o a belief t hat current invest ors
repeat t he behavior of t he invest ors t hat preceded t hem and t herefore recognizable
price pat t erns can be observed if a chart is drawn.
There are various concept s t hat are used by t echnical analyst s like support prices, resist ance
levels, breakout s, moment um, et c. These concept s can be heard very oft en in business channels
and business newspapers. Support s refer t o t he price level t hrough which a st ock price seldom
falls and resist ance is t he price level t hrough which a st ock seldom surpasses. Breakout refers
t o sit uat ion when t he price act ually falls below t he support level or rises above t he resist ance
level. Once a breakout occurs, t he role is reversed. I f t he price increases beyond t he resist ance
level, t he resist ance level becomes t he support level and when t he price falls below t he support
level, t he support level becomes t he new resist ance level for t he st ock. Moment um refers t o
t he rat e at which price of a st ock changes.
PDF created with pdfFactory trial version www.pdffactory.com
55
5.5.1 Chal l enges t o Techni cal Anal ysi s
There are many quest ions, primarily raised by fundament al analyst s, about t he assumpt ions
of t echnical analysis. While it is underst andable t hat price movement s are caused by t he
int eract ion of supply and demand of securit ies and t hat t he market assimilat es t his informat ion
( as ment ioned in t he first assumpt ion) , t here is no consensus on t he speed of t his adj ust ment
or it s ext ent . I n ot her words, while prices may react t o changes in demand- supply and ot her
market dynamics, t he response could easily differ across securit ies, bot h in t he t ime t aken,
and t he degree t o which prices change. Ot her obj ect ions t o t echnical analysis arise from
Efficient Market s Hypot hesis, which we have seen in Chapt er 4. Proponent s of t he EMH aver
t hat market efficiency would preclude any t echnical t rading pat t erns t o repeat wit h any
predict able accuracy, rendering t he profit abilit y of most such t rading rules subj ect t o chance.
Furt her, t he success of a t rading rule could also make it crowded, in t he sense t hat most
t echnical t raders follow a small set of rules ( albeit wit h possibly different paramet erizat ions) ,
speeding up t he adj ust ment of t he market , and t hus reducing t he pot ent ial gains. Finally,
t echnical analysis involves meaningful levels of subj ect ivit y- int erpret at ions may vary widely
on t he same pat t ern of st ock, or index prices- which also hinders syst emat ic reasoning and
ext ensibilit y across different securit ies.
PDF created with pdfFactory trial version www.pdffactory.com
56
CHAPTER 6: Moder n Por t f ol i o Theor y
6.1 I nt r oduct i on
Underst anding t he risky behaviour of asset and t heir pricing in t he market is crit ical t o various
invest ment decisions, be it relat ed t o financial asset s or real asset s. This underst anding is
most ly developed t hrough t he analysis and generalizat ion of t he behaviour of individual invest ors
in t he market under cer t ai n assumpt ions. The t wo buil ding blocks of t hi s anal ysi s and
generalizat ion are (i) t heory about t he risk-ret urn charact erist ics of asset s in a port folio (port folio
t heory) and ( ii) generalizat ion about t he preferences of invest ors buying and selling risky
asset s ( equilibrium models) . Bot h t hese aspect s are discussed in det ail in t his chapt er, where
our aim is t o provide a brief overview of how finance t heory t reat s st ocks ( and ot her asset s)
individually, and at a port folio level. We first examine t he modern approach t o underst anding
port folio management using t he t rade- off bet ween risk and ret urn and t hen look at some
equilibrium asset- pricing models. Such models help us underst and t he t heoret ical underpinning
and ( hopefully predict ) t he dynamic movement of asset prices.
6.2 Di v er si f i cat i on and Por t f ol i o Ri sk s
The age- old wisdom about not put t ing “ all your eggs in one basket ” applies very much in t he
case of port folios. Port folio risk ( generally defined as t he st andard deviat ion of ret urns) is not
t he weight ed average of t he risk ( st andard deviat ion) of individual asset s in t he port folio. This
gives rise t o opport unit ies t o eliminat e t he risk of asset s, at least part ly, by combining risky
asset s in a port folio. To give an example, consider a hypot het ical port folio wit h say, t en st ocks.
Each of t hese st ocks has a risk profile, a simple and widely used indicat or of which is t he
st andard deviat ion of it s ret urns. I nt uit ively, t he overall risk of t he port folio simply ought t o be
an aggregat ion of individual port folio risks, in ot her words, port folio risk simply ought t o be a
weight ed average of individual st ock risks. Our assert ion here is t hat t he risk of t he port folio is
usually much lower. Why? As we shall see in t he discussion here, t his is largely due t o t he
int errelat ionships t hat exist bet ween st ock price movement s. These so- called covariances
bet ween st ocks, could be posit ive, negat ive, or zero. An example of t wo I T services st ocks,
react ing favourably t o a depreciat ion in t he domest ic currency—as t heir export realizat ions
would rise in t he domest ic currency—is one of posit ive covariance. I f however, we compare
one I T services company wit h anot her from t he met als space, say st eel, which has high foreign
debt , t hen a drop in t he share price of t he st eel company ( as t he falling rupee would increase
t he debt - service payment s of t he st eel firm) and rise in share price of t he I T services company,
would provide an example of negat ive covariance. I t follows t hat we would expect t o have zero
covariance bet ween st ocks whose movement s are not relat ed.
PDF created with pdfFactory trial version www.pdffactory.com
57
Let us now examine why and how port folio risk is different from t he weight ed risk of const it uent
asset s. Assume t hat we have t he following t wo st ocks, as given in t able 6.1 here, and t hen
assume furt her t hat t he ret urns of t he t wo hypot het ical st ocks behave in opposit e direct ions.
When A gives high ret urns, B does not and vice versa. We know t his is quit e possible, as in our
earlier comparison of a soft ware company wit h a commodit y play. For a port folio wit h 60%
invest ed in A, t he port folio st andard deviat ion becomes zero. Alt hough t he t wo st ocks involved
were risky ( indicat ed by t he st andard deviat ions) , a port folio of t he t wo st ocks wit h a cert ain
weight may become t ot ally risk- free. The t able below shows a port folio of t he t wo st ocks wit h
weight of St ock A ( W) being 0.6 and weight of st ock B being ( 1- 0.6) or 0.4. I t can be seen t hat
irrespect ive of t he market condit ion, t he port folio gives a ret urn of 10%.
Tabl e 6.1 : Por t f ol i o of Tw o Asset s
Mar k et Condi t i on Ret ur n on A Ret ur n on B Ret ur n on por t f ol i o
( W= 0.6)
Good 16% 1% 10%
Average 10% 10% 10%
Poor 4% 19% 10%
St andard deviat ion 5% 7% 0%
Correlat ion - 1.0
Why does t he port folio st andard deviat ion go t o zero? I nt uit ively, t he negat ive deviat ion in t he
ret urns of one st ock is get t ing offset by t he posit ive deviat ion in t he ot her st ock. Let us
examine t his in a somewhat more formal and general cont ext .
Let us assume t hat you can form port folios wit h t wo st ocks, A & B, having t he following
charact erist ics:
B
B
B
A
A
A
B st ock of ret urn t he of deviat ion St d
R B st ock on ret urn Mean
R B St ock on Ret urn
A st ock of ret urn t he of deviat ion St d.
R A st ock on ret urn Mean
R A St ock on Ret urn
σ ·
·
·
σ ·
·
·
.
The t ot al available amount t hat can be invest ed, is Re. 1. The proport ional invest ment s in each
of t he st ocks are as below,
PDF created with pdfFactory trial version www.pdffactory.com
58
St ock A = W
St ock B = ( 1 - W)
where W is bet ween 0 and 1.
Given t his informat ion, we can show t hat
) , ( ) – 1 ( 2 ) – 1 (
2 2 2 2 2
B A Cov W W W W
B A p
+ σ + σ · σ
That is, we would show t hat t he variance of our port folio, as denot ed by t he left hand side of
t his equat ion, is dependent on t he variance of st ock A, t hat of st ock B, and a t hird t erm, called
Cov( A,B) . I t is t his t hird t erm t hat denot es t he int errelat ionship bet ween t he t wo st ocks. As
discussed before, such a relat ion could be posit ive, negat ive or zero. I n cases wit h negat ive
covariance, port folio variance would act ually be lower t han t he ( weight ed) sum of st ock
variances! I n ot her words, since variance ( or st andard deviat ion) is t he primary met ric of risk
measurement , t hen we can say t hat t he risk of t he port folio would be lower t han individual
st ocks considered separat ely.
So here is how we go about deriving t his expression:
Wit h t hese invest ment s t he port folio ret urn is,
B A P
R W R W R ) – 1 ( + · ( 1)
B A P
R W R W R ) – 1 ( + ·
( 2)
wher e,
P
R = Ret ur n on t he por t f ol i o and
P
R
= Mean r et ur n on t he por t f ol i o. Let ,
P
σ = St d.deviat ion of port folio ret urns, t hen t he variance of t he port folio ret urns can be
derived as,
( )

· σ
2
2

1
P p P
R R
n
( 3)
wit h a st raight forward rearrangement and subst it ut ion for
P
R = and
P
R
= from t he expressions
( 1) and ( 2) , t he port folio variance is,
=
( ) ( ) ( ) ( ) ( )
B B A A B B A A
R R R R
n
W W R R
n
W R R
n
W – –
1
) – 1 ( 2 –
1
– 1 –
1
2
2
2
2
∑ ∑ ∑
+ +
We know t hat ,
( )
2
2

1
A A A
R R
n
σ ·

,
( )
2
2

1
B B B
R R
n
σ ·

PDF created with pdfFactory trial version www.pdffactory.com
59
( ) ( )

· ) , ( – –
1
B A Cov R R R R
n
B B A A
The covariance can be regarded as a measure of how much t wo variables change t oget her
from t heir means. I t can also be expressed as,
B A B A
B A Cov σ σ ρ ·
,
) , ( , where
B A,
ρ is t he
correlat ion bet ween ret urns of st ocks A and B. Therefore, if t he correlat ion is posit ive and t he
st ocks have high st andard deviat ions, t hen t he covariance would be posit ive and large. I t
would be negat ive if t he correlat ion is negat ive.
Subst it ut ing t hese, t he port folio variance can be expressed as,
( ) ) , ( ) – 1 ( 2 – 1
2 2 2 2 2
B A Cov W W W W
B A P
+ σ + σ · σ
. ( 4)
Equat ion ( 4) suggest s t hat t he t ot al port folio variance comprises t he weight ed sum of variances
and weight ed sum of t he covariances t oo. Let us examine t he insight s from expression ( 4) for
t he variance of combinat ions of st ocks ( or any ot her asset ) wit h varying level of correlat ions.
Given t he nat ure of t he ret urn relat ionship bet ween t he A and B ( in Table 6.1) , it is easy t o see
t hat t heir correlat ion is - 1.0. For t he port folio of st ock A and B, t he risk becomes zero, when
weight of st ock A ( W) = 0.6.
Tabl e 6.2 : Decomposi t i on of t he Tot al Por t f ol i o Var i ance
Element of variance Proport ion Sigma Var/ Covar
Var – A 0.6 0.05 0.000864
Var – B 0.4 0.07 0.000864
Covar - 0.001728
Alt hough t he t wo st ocks involved were risky ( indicat ed by t he st andard deviat ions) , one of
t heir possible combinat ions becomes t ot ally risk- free. The variances of t he individual st ocks
are offset by t heir covariance in t he port folio ( as shown in Table 6.2) .
When t he correlat ion bet ween t he t wo st ocks is 1.0, t he st andard deviat ion of t he port folio
shall be j ust a weight ed average of t he st andard deviat ion of t he t wo st ocks involved. This
implies t hat a port folio wit h t wo perfect ly posit ively correlat ed st ocks cannot reduce risk. The
minimum port folio st andard deviat ion would always correspond t o t hat of t he st ock wit h t he
least st andard deviat ion.
The st andard deviat ion of t he port folio wit h t wo uncorrelat ed ( correlat ion = 0) st ocks would
always be lower t han t he case wit h correlat ion 1.0. I t is possible t o choose a value for W in
such a way, so t hat t he port folio risk can be brought down below t hat of t he least less risky
st ock involved in t he port folio.
PDF created with pdfFactory trial version www.pdffactory.com
60
However, in t he real world t he correlat ions almost always lie bet ween 0 and 1. I t is very
st raight forward t o underst and t hat t he variance of port folios wit h st ocks having correlat ion in
t he 0 t o 1 range would cert ainly be lower t han t hose wit h st ocks having correlat ion 1. At t he
same t ime, t he variance of t hese port folios shall be higher t han t hose wit h uncorrelat ed st ocks.
Let us examine if we can reduce t he port folio variance by combining st ocks wit h correlat ion in
t he range of 0 t o 1. Consider t he t wo st ocks, ACC and Dr. Reddy’s Laborat ories ( DRL) wit h
correlat ion around 0.21. As given in t he following t able, for a unique combinat ion, t he t ot al
variance ( st andard deviat ion) of t he port folio is less t han t hat of ACC, t he least risky st ock.
The det ails of t he risk of t his port folio are provided in t he following t able.
Tabl e 6.3 : Ret ur n and st andar d devi at i on of ACC, DRL and Por t f ol i o
Year ACC DRL Combinat ions
W= 0.25 W= 0.50 W= 0.75
2001 1.24 1.5 1.44 1.37 1.31
2002 0.98 0.84 0.88 0.91 0.95
2003 1.41 1.42 1.42 1.42 1.41
2004 1.37 0.49 0.71 0.93 1.15
2005 1.61 1.2 1.30 1.41 1.51
St d. deviat ion 0.23 0.42 0.33 0.26 0.22
Average Ret urn 1.322 1.09 1.148 1.206 1.264
Not e: W represent s t he invest ment in ACC
This suggest s t hat for cert ain values of W, t he variance of t he port folio can be brought down by
combining securit ies wit h correlat ion t he range of 0 t o 1.
A comparison of t he behaviour ( ret urn-variance) of port folios made wit h st ocks of varying
correlat ion is given in t he following figure:
PDF created with pdfFactory trial version www.pdffactory.com
61
Fi gur e 6.1 : Por t f ol i o Ri sk and Ret ur n f or Asset s w i t h Di f f er ent Cor r el at i ons

Not e: t he port folio sigma is t he st andard deviat ion. The port folios are creat ed by using act ual
ret urn dat a and assumed correlat ions, except 0.4, which is t he act ual correlat ion bet ween t he
t wo st ocks.
Wit h t hese insight s we can now examine t he behaviour of port folios wit h a larger number of
asset s.
6.2.1 Por t f ol i o var i ance - Gener al case
Let us assume t hat t here are N st ocks available for generat ing port folios. Then, t he port folio
variance ( given by equat ion 4) can be expressed as,
∑ ∑∑
σ + σ · σ
ij i i i i P
W W W
2 2 2
( 5)
where W
i
is t he proport ional invest ment in each of t he asset s and
ij
σ
is t he covariance bet ween
t he pair of asset s i and j . The double summat ion sign in t he second part indicat es t hat t he
covariance would appear for all possible combinat ions of i and j , except wit h t hemselves. For
i nst ance, i f t h er e ar e 3 st ock s, t h er e woul d be si x cov ar i an ce t er ms
( 1- 2, 1- 3, 2- 1, 2- 3, 3- 1, 3- 2) .
To examine t he charact erist ics of including a large number of st ocks in t he port folio, assume
t hat
N
W
i
1
·
ij i P
N N
σ ∑ ∑ + σ ∑ · σ
2
2
2
2
1 1
PDF created with pdfFactory trial version www.pdffactory.com
62
ij i
N N N
N
N N
σ ∑ ∑ + σ ∑ ·
) 1 – (
1 1 – 1 1
2
ij i
N
N
N
σ + σ ·
1 – 1
2
) ( Covariance Avg.
N
Variance Avg
N

,
_

¸
¸
+ ·
1
– 1 ) . (
1
we creat e an equally weight ed port folio ( equal invest ment in t he st ocks) of N asset s. Then,
The expression j ust above gives t he following insight s:
1. As N becomes a large number, t he port folio variance would be dominat ed by t he
covariances rat her t han variances. The variance of t he individual st ocks does not mat t er
much for t he t ot al port folio variance. This is one of t he most powerful argument s for
port folio diversificat ion.
2. Even by including a large number of asset s, t he port folio variance cannot be reduced
t o zero ( except when t hey are perfect ly negat ively correlat ed) . The part of t he risk
t hat cannot be eliminat ed by diversifying t hrough invest ment s across asset s is called
t he market risk ( also called t he syst emat ic risk or non- diversifiable risk) . This is
somet hing all of us commonly experience while invest ing in t he market . One can
reduce t he risk of exposure t o say HCL Technologies in t he I T indust ry, by including
ot her st ocks from t he I T indust ry, like I nfosys t echnologies, Tech Mahindra and so on.
I f you consider t he exposure t o I T indust ry alone is t roubling, you can also spread your
invest ment t o ot her indust ries like Banking, Telecom, Consumer product s and so on.
Going furt her, you can even invest across different market s, if you do not like t o be
exposed t o anyone economy alone. But even aft er int ernat ional diversificat ion a cert ain
amount of risk would remain. ( int ernat ional market s in t he globalize world t end t o
move t oget her) . This is t he market risk or syst emat ic risk or non- diversifiable risk.
3. Given t he above, it appears t hat t he relevant risk of an asset is what it cont ribut es t o
a widely- held port folio, in ot her words, it s covariance risk.
6.3 Equi l i br i um Model s: The Capi t al Asset Pr i ci ng Model
The most import ant insight from t he analysis of port folio risk is t hat a part of t he port folio
variance can be diversified away ( unsyst emat ic or diversifiable risk) by select ing securit ies
wit h less t han perfect correlat ion. This along wit h t he ot her insight s obt ained from t he analysis
would help us t o underst and t he pricing of risky asset s in t he equilibrium for any asset in t he
capit al market , under cert ain assumpt ions.
PDF created with pdfFactory trial version www.pdffactory.com
63
These addit ional assumpt ions required are as follows:
• Al l invest or s ar e mean- var iance opt i mi zers. Thi s impl ies t hat invest or s ar e
concerned only about t he mean and variance of asset ret urns. I nvest ors would
eit her prefer port folios which offer higher ret urn for t he same level of risk or
prefer port folios which offer minimum risk for a given level of ret urn ( t he indirect
assumpt ion of mean-variance invest ors is t hat all ot her charact erist ics of t he asset s
are capt ured by t he mean and variance) .
• I nvest ors have homogenous informat ion about different asset s. The well-organized
f i nanci al mar ket s have r emar kabl e abi l i t y t o di gest i nf or mat i on al most
inst ant aneously ( largely reflect ed as t he price variat ion in response t o sensit ive
informat ion) .
• Transact ion cost s are absent in t he market and securit ies can be bought and sold
wit hout significant price impact .
• I nvest ors have t he same invest ment horizon.
Given t hese assumpt ions, it is not impossible t o see t hat subst ant ive arbit rage opport unit ies
would not exist in t he market . For inst ance, if t here is a port folio which gives a higher ret urn
for same level of risk, invest ors would prefer t hat port folio compared t o t he exist ing one.
I n light of t he behaviour of port folio risk and t he above assumpt ions, let us t ry t o visualize
what would be t he relat ionship bet ween risk and ret urn of asset s in t he equilibrium.
6.3.1 Mean- Var i ance I nvest or s and Mar k et Behavi our
We can use a so- called mean-variance space t o examine t he aggregat e behaviour of t he
market (as all invest ors are mean-variance opt imizers, t hese are t he only variables t hat mat t er).
Evident ly, all t he asset s in t he market can be mapped on t o a ret urn- st andard deviat ion space
as follows.
Fi gur e 6.2 : Ret ur n and Ri sk of Some of t he Ni f t y st ock s
Source: NSE
PDF created with pdfFactory trial version www.pdffactory.com
64
All t hese st ocks ( in figure 6.2) have correlat ions bet ween 0 and 1. Therefore, t heir combinat ion
could t heoret ically be charact erized as given in figure 6.3.
Fi gur e 6.3 : Feasi bl e Set of Por t f ol i os
All t he feasible port folio combinat ions can be represent ed by t he space enclosed by t he curved
line and t he st raight - line. The curved line represent s combinat ions of st ocks or port folios
where correlat i ons are less t han 1, wher eas port foli os along t he st raight - line represent
combinat ions of st ocks or port folios wit h t he maximum correlat ion (+ 1.0) ( no port folios would
lie t o t he right of t he st raight - line) .
Obviously, a mean-variance invest or would prefer port folio A t o B, given t hat it has lower risk
for t he same level of ret urn offered by B. Similarly, port folio A would be preferred t o port folio
C, given t hat it offers higher ret urn for t he same level of risk. D is t he minimum variance
port folio among t he ent ire feasible set . A close examinat ion of t he feasible set of port folios
reveals t hat port folios t hat lie along D-E represent t he best available combinat ion of port folios.
I nvest ors wi t h var ious r isk t ol erance level s can choose one of t hese por t f oli os. These
port folios offer t he maximum ret urn for any given level of risk. Therefore, t hese are called t he
efficient port folios ( and t he set of all such port folios, t he efficient front ier) , as represent ed in
Figure 6.4.
PDF created with pdfFactory trial version www.pdffactory.com
65
Fi gur e 6.4: Ef f i ci ent Fr ont i er
Ordinarily, t he invest or also has t he opport unit y t o invest in a risk- free asset . Pract ically, t his
could be a bank deposit , t reasury bills, Government securit ies or Government guarant eed
bonds. Wit h t he availabilit y of a risk- free securit y, t he choice facing t he mean-variance invest or
can be convenient ly charact erised as follows:
Fi gur e 6.5 : Ef f i ci ent Por t f ol i o i n t he Pr esence of a Ri sk - Fr ee Asset
As given in figure 6.5, wit h t he presence of t he risk-free asset , t hat has no correlat ion wit h any
ot her risky asset , t he invest or also get s an added opport unit y t o combine port folios along t he
efficient front ier wit h t he risk- free asset . This would imply t hat t he invest or could part ly put
t he money in t he risky securit y and t he remaining in any of t he risky port folios.
Apparent ly, t he port folio choice of t he mean-variance invest or is no more t he securit ies along
t he efficient front ier ( D- E) . I f an invest or prefers less risk, t hen rat her t han choosing D by
going down t he efficient front ier, he can choose G, a combinat ion of risky port folio M and t he
risk- free asset . G gives a higher ret urn for t he level of risk of D. I n fact , t he same applies for
PDF created with pdfFactory trial version www.pdffactory.com
66
all t he port folios along t he efficient front ier t hat lie bet ween D and M ( t hey offer only lower
ret urns compared t o t hose which lie along t he st raight - line connect ing t he risk- free asset and
risky port folio M) .
This gives t he powerful insight t hat , wit h t he presence of t he risk- free securit y, t he most
preferred port folio along t he efficient front ier would be M ( port folios t o t he right of M along t he
st raight line indicat es borrowing at t he risk- free rat e and invest ing in M) .
An invest or who does not want t o t ake t he risk of M, would be bet t er off by combining wit h t he
risk- free securit y rat her t han invest ing in risky port folios wit h lower st andard deviat ion ( t hat
lie along t he M- D) .
I dent ificat ion of M as t he opt imal port folio, combined wit h t he assumpt ions ( 1) t hat all invest ors
have t he same informat ion about mean and variance of securit ies and ( 2) t hey all have t he
same invest ment horizon, suggest t hat all t he invest ors would hold only t he following port folios
depending on t he risk appet it e.
1. The port folio purely of risky asset s, which would be M.
2. The port folio of risky asset s and risk- free asset , which would be a combinat ion of
M and R
F
.
All ot her port folios are inferior t o t hese choices, for any level of risk preferred by t he invest ors.
Let us examine what would be t he nat ure of t he port folio M. I f all invest ors are mean-variance
opt imizers and have t he same informat ion, t heir port folios would invariably be t he same.
Then, all of t hem would ident ify t he same port folio as M. Obviously, it should be a combinat ion
of all t he risky st ocks ( asset s) available in t he market ( somebody should be willing t o hold all
t he asset s available on t he market ) . This port folio is referred t o as t he market port folio.
Pract ically, t he mar k et por t f ol i o can be regarded as one represent ed by a very liquid index
like t he NI FTY. The line connect ing t he market port folio t o t he risk- free asset is called t he
Capi t al Mar k et Li ne ( CML) . All point s along t he CML have superior risk- ret urn profiles t o any
port folio on t he efficient front ier.
Wit h t he underst anding about t he aggregat e behaviour of t he invest ors in t he securit ies market ,
we can est imat e t he risk premium t hat is required for any asset . Underst anding t he risk
premium dramat ically solves t he asset pricing problem t hrough t he est imat ion of t he discount ing
fact or t o be applied t o t he expect ed cash flows from t he asset . Wit h t he expect ed cash flows
and t he discount ing rat e, t he price of any risky asset can be direct ly est imat ed.
Let R
M
be t he required rat e of ret urn on t he market ( market port folio, M) , R
F
be t he required
rat e of ret urn on t he risk free asset and
M σ
be t he st andard deviat ion of t he market port folio. .
Fr om Figur e 6.5, t he rat e of r isk premi um requir ed f or unit vari ance of t he mar ket is
est imat ed as,
PDF created with pdfFactory trial version www.pdffactory.com
67
2

M
F M
R R
σ
( 6)
I n a very liquid market ( where asset s can be bought and sold wit hout much hassles) , invest or
has t he opport unit y t o hold st ocks as a port folio rat her t han in isolat ion. I f invest ors have t he
opport unit y t o hold a well- diversified port folio, t he only risk t hat mat t ers in t he individual
securit y is t he increment al risk t hat it cont ribut es t o a well- diversified port folio. Therefore, t he
risk relevant t o t he prospect ive invest or (or firm) is t he covariance risk. Then, one can comput e
t he risk premium required on t he securit y as follows
Risk premium on st ock =
) , (

2
M i Cov
R R
M
F M
×
σ
where, Cov( i,M) , is t he covariance bet ween t he ret urns of st ock i and t he market ret urns
( ret urns on port folio M) . The quant it y represent ed by
2
) , (
M
M i Cov
σ
is popularly called t he bet a
( β ) . This measures t he sensit ivit y of t he securit y compared t o t he market . A bet a of 2.0
indicat es t hat if t he market moves down ( up) by 1%, t he securit y is expect ed t o move down
( up) 2%. Therefore, we would expect t wice t he risk premium as compared t o t he market . This
implies t hat t he minimum expect ed ret urn on t his st ock is 2 x ) – (
f m
R R . I n general, t he risk
premium on a securit y is β t imes ) – (
f m
R R . Obviously, t he market port folio will have a bet a of
1.0 ( covariance of a st ock wit h it self is variance) .
Now by combining t he risk- free rat e and t he risk premium as est imat ed above, t he t ot al
required rat e of ret urn on any risky asset is,
i F M F i
R R R R β + · ) – ( ( 7)
This approach t o t he est imat ion of t he required ret urn of asset s ( cost of equit y, in case of
equit y) is called t he Capit al Asset Pricing Model ( CAPM, pioneered by William Sharpe) .
I f CAPM holds in t he market , all t he st ocks would be priced according t o t heir bet a. This would
imply t hat t he st ock prices are est imat ed by t he market by discount ing t he expect ed cash
flows by applying a discount ing rat e as est imat ed based on equat ion ( 7) .
Hence, all t he st ocks can be ident ified in t he mean ret urn- bet a space, as shown below and
relat ionship bet ween bet a and ret urn can be est imat ed. The line present ed in t he following
figure is popularly called the Secur i t i es Mar k et Li ne ( SML) .
PDF created with pdfFactory trial version www.pdffactory.com
68
Fi gur e 6.6 : Secur i t y Mar k et Li ne

Not e: t his figure is not based on any real dat a.
Prices ( ret urns) which are not according t o CAPM shall be quickly ident ified by t he market and
brought back t o t he equilibrium. For inst ance, st ocks A and B given in t he following figure
( 6.7) shall be brought back t o t he equilibrium t hrough market dynamics.
This works as follows. St ock A, current ly requires a lower risk premium ( required rat e of
ret urn) t han a specified by CAPM ( t he price is higher) . Sensing t his price of A as relat ively
expensive, t he mean-variance invest ors would sell t his st ock. The decreased demand for t he
st ock would push it s price downwards and rest ore t he ret urn back t o as specified by CAPM ( will
be on t he line) . The reverse happens in case of st ock B, wit h increased buying pressure.
Fi gur e 6.7 : Ar bi t r ages ar ound SML
6.3.2 Est i mat i on of Bet a
The bet a of a st ock can be est imat ed wit h t he formula discussed above. Pract ically, t he bet a
PDF created with pdfFactory trial version www.pdffactory.com
69
of any st ock can be convenient ly est imat ed as a regression bet ween t he ret urn on st ock and
t hat of t he market , represent ed by a st ock index like NI FTY ( t he dependent variable is t he
st ock ret urn and t he independent variables is t he market ret urn) .
Accordingly, t he regression equat ion is,
i M i i i
e R R + β + α · , ( 8)
where t he regression coefficient
i
β represent s t he slope of t he linear relat ionship bet ween t he
st ock ret urn and t he market ret urn and
i
α denot e t he risk- free rat e of ret urn. The SLOPE
funct ion in MS- Excel is a convenient way t o calculat e t his coefficient from t he model.
The bet a of an exist ing firm t raded in t he market can be derived direct ly from t he market
prices. However, on many occasions, we might be int erest ed t o est imat e t he required rat e of
ret urn on an asset which is not t raded in t he market . For inst ances like, pricing of an I PO,
t akeover of anot her firm, valuat ion of cert ain specific asset s et c.. I n t hese inst ances, t he
required rat e of ret urn can be est imat ed by obt aining t he bet a est imat es from similar firms in
t he same indust ry.
The bet a can be relat ed t o t he nat ure of t he asset s held by a firm. I f t he firm holds more risky
asset s t he bet a shall also be higher. Now, it is not difficult t o see why invest ors like vent ure
capit alist s demand higher ret urn for invest ing in st art - up firms. A firm’s bet a is t he weight ed
average of t he bet a of it s asset s ( j ust as t he bet a of a port folio is t he weight ed average of t he
bet a of it s const it uent asset s) .
6.4 Mul t i f act or Model s: The Ar bi t r age Pr i ci ng Theor y ( APT)
The CAPM is founded on t he following t wo assumpt ions ( 1) in t he equilibrium every mean
variance invest or holds t he same market port folio and ( 2) t he only risk t he invest or faces is
t he bet a. Evident ly, t hese are st rong assumpt ions about t he market st ruct ure and behaviour
of invest ors. A more general framework about asset pricing should allow for relaxat ion of
t hese st rong and somewhat count erfact ual assumpt ions. A number of alt ernat ive equilibrium
asset pricing models, including t he general arbit rage pricing t heory ( APT) , at t empt t o relax
t hese assumpt ions t o provide a bet t er underst anding about asset pricing.
The arbit rage pricing t heory assumes t hat t he invest or port folio is exposed t o a number of
syst emat ic risk fact ors. Arbit rage in t he market ensures t hat port folios wit h equal sensit ivit y t o
a fundament al risk fact or are equally priced. I t furt her assumes t hat t he risk fact ors which are
associat ed wit h any asset can be expressed as a linear combinat ion of t he fundament al risk
f act ors and t he f act or sensi t i vi t ies ( bet as) . Ar bit rage is t hen assumed t o eli mi nat e al l
opport unit ies t o earn riskless profit by simult aneously selling and buying equivalent port folios
( in t erms of risk) which are overpriced and underpriced.
PDF created with pdfFactory trial version www.pdffactory.com
70
Under t hese assumpt ions, all invest ors need not have t he same market port folio as under
CAPM. Hence, APT relaxes t he assumpt ion t hat all invest ors in t he market hold t he same
port folio. Again, as compared t o CAPM, which has only one risk dimension, under t he APT
charact erizat ion of t he asset s, t here will be as many dimensions as t here are fundament al
risks, which cannot be diversified by t he invest ors. The fundament al fact ors involved could
for inst ance be t he growt h rat e of t he economy ( GDP growt h rat e) , inflat ion, int erest rat es
and any ot her macr oeconomi c f act or whi ch woul d expose t he i nvest or ’s por t f ol i o t o
syst emat ic risk.
I n t he lines of t he assumpt ions of arbit rage pricing t heory, a number of mult ifact or asset
pricing models have been proposed. One such empirically successful model is t he so- called
Fama- French t hree- fact or model. The Fama- French model has t wo more risk fact ors, viz.,
size, and book- t o- market rat io as t he addit ional risk fact ors along wit h t he market risk as
specified by CAPM. The size risk fact or is t he difference bet ween t he expect ed ret urns on a
port folio of small st ocks and t hat of large st ocks. And t he book- t o- market rat io is t he difference
in t he expect ed ret urn of t he port folio of high book- t o market - rat io st ocks and t hat of low
book- t o market - rat io st ocks.
Theoret ical and empirical evidence suggest s t hat in t he real market , expect ed ret urns are
probably det ermined by a mult ifact or model. Against t his evidence, t he most popular and
simple equilibrium model, CAPM, could be regarded as a special case where all invest ors hold
t he same port folio and t heir only risk exposure is t he market risk.
PDF created with pdfFactory trial version www.pdffactory.com
71
CHAPTER 7: Val uat i on of Der i v at i v es
7.1 I nt r oduct i on
Derivat ives are a wide group of financial securit ies defined on t he basis of ot her financial
securit ies, i.e., t he price of a derivat ive is dependent on t he price of anot her securit y, called
t he underlying. These underlying securit ies are usually shares or bonds, alt hough t hey can be
various ot her financial product s, even ot her derivat ives. As a quick example, let ’s consider t he
derivat ive called a ‘call opt ion’, defined on a common share. The buyer of such a product get s
t he right t o buy t he common share by a fut ure dat e. But she might not want t o do so—t here’s
no obligat ion t o buy it , j ust t he choice, t he opt ion. Let ’s now flesh out some of t he det ails. The
price at which she can buy t he underlying is called t he st rike price, and t he dat e aft er which
t his opt ion expires is called t he st rike dat e. I n ot her words, t he buyer of a call opt ion has t he
right , but not t he obligat ion t o t ake a long posit ion in t he underlying at t he st rike price on or
before t he st rike dat e. Call opt ions are furt her classified as being European, if t his right can
only be exercised on t he st rike dat e and American, if it can be exercised any t ime up and unt il
t he st rike dat e.
Derivat ives are amongst t he widely t raded financial securit ies in t he world. Turnover in t he
fut ures and opt ions market s are usually many t imes t he cash ( underlying) market s. Our
t reat ment of derivat ives in t his module is somewhat limit ed: we provide a short int roduct ion
about of t he maj or t ypes of derivat ives t raded in t he market s and t heir pricing.
7.2 For w ar ds and Fut ur es
Forward cont ract s are agreement s t o exchange an underlying securit y at an agreed rat e on a
specified fut ure dat e ( called expiry dat e) . The agreed rat e is called forward rat e and t he
difference bet ween t he spot rat e, t he rat e prevailing t oday, and t he forward rat e is called t he
forward margin. The part y t hat agrees t o buy t he asset on a fut ure dat e is referred t o as a long
invest or and is said t o have a long posit ion. Similarly, t he part y t hat agrees t o sell t he asset in
a fut ure dat e is referred t o as a short invest or and is said t o have a short posit ion.
Forward cont ract s are bilat eral ( privat ely negot iat ed bet ween t wo part ies) , t raded out side a
regulat ed st ock exchange ( t raded in t he OTC or ‘Over t he Count er ’ market ) and suffer from
count er- part y risks and liquidit y risks. Here count er- part y risk refers t o t he default risk t hat
arises when one part y in t he cont ract default s on fulfilling it s obligat ions t hereby causing loss
t o t he ot her part y.
Fut ures cont ract s are also agreement s t o buy or sell an asset for a cert ain price at a fut ure
t ime. Unlike forward cont ract s, which are t raded in t he over-t he-count er market wit h no st andard
cont ract size or delivery arrangement s, fut ures cont ract s are st andardized cont ract s and are
PDF created with pdfFactory trial version www.pdffactory.com
72
t raded on recognized and regulat ed st ock exchanges. They are st andardized in t erms of cont ract
sizes, t rading paramet ers and set t lement procedures, and t he cont ract or lot size ( no. of
shares/ unit s per cont ract ) is fixed.
Since fut ures cont ract s are t raded t hrough exchanges, t he set t lement of t he cont ract is
guarant eed by t he exchange or a clearing corporat ion ( t hrough t he process of novat ion) and
hence t here is no count er- part y risk. Exchanges guarant ee execut ion by holding a caut ion
amount as securit y from bot h t he part ies ( buyers and sellers) . This amount is called as t he
margin money, and is adj ust ed daily based on price movement s of t he underlying t ill t he
cont ract expires.
Compared t o forward cont ract s, fut ures also provide t he flexibilit y of closing out t he cont ract
prior t o t he mat urit y by squaring off t he t ransact ion in t he market . Occasionally t he fact
forward cont ract s are bilat eral comes in handy—t wo part ies could suit a cont ract according t o
t heir needs; such a fut ures may not be t raded in t he market . Primary examples are long- t erm
cont ract s—most fut ures cont ract s have short mat urit ies of less t han a few mont hs.
The t able here draws a comparison bet ween a forward and a fut ures cont ract .
Tabl e 7.1 : Compar i son of For w ar d and Fut ur es Cont r act s
For w ar d Cont r act Fut ur es Cont r act
Nat ure of Cont ract Non-st andardized/ St andardized cont ract
Cust omized cont ract
Trading Privat e cont ract bet ween Traded on an exchange
part ies – I nformal,
Over- t he- Count er market
Set t lement Set by t he part ies. Final Set t lement dat e is
Pre- specified in t he fixed by t he exchange. I n
cont ract . addit ion, t here is a provision
of daily set t lement , known as
daily mark t o market
set t lement .
Risk Count erpart y risk exist s, Exchange provides t he
no independent guarant ee. guarant ee of set t lement and
hence no count er part y risk.
PDF created with pdfFactory trial version www.pdffactory.com
73
7.3 Cal l and Put Opt i ons
Like forwards and fut ures, opt ions are derivat ive inst rument s t hat provide t he opport unit y t o
buy or sell an underlying asset on a fut ure dat e. As explained in t he int roduct ion, an opt ion
cont ract is a cont ract writ t en by a seller t hat conveys t he buyers a right , but not an obligat ion
t o eit her sell ( put opt ion) or buy ( call opt ion) a part icular asset at a specified price in t he
fut ure. I n case of call opt ions, t he opt ion buyer has a right t o buy and in case of put opt ions,
t he opt ion buyer has a right t o sell t he securit y at t he agreed upon price ( called st rike rat e or
exercise price) . I n ret urn for grant ing t he opt ion, t he part y ( seller) grant ing t he opt ion collect s
a payment from t he ot her part y. This payment collect ed is called t he “ premium” or price of
t he opt ion.
Opt ions are like insurance cont ract s. Unlike fut ures, where t he part ies are denied of any favorable
movement in t he market , in case of opt ions, t he buyers are prot ect ed from downside risks and
in t he same t ime, are able t o reap t he benefit s from any favorable movement in t he exchange
rat e. The buyer of t he opt ion has a right but no obligat ion t o enforce t he execut ion of t he
opt ion cont ract and hence, t he maximum loss t hat t he opt ion buyer can suffer is limit ed t o t he
premium amount paid t o ent er int o t he cont ract . The buyer would exercise t he opt ion only
when she can make some profit from t he exercise, ot herwise, t he opt ion would not be exercised,
and be allowed t o lapse. Recall t hat in case of American opt ions, t he right can be exercised on
any day on or before t he expiry dat e but in case of a European opt ion, t he right can be
exercised only on t he expiry dat e.
Opt ions can be used for hedging as well as for speculat ion purposes. An opt ion is used as a
hedging t ool if t he invest or already has ( or is expect ed t o have) an open posit ion in t he spot
market . For example, in case of currency opt ions, import ers buy call opt ions t o hedge against
fut ure depreciat ion of t he local currency ( which would make t heir import s more expensive)
and export ers could buy put opt ions t o hedge against currency appreciat ion. There are ot her
met hds of hedging t oo—using forwards, fut ures, or combinat ions of all t hree—and t he choice
of hedging is det ermined by t he cost s involved.
7.4 For w ar d and Fut ur es Pr i ci ng
Forwards/ fut ures cont ract are priced using t he cost of carry model. The cost of carry model
calculat es t he fair value of fut ures cont ract based on t he current spot price of t he underlying
asset . The formula used for pricing fut ures is given below:
: Where Se F
rT
·
F = Fut ures Price
S = Spot price of t he underlying asset
PDF created with pdfFactory trial version www.pdffactory.com
74
R = Cost of financing ( using a cont inuously compounded int erest rat e)
T = Time t ill expirat ion in years
E = 2.71828 ( The base of nat ural logarit hms)
Example: Securit y of ABB Lt d t rades in t he spot market at Rs. 850. Money can be invest ed at
11% per annum. The fair value of a one- mont h fut ures cont ract on ABB is calculat ed as
follows:
80 . 857 * 850
12
1
1 1 . 0
· · · e Se F
rT
The presence of arbit rageurs would force t he price t o equal t he fair value of t he asset . I f t he
fut ures price is less t han t he fair value, one can profit by holding a long posit ion in t he fut ures
and a short posit ion in t he underlying. Alt ernat ively, if t he fut ures price is more t han t he fair
value, t here is a scope t o make a profit by holding a short posit ion in t he fut ures and a long
posit ion in t he underlying. The increase in demand/ supply of t he fut ures ( and spot ) cont ract s
will force t he fut ures price t o equal t he fair value of t he asset .
7.4.1 Cost - of - car r y and conveni ence yi el d
The cost of carry is t he cost of holding a posit ion. I t is usually represent ed as a percent age of
t he spot price. Generally, for most invest ment , we consider t he risk- free int erest rat e as t he
cost of carry. I n case of commodit ies cont ract s, cost of carry also includes st orage cost s ( also
expressed as a percent age of t he spot price) of t he underlying asset unt il mat urit y.
Fut ures prices being lower t han spot price ( backwardat ion) is also explained by t he concept of
convenience yield. I t is t he opposit e of carrying charges and refers t o t he benefit accruing t o
t he holder of t he asset . For example, one of t he benefit s t o t he invent ory holder is t he t imely
availabilit y of t he underlying asset during a period when t he underlying asset is ot herwise
facing a st ringent supply sit uat ion in t he market . Convenience yield has a negat ive relat ionship
wit h invent ory st orage levels ( and st orage cost ) . High st orage cost / high invent ory levels lead
t o negat ive convenience yield and vice versa.
The cost of carry model expresses t he forward ( fut ure) price as a funct ion of t he spot price and
t he cost of carry and convenience yield.
t c r
e cost st orage PV S F
) – (
* ) ] ( [ + ·
Where F is t he forward price, S is t he spot price, r is t he risk- free int erest rat e, c is t he
convenience yield and t is t he t ime t o delivery of t he forward cont ract ( expressed as a fract ion
of 1 year) .
PDF created with pdfFactory trial version www.pdffactory.com
75
7.4.2 Back w ar dat i on and Cont ango
The t heory of normal backwardat ion was first developed by J. M. Keynes in 1930. The t heory
suggest s t hat t he fut ures price is a biased est imat e of t he expect ed spot price at t he mat urit y.
The underlying principle for t he t heory is t hat hedgers use t he fut ure market t o avoid risks and
pay a significant amount t o t he speculat ors for t his insurance. When t he fut ure price is lower
t han t he current spot price, t he market is said t o be backwarded and t he opposit e is called as
a cont ango market . Since fut ure and spot prices have t o converge on mat urit y (t his is somet imes
called t he law of one price) , in t he case of a backwarded market , t he fut ure price will increase
relat ive t o t he expect ed spot price wit h passage of t ime, t he process referred t o as backwardat ion.
I n case of cont ango, t he fut ure price decreases relat ive t o t he expect ed spot price.
Backwardat ion and cont ango is easily explained in t erms of t he seasonal nat ure of commodit ies.
Commodit y fut ures wit h expirat ion dat es falling in post harvest mont h would face backwardat ion,
as t he expect ed spot price would be lower. When hedgers are net short ( farmers willing t o sell
t he produce immediat ely aft er harvest ) , or t he risk aversion is more for short hedgers t han t he
long hedgers, t he fut ures price would be a downward biased est imat e of t he expect ed spot
price, result ing int o a backwarded market .
7.5 Opt i on Pr i ci ng
Our brief t reat ment of opt ions in t his module init ially looks at pay- off diagrams, which chart
t he price of t he opt ion wit h changes in t he price of t he underlying and t hen describes how call
and opt ion prices are relat ed using put - call parit y. We t hen briefly describe t he celebrat ed
Black- Scholes formula t o price a European opt ion.
7.5.1 Payof f s f r om opt i on cont r act s
Payoffs from an opt ion cont ract refer t o t he value of t he opt ion cont ract for t he part ies ( buyer
and seller) on t he dat e t he opt ion is exercised. For t he sake of simplicit y, we do not consider
t he init ial premium amount while calculat ing t he opt ion payoffs.
I n case of call opt ions, t he opt ion buyer would exercise t he opt ion only if t he market price on
t he dat e of exercise is more t han t he st rike price of t he opt ion cont ract . Ot herwise, t he opt ion
is wort hless since it will expire wit hout being exercised. Similarly, a put opt ion buyer would
exercise her right if t he market price is lower t han t he exercise price.
The payoff of a call opt ion buyer at expirat ion is:
] 0 ) , – [ ( Price Exercise share t he of price Market Max
The following figures shows t he payoff diagram for call opt ions buyer and seller ( assumed
exercise price is 100)
PDF created with pdfFactory trial version www.pdffactory.com
76
The payoff for a buyer of a put opt ion at expirat ion is:
] 0 ) , – [ ( share t he of price Market price Exercise Max
The payoff diagram for put opt ions buyer and seller ( assumed exercise price is 100)
From t he pay- off diagrams it ’s apparent t hat a buyer of call opt ions would expect t he market
price of t he st ock t o rise, and buying t he call opt ion allows him t o lock in t he benefit s of such
a rise, and also cap t he downside in t he event of a fall. The price of course is t he premium. On
t he ot her side, a seller of call opt ions has a cont rarian view, and hopes t o profit from t he
premium of t he call opt ions sold t hat would expire unexercised. I t ’s clear from t he vert ical axis
of t he payoff diagram ( which provides t he payoff t he cont ract ) , t hat while t he downside of a
call opt ion buyer is limit ed, it is not so for t he seller.
I n a similar sense, a buyer of put opt ions would expect t he market t o fall, and profit from it ,
wit h an insurance, or a hedge ( in t he event of an unexpect ed rise in t he market ) , t o cap t he
downside. The price of t he hedge is t he put opt ion premium.
PDF created with pdfFactory trial version www.pdffactory.com
77
7.5.2 Put - cal l par i t y r el at i onshi p
The put - call parit y relat ionship gives us a fundament al relat ionship bet ween European call
opt ions and put opt ions. The relat ionship is derived by not icing t hat t he payoff from t he following
t wo st rat egies is t he same irrespect ive of t he st ock price at mat urit y. The t wo st rat egies are:
St rat egy 1: Buy a call opt ion and invest ing t he present value of exercise price in risk- free
asset .
St rat egy 2: Buy a put opt ion and buying a share.
This can be shown in t he form of t he following diagram:
St r at egy 1:
St r at egy 2:
Since t he payoff from t he t wo st rat egies is t he same t herefore:
Value of call opt ion ( C) + PV of exercise price
( )
rt
Ke

= value of put opt ion ( P) + Current share
price ( )
0
S , i.e.
0

S P Ke C
rt
+ · +
PDF created with pdfFactory trial version www.pdffactory.com
78
7.6 Bl ack - Schol es f or mul a
The main quest ion t hat is st ill unanswered is t he price of a call opt ion for ent ering int o t he
opt ion cont ract , i.e. t he opt ion premium. The premium amount is dependent on many variables.
They are:
- Share Price ( )
0
S
- Exercise Price ( K)
- The t ime t o expirat ion i.e. period for which t he opt ion is valid ( T)
- Prevailing risk- free int erest rat e ( r)
- The expect ed volat ilit y of t he underlying asset ( σ )
One of t he landmark invent ions in t he financial world has been t he Black- Scholes formula t o
price a European opt ion. Fischer Black and Myron Scholes2 in t heir seminal paper in 1973 gave
t he world a mat hemat ical model t o value t he call opt ions and put opt ions. The formula proved
t o be very useful not only t o t he academics but also t o pract it ioners in t he finance world. The
aut hors were lat er awarded The Sveriges Riksbank Prize in Economic Sciences in Memory of
Alfred Nobel in 1997. The Black- Scholes formula for valuing call opt ions ( c) and value of put
opt ions ( p) is as under:
) ( – ) ( ) , (
2
) – ( –
1
d N ke d SN t S c
t T r
·
and
) ( – – ) ( – ) , (
1 2
) – ( –
d SN d N Ke t S p
t T r
·
Where
t T
t T r
K
S
d

) – (
2
ln
2
1
σ

,
_

¸
¸ σ
+ +

,
_

¸
¸
·
t T d d – –
1 2
σ ·
Where,
(.) N is t he cumulat ive dist ribut ion funct ion ( cdf ) of t he st andard normal dist ribut ion
T- t is t he t ime t o mat urit y
S is t he spot price of t he underlying asset
K is t he st rike price
r is t he cont inuously compounded annual risk- free rat e
σ is t he volat ilit y in t he log ret urns of t he underlying.
PDF created with pdfFactory trial version www.pdffactory.com
79
Example: Calculat e t he value of a call opt ion and put opt ion for t he following cont ract :
St ock Price ( S) = 100
Exercise Price ( K) = 105
Risk- free, cont inuously compounded int erest Rat e ( r) = 0.10 ( 10%)
Time t o expirat ion ( T- t ) = 3 mont h = 0.25 years
St andard deviat ion ( σ ) = 0.30 per year
0836 . 0 –
25 . 0 * 3 . 0
) 25 . 0 (
2
3 . 0
10 . 0
105
100
ln

) – (
2
ln
2 2
1
·

,
_

¸
¸
+ +

,
_

¸
¸
·
σ

,
_

¸
¸ σ
+ +

,
_

¸
¸
·
t T
t T r
K
S
d
0236 . – 25 . 0 3 . 0 – 0836 . 0 – –
1 2
· · σ · t T d d
4667 . 0 ) 0836 . 0 ( – ) (
1
· · N d N
4076 . 0 ) 0236 . 0 ( – ) (
2
· · N d N
5333 . 0 ) 0836 . 0 ( ) ( –
1
· · N d N
5924 . 0 ) 0236 . 0 ( ) ( –
2
· · N d N
Value of call opt ion ( c) =
9225 . 4 4076 . 0 * * 105 – 4667 . 0 * 100 ) ( – ) ( ) , (
25 . 0 * 10 –.
2
) ( –
1
· · ·

e d N ke d SN t S c
t T r
Value of Put opt ion ( p) =
33 . 7 5333 . 0 * 100 – 5924 . 0 * * 105 ) ( – – ) ( – ) , (
25 . 0 * 10 . 0 –
1 2
) – ( –
· · · e d SN d N Ke t S p
t T r
2
Bl ack, Fischer ; Myron Scholes ( 1973) . "The Pri cing of Opt i ons and Corporat e Liabil it i es" . Jour nal of Poli t ical
Economy 81 ( 3) : 637- 654
PDF created with pdfFactory trial version www.pdffactory.com
80
CHAPTER 8: I nv est ment Management
8.1 I nt r oduct i on
I n t he final chapt er of t his module we t ake a brief look at t he professional asset management
indust ry. Worldwide, t he last few decades have seen an increasing t rend away from direct
invest ment in t he market s, wit h t he ret ail invest or now preferring t o invest in funds or t he
index, rat her t han direct exposure int o equit ies. This has nat urally led t o a sharp increase in
t he asset s under management of such firms.
The asset management indust ry primarily consist s of t wo kinds of companies, t hose engaged
i n i nvest ment advi sor y or weal t h management act i vi t i es, and t hose i nt o i nvest ment
management . I n t he first cat egory, invest ment advisory firms recommend t heir client s t o t ake
posit ions in various securit ies, and wealt h management firm eit her recommend, or have cust ody
of t heir client s’ funds, t o be invest ed according t o t heir discret ion. I n bot h cases, t he engagement
wit h client s is at an account level, i.e., funds are separat ely managed for each client . I n
cont rast , invest ment management companies combine t heir client s’ asset s t owards t aking
posit ions in a single port folio, usually called a fund ( or a mut ual fund) . A unit of such a fund
t hen represent s posit ions in each of t he securit ies owned in t he port folio. I nst ead of t racking
ret urns on t heir own port folios, client s t rack ret urns on t he net asset value ( NAV) of t he fund.
I n addit ion t o t he perceived benefit s of professional fund management , t he maj or reason
of invest ment int o funds is t he diversificat ion t hey afford t he invest or. For inst ance, inst ead
of owni ng ever y l ar ge- cap st ock i n t he mar ket , an i nvest or could j ust buy uni t s of a
large- cap fund.
I n t his chapt er, we shall examine t he various t ypes of such funds, different iat ed by t heir
invest ment mandat es, choice of securit ies, and of course, invest ment performance, where we
would out line a few of t he key met rics used t o measure invest ment performance of funds.
8.2 I nv est ment Compani es
I nvest ment companies pool funds from various invest ors and invest t he accumulat ed funds in
various financial inst rument s or ot her asset s. The profit s and losses from t he invest ment
( aft er repaying t he management expenses) are dist ribut ed t o t he invest ors in t he funds in
proport ion t o t he invest ment amount . Each invest ment company is run by an asset management
company who simult aneously operat e various funds wit hin t he invest ment company. Each
fund is managed by a fund manager who is responsible for management of t he port folio.
I nvest ment companies are referred t o by different names in different count ries, such as mut ual
funds, invest ment funds, managed funds or simply funds. I n I ndia, t hey are called mut ual
funds. Our t reat ment would use t hese names int erchangeably, unless explicit ly st at ed.
PDF created with pdfFactory trial version www.pdffactory.com
81
8.2.1 Benef i t s of i nvest ment s i n managed f unds
The main advant ages of invest ing t hrough collect ive invest ment schemes are:
- Choi ce of Schemes: There are various schemes wit h different invest ment t hemes.
Through each scheme an invest or has an opport unit y t o invest in a wide range of
invest able securit ies.
- Pr of essi onal Management : Professionally managed by t eam of expert s.
- Di ver si f i cat i on: Scope for bet t er diversificat ion of invest ment since mut ual fund asset s
are invest ed across a wide range of securit ies.
- Li qui di t y: Easy ent ry and exit of invest ment : invest ors can wit h ease buy unit s from
mut ual funds or redeem t heir unit s at t he net asset value eit her direct ly wit h t he
mut ual fund or t hrough an advisor / st ock broker.
- Tr anspar ency: The asset management t eam has t o on a regular basis publish t he
NAV of t he asset s and broad break- up of t he inst rument s where t he invest ment
is made.
- Tax benef i t s: Dividends received on invest ment s held in cert ain schemes, such as
equit y based mut ual funds, are not subj ect t o t ax.
8.3 Act i v e v s. Passi v e Por t f ol i o Management
I f asset prices always reflect t heir equilibrium values ( expect ed ret urns equal t o t he value
specified by an asset pricing model) , t hen an invest or is unlikely t o benefit from act ively
searching for mispriced ( overpriced/ underpriced) opport unit ies in asset s. I n ot her words, t he
invest or is bet t er off by simply invest ing in t he market , or a represent at ive benchmark. For
inst ance, under such assumpt ions, an I ndian equit y invest or would achieve t he best possible
out come by t rying t o replicat e t he Nift y 50 by invest ing in t he const it uent st ocks in t he same
proport ion as t hey are in t he index.
Such invest ment assumes t hat gains in t he market are t hose of t he benchmark, and not in t he
choice of individual securit ies, as opport unit ies in t heir select ion, or t iming of ent ry/ exit are
t oo short t o be t aken advant age of. This, passive approach t o invest ment rest s upon t he
t heory of market efficiency, which we saw in chapt er 4. Recall t hat t he EMH post ulat es t hat
prices always fully reflect all t he available informat ion and any deviat ion from t he full informat ion
price would be quickly arbit raged away. I n an efficient market , informat ion about fundament al
fact ors relat ed t o t he asset , or it s market price, volume or any ot her relat ed t rading dat a
relat ed has lit t le value for t he invest or.
PDF created with pdfFactory trial version www.pdffactory.com
82
Passive fund managers t ry t o replicat e t he performance of a benchmark index, by replicat ing
t he weight s of it s const it uent st ocks. Given daily price movement in st ock prices, t he challenge
for such managers is t o minimize t he so- called ‘t racking error ’ of t he fund, which is calculat ed
as t he deviat ion in it s ret urns from t hat of t he index. The choice of t he index furt her different iat es
bet ween t he funds, for example, an equit y index fund would simply t ry t o maint ain t he ret urn
profile of t he benchmark index, say, t he NI FTY 50; but if invest ment s are allowed across asset
classes, t hen t he ‘benchmark’ could well consist of a combinat ion of a equit y and a debt index.
Recent evidence of syst emat ic depart ures of asset prices in t he from equilibrium values, as
envisaged under t he market efficiency, has renewed int erest in ‘act ive’ fund management ,
which ent ails t hat opt imal select ion of st ocks, and t he t iming of ent ry/ exit could lead t o ‘market-
beat ing’ ret urns.
This represent s an opport unit y for invest ors t o engage in act ive st rat egies based on t heir
obj ect ive views about t he asset s. I n a generic sense, such views are about t he relat ive under
pricing or over pricing of an asset . Over pricing present s an opport unit y t o engage in short
selling, under pricing an opport unit y t o t ake a long posit ion, and combinat ions of t he t wo are
also possible, across st ocks, and port folios.
The obj ect ive of an act ive port folio manager is t o make higher profit s from invest ing, wit h
similar, or lower risks at t ached. The risk of a port folio, as not ed in an earlier chapt er, is usually
measured wit h t he st andard deviat ion of it s asset s. A good port folio manager should have
good forecast ing abilit y and should be able t o do t wo t hings bet t er t han his compet it ors:
market t iming and securit y select ion.
By market t iming, we refer t o t he abilit y of t he port folio manager t o gauge at t he beginning of
each period t he profit abilit y of t he market port folio vis-à-vis t he risk-free port folio of Government
bonds. The st rengt h of such a signal would indicat e t he level of invest ment required in t he
market .
By securit y select ion, we refer t o abilit y of a port folio manager in ident ifying mispricing in
individual securit ies and t hen invest ing in securit ies wit h t he maximum mispricing, which
maximizes t he so- called alpha. The alpha of a securit y refers t o t he expect ed excess ret urn of
t he securit y over t he expect ed rat e of ret urn (for example, est imat ed by an equilibrium asset -
pricing model like t he CAPM) . The mispricing may be eit her way: I f t he port folio manager
believes t hat a securit y is going t o generat e negat ive ret urn, his port folio should give a negat ive
weight for t he same i.e. short t he securit y and vice versa. The t radeoff for t he act ive invest or
is t he presence of nonsyst emat ic risk in t he port folio. Since t he port folio of an act ive invest or
is not fully diversified, t here is some nonsyst emat ic ( firm- specific) risk t hat is not diversified
away. Act ive fund management is a diverse business—t here are many ways t o make money in
PDF created with pdfFactory trial version www.pdffactory.com
83
t he market —almost all t he invest ment st yles we would examine furt her in t he chapt er are
illust rat ive examples.
Act ive and passive fund management are not always chalk and cheese—t here are t echniques
t hat ut ilize bot h, like port folio t ilt ing. A t ilt ed port folio shift s t he weight s of it s const it uent s
t owards one or more of cert ain pre- specified market fact ors, like earnings, valuat ions, dividend
yields, or t owards one or more specific sect ors.
By t heir very nat ure of operat ions, act ive and passive invest ment s differ meaningfully in t erms
of t heir cost s t o t he invest ors. Passive invest ment is charact erized by low t ransact ion cost s
( given t heir low t urnover) , management expenses, and t he risks at t ached. Act ive fund
management is underst andably more expensive, but has seen cost s falling over t he years on
compet it ive pricing and increased liquidit y of t he market s, which reduced t ransact ion cost s.
8.4 Cost s of Management : Ent r y / Ex i t Loads and Fees
Running a mut ual fund involves cert ain cost s ( e.g. remunerat ion t o t he management t eam,
advert ising expenses et c.) which may be recurring or non- recurring in nat ure. These cost s are
recovered by t he fund from t he invest ors ( e.g. from redempt ion fees) or from charges on t he
asset s ( t ransact ion fees, management fees and commission et c.) of t he funds.
Generally, t he management t eam is paid a fixed percent age of t he asset under management
as t heir fees.
I nvest ment management companies can be broadly classified on t he basis of t he securit ies
t hey invest in and t heir invest ment obj ect ives. Before we look at eit her, we define t he core
measure of ret urn for a fund, t he NAV, and so- called open, and closed- ended funds.
8.5 Net Asset Val ue
The net asset value NAV is t he most i mport ant and widely f oll owed met ri c of a fund’s
performance. I t is calculat ed per share using t he following formula:
dign out s shares of Number
s liabilit ie of Value Market Asset s of Value Market
share per NAV
t an

) ( ·
Net asset value ( NAV) is a t erm used t o describe t he per unit value of t he fund’s net asset s
( asset s less t he value of it s liabilit ies) . Hence t he NAV for a fund is
Fund NAV = ( Market Value of t he fund port folio – Fund Expenses) / Fund Shares Out st anding
Just like t he share price of a common st ock, t he NAV of a fund would rise wit h t he value of t he
fund port folio, and is inst ant ly reflect ive of t he value of invest ment .
PDF created with pdfFactory trial version www.pdffactory.com
84
8.6 Cl assi f i cat i on of f unds
8.6.1 Open ended and cl osed- ended f unds
Funds are usually open or closed- ended. I n an open- ended fund, t he unit s are issued and
redeemed by t he fund, at any t ime, at t he NAV prevalent at t he t ime of issue / redempt ion.
The fund discloses t he NAV on a daily basis t o facilit at e issue and redempt ion of unit s. Unlike
open- ended funds, closed- ended funds sell unit s only at t he out set and do not redeem or sell
unit s once t hey are issued. The invest ors can sell or purchase unit s t o ( or from) ot her invest ors
and t o facilit at e such t ransact ions, such unit s are t raded on st ock exchanges. Price of closed
ended schemes are det ermined based on demand and supply for t he unit s at t he st ock exchange
and can be more or less t han t he NAV of t he unit s.
We now examine t he different kind of funds on t he basis of t heir invest ment s. While we had
earlier ment ioned mut ual fund invest ment s represent ed as unit s in a single port folio, in real
life, fund houses float various schemes from t ime- t o- t ime, each a const it ut ing a port folio
where input s t ranslat e int o unit s. These schemes are different iat ed by t heir chart er which
mandat es t heir invest ment int o asset classes.
Beyond t he t ype of inst rument s t hey invest in, fund houses are also different iat ed in t erms of
t heir invest ment st yles. The approaches t o equit y invest ing could be diversified or undiversified,
growt h, income, sect or rot at ors, value, or market - t iming based.
Each mut ual fund scheme has a part icular invest ment policy and t he fund manager has t o
ensure t hat t he invest ment policy is not breached. The policy is laid right at t he out set when
t he fund is launched and is specified in t he prospect us, t he ‘Offer Document ’ of t he scheme.
The invest ment policy det ermines t he inst rument s in which t he money from a specific scheme
will be primarily invest ed. Based on t hese securit ies, mut ual funds can be broadly classified
int o equit y funds ( growt h funds and income funds) , bond funds, money market funds, index
funds, et c. Generally, fund houses have dozens of schemes float ing in t he market at any given
t ime, wit h separat e invest ment policies for each scheme.
8.6.2 Equi t y f unds
Equit y funds primarily invest in common st ock of companies. Equit y funds can be growt h
funds or income funds. Growt h funds focus on growt h st ocks, i.e., companies wit h st rong
growt h pot ent ial, wit h capit al appreciat ion being t he maj or driver, while income funds focus on
companies t hat have high dividend yields. I ncome funds focus on dividend income or coupon
payment s from bonds ( if t hey are not pure equit y) .
Equit y funds may also be sect or- specific wherein t he invest ment is rest rict ed t o st ocks from a
specific indust ry. For example, in I ndia we have many funds focusing on companies in power
sect or and infrast ruct ure sect or.
PDF created with pdfFactory trial version www.pdffactory.com
85
8.6.3 Bond f unds
Bond funds invest primarily in various bonds t hat were described in t he earlier segment . They
have a st able income st ream and relat ively lower risk. They could pot ent ially invest in corporat e
bonds, Government . bonds, or bot h.
8.6.4 I ndex f unds
I ndex funds have a passive invest ment st rat egy and t hey t ry t o replicat e a broad market
index. A scheme from such a fund invest s in component s of a part icular index proport ionat e t o
t heir represent at ion in t he benchmark. I t is possible t hat a scheme t racks more t han one index
( in some pre- specified rat io) , in eit her equit y, or across asset classes.
8.6.5 Money mar k et f unds
Money market mut ual funds invest in money market inst rument s, which are short-t erm securit ies
issued by banks, non- bank cor porat i ons and Government s. The var ious money market
inst rument s have already been discussed earlier.
8.6.6 Fund of f unds
Fund of funds add anot her layer of diversificat ion bet ween t he invest or and securit ies in t he
market . I nst ead of individual st ocks, or bonds, t hese mut ual funds invest in unit s of ot her
mut ual funds, wit h t he fund managers’ mandat e being t he opt imal choice across mut ual fund
schemes given ext ant market condit ions.
8.7 Ot her I nv est ment Compani es
I n addit ion t o t he broad cat egories ment ioned here, t here are many ot her kinds of funds,
depending on market oppor t unit ies, and invest or appet i t e. Tot al r et ur n funds look at a
combinat ion of capit al appreciat ion and dividend income. Hybrid funds invest in a combinat ion
of equit y, bonds, convert ibles, and derivat ive inst rument s. These funds could be furt her
dist ribut ed as ‘asset allocat ion’, ‘balanced’, or ‘flexible port folio’ funds, based on t he breadt h of
t heir invest ment in different asset classes, and t he frequency of modifying t he allocat ion.
Global, regional, or emerging market funds recognize invest ment opport unit ies across t he
world, and accordingly base t heir invest ment focus. Such funds could again comprise eit her, or
a combinat ion of equit y, debt , or hybrid inst rument s. We ment ion some ot her, specific t ypes of
invest ment vehicles below.
8.7.1 Uni t I nvest ment Tr ust s ( UI T)
Similar t o mut ual funds, UI Ts also pool money from invest ors and have a fixed port folio of
asset s, which are not changed during t he life of t he fund. Alt hough t he port folio composit ion is
act ively decided by t he sponsor of t he fund, once est ablished t he port folio composit ion is not
changed ( hence called unmanaged funds) .
PDF created with pdfFactory trial version www.pdffactory.com
86
The way an UI T is est ablished is different from t hat of ot her mut ual funds. UI Ts are usually
creat ed by sponsors, who first make invest ment in t he port folio of securit ies. The ent ire port folio
is t hen t ransferred t o a t rust and t he t rust ees issue t rust cert ificat es t o t he public, which is
similar t o shares. The t rust ees dist ribut e t he incomes from t he invest ment and t he mat urit y
( capit al) amount t o t he shareholders on mat urit y of t he scheme.
8.7.2 REI TS ( Real Est at e I nvest ment Tr ust s)
REI TS are also similar t o mut ual funds, but t hey invest primarily in real est at es or loans
secured by real est at e. REI T can be of t hree t ypes – equit y, mort gage or hybrid t rust s. Equit y
t rust s invest in real est at e asset s, mort gage t rust s invest in loans backed by mort gage and
hybrid t rust s invest in eit her.
8.7.3 Hedge Funds
Hedge funds are generally creat ed by a limit ed number of wealt hy invest ors who agree t o pool
t heir funds and hire experienced professionals ( fund managers) t o manage t heir port folio.
Hedge funds are privat e agreement s and generally have lit t le or no regulat ions governing
t hem. This gives a lot of freedom t o t he fund managers. For example, hedge funds can go
short ( borrow) funds and can invest in derivat ives inst rument s which mut ual funds cannot do.
Hedge funds generally have higher management fees t han mut ual funds as well as performance
based fees. The management fee ( paid t o t he fund managers) , in t he case of hedge funds is
dependent on t he asset s under management ( generally 2 - 4%) and t he fund performance
( generally 20% of t he excess ret urns over t he market ret urn generat ed by t he fund) .
8.8 Per f or mance assessment of managed f unds
Prior t o t he development of t he modern port folio t heory ( MPT) , port folio managers were
evaluat ed by comparing t he ret urn generat ed by t hem wit h some broad yardst ick. The risk
borne by t he port folio managers or t he source of performance such as market t iming, market
volat ilit y, t he securit y select ions and valuat ions were not considered. Wit h t he development of
t he MPT, t he goal of performance evaluat ion is t o st udy whet her t he port folio has provided
superior ret urns compared t o t he risks involved in t he port folio or compared t o an equivalent
passive benchmark.
The performance evaluat ion approach t ries t o at t ribut e t he performance t o t he following:
- Risk
- Timing: market or volat ilit y
- Securit y select ion – of indust ry or individual st ocks
PDF created with pdfFactory trial version www.pdffactory.com
87
Therefore:
a) The focus of evaluat ion should be on excess ret urns
b) The port folio performance must account for t he difference in t he risk
c) I t should be able t o dist inguish t he t iming skills from t he securit y select ion skills.
The assessment of managed funds involves comparison wit h a benchmark. The benchmark
could be based on t he Capit al Market Line ( CML) or t he Securit y Market Line ( SML) . When it is
based on capit al Market Line, t he relevant measure of t he port folio risk is σ and when based
on Securit y Market Line, t he relevant measure is β . Various measures are devised t o evaluat e
port folio performance, viz. Sharpe Rat io, Treynor Rat io and Jensen Alpha.
8.8.1 Shar pe Rat i o
Sharpe rat io or ‘excess ret urn t o variabilit y’ measures t he port folio excess ret urn over t he
sample period by t he st andard deviat ion of ret urns over t hat period. This rat io measures t he
effect iveness of a manager in diversifying t he t ot al risk ( σ ) . This measure is appropriat e if one
is evaluat ing t he t ot al port folio of an invest or or a fund, in which case t he Sharpe rat io of t he
port folio can be compared wit h t hat of t he market . The formula for measuring t he Sharpe
rat io is:
p f p
r r Rat io Shar pe σ · / ) – (
This will be compared t o t he Shape rat io of t he market port folio. A higher rat io is preferable
since it implies t hat t he fund manager is able t o generat e more ret urn per unit of t ot al risks.
However, managers who are operat ing specific port folios like a value t ilt ed or a st yle t ilt ed
port folio generally t akes a higher risks, and t herefore may not be willing t o be evaluat ed based
on t his measure.
8.8.2 Tr eynor Rat i o
Treynor ’s measure evaluat es t he excess ret urn per unit of syst emat ic risks ( β ) and not t ot al
risks. I f a port folio is fully diversified, t hen β becomes t he relevant measure of risk and t he
performance of a fund manager may be evaluat ed against t he expect ed ret urn based on t he
SML ( which uses β t o calculat e t he expect ed ret urn) . The formula for measuring t he Treynor
Rat io is:
p f p
r r Rat io Theynor β · / ) – (
8.8.3 Jensen measur e or ( Por t f ol i o Al pha)
The Jensen measure, also called Jensen Alpha, or port folio alpha measures t he average ret urn
on t he port folio over and above t hat predict ed by t he CAPM, given t he port folio’s bet a and t he
average market ret urns. I t is measured using t he following formula:
PDF created with pdfFactory trial version www.pdffactory.com
88
) ] – ( [ –
f M p f p p
r r r r β + · α
The ret urns predict ed from t he CAPM model is t aken as t he benchmark ret urns and is indicat ed
by t he formula wit hin t he bracket s. The excess ret urn is at t ribut ed t o t he abilit y of t he managers
for market t iming or st ock picking or bot h. This measure invest igat es t he performance of
funds and especially t he abilit y of t he managers in st ock select ion in t erms of t hese cont ribut ing
aspect s.
This measure is widely used in evaluat ing mut ual fund performance. I f
P
α is posit ive and
significant , it implies t hat t he fund managers are able t o ident ify st ocks wit h high pot ent ial for
excess ret urns. Market t iming would refer t o t he adj ust ment in t he bet a of t he port folio in
t andem wit h market movement s. Specifically, t iming skills call for increasing t he bet a when
t he market is rising and reducing t he bet a, when t he market declines, for example t hrough
fut ures posit ion. I f t he fund manager has poor market t iming abilit y, t hen t he bet a of t he
port folio would not have been significant ly different during a market decline compared t o t hat
during a market increase.
Example: The dat a relat ing t o market port folio and an invest or ‘P’ port folio is as under:
I nvest or P’s Port folio Market Port folio ( M)
Average Ret urn 28% 18%
Bet a ( β ) 1.4 1
St andard Deviat ion ( σ ) 30% 20%
Assumi ng t hat t he r i sk- f r ee r at e f or t he mar ket i s 8%, cal cul at e ( a) Shar pe Rat i o
( b) Treynor Rat io and ( c) Jensen Alpha for t he invest or P and t he market .
Answer:
I nvest or P Port folio Market Port folio ( M)
p f p
r r Rat io Shar pe σ · / ) – ( ( 28% - 8%) / 30% = 0.67 ( 18% - 8%) / 20% = 0.5
p f p
r r Rat io Tr eynor β · / ) – ( ( 28% - 8%) / 1.4 = 5 ( 18% - 8%) / 1 = 10
Alpha Jensen 28% - [ 8% + 1.4* ( 18% - 8%) ] 18% - [ 8% + 1
) ] – ( [ – ) (
f M p f p p
r r r r β + · α = 28% - 22% = 6% ( 18% - 8%) ] = 0
* * *
PDF created with pdfFactory trial version www.pdffactory.com
89
MODEL TEST
I NVESTMENT ANALYSI S AND PORTFOLI O
MANAGEMENT MODULE
Q: 1. __________ would mean t hat no invest or would be able t o out perform t he market
wit h t rading st rat egies based on publicly available informat ion. [ 1 Mark]
( a) Semi st rong form efficiency
( b) Weak-form efficiency
( c) St rong form efficiency
Q: 2. A company' s __________ provide t he most accurat e informat ion t o it s management
and shareholders about it s operat ions. [ 1 Mark]
( a) advert isement s
( b) financial st at ement s
( c) product s
( d) vision st at ement
Q: 3. ______ fund managers t ry t o replicat e t he performance of a benchmark index, by
replicat ing t he weight s of it s const it uent st ocks. [ 2 Marks]
( a) Act ive
( b) Passive
Q: 4. Unlike t erm insurance, __________ ensure a ret urn of capit al t o t he policyholder on
mat urit y, along wit h t he deat h benefit s. [ 1 Mark]
( a) high premium or low premium policies
( b) fixed or variable policies
( c) assurance or endowment policies
( d) growt h or value policies
Q: 5. Gross Profit Margin = Gross Profit / Net Sales [ 2 Marks]
( a) FALSE
( b) TRUE
Q: 6. Securit y of ABC Lt d. t rades in t he spot market at Rs. 595. Money can be invest ed at
10% per annum. The fair value of a one- mont h fut ures cont ract on ABC Lt d. is ( using
cont inuously compounded met hod) : [ 2 Marks]
( a) 630.05
( b) 620.05
( c) 600.05
( d) 610.05
PDF created with pdfFactory trial version www.pdffactory.com
90
Q: 7. Account s payable appears in t he Balance Sheet of companies. [ 2 Marks]
( a) TRUE
( b) FALSE
Q: 8. A port folio comprises of t wo st ocks A and B. St ock A gives a ret urn of 8% and st ock B
gives a ret urn of 7%. St ock A has a weight of 60% in t he port folio. What is t he
port folio ret urn? [ 2 Marks]
( a) 9%
( b) 11%
( c) 10%
( d) 8%
Q: 9. Evidence accumulat ed t hrough research over t he past t wo decades suggest s t hat
dur i ng many epi sodes t he mar ket s ar e not ef f i ci ent even i n t he weak f or m.
[ 2 Marks]
( a) FALSE
( b) TRUE
Q: 10. Mr. A buys a Put Opt ion at a st rike price of Rs. 100 for a premium of Rs. 5. On expiry
of t he cont ract t he underlying shares are t rading at Rs. 106. Will Mr. A exercise his
opt ion? [ 3 Marks]
( a) No
( b) Yes
Q: 11. Price movement bet ween t wo I nformat ion Technology st ocks would generally have a
______ co-variance. [ 1 Mark]
( a) zero
( b) posit ive
( c) negat ive
Q: 12. I n t he case of callable bonds, t he callable price ( redempt ion price) may be different
from t he face value. [ 2 Marks]
( a) FALSE
( b) TRUE
Q: 13. Term st ruct ure of int erest rat es is also called as t he ______. [ 2 Marks]
( a) t erm curve
( b) yield curve
( c) int erest rat e curve
( d) mat urit y curve
PDF created with pdfFactory trial version www.pdffactory.com
91
Q: 14. Each invest ment company is run by an _______. [ 1 Mark]
( a) asset deployment company
( b) revenue management company
( c) asset management company
( d) asset reconst ruct ion company
Q: 15. A ________, is a t ime deposit wit h a bank wit h a specified int erest rat e. [ 1 Mark]
( a) cert ificat e of deposit ( CD)
( b) commercial paper ( CP)
( c) T- Not e
( d) T- Bill
Q: 16. Prices ( ret urns) which are not according t o CAPM shall be quickly ident ified by t he
market and brought back t o t he __________. [ 1 Mark]
( a) average
( b) st andard deviat ion
( c) mean
( d) equilibrium
Q: 17. Net acquisit i ons / disposals appears in t he Cash Flow St at ement of Companies.
[ 3 Marks]
( a) TRUE
( b) FALSE
Q: 18. ______ are a fixed income securit y. [ 1 Mark]
( a) Equit ies
( b) Forex
( c) Derivat ives
( d) Bonds
Q: 19. I nvest ment advisory firms manage ______. [ 1 Mark]
( a) each client ' s account seperat ely
( b) all client s account s in a combined manner
( c) only t heir own money and not client ' s money
PDF created with pdfFactory trial version www.pdffactory.com
92
Q: 20. _______ measures t he percent age of net income not paid t o t he shareholders in t he
form of dividends. [ 1 Mark]
( a) Wit hholding rat io
( b) Ret ent ion rat io
( c) Preservat ion rat io
( d) Maint enance rat io
Q: 21. I n a Bond t he ____ is paid at t he mat urit y dat e. [ 1 Mark]
( a) face value
( b) discount ed value
( c) compounded value
( d) present value
Q: 22. Banks and ot her financial inst it ut ions generally creat e a port folio of fixed income
securit ies t o fund known _______ . [ 2 Marks]
( a) asset s
( b) liabilit ies
Q: 23. Which of t he following account ing st at ement s form t he backbone of financial analysis
of a company? [ 1 Mark]
( a) t he income st at ement ( profit & loss) ,
( b) t he balance sheet
( c) st at ement of cash flows
( d) All of t he above
Q: 24. The balance sheet of a company is a snapshot of t he ______ of t he firm at a point in
t ime. [ 2 Marks]
( a) t he sources and applicat ions of funds of t he company.
( b) expendit ure st ruct ure
( c) profit st ruct ure
( d) income st ruct ure
Q: 25. The need t o have an underst anding about t he abilit y of t he market t o imbibe informat ion
int o t he prices has led t o count less at t empt s t o st udy and charact erize t he levels of
efficiency of different segment s of t he financial market s. [ 1 Mark]
( a) TRUE
( b) FALSE
PDF created with pdfFactory trial version www.pdffactory.com
93
Q: 26. I n invest ment decisions, _______ refers t o t he market abilit y of t he asset .
[ 2 Marks]
( a) value
( b) profit abilit y
( c) price
( d) liquidit y
Q: 27. Mr. A buys a Call Opt ion at a st rike price of Rs. 700 for a premium of Rs. 5. Mr. A
expect s t he price of t he underlying shares t o rise above Rs. ______ on expiry dat e in
order t o make a profit . [ 3 Marks]
( a) 740
( b) 700
( c) 720
( d) 760
Q: 28. The ______ refers t o t he lengt h of t ime for which an invest or expect s t o remain
invest ed in a part icular securit y or port folio, before realizing t he ret urns. [ 2 Marks]
( a) invest ment horizon
( b) credit cycle horizon
( c) durat ion horizon
( d) const raint horizon
Q: 29. A ________ provides an account of t he t ot al revenue generat ed by a firm during a
period ( usually a financial year, or a quart er) . [ 1 Mark]
( a) Account ing analysis st at ement
( b) financial re-engineering st at ement
( c) promot ional expenses st at ement
( d) profit & loss st at ement
Q: 30. New st ocks/ bonds are sold by t he issuer t o t he public in t he ________ . [ 1 Mark]
( a) fixed income market
( b) secondary market
( c) money market
( d) primary market
PDF created with pdfFactory trial version www.pdffactory.com
94
Q: 31. Securit y of ABC Lt d. t rades in t he spot market at Rs. 525. Money can be invest ed at
10% per annum. The fair value of a one- mont h fut ures cont ract on ABC Lt d. is ( using
cont inously compounded met hod) : [ 2 Marks]
( a) 559.46
( b) 549.46
( c) 539.46
( d) 529.46
Q: 32. I f t he market is _______, t he period aft er a favorable ( unfavorable) event would not
generat e ret urns beyond ( less t han) what is suggest ed by an equilibrium model such
as CAPM. [ 1 Mark]
( a) weak- form efficient
( b) st rong form efficient
( c) semi- st rong form efficient
Q: 33. A sell order comes int o t he t rading syst em at a Limit Price of Rs. 120. The order will
get execut ed at a price of _______. [ 2 Marks]
( a) Rs. 120 or more
( b) Rs. 120 or less
Q: 34. __________ have precedence over common st ock in t erms of dividend payment s,
and t he residual claim t o it s asset s in t he event of liquidat ion. [ 1 Mark]
( a) Preferred shares
( b) Equit y shares
Q: 35. One needs t o average out t he t ime t o mat urit y and t ime t o various coupon payment s
t o find t he effect ive mat urit y for a bond. The measure is called as _____ of a bond.
[ 2 Marks]
( a) durat ion
( b) I RR
( c) YTM
( d) yield
Q: 36. I n case of compound i nt er est rat e, we need t o know t he _______ f or whi ch
compounding is done. [ 1 Mark]
( a) period
( b) frequency
( c) t ime
( d) durat ion
PDF created with pdfFactory trial version www.pdffactory.com
95
Q: 37. Net change in Working Capit al appears in t he Cash Flow St at ement of Companies.
[ 3 Marks]
( a) FALSE
( b) TRUE
Q: 38. A company's net income for a period is Rs. 15,00,00,000 and t he average shareholder's
fund during t he period is Rs. 1,00,00,00,000. The Ret urn on Average Equit y is :
[ 3 Marks]
( a) 13%
( b) 12%
( c) 15%
( d) 16%
Q: 39. A port folio comprises of t wo st ocks A and B. St ock A gives a ret urn of 14% and st ock
B gives a ret urn of 1%. St ock A has a weight of 60% in t he port folio. What is t he
port folio ret urn? [ 2 Marks]
( a) 10%
( b) 9%
( c) 12%
( d) 11%
Q: 40. Average Ret urn of an invest or' s port folio is 10%. The risk free ret urn for t he market is
8%. The Bet a of t he invest or's port folio is 1.2. Calculat e t he Treynor Rat io. [ 3 Marks]
( a) 4
( b) 8
( c) 2
( d) 6
Q: 41. The share price of PQR Company on 1st April 2009 and 31st March 2010 is Rs. 20 and
Rs. 24 respect ively. The company paid a dividend of Rs. 5 for t he year 2009- 10.
Cal culat e t he r et ur n f or a shar eholder of PQR Company i n t he year 2009- 10.
[ 1 Mark]
( a) 45%
( b) 65%
( c) 75%
( d) 55%
PDF created with pdfFactory trial version www.pdffactory.com
96
Q: 42. Port folio management is t he art of managing t he expect ed _______ requirement for
t he corresponding ________. [ 1 Mark]
( a) income, expendit ure
( b) gain, losses
( c) profit , loss t olerance
( d) ret urn, risk t olerance
Q: 43. Average Ret urn of an invest or' s port folio is 55%. The risk free ret urn for t he market is
8%. The Bet a of t he invest or' s port folio is 1.2. Calculat e t he Treynor Rat io.
[ 3 Marks]
( a) 41
( b) 39
( c) 43
( d) 45
Q: 44. I n addit ion t o t he perceived benefit s of professional fund management , t he maj or
reason of invest ment int o funds is t he ______ t hey afford t he invest or. [ 1 Mark]
( a) specialisat ion
( b) diversificat ion
( c) variet y
( d) expansion
Q: 45. ABC Lt d. has paid a dividend of Rs. 10 per share last year and it is expect ed t o grow
at 5% every year. I f an invest or' s expect ed rat e of ret urn from ABC Lt d. share is 7%,
cal cul at e t he mar ket pr i ce of t he shar e as per t he di vi dend di scount model .
[ 2 Marks]
( a) 540
( b) 530
( c) 525
( d) 535
Q: 46. The CAPM is founded on t he following t wo assumpt ions ( 1) in t he equilibrium every
mean variance invest or holds t he same market port folio and ( 2) t he only risk t he
invest or faces is t he bet a. [ 1 Mark]
( a) TRUE
( b) FALSE
PDF created with pdfFactory trial version www.pdffactory.com
97
Q: 47. Market s are inefficient when prices of securit ies assimilat e and reflect informat ion
about t hem. [ 1 Mark]
( a) TRUE
( b) FALSE
Q: 48. St ock ret urns are generally expect ed t o be independent across weekdays, but a number
of st udies have found ret urns on Monday t o be lower t han in t he rest of t he week. This
depart ure from market efficiency is also somet imes called t he _____ effect . [ 2 Marks]
( a) Monday- Friday
( b) weekday
( c) Monday
( d) weekend
Q: 49. Over pr icing in a st ock present s an opport unit y t o engage in _____ t he st ock.
[ 2 Marks]
( a) short covering
( b) short selling
( c) act ive buying
( d) going long
Q: 50. What is t he amount an invest or will get on a 1-year fixed deposit of Rs. 10000 t hat
pays 8% int erest compounded quart erly? [ 1 Mark]
( a) 12824.32
( b) 13824.32
( c) 10824.32
( d) 11824.32
Q: 51. For longer invest ment horizons invest ors look at ______ . [ 2 Marks]
( a) riskier asset s like equit ies.
( b) low risk asset s like government securit ies.
Q: 52. Dividend Per Share = Tot al Dividend / Number of Shares in issue [ 1 Mark]
( a) TRUE
( b) FALSE
Q: 53. Price movement bet ween t wo St eel company st ocks would generally have a ______
co-variance. [ 1 Mark]
( a) posit ive
( b) negat ive
( c) zero
PDF created with pdfFactory trial version www.pdffactory.com
98
Q: 54. The price of a derivat ive is dependent on t he price of anot her securit y, called t he
_____ . [ 1 Mark]
( a) basis
( b) variable
( c) underlying
( d) opt ions
Q: 55. Call Opt ions can be classified as : [ 1 Mark]
( a) European
( b) American
( c) All of t he above
Q: 56. I n I ndia, Commercial Papers ( CPs) can be issued by _____. [ 3 Marks]
( a) Mut ual Fund Agent s
( b) I nsurance Agent s
( c) Primary Dealers
( d) Sub- Brokers
Q: 57. An endowment fund is an inst it ut ional invest or. [ 1 Mark]
( a) FALSE
( b) TRUE
Q: 58. ______ orders are act ivat ed only when t he market price of t he relevant securit y
reaches a t hreshold price. [ 2 Marks]
( a) Limit
( b) Market - loss
( c) St op- loss
( d) I OC
Q: 59. A port folio comprises of t wo st ocks A and B. St ock A gives a ret urn of 9% and st ock B
gives a ret urn of 6%. St ock A has a weight of 60% in t he port folio. What is t he
port folio ret urn? [ 2 Marks]
( a) 11%
( b) 9%
( c) 10%
( d) 8%
PDF created with pdfFactory trial version www.pdffactory.com
99
Q: 60. The issue price of T- bills is generally decided at an ______ . [ 3 Marks]
( a) OTC market
( b) int er- bank market
( c) exchange
( d) auct ion
________________________________________
Cor r ect Answ er s :
Quest i on No. Answ er s Quest i on No. Answ er s
1 ( a) 31 ( d)
2 ( b) 32 ( c)
3 ( b) 33 ( a)
4 ( c) 34 ( a)
5 ( b) 35 ( a)
6 ( c) 36 ( b)
7 ( a) 37 ( b)
8 ( d) 38 ( c)
9 ( b) 39 ( b)
10 ( a) 40 ( c)
11 ( b) 41 ( a)
12 ( b) 42 ( d)
13 ( b) 43 ( b)
14 ( c) 44 ( b)
15 ( a) 45 ( c)
16 ( d) 46 ( a)
17 ( a) 47 ( b)
18 ( d) 48 ( d)
19 ( a) 49 ( b)
20 ( b) 50 ( c)
21 ( a) 51 ( a)
22 ( b) 52 ( a)
23 ( d) 53 ( a)
24 ( a) 54 ( c)
25 ( a) 55 ( a)
26 ( d) 56 ( c)
27 ( b) 57 ( b)
28 ( a) 58 ( c)
29 ( d) 59 ( d)
30 ( d) 60 ( d)
________________________________________
PDF created with pdfFactory trial version www.pdffactory.com
PDF created with pdfFactory trial version www.pdffactory.com

Test Details
Sr. No. Name of Module Fees (Rs.) Test No. of Maximum Pass Duration Questions Marks Marks (in (%) minutes) 120 120 60 60 120 105 105 120 120 120 120 120 60 60 50 50 60 60 60 60 60 60 60 100 100 100 100 100 100 100 100 100 100 100 100 100 50 50 50 50 50 60 50 60 60 60 60 50 Certificate Validity (in years) 5 5 5 5 5 5 5 3 5 5 3 3

1 2 3 4 5 6 7 8 9 10 11 12

Financial Markets:A Beginners' Module Mutual Funds : A Beginners' Module Currency Derivatives: A Beginner's Module ### Equity Derivatives: A Beginner's Module ### Interest Rate Derivatives: A Beginner's Module Securities Market (Basic) Module Capital Market (Dealers) Module * Derivatives Market (Dealers) Module ** FIMMDA-NSE Debt Market (Basic) Module Investment Analysis and Portfolio Management Module NISM-Series-I: Currency Derivatives Certification Examination NISM-Series-II-A: Registrars to an Issue and Share Transfer Agents Corporate Certification Examination NISM-Series-II-B: Registrars to an Issue and Share Transfer Agents - Mutual Fund Certification Examination NSDL-Depository Operations Module Commodities Market Module AMFI-Mutual Fund (Basic) Module AMFI-Mutual Fund (Advisors) Module ## Surveillance in Stock Exchanges Module Corporate Governance Module Compliance Officers (Brokers) Module Compliance Officers (Corporates) Module Information Security Auditors Module (Part-1) Information Security Auditors Module (Part-2)

1500 1500 750 750 1500 1500 1500 1500 1500 1500 1000 1000

13

1000

120

100

100

50

3

14 15 16 17 18 19 20 21 22

1500 1800 1000 1000 1500 1500 1500 1500 2250 2250 2000 per exam 1500

75 120 90 120 120 90 120 120 120 120 120

60 60 62 72 50 100 60 60 90 90 75

100 100 100 100 100 100 100 100 100 100 140

60 # 50 50 50 60 60 60 60 60 60 60

5 3 No limit 5 5 5 5 5 2

23

FPSB India Exam 1 to 4***

NA

24 * ** # ##

Options Trading Strategies Module

120

60

100

60

5

Candidates have the option to take the CMDM test in English, Gujarati or Hindi language. The workbook for the module is presently available in ENGLISH. Candidates have the option to take the DMDM test in English, Gujarati or Hindi language. The workbook for the module is also available in ENGLISH, GUJARATI and HINDI languages. Candidates securing 80% or more marks in NSDL-Depository Operations Module ONLY will be certified as 'Trainers'. Candidates have the option to take the AMFI (Adv) test in English, Gujarati or Hindi languages. The workbook for the module, which is available for a fee at AMFI, remains in ENGLISH.

### Revision in test fees and test parameters with effect from April 01, 2010. Please refer to circular NSE/NCFM/ 13815 dated 01-Jan-2010 for details. *** Modules of Financial Planning Standards Board India (Certified Financial Planner Certification) i.e. (i) Risk Analysis & Insurance Planning (ii) Retirement Planning & Employee Benefits (iii) Investment Planning and (iv) Tax Planning & Estate Planning. The curriculum for each of the module (except FPSB India Exam 1 to 4) is available on our website: www.nseindia.com > NCFM > Curriculum & Study Material.

CONTENTS
CHAPTER 1: OBJECTIVES OF INVESTMENT DECISIONS ......................................... 1 1.1 1.2 Introduction ............................................................................................... 1 Types of investors ....................................................................................... 1 1.2.1 1.2.2 Individuals ............................................................................................. 1 Institutions ............................................................................................ 2 Mutual funds ................................................................................. 2 Pension funds ................................................................................ 2 Endowment funds .......................................................................... 3

1.2.2.1 1.2.2.2 1.2.2.3

1.2.2.4 Insurance companies (Life and Non-life) ............................................. 3 1.2.2.5 Banks ............................................................................................. 3 1.3 Constraints ................................................................................................. 4 1.3.1 1.3.2 1.3.3 1.4 Liquidity ................................................................................................ 4 Investment horizons ............................................................................... 4 Taxation ................................................................................................ 5

Goals of Investors ....................................................................................... 5

CHAPTER 2: FINANCIAL MARKETS ........................................................................ 6 2.1 2.2 2.3 Introduction ............................................................................................... 6 Primary and Secondary Markets .................................................................... 6 Trading in Secondary Markets ....................................................................... 7 2.3.1 2.3.2 2.4 Types of Orders ...................................................................................... 7 Matching of Orders ................................................................................. 8

The Money Market ....................................................................................... 9 2.4.1 2.4.2 2.4.3 T-Bills ................................................................................................... 9 Commercial Paper .................................................................................. 9 Certificates of Deposit ........................................................................... 10

2.5 2.6

Repos and Reverses ................................................................................... 10 The Bond Market ....................................................................................... 11 2.6.1 2.6.2 2.6.3 2.6.4 Treasury Notes (T-Notes) and T-Bonds .................................................... 11 State and Municipal Government bonds ................................................... 11 Corporate Bonds .................................................................................. 11 International Bonds .............................................................................. 12 1

2.6.5 2.7

Other types of bonds ............................................................................ 12

Common Stocks ........................................................................................ 13 2.7.1 Types of shares .................................................................................... 14

CHAPTER 3 FIXED INCOME SECURITIES ............................................................. 15 3.1 3.2 Introduction: The Time Value of Money ........................................................ 15 Simple and Compound Interest Rates .......................................................... 15 3.2.1 3.2.2 3.3 3.4 Simple Interest Rate ............................................................................. 15 Compound Interest Rate ....................................................................... 16

Real and Nominal Interest Rates ................................................................. 18 Bond Pricing Fundamentals ......................................................................... 19 3.4.1 Clean and dirty prices and accrued interest .............................................. 20

3.5

Bond Yields .............................................................................................. 20 3.5.1 3.5.2 3.5.3 3.5.4 Coupon yield ........................................................................................ 20 Current Yield ........................................................................................ 20 Yield to maturity ................................................................................... 21 Yield to call .......................................................................................... 23

3.6

Interest Rates ........................................................................................... 24 3.6.1 3.6.2 3.6.3 3.6.4 Short Rate ........................................................................................... 24 Spot Rate ............................................................................................ 24 Forward Rate ....................................................................................... 25 The term structure of interest rates ........................................................ 26

3.7

Macaulay Duration and Modified Duration ..................................................... 28

CHAPTER 4 CAPITAL MARKET EFFICIENCY .......................................................... 32 4.1 4.2 Introduction ............................................................................................. 32 Market Efficiency ....................................................................................... 32 4.2.1 4.2.2 4.2.3 4.3 Weak-form Market Efficiency .................................................................. 32 Semi-strong Market Efficiency ................................................................ 32 Strong Market Efficiency ........................................................................ 33

Departures from the EMH ........................................................................... 33

CHAPTER 5: FINANCIAL ANALYSIS AND VALUATION .......................................... 35 5.1 5.2 Introduction ............................................................................................. 35 The Analysis of Financial Statement ............................................................. 35

2

5.2.1 5.2.2 5.2.3 5.3

Income Statement (Profit & Loss) ........................................................... 36 The Balance Sheet ................................................................................ 36 Cash Flow Statement ............................................................................ 37

Financial Ratios (Return, Operation and, Profitability Ratios) .......................... 38 5.3.1 5.3.2 5.3.3 5.3.4 5.3.5 Measures of Profitability: RoA, RoE ......................................................... 39 Measures of Liquidity ............................................................................ 39 Capital Structure and Solvency Ratios ..................................................... 39 Operating Performance ......................................................................... 39 Asset Utilization ................................................................................... 39

5.4

The valuation of common stocks ................................................................. 40 5.4.1 5.4.2 Absolute (Intrinsic) Valuation ................................................................. 40 Relative Valuation ................................................................................. 44

5.5

Technical Analysis ..................................................................................... 49 5.5.1 Challenges to Technical Analysis ............................................................. 50

CHAPTER 6: MODERN PORTFOLIO THEORY ......................................................... 51 6.1 6.2 Introduction ............................................................................................. 51 Diversification and Portfolio Risks ................................................................ 51 6.2.1 6.3 Portfolio variance - General case ............................................................ 56

Equilibrium Module: The Capital Asset Pricing Module .................................... 57 6.3.1 6.3.2 Mean-Variance Investors and Market Behaviour ....................................... 58 Estimation of Beta ................................................................................ 63

6.4

Multifactor Modules ................................................................................... 64

CHAPTER 7: VALUATION OF DERIVATIVES ......................................................... 66 7.1 7.2 7.3 7.4 Introduction ............................................................................................. 66 Forwards and Futures ................................................................................ 66 Call and Put Options .................................................................................. 68 Forward and Future Pricing ......................................................................... 68 7.4.1 7.4.2 7.5 Cost-of carry and convenience yield ........................................................ 69 Backwardation and Contango ................................................................. 70

Option Pricing ........................................................................................... 70 7.5.1 7.5.2 Payoffs from option contracts ................................................................. 70 Put-call parity relationship ..................................................................... 72

7.6 Black-Scholes formula ...................................................................................... 73 3

CHAPTER 8: INVESTMENT MANAGEMENT ............................................................ 75 8.1 8.2 Introduction ............................................................................................. 75 Investment Companies .............................................................................. 75 8.2.1 8.3 8.4 8.5 8.6 Benefits of investments in managed funds ............................................... 76

Active vs. Passive Portfolio Management ...................................................... 76 Costs of Management: Entry/Exit Loads and Fees .......................................... 78 Net Asset Value ......................................................................................... 78 Classification of funds ................................................................................ 79 8.6.1 8.6.2 8.6.3 8.6.4 8.6.5 8.6.6 Open ended and closed-ended funds ....................................................... 79 Equity funds ........................................................................................ 79 Bond funds .......................................................................................... 80 Index funds ......................................................................................... 80 Money market funds ............................................................................. 80 Fund of funds ....................................................................................... 80

8.7

Other Investment Companies ..................................................................... 80 8.7.1 8.7.2 8.7.3 Unit Investment Trusts (UTI) ................................................................. 80 REITS (Real Estate Investment Trusts) .................................................... 81 Hedge Funds ........................................................................................ 81

8.8

Performance assessment of managed funds ................................................. 81 8.8.1 8.8.2 8.8.3 Sharpe Ratio ........................................................................................ 82 Treynor Ratio ....................................................................................... 82 Jensen measure or (Portfolio Alpha) ........................................................ 82 ................................................................................................. 82

MODEL TEST

4

reproduced. data compilation etc.nseindia. Mumbai 400 051 INDIA All content included in this book. the book in its entirety or any part cannot be stored in a retrieval system or transmitted in any form or by any means. regarding revisions/updations in NCFM modules or launch of new modules. Copyright © 2010 by National Stock Exchange of India Ltd. resold or exploited for any commercial purposes. recording or otherwise. such as text. are the property of NSE. graphics. Bandra (East). Bandra Kurla Complex. logos. Furthermore. images. (NSE) Exchange Plaza. click on 'NCFM' link and then go to 'Announcements' link. if any. This book or any part thereof should not be copied. duplicated. photocopying. 5 .Distribution of weights in the Investment Analysis and Portfolio Management Module Curriculum Chapter No 1 2 3 4 5 6 7 8 Title Objectives of Investment Decisions Financial Markets Fixed Income Securities Capital Market Efficiency Financial Analysis and Valuation Modern Portfolio Theory Valuation of Derivatives Investment Management Weighs (%) 9 13 12 8 23 10 12 13 Note: Candidates are advised to refer to NSE's website: www.com. electronic. sold. mechanical.

Risk appetites and return requirements greatly vary across investor classes and are key determinants of the investing styles and strategies followed as also the constraints faced. like houses. we start with the various types of investors in the markets today. and assets under management. Savings arise from deferred consumption. higher the returns.e. in anticipation of future returns. higher the risk. In our first chapter. depending on their investment styles. where they invest on behalf of others. 1. the size of the portfolio of each investor is usually quite small. Requirements of individuals also evolve according to their life-cycle positioning.2. Our aim in this book is to provide a brief overview of three aspects of investment: the various options available to an investor in financial instruments. in India. or commodities. Those averse to risk in their portfolios would be inclined towards safe investments like Government securities and bank deposits. horizons. people indulge in economic activity to support their consumption requirements. generally rising with the expected risk. their return requirements and the various constraints that an investor faces. mandates. like stocks. bonds. while others may be risk takers who would like to invest and / or speculate in the equity markets. an individual 6 . Individuals differ across their risk appetite and return requirements. Portfolio management is the art of managing the expected return requirement for the corresponding risk tolerance. Primarily. i. individuals comprise the single largest group in most markets. a good portfolio manager’s objective is to maximize the return subject to the risk-tolerance level or to achieve a pre-specified level of return with minimum risk. to be invested.1 Individuals While in terms of numbers. investors are either individuals. Investments could be made into financial assets..2 Types of investors There is wide diversity among investors. the tools used in modern finance to optimally manage the financial portfolio and lastly the professional asset management industry as it exists today. in that they invest for themselves or institutions. Simply put. 1.CHAPTER 1 : Objectives of Investment Decisions 1.1 Introduction In an economy. and similar instruments or into real assets. For example. A quick look at the broad groups of investors in the market illustrates the point. Returns more often than not differ across their risk profiles. land. The underlying objective of portfolio management is therefore to create a balance between the trade-off of returns and risk across multiple asset classes.

2.e. 1. Over the years the share of institutions has risen in share ownership of companies. it may not be optimal for an individual to spend his or her time analyzing various possible investment strategies and devise investment plans and strategies accordingly.1: The Indian financial markets are also witnessing active participation by institutions with foreign institutional investors. hedge funds. Funds are contributed by the employers and employees during the working life of the employees and the objective is to provide benefits 7 . they could rely on professionals who possess the necessary expertise to manage thier funds within a broad. We briefly describe some of them here. with the Government and promoters another 50%. pension funds. Mutual funds pool investors’ money and invest according to pre-specified.2. The profit or capital gain from the funds. Examples of such organizations are mutual funds.1 Mutual funds Individuals are usually constrained either by resources or by limits to their knowledge of the investment outlook of various financial assets (or both) and the difficulty of keeping abreast of changes taking place in a rapidly changing economic environment.2. Instead.2. banks. depending on their investment objectives. As mentioned earlier. an individual belonging to the age group of 35-45 years may plan for children’s education and children’s marriage. Mutual funds vary greatly. private equity and venture capital firms and other financial institutions.in the 25-35 years age group may plan for purchase of a house and vehicle. and domestic insurance companies comprising the three major groups. The investment portfolio then changes depending on the capital needed for these requirements. These funds are managed and operated by professionals whose remunerations are linked to the performance of the funds. Assets under management are generally large and managed professionally by fund managers. domestic mutual funds. like individuals or other institutions. after paying the management fees and commission is distributed among the individual investors in proportion to their holdings in the fund. 1.. 1. owning more than a third of the shareholding in listed companies. endowment funds. institutions are representative organizations. Given the small portfolio size to manage.2 Institutions Institutional investors comprise the largest active group in the financial markets. insurance companies.2. Box No. pre-specified plan. i. 1. broad parameters. and the overall strategy they adopt towards investments. the set of asset classes they invest in. an individual in his or her fifties would be planning for post-retirement life.2 Pension funds Pension funds are created (either by employers or employee unions) to manage the retirement funds of the employees of companies or the Government. they invest capital on behalf of others.

2. 1. are stipulated by the Reserve Bank of India and banks need to adhere to them. Insurance companies are generally conservative in their attitude towards risks and their asset investments are geared towards meeting current cash flow needs as well as meeting perceived future liabilities. 1. They are statutorily required to maintain a certain portion of the deposits as cash and another portion in the form of liquid and safe assets (generally Government securities). The contributor generally specifies the purpose (specific or general) and appoints trustees to manage the funds.3 Endowment funds Endowment funds are generally non-profit organizations that manage funds to generate a steady return to help them fulfill their investment objectives. The investment strategy of insurance companies depends on actuarial estimates of timing and amount of future claims. The management of pension funds may be in-house or through some financial intermediary. speculators and arbitrageurs. non-Government organizations. In addition to the broad categories mentioned above.2. Their main source of income is from what is called as the interest rate spread. along with the death benefits.4 Insurance companies (Life and Non-life) Insurance companies. Pension funds of large organizations are usually very large and form a substantial investor group for various financial instruments. Banks generally do not lend 100% of their deposits. Hedgers invest to provide a cover for risks on a portfolio they already hold.5 Banks Assets of banks consist mainly of loans to businesses and consumers and their liabilities comprise of various forms of deposits from consumers. hold large portfolios from premiums contributed by policyholders to policies that these companies underwrite. The investment policy of endowment funds needs to be approved by the trustees of the funds. speculators take additional risks to earn supernormal returns and arbitrageurs take simultaneous positions (say in two equivalent assets or same asset in two different 8 . there are hedgers.2. 1. Such funds are usually managed by charitable organizations. unlike term insurance. The premium for such poliices may be higher than term policies. These requirements.2. Under this classification. educational organization.2. which yield a lower rate of return. There are many different kinds of insurance polices and the premiums differ accordingly. investors in the markets are also classified based on the objectives with which they trade. assurance or endowment policies ensure a return of capital to the policyholder on maturity.2. For example. Endowment funds are usually initiated by a non-refundable capital contribution. both life and non-life.to the employees post their retirement. which is the difference between the lending rate (rate at which banks earn) and the deposit rate (rate at which banks pay). known as the Cash Reserve Ratio (CRR ratio) and Statutory Liquidity Ratio (SLR ratio) in India. etc.

the size of the transaction needed to bring about a unit change in the price. simply put.markets etc. this is also referred to as the impact cost. Adequate liquidity is usually characterized by high levels of trading activity.1 Liquidity In investment decisions. Further. optimal use of tax rules etc. instruments that derive their value from the underlying securities.) to earn riskless profits arising out of the price differential if they exist. (i) market breadth. the choice of securities. and (ii) market depth. High demand and supply of the security would generally result in low impact costs of trading and reduce liquidity risk. they also invest in derivatives.3. Traders in the markets not only invest directly in securities in the socalled cash markets.2 Investment horizons The investment horizon refers to the length of time for which an investor expects to remain invested in a particular security or portfolio.3.. like liquidity. before realizing the returns. 1. Another category of investors include day-traders who trade in order to profit from intra-day price changes.3 Constraints Portfolio management is usually a constrained optimization exercise: Every investor has some constraint (limits) within which she wants the portfolio to lie. 1.. like fixed-income securities. viz. Knowing the investment horizon helps in security selection in that it gives an idea about investors’ income needs and desired risk exposure. besides having some constraints of his or her own. We provide a quick outline of the various constraints and limitations that are faced by the broad categories of investors mentioned above. cash levels mandated across certain asset classes etc. The professional portfolio advisor or manager also needs to consider the constraint set of the investors while designing the portfolio. market risk. ensuring that they do not carry any open position to the next trading day. Risk-adjusted returns for equity are generally found to be higher for longer investment horizon. the ability and ease of an asset to be converted into cash and vice versa. typical examples being the risk profile. but lower in case of short investment horizons. certain securities require commitment 9 . In general. 1. the time horizon. It is generally measured across two different parameters. whereas for longer investment horizons investors look at riskier assets like equities.e. They generally take a position at the beginning of the trading session and square off their position later during the day. liquidity refers to the marketability of the asset. which measures the cost of transacting a given volume of the security. largely due to the high volatility in the equity markets. investors with shorter investment horizons prefer assets with low risk. which measures the units that can be traded for a given price impact. i.

the net return for the investors would be higher for asset B and hence asset B would trade at a premium as compared to asset A. 1. For individual investors.3 Taxation The investment decision is also affected by the taxation laws of the land.. For example. housing etc. In addition to the few mentioned here.to invest for a certain minimum investment period. The following example will give a better understanding of the concept: Table 1. there are other constraints like the level of requisite knowledge (investors may not be aware of certain financial instruments and their pricing). An investment decision will depend on the investor’s plans for the above needs.3. 10 . are major event triggers that cause an increase in the demands for funds. small investors may not be able to invest in Certificate of Deposits).g. Investment horizon also facilitates in making a decision between investing in a liquid or relatively illiquid investment. Such taxation benefits should also be considered before deciding the investment portfolio. Similarly. there are certain specific needs for institutional investors also. for a pension fund the investment policy will depend on the average age of the plan’s participants. whereas if the investment horizon is a short period (say 1 month) then the impact cost (liquidity) becomes significant as it could form a meaningful component of the expected return. 1. In some cases taxation benefits on certain types of income are available on specific investments. liquidity costs may not be a significant factor. for example in India. If an investor wants to invest for a longer period. Investors are always concerned with the net and not gross returns and therefore tax-free investments or investments subject to lower tax rate may trade at a premium as compared to investments with taxable returns.1: Asset A B Type 10% taxable bonds (30% tax) 8% tax-free bonds Expected Return 10% 8% Net Return 10%*(1-0.4 Goals of Investors There are specific needs for all types of investors. the Post Office savings or Government small-saving schemes like the National Savings Certificate (NSC) have a minimum maturity of 3-6 years. which also serve to outline the investment choices faced by investors. regulatory provisions (country may impose restriction on investments in foreign countries) etc.3) = 7% 8% Although asset A carries a higher coupon rate. children’s marriage / education. investment size (e. retirement.

Instruments in the money markets include mainly short-term. usually equities and bonds. in contrast. When an issuer wants to issue more securities of a category that is already in existence in the market it is referred to as Follow-up Offerings. There is also a wide range of derivatives instruments that are traded in the capital markets. It is in the interest of the company to estimate the correct price of the offer. it is called an Initial Public Offering (IPO).CHAPTER 2: Financial Markets 2. New stocks/bonds are sold by the issuer to the public in the primary market. since there is a risk of failure of the issue in case of non-subscription if the offer is overpriced.1 Introduction There are a wide range of financial securities available in the markets these days. forwards and options on the underlying instruments. we take a look at different financial markets and try to explain the various instruments where investors can potentially park their funds. When a particular security is offered to the public for the first time. It is generally easier to price a security during a Follow-up Offering since the market price of the security is actually available before the company comes up with the offer. whereas in the case of an IPO it is very difficult to price the offer since there is no prevailing market for the security. which deals with the raising of capital from investors via issuance of new securities. Whereas. Money market instruments are of very short maturity period. If the issue is underpriced.2 Primary and Secondary Markets A primary market is that segment of the capital market. liquid. include longer-term and riskier securities. Both bond market and money market instruments are fixed-income securities but bond market instruments are generally of longer maturity period as compared to money market instruments. 2. Derivative market instruments are mainly futures. offered securities to the public. Capital markets. marketable. 11 . BEML’s public offer in 2007 was a Follow-up Offering as BEML shares were already issued to the public before 2007 and were available in the secondary market. the company stands to lose notionally since the securities will be sold at a price lower than its intrinsic value. resulting in lower realizations. In this chapter. Example: Reliance Power Ltd. Financial markets can mainly be classified into money markets and capital markets. The equities market can be further classified into the primary and the secondary market. which include bonds and equities. low-risk debt securities.’s offer in 2008 was an IPO because it was for the first time that Reliance Power Ltd.

if there is a pending order of the opposite type against which the order can match. which is widely referred to as the third market in the investment world. etc. Thus the primary market facilitates capital formation in the economy and secondary market provides liquidity to the securities. There may be regulatory restrictions on trading some products in the OTC markets. The matching is done automatically at the best available price (which is called as the 12 . funds and the securities are transferred from the hands of one investor to the hands of another. In addition to these three. We outline some of the most popular orders below: 2. which have been issued before are traded. are referred to as the fourth market. Orders refer to instructions provided by a customer to a brokerage firm.3 Trading in Secondary Markets Trading in secondary market happens through placing of orders by the investors and their matching with a counter order in the trading system.3. 2. The order gets executed only at the quoted price or at a better price (a price lower than the limit price in case of a purchase order and a price higher than the limit price in case of a sale order). Advances in technology have led to most secondary markets of the world becoming electronic exchanges. The secondary market helps in bringing potential buyers and sellers for a particular security together and helps in facilitating the transfer of the security between the parties. in India equity derivatives is one of the products which is regulatorily not allowed to be traded in the OTC markets. The OTC market refers to all transactions in securities that are not undertaken on an Exchange. These conditions may be related to the price of the security (limit order or market order or stop loss orders) or related to time (a day order or immediate or cancel order).The secondary market (also known as ‘aftermarket’) is the financial market where securities.).1 Types of Orders Limit Price/Order: In these orders. undertaken primarily with transaction costs in mind. and use their trading terminals to key in orders for transaction in securities. direct transactions between institutional investors. It gets executed at the best price obtainable at the time of entering the order. Unlike in the primary market where the funds move from the hands of the investors to the issuer (company/ Government. Trading in the OTC market is generally open to all registered broker-dealers. Securities traded on an OTC market may or may not be traded on a recognized stock exchange. the price for the order has to be specified while entering the order into the system. for buying or selling a security with specific conditions. Market Price/Order: Here the constraint is the time of execution and not the price. in case of the secondary market. The system immediately executes the order. Disaggregated traders across regions simply log in the exchange. For example. There is another market place. It is called the over-the-counter market or OTC market.

the order is matched against the best ask (sell) price.. Partial match is possible for the order and the unmatched portion of the order is cancelled immediately. the order is matched against the best bid (buy) price and if it is a purchase order. orders are looked at from the point of view of the opposite party). An order can also be executed against multiple pending orders. the best buy order is the one with highest price offered.3. Until the threshold price is reached in the market the stop loss order does not enter the market and continues to remain in the order book. by time priority 13 . When the market reaches the threshold or pre-determined price. The best buy order is then matched with the best sell order. If a match is found then the order is executed and a trade happens. The best bid price is the order with the highest buy price and the best ask price is the order with the lowest sell price. Time Related Conditions Day Order (Day): A Day order is valid for the day on which it is entered. the order is stored in the pending orders book till a match is found or till the end of the day whichever is earlier. get activated only when the market price of the relevant security reaches a threshold price. Stop Loss (SL) Price/Order: Stop-loss orders which are entered into the trading system. The order. which will result in more than one trade per order.2 Matching of orders When the orders are received. gets cancelled automatically at the end of the trading day. if not matched. The matching of orders at NSE is done on a price-time priority i. and the best sell order is the one with lowest price also called the lowest ask (i. A buy order in the stop loss book gets triggered when the last traded price in the normal market reaches or exceeds the trigger price of the order. The trigger price should be less than the limit price in case of a purchase order and vice versa. Immediate or Cancel order (IOC): An IOC order allows the investor to buy or sell a security as soon as the order is released into the market.e. For this purpose. That is the orders are matched during the day and all unmatched orders are flushed out of the system at the end of the trading day. the stop loss order is triggered and enters into the system as a market/limit order and is executed at the market price / limit order price or better price. A sell order in the stop loss book gets triggered when the last traded price in the normal market reaches or falls below the trigger price of the order. If it is a sale order. they are time-stamped and then immediately processed for potential match. also called the highest bid..e. failing which the order is removed from the system. At the National Stock Exchange (NSE) all orders are Day orders. 2. If an order cannot be matched with pending orders.market price). in the following sequence: • • Best Price Within Price.

Since money market instruments are of high denominations they are generally beyond the reach of individual investors. 2.1 T-Bills T-Bills or treasury bills are largely risk-free (guaranteed by the Government and hence carry only sovereign risk .risk that the government of a country or an agency backed by the government. These instruments are generally traded by the Government. Given their nature. The set of such orders across stocks at any point in time in the exchange. which individuals can also access. They are issued weekly (91-days maturity) and fortnightly (182-days and 364days maturity).4. 2. Once issued.2 Commercial Paper Commercial papers (CP) are unsecured money market instruments issued in the form of a promissory note by large corporate houses in order to diversify their sources of short-term borrowings and to provide additional investment avenues to investors.4 The Money Market The money market is a subset of the fixed-income market. participants borrow or lend for short period of time. very liquid. very safe but offer relatively low interest rates.4. very liquid instruments that are issued by the central bank of a country. We take a quick look at the various products available for trading in the money markets.Orders lying unmatched in the trading system are ‘passive’ orders and orders that come in to match the existing orders are called ‘active’ orders. which remain in the trading system until their market prices are reached. In India. 2. However. Issuing companies are required to obtain investment-grade credit ratings from approved rating agencies and in some 14 . T-bills are issued by the Reserve Bank of India for maturities of 91-days. individual investors can invest in the money markets through money-market mutual funds. These securities are of very large denominations. 182 days and 364 days. financial institutions and large corporate houses. Orders are always matched at the passive order price. will refuse to comply with the terms of a loan agreement). short-term. The maturity period for T-bills ranges from 3-12 months. is called the Limit Order Book (LOB) of the exchange. The cost of trading in the money market (bid-ask spread) is relatively small due to the high liquidity and large size of the market. T-bills are circulated both in primary as well as in secondary markets. In the money market. as compared to limit orders. The top five bids/asks (limit orders all) for any security are usually visible to market participants and constitute the Market By Price (MBP) of the security. usually up to a period of one year. T-bills are also traded in the secondary markets. T-bills are usually issued at a discount to the face value and the investor gets the face value upon maturity. market orders are instantly executed. The issue price (and thus rate of interest) of T-bills is generally decided at an auction.

15 . scheduled banks can issue CDs with maturity ranging from 7 days – 1 year and financial institutions can issue CDs with maturity ranging from 1 year – 3 years. Normal term deposits are of smaller ticket-sizes and time period. a repo for the borrower is a reverse repo for the lender. Unlike other bank term deposits. CPs are also issued at a discount to their face value. 100000 in India). and the Deposit Insurance and Credit Guarantee Corporation (DICGC) in India) to bank depositors up to a certain amount (Rs. is a term deposit with a bank with a specified interest rate. backed by an agreement that the borrower will repurchase the same at a future date (usually the next day) at an agreed price. CPs can be issued by companies. The arrangement involves selling of a tranche of Government securities by the seller (a borrower of funds) to the buyer (the lender of funds). they virtually eliminate the credit risk.. CDs are also treated as bank deposit for this purpose. 2. In many countries. Further.S.000 and in multiples thereof. 2. CD are issued for denominations of Rs. satellite dealers (SD) and other large financial institutions. CDs are rated (sometimes mandatory) by approved credit rating agencies and normally carry a higher return than the normal term deposits in banks (primarily due to a relatively large principal amount and the low cost of raising funds for banks).3 Certificates of Deposit A certificate of deposit (CD). Here the buyer (the lender of funds) buys Government securities from the seller (a borrower of funds) agreeing to sell them at a specified higher price at a future date. The difference between the sale price and the repurchase price represents the yield to the buyer (lender of funds) for the period. In India. The duration is also pre-specified and the deposit cannot be withdrawn on demand. Federal Deposit Insurance Corporation (FDIC) in the U. these papers are also backed by a bank line of credit. Since Repo arrangements have T-bills as collaterals and are for a short maturity period. Repos allow a borrower to use a financial security as collateral for a cash loan at a fixed rate of interest. primary dealers (PDs). have the flexibility of premature withdrawal and carry a lower interest rate than CDs.000 or multiples thereof. In India. used mainly by investors dealing in Government securities.4.00. for maturities ranging from 15 days period to 1-year period from the date of issue.5 Repos and Reverse Repos Repos (or Repurchase agreements) are a very popular mode of short-term (usually overnight) borrowing and lending.cases.g. 1. Reverse repo is the mirror image of a repo.. i.e. CPs can be issued either in the form of a promissory note or in dematerialized form through any of the approved depositories. the central bank provides insurance (e. CP denominations can be Rs. CDs are freely negotiable and may be issued in dematerialized form or as a Usance Promissory Note. 500.

maturity amount (face value).6. the debts are either repaid from future revenues generated from such projects or by the Government from its own funds. Interest on both these instruments is usually paid semi-annually and the payment is referred to as coupon payments. 2. Central Government securities and State Government securities) are issued by the Reserve Bank of India on behalf of the Government of India. They usually are also backed by guarantees from the respective Government.6 The Bond Market Bond markets consist of fixed-income securities of longer duration than instruments in the money market. Government bonds etc. airports etc.1 Treasury Notes (T-Notes) and T-Bonds Treasury notes and bonds are debt securities issued by the Central Government of a country. Similar to T-notes and T-bonds.6. Treasury notes maturity range up to 10 years. 2. Similar to T-bills. they are usually issued at a higher discount than equivalent Government bonds.6. Corporate bonds are classified as secured bonds (if backed by specific collateral).3 Corporate Bonds Bonds are also issued by large corporate houses for borrowing money from the public for a certain period. corporate bonds. these bonds are also sold through auction and once sold they are traded in the secondary market. These bonds may also be issued to finance specific projects (like road.) and in such cases. These bonds are not exempt from taxes. since the default risk is higher for corporate bonds. unsecured bonds (or debentures which do not have any specific collateral but have a preference over the equity holders in the 16 . issue price (discount to face value) etc. 2. In order to make these instruments attractive. whereas treasury bonds are issued for maturity ranging from 10 years to 30 years. The structure of corporate bonds is similar to T-Notes in terms of coupon payment. Coupons are attached to the bonds and each bondholder has to present the respective coupons on different interest payment date to receive the interest amount. The securities are usually redeemed at face value on the maturity date. the Government securities (includes treasury bills. Another distinction between T-notes and T-bonds is that Tbonds usually consist of a call/put option after a certain period. The bond market instruments mainly include treasury notes and treasury bonds. these bonds are also granted tax-exempt status. various State Governments and sometimes municipal bodies are also empowered to borrow by issuing bonds.2 State and Municipal Government bonds Apart from the central Government.2. In India. the interest income is usually made tax-free. bridge. However.

issuer and Samurai bonds are yen-denominated bonds issued in Japan by non-Japanese issuers. Eurodollar bonds are US dollar-denominated bonds issued outside the United States. Some international bonds are issued in foreign countries in currency of the country of the investors. The bonds are issued at a discount to the face value and the face value is repaid at the maturity. by a non-U.6. Yankee bonds are US dollar denominated bonds issued in U. Convertible Bonds Convertible bonds offer a right (but not the obligation) to the bondholder to get the bond converted into predetermined number of equity stock of the issuing company. The return to the bondholder is the discount at which the bond is issued. in the currency of a foreign country which represents a large potential market of investors for the bonds.6. However. now they are called by various names depending on the currency in which they are issued. Bonds issued in a currency other than that of the country which issues them are usually called Eurobonds. at certain. 2. Thus. 2. In this section.event of liquidation) or subordinated debentures (which have a lower priority than bonds in claim over a firms’ assets). Zero Coupon Bonds Zero coupon bonds (also called as deep-discount bonds or discount bonds) refer to bonds which do not pay any interest (or coupons) during the life of the bonds.4 International Bonds These bonds are issued overseas. in terms of an option to convert the bond into stock (equity shares) and thereby participate in the growth of the company’s equity value.S. the value of the equity shares in the market generally falls upon issue of such bonds in anticipation of the stock dilution that would take place when the option (to convert the bonds into equity) is exercised by the bondholders. However. The most popular of such bonds are Yankee bond and Samurai Bonds. the holder of the bond gets an additional value. prespecified times during its life. which is the difference between the issue price and the face value. The investor receives the potential upside of conversion into equity while protecting downside with cash flow from the coupon payments.The issuer company is also benefited since such bonds generally offer reduced interest rate. we discuss the various clauses that can be associated with a bond. 17 . Euro-yen bonds are yendenominated bonds issued outside Japan.5 Other types of bonds Bonds could also be classified according to their structure/characteristics.S.

The right has a cost and hence one would expect a lower yield in such bonds. it carries a higher discount (higher yield) than normal bonds.Callable Bonds In case of callable bonds. appoints the management team to look after the day-to-day running of the business. the shareholders of a company are its owners. each priced at par value. The bondholder has a right (but not the obligation) to sell back the bond to the issuer after a certain time at a pre-specified price. set overall policies aimed at maximizing profits and shareholder value. The call price may be more than the face value of the bond. a bond may have both option embedded. The face value of shares is usually set at nominal 18 . or face value in India. the interest rate is fixed and does not change over time. This implies that the maximum loss of shareholder in a company is limited to her original investment. Fixed rate and floating rate of interest In case of fixed rate bonds.or bondholders always have precedence over equity shareholders. the interest rate is variable and is a fixed percentage over a certain pre-specified benchmark rate. they participate in the management of the company by appointing its board of directors and voicing their opinions. 2. Shareholders of a company are said to have limited liability. bank rate. every company is authorized to issue a fixed number of shares. As owners. shareholders have the last claim on the assets of the company at the time of liquidation. The option gives the right to the issuer to repurchase (cancel) the bond by paying the stipulated call price. Puttable Bonds A puttable bond is the opposite of callable bonds.7 Common Stocks Simply put. The coupon rate is usually reset every six months (time between two interest payment dates). These bonds have an embedded put option. whereas in the case of floating rate bonds. and voting in the general meetings of the company. The benchmark rate may be any other interest rate such as T-bill rate. while debt. Since the call option and the put option are mutually exclusive. The bondholders generally exercise the right if the prevailing interest rate in the market is higher than the coupon rate. The board of directors have general oversight of the company. The right is exercised if the coupon rate is higher than the prevailing interest rate in the market. the three-month LIBOR rate. the bond issuer holds a call option. which can be exercised after some pre-specified period from the date of the issue. The term means that the liability of shareholders is limited to the unpaid amount on the shares. At its incorporation. etc. MIBOR rate (in India). Since the option gives a right to the issuer to redeem the bond. Being the owners.

1 in India for the most part). 19 . preference shares are redeemable (callable by issuing firm) and preference dividends are cumulative. it gets accumulated and the company has the obligation to pay the accrued dividend and current year’s dividend to preferred stockholders before it can distribute dividends to the equity shareholders. each representing a unit of the overall ownership of the company.g. An additional feature of preferred stock in India is that during such time as the preference dividend remains unpaid.levels (Rs. we mean that in case the preference dividend remains unpaid in a particular year. 10 or Re. the derivatives market is one of India’s largest and most liquid. These preferred shares have precedence over common stock in terms of dividend payments and the residual claim to its assets in the event of liquidation. A portion of these earnings are distributed back to the shareholders as dividend. for future issuance at any point in time. the rest retained for future investments. investing and other activities. In addition to the equity and fixed-income markets. However. Corporations generally retain portions of their authorized stock as reserved stock. there is another category. the equity share. By cumulative dividends. preference shareholders enjoy all the rights (e. We take a short tour of derivatives in the 5th chapter of this module. The company then generates earnings from its operating. 2. voting rights) enjoyed by the common equity shareholders.7. The sum total of the paid-in capital and retained earnings is called the book value of equity of the company. In addition to the most common type of shares. In India. preference shareholders are generally not entitled to equivalent voting rights as the common stockholders. shares are mainly of two types: equity shares and preference shares. called preference shares.1 Types of shares In India. Some companies also issue convertible preference shares which get converted to common equity shares in future at some specified conversion ratio. Shares are usually valued much higher than the face value and this initial investment in the company by shareholders represents their paid-in capital in the company.

2.2 Simple and Compound Interest Rates In simple terms. In case of both simple and compound interest rates.. Such securities generally form part of the debt capital of the issuing firm. for a compound interest rate calculation we assume that all interest payments are re-invested at the end of each period. an interest payment refers to the payment made by the borrower to the lender as the price for use of the borrowed money over a period of time.CHAPTER 3: Fixed Income Securities 3. daily or even instantaneously (continuously compounded). 3. such compounding may be done semi-annually. 3. In case of compound interest rate. i. monthly.1 Introduction: The Time Value of Money Fixed-income securities are securities where the periodic returns. time when the returns fall due and the maturity amount of the security are pre-specified at the time of issue. For example. we also mention the frequency for which compounding is done. Some of the common examples are bonds. In case of compound interest rate. While simple interest is calculated on the principal amount alone. P = principal amount R = Simple Interest Rate for one period (usually 1 year) T = Number of periods (years) 20 . in that it may be linked to some other benchmark interest rate or in some cases to the inflation in the economy. treasury bills and certificates of deposit.1 Simple Interest Rate The formula for estimating simple interest is : I = P *R *T Where. Interest calculations are either simple or compound. the subsequent period’s interest is calculated on the original principal and all accumulated interest during past periods. the return that could have been generated had the lender invested in some other assets and a compensation for default risk (risk that the borrower will not refund the money on maturity).e. the interest rate stated is generally annual. quarterly. The rate of interest may be fixed or floating. The interest cost covers the opportunity cost of money.

100 for a period of 1 year. 3.2 What is the amount an investor will get on a 3-year fixed deposit of Rs. which will come to 105*5% = 5. 10000 that pays 8% simple interest? Answer: Here we have P = 10000. which is usually represented in terms of number of times the compounding is done in a year (m).25.Example 3. Time (T)) used for calculation of interest in case of simple interest rate method.2. if compounded annually becomes R  ((110. 105 in 6 months and for the second half. –P .25.25 = 110. The fourth parameter is the compounding period. The equivalent interest rate.1 What is the amount an investor will get on a 3-year fixed deposit of Rs. Let us consider an interest rate of 10% compounded semi-annually and an investment of Rs.25%. So for semi-annual compounding the value for m = 2. m = 4 and so on. 105. The equivalent annual interest rate is 1 +  m  The formula used for calculating total amount under this method is as under: R  A = P 1 +  m  Where A = Amount on maturity R = interest rate m = number of compounding in a year T = maturity in years Example 3. there is an additional parameter that affects the total interest payments. The investment will become Rs. Interest Rate (R). the interest will be calculated on Rs. for quarterly compounding. R = 8% and T = 3 years I = P * R * T = 10000 * 8% * 3 = 2400 Amount = Principal + Interest = 10000+2400 = 12400. 10000 that pay 8% interest compounded half yearly? 21 T *m m –1.2 Compound Interest Rate In addition to the three parameters (Principal amount (P).25-100)/100)*100 = 10. The total amount the investor will receive at the end of 1 year will become 105 + 5.

718. which can be shown (using tools from ∞  differential calculus).71828… is the base for natural logarithms).718r – 1] or e r – 1 in the limit.33%. the interest rate is compounded continuously throughout the year i. m = 2. 1 at 8% continuously compounded interest becomes e 0.08  = 10000 * 1 +    – 10000 = Rs. for convenience. Continuous compounding is widely assumed in finance theory.Answer: Here P = 10000. (where e=2. The total interest income comes to: T m   R *  Interest = P 1 +  –P m      12 *3   0. R = 8% and T = 3. m = 12.20 = 12653. The total interest income comes to: T m  R *  Interest = P 1 +   –P m      2 *3  0.08   = 10000 * 1 +   – 10000 = Rs.37 = 12702.20  2       Amount = Principal + Interest = 10000+2653.3 Consider the same investment.2702.08 = 1. What is the amount if the interest rate is compounded monthly? Answer: Here P = 10000.0833 after 1 year and the equivalent annual interest rate becomes 0. we use ‘r’ (in small letters) to represent continuously compound interest rate. to tend to [2. Continuous compounding Consider a situation. and used in various asset pricing models—the famous Black-Scholes model to price a European option is an illustrative example.37 12       Amount = Principal + Interest = 10000+2702.20.4 Consider the same investment (Rs. If the investment is for T years. Example 3. R  the equivalent annual interest rate is 1 +  – 1 . If m approaches infinity. Example 3. Further. R = 8% and T = 3.2653. where e = 2. What is the amount received on 22 ∞ . the maturity amount is simply 1* e rT .37.0833 or 8. where instead of monthly or quarterly compounding. m rises indefinitely.e. an investment of Re. 10000 for 3 years). Thus.

Rs.05  23 . the cash flow from bonds and deposits are certain and known in advance. Nominal cash flow measures the cash flow in terms of today’s prices and real cash flow measures the cash flow in terms of its base year’s purchasing power.76%. 112 by the end of the year but an investment of Rs. Normally. This implies that an investor who has deposited money in a risk-free asset will find goods beyond his reach. 104. Goods worth Rs.05 = Rs. If the interest rate is 10%.718. the value of goods and services in an economy may change due to changes in the general price level (inflation). the year in which the asset was bought/ invested.0476 or 4.maturity if the interest rate is 8% compounded continuously? Answer: Here P = 10000. However.. This brings an uncertainty about the purchasing power of the cash flow from an investment. 100 becomes Rs. then an investor in a bond with 10% interest rate annually stands to lose.76%  1 + . i.76 and the real interest rate is 4. r = 8% and T = 3 The final value of the investment is P * e rT . It comes to 10000 * e0. if inflation rate is 5% then each Rupee will be worth 5% less next year. An economist would look at this in terms of nominal cash flow and real cash flows.08 *3 = 12712. The real payoff is Rs. 110 at the end of the year. an investment of Rs. 110 by end of the year. 110 will be worth only 110/1.3 Real and Nominal Interest Rates The relationship between interest rates and inflation rates is very significant. The relationship between real and nominal interest rate can be established as under: Real Cash Flow = And (1 + real int erest rate = 1 + nominal interest rate 1 + inflation rate Nominal Cash Flow (1 + inflation rate) In our example. 100 becomes only Rs.76 in terms of the purchasing power at the beginning of the year. e = 2. 104. This means at the end of the year. If inflation (say 12%) is rising and is greater than the interest rate (say 10% annually) in a particular year. However. Take a small example. the real interest rate can be directly calculated using the formula: 1 + 0. 3.50 .10  Real interest rate =   – 1 = 0.e. 100 at the beginning of the year are worth Rs.

Since the coupon rate is generally fixed and the maturity value is known at the time of issue of the bond. Example 3.1)3 Now let us see what happens if the discount rate is lower than the coupon rate: 24 . Assume that the discount rate is 10%.1 (1 + 0. usually twice each year.4 Bond Pricing Fundamentals The cash inflow for an investor in a bond includes the coupon payments and the payment on maturity (which is the face value) of the bond.26 2 3 1 + 0.3. The face value is paid at the maturity date. the formula can be re-written as under: Bond Price = ∑ (1 + y) t T Coupon t + Face Value (1 + y)T (2) Here t represents the time left for each coupon payment and T is the time to maturity. Also note that the discount rate may differ for cash flows across time periods.1) (1 + 0. 1000 and coupon rate being 8% paid annually. etc. 80 Discount Rate = 10% t=1 to 3 T=3 Bond Price = 80 80 80 1000 + + + = 950 . 1000 = Rs. Thus the price of the bond should represent the sum total of the discounted value of each of these cash flows (such a total is called the present value of the bond). 1000 Coupon Payment = 8% of Rs. Bond Price = PV (Coupons and Face Value) Note that the coupon payments are at different points of time in the future. The discount rate used for valuing the bond is generally higher than the risk-free rate to cover additional risks such as default risk. liquidity risks. Therefore.1) (1 + 0.5 Calculate the value of a 3-year bond with face value of Rs. Here: Face value = Rs. the price is calculated using the following formula: Bond Price = ∑ (1 + y) t C(t ) t (1) Where C(t) is the cash flow at time t and y is the discount rate.

Clean price is the price of the bond on the most recent coupon payment date. such as zero coupon bonds.06 (1 + 0.5. they are not measurable for bonds that do not pay any interest.6 Calculate the bond price if the discount rate is 6%.06)3 Since the discount rate is higher than the coupon rate. Bond Price = 80 80 80 + + = 1053 .Example 3. when the accrued interest is zero. the bond trades at a premium.46 2 1 + 0. 3. 3. Since they consider only coupon payments. usually of more interest to the bond market. bonds are quoted at ‘clean price’ for ease of comparison across bonds with differing interest payment dates (dirty prices ‘jump’ on interest payment dates). the bond is traded at a discount. The price of the bond including the accrued interest since issue or the most recent coupon payment date is called the ‘dirty price’ and the price of the bond excluding the accrued interest is called the ‘clean price’.2 Coupon Payment Face Value Current Yield It is calculated using the following formula: Coupon Yield = Coupon Payment Current Market Price of the Bond The main drawback of coupon yield and current yield is that they consider only the interest payment (coupon payments) and ignore the capital gains or losses from the bonds.5. The market price of the bonds also includes the accrued interest on the bond since the most recent coupon payment date.06) (1 + 0. If the discount rate is less than the coupon rate.1 Clean and dirty prices and accrued interest Bonds are not traded only on coupon dates but are traded throughout the year. Dirty Price = Clean price + Accrued interest For reporting purpose (in press or on trading screens).4. Changes in the more stable clean prices are reflective of macroeconomic conditions.5 Bond Yields Bond yield are measured using the following measures: 3.1 Coupon yield It is calculated using the following formula: Coupon Yield = 3. The other measures of yields are yield to maturity and 25 .

1. 8% bond (interest is paid annually) that is trading in the market for Rs. Example 3. It refers to the internal rate of return earned from holding the bond till maturity.000 = 80 Putting the values in equation (1). we get the yield to maturity for the bond to be 10%. which is the YTM. t= 1 to 5 T=5 Face Value = 1000 Coupon payment = 8% of 1. t= 1 to 5 T=5 Face Value = 1000 Coupon payment = 8% of Rs. we have: 924 . Yield and Bond Price: There is a negative relationship between yields and bond price. there will be only one rate that equalizes the present value of the cash flows to the observed market price in equation (2) given earlier. That rate is referred to as the yield to maturity.5.7 What is the YTM for a 5-year.000 = 80 Putting the values in equation (1).20 = ∑ (1 + y ) 1 5 80 t + 1000 (1 + y )5 Solving for y. Example 3.yield to call. 3.8 What will be the market price of the above bond (Example 3 7) if the YTM is 12%. the bond price comes to: 26 . These measures consider interest payments as well as capital gains (or losses) during the life of the bond. Assuming a constant interest rate for various maturities.20? Here.3 Yield to maturity Yield to maturity (also called YTM) is the most popular concept used to compare bonds. The bond price falls when yield increases and vice versa. 924.

price of long-term bonds are more sensitive to interest rate changes. in effect amounts to 1 + 0. the cash flows are more distant in the future and hence the impact of change in interest rate is higher for such cash flows.20 Further.80? What is the effective annual yield for the bond? Here. the cash flows are not far and discounting does not have much effect on the bond price. For example. for a long-term bond. Yield rate calculated using the above formula is called effective annual yield. 852.10    2   2 = 1. if we assume that one can reinvest the coupon payments at the bond equivalent yield (YTM). In such cases.25% . 8% bond (semi-annual coupon payments). Bond equivalent yield and Effective annual yield: This is another important concept that is of importance in case of bonds and notes that pay coupons at time interval which is less than 1 year (for example. t= 1 to 10 T = 10 Face Value = 1000 Coupon payment = 4% of 1.000 = 40 Bond Price = 852.Bond Price = ∑ (1 + 0. Example 3. wherein we assume that the annual discount rate is the product of the interest rate for interval between two coupon payments and the number of coupon payments in a year: Bond Price = ∑ t T Coupon t y 1 +  2  + Face Value 1 + y    2  T (3) YTM calculated using the above formula is called bond equivalent yield.9 Calculate the bond equivalent yield (YTM) for a 5-year. the yield to maturity is the discount rate solved using the following formula. Alternatively. Thus. that is trading in the market for Rs. the effective interest rate will be different. semi-annually or quarterly). for short-term bonds.12) 1 5 80 t + 1000 (1 + 0.a. However.12)5 = 901 . a semi-annual interest rate of 10% p.1025 or 10.80 27 .

Example 3. that is trading in the market for Rs.05 Putting the values in the following equation: Bond Price = ∑ t T Coupon t y 1 +  2  + Callable Value 1 + y    2  T we have: 28 . A callable bond is a bond where the issuer has a right (but not the obligation) to call/redeem the bond before the actual maturity. Yield to call is calculated with the same formula used for calculating YTM (Equation 2). Generally the callable date or the date when the company can exercise the right. the callable price (redemption price) may be different from the face value. Further.05.1236 or 12. Here: t= 1 to 6 T=6 Coupon payment = 3.5. in the case of callable bonds.4 2 0.5% of 1.000 = 35 Callable Value = 1040 Bond Price = 877. 1040. The effective yield rate is 1 + y    2  3. 7% callable bond (semi-annual coupon payments). we get the Yield to Maturity (y) = 0. The bond is callable at the end of 3rd year at a call price of Rs. we have: 852. is pre-specified at the time of issue.10 Calculate the yield to call for a 5-year.12 or 12%. with an assumption that the issuer will exercise the call option on the exercise date. 877.Putting the values in equation (3).80 = ∑ 1 10 40 t y 1 +  2  + 1000 1 + y    2  10 Solving.12  – 1 = 1 +  – 1 = 0.36%  2   2 Yield to call Yield to call is calculated for callable bond.

35 1.11 If the short rate for a 1-year investment at year 1 is 7% and year 2 is 8%.. 1000 : P = 1000 1000 = = 865. we assumed that the interest rate is constant across different maturities.1556 (Initial Investment) (1 + r1 ) (1 + r2 ) .35. is the expected (annualized) interest rate at which an entity can borrow for a given time interval starting from time t. this may not be true for different reasons. 3.6. the YTM can be calculated by solving the following equation: 865 . Therefore. 3.(1 + rT ) For a 2-year zero coupon bond trading at 865.2 Spot Rate Yield to maturity for a zero coupon bond is called spot rate.35 = 1000 (1 + y 2 )2 The resulting value for y is 7.07 * 1. we account for the fact that the interest demanded by investors also depends on the time horizon of the investment. Since zero coupon bonds of varying maturities are traded in the market simultaneously. Relationship between short rate and spot rate: Investors discount future cash flows using interest rate applicable for that period. Short rate is usually denominated as rt.6 Interest Rates While computing the bond prices and YTM.. what is the present value of a 2-year zero coupon bond with face value Rs. the PV of an investment of T years is calculated as under: PV (Investment) = Example 3. 29 . we get the yield to call = 12% 3. For example.877. we can get an array of spot rates for different maturities. Let us first introduce certain common concepts. which is nothing but the 2-year spot rate. In this section.1 Short Rate Short rate for time t.05 = ∑ 1 6 35 t y 1 +  2  + 1000  + y 1  2  6 Solving for y.6.4988%.08 1. investors may perceive longer maturity periods to be riskier and hence may demand higher interest rate for cash flow occurring at distant time intervals than those occurring at short time intervals. However.

Future short rates computed using the market price of the prevailing zero coupon bonds’ price (or prevailing spot rates) are called forward interest rates. The term structure of interest rates is the set of relationships between rates of bonds of different maturities. we can calculate 1-year short rate at year 3. because if it is not true then there will be an arbitrage opportunity in the market. 1 in a 4-year zero coupon bond.2949. and connections with each other. 1. If we reinvest this (maturity) amount in a 1-year zero coupon bond.2949*(1+r3). Example 3.3. It is sometimes also called the 30 .6. forward. assuming equal holding period return. the proceeds at year 4 will be 1. and also seen their behaviour. For example. 3. Given the spot rates. discount rates). we can calculate short rates for a future interval by knowing the spot rates for the two ends of the interval. For example.2949 * (1 + r3 ) = 1. 1 in a 4-year zero coupon bond is 1*1.3 Forward Rate One can assume that all bonds with equal risks must offer identical rates of return over any holding period. reinvested for 1 year should result in a cash flow equal to the cash flow from an investment in a 4-year zero coupon bond (since the holding period is the same for both the strategies).093714 = 1. This is because.4309 r3= 0. 1 in a 3-year zero coupon bond will be 1* 1. if we have the 3-years spot rate and 4-years spot rate (or in other words are there are 3-year zero coupon and a 4-year zero coupon treasury bonds trading in the market).6. We use the notation fi to represent the 1-year forward interest rate starting at year i. f2 denotes the 1-year forward interest rate starting from year 2. find the 1-year short rate at end of year 3. Proceeds from investment of Re. proceeds from investment of Re.4309 Solving.12 If the 3-year spot rate and 4-year spot rates are 8. which is nothing but the 1 year short rate at the end of year 3.371% respectively. This should be equal to the proceeds from an investment of Rs.997% and 9.089973 = 1.4 The term structure of interest rates We have discussed various interest rates (spot. If we assume that all equally risky bonds will have identical rates of return. the proceeds from an investment in a 3-year zero coupon bond on the maturity day.11 or 11%.

The use of forward interest rates has long been standard in financial analysis such as in pricing new financial instruments and in discovering arbitrage possibilities.5% (f2). 31 . a short-term investment is preferred to a long-term investment. For example. the forward rate will exceed the expected short rate. Formally put.5% (f4) and 10%(f5) respectively. The liquidity premium causes the yield curve to be upward sloping since long-term yields are higher than short-term yields. medium and long term more easily than the standard yield curve. Example 3. where f2 – E(r2 ) represent the liquidity premium.5 is 8. Therefore. Yield curves are also used as a key tool by central banks in the determination of the monetary policy to be followed in a country. which generally is a smooth curve and reflects the rates of return on various default-free pure discount (zero-coupon) bonds held to maturity along with their term to maturity. they allow a separation of market expectations for the short.e. i. Liquidity preference theory suggests that investors prefer liquidity and hence. f2 > E(r2 ) .yield curve. where i is a future period. the term structure of interest rates defines the array of discount factors on a collection of default-free pure discount (zero-coupon) bonds that differ only in their term to maturity. investors will be induced to hold a long-term investment. The forward interest rate is interpreted as indicating market expectations of the timepath of future interest rates. only by paying a premium for the same. The market expectation hypothesis assumes that various maturities are perfect substitutes of each other and that the forward rate equals the market expectation of the future short interest rate i. the expected interest rate can be used to construct a yield curve. This premium or the excess of the forward rate over the expected interest rate is referred to as the liquidity premium.13 Calculate the YTM for year 2-5 if the 1-year short rate is 8% and the future rates for years 2.e. the YTM can be determined solely by y current and expected future one-period interest rates. future inflation rates and future currency depreciation rates. Since forward rates helps us indicate the expected future time path of these variables. we can find the 2-year yield if we know the 1-year short rate and the futures short rate for the second year by using the following formula: (1 + y2 )2 = (1 + r1 ) * (1 + f2 ) Since. Therefore. 9. 9% (f3). as per the expectation hypothesis − f2 = E(R2 ) . The market expectations hypothesis and the liquidity preference theory are two important explanations of the term structure of interest in the economy. The most common approximation to the term structure of interest rates is the yield to maturity curve. Assuming minimal arbitrage opportunities. fi = E(ri ) .

Because spot interest 32 . The YTM is the average cost of borrowing for m periods whereas the implied forward rate is the marginal cost of extending the time period of the loan. There is a different forward rate for every pair of maturity dates. m = e m*–S1m and St . m m The estimation of a zero coupon yield curve is based on an assumed functional relationship between either par yields.1: Relationship between spot. i.m) is the collection of discount factors at time t for all maturities m.75% (1 + y5 )5 + (1 + y 4 )4 * (1 + f5 ). forward. Box No.. 3. it describes the marginal one-period interest rate implied by the current term structure of spot interest rate.08503 * 1. which just means that the redemption yield is equal to the coupon rate of the bond. m = – 1 1ndt .25% (1 + y3 )3 + (1 + y2 )2 * (1 + f3 ). i. in order to obtain their present value.095) = 1. i. Spot rates (st.08754 * 1. forward rates or discount factors on the one hand and maturities on the other. y2 = 8.08 * 1.e.10) = 1.00% It can be seen that because of the liquidity premium.085) = 1. spot rates.e. y3 = 3 (1. So how do spot rates. y5 = 9. y3 = 8. forward rates.e.e. the yields earned on bonds which pay no coupon.08252 * 1. and discount rates Recall that discount factors are the interest rates used at a given point in time to discount cash flows occurring in the future. y2 = 2 (1. y5 = 5 (1. y 4 = 4 (1.09 .0850 . i. Par yield curves are those that reflect return on bonds that are priced at par.0875 . and discount rates relate to each other? A discount function (dt. i. y4 = 8.m).Answer: y1 = r1 = 8% (1 + y2 )2 + (1 + r1 ) * (1 + f2 ). the future interest rate increases with time and this causes the yield curve to rise with time. are related to discount factors according to: dt .50% (1 + y 4 )4 + (1 + y3 )3 * (1 + f4 ). i.09) = 1. The relation between the yield-to-maturity (YTM) and the implied forward rate at maturity is analogous to the relation between average and marginal costs in economics.e.e.0825 .

in the case of other bonds. Duration = t=1 ∑t * w T t The weights (Wt) associated for each period are the present value of the cash flow at each period as a proportion to the bond price. 33 . One needs to average out the time to maturity and time to various coupon payments to find the effective maturity for a bond.7 Macaulay Duration and Modified Duration The effect of interest rate risks on bond prices depends on many factors. the cash flows are through coupon payments and the maturity payment. m = – 1 m m y ∫ f (u) du . The price changes for fixed income securities are dependent mainly on the interest rate changes and the average 1 The method was designed by Frederick Macaulay in 1856 and hence named as Macaulay Duration. knowing any of the four means that the other four can be readily computed.rates depend on the time horizon.e. maturity date etc. St . where the cash flows are only at the end. Unlike in case of zero-coupon bonds. or we can say 0  m dt . higher will be the sensitivity towards interest rate fluctuations and hence higher the volatility in the bond price.m as the instantaneous rates which when compounded continuously up to the time to maturity. 3. yield the spot rates (instantaneous forward rates are thus rates for which the difference between settlement time and maturity time approaches zero). The measure is called as duration of a bond. Higher the duration of the bond. This tool is widely used in fixed income analysis. duration. However. it is natural to define the forward rates ft. i. It is the weighted (cash flow weighted) average maturity of the bond. Banks and other financial institutions generally create a portfolio of fixed income securities to fund known liabilities. the real problem is that neither of these curves is easily forecast able. m = exp  f (u)du   0   ∫ Thus. but mainly on coupon rates. PV of cash flow (1 + y)t = Bond Price Bond Price CFt Wt = This measure is termed as Macaulay’s duration1 or simply.

96 20.0000 0.000 = 35 YTM = 12 % or 6% for half year.0382 0.14 What is the duration for a 5-year maturity.02/816) 1 2 3 4 5 6 7 8 9 10 Sum 0.15 24.5 4 4.0285 0.15 29.1076 0.5413 4. This is also called bond portfolio immunization. 7% (semi-annual) coupon bond with yield to maturity of 12%? Here: t = 1 to 10 T = 10 Coupon payment = 3. it is essential for them to match the duration of the portfolio of fixed income securities with that of the liabilities.00 = 0.0269 0.02 31.0202 0.0907 0.5 2 2. When interest rates fall.5% of 1.5 5 35 35 35 35 35 35 35 35 35 1035 33.0405 0. The net realized yield at the target date will be equal to the yield to maturity of the original portfolio. In order to hedge against interest rate risks.maturity (duration).72 577.94 816.0340 0.0801 0. Period (a) Time till payment (b) Cash Flow (c ) PV of Cash Flow (discount = 6% per period) (d) Weights (e) (33. One should note that the duration of a short-term bond declines faster than the duration of the long-term bond.0254 0.0540 0. The increase or decrease in the coupon income arising from changes in the reinvestment rates will offset the opposite changes in the market values of the bonds in the portfolios.7083 1.39 27.0998 0.28 21.2142 (b)*(e) (f) 34 . the reinvestment of interests (until the target date) will yield a lower value but the capital gain arising from the bond is higher.5 1 1. A bank thus needs to rebalance its portfolio of fixed-income securities periodically to ensure that the aggregate duration of the portfolio is kept equal to the time remaining to the target date.0302 0.5 3 3.72 26.0321 0.0360 0.0382 0.0679 0.1142 3. Example 3.67 23.

15 What is the duration for a 5-year maturity zero coupon bond with yield to maturity of 12%? Answer: One does not need to do any calculation for answering this question. A bond with high coupon rate will have lower duration as compared to a bond with low coupon rate. Example 3. All cash flows are only on the maturity date and hence the duration for this bond is the maturity date. Since for a zero coupon bond. In order to measure the price sensitivity of the bond with respect to the interest rate movements. 7% (semi-annual) coupon bond with yield to maturity of 12%.16 Refer to the bond in Example 3 14 i. For coupon-paying bonds.e. 816. 5-year maturity. y = yield to maturity of the bond n = number of coupon payments in a year. Example 3. Although duration helps us in measuring the effective maturity of the bond. Modified duration is calculated from duration (D) using the following formula: MD = D 1+ y . the duration of a bond is inversely related to the coupon rate. investors are concerned more about the bond price sensitivity with respect to change in interest rates. the duration equals the bond maturity. This is because price of a bond is negatively related to the yield of the bond. Answer: In Example 3 14. The duration of the bond is 4.The selling price of the bond as calculated from column (d) is Rs. n Where. The modified duration of the bond is: 35 . Since cash flows at each time are used as weights.00. we calculated the duration to be 4.2142 years. the cash flow is only on the maturity date. the duration will be less than the maturity period. we need to find the so-called modified duration (MD) of the bond.2142 and the bond price to be 816. The price change sensitivity of modified duration is calculated using the following formula: Price Change (%) = (–) MD * Yield Change Note the use of minus (-) term. Calculate the change in bond price if the YTM falls to 11%.

11  1 +  2   + 1000  + 0.06 1+ 2 The price change will -3. we would not be covering the concept in this chapter.976*1 = 3. However.2142 4.MD = D y 1+ n = 4.45 = 848.45 New Price = 816 + 32.45 Check: The actual market price of a 5-year maturity.11  1  2   10 = 849.976 .12 1.2142 = = 3.976% or Rs.976% = 32. 36 . 7% (semi-annual) coupon bond with YTM = 11% would be: Bond Price = ∑ t T Coupon t y 1 +  2  + Face Value  + y 1  2  T = t =1 ∑ 10 35 t 0. due to what is called ‘convexity’.25 Note that there is still some minor differences in the actual price and the bond price calculated using the modified duration formula. 816 * 3.

in such markets the impact of positive (negative) 37 . technical analysis that uses past price or volume trends do not to help achieve superior returns in the market.2. then market prices could be reliably used for various economic decisions. The early evidence suggests a high degree of efficiency of the market in capturing the price relevant information. Similarly.2 Semi-strong Market Efficiency The semi-strong form efficiency implies that all the publicly available information gets reflected in the prices instantaneously.CHAPTER 4: Capital Market Efficiency 4. While markets have been generally found to be efficient.1 Weak-form Market Efficiency The weak-form efficiency or random walk would be displayed by a market when the consecutive price changes (returns) are uncorrelated. Markets are efficient when prices of securities assimilate and reflect information about them.2. For instance.2 Market Efficiency The extent to which the financial markets digest relevant information into the prices is an important issue. 4. Hence. the number of departures seen in recent years has kept this topic open to debate. 4.1 Introduction The Efficient Markets Hypothesis (EMH) is one of the main pillars of modern finance theory. This implies that any past pattern of price changes are unlikely to repeat by itself in the market. the level of efficiency of a market is characterized as belonging to one of the following (i) weak-form efficiency (ii) semi-strong form efficiency (iii) strongform efficiency. The need to have an understanding about the ability of the market to imbibe information into the prices has led to countless attempts to study and characterize the levels of efficiency of different segments of the financial markets. If the prices fully reflect all relevant information instantaneously. 4. and has had an impact on much of the literature in the subject since the 1960’s when it was first proposed and on our understanding about potential gains from active portfolio management. a firm can assess the value of a new investment taken up by ascertaining the impact on its market price on the announcement of the investment decision. Formally. Hence. Policymakers can also judge the impact of various macroeconomic policy changes by assessing the market value impact. a firm can assess the potential impact of increased dividends by measuring the price impact created by the dividend increase. Absence of serial correlation indicates a weak-form efficient market. The weak-form efficiency of a market can be examined by studying the serial correlations in a return time series.

Here.3 Strong Market Efficiency The level of efficiency ideally desired for any market is strong form efficiency. They include. A typical event study would involve assessment of the abnormal returns around a significant information event such as buyback announcement. however. The semi-strong form efficiency can be tested with event-studies.information about the stock would lead to an instantaneous increase (decrease) in the prices. the claim about strong form efficiency of any market at the best remains tenuous.2. The lack of reliability about the level of efficiency of the market prices makes it less reliable as a guideline for decision-making. 38 . All other information is accounted for in the stocks price and regardless of the amount of fundamental and technical analysis one performs. Then there is a whole host of other documented deviations from efficiency.3 Departures from the EMH Evidence accumulated through research over the past two decades. above normal returns will not be had. Semi-strong form efficiency would mean that no investor would be able to outperform the market with trading strategies based on publicly available information. the predictability of future returns based on certain events and high volatility of prices compared to volatility of the underlying fundamentals. Over time. stock splits. tests of various forms of efficiency had suggested that the markets are reasonably efficient. The hypothesis suggests that only information that is not publicly available can benefit investors seeking to earn abnormal returns on investments. All these evidences have started to offer a challenge to the earlier claim of efficiency of the market. suggests that during many episodes the markets are not efficient even in the weak form. a time period close to the selected event including the event date would be used to examine the abnormal returns. the period after a favorable (unfavorable) event would not generate returns beyond (less than) what is suggested by an equilibrium pricing model (such as CAPM. If the market is semi-strong form efficient. Testing the strong-form efficiency directly is difficult. The returns are found to be correlated both for short as well as long lags during such episodes. this led to the gradual acceptance of the efficiency of markets. In the years immediately following the proposal of the market efficiency. Absence of superior return by the insiders would imply that the market is strongly efficient. Therefore. The downward and upward trending of prices is well documented across different markets (momentum effect). 4. bonus etc. A test of strong form efficiency would be to ascertain whether insiders of a firm are able to make superior returns compared to the market. which has been discussed later in the book). 4. Such efficiency would imply that both publicly available information and privately (non-public) available information are fully reflected in the prices instantaneously and no one can earn excess returns.

given that they are across Friday-end-to-Monday-morning. as we would see in later chapters. Departures from market efficiency. The market efficiency claim was based on the assumption that irrational (biased) investors would be exploited by the rational traders. instead at many instances they appear to make profits at the expense of the rational traders. Stock returns are generally expected to be independent across weekdays. Some of the well-known anomalies—or departures from market efficiency—are calendar effects like the January effect and various day-of-the-week effects and the so-called size effect. they would not pay close attention to new price relevant information that arises in the market. However. London. One of the reasons put forward to explain this anomaly is that returns on Monday are expected to be different. more recent evidence suggest that the irrational traders are not exiting the market as expected. This again would lead to under reaction. and would eventually lose out in the market. Since then. if the investors on an average are overconfident about their investment ability. and (ii) there could be many profitable trading strategies based on the collective irrationality of the markets. but a number of studies have found returns on Monday to be lower than in the rest of the week. The January effect was first documented in the US markets—stock returns were found to be higher in January than in any other month. and hence with more information. Therefore. Biased investor preferences include aversion to the realization of losses incurred in a stock. the fact that it exists implies a persistent deviation from market efficiency. It implies that (i) the estimation of expected returns based on methods such as the capital asset pricing model is unreliable. it has been empirically tested in a number of international markets. and Paris among others.Alternative prescriptions about the behaviour of markets are widely discussed these days. or the delays in markets reaching equilibrium (and thus efficiency) leave scope for active portfolio managers to exploit mispricing in securities to their benefit. like Tokyo. A number of investment strategies are tailored to profit from such phenomena. even in the presence of biased traders the market was expected to evolve as efficient. Most of these prescriptions are based on the irrationality of the markets in either processing the information related to an event or based on biased investor preferences. The alternative prescriptions about the behaviour of markets based on various sources and forms of investor irrationality are collectively known as behavioral finance. This leads to inadequate price response to the information event and possibly continuation of the trend due to the under reaction. a much longer period than any other day. While the evidence has been mixed. leading to their exit. This is why this departure from market efficiency is also sometimes called the weekend effect. For instance. 39 . This bias in processing information is claimed to be the cause of price momentum.

or services rendered by the company. Taxes payable to the Government are then debited to provide the Profit After Tax (PAT) or the net income to the shareholders of the company. debentures.e. and the statement of cash flows. 5. i. the balance sheet. Let us quickly summarize each of these. efficiency in the allocation of its capital and its earnings profile.. and non-recurring. The decision to invest in these securities is thus linked to the evaluation of these companies. with socalled ‘other income’ (income from non-core activities). the cash flows expected from the asset. Actual P&L statements of companies are usually much more complicated than this. and other financial products issued by companies. The example given below is that of a large company in the Pharmaceutical sector over the period 2006-2008. Beyond operating expenses are interest costs based on the debt profile of the company. their present discounted value.1 Income Statement (Profit & Loss) A profit & loss statement provides an account of the total revenue generated by a firm during a period (usually a financial year or a quarter). the expenses involved and the money earned.2 The Analysis of Financial Statements A company’s financial statements provide the most accurate information to its management and shareholders about its operations. In its simplest form. bonds. exceptional income or expenses. Operating expenses include the costs of these goods and services and the costs incurred during the manufacture. in other words. Valuation is all about how well we predict these cash flows. and potential for future growth. Valuation. their earnings.1 Introduction Investments in capital markets primarily involve transactions in shares. ‘negative’ interest expenses (from cash reserves with the company). preferred dividends. Three basic accounting statements form the backbone of financial analysis of a company: the income statement (profit & loss). their growth in future. In this chapter we look at one of the most important tools used for this purpose. 5. revenue generation or sales accrues from selling the products manufactured.CHAPTER 5: Financial Analysis and Valuation 5. The fundamental valuation of any asset (and companies are indeed assets into which we invest) is an examination of future returns. The ‘value’ of the asset is then simply what these cash flows are worth today.2. taking into account future risks involved. 40 .

534) (3. a company could also own other assets which carry value. current assets (manufacturing goods in progress.869 (239) 3 0 100 5.334 67 (559) 0 0 7.369) 14.926 1.725) (5. 41 .1 Income Statement (US$M) Net sales Cost of sales SG&A Research & development Other operating items EBIT Total other non-operating items Associates Net interest income/expense Exceptional items Pretax profit Taxation Minority interest Preferred dividends Net extraordinary items Reported net income 5.650) 4.457 543 0 869 0 5.340 (6. inventory etc.565 (8.843 2008 33.440) (4.190) (2.408) (1.620) 5.2. but realized from acquisitions.584) (1.).733 2007 21. but are not directly marketable.072 0 8. These assets are financed either by the company’s equity (investments by shareholders) or by debt. money it expects to receive from business partners— receivables. like patents. and ‘goodwill’—value not linked to assets. cash and other financial investments.994 (485) (640) 0 0 14. The illustrative example shown below is the balance sheet of a large Pharmaceutical company. In addition to these three. trademarks.738) (2.Illustration 5. A company owns fixed assets (machinery. and other infrastructure).2 The Balance Sheet 2006 16.543 305 0 1.336 0 1.380 (5.771) (2. the sources and applications of funds of the company.332) (1.869 Assets owned by a company are financed either by equity or debt and the balance sheet of a company is a snapshot of this capital structure of the firm at a point in time.146 0 15.

122 2. etc).659 1.3 Cash Flow Statement 2006 15. As the name implies.701 3.789 6.651 6.609 5.233 39. and payments during the period.079 44.901 1.192 10.628 3.177 7.166 43.645 2.977 3.144 895 0 15. Cash flows are tracked across operating.373 1. and non-core accruals (like depreciation. particularly from a valuations perspective. receivables and payables). A firm’s investment activities comprise fixed.236 3.046 11.547 2007 14.653 30. 42 .436 92 0 7.886 49. The sum total of cash flows from these three heads represents the net change in cash balances of the firm over the period.471 26. and current assets (capitaland operating expenditure).2 Balance Sheet (US$m) Cash and marketable securities Accounts receivable Inventory Other current assets Current assets Net tangible fixed assets Total financial assets Net goodwill Total assets Accounts payable Short-term debt Total other current liabilities Current liabilities Long-term debt Total other non-current liabilities Total provisions Total liabilities Minority interest – accumulated Shareholders’ equity Shareholders’ funds Liabilities and shareholders’ funds 5. Cash flows in financing activities are the net result of the firm’s borrowing.290 14. and financing activities.728 28.515 18.117 2.826 8. such a statement is used to track the cash flows in the company over a period.314 332 15.966 0 80 3. sometimes into other firms (like an acquisition).250 2.Illustration 5.722 0 2.279 0 1.237 507 39.085 438 27.053 0 23. investing. and generally represent negative cash flows.915 51.239 697 43.040 2.729 59.2.274 11.747 1.728 5.701 The cash flow statement is the most important among the three financial statements.800 59.106 6.547 2.902 16. Cash flows from operations include net income generation adjusted for changes in working capital (like inventories.250 2008 17.

financial ratios also allow a company to be viewed.367 1.394 (2.242) 1. 43 . Our illustrative example below shows the cash flow statement (and free cash flows) of a large pharmaceutical company over the period 2006-2008.177 (6.156) (4. In addition to providing information about the financial health and prospects of a company.3 Cash Flow (US$M) Reported net income Preferred dividends Minority interest Depreciation and amortization Cash tax adjustment Total other operating cash flow Net change in working capital Cash from operations Capital expenditure Net acquisitions/disposals Total other investing cash flows Cash from investing activities Change in borrowings Equity raised/share buybacks Dividends paid Total other financing cash flows Cash from financing activities Change in cash Free cash flow 2006 5.387) 3. Operating and.337) (753) (9.733 0 (3) 610 75 (1.Cash generation from operating activities of the firm.518 (1. or distribution among its shareholders.514) 2007 7.3 Financial Ratios (Return.365) (3. free cash flows are the key to calculating the so-called intrinsic value of an asset in any discounted valuation model. when adjusted for its capital expenditure represent the ‘free cash’ available to it.000) 1.869 0 640 969 (1.154) 2. in comparison with its own historical performance.177) 1.872 (3.340) 5. As we will see in later topics. or between any two companies in general. others in its sector of the economy.465) 394 2008 14. acquiring other firms or businesses. Illustration 5.048 (1. grouped into categories that allow comparison of size. as by themselves the financial entries offer little to examine a company. solvency. for potential investment activities.995) (5.843 0 559 813 (511) (2.742) 0 (2.498) (1.272 639 (1. In this section we examine a few such ratios.511 634 758 805 0 (793) (156) (144) 3.052 5. Profitability Ratios) Financial ratios are meaningful links between different entries of financial statements.629) (127) (4. in a relative sense.060) 768 0 (18) (88) 661 (352) 3.

financial. In addition to the two below there are others like Sales to inventories. The list below is by no means exhaustive.1 Measures of Profitability: RoA. 5. Capital Structure and Solvency Ratios Total debt to total capital = (Current Liabilities + Long-term Liabilities) / (Equity + Total Liabilities) Long-term Debt-Equity = Long-term Liabilities / Equity 5. Total Asset Turnover = Net Sales / Average Total Assets Fixed Asset Turnover = Net Sales / Average Net Fixed Assets There are many other categories.3. A high turnover implies optimal use of assets. The ratios below get increasingly conservative in terms of the demands on a firm to meet near-term payables. like Net Sales.operating performance. RoE Return on Assets (RoA) in its simplest form denotes the firm’s ability to generate profits given its assets : RoA = (Net Income + Interest Expenses)*(1. or the market capitalization.2 Measures of Liquidity Short-term liquidity is imperative for a company to remain solvent.3.3. which serve to present the company in terms of one of its own denominators. to account for recent capital raising by the firm Return on Average Equity = Net Income / Average Shareholder Funds Return on Total Capital = Net Income + Gross Interest Expense / Average total capital 5.Tax Rate) / Average Total Assets Return on Equity (RoE) is the return to the equity investor : RoE = Net Income / Shareholder Funds Sometimes this ratio is also calculated as RoAE. 44 .3.4 Operating Performance Gross Profit Margin = Gross Profit / Net Sales Operating Profit Margin = Operating Income / Net Sales Net Profit Margin = Net Income / Net Sales 5. and Sales to Working capital. and merely serves to illustrate a few of the important ones.3. especially its fixed assets. Current ratio = Current Assets / Current Liabilities Quick Ratio = (Cash + Marketable Securities + Receivables) / Current Liabilities Acid test ratio = (Cash + Marketable Securities) / Current Liabilities Cash Ratio = (Cash + Marketable Securities) / Current Liabilities 5.3.5 Asset Utilization These ratios look at the effectiveness of a firm to utilize its assets. like the ‘common size’ ratios. and others that specifically look at the risk aspect of things (business. and liquidity). growth profile and risks.

4. the market measures. and facing the same risks ought to be priced comparably. and valuation ratios. after the discussion on valuations.4 The valuation of common stocks In chapter 3. The estimation of intrinsic value is what we would be dealing with in details in this chapter. we now examine some of the concepts relating to share valuations and to be more specific. 5. We now examine the valuation of common shares in some detail. Using financial statements and ratios.4. Such a methodology provides what is called the ‘intrinsic’ value of the asset—a common stock in our case. As mentioned above. It is defined as the present value of all expected cash flows to the company. an investor can always sell her holdings in the market (secondary market). the valuation of any asset is based on the present value of its future cash flows.We shall take a look at another two categories. similar assets— instead of pricing them independently—the core assumption being that assets with similar earnings and growth profile. 5. and as such are the final stakeholders in its growth. we examined a few of the major valuation methods for fixed income-generating assets. The cash flows (return) to common shareholders from the company are generally in the form of current and future dividends distributed from the profits of the firm. we will deal with valuation of common stocks. The problem of valuing the stock then translates into one of predicting the future free cash flow profile of the company. they appoint the management to run its day-to-day affairs and the Board of Directors to oversee the management’s activities.1 Discounted Cash Flows The discounted cash flow method values the share based on the expected dividends from the 45 . The discussion on relative valuation follows that of absolute or intrinsic valuation.1 Absolute (Intrinsic) Valuation Intrinsic value or the fundamental value refers to the value of a security. Alternatively. and realize capital appreciation if the returns are positive. The appropriately named discounted-cash flow technique is also referred to as absolute valuation. and the same sector (and its stocks) across countries. Common shareholders are the owners of the firm. get the prevailing market price. 5. called relative valuation. and then using the appropriate discount factor to measure what they are worth today. Relative valuation looks at pricing assets on the basis of the pricing of other. particularly when compared to another widely-followed approach in valuation. and risks. Two stocks in the same sector of the economy could thus be compared.1. which is intrinsic to or contained in the security itself.

shares. P1 = Div2 + P2 (1 + r ) Similarly. The price of a share according to the discounted cash flow method is calculated as under: P0 = t =1 ∑ (1 + r ) ∞ Div t t Since the profits of the firm are not certain. + + N 2 3 (1 + r ) 1+ r (1 + r ) (1 + r ) (1 + r ) (1 + r )N PN tends to zero Now when N tends to infinity. we can write the share price at the end of the year 1 as a function of the 2nd year dividend and price of share at the end of the year 2. the market forms an expectation of the future dividends and the value of a share is the present value of expected future dividends of the company. the constant dividend 46 ... where the dividend amount grows at a constant rate. (1 + r ) Putting the values of P1.1. P2.2 Constant Dividend Growth Let us see a special case of the above model when it is assumed that amount paid as dividends grows at a constant rate (say g) every year. Or. In this case. (1 + r ) As explained above.. However. So the current share price (P0) can be written as: P0 = t =1 ∑ (1 + r) ∞ Divt t 5. (1 + r )N tends to infinity and the value of (1 + r )N and therefore may be ignored. the actual future dividends are not known in advance. P2 = Div3 + P3 and so on. P4. It can be shown that the formula can be seen as an extension of the formula P0 = Div1 + P1 .4. P3. we can write: P0 = Div N PN Div1 + P1 Div1 Div 2 Div 3 = + + + . the cash flows in various years will be as under: Year 0 1 2 3 4 Cash Flow -P0 Div1 Div2 = Div1*(1+g) Div3 = Div2*(1+g) = Div1*(1+g)2 Div4 = Div3*(1+g) = Div2*(1+g)2= Div1*(1+g)3 In this circumstance.

07. It is not possible for a stock’s dividend to grow at a rate g. Answer: The following are given: Div0 = 10.50 P0 = Div1 10. This is even true in real world.4. 10 per share last year (D0) and it is expected to grow at 5% every year. the dividend amount and the dividend growth rate. It can only be for a limited number of years. then we can compute the expected rate of return (r) by using the following formula: r = Div1 + g P0 5. which is greater than r for infinite period.50 = = = 525 0. calculate the market price of the share as per the dividend discount model. Otherwise. Example: RNL has paid a dividend of Rs.05 The market price of RNL share as per the dividend discount model with constant growth rate is Rs. then for every penny re-invested (plowbacked rather than distributed as dividend) will generate a return that is higher than the market expectation.50 10. there’s no need to retain any of the earnings) and the present value of growth opportunities.05. Now when the firm’s income potential from additional investment is more than the market expected rate of return. with no growth. If an investor’s expected rate of return from RNL share is 7%. The 47 .growth model states that the share price can be obtained using the simple formula: P0 = Div1 r–g This formula can be used only when the expected rate of return (r) is greater than the growth rate (g). 525.3 Present Value of Growth opportunities (PVGO) One can split the value of the shares as computed in the constant growth model into two parts – the present value of the share assuming level stream of earnings (a level stream of earnings is simply the current income extrapolated into the future. If we know the market price of the share. Div1 + Div0 * (1 + g) = 10 * 1.1. the present value of the growing perpetuity will reach infinite.05 = 10. r = 7% or 0. g = 5% or 0.07 – 0. This model is not applicable in such cases.02 r – g 0. in which case. The value of growth opportunities is positive if the firm (and the market) believes that the firm has avenues to invest which will generate a return that is more than the market expected rate of return.

with the discounted free cash flow model. It is simple to calculate the debt value since the payments to be made to debt holders is predetermined and certain.4. The discounting rate is the firms weighted average cost of capital (WACC) and not the market expected rate of return on equity investment.1. Thus: Market value of equity (V0) = Value of the firm + Cash in hand – Debt Value The price of the share (P0) is the market value of the equity divided by the number of shares outstanding.4 Discounted Free-cash flow valuation models Using the above concepts. the value of a firm is the present value of the future free cash flow of the firm. 48 . the real problem lies with determining the value of the firm..e. We first determine the value of the enterprise and then value the equity by deducting the debt value from the firm value. The growth rate in dividend (g). + 1 + rwacc (1 + rwacc )2 (1 + rwacc )3 (1 + rwacc )N + (Terminal Valu eN ) (1 + rwacc )N E D + rE * D+ E D+ E The terminal value at year N is often computed by assuming that the FCF will grow at a constant growth rate beyond year N. E = the market value of equity The firm value (V0) is calculated using the following formula: V0 = FCF1 FCF2 FCF3 FCFN + + + .. i. the Plowback ratio * ROE. However. plowbacks and invests certain portion of the current year profit on projects whose yield will be greater than the market expected rate of return.. instead of distributing 100% of the earnings as dividends. WACC is the cost of capital that reflects the risk of the overall business and not the risk associated with the equity investment alone. As per the discounted free cash flow model. PVGO = Share Price – Present value of level stream of earnings = Share price – EPS / r The growth in the future dividend arises because the firms. WACC is calculated using the following formula: WACC = rD (1 – T ) * where rD and rE is the expected rate of return on debt and equity T = Income Tax Rate D = the market value of debt . 5. equals.value of such excess return is referred to as present value of growth opportunities. we are now in a position to look at valuation using cash flows.

4. Various valuation multiples such as price-earning ratio. etc. 49 . The issue price is generally more than the face value and the difference between the issue price and the face value is called as share premium.2 Relative Valuation Relative valuation models do calculate the share price but they are generally based on the valuation of comparable firms in the industry. Since the firm has to incur any planned capital expenditure and has to finance any working capital requirement before distributing the profits to the shareholders the same is deducted while calculating the free cash flows. We start with EBIT since we do not consider cash outflow in the form of interest payments. Market price is the price at which the share is traded in the market. are used by the finance professionals which depends on the industry. 5. As discussed in the first chapter. In an efficient market.Terminal ValueN = FCF * (1 + gFCF ) FCFN +1 = ((r ) WACC – gFCF ) ((r )WACC – gFCF ) where gFCF is the expected growth rate of the firms free cash flow What is free cash flow (FCF)? The free cash measures the cash generated by the firm that can be distributed to the equity shareholders after budgeting for capital expenditure and working capital requirements. the face value or nominal value of a share is the price printed on the share certificate. Most of these models are generally used for evaluation purpose as to whether a particular stock is overvalued or undervalued and less for actual valuation of the shares. Thus the formula for computing FCF is: Terminal VFCF = EBIT * (1 – T ) + Depn – Capital Expenditure – Increase in Working Capital where T in the tax rate. Market capitalization of a company is the total value of all shares of the company and is calculated by multiplying the market price per share with the number of shares outstanding in the market. we assume that the market is able to gather all information about the company and price accordingly. The price at which a company issues shares may be more or less than the face value. current economic scenario. enterprise value multiples. we assume that the firm is a 100% equity owned company and hence we do not consider any payment to debt or equity holders while calculating the free cash flow. etc. Depreciation lowers the EBIT but is added back since it is a non-cash expenditure (does not result in cash payments). One should not confuse a share’s nominal value with the price at which the company issues shares to the public. While computing FCF. It is determined by the demand and supply of the share in the market and depends on the market (buyers and sellers) estimation of the present value of all future cash flows to the company.

but decide to retain some portion of it for financing growth opportunities. In this case. 400. The net asset of the company is the values of all assets less values of all liabilities outstanding in the books of accounts. dividend per share (DPS). The firm may not distribute the entire income to the shareholders. a firm may pay dividends from past years profit during years where there is insufficient income.1 Earning per Share (EPS) Earning per share is the firms’ net income divided by the average number of shares outstanding during the year. The dividend per share is the amount that the firm pays as dividend to the holder of one share i. total dividend / number of shares in issue. amortization or impairment costs made against the asset. For assets. dividend payout ratio and 50 . The dividend payout ratio (DPR) measures the percentage of income that the company pays out to the shareholders in the form of dividends.000 Number of equity shares (2009): 250.e.2 Dividend per Share (DPS) Dividends are a form of profit distribution to the shareholders.000 Dividend paid: Rs. the dividends amount will be higher than the earnings. It is nothing but (1-DPR).The book value or carrying value in accounting. The formula for calculating DPR is: DPR = Dividends DPS = Net Income EPS Retention ratio is the opposite of dividend payout ratio and measures the percentage of net income not paid to the shareholders in the form of dividends. Alternatively. 5. Calculated as: EPS = Net Proift – Dividend on Preference Shares Average number of shares outstanding during the year 5.2.000 Number of equity shares (2008): 150.4. Book value per share is calculated by dividing the net assets of the company with the number of shares outstanding. is the value of an asset according to its balance sheet account balance. E xample: Th e f ol lowi ng i s t he f igu re f or A sh a In t ern ati on al duri ng t he year 2008-09: Net Income: Rs.4.2.000 Calculate the earnings per share (EPS). 1. the value is based on the original cost of the asset less any depreciation.000.

000 + 250. whose earning per share is Rs. Price Earnings Ratio = Market price per share Annual earning per share The earning per share is usually calculated for the last one year. Investors also widely use the ratio to judge whether the stock is undervalued or overvalued. What is the price to earnings ratio for XYZ? Answer: Price Earnings Ratio = 2000 Market price per share = = 40 Annual earning per share 50 We cannot draw any conclusion as to whether a stock is undervalued or overvalued in the market by just considering the PE ratio.3 Price-earnings ratio (P/E Ratio) Price earning ratio for a company is calculated by dividing the market price per share with the earnings per share (EPS). A higher PE ratio implies that the investors are paying more for each unit of net income. In such case.4 Price-Book Ratio The price-book ratio is widely used as a conservative measure of relative valuation of an asset.DPR = 0.000 = =2 Average Number of shares 200. we also calculate the PE ratio using the expected future one-year return. Stocks with higher PE ratio are also called growth firms and stocks with lower PE ratio are called as income firms.000 Dividends 4. 50 is trading in the market at Rs.000. we call forward PE or estimated PE ratio.2.4.00.0000 = =5 Average Number of shares 200. where the assets of the firm are valued at book. Sometimes. 5.4 or 40 % EPS 5 DPS = DPR = Retention Ratio = 1. as it’s less susceptible to fluctuations than the 51 . Answer: Average number of shares = Opening + closing 150.000 DPS 2 = = 0.retention ratio for Asha International.000 = = 200.6 or 60% 5.2. Example: Stock XYZ.000 2 2 EPS = Net Income 1.4. 2000. which implies that the investors are optimistic about the future performance (or future growth rate) of the company.

It is the return to the equity shareholders and is measured by the following formula: ROE = Net Income after Tax – Preferred Dividends Average Shareholder Equity Excluding Preferred Share Capital Example: XYZ Company net income after tax for the financial year ending 31st March. It shows that the firm could improve its RoE by a combination of profitability (higher profit margins).6 The DuPont Model The Du Pont model is widely used to decide the determinants of return profitability of a company. The second component. Calculate the return on equity of XYZ company for the year 2008-09. Answer: Average Equity = Opening Equity + Closing Equity 80 + 120 = = 100 million 2 2 Return on Equity = 10 Net Profit after Tax = = 0. 120 million respectively. 2009 was Rs. and its financial leverage. measures the efficiency in usage of assets by the firm and the third component measures the financial leverage of the firm through the equity multiplier.5 Return on Equity Return on equity measures profitability from the equity shareholders point of view. by using its assets better (higher asset turn) or a combination of all three.4. 80 million and Rs. or a sector of the economy.10 or 10% 100 Average Equity 5. The analysis reflects a firms’ efficiency in different aspects of business and is widely used now for control purpose. 10 million and the equity share capital as on 31st March. raising leverage (by raising debt). 2008 and 31st March 2009 was Rs. The formula to calculate the ratio is: Price-book ratio = Market price of the share / Book Value per share. asset turn. called the asset turnover ratio. Returns on shareholder equity are expressed in terms of a company’s profit margins.2.4. 52 . 5. DuPont Model breaks the Return on equity as under: RoE = Return on Equity = Net Profits/Equity = Net Profits/Sales * Sales/Assets * Assets/Equity = Profit Margin * Asset Turnover * Financial Leverage The first component measures the operational efficiency of the firm through its net margin ratio.PE ratio.2.

5% Opening Market Price 80 80 If we write the dividends during the year as Div1.The DuPont analysis could be easily extended to ascertain a sector’s profitability metrics for comparability. an entire market. or the financial year. or. Answer: Dividend Yield = Last year dividend 5 = = 0.2. we can write the above formula as: r= Div1 + P1 – P0 P0 This can be re-written as: P0 = Div1 – P1 (1 + r ) 53 . An investor’s earning is the sum of the dividend amount that he received from the company and the change in the market price of the share. for that matter. for either the next 12 months. the price of the share at the beginning and at the end of the year as P0 and P1 respectively. The ratio could also be used with the forward dividend yield instead— expected dividends. The company paid a dividend of Rs. An investor’s return can be calculated using the following formula: Expected Return(r) = Dividends + Δ (market price of the share) Opening Market Price Example: The share price of PQR Company on 1st April 2008 and 31st March 2009 is Rs. 5 per share in 2009 and the market price of ABC share at the end of 2009 was Rs. Answer: Expected Return(r) = Dividends + ∆ (market price of the share) 6 + (84 – 80) 10 = = = 12.2.4. 84 respectively. 5. Calculate the dividend yield for ABC stock.7 Dividend Yield Dividend yield is the ratio between the dividend paid during the last 1-year period and the current price of the share. 6 for the year 2008-09.8 Return to Investor The return what the investor earns during a year by holding the share of a company is not equal to the dividend per share or the earnings per ratio.4. 25. Calculate the return for a shareholder of PQR Company in the year 2008-09.20 or 20% Current Price per share 25 5. 80 and Rs. The investment amount is equal to the market price of the share at the beginning of the year. Example: ABC Company paid a dividend of Rs.

etc. Supports refer to the price level through which a stock price seldom falls and resistance is the price level through which a stock seldom surpasses. the role is reversed. These concepts can be heard very often in business channels and business newspapers. momentum. There are various concepts that are used by technical analysts like support prices. the resistance level becomes the support level and when the price falls below the support level. using CAPM). the price moves in the same direction as the trends suggests. what is important is an analysis of the price movement that reflects the demand and supply of a stock in the short run. The field of technical analysis is based on the following three assumptions. c) History tends to repeat itself: This assumption leads to a belief that current investors repeat the behavior of the investors that preceded them and therefore recognizable price patterns can be observed if a chart is drawn. price correlations. If the price increases beyond the resistance level. Once a breakout occurs. b) Price moves in trends: Trends are of three types. 54 . moving averages. breakouts. regressions. Technical analysts use statistical tools like time series analysis (in particular trend analysis). Technical analysis involves making trading decisions by studying records or charts of past stock prices and volume. with the numbers of believers balancing those who find fault with the methodology. The technical analysts do not attempt to measure a security’s intrinsic value but believe in making short-term profit by analyzing the volume and price patterns and trends. We have already learned in the previous chapter about the factors that affect the expected rate of returns and how one can calculate the expected rate of returns (e. resistance levels. Therefore. 5. etc. the price of a share can be calculated based on the investor expectation of the future dividends and the future share price. viz.g. open interest. Breakout refers to situation when the price actually falls below the support level or rises above the resistance level. and in the case of futures. uptrend. the support level becomes the new resistance level for the stock.5 Technical Analysis Our final approach to valuation is also considered the most controversial. relative strength index. a) The market discounts everything: Technical analysts believe that the market price takes into consideration the intrinsic value of the stocks along with broader economic factors and the market psychology. Momentum refers to the rate at which price of a stock changes.This implies that given the expected rate of return for an investor. downtrend and horizontal trend. Technical analysts believe that once trends are established in the prices. Now the question arises what determines the next year price (P1) of a share.

Proponents of the EMH aver that market efficiency would preclude any technical trading patterns to repeat with any predictable accuracy. about the assumptions of technical analysis. technical analysis involves meaningful levels of subjectivity-interpretations may vary widely on the same pattern of stock. primarily raised by fundamental analysts. 55 .5. While it is understandable that price movements are caused by the interaction of supply and demand of securities and that the market assimilates this information (as mentioned in the first assumption).5. Finally. In other words. Further. there is no consensus on the speed of this adjustment or its extent. speeding up the adjustment of the market. rendering the profitability of most such trading rules subject to chance. in the sense that most technical traders follow a small set of rules (albeit with possibly different parameterizations).1 Challenges to Technical Analysis There are many questions. while prices may react to changes in demand-supply and other market dynamics. which we have seen in Chapter 4. and thus reducing the potential gains. the success of a trading rule could also make it crowded. Other objections to technical analysis arise from Efficient Markets Hypothesis. the response could easily differ across securities. both in the time taken. or index prices-which also hinders systematic reasoning and extensibility across different securities. and the degree to which prices change.

It follows that we would expect to have zero covariance between stocks whose movements are not related. Portfolio risk (generally defined as the standard deviation of returns) is not the weighted average of the risk (standard deviation) of individual assets in the portfolio. To give an example. 56 . Our assertion here is that the risk of the portfolio is usually much lower. These so-called covariances between stocks. reacting favourably to a depreciation in the domestic currency—as their export realizations would rise in the domestic currency—is one of positive covariance. Each of these stocks has a risk profile. which has high foreign debt. could be positive. this is largely due to the interrelationships that exist between stock price movements. or zero. negative. and at a portfolio level. the overall risk of the portfolio simply ought to be an aggregation of individual portfolio risks. Why? As we shall see in the discussion here.1 Introduction Understanding the risky behaviour of asset and their pricing in the market is critical to various investment decisions. 6. The two building blocks of this analysis and generalization are (i) theory about the risk-return characteristics of assets in a portfolio (portfolio theory) and (ii) generalization about the preferences of investors buying and selling risky assets (equilibrium models). We first examine the modern approach to understanding portfolio management using the trade-off between risk and return and then look at some equilibrium asset-pricing models. This gives rise to opportunities to eliminate the risk of assets. by combining risky assets in a portfolio. Such models help us understand the theoretical underpinning and (hopefully predict) the dynamic movement of asset prices. in other words. say steel. An example of two IT services stocks. portfolio risk simply ought to be a weighted average of individual stock risks. then a drop in the share price of the steel company (as the falling rupee would increase the debt-service payments of the steel firm) and rise in share price of the IT services company. where our aim is to provide a brief overview of how finance theory treats stocks (and other assets) individually. would provide an example of negative covariance. This understanding is mostly developed through the analysis and generalization of the behaviour of individual investors in the market under certain assumptions. If however. Both these aspects are discussed in detail in this chapter.2 Diversification and Portfolio Risks The age-old wisdom about not putting “all your eggs in one basket” applies very much in the case of portfolios.CHAPTER 6: Modern Portfolio Theory 6. we compare one IT services company with another from the metals space. a simple and widely used indicator of which is the standard deviation of its returns. be it related to financial assets or real assets. at least partly. consider a hypothetical portfolio with say. Intuitively. ten stocks.

the negative deviation in the returns of one stock is getting offset by the positive deviation in the other stock.6 and weight of stock B being (1-0. It can be seen that irrespective of the market condition. as in our earlier comparison of a software company with a commodity play. as given in table 6. The table below shows a portfolio of the two stocks with weight of Stock A (W) being 0.1 : Portfolio of Two Assets Market Condition Return on A Return on B Return on portfolio (W= 0. 1. the portfolio gives a return of 10%. Let us assume that you can form portfolios with two stocks. deviation of the return of stock A = σ A Return on Stock B = RB Mean return on stock B = RB Std. When A gives high returns. Assume that we have the following two stocks.6) Good Average Poor Standard deviation Correlation 16% 10% 4% 5% -1.6) or 0. deviation of the return of stock B = σ B The total available amount that can be invested.0 1% 10% 19% 7% 10% 10% 10% 0% Why does the portfolio standard deviation go to zero? Intuitively.Let us now examine why and how portfolio risk is different from the weighted risk of constituent assets. a portfolio of the two stocks with a certain weight may become totally risk-free. Table 6. the portfolio standard deviation becomes zero.4. and then assume further that the returns of the two hypothetical stocks behave in opposite directions. having the following characteristics: Return on Stock A = RA Mean return on stock A = RA Std. B does not and vice versa. The proportional investments in each of the stocks are as below. is Re. Let us examine this in a somewhat more formal and general context.1 here. Although the two stocks involved were risky (indicated by the standard deviations). 57 . We know this is quite possible. For a portfolio with 60% invested in A. A & B.

Given this information. In cases with negative covariance. is dependent on the variance of stock A. As discussed before.B). the portfolio variance is. B) p A B That is. we would show that the variance of our portfolio. portfolio variance would actually be lower than the (weighted) sum of stock variances! In other words. called Cov(A.Stock A = W Stock B = (1 . 2 =W 1 n ∑ (R A – RA )2 + (1 – W )2 1 n ∑ (R B – RB )2 + 2W (1 – W) 1 ∑ (RA – RA ) (RB – RB ) n We know that. that of stock B.deviation of portfolio returns. we can show that σ 2 = W 2 σ 2 + (1 – W )2 σ 2 + 2W (1 – W ) Cov ( A.W) where W is between 0 and 1. since variance (or standard deviation) is the primary metric of risk measurement. 1 n 1 n ∑ (R ∑ (R A – RA – RB )2 = σ2 A )2 = σ2 B . and a third term. RP = Return on the portfolio and RP derived as. as denoted by the left hand side of this equation. B 58 . negative or zero. then the variance of the portfolio returns can be ∑ (R p – RP ) 2 (3) with a straightforward rearrangement and substitution for RP = and RP = from the expressions (1) and (2). Let. such a relation could be positive. RP = W RA + (1 – W )RB RP = W RA + (1 – W ) RB where. It is this third term that denotes the interrelationship between the two stocks. σ2 = P 1 n (1) (2) = Mean return on the portfolio. then we can say that the risk of the portfolio would be lower than individual stocks considered separately. σ P = Std. So here is how we go about deriving this expression: With these investments the portfolio return is.

The minimum portfolio standard deviation would always correspond to that of the stock with the least standard deviation. B is the correlation between returns of stocks A and B. B) .6. Substituting these.2 : Decomposition of the Total Portfolio Variance Element of variance Var – A Var – B Covar Proportion 0. When the correlation between the two stocks is 1.4 Sigma 0. P A B 2 (4) Equation (4) suggests that the total portfolio variance comprises the weighted sum of variances and weighted sum of the covariances too. σ2 = W 2 σ2 + (1 – W ) σ2 + 2W (1 – W ) Cov ( A. then the covariance would be positive and large. It would be negative if the correlation is negative.07 Var/Covar 0. it is easy to see that their correlation is -1. Cov ( A.000864 0. the portfolio variance can be expressed as. Let us examine the insights from expression (4) for the variance of combinations of stocks (or any other asset) with varying level of correlations. B σ A σ B . The variances of the individual stocks are offset by their covariance in the portfolio (as shown in Table 6. Table 6.05 0. The standard deviation of the portfolio with two uncorrelated (correlation = 0) stocks would always be lower than the case with correlation 1. the risk becomes zero. when weight of stock A (W) = 0. This implies that a portfolio with two perfectly positively correlated stocks cannot reduce risk.6 0.1 n ∑ (R A – R A RB – RB = Cov ( A.0. where ρ A. B) = ρ A. It can also be expressed as. the standard deviation of the portfolio shall be just a weighted average of the standard deviation of the two stocks involved.1).2).0. 59 . Therefore. one of their possible combinations becomes totally risk-free. For the portfolio of stock A and B.000864 -0. so that the portfolio risk can be brought down below that of the least less risky stock involved in the portfolio. Given the nature of the return relationship between the A and B (in Table 6. if the correlation is positive and the stocks have high standard deviations. It is possible to choose a value for W in such a way.001728 Although the two stocks involved were risky (indicated by the standard deviations).0. B) )( ) The covariance can be regarded as a measure of how much two variables change together from their means.

49 1.26 1.95 1.42 0. the variance of these portfolios shall be higher than those with uncorrelated stocks.322 1.23 1. the least risky stock.41 1.31 0.3 : Return and standard deviation of ACC.15 1.93 1.37 0.71 1.However. for a unique combination.41 0.22 1. As given in the following table.75 1.33 1.148 Combinations W=0. A comparison of the behaviour (return-variance) of portfolios made with stocks of varying correlation is given in the following figure: 60 . in the real world the correlations almost always lie between 0 and 1.88 1.24 0. It is very straightforward to understand that the variance of portfolios with stocks having correlation in the 0 to 1 range would certainly be lower than those with stocks having correlation 1.42 0.42 1. the total variance (standard deviation) of the portfolio is less than that of ACC. Table 6.50 1. deviation Average Return 1. The details of the risk of this portfolio are provided in the following table. Let us examine if we can reduce the portfolio variance by combining stocks with correlation in the range of 0 to 1. DRL and Portfolio Year ACC DRL W=0.25 2001 2002 2003 2004 2005 Std.98 1.41 1.61 0.42 0.37 1.51 0.84 1.5 0.21. the variance of the portfolio can be brought down by combining securities with correlation the range of 0 to 1.44 0.264 Note: W represents the investment in ACC This suggests that for certain values of W.91 1. ACC and Dr.2 0. At the same time.206 W=0. Reddy’s Laboratories (DRL) with correlation around 0.30 0.09 1. Consider the two stocks.

assume that Wi = 1 N 1 N 2 σ2 = ∑ P σ2 + ∑ ∑ i 1 N2 σ ij 61 .1 Portfolio variance . the portfolio variance (given by equation 4) can be expressed as.1 : Portfolio Risk and Return for Assets with Different Correlations Note: the portfolio sigma is the standard deviation. 6.2. th ere woul d be six covarian ce t erms (1-2.General case Let us assume that there are N stocks available for generating portfolios. The portfolios are created by using actual return data and assumed correlations. σ2 = P ∑W 2 i σ2 + i ∑∑W W σ i i ij (5) where Wi is the proportional investment in each of the assets and σij is the covariance between the pair of assets i and j. For i nst ance. except with themselves. Then. if th ere are 3 st ocks. The double summation sign in the second part indicates that the covariance would appear for all possible combinations of i and j.4. 3-2). To examine the characteristics of including a large number of stocks in the portfolio.Figure 6. 1-3. 3-1. 2-3. With these insights we can now examine the behaviour of portfolios with a larger number of assets. except 0. which is the actual correlation between the two stocks. 2-1.

62 . if you do not like to be exposed to anyone economy alone. you can also spread your investment to other industries like Banking. Variance) + 1 –  ( Avg. in other words. it appears that the relevant risk of an asset is what it contributes to a widely-held portfolio. Given the above. Tech Mahindra and so on. One can reduce the risk of exposure to say HCL Technologies in the IT industry. This along with the other insights obtained from the analysis would help us to understand the pricing of risky assets in the equilibrium for any asset in the capital market. Even by including a large number of assets. the portfolio variance cannot be reduced to zero (except when they are perfectly negatively correlated). 2. 3. under certain assumptions. This is something all of us commonly experience while investing in the market. Then. Going further. 6. the portfolio variance would be dominated by the covariances rather than variances. The part of the risk that cannot be eliminated by diversifying through investments across assets is called the market risk (also called the systematic risk or non-diversifiable risk). Consumer products and so on.3 Equilibrium Models: The Capital Asset Pricing Model The most important insight from the analysis of portfolio risk is that a part of the portfolio variance can be diversified away (unsystematic or diversifiable risk) by selecting securities with less than perfect correlation. But even after international diversification a certain amount of risk would remain. As N becomes a large number. like Infosys technologies. This is the market risk or systematic risk or non-diversifiable risk. This is one of the most powerful arguments for portfolio diversification. by including other stocks from the IT industry. you can even invest across different markets. Telecom. The expression just above gives the following insights: 1. its covariance risk. If you consider the exposure to IT industry alone is troubling.= 1 1 2 N –1 1 ∑ σi + ∑∑ σ ij N N N N(N – 1) 1 2 N –1 σi + σ ij N N = = 1 1  ( Avg. The variance of the individual stocks does not matter much for the total portfolio variance. Covariance) N N  we create an equally weighted portfolio (equal investment in the stocks) of N assets. (international markets in the globalize world tend to move together).

Investors would either prefer portfolios which offer higher return for the same level of risk or prefer portfolios which offer minimum risk for a given level of return (the indirect assumption of mean-variance investors is that all other characteristics of the assets are captured by the mean and variance).2 : Return and Risk of Some of the Nifty stocks Source: NSE 63 . Investors have the same investment horizon. investors would prefer that portfolio compared to the existing one. if there is a portfolio which gives a higher return for same level of risk. 6. • • Transaction costs are absent in the market and securities can be bought and sold without significant price impact. Given these assumptions. • Investors have homogenous information about different assets. Figure 6. Evidently.3. This implies that investors are concerned only about the mean and variance of asset returns. all the assets in the market can be mapped on to a return-standard deviation space as follows. In light of the behaviour of portfolio risk and the above assumptions. these are the only variables that matter).1 Mean-Variance Investors and Market Behaviour We can use a so-called mean-variance space to examine the aggregate behaviour of the market (as all investors are mean-variance optimizers. let us try to visualize what would be the relationship between risk and return of assets in the equilibrium. The well-organized financial markets have remarkable ability to digest information almost instantaneously (largely reflected as the price variation in response to sensitive information). it is not impossible to see that substantive arbitrage opportunities would not exist in the market. For instance.These additional assumptions required are as follows: • All investors are mean-variance optimizers.

D is the minimum variance portfolio among the entire feasible set.3 : Feasible Set of Portfolios All the feasible portfolio combinations can be represented by the space enclosed by the curved line and the straight-line. Obviously. Figure 6. these are called the efficient portfolios (and the set of all such portfolios. as represented in Figure 6. A close examination of the feasible set of portfolios reveals that portfolios that lie along D-E represent the best available combination of portfolios. a mean-variance investor would prefer portfolio A to B. their combination could theoretically be characterized as given in figure 6. 64 . whereas portfolios along the straight-line represent combinations of stocks or portfolios with the maximum correlation (+1. portfolio A would be preferred to portfolio C. Similarly. The curved line represents combinations of stocks or portfolios where correlations are less than 1. given that it has lower risk for the same level of return offered by B. These portfolios offer the maximum return for any given level of risk. Investors with various risk tolerance levels can choose one of these portfolios. Therefore.4. the efficient frontier). Therefore.All these stocks (in figure 6. given that it offers higher return for the same level of risk.0) (no portfolios would lie to the right of the straight-line).3.2) have correlations between 0 and 1.

that has no correlation with any other risky asset. Government securities or Government guaranteed bonds.5 : Efficient Portfolio in the Presence of a Risk-Free Asset As given in figure 6. G gives a higher return for the level of risk of D. with the presence of the risk-free asset.4: Efficient Frontier Ordinarily. a combination of risky portfolio M and the risk-free asset. This would imply that the investor could partly put the money in the risky security and the remaining in any of the risky portfolios. Apparently. the portfolio choice of the mean-variance investor is no more the securities along the efficient frontier (D-E). he can choose G. then rather than choosing D by going down the efficient frontier.Figure 6. the investor also has the opportunity to invest in a risk-free asset. In fact. With the availability of a risk-free security.5. the same applies for 65 . If an investor prefers less risk. this could be a bank deposit. the choice facing the mean-variance investor can be conveniently characterised as follows: Figure 6. treasury bills. Practically. the investor also gets an added opportunity to combine portfolios along the efficient frontier with the risk-free asset.

with the presence of the risk-free security. suggest that all the investors would hold only the following portfolios depending on the risk appetite.5. Obviously. the most preferred portfolio along the efficient frontier would be M (portfolios to the right of M along the straight line indicates borrowing at the risk-free rate and investing in M). the rate of risk premium required for unit variance of the market is estimated as. From Figure 6. The portfolio of risky assets and risk-free asset. This portfolio is referred to as the market portfolio. Then. Understanding the risk premium dramatically solves the asset pricing problem through the estimation of the discounting factor to be applied to the expected cash flows from the asset. we can estimate the risk premium that is required for any asset. The line connecting the market portfolio to the risk-free asset is called the Capital Market Line (CML). With the expected cash flows and the discounting rate.all the portfolios along the efficient frontier that lie between D and M (they offer only lower returns compared to those which lie along the straight-line connecting the risk-free asset and risky portfolio M). for any level of risk preferred by the investors. all of them would identify the same portfolio as M. Practically. . An investor who does not want to take the risk of M. Let RM be the required rate of return on the market (market portfolio. M). their portfolios would invariably be the same. Identification of M as the optimal portfolio. which would be a combination of M and RF. 66 . would be better off by combining with the risk-free security rather than investing in risky portfolios with lower standard deviation (that lie along the M-D). the price of any risky asset can be directly estimated. With the understanding about the aggregate behaviour of the investors in the securities market. which would be M. This gives the powerful insight that. the market portfolio can be regarded as one represented by a very liquid index like the NIFTY. Let us examine what would be the nature of the portfolio M. 1. 2. it should be a combination of all the risky stocks (assets) available in the market (somebody should be willing to hold all the assets available on the market). combined with the assumptions (1) that all investors have the same information about mean and variance of securities and (2) they all have the same investment horizon. If all investors are mean-variance optimizers and have the same information. All other portfolios are inferior to these choices. RF be the required rate of return on the risk free asset and σM be the standard deviation of the market portfolio. The portfolio purely of risky assets. All points along the CML have superior risk-return profiles to any portfolio on the efficient frontier.

the market portfolio will have a beta of 1. If CAPM holds in the market. Ri = RF + (RM – RF ) β i (7) This approach to the estimation of the required return of assets (cost of equity. In general.0 (covariance of a stock with itself is variance). The line presented in the following figure is popularly called the Securities Market Line (SML). the risk relevant to the prospective investor (or firm) is the covariance risk. M ) σ2 M is popularly called the beta ( β ). the risk premium on a security is β times (Rm – Rf ) . If investors have the opportunity to hold a well-diversified portfolio. all the stocks can be identified in the mean return-beta space. M ) where.M). one can compute the risk premium required on the security as follows Risk premium on stock = RM – RF σ2 M × Cov (i . Then. we would expect twice the risk premium as compared to the market. This implies that the minimum expected return on this stock is 2 x (Rm – Rf ) .RM – RF σ2 M (6) In a very liquid market (where assets can be bought and sold without much hassles). Obviously. as shown below and relationship between beta and return can be estimated. Therefore. This measures the sensitivity of the security compared to the market. The quantity represented by Cov (i.0 indicates that if the market moves down (up) by 1%. A beta of 2. all the stocks would be priced according to their beta. 67 . the only risk that matters in the individual security is the incremental risk that it contributes to a well-diversified portfolio. pioneered by William Sharpe). is the covariance between the returns of stock i and the market returns (returns on portfolio M). the total required rate of return on any risky asset is. investor has the opportunity to hold stocks as a portfolio rather than in isolation. This would imply that the stock prices are estimated by the market by discounting the expected cash flows by applying a discounting rate as estimated based on equation (7). Cov(i. Hence. in case of equity) is called the Capital Asset Pricing Model (CAPM. Therefore. the security is expected to move down (up) 2%. Now by combining the risk-free rate and the risk premium as estimated above.

6 : Security Market Line Note: this figure is not based on any real data. the mean-variance investors would sell this stock.Figure 6. Stock A. Prices (returns) which are not according to CAPM shall be quickly identified by the market and brought back to the equilibrium.7) shall be brought back to the equilibrium through market dynamics. Figure 6. with increased buying pressure. Sensing this price of A as relatively expensive. This works as follows. The reverse happens in case of stock B. Practically. The decreased demand for the stock would push its price downwards and restore the return back to as specified by CAPM (will be on the line).2 Estimation of Beta The beta of a stock can be estimated with the formula discussed above. currently requires a lower risk premium (required rate of return) than a specified by CAPM (the price is higher).3.7 : Arbitrages around SML 6. For instance. the beta 68 . stocks A and B given in the following figure (6.

attempt to relax these assumptions to provide a better understanding about asset pricing. However. valuation of certain specific assets etc. Arbitrage in the market ensures that portfolios with equal sensitivity to a fundamental risk factor are equally priced.of any stock can be conveniently estimated as a regression between the return on stock and that of the market. takeover of another firm. the regression equation is. In these instances. Evidently. The SLOPE function in MS-Excel is a convenient way to calculate this coefficient from the model. we might be interested to estimate the required rate of return on an asset which is not traded in the market. the required rate of return can be estimated by obtaining the beta estimates from similar firms in the same industry. If the firm holds more risky assets the beta shall also be higher. 6. including the general arbitrage pricing theory (APT).. on many occasions. represented by a stock index like NIFTY (the dependent variable is the stock return and the independent variables is the market return). A more general framework about asset pricing should allow for relaxation of these strong and somewhat counterfactual assumptions. The arbitrage pricing theory assumes that the investor portfolio is exposed to a number of systematic risk factors. The beta of an existing firm traded in the market can be derived directly from the market prices.4 Multifactor Models: The Arbitrage Pricing Theory (APT) The CAPM is founded on the following two assumptions (1) in the equilibrium every mean variance investor holds the same market portfolio and (2) the only risk the investor faces is the beta. Now. Accordingly. (8) where the regression coefficient βi represents the slope of the linear relationship between the stock return and the market return and α i denote the risk-free rate of return. pricing of an IPO. Ri = α i + β i RM + ei . A firm’s beta is the weighted average of the beta of its assets (just as the beta of a portfolio is the weighted average of the beta of its constituent assets). Arbitrage is then assumed to eliminate all opportunities to earn riskless profit by simultaneously selling and buying equivalent portfolios (in terms of risk) which are overpriced and underpriced. it is not difficult to see why investors like venture capitalists demand higher return for investing in start-up firms. A number of alternative equilibrium asset pricing models. It further assumes that the risk factors which are associated with any asset can be expressed as a linear combination of the fundamental risk factors and the factor sensitivities (betas). For instances like. these are strong assumptions about the market structure and behaviour of investors. The beta can be related to the nature of the assets held by a firm. 69 .

viz. 70 . CAPM. interest rates and any other macroeconomic factor which would expose the investor’s portfolio to systematic risk.Under these assumptions. could be regarded as a special case where all investors hold the same portfolio and their only risk exposure is the market risk. One such empirically successful model is the so-called Fama-French three-factor model. which cannot be diversified by the investors. there will be as many dimensions as there are fundamental risks. and book-to-market ratio as the additional risk factors along with the market risk as specified by CAPM. Against this evidence. The fundamental factors involved could for instance be the growth rate of the economy (GDP growth rate). which has only one risk dimension. all investors need not have the same market portfolio as under CAPM. a number of multifactor asset pricing models have been proposed. The size risk factor is the difference between the expected returns on a portfolio of small stocks and that of large stocks. And the book-to-market ratio is the difference in the expected return of the portfolio of high book-to market-ratio stocks and that of low book-to market-ratio stocks. APT relaxes the assumption that all investors in the market hold the same portfolio. Again. Theoretical and empirical evidence suggests that in the real market. The Fama-French model has two more risk factors. expected returns are probably determined by a multifactor model. the most popular and simple equilibrium model.. In the lines of the assumptions of arbitrage pricing theory. size. Hence. as compared to CAPM. under the APT characterization of the assets. inflation.

Turnover in the futures and options markets are usually many times the cash (underlying) markets. The agreed rate is called forward rate and the difference between the spot rate. The buyer of such a product gets the right to buy the common share by a future date. Unlike forward contracts. the price of a derivative is dependent on the price of another security. defined on a common share. Our treatment of derivatives in this module is somewhat limited: we provide a short introduction about of the major types of derivatives traded in the markets and their pricing. the rate prevailing today. let’s consider the derivative called a ‘call option’. 7. the buyer of a call option has the right. Call options are further classified as being European. if this right can only be exercised on the strike date and American. In other words. The price at which she can buy the underlying is called the strike price.e. Futures contracts are also agreements to buy or sell an asset for a certain price at a future time. Similarly. Let’s now flesh out some of the details.1 Introduction Derivatives are a wide group of financial securities defined on the basis of other financial securities. i. But she might not want to do so—there’s no obligation to buy it. futures contracts are standardized contracts and are 71 . Forward contracts are bilateral (privately negotiated between two parties).. These underlying securities are usually shares or bonds. the option. the party that agrees to sell the asset in a future date is referred to as a short investor and is said to have a short position. The party that agrees to buy the asset on a future date is referred to as a long investor and is said to have a long position. and the forward rate is called the forward margin. just the choice.CHAPTER 7: Valuation of Derivatives 7. which are traded in the over-the-counter market with no standard contract size or delivery arrangements. although they can be various other financial products. even other derivatives. As a quick example. Here counter-party risk refers to the default risk that arises when one party in the contract defaults on fulfilling its obligations thereby causing loss to the other party. but not the obligation to take a long position in the underlying at the strike price on or before the strike date. traded outside a regulated stock exchange (traded in the OTC or ‘Over the Counter’ market) and suffer from counter-party risks and liquidity risks. and the date after which this option expires is called the strike date. called the underlying. Derivatives are amongst the widely traded financial securities in the world. if it can be exercised any time up and until the strike date.2 Forwards and Futures Forward contracts are agreements to exchange an underlying security at an agreed rate on a specified future date (called expiry date).

1 : Comparison of Forward and Futures Contracts Forward Contract Nature of Contract Non-standardized/ Customized contract Trading Private contract between parties – Informal. Final Settlement date is fixed by the exchange. no independent guarantee. Since futures contracts are traded through exchanges. and the contract or lot size (no. Exchanges guarantee execution by holding a caution amount as security from both the parties (buyers and sellers). there is a provision of daily settlement. Traded on an exchange Futures Contract Standardized contract 72 . and is adjusted daily based on price movements of the underlying till the contract expires. Pre-specified in the contract. Table 7. This amount is called as the margin money. of shares/units per contract) is fixed. the settlement of the contract is guaranteed by the exchange or a clearing corporation (through the process of novation) and hence there is no counter-party risk. Exchange provides the guarantee of settlement and hence no counter party risk. Primary examples are long-term contracts—most futures contracts have short maturities of less than a few months. The table here draws a comparison between a forward and a futures contract. In addition. Compared to forward contracts. Occasionally the fact forward contracts are bilateral comes in handy—two parties could suit a contract according to their needs. Over-the-Counter market Settlement Set by the parties. They are standardized in terms of contract sizes. Risk Counterparty risk exists. futures also provide the flexibility of closing out the contract prior to the maturity by squaring off the transaction in the market. trading parameters and settlement procedures. such a futures may not be traded in the market.traded on recognized and regulated stock exchanges. known as daily mark to market settlement.

Options can be used for hedging as well as for speculation purposes. Unlike futures. in case of options. otherwise. are able to reap the benefits from any favorable movement in the exchange rate. the buyers are protected from downside risks and in the same time. Recall that in case of American options. the option buyer has a right to sell the security at the agreed upon price (called strike rate or exercise price). futures. 7. Options are like insurance contracts. the option would not be exercised. the party (seller) granting the option collects a payment from the other party. In case of call options. The buyer would exercise the option only when she can make some profit from the exercise. The buyer of the option has a right but no obligation to enforce the execution of the option contract and hence. the right can be exercised only on the expiry date.3 Call and Put Options Like forwards and futures. There are other methds of hedging too—using forwards. the maximum loss that the option buyer can suffer is limited to the premium amount paid to enter into the contract. but not an obligation to either sell (put option) or buy (call option) a particular asset at a specified price in the future. options are derivative instruments that provide the opportunity to buy or sell an underlying asset on a future date.7. The formula used for pricing futures is given below: F = Se rT Where : F = Futures Price S = Spot price of the underlying asset 73 . For example. where the parties are denied of any favorable movement in the market. This payment collected is called the “premium” or price of the option. As explained in the introduction.4 Forward and Futures Pricing Forwards/ futures contract are priced using the cost of carry model. in case of currency options. or combinations of all three—and the choice of hedging is determined by the costs involved. an option contract is a contract written by a seller that conveys the buyers a right. The cost of carry model calculates the fair value of futures contract based on the current spot price of the underlying asset. the right can be exercised on any day on or before the expiry date but in case of a European option. An option is used as a hedging tool if the investor already has (or is expected to have) an open position in the spot market. In return for granting the option. and be allowed to lapse. importers buy call options to hedge against future depreciation of the local currency (which would make their imports more expensive) and exporters could buy put options to hedge against currency appreciation. the option buyer has a right to buy and in case of put options.

if the futures price is more than the fair value. It is the opposite of carrying charges and refers to the benefit accruing to the holder of the asset. Alternatively. 850.4.71828 (The base of natural logarithms) Example: Security of ABB Ltd trades in the spot market at Rs. there is a scope to make a profit by holding a short position in the futures and a long position in the underlying. c is the convenience yield and t is the time to delivery of the forward contract (expressed as a fraction of 1 year). If the futures price is less than the fair value. It is usually represented as a percentage of the spot price.R = Cost of financing (using a continuously compounded interest rate) T = Time till expiration in years E = 2. F = [S + PV (storage cost )] * e(r – c )t Where F is the forward price. cost of carry also includes storage costs (also expressed as a percentage of the spot price) of the underlying asset until maturity. Convenience yield has a negative relationship with inventory storage levels (and storage cost). The increase in demand/ supply of the futures (and spot) contracts will force the futures price to equal the fair value of the asset. we consider the risk-free interest rate as the cost of carry. For example. In case of commodities contracts. S is the spot price. Futures prices being lower than spot price (backwardation) is also explained by the concept of convenience yield. 74 . The cost of carry model expresses the forward (future) price as a function of the spot price and the cost of carry and convenience yield. The fair value of a one-month futures contract on ABB is calculated as follows: F = Se rT = 850 * e 0. 7. r is the risk-free interest rate.1 1 1 12 = 857. High storage cost/high inventory levels lead to negative convenience yield and vice versa. for most investment.1 Cost-of-carry and convenience yield The cost of carry is the cost of holding a position.80 The presence of arbitrageurs would force the price to equal the fair value of the asset. one of the benefits to the inventory holder is the timely availability of the underlying asset during a period when the underlying asset is otherwise facing a stringent supply situation in the market. Generally. one can profit by holding a long position in the futures and a short position in the underlying. Money can be invested at 11% per annum.

The theory suggests that the futures price is a biased estimate of the expected spot price at the maturity. In case of call options. When hedgers are net short (farmers willing to sell the produce immediately after harvest).4. the process referred to as backwardation. M. 0] The following figures shows the payoff diagram for call options buyer and seller (assumed exercise price is 100) 75 . the option is worthless since it will expire without being exercised. resulting into a backwarded market. We then briefly describe the celebrated Black-Scholes formula to price a European option.5 Option Pricing Our brief treatment of options in this module initially looks at pay-off diagrams. the future price decreases relative to the expected spot price. The payoff of a call option buyer at expiration is: Max [(Market price of the share – Exercise Price). 7. In case of contango. For the sake of simplicity. the futures price would be a downward biased estimate of the expected spot price.2 Backwardation and Contango The theory of normal backwardation was first developed by J. or the risk aversion is more for short hedgers than the long hedgers. Keynes in 1930. Backwardation and contango is easily explained in terms of the seasonal nature of commodities.5.7. a put option buyer would exercise her right if the market price is lower than the exercise price. the option buyer would exercise the option only if the market price on the date of exercise is more than the strike price of the option contract. 7. Similarly.1 Payoffs from option contracts Payoffs from an option contract refer to the value of the option contract for the parties (buyer and seller) on the date the option is exercised. When the future price is lower than the current spot price. the market is said to be backwarded and the opposite is called as a contango market. Commodity futures with expiration dates falling in post harvest month would face backwardation. Since future and spot prices have to converge on maturity (this is sometimes called the law of one price). we do not consider the initial premium amount while calculating the option payoffs. The underlying principle for the theory is that hedgers use the future market to avoid risks and pay a significant amount to the speculators for this insurance. in the case of a backwarded market. as the expected spot price would be lower. Otherwise. which chart the price of the option with changes in the price of the underlying and then describes how call and option prices are related using put-call parity. the future price will increase relative to the expected spot price with passage of time.

a buyer of put options would expect the market to fall. On the other side. and also cap the downside in the event of a fall. It’s clear from the vertical axis of the payoff diagram (which provides the payoff the contract). and profit from it. with an insurance. 76 . or a hedge (in the event of an unexpected rise in the market). The price of course is the premium. to cap the downside. it is not so for the seller. The price of the hedge is the put option premium. 0] The payoff diagram for put options buyer and seller (assumed exercise price is 100) From the pay-off diagrams it’s apparent that a buyer of call options would expect the market price of the stock to rise. a seller of call options has a contrarian view. and buying the call option allows him to lock in the benefits of such a rise.The payoff for a buyer of a put option at expiration is: Max [(Exercise price – Market price of the share). that while the downside of a call option buyer is limited. In a similar sense. and hopes to profit from the premium of the call options sold that would expire unexercised.

C + Ke–rt = P + S0 77 ( ) .e.7.2 Put-call parity relationship The put-call parity relationship gives us a fundamental relationship between European call options and put options. The relationship is derived by noticing that the payoff from the following two strategies is the same irrespective of the stock price at maturity.5. Strategy 2: Buy a put option and buying a share. This can be shown in the form of the following diagram: Strategy 1: Strategy 2: Since the payoff from the two strategies is the same therefore: Value of call option (C) + PV of exercise price Ke–rt = value of put option (P) + Current share price (S0 ) . i. The two strategies are: Strategy 1: Buy a call option and investing the present value of exercise price in risk-free asset.

) is the cumulative distribution function (cdf) of the standard normal distribution T-t is the time to maturity S is the spot price of the underlying asset K is the strike price r is the continuously compounded annual risk-free rate σ is the volatility in the log returns of the underlying. The Black-Scholes formula for valuing call options (c) and value of put options (p) is as under: c(S.e. period for which the option is valid (T) Prevailing risk-free interest rate (r) The expected volatility of the underlying asset ( σ ) One of the landmark inventions in the financial world has been the Black-Scholes formula to price a European option. t ) = Ke–r (T –t ) N(–d2 ) – SN(–d1 ) Where  S σ2   (T – t ) ln   +  r +    2  K    d1 = σ T –t d2 = d1 – σ T – t Where. i.e.6 Black-Scholes formula The main question that is still unanswered is the price of a call option for entering into the option contract. the option premium. The formula proved to be very useful not only to the academics but also to practitioners in the finance world. Fischer Black and Myron Scholes2 in their seminal paper in 1973 gave the world a mathematical model to value the call options and put options. 78 . t ) = SN (d1 ) – ke –r (T –t ) N(d2 ) and p(S. N (. The authors were later awarded The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel in 1997. The premium amount is dependent on many variables.7. They are: Share Price (S0 ) Exercise Price (K) The time to expiration i.

25 = – .30 per year  100   0.5924 – 100 * 0. Myron Scholes (1973).4076 N(–d1 ) = N (0.0836 = d1 = 0.3 0.4667 – 105 * e–.4667 N(d2 ) = N (–0.25)  (T – t ) ln   +  r + ln    +  0.0836) = 0.10 (10%) Time to expiration (T-t) = 3 month = 0.0236 N(d1 ) = N (–0.25 years Standard deviation ( σ ) = 0. "The Pricing of Options and Corporate Liabilities". t ) = Ke–r (T – t ) N(–d2 ) – SN(–d1 ) = 105 * e–0.10 *0.0836) = 0.Example: Calculate the value of a call option and put option for the following contract: Stock Price (S) = 100 Exercise Price (K) = 105 Risk-free.5924 Value of call option (c) = c (S.33 2 Black.10 *0.0836 – 0.25 * 0.3 * 0.32  S σ2   (0. continuously compounded interest Rate (r) = 0.25 * 0. Journal of Political Economy 81 (3): 637-654 79 .5333 = 7.0236) = 0.9225 Value of Put option (p) = p(S. t ) = SN (d1 ) – ke–r (T − t ) N(d2 ) = 100 * 0. Fischer.10 +    2  2   105   K      = – 0.5333 N(–d2 ) = N (0.0236) = 0. 4076 = 4.25 σ T –t d2 = d1 – σ T – t = 0.

CHAPTER 8: Investment Management
8.1 Introduction

In the final chapter of this module we take a brief look at the professional asset management industry. Worldwide, the last few decades have seen an increasing trend away from direct investment in the markets, with the retail investor now preferring to invest in funds or the index, rather than direct exposure into equities. This has naturally led to a sharp increase in the assets under management of such firms. The asset management industry primarily consists of two kinds of companies, those engaged in investment advisory or wealth management activities, and those into investment management. In the first category, investment advisory firms recommend their clients to take positions in various securities, and wealth management firm either recommend, or have custody of their clients’ funds, to be invested according to their discretion. In both cases, the engagement with clients is at an account level, i.e., funds are separately managed for each client. In contrast, investment management companies combine their clients’ assets towards taking positions in a single portfolio, usually called a fund (or a mutual fund). A unit of such a fund then represents positions in each of the securities owned in the portfolio. Instead of tracking returns on their own portfolios, clients track returns on the net asset value (NAV) of the fund. In addition to the perceived benefits of professional fund management, the major reason of investment into funds is the diversification they afford the investor. For instance, instead of owning every large-cap stock in the market, an investor could just buy units of a large-cap fund. In this chapter, we shall examine the various types of such funds, differentiated by their investment mandates, choice of securities, and of course, investment performance, where we would outline a few of the key metrics used to measure investment performance of funds.

8.2

Investment Companies

Investment companies pool funds from various investors and invest the accumulated funds in various financial instruments or other assets. The profits and losses from the investment (after repaying the management expenses) are distributed to the investors in the funds in proportion to the investment amount. Each investment company is run by an asset management company who simultaneously operate various funds within the investment company. Each fund is managed by a fund manager who is responsible for management of the portfolio. Investment companies are referred to by different names in different countries, such as mutual funds, investment funds, managed funds or simply funds. In India, they are called mutual funds. Our treatment would use these names interchangeably, unless explicitly stated. 80

8.2.1

Benefits of investments in managed funds

The main advantages of investing through collective investment schemes are: Choice of Schemes: There are various schemes with different investment themes. Through each scheme an investor has an opportunity to invest in a wide range of investable securities. Professional Management: Professionally managed by team of experts. Diversification: Scope for better diversification of investment since mutual fund assets are invested across a wide range of securities. Liquidity: Easy entry and exit of investment: investors can with ease buy units from mutual funds or redeem their units at the net asset value either directly with the mutual fund or through an advisor / stock broker. Transparency: The asset management team has to on a regular basis publish the NAV of the assets and broad break-up of the instruments where the investment is made. Tax benefits: Dividends received on investments held in certain schemes, such as equity based mutual funds, are not subject to tax.

8.3

Active vs. Passive Portfolio Management

If asset prices always reflect their equilibrium values (expected returns equal to the value specified by an asset pricing model), then an investor is unlikely to benefit from actively searching for mispriced (overpriced/underpriced) opportunities in assets. In other words, the investor is better off by simply investing in the market, or a representative benchmark. For instance, under such assumptions, an Indian equity investor would achieve the best possible outcome by trying to replicate the Nifty 50 by investing in the constituent stocks in the same proportion as they are in the index. Such investment assumes that gains in the market are those of the benchmark, and not in the choice of individual securities, as opportunities in their selection, or timing of entry/exit are too short to be taken advantage of. This, passive approach to investment rests upon the theory of market efficiency, which we saw in chapter 4. Recall that the EMH postulates that prices always fully reflect all the available information and any deviation from the full information price would be quickly arbitraged away. In an efficient market, information about fundamental factors related to the asset, or its market price, volume or any other related trading data related has little value for the investor.

81

Passive fund managers try to replicate the performance of a benchmark index, by replicating the weights of its constituent stocks. Given daily price movement in stock prices, the challenge for such managers is to minimize the so-called ‘tracking error’ of the fund, which is calculated as the deviation in its returns from that of the index. The choice of the index further differentiates between the funds, for example, an equity index fund would simply try to maintain the return profile of the benchmark index, say, the NIFTY 50; but if investments are allowed across asset classes, then the ‘benchmark’ could well consist of a combination of a equity and a debt index. Recent evidence of systematic departures of asset prices in the from equilibrium values, as envisaged under the market efficiency, has renewed interest in ‘active’ fund management, which entails that optimal selection of stocks, and the timing of entry/exit could lead to ‘marketbeating’ returns. This represents an opportunity for investors to engage in active strategies based on their objective views about the assets. In a generic sense, such views are about the relative under pricing or over pricing of an asset. Over pricing presents an opportunity to engage in short selling, under pricing an opportunity to take a long position, and combinations of the two are also possible, across stocks, and portfolios. The objective of an active portfolio manager is to make higher profits from investing, with similar, or lower risks attached. The risk of a portfolio, as noted in an earlier chapter, is usually measured with the standard deviation of its assets. A good portfolio manager should have good forecasting ability and should be able to do two things better than his competitors: market timing and security selection. By market timing, we refer to the ability of the portfolio manager to gauge at the beginning of each period the profitability of the market portfolio vis-à-vis the risk-free portfolio of Government bonds. The strength of such a signal would indicate the level of investment required in the market. By security selection, we refer to ability of a portfolio manager in identifying mispricing in individual securities and then investing in securities with the maximum mispricing, which maximizes the so-called alpha. The alpha of a security refers to the expected excess return of the security over the expected rate of return (for example, estimated by an equilibrium assetpricing model like the CAPM). The mispricing may be either way: If the portfolio manager believes that a security is going to generate negative return, his portfolio should give a negative weight for the same i.e. short the security and vice versa. The tradeoff for the active investor is the presence of nonsystematic risk in the portfolio. Since the portfolio of an active investor is not fully diversified, there is some nonsystematic (firm-specific) risk that is not diversified away. Active fund management is a diverse business—there are many ways to make money in

82

the market—almost all the investment styles we would examine further in the chapter are illustrative examples.) which may be recurring or non-recurring in nature. Investment management companies can be broadly classified on the basis of the securities they invest in and their investment objectives. which reduced transaction costs. but has seen costs falling over the years on competitive pricing and increased liquidity of the markets. valuations. Before we look at either. and closed-ended funds.g. and so-called open. and is instantly reflective of the value of investment.) of the funds. active and passive investments differ meaningfully in terms of their costs to the investors. A tilted portfolio shifts the weights of its constituents towards one or more of certain pre-specified market factors. By their very nature of operations. we define the core measure of return for a fund.g. 8. advertising expenses etc. like earnings. Active and passive fund management are not always chalk and cheese—there are techniques that utilize both. Passive investment is characterized by low transaction costs (given their low turnover).4 Costs of Management: Entry/Exit Loads and Fees Running a mutual fund involves certain costs (e. the NAV. Active fund management is understandably more expensive.5 Net Asset Value The net asset value NAV is the most important and widely followed metric of a fund’s performance. remuneration to the management team. the NAV of a fund would rise with the value of the fund portfolio. the management team is paid a fixed percentage of the asset under management as their fees. It is calculated per share using the following formula: NAV (per share) = Market Value of Assets – Market Value of liabilities Number of shares outs tan dign Net asset value (NAV) is a term used to describe the per unit value of the fund’s net assets (assets less the value of its liabilities). dividend yields. management fees and commission etc. 8. like portfolio tilting. 83 . Hence the NAV for a fund is Fund NAV = (Market Value of the fund portfolio – Fund Expenses) / Fund Shares Outstanding Just like the share price of a common stock. from redemption fees) or from charges on the assets (transaction fees. or towards one or more specific sectors. These costs are recovered by the fund from the investors (e. and the risks attached. management expenses. Generally.

or market-timing based. For example. bond funds. These schemes are differentiated by their charter which mandates their investment into asset classes. The investment policy determines the instruments in which the money from a specific scheme will be primarily invested. i. mutual funds can be broadly classified into equity funds (growth funds and income funds). the units are issued and redeemed by the fund. Generally.2 Equity funds Equity funds primarily invest in common stock of companies. such units are traded on stock exchanges.8. each a constituting a portfolio where inputs translate into units. Income funds focus on dividend income or coupon payments from bonds (if they are not pure equity). fund houses have dozens of schemes floating in the market at any given time. with separate investment policies for each scheme. fund houses float various schemes from time-to-time. fund houses are also differentiated in terms of their investment styles. Equity funds may also be sector-specific wherein the investment is restricted to stocks from a specific industry. 84 . growth. The investors can sell or purchase units to (or from) other investors and to facilitate such transactions. Equity funds can be growth funds or income funds.6. sector rotators. Beyond the type of instruments they invest in. In an open-ended fund. in real life. the ‘Offer Document’ of the scheme. while income funds focus on companies that have high dividend yields. etc. value.6.6 8. The fund discloses the NAV on a daily basis to facilitate issue and redemption of units. Each mutual fund scheme has a particular investment policy and the fund manager has to ensure that the investment policy is not breached.1 Classification of funds Open ended and closed-ended funds Funds are usually open or closed-ended. companies with strong growth potential. at the NAV prevalent at the time of issue / redemption. The policy is laid right at the outset when the fund is launched and is specified in the prospectus. Unlike open-ended funds. in India we have many funds focusing on companies in power sector and infrastructure sector. We now examine the different kind of funds on the basis of their investments. While we had earlier mentioned mutual fund investments represented as units in a single portfolio. Based on these securities.. income.e. at any time. 8. closed-ended funds sell units only at the outset and do not redeem or sell units once they are issued. The approaches to equity investing could be diversified or undiversified. Growth funds focus on growth stocks. index funds. Price of closed ended schemes are determined based on demand and supply for the units at the stock exchange and can be more or less than the NAV of the units. with capital appreciation being the major driver. money market funds.

bonds. specific types of investment vehicles below. with the fund managers’ mandate being the optimal choice across mutual fund schemes given extant market conditions. Government. and the frequency of modifying the allocation. these mutual funds invest in units of other mutual funds. 8. or both. non-bank corporations and Governments. there are many other kinds of funds. once established the portfolio composition is not changed (hence called unmanaged funds). 85 .4 Index funds Index funds have a passive investment strategy and they try to replicate a broad market index. Total return funds look at a combination of capital appreciation and dividend income. or hybrid instruments. Although the portfolio composition is actively decided by the sponsor of the fund. convertibles. UITs also pool money from investors and have a fixed portfolio of assets. A scheme from such a fund invests in components of a particular index proportionate to their representation in the benchmark. bonds. We mention some other.1 Unit Investment Trusts (UIT) Similar to mutual funds.6 Fund of funds Fund of funds add another layer of diversification between the investor and securities in the market.6. debt. They could potentially invest in corporate bonds.6. which are not changed during the life of the fund. Instead of individual stocks. and accordingly base their investment focus. or bonds.8. Global. They have a stable income stream and relatively lower risk. and derivative instruments. or emerging market funds recognize investment opportunities across the world. or a combination of equity. It is possible that a scheme tracks more than one index (in some pre-specified ratio). 8.5 Money market funds Money market mutual funds invest in money market instruments.6.7. ‘balanced’. 8. 8. Such funds could again comprise either. or ‘flexible portfolio’ funds.7 Other Investment Companies In addition to the broad categories mentioned here. These funds could be further distributed as ‘asset allocation’. or across asset classes.6. Hybrid funds invest in a combination of equity. depending on market opportunities. based on the breadth of their investment in different asset classes. which are short-term securities issued by banks. The various money market instruments have already been discussed earlier. 8. regional. and investor appetite.3 Bond funds Bond funds invest primarily in various bonds that were described in the earlier segment. in either equity.

The way an UIT is established is different from that of other mutual funds. Hedge funds generally have higher management fees than mutual funds as well as performance based fees. portfolio managers were evaluated by comparing the return generated by them with some broad yardstick. The trustees distribute the incomes from the investment and the maturity (capital) amount to the shareholders on maturity of the scheme. 8. Equity trusts invest in real estate assets.4%) and the fund performance (generally 20% of the excess returns over the market return generated by the fund). UITs are usually created by sponsors. With the development of the MPT. REIT can be of three types – equity. 8. mortgage or hybrid trusts. The management fee (paid to the fund managers). The entire portfolio is then transferred to a trust and the trustees issue trust certificates to the public. mortgage trusts invest in loans backed by mortgage and hybrid trusts invest in either. Hedge funds are private agreements and generally have little or no regulations governing them.3 Hedge Funds Hedge funds are generally created by a limited number of wealthy investors who agree to pool their funds and hire experienced professionals (fund managers) to manage their portfolio. market volatility. The risk borne by the portfolio managers or the source of performance such as market timing. which is similar to shares. For example. who first make investment in the portfolio of securities. in the case of hedge funds is dependent on the assets under management (generally 2 . 8. hedge funds can go short (borrow) funds and can invest in derivatives instruments which mutual funds cannot do. This gives a lot of freedom to the fund managers. the security selections and valuations were not considered. the goal of performance evaluation is to study whether the portfolio has provided superior returns compared to the risks involved in the portfolio or compared to an equivalent passive benchmark.7.8 Performance assessment of managed funds Prior to the development of the modern portfolio theory (MPT).7.2 REITS (Real Estate Investment Trusts) REITS are also similar to mutual funds. but they invest primarily in real estates or loans secured by real estate. The performance evaluation approach tries to attribute the performance to the following: Risk Timing: market or volatility Security selection – of industry or individual stocks 86 .

8. and therefore may not be willing to be evaluated based on this measure. If a portfolio is fully diversified. A higher ratio is preferable since it implies that the fund manager is able to generate more return per unit of total risks.8. Sharpe Ratio. When it is based on capital Market Line. The formula for measuring the Treynor Ratio is: Theynor Ratio = (rp – rf ) / β p 8. 8. the relevant measure of the portfolio risk is σ and when based on Security Market Line. given the portfolio’s beta and the average market returns. The formula for measuring the Sharpe ratio is: Sharpe Ratio = (rp – rf ) / σ p This will be compared to the Shape ratio of the market portfolio.2 Treynor Ratio Treynor’s measure evaluates the excess return per unit of systematic risks ( β ) and not total risks.3 Jensen measure or (Portfolio Alpha) The Jensen measure. also called Jensen Alpha. The assessment of managed funds involves comparison with a benchmark. then β becomes the relevant measure of risk and the performance of a fund manager may be evaluated against the expected return based on the SML (which uses β to calculate the expected return). Various measures are devised to evaluate portfolio performance. Treynor Ratio and Jensen Alpha. This ratio measures the effectiveness of a manager in diversifying the total risk ( σ ). The benchmark could be based on the Capital Market Line (CML) or the Security Market Line (SML). or portfolio alpha measures the average return on the portfolio over and above that predicted by the CAPM.Therefore: a) b) c) The focus of evaluation should be on excess returns The portfolio performance must account for the difference in the risk It should be able to distinguish the timing skills from the security selection skills. viz. 8. It is measured using the following formula: 87 . the relevant measure is β .8. managers who are operating specific portfolios like a value tilted or a style tilted portfolio generally takes a higher risks. This measure is appropriate if one is evaluating the total portfolio of an investor or a fund. in which case the Sharpe ratio of the portfolio can be compared with that of the market. However.1 Sharpe Ratio Sharpe ratio or ‘excess return to variability’ measures the portfolio excess return over the sample period by the standard deviation of returns over that period.

5 (18% . calculate (a) Sharpe Ratio (b) Treynor Ratio and (c) Jensen Alpha for the investor P and the market.4 = 5 Jensen Alpha (α p ) = rp – [ rf + β p (rM – rf )] 28% . Answer: Investor P Portfolio Sharpe Ratio = (rp – rf ) / σ p Treynor Ratio = (rp – rf ) / β p Market Portfolio (M) (18% .[8% + 1 = 28% .α p = rp – [rf + β p (rM – rf )] The returns predicted from the CAPM model is taken as the benchmark returns and is indicated by the formula within the brackets.67 (28% .8%)/1.8%)/20% = 0. Specifically.4*(18% . then the beta of the portfolio would not have been significantly different during a market decline compared to that during a market increase.[8% + 1. for example through futures position. Market timing would refer to the adjustment in the beta of the portfolio in tandem with market movements.8%)] = 0 *** 88 . when the market declines.8%)] 18% . Example: The data relating to market portfolio and an investor ‘P’ portfolio is as under: Investor P’s Portfolio Average Return Beta ( β ) Standard Deviation ( σ ) 28% 1. timing skills call for increasing the beta when the market is rising and reducing the beta. it implies that the fund managers are able to identify stocks with high potential for excess returns. If α P is positive and significant.22% = 6% (18% . This measure investigates the performance of funds and especially the ability of the managers in stock selection in terms of these contributing aspects.8%)/1 = 10 (28% . The excess return is attributed to the ability of the managers for market timing or stock picking or both.8%)/30% = 0. This measure is widely used in evaluating mutual fund performance. If the fund manager has poor market timing ability.4 30% Market Portfolio (M) 18% 1 20% Assuming that the risk-free rate for the market is 8%.

05 610. Security of ABC Ltd. 595. Money can be invested at 10% per annum. trades in the spot market at Rs. __________ would mean that no investor would be able to outperform the market with trading strategies based on publicly available information. (a) (b) (c) (d) advertisements financial statements products vision statement [1 Mark] Q:3. along with the death benefits. is (using continuously compounded method): (a) (b) (c) (d) 630.05 89 [2 Marks] . Gross Profit Margin = Gross Profit / Net Sales (a) (b) FALSE TRUE Q:6. __________ ensure a return of capital to the policyholder on maturity.05 600. by replicating the weights of its constituent stocks. (a) (b) (c) (d) high premium or low premium policies fixed or variable policies assurance or endowment policies growth or value policies [2 Marks] [1 Mark] Q:5. Semi strong form efficiency Weak-form efficiency Strong form efficiency [1 Mark] A company's __________ provide the most accurate information to its management and shareholders about its operations. The fair value of a one-month futures contract on ABC Ltd. ______ fund managers try to replicate the performance of a benchmark index. (a) (b) (c) Q:2. (a) (b) Active Passive [2 Marks] Q:4.MODEL TEST INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT MODULE Q:1.05 620. Unlike term insurance.

the callable price (redemption price) may be different from the face value. 106. A portfolio comprises of two stocks A and B. [2 Marks] (a) (b) FALSE TRUE Q:10. (a) (b) (c) zero positive negative [1 Mark] Q:12. A buys a Put Option at a strike price of Rs. 100 for a premium of Rs.Q:7. (a) (b) TRUE FALSE [2 Marks] Q:8. On expiry of the contract the underlying shares are trading at Rs. Accounts payable appears in the Balance Sheet of companies. Mr. Stock A gives a return of 8% and stock B gives a return of 7%. In the case of callable bonds. A exercise his option? (a) (b) No Yes [3 Marks] Q:11. (a) (b) (c) (d) term curve yield curve interest rate curve maturity curve 90 . Will Mr. Stock A has a weight of 60% in the portfolio. Term structure of interest rates is also called as the ______. Evidence accumulated through research over the past two decades suggests that during many episodes the markets are not efficient even in the weak form. What is the portfolio return? (a) (b) (c) (d) 9% 11% 10% 8% [2 Marks] Q:9. Price movement between two Information Technology stocks would generally have a ______ co-variance. (a) (b) FALSE TRUE [2 Marks] [2 Marks] Q:13. 5.

(a) (b) (c) (d) Equities Forex Derivatives Bonds Q:19. A ________. [3 Marks] (a) (b) TRUE FALSE [1 Mark] Q:18. (a) (b) (c) each client's account seperately all clients accounts in a combined manner only their own money and not client's money [1 Mark] 91 . Investment advisory firms manage ______.Q:14. (a) (b) (c) (d) certificate of deposit (CD) commercial paper (CP) T-Note T-Bill [1 Mark] Q:16. Prices (returns) which are not according to CAPM shall be quickly identified by the market and brought back to the __________. (a) (b) (c) (d) asset deployment company revenue management company asset management company asset reconstruction company [1 Mark] Q:15. Each investment company is run by an _______. is a time deposit with a bank with a specified interest rate. Net acquisitions / disposals appears in the Cash Flow Statement of Companies. (a) (b) (c) (d) average standard deviation mean equilibrium [1 Mark] Q:17. ______ are a fixed income security.

(a) (b) TRUE FALSE [1 Mark] 92 . Which of the following accounting statements form the backbone of financial analysis of a company? (a) (b) (c) (d) the income statement (profit & loss). (a) (b) (c) (d) Withholding ratio Retention ratio Preservation ratio Maintenance ratio [1 Mark] [1 Mark] Q:21. In a Bond the ____ is paid at the maturity date. The need to have an understanding about the ability of the market to imbibe information into the prices has led to countless attempts to study and characterize the levels of efficiency of different segments of the financial markets. expenditure structure profit structure income structure [2 Marks] Q:25. (a) (b) assets liabilities [2 Marks] Q:23.Q:20. the balance sheet statement of cash flows All of the above [1 Mark] Q:24. The balance sheet of a company is a snapshot of the ______ of the firm at a point in time. (a) (b) (c) (d) the sources and applications of funds of the company. (a) (b) (c) (d) face value discounted value compounded value present value Q:22. Banks and other financial institutions generally create a portfolio of fixed income securities to fund known _______ . _______ measures the percentage of net income not paid to the shareholders in the form of dividends.

Mr. [2 Marks] (a) (b) (c) (d) value profitability price liquidity Q:27. A ________ provides an account of the total revenue generated by a firm during a period (usually a financial year. The ______ refers to the length of time for which an investor expects to remain invested in a particular security or portfolio. In investment decisions. New stocks/bonds are sold by the issuer to the public in the ________ . before realizing the returns. or a quarter).Q:26. ______ on expiry date in order to make a profit. _______ refers to the marketability of the asset. (a) (b) (c) (d) Accounting analysis statement financial re-engineering statement promotional expenses statement profit & loss statement [1 Mark] [1 Mark] Q:30. 5. Mr. [2 Marks] (a) (b) (c) (d) investment horizon credit cycle horizon duration horizon constraint horizon Q:29. A buys a Call Option at a strike price of Rs. 700 for a premium of Rs. (a) (b) (c) (d) fixed income market secondary market money market primary market 93 . A expects the price of the underlying shares to rise above Rs. (a) (b) (c) (d) 740 700 720 760 [3 Marks] Q:28.

trades in the spot market at Rs. 120 or less [2 Marks] Q:34. is (using continously compounded method): (a) (b) (c) (d) 559. (a) (b) (c) weak-form efficient strong form efficient semi-strong form efficient [1 Mark] Q:33. In case of compound interest rate.46 549. the period after a favorable (unfavorable) event would not generate returns beyond (less than) what is suggested by an equilibrium model such as CAPM. __________ have precedence over common stock in terms of dividend payments. If the market is _______. A sell order comes into the trading system at a Limit Price of Rs. The fair value of a one-month futures contract on ABC Ltd. (a) (b) (c) (d) period frequency time duration 94 [1 Mark] . The measure is called as _____ of a bond. and the residual claim to its assets in the event of liquidation. we need to know the _______ for which compounding is done. (a) (b) Preferred shares Equity shares [1 Mark] Q:35. [2 Marks] (a) (b) (c) (d) duration IRR YTM yield Q:36. Security of ABC Ltd. One needs to average out the time to maturity and time to various coupon payments to find the effective maturity for a bond. Money can be invested at 10% per annum.46 [2 Marks] Q:32. 120 or more Rs. 120. 525. The order will get executed at a price of _______.46 529.Q:31.46 539. (a) (b) Rs.

00. The share price of PQR Company on 1st April 2009 and 31st March 2010 is Rs. The Beta of the investor's portfolio is 1. The risk free return for the market is 8%. Net change in Working Capital appears in the Cash Flow Statement of Companies. 15. (a) (b) (c) (d) 4 8 2 6 [3 Marks] Q:41. What is the portfolio return? (a) (b) (c) (d) 10% 9% 12% 11% [2 Marks] Q:40.00.00. Average Return of an investor's portfolio is 10%.000.00. A portfolio comprises of two stocks A and B.Q:37. [1 Mark] (a) (b) (c) (d) 45% 65% 75% 55% 95 . [3 Marks] (a) (b) FALSE TRUE Q:38. Stock A has a weight of 60% in the portfolio. Stock A gives a return of 14% and stock B gives a return of 1%. The company paid a dividend of Rs.00.000 and the average shareholder's fund during the period is Rs. The Return on Average Equity is : [3 Marks] (a) (b) (c) (d) 13% 12% 15% 16% Q:39. Calculate the return for a shareholder of PQR Company in the year 2009-10. 1. A company's net income for a period is Rs. Calculate the Treynor Ratio. 20 and Rs. 5 for the year 2009-10. 24 respectively.2.

The Beta of the investor's portfolio is 1. Calculate the Treynor Ratio. expenditure gain. If an investor's expected rate of return from ABC Ltd. has paid a dividend of Rs. loss tolerance return. losses profit. Portfolio management is the art of managing the expected _______ requirement for the corresponding ________. (a) (b) (c) (d) specialisation diversification variety expansion [1 Mark] Q:45.Q:42. The CAPM is founded on the following two assumptions (1) in the equilibrium every mean variance investor holds the same market portfolio and (2) the only risk the investor faces is the beta. 10 per share last year and it is expected to grow at 5% every year. ABC Ltd. share is 7%. Average Return of an investor's portfolio is 55%. (a) (b) TRUE FALSE [1 Mark] 96 . the major reason of investment into funds is the ______ they afford the investor. [3 Marks] (a) (b) (c) (d) 41 39 43 45 Q:44. [2 Marks] (a) (b) (c) (d) 540 530 525 535 Q:46. (a) (b) (c) (d) income. risk tolerance [1 Mark] Q:43. calculate the market price of the share as per the dividend discount model.2. In addition to the perceived benefits of professional fund management. The risk free return for the market is 8%.

32 10824. 10000 that pays 8% interest compounded quarterly? (a) (b) (c) (d) 12824. This departure from market efficiency is also sometimes called the _____ effect. low risk assets like government securities. What is the amount an investor will get on a 1-year fixed deposit of Rs. Over pricing in a stock presents an opportunity to engage in _____ the stock. (a) (b) (c) positive negative zero 97 [1 Mark] . Dividend Per Share = Total Dividend / Number of Shares in issue (a) (b) TRUE FALSE [1 Mark] Q:53.32 [2 Marks] [1 Mark] Q:51. Price movement between two Steel company stocks would generally have a ______ co-variance. Q:52. but a number of studies have found returns on Monday to be lower than in the rest of the week. For longer investment horizons investors look at ______ .32 11824. (a) (b) riskier assets like equities.32 13824. [2 Marks] (a) (b) (c) (d) short covering short selling active buying going long Q:50. Stock returns are generally expected to be independent across weekdays. (a) (b) TRUE FALSE [1 Mark] Q:48.Q:47. [2 Marks] (a) (b) (c) (d) Monday-Friday weekday Monday weekend Q:49. Markets are inefficient when prices of securities assimilate and reflect information about them.

(a) (b) FALSE TRUE [1 Mark] Q:58. An endowment fund is an institutional investor. A portfolio comprises of two stocks A and B. Stock A has a weight of 60% in the portfolio. What is the portfolio return? (a) (b) (c) (d) 11% 9% 10% 8% [2 Marks] 98 . (a) (b) (c) (d) basis variable underlying options [1 Mark] [1 Mark] Q:55. called the _____ . Commercial Papers (CPs) can be issued by _____. In India. Call Options can be classified as : (a) (b) (c) European American All of the above Q:56. (a) (b) (c) (d) Limit Market-loss Stop-loss IOC [2 Marks] Q:59. Stock A gives a return of 9% and stock B gives a return of 6%.Q:54. ______ orders are activated only when the market price of the relevant security reaches a threshold price. (a) (b) (c) (d) Mutual Fund Agents Insurance Agents Primary Dealers Sub-Brokers [3 Marks] Q:57. The price of a derivative is dependent on the price of another security.

31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 Answers (d) (c) (a) (a) (a) (b) (b) (c) (b) (c) (a) (d) (b) (b) (c) (a) (b) (d) (b) (c) (a) (a) (a) (c) (a) (c) (b) (c) (d) (d) (d) 60 ________________________________________ 99 . The issue price of T-bills is generally decided at an ______ .Q:60. (a) (b) (c) (d) OTC market inter-bank market exchange auction ________________________________________ [3 Marks] Correct Answers : Question No. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 Answers (a) (b) (b) (c) (b) (c) (a) (d) (b) (a) (b) (b) (b) (c) (a) (d) (a) (d) (a) (b) (a) (b) (d) (a) (a) (d) (b) (a) (d) Question No.

You're Reading a Free Preview

Download
scribd
/*********** DO NOT ALTER ANYTHING BELOW THIS LINE ! ************/ var s_code=s.t();if(s_code)document.write(s_code)//-->