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Security Analysis & Portf olio Management
Subject: SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT Credits: 4
Overview of Investment
Concept of Investment; Various Investment Alternatives; Application of Investment Alternatives; a Case Study
on Investment Alternatives
Overview of Risk Management
Concept of Risk Management; Analysis of Risk Management; a Case Study on Risk Management
Equities in India
Basic of Stocks; Different Types of Stocks; National Stock Exchange; Trading of Equities
Trading of Securities
Introduction to Markets and their Functions; Development of Securities Market in India; SEBI and its Role in
Primary and Secondary Market; SEBI and its Functions; a Case Study on OTCBB
Analysis and Valuation of Debt and Equity
Introduction to Bonds; Embedded Options; Analysis of Bond, Relationship between Price and Yield; a Case
Study on Mirage Resorts: Refunding a Bond Issue, Various Models of Stock Valuation, Concept of Credit
Rating, Analysis of Credit Rating Framework, Rationales of Rating; Case Study: Aether Systems - Common
Stock Valuation; the Variable Growth Model
Security Analysis and Valuation: Fundamental and Technical Analysis
Stock Prices Change; its Causes; Effect of Macroeconomics Variable on Stock Market; Difference between
Technical and Fundamental Analysis; Company Analysis; Basics and usefulness of Technical Analysis; Case
Study: Coca Cola.
Efficient Market Hypothesis
Introduction; Concept of Market Efficiency; Tests of Efficient Market Hypothesis; Case Study: EBay- Stock
Introduction to Portfolio Management; Relation between Risk and Return; Optimal Portfolio; Capital Asset
Pricing Model; its Valuation and Validity; Case Study: Nations Bank - Valuation: Stock Valuation: the Gordon
Growth Model; Portfolio Evaluation; Case Study: Vanguard - Mutual Funds and Taxes.
Bonds and Bond Funds; Nate Pile’s Small Cap Classroom; Dangers of Inaction; Bond with the Best; Take your
Time to Plan Investment.
1. Security Analysis and Portfolio Management by Donald E. Fischer Ronald J. Jordan, Publisher:
Prentice-Hall of India
2. Security Analysis And Portfolio Management by V. Gangadhar, Publisher: Anmol Publications
3. Security Analysis And Portfolio Management 6th Edition, by Fischer Donald E and Jordan Ronald J,
Publisher: Prentice hall of India
4. Security Analysis And Portfolio Management by S Kevin Publisher: Prentice hall of India
OVERVIEW OF INVESTMENT
1.0 Concept Of Investment
1.1 Various Investment Alternatives
1.1.1 Application Of Investment Alternatives
1.2 CASE STUDY on Investment Alternatives
1. 3 Questions
1.0 Concept Of Investment
Investment or investing is a term with several closely-related meanings in business
management, finance and economics, related to saving or deferring consumption.
Investment is the choice by the individual to risk his savings with the hope of gain. Rather
than store the good produced, or its money equivalent, the investor chooses to use that good
either to create a durable consumer or producer good, or to lend the original saved good to
another in exchange for either interest or a share of the profits.
In the first case, the individual creates durable consumer goods, hoping the services from the
good will make his life better. In the second, the individual becomes an entrepreneur using
the resource to produce goods and services for others in the hope of a profitable sale. The
third case describes a lender, and the fourth describes an investor in a share of the business.
In each case, the consumer obtains a durable asset or investment, and accounts for that asset
by recording an equivalent liability. As time passes, and both prices and interest rates change,
the value of the asset and liability also change.
An asset is usually purchased, or equivalently a deposit is made in a bank, in hopes of getting
a future return or interest from it. The word originates in the Latin "vestis", meaning garment,
and refers to the act of putting things (money or other claims to resources) into others'
pockets. See Invest. The basic meaning of the term being an asset held to have some
recurring or capital gains. It is an asset that is expected to give returns without any work on
the asset per se.
Investing in various types of assets is an interesting activity that attracts people from all
walks of life irrespective of their occupation, economic status, education and family
background. When a person has more money than he requires for current consumption, he
would be coined as a potential investor. The investor who is having extra cash could invest it
in securities or in any other assets like or gold or real estate or could simply deposit it in his
bank account. The companies that have extra income may like to invest their money in the
extension of the existing firm or undertake new venture. All of these activities in a broader
sense mean investment.
We can define investment as the process of, “sacrificing something now for the prospect of
gaining something later”. So, the definition implies that we have four dimensions to an
investment- time, today’s sacrifice and prospective gain.
“Investments“ As Per Definition!
1. In order to settle down, a young couple buys a house for Rs.3 lakhs in Bangalore.
2. A wealthy farmer pays Rs l lakh for a piece of land in his village.
3. A cricket fan bets Rs..100 on the outcome of a test match in England.
4. A government officer buys ‘units’ of Unit Trust of India worth Rs 4,000.
5. A college professor buys, in anticipation of good return, 100 shares of Reliance
Industries Ltd. for Rs.24, 000
6. A lady clerk deposits Rs.5, 000 in a Post Office Savings Account.
7. Based on the rumour that it would be a. hot issue in the market in no distant future, our
friend John invests all his savings in the newly floated share issue of Fraternity
Electronics Ltd., a company intending to manufacture audio and video magnetic tapes
to start with, and cine sound tapes at a later stage.
A common feature of all these transactions is that something is sacrificed now for the
prospects of gaining something later. For example, the wealthy farmer in transaction 2
sacrifices Rs1 lakh now for the prospects of crop income later. The lady clerk in transaction 6
sacrifices Rs.5,000 now for the prospect of getting a larger amount later due to interest earned
on the savings account. Thus, in a broad sense, all these seven transactions Qualify as
We know that investment means sacrificing or committing Some money today in anticipation
of a financial return later. The investor indulges in a bit of speculation involved in all
investment decisions. It does not follow through that all investments are all speculative by
nature. Genuine investments are carefully thought out decisions. They involve only
calculated risks. The expected return is consistent with the underlying risk of the investment.
A genuine investor is risk averse and usually has a long-term prospective in mind.
The government officer’s investment in the units of UTI, the college professor’s Reliance
stockholding, the lady clerk’s Post Office Savings Deposit, all may be regarded as genuine
investments. Each person seems to have made carefully thought out decision and each has
only calculated risk. Speculative investments on the other hand are not carefully thought out
decisions. They are based on rumors, hot tips, inside dopes and often simply on hunches. The
risk assumed is disproportionate to the return expected from speculation. The intention is to
profit from short-term market fluctuations. In other words, a speculator is relatively less risk-
averse and has a short-term perspective for investment.
1.1 Various Investment Alternatives
The term "investment" is used differently in economics and in finance. Economists refer to a
real investment (such as a machine or a house), while financial economists refer to a financial
asset, such as money that is put into a bank or the market, which may then be used to buy a
Various Investment Alternatives as per Business management
The investment decision (also known as capital budgeting) is one of the fundamental
decisions of business management: Managers determine the investment value of the assets
that a business enterprise has within its control or possession. These assets may be physical
(such as buildings or machinery), intangible (such as patents, software, goodwill), or financial
(see below). Assets are used to produce streams of revenue that often are associated with
particular costs or outflows. All together, the manager must determine whether the net
present value of the investment to the enterprise is positive using the marginal cost of capital
that is associated with the particular area of business.
In terms of financial assets, these are often marketable securities such as a company stock (an
equity investment) or bonds (a debt investment). At times the goal of the investment is for
producing future cash flows, while at others it may be for purposes of gaining access to more
assets by establishing control or influence over the operation of a second company (the
Various Investment Alternatives as per Economics
In economics, investment is the production per unit time of goods which are not consumed
but are to be used for future production. Examples include tangibles (such as building a
railroad or factory) and intangibles (such as a year of schooling or on-the-job training). In
measures of national income and output, gross investment (represented by the variable I) is
also a component of Gross domestic product (GDP), given in the formula GDP = C + I + G +
NX, where C is consumption, G is government spending, and NX is net exports. Thus
investment is everything that remains of production after consumption, government spending,
and exports are subtracted.
Both non-residential investment (such as factories) and residential investment (new houses)
combine to make up I. Net investment deducts depreciation from gross investment. It is the
value of the net increase in the capital stock per year.
Investment, as production over a period of time ("per year"), is not capital. The time
dimension of investment makes it a flow. By contrast, capital is a stock, that is, an
accumulation measurable at a point in time (say December 31st).
Investment is often modeled as a function of Income and Interest rates, given by the relation I
= f(Y, r). An increase in income encourages higher investment, whereas a higher interest rate
may discourage investment as it becomes more costly to borrow money. Even if a firm
chooses to use its own funds in an investment, the interest rate represents an opportunity cost
of investing those funds rather than loaning them out for interest.
Various Investment Alternatives Finance
In finance, investment is the buying securities or other monetary or paper (financial) assets in
the money markets or capital markets, or in fairly liquid real assets, such as gold, real estate,
or collectibles. Valuation is the method for assessing whether a potential investment is worth
its price. Returns on investments will follow the risk-return spectrum.
Types of financial investments include shares, other equity investment, and bonds (including
bonds denominated in foreign currencies). These financial assets are then expected to provide
income or positive future cash flows, and may increase or decrease in value giving the
investor capital gains or losses.
Trades in contingent claims or derivative securities do not necessarily have future positive
expected cash flows, and so are not considered assets, or strictly speaking, securities or
investments. Nevertheless, since their cash flows are closely related to (or derived from)
those of specific securities, they are often studied as or treated as investments.
Investments are often made indirectly through intermediaries, such as banks, mutual funds,
pension funds, insurance companies, collective investment schemes, and investment clubs.
Though their legal and procedural details differ, an intermediary generally makes an
investment using money from many individuals, each of whom receives a claim on the
Within personal finance, money used to purchase shares, put in a collective investment
scheme or used to buy any asset where there is an element of capital risk is deemed an
investment. Saving within personal finance refers to money put aside, normally on a regular
basis. This distinction is important, as investment risk can cause a capital loss when an
investment is realized, unlike saving(s) where the more limited risk is cash devaluing due to
In many instances the terms saving and investment are used interchangeably, which confuses
this distinction. For example many deposit accounts are labeled as investment accounts by
banks for marketing purposes. Whether an asset is a saving(s) or an investment depends on
where the money is invested: if it is cash then it is savings, if its value can fluctuate then it is
In real estate, investment money is used to purchase property for the purpose of holding or
leasing for income and there is an element of capital risk.
Residential real estate
The most common form of real estate investment as it includes property purchased as a
primary residence. In many cases the buyer does not have the full purchase price for a
property and must engage a lender such as a bank, finance company or private lender.
Different countries have their individual normal lending levels, but usually they will fall into
the range of 70-90% of the purchase price. Against other types of real estate, residential real
estate is the least risky.
Commercial real estate
Commercial real estate consists of multifamily apartments, office buildings, retail space,
hotels and motels, warehouses, and other commercial properties. Due to the higher risk of
commercial real estate, loan-to-value ratios allowed by banks and other lenders are lower and
often fall in the range of 50-70%.
1.1.1 Application Of Investment Alternatives
Application of investment alternatives can be summarized as below:-
1. Where Not To Invest?
2. Are Company Fixed Deposits Suitable for an Increase in Investment?
3. Are Company Fixed Deposits Suitable for Income?
4. To What Extent Does a Company Deposit Protect Me Against Inflation?
5. Can I Borrow Against a Company Fixed Deposit?
6. How Assured Can I be Of Getting My Full Investment Back?
7. How Assured Is My Income?
8. Are There any Risks Unique to Company Fixed Deposits?
9. Are Company/NBFC Deposits rated for their credit Quality?
10. Buying, Selling, and Holding
11. How do I Buy a Company/NBFC Fixed Deposit?
12. What Is The Minimum Investment And The Range Of Investment for A
Company/NBFC Fixed Deposit?
13. Tax Implications?
1. Where Not To Invest?
Companies, which offer very high rates of interest, say 16% or above, when others are
• Companies with poor cash flows.
• Avoid unincorporated companies/ private limited companies, as it is difficult to judge
their performance in absence of information.
• Companies with accumulated losses on their balance sheets.
• Companies with a poor dividend paying record.
2. Are Company Fixed Deposits Suitable for an Increase in My Investment?
A Company/NBFC Fixed Deposit provides for faster appreciation in the principal amount
than bank fixed deposits and post-office schemes. However, the increase in the interest rate is
Essentially due to the fact that it entails more risk as compared to banks and post-office
3. Are Company Fixed Deposits Suitable for Income?
Yes, Company/NBFC Fixed Deposits are suitable for regular income with the option to
receive monthly, quarterly, half-yearly, and annual interest income. Moreover, the interest
rates offered are higher than banks.
4. To What Extent Does a Company Deposit Protect Me Against Inflation?
A Company/NBFC Fixed Deposit provides you with limited protection against inflation, with
comparatively higher returns than other assured return options.
5. Can I Borrow Against a Company Fixed Deposit?
Company Fixed Deposits are unsecured instruments, i.e., there are no assets backing them up.
Therefore, in case the company/NBFC goes under, chances are that you may not get your
principal sum back. It depends on the strength of the company and its ability to pay back your
deposit at the time of its maturity. While investing in an NBFC, always remember to first
check out its credit rating. Also, beware of NBFC offering ridiculously high rates of interest.
6. How Assured Can I be Of Getting My Full Investment Back?
We have to look in following things to get the answer for the same question.
• Credit rating/ reputation of the group
The rating is possibly the best way to judge the credit worthiness of a company. However, for
manufacturing company deposits, it is not mandatory to get a rating. In such cases, it is better
to check the size and reputation of the company or the industrial group it belongs to.
• Interest rate
Within the same safety level (or rating), a higher interest rate is a better option. The
difference in some cases can be as high as 1%.
The portfolio principle applies to company deposits also. It is always better to spread deposits
over different companies and industries so as to reduce risk.
• Period of deposit
The ideal period for a company deposit is 6 months to one year as it offers the liquidity
option. Also, it gives an opportunity to review the company’s performance.
• Periodic review of the company
As your principal and interest rests in the hand of the company, it is advisable to review the
company’s performance periodically. post-office schemes. However, the increase in the
interest rate is essentially due to the fact that it entails more risk as compared to banks and
7. How Assured Is My Income?
Not at all secured. Some NBFCs have known to default on their interest and principal
payments. You must check out the liquidity position and its revenue plan before investing in
8.Are There any Risks Unique to Company Fixed Deposits?
If the Company/NBFC goes under, there is no assurance of your principal amount. Moreover,
there is no guarantee of your receiving the regular-interval income from the company.
Inflation and interest rate movements are one of the major SECURITY factors affecting the
decision to invest in a Company/NBFC Fixed Deposit. Also, you must keep the safety
considerations and the company/NBFC’s credit rating and credibility in mind
Before investing in one.
9. Are Company/NBFC Deposits rated for their credit Quality?
Yes, Company/NBFC Fixed Deposits are rated by credit rating agencies like CARE, CRISIL
and ICRA. A company rated lower by credit rating agency is likely to offer a higher rate of
interest and vice-versa. An AAA rating signifies highest safety, and D or
FD means the company is in default.
10. Buying, Selling, and Holding
Buying, selling, and holding are the three steps to be taken, taking market sentiment as the
base. In bull market do hold and sell and in bear market do sell.
11. How do I Buy a Company/NBFC Fixed Deposit?
Company Fixed Deposits forms are available through various broking agencies or directly
with the companies. Similar is the case for the NBFCs Some of the options available are:-
Monthly income deposits, where interest is paid every month – Quarterly income deposits,
where interest is paid once every quarter. Cumulative deposits, where interest is accumulated
and paid along with the principal at the time of maturity. – Recurring deposits, similar to the
recurring deposits of banks.
12. What Is The Minimum Investment And The Range Of Investment for A
Company/NBFC Fixed Deposit?
Minimum investment in a Company/NBFC Fixed deposit varies from company to company.
Normally, the minimum investment is Rs 5,000. For individual investors, there is no upper
ceiling. In case of recurring deposits, the minimum amount is normally Rs 100 per month.
13. Tax Implications?
According to Section 88 of the Income Tax Act, 1961, subscription to the Tax Saving Bond
would entitle Individuals and HUFs to a rebate from Income-tax as indicated below:
Gross Total Income (Rs) Rebate
0 - 150,000 20%
150,001 - 500,000 15%
500,001 & Above Nil
• Rebate under section 88 is available on the aggregate of the sums paid or deposited up
to Rs. 1,00,000/-, including subscription to Tax Saving Bonds of the Issuer Company.
• An individual would be entitled to an enhanced rate of rebate @ 30% if his income
chargeable under the head “salaries” does not exceed Rs.1,00,000 before allowing
deduction under section 16 and is not less than 90% of the gross total income subject
to provisions under section 88 of the Income-tax Act.
1.2 CASE STUDY on Investment Alternatives
Mr. Sukhbinder Sarnal has a roadways business in Kolkata and often travels to Chandigard
and Mumbai. He has one daughter and one son, aged 14 and 15yrs respectively, and his wife
helps him in his business. After a number of tiring business trips, he is going with his family
to visit Goa and Mumbai. He strongly believes that a holiday trip with his family once in a
year makes him fit to work with full energy. No matter, even if it is expensive. Sukhbinder
also promised his wife to take the entire family to Singapore within a couple of years.
Sukhbinder loves investment but he invests to meet short-term needs. He argues that his
present investment objective is his planned trip to Singapore and a budget with a long-run
perspective does not work well. For him, budget is just a method of worrying before and after
spending money. His present investment portfolio includes Equities- 20%, Growth Funds -
20%, Income Funds-30%, Bonds- 10%, Company FDs –10%, Bank FDs- 10% Liquidity
Focus: 70%- High, Safety Focus: 30%- Low Earnings Focus: High, Tax Angle: Less taken
care of Martin D’Souza is a chemical engineer by profession. He works in a FMCG plant in
Pune and is on his way back to his home in Mumbai after spending his holidays at his in-
law’s place. His wife is a teacher in a secondary school in Pune and their twin daughters are
in 7th standard. Martin p refers spending money as and when required. He likes to follow
what Harvey Mackay, the popular business motivational speaker says “A dream is just a
dream. A goal is a dream with a plan and a deadline”.
His investment approach is first to establish a relatively large foundation of secure, low risk
investments and then move up, step by step to potentially more rewarding growth oriented
schemes. Martin believes, investment portfolio made for long-run is the best way to lay a
secure foundation for his life goals. His present investment portfolio includes Equities-10%,
Mutual Fund-20%, PPF-5%, PO-Recurring De-posit- 5%, Insurance- 20%, Bonds- 25%,
Bank FDs- 15% Liquidity Focus: 30%- Low, Safety Focus: 70%- High Earnings Focus: Less,
Tax Angle: Highly taken care of The Up, Howrah-Mumbai Geetanjail Express halts at
Raipur. This is a small station in MP where the train stops for 5 minutes during normal
Circumstances. However, a coach of another passenger train is derailed at a place 20 km from
here and Geetanjali has not been given the green signal. Most of the passengers of coach
number AS-2 are lazily lying down, except for the members of two families. Sukhbinder is
reading ‘The Tribune’. The news of YV Reddy Commission, recommending the withdrawal
of tax benefits from all types of investment avenues with tenure of less than 6 years, catches
his attention. Nimmo and Vikram (his son and daughter) are playing with his co-passenger’s
kids. His wife is sharing a cup of tea with Mrs D’Souza, co-passenger. Martin is tired of
Searching for a copy of ‘Financial Express’ at the station. He finally gives up and starts
sharing the morning news with his co-passenger cum new friend, Sukhbinder. Martin begins
by asking Sukhbinder “What do you think will be the implication, if the government decides
to withdraw tax benefits for investments of tenure less than 6 years?” wife maintains an
account in post-office scheme and surely it’s not going to be a good news for her”. Martin is
worried with this news because he has a significant amount of money invested in tax-savings
bonds. Martin agrees “That’s right, all investors like me will be badly affected with this
decision, after all you can’t rely on provident fund every time as a tax savings option because
the lock-in period is 15 years; too long”. This time Sukhbinder finds his co-passenger’s views
interesting and argues back “Martin Saab, I do not believe in these tax-savings tools. My
point is very simple; you earn money from different sources and pass 30% to government.
When, you are looking for tax-free income of 2 lakh in a year, you better look for earning of
2.9 lakh in a year and pass 30% to government. I first calculate my target tax-free income and
then find out the sources of earning additional money to cover-up the tax outflow.
It’s really troublesome to find tax-savings tool because all these kinds of tools require your
money to be blocked for a period of 3-5 years. I do not like it, because I prefer to build my
investment portfolio for an earning purpose. However, this does not mean that I am careless
of my tax burden but I prefer to ignore this kind of news items.” Martin likes Sukhbinder’s
style of thinking and smiles at him saying, “Mr Sukhbinder, I wish, everyone of us could
think like you. And then, the future of all these tax-savings bond will go for a toss, but don’t
you think, these tax-savings option play a big role in your portfolio generation?
Ultimately, you can maximize your earnings if you minimize your tax burden.”
Rule of 72
The Rule of 72 helps you estimate about how long it will take for your investments to double
given a hypothetical rate of return. Divide 72 by your rate of return (say 10% and you’ve got
your answer-seven years approximately. The Rule of 72 assumes your investments are tax
deferred and earning compound interest. Martin is curious to hear Sukhbinder’s reply this
time. Sukhbinder pauses and ignores Martin’s point “Sir, I prefer to build my investment
Portfolio for earning purpose that will be very liquid in nature; your argument of tax savings
tool does not stand good for me as that is illiquid investment”. Martin tries to counter
Sukhbinder “But, a good portfolio does not mean only good earnings or good liquidity, you
need to also consider safety of your investment and tax implication as a whole. Look at
investments in equities, they are good from liquidity angle and can give good returns, but
they fail on the safety front and any short term gains you make, you shell out a capital gains
tax of 30%”. This time Sukhbinder looks quiet cornered but is not yet ready to give up.
Sukhbinder says “You are right Mr. Martin but you can make enough money if you know
how to manage your equity investment. I invested in growth stocks and debt mutual funds.
Growth stocks are risky but my investment in debt funds will balance that risk. I’ve also
invested in tax-free bonds to minimize my tax-burden.” In the mean time, Vikram, the son of
Sukhbinder asks his father “Papa, do you know the answer to this?” Vikram is looking for an
answer to a puzzle, which he explains to his father – “There is an old lady with her pet tiger, a
goat and a stack of grass, who wants to cross a river. But there is a small problem. The lady
can not move alone anywhere. In her presence, the tiger will not attack the goat nor will the
goat consume the grass but in her absence, there is a chance that the tiger can eat the goat or
the goat can eat the grass. Now she wants to cross the river and there is only one boat, which
can take only two of them at a time. How can the lady cross the river in four attempts”.
Sukhbinder thinks for a while and tries to ignore his son saying “Beta, you ask Nimmo. She
will tell you.”
He Wanted to Convince Martin that his Portfolio is Good One as it Promises to Fetch
Best Turnings, Liquid in Nature
Sukhbinder comes back to the discussion. He wanted to convince Martin that his portfolio is
a good one as it promises to fetch best earnings, liquid in nature although it does not consider
safety and tax minimization. Sukhbinder says to Martin “ You know Mr. Martin, this
argument between portfolio for long-term and portfolio for short term always remind me one
basic question-Why do we invest?” Sukhbinder continues, “Because, we need to earn more
but more earnings are possible only if you take more risk, which in turn implies less safety.
And you also require liquidity for your investment.
Considering all these factors, there cannot be something like an ideal investment portfolio.”
Martin defends his views “No, Mr Sukhbinder, an ideal investment portfolio never clashes
with the approaches to build an ideal investment portfolio”. “ What does that mean?” asks
Sukhbinder. Martin replies “Your investment portfolio could be meant for different kinds of
objectives like one may look for regular returns from his portfolio and one may like to see his
portfolio growing consistently with time. But, even in the trajectory of these two objectives,
your approach for building the suitable portfolio must be same. That is, you need to maintain
a good balance among your earnings, safety, liquidity and tax savings. Balance is the most
Prepare an Investment Grid and compare different investment avenues available I today’s
scenario taking care of the financial objectives of Sukhbinder and Martin.
The Do’s and Dont’s of Wise Investing
1. Almost the first and last rule- DIVERSIFY: Make sure your investments are diversified.
Include different asset classes in your portfolio such as property, shares and fixed interest
2. Start conservatively: If you’re just starting out, build a firm base around Blue Chip
shares and gain experience from this. Investing in professionally managed funds is also
an excellent way to build a diversified portfolio.
3. Rome wasn’t built in a day: History shows that shares perform well over the long term,
so make sure your goals include long-term strategies.
4. Talk to an expert: If you’re a first time investor or have complex financial needs, consult
a financial advisor. As a general rule, look for an individual or group with access to high
quality research and the technical support to give you up-to-date information. Above all
choose an advisor who takes into account your personal circumstances.
Q1 The negotiable financial investment is different from the non-negotiable financial
investment in terms of:
a. Maturity period
b. Interest rate
d. Face value
Q2 Investment made on a house property is a:
a. Financial investment
b. Economic Investment
c. Non-negotiable financial investment
d. Non-financial investment
Q3 Which one of the following is not money market security
a. Treasury Bills
b. National Savings Certificate
c. Certificate of deposit
d. Commercial paper
Q4 Commercial papers are:
a. Unsecured promissory notes
b. Secured promissory notes
c. Sold at a premium
d. Issued for a period of 1-3 years.
Q5 The present (2004) interest rate of PPF is:
Q6 The particular scheme helps in deferring the tax payment:
Q7 NBFC’s offer highest interest rate because of:
a. The best management funds
b. The competition between the NBFC’s
c. The risk involved
d. The credit rating
Q8 The open-ended schemes are:
a. Open for a particular period
b. Have fixed period of maturity
c. Listed in the stock exchanges
d. Open on a continuous basis
Q9 Interval fund is:
a. Index fund
b. Open-end fund
c. A close end fund
d. A combination of close and open-end fund
Q10 Index schemes:
a. Returns equal to index returns
b. Reflect the market
c. Are income schemes
d. Are tax saving schemes
Q11 Investments is the:
a. Net additions made to the nations capital stock
b. Person’s commitment to buy a flat or a house.
c. Employment of funds on assets to earn returns.
d. Employment of funds on goods and services that are used in production process.
Q 12 To frame the investment policy the investor should have:
a. Knowledge about the company and brokers
b. Investible funds
c. Knowledge about the investment alternatives
d. Knowledge about the market with funds
Q 13 The stock is:
a. Small units of equal value called shares.
b. Expressed in terms of money
c. Expressed in terms of number of shares
d. Fully paid up and partly paid up shares.
Q 14 Capital index bonds are links with:
a. BSE index
b. NSE Nifty
c. Consumer price index
Q15 Zero coupon bonds have their origin in:
a. U.S.security market
b. Wall street
c. Japan’s security market
d. Dalal street
1(c), 2(d), 3(b), 4(a), 5(c), 6(b), 7(c),8(d), 9(d), 10(a), 11(c), 12(d), 13(b), 14(c), 15(a)
BUSINESS RISK MANAGEMENT AND COVERAGE
2.0 RISK MANAGEMENT
2.0.2 Principles of risk management
2.0.6 Potential Risk Treatment
2.1 Risk Avoidance
2.2 Risk Reduction
2.3 Risk Retention
2.4 Risk Transfer
2.5 Create a Risk Management Plan
2.7 Review and evaluation of the plan
2.8 Area of Risk Management
2.9 Enterprise Risk Management
2.10 Risk Management and Business Continuity
2.11 UCP600: Opportunity Or Challenges
2.12 CASE STUDY
2.0 Risk management
Risk management is activity directed towards the assessing, mitigating (to an acceptable
level) and monitoring of risks. In some cases the acceptable risk may be near zero. Risks can
come from accidents, natural causes and disasters as well as deliberate attacks from an
In businesses, risk management entails organized activity to manage uncertainty and threats
and involves people following procedures and using tools in order to ensure conformance
with risk-management policies.
The strategies include transferring the risk to another party, avoiding the risk, reducing the
negative effect of the risk, and accepting some or all of the consequences of a particular risk.
Some traditional risk management programs (e.g., health risk assessment) are focused on
risks stemming from physical or legal causes (e.g. natural disasters or fires, accidents,
ergonomics, death and lawsuits). Financial risk management, on the other hand, focuses on
risks that can be managed using traded financial instruments.
In ideal risk management, a prioritisation process is followed whereby the risks with the
greatest loss and the greatest probability of occurring are handled first, and risks with lower
probability of occurrence and lower loss are handled in descending order. In practice the
process can be very difficult, and balancing between risks with a high probability of
occurrence but lower loss versus a risk with high loss but lower probability of occurrence can
often be mishandled.
Intangible risk management identifies a new type of risk - a risk that has a 100% probability
of occurring but is ignored by the organization due to a lack of identification ability. For
example, when deficient knowledge is applied to a situation, a knowledge risk materializes.
Relationship risk appears when ineffective collaboration occurs. Process-engagement risk
may be an issue when ineffective operational procedures are applied. These risks directly
reduce the productivity of knowledge workers, decrease cost effectiveness, profitability,
service, quality, reputation, brand value, and earnings quality. Intangible risk management
allows risk management to create immediate value from the identification and reduction of
risks that reduce productivity.
Risk management also faces difficulties allocating resources. This is the idea of opportunity
cost. Resources spent on risk management could have been spent on more profitable
activities. Again, ideal risk management minimizes spending while maximizing the reduction
of the negative effects of risks.
2.0.2 Principles of risk management
The International Organization for Standardization identifies the following principles of risk
• Risk management should create value.
• Risk management should be an integral part of organizational processes.
• Risk management should be part of decision making.
• Risk management should explicitly address uncertainty.
• Risk management should be systematic and structured.
• Risk management should be based on the best available information.
• Risk management should be tailored.
• Risk management should take into account human factors.
• Risk management should be transparent and inclusive.
• Risk management should be dynamic, iterative and responsive to change.
• Risk management should be capable of continual improvement and enhancement.
According to the standard ISO/DIS 31000 "Risk management -- Principles and guidelines on
implementation” the process of risk management consists of several steps as follows:
Establishing the context
Establishing the context involves
1. Identification of risk in a selected domain of interest
2. Planning the remainder of the process.
3. Mapping out the following:
o The social scope of risk management
o The identity and objectives of stakeholders
o The basis upon which risks will be evaluated, constraints.
4. Defining a framework for the activity and an agenda for identification.
5. Developing an analysis of risks involved in the process.
6. Mitigation of risks using available technological, human and organizational resources.
After establishing the context, the next step in the process of managing risk is to identify
potential risks. Risks are about events that, when triggered, cause problems. Hence, risk
identification can start with the source of problems, or with the problem itself.
• Source analysis Risk sources may be internal or external to the system that is the
target of risk management. Examples of risk sources are: stakeholders of a project,
employees of a company or the weather over an airport.
• Problem analysis Risks are related to identified threats. For example: the threat of
losing money, the threat of abuse of privacy information or the threat of accidents and
casualties. The threats may exist with various entities, most important with
shareholders, customers and legislative bodies such as the government.
When either source or problem is known, the events that a source may trigger or the events
that can lead to a problem can be investigated. For example: stakeholders withdrawing during
a project may endanger funding of the project; privacy information may be stolen by
employees even within a closed network; lightning striking a Boeing 747 during takeoff may
make all people onboard immediate casualties.
The chosen method of identifying risks may depend on culture, industry practice and
compliance. Templates or the development of templates for identifying source, problem or
event forms the identification methods. Common risk identification methods are:
• Objectives-based risk identification Organizations and project teams have objectives.
Any event that may endanger achieving an objective partly or completely is identified
• Scenario-based risk identification in scenario analysis different scenarios are created.
The scenarios may be the alternative ways to achieve an objective, or an analysis of
the interaction of forces in, for example, a market or battle. Any event that triggers an
undesired scenario alternative is identified as risk - see Futures Studies for
methodology used by Futurists.
• Taxonomy-based risk identification the taxonomy in taxonomy-based risk
identification is a breakdown of possible risk sources. Based on the taxonomy and
knowledge of best practices, a questionnaire is compiled. The answers to the
questions reveal risks. Taxonomy-based risk identification in software industry can be
found in CMU/SEI-93-TR-6.
• Common-risk checking in several industries lists with known risks are available. Each
risk in the list can be checked for application to a particular situation. An example of
known risks in the software industry is the Common Vulnerability and Exposures list
found at http://cve.mitre.org.
• Risk charting (risk mapping) this method combines the above approaches by listing
Resources at risk, Threats to those resources Modifying Factors, which may increase
or decrease the risk and Consequences it is wished to avoid. Creating a matrix under
these headings enables a variety of approaches. One can begin with resources and
consider the threats they are exposed to and the consequences of each. Alternatively
one can start with the threats and examine which resources they would affect, or one
can begin with the consequences and determine which combination of threats and
resources would be involved to bring them about.
Once risks have been identified, they must then be assessed as to their potential severity of
loss and to the probability of occurrence. These quantities can be either simple to measure, in
the case of the value of a lost building, or impossible to know for sure in the case of the
probability of an unlikely event occurring. Therefore, in the assessment process it is critical to
make the best educated guesses possible in order to properly prioritize the implementation of
the risk management plan.
The fundamental difficulty in risk assessment is determining the rate of occurrence since
statistical information is not available on all kinds of past incidents. Furthermore, evaluating
the severity of the consequences (impact) is often quite difficult for immaterial assets. Asset
valuation is another question that needs to be addressed. Thus, best educated opinions and
available statistics are the primary sources of information. Nevertheless, risk assessment
should produce such information for the management of the organization that the primary
risks are easy to understand and that the risk management decisions may be prioritized. Thus,
there have been several theories and attempts to quantify risks. Numerous different risk
formulae exist, but perhaps the most widely accepted formula for risk quantification is:
Rate of occurrence multiplied by the impact of the event equals risk
Later research has shown that the financial benefits of risk management are less dependent on
the formula used but are more dependent on the frequency and how risk assessment is
In business it is imperative to be able to present the findings of risk assessments in financial
terms. Robert Courtney Jr. (IBM, 1970) proposed a formula for presenting risks in financial
terms. The Courtney formula was accepted as the official risk analysis method for the US
governmental agencies. The formula proposes calculation of ALE (annualized loss
expectancy) and compares the expected loss value to the security control implementation
costs (cost-benefit analysis).
2.0.6 Potential risk treatments
Once risks have been identified and assessed, all techniques to manage the risk fall into one
or more of these four major categories.
• Avoidance (eliminate)
• Reduction (mitigate)
• Transfer (outsource or insure)
• Retention (accept and budget)
Ideal use of these strategies may not be possible. Some of them may involve trade-offs that
are not acceptable to the organization or person making the risk management decisions.
Another source, from the US Department of Defense, Defense Acquisition University, calls
these categories ACAT, for Avoid, Control, Accept, or Transfer. This use of the ACAT
acronym is reminiscent of another ACAT (for Acquisition Category) used in US Defense
industry procurements, in which Risk Management figures prominently in decision-making
2.1 Risk avoidance
Includes not performing an activity that could carry risk. An example would be not buying a
property or business in order to not take on the liability that comes with it. Another would be
not flying in order to not take the risk that the airplane were to be hijacked. Avoidance may
seem the answer to all risks, but avoiding risks also means losing out on the potential gain
that accepting (retaining) the risk may have allowed. Not entering a business to avoid the risk
of loss also avoids the possibility of earning profits.
2.2 Risk reduction
Involves methods that reduce the severity of the loss or the likelihood of the loss from
occurring. For example, sprinklers are designed to put out a fire to reduce the risk of loss by
fire. This method may cause a greater loss by water damage and therefore may not be
suitable. Halon fire suppression systems may mitigate that risk, but the cost may be
prohibitive as a strategy.
Modern software development methodologies reduce risk by developing and delivering
software incrementally. Early methodologies suffered from the fact that they only delivered
software in the final phase of development; any problems encountered in earlier phases meant
costly rework and often jeopardized the whole project. By developing in iterations, software
projects can limit effort wasted to a single iteration.
Outsourcing could be an example of risk reduction if the outsourcer can demonstrate higher
capability at managing or reducing risks.
In this case companies outsource only some of
their departmental needs. For example, a company may outsource only its software
development, the manufacturing of hard goods, or customer support needs to another
company, while handling the business management itself. This way, the company can
concentrate more on business development without having to worry as much about the
manufacturing process, managing the development team, or finding a physical location for a
2.3 Risk retention
Involves accepting the loss when it occurs. True self insurance falls in this category. Risk
retention is a viable strategy for small risks where the cost of insuring against the risk would
be greater over time than the total losses sustained. All risks that are not avoided or
transferred are retained by default. This includes risks that are so large or catastrophic that
they either cannot be insured against or the premiums would be infeasible. War is an example
since most property and risks are not insured against war, so the loss attributed by war is
retained by the insured. Also any amounts of potential loss (risk) over the amount insured are
retained risk. This may also be acceptable if the chance of a very large loss is small or if the
cost to insure for greater coverage amounts is so great it would hinder the goals of the
organization too much.
2.4 Risk transfer
In the terminology of practitioners and scholars alike, the purchase of an insurance contract is
often described as a "transfer of risk." However, technically speaking, the buyer of the
contract generally retains legal responsibility for the losses "transferred", meaning that
insurance may be described more accurately as a post-event compensatory mechanism. For
example, a personal injuries insurance policy does not transfer the risk of a car accident to the
insurance company. The risk still lies with the policy holder namely the person who has been
in the accident. The insurance policy simply provides that if an accident (the event) occurs
involving the policy holder then some compensation may be payable to the policy holder that
is commensurate to the suffering/damage.
Some ways of managing risk fall into multiple categories. Risk retention pools are technically
retaining the risk for the group, but spreading it over the whole group involves transfer
among individual members of the group. This is different from traditional insurance, in that
no premium is exchanged between members of the group up front, but instead losses are
assessed to all members of the group.
2.5 Create a risk-management plan
Select appropriate controls or countermeasures to measure each risk. Risk mitigation needs to
be approved by the appropriate level of management. For example, a risk concerning the
image of the organization should have top management decision behind it whereas IT
management would have the authority to decide on computer virus risks.
The risk management plan should propose applicable and effective security controls for
managing the risks. For example, acquiring and implementing antivirus software could
mitigate an observed high risk of computer viruses. A good risk management plan should
contain a schedule for control implementation and responsible persons for those actions.
According to ISO/IEC 27001, the stage immediately after completion of the Risk Assessment
phase consists of preparing a Risk Treatment Plan, which should document the decisions
about how each of the identified risks should be handled. Mitigation of risks often means
selection of security controls, which should be documented in a Statement of Applicability,
which identifies which particular control objectives and controls from the standard have been
selected, and why.
Follow all of the planned methods for mitigating the effect of the risks. Purchase insurance
policies for the risks that have been decided to be transferred to an insurer, avoid all risks that
can be avoided without sacrificing the entity's goals, reduce others, and retain the rest.
2.7 Review and evaluation of the plan
Initial risk management plans will never be perfect. Practice, experience, and actual loss
results will necessitate changes in the plan and contribute information to allow possible
different decisions to be made in dealing with the risks being faced.
Risk analysis results and management plans should be updated periodically. There are two
primary reasons for this:
1. To evaluate whether the previously selected security controls are still applicable and
2. To evaluate the possible risk level changes in the business environment. For example,
information risks are a good example of rapidly changing business environment.
If risks are improperly assessed and prioritized, time can be wasted in dealing with risk of
losses that are not likely to occur. Spending too much time assessing and managing unlikely
risks can divert resources that could be used more profitably. Unlikely events do occur but if
the risk is unlikely enough to occur it may be better to simply retain the risk and deal with the
result if the loss does in fact occur.
Prioritizing too highly the risk management processes could keep an organization from ever
completing a project or even getting started. This is especially true if other work is suspended
until the risk management process is considered complete.
It is also important to keep in mind the distinction between risk and uncertainty. Risk can be
measured by impacts x probability.
2.8 Areas of risk management
As applied to corporate finance, risk management is the technique for measuring, monitoring
and controlling the financial or operational risk on a firm's balance sheet. See value at risk.
The Basel II framework breaks risks into market risk (price risk), credit risk and operational
risk and also specifies methods for calculating capital requirements for each of these
2.9 Enterprise risk management
In enterprise risk management, a risk is defined as a possible event or circumstance that can
have negative influences on the enterprise in question. Its impact can be on the very
existence, the resources (human and capital), the products and services, or the customers of
the enterprise, as well as external impacts on society, markets, or the environment. In a
financial institution, enterprise risk management is normally thought of as the combination of
credit risk, interest rate risk or asset liability management, market risk, and operational risk.
In the more general case, every probable risk can have a pre-formulated plan to deal with its
possible consequences (to ensure contingency if the risk becomes a liability).
From the information above and the average cost per employee over time, or cost accrual
ratio, a project manager can estimate:
• The cost associated with the risk if it arises, estimated by multiplying employee costs
per unit time by the estimated time lost
• the probable increase in time associated with a risk Sorting on this value puts the
highest risks to the schedule first. This is intended to cause the greatest risks to the
project to be attempted first so that risk is minimized as quickly as possible.
• This is slightly misleading as schedule variances with a large P and small S and vice
versa is not equivalent. (The risk of the RMS Titanic sinking vs. the passengers' meals
being served at slightly the wrong time).
• The probable increase in cost associated with a risk (cost variance due to risk, Rc
where Rc = P*C = P*CAR*S = P*S*CAR)
o Sorting on this value puts the highest risks to the budget first.
o see concerns about schedule variance as this is a function of it, as illustrated in
the equation above.
Risk in a project or process can be due either to Special Cause Variation or Common Cause
Variation and requires appropriate treatment. That is to re-iterate the concern about extreme
cases not being equivalent in the list immediately above.
Risk-management activities as applied to project management
In project management, risk management includes the following activities:
Planning how risk will be managed in the particular project. Plan should include risk
management tasks, responsibilities, activities and budget.
Assigning a risk officer - a team member other than a project manager who is responsible
for foreseeing potential project problems. Typical characteristic of risk officer is a healthy
Maintaining live project risk database. Each risk should have the following attributes:
opening date, title, short description, probability and importance. Optionally a risk may
have an assigned person responsible for its resolution and a date by which the risk must
Creating anonymous risk reporting channel. Each team member should have possibility to
report risk that he foresees in the project.
Preparing mitigation plans for risks that are chosen to be mitigated. The purpose of the
mitigation plan is to describe how this particular risk will be handled – what, when, by
who and how will it be done to avoid it or minimize consequences if it becomes a
Summarizing planned and faced risks, effectiveness of mitigation activities, and effort
spent for the risk management.
2.10 Risk management and business continuity
Risk management is simply a practice of systematically selecting cost effective approaches
for minimizing the effect of threat realization to the organization. All risks can never be fully
avoided or mitigated simply because of financial and practical limitations. Therefore all
organizations have to accept some level of residual risks.
Whereas risk management tends to be preemptive, business continuity planning (BCP) was
invented to deal with the consequences of realized residual risks. The necessity to have BCP
in place arises because even very unlikely events will occur if given enough time. Risk
management and BCP are often mistakenly seen as rivals or overlapping practices. In fact
these processes are so tightly tied together that such separation seems artificial. For example,
the risk management process creates important inputs for the BCP (assets, impact
assessments, cost estimates etc). Risk management also proposes applicable controls for the
observed risks. Therefore, risk management covers several areas that are vital for the BCP
process. However, the BCP process goes beyond risk management's preemptive approach and
moves on from the assumption that the disaster will realize at some point.
2.11 UCP600: OPPORTUNITIES OR CHALLENGES?
The UCP is a set of rules on the issuance and use of letters of credit that is
Contemporaneously utilized by bankers and commercial parties in international sale and
purchase transactions in more than 175 countries
Historically letters of credit were so often used in international trade that commercial parties,
particularly banks, and had developed their own varied and diverse techniques and methods
for handling letters of credit in international trade finance. Faced with uncertain trade
practices in different quarters, these differing practices were standardized by the International
Chamber of Commerce (ICC) by first publishing the Uniform Customs and Practice for
Documentary Credits (UCP) in 1933. Subsequently through the years, the ICC have taken
upon themselves the arduous task of updating the same to best reflect the contemporaneous
reality of international trade in these documents of finance and credit.
The UCP is a set of norms and formalities – and interestingly for the first time in the history
of the UCP in their latest revision of the same, they term themselves as “Rules” – on the
issuance and usage of letters of credit that is contemporaneously incorporated by bankers and
commercial parties alike in international sale and purchase transactions in more than 175
countries. Recent surveys show that about 11-15% of international trade utilizes letters of
credit, totaling more than a trillion US dollars per annum.
At the outset, it is worth reminding the reader that as much as they are universally applied,
the UCP are not automatically incorporated into every letter of credit. Article 1 clearly states
that the Rules will only apply “when the text of the credit expressly indicates that it is subject
to these rules”.
The advantage in incorporating such provisions is quite clear: i) the seller will know in
advance the criteria against which he will be paid and ii) the buyer will know the criteria
against which the price will be paid. However, no authority or conflicting opinions in the
commentaries can be found to impose a duty on the buyer to necessarily open a letter of
credit subject to the UCP600. In this scenario it is thus in the best interest of the party who
wish to incorporate the Rules to expressly stipulate in the sale contract for the application of
the UCP600 to the letter of credit. De Plano, incorporation leads to the point of derogation.
As the Rules can only apply if they are incorporated into the letter of credit, it must follow as
a corollary that the parties can choose to derogate from any part of them as well. And again
they can do so by agreement – cfr. art. 1 “unless expressly modified or excluded by the
credit” – and again they must so agree in the sale contract. The draftsmen of the ICC have in
their revision paid attention to clarify the default position of the credit as a revocable or
irrevocable one. By assuming a credit was irrevocable if it failed to describe itself, the
previous UCP500 favored irrevocable over revocable credits, but still expressly contemplated
their application to revocable letters of credit.
By mean of art. 2 instead, the UCP600 define the “Credit” as “any arrangements, howsoever
named or described, that is irrevocable” and art. 3 state that a credit is irrevocable “even if
there is no indication to that effect”. The default type of credit in the new Rules is thus now
an irrevocable credit, and only an implicit possibility for the opening of revocable credits is
left. Under this new provision, the advantages for sellers are quite obvious: because of the
new default position, a buyer cannot be tempted to open a revocable letter of credit, even in
the silence of the sale contract on the point.
This latest UCP revision has had the general aim of addressing “developments in the banking,
transport and insurance industries”. However, the main reason for this review can be seen as
a general improvement of the language and style so as to propagate and increase the
consistent application and interpretation of the Rules in an attempt to stem the rate of
unnecessary rejections of documentary tenders by financial institutions.
In fact, under the present UCP500 regime, the best way for banks to avoid further risk is to
reject the presented documents and refuse the payment. Surveys have shown that as much as
70% of the documents tendered at first presentation were rejected. And this is because
avoidance of risks is the first priority for the issuing bank.
But, is avoidance of risk a priority for traders as well? It seems not, as closing the deal is the
real purpose and function of the letter of credit itself and the letter of credit is an instrument
of payment. Buyers are absolutely in need of the shipment, and the moment the issuing bank
issues the letter of credit, it signifies the intention of the buyer to purchase and to pay.
Likewise, when the seller tenders the required document, he agrees to accept the payment
from the buyer.
Article 14 is particularly of interest to banks as it establishes the basic responsibility of the
banks to examine the documents tendered under the letter of credit. Article 14(a) imposes the
duty to examine the documents in order “to determine, on the basis of the documents alone,
whether or not the documents appear on their face to constitute a complying presentation”. It
is worth noting that the “reasonable care” to be exercised under the UCP500 regime has now
been omitted. However, it is still too early to predict whether such an omission will lead to
any substantial difference in the way this duty will be construed by the banks.
This being in fact the duty to ascertain whether the documents appear to conform, such a duty
should not be construed to be any more stringent than the exercise of reasonable care
previously imposed. It therefore seems to be plausible that the banks will continue to exercise
reasonable care rather than any more rigid duty of examination.
A possible major change is instead inherent in article 14(b). This new article defines the
number of days required to hold the documents for processing or examining by banks. The
“reasonable time” in article 13(b) of UCP500 that led to a number of disputes – and hence
uncertainty – has been eliminated and a more welcome, even if not very precise, five banking
days will be used under the UCP600. Further the stipulated time will now begin to count
from the day of presentation, and hence the “day of receipt of the documents” will no longer
be the starting point of the period.
The definition of banking days though is not extremely accurate as art. 2 defines it as “a day
on which a bank is regularly open at the place at which an act subject to those rules is to be
performed” and even if the omission of the phrase “reasonable time” may have resolved
differences in interpretation between different Courts, at this point we cannot be sure whether
a new problem may arise.
But one of the most important issues is the linkage between the documents tendered, i.e. the
Provisions of art. 14(d) and (e) and the degree to which inconsistencies between the
documents tendered are to constitute a discrepancy preventing payment, as under the
UCP500 a large number of rejection was based on inconsistencies between documents. It will
be interesting to see if the new wording will be interpreted as a mere explanation of the old
art. 13, or if a purpose for such a detailed change will be looked for and banks will
accordingly be obliged to be far more rigorous in scrutinizing the data in each document
tendered. As the aim of the revision is to curtail the rate of rejection, it is hoped this article
will be read as an explanation rather than an extension.
Another interesting decision that has been incorporated under the new UCP 600 and that
better clarifies the duties of a bank in screening the documents is that with regard to non-
documentary requirements. Under the regime of the UCP500 in fact, the rule that the bank
would ignore such requirements was in some way mitigated by Position Paper No.3 by means
of which only those no documentary conditions which could not be implicitly connected to a
document listed for tender were to be disregarded by the bank. It is clear from the above that
the position was unnecessarily complicated, and also because the Position Papers issued
under the UCP500 will not be applicable under the UCP600, it seems clear that since July the
banks will disregard all non documentary requirements (cfr. art. 14(h): “banks will deem such
conditions as not stated and will disregard them”). The practical consequence is that where a
buyer is particularly keen on a condition (i.e., age or class of carrying vessel), he must
exercise greater care in formulating the documentary requirement. Undoubtedly, this revision
will make it easier for bankers and traders to incorporate the UCP in their business
As in any contract, the Definitions and Interpretations are helpful, and the changes
highlighted above are of course welcome and will contribute in making letters of credit an
even safer and standardized payment term for contract between buyers and sellers. Traders
are still to be aware though that the main contract is and remain the sale contract, hence it has
to be clear and specific in relation to the letter of credit requirements as this is the first and
most important step to reduce the possibilities of rejection.
2.12 CASE STUDY- Wal-Mart
Marvin Brown is a savvy investor who is always looking for a sound company to include in
his portfolio of stocks and bonds. Being somewhat risk-averse, his main objective is to buy
stock in firms that are mature and well-established in their respective industries. Wal-Mart is
one of the stocks Marv is currently considering for inclusion in his portfolio.
Wal-Mart has four major areas of business: traditional Wal-Mart discount stores,
Supercenters, Sam’s Clubs, and international operations. Although Wal-Mart was established
over 50 years ago, it continues to achieve growth through expansion. The Supercenter
concept, which combines groceries and general merchandise, is extreme success as were
converted to Sam’s stores in 1995. In addition to taking over competitor stores, Sam’s also
opened 22 new stores of its own. Internationally, the picture is equally as rosy. In Canada,
122 former Woolco stores were converted to Wal-Mart discount stores. Expansion has
reached Mexico and Hong Kong as well, as 24 Clubs and Super centers and 3 “Value Clubs”
were established, respectively.
Wal-Mart plans to continue its reign as the world’s largest retailer through expansion by
developing the previously discussed 95 Wal-Mart discount stores, 12 new Super centers and
9 new Sam’s Clubs. Internationally, 20 to 25 new stores will be built in Hong Kong, China,
Argentina, Brazil and Canada. In order to determine if Wal-Mart is a “good buy,” Marv has
to perform several analyses. First, he must calculate the returns on Wal-Mart’s common stock
over the past eight quarters as an indicator of how the stock might perform over the next year.
He must then calculate the standard deviation of the stock as a proxy for its risk. To aid in his
calculation, Marv has gathered the following stock price and dividend data.
• Calculate the returns for each of the seven quarters.
• Calculate the standard deviation of the returns from
Assume that Wal-Mart has a Beta of 1.2, the risk-free rate of interest (i.e. as proxied by the
return on a 3-month treasury bill) is 5.25%, and the return on the market is 12.2% annually
(as proxied by the return on the Standard & Poor’s 500). Based on CAPM, what is the
required rate of return on Wal-Mart’s stock?
EQUITIES IN INDIA
3.1 Basic Of Stock
3.2 Different Type Of Stock
3.3 National Stock Exchange
3.4 Trading In Equities
3.1 Basic Of Stock
In business and finance, a share (also referred to as equity share) of stock means a share of
ownership in a corporation (company). In the plural, stocks is often used as a synonym for
shares especially in the United States, but it is less commonly used that way outside of North
In the United Kingdom, South Africa, and Australia, stock can also refer to completely
different financial instruments such as government bonds or, less commonly, to all kinds of
The Definition of a Stock
Plain and simple, stock is a share in the ownership of a company. Stock represents a claim on
the company’s assets and earnings. As you acquire more stock, your ownership stake in the
company becomes greater. Whether you say shares, equity, or stock, it all means the same
thing. Being an Owner Holding a company’s stock means that you are one of the many
owners (shareholders) of a company, and, as such, you have a claim (albeit usually very
small) to everything the company owns. Yes, this means that technically you own a tiny
sliver of every piece of furniture, every trademark, and every contract of the company. As an
owner, you are entitled to your share of the company’s earnings as well as any voting rights
attached to the stock.
A stock is represented by a stock certificate. This is a fancy piece of paper that is proof of
your ownership. In today’s computer age, you won’t actually get to see this document
because your brokerage keeps these records electronically, which is also known as holding
shares “in street name.” This is done to make the shares easier to trade. In the past when a
person wanted to sell his or her shares, that person physically took the certificates down to
the brokerage. Now, trading with a click of the mouse or a phone call makes life easier for
Being a shareholder of a public company does not mean you have a say in the day-to-day
running of the business. Instead, one vote per share to elect the board of directors at annual
meetings is the extent to which you have a say in the company.
For instance, being a Microsoft shareholder doesn’t mean you can call up Bill Gates and tell
him how you think the company should be run. In the same line of thinking, being a
shareholder of Anheuser Busch doesn’t mean you can walk into the factory and grab a free
case of Bud Light! The management of the company is supposed to increase the value of the
firm for shareholders. If this doesn’t happen, the shareholders can vote to have the
management removed—well, this is the theory anyway. In reality, individual investors like
you and I don’t own enough shares to have a material influence on the company. It’s really
the big boys like large institutional investors and billionaire entrepreneurs who make the
Shareholders not being able to manage the company aren’t too big a deal. After all, the idea is
that you don’t want to have to work to make money, right? The importance of being a
shareholder is that you are entitled to a portion of the company’s profits and have a claim on
assets. Profits are sometimes paid out in the form of dividends. The more shares you own, the
larger the portion of the profits you get. Your claim on assets is only relevant if a company
goes bankrupt. Incase of stock ownership is your claim on assets and earnings. Without this,
the stock wouldn’t be worth the paper it’s printed on.
Another extremely important feature of stock is its limited liability, which means that, as an
owner of a stock, you are not personally liable if the company is not able to pay its debts.
Other companies such as partnerships are set up so that if the partnership goes bankrupt the
creditors can come after the partners (shareholders) personally and sell off their house, car,
furniture, etc. Owning stock means that, no matter what, the maximum value you can lose is
the value of your investment. Even if a company of which you are a shareholder goes
bankrupt, you can never lose your personal assets.
Debt vs. Equity
Why does a company issue stock? Why would the founders share the profits with thousands
of people when they could keep profits to themselves? The reason is that at some point every
company needs to raise money. To do this, companies can either borrow it from somebody or
raise it by selling part of the company, which is known as issuing stock. A company can
borrow by taking a loan from a bank or by issuing bonds. Both methods fit under the
umbrella of “debt financing.” On the other hand, issuing stock is called “equity financing.”
Issuing stock is advantageous for the company because it does not require the company to
pay back the money or make interest payments along the way. All that the shareholders get in
return for their money is the hope that the shares will some day is worth more. The first sale
of a stock, which is issued by the private company itself, is called the initial public offering
It is important that you understand the distinction between a company financing through debt
and financing through equity. When you buy a debt investment such as a bond, you are
guaranteed the return of your money (the principal) along with promised interest payments.
This isn’t the case with an equity investment. By becoming an owner, you assume the risk of
the company not being successful. Just as a small business owner isn’t guaranteed a return,
neither is a shareholder. As an owner your claim on assets is lesser than that of creditors. This
means that if a company goes bankrupt and liquidates, you, as a shareholder, don’t get any
money until the banks and bondholders have been paid out; we call this absolute priority.
Shareholders earn a lot if a company is successful, but they also stand to lose their entire
investment if the company isn’t successful.
It must be emphasized that there are no guarantees when it comes to individual stocks. Some
companies pay out dividends, but many others do not. And there is no obligation to pay out
dividends even for those firms that have traditionally given them. Without dividends an
investor can make money on a stock only through its appreciation in the open market. On the
downside, any stock may go bankrupt, in which case your investment is worth nothing.
Although risk might sound all negative, there is also a bright side. Taking-on greater risk
demands a greater return on your investment. This is the reason why stocks have historically
outperformed other investments such as bonds or savings accounts. Over the long term, an
investment in stocks has historically had an average return of around 10%-12%. A great
proof of the power of owning equities is General Electric.
3.2 Different Types of Stock
There are two main types of stocks: common stock and preferred stock.
Common stock is, well, common. When people talk about stocks in general they are most
likely referring to this type. In fact, the majority of stock issued is in this form. We basically
went over features of common stock in the last section. Common shares represent ownership
in a company and a claim (dividends) on a portion of profits. Investors get one vote per share
to elect the board members, who oversee the major Decisions made by management. Over the
long term, common stock, by means of capital Growth, yields higher returns than almost
every other investment. his higher return comes at a cost since common stocks entail the most
risk. If a company goes bankrupt and liquidates, the common shareholders will not receive
money until the creditors, bondholders, and preferred shareholders are paid.
Preferred stock represents some degree of ownership in a company but usually doesn’t come
with the same voting rights. (This may vary depending on the company.) With preferred
shares investors are usually guaranteed a fixed dividend forever in the event of liquidation
preferred shareholders are paid off before the common shareholder (but still after debt
holders). Preferred stock may also be callable, meaning that the company has the option to
purchase the shares from shareholders at anytime for any reason (usually for a premium).
Some people consider preferred stock to be more like debt than equity. A good way to think
of these kinds of shares is to see hem as being in between bonds and common shares.
How Stocks Trade?
Most stocks are traded on exchanges, which are places where buyers and sellers meet and
decide on a price. Some exchanges are physical locations where transactions are carried out
on a trading floor. You’ve probably seen pictures of a trading floor, in which traders are
wildly throwing their arms up, waving, yelling, and signaling to each other. The other type of
exchange is virtual, composed of a network of computers where trades are made
The purpose of a stock market is to facilitate the exchange of securities between buyers and
sellers, thus reducing the risks of investing. Just imagine how difficult it would be to sell
shares if you had to call around the neighborhood trying to find a buyer. Really, a stock
market is nothing more than a super-sophisticated farmers market linking buyers and sellers.
Before we go on, we should distinguish between the “primary” market and the “secondary”
market. The primary market is where securities are created (by means of an IPO) while, in the
secondary market, investors trade previously issued securities without the involvement of the
issuing-companies. The secondary market is what people are referring to when they talk
about “the stock market.” It is important to understand that the trading of a company’s stock
does not directly involve that company. To learn more about this, lets go in depth of “Where
Securities Are Traded.”
The New York Stock Exchange
The most prestigious exchange in the world is the New York Stock Exchange (NYSE). 24
New York City stockbrokers and merchants founded the “Big Board” over 200 years ago in
1792 with the signing of the Buttonwood Agreement. Currently the NYSE, with stocks like
General Electric, McDonald’s, Citigroup, Coca-Cola, Gillette, and Wal-mart, is the market of
choice for the largest companies in America. The NYSE is the first type of exchange where
much of the trading is done face-to-face on a trading floor. This is also referred to as a
“listed” exchange. Orders come in through brokerage firms that are members of the exchange
and flow down to floor brokers who go to a specific spot on the floor where the stock trades.
At this location, known as the trading post, there is a specific person known as the
“specialist” whose job is to match buyers and sellers. Prices are determined using an auction
method: the current price is the highest amount any buyer is willing to pay and the lowest
price at which someone is willing to sell. Once a trade has been made, the details are sent
back to the brokerage firm, who then notifies the investor who placed the order. Although
there is human contact in this process, don’t think that the NYSE is still in the Stone Age;
computers do play a huge role in the process.
The Nasdaq/ (OTC)
The second type of exchange is the virtual sort called an over-the-counter (OTC) market, of
which the Nasdaq is the most popular. (OTC is when security is not traded on an exchange,
usually due to an inability to meet listing requirements. For such securities, brokers/dealers
negotiate directly with one another over computer networks and by phone.) These markets
have no central location or floor brokers whatsoever. Trading is done through a computer and
telecommunications network of dealers. It used to be that the largest companies were listed
only on the NYSE while all other “second tier” stocks traded on the other exchanges. The
tech boom of the late 90s changed all this; now the Nasdaq is home to several big technology
companies such as Microsoft, Cisco, Intel, Dell, and Oracle. This has resulted in the Nasdaq
becoming a serious competitor to the NYSE.
On the Nasdaq brokerages act as “market makers” for various stocks. A market maker
provides continuous bid and ask prices within a prescribed percentage spread for shares for
which they are designated to make a market. They may match up buyers and sellers directly
but usually they will maintain an inventory of shares to meet demands of investors. We won’t
get into the process here since we cover this in detail in our tutorial entitled “Electronic
Trading and Market Makers.”
Who are Market Makers in Nasdaq?
Market makers keep the financial markets running efficiently because they are willing to
quote both bid and offer prices for an asset. There are over 500 member firms that act as
Nasdaq Market Makers Some examples of major market maker firms are J.P. Morgan,
Etrade, and Lehman Bros.
What is a Bid Price?
An offer made by an investor, trader, or dealer to buy a security
What is a Ask Price?
The price at which a market maker is willing to sell a security.
Mumbai Stock Exchange (BSE)
The Stock Exchange, Bombay, which was established in 1875 as The Native Share and
Stockbrokers’ Association, is the oldest Stock Exchange in Asia, even older than the Tokyo
Stock Exchange, which was founded in 1878. The Stock Exchange, Bombay, is the most
active stock market in India counting for over 70 percent of the listed capital and 90 percent
of market capitalisation - as such, it is the premier Stock Exchange in India.
Trading System at BSE
Till Now, buyers and sellers used to negotiate face-to-face on the trading floor over a security
until agreement was reached and a deal was struck in the open outcry system of trading, that
used to take place in the trading ring. The transaction details of the account period (called
settlement period) were submitted for settlement by members after each trading session. The
computerized settlement system initiated the netting and clearing process by providing on a
daily basis statements for each member, showing matched and unmatched transactions.
Settlement processing involves computation of each member’s net position in each security,
after taking into account all transactions for the member during the settlement period, which
is 10 working days for group ‘A’ securities and 5 working days for group ‘B’ securities.
Trading is done by members and their authorized assistants from their Trader Work Stations
(TWS) in their offices, through the BSE On-Line Trading (BOLT) system. BOLT system has
replaced the open outcry system of trading. BOLT system accepts two-way quotations from
jobbers, market and limit orders from client-brokers and matches them according to the
matching logic specified in the Business Requirement Specifications BRS document for this
system. The matching logic for the Carry-Forward System as in the case of the regular
trading system is quote driven with the order book functioning as an “auxiliary jobber”.
Securities traded on BSE are classified into three groups, namely, specified shares or ‘A’
group and non-specified securities that are sub-divided into ‘B1’ and ‘B2’ groups. Presently,
equity shares of thirty-two companies are classified as specified shares. These companies
typically have a large capital base with widespread shareholding, a steady dividend, good
growth record and a large volume of business in the secondary market. Contracts in this
group are allowed to be carried over to subsequent settlements upto a maximum permissible
period of 75 days.
Settlement of transactions is done on an ‘Account Period’ basis. The period is a calendar
week in the case of ‘A’ and ‘B1’ groups and 14 calendar days in the case of ‘B2’ group.
During an account period, buy or sell positions in a particular security can be either squared
up by entering into contra transactions or can be further accumulated by entering into more
buy or sell transactions.
The Exchange compiles four indices, which are based on market capitalization. The first
index to be compiled was the BSE Sensitive Index with 1978-79 as the base year. It
comprises of equity shares of 30 companies from both specified and nonspecified securities
groups. The companies have been selected on the basis of market activity. Subsequently, a
more broad based index, BSE National Index with 1983-84 as base year, was compiled. This
index is made up of 100 scrips, 98 of which are quoted on Bombay. This index also includes
prices on the other major stock exchanges of Delhi, Calcutta, Ahmedabad and Madras. If
scrip is actively quoted on more than one Exchange the average price of the scrip is used in
the compilation of the index.
3.3 National Stock Exchange (NSE)
The National Stock Exchange (NSE), located in Bombay, is India’s first debt market. It was
set up in 1993 to encourage stock exchange reform through system modernization and
competition. It opened for trading in mid-1994. It was recently accorded recognition as a
stock exchange by the Department of Company Affairs. The instruments traded are, treasury
bills, government security and bonds issued by public sector companies.
The National Stock Exchange of India Limited has genesis in the report of the High Powered
Study Group on Establishment of New Stock Exchanges, which recommended Promotion of
a National Stock Exchange by financial institutions (FIs) to provide access to investors from
all across the country on an equal footing. Based on the recommendations, NSE was
promoted by leading Financial Institutions at the behest of the Government of India and was
incorporated in November 1992 as a tax-paying company unlike other stock exchanges in the
country. On its recognition as a stock exchange under the Securities Contracts (Regulation)
Act, 1956 in April 1993, NSE commenced operations in the Wholesale Debt Market (WDM)
segment in June 1994. The Capital Market (Equities) segment commenced operations in
November 1994 and operations in Derivatives segment commenced in June 2000.
Securities Exchange Board Of India (SEBI): What Role Does it Play?
The Controller of Capital Issue (CCI) formed under the Capital Issues Control Act controlled
Upto 1992, the capital primary market. During that period, the pricing of capital issues was
controlled by CCI. The premium on issue of equity shares issued through the primary
markets was done in accordance with the Capital Issues Control Act.
The CCI guidelines were abolished with the introduction of Securities & Exchange Board of
India (SEBI) formed under the SEBI Act, 1992 with the prime objective of protecting the
interests of investors in securities, promoting the development of, and regulating, the
securities market and for matters connected therewith or incidental thereto.’
The SEBI Act came into force on 30th January 1992 and with its establishment, all public
issues are governed by the rules & regulations issued by SEBI. SEBI was formed to promote
fair dealing in issue of securities and to ensure that the capital markets function efficiently,
transparently and economically in the better interests of both the issuers and the investors.
The promoters should be able to raise funds at a relatively low cost. At the same time,
investors must be protected from unethical practices and their rights must be safeguarded so
that there is a steady flow of savings into the market. There must be proper regulation and
code of conduct and fair practice by intermediaries to make them competitive and
professional. Since, its formation, SEBI has been instrumental in bringing greater
transparency in capital issues. Under the umbrella of SEBI, companies issuing shares are free
to fix the premium provided adequate disclosure is made in the offer documents.
SEBI as the watchdog of the industry has an important and crucial role in the market in
ensuring that the market participants perform their duties in accordance with the regulatory
The Stock Exchange as a responsible Self Regulatory Organization (SRO) function to
regulate the market and its prices as per the prevalent regulations. SEBI and the Exchange
play complimentary roles to enhance the investor protection and the overall quality of the
Role of Intermediaries
Many intermediaries are involved in connection with the public issue. Intermediaries who
have to be registered with SEBI and must have valid certificate from SEBI to act as an
• Merchant Bankers
• Registrar and Share Transfer Agents
• Bankers to the Issue
• Stock Brokers and Sub Brokers
Merchant Bankers play the most vital role amongst all intermediaries. They assist the
company right from preparing prospectus to the listing of securities at the stock exchanges.
Merchant Bankers have to satisfy themselves about the correctness and propriety of all the
information provided in the prospectus. It is mandatory for them to carry due diligence for all
the information provided in the prospectus and they must issue a certificate to this effect to
SEBI. A Company may appoint more than one Merchant Banker provided Inter-Se
Allocation of Responsibilities between the Merchant Bankers are properly structured.
Underwriters are those intermediaries who underwrite the securities offered to the public. In
case there is under subscription (in short, the company does not receive good response from
public and amount received from is less Than the issue size), underwriters subscribe to the
unsubscribe amount so that the issue is successful. Registrar & Share Transfer Agents
processes all applications received from the public and prepare the basis of allotment. The
dispatch of share certificates / refund orders are handled by them. Bankers to the Issue are
banks, which accept application from the public on behalf of the company. These
applications are then forwarded to Registrar & Share Transfer Agent for further processing.
Stock Brokers & Sub-Brokers are those intermediaries who through their contacts / sources
invite the public for subscribing shares for which they get commission. Depositories are the
intermediaries who hold securities in dematerialized form on behalf of the shareholders
Vetting By SEBI/Stock Exchanges:
• A company cannot come out with public issue unless draft prospectus is filed with
• A company cannot file prospectus directly with SEBI. It has to be filed through a
merchant banker. After the preparation of prospectus, the merchant banker along with
the due diligence certificates and other compliances send the same to SEBI for
• SEBI on receiving the same scrutinizes it and may suggest changes within 21 days of
receipt of prospectus. (Earlier, the situation was that the company was required to
• Acknowledgement Card from SEBI).
• However, now the concept of obtaining acknowledgement card has been removed and
the company can come out with a public issue any time within 365 days from the date
of the letter from SEBI or if no letter is received from SEBI, within 365 days from the
date of expiry of 21 days of submission of prospectus with SEBI.
• If the issue size is unto Rs. 20 crores then the merchant bankers are required to file
prospectus with the regional office of SEBI falling under the jurisdiction in which
• registered office of the company is situated.
• If the issue size is more than Rs. 20 crores, merchant bankers are required to file
prospectus at SEBI, Mumbai office.
• Prospectus is also required to be filed with the concerned stock exchanges along with
the application for listing its securities. Presently, companies approaching the stock
• exchange for public issues should obtain in-principal approval from such stock
What Causes Prices to Change?
Stock prices change everyday by market forces. By this we mean that share prices change
because of supply and demand. If more people want to buy a stock (demand) than sell it
(supply), then the price moves up. Conversely, if more people wanted to sell a stock than buy
it, there would be greater supply than demand, and the price would fall.
Understanding supply and demand is easy. What is difficult to comprehend is what makes
people like a particular stock and dislike another stock. This comes down to figuring out what
news is positive for a company and what news is negative. There are many answers to this
problem and just about any investor you ask has their own ideas and strategies. That being
said, the principal theory is that the price movement of a stock indicates what investors feel a
company is worth. Don’t equate a company’s value with the stock price. The value of a
company is its market capitalization, which is the stock price multiplied by the number of
For example, a company that trades at Rs 100 per share and has 1,000,000 shares outstanding
has a lesser value than a company that trades at Rs 50 but has 5,000,000 shares outstanding
(Rs 100 x 1,000,000 = Rs 100,000,000 while Rs 50 x 5,000,000 = Rs 250,000,000). To
further complicate things, the price of a stock doesn’t only reflect a company’s current
value—it also reflects the growth that investors expect in the future.
The most important factor that affects the value of a company is its earnings. Earnings are the
profit a company makes, and in the long run no company can survive without them. It makes
sense when you think about it. If a company never makes money, they aren’t going to stay in
business. Public companies are required to report their earnings four times a year (once each
quarter).. The reason behind this is that analysts base there future value of a company on their
earnings projection. If a company’s results surprise (are better than expected), the price jumps
up. If a company’s results disappoint (are worse than expected), then the price will fall.
Of course, it’s not just earnings that can change the sentiment towards a stock (which, in turn,
changes its price). It would be a rather simple world if this were the case! During the dot-com
bubble, for example, dozens of Internet companies rose to have market capitalization’s in the
billions of dollars without ever making even the smallest profit. As we all know, these
valuations did not hold, and most all Internet companies saw Their values shrink to a fraction
of their highs. Still, the fact that prices did move that much demonstrates that there are factors
other than current earnings that influence stocks. Investors have developed literally hundreds
of these variables, ratios and indicators. Some of you may have already heard of, such as the
P/E ratio, while others are extremely complicated and obscure with names like Chaikin
Oscillator or Moving Average Convergence Divergence (MACD). So, why do stock prices
change? The best answer is that nobody really knows for sure. Some believe that it isn’t
possible to predict how stocks will change in price while others think that by drawing charts
and looking at past price movements, you can determine when to buy and sell. The only thing
we do know as a certainty is that stocks are volatile and can change in price extremely
The important things to grasp about this subject are the following:
• At the most fundamental level, supply and demand in the market determine stock price.
• Price times the number of shares outstanding (market capitalization) is the value of a
company. Comparing just the share price of two companies is meaningless.
• Theoretically earnings are what affect investors’ valuation of a company, but there are
other indicators that investors use to predict stock price. Remember, it is investors’
sentiments, attitudes, and expectations that ultimately affect stock prices.
• There are many theories that try to explain the way stock prices move the way they do.
Unfortunately, there is no one theory that can explain everything.
Stock market quotations.
How To Read A Stock Table/Quote?
Stock Price Change %Change Volume Close Open High Low
TATACHEM 147.40 7.30 5.21 90154 140.10 145.45 148.40 143.50
TELCO 512.40 24.45 5.01 3761251 487.95 491.00 514.90 488.20
TISCO 409.45 18.00 4.60 6117054 391.45 399.00 410.75 397.00
ZEETV 144.25 5.95 4.30 1456569 138.30 145.60 145.90 143.15
SATYAM 334.85 10.85 3.35 5636872 324.00 330.00 336.50 315.05
Company Name & Type of Stock - This column lists the name of the company. If there are
no special symbols or letters following the name, it is common stock. Different symbols
imply different classes of shares. For example, “pf ” means the shares are preferred stock.
Ticker Symbol - This is the unique alphabetic name, which identifies the stock. If you watch
financial TV, you have seen the ticker tape move across the screen, quoting the latest prices
alongside this symbol. If you are looking for stock quotes online, you always search for a
company by the ticker symbol.
Trading Volume - This figure shows the total number of shares traded for the day, listed in
hundreds. To get the actual number traded, add “00” to the end of the number listed. Day
High & Low - This indicates the price range at which the stock has traded at throughout the
day. In other words, these are the maximum and the minimum prices that people have paid
for the stock.
Close - The close is the last trading price recorded when the market closed on the day. If the
closing price is up or down more than 5% than the previous day’s close, the entire listing for
that stock is bold-faced. Keep in mind, you are not guaranteed to get this price if you buy the
stock the next day because the price is constantly changing (even after the exchange is closed
for the day). The close is merely an indicator of past performance and except in extreme
circumstances serves as a ballpark of what you should expect to pay.
Net Change - This is the rupee value change in the stock price from the previous day’s
closing price. When you hear about a stock being “up for the day,” it means the net change
Quotes on the Internet
Nowadays, it’s far more convenient for most to get stock quotes off the Internet. This method
is superior because most sites update throughout the day and give you more information,
news, charting, research, etc.
What Type of Investor Will You Be?
There are plenty of different investment styles and strategies out there. Make sure you don’t
get into the market before you are aware of the various terms. Before you jump in without the
right knowledge, you should be aware of various investors:
A bull market is when everything in the economy is great, people are finding jobs, GDP is
growing, and stocks are rising. Things are just plain rosy! Picking stocks during a bull market
is easier because everything is going up. Bull markets cannot last forever though, and
sometimes they can lead to dangerous situations if stocks become overvalued. If a person is
optimistic, believing that stocks will go up, he or she is called a “bull”
and said to have a “bullish outlook.”
A bear market is when the economy is bad, recession is looming, and stock prices are falling.
Bear markets make it tough for investors to pick profitable stocks. One solution to this is to
make money when stocks are falling using a technique called short selling. Another strategy
is to wait on the sidelines until you feel that the bear market is nearing its end, only starting to
buy in anticipation of a bull market. If a person is pessimistic, believing that stocks are going
to drop, he or she is called a “bear” and said to have a “bearish outlook.”
The Other Animals on the Farm - Chickens and Pigs Chickens are afraid to lose anything.
Their fear overrides their need to make profits and so they turn only to money-market
securities or get out of the markets all together. While it’s true that you should never invest
into something over which you lose sleep, you are also guaranteed never to see any return if
you avoid the market completely and never take any risk, Pigs are high-risk investors looking
for the one big score in a short period of time. Pigs buy on hot tips and invest in companies
without doing their due diligence. They get impatient, greedy, and emotional about their
investments, and they are drawn to high-risk securities without putting in the proper time or
money to learn about these investment vehicles.
Professional traders love the pigs, as it’s often from their losses that the bulls and bears reap
their profits. Even though the bulls and bears are constantly at odds, they both can make
money with the changing cycles in the market. Even the chickens see some returns, though
not a lot. The one loser in this picture is the pig. . Be conservative and never invest in
anything you do not understand. Bulls make money, bears make money, but pigs just get
3.4 TRADING OF SECURITIES: PRIMARY EQUITY MARKET
Companies raise funds to finance their projects through various methods. The promoters can
bring their own money of borrow from the financial institutions or mobilise capital by issuing
securities. The funds maybe raised through issue of fresh shares at par or premium,
preferences shares, debentures or global depository receipts. The main objectives of a capital
issue are given below:
• To promote a new company
• To expand an existing company
• To diversify the production
• To meet the regular working capital requirements
• To capitalise the reserves
New Issue Market (Primary Market)
Stock available for the first time is offered through new issue market. The issuer may be a
new company or an existing company. These issues may be of new type or the security used
in the past. In the new issue market the issuer can be considered as a manufacturer. The
issuing houses, investment bankers and brokers act as the channel of distribution for the new
issues. They take the responsibility of selling the stocks to the public.
Relationship Between the Primary and Secondary Market
1. The new issue market cannot function without the secondary market. The secondary
market or the stock market provides liquidity for the issued securities the issued
securities are traded in the secondary market offering liquidity to the stocks at a fair
2. The stock exchanges through their listing requirements, exercise control over the
primary market. The company seeking for listing on the respective stock exchange
has to comply with all the rules and regulations given by the stock exchange.
3. The primary market provides a direct link between the prospective investors and the
company. By providing liquidity and safety, the stock markets encourage the public
to subscribe to the new issues. The market ability and the capital appreciation
provided in the stock market are the major factors that attract the investing public
towards the stock market. Thus, it provides an indirect link between the savers and
4. Even though they are complementary to each other, their functions and the
organizational set up are different from each other. The health of the primary market
depends on the secondary market and and vice-versa.
The main service functions of the primary market are origination, under writing and
distribution. Origination deals with the origin of the new issue. The proposal is analyzed in
terms of the nature of the security, the size of the issue, timing of the issue and floatation
method of the issue. Underwriting contract makes the share predictable and removes the
element of uncertainty in the subscription (underwriting is given in the latter part of this
chapter). Distribution refers to the sale of securities to the investors. This is carried out with
the help of the lead managers and brokers to the issue.
Parties Involved in the New Issue
In the sixties and seventies, the company and its personal managed public issue. But, at
present public issue involves a number of agencies. The rules and regulations, the changing
scenario of the capital market necessitated the company to seek for the support of many
agencies to make the public issue a success. As a student of investment management, one
should know the number of agencies involved and their respective role in the public issue.
The promoters also should have a clear idea about the agencies to coordinate their activities
effectively in the public issue. The main issue, registrars to the issue, underwriters, bankers,
advertising agencies, financial institutions and government /statutory agencies.
Managers to the Issue
The company to mange the public issue programmes appoints lead managers. Their main
duties are (a) drafting of prospectus (b) preparing the budget of expenses related to the issue
(c) suggesting the appropriate timings of the public issue (d) assisting in marketing the
public issue successfully (e) advising the company in the appointment of registrars to the
issue, underwriters, brokers, bankers to the issue, advertising agents etc. (f) directing the
various agencies involved in the public issue.
Many agencies are performing the role of lead managers to the issue. The merchant banking
division of the financial institutions, subsidiary of commercial banks, foreign banks, private
sector banks and private agencies are available to act as lead mangers. Some of them are SBI
Capital Markets Ltd., Bank of Baroda, Canara Bank, DSP Financial Consultant Ltd. ICICI
Securities & Finance Company Ltd., etc. The company negotiates with prospective mangers
to its issue and settles its selection and terms of appointment. Usually companies appoint lead
managers with a successful background. Their maybe more than one manager to the issue.
Some times the banks or financial institutions impose a condition while sanctioning term loan
or underwriting assistance to be ap-pointed as one of the lead managers to the issue. The fee
payable to the lead managers is negotiable between the company and the lead manager. The
fee agreed upon is revealed in the memorandum of the under standing filed along with the
Registrar to the Issue
After the appointment of the lead managers to the issue, in consultation with them, the
Registrar to the issue is appointed. Quotations containing the details of the various functions
they would be performing and charges for them are called for selection. Among them the
most suitable one is selected. It is always ensured that the registrar to the issue has the
necessary infrastructure like computer, Internet and telephone.
The Registrars normally receive the share application from various collection centers. They
recommend the basis of allotment in consultation with the Regional Stock Exchange for
approval. They arrange for the dispatching of the share certificates. They hand over the
details of the share allocation and other related registers to the company. Usually registrars to
the issue retain the issuer records at least for a period of six months from the last date of
dispatch of letters of allotment tenable the investors to approach the registrars for redressal of
Underwriting is a contract by means of which a person gives an assurance to the issuer to the
effect that the former would subscribe to the securities offered in the event of non-
subscription by the person to whom they were offered. The person who assures is called an
underwriter. The underwriters do not buy and sell securities. They stand as back-up
supporters and underwriting is done for a commission. Underwriting provides an insurance
against the possibility of inadequate subscription. Underwriters are divided into two
categories (I) financial institutions and banks (ii) brokers and approved investment
companies. Some of the underwriters are financial institutions, commercial banks, merchant
bankers, members of the stock exchange, Export and Import Bank of India etc. The under-
writers are exposed to the risk of non-subscription and for such risk exposure they are paid an
Before appointing an underwriter, the financial strength of the prospective underwriter is
considered because he has to undertake the agree non-subscribed portion of the public issue.
The other aspects considered are
(a) experience in the primary market
(b) past underwriting performance and default
(c) outstanding underwrting commitment
(d) the network of investor clientele of the under underwriter and
(e) his overall reputation.
The company after the closure of subscription list communicates in writing to the
underwriter the total number of shares/ debentures remains unsubscribes, the number of
shares/ debentures required to betaken up by the underwriter. The underwriter would take up
the agreed portion. If the under-writer fails to pay, the company is free to allot the shares to
others or take up proceeding against the underwriter to claim damages for any loss suffered
by the company for his denial.
Bankers to the Issue
Banker’s to the issue have the responsibility of collecting the application money along with
the application form. The bankers to the issue generally charge commission besides the
brokerage, if any. Depending upon the size of the public issue more than one banker to the
issue is appointed. When the size of the issue is large, to central government. The bankers to
the issue should have branches in the specified collection centers. In big or metropoli-tan
cities more than one branch of the various bankers to the issue are designated as collecting
branches are designated in the different towns of the state where the project is being set up. If
the collection centers for application money are located nearby people are likely to invest the
money in the company shares.
Advertising plays a key role in promoting the public issue. Hence, the past track record of the
advertising agency is studied carefully. Tentative programmes of each advertising agency
long with the estimated cost are called for. After comparing the effectiveness and cost of each
programme with the other, a suitable advertising agency if selected in consultation with the
lead managers to the issue. The advertising agencies take the responsibility of giving ublicity
to the issue on the suitable media. The media may be newspapers/magazines/hoardings/ press
release or a combination of all.
The Financial Institutions
Financial institutions generally underwrite the issue and lend term loans to the companies.
Hence, normally they go through the draft of prospectus, study the proposed programme for
public issue and approve them. IDBI, IFCI & ICICI, LIC, GIC AND UTI are the some of the
financial institutions that underwrite and give financial assistance. The lead manager sends
compay of the draft prospectus to the financial institutions and includes their comments, if
any in the revised draft.
Government and Statutory Agencies
The various regulatory bodies related with the public issue are:
1. Securities Exchange Board of India
2. Registrar of companies
3. Reserve Bank of India (if the project involves foreign investment)
4. Stock Exchange where the issue is going to be listed
5. Industrial licensing authorities
6. Pollution control authorities (clearance for the project has to be stated in the
Generally there should be at least 30 mandatory collection centres inclusive of the places
where stock exchange is located. If the issue is not exceeding Rs 10 Cr (excluding premium
if any) the mandatory collection centres are the four metropolitan centres viz. Mumbai,
Delhi, Calcutta and Chennai and at all such centres where stock exchanges are located in the
region in which the registered office of the company is situated. The regional divisions of
the various stock exchanges and the places of their locations are given in table 4 banks are
appointed as bankers to the issue. The table specifies the number of collection centres
Region Exchange City
Northern Ludhinana Stock Exchange Ludhiana
Region Delhi Stock Exchange Delhi
Jaipur Stock Exchange Jaipur
U.P. Stock Exchange Kanpur
Southern Hyderabad Stock Exchange Hyderabad
Region Banalgore Stock Exchange Bangalore
Mangalore Stock Exchange Mangalore
Madras Stock Exchange Chennai
Coimbatore Stock Exchange Coimbatore
Cochin Stock Exchange Cochin
Eastern Calcutta Stock Exchange Calcutta
Region Gawahati Stock Exchange Gauhati
Magadh Stock Exchange Patna
Bhubaneswar Stock Exchange Bhubaneswar
Western Bombay Stock Exchange Mumbai
Region National Stock Exchange Mumbai
OTCEL Stock Exchange Mumbai
M.P. Stock Exchange Indore
Pune Stock Exchange Pune
Vadodara Stock Exchange Vadodara
Ahmedabad Stock Exchange Ahmedabad
Saurashtra Kutch Stock Exchange Rajkot
In addition to the collection branch, authorized collection agents may also be appointed. The
names and addresses of such agent should be given in the offer documents. The collection
agents are permitted to collect such application money in the form of cheques, draft, stock
invests and not in the form of cash. The application money so collected should be deposited
in the special share application account with the designated scheduled bank either on the
same day or latest by the next working day.
The application collected by the bankers to the issue at different centres are forwarded to the
Registrar after realization of the cheques, within a period of 2 weeks from the date of closure
of the public issue. The applications accompanied by stock invests are sent directly to the
Registrars to the issue along with the schedules within one week from the date of closure of
the issue. The investors who reside in places other than mandatory and authorized centres,
can send their application with stock invests to the Registrar to the issue directly by registered
post with acknowledgement due card.
Placement of the Issue
Initial issue are floated
1. Through prospectus
2. Bought out deals/offer for sale
3. Private placement
4. Right issue
5. Book building.
Offer Through Prospectus
According to Companies (Amendment) Act 1985, application forms for shares of a company
should be accompanied by a Memorandum (abridged prospectus). In simple terms a
prospectus document gives details regarding the company and invites offers for subscription
or purchase of any shares or debentures from the public. The draft prospectus has to be sent
to the Regional Stock Exchange where the shares of the company are to be listed and also to
all other stock exchanges where the shares are proposed to be listed. The stock exchange
scrutinizes the draft prospectus. After scrutiny if there is any clarification needed, the stock
exchange writes to the company and also suggests modification if any. The prospectus
should contain details regarding the statutory provisions for the issue, programme of public
issue opening, closing and earliest closing date of the issue, issue to be listed at, highlights
and risk factors, capital structure, board of directions, registered office of the company,
brokers to the issue, brief description of the issue, cost of the project, projected earnings and
other such details. The board, lending financial institutions and the stock exchanges in which
they are to be listed should approve the prospectus. Prospectus is distributed among the stock
ex-changes, brokers, and underwriters, collecting branches of the bankers and to the lead
The salient features of the prospectus are
1. General Information
a. Name and address of the registered office of the company.
b. The name (s) of the stock exchanges (s) where applications have been made
for permission to deal in and for official quotations of shares/debentures.
c. Opening, closing and earliest closing dates of the issue.
d. Name and address of lead managers.
e. Name and address of Trustees under Debenture Trust Deed (in case of
f. Rating for debenture/preference shares, if any, obtained from CRISIL or any
other recognized rating agency.
2. Capital structure of the company
Issued, subscribed and paid up capital, Size of the present issue giving separately
reservation for preferential allotment to promoters and others.
Paid up capital –
a. After the present issue.
b. After conversion of debentures (if applicable).
Details regarding the promoters’ contribution.
3. Terms of the present issue
i. Authority for the issue, terms of payment, procedure and time schedule for allotment,
issue of certificate and rights of the instrument holders.
ii. How to apply - availability of forms, prospectus and mode of payment.
iii. Special tax benefits to the company and share holders under the Income Tax Act if
4. Particulars of the Issue
i. Object of the issue b. Project cost
ii. Means of financing (including promoter’s contribution)
5. Company,. Management and Project
a. History, main objects and present business of the company.
b. Subsidiary of the company, if any c Promoters and their back ground.
d. Names, addresses and occupation of managing directors and other directors
including nominee directors and whole-time directors.
e. Location of the project.
f. Plant and machinery, technological process etc.
g. Collaboration, any performance guarantee or assistance in marketing by the
h. Infrastructure facilities for raw materials and utilities like water, electricity etc.
i. Schedule of implementation of the project and progress sofar, giving details of land
acquisition, civil works, installation of plant and machinery, trial production,
consumer production etc.
j. The product
1. Nature of the products-consumer/industrial and end users.
2. Approach to marketing and proposed marketing set up.
3. Export possibilities and export obligations, if any.
Future-prospects - expected capacity utilization during the first three years from the date of
commencement of production and the expected year when the company would be able to
earn cash profit and net profit. Stock market data for shares, debentures of the company
(high, low price in each of the last).
Particulars regarding the other listed companies under the same management, which have
made any capital issues during the last three years.
Details of the outstanding litigations pertaining to matters likely to affect the operations and
finances of the company including disputed tax liabilities of any nature, any other default
and criminal prosecution launched against the company
Management perception of risk factors like sensitivity to foreign exchange rate
fluctuations, difficulty in the availability of raw materials or in marketing of products, cost,
time over-run etc.
Justification of the issue premium,. The justification for price is given, taking into account
the following parameters.
1. Earnings per share and book value of shares reflect performance of the company for
the past five years.
2. Future projections in terms of EPS and books value of shares in the next three years.
3. Stock market data.
4. Net asset value as per the latest audited balance sheet.
5. If the projections are not based on the past data, appraisal made by a banker or
financial institution should be specifically stated.
6. Financial Information
• Financial performance of the company for last five years should be given from
the audited annual accounts in tabular form Balance sheet data: equity capital,
reserves (revaluation reserve, the year of revaluation and its monetary effect on
assets) and borrowings.
• Profit and loss data: sales, gross profit, net profit, dividend paid if any.
• Any change in the accounting policy during the last three years and its effect on
the profit and reserves of the company.
7. Statutory and other information
• Minimum subscription
• Details of the fee payable to Advisers, Registrar,
• Managers, Trustees of the debenture holders and underwriters.
• Details regarding the previous issues if any.
Bought out Deals (Offer for Sale)
Here, the promoter places his shares with an investment banker (bought out dealer or
sponsor) who offer it to the public at a later date. In other works in a bought out deal, an
existing company off-loads a part of the promoters’ capital to a wholesaler instead of making
a public issue. The whole seller is invariably a merchant banker or some times just a
company with surplus cash. In addition to the main sponsor, there could be individuals and
other smaller companies participating in the syndicate. The sponsors hold on to these shares
for a period and at an appropriate date they offer the same to the public. The hold on period
may be as low as 70 days or more than a year.
In a bought out deal, proving is the essential element to be decided. The bought out dealer
decides the price after analyzing the viability, the gestation period, promoters’ background
and future projections. Bought out dealer should the shares at a premium to the public.
There are many advantages for the issuing company. Firstly, a medium or small sized
company, which is already facing working capital shortage, cannot afford to have long
lead-time before the funds could be mobilized from the public. Bought out deal helps the
promoters to realize the funds without any loss of time.
Secondly, the cost of raising funds is reduced in bought out deals. For issuing share to the
public the company incurs heavy expenses, which may invariably be as high as 10 percent of
the cost of the project, it not more.
Thirdly, bought out deal helps the entrepreneurs who are not familiar with the capital market
but have sound professional knowledge to raise funds. Sponsors of the deal are mostly
concerned with the promoters’ background and government policies than about the past
track record or financial projections. This helps the new entrepreneur to raise adequate
capital from the market.
Fourthly, for a company with no track record of projects, public issues at a premium may
pose problems, as SEBI guidelines come in the way. The stipulations can be avoided by a
bought our deal. Companies sell the shares at a premium to the sponsors and they can off-
load the shares to the public at a higher premium.
Fifthly, to the investors bought out deals possess low risk sine the sponsors have already held
the shares for a certain period and the projects might have been completed or in the verge of
completion, the investors carried out, which can be neither detected nor penalized.
In this method the issue is placed with a small number of financial institutions, corporate
bodies and high net worth individuals. The financial intermediaries purchase the shares and
sell them to investors at a later date at a suitable price. The stock is placed with issue house
client with the medium of placing letter and other documents which taken together contribute
a prospectus, giving the information regarding the issue. The special feature of the private
placement is that the issues are negotiated between the issuing company and the purchasing
intermediaries. Listed public limited company as well as closely held private ltd. company
can access the public through the private placement method. Mostly in the private placement
securities are sold to financial institutions like Unit Trust of India, mutual funds, insurance
companies, merchant banking subsidiaries of commercial banks and so on.
Through private placement equity shares, preference shares, cumulative convertible
preference shares, debentures and bonds are sold. In India private placement market is
witnessing the introduction of several innovative debt market instruments such as step
down/step - up debentures, liquid debentures, bonds etc.
Private placement has several inherent advantages:
Private placement is a cost-effective method of rasing funds. In a public issue underwritng,
brokerage, printing, mailing and promotion account for 8 to 10 per cent of the issue cost. In
the case of the private placement several statutory and non-statutory expenses are avoided.
In the public issue the time required for completing the legal formalities and other
formalities takes usually six months or more. But in the private placement the requirements
to be fulfilled are less and hence, the time required to place the issue is less, mostly 2 to 3
It can be structured to meet the needs of the entrepreneurs. It is flexible to suit the
entrepreneurs and the financial intermediaries. To make the issue more attractive the
corporate can provide discounts to the intermediaries who are buying it. This is not possible
with the public issue with stringent rules and regulations. In the case of debentures the
interest ceiling cannot be breached in a public issue. Here the terms of the issue can be
negotiated with purchasing institutions easily since they are few in number.
Through private placement a public limited company listed or unlisted can mobilize
capital. Like-wise issue of all size can be accommodated through the private placement
either small or big where as in the public issue market, the size of the issue cannot fall
below a certain minimum size.
Private Placement in India
The private placement technique is gaining importance in the Indian capital market. Private
placements increased by 12.8 percent, accounting for as much as 49.1 per cent of the total
resources mobilized by the government and non-government companies during 1996-97.
The public sector has become a major user of private placements as its share in total private
placement rose from an already high level of 69.5 per cent in 1995-96 to 83.4 per cent in
According to Sec 81 of the Companies Act 1956, if a public company wants to increase its
subscribed capital by allotment of further shares after two years from the date of its formation
or one year from the date of its first allotment, which ever is earlier should offer share at first
to the existing scare holders in proportion to the shares held by them at the time of offer. The
shareholders have no legal binding to accept the offer and they have the right to renounce the
offer in favour of any person. Shares of this type are called right shares. Generally right
shares are offered at a advantageous rate compared with the market rate.
According to Section 81, the company has to satisfy certain conditions to issue right
1. Right shares must be offered to the equity share holders in the proportion to the
capital paid on those shares.
2. A notice should be issued to specify the number of shares issued.
3. The time given to accept the right offer should not be less than 15 days.
4. The notice also should state the right of the share holders to renounce the offer in
favor of others.
5. After the expiry of the time given in the notice, the Board of Directors has the right to
dispose the unsubscribe shares in such a manner, as they think most beneficial to the
Book building is a mechanism through which the initial public offerings (IPOS) take place in
the U.S. Similar mechanisms are used in the primary market offerings of GDRs also. In this
process the price determination is based on orders placed and investors have an opportunity
to place orders at different prices as practiced in international offerings. The
recommendations given by Malegam Committee paved way for the introduction of the book
building process in the capital market in Oct 1995. Book building involves firm allotment of
the instrument to a syndicate created by lead managers who sell the issue at an acceptable
price to the public. Originally the potion of book building process was available to companies
issuing more than Rs 100 cr. The restriction on the minimum size was removed and SEBI
gave impression to adopt the book building method to issue of any size. In the prospectus, the
company has to specify the placement portion under book building process. The securities
available to the public are separately known as net offer to the public. Nirma by offering a
maximum of 100 lakh equity shares through this process is set to be first company to adopt
Among the lead managers or the syndicate members of the issue or the merchant bankers a
member is nominated by the issuer company as a book runner and his name is mentioned in
the draft prospectus. The book runner has to circulate the comply of the draft prospectus to be
filed with SEBI among the institutional buyers who are eligible for firm allotment. The draft
prospectus should indicate the price band within which the securities are being offered for
The offers are sent to the book runners. He maintains a record of names and number of
securities offered and the price offered by the institutional buyer within the placement
portion and the price for which the order is received to the book runners. The book runner
and the issuer company finalize the price. The issue price for the placement portion and offer
to the public should be the same. Underwriting agreement is entered into after the fixation of
One day earlier to the opening of the issue to the public, the book runner collects the
application forms along with the application money from the institutional buyers and the
underwriters. The book runner and other intermediaries involved in the book building
process should maintain records of the book building process.. The SEBI has the right to
inspect the records.
Pricing of New Issues
The Controller of Capital Issues Act governed issue of capital prior to May27, 1992 1947.
Under the Act, the premium was fixed as per the valuation guidelines issued. The guidelines
provided for fixation of a fair price on the basis of the net asset value per share on the
expanded equity base taking into account, the fresh capital and the profit earning capacity.
The repealing of the Capital Issue Control Act resulted in an era of free pricing of securities.
Issuers and merchant bankers fixed the offer prices. Pricing of the public issue has to be
carried out according to the guidelines issued by SEBI.
At premium Companies are permitted to price their issues at premium in the case of the
• First issue of new companies set up by existing companies with the track
• First issue of existing private/closely held or other existing unlisted companies
with three-year track record of consistent profitability.
• First public issue by exiting private/closely held or other existing unlisted
companies without three-year track recorded but promoted by existing
companies with a five-year track record of consistent profitability.
• Existing private/closely held or other existing unlisted company with three-
year track record of consistent profitability, seeking disinvestments by offers
to public without issuing fresh capital (disinvestments).
Public issue by existing listed companies with the last three years of dividend paying track
record At par value In certain cases companies are not permitted to fix their issue prices at
premium. The prices of the share should be at par. They are for
First public issue by existing private, closely held or other existing unlisted companies
without three-year track record of consistent profitability and Existing private/closely held
and other unlisted companies without three-year track record of consistent profitability
seeking disinvestments offer to public without issuing fresh capital (disinvestments).
Allotment of Shares
According to SEBI regulation, the allocation of shares is done under proportionate allotment
method. The allotment for each category is inversely proportional to the over subscription
The applications will be categorized according to the number of shares applied for. The
allocation is done by proportionate basis. If the allocation to a applicant works out to be more
than hundred but is not a multiple of hundred, the number excess of hundred and fifty would
be rounded off to the higher multiple of 100 i.e. 200. If it is 148 then, it would be rounded off
to 100. If the shares allocated on a proportionate basis to any category are more than the
shares allotted to applications in that category, the balance share allotment shall be first
adjusted against any other category where the allotment of shares are not sufficient for
proportionate allotment in that category. The balance shares, if any remaining after such
adjustment will be added to the category comprising of applicants applying for minimum
number of shares.
Total number of applicants in the category of 100 s - 2000 Total number of shares
applied for -2,00,000
Number of times over subscribed -5
Proportionate allotment to that category 2,00,000 ×1/5
Since the allotment has to be made in marketable lots, 100 shares will be allotted to 400
Factors to be considered by the Investors
The number of stocks, which has remained inactive, increased steadily over the past fiew
years, irrespective of the overall market levels. Price rigging, indifferent usage of funds,
vanishing companies, lack of transparency, the notion that equity is a cheap source of fund
and the permitted free pricing of the issuers are leading to the prevailing primary market
conditions. In this context, the investor has to be alertly and careful in his investment. He has
to analyze several factors. They are given below
1 Promoters’ Credibility
a. Promoters’ past performance with reference to the companies promoted by them
b. The integrity of the promoters should be found out with enquiries and from financial
magazines and newspapers.
c. Their knowledge and experience in the related field.
2. Efficiency of the Management
a. The managing directors’ background and experience in the field.
b. The composition of the Board of Directors is to be studied to find out whether it is
broad based and professionals are included.
3. Project Details
a. The credibility of the appraising institution or agency.
b. The stake of the appraising agency in the forthcoming issue.
a Reliability of the demand and supply projections of the product.
b. Competition faced in the market and the marketing strategy.
c. If the product is export oriented, the tie-up with the foreign collaborator or agency for
the purchase of products.
5. Financial Data
a. Accounting policy.
b. Revaluation of the assets, if any.
c. Analysis of the data related to capital, reserves, turnover, profit, dividend record
and profitability ratio.
Pending litigations and their effect on the profitability of the company. Default in the
payment of dues to the banks and financial institutions.
7. Risk Factors
A careful study of the general and specific risk factors should be carried out.
8. Auditor’s Report
A through reading of the auditors’ report is needed especially with reference to
significant notes to accounts, qualifying remarks and changes in the accounting policy. In
the case of letter of offer the investors have to look for the recent lug-audited working
results at the end of letter of offer.
9. Statutory Clearance
Investor should find out whether all the required statutory clearance has been obtained if
not what is the current status. The clearances used to have a bearing on the completion of
10. Investor Service
Promptness in replying to the enquiries of allocation of shares, refund of money,
annual reports, dividends and share transfer should be assessed with the help of past
Investors Protection in the Primary Market
To ensure healthy growth of primary market, the investing public should be protected. The
term investor’s protection has a wider meaning in the primary market. The principal
ingredients of investor protection are
a. Provision of all the relevant information,
b. Provision of accurate information and
c. Transparent allotment procedures without any bias.
To provide the above-mentioned factors several steps have been taken. They are project
appraisal, under writing, clearance of the issue document by the stock exchange and SEBI’s
scrutiny of the issue document.
1. Project Appraisal
This is the first step in the entire process of the project. Technical and economic
feasibility of the project is evaluated. If the project itself is not technically feasible and
economically viable, whatever may be the other steps taken to protect the investors are
defeated. Appraisal shows whether the project is meaningful and can be financed. The
investors’ protection starts right from the protection of the principal amount of
investment. Based on the appraisal, the project cost is finalised. The cost should be
neither understand nor overstated. The profitability of the project should be estimated and
given. To ensure fair project appraisal, SEBI has made it mandatory for the project
appraisal body to participate a certain amount in the forthcoming issue.
Once the issue is finalized the under writing procedure starts. Reputed institutions and
agencies, providing credibility to the issue normally underwrite the issue. If the lead
managers participate more than 5 per cent of the minimum stipulated amount offered to
the public, it would increase the confidence of the public regarding the pricing and
salability of the issue.
3. Disclosures in the Prospectus
SEBI has issued stringent norms for the disclosure of information in the prospectus. It is
the duty of the lead manager to verify the accuracy of the data provided in the prospectus.
The pending litigation should be given clearly. The promoters’ credibility in fulfilling the
premises of the previous issues (if any) should be stated. A clear version of the risk
factors should be given. Any adverse development that affects the normal functioning and
the profit of the company should be highlighted in the risk factor.
4. Clearance by the Stock Exchange
The issue document has to be cleared by the stock exchange on which the proposed listing
is offered. The stock exchanges verify the factors related with the smooth trading of the
shares. Any bottleneck in this area will be eliminated since the transferability is the basic
right of the shareholders. Trading of the shares helps the investor to liquidate his share at
anytime. If the issues are not traded in the secondary market at a good price, they would
dampen the spirit of the investor. According to a study conducted by Mr. Prithvi Haldea,
between April 1992 and March 1996 out of 3,872 issues, 2,987 were traded below the
offer price. As on January 14, 1997 nearly 205 shares were not traded at all and another
118 companies just proved to be fly by night operators.
5. Signing by Board of Directors
The Board of Directors should sign the prospectus. A comply is also filed with the office
to the Registrar of the Companies. This along with the soothers material documents
referred to in the prospectus is available for inspection by the members of the public. The
minimum amount to be subscribed by the promoters and maintained for a minimum
number of years also safeguards the interest of the investors.
7. SEBI’s Role
a. SEBI scrutinizes the various offer documents from the view point of investors’
protection and full disclosure. It has the power to delete the unsubstantiated claims and
ask for additional information where ever needed. This makes the lead manager to prepare
the offer document with due care and diligence.
b. When the disclosure of the information is complete, wide publicity has to be given in
c. In the allotment procedure to make sure of transparency, SEBI’s nominee is appointed
apart from the stock exchange nominee in the allotment committee. Inclusion of valid
applications and rejection of invalid applications are checked. The representative of the
SEBI’s see to it that undue preference is not given to certain group of investors.
8. Redressal of Investors Grievances
The Department of Company Affairs has introduced computerized system of processing
the complaints to handle it effectively. The companies are requested to give feed back
regarding the action taken on each complaint within a stipulated time period. If the
companies do not respond and are slow in the process of settlement of complaints, penal
action can be taken against the companies under the provisions of the Companies Act. If
the performance of the Registrar to the issue is not satisfactory in settling the complaints,
SEBI can take appropriate action against such Registrar. Several Investors Associations
are also functioning to help the investors complaints redressed promptly.
Factors Needed to Make the Investor Protection Effective
1. Investors’ Awareness
Even though many mechanisms exist in the various stages of the issue, the investor
awareness regarding the mechanism is limited. To remove this, provision of information
regarding the status of an application and redressal of grievances should be provided at
all centres where applications are collected.
2. Strict norms for Premium Fixation
The guidelines issued by SEBI in Dec 1996 nfor justification of premium on the basis of
Malegam Committee recommendations still leave scope for fixation of relatively high
premiums. It is desirable to evolve a straight jacket formula on the lines of erstwhile
valuation guidelines under the Capital Issues Control Act.
3. Safety Nets
It is imperative to provide need not wait for returns . The major disadvantage of the
bought out deals is, sponsors future deals is, sponsors are able to create a positive image
about the shares and sell them at a hefty premium. Single investment banker gives scope
for manipulation of the results. Insider trading and price rigging could be for safety nets
atleast in respect of small investors holding shares up to 200 for at least one year. The
safety net has to be honoured by the issuers, merchant bankers and underwriters under a
formula normally agreed upon. The stipulation of safety net itself will result in the fixtion
of realistic premium.
4. Punitive action
a. The punitive action under the companies Act needs to be stepped up, especially under
section 62, 63 and 209 A. Sec 62 provide for compensation to investors for losses arising
out of misstatement in the prospectus. SEBI, stock exchanges and investors association
file the cases under this section because the individual investor finds it impossible to
institute cases under this section.
b. In case of successful prosecution and promoters being declared insolvency,
compensation should come from Investors Protection Fund.
c. Regarding the fly by nigh operators, the Department of company Affairs should step up
action under Sec 209 A of the Companies Act. Powers under this section should be
delegated to SEBI for effective functioning.
5. Promoters Stake
It is necessary to raise the promoters’ stake in new issues which has been curtailed
drastically from 60 per cent earlier to 20 per cent now. It needs to be raised to at least 40
per cent. This reduces the scope for manipulation of prices.
Recent Trends in the Primary Market
The liberalization policy adopted by the government in the early nineties resulted in a
boom in the secondary market. The boom was not restricted to the secondary market
alone, the primary market, which till then was working under the Controller of Capital
Issue, also enjoyed the boom withthe repealing of the Controller of Capital Issue Act.
With the dawn of an era of free pricing more and more companies accessed the primary
There was a fall in the amount raised through primary market from March 1995 with much-
publicized M.S. shoe episode. This episode put a break on the new issues activity. the
collapse of the CRB capital market was another fatal blow on the primary market. The
primary market was dull and insipid in 1997-98. The number of primary issues, which were
813 in 1996-97 drastically, fell down to 62 issues in 1997-98. It is interesting to note that out
of every 100 public issues 39 was over subscribed in 1995-96 but in 1996-97 it was 8. At the
same time the 7 out of every 100 companies in 1996-97 had to return application money to
investors for failing to raise minimum stipulated amount in capital issue. The reasons for this
sordid state of affairs are given below.
This is the major cause for the sorry state of affairs in the primary market. The near
complete freedom given to the issuers and the merchant bankers to fix the premium
following the repeal of Capital Issue Act resulted in high premium, sharp erosion of post
listing prices and very little scope for appreciation. This made the investors to shy away
from the market.
The poor quality of the primary issues has contributed to a growing inactive list in the stock
market. A glance at the profile of the in active scripts as on June 1997, provides an
interesting insight of the 3617 scripts that were on the inactive list (based on trading in the
first half of 1997). In those shares, 2,900 were listed prior to 1996 and 1,200 were
companies listed prior to 1994. There is no way out for the investors and their fears have
resulted in poor response to the primary market.
Non-implementation of projects, delays, changes in the scope and scale of projects to justify
the cost and non-attainment of projected earnings have resulted in the fall in listing price.
Though large sums were raised in 1992-96 period, capital formation with concomitant
earnings has been now here near that reflected in the offer documents. Poor returns have
drained the investors’ confidence.
The scrips that are traded in the market, the number of transactions and the amount traded
are so low that an investor funds to sell the scrip would have difficulty in doing so. Many
scrips in the current B1 group show this trend.
Economic Slow Down
The growth of the GDP has fallen from 7 per cent in 1995-96 to mere 6 per cent in 1996-97.
Recession faced-by the economy had a direct impact on the secondary and tertiary sector. It
had an indirect effect upon the primary market.
One should not jump to the conclusion that there are no takers in primary market. Even today
there are takers for good quality issues. Several new issues by the banks - both private and
public sectors have proved to be quite a success on the stock market in the recent past. Of late
the stocks like HDFC Bank, Global Trust Bank, Infosys etc al are performing well on the
stock market. The year 1999 saw renewed entrees in the primary market. The initial public
offer from companies of IT sector was received well. The funds mobilized through the debt
and equity role aggregated to Rs 54,352 cr, a rise of around 24 per cent com-pared Rs 44,115
crores in 1998.
Measures Taken to Revive the Market
A listed company having immediate three years of dividend paying track record only can
access the market.
1. If a manufacturing company did not have such a track record, it could access the
public issue market provided the financial institution or a scheduled commercial
Bank and such appraising entities also participating in the project fund appraised its
2. The companies were required to complete the allotment of securities within 30 days
of the closure of the issue.
3. It would be necessary for a corporate body making a public issue to have at least
five public shareholders forever Rs 1 lakh of the net capital offer made to the public.
SEBI does not vet offer documents of companies having track record of 3 years
4. Removal of mandatory requirement of 90 per cent subscription clause in cases
of offer for sale.
5. Reducing the minimum application size for subscribing to a public issue from Rs.
5000 from Rs. 2000.
6. In case of no-underwritten public issues, promoters could bring in their own money
or procure subscription from elsewhere within 60 days of the closure of the issue
subject to such disclosures in the offer documents.
7. SEBI lifted the provision of the lock in period for promoters’ contribution in case of
listed companies with 3 years track record of dividend.
8. SEBI has made it mandatory to disclose un audited results of companies for every
quarter. Timely information would now be available to the public.
9. SEBI has directed different stock exchange to segregate the cash flow statement of
all companies that came out with IPO since 1992-93 and are in the exchange to have
a check over these companies.
10. SEBI abolished the fixed par value concept and, instead companies can fix the par
value of the shares. HCL Technologies IPO has a par value of Rs 4 per share, offered
at Rs 580 per share.
In the new issue market stocks are offered for the first time. The functions and organization
of the new issue market is different from the secondary market.
1. In the new issue the lead managers manage the issue, the underwriters assure to
take up the unsubscribe portion according to his commitment for a commissioned
the bankers take up the responsibility of collecting the application form and money.
2. Advertising agencies promote the new issue through advertising. Financial
institutions and underwriter lend terms loans to the company. Government agencies
regulate the issue.
3. The new issue is offered through prospectus. The prospectus is drafted according to
SEBI guidelines disclosing the needed information to the investing public.
4. In the bought out deal banks or a company buys the promoters shares and they offer
them to the public at a later date. This reduces the cost of raising the fund.
5. Private placement means placing of the issue with financial institutions. They sell
shares to the investors at a suitable price.
6. Right issue means the allotment of shares to the previous shareholders at a pro-ratio
7. Book building involves firm allotment of the instrument to a syndicate created by the
lead manages. The book runner manages the issue.
8. Norms are given by SEBI to price the issue. Proportionate allotment method is
adopted in the allocation of shares. Project appraisal, disclosure in the prospectus and
clearance of the prospectus by the stock exchanges protect the investors in the
primary market along with the active role played by the SEBI.
1. Why do companies issue shares in the primary market? What is the relationship
between the new issue market and the secondary market?
2. Define the new issue market? How is it related to the secondary market?
3. “Primary and secondary markets are complementary to each other but their
organizational set up are different”-Explain.
4. What are the parties involved in the issue of shares in the stock market?
5. Give an account of the agencies that help in the of public issue of a company.
6. What are the different functions of the lead manager, registrars and underwriters?
7. Explain the functions of the primary market?
8. What are the roles played by the underwriter and the bankers to the issue?
9. Discuss the various methods of floating the new issue.
10. What are the factors to be disclosed in the prospectus?
11. How does bought out deal differ from the offer through prospectus?
12. What are the reasons for growth of the private placement method?
13. How does book building differ from private placement?
14. What are the advantages of private placement?
15. What are the guidelines issued by the SEBI in pricing and allotment of the new
16. What are the factors to be considered by the investors in selecting a public issue?
17. Vigilance on the part of investors could avoid their being caught up in the poor
public issue’. How is it possible?
18. What are the steps taken by SEBI in the primary market to protect the investors?
19. Explain the investor’s protection measures taken by the regulatory authorities in
the primary market.
20. How can the investors protection be made effective?
21. Give an account of the recent trends in the primary market?
TRADING OF SECURITIES
4.1 Introduction Of Market And Their Function
4.2 Development Of Security Market In India
4.3 SEBI And Its Role In Primary And Secondary Market
4.4 A Case Study On OTCBB
4.1 Introduction Of Market And Their Function
The market for long-term securities like bonds, equity stocks and preferred stocks is divided
into primary market and secondary market. The primary market deals with the new issues of
securities. Outstanding securities are traded in the secondary market, which is commonly
known as stock market predominantly deals in the equity shares. Debt instruments like bonds
and debentures are also traded in the stock market. Well-regulated and active stock market
promotes capital formation. Growth of the primary market depends on the secondary market.
The health of the economy is reflected by the growth of the stock market.
History of Stock Exchanges in India
The origin of the stock exchanges in India can be traced back to the later half of 19th
century. After the American Civil War (1860-61) due to the share mania of the public, the
number of brokers dealings in shares increased. The brokers organized an informal
association in Mumbai named “The National Stock and Share Brokers Association” in 1875.
Increased activity in trade and commerce during the First World War and Second War
resulted in an increase in the stock trading. Stock exchanges were established indifferent
centers like Chennai, Delhi, Nagpur, Kanpur, Hyderabad and Banaglore. The growth of
stock exchanges suffered a set back after the end of World War. Worldwide depression
affected them. Most of the stock exchanges in the early stages had a speculative nature of
working without technical strength. Securities and Contract Regulation Act, 1956 gave
powers to the central government to regulate the stock exchanges. The SCR Act recognized
the stock exchanges in Mumbai, Calcutta, Chennai, Ahmedabad, Delhi, Hyderabad and
Indore. The Bangalore stock exchange was recognized only in 1963. At present we have 23
stock exchanges and 21 of them had hardware and software comply-ant to solve Y2K
Till recent past, floor trading took place in all the stock ex-changes. In the floor trading
system, the trade takes place through open outcry system during the official trading hours.
Trading posts are assigned for different securities where buy and sell activities of securities
took place. This system needs a face-to-face contact among the traders and restricts the
trading volume. The speed of the new information reflected on the prices was rather slow.
The deals were also not transparent and the system favoured the brokers rather than the
The setting up of NSE and OTCEI with the screen based trading facility resulted in more and
more stock exchanges turning towards the computer based trading. Bombay stock exchange
introduced the screen based trading system in 1995, which is known as BOLT (Bombay On-
line Trading System).
Madras stock exchange introduced Automated Network Trading System (MANTRA) on Oct
7th 1996. Apart from Bombay stock exchange, Vadodara, Delhi, Pune, Bangalore, Calcutta
and Ahmedabad stock exchanges have introduced screen based trading. Other exchanges are
also planning to shift to the screen Based trading.
Functions of Stock Exchange
Maintains Active Trading
Shares are traded on the stock exchanges, enabling the investors to buy and sell securities.
The prices may vary from transaction to transaction. A continuous trading increases the
liquidity or marketability of the shares traded on the stock exchanges.
Fixation of Prices
Price is determined by the transactions that flow from investors’ demand and supplier’s
preferences. Usually the traded prices are made known to the public. This helps the investors
to make better decisions.
Ensures Safe and Fair Dealing
The rules, regulations and by-laws of the stock exchanges’ provide a measure of safety to the
investors. Transactions are conducted under competitive conditions enabling the investors to
get a fair deal.
Aids in Financing the Industry
A continuous market for shares provides a favorable climate for raising capital. The
negotiability and transferability of the securities helps the companies to raise long-term
funds. When it is easy to trade the securities, investors are willing to subscribe to the initial
public offerings. This stimulates the capital formation.
Dissemination of Information
Stock exchanges provide information through their various publications. The publish the
share prices traded on daily basis along with the volume traded. Directory of Corporate
information is useful for the investors’ assessment regarding the corporate. Handouts,
handbooks and pamphlets provide information regarding the functioning of the stock
The prices of stock reflect the performance of the traded companies. This makes the
corporate more concerned with its public image and tries to maintain good performance.
The stock exchanges monitor the integrity of the members, brokers, listed companies and
clients. Continuous internal audit safeguards the investors against unfair trade practices. It
settles the disputes between member brokers, investors and brokers.
The Securities Contract Regulation Act, 1956 and the Securities and Exchanges Board of
India Act, 1992, provided a comprehensive legal framework. A three tire regulatory structure
comprising the Ministry of Finance, the Securities and Exchanges Board of India and the
Governing Boards of the Stock Exchanges regulates the functioning of stock exchanges.
Ministry of Finance
The stock Exchanges Division of the Ministry of Finance has powers related to the
application of the provision of the SCR Act and licensing of dealers in the other area.
According to SEBI Act, the Ministry of Finance has the appellate and supervisory powers
over the SEBI. It has power to grant recognition to the stock Exchanges and regulation of
their operations. Ministry of Finance has the power to approve the appointments of
executive chiefs and nominations of the public representatives in the Governing Boards of
the stock exchanges. It has the responsibility of preventing undesirable speculation.
The Securities and Exchange Board of India The Securities and Exchange Board of India
even though established in the year 1988, received statutory powers only on 30th Jan 1992.
Under the SEBI Act, a wide variety of powers is vested in the hands of SEBI. SEBI has the
powers to regulate the business of stock exchanges, other security markets and mutual funds.
Registration and regulation of market intermediaries are also carried out by SEBI. It has the
responsibility to prohibit the fraudulent unfair trade practices and insider dealings. Take over
are also monitored by the SEBI. Stock Exchanges have to submit periodic and annual returns
to SEBI. SEBI has the multi-pronged duty to promote the healthy growth of the capital
market and protect the investors.
The Governing Board
The Governing Board of the stock exchange consists of elected member directors,
government nominees and public representatives. Rules, byelaws and regulations of the stock
exchange provide substantial powers to the Executive Director for maintaining efficient and
smooth day-to-day functioning of the stock exchange. The governing Board has the
responsibility to maintain and orderly and well-regulated market.
The governing body of the stock exchange consists of 13 members of which (a0 6 members
of the stock exchange are elected by the members of the stock exchange (b) central
government nominates not more than three members. (c) the board nominates three public
representatives (d) SEBI nominates persons not exceeding three and (e) the stock exchange
appoints one Executive Director.
One third of the elected members retire at annual general meeting. The retired member can
offer himself for election if he is not elected for two consecutive years. If a member serves in
the governing body for two years consecutively, he should refrain from offering himself for
another two year.
The members of the governing body elect the President and vice-president. It needs no
approval from the Central Govern-ment or the Board. The office tenure for the President
and Vice-President is one year. They can offer themselves for re-election, if they have not
held office for two consecutive years. In that case they can offer themselves for re-election
after agap of one-year period.
The Stock Exchanges
The names of the stock exchanges are given below
1. Ahmedabad Stock Exchange
2. Bangalore Stock Exchange
3. Bhubaneswar Stock Exchange
4. Bombay Stock Exchange
5. Calcutta Stock Exchange
6. Cochin Stock Exchange
7. Coimbatore Stock Exchange
8. Delhi Stock Exchange
9. Guwahati Stock Exchange
10. Hyderabad Stock Exchange
11. Indore Stock Exchange
12. Jaipur Stock Exchange
13. Kanpur Stock Exchange
14. Ludhiana Stock Exchange
15. Madras Stock Exchange
16. Magadh Stock Exchange
17. Managlore Stock Exchange
18. Pune Stock Exchange
19. Saurashtra Stock Exchane
20. Vadodhara Stock Exchange
21. N S E
23. Inter Connected Stock Exchange
Stock exchanges normally function between 10:00 a.m. and 3:45 p.m. on the working
days. Badla sessions are held on Saturdays.
Member of the Stock Exchange
The Securities Contract Regulation Act of 1956 has provided uniform regulation for the
admission of members in the stock exchanges. The qualifications for becoming a member of
a recognized stock exchange are given below
1. The minimum age prescribed for the members is 21 years.
2. He/she should be an Indian Citizen.
3. He should be neither a bankrupt nor compounded with the creditors.
4. He should not be convicted for fraud or dishonesty.
5. He should not be engaged in any other business connected with a company.
6. He should not be a defaulter of any other stock exchange.
7. The minimum required educational qualification is a pass in 12th examination.
The Mumbai and Calcutta stock exchanges have set up training institutes to enable the
members to understand the complexes of the stock trading. In recent days highly qualified
persons such as Company secretaries, Charted accountants and MBA’s are becoming
members. Corporate membership is also permitted now. The members transacting business
through there appointed members. The governing board has to approve the partnership and
the appointed membership in other stock exchanges. If he applies before the completion of
five years he has to relinquish the If membership of the present member-ship before
accepting the other.
A member/broker registered with the recognized stock exchange has to apply to the SEBI
for registration. Likewise a sub-broker even though he is registered with the stock
exchange should apply to SEBI for registration. Usually the agreement between the broker
and the sub broker is carried out on a non-judicial stamp paper of Rs 10. The agreement
generally specifies the authority and responsibility of the broker and sub broker.
The broker has to abide by the code of conduct laid down by the SEBI. The code of conduct
prevents the malpractice, manipulation and gives other statutory requirements. If a broker is
involved in manipulation or price rigging or gives false information, his registration is likely
to be suspended. If the rules and regulations regarding insiders’ trading and take over codes
are not adhered to, the registration may even be cancelled.
Broker and the Investor
1. The broker should provide adequate information regarding the stocks.
2. The broker should be capable of giving short term and long term investment
suggestions to the investors.
3. The broker should be able to confirm the purchase and sale of the securities quickly.
4. He should be able to provide price quotes quickly, which is now possible with the
5. The broker should be noted for his integrity. He should have a good name in the
6. The broker should have adequate experience in the market to take correct decision.
7. The broker should have contact with other stock exchanges to execute the order
8. The broker should also offer incidental service like arranging for financing the
Types of Orders
Buy and sell orders are placed with the members of the stock exchanges by the investors.
The orders are of different types.
Orders are limited by a fixed price. ‘Buy Reliance Petroleum at Rs 50. Here, the order has
clearly indicated the price at which it has to be bought and the investor is not willing to
give more than Rs 50.
Best Rate Order
Here, the buyer or seller gives the freedom to the broker to execute the order at the best
possible rate quoted on that particular date for buying. It may be the lowest rate for buying
and the highest rate for selling.
The investor gives the range of price for purchase and sale. The broker can use his discretion
to buy within the specified limit. Generally the approximate price is fixed. The order stands
as this ‘Buy BRC 100 shares around Rs 40’.
Stop Loss Order
The orders are given to limit the loss due to unfavorable price movements in the market. A
particular limit is given for waiting. If the price falls below the limit, the broker is
authorized to sell the shares to prevent further loss. Ex. Sell BRC Ltd at Rs 25, stop loss at
Buying and Selling Shares
To buy and sell shares the investor has to locate a registered broker or sub broker who can
render prompt and efficient service to him. Then orders to buy or sell the specified number of
shares of a company of the investor’s choice are placed with the broker. The order may be of
any of the above-mentioned type. After receiving the order, the broker tries to execute the
order in his computer terminal. Once matching order is found, the order is executed.
The broker delivers the contract note to the investors. It gives details regarding: the name of
the company, number of shares bought, price, brokerage, and date of delivery of shares. In
the physical trading form, once the broker gets the share certificate through the clearing
houses he delivers the share certificate along with transfer deed to the investor. The investor
has to fill the transfer deed and stamp it. Stamp duty is one-half percentage of the purchase
consideration; the investor should lodge the share certificate and transfer deed to the registrar
or transfer agent of the company. If it is bought in the demat form, the broker has to give a
matching instruction to his depository participant to transfer the share bought to the
The investor should be an account holder in any of the depository participant. In the case of
sale of shares on receiving payment from the purchasing broker, the broker effects the
payment to the investor.
The listed shares are divided into three categories: Group A shares (specified shares) B1
shares and B shares. The last two groups are referred to cleared securities or no-specified
shares. The shares that come under specified group can avail the carry forward transactions.
In ‘A’ group, shares are selected on the basis of equity, market capitalisation and public
holding. Further it should have a good track record and a dividend paying company. It
should have good growth potential too. The trading volumes and the investors base are high
in ‘A’ group share. Any company when it satisfies these criteria would be shifted from ‘B’
group to “A” group.
In the B1 group actively traded shares are included. Carry forward transactions are not
allowed in this group. Settlement take place through the clearing house along with the “A”
group shares. The settlement cycle and the procedure are identical to “A” group security.
The rest of the company shares listed form the B group.
A settlement cycle consists of five days trading period within which any transaction buy/sell
must be completed. There are two types of settlement: fixed and rolling. A fixed cycle starts
on a particular day and ends after five days. For example, in the Mumbai stock exchange the
settlement cycle starts on Monday and ends of Friday. In the NSE it starts on Wednesday of
one week and ends on the Tuesday of the following week. A pay-in day and a pay-out day
follow the settlement cycle. The pay-in day refers to all the buyer brokers depositing the
money for the purchase of shares. The payout day refers to the exchange handing over the
proceeds to the seller brokers
A settlement cycle is important for the investors and brokers. If, an investor purchases 1000
shares of Asian Paints on Monday, to square up the position by the end of the settlement, the
sale will have to take place before Friday, the same week. If the sale has not taken place, he
has to play a consideration for the broker at the end of the settlement period. The broker
collects the payments from the clients and deposits it with the exchange on the pay-in day.
The exchange allows four days, from the end of the settlement cycle to the pay-in day to
enable the brokers to collect the payments from the clients. After found days, on the payout
day the exchange hands over the proceeds to the seller broker.
The same trading/settlement cycle and procedure of the specified group are followed in the
“B1” non-specified group. But no carry forward (Badla) transaction is allowed for “B1”
group shares. The pay-in for B1 group securities can be done with “A” group
simultaneously under one balance sheet.
In the B group shares, clearing house handles the money and part of the transaction. Physical
delivery of securities is done by the members. In the pay-in day the balance sheet is filed
along with cheques/drafts. Only on the payout day monetary are made by the clearinghouse.
SEBI introduced rolling settlement from Jan 10, 2000. Ten stocks are selected for rolling
settlement. They are BFL Software, Citicorp Securities, Cybertech Securities, Hitech
Drilling, Lupin Laboratories, Mars Software, More pen labs, Sri Adhikari Brothers, Tata
Infotech and Visuals Soft. SEBI has announced a list of 156 stocks which would be included
in rolling settle-ment made by the first fortnight of May 2000.
In a rolling settlement of a T+5 period trades are settled five days from the date of
tansaction. If an investor purchase of 3000 shares of Tata Infotech and sells 2000 shares on
Monday he would be asked to settle the net outstanding that is 1000 shares on the following
Monday, the fifth or sixth day. This means all open positions on a trading day are settled on
the fifth working day after the trading day. Institutional trade adopts already rolling settle-
A normal rise or fall in the prices of the securities destroys the investors’ confidence and
such price fluctuations can lead to high transaction risk. Brokers create instability in prices to
earn quick profits. Broker’s interest in the stock is initially triggered by market rumours such
as takeover, bonus issue, good or bad financial performance and management problems. If
the rumours are positive, there would be a scramble for the company’s shares. This is done
in anticipation of the increase in demand once the information becomes public. The traders
through circular trading can increase prices.
Circular trading refers to the trading that takes place among the brokers to mainpulate the
prices for their personal gain. For example, if there is a rumour about the issue of bonus share
by a company, the traders enter into matching deals among themselves (that is buy and sell
order) at a price higher than the prevailing market price. Market psychology is that when the
price increases investors think that it will go up further and enter into the market. At this
juncture, the traders exit booking profits from the transactions. The investors are caught
unaware of the real situation. To prevent these happenings price filters are introduced.
Intra day Price Bands
Here the price range is fixed to restrict the price movement of a scrip during a trading session.
For example take the case of TVS Suzuki scrip. Suppose, the stock closed on Monday at Rs.
500 at the NSE, it would be allowed to trade on Tuesday only in a 10% percent variation of
Monday’s close. It would be allowed to trade between Rs. 450 and Rs. 550. The intra day
price bank is laid by all the exchanges depending upon the price and volatility of the stock. At
NSE the Nifty and Junior Nifty stocks’ have 10 per cent and other stocks have fiver per cent
intra day price bands. In August 1997, BSE reduced the filter limit from 10 per cent to5 per
cent in 32 stocks because of the uncertain market conditions.
Price filter ensures that the stock is traded only witin the given range. Transaction beyond
the band is rejected by the system. For example if thereis an order to buy TVS Suzuki scrip
at Rs. 555, the system will not accept the trade.
The intra day price band does not allow for the proper reaction in prices for the given
information. Consider the situation of the Thai currency crisis, it affected exports to that
nation and in turn the share prices of some companies might have a retreat. However, the
price band places an artificial check on the reaction of the price. If the price band has to be
released, the NSE has to get special permission from the SEBI.
Secondly, the intra day price band does not curb the automatic price movements within a day.
For example, the TVS Suzuki scrip may open on Tuesday at Rs. 470 and rise immediately to
an intra day high of Rs. 535 and may finally close at Rs. 485. The sudden increase of Rs. 65
would increase the investment risk due to the heavy transactions that take place on BSE and
To smoothen the price volatility Madras stock exchange has introduced graded price filters.
In MSE, intra day price band prevents an order being executed at Rs. 530 after being opened
at Rs. 470. An intermediate price filter is applied at Rs. 468,80 (that is 4 per cent of Rs. 470).
If there is no matching orders at this price, the stock price is frozen at this level for the day. If
the matching is order is found, it would be allowed to rise further by another intermediate
price filter level, say 6 percent. Such graded price filters effectively prevent the knee-jerk
Inter Week Price Band
Here applying a weekly price band controls the weekly price movements. The range would
be fixed for the weekly price movement. This range is fixed in accordance with the price
volatility. The inter week price band is 25 per cent of the previous week’s close on Nifty and
Junior Nifty stocks.
Margins are additional filters applied by the stock exchanges to curb the price volatility. For
every transaction undertaken by the broker he has to deposit a margin amount to the stock
exchange. The margin amount paid is used as a tool to discourage the speculative and
circular trading. it can be made simple with an example, if the MSE were to impose a margin
of 20 per cent, traders would have to deposit Rs. 20 with the Exchange for every Rs. 100
worth of shares transacted. This would certainly dampen the circular trading.
Margins are of different types
1. Gross Exposure margin
2. Net Exposure margin
3. Mark to Market margin
4. Concentration margin
5. Special margin
Gross Exposure Margin
This margin limits the risk exposure of the trader by putting an upper limit to his transaction.
This would prevent him from trading beyond his means and the default risk. In the NSE the
gross exposure is up to 7 times of the traders base capital, with Rs. 1 lakh he can trade up to
Rs. 7 lakh. If it crosses that limit, he has to either switch over his terminal or should bring the
gross exposure within the limits or he can deposit additional margin with the exchange to
increase the limit.
The enhanced limit would exist for three months. At the end of the period the broker has the
choice to continue the present level or revert to the older level. The outstanding exposures at
the end of the settlement cycle i.e. Wednesday to Tuseday at NSE and Monday to Friday at
BSE, would be added to the first trading day of the next settlement period.
Net Exposure Margin
Here, the trader has to deposit margins at a graded basis if the purchase is greater than sales
in any day. This is imposed to curtail the risk involved in heavy purchase of shares without
matching sales. For example, if a trader buys one lakh shares of Reliance at Rs 185 and sells
only 30,000 for the net outstanding position of 70,000 shares poses as threat. Hence, the
trader has to deposit a margin for the net exposure. Ten per cent margin is for net exposures
excees of the total purchase.
The gross and net exposure margins try to stabiles the high transaction volume. The risk
arises not only through the volume transacted but also through the price volatility. The trader
may be able to find a matching order only at a lower price. For example, if Reliance stock
price falls from Rs 185/- at the end of the trading session, the exposure risk would be high
for the trader.
In the mark to market margin the trader has to deposit a sum that would be a fixed percentage
of the product of the difference between the closing selling and purchasing price and the
outstanding net position at the end of the day. This would be 50% of the price difference on
the scrips, which fluctuate by 5% in a day or 10% over a settlement period. This margin is not
imposed on share with market value of Rs 50 or less. In our example the Reliance share price
closes at Rs 180, the broker has to deposit Rs. 1,75000 = .5(185-180×70,000). If, the trader
buys two stocks and if, one of the stock closed at Rs 5 higher and other Rs 5 lower the
exchange markets the trader to deposit the margin for the latter transaction not for the first
transaction. This mark to market margin is refunded by the stock exchange to the concerned
broker at the end of the settlement period.
4.2 Development Of Security Market In India
Stock Markets in India
“Stock Exchange means any body or individuals whether incorporated or not, constituted for
the purpose of assisting, regulating or controlling the business of buying, selling or dealing
ins securities.” It is an association of member brokers for the purpose of self-regulation and
protecting the interests of its members. With the stock exchanges becoming corporate bodies
with demutualisation the control and ownership will be in different hands the above
definition will change accordingly. It can operate only if it is recognized by the Government
under the Securities Contracts (Regulation) Act, 1956. The Central Govern-ment, Ministry
of Finance, grants the recognition under Section 3 of the Act
The powers of the Central Government under the Act are far-reaching and include the
following in particular:
• Grant and withdrawal of recognition, approval or change of byelaws.
• Call for periodical returns from the Stock Exchange.
• Direct enquiries on the members or on the Stock Exchange.
• Liability of the Exchange to submit annual reports.
• Directing the Stock Exchange to make certain rules.
• Supersedes the Governing Board of the Exchange.
• Suspend the Governing Board of the Exchange.
• Impose any other conditions or regulations for trading.
Besides the above Act, the Securities Contracts (Regulation) Rules were also made in 1957
to regulate certain matters relating to trading on the Stock Exchanges. There are also byelaws
of the Exchanges, which are concerned with the following subjects Opening/Closing of the
stock exchanges, administration timing of trading, regulation of blank transfers, regulation of
badla or carryover business, control of the settlement and other activities of the Stock
Exchange, fixation of margins, fixation of market prices or making up prices (Havala rates),
regulation of taravani business (jobbing), etc., regulation of brokers’ trading, brokerage
charges, trading rules on the Exchange, arbitration and settlement of disputes, settlement and
clearing of the trading etc.
Regulation of Stock Exchange
The Securities Contracts (Regulation) Act is the basis for operations of the stock
exchanges in India. No exchange can operate legally without the government permission
or recognition. Stock exchanges are given monopoly in certain areas under Section 19 of
the above Act to ensure that the control and regulation are facilitated. Recognition can be
granted to a stock exchange provided certain conditions are satisfied and the necessary
information is supplied to the government. Recogni-tion can also be withdrawn, if
necessary. Where there are no stock exchanges, the government can license some of the
brokers (licensed dealers) to perform the functions of a stock exchange in its absence.
Recognition by Government
As referred to earlier, a Stock Exchange is recognized only after the government is satisfied
that its Rules and Byelaws conform to the conditions prescribed for ensuring fair dealings
and protection to investors. Government has also to be satisfied that it would be in the
interest of the trade and public interest to grant such recognition. Mumbai, Calcutta, Delhi,
Chennai, Ahmadabad, Hyderabad, Bangalore, Indore etc. have so far been granted
permanent recognition. Others are granted temporary recognition from time to time.
The rules of a recognized stock exchange relating in general to the constitution of the
Exchange, the powers of management of its governing body and its constitution (including
the appointment thereon of not more than three government nominees), the admission of
members, the qualifications for membership, the expulsion, suspension and readmission of
members, the registration of partnerships and the appointment of authorised representatives
and clerks must be duly approved by Government. These rules can be amended, varied or
rescinded only with the previous approval of government. Likewise, the byelaws of the
recognised exchanges providing in detail for the regulation and control of contracts in
securities and for every aspect of the trading activities of members must also be sanctioned
by government and any amendments or modifications must be similarly approved.
Government’s authority extends much further to make or amend suo motto any rules of
byelaws of a recognised stock exchange, if it so considers desirable in the interest of trade
and in public interest.
The Act empowered the government with even more drastic powers - the power to make
enquiries into the affairs of a recognized stock exchange and its members, to supersede the
governing body and take over the property or a recognised exchange, to suspend its
business, and lastly, to withdraw the recognition granted to an exchange should such steps
be deemed indispensable in the interest of trade and in public interest. Government has thus
complete control over the recognized stock exchanges.
The recognized stock exchanges are the media through which government regulation of the
stock market is made effective. Where there are no stock exchanges, the Securities Contracts
(Regulation) Act, 1956 empowers government to license dealers in securities and prescribe
the conditions subject to which they can carry on the business of dealing in securities. These
licensed dealers are now operating for OTCEI and NSE.
Securities Contracts (Regulation) Rules, 1957
Under the Act, government has promulgated the Securities things, for the procedure to be
followed for recognition of stock exchanges; submission of periodical returns and annual
reports by recognized stock exchanges; inquiry into the affairs of recognized stock exchanges
and their members ; and requirements for listing of securities. The rules are statutory and
they constitute a code of standardized regulations uniformly applicable to all the recognised
Present Recognised Stock Exchanges
At present, there are 21 stock exchanges recognised under the Securities Contracts
(Regulation) Act, 1956. They are located at Bombay, Calcutta, Madras, Delhi, Ahmedabad,
Hyderabad, Indore, Bhuwaneshwar, Mangalore, Patna, Bangalore, Rajkot, Guwahati, Jaipur,
Kanpur, Ludhiana, Baroda Cochin, and Pune. The recently recognised stock exchanges are at
Coimbatore and Meerut. Visakhapatnam Stock Exchange was recognised in 1996 for
electroic trading. A stock exchange has also been set up at Gangtok, Sikkim early in 1986.
No recognition has been sought for this body as the jurisdiction of the Securities Contracts
(Regulation) Act, 1956 has not so far been extended to the areas covered by the State. A
decade ago, there were hardly 8 stock exchanges in the country. There is no trading, however,
in Merrut and Vishakhapatnam Stock Exchanges.
The stock exchanges operate under the rules, byelaws and regulations duly approved by
government and constitute an organised marker for securities. They offer the most perfect
type of market for various reasons. There is an active bidding and in the case of shares and
debentures a two-way auction trading, so that purchases and sales are made in conditions of
free and perfect competition. The bargains that are struck by members of the exchanges are
the fairest price determined by the basic laws of supply and demand. In consequence, though
gilt-edged securities represent ownership of public debt and share and debentures of joint-
stock companies represent interest in industrial property - mills and factories, plant,
machinery and equipment - they become the most liquid of assets and capable of being easily
Qualifications for Membership
The members of recognised stock exchanges should have the following qualifications:
1. Age 21, Indian Citizen, not bankrupt.
2. Not compounded with the creditors.
3. Not convicted for fraud or dishonesty.
4. Not engaged in any other business except as agent or broker.
5. Educational Qualifications should be graduate.
6. Not connected with a company or corporation.
7. Not a defaulter of any other stock exchange.
Companies and financial institutions are not members as per the earlier rules. But the
government has permitted change in the byelaws of the exchanges to permit corporate and
institutional members and also grant permission for a member of any stock exchange to be a
member of another stock exchange in 1993.
Members are prohibited from entering into contracts with persons other than members or
from dealing with clients as principals. Spot deliveries transactions are exempt fro the provi-
Contracts (Regulation) Rules, 1957 for carrying into effect the objects of the legislation.
These rules provide, among other signs of the Act. Only the members in the notified areas
where the stock exchange exists can pass contracts. The sub-brokers can also pass valid
contract notes or confirmation Notes, if they are registered with SEBI.
The recognised stock exchanges at Mumbai, Ahmedabad, Indore are voluntary non-profit-
making associatons, while the Calcutta, Delhi, Bangalore, Cochin, Kanpur, Ludhiana,
Gauhati and Kanara Stock Exchanges are joint-stock copanies limited by shares and the
Chennai, Hyderabad and Pune stock exchanges are companies limited by guarantee. Since
the Central Governent approves the Rules or Articles of Association defining the consttution
of the recognised stock exchanges, there is a broad unifomity in their organisation. In fact,
the Madras Stock Exchange was reconstituted and the Calcutta Stock Exchange had to
undergo a major reorganisation as a condition procedent to their recognition by the
Government of India.
Demutualisation of Stock Exchanges
It is dissociation of ownership from control and Regulation of Stock Market operations. The
Stock Exchanges are self-Regulatory organisations, owned and regulated by the member
brokers themselves. Traditionally, the control and ownership rested with the same member
brokers. But in India OTCEI set up in 1992 and NSE made the first attempt at
Demutualisation in 1994. Banks, FIs and other agencies other than member brokers own
both. BSF has now chosen to become a corporate unit with its shares listed for trading with-
in a short time.
Advantages of Demutualisation
Firstly, the interests of public and investors can be better taken care of by the vesting of
control and regulation in a separate agency other than the trading members. Secondly,
professional-ism in Management is possible when it is owned by non-trading public. Thirdly,
the derivative markets can be better controlled and regulated by professionals and experts.
Fourthly, the larger funds needed by the Stock Exchanges for infrastructure development and
electronic trading can be better accessed from the Capital Market and the public.
Firstly, if it is owned by the public profit motive and the return on investment become
paramount concerns, which is not good for regulation. Secondly, it dilutes the regulatory
authority given to Stock Exchanges, which are SROs, under Article 226 of the constitution.
Sometimes the volumes go down and the capacity utilisation of the Stock Exchange
infrastructure will be poor leading to poor return on investment. Lastly, in India
demutualisation may not be needed as the competition from the ATS and ECNs (Alternative
trading system and Electronic trading) would not be there as the matching of Buy and sell
orders in the broker firms is not allowed by SEBI.
The governing body of a recognised stock exchange has wide governmental and
administrative powers and is the decision-making body. It has the power, subject to
governmental approval, to make, amend and suspend the operation of the rule’s byelaws and
regulations of the exchanges. It also has complete jurisdiction over all members and in
practice, its power of management and control is almost absolute.
Under the constitution, the governing body has the power to admit and expel members, to
warn, censure, fine and suspend members and their partners, attorneys, remisiers,
authorized clerks and employees, to approve the formation and dissolution of partnerships
and appointment of attorneys, remisiers and authorized clerks, to enforce attendance and
information, adjudicate disputes and impose penalties, to determine the mode and
conditions of stock exchange business and regulate stock exchange trading in all its aspects
and generally to super-vise, direct and control all matters and activities affecting the stock
exchange. The organization of Bombay Stock Exchange is typical. The members on roll
elect 16 members to be Directors on the Governing Board, who iin turn elect a President,
Vice-President and Treasurer. The Executive Director is appointed by the government on
the recommendation of the Governing Board to be the Chief Administrator of the
Exchange. There are also three representatives from the Government, three from the public
and one from the RBI on the Board to represent their interest. As per the SEBI guidelines,
the Exchanges have agreed to have 50% representation to non-members on the Governing
4.3 SEBI And Its Role In Primary And Secondary Market
The Government has set up the Securities & Exchange Board of India (SEBI) in April, 1988.
For more than three years, it has no statutory powers. Its interim functions during the period
(i) To collect information and advice the Government on matters relating to Stock and
(ii) Licensing and regulation of merchant banks, mutual funds etc.
(iii) To prepare the legal drafts for regulatory and development role of SEBI and
(iv) To perform any other functions as may be entrusted to it by the Government.
The need for setting up independent Govt. agency to regulate and develop the Stock and
Capital Market in India as in many developed countries was recognized since the Sixty Five
Year Plan was launched (1985) when some major industrial policy changes like opening up
of the economy to outside world and greater role to the Private Sector were initiated. The
rampant malpractices noticed in the Stock and Capital Market stood in the way of infusing
confidence of investors, which is necessary for mobilizations of larger quantity of funds
from the public, and helps the growth of the industry.
The malpractices were noticed in the case of companies, merchants bankers and brokers
who are all operating in the Capital Market. The need to curb these malpractices and to
promote healthy Capital Market in India was felt. The security industry in India has to
develop on the right lines for which a competent Govt. agency as in U.K. (SIB) or in
U.S.A. (SEC) is needed.
As referred to earlier, malpractices have been reported in both the primary market and
secondary market. A few examples of malpractices in the primary market are as follows:
a. Too many self style Investment Advisors and Consultants.
b. Grey Market or unofficial premiums on the new issues.
c. Manipulation of market prices before new issues are floated.
d. Delay in allotment letters or refund orders or in dispatch of share certificates.
e. Delay in listing and commencement of trading in shares. A few examples of
malpractices in the secondary Market are as follows:
f. Lack of transparency in the trading operations and prices charged to clients.
g. b. Poor services due to delay in passing contract notes or not passing contract notes, at
h. c. Delay in making payments to clients or in giving delivery of shares.
i. Persistence of odd lots and refusal of companies to stop this practice of allotting
shares in odd lots.
j. Insider trading by agents of companies or brokers rigging and manipulating prices.
k. Take over bids to destabilize management.
The SEBI has been entrusted with both the regulatory and developmental functions. The
objectives of SEBI are as follows:
a. Investor protection, so that there is a steady flow of savings into the Capital Market.
b. Ensuring the fair practices by the issuers of securities, namely, companies so that they
can raise resources at least cost.
c. Promotion of efficient services by brokers, merchant bankers and other
intermediaries so that they become competitive and professional.
Pending the legislative sanction to SEBI it carried out the functions of supervisory and
advisory body of the Govt. It has initiated the basis for control and regulation of the market,
arranged for the licensing of merchant banks, mutual funds etc. and performed the advisory
functions to the Govt.
The legislation giving powers to SEBI was passed on 4th April 1992 in the form of the
Securities & Exchange Board of India Act to protect the interests of investors in securities
and to promote the development of and to regulate the securities market and for matters
connected therewith or incidental thereto.
4.4 Function of SEBI
In 1988 the Securities and Exchange Board of India (SEBI) was established by the
Government of India through an executive resolution, and was subsequently upgraded as a
fully autonomous body (a statutory Board) in the year 1992 with the passing of the Securities
and Exchange Board of India Act (SEBI Act) on 30th January 1992. In place of Government
Control, a statutory and autonomous regulatory board with defined responsibilities, to cover
both development & regulation of the market, and independent powers have been set up.
Paradoxically this is a positive outcome of the Securities Scam of1990-91. The basic
objectives of the Board were identified as:
• to protect the interests of investors in securities;
• to promote the development of Securities Market;
• to regulate the securities market and
• for matters connected therewith or incidental thereto.
Since its inception SEBI has been working targeting the securities and is attending to the
fulfillment of its objectives with commendable zeal and dexterity. The improvements in the
securities markets like capitalization requirements, margining, establishment of clearing
corporations etc. reduced the risk of credit and also reduced the market.
SEBI has introduced the comprehensive regulatory measures, prescribed registration norms,
the eligibility criteria, the code of obligations and the code of conduct for different
intermediaries like, bankers to issue, merchant bankers, brokers and sub-brokers, registrars,
portfolio managers, credit rating agencies, underwriters and others. It has framed bye-laws,
risk identification and risk management systems for Clearing houses of stock exchanges,
surveillance system etc. which has made dealing in securities both safe and transparent to the
Another significant event is the approval of trading in stock indices (like S&P CNX Nifty &
Sensex) in 2000. A market Index is a convenient and effective product because of the
• It acts as a barometer for market behavior;
• It is used to benchmark portfolio performance;
• It is used in derivative instruments like index futures and index options;
• It can be used for passive fund management as in case of Index Funds.
Two broad approaches of SEBI is to integrate the securities market at the national level, and
also to diversify the trading products, so that there is an increase in number of traders
including banks, financial institutions, insurance companies, mutual funds, primary dealers
etc. to transact through the Exchanges. In this context the introduction of derivatives trading
through Indian Stock Exchanges permitted by SEBI in 2000 AD is a real landmark.
SEBI appointed the L. C. Gupta Committee in 1998 to recommend the regulatory framework
for derivatives trading and suggest bye-laws for Regulation and Control of Trading and
Settlement of Derivatives Contracts. The Board of SEBI in its meeting held on May 11, 1998
accepted the recommendations of the committee and approved the phased introduction of
derivatives trading in India beginning with Stock Index Futures. The Board also approved the
"Suggestive Bye-laws" as recommended by the Dr LC Gupta Committee for Regulation and
Control of Trading and Settlement of Derivatives Contracts.
SEBI then appointed the J. R. Verma Committee to recommend Risk Containment Measures
(RCM) in the Indian Stock Index Futures Market. The report was submitted in
However the Securities Contracts (Regulation) Act, 1956 (SCRA) required amendment to
include "derivatives" in the definition of securities to enable SEBI to introduce trading in
derivatives. The necessary amendment was then carried out by the Government in 1999. The
Securities Laws (Amendment) Bill, 1999 was introduced. In December 1999 the new
framework was approved.
Derivatives have been accorded the status of `Securities'. The ban imposed on trading in
derivatives in 1969 under a notification issued by the Central Government was revoked.
Thereafter SEBI formulated the necessary regulations/bye-laws and intimated the Stock
Exchanges in the year 2000. The derivative trading started in India at NSE in 2000 and BSE
started trading in the year 2001.
4.5 Case Study on OTCBB
The Trading of Stocks in the OTCBB Market Having just made senior partner in his Hawaii
based architectural firm, Matt Gilbertson sought to invest a substantial portion of his new,
much higher salary in speculative grade stock. Normally in the habit of deleting mass e-mail,
Matt’s attention was drawn to the subject line: “Bulletin Board Trading Now Available,” that
was sent by Datek Online. Datek is an online trading company where investors pay $9.99 per
transaction and can trade up to 5,000 shares of a single stock. This emerging trend of do-it-
yourself investing (at a much lower commission cost) was attractive to Matt. However, since
Matt did not know what a Bulletin Board Stock was, he carefully read the e-mail to learn
more about them.
Bulletin Board stocks are recommended for investors at the high end of the risk-return
spectrum. There are several sources of risk associated with these securities. OTCBB stocks
are not required to meet minimum listing and reporting requirements as are stocks listed on
organized exchanges, such as the New York Stock Exchange (NYSE) or the American Stock
Exchange (ASE or AMEX). This means that investors will find it more difficult to find
publicly available information and news that affects the value of the firm. Moreover, since
national exchanges have stringent listing requirements, OTCBB stocks tend to be less stable
companies with short track records, possibly facing regulatory actions or maybe even
Another concern with OTCBB stocks is that because of low volume or liquidity, they have
dramatically higher bid-ask spreads and are subject to partial order executions and in some
cases unfilled orders. Finally, automation, which so many
investors have become accustomed to in recent years, is not available in the OTCBB. For all
these reasons, OTCBB stock investing opportunities are being presented by Datek with a
warning label that investors should do their homework, not only about the firm itself, but on
this risky marketplace as well.
1. With the added risk associated with OTCBB stocks, why are investors so attracted to
2. If we assume the added risk of the OTCBB stocks is not sufficiently compensated for
by higher rates of return, should Date continue to offer these stocks for sale to their
3. Should stocks be allowed to be available for sale if they do not have to disclose
information and have no reporting requirements?
4. Should an investor in Matt’s position decide to invest in OTCBB stocks?
ANALYSIS AND VALUATION OF DEBT AND EQUITY
5.1 Introductions to bond
5.2 Embedded option
5.3 Analysis of bond
5.4 Relationship between price and a yield
5.5 Various model of stock valuation
5.6 Concept, analysis, rationale of credit rating
5.7 Case study
5.1 Introductions to bond
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt
and, depending on the terms of the bond, is obliged to pay interest (the coupon) and/or to
repay the principal at a later date, termed maturity. It is a formal contract to repay borrowed
money with interest at fixed intervals.
Thus a bond is a loan: the issuer is the borrower, the bond holder is the lender, and the
coupon is the interest. Bonds provide the borrower with external funds to finance long-term
investments, or, in the case of government bonds, to finance current expenditure. Certificates
of deposit (CDs) or commercial paper are considered to be money market instruments and not
Bonds and stocks are both securities, but the major difference between the two is that stock-
holders are the owners of the company (i.e., they have an equity stake), whereas bond-holders
are lenders to the issuer. Another difference is that bonds usually have a defined term, or
maturity, after which the bond is redeemed, whereas stocks may be outstanding indefinitely.
An exception is a consol bond, which is a perpetuity (i.e., bond with no maturity).
5.2 Embedded option
An option that is an inseparable part of another instrument. Compare this to a normal (or
bare) option, which trades separately from the underlying security. A common embedded
option is the call provision in most corporate bonds.
5.3 Analysis of Bond
Bond market analysis is an important investment strategy tool for those investors who are
interested in this particular market. This analysis is used to secure the bond’s future
and provide a history of the issuer, an important factor in determining the investment plan.
Bond indexes and various bond market quotes are consulted for the purpose of bond market
The companies and the government to generate funds for varying needs generally use Bond
markets. The investment is considered a loan to the bond issuer. These loans are given by the
general or institutional investor in order to secure fixed income through the dividend.
After a given maturity period, the invested amount is returned to the investor with the
predetermined interest rate. Now, the bond market analysis becomes essential in such
situations as it can provide the complete history and expected future of the particular bond.
Bond market analysis, if done properly, reduces a huge amount of risk on the
investor’s part. When new issues of existing stocks are introduced in the primary
market, the previous performance of a particular stock can be analyzed. This may help the
investor in making an investment decision.
Additionally, when IPOs are introduced in the market, the bond market analysis is essential
before any type of investment is made as it may aid in foreseeing the stocks future. The bond
market analysis can be divided into two types, known as technical bond market analysis, and
basic bond market analysis. Basic bond market analysis is concerned with the calculation of
the intrinsic value by measuring the bonds financial, economic, qualitative and quantitative
The basic analysis is also determined by the bank interest rate, as changes in the bond market
are related to one another. Technical analysis is done through the charts and indexes to find
out the historical facts about the stock.
5.4 Relationship between price and a yield
The general definition of yield is the return an investor will receive by holding a bond to
maturity. So if you want to know what your bond investment will earn, you should know how
to calculate yield. Required yield, on the other hand, is the yield or return a bond must offer
in order for it to be worthwhile for the investor. The required yield of a bond is usually the
yield offered by other plain vanilla bonds that are currently offered in the market and have
similar credit quality and maturity.
Once an investor has decided on the required yield, he or she must calculate the yield of a
bond he or she wants to buy.
Calculating Current Yield
A simple yield calculation that is often used to calculate the yield on both bonds and the
dividend yield for stocks is the current yield. The current yield calculates the percentage
return that the annual coupon payment provides the investor. In other words, this yield
calculates what percentage the actual dollar coupon payment is of the price the investor pays
for the bond. The multiplication by 100 in the formulas below converts the decimal into a
percentage, allowing us to see the percentage return:
So, if you purchased a bond with a par value of $100 for $95.92 and it paid a coupon rate of
5%, this is how you'd calculate its current yield:
Notice how this calculation does not include any capital gains or losses the investor would
make if the bond were bought at a discount or premium. Because the comparison of the bond
price to its par value is a factor that affects the actual current yield, the above formula would
give a slightly inaccurate answer - unless of course the investor pays par value for the bond.
To correct this, investors can modify the current yield formula by adding the result of the
current yield to the gain or loss the price gives the investor: [(Par Value – Bond Price)/Years
to Maturity]. The modified current yield formula then takes into account the discount or
premium at which the investor bought the bond. This is the full calculation:
Let's re-calculate the yield of the bond in our first example, which matures in 30 months and
has a coupon payment of $5:
The adjusted current yield of 6.84% is higher than the current yield of 5.21% because the
bond's discounted price ($95.92 instead of $100) gives the investor more of a gain on the
One thing to note, however, is whether you buy the bond between coupon payments. If you
do, remember to use the dirty price in place of the market price in the above equation. The
dirty price is what you will actually pay for the bond, but usually the figure quoted in U.S.
markets is the clean price.
Now we must also account for other factors such as the coupon payment for a zero-coupon
bond, which has only one coupon payment. For such a bond, the yield calculation would be
n = years left until maturity
If we were considering a zero-coupon bond that has a future value of $1,000 that matures in
two years and can be currently purchased for $925, we would calculate its current yield with
the following formula:
Calculating Yield to Maturity
The current yield calculation we learned above shows us the return the annual coupon
payment gives the investor, but this percentage does not take into account the time value of
money or, more specifically, the present value of the coupon payments the investor will
receive in the future. For this reason, when investors and analysts refer to yield, they are most
often referring to the yield to maturity (YTM), which is the interest rate by which the present
values of all the future cash flows are equal to the bond's price.
An easy way to think of YTM is to consider it the resulting interest rate the investor receives
if he or she invests all of his or her cash flows (coupons payments) at a constant interest rate
until the bond matures. YTM is the return the investor will receive from his or her entire
investment. It is the return that an investor gains by receiving the present values of the
coupon payments, the par value and capital gains in relation to the price that is paid.
The yield to maturity, however, is an interest rate that must be calculated through trial and
error. Such a method of valuation is complicated and can be time consuming, so investors
(whether professional or private) will typically use a financial calculator or program that is
quickly able to run through the process of trial and error. If you don't have such a program,
you can use an approximation method that does not require any serious mathematics.
To demonstrate this method, we first need to review the relationship between a bond's price
and its yield. In general, as a bond's price increases, yield decreases. This relationship is
measured using the price value of a basis point (PVBP). By taking into account factors such
as the bond's coupon rate and credit rating, the PVBP measures the degree to which a bond's
price will change when there is a 0.01% change in interest rates. The charted relationship
between bond price and required yield appears as a negative curve:
This is due to the fact that a bond's price will be higher when it pays a coupon that is higher
than prevailing interest rates. As market interest rates increase, bond prices decrease.
The second concept we need to review is the basic price-yield properties of bonds:
Premium bond: Coupon rate is greater than market interest rates.
Discount bond: Coupon rate is less than market interest rates.
Thirdly, remember to think of YTM as the yield a bondholder receives if he or she reinvested
all coupons received at a constant interest rate, which is the interest rate that we are solving
for. If we were to add the present values of all future cash flows, we would end up with the
market value or purchase price of the bond.
The calculation can be presented as:
Example 1: You hold a bond whose par value is $100 but has a current yield of 5.21%
because the bond is priced at $95.92. The bond matures in 30 months and pays a semi-annual
coupon of 5%.
1. Determine the Cash Flows: Every six months you would receive a coupon payment of
$2.50 (0.025*100). In total, you would receive five payments of $2.50, plus the future value
2. Plug the Known Amounts into the YTM Formula:
Remember that we are trying to find the semi-annual interest rate, as the bond pays the
3. Guess and Check: Now for the tough part: solving for “i,” or the interest rate. Rather than
pick random numbers, we can start by considering the relationship between bond price and
yield. When a bond is priced at par, the interest rate is equal to the coupon rate. If the bond is
priced above par (at a premium), the coupon rate is greater than the interest rate. In our case,
the bond is priced at a discount from par, so the annual interest rate we are seeking (like the
current yield) must be greater than the coupon rate of 5%.
Now that we know this, we can calculate a number of bond prices by plugging various annual
interest rates that are higher than 5% into the above formula. Here is a table of the bond
prices that result from a few different interest rates:
Because our bond price is $95.52, our list shows that the interest rate we are solving for is
between 6%, which gives a price of $95, and 7%, which gives a price of $98. Now that we
have found a range between which the interest rate lies, we can make another table showing
the prices that result from a series of interest rates that go up in increments of 0.1% instead of
1.0%. Below we see the bond prices that result from various interest rates that are between
6.0% and 7.0%:
We see then that the present value of our bond (the price) is equal to $95.92 when we have an
interest rate of 6.8%. If at this point we did not find that 6.8% gives us the exact price that we
are paying for the bond, we would have to make another table that shows the interest rates in
0.01% increments. You can see why investors prefer to use special programs to narrow down
the interest rates - the calculations required to find YTM can be quite numerous!
Calculating Yield for Callable and Puttable Bonds
Bonds with callable or puttable redemption features have additional yield calculations.
A callable bond's valuations must account for the issuer's ability to call the bond on the call
date and the puttable bond's valuation must include the buyer's ability to sell the bond at the
pre-specified put date. The yield for callable bonds is referred to as yield-to-call, and the
yield for puttable bonds is referred to as yield-to-put.
Yield to call (YTC) is the interest rate that investors would receive if they held the bond until
the call date. The period until the first call is referred to as the call protection period. Yield to
call is the rate that would make the bond's present value equal to the full price of the bond.
Essentially, its calculation requires two simple modifications to the yield-to-maturity
Note that European callable bonds can have multiple call dates and that a yield to call can be
calculated for each.
Yield to put (YTP) is the interest rate that investors would receive if they held the bond until
its put date. To calculate yield to put, the same modified equation for yield to call is used
except the bond put price replaces the bond call value and the time until put date replaces the
time until call date.
For both callable and puttable bonds, astute investors will compute both yield and all yield-
to-call/yield-to-put figures for a particular bond, and then use these figures to estimate the
expected yield. The lowest yield calculated is known as yield to worst, which is commonly
used by conservative investors when calculating their expected yield. Unfortunately, these
yield figures do not account for bonds that are not redeemed or are sold prior to the call or put
Now you know that the yield you receive from holding a bond will differ from its coupon rate
because of fluctuations in bond price and from the reinvestment of coupon payments. In
addition, you are now able to differentiate between current yield and yield to maturity. In our
next section we will take a closer look at yield to maturity and how the YTMs for bonds are
graphed to form the term structure of interest rates, or yield curve.
5.5 Various model of stock valuation
In order to beat the market by large margins, you need to know how much a stock is
worth. The Stock Valuation Model will calculate the value of a stock enabling you to
know when to buy and sell a stock.
The Stock Valuation Model incorporates the teachings of the master investors like
Warren Buffet, Philip Fisher, Peter Lynch, Benjamin Graham, Charlie Munger and
Stock Valuation Models
The Valuation Tool consists of two Stock Valuation Models:
• DCF Stock Valuation Model
• PE Valuation Model
DCF Stock Valuation Model
The most theoretically sound stock valuation method, called income valuation or the
discounted cash flow (DCF) method, involves discounting of the profits (dividends, earnings,
or cash flows) the stock will bring to the stockholder in the foreseeable future, and a final
value on disposition. The discounted rate normally includes a risk premium which is
commonly based on the capital asset pricing model
Approximate valuation approaches
Average growth approximation: Assuming that two stocks have the same earnings growth,
the one with a lower P/E is a better value. The P/E method is perhaps the most commonly
used valuation method in the stock brokerage industry. By using comparison firms, a target
price/earnings (or P/E) ratio is selected for the company, and then the future earnings of the
company are estimated. The valuation's fair price is simply estimated earnings times target
P/E. This model is essentially the same model as Gordon's model, if k-g is estimated as the
dividend payout ratio (D/E) divided by the target P/E ratio.
Constant growth approximation: The Gordon model or Gordon's growth model is the best
known of a class of discounted dividend models. It assumes that dividends will increase at a
constant growth rate (less than the discount rate) forever. The valuation is given by the
and the following table defines each symbol:
Symbol Meaning Units
estimated stock price $ or € or £
last dividend paid $ or € or £
discount rate %
the growth rate of the dividends %
Limited high-growth period approximation:
When a stock has a significantly higher growth rate than its peers, it is sometimes assumed
that the earnings growth rate will be sustained for a short time (say, 5 years), and then the
growth rate will revert to the mean. This is probably the most rigorous approximation that is
While these DCF models are commonly used, the uncertainty in these values is hardly ever
discussed. Note that the models diverge for and hence are extremely sensitive to the
difference of dividend growth to discount factor. One might argue that an analyst can justify
any value (and that would usually be one close to the current price supporting his call) by
fine-tuning the growth/discount assumptions.
Market criteria (potential price)
Some feel that if the stock is listed in a well organized stock market, with a large volume of
transactions, the listed price will be close to the estimated fair value. This is called the
efficient market hypothesis.
On the other hand, studies made in the field of behavioral finance tend to show that
deviations from the fair price are rather common, and sometimes quite large.
Thus, in addition to fundamental economic criteria, market criteria also have to be taken into
account market-based valuation. Valuing a stock is not only to estimate its fair value, but also
to determine its potential price range, taking into account market behavior aspects. One of
the behavioral valuation tools is the stock image, a coefficient that bridges the theoretical fair
value and the market price.
PE Valuation Model
The price-earning ratio (PE) is a widely watched measure of how much the market is willing
to pay for $1 of earnings from a firm. A high PE has two interpretations:
A higher than average PE may mean that the market expects earnings to rise in the future.
A high PE may indicate that the market thinks the firm's earnings are very low risk and is
therefore willing to pay a premium for them.
5.6 Concept, analysis, rationale of credit rating
A credit rating assesses the credit worthiness of an individual, corporation, or even a
country. It is an evaluation made by credit bureaus of a borrower’s overall credit history.
Credit ratings are calculated from financial history and current assets and liabilities.
Typically, a credit rating tells a lender or investor the probability of the subject being able to
pay back a loan. However, in recent years, credit ratings have also been used to adjust
insurance premiums, determine employment eligibility, and establish the amount of a utility
or leasing deposit.
A poor credit rating indicates a high risk of defaulting on a loan, and thus leads to high
interest rates, or the refusal of a loan by the creditor.
Personal credit ratings
In the United States, an individual's credit history is compiled and maintained by companies
called credit bureaus. Credit worthiness is usually determined through a statistical analysis of
the available credit data. A common form of this analysis is a 3-digit credit score provided by
independent financial service companies such as the FICO credit score. (The term, a
registered trademark, comes from Fair Isaac Corporation, which pioneered the credit rating
concept in the late 1950s.)
An individual's credit score, along with his or her credit report, affects his or her ability to
borrow money through financial institutions such as banks.
In Canada, the most common ratings are the North American Standard Account Ratings, also
known as the "R" ratings, which have a range between R0 and R9. R0 refers to a new
account; R1 refers to on-time payments; R9 refers to bad debt.
The factors which may influence a person's credit rating are
• ability to pay a loan
• amount of credit used
• saving patterns
• spending patterns
Corporate credit ratings
The credit rating of a corporation is a financial indicator to potential investors of debt
securities such as bonds. These are assigned by credit rating agencies such as Standard &
Poor's, Moody's or Fitch Ratings and have letter designations such as AAA, B, CC. The
Standard & Poor's rating scale is as follows: AAA, AA, A, BBB, BB, B, CCC, CC, C, D.
Anything lower than a BBB rating is considered a speculative or junk bond. The Moody's
rating system is similar in concept but the verbage is a little different. It is as follows: AAA,
Aa1, Aa2, Aa3, A1, A2, A3, Baa1, Baa2, Baa3, Ba1, Ba2, Ba3, B1, B2, B3, Caa1, Caa2,
Caa3, Ca, C.
Sovereign credit ratings
A sovereign credit rating is the credit rating of a sovereign entity, i.e. a country. The
sovereign credit rating indicates the risk level of the investing environment of a country and
is used by investors looking to invest abroad. It takes political risk into account.
Credit rating agencies
Credit scores for individuals are assigned by credit bureaus (US; UK: credit reference
agencies). Credit ratings for corporations and sovereign debt are assigned by credit rating
In the United States, the main credit bureaus are Experian, Equifax, and TransUnion. A
relatively new credit bureau in the US is Innovis
In the United Kingdom, the main credit reference agencies for individuals are Experian,
Equifax, and Callcredit. There is no universal credit rating as such, rather each individual
lender credit scores based on its own wish-list of a perfect customer.
In Canada, the main credit bureaus for individuals are Equifax, TransUnion and Northern
Credit Bureaus/ Experian
In India, the main credit bureaus are CRISIL, ICRA and Credit Registration Office
(CRO).The credit rating agency for individuals in India is CIBIL(Credit Information Bureau
The largest credit rating agencies (which tend to operate worldwide) are Moody's, Standard
and Poor's and Fitch Ratings.
5.6 Case study
Paint industry growth was at a rate of 12% during 1995-96. The industry as a whole will
continue its grow at not less than 8-10% rate in the coming years. Asian Paints is the leader in
decorative paints, controlling 45% of market segment of the total of Rs. 1,800 crore paints
and varnishes industry. In industrial paints, it is the largest player with a market share of
With a low per capita consumption of paints in our country, it has good future prospects.
The prospects for exports are good with an actual export of Rs. 16 crore in 1995-96. The
users in industrial sector, namely, automobiles and its accessories, Household appliances
and consumer durables etc. are showing prospects of rapid growth Thus, the potential for the
industry both in the domestic and export sector is good.
Asian Paints that is a leader in this industry has an installed capacity of 1.08 lakh T.P.A. of
Paints enamels and varnishes. Its gross block grew from Rs. 123 crores in 1993-94 to Rs. 187
crores in 1995-96, due to continuous expansion of capacity. The sales turnover recorded a
compound growth rate of 13.5% p.a. during the last five years, while its net profit grew faster
by 27.5% during the same period.
This company has many plus factors:
1. Good Collaborator namely, Chemische Werke Hals A.G. Germany for manufacture
of Vinyl Pyrdine Latex and PPG Industries Inc. USA, for electro deposition coating
2. Product differentiation and brand image is secured by Asian Paints by spending only
3. 1.5% of revenue on advertisements to testing the quality, availability and
4. Plants well distributed geographically.
5. Six joint collaborations in foreign countries and good export growth
Asian Paints is one of the three winners of the ET - Harward Business School Association
of India awards for its perfor-mance in 1994-95. The measures used by them are as follows
Financial Ratios of the Company
Gross Profits / Total assets 21.36%
Retained Profits/Net worth 18.24 %
Net Profit / Net Worth 25.96%
Growth in Market Cap / Growth in Net worth (over 5 years) 1.60
Cash flow to gross assets 20.64
Example of Company Analysis
It is necessary to analyze the financial data of the company in the background of the industry
performance as shown below :
The data relates to 1996, but that may not matter as it is for illustration. Only selected
companies are studied above. The debt-equity ratio representing leverage is good for NOCIL
and Cochin Refineries. But PAT to NW is higher and the actual market price is covered by
book value three times in the case of of Cochin Refineries As compared to the industry
averages, although the gross profit margin is lower, capital efficiency is higher, and P/E ratio
is lowest indicating that a multiple of 7 of price to earnings exhibits some potential for capital
appreciation in the case of Cochin Refineries. Besides, examine the date of Gross Block,
NW, Sales, Gross and Net Profits and their growth rates over a period of 5 years. Then assess
whether the company’s EPS and P/E ratios are better than the average industry performance
and whether the scrip is under priced or overpriced and buy only if it is under priced with
growth prospects or is fairly priced for its fundamentals. In the above example, Cochin
Refineries is the best buy at its price.
How to Pick Up Growth Shares?
The growth companies are also called blue chip companies. The blue chips of yesteryears
are not necessarily the blue chips of today. The investor has to review and assess the
companies from time to tie to locate the blue chips, based on fundamental analysis, In order
to enable one to identify these blue chips of tomorrow, one should know the nature and
characteristics of these companies. A few guidelines in this regard are set out below.
Firstly, the management should be experienced and efficient; they should have the honesty,
integrity and vision for expansion and growth. Such is the case with Ambanis, Tatas and
Secondly, the market share of the company should be substantial and at least more than one-
third. The larger the share, the better the prospects of controlling the market and profit
margins and expanding the operations. Bajaj Auto has a share of two-thirds in the two-
wheeler and three-wheeler market. So is the case with Asian Paints, Laxmi Machine Works
Thirdly, the company must be well diversified into areas of growth potential. The growth
potential changes from time to time. At present, industries with a growth potential are
cement, paper, petrochemicals, etc. Thus a company with a good deiversificant into such
growth areas woudl does well in sales, profits, and earnings. Some of the consumer product
industries producing soaps, cosmetics, toothpaste and powders etc. would generally record a
consistent growth. A well-diversified company like L & T, Hindustan Lever, or Century
Textiles is a good buy at any reasonable price.
Fourthly, the company’s policy of expansion should be consistent and has a long-term
perspective. Its assets growth should be reasonably good, reflecting its expansion goals.
Growth helps the industry to stabilize its earnings from undue fluctuations and help the
diversification process. The companies with a good asset growth are Reliance, L & T. GSFC
Fifthly, the company should have a consistent and stable distribution policy with good
profit margins. The company should distribute a reasonable proportion of its profits as
dividends, bonus etc. Such companies like Ponds, Colgate, Glaxo etc., would be in good
demand, as investors prefer regular dividend-paying companies.
Sixthly, such a company services the investors well with bonus or rights issue or
convertible debentures, from time to time in addition to increasing dividend payments. The
financial structure and utilization of capital are efficient. The profit margins are growing
and the company is gaining in financial strength.
Lastly, the industry or industries in which the company is operating should have good growth
prospects Pharmaceuticals, Biotech or multimedia. The products should be in continuous
demand like food products, paper soaps, etc. or consumer non-durable goods. The future
outlook of the company and prospects of the industry are interlinked. the prospects would
depend also on the government policy and whether it is subject to price and distribution
control or any restrictions or regulations. The prospects of the industry in which the company
is operating should be assessed from all points of view.
Thus, in the choice of blue chips, the investor has to examine the fundamentals of the
companies through balance sheet analysis for a period of at least five yeas before finally
selecting the shares. The time of purchase should be decided on the basis of technical analysis
referred to later. But for a layman, the purchase time should be in the bearish phase of the
market, when an all-round decline in prices is recorded. At such times, the companies with
strong fundamentals should be picked up at low prices for long-term investment if they can
be classified as blue chips as per the above guidelines.
1. Explain the relationship between the price and the yield?
2. How can we pick a higher return security?
Security Analysis and Valuation - Fundamental and Technical
6.0 Types of Analysis
6.1 Effect of macroeconomics variable on stock market.
6.2 Model for Analysis.
6.3 Technical Analysis
6.4 Summary and Quiz.
6.0 Types of Analysis
Active portfolio managers undertake a variety of different types of analysis in order to
attempt to select outperforming equities for the portfolios they manage. The two extremes are
fundamental analysis and technical analysis. Fundamental analysis focuses on the economic
strengths and weaknesses of the market being assessed, and on the individual features of the
stocks within the market. Technical analysis looks at patterns in the trading history of a
particular market or stock to predict future price direction and levels. Usually portfolio
managers will adamantly stick to one method of analysis, with the majority sitting in the
fundamental analysis camp. Occasionally fund managers will combine the two approaches –
fundamental analysis to determine the stocks and markets they wish to buy or sell, and
technical analysis to determine the timing of the purchases and sales.
For asset allocation purposes, fund managers will study the macroeconomic environment in
order to assess the direction of potential price movements of the different assets and markets
in which their funds may invest. With stock selection, in addition to assessing the economic
environment, fund managers will take into account the individual company’s credit and
operational risk along with details of its share price valuation.
6.1 Effect of macroeconomics variable on stock market
When portfolio managers must choose in which countries within a regional portfolio to go
over- or under-weight (asset allocation), they will often start with an assessment of the
macro-economic conditions of the countries in the index being followed. Likewise, prospects
for individual companies are tied to the broader economies in which they operate. As a result,
it is important for fund managers and analysts to determine the state of the aggregate
economy. The following are some of the indicators that they will examine:
• GDP growth
• Inflation rates
• Interest rates
• Trade accounts
• Current account balances
• Fiscal account balances
• Currency rates
• Unemployment levels
• Industrial production and manufacturing output data
• Proposed economic reforms
• Sovereign debt ratings
• Political issues and cycles.
Both the historic trends and attempted projections will be looked at to determine where in an
economic cycle each country finds itself. This type of analysis may assist fund managers in
both the selection and the timing of the proper countries within a fund. The analysis will also
assist in determining the asset allocation to sectors within the countries. For example, a fund
manager who notices that the currency in one country appears to be particularly undervalued
may want to increase the asset weighting in this country (having screened the other macro
parameters) in order to take advantage of a potential currency appreciation and subsequently
enhanced currency-based returns for the portfolio. Another example of how macro-economic
analysis might influence portfolio decisions is where interest rates are expected to decrease in
a country. Under this scenario, portfolio managers may want to buy interest-rate sensitive
sectors (such as banks) or companies (such as highly indebted corporations) within the
Below, some of the more influential economic data points are reviewed.
Gross domestic product
Gross domestic product (GDP) is the most widely-used statistic to determine the overall
health of an economy. GDP figures are typically produced quarterly or annually by
government organizations. Preliminary estimates are given throughout the year, and these are
subsequently revised. GDP measures the total production of an economy’s goods and
services. A high GDP growth figure indicates that an economy is growing rapidly, which, in
turn, may mean that firms operating in that economy may have increased prospects for higher
sales growth. The components of GDP are:
GDP = C + I + G + (X – M)
C = consumption
I = investment
G = government spending
X = exports
M = imports
(X – M) = net exports.
Analysts often watch the different components of GDP closely because some of the
components tend to provide a good indication of the future direction of the economy.
Generally, GDP figures are adjusted for inflation by dividing the nominal GDP figure by a
deflator (inflation rate adjustment). The resulting figure is the real GDP figure, which can be
compared to historical figures. Industrial production is another popular measure of the
condition of an economy. This statistic is a narrower measure of economic activity, and
focuses only on the manufacturing side of the economy.
Interest rates affect the present value of future cash flows – high interest rates reduce the
attractiveness of investment opportunities, and low interest rates increase the appeal of
investment opportunities. A low interest rate environment is aimed at promoting business
investment expenditures and, subsequently, higher growth rates. Mortgage payments and
high-priced consumer durable goods such as automobiles are also sensitive to interest-rate
movements. When interest rates are high, consumers spend less.
Inflation is the rate at which the general price of goods rises. High rates of inflation are
sometimes associated with economies that are growing too fast – where the demand for goods
and services is outpacing productive capacity. The implication is that there will be an upward
pressure on prices. Inflation expectations also lead to interest rate increases. The opposite of
inflation is deflation, where prices spiral downwards. Deflation can put recessionary
pressures on an economy as lower prices translate into lower profits for companies.
The unemployment rate is the percentage of the labour force that is actively looking for work.
The unemployment rate measures the level to which an economy is operating at full capacity.
A rising unemployment figure can point to a slowdown in the economy.
The budget deficit of a government is the difference between government spending and
government revenues. Shortfalls in the budget must be offset by government borrowing. If
government borrowing is excessive, interest rates may be forced to go up and total demand
for credit in the economy will increase. Higher interest rates are negative for business
investment and, consequently, company growth.
Current account deficit
The current account is the difference between imports and exports, including merchandise,
services, and transfers such as foreign aid. If the current account shows a deficit, this means
that the country imports more than it exports; a surplus indicates that the country exports
more than it imports. Current account deficits have to be funded somehow. Sometimes,
foreign direct investment into a country will offset a current account deficit, or high interest
rates may attract capital flow into a country. The level of the current account is affected by
changes in the exchange rate. If a currency depreciates exports may increase, as it becomes
less costly for foreigners to purchase domestically produced goods.
The exchange rate is the rate at which domestic currency can be converted into foreign
currency. Movements in exchange rates can affect the international competitiveness of
domestically produced products. A sharp currency devaluation can lead to a rise in exports.
Exchange rates can also have an effect on inflation rates. Depreciation of a currency increases
the cost of imported goods, which results in an increase in local prices and consequently, the
The government uses the tools of fiscal policy and monetary policy to promote GDP growth,
regulate employment levels, and stabilize prices. These policies are described below.
Fiscal policy refers to the taxation and spending policies of the government designed to
calibrate the economy. Government can stimulate growth in real GDP by creating tax
incentives for investment. Likewise, increases in general tax rates immediately divert income
from consumers and result in decreases in consumption. Decreases in government spending
reduce the demand for goods and services. Fiscal policy is a direct way to stimulate or slow
down an economy. One way to examine the net impact of a fiscal policy is to look at the
government’s budget deficit. If a large deficit is present, this means the government is
spending more than it is taking in by the way of taxes. The net effect will be an increase in
the demand for goods (through spending) by more than it reduces the demand for goods
(through taxes). As a result, the economy will experience a push towards growth. Budget
deficits are, however, associated with increased interest rates.
Monetary policy refers to actions taken by a central bank to control interest rates and the
money supply (the supply of money in the economy).Increases in the money supply lower
short-term interest rates, subsequently encouraging investment and consumption demand.
Over a longer period of time, however, many economists believe that a higher money supply
will lead only to higher prices and inflation, and will not have a permanent effect on
economic growth levels. Tools that the central bank has at its disposal include: buying and
selling bonds for its own account to increase or decrease the money supply in the system; the
interest rate charged to banks on short-term loans; and reserve requirements dealing with the
amount of deposits that banks must hold as cash on hand or as deposits with the central bank.
The ability of a central bank to maintain stable prices and interest rates whilst stimulating
growth and maintaining a high level of employment is essential for providing an environment
conducive to running profitable businesses.
The business cycle
Even though governments can use fiscal and monetary policies to attempt to keep inflation at
bay and unemployment low, economies still repeatedly seem to pass through good and bad
times. Analysts and fund managers must determine whether the economies in which they will
invest are improving or deteriorating. A forecast that is wrong may have a negative impact on
the investment strategy.
A business cycle incorporates periods of expansion and contraction of aggregate
economic activity measured by the real GDP. The length and depth of the cycles can be
irregular. Generally speaking, business cycles tend to last between six and ten years;
however, this can be very difficult to forecast. The transition points across cycles are called
peaks and troughs, with the high point of economic activity being the peak and the low point
the trough. An economy is in an expansion phase between a trough and a peak, and in a
contraction phase just after a peak and before a trough. Historically, periods of contraction
have tended to be shorter than periods of expansion. Various types of cyclical indicators have
been developed to help forecast the business cycle. Leading economic indicators (such as
new orders for manufacturers) are indicators that tend to rise and fall with antecedence to the
rest of the economy. Coincident and lagging indicators, such as industrial production and
changes in the consumer price index, tend to move in tandem with or somewhat after the
A practical look at macro-economic data
Portfolio managers often rely on external sources of economic data and forecasts to make
informed decisions. They will have to be aware of any biases in the data that these sources
may incorporate in their information, such as timeliness of change of estimates given new
macro information available.
For example, given the data in Table 7.1, the following conclusions can be drawn:
1. Comparing GDP growth amongst the countries, between last year and this year, all the
countries are expected to experience increased growth. Country Q in particular is
expected to come out of a recession from –11.1% to 4.3%. This is probably due, in part,
to the effects of the depreciation of its currency leading the trade balance to increase in
2. It can be seen that the sharp devaluations of the currencies in Countries Q and R have led
to inflation rates (CPI) being forecast to increase (quite dramatically, in the case of
3. The current accounts as a percentage of GDP show that most of the countries in the
region hold current account deficits (apart from Country Q). It would be necessary to
analyse how these account deficits are being financed within each country in order to
gauge how accurate the forecasts really are. In some cases the devaluation of the
currency is causing the trade balances to improve, with exports surpassing imports.
4. Regarding the exchange rate movements, it can be seen that Countries Q and R have
experienced sharp currency depreciations in recent years. The currencies of Countries S
and T have shown milder devaluations. Further research would have to be done to see
whether currency stabilization would, in fact continue past next year.
The above exercise is just the beginning of macro-economic analysis that would be
performed on a region or on countries. The next step would be to determine in which
regions/countries to go over or underweight. Some fund management companies have macro-
economic screens and templates that they superimpose on macro data to determine their asset
allocation. Nonetheless the process must be dynamic, as new macro-economic data are
disclosed weekly, monthly, and annually.
Industry life cycle
Many analysts believe that industries go through life cycles with respect to unit sales. There
are several stages to the life cycle of an industry. At the beginning of the life cycle is the
stage of early development, which is characterized by modest sales growth and very small or
even negative profit margins and profits. Major development costs are incurred during this
phase, as the market for the industry’s product or services is still fledgling. Next is the phase
of rapid growth and expansion, where a market develops for the product or service and
demand becomes substantial. Little competition exists at this stage, and profit margins can be
large. The industry builds productive capacity as sales grow and the industry attempts to meet
The next phase is the mature growth phase. Here, the rapid growth of sales and the high profit
potential attract competitors to the industry, which in turn causes an increase in supply and
lower profit margins. The future sales growth may still be above the general average for the
economy, but it is no longer accelerating. Profit margins begin to reach more normalized
Following the mature growth phase is the stabilization phase, where the rapid growth of sales
and high profit margins attract competition into the industry. This causes an increase in
supply and lower prices, and as a result profit margins begin to decline to normalized levels.
Typically, the industry growth rate declines to match the growth rate of the aggregate
economy or of the segment of the economy of which the industry is a part. Profit growth will
vary from company to company and industry to industry. The final stage of maturation
involves deceleration of growth and decline of the industry. This stage of industry maturity is
characterized by the industry’s sales growth declining because of shifts in demand or growth
of substitutes. Profit margins will be squeezed and some companies may experience losses.
Investors may start to question the use of capital employed by the industry.
Industries in the early phases of their life cycles offer high-risk/high-reward investments.
Industries that have recently reached maturity offer a low-risk/ low-return investment
strategy. Also, each industry is quite unique in how long it takes to progress through each
phase. Some industries, such as the biotechnology industry, develop rapidly, whilst other
industries, such as the natural gas industry, develop more slowly. External forces, such as
political and regulatory changes, can influence a particular industry’s progression through its
life cycle. Social and democratic factors also play an important role in the development of an
6.3 Model for Analysis
Fundamental analysis for individual shares implies assessing the fundamentals not only of the
company being considered, but also of the industry and sector in which it is situated. An
analyst/fund manager would look closely at the balance sheet, income statement, and cash
flow statement of the company being analysed. In order to determine earnings and cost
projections, the analyst must be aware of the factors influencing (and expected to influence)
the company and the sector. One of the frameworks often utilized for industry analysis is the
Porter’s Five Forces analysis, whereby the analyst looks at several features that might push or
pull an industry and companies within that industry in a certain direction.
Figure 7.1 provides a summary of the basic Porter’s Five Forces model. The application of
this framework to each company/industry being analysed provides a systematic method of
looking at the factors that might influence a company/industry positively or negatively. This
information would be taken into consideration when finalizing a stock purchase or sale
Sources of risk for equity
The required rate of return and risk premiums for a stock are based on several risks. Some of
the most influential of these are listed below:
Business risk is summarized by the variability of a company’s profit margins based on the
predictability of consistency of its earnings and sales. The higher the volatility of the profit
margins, the higher the risk. This risk is sometimes also referred to as operating leverage.
Both internal and external factors can affect a company’s profits. To assess the risk from
internal factors, it is necessary to look at the overall operating efficiency of the firm.
Questions asked might ask include: Does the firm utilize the most effective mix of labour and
capital? Do any expansion projects make sense? Is too much being spent on research and
114 External factors such as the price of oil or interest rate levels will affect certain
companies. When oil prices are high for a sustained period of time, both oil companies and
auto companies may be affected – whereas oil companies may benefit from higher revenues
for the higher oil prices, auto companies may be negatively affected as people drive less and
purchase fewer cars.
Therefore, the more sensitive the company’s profits are to changes in prices and
macroeconomic factors, the larger the firm’s business risk. The business risk of a utility firm
that supplies electricity will be smaller than the business risk of a bank, which is dependent
on the level of interest rates prevalent.
Financial risk is the risk of insolvency, where the firm’s total liabilities exceed total assets.
Here, the riskiness of the firm’s capital structure is measured. The degree of risk can be
determined by the company’s financial leverage or by the level of fixed charges relative to
net income. Firms with a large amount of debt are riskier than firms that are financed
primarily with equity. Consequently, the larger the proportion of debt obligations, the greater
the financial risk for the firm. The firm’s ability to meet interest and principal payments is a
critical factor in determining the firm’s financial risk.
Liquidity risk relates to poor marketability of a company’s common stock. If the market for a
company’s assets becomes too thin to enable fair and efficient trading to take place, the
liquidity risk will be deemed to be high. If the owner of an asset has difficulty in selling it
when needed (no natural buyers in the market), he or she may have to offer the security at a
price dramatically higher than the value of the asset to obtain the sale. For a bank, liquidity
risk refers to the risk that the bank has insufficient funding to meet commitments as they
arise. For other companies, the risk arises when the entity cannot meet payments when they
Agency risk is the risk that managers – agents of the company owners – will not act in the
best interest of the firm. Managers might take a decision that would benefit themselves rather
than the shareholders. For example, a manager might decide to open a branch office in a
location closer to his or her home, rather than closer to the suppliers and customers. To avoid
agency risk, firms try to align the interests of management with those of the shareholders.
This is sometimes done by forcing the managers to hold a large number of company shares
and/or share options.
Regulatory risk involves the possibility that new regulations imposed by government
agencies may affect the operations of a company. For instance, a manufacturer could locate a
factory in a certain area, only to find that the zoning laws change, disallowing any
manufacturing in that area.
Interest rate risk
Interest rate risk arises from the impact of fluctuating interest rates, and will directly affect
the firm’s borrowing and investing of funds. Additionally, some investments may be exposed
not only to the level of interest rates, but also to the shape of the yield curve (the trajectory
between long- and shortterm interest rates). Some types of institutions, particularly banks and
highly leveraged companies, will be very sensitive to interest rate changes. Additionally, the
investor’s required rate of return will change as interest rates change.
Inflation can cause distortions in the accounting measurement of a company’s depreciation
costs, inventory, and interest expense. For example, during periods of high inflation,
depreciation values are understated relative to replacement costs and real economic income or
cash flow is overstated. The same occurs with First In First Out (FIFO) inventory accounting.
With high inflation, FIFO results in an overstatement of real income. The effect of inflation
on interest is to understate real income.
Operational risk is the risk linked to non-financial matters, such as fraud, system failure,
accidents, and breaches in corporate governance.
Currency risk arises from exposure to movements in foreign currency (FX) rates. This risk
can be sub-divided into transaction risk, where currency movements affect the proceeds from
day-to-day transactions, and translation risk, which affects the value of assets and liabilities
on the balance sheet. Holdings within a fund in different currencies that appreciate or
depreciate against the base currency in which the fund is quoted may have a positive or
negative impact on the overall value of the fund.
Systematic risk is the movement in securities that results from economic changes affecting
the entire market. Market beta is the measure of systematic risk.
6.4 Technical Analysis
Rather than looking at the fundamentals of the economy or of a company, technical analysts
look at the patterns of share prices and trading history to determine the appropriate strategy to
adopt. A technical analyst, often known as a chartist, monitors share price behaviour – the
patterns of share prices and relationships between prices and other market data – and then,
using historic information of recurring patterns, endeavours to select money-making stocks.
Through the use of charts, technical analysts develop patterns of market behaviour that they
expect can be repeated over and over again. To some extent, these predictions may be self-
fulfilling. If the charts predict that a share price will fall and investment managers sell this
share, then supply and demand factors will force the price of that share down. The technique
is based heavily on recognizing past patterns, the supply and demand for a stock, investor
psychology (the behaviour of crowds), and the use of certain mechanical rules. These rules
1. The use of moving averages of share prices over time (often 20, 40 days or 200 days),
trying to spot when a share has been over-sold and is due for an upwards price
correction (or vice versa)
2. Studying the number of daily price rises and falls and the number of shares traded on
that day – a rise in price and volume indicates increasing investor interest which
3. Spotting support areas (prices at which investors will buy more shares) and resistance
zones (prices at which investors will sell). For example, if a company issued shares at
100p a year ago and the price today is 90p, it is likely that a number of investors will
sell once the price reaches 100p.
Most approaches to technical analysis assume that financial prices follow a market cycle
model, where overall prices tend to move through long trends of either rising or falling price
levels. The founder of one of the original trend theories was Charles Dow (founder of the
Dow Jones news service), whose method, designed in the early 1900s, of analysing and
interpreting stock market movement bears his name – the Dow Theory. The essence of the
Dow Theory is that there are always three forces working on the stock market:
1 A primary or major trend akin to the tides in the ocean
2 A secondary reaction or intermediate trend that resembles waves
3 Daily fluctuations or short-term movements that resemble ripples.
The Dow Theory asserts that a bull market is established when both the Dow Jones Industrial
Average and the Dow Jones Transportation Average are moving upwards. A bear market
occurs when the indices are moving down. If one of the indices departs from the trend and is
followed by a departure of the other index from the trend, then this is viewed as confirmation
that the primary trend has changed. The basic tenets of the theory also purport that no
additional information is required about the stock market outside of data on stock indices and
that, usually, a positive relationship exists between the trend and volume of shares traded.
The Dow Theory has been extended and changed over the years. However, most technical
analysis theories stem from the Dow Theory.
Technical analysts study moving average charts in order to identify short and long-term
trends (as suggested by the Dow Theory). To construct a 30-day moving average chart, the
arithmetic average of the prices from the previous 30 trading days would be taken. This
calculation would be done every day by dropping the oldest day and adding the most recent
day, thus creating a rolling or moving average. A technical analyst might compare the 200-
day moving average to the 30-day moving average to contrast a long term trend with a short-
term trend. If the 200-day moving average was rising while the 30-day average was falling,
one interpretation could be that price declines are expected in the short term, but not in the
long term. Moving averages can be used for market indices and for individual stocks.
Technical analysts will look for moving average charts to cross each other to indicate a
change in direction of a trend. Likewise, if prices of a stock or index reverse and break
through or cross a moving average line from below on heavy volume, then this points to a
strongly positive change. The indication is then that this breakthrough signals a reversal of a
declining trend. The opposite would be true if prices crossed the moving average line from
Relative strength charts assess the performance of one company, industry or market relative
to another. Typically, the relationship between two historical series of data is expressed as a
ratio of one security or index divided by another security or index. For example, a technical
analyst may want to compare the performance of a particular share to overall market
performance. The share price may have shown a trend of out performance compared to the
index over a given period of time.
The relative strength indicator (RSI) measures the relative internal strength of a price
pattern and is a percentage ranging from 0% to 100%. Typically, a reading of 30 or less
indicates an oversold condition, while a reading of 70 or above points to an overbought
situation. The actual numerical calculation for RSI is rather complex, and most data services,
such as Bloomberg provide the calculations. The best signals are noted when the RSI enters
overbought or oversold areas and begins to pull back. Here, it could be deduced that the price
movement has reached an extreme and is likely to reverse soon. Alternatively, some technical
analysts believe that high RSI figures signify an ongoing trend and consequently a buy signal
(the trend is your friend). In this case, the analyst will only sell after the RSI has fallen
Market breadth indicators
Several technical indicators exist that are believed to be leading indicators of future direction
in price movement of a security or index. These indicators can be classified into breadth or
sentiment indicators. Breadth indicators highlight overall market strength or weakness. The
following are some examples of momentum indicators, or breadth indicators. The advance–
The advance–decline line is a cumulative measure of how many stocks are up for the day on
an exchange relative to how many stocks are down for the day. For example, given the
information for a particular week (see Table 7.2), the advance–decline line can be calculated.
In Table 7.2, the difference between the advancing and declining issues is taken and the
cumulative sum is then calculated. On Wednesday, more issues declined than advanced, and
the cumulative advance–decline for that day was: –550 + 200 = –350.
The cumulative advance–decline figures can then be plotted to create the advance–decline
line. Most technical analysts view a falling advance– decline line in a rising market as a
bearish warning signal, and a rising advance–decline line in a falling market as a bullish sign.
52-week new high/new low ratio This category of breadth indicator compares 52-week new
highs and 52-week new lows, where the new high is expressed as a percentage of (new highs
+ new lows). The raw ratio can sometimes be volatile, but if a 10-day and 25-day moving
average is applied, the change in trend indicator becomes more useful. When the 10-day
moving average crosses over the 25-day moving average in a counter-swing fashion,
particularly after sharp moves when the 10-day moving average greatly exceeds the 25-day
moving average, the result is a fairly strong buy or sell signal.
Sentiment indicators attempt to gauge the overall mood and prevailing psychology of the
general marketplace. Sentiment indicators can confirm general trends, but can also determine
when a trend is likely to reverse soon. As a result they become most indicative when they
reach extreme levels, where the assumption is made that the market is about to exhaust itself
and that the prevailing trend is likely to change. When sentiment indicators are used in this
way, they are known as contrary indicators. The idea is that the crowd is usually wrong at
significant market turning points. There are many sentiment indicators, including:
• Put/call ratio
• Cash balances held by mutual funds or unit trusts
• Credit balances held by brokerage accounts
• Consensus estimates
• Short-selling data
• Odd-lot trading
• Directors’ dealings.
Some of these are discussed below.
The put/call ratio is probably the most widely used sentiment indicator. The ratio is
calculated by dividing the volume of put option trading by the volume of call option trading.
Excessive put buying or a high ratio is viewed as a bearish signal, and excessive call buying
or a low ratio is considered bullish. Investors buy put options (the right to sell stocks in the
future) when they believe that the stock prices will fall, and call options (the right to buy
stocks in the future) when they believe prices will rise. Typically, the volume
for call options is greater than the volume for put options, and the indicator will usually be
below 1.0 (or less than 100%). Put/call ratios may be calculated for most indices.
Various agencies conduct polls of the investment community asking for evaluations of
various markets, including the stock market. These polls are usually conducted weekly and
published the following week. The data obtained from these polls are used as contrary
indicators. When the investment community becomes excessively bullish, technical analysts
become more cautious. Conversely, when the investment community becomes more bearish,
the technical analysts become more bullish. The same analysis could be performed by
comparing the number of stock market newsletters that are positive to those newsletters that
Corporate officers or main shareholders of a company that hold more than 5% of the total
voting stock of a company are known as ‘insiders’. They are required to file with the
Securities and Exchange Commission (SEC) or other local stock authorities, their sales and
purchases. Generally, insiders are fairly accurate in their buying and selling decisions because
of their intimate knowledge of the company. Also, they are in the best position to assess their
company’s relative value in the marketplace. Thus company directors tend to sell before their
stock hits the top and buy before their stock completes a bottoming phase. One caveat,
though: insider buying tends to be more accurate than insider selling. Sometimes a director
may sell shares to raise cash for personal reasons, such as to fund a child’s education or to
buy a new home. A strong positive signal is set when a number of insiders are buying
significant volumes of their company stock. When insiders are selling considerable volumes
of their company stock, this should be a cause for concern.
Technical analysts plot market data in charts, such as bar charts, point-and figure charts, and
candlestick charts, to make inferences about future prices. Bar charts show each day’s,
week’s or month’s high, low and closing price movements for a designated time period.
Point-and-figure charts distinguish reversals in the stock price direction. These charts
comprise of a series of x’s and o’s positioned within a grid. The x’s represent price
increases over a specified amount, and the o’s represent price decreases over a specified
amount. Candlestick charts were originally developed in Japan and are similar to bar charts,
but also include opening and closing prices.
Some examples of often-used technical analysis charts are given below.
A trend is the direction in which a share price is heading. Three choices of trend exist:
1 Positive or advancing trend
2 Negative or declining trend
3 Neutral or sideways trading range.
Assessing prevailing trends is important, because positioning trades with the trend tends to
make most money – i.e. buying in up trends and selling in down trends.
A positive trend (see Figure 7.2) is characterized by higher highs and higher lows.123
Prices do not usually continue straight up or straight down for very long. Corrections within
the major trend usually occur, which will then carry prices either sideways or slightly against
the trend. These interruptions are known as consolidations, because share price patterns pause
to consolidate the gains or losses. Consolidation patterns are generally known as continuation
patterns because they usually indicate that prices will continue to move in the overall
direction of the major trend, after a short pause. Often, there is a noticeable drop in volume
during the pause. Triangles (Figure 7.3) are drawn from very short-term trend lines
connecting the relevant tops and bottoms of very short-term price swings
Reversal patterns are transition areas in which market tendencies begin to shift from bullish
to bearish or vice versa. The volume of shares being traded during this period usually helps to
identify the phase of the reversal formation.
Head and shoulders (see Figure 7.4) – the most reliable reversal pattern – occurs as either a
head and shoulders top or head and shoulders bottom.
6.5 Summary and QUIZ
The above are just some of the types of technical analysis performed by analysts and fund
managers. Optimally, technical analysis involves a great deal of scientific concepts and
discipline. In practice, not all analysts have access to the software needed to do the full
optimization necessary. However, many current pricing systems, such as Bloomberg, do offer
some of the basic technical analysis charts on most equities. It must be realized that technical
analysis indicators are merely tools to help fund managers and analysts predict price
movements, and that their reliability varies over time. They can be used as inputs in a wider
context of stock analysis, including fundamental analysis, to assist in stock selection and
Quiz: Unit 6
1. High rates of are sometimes associated with economies that are growing too fast – where
the demand for goods and services is outpacing productive capacity.
(C) foreign exchange
(D) budget deficits
2. Increasing general tax rates is a tool used in .
(A) fiscal policy
(B) exchange rate control
(C) monetary policy
(D) employment balancing
(E) currency depreciation
3. During the of the industry life cycle, competition is attracted into an industry, causing
profit margins to normalize.
(A) maturation phase
(B) mature growth phase
(C) rapid growth phase
(D) expansion phase
(E) stabilization phase
4. Analysis of an industry or sector shows that new technology about to be launched would
make it cheaper for a customer to move into using this newer technology rather than the
existing, more conventional method. Under Porter’s Five Forces model, this would be
(A) threat of new entrants
(B) power of the customer
(D) power of the suppliers
(E) threat of substitution
5. Breaches in corporate governance would be an example of
(A) systematic risk
(B) operational risk
(C) liquidity risk
(D) regulatory risk
(E) interest rate risk
6. The is a percentage measuring the internal
strength of a price pattern.
(A) resistance level
(B) moving average
(D) support level
(E) volume peak
7. The occurs when a price reaches a certain point from which, technically, it is expected to
(A) resistance level
(B) consolidation pattern
(D) volume peak
(E) support level
8. are probably the most reliable reversal patterns in technical analysis.
(B) resistance levels
(C) head and shoulders
(D) support levels
(E) volume peaks
Efficient Market Hypothesis
7.2 Concept of market efficiency
In finance, the efficient-market hypothesis (EMH) asserts that financial markets are
"informationally efficient", or that prices on traded assets, e.g., stocks, bonds, or property,
already reflect all known information. The efficient-market hypothesis states that it is
impossible to consistently outperform the market by using any information that the market
already knows, except through luck. Information or news in the EMH is defined as anything
that may affect prices that is unknowable in the present and thus appears randomly in the
The EMH was developed by Professor Eugene Fama at the University of Chicago Booth
School of Business as an academic concept of study through his published Ph.D. thesis in the
early 1960s at the same school. It was widely accepted up until the 1990s, when behavioral
finance economists, who were a fringe element, became mainstream. Empirical analyses have
consistently found problems with the efficient markets hypothesis, the most consistent being
that stocks with low price to earnings (and similarly, low price to cash-flow or book value)
outperform other stocks. Alternative theories have proposed that cognitive biases cause these
inefficiencies, leading investors to purchase overpriced growth stocks rather than value
stocks. Although the efficient markets hypothesis has become controversial because
substantial and lasting inefficiencies are observed, it remains a worthwhile starting point.
The efficient-market hypothesis was first expressed by Louis Bachelier, a French
mathematician, in his 1900 dissertation, "The Theory of Speculation". His work was largely
ignored until the 1950s; however beginning in the 30s scattered, independent work
corroborated his thesis. A small number of studies indicated that US stock prices and related
financial series followed a random walk model.
Research by Alfred Cowles in the ’30s and ’40s suggested that professional investors were in
general unable to outperform the market.
The efficient-market hypothesis emerged as a prominent theoretic position in the mid-1960s.
Paul Samuelson had begun to circulate Bachelier's work among economists. In 1964
Bachelier's dissertation along with the empirical studies mentioned above were published in
an anthology edited by Paul Coonter. In 1965 Eugene Fama published his dissertation
arguing for the random walk hypothesis and Samuelson published a proof for a version of the
efficient-market hypothesis In 1970 Fama published a review of both the theory and the
evidence for the hypothesis. The paper extended and refined the theory, included the
definitions for three forms of market efficiency: weak, semi-strong and strong (see below).
Further to this evidence that the UK stock market is weak-form efficient, other studies of
capital markets have pointed toward their being semi-strong-form efficient. Studies by Firth
(1976, 1979, and 1980) in the United Kingdom have compared the share prices existing after
a takeover announcement with the bid offer. Firth found that the share prices were fully and
instantaneously adjusted to their correct levels, thus concluding that the UK stock market was
semi-strong-form efficient. The market's ability to efficiently respond to a short term and
widely publicized event such as a takeover announcement, however, cannot necessarily be
taken as indicative of a market efficient at pricing regarding more long term and amorphous
factors. David Dreman has criticized the evidence provided by this instant "efficient"
response, pointing out that an immediate response is not necessarily efficient, and that the
long-term performance of the stock in response to certain movements are better indications.
A study on stocks response to dividend cuts or increases over three years found that after an
announcement of a dividend cut, stocks underperformed the market by 15.3% for the three-
year period, while stocks outperformed 24.8% for the three years afterward after a dividend
Beyond the normal utility maximizing agents, the efficient-market hypothesis requires that
agents have rational expectations; that on average the population is correct (even if no one
person is) and whenever new relevant information appears, the agents update their
Note that it is not required that the agents be rational. EMH allows that when faced with new
information, some investors may overreact and some may underreact. All that is required by
the EMH is that investors' reactions be random and follow a normal distribution pattern so
that the net effect on market prices cannot be reliably exploited to make an abnormal profit,
especially when considering transaction costs (including commissions and spreads). Thus,
any one person can be wrong about the market — indeed, everyone can be — but the market
as a whole is always right.
7.2 Market Efficiency
There are three common forms in which the efficient-market hypothesis is commonly stated
— weak-form efficiency, semi-strong-form efficiency and strong-form efficiency, each of
which have different implications for how markets work.
• Excess returns can not be earned by using investment strategies based on historical
• Technical analysis techniques will not be able to consistently produce excess returns,
though some forms of fundamental analysis may still provide excess returns.
• Share prices exhibit no serial dependencies, meaning that there are no "patterns" to
asset prices. This implies that future price movements are determined entirely by
information not contained in the price series. Hence, prices must follow a random
• Semi-strong-form efficiency implies that share prices adjust to publicly available new
information very rapidly and in an unbiased fashion, such that no excess returns can
be earned by trading on that information.
• Semi-strong-form efficiency implies that neither fundamental analysis nor technical
analysis techniques will be able to reliably produce excess returns.
• To test for semi-strong-form efficiency, the adjustments to previously unknown news
must be of a reasonable size and must be instantaneous. To test for this, consistent
upward or downward adjustments after the initial change must be looked for. If there
are any such adjustments it would suggest that investors had interpreted the
information in a biased fashion and hence in an inefficient manner.
• Share prices reflect all information, public and private, and no one can earn excess
• If there are legal barriers to private information becoming public, as with insider
trading laws, strong-form efficiency is impossible, except in the case where the laws
are universally ignored.
• To test for strong-form efficiency, a market needs to exist where investors cannot
consistently earn excess returns over a long period of time. Even if some money
managers are consistently observed to beat the market, no refutation even of strong-
form efficiency follows: with hundreds of thousands of fund managers worldwide,
even a normal distribution of returns (as efficiency predicts) should be expected to
produce a few dozen "star" performers
Criticism and behavioral finance
Investors and researchers have disputed the efficient markets hypothesis empirically and
theoretically. Behavioral economists attribute the imperfections in financial markets to a
combination of cognitive biases such as overconfidence, overreaction, representative bias,
information bias, an inability to use configural rather than linear reasoning, and various other
predictable human errors in reasoning and information processing. These have been
researched by psychologists such as Daniel Kahneman, Amos Tversky, Richard Thaler, and
Paul Slovic. These errors in reasoning lead most investors to avoid high-value stocks and buy
growth stocks at expensive prices, which allow those who reason correctly to profit from
bargains in neglected value stocks and the overreacted selling of growth stocks.
Empirical evidence has been mixed, but has generally not supported strong forms of the
efficient markets hypothesislow P/E stocks have greater returns. In this paper he also refuted
the assertion by Ray Ball that these higher returns could be attributed to higher beta, whose
research had been accepted by efficient market theorists as explaining the anomaly in neat
accordance with modern portfolio theory.
Speculative economic bubbles are an obvious anomaly, in that the market often appears to be
driven by buyers operating on irrational exuberance, who take little notice of underlying
value. These bubbles are typically followed by an overreaction of frantic selling, allowing
shrewd investors to buy stocks at bargain prices. Rational investors have difficulty profiting
by shorting irrational bubbles because, as John Maynard Keynes commented, "Markets can
remain irrational longer than you can remain solvent." Sudden market crashes as happened on
Black Monday in 1987 are mysterious from the perspective of efficient markets.
Burton Malkiel, a well-known proponent of the general validity of EMH, has warned that
certain emerging markets such as China are not empirically efficient; that the Shanghai and
Shenzhen markets, unlike markets in United States, exhibit considerable serial correlation
(price trends), non-random walk, and evidence of manipulation.
Behavioral psychology approaches to stock market trading are among some of the more
promising alternatives to EMH (and some investment strategies seek to exploit exactly such
inefficiencies). But Nobel Laureate co-founder of the programme—Daniel Kahneman—
announced his skepticism of investors beating the market: "They're [investors] just not going
to do it [beat the market]. It's just not going to happen." Richard Thaler has started a fund
based on his research on cognitive biases. In a 2008 report he identified complexity and the
herd behavior as central to the global financial crisis of 2008
8.0 Introduction to portfolio Management
8.1 Portfolio theory
8.2 Capital Assets Pricing Model
8.3 Measuring returns
8.4 Valuation-Stock Valuation
8.0 Introduction to portfolio Management
The single most prominent factor that has spurned the growth of portfolio management
globally has been demographics. As more and more people across the developed world live
longer, accumulate more wealth and have progressively higher standards of living, the need
for financial security for the ageing population becomes vital. Increasingly, governments are
withdrawing from the responsibility of providing retirement benefits to individuals, leading to
a reduction in the welfare system. Corporations are also diminishing their role in the
provision of retirement benefits to their employees. Individuals themselves are becoming
more accountable for their own financial well-being after retirement. And trends that start in
developed countries are often later replicated in the developing world. Thus, portfolio
management as a vehicle for increasing personal wealth is set to continue in an expansionary
phase. Granted, markets go up and down, and individuals’ inclinations towards investments
in certain assets such as in bonds or in equities fluctuate over time. Nonetheless, portfolios or
funds of pooled assets remain a means by which both individuals and institutions can, over
time, enhance the returns on their savings. The choices of types of funds in which to invest
are also continually evolving as markets change and as innovative products surface and are
incorporated into new categories of funds. The goal of portfolio management is to bring
together various securities and other assets into portfolios that address investor needs, and
then to manage those portfolios in order to achieve investment objectives. Effective asset
management revolves around a portfolio manager’s ability to assess and effectively manage
risk. With the explosion of technology, access to information has increased dramatically at all
levels of the investment cycle. It is the job of the portfolio manager to manage the vast array
of available information and to transform it into successful investments for the portfolio for
which he/she has the remit to manage.
8.1 Portfolio theory
A discussion of portfolio or fund management must include some thought given to the
concept of risk. Any portfolio that is being developed will have certain risk constraints
specified in the fund rules, very often to cater to a particular segment of investor who
possesses a particular level of risk appetite. It is, therefore, important to spend some time
discussing the basic theories of quantifying the level of risk in an investment, and to attempt
to explain the way in which market values of investments are determined. Risk and risk
aversion Risk versus return is the reason why investors invest in portfolios. The ideal goal in
portfolio management is to create an optimal portfolio derived from the best risk–return
opportunities available given a particular set of risk constraints. To be able to make decisions,
it must be possible to quantify the degree of risk in a particular opportunity. The most
common method is to use the standard deviation of the expected returns. This method
measures spreads, and it is the possible returns of these spreads that provide the measure of
risk. The presence of risk means that more than one outcome is possible. An investment is
expected to produce different returns depending on the set of circumstances that prevail.
For example, given the following for Investment A:
It is possible to calculate:
The standard deviation is a measure of risk, whereby the greater the standard deviation, the
greater the spread, and the greater the spread, the greater the risk. If the above exercise were
to be performed using another investment that offered the same expected return, but a
different standard deviation, then the following result might occur:
Since both investments have the same expected return, the best selection of investment would
be Investment A, which provides the lower risk. Similarly, if there are two investments
presenting the same risk, but one has a higher return than the other, that investment would be
chosen over the investment with the lower return for the same risk.
In the real world, there are all types of investors. Some investors are completely risk averse
and others are willing to take some risk, but expect a higher return for that risk. Different
investors will also have different tolerances or threshold levels for risk–return trade-offs – i.e.
for a given level of risk, one investor may demand a higher rate of return than another
Suppose the following situation exists:
The question to ask here is, does the extra 10% return compensate for the extra risk? There is
no right answer, as the decision would depend on the particular investor’s attitude to risk. A
particular investor’s indifference curve can be ascertained by plotting what rate of return the
investor would require for each level of risk to be indifferent amongst all of the investments.
For example, there may be an investor who can obtain a return of £50 with zero risk and a
return of £55 with a risk or standard deviation of £5 who will be indifferent between the two
investments. If further investments were considered, each with a higher degree of risk, the
investor would require still higher returns to make all of the investments equally attractive.
The investor being discussed could present the following as the indifference curve shown in
It could be the case that this investor would have different indifference curves given a
different starting level of return for zero risk. The exercise would need to be repeated for
various levels of risk–return starting points. An entire set of indifference curves could be
constructed that would portray a particular investor’s attitude towards risk (see Figure 2.2).
There are several different factors that cause risk or lead to variability in returns on an
individual investment. Factors that may influence risk in any given investment vehicle
include uncertainty of income, interest rates, inflation, exchange rates, tax rates, the state of
the economy, default risk and liquidity risk (the risk of not being able to sell on the
investment). In addition, an investor will assess the risk of a given investment (portfolio)
within the context of other types of investments that may already be owned, i.e. stakes in
pension funds, life insurance policies with savings components, and property. One way to
control portfolio risk is via diversification, whereby investments are made in a wide variety
of assets so that the exposure to the risk of any particular security is limited. This concept is
based on the old adage ‘do not put all your eggs in one basket’. If an investor owns shares in
only one company, that investment will fluctuate depending on the factors influencing that
company. If that company goes bankrupt, the investor might lose 100 per cent of the
investment. If, however, the investor owns shares in several companies in different sectors,
then the likelihood of all of those companies going bankrupt simultaneously is greatly
diminished. Thus, diversification reduces risk. Although bankruptcy risk has been considered
here, the same principle applies to other forms of risk.
Covariance and correlation
The goal is to hold a group of investments or securities within a portfolio potentially to
reduce the risk level suffered without reducing the level of return. To measure the success of
a potentially diversified portfolio, covariance and correlation are considered. Covariance
measures to what degree the returns of two risky assets move in tandem. A positive
covariance means that the returns of the two assets move together, whilst a negative
covariance means that they move in inverse directions.
for two investments x and y, where p is the probability.
Covariance is an absolute measure, and covariances cannot be compared with one another.
To obtain a relative measure, the formula for correlation coefficient [r] is used.Correlation
To illustrate the above, here is an example:
For data regarding (y – y), see earlier example. Assume that a similar exercise has been run
for data regarding (x – x). Assume the variance of × = 2.45, and the variance of y = 7.06.
Thus, the correlation coefficient would be:
If the same example is run again, but using a different set of numbers for y, a different
correlation coefficient might result of, say, –0.988. It can be concluded that a large negative
correlation confirms the strong tendency of the two investments to move inversely.
Perfect positive correlation (correlation coefficient = +1) occurs when the returns from two
securities move up and down together in proportion. If these securities were combined in a
portfolio, the ‘offsetting’ effect would not occur.
Perfect negative correlation (correlation coefficient = –1) takes place when one security
moves up and the other one down in exact proportion. Combining these two securities in a
portfolio would increase the diversification effect.
Uncorrelated (correlation coefficient = 0) occurs when returns from two securities move
independently of each other – that is, if one goes up, the other may go up or down or may not
move at all. As a result, the combination of these two securities in a portfolio may or may not
create a diversification effect. However, it is still better to be in this position than in a perfect
positive correlation situation.
Unsystematic and systematic risk
As mentioned previously, diversification diminishes risk: the more shares or assets held in a
portfolio or in investments, the greater the risk reduction. However, it is impossible to
eliminate all risk completely even with extensive diversification. The risk that remains is
called market risk; the risk that is caused by general market influences. This risk is also
known as systematic risk or non-diversifiable risk. The risk that is associated with a specific
asset and that can be abolished with diversification is known as unsystematic risk, unique risk
or diversifiable risk.
Total risk = Systematic risk + Unsystematic risk
Systematic risk = the potential variability in the returns offered by a security or asset caused
by general market factors, such as interest rate changes, inflation rate movements, tax rates,
state of the economy.
Unsystematic risk = the potential variability in the returns offered by a security or asset
caused by factors specific to that company, such as profitability margins, debt levels, quality
of management, susceptibility to demands of customers and suppliers. As the number of
assets in a portfolio increases, the total risk may decline as a result of the decline in the
unsystematic risk in that portfolio
The efficient frontier
Given the following inputs – returns, standard deviations, and correlations – a minimum-
variance portfolio for any targeted expected return can be calculated. For example, assume
that for the given level of returns, the best portfolio for each had been calculated:
The data could be plotted as in Figure 2.3.
The part of the curve between points B and C (i.e. above point B, which is the point of global
minimum variance) represents the efficient frontier, as this part of the curve represents the
highest return possible for a given level of risk. The points on the curve between A and B
produce a lower return for a higher risk than point B. Drawing on the previous section
regarding indifference curves and utility values, the investor would prefer that investment or
portfolio that lay furthest through the indifference curve. In practice, it may be difficult to
assess the various indifference curves and the efficient frontier for a particular investor.
Fortunately, software programs known as quadratic optimization programs can help to
calculate efficient sets of portfolios.
If a portfolio manager is dealing with n (i.e. 50) securities, he or she will need n estimates of
expected return, n estimates of variances and (n2 – n)/2 (i.e. 1225) covariances.
The capital market line
Following the development of the efficient frontier of presumably risky assets, it is possible
to combine this portfolio with a risk-free asset with a return of Rf and a risk of 0. The line
with the highest reward to variability ratio (steepest slope) can be drawn, giving the graph
shown in Figure 2.5.
The efficient frontier is arrived at by considering risky investments in the original curve
calculated ABC, and by introducing the risk-free investments. The efficient frontier is now
the straight line. The assumption is that borrowing and lending are allowed. Thus, the line
RfM assumes that an investor invests a portion of his or her investment in the risk-free
investment and the rest in the risky portfolio M. The other section of the curve MD assumes
that the investor can borrow at the risk-free rate and invest more than 100% of his or her
investment in the market portfolio M. The line RfMD is the capital market line (CML). The
equation for the CML is:
E(Rp) = expected return given risk = _p
E(Rm) = risk-free rate for portfolio m given risk = _m
Thus, for a portfolio on the CML, the expected rate of return in excess of the risk-free rate is
proportional to the standard deviation of that portfolio. To use an example: if the market
return is 8%, the market standard deviation is 15%, and the risk-free return is 4.5%, what is
the expected return on an efficient portfolio with a risk of 12%?
8.2 The capital asset pricing model
According to the IIMR Investment Management Certificate Official Training Manual in the
UK: The capital asset pricing model (CAPM) was developed in the early 1960s from modern
portfolio theory by academic finance theorists. Although much maligned, the model remains
as perhaps the most popular tool for quantifying and measuring risk for equities in academic
circles and in the investment industry in the USA, but is less popular with the UK investment
community. The main attraction of the CAPM is the simplicity 2of its predictions. However,
according to detractors of the model, the simplicity is achieved at the expense of a realistic
view of how financial markets work.
The derivation of the model requires certain assumptions and simplifications about financial
markets and investors. These assumptions are that:
1 Investors are risk averse and maximize expected utility
2 Investors choose portfolios or investments on the basis of their expected mean and
variance of returns
3 Investors have a single-period time horizon that is the same for all investors
4 Borrowing and lending at the risk-free rate are unrestricted
5 Investor expectations regarding the means, variances and covariances of asset returns
6 There are no taxes and no transaction costs.
The security market line
The conclusion of the CAPM is known as the security market line (SML), and can be
expressed as follows:
rp = the expected return on asset or portfolio p
rf = the return available from a risk-free asset (this could be the return on a government bill or
rm = the expected return on the market, such as the return on the FT All Share Index =
measure of the sensitivity of the asset to the market (see below for further discussion). rm – rf
= the market risk premium, or the excess return over the risk-free rate received by investing
in a portfolio of risky assets. This figure has been coming down over the last few years, and is
predicted to be lower over the next 100 years compared to the past 100 years.
The CAPM provides the framework to determine the relationship between expected return
and risk for individual securities as well as for portfolios. The security market line shows that
the expected return on a share is the sum of the risk-free return and the market risk premium
adjusted for the relative volatility of the share. One of the forecasts of the CAPM is that in
equilibrium, all assets or portfolios lie on the security market line. If an investment lay above
the SML it would be accepted by an investor as it is offering a return higher than that
required for its level of risk (undervalued). If an investment lay below the SML, it would be
rejected as its return is too low (undervalued).
The beta coefficient is a key factor of the CAPM, and can be written as:
COV (rp, rm) = the covariance of the return on portfolio p with the return on the market VAR
(rm) = the variance of the return on the market
Beta determines the relative sensitivity of the investment to the market. Another way of
looking at the beta of an investment is that it is a relative measure of the systematic risk of
For a situation where > 1, the investment will produce returns in the same direction as the
market’s, but to a larger extent.
When = 1, the investment’s returns should move in the same direction as the market’s
returns and by the same amount.
For situations where 0 < < 1, the investment will deliver returns in the same direction as
the market’s, but to a lesser degree. For example, a beta of 0.5 would mean that, on average,
the investment’s returns move half as much as the market’s do (in the same direction), and
could be considered less risky than investing in the market.
If = 0, then the investment’s returns are not correlated with those of the market. This could
occur if the investment is risk free, or when all of the investment’s risk is non-systematic.
When the beta is a negative number, this means that the investment’s returns will move in the
opposite direction to those of the market.
The following example illustrates CAPM:
Suppose the risk free rate of return is 5%, and the expected market return is 10%. What return
will a diversified investor require from investments with betas of 0, 0.5, 1, and 1.5?
Again, the formula is: rp = rf + (rm – rf )
Where the beta = 1 the expected return of the investment is equal to the expected return on
the market, and the higher the beta coefficient, the higher the expected return. CAPM can be
used for the formation of portfolios where the portfolio manager has determined the degree of
risk that the client is willing to bear. An individual seeking a high return would take on more
risk and a portfolio constructed using a higher beta. A young pension fund, for example, with
a longer term horizon, may employ an investment strategy that would invest in a portfolio
with a beta greater than 1. This portfolio could be expected to give returns greater than those
of the market, but at a correspondingly higher level of risk. Likewise, a mature pension fund
is more likely to seek a safer portfolio and would probably prefer a portfolio with a beta of
less than 1. As the proportion of risk-free investments is increased in the portfolio and the
proportion of equities decreased, the portfolio beta reduces towards 0. Using another
example, if an investor wanted to buy units in a unit trust with a beta of 0.75, but no such
fund existed, the investor could put 50% of the investment in a unit trust with a beta of 0.5
and the rest of the funds in a unit trust with a beta of 1.0. Holding both these funds replicates
holding units in one unit trust with a beta of 0.75.
In a similar vein, if a new investment is added to a portfolio, the beta of the new portfolio will
be the weighted average of the beta of the old portfolio and the new security. Thus:
wi = market value weighting of portfolio component i
i = the of the portfolio constituent i.
For example, an existing portfolio of £50m has a beta of 0.75. A new investment of £5m with
a beta of 1.2 is added to the portfolio. The new overall beta of the portfolio will therefore be:
8.3 Measuring returns
Once a portfolio has been established, it is important to monitor the fund’s performance.
Measuring the performance of a portfolio involves calculating the returns achieved by the
fund over a particular period of time, known as the evaluation period. The evaluation period
used to monitor performance may be weekly, monthly, quarterly or annually. Various
methods may be used to calculate returns, each giving a different result. Parties interested in
evaluating performance use consistent and standard methods for calculating and presenting
returns, several of which are reviewed below. Performance evaluation involves comparing
the performance of a fund against a suitable yardstick or benchmark (usually a relevant
index) after adjusting for risk in order to determine how the fund manager has performed and
how the returns were actually achieved. Evaluation enables the investor to check that the
agreed investment strategy has been followed, and to assess the skill of the fund manager.
Calculating returns Clients, trustees of pension funds and unit trusts, board of directors of
investment trust companies and managers of fund management departments are amongst the
groups interested in monitoring the capabilities of the fund managers and analysts who
contribute to the running of the funds. Although calculating returns is simple in theory, it is
relatively more complex in practice. The methods considered are money return, time
weighted return and money-weighted return.
Total return or money return
The first step in assessing performance is to measure the total return that a fund has produced.
To calculate this return, the value of each share in the fund at the beginning of the evaluation
period is multiplied by the number of shares held. The sum of these values is the market
value of the portfolio at the beginning of the time period. The same procedure is carried out
using the market prices and amounts of the holdings at the end of the time period to calculate
the market value of the portfolio at the end of the evaluation period. The total return (also
known as money return) from the portfolio is calculated as follows:
Vbeginning = market value of the fund at the beginning of the period
Vend = market value of the fund at the end of the period (including reinvested dividends or
If, for example, Vend is £5 million, Vbeginning is £4 million, calculate the money return:
r = £5 – £4/£4 × 100 = 25%
The next step to examine is what happens when clients add new money to the fund or
withdraw money from the fund. Money may be added or withdrawn at any time during the
examination period. If the money is added just before the end of the period, the above
formula would have to be adjusted as follows:
Vend = the portfolio value at the end of the period
Vbeginning = the portfolio value at the beginning of the period
D = deposits into the fund by the investor.
For example, if Vend is £5 million, Vbeginning is £4 million and a cash input (D) of £250
000 is made, the money return is calculated as:
r = (£5 – £0.25) – £4/£4 × 100 = 12.5%
If the cash input had not been subtracted, the return quoted would have been 25% rather than
12.5%. This would have been misleading, since part of the increase was due to money
coming into the fund and not to the fund manager’s skill. Withdrawals from a fund or
distributions made from a fund to shareholders can also produce a distorting effect, and thus
the timing of deposits into and withdrawals from a portfolio must be taken into account. The
above example assumes distributions into and out of the fund are made at the end of the
period. This is unlikely to be true in practice, and the following two methods overcome the
problem by breaking the evaluation period into smaller sub-periods.
Risk-adjusted portfolio performance measures
Measuring the risk associated with a portfolio is one important aspect of measuring portfolio
performance. Portfolio returns must be adjusted for risk before they can be compared
meaningfully. The easiest way to adjust returns for portfolio risk is to compare rates of return
amongst portfolios with similar risk profiles. This process may be misleading, however, for
some managers may concentrate on particular subgroups, so that the portfolio profiles are not
actually that comparable. More accurate measures of portfolio returns have come into vogue
to calculate risk-adjusted returns using mean-variance criteria and measuring both risk and
return. Riskadjusted returns are not necessarily perfect measurements, as they do not take into
account transaction costs. They are, however, important tools for providing information about
portfolios. Three of the most popular riskadjusted measures will now be examined. They
differ from one another according to the risk measure used.
The Sharpe measure
The Sharpe ratio measures excess return per unit of risk, or, in other words, uses an estimate
of total risk of a portfolio to calculate excess return to volatility (volatility being the standard
deviation of the returns).
Rp = the return achieved on the portfolio
Rf = the return available from a risk-free asset
= the standard deviation of the return on the portfolio.
The higher the value of this measure the better value the portfolio represents, since as
gets smaller the total risk of the portfolio gets smaller. If the Sharpe ratio is negative the
portfolio’s performance is less than the risk-free rate and the negative figure itself cannot be
compared to other negative figures.
The Treynor measure
The Treynor ratio uses the beta coefficient or the systematic risk of the portfolio as its
measure of risk. It is a measure of the portfolio’s excess return with respect to its beta.
Rp = the return achieved on the portfolio
Rf = the return from the risk-free asset
= the CAPM beta of the portfolio.
The higher the value of the Treynor measure the better the value represented by the portfolio,
since a higher beta represents higher systematic risk. The Treynor measure may be preferred
by investors who are running highly diversified portfolios, as the measure does not consider
unsystematic risk. A portfolio holding a large number of investments should see the
unsystematic risk diversified away. The Sharpe measure, which considers total risk, may be
preferred by investors with less diversified portfolios.
The Jensen measure
The Jensen ratio calculates the excess return that a portfolio generates over that predicted by
CAPM based on the beta of the portfolio and the average market return. Jensen’s measure is
the portfolio’s alpha value. CAPM can be used to construct a benchmark portfolio with a
given amount of systematic risk and measure the difference in return of this portfolio
(benchmark) and the return achieved by the portfolio manager.
Jensen measure =
Rp = the return on the portfolio being evaluated
Rb = the return on the benchmark portfolio
= the benchmark portfolio’s CAPM beta.
The Sharpe ratio looks at total risk
The Treynor ratio takes into account systematic risk
The Jensen measure looks at the performance of the portfolio over and above that of a
If an investor has limited holdings, then standard deviation may provide a more accurate
measure of risk. Likewise, if an investor holds a wide variety of holdings outside of one
particular mutual fund, then beta may be a more accurate measure of risk.
For example, two fund managers are employed to manage two portfolios with identical
objectives. Details of their portfolios are as follow:
ng the Sharpe measure,
where:it can be concluded that, on a risk-adjusted basis considering total risk, fund manager
A has outperformed fund manager B.
Using the Treynor measure, where:
it can be concluded that, on a risk-adjusted basis taking into account systematic risk, fund
manager B has outperformed fund manager A.
Using the Jensen measure, where:
it can be concluded that on a risk-adjusted basis (systematic risk), fund manager B has
performed better than fund manager A. One more point to note is that returns will be affected
by tax rates, inflation over time, and foreign exchange rates when applicable.
8.4 Valuation: stock valuation
How does an investor determine whether or not a share is fairly valued or represents a
bargain investment? Many investors rely on values obtained from various valuation
techniques to make investment decisions and to interpret financial information. Some
theorists claim that stock prices cannot be predicted, particularly in the short term, and that no
stock valuation model can accurately uncover under- or overpriced stocks. Nonetheless, it is
important for fund managers and analysts to have some sort of consistent methodology with
which to rank a universe of shares. Also, if the market is using a particular valuation
technique, the ‘herd mentality’ could affect the prices of the underlying shares. Thus it is
useful to be aware of some of the most popular valuation methods currently utilized. Stock
valuation methodologies can either be based on the discounted cash flow (DCF) principle,
which states that the current value of an asset is the present value of all its future cash flows,
or on financial ratio analysis. Using discounted cash flows involves forecasting future cash
flows and estimating the appropriate discount rate to use for the calculation. With DCF, it is
possible to establish whether a stock is undervalued, fairly or overvalued:
If the PV > P0, investors would buy the stock
If the PV < P0, investors would not buy the stock
If the PV = P0, investors would be indifferent to buying or not where PV is the present value
of the expected cash flows and P0 is the current share price.
Price ratio analysis, however, is more widely used by financial analysts than discounted cash
flow models, and can be considered easier to calculate by the general public. Both
methodologies are covered in this chapter.
Dividend discount model
One widely used method to value common stock is the dividend discount model (DDM),
which values a share as the sum of all its expected future dividend payments, with the
dividends adjusted for risk and the time value of money. The formula is as follows:
Dt = the dividend to be paid t years from now
V0 = the present value of the future dividend to be paid t years from now
k = the appropriate risk-adjusted discount rate.
This formula assumes that the last dividend is paid t years from now and the value of t
depends on the specific situation being considered.
For example, suppose that a stock pays three annual dividends of 100p per year and that the
discount rate is k = 7%. What is the present value of the stock?
Thus, the stock price should be valued at about 262p per share.
Constant dividend growth rate model
The constant dividend growth rate model is another common valuation model utilized to
determine a stock’s value as well as a firm’s cost of equity. This model assumes that
dividends will grow at a constant growth rate. By letting a constant growth rate be denoted by
g, then successive annual dividends are stated as:
For example, if the first dividend D1 = 100p and the dividend growth rate g = 10%, then the
second dividend payment would be D2 = 100p *1.10 = 110p. The third dividend payment
would equal D(3) = 100p *1.10 *1.10 = 100p *(1.10)2= 121p. Assuming the discount rate is
k = 8%, the present value of the three dividend payments is the sum of their separate present
Usually the number of dividends to be paid is large and calculating the present value of each
dividend separately is time consuming. However, if the growth rate is constant, some
simplified formulas are available to handle certain special cases. If, for example, a stock pays
annual dividends over the next t years and these dividends are expected to grow at the
constant growth rate g and to be discounted at the rate k, then the calculation is as follows:
Current dividend = D0
Dividend at time 1 = D1 = D0 (1 + g)
Dividend at time 2 = D2 = D1 (1 + g)
The present value of the next t dividends following D0, can be calculated using the following
where g does not equal k.
For example, assume that the growth rate is 6% and that the discount rate is 12%. If the
number of annual dividends is 10 and the current dividend is 10p, what is the present value
Constant perpetual growth model
A simplified version of the constant dividend growth rate model occurs when dividends are
expected to grow at the constant rate g in perpetuity. The constant perpetual growth model is
calculated using the following formula:
where g < k.
Since D0 (1 + g) = D1, the constant perpetual growth model can be written as:
where g < k.
Thus the constant dividend growth model demonstrates that the value of a stock is the first
year dividend per share, divided by the discount rate, minus the constant growth rate. The
greater the growth rate, all other factors being equal, the larger the discounted future
dividends will be, resulting in a higher share price. With this model, future dividends do not
have to be estimated directly; only the growth rate has to be estimated. Also, this formula
only holds true when the growth rate is lower than the discount rate. If the growth rate were
higher than the discount factor, the dividends would grow faster than the discount rate. The
discounted cash flow of an infinite stream of dividends would yield an infinite price which
would not be viable. Also, another limitation of the model is that it should only be applied to
companies that have stable earnings and dividend growth.
For example, a certain company’s dividends are projected to grow at 5% forever. If the
discount rate is 12%, and the current dividend is $20, what is the value of the stock?
Thus, the stock should be priced at $300.
Estimating sustainable growth rates
When using the constant perpetual growth model, it is essential to establish an estimate of the
growth rate (g) in dividends. There are a few ways of estimating the g – such as using the
company’s historical average growth rate, or using an industry median or average growth
rate. In addition, a company’s earnings growth rate can be used to estimate g. Usually the
earnings per share (EPS) and the dividends per share (DPS) grow concurrently. However, the
EPS may increase or decrease over time, making it difficult to estimate accurately. The focus
is on the growth rate of the dividends for the model, because they represent the cash flows
that the investors actually receive. A company’s earnings can be paid out as dividends to its
shareholders or the earnings can be kept within the firm to finance future growth The portion
of the earnings paid out as dividends is known as the payout ratio and the portion of the
earnings retained within the firm is known as the retention ratio. Firms grow by reinvesting
the retained earnings. If a company pays fewer dividends and increases the amount invested
in profitable projects, higher future earnings should ensue. Such a company will achieve
growth in earnings and dividends. The lower the proportion of earnings paid out as dividends,
the greater the company’s future growth rate.
The payout ratio is equal to
where D = dividends
and EPS = earnings per share.
What is not paid out is retained, and the retention rate
For example, if a company’s current dividend is 5p per share and its EPS is currently 12p,
then the payout ratio is 5p/12p = 42%. The retention ratio is 1 – 0.40 = 0.58, or 58%.
A company’s sustainable growth rate is equal to its return on equity (ROE) times its retention
Sustainable growth rate = ROE * Retention ratio
= ROE*(1 – Payout ratio)
The calculation for return on equity is as follows:
ROE = net income/Equity
Below are a couple of examples.
For example, Company A has a return on equity (ROE) = 6.8%, earnings per share (EPS) =
$1.36 and a share dividend of D0 = $1.05. Assuming a 7.5% discount rate, what is the value
of Company A’s stock?
Payout ratio =$1.05/$1.32
= 0.80, or 80%.
Retention ratio = 1 – 0.80 = 0.20, or 20%.
Company A’s sustainable growth rate = 0.20 *6.8% = 0.0136, or 1.36%.
Using the constant growth model
V0 = D0 (1 + g)/k – g
the value of the stock is calculated as:
V0 =$1.05(1.0136)/(0.075 – 0.0136)
This estimated value of the share can be compared to the actual price at which Company A’s
shares are trading in the market. If the value determined by the constant growth model is
lower than the market price, then it can be assumed that Company A’s stock may be
overvalued, but it could also mean that a 1.36% growth rate underestimates the company’s
future dividend growth.
Again for example, Company B has an ROE of 10%, EPS of $2.15, and a dividend per share
D0 of $1.40. First calculate the retention ratio and the sustainable growth rate, then calculate
the value of Company B’s stock using a discount rate of 8.00%.
The dividend payout = $1.40/$2.15
= 0.651, or 65.1%.
Retention ratio = 1 – 0.651 = 0.349, or 34.9%.
Company B’s sustainable growth rate = 0.349*10% = 3.49%.
Using this data in the perpetual growth model, the value for the share can be calculated.
V0 = $1.40(1.0349)/(0.80 – 0.0349)
This value can be compared to the actual share price to determine whether the stock is over-
or undervalued. The limitation with sustainable growth rates is that they are sensitive to
fluctuations in earnings. Fund managers and analysts will usually adjust sustainable growth
rate estimates to smooth out the effects of earning oscillations. However, there is no standard
method of adjusting growth rates, and analysts and fund managers depend on personal
experience and their own judgment to fine tune the growth rates within their models.
The two-stage dividend growth model
In reality, companies do not experience just one growth rate throughout their life cycle, but
may experience temporary periods of unusually high or low growth. Also the company’s
growth rate will probably eventually converge to an industry- or economy-wide average. For
example, firms involved in the research and development of a new pharmaceutical product
can achieve higher than average growth or supergrowth for a limited period of time. If the
company’s research is successful, the company can obtain a patent on the product for a
limited number of years, during which the high growth prevails. For companies experiencing
varied growth rates, the two-stage dividend growth model is utilized. To determine the proper
value of the stock, dividends must be discounted by the applicable growth rate for the
specified periods. The company will have one growth rate for one period and another growth
rate after that. The two-stage dividend growth model (also known as the multi-stage dividend
discount model) can be written as follows:
V0 = value of the stock
D1 = next period’s estimated dividend based on the company’s growth rate in dividends
k = required rate of return or discount rate
g1 = company’s growth rate in stage 1
g2 = company’s growth rate in stage 2.
For example, Company C pays an annual divided of $1.00 and has a dividend growth rate of
10% per annum. Assuming the growth rate in dividends is expected to drop to 6% per starting
in year 3 and the required rate of return on the stock is 7%, calculate the value of the stock
using the two-stage dividend growth model.
At the end of year 2, the company’s following year growth rate becomes 8% and
D1 = ($1.00 *1.10) = $1.10
D2 = ($1.10 *1.10) = $1.21
D3 = ($1.21 *1.06*) = $1.28
* At the end of year 2, next year’s growth rate becomes 6% and D3 = D2 *1.06.
Using the formula, the value of the company’s stock is:
The longer the number of years that a firm can enjoy extraordinary profits, the bigger the
expected jump in the stock price due to the availability of these profitable projects. The
original dividend growth formula can be adjusted for a stock with a higher growth rate for t
years and normal growth thereafter, as follows:
this formula, the first part of the equation measures the present value of the dividends through
time t and the second part of the equation measures the present value of the subsequent
dividends. For example, suppose that a company has a current dividend of $2, and that
dividends are expected to grow at the rate of g1 = 10% for t = 6 years and thereafter at the
rate of g2 = 5%. With a discount rate of k = 7%, what is the present value?
requirement for the two-stage growth formula is that the second stage growth rate is strictly
less than the discount rate and that g2 < k. However, the first stage growth rate g1 can be
greater than, smaller than, or equal to the discount rate.
Estimating the discount rate or cost of equity capital
The discount rates used in the examples above come from the Capital Asset Pricing Model
(CAPM). To review, Discount rate = Risk-free rate + (stock beta stock market risk
premium) In actuality, the discount rate is the cost of equity capital required by the
stockholders given the firm’s risk. The constant dividend growth model can be used to
estimate the cost of equity. The assumption in this case is that the stock price is fairly valued
and the formula solves for the discount rate k. The constant dividend growth model provides
V0 = D1/k – g
which can be rewritten as
k =D1/V0+ g
The values for D0 and V0 can be found in the market. If g can be estimated, D1 = D0 (1 + g)
can be calculated and it is possible to solve for the required cost of equity. This represents the
expected rate of profit on the equity. Using an example that relates to the constant growth
model (not two-stage growth model), where:
V0 = $100
g = 5%
k = $5/$100 + 0.05 = 0.05 + 0.05 = 0.10
The investors who determine the stock price in the market are requiring a return of 10% on
their investment. If a particular investor’s required rate of return is more than 10%, then that
investor should steer clear of buying or investing in that stock. If the investor’s rate of return
is lower than 10%, than this stock provides an attractive investment.
Free cash flow approach
One assumption made with the dividend discount approach to share valuation is that retained
earnings are the only source of financing of new equity investment in the firm. The results
may be affected if external equity financing plus debt financing of new investments were
allowed. The principle behind the free cash flow approach to valuing stocks is that the
intrinsic value of the equity in a firm is the present value of the net cash flows to shareholders
that can be created by the company’s existing asset base plus the net present value of
investments that will be made in the future. The free cash flow model estimates the value of
the firm as a whole, and derives the value of the equity by subtracting the market value of the
nonequity claims. The estimate of the value of the firm is found by calculated the present
value of the cash flows, assuming the firm is financed only by equity, and then adding the
present value of tax shields created by using debt if applicable In the model,
Free cash flow to equity (FCFE) = Net income + Depreciation expense – Capital expenditure
requirements (CAPEX) – Change in working capital requirements – Principal debt
repayments + New debt issued
138 A reduced form of the dividend discount model can be used to determine the value of
equity from the FCFE model:
Ve = value of equity
FCFE= expected free cash flow to flow to equity in year 1
g = expected growth rate
ke = cost of equity capital
For example, assuming that Company D has 1 million common shares outstanding and no
preferred shares, that cost of equity is 8% and the growth rate is 3%, calculate the value of
equity from the FCFE given the information in Table 8.1.
Using the formula described above:
Ve = 9 000 000(1.03) /0.10 – 0.03
= 132 428 571, or $132.43 per share.
This is a simple example using the discounted cash flow approach. In corporate finance, this
approach is expanded upon to determine the values of companies for merger and acquisition
purposes. The discount rate or weighted average cost of capital (WACC) will equal the
weighted average cost of equity plus the weighted average cost of debt. Some analysts also
use the expanded DCF model to ascertain share value.
1. What are the expected return and standard deviation, given the following data?
Circumstance Return Probability
I 10% 0.2
II 6% 0.5
III 4% 0.3
(A) 5.1%, 3.0%
(B) 6.2%, 1.96%
(C) 6%, 2.55%
(D) 6.2%, 3.88%
(E) 1.96%, 3.88%
2. Controlling risk in a portfolio by investing in a wide variety of assets is known as:
3. Assuming the following data, what is the correlation coefficient and how would this be
Circumstance Probability (x – x) (y – y)
I 0.2 –3.0 –1.5
II 0.5 +1.0 +0.8
III 0.3 +5.0 +2.5
Variance of x = 8.02
Variance of y = 2.30
(A) 0.961, very high positive correlation
(B) 0.121, very little correlation
(C) –0.961, very high negative correlation
(D) –0.121, very low negative correlation
(E) 0.690, some positive correlation
4. Market risk that remains in a portfolio and is impossible to diversify completely is also
(A) Total risk
(B) Systematic risk
(C) Unsystematic risk
(D) Uncorrelated risk
(E) Company risk
5. A share has a beta of 1.3. If the risk-free rate is 5% and the market return is 15%, what is
the expected return on the share?
6. An existing £100 million portfolio has a beta of 1.5. A new investment of £50 million
with a beta of 0.8 is added to this portfolio. What is the new beta of the portfolio?
7. Suppose that a stock pays four annual dividends of $50 per year and that the discount
rate (k) = 10%. Using the simple dividend discount model, what is the present value of
8. Assuming that a company has a dividend growth rate of 5%, the discount rate is 8%,
there are 15 years of annual dividends to be paid and the current dividend is 80p, what is
the value of the company’s stock, based on the constant dividend growth rate model?
9. If a company’s dividends are projected to grow at 3% in perpetuity, the discount rate is
10%, and the current dividend is $15, what is the value of the stock, using the constant
perpetual growth model?
10. A company has an ROE of 10%, an EPS of $3.00, and a dividend per share D0 of $2.48.
The discount rate is 7.00% and the current share price is $75. The value of the
company’s stock is and it is considered to be . (Calculate the retention ratio and the
sustainable growth rate and use the perpetual growth model.)
(A) $112, undervalued
(B) $48, undervalued
(C) $48, overvalued
(D) $112, overvalued
11. Consider that a company has a current dividend of $4, and that dividends are expected to
grow at the rate of g1 = 6% for t = 5 years and thereafter grow at the rate of g2 = 3%.
With a discount rate of k = 9%, what is the value of the stock?
12. The idea behind the approach of valuing stocks is that the intrinsic value of the equity in
a firm is equal to the present value of the net cash flows to shareholders that can be
created by the company’s existing asset base plus the net present value of investments
that will be made in the future.
(A) two-stage dividend growth model
(B) constant perpetual growth model
(C) free cash flow model
(D) constant dividend growth rate model
(E) retention ratio model
9.1 Bond and bond fund
9.2 Nate pile’s small classroom
9.3 Danger of inaction
9.4 Bond with the best
9.5 Take your time to plan investment
9.1 Bond and bond fund
A bond fund is a collective investment scheme that invests in bonds and other debt
securities. Bond funds typically pay periodic dividends that include interest payments on the
fund's underlying securities plus periodic realized capital appreciation. Bond funds typically
pay higher dividends than CDs and money market accounts. Most bond funds pay out
dividends more frequently than individual bonds.
Bond funds can be classified by their primary underlying assets:
• Government/Treasury: Composed primarily of treasury securities, which are the
safest debt securities, as they are backed by the full faith and credit of the United
States government. Due to the safety, the yields are typically low.
• Mortgage: Mortgage loans issued or guaranteed by government agencies such as the
Government National Mortgage Association (Ginnie Mae), Federal Home Loan
Mortgage Corp. (Freddie Mac), and Federal National Mortgage Association (Fannie
• Corporate: Bonds are issued by corporations. All corporate bonds are guaranteed by
the borrowing (issuing) company, and the risk depends on the company's ability to
pay the loan at maturity. Some bond funds specialize in junk bonds, which are
corporate bonds carrying a higher risk, due to the potential inability of the issuer to
repay the bond. Bond funds specializing in junk bonds – also known as "below
investment-grade bonds" – pay higher dividends than other bond funds, with the
dividend return correlating approximately with the risk.
• Municipal: Bonds issued by state and local governments and agencies are subject to
certain tax preferences and are typically exempt from federal taxes. In some cases,
these bonds even states or local taxes.
Bond funds may also be classified by factors such as type of yield (high income) or term
(short, medium, long) or some other specialty such as zero-coupon bonds, international
bonds, multisector bonds or convertible bonds.
Advantages over individual bonds
• Management: Fund managers provide dedicated management and save the individual
investor from researching issuer creditworthiness, maturity, price, face value, coupon
rate, yield, and countless other factors that affect bond investing.
• Diversification: Bond funds invest in many individual bonds, so that even a relatively
small investment is diversified—and when an underperforming bond is just one of
many bonds in a fund, its negative impact on an investor's overall portfolio is
• Automatic income reinvestment: In a fund, income from all bonds can be reinvested
automatically and consistently added to the value of the fund.
• Liquidity: You can sell shares in a bond fund at any time without regard to bond
Price charts on bond funds typically do not reflect their performance due to the lack of yield
consideration. To accurately evaluate a bond fund's performance, both the share price and
yield must be considered. The combination of these two indicators is known as the Total
9.2 Nate pile’s small classroom
NEW YORK - Next time you're out to eat, try bouncing some investment ideas off of your
waiter. Nate Pile, editor of Nate's Notes, got his start as an investment adviser in the fall of
1989, during his sophomore year at the University of California at Berkeley. He was working
in a café near campus and had the good fortune of hooking up with Jim McCamant of the
Medical Technology Stock Letter. One of McCamant's lieutenants saw him reading a book by
Peter Lynch and invited him to stop by and see if he wanted to work there. After spending
close to five years at MTSL, he briefly held a position in the corporate finance division of a
boutique investment banking firm in San Francisco before launching his own newsletter in
1995. Mark Hulbert calculates the average gain of the two model portfolios in Nate's Notes to
be 108% over the last year. Pile also serves as a registered investment advisor to Elensius
Capital, LP, the hedge fund he started in 2001. In his "spare" time, he teaches mathematics to
seventh graders at a private school near his hometown of Healdsburg, Calif.
When choosing stocks, do you pay more attention to fundamental or technical analysis?
The first screen is always at the fundamental level. Though I often make trades in existing
positions based on the action I see on charts, when getting into a new stock, I always ask
myself a question that I believe I first saw posed in a book on Warren Buffet's investment
philosophy, namely: "If the stock market closed for five years and we could not trade this
stock, would we still be happy owning it five years from now?" There has to be something
compelling about the long-term growth prospects of the company for me to even consider
putting it in the newsletter or my hedge fund.
Once the stock is in our portfolios, decisions to increase or decrease the size of our holdings
is based on a combination of fundamental and intuitive technical analysis. For example, if a
company releases a number of positive press releases that, for whatever reason, do not move
the stock higher, I would likely add to our position for the simple reason that the underlying
value of the company has clearly increased, but the shares are still for sale at the same price.
This does not happen often with large stocks that are well-followed on Wall Street, but it is
much more common with smaller stocks that are not really on anyone's radar screen yet--
although the Internet has also reduced a lot of market inefficiencies.
9.3 Danger of inaction
With investment options proliferating there is a danger that the array of choices may leave
you too bewildered to do anything. A guide to overcoming of investment inertia. All financial
planning strategies try to tackle only one issue: where should you invest your money? That
decision was easy a decade ago. There were only a handful of assets you could have in your
portfolio - bank and company deposits, units of UTI, small savings plans, property and
stocks. Over the last ten years, the range has widened beyond expectations. You can now
choose from a vast variety of mutual funds investing in domestic and overseas bonds, stocks
and possibly even real estate in the near future; stocks and derivatives; capital protection
plans from banks that link deposits with mutual funds; a variety of bonds with call and put
options; property; and of course, the good old staple of bank deposits and small savings plans
Financial planners will tell you that this is fantastic. What choice you have! Your parents
merely saved without linking their goals to their strategies. But you can fine-tune investment
planning to an extent where it is tailor-made to a goal such as sending your daughter abroad
for higher education to a particular country for a specific course ten years later.
All the zeal of financial planning is done hides one critical issue: you have only limited time
and mind space to think about what you should do with your money. You are too busy
earning money. Besides, the stress of living in a metro like Delhi leaves you so tired that at
the end of the day that your mind is incapable of making rational choices, specially because
there are so many options to choose from. So you do nothing.
Experts call this ‘analysis paralysis’ or ‘decision paralysis’. You are unable to make decisions
about money because there are too many choices and just as many opinions. With a deluge of
information about investing in insurance, retirement plans, tax saving plans, home loans, etc,
it can get too difficult to decide, and hence you do nothing. Studies have shown that an
abundance of choice, while initially appealing, later becomes a hindrance to decision making.
The sad outcome of all this is that having more choices actually inhibits people from saving
for their future. Research supports this inference. In the US, Columbia University professor
Sheena Iyengar studied 647 employer-sponsored retirement plans and made a fascinating
discovery. As the number of choices in an investment plan increased, the percentage of
employees who participated decreased. Participation declined by 2 per cent for every 10
additional investment options. The lesson is clear: more options mean more work, and many
people don’t have the time, inclination or know-how. This is a universal truth. It applies as
much to India as to the US.
If you suffer from decision paralysis, you cannot simply acknowledge it and ignore it. What
is at stake is your and your dependants’ financial future. Your lifetime goals, even if you
recognise them only vaguely now, need to be met. You need a simple recipe for a well-
rounded money diet.
9.4 Bond with the best
Bond with the best
BEING the highly social creatures that we are, our brains are designed to bond with other
people. It is natural for us to interact with others, as any anthropologist would tell you, and
form social groups. So why is it that we sometimes struggle in our efforts to connect with the
people around us? What are the things that prevent us from bonding and building
relationships, both personal and professional with those around us? Truth be told, a lot of our
social challenges are of our own making, and most of the things that stand in the way of
connecting with other people can be overcome if we put our minds to it. Some common
factors that prevent us from bonding with others or building successful working relationships
Lack of interest
If you want to connect with other people, you must be interested in other people. Genuinely
interested. As one author puts it, `No-one wants to connect with someone who is only
interested in himself.'
Lack of effort
Building any relationship takes time and dedicated effort. So the next time you feel like
berating the world for shutting you out, remember only you can do something about it. Do
not sit at home waiting for the phone to ring - call someone. Do not wait for your boss to tell
you why he or she is not happy - ask. Do not wait for a major crisis to occur before you
attend to a problem-- solve it now. Lack of trust
If you are the type who is suspicious of his coworker because he is too efficient, and wary of
the boss because he appears too good to be true, you are bound to have trouble building
relationships with others. Trust is the basis for any relationship. Without trust, relationships
are reduced to being compromises that lack credibility and reliability. Building a culture of
trust is not easy; you can only do that through genuine appreciation, courtesy and respect for
other people and their points of view. It is a slow process.
Lack of humor
A lot of people take themselves way too seriously. You do not have to goof around or act like
a stand up comedian to connect with people, but nobody likes to be around someone who
thinks life is one long funeral. If you find it difficult to laugh out loud easily, you are
probably not a lot of fun to be around. If you learn to look forward to the bright and sunny
side of life, you will find it easy to build and bond with others.
It must be remembered that people who enjoy being with one another are usually more
productive in the workplace; they have greater loyalty to each other and to the organization.
And, unlike personal relationships, the relationship between an employer and an employee is
built on a mutual understanding of expectations and responsibilities. And it is in this context
that the ability to build relationships with others assumes great importance.
So, the next time you find yourself struggling to build relationships either at a professional or
at a personal level, do not blame it on stress, circumstances, or some such thing. Difficulty in
connecting with others is a challenge you can surmount with a little effort.
9.5 Take Your Time To Plan Investment
Plan ahead, seek advice and take your time in making an investment
In the second part of his recent presentation to the acsis/Personal Finance Financial Planning
Club, Bruce Cameron, provides 20 steps you should take to protect yourself from scams
May 5, 2007
By Bruce Cameron
Personal Finance editor Bruce Cameron, who was speaking at recent meetings of the acsis/
Personal Finance Financial Planning Club, says if you have a well-defined plan, receive
sound advice and have a full understanding of what you require, you can dramatically lessen
your chances of falling prey to a scam.
To achieve this, you need to follow a 20-step strategy.
1. Investment is for the long term. Short-term trading and investment is gambling.
2. Get good advice from a well-qualified financial planner who is prepared to work on a
fee basis. There will then be no temptation to sell you a product you do not need,
because of the commission incentive. Many financial salespeople are simply product
floggers chasing commission earnings and may not act in your best interests. It is better
to use a financial adviser who you pay by way of an hourly fee, with any commission
rebated to you. This way, there is no incentive for your adviser to missell you a product
you do not need to earn a living. Ensure that your financial planner is registered with
the Financial Services Board (FSB). Go to the website fsb.co.za and click on the FAIS
link at the top right of your screen. Your adviser must also tell you what products he or
she is authorized to sell. To find a financial adviser go to the websites: fpi.co.za or
3. With the help of a well-qualified financial planner, structure your strategy on a financial
needs analysis, which will help you understand your financial risks, needs and wants,
and to determine the products you need to meet your goals.
4. Get rid of debt and be very judicious about borrowing to invest, particularly in high-risk
5. Decide whether you want capital growth or income or both. Often "never-to-be-missed"
investment opportunities are aimed at providing high-risk capital gains when the
investor (particularly pensioners) require income returns.
6. Understand investment risks. There are many risks to investing - from receiving the
wrong advice, to investing in dubious products, to volatility in investment markets
through to you making incorrect decisions based on fear (withdrawing investments
when markets are down) and greed (investing all when markets are at their highs).
There is also the risk of not investing at all, as inflation will simply erode the buying
value of your money.
7. Decide on your risk profile. Base this on what you can afford to lose … not on what you
want to win.
8. Diversify your financial investments (but into recognised asset classes and products,
rather than into high-risk, unregulated opportunities).
9. Understand how financial markets work in broad terms. For example, knowing that
supply and demand will affect prices, and that this usually happens in cycles.
10. Understand what drives markets. The main markets are equities (share markets) and
bonds (long-term borrowings of governments, large institutions and corporates).
11. Understand the investment styles used to provide investment growth. For example,
investment in growth shares, which are expected to deliver high profits in the future, as
opposed to value shares, which provide a steady flow of dividend income based on
consistent profits. If you understand how the profits are being made, you are less likely
to be a victim of smoke and mirrors.
12. Take account of the liquidity of an investment. For example, you can withdraw a unit
trust investment at short notice, whereas with a life assurance investment product and
property you may not be able to access your funds when you need them without
incurring some form of penalty.
13. Consider all proper guarantees, which really only come from the life assurance industry.
The guarantees may be on capital and/or growth and/or an income stream (annuity). But
watch out for the costs of guarantees and whether you really need them. For example,
acsis research showed guarantees provided by capital-guaranteed, index-linked
structured products to be an unnecessary cost because 99 percent of the time you will do
better by investing directly into the indices.
14. Costs can wreak havoc on your eventual benefits. This was proved by independent
actuary Rob Rusconi in research that showed that the costs of a life assurance
retirement annuity (RA) can reduce your final benefit by as much as 50 percent over 40
years, as opposed to far less with a unit trust fund RA.
15. Be aware of tax. Retirement products have tax incentives whereas on traded endowment
policies you may pay capital gains tax three times.
16. Compare investment products such as a unit trust fund, a life assur-ance endowment, a
linked investment service product and a share portfolio (taking into account steps one to
Also ensure that the products are regulated by the FSB.
17. Only once you have followed steps 1 to 16 should you choose a product provider. The
biggest mistake many people make is to select a product provider and its product first,
because it sounds attractive, rather than ensuring that the product and the provider fit
into a properly devised strategy.
18. Measure the results against benchmarks such as the inflation rate and indices over the
medium to long term, not against short-term market fluctuations.
19. Rebalance your portfolio if it no longer meets your required diversification strategy.
20. Revisit your investment strategy when there are changes in such things as the tax
regime and your personal circumstances (changes in your assets) but avoid doing so
when you are spooked by temporary adverse market conditions, or you fear you may
lose out because you are not participating in what will turn out to be a market bubble.
Some high-risk investments
There are a number of so-called investments that are extremely high risk or are unlikely to
deliver what is promised, for a number of reasons. These products include:
You should be particularly careful if there is a complex structure of companies, debentures
and shares. This makes the recovery of your capital difficult if things go wrong. Many of the
current schemes also have very high costs and they pay high commissions to financial
advisers. The only reason why there has not been a major scandal so far is that buoyant
property prices have camouflaged the high costs.
Even J Arthur W Brown, the executive chairman of Fidentia who is facing criminal charges,
saw opportunities in this sector. Apart from scams such as the R280 million losses in Leader
guard, investing in forex trade is high-risk speculation and not investment.
This comes in both a legal and illegal form, neither of which is an investment. The basic
structure is that of a pyramid with, for example, the first person recruiting between five and
10 people, who in turn introduce another five or 10 people. Each person receives a portion of
the fee/commission from those recruited below. The pyramids are normally capped at five
levels or have diminishing percentages accruing from the lower levels. They are illegal if
they are simply based on part of a "membership" fee being divided up. Pyramids are legal if a
product is included.
The product can range from beauty products to financial products. These often come at a high
price to enable the commissions/fees to be paid to the members as well as to the pyramid-
sponsoring company. The on-going savings from using a more competitive product would
probably save you the money and the time you put into constructing and maintaining a
Jorethang, District Namchi, Sikkim- 737121, India
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