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TECHNICAL ANALYSIS

Technical analysis is based on the widely accepted premise that security prices are determined by the supply of and the demand for securities. The tools of technical analysis are therefore designed to measure supply and demand indicators. Typically technical analysts record historical financial data on charts, study these charts in technical search of meaningful patterns and endeavor to use the patterns to predict the future. PRINCIPLES: The Basis of Technical Analysis A classic book by Edwards and Magee articulates the basic assumptions underlying technical analysis: Market value is determined by the interaction of supply and demand. Supply and demand are governed by numerous factors both rational and irrational. Despite minor fluctuations in the market, security prices tend to move in trends that persist for an appreciable length of time. Changes in a trend are caused by shifts in supply and demand. Shifts in supply and demand no matter why they occur can be detected sooner or later in charts of market transactions. Some chart patterns tend to repeat themselves. In essence, technical analysts believe that past patterns will occur in the future and can therefore be used for predictions.

A technical analyst is a security analyst who uses an approach completely different from that of fundamental analysts. A technical analysts or technicians believes it is not productive to sift through all the fundamental facts about an issuing corporation like company earnings, its products, forthcoming legislation that might affect the firm, summarized in the market prices of a security. Technical analysts therefore focus on charts of security market price and summary statistics about security transactions. therefore they are also known as CHARTISTS.

The Dow theory is one of the oldest and most famous technical tools it was originated by Charles Dow a founder of the Dow Jones Company and editor of The Wall Street Journal at the turn of the MANAGEMENT OF INVESTMENT BY JACK CLARK FRANCIS 3RD EDITION

2 century.Today,the theory is the basis for much of the work done by technical analysts; it is used to delineate trends in the market as a whole or in individual securities.

Definition

The market is always considered as having three movements, all going at the same time. The first is the narrow movement from day to day. The second is the sort swing ,running from 2 weeks to a month or more; the thirds is the main movements, covering at least 4 years in durations.

Primary trends, which are long term movements, commonly called bear or bull markets. Delineating the beginnings and endings of the primary trends in the main goal of Dow theorist. Secondary movements, which last only a few months. Secondary movements are sometimes called corrections. Tertiary Moves, Which are simply the daily fluctuations. The Dow theory asserts that daily fluctuations are essentially meaningless random wiggles.

Line Chart

Dow theorist develop a line chart which is constructed by plotting each days closing (or Opening, or high or Low) prices and then drawing a line through these points. An Abortive Recovery is said to occur when a secondary movement fails to rise above the preceding top. Confirmation occurs when the pattern of ascending or descending tops also occurs in both the industrial and the railroad averages.

Bar Chart

Bar chart can be prepared for a market index or for an individual asset. Bar charts have one vertical bar representing each days price movement. Each bar spans the distance from the days highest price to the days lowest price and a small cross on each bar marks that days closing price.

A head and shoulder top formation is supposed to signal that the securitys price has reached a top and will decline in the future. As its name suggest the head and the shoulders top pattern has a left shoulder, a MANAGEMENT OF INVESTMENT BY JACK CLARK FRANCIS 3RD EDITION

3 head and a right shoulder. The market action that form a head and shoulders top can be broken down into four phases which are as follow 1. Left Shoulder: A period of heavy buying followed by a lull in trading pushes the price up to a new peak before the price begins to slide down. 2. Head: A spurt of heavy buying raises prices to a new high and then allows the price to fall back below the top of the left shoulder. 3. Right Shoulder: A moderate rally lifts the price somewhat but fails to push prices as high as the top of the head before a decline begins. 4. Breakout: Prices fall below the neckline that is the line drawn tangent to the left and right shoulders. This breakout presumably precedes a price drop and is a signal to sell.

Odd-Lot Theory

Theories of contrary opinion advocate doing the opposite of what some particular group of investors is doing. The odd lot theory for instance assumes that small investors are usually wrong and it is therefore advantageous to pursue strategies that are opposite of what they are doing.

Breadth-of-Market Indicators

Breadth-of-Market Indicators are used to measure the underlying strength of market advances or declines.

Net advance or declines One of the easiest methods for measuring the breadth of the market is to subtract the number of issues that declined in price form the number that advanced in price in some particular market it is known as Net advance or declines. Advance-decline Line The breadth of market statistics is obtained by cumulating the net advances and declines so it is also called the advance-decline line. This advance decline statistics may become negative during a bear market.

The relative strength approach suggests that the prices of some securities rise relatively faster in a bull market and decline relatively slowly in a bear market compared with other securities. Technicians who use this approach invest in securities that have demonstrated relative strength in the recent past, because relative strength sometimes continuous undiminished for a considerable period. As a result these investors expect to earn higher returns. The relative-Strength concept may be applied to individual securities or to whole industries. To interpret relative strength data a technician typically plots the ratios of the security relative to its industry and to its industry and to the market.

Many technical analysts believe they can get a better idea of whether a market is bullish or bearish by studying the volume of shares traded ,because volume is thought to measure the intensity of investors aggregate desires.

Important Note:

Securities transactions are sometimes grouped into two categories Information trading and Liquidity trading. Sometimes a large volume of liquidity trading can take place without causing any price change. Technicians watch volume most closely on days when supply and demand appear to be moving to a new equilibrium. If high volume occurs on days when prices move up the market is considered to be bullish .High volume on days when prices are falling is a bearish sign. If the same price changes occurred with low trading volume, they would be considered less significant. When technicians feel the end of a bear market is near,they watch for a high volume of selling as the last of the bearish investors liquidate their holdings in what is called selling climax. A selling climax is supposed to eliminate the last of the bears who drive prices down and clear the way for the market to turn up. Some technicians also look for a speculative blowoff to mark the end of a bull market. A speculative blowoff is a high volume of buying that pushes prices up to a peak; it is supposed to exhaust the enthusiasm of speculators and make way for bear market .Technicians who hold this belief say that BULL MUST DIE WITH A BAND,NOT A WHIMPER

A moving average stock price is used to provide a smoothed reference value against which daily fluctuations can be compared. As a result technical analysis done with moving average is also called rateof-change analysis.

This theory was pioneered by Harry Markowitz in his paper "Portfolio Selection," published in 1952 by the Journal of Finance. A theory on how risk-averse investors can construct portfolios to optimize or maximize expected return based on a given level of market risk, emphasizing that risk is an inherent part of higher reward. Also called "portfolio theory" or "portfolio management theory." According to the theory, it's possible to construct an "efficient frontier" of optimal portfolios offering the maximum possible expected return for a given level of risk. This theory was pioneered by Harry Markowitz in his paper "Portfolio Selection," published in 1952 by the Journal of Finance. There are four basic steps involved in portfolio construction Security valuation Asset allocation Portfolio optimization Performance measurement

An investing theory, postulated by Nobel laureate James Tobin, that states that all investors should hold an identically comprised portfolio of "risky assets" combined with some percentage of risk-free assets or cash. A conservative investor would hold a higher percentage of cash, but would have the same basket of risky investments in his or her portfolio as an aggressive investor. The mutual fund theorem came about as a result of the mean-variance framework laid out by Harry Markowitz and his theories on how diversification limits portfolio risk. The viability of the mutual fund theorem has been questioned because several important assumptions must be in place for the theorem to be proved. These include a lack of transaction costs and perfectly transparent markets.

Treynor-Black Model

A type of asset allocation model that was developed by Jack Treynor and Fischer Black. The model tries to determine the optimal combination of passively and actively managed assets in an investment portfolio. When determining the optimal allocation of assets, the model focuses primarily on securities' systematic and unsystematic risk. If using the Treynor-Black model, an individual can see that the model focuses less on the Beta of a security and more on its unsystematic risk. The more unsystematic risk a security has, the less weight it is given in the Treynor-Black model. As a result of this tendency, the Treynor-Black model is said to favor low-return, low-risk securities over those with higher return and higher risk.

A mathematical formula relating to the long-term growth of capital developed by John Larry Kelly Jr. The formula was developed by Kelly while working at the AT&T Bell Laboratories. The formula is currently used by gamblers and investors to determine what percentage of their bankroll/capital should be used in each bet/trade to maximize long-term growth. [

( )

There are two key components to the formula: the winning probability factor (W) and the win/loss ratio (R). The winning probability is the probability a trade will have a positive return. The win/loss ratio is equal to the total positive trade amounts divided by the total negative trading amounts. The result of the formula will tell investors what percentage of their total capital that they should apply to each investment. After being published in 1956, the Kelly Criterion was picked up quickly by gamblers who were able to apply the formula to horse racing. It was not until later that the formula was applied to investing.

A mathematical formula used to model interest rate movements driven by a sole source of market risk. The Cox-Ingersoll-Ross model (CIR model) believes that short-term interest rates can be represented via a square root diffusion model with a mean reversion. The CIR model is often used in the valuation of interest rate derivatives. The CIR model was developed in 1985 by John C. Cox, Jonathan E. Ingersoll and Stephen A. Ross as an offshoot of the Vasicek Interest Rate model. Like the CIR model, the Vasicek model is also a one-factor modeling method. However, the Vasicek model allows for negative interest rates. This is the biggest advantage of the CIR model.

A financial model that takes into account major sources of risk when optimizing consumption over a period of time. The intertemporal capital asset pricing model (ICAPM) assumes that security returns are normally distributed over multiple time periods, and that all future consumption will be funded by security returns. ICAPM was described by Nobel laureate Robert Merton in 1973.

ICAPM is a consumption-based asset-pricing model, and it goes a step further than CAPM in taking into account how investors participate in the market. Most investors do not participate in financial markets for one year, but instead for multiple years. Over longer time periods, investment opportunities might shift as expectations of risk change, resulting in situations in which investors may wish to hedge. For example, an MANAGEMENT OF INVESTMENT BY JACK CLARK FRANCIS 3RD EDITION

7 investment may perform better in bear markets, and an investor may consider holding that asset if a downturn in the business cycle is expected. ICAPM uses mean-variance analysis to create normal distribution of consumption risk over time. Because ICAPM covers multiple time periods, multiple beta coefficients are used to determine how many security concerns covary with a basket of risky securities. A criticism of ICAPM is that it assumes that consumer expectations are homogenous, meaning that it cannot take into account individual risk preferences.

HullWhite Model

A single-factor interest model used to price derivatives. The Hull-White model assumes that short rates have a normal distribution, and that the short rates are subject to mean reversion. Volatility is likely to be low when short rates are near zero, which is reflected in a larger mean reversion in the model. The HullWhite model extends the Vasicek and Cox-Ingersoll-Ross (CIR) models.

Explanation

Investments whose values are dependent on interest rates, such as bond options and mortgage-backed securities, have grown in popularity as financial systems have become more sophisticated. Determining the value of these investments often entailed using different models, with each model having its own set of assumptions. This made it difficult to match the volatility parameters of one model with another model, and also made it difficult to understand risk across a portfolio of different investments.

Like the Ho-Lee model, the Hull-White model treats interest rates as normally distributed. This creates a scenario in which interest rates are negative, though there is a low probability of this occurring as a model output. The Hull-White model also prices the derivative as a function of the entire yield curve, rather than at a single point. Because the yield curve estimates future interest rates rather than observable market rates, analysts will hedge against different scenarios that economic conditions might create.

A model of price variation over time of financial instruments such as stocks that can, among other things, be used to determine the price of a European call option. The model assumes that the price of heavily traded assets follow a geometric Brownian motion with constant drift and volatility. When applied to a stock option, the model incorporates the constant price variation of the stock, the time value of money, the option's strike price and the time to the option's expiry.

Also known as the Black-Scholes-Merton Model. The Black Scholes Model is one of the most important concepts in modern financial theory. It was developed in 1973 by Fisher Black, Robert Merton and Myron Scholes and is still widely used today, and regarded as one of the best ways of determining fair prices of options.

There are a number of variants of the original Black-Scholes model. MANAGEMENT OF INVESTMENT BY JACK CLARK FRANCIS 3RD EDITION

Bull FRN A floating-rate note (FRN) in which the coupon moves inversely to the movement of the reference rate. That is, if the reference rate moves down, the coupon payment of a bull FRN increases, and if the reference rate moves up, the coupon payment decreases. A practical example of a bull FRN is the Lira-denominated one issued by the World Bank in December 1997 with a maturity of 12 years. For the first four years, rates were set on a decreasing scale from 12% down to 7%. For the next sever years the rate was specified by this formula: 15.5% - 2% LIBOR. This formula implies that when reference rate rises, rates fall and vice versa. A bull FRN is also known as an inverse FRN or a reverse FRN. Bear FRN A type of floating rate note where the coupon increases disproportionately in relation to increases in interest rates (cf. leverage). It is the opposite structure to a reverse floating rate note, in that the coupon payment is calculated as a multiple of the reference rate less a fixed amount. For example, such an instrument might pay three times London interbank offered rate (LIBOR) less 18%. If LIBOR was 7%, then the note would pay a coupon of 21% 18%, or 3%; if LIBOR moved to 7.25% (an increase of 3.6%), the new coupon would be 3.75% (an increase of 25%). Dual Currency Bond A debt instrument in which the coupon and principal payments are made in two different currencies. The currency in which the bond is issued, which is called the base currency, will be the currency in which interest payments are made. The principal currency and amount are fixed when the bond is issued.

A structured financial product that pools together cash flow-generating assets and repackages this asset pool into discrete tranches that can be sold to investors. A collateralized debt obligation (CDO) is so-called because the pooled assets such as mortgages, bonds and loans are essentially debt obligations that serve as collateral for the CDO. The tranches in a CDO vary substantially in their risk profile. The senior tranches are relatively safer because they have first priority on the collateral in the event of default. As a result, the senior tranches of a CDO generally have a higher credit rating and offer lower coupon rates than the junior tranches, which offer higher coupon rates to compensate for their higher default risk.

MANAGEMENT OF INVESTMENT BY JACK CLARK FRANCIS 3RD EDITION

Securities firms, who approve the selection of collateral, structure the notes into tranches and sell them to investors; CDO managers, who select the collateral and often manage the CDO portfolios; Rating agencies, who assess the CDOs and assign them credit ratings; Financial guarantors, who promise to reimburse investors for any losses on the CDO tranches in exchange for premium payments; and Investors such as pension funds and hedge funds. The earliest CDOs were constructed by Drexel Burnham Lambert the home of former junk bond king Michael Milken in 1987 by assembling portfolios of junk bonds issued by different companies. Securities firms subsequently launched CDOs for a number of other assets with predictable income streams, such as automobile loans, student loans, credit card receivables and even aircraft leases. However, CDOs remained a niche product until 2003-04, when the U.S. housing boom led the parties involved in CDO issuance to turn their attention to non-prime mortgage-backed securities as a new source of collateral for CDOs.

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