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.
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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
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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
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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
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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
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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.
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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
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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
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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
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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
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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.
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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.
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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
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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
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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
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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.
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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
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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.
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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
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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.
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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)
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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?
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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
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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
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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:
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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
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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:
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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
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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:
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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.
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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
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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.
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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
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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.
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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
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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:
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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.
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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)
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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.
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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.
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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.
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I l l ust r at i on 5.1
I ncome St at ement ( US$M) 2006 2007 2008
Net sales 16,380 21,340 33,565
Cost of sales ( 5,332) ( 6,584) ( 8,190)
SG&A ( 1,408) ( 1,771) ( 2,738)
Research & development ( 1,534) ( 2,440) ( 2,725)
Ot her operat ing it ems ( 3,650) ( 4,620) ( 5,369)
EBI T 4,457 5,926 14,543
Tot al ot her non- operat ing it ems 543 1,336 305
Associat es 0 0 0
Net int erest income/ expense 869 1,072 1,146
Except ional it ems 0 0 0
Pr et ax pr of i t 5,869 8,334 15,994
Taxat ion ( 239) 67 ( 485)
Minorit y int erest 3 ( 559) ( 640)
Preferred dividends 0 0 0
Net ext raordinary it ems 100 0 0
Repor t ed net i ncome 5,733 7,843 14,869
5.2.2 The Bal ance Sheet
Asset s owned by a company are financed eit her by equit y or debt and t he balance sheet of a
company is a snapshot of t his capit al st ruct ure of t he firm at a point in t ime; t he sources and
applicat ions of funds of t he company.
A company owns f i xed asset s ( machi ner y, and ot her i nf r ast r uct ur e) , cur r ent asset s
( manufact uring goods in progress, money it expect s t o receive from business part ners—
receivables, invent ory et c.) , cash and ot her financial invest ment s. I n addit ion t o t hese t hree,
a company could also own ot her asset s which carry value, but are not direct ly market able, like
pat ent s, t rademarks, and ‘goodwill’—value not linked t o asset s, but realized from acquisit ions.
These asset s are financed eit her by t he company’s equit y (invest ment s by shareholders) or by
debt . The illust rat ive example shown below is t he balance sheet of a large Pharmaceut ical
company.
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I l l ust r at i on 5.2
Bal ance Sheet ( US$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.
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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,
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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) .
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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
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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
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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
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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.
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) – ) ( (
) 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 .
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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
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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
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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.
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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
+
·
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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.
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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.
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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.
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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,
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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 ·

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( ) ( )

· ) , ( – –
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.
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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:
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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
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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.
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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
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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.
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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
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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,
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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) .
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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
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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.
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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.
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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
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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.
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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
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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) .
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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)
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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.
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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
+ · +
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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.
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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
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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.
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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.
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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
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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 .
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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.
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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) .
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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
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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:
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) ] – ( [ –
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
* * *
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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
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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
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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
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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
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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
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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
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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%
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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
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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
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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%
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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)
________________________________________
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