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SECURITY ANALYSIS

Security analysis fundamental analysis and technical analysis;


portfolio management; portfolio selection, risk diversification;
portfolio risk and return; security market line and capital market
line; capital Asset Pricing Model

Security Analysis
The investor while buying stock has the primary purpose of gain. If he invests for a
short period of time it is speculative but when he holds it for a fairly long period of
time the anticipation is that he would receive some return on his investment. There
are basically two approaches in analyze share price movement. They are
fundamental approach and technical approach.

Fundamental Approach: fundamental analysis is a method of finding out the


future prices of a stock which an investor wishes to buy. The method for forecasting
the future behaviour of investments and the rate of return on them is clearly
through an analysis of the broad economic forces in which they operate , the kind of
industry to which they belong and the analysis of the companys internal working
through statements like income statement, balance sheet, and statement of changes
of income.
Fundamental approach appraises intrinsic value of share through (a) economic
analysis (b) industry analysis (c) company analysis

a) Economic Analysis: The investment largely depends on the level of economic


activities in a nation. When the economic growth is high the industry can also be
expected to show rapid growth, resulting in increased stock prices. It is essential to
make analysis of macro economic environment to understand the behaviour of stock
prices. Such economic factors are listed below:

1. Gross domestic product: GDP is the indicator of economic growth of a

country. It represents aggregate value of


Goods and services produced in the economy. It is around 6% in India and any
growth in GDP reflects good prospects in the industrial sector and increases the
morale of the investors.

1. Savings and Investment: Economic growth leads to increased savings which


lead to increased investment in assets like equity shares, deposits, mutual
funds, real estates, bullion and others. Such savings of investors are available
to the companies through stock market. Savings represent 23.1`% of GDP
in1997-98 with investment at 24.8 %.
2. Interest Rates: the cost of financing to the firms depends on the availability of
funds at low rates of interest. Any decrease in interest rates leads to lower
cost of finance for firms and increase profitability. The rate of interest which
was 11% per annum in 1997 got reduced to 8% and in 2000 and thereafter.
3. Inflation: Inflationary trends halt the progress of any nation. When it
increases rate of growth falls leading to increase in prices. However mi9ld
inflation is needed for industrial stock market as well. The rate of inflation
was 5.03 % for the week ended May 29 in 2004.
4. Budget: The fiscal policy of a country has a strong bearing on the behavior of
stock market. The budget which provides account of government revenues
and expenditure must be a balanced one to make it favorable to the stock
market.
5. Tax Structure: The tax relief measures announced by the govt would boost
savings. Tax holidays, concessions and incentives offered to an industry
promote investment in the industry and increase profitability.
6. Growth of Agriculture: stock market behaviour is connected with agriculture
development of a nation. A good onset of monsoon leads to bumper crop,
sugar, cotton, and food processing depend on agriculture for their raw
materials. Further economic development of a nation hinges on the ability to
attain self sufficiency in agriculture.
7. Balance of Payments: Balance of payments is an indicator of competitiveness
of a nation. When a country earns money through its exports more than it
spends for its imports, it is implied to have favorable balance of payments. It
is a measure of strength of rupee on external account. The stability in foreign
exchange rate leads to a positive effect on the stock market.
8. Infrastructure Facilities: For the development of any country infrastructure
viz, transport, banking, power, communication and financial sectors have to
be made available sufficiently. Lot of private sector companies and foreign

companies has shown interests in making investments for the promotion of


infrastructure facilities in our nations.
9. Supply of Labour: Study of population provides information about ages,
occupation, literacy, and geographic distribution of population. In out country
labour is available cheaply thus encouraging multinationals to set up their
plants in different parts of the country. Adequate supply of labour promotes
the growth of industries and stock market.

Scanning Of Economic Environment


The macro economic environment has to be analyzed in order to estimate stock
price fluctuations. Any fall in corporate profits and the security prices also tend
to fall. In order to make a proper analysis of economy, one has to be familiar with
economic indicators, diffusion index and econometric model building the
techniques which are used in economic forecasting.
Economic indicators include capital investment, corporate profits, money supply,
interest rates, fiscal policy, productivity etc. There are leading indicators which
help the investor to estimate the path of economy. For instance a deficit budget
may lead to high rate inflation, affecting the cost of production adversely. The
incentives offered to export oriented units may improve exports of nation. The
monetary policy followed by the govt also has the effect on the industry.
There are coincidental indicators which indicate the state of the economy. These
include GNP, interest rates, industrial production and reserve funds.
Recessionary trend will affect corporate profits and industrial production.
Lagging indication include unemployment rate, consumer price index and flow of
foreign funds. The lagging indicators reflect the changes occurring leading and
coincidental indicators.
Diffusion index is am consensus index consisting of leading, coincidental and
lagging indicators. This type of index has been constructed by National Bureau
Of Economic Research in USA. The drawback of diffusion index is that it is
difficult to calculate and the irregular movements in individual indicators cannot
be fully eliminated. Economic model building required construction of
mathematical model showing relationship between the independent and the

dependent variables. Simultaneous equations are used in these models to make a


forecast.
b) Industry analysis.
A group of companies manufacturing same products belong to single industry.
They use more or less same technology for the production. Industries may be
classified as
Food and beverages
Textiles
Leather and leather products
Chemicals
Wood and wood product
Basic metals, alloys and metal products
Non-metallic mineral products
Rubber and plastics
Machinery and machine tools
Transport equipment and parts
Power, tobacco products

Other manufacturing industries.


The industries can be classified on the basis of business cycle phases viz, growth,
cyclical, defensive and cyclical growth.
Growth industries have high rate of earnings and expansion. Industries like IT,
pharmaceuticals and telecommunications have shown remarkable growth.
Cyclical industries experience prospects and down falls along with the business
cycle. For instance consumer durables have good market during the boom phase and
slack season during recession.
Defensive industries with stand even bad phases of cycle namely recession and
depression. e.g., food industry.
Cyclical growth industries have the nature of cyclical and growth as well. The
automobile industry has both experienced slackness and growth. Introduction of
large number of consumer friendly models with improved technology proves the
point.

Industry analysis also involves life cycle analysis which involves four stage. Viz
introduction stage. Growth stage, maturity stage, and finally decline stage. This is
similar to product life cycle. The firm which has introduced a new product has
distinct advantages over others. It can establish its brand name widely and create a
good product image. It can adopt skimming the cream pricing policy to make huge
profits by fixing prices at a high level.
In the growth stage many firms enter the market with their products, posing severe
competition to the pioneering firm. All companies have more or less stable growth
rate and declare dividends to their share holders. Firms in information technology
have achieved a higher growth rate than the industrys average.
In maturity stage growth rate tends to be moderate with technology becoming
obsolete. The firms in order to survive have to bring innovation in technology.
The last stage is decline stage in which the product becomes liability to a firm as the
earnings of the companies tend to fall rapidly. The investors have to avoid investing
in such firms even in the boom conditions.
The industry cycle analysis apart an investor has to take into consideration certain
other factors which are discussed as follows:

Industrial Growth: the performance of industries over the past few years to be
analysed to drive home the point. For instance Indian industry has achieved an
impressive growth of 9.4% in April 2004 with mining sector achieving 9.5% increase
up from 6.3%in the same month last year. Electricity generation was at a record high
of 10.7%. Use based data released by the CSO show that basic goods production was
higher by 8.2 %, capital goods by 23.2% and intermediate goods by 9.4%. consumer
durables achieved a growth rate 17.7%. the highest growth of 88% was achieved in
the case of wool, silk and man made fiber textile, followed by 24.9% in the case of
chemicals and chemical products. Food products showed a decline of 21.9% and wood
products had a decline of 9.7% during April 2004.

Nature of the product: The products may be classifies into industrial and consumer
goods. The consumer goods can further classified into durables and non durables.
Industrial goods like iron sheet, cranes, trucks, steel wires and coils are demanded
by engineering industry. The investor has to determine the condition of related goods
manufacturing units to ascertain the demand for industrial goods.

Cost structure and profitability: The investor has to analyze the cost structure of

the product manufactured by the industry in which he is desirous of investing. The


cost is divided into which has to be incurred in the form of plant and equipment
required for the manufacture of products and variable cost which varies depending
on the level of output. The cost sheet of a product helps to find out the cost of
production and ultimately cost of sales. It is essential for a firm to maximize the
output to keep the fixed cost per unit minimum. The firm has to first achieve break
even sales to avoid losses. When the firm desires to increases its output beyond the
maximum it has to bring in additional capital to get it invested in machinery and
equipments. A firm has resort to this only when it expects increased demand for its
products.

Level competition: Market share of a firm indicates the market standing of the

firm in the industry. All firms in an industry design appropriate strategies to


withstand onslaught of competition and get their positions secured. MRTP
companies are allowed to augment their capacities and augment their capacities and
multinationals have entered the fray with high stakes in the economy. This situation
has posed a great threat to the survival of many Indians companies and led the
prices decline. The investor has to study the level of competition demand for the
product concerned, profitability and price of scrips of the company before making
investment.

SWOT Analysis: The investor has to make SWOT analysis of the industry. It
means strength, weakness, opportunities and threats analysis. In order to make
such an analysis the investor has to possess adequate knowledge of the industry. For
example brand equity is the strength of coco cola, weaknesses may include poor
financial strength, inadequate promotional measures, irregular supply of products to
the markets etc. the investor has to see that how far an industry makes uses of
opportunities available. Threats may come in the form of competition, import
restrictions followed by importing countries. The industry has to survive all these to
emerge successful and boost the confidence of investors.

Government policy: In order to augment exports, tax holidays, and tax concessions
are provided to export oriented products. Government regulates the size of
production and of certain products. The sugar, fertilizers and pharmaceuticals
industries are very often affected by the inconsistent govt policies. Hence it becomes
essential to make careful evaluation of govt policies regarding a particular industry.

Research and Development: Innovations in products and process are needed to


make them technically competitive. Constant Endeavour has to be made to update
technology. Economies of scale have to be achieved to cut down the cost of
production. Technological supremacy gives great hopes both in domestic market and
abroad.

Supply of Labour: The investor has to ensure that abundant supply of labour is
available for the industry concerned. The firms have to establish cordial relationship
with the trade unions to bring in new measures. Industrial disputes lead to loss of
man days and there would be fall in industrial production. This situation has to be
avoided to achieve labour productivity. Availability of required type of labour in
adequate size at cheaper rates is a welcome measure and this is the reason as to why
many MNC prefer to make investments in India.

Company analysis: All information pertaining to the company must be collected by


the investor in order to evaluate present and future stock values. The risk and
returns associated with the purchase of stock have to be analyzed to take sound
decisions. A companys performance depends on many factors which include
competitive edge, earnings, capital structure, operating efficiency, financial
performance apart from the style of management. These factors have strong effect on
price earning ration of the firm along with external factors viz economic and stock
market conditions.

Competitive edge of a company


Every industry consists of many individual companies which depending on their
performance acquire different market shares. For example in automobile industry
Maruti leads in front IT industry is dominated by Tata InfoTech, Satyam computers
Infosys and others. The competitiveness of a firm can be studied through its market
share, annual sales, growth achieved over the years etc. Technical supremacy, wide
distribution network, economies of scale, brand equity, heavy promotional
expenditure etc give dominant positions to such business undertakings and offer
sizable market shares.
The sales of company should constantly grow at a steady rate if not rapidly. The
shareholders would be happier if they bought the shares of a firm which leads
others. Stagnant growth rate demoralizes the investors. The growth should both be

in rupee terms and physical units. When a firm grows in size that will delight the
investors as the firm will gain strength to withstand changes in the business cycle.
The investors are very much concerned with the present sales and as also the future
one. This requires an investor to make a rather accurate sales forecast by adopting
mathematical techniques like the method of least squares. The different components
of demand for the companys product demand for the substitutes and competitors
products have to be analyzed.

Earnings of the company

The earnings of a company have to increase in the same proportion as that of sales.
When sales alone shows increasing trend with earnings not matching the increase it
is cause for worry as the expenses start increasing in the concern. Analysis of both
sales and earnings by an investor helps him to get a real picture of the concern. It is
the precaution to be taken by the investor to see whether the income generated is out
of sale of assets or from investments.
Income of the company is affected due to the following reasons viz changes in costs
and sales, depreciation method adopted, stock valuation, depletion of resources,
income taxes, wages, salaries and fringe benefits etc.

Capital structure

A company may increase return of equity shareholders by financial leverage. The


debt ration indicates the status of short term and long term debts in the companys
capita structure. The proportion of preference shares in the capital structure has to
be assessed by the investors. The preference shares have lesser leverage effects than
the debts since the dividend to preference shares are not tax deductible. The
instability in the earnings of equity shares may be caused by fluctuations in the
earnings of the company particularly when the preference share occupies larger
portions in the capital structure.
The debt element in the capital structure needs scrutiny. During boom period the
positive side of the leverage effect increases earnings of the shareholders and there is
instability in earnings per share during recession due to the leverage effect. The
interest coverage ratio shows the ability of the firm to pay interest charges. Fixed
asset to debt ratio has to be worked out to check whether financing of fixed assets by
the debt is within a reasonable limit.

Style of management

The performance of any firm depends on the way it is managed. The managers
abilities to plan, organize, direct and control have great impact in the functioning of
an enterprise. The symptoms of well managed concern can be summarized as follows
1. There is steady growth in sales and earnings of the firm. Market share tends
to increase steadily.
2. Customers are well satisfied with the products offered by the firms. The
products with proven quality are offered at the right prices at the right time
to the customers to force them to make repeat purchases.
3. There is optimum utilization of plant and equipment. When the percentage
utilization of capacity increases the cost gets decreased leading to increased
profitability.
4. Constant endeavour is made to make innovations in products design and
performance and processes to achieve technical supremacy over the
competitors.

5.

Production planning and control is made effective leading to timely


completion of production activities thus ensuring strict adherence to
production schedules.
6. Wastages due to quality variations gets minimized by fixing appropriate
quality standards.
7. Cordial industrial relations are maintained paving the way for the
management to introduce their schemes with little objections from the
labour. mandays lost due to strikes and lock outs get reduced and
productivity tends to increases.
8. SWOT analysis of the firm and competing firms is made which will enable
the former to convert the weakness of the latter into opportunities.
9. The firm discharges its functions effectively for the causes of the society
consisting of shareholders. Customers, employees, community and the govt.
It cannot shrink social responsibility.
10. The inventories of the firm are kept at optimum level to avoid the capital
getting locked up. At the same time stock outs are avoided by timely
placement of purchase orders.

11. All the factors that lead to increase in cost have to be taken into account.
Cost reduction techniques like value analysis of inventory control etc have to
be followed to effect cost control.
All the above depend on the educational back ground, skills and experience of
management personnel apart from their abilities to keep the firm flexible enough to
accommodate changes in the environment.
Operating efficiency
High operating efficiency is the need of the hour for a company aiming at expansion.
The production resources like machinery and equipment, materials and labour have
to be effectively utilized to derive more income from sales.
Operating leverage
A firm is said to have high degree of operating leverage when a small change in sales
leads to a big change is return on equity. Companies which invest heavily on fixed
assets experience high operating leverage. On the other hand production of
consumer non durables especially cosmetics does not have huge fixed assets thus
experiencing lower operating leverage.

Financial Analysis:

Financial statements of a company provide the historical and current


informations about the companies operation. This statement includes profit and
loss account and balance sheet, comparative financial statement, trend analysis,
common size statement, fund flow and cash flow analysis.

Leverage. On the other hand production of consumer non durables especially


cosmetics does not have huge fixed assets thus experiencing lower operating
leverage.

Technical analysis

Technical analysis is probably the most controversial aspect of investment


management. That technical analysis is a delusion that it can never be any more
useful in predicting stock performance than examining the insides of dead sheep in
the ancient Greek traditions.
Technical analysis attempts to explain and estimate changes in prices of securities
by studying only the market data rather than information about a company or its
prospects. The technical analysis considers that the price of a stock depends on
supply and demand in the market place not on the value to a great extent.
John Magee whose book Technical Analysis of stock trends is considered a classic
for technical analysis says ;
The technician has elected to study not the mass of fundamentals but certain
abstraction namely the market data alone. He is fully aware that is not all also he is
aware that what he is looking it is needed a fairly high order of abstraction and that
on the back of it lies the whole complicated world of things and events. But this
technical view provides a simplified and more comprehensible picture of what is
happening to the price of a stock. It is like a shadow or reflection in which we can see
the broad outline of the whole situation.
The characteristic features of technical analysis Vs fundamental analysis include the
following
1. Technical analysis considers volume as the vital factor: when the number of
shares traded is greater volume is favorable and when it is lower the volume
comes down. The decision points of investors can be spotted on charts.
2. Formations and patterns signify changes in real value: the changes in real
value are caused by investor expectations, hopes, industry developments etc.
3. Technicians are not committed to a buy and hold policy:
Technical analysts hold a stock as long as the trend is on the upper
side. They will start selling it immediately on watching the reversal of
trends

4.. Separation of income from capital gains is not undertaken: Technicians do not

hold high dividend paying stock years together. Instead they look for total returns
that are the price realized minus price paid plus dividends received.
5. The activities of technician are quick whether to make commitments or to
make profit and losses: The technicians show willingness to assume smaller
gains in the up market and accept quick losses when the market shows a
declining trend.
6. Technical analysis calls for more experience: Technical analysis requires
attention and discipline keeping the quality stocks for long terms. They use
technical indicators to gain experience in facing pitfalls.
7. Technical analyst believe in historic performance: Current movements in
stock prices would repeat in the future thus being used for future projection.
The charts used in technical analysis provide the most convenient method of
comparison.
8. Technical analysis recognizes even small breakouts that would have
important impact: Any shift in the supply and demand is considered as an
important signal by the technicians.
9. Charts are used to confirm fundamentals: When the trend of overall stock
market is favorable both fundamental and technical analysis agrees leading
to favorable profitable movement.
10. Technical analysis recognizes that securities of strong companies are often
weak and vice versa.
Fundamentalists are generally conservatives who invest for the long term where
as the technicians are traders who buy and sell for short term profits.
Fundamentalists make their decisions based on quality and value. They take the
corporations financial strength past growth in sales and earnings, profitability,
investment acceptance etc into account.
Fundamentalists select quality stocks when they are undervalued and sell them
when they become fully priced thus making huge profit. Technicians are in
general interested in keeping their money working as profitably as possible at all
times. They want to make profits quickly and if the market does not perform well
they are willing to take a small fast loss. Investors with technical orientation
check the market action of the stock and when it is favorable they examine the
fundamentals to ensure the strength and profitability of the company.

Tools of Technical Analysis:

Technical analysis measure supply and demand of the stock and forecast prices of
securities, suing the following tools.

FIBONACCI Numbers

Fibonacci was a mathematician who discovered the series of numbers, while


making the study on reproductive behaviour of rabbits.
1,1,2,3,5,8,13,21,34,5,589,144
The unique feature of the above series is that after the initial pair of ones (1,1)
each succeeding number is simply the sum of previous two numbers. Technical
analysis makes use of the number 1.618, which the analysis call it golden mean.
It is obtained by dividing each Fibonacci number by its immediate predecessor
[55/34, 89/55, 144/89..]

Fibonacci Ratios
0.618

0.618

1.000

1.618

2.618

1.618

1.618

1.618

1.618

1.618

1.618

0.382

0.618

1.000

1.618

2.618

4.236

Those who follow Fibonacci ratios for the investment purpose, use the first two ratios
viz., 0.382 and 0.618 for completing retracement levels of a previous move. For
instance, a stock falling from Rs. 50 to Rs. 35 (30 percent drop) encounters resistance
to further advances after it checks the loss to the extent of 38.2 percent.
A male bee has only a mother; it comes from an unfertilized egg. A female bee (a
queen) comes from a fertilized egg and has both a mother and father. This means one
drone has one parent two grandparents, three great grand parents, and five great
great grand parents and so on. The number of ancestors at each generation is the
Fibonacci ratios.

Dow Theory

The theory advocated by Charles Dow is one of the oldest technical methods, being
widely followed. The theory consists of three types of market movements, namely
the major market trend lasting a year or more; a secondary intermediate trend,
moving against the primary trend for one of several months; and minor movements
lasting for hours to a few days.
Dow Theory asserts that stock prices demonstrate patterns for over four to five years
and these patterns are reflected by stock price indices. The Dow Theory employs the
industrial average and the transportation average, two of the Dow Jones Averages.
Dow Theory believes that its measures of stock prices tend to move together. When
the Dow Jones industrial average is on the rise, the transportation average will also
tend to rise. Such simultaneous movements in prices signify a strong bull market.
When the industrial average is rising and the transportation average is falling, the
industrials may not continue to rise, with the result, that the market investor starts
selling the securities and converts them into cash. The reverse occurs when one of
the averages starts to rise after a period of falling, while the other continues falling.
The Dow Theory suggests that this divergent phase is over and the security prices
will soon start to rise in general. The shrewd investor will then start purchasing
securities in anticipation of increase in prices.

The above signals are illustrated in the following figures.

Figure A illustrates a buy signal. When the industrial starts to rise, both the
industrial and transportation averages have been declining. The increased
industrial average even there is a decline in the transportation index, suggests

that the declining market is over. The above change is confirmed when the
transportation average also starts to rise.
The sell signal is illustrated in figure (B). Here, both the industrial and
transportation averages are on the rise. The industrial average continues rising.
This implies that the market is witnessing an unsettled period, signifying
uncertainty regarding the future direction of stock prices.
The falling
transportation average confirms the direction of industrial average, indicating
the bear market underway.
When there is a sell signal, the believer (investor) of this theory will try to
liquidate, thus driving down prices. Buy signals force investors to purchase
securities, which will ultimately drive up their prices.
There are certain criticisms of the Dow Theory. The Dow theory does not explain
why the two averages should be able to forecast future stock prices. Further,
there may be time lag between actual turning points and those determined by
the forecast. The Dow theory was well only when a long, wide movement is found
in the market. When the market trend frequently reverses itself in the short
term, this theory is not found useful. Another drawback is that this theory does
not make attempt to explain consistent pattern of stock price movements .

Elliott Wave Principle


Elliot Wave principle develops a rationale for a long term pattern in stock price
movements by advocating five successive steps resembling tidal waves. In a bull
market the first move is upward, the next downward, the third are upward, the
fourth downward and the last phase upward. The above steps show a reverse
trend in a bear market.

Stock
Price

Time
The above figure is a simple demonstration of Elliot Wave Principle (EWP). The
EWP can be applied to real situations by recording past movements in stock prices
at different points of time. The EWP offers investors a basis for developing
important market strategies. However, it is difficult to identify the turning point of
each stage. Further, an investor cannot differentiate major movement from a minor
movement.

Kondratev Wave Theory


Kondratev was a Russian economist who studies economics of western nations. He
was known after the U.S market crash in 1929, which he predicated that would
follow U.S crash of 1870. His hypothesis of a long term business cycle is known as
the Kondratev Wave Theory.
The market crash in 1987 came after 55 years of previous crisis which was found
consistent with Kondratev theory. Though certain factors like exchange rates,
elimination of gold standard, minimization of barriers to free trade etc. make the

decision cycle less predictable, the market analysts consider the work of Kondratev
commendable.

Neutral Networks
Neutral network is a trading system in which desired output from past trading data is obtained by
trying a forecasting model. If the desired output is not found, more volume of data are included.
It has feedback mechanism to gain experience from past errors. However, the stock market is not
always deterministic. The changes in situations would affect the stock market, making neutral
network vulnerable

Charts
Charts of prices and trading volume are used for analysis by the technicians. The
chart analysis is used to determine the probable strength of demand in relation to
supply at various price levels so that prediction of direction of stock movement is
made possible. Technical analysts believe that stock price fluctuations generally
form characteristic pattern, having important predictive value.

Types of charts
1.

Line Chart

The closing prices of successive time periods are connected by means of straight
lines, without taking note of high or low prices of stock for each period as shown
below:

2.

Bar chart

Bar chart is drawn with time taken in the X axis and stocl prices in the Y axis. It
can be drawn for different time periods, a day, a week, a month or even a year.
The bar chart as shown below shows the high price, low price and the closing
price represented by a small horizontal line projected from the vertical line.
The below chart shows weekly stock price movements for a 5-week period. The
trading volume can be placed at the bottom of the chart, thus giving move details
about the stock.

Point and Figure Chart

The advocates of point and figure chart believe that the changes in prices need
only be analysed to predict future price fluctuations. They ignore both volume
action and time dimension. Point and figure chart starts with putting X in the
appropriate price column of a graph. Successive price increases are entered in
the upward. Column by putting X, if the price drops, the figures move to the next

column and Os are entered in a downward progression until the trend is


revered. Covering a fairly long period gives definite shapes. The following figure
is the simple point and figure chart.

Bar chart with head and shoulders


Technical analysis identify the turning points through basic reversal patterns to
decide when to buy or sell stock. Such a key reversal pattern is known as head
and shoulders configuration.

The figure (a) is a bar chart that exhibit head and shoulders pattern. It can be
inferred form the figure that when time passed, the price of stock rises to the point A
only to fall down to B. It starts recovering by reaching the point C and falls again to
the bottom (D). It once again rises to the peak of E and shows declining trend finally.
The figure (b) shows the inverted head and shoulders pattern which starts with
falling trend and finally results in a forecast that its stock is about to rise to a
great extent.

Trend Analysis
A technical analyst very often confronts the problem of establishing a major
trend. Any reversal in trend is termed as major when there is a move between 20
and 45. Advancement in price generally precedes a major trend. The analyst has
to check whether there is an occurrence of trend violation. Trend violation is an
indication of reversal in the major direction of stock price movement. The
technical analyst has to watch out the signs of distribution or accumulation.
Accumulation is followed by a major up trend, whereas unusual price and or
volume action.
There are certain price configurations which are more easily identified than
head and shoulders configurations. These include triangles, pennants, wedges
and flags.

Ascending Triangle

The above figure shows a falling wedge, which usually occurs in a major uptrend
pattern. Line A shows steep decline, since the sellers are found aggressive. The
charts, though are found useful, have a few limitations. Charts need proper
interpretation. Further, analysis give their options to buy stock at a time only to
change their decisions in the immediate future. This makes the investors to be
in an doubt of the market time and again. The buyers are totally relying on
actions of the stock, assuming that investors who are causing changes, have
thorough knowledge of the company. They make decisions on the basis of chart
patterns, instead of analyzing the real causes of stock price movements.
Limitations of chart
The technical analyst may have charts of all the principal shares in the market.
But all that is necessary is a proper interpretation of charts. Interpretation of
charts is very much like a personal offer. Ina way it is like abstract art. Take an
abstract painting and show it to ten people and you will get at least eight
interpretations of what is seen. Take one set for chart figures and show it to ten

chartist and you are liable to get almost as many interpretations of which way
the stock is going .
The trouble with most chart patterns is that they cause their followers to change
their opinion so frequently. Most chart service change like the wind. One day
they put out a strong buy signal two weeks later they see a change in the pattern
and tell their clients to sell then two weeks later they tell them to buy again. The
result is that these patterns force their followers in and out of the market time
and time again. Though this is great for brokers commission but not so great for
the investor.
Another disadvantage and a great one which exists in charting is that decisions
are almost always made on the basis of the chart alone. Most buyers under this
method have no idea why they are buying companys stock. They rely alone on a
stocks action assuming that the people who have caused or are currently causing
this action really know something about the company. This is generally negative
thinking simply because as more and more chartists are attracted to a stock
there are simply more and more owners who know little or nothing about the
company.

Technical Indicators

Technical indicators provide useful information when they are examined


individually, but when many technical indicators are interpreted collectively,
they provide confusing results.

1. Short interest Ratio

The short interest ratio is derived by dividing the number of shares sold short by
the average volume for about 30 days. The ratio has the logic that speculators
and other investors sell stocks at high prices in anticipation of buying them back
at lower prices.

2. Confidence Index

It is the ratio of a group of lower grade bonds to a group of higher grade bonds.
When the ratio is high, investors confidence is high, reflecting in the purchase of
relatively more of lower grade securities.

3. Spreads
Large spreads between yields indicated low confidence among investors, leading
to bearish market. Small spreads indicate high confidence and are bullish in
nature.

4. Advance Decline ratio

When advances are more than the decline, the ratio increases. Such a situation
will lead to bullish condition.

4. Market Breadth Index

It is computed by taking the net difference between the number of stocks rising
and number of stocks falling and adding it to (or subtracting from) the previous
one. If both the stock index and the market breadth index increase, the market
leads to bullish condition.

5. Insider Transactions

Insiders (people who are connected with the company) have knowledge about
performance of the company, future earnings, dividend and stock price
performance. It is bearish indicator when insiders start selling heavily.

Moving Average

It is a statistical technique, making use of the historical data. For instance, a ten
day moving average measures the average over the previous en trading days.
Under this method, the changes in the slope of the line are important
There are certain witchcraft indictors like super bowl indicator, sunspots, and
hemline indicator, attracting the attention of investment personnel.
For
instance, super bowl indicator states that stock market will register advances if
the super bowl foot ball game is won by a team from the original national foot

ball league in U.S. The sunspot theory is based on the principle that increased
sunspots lead to more rains finally resulting in higher stock prices.

Assumptions of Technical Analysis

Technical Analysis is based on the following assumptions.


1.
The market value of a scripts determined by the interaction of demand and
supply.
2.
The price of security quoted represents hopes and fears of players in the
market. Any information regarding issue of bonus shares and right issues
cause increase in prices whereas information on any strike in the near
future may cause fall in price.
3.
The market always exhibit trends. The trend may be either increasing
trend or decreasing trend. It continues for sometime.

4.

The technical analysis assume that past prices predict the future. For
instance, the rising market leads to increased purchases and the
downtrend causes large scale selling of shares.

Evaluation of Technical Analysis


Successful use of technical analysis requires talent, intuition and experience. It is
a tool to be used along with fundamental analysis and commonsense. It is because
the data used in technical analysis are past data. It may provide false signal to
sell, forcing the believers of technical analysis to sell out he shares immediately
without waiting for confirmation. This would lead to the payment of commissions
for the sale and repurchase if the value bounces back.

Theory of Portfolio Management


Financial markets are in general influenced by the flow of money and information. In
free and highly competitive markets demand and supply pressures determine the
prices or interest rates. Markets are considered efficient when there is a free flow of
information and the market absorbs this information quickly.

In the words of James Lorie efficiency of market means the ability of capital market
to new information. Such efficiency will produce prices that are appropriate in terms
of current knowledge and investors will be less likely to make unwise investments.
Efficient market theory states that fluctuations in share process are random and
they do not follow any regular pattern.

Characteristic of perfectly efficient market

1. Investors anticipate to make a fair return of investment: It is generally


believed that investors relying wither technical analysis or fundamental
analysis do not generate abnormal returns.
2. Market is considered efficient only when sufficient number of investors feel
that they not efficient: Investors who are watchful tend to analyze securities
very carefully. However everyone starts believing that the market is efficient
thus not bothering to analyze securities.
3. Investment strategies known publicly do not provide abnormal returns: The
investors must be aware of a strategy that provides means of identifying
mispriced securities and they have to capitalize on the strategy.
4. There are some investors who exhibit excellent performance: It is also a fact
that not all the investors are skillful. Few investors make a forecast an up
market for certain securities and the rest think otherwise. The former might
have made an accurate forecast in the first year. A portion of the same
investors who made accurate forecasts previously might have made reliable
forecast and this may continue for an few more year.
5. Professional investors and ordinary investors are alike in selecting securities:
As the prices reflect investment values, there is no point in searching for
mispriced securities in order to generate abnormally high returns.

Future performance does not have past performance as any indicator: Investors who
fared better in the past may end up with failure now. Some might had an element of
luck whereas others suffered due to misfortune.

Random Walk Theory


It is the French Mathematician Louis Bachelier who wrote in his paper that security
price fluctuation was random. Maurice Kendall also accepted his view point. In 1970
Fama stated that efficient markets fully reflect the available information. According
to Random Walk Theory changes in stock prices are independent of each other. The
present price is in no way connected with the past trends and is randomly
determined. It is the information flow that can influence the process. Since
information is free and independent the prices resulting from it are also free and
independent. Only market efficiency promotes randomness and the fact that prices
move independently has been proved by empirical studies. The equilibrium price of a
stock is determined by demand and supply forces based on available information.

Assumptions of Random Walk Theory


1. An individual investor or a group of investors cannot have any influence over
market operations.
2. Stock prices discount all informations quickly.
3. Markets are efficient and there is free and unbiased flow of information.
4. Every investor has free access to the same information and no one is
considered have superior knowledge.
5. The free forces of demand and supply make the market quickly adjusted to
any deviation from the equilibrium level.

6. Only when the equilibrium level shifts market process tend to change only as
information relating to the fundamentals
7. There is no undue pressure or manipulation acting on the prices as the latter
move independently.
8. Nobody has better knowledge or inside information.
9. Investors are rational and the demand and supply forces are the result of
rational investment decisions.
10. Institutional investors have to follow the market and market cannot be
influenced by them.
11. There is a large number of buyers and sellers leading to perfect competition.
According to Fama the efficient market hypothesis can be divided in to three
categories namely weak form, semi strong form, and the strong from. The level of
information considered in the market is the basis for this classification represented
by the following figure:
Strongly efficient market that all information is reflected on
security prices

Semi strong efficient market with all public information


reflected on
Security prices.
Weakly efficient market with all historical information
reflected on
Security prices

Thus efficient market hypothesis is based on the flow of free and correct information
and the absorption of it by the market. There are three types of information affecting
the market as shown in the figures viz, past prices, and trends, other public

information and inside information. As indicated by the figure the analysis have
placed the market absorption and the related theory under the following head viz,
weak form of efficient market hypothesis, semi strong form and strong form.

Weak form of EMH


According to weak form of EMH current prices reflect all information found in the
past prices and traded volumes. It is closely related to the Random walk Hypothesis.
The past prices are already absorbed by the market with the present prices moving
independently of the past. The present trends are nothing but random variables and
past data cannot be used to predict the future.
In weak form of the market the price of the stock and its intrinsic value diverse
substantially and short term traders may earn a positive return .

Empirical Test:

Empirical Test were conducted both in the past and present on the validity of
Random Walk Hypothesis. Cowles, Jones and Kendall conducted research and
showed that security prices moved in a random fashion. Investors who made analysis
of the past fundamental involving price behavior of the past went on to pick up blue
chips in their portfolio but did not show up superior portfolio performance.

Filter Test:

These tests are based on the principle of fixing a filter level varying from 0.5 % to
50% and examining how well price changes pick up both trends and reversal. For
instance when a stock moves up a filter point to 5% the stock is bought and is held
for long. When it reverses by the same filter point 5% it is sold and a short position is
taken. A short position is one sells even without holding shares to deliver.
Filtering is thus screening of the important information affecting the prices from
unimportant and to see how well the price changes picking up the trends and
reversals.
When the filter level is slow the market fluctuations capture these levels and when
the filter level is taken as large the results do not prove the hypothesis. Even in case
of small filters the investors do not gain by using filter tests when the transactions
costs and charges are taken into account.
Stock prices do not move in an unexpected movement and reversals. Hence one
cannot make return in excess of the results warranted by the risks assumed by the

investors. All theses prove that the weak form of market efficiency holds food since it
is not possible to gain more price information of the market.

Serial correlation Test:

These test were conducted by Moore to study the movement of stock prices. Serial
correlation was used for the study. He measures correlation coefficient of changes in
prices for a week with the price changes a week later and so on down the line. The
result indicated that there is very low correlation coefficient implying that a price
increases not showing the tendency to the price fall and vice versa in any predictable
manner. Hence the price changes of the current week do not depend on the past price
changes to any significant extent.
Fama conducted the correlation tests on daily price changes taking into account the
companies included in the Dow Jones industrial average for five years. Serial
correlation price data of different periods of time did not show any significant
positive results. Thus it is proved that the prices move in an independent fashion in
a large extent.

Run Test:
A run is a set of consecutive price changes in the same direction. The time series
data on price changes of stocks are used to study whether there are dependencies
among these series in terms of signs and reversal of signs. Fama used run tests to
examine whether the changes in prices were likely to be followed by further price
changes in the same direction.
There are certain other tests conducted in this regard. For instance the research
conducted by Osborne indicated that stock prices moved in a Brownian fashion. It
means that simulation tests conducted by a few authors showed that the mechanism
of Random Walk generated variables which are similar to movement of stock prices.
Sharpe and Jensen studied relative performance of mutual funds. The hypothesis
that the mutual funds could earn extraordinary returns and constantly achieve a
higher average performance as they have better access to insider information was
tested and was found void. Blume and William in the studies proved that the mutual
fund performance was not extraordinary or superior to average market performance.

Semi Strong Form


According to semi strong form of efficient market hypothesis the market
absorbs quickly and efficiently the price information and all publicly available
information. Such public information is found in the financial reports,
balance sheets, profit and loss accounts, earnings and dividend reports,
financial results etc. Any other information that affects financial position such
as liquidity, financial structure, solvency etc is also found useful and is
absorbed by the market in the price formation. Thus the prices not only
reflect the past price data but also information which relates to the earnings
of the company, dividend, bonus issue, mergers etc. semi strongly efficient
market offers profits to a few insiders as a short run price changes. Timely
and correct dissemination of information is needed to have semi strongly
efficient market. However the semi strong form is not well supported by
empirical evidences. Fama, Fisher, Jenses, and Roll analysed the effect of
stock spilt on share prices. The study threw light to the existence of semi
strong form market and it analyzed whether stock splits lead to an increase
in the wealth of shareholders.
In 1972 Scholes conducted a study to analyze the reaction of security prices to
the offer of secondary stock issues. The study showed that the price of
security decreases when the company assuring the securities indicated that
such an offer contained bad news. However secondary offerings so investors,
banks and insurance companies were not viewed negatively and the security
prices did not fall significantly.
Pettit and watts examined the reaction of market when changes in dividends
were announced. They concluded that there was no evidence that a firms
dividend announcement affected the firms price in the period which
immediately followed the announcement. Beaver conducted a study which
looked into the information of the announcements of annual earnings and the
speed of changes in the prices of securities. He examined the level of trading
volume and the size of changes in prices. He inferred that the absolute values
of price changes and levels of trading were significantly higher during the
week announcement. However they returned to pre announcement levels

after a week. This leads to a conclusion that abnormal returns cannot be


realized after the announcement was made.
Strong Form

In the strong form of market it is stated that all information is represented in the
security prices in such a way that there is no opportunity for any person to make an
abnormal gain on the basis of any information. The strong form of efficient market
hypothesis maintains that all available information including the publicly available
us useless to an investor. Most of the research work indicate that efficient market
hypothesis in the strongest form does not hold good. Collins listed the strong form of
market in 1975 and showed that the consolidated earnings of multi product firm
would be accurately predicted by using data as segment and profit rather than
making use of consolidated historical earnings data.

Friend, Sharke and Jensen tested the performance of mutual funds. The hypothesis
was that mutual funds could earn extraordinary return and constantly achieve
higher than average performance as they are likely to have access to inside
information not publicly known different samples of firms and time periods were
chosen for the study. However it was inferred that the mutual funds were not better
in performance than the individual investor who makes purchase of same securities
with the same risk. Mutual funds are expected to earn extraordinary return but
empirical evidence shows otherwise.

Random Walk Theory- An overview


Random Walk Theory mainly deals with the successive changes rather than the
price or return level
. The theory postulates that the market may have imperfections like transaction
costs and delay in disseminating relevant informations to all market investors.
However these sources of inefficiency may not result in excess returns above the level
of normal or equilibrium.
The random theory is criticized on the ground that it does not say anything about
the relative price changes. It does not make any remark on the decomposing of price
into market industry or firm factors. The random walk hypothesis deals only with
absolute price changes but not with the relative prices. The hypothesis is entirely
consistent with the upward and downward movement of stock prices.

There are studies to prove that their stocks with low price earning ratios yield
higher returns than stocks with high price earnings. Several studies confirmed the
existence of small firms effect which maintains that investing in small firms that us
those with low capitalization offers superior risk adjusted returns. The average
returns for the smallest firms and largest firms were computed with small firm
portfolio gaining upper hand over that of large firm. There is also weekend effect as
in Bombay Stock Exchange it was observed in the part that Mondays were
characterized by trading blue chips where as Fridays experience heavy rush.

Portfolio Management

A portfolio is a mixture of securities. It is combination of various securities viz


stocks, bonds and money market instruments. Portfolio management is concerned
with the determination of future risk and return in holding various blends of
securities in order to obtain optimum return with minimum risk. In diversified
portfolio actual return of the portfolio is close to the anticipated one as the poor
performance of a few securities is offset by the food performance by other securities.
The expected return of portfolio depends on the expected return of each of the
securities entailed in the portfolio. Portfolios expected return is weighted average of
expected return of its securities. The contribution of each security depends on its
expected returns and its proportionate share in portfolio. Investors who want to
maximize their returns have to hold just one security which yields the highest
returns. However investors have to diversify in order to reduce risk.

Measure of risk

Actual return from a security may not be equal to the expected return. There is an
element of probability of loss. A useful measure of risk has to be considered in order
to take into account various possible outcomes of losses and their magnitude. The
standard deviation may serve the purpose.
Standard deviations of returns of securities are used to determine the standard
deviations of portfolios return. Hence it is preferred for investment analysis.

Portfolio risk

The portfolio risk has to be estimated using the variance of each individual security
in the portfolio and the correlation coefficient of each security with each other
securities.

A positive value of co variance shows that the returns of securities in a offsetting of


returns that is a few securities showing better than expected results and a few
others fall below the expectations.
The relationship between the covariance and the correlation co efficient can be
represented as follows
rxy = Cxy/ x y
Where rxy = coefficient of correlation between return on x and y
Cxy = covariance between return on x and return on y
x= standard deviation on return for x
y= standard deviation on return for y
For two securities namely x and y the relationship between the risk of a portfolio of
two securities and the relevant variables, the following formula is used.
2p = x2 2 x+2x y Cxy + y 22 y
2p = the variance of return for the portfolio
2x= variance of return for security x
2y = variance of return for security y
X = proportion of portfolios value invested in security x
Y = proportion of value of portfolio invested in security y
Cxy = covariance between the return on security x and the return on security y
When a portfolio has more than two securities the formula for the variance of
portfolio is
N N
Vp = x y rxy x y
x=1 y=1
Where N= number of securities
To ascertain the percentage of investment in each of the securities in the portfolio
resulting in the lowest risk, the following formula is used.
X= y2 - x y rxy/ x2 +y2 - xy rxy
X = percentage of investment in security x

where

Portfolio Analysis
Traditional Versus Modern Porfolio Analysis

Traditional portfolio analysis has been of a very subjective nature but is has
provided success to some persons who have made their investments by making
analysis of individual securities through the evaluation of return and risk conditions
in each security. Infact, the investor has be able to get the maximum return at the
minimum risk or achieve his return position at that indifferent curve which states
his risk condition. The normal method of calculating the return on an individual
security was by finding out the amount of dividends that have been given by the
company, the price earning ratios, the common holding period and by an estimation
of the market value of the shares.
The modern portfolio theory believes in the maximization of return through a
combination of securities. The modern portfolio theory discusses the relationship
between different securities and then draws inter-relationships of risks between
them. It is not necessary to achieve success only by trying to get all securities of
minimum risk. The theory states that by combining a security if low risk with
another security of high risk. The theory states that by combining a security of low
risk with another security of high risk, success can be achieved by an investor in
making a choice of investment outlets.
Traditional theory was based on the fact that risk could be measured on each
individual security through the process of finding out the standard deviation and
that security should be chosen where the deviation was the lowest. Greater
variability and higher deviations showed more risk than those securities which had
lower variation. The modern theory is of the view that by diversification, risk can be
reduced. Diversification can be made by the investor either by having a large
number of companies in different regions, in different industries or those producing
different types of product lines. Diversification is important but the modern theory
states that there cannot be only diversification to achieve the maximum return. The
securities have to be evaluated and thus diversified to some limited extent within
which the maximum achievement can be sought by the investor. The theory of
diversification was based on the research work of Harry Markowitz. Markowitz is of
the view that a portfolio should be analysed depending upon
a.
The attitude of the investor towards risk and return and
b.
The quantification of risk.
Thus, traditional theory and modern theory are both framed under the constraints of
risk and return, the former analyzing individual securities and the latter believing
in the perspective of combination of securities.

Traditional theory believes that the market is inefficient and the fundamental
analyst can take advantage of the situation. By analyzing internal financial
statements of the company, he can make superior profits through higher returns.
The technical analyst believed in the market behaviour and past trends to forecast
the future of the securities. These analysis were mainly under the risk and return
criteria of single security analysis.
Modern portfolio theory, as brought out by Markowitz and Sharpe, is the
combination of the securities to get the most efficient portfolio. Combination of
securities can be made in many ways. Markowitz developed the theory of
diversification through scientific reasoning and method .

The Rationale of Diversification of Investments


Before the development of Markowitz theory, combination of securities was made
through simple diversification. The layman could make superior returns on his
investments by making a random diversification in his investments. A portfolio
consisting of securities of a large number will always bring a superior return than a
portfolio consisting of ten securities because he portfolio is ten times more
diversified. The simple diversification would be able to reduce unsystematic or
diversifiable risk. In securities, both diversifiable and undiversifiable risks are
present and an investor can expect 75% risk to be diversifiable and 25% to be
undiversifiable. Simple diversification at random would be able to bring down the
diversifiable risk if about 10 to 15 securities are purchased. Unsystematic risks,
were supposed to be independent in the case of each security. Many research studies
were made on diversification of securities. It was found that 10 to 15 securities in a
portfolio would bring adequate returns. Too much diversification would also not
yield the expected return.
Some experts have suggested that diversification at random does not bring the
expected return results. Diversification should, therefore , be related to industries
which are not related to each other. Many industries are correlated with each other
in such a way that if the stock of S increases in price the stock of Y also increases
and vice versa. By looking at the trends, industries should be selected in such a way
that they are unrelated to each other. A person having on his portfolio about 8 to 10
securities will reduce his risk but if he has too many securities as described above, it
would not lead to any gain.

If systematic risk is reduced by simple diversification, research studies have shown


that an investor should spread his investments but he should not spread himself in
so many investments that it leads to superfluous diversification. When an investor
has too many assets on his portfolio, he will have many problems. These problems
relate to inadequate return. IT is very difficult for the investor to measure the
return on each of the investments that he has purchased. Consequently, he will find
that the return he expects on the investments will not be up to his expectations by
over-diversifying. The investor will also find it impossible to manage the assets
requires a knowledge of the liquidity of each investment, return, the tax liability and
this will become impossible without specialized knowledge. An investor will also find
it both difficult and expensive to look after a large number of investments. If the
investor will also find it both difficult and expensive to look after a factor of in the
investments. If the investor plans to switch over investments by selling those which
are unprofitable and purchasing those which will be offering him a high rate off
return, he will involve himself in high transaction costs and more money will be
spent in managing superfluous diversification. The research studies have shown
that random diversification will not lead to superior returns unless it is scientifically
predicted. Markowitz theory is also based on diversification. He believes in asset
correlation and in combining assets in a manner to lower risk.

Cut off rate and New Securities

An investor may either add new securities or remove from his investment some other
security. In this case, the cut-off rate will change and this would lead to a change in
the optimum portfolio. Cot-off rate determines not only the vale of the existing
securities with the change in beta. An example may be given to illustrate this. If
cut-off rate was equal to a given amount at he existing moment, with the change in
the securities, the return to risk ratio may be more or less other than the previous
cut-off rate. This may or may not enter in the optimum portfolio to determine
whether it enters the portfolio again the same process or ranking the securities and
finding out the excess to beta ratios above the cut-off rate would have to be chosen to
find out the optimum portfolio.
A new security whenever it is introduced in a portfolio will have its importance. It
will have the effect on either adding to the result of the existing portfolio or making a
change from it. The results will show whether with the addition of the new security,
the optimum portfolio will also affect the change in those securities which were quite
close to he existing cut-off rate.

Efficient Frontier and Portfolio Selection

The portfolio is selected by the introduction of a borrowing and lending line making the
efficient frontier a straight line. Illustration 16.7 shows a risk-free security of 6% with a
standard deviation of 6.90. The graph represents a portfolio return and risk and he best
portfolio is the corner portfolio of 9. The corner which is beyond 9 with an addition of the
fact of leading. The choice of portfolio which are on the right side of 9 i,e from 1 to 8 are
seen to show borrowing and are in some way dominated by 9. 9 is the stage in which the
maximum benefit can be derived after using the formula (Rp Rt/bp).
Sharpe finds the beta relationship to be the most significant in the portfolios, it shows the
activity or movement of stock ,as sown in example. According to him, a portfolio has
unsystematic risk as well as systematic risk but although unsystematic risk can be reduced
to zero the systematic portion of the risk is determined by the behaviour of stocks in the
market and can in no way be absolutely reduced or dominated to zero. Sharpe also gives
importance to the presence of both beta coefficient () and systematic risk. In the selection of

a portfolio on beta, the negative and positive betas should be considered. While assessing a
portfolio on beta, the negative beta should be preferred to positive beta. The presence of
negative beta in a portfolio is efficient. Also, there is reduced or eliminated amount of risk
when the negative betas are present.
Portfolio betas are used to measure risk in a portfolio but with proper diversification and
elimination of unsystematic risk, the portfolio can become efficient. Betas on a portfolio, are
therefore, the weighted average of the betas of each of the securities on the portfolio. Beta
can be used to move systematic risk above or below and since beta is measured by the
market. If there is a presence of a high beta, ten the investor can be expected to be
aggressive as this indicates an aggressive portfolio. When the market price rises and moves
up the corner, portfolio 9 also shows a rise. But the value of the portfolio alls whenever he
market prices fall.

Beta and its Significance in the Portfolio

We have just send that beta is a measure which has been used for reducing risk or
determining the risk and return for stocks and portfolios. A number of research studies have
been made to give indications of beta co-efficient for selection of stock. When beta is used
significantly for stock selection it is to be compared with the market. The investor can
construct his portfolio by drawing the relationship of beta coefficient with the prices
prevailing in the market. When there is buoyance in the market , then beta coefficient which
are large can be selected. These betas would also carry with them a high risk but during the
boom period, high risk is expected to give a maximim of return. If the market is bear market
and the prices are falling, then it is possible to sell short stocks which have high positive
beta coefficient. The stocks which have a negative beta would withstand the tag in the prices
in the market. For example, when the beta is +1.0, the volatility which is relative to the
market would indicate an average sock. But when the beta changes o +2.0 , it is excluding
the value which is provided by alpha, the stock would be estimated to show a return of 20%
when the market return is forecasted at 10%. This is in the case of a rising market. But
when the prices shows a decline and the future is expected to provide a decline of 10%, then a
beta which shows +2.0 would show that it is providing a negative return of 20% if the stock is
held by the investor for very long. But if the investor sells short stock, then he can plan to
gain 20%. But if the beta is negative 1.0, then there would be a gain of a positive 10%, I,e (1.0 X.10).

Although betas help in selecting stock, care should be taken to select he stock with
the beta approach because selection of portfolio with beta is followed only when the
following assumptions are considered:

a.
b.

The market movement in positive and negative directions have to be


carefully analysed and
The past historical considerations of beta must be analysed for future
prediction of beta.

If portfolios selection is not made by an accurate reading of the movement of


markets, then the portfolio selection will be incorrect and will not determine the
preferences of the investor. The market movements explain between 15 and 65% of
the movement of the individual securities. The variability of returns is explained
further between 75 and 95% in the measurement of betas. The technique of bet,
therefore, although it is useful, has to be conducted with precision.
Beta has been found useful by Smith Barney research work and by a study
conducted by Barr Rosenberg and also another study by Levy. All the three research
studies have shown that beta was not good when securities were to be selected
individually. They were partially useful in the selection of small portfolios but
portfolio selection through beta was very useful in the case of large portfolios which
were kept by the investor for a greater length of time. Smith Barney found that beta
gives an indication for selection of stock but it must be predicted with care. They
made a study of fifty-six stocks and found out the difference of movement of stocks
during two-time periods. This proved that when portfolios of long-time and stable
securities were analysed, then beta was found useful. Betas have also been found to
change or move betas are the economic factors in a country. The information has
been found to be one of the factors which have caused changes in the beta. To find a
result by predicting beta is found to be useful when beta is quantified and the
changes of the returns of individual securities and the market have been related to
the expected rate of inflation. It can be safely said that the relationship between
market and security returns are an indicator for finding out the beta changes
because return, as already studied, is related to risk and both these factors are
linked with the market behaviour of stock. The relationship between the returns of
security and changes in the economic activity of the country are related by finding
out fundamental betas.
The fundamental betas were found out by Barr Rosenbergs research study.
According to him, the fundamental betas could be predicted by finding out relative
response coefficient. The relative response co-efficient quantify between market
return and security return.

a.
b.
c.

The sensitivity of the security to inflation;


Economic events as Market Index causes systematic change and
Risk and return with portfolio.

The relative response coefficient depends on the events that are happening in the
economy and a reaction in favour of inflation shows high relative response coefficient.
Also, betas in order to be useful have to be predictive and cannot be upward looking.
A well diversified portfolio is linked with securities with the market movement. But
the market movement can be considered only when a survey of fundamental factors
is taken into consideration. The fundamental factors are the following:
a.
b.
c.
d.

The earnings of a firm;


The movements of the market;
Continuous valuation of stock;
Survey of stock, whether it represents large or small firms, old and
established and new firms;
e.
Growth of firms historically and
f.
The Capital structure of the firm.
These factors are to be projected with the movements of the stock by assigning
probabilities for the occurrence of the particular factors. These fundamental factors
would also represent the changes in the returns of securities over the years., the
variability in their structure of earnings and the kind of success that is made by
each stock. When the stock is valued, a firm which has continuous high market
valuation will be considered as a good stock. The small firm analysis as opposing
analysis of an established firm will show whether the stock in the firm is risky or
safe and the financial structure will be a means of finding out the kind of operations
of a firm relating to its liquidity position and the coverage of fixed charges.
Rosenberg found that these fundamental factors help in making an optimum
portfolio. According to him, risks are not only systematic and unsystematic but the
latter one can be also sub-divided as specific risk and extra market co- variance.
Specific risk which is a unique risk , is independent to a particular firm. IT
comprises the risk and uncertainty of only one particular firm in isolation. The
extra market co-variance is independent of the market and it shows a tendency of the

stock to move together. It also shows the co-variance of a homogenous group of the
finance group. It is in between the systematic and specific risk. The specific risk
covers about 50% of the total risk and the co-variance and systematic risk together
comprise the other half of 50% . While systematic risk covers all the firms, the extra
market co-variance is in between and covers one group classification of industries. A
portfolio which is properly selected and is well diversified usually consists of 8090%of the systematic risk involved in those securities.

Internal Diversification
Diversification, as expected, reduces the risk and also the co-variance between
the asset and the market portfolio of all risky assets in the economy.
Diversification internationally has become from he point of view of lowering the
co-variance of he securities. Securities should be purchased generally from the
domestic investments but international investments diversify assets to a greater
extend and help he investor to reduce the systematic risk. Real estate
investment has been used by investors for reducing risk.
International
diversification is possible by investing in multinational companies or in foreign
companies, as this will induce investor to make a combination of risk and return
in a manner to make he portfolio superior to the stocks which are confined only
to one stock market.
International investment of money means to investors to combat inflationary
trends because the markets in different countries do not move together. Each
market has its own constraints, environmental factors, socio-economic and
political factors and the gains in one stock purchase in country A is offset by
losses in country B. This reduces the uncertainty of portfolio return. Before an
investor diversifies his portfolio through international diversification, he must
make a careful consideration of the economic, fundamental and social factors of
the countries in which he is interested in gaining in the stock market .

The gain to an investor by international diversification will depend on the interrelationship of the markets of his domestic country as well as the international
market in which he is investing. Correlation between the markets is measured to
find out the risk constraints. When there is low correlation between the domestic
and foreign investments then there will be considerable reduction in risk but a
high correlation in the movement of markets in both the countries will show that
it is risky and beneficial not to diversify.
There are many constraints in international investments. These are: (a) political
risks, (b) liquidity of markets and (c) the currency effects .

a. Political Risks:

The economic environment of a country is usually

dominated by the policies taken by the government. A change in government


or change in its policies will affect the investments either favorably or
unfavourably. When here are a high degree of political risks then both local
and foreign investors are interested in selling the securities and will reach an
equilibrium where the investors are happy to hold their securities. A
favourable political climate will make foreign investors buy chunks of
securities. For example, in India the Non-resident Indian Tax Laws created a
favourable climate for Indians staying abroad to make their investments in
different firms in their home country. But the withdrawal of certain
privilieges or the problem in trying to clarify obstacles have reduced some
element of investment from them.\

b. Liquidity in the Markets:

Liquidity in the markets also pervade a

favorable climate for investors. The United States Stock Market is highly
liquid but there are many other countries which lack this liquidity. United
Kingdom, West Germany, Japan, Australia and India may be considered to be
markets having less liquidity and governed by certain political and economic
factors. These bring about some constraints in international investment .

c. Currency Effects: An investor is faced by different kinds of currencies


whose values are constantly revised and they are fluctuating in nature. It is
important for him to identify the different kinds of currencies and their rates
constantly. If these are not complex in nature, he may plan to diversify and
get a better borrowing and lending on his diversification pattern.

Markowitz Model

Dr. Harry M. Markowitz is credited with developing the first modern portfolio
analysis model since the basic elements of modern portfolio theory emanate from a
series of propositions concerning rational investor behaviour set forth by Markowitz
then of the Rand Corporations in 1952 and later in a more complete monograph
sponsored by the Cowles foundation. It was this work that has attracted everyones
perspective regarding portfolio management. Markowitz used mathematical
programming and statistical analysis in order to arrange for the optimum allocation
of assets with portfolio. To reach this objective Markowitz generated portfolios
within a reward risk context. In other words he considered the variance in the
expected returns from investments and their relationship to each other in
constructing portfolios. In so directing the focus Markowitz and others following the
same reasoning recognized the function of portfolio management as one of
composition and not individual security selection as it is more commonly practiced.
Decisions as to individual security additions to and deletions from an existing
portfolio are then predicted on the effect such a maneuver has on the delicate
diversification balance. In essence Markowitzs model is a theoretical framework for
the analysis of risk return choices. Decisions are based on the concept of efficient
portfolio.
A portfolio is efficient when it is expected to yield the highest return for the level of
risk accepted or alternatively the smallest portfolio risk for a specified level of
expected return. To build an efficient portfolio an expected return level is chosen and
assets are substituted until the portfolio combination with the smallest variance at
the return level is found. As this process is repeated for other expected returns set of
efficient portfolios is generated.

Assumptions under Markowitz Theory


1. The stock market is efficient and all investors have in their knowledge all the
facts about the stock market and so an investor can continuously make
superior returns either by predicting the past behaviour of stocks through
technical analysis or by fundamental analysis of internal company

2.
3.
4.

5.

6.

7.

8.
9.

management or by finding out the intrinsic value of shares. Thus all investors
are in equal category.
All investors before making any investment have a common goal. This is the
avoidance of risk because they risk averse.
All investors would like to earn the maximum rate of return that they can
achieve from their investment.
The investors base their decisions on the expected rate of return of an
investment. The expected rate of return can be found out by finding out the
purchase price of a security divided by the income per year and by adding
annual capital gains. It is also necessary to know the standard deviation of
the rate of return expected by an investor and the rate of return which is
being offered on the investment. The rate of return and standard deviation
are important parameters for finding out whether the investment is
worthwhile for a person.
Markowitz brought out the theory that it was a useful insight to find out how
the security returns are correlated to each other. By combining the assets in
such a way that they give the lowest risk, maximum returns could be brought
out by the investor.
From the above it is clear that every investor assumes that while making an
investment he will combine his investments in such a way that he gets a
maximum return and is surrounded by minimum risk.
The investor assumes that greater or larger the return that he achieves on
his investments the higher the risk factor that surrounds him. On the
contrary when risks are low, the return can also be expected to be low.
The investor can reduce his risk if he adds investments to his portfolio.
An investor should be able to get higher returns for each level of risk by
determining the efficient set of securities.
By intelligent balancing of proportion of investments in different
Securities the portfolio risk can be minimized. For different values of
correlation coefficients and different proportions of securities ABC and XYZ
expected returns and portfolio risks can be calculated. The results
Securities the portfolio risk can be minimized. For different values of
correlation coefficients and different proportions of securities ABC and XYZ
expected returns and portfolio risks can be calculated. The results Can be
presented in the form of a graph as shown below

r=
expected
return 10

P
B

r= 0

r =+1

r= +.5

Q
r= -1
A

Portfolio risk

The portfolio risk (p) is shown in the X axis and portfolio return (Rp) in the Y axis.
Point A represents 100% investment on security X and point D represents 100%
holdings on Y. the straight line (AD)r=+1 shows that there is an increased portfolio
risk when there is an increase in portfolio return. In the line segment ACD, rxy= 0,
CD contains portfolios which are superior to those along the line segment AC.
According to Markowitz all portfolios along the ACD line segment are possible. The
line segment ABD (rxy=-1) shows perfect inverse correlation. Portfolios on line
segment BD shows superior returns to those on line segment AB. For instance with
the portfolio risk remaining the same point p on BD has higher returns than point Q
on AB. Thus it can be concluded that Markowitz diversification can lower the risk if
the securities in the portfolio have low correlation coefficients.

Markowitz Efficient frontier

The portfolios which offer the highest return at particular level of risk are known as
efficient portfolios. It can be illustrated by means of the following table and diagram.

Portfolio risk and return


Portfolio

Expected return(Rp)%

Risk (p)

18

13

15

10

10

10

All the portfolios fall along or within the line ABCDEFGH. Outside this perimeter
portfolios do not fall as there is no existence of expected return and risk combination.
In the above diagram B is more attractive than H as for the same level or risk or 6,
there is higher return for B (15%) C and F have same returns like E and G but is
found superior to both it has the lowest risk of all. Hence in the above diagram A,
B,C and D are efficient portfolios. ABCD line is thus considered as efficient frontier
on which all attachable and efficient portfolios are plotted.

Utility analysis
It is essential to make utility analysis to determine the portfolio which maximizes its
utility. It is the satisfaction, the investor enjoys from the returns of the portfolio.
Utility increases with an increase in the return. There are three types of investors as
assumed by this analysis viz investor avoiding risk, investor who is indifferent and
risk seeking investor. For instance in a gamble costing Rs.2 winner will get Rs. 4 and
the loser will get nothing. The chances of occurrence of both are 50% each. The
expected value of investment is (.5x4)+(.5x0)=2. Hence it is a fair gamble. But it is
rejected by the investor who avoids risk as disutility of loss is greater for him. The
indifferent investor is risk neutral. Risk seeker will select such a fair gamble.

According to him the utility of investment is more than utility of non investment.
This can be illustrated by means of utility curve.

There are three utility curves viz A, B, and c. A shows upward sloping, implying
increased marginal utility, obviously the risk seeker B shows constant utility,
preferred by indifferent investor and c represents diminishing marginal utility (the
risk avoider)
The utility curve of risk seeker is negatively sloped and coverges towards the origin.
Lower the risk of the portfolio happier will be the risk avoider. The risk seeker is
willing to undertake greater risk for smaller returns .

Risk free assets

Risk free assets have no default risk and interest risk there is full payment of
principal and interest amount. The risk free asset has certainly of return and has
zero standard deviation. Generally they are fixed income securities.
When the risk free asset is introduced and the investor invests a portion of his
investment on risk free asset and the rest in risky assets, efficient set of portfolios
will witness a change. It is assumed that investor is able to borrow money at risk
free rate of interest.
Return

Rp

In the above diagram OP is the return with zero risk. As one moves along PQ
combinations of risky and risk less assets are found. The investor up to PQ makes
investments in both fixed income securities by lending some amount of money and
risky investments within the point PQ that is he uses his own funds. But if goes
beyond Q he has to make the borrowings. So portfolios between P and Q are lending
portfolios and beyond Q are borrowing portfolios, risk free securities fall on PQ
segment which reduces the risk more than the reductions as far as returns are
concerned.

Single index model

William F. Sharpe brought out a model simplifying the one advocated by Markowitz.
Markowitz model relates each security to every other one in portfolios requiring
sophistication and great volume of work. Sharpe assumed that the return on a
security can be regarded as linearly related to a single index known as the market
index.
According to Sharpe the market index eliminates the need for calculating large
number of co variances between individual securities as any movements in securities
is attributed to movements in a single underlying factor measured by the market
index. This is known as Single Index Model or Market Model.

Characteristic line
Market is divided into pessimists (bear- selling the stock fearing the fall in prices)
and optimists (bulls). When the market moves many securities move in the same
direction though at different rates. The relationship between returns on individual
securities and returns on market portfolio is expressed with the use of a
characteristic line.

Excess return as the market portfolio = Rm-T where


Rm = holding period return on the
market portfolio
T = riskless rate of interest
Excess return on security = Ri T where

Ri = holding period return on security i


T= riskless rate of interest

Y
Excess returns on security

Z
im

X
Excess return on market
Portfolio

Market portfolio includes all securities each in proportion to market value. The
characteristic line showing the relationship between the excess return as security
and excess return on market portfolio can be written as

Ri T= i+m( - T) +i
R
m
i indicates vertical intercept and im indicates the slope of the line. The value of
is an excess return on the security that corresponds with an excess return of zero on
the market portfolio whereas im is the ratio of a change in the excess returns of the
security to a change in market portfolio. A Beta of indicates that if the excess return
of market portfolio is 1% larger than expected.
Aggressive securities have higher beta values (greater than one). In up markets their
prices rise at a faster rate than the average security. In down markets they tend to
fall rapidly defensive securities have beta value lesser than one.
The nature of residual component of unsystematic return is known as error termi
which represents uncertain portion of non market of excess return on security i.
Excess return on security

Ri T = im (Rm T) + i + i where
im (
Rm-T) is the systematic market component of excess return and i+i is the
non market (unsystematic) component of excess return. The former is market related

portion of excess return and the latter is the non market portion.i represent
expected non market excess return whereas represents

CAPITAL ASSET PRICING THEORY [CAMP]


CAMP has an economic model namely capital asset pricing model which describes
how securities are priced in the market place. The basic structure for the model was
provided by Markowitz, Sharpe, Linter and Mossin. It is model of linear general
equilibrium return. The CAMP theory helps the investor to understand risk-return
relationship of the securities.
CAMP theory is based on following assumptions;
1. The objective of an investor is to maximize utility of terminal wealth:
The investor is maximizing utility of wealth not wealth itself. Risk lover has positive
marginal utility for wealth. A diminishing marginal utility is the most frequently
described utility function. Given the wealth of an investor the total utility depends
on the combinations of risk and return.

2. Investors make their decisions on the basis of expected returns, standard


deviations and covariance of all pairs of securities concerned. In both modern
portfolio theory and CAPM it is assumed that portfolio variance is an appropriate
measure of risk. Beta and return are directly and linearly related. Thus it can be
presumed that the investors goal is to maximize utility of terminal wealth and his
decisions are based on expected risk and rates of return. Investors chose only those
portfolios with the highest rate of return for their preferred level of risk.
3. Investors are assumed to have homogeneous expectations of risks and returns
during the decision making process. Investors define market portfolio the risks and
return differently however in CAPM homogeneity is used to make it simple and
generalized model.
4. CAMP assumes that investors buy all the securities in the portfolio at one point of
time and sell them at some undefined common point in the future. However the
investors who are of different types do not behave similarly in practice.

5. Investors have free simultaneous access to information. Such informations is


generally available to the holders of large portfolio.
6. The investors can lend or borrow any amount of funds at risk free rate of interest.
When a risk free asset is added to the portfolio there is a change in the risk of
market portfolio when an investor opts for short sale of shares the risky assets of a
portfolio are balanced by short sold assets thus creating a riskless portfolio.
7. There are no taxes and transaction costs and restrictions on short sales. It is
assumed that there must be either a risk free asset or a portfolio of short sold
securities.
8. Assets are marketable and infinitely divisible. This assumption however ignores
liquidity and new security issues.
Under CAMP it is assumed that an investor can borrow or lend any amount of
money at risk free rate of interest. The risk free assets and risky assets can be mixed
to achieve a desired rate of risk return combination
Rp = Rf Xf +Rm(1-Xf) where
Rp = return of the portfolio
Xf = the proposition of funds invested in risk free assets
Rf = Risk free rate of return
Rm = return on risky assets
1-Xf = proposition of funds invested in risky assets
The above formula can be used for calculating expected return under a) mixing risk
free assets with risky assets b) investing only in the risky assets and c) mixing the
borrowing with risky assets.
These eight assumptions are basic to create the simple CAPM. Since these
assumptions are critical to understanding the CAPM let we review their
implications. The following list describes the logical sequence of these assumptions.

1. Risk is the variance of expected portfolio returns.


2. Risk can be broken into two components; diversifiable risk and non
diversifiable risk.
3. Proper diversification can reduce unsystematic risk.

4. Beta is the relevant measure of risk for investors with diversified portfolios.
5. Risk and return are linearly related by beta that is risk and returns are in
equilibrium.
6. Return is total return.
7. An investor holds portion of two portfolios. The risk-free asset and the market
portfolio.

8. The return that an investor actually receives is derived from only two sources:
risk proportional market return plus non systematic random return. No other
factor is consistent in its effect on security returns .

THE CAPITAL MARKET LINE [CML]


In the fictional world of CAMP it is a simple matter to determine the relationship
between risk and return for efficient portfolio.

FIG1

(Sm - O)

Em

(Em -7)

Expected p
Return

Sm
Risk (Standard Deviation of return)

In the above figure point M represents the market portfolio and point T the riskless
rate of interest. Preferred investment strategies plot along line TMZ representing
alternative combinations of risk and return obtainable by combining the market
portfolio with borrowing or lending. This is known as the Capital Market Line CML.
All investment strategies other than those employing the market portfolio and
borrowing or lending below the capital line in an efficient market although some may
plot very close to it.
The slope of the capital market line can be regarded as the reward per unit of risk
borne. As figure 1 shows this equals the difference between the expected return on

the market portfolio and that of riskless security (Em-T) divided by the difference in
their risks( SDm-0).
Equilibrium in the capital market can be characterized by the key numbers. The first
is the reward for waiting or riskless interest rate shown by the vertical intercept of
the capital market line (point T in the above figure). The second is the reward per
unit of risk borne shown by the slope line. In essence the capital market line
provides a place where time and risk can be traded and their prices determined by
the forces of demand and supply. The internal rate can be thought of as the price of
time and the slope of the capital market line as the price of the risk.
The selection of a portfolio intended to act as a surrogate for the market portfolio can
be considered a passive strategy for it requires no security analysis. In a completely
efficient market it may constitute the most reasonable approach to investment. In
real world one hopes to beat such a strategy. But the odds are not favorable. by
investing in proportion to values outstanding an investor can be assured pf
performance equal to that of the average in the market. If one advisor or investor is
to consistently outperform this average without taking on disproportionate amounts
of risks, others must consistently under perform it. Investors of this latter variety
may exist but they are not likely to be masochists or completely oblivious to their
situation. Eventually they should realize that they would be better off following a
passive strategy or paying one of the winners of the game to play for them.
Managers employing passive strategies can provide a number of valuable services,
risk control, diversification at low cost , convenient ways to ass or withdraw funds
etc. but some managers and some investors prefer to go beyond this actively
managing a portfolio to try to beat the market. Fig2 analyst owns opinions are
shown here not the consensus of professional analysts opinion. Realistically even
superior analysts must assume that combinations of the market portfolio and
borrowing or lending (shown by line TMZ) dominates most alternative strategies.
However truly superior analyst might find a few combinations that offer higher
expected returns than naives strategies of comparable risk. Such combinations are
shown by the points above the line TMZ in fig2

Active investment management can have its benefits. But it brings costs as well. In the
real world trading costs money and may impact price adversely. Moreover even a
superior analyst cannot hope to identify large numbers of seriously +
securities. Often an investors circumstances restrict the alternative that can be
considered. Many institutions are required to avoid certain classes of securities. Others
can spend only out of dividend and interest income. Taxes do matter in the real world
and different investors are affected differently by them. These factors make investment
management more complicated than the CAMP would suggest. Accepting the inability of
most managers to consistently beat the market one still must accept the need for
potentially rather complicated procedures designed to tailor an investment strategy to
fit the circumstances of a particular individual or institution.

FIG2

Expected
Return
EM

Sm
Risk (standard Deviation of return)

THE SECURITY MARKET LINE

The CML defines the relationship between total risk and expected return for
portfolios consisting of the risk free asset and the market portfolio. The capital asset
pricing model identifies security return net of the risk free rate as proportional to
the expected net return where beta serves as the constant if proportionality. As a
consequence of this relationship all securities in equilibrium plot along a straight
line called the security market line (SML). Since the unsystematic risk tends to be
diversified away by the construction of an efficient portfolio it is desirable to develop
an alternative to CML which will use beta as he independent variable and will
accommodate both portfolios and individual assets. Such a line is called Securities
Market Line (SML). In other words SML is a linear relationship between expected
return and beta or systematic risk on which both portfolio s and individual securities
can lie where as capital market line is a linear relationship between the expected
return of a portfolio and the total risk associated with it; it generates a line on which
efficient portfolio can lie. Fig 3 presents a SML which has beta as the independent
variable and the expected return of portfolios and the individual securities as the
dependent variable.

The SML has a positive slope indicating that the expected return increases with risk
(beta). By definition the risk of a risk less asset, T is zero therefore T is the point at
which the SML crosses the vertical axis the Y intercept point. The beta of the market
portfolio which measures the systematic risk of the market relative to it self, is 1.
Therefore the point where beta equals 1 is associated with the expected market
return. This is an important point since all securities and portfolios with a beta of
less than 1 lie to the left of M on the SML and is called defensive securities. Likewise
securities with a beta of more than 1 are riskier than the market and are called
aggressive securities. In addition the expected return of a security on the SML is
determined by the risk less rate plus a systematic risk premium which is
proportional to its beta.

MODULE - II
Capital market securities: types ; valuation of securities: Investment

risks: systematic risks and unsystematic risk; measurement of risk


and return ; Derivatives options and futures; option pricing
Prepared by: REKHA VENUGOPAL
Different types of Securities:
The Capital market instruments as a long-term sources of finance fall under
two broad categories i) Directs and 2) Derivatives. The direct categories
are : 1) Equity or ordinary shares 2) Preference Shares 3) Debentures/notes
and 4) Innovative debt instruments. While the equity shares and preference
shares are included as ownership securities and debentures/ notes and
innovative debt instruments are creditorship securities. Section 1-4 describe
their features and evaluate them from the point of view of the investors as
well as the companys Derivative instruments are defined by the Securities
Contracts (Regulation) Act to include 1)a Security derived from a debt
instrument share, secured, unsecured loan, risk instrument or contract for
differences or any other form of security and
2)
A contract that derives its value from the prices/index of prices of
underlying securities. Derivative contracts have several variants. The most
common variants are forwards, future and option. Three broad categories of
participants ledgers speculators and arbitrageurs trade in the derivatives
market.

Hedgers face risk associated with the price of an asset. They use futures or
options markets to reduce/ eliminate this risk. Speculators wish to bet on
future and option contracts can give them an extra leverage that is they can
increase both the potential gains and potential losses in a speculative
venture. Arbitrageurs are

Debentures:
According to Sec 2(10) of the companies Act Debentures includes debenture
Stock bonds and any other security of a company whether constituting a
charge on the assets of the company or not to make it more clear debenture is
acknowledgement of debt, given under the seal of the company and contain a
contract for the repayment of the principal sum at a specified date and for the
payment of interest at a fixed rate per cent until the principal sum is repaid,
and it mayor may not give charge on the assets to the company as security of
the loan.
A debenture is a marketable legal contract whereby the company promises to
pay its owner a specified rate of interest for a defined period of time and to
repay the principal at the specific date of maturity. Debentures are usually
secured by a charge on the immovable properties of the company.
The interest of the debenture holders is usually represented by a trustee and
this trustee is responsible for ensuring that the borrowing company fulfills
the contractual obligation embodied in the contract. If the company issues
debentures with a maturity period of more than 18 months, then it has to

create a Debenture Redemption Reserve which should be atleast half of these


amount before the redemption commences. The company can also attach call
and put options with the call option the company can redeem the debentures
at a price before the maturity date and similarly the put option allows the
debenture holder to surrender the debentures at a certain price before the
maturity period.
Kinds of debentures:
Bearer Debentures:

1.

Bearer debentures are similar to share

warrants in that they too are negotiable instruments transferable by


delivery. The interest on bearer debentures is paid by means of attached
coupons. On maturity the principal sum is paid to the bearers.
2.
Registered Debentures
These are debentures which are payable to the registered holders I,e the persons whose
name appears in the register of debenture holders. These debentures are transferred in the
same way as shares.
3.
Perpetual Debentures
Debentures which contains no clause to as to payment or which contain clause that it
shall not be paid back is called perpetual debentures. These are redeemable only on the
happening of contingencies or on the expiration of a period, however long. If follows that
dentures can be made perpetual i.e. the loans is repayable only on winding up or after
period of time.
Redeemable debentures These debentures are issued for a

4.

specified period of time on the expiry of that specified time the company has
the right to pay back the debenture holders and have its properties based
from the mortgage or charge. Generally debentures are redeemable.
5.

Debentures issued as collateral security for a loan. The term


collateral security or secondary security means a security which can
be realized by the party holding it in the event of the loan being not
paid at the proper time or according to the agreement of the parties.
At times the lenders of money are given debentures as a collateral
security for loan. The nominal value of such debentures is always
more than the loan. In case the loan is repaid, the debentures
issued as collateral security are automatically redeemed.

6.

Naked Debentures: Normally debentures are secured by a


mortgage or a charge on the company is assets.
However
debentures may be issued without any charge on the assets of the
company. Such debentures are called naked debentures.

7.

Secured Debentures: When any particular or specified property


of the company is offered as security to the debenture holders and
when the company can deal with it only subject to the prior right of
the debenture holders. Fixed charge is said to have been created.
On the other hand when the debenture holders have a charge on the
undertaking of the company the whole of the property of the
company present and future and when can deal with the property in
the ordinary course of business until the charge crystallizes .

The interest payable to the debenture holders is a charge on profit and


hence tax liability on the companys profile is reduced, which result the
debentures as a source of finance at chapter, cost as compared to the
cost of equity capital and preference capital.
At the time of winding up the debenture holders are placed before the
share capital provides.
Debentures are generally secured on the assets of the company and
therefore carry lesser risk and assured return on investment.

Drawback

It is obligatory on the part of the companies to pay interest at regular


intervals and repayment of Principal on scheduled dates. Any failure
to meet this obligation may paralyze the companys operation.
The debenture trust deed will contain restrictive covenants which may
not be favorable to the management control or equity share holders.
Financing through debenture is associated with financial risk of the
firm. This will increase the cost of equity capital.
Higher risks bring higher capitalization rates on equity earnings.
Thus even though gearing is favourable and raises EPS the higher
capitalization rate attributable to gearing may drive down the market
price of ordinary shares.
Debentures usually have a fixed maturity date. Because of this fixed
maturity date, provision must be made for repayment of the cost.

There is a limit to the extent to which funds can be raised through long
term debt.
Since long term debt is a commitment for a long period it involves risk
during that time the debt may prove a burden or it may prove to have
been advantageous.

New Debt instrument :


Refer Page No.431 Taxman

Interest rate
The interest rate is an important consideration for a modern financial
manager in taking the investment and finance decisions. Interest rate are
the measure of cost of borrowing. The interest rates of a country will
influence the foreign exchange value of its own currency. Interest rates are
taken as a guide in making investments into shares, debentures deposits, real
estates, loan lending etc. The interest rates differ in different market
segments due to the following reasons.

Risk: Borrowers carrying high risk will pay higher rates of interest
than the borrowers with less risk.

Size of loan: The higher amounts of deposits carry higher interest

than small deposits.


Profit on re lending:
Financial intermediaries make their profits from relending at a higher
rate of interest then the cost of their borrowing.

Type of financial assets:

Different types of financial assets attract different types of interest.


International interest rates
The rate of interest may vary from country to country due to differing
rates of inflation.
Government policies and regulations foreign
exchange rates etc.

Nominal and Real rates of interest:

Nominal rates of interest are the actual rates of interest rates of


interest paid.
Real rates of interest are the rates of interest adjusted for the inflation.
The real rate is therefore a measure of the increase in real wealth
expressed in terms of buying power of the investor or lender.

Real rates interest will usually e positive although when the rate of
inflation is very high because the lenders will want to earn a real return
and will therefore want nominal rates of interest to exceed the inflation
rate. A positive real rate of interest adds to an investors real wealth from
the income he earns from his investment.
Interest rate and share prices
The shares and debt instruments are alternative ways of investment. If
the interest rates on debt instrument fall, shares become more attractive
to buy. As demand for shares increases their prices rise too; and so the
dividend return gained from them fall in percentage terms. If interest
rates went up the share holder would probably wait a higher return from
his shares ad prices would fall.

Charges in interest rates and financing decisions


The changes in interest rates will have strong impact on financing
decisions taken by a finance manager5. Financial strategy to be followed
when interest rates are low.

Borrow more money at fixed rate of interest to increase the

Companys gearing and to maximize return on equity.


Borrow long term funds rather than short term funds.
Replace the high cost debt with low cost debt.
Financial strategy to be followed when interest rates are higher.

Raise funds by issue of equity shares and to stay away from raising
debt finances.
Debt finance can be taken from short term rather than long term.
Surplus liquid assets can profitably be invested by switching of
investments fro equity shares to interest bearing investments.
Reduce the need to borrow funds by selling unwanted and inefficient
assets keeps the stocks and debtors balances at lower levels etc.
New projects need to be given careful consideration, which must be
able to earn the increased cost of financing the projects.

Term Structure and Interest Rates:


The term structure of interest rates and the levels of interest rates are
obviously of prime importance. We will consider first the nature of the
different types of interest rates. The most commonly quoted interest rates in
the financial markets are:
a.
Banks base rate
b.
The inter-bank lending rate.
c.
The Treasury bill rate
d.
The yield on long dated gilt edged securities.
The term structure of interest rate described the relationship between
interest rate and loan maturity.
Yields to maturity:
Yield to maturity means the rate of return earned on security if it is held till
maturity. This can be presented in a graph called yield to maturity curve
which represents the interest rate and the maturity of a security. The term
structure of interest rates refers to the way in which the yield on a security
varies according to the term of borrowing the length of time until debt will be
repaid as shown by the yield curve. Normally longer the term of an asset to
maturity the higher the rate of interest paid on the asset. In normal
situation YTM curve is upward due to following reasons:

The risk is more in holding securities for a longer period than short
period. This is due to the conditions of business which cannot be
predicted with accuracy and hence the investors holding long-term

securities prefer to be compensated for the additional risk than on


short term securities.
In the long term securities the funds of the investors are tied up for
long periods and for than the inventors. Naturally expects for higher
returns than short term securities.

Factors determining yields:


The general level of yields on stocks is determined by a complex of
factors.
1.

3.

The bank rate and corresponding level of interest rate. A change in


interest rates will affect security prices and yields as follows:
A fall in interest rates brings about a rise in the price of fixed
interest securities and fall in yields.
A rise in interest rates has the opposite effect.

4.

The borrowers financial standing

5.

The Government offers absolute security for its debts so that yields
on gilt edged security are finest in the market and establish all
standard for other yields. Since the standing of other borrowers is
lower. Investors expect higher yields. The difference is known as
the yield differential or yield gap.
Duration of the loan

2.

6.

The element of the risk increases with the duration of the loan so
that, investors expect higher yields on long term bonds than for
short by way of compensation.
General outlook of economy:
A bullish outlook for industry or the prospect of inflation and high
rates of interest will cause investors to switch to equities to depress
the prices of gilts and to raise their yields.

7.

Political events:
Prices and yields are also influenced by political events Eg: change
of government, industrial unrest, publication of trade figures
international crisis or any events likely to effect business confidents
etc.

Different types of Securities:


The Capital market instruments as long-term sources of finance fall under
two broad categories i) Directs and 2) Derivatives. The direct categories are :
1) Equity or ordinary shares 2) Preference Shares 3) Debentures/notes and
4) Innovative debt instruments. While the equity shares and preference
shares are included as ownership securities and debentures/ notes and
innovative debt instruments are creditorship securities. Section 1-4 describe
their features and evaluate them from the point of view of the investors as
well as the companys Derivative instruments are defined by the Securities
Contracts (Regulation) Act to include 1)a Security derived from a debt
instrument share, secured, unsecured loan, risk instrument or contract for
differences or any other form of security and
2)
A contract that derives its value from the prices/index of prices of
underlying securities. Derivative contracts have several variants. The most
common variants are forwards, future and option. Three broad categories of
participants ledgers speculators and arbitrageurs trade in the derivatives
market.
Hedgers face risk associated with the price of an asset. They use futures or
options markets to reduce/ eliminate this risk. Speculators wish to bet on
future and option contracts can give them an extra leverage that is they can

increase both the potential gains and potential losses in a speculative


venture. Arbitrageurs are
Equity or ordinary shares:
An equity interest in a company may be said to represent a share of the
companys assets0 and a share of any profits earned on those assets after
other claims have been met. The equity share holders are the owners of the
business; they purchases the share, the money is used by the company to buy
assets, the assets are used to earn profits, which belong to the ordinary
shareholders.
After satisfying the rights of preference shares, the equity share shall be
entitled to share in the remaining amount of distributable net profits of the
company. The dividend of equity shares is not fixed any may vary from year
to year depending upon the amounts of profit available. The rate of dividend
is recommended by the Board of Directors of the Company and declared by
share holders in the Annual General Meeting. Equity share holders have
right to vote on every resolution placed in the meeting and the ordinary
shares have some special features in terms of the rights and claims of their
holders:
1.
2.
3.
4.

Residual claim to income/asset


Right to control
Pre-emptive rights and
Limited ability

Residual Claim to income: The equity share holders have a residual claim to
the income of the company. They are entitled to the remaining income/profits
of the company after all outsider claims are met. The income available to
share holders equal profit after tax minus preference dividend. PAT is equal
to operating profit (EBIT). However residual claim is only a theoretical
entitlement as the amount actually received by the share holders in the form
of dividend will depend on the division of the Board of Directors.
Residual Claim on Assets: The ordinary share holders claim in the assets
of the company is also residual in that their claim would rank after the claims
of the creditors and preference. Share holders in the event of liquidation if

the liquidation value of the asset is insufficient their claims may remain
unpaid.
Right to control: As owners of the company equity holders have the right to
control the operation to participate in the management of the company. Their
control is however indirect. The major policies or decision are approved by
the Board of Directors and the Board appointed Management carries out the
day to day operations. The share holders have the legal power to elect the
Board of Directors as well as vote on every resolution placed in various
meetings of the company. Though in theory they have indirect right to control
or participate with the management. In actual practice it is weak and
ineffective partly because of the apathy and indifference of the majority of the
share holders who rarely bother to cast their votes and partly because
scattered and by and large unorganized equity share holders are unable to
exercise their collective powers effectively.
Voting System: The ordinary shareholders exercise their rights to control
through voting. In the meeting of the company, according to the most
commonly used system of voting in India viz majority rule voting is elected
individually. Therefore a share holder can cast the total number of shares
held by him separately. Shareholders or groups holding more than 50% of the
voting right would be able to elect all the directors of their choice.
Pre-emptive rights: The ordinary shareholders of a company enjoy preemptive rights in the sense that they have a legal right to be offered by the
company. The first opportunity to purchase additional issues of equity capital
in proportion to pro rata basis their existing or current holdings/ownership.
The option to the share holders to purchase a specified number of equity
shares at a stated price during a given period is called rights. The share
holders can exercise, sell in the market and renounce or forefeit their preemptive right partially or completely. The pre-emptive rights ensures that
the management cannot issue additional shares to strengthen its control by
selling them to persons or groups favourably inclined to it. On the other hand
it protects the existing share holders from deletion of their financial interest
as a result of new equity issue on the other.

Although the equity holders share the ownership risk their liability is limited
to the extent of their investment in the share capital of the company.
While evaluating the equity share holding it has got its own merit and
demerit.
Advantages:
1.

2.
3.

4.
5.

There are no fixed charges attached to ordinary shares. If the company


generates enough earnings it will be able to pay a dividend but there is
no legal obligation to pay dividend.
Ordinary shares carry to fixed maturity.
They provide a cushion against losses for creditors, thus the sale of
ordinary shares rather than other securities increases the credit
worthies of the firm
Ordinary shares can often be sold more easily than debentures.
Returns from the sales of ordinary shares in the form of capital gains
are subject to capital gains tax rather than corporate tax.

Disadvantages:
1. The sale of ordinary shares extended voting rights to control to the
additional share holders who are brought into the company..
2. More ordinary shares give more people the right to share with the existing
owners in the company profit
3.
The cost of underwriting and distributing new issues of ordinary
shares are usually higher than those for underwriting and distributing new
issues of ordinary shares are usually higher than those for underwriting and
distributing preference shares or debentures.
4. If the firm has more equity or less debt that is called for in the optimum
capital structure the average cost of capital will e higher than necessary.
5. Dividends payable to ordinary shares holders are not deductible as
expense for the purpose of corporation tax but debenture interest is
deductable.
In brief equity share capital is a high risk high reward permanent capital
market instrument or sources of long term finance for corporate enterprises.
Share holders who desire to share the risk, return and control associated

with ownership of companies would invest in corporate equity. As a source of


long term fund it has high cost/low risk does not delete control and puts no
restraint on managerial freedom.

RISK
Risk and uncertainty are an integral part of an investment decision. Technically
risk can be defined as a situation where the possible consequences of the decision
that is to be taken are known. Uncertainty is generally defined to apply to
situations where the probabilities cannot be estimated. However risk, and
uncertainty are used interchangeably.
Risk is composed of the demands that bring in variations in return of income. The
main forces contributing to the risk are price and interest. Risk is also influenced by
external and internal considerations. External risks are uncontrollable and broadly
affect investments. These external risks are called systematic risk. Risk due to
internal environment of a firm or those affecting a particular industry are referred
to as unsystematic risk.
Systematic risk is non diversifiable and is associated with the securities market as
well as the economic, sociological, political and legal considerations of the prices of
all securities in the economy. The effect of these factors is to put pressure on all the
securities in such a way that the prices of all stocks will move in the same direction.
Unsystematic risk is unique to a firm or industry. It does not affect an average
investor. Unsystematic risk is caused by factors like labour strikes, irregular
disorganized management policies and consumer preferences. These factors are
independent of the price mechanism operating in the securities market. The
problems of both systematic and unsystematic risk are inherent in industries
dealing with basic raw materials as well as in consumer goods industries.
Those industries producing industrial products and dealing with basic raw materials
follow the level of economic activity and price levels of the securities markets. High
degree of systematic risk can be discerned in such industries and low degree of
unsystematic risk. Example rubber, glass, automobile etc.

Classification of risk

1.
2.
3.
4.

Systematic

Economic
Sociological
Political
Legal Risk

1. Securities Market
2. Economy

External Environment Risks

unsystematic
1. Industry Risks

Unique Risks
1. Labour strikes
2. Weak Marginal Policies
3. Consumer Preferences

Internal Risks
1. Business Risk
2. Financial Risk

1. Market Risk
2. Interest Rate Risk
3. Purchasing Power Risk
Systematic Risk
As defined earlier systematic risk is uncontrolled and it indicates the direction of the
movement of stock market. When the stock market is in the hands of bulls, it implies
that there is an upward trend. The reasons beyond the control of an industry include
economic conditions, political situations and sociological changes. For example the
recessions experienced by the world in 1998 affected the stock market all over the
world. An individual investor cannot avoid the systematic risks. The systematic risk
can be classified into
a. market risk
b. interest rate risk and
c. purchasing power risk

1. Market Risk

The market risk can be defined in the words of Francis as that portion of total
variability of return caused by the alternative forces of bull and bear markets. Bear
market has the index declining from the peak to a low point for a considerable point
of time. The bull market is characterized by the moving index from a low level to the
peak. There are many events which cause buoyancy and debacles in stock market.
These include war, earthquake, political uncertainty, depreciation in the value of
currency, trade protectionist measures followed by importing countries etc. when
political turmoil and recession cause havoc in the economy there would be a rush to
sell the share and the stocks which are floated in the primary market, do not get
adequate market reception. Further when a leading financial institution starts
disposing the stocks the investors get panic and start selling the stocks. Such an over

reaction

of

the

market

is

beyond

the

control

of

investors.

2. Interest Rate Risk

It is the variation in the rates of return in a particular period caused by the


fluctuations in the market rate. The monetary policy of the government and changes
in the interest rates of treasury bills and the government bonds affect the interest
rates of treasury bills and the govt bonds affect the interest rates. The bonds issued
by the govt and quasi govt are considered risk free. When higher interest rate is
offered by the govt for a new bond or a loan there would be shift in the funds from
low yielding bonds to high yielding bonds. Further the investors would tend to shift
their funds to the bond market during depression to ensure assured rate of return.
For instance in 1996 IDBI and IFC bonds were over subscribed when public offerings
of many companies went under subscribed. The cost of borrowing funds is affected by
the rise or fall in the interest rate. Many stock traders use borrowed funds to trade
in the stock market. Any increase in the interest rate affects the morale of
speculative traders leading to a fall in the demand for securities. Interest rate
increases affect the corporate bodies too. When the cost of borrowing goes up the
companies would witness a heavy outflow of profit in the form of interest leading to a
reduction in EPS and fall in the price of share.

Purchasing Power Risk


Purchasing power of currency is another important factor that affects variations in
returns. Inflation leads to loss of purchasing power of the returns. Any rise in price is
not desirable to the investors as he receives lesser returns. Demand pull inflation
leads to the supply not matching the demand which finally results in upward push in
the price. Increase in cost of raw materials, labour and equipment leads to increase
cost of production ultimately resulting in higher price level. The consumer price
index measures the changes in the price levels by taking into account the goods used
by the consumer viz industrial workers in different parts of the country. Whole sale
price index is also used to measure the rate of inflation.
Real return of any investment could be calculated by using the equation given below:

Real future value = nominal future value/1.0+inflation rate


Hence real rate if return = 1+Acutal rate of return /1+inflation rate -1

Unsystematic Risk

Unsystematic risk is peculiar to a firm or an industry and it is caused by inefficiency


of the management, changes in the technology relating to production processes,
availability of raw materials, changes in consumer preferences, industrial relations
etc. changes in technology are not uniform in all industries. Debt equity ratio is not
the same for all the firms. Consumers of durables like washing machines etc do not
have the same preference like the consumers of individual products. All these lead to
unsystematic risk, contributing a significant part in the total variability of the
return. Unsystematic risk may be classified into 1) Business risk and 2) Financial
risk and 3) External risk.

1. Business Risk
Business risk arises from the inability of a firm to maintain its competitive edge over
other firms and maintain the growth or the stability of the earnings. The variations
in the expected operating income indicate the business risk. It is concerned with the
difference between revenue and earnings before interest and tax. Business can be
classified into internal risk and external business risk.
Internal business risk is associated with the operational efficiency of a firm. The
operational efficiency is affected by sales fluctuations, research and development
measures of the firm, management of human resources, fixed cost, product
diversification, industrial relations, credit policy etc.
Firms having several products lines are facing lesser business risk than those which
have single product line. It is because some products are more vulnerable to the
business cycle while others withstand and start achieving growth against the tide.
However diversification must be limited to the known path of the company as
unwieldy diversification would land the firm in deep trouble.

2. External Risk

The factors in the external environment of a firm have strong impact on the
operations. These include monetary and fiscal policies of the government, various
phases of business cycle , social and regulatory factors, general economic
environment, political situation others.
Regulatory measures followed by the govt would affect business operations. For
example the govt may exercise price control volume control etc. The pollution control
board has brought 0ut strict guidelines for safe guarding the natural environment
and asked many tanneries in Tamilnadu to close down the business for falling to set
up effluent treatment plants.
Political stability has to be ensured as political uncertainties would lead to crash in
stock prices. For instance immediately on assuming power, the congress govt at the
centre ruled out disinvestment of companies in oil sector. When there is a change in
the ruling party changes are expected in the economic policies which would affect
share market operations. The business cycle fluctuations lead to fluctuations in the
fortunes of a company. Almost all industries would suffer when the recessions sets
in. During the boom period the development of economy would be witnessed in the
form of increased earnings and consumptions. Many firms may be forced to close
down others witness fall in profits.

3. Financial Risk

Financial risk is associated with the capital structure of a company. A companys


capital consists of both equity funds and borrowed funds. The presence of debt and
preference capital results in financial commitment of paying interest or
predetermined rate of dividend. This affects the payments of dividend to the equity
shareholders. Such a debt financing causes variability of returns to equity
shareholders. Financial leverage uses the debt with the owned funds to increase the
return to the shareholders. The earnings of a company must be more than the cost of
borrowed funds in order to achieve an increase in the earnings of shareholders. Debt
financing enables the corporate to have funds at a low cost and ensures financial
leverage to the shareholders. Debt financing enables the corporate to have funds at a
low cost and ensures financial leverage to the shareholders.

Measures to minimize the effect of risk

The investor has to understand nature of risk and take suitable precautions to
minimize the dangers caused by various risks.

Protection against Market Survey


1. The stock which shows steady growth may be preferred to the ones which are
cyclical in nature.
2. The investor has to choose appropriate times for purchase and sale of stock.
Holding the stock during rising trend in the market for a certain period only to
dispose it later, would give the required benefits.

3. The information on the standard deviation and beta values of the stock
provided by the National Stock Exchange bulletin is useful in gauging the risk
factor to take correct decisions.

Warding of interest rate


1. The investment in securities with predetermined maturity periods has to be
preferred and it is essential to hold the investment till the maturity. This
would protect against heavy loss of capital.
2. Bonds with different maturity dates may be preferred. This would provide
sufficient funds for reinvestment.
3. The bond of short maturity and treasury bills can be brought, to enable an
investment to reinvest in the market at the appropriate time.

Facing inflationary trend


1. The yield from a bond should be around 15% with low risk factor to prevent
inflation from causing panic among the investors.

2. Investment in short term securities would minimize the risk associated with
the inflation. It is because rising consumer price index would eat away the
real rate of interest in the long run.
3. Diversified investment would to a great extent provide a hedge against
inflation. The effect of fall in purchasing power can be minimized.

Measures against Business and Financial Risk


1. it is essential that an investor has to make SWOT analysis of the firm in a
particular industry. He should have the confidence in the ability of the
company that it would create opportunities from the weakness of its
competitors.
2. The consistency in the earnings of a firm has to ensured. Standard deviation
tells the variability of the return and facilitates comparison.
3. The debt-equity ratio of a company has to be kept at the manageable level as
the interest payments as borrowings would affect the earnings of the
investors. An investor can opt for a high levered company in a boom period.

Investors Attitude Towards Return and Risk

Understanding and measuring return and risk is fundamental to the investment


process and increased an awareness of the investment problem. Most investors
are risk averse. They must be aware of the risks in different investment
whether they are confronted with high, moderate or low risk and the kinds of
risks investment are exposed to before making their investment. To have a higher
return the investor should be able to accept the fact that he has to be faced with
greater risks. In commercial bank and life insurance savings, most of the risks
are low but purchasing power risk is high.
Most investors are risk averse and attempt to maximize their wealth at
the
minimum risk. Risk it is established can be reduced to a minimum but cannot be
completely erased or eliminated. Risk and return are related. The higher the risk
a person is willing to accept the better the returns he is able to achieve.

Beta
The most important part of equation is b or beta. It is used to describe the
relationship between the stocks return and market indexs returns. If the
regression line is at an exact 45 angle, beta will be equal to +1.0. A 1% change in
the market index (horizontal axis) shows that it is on an average accompanied by
a 1% change in the stock on the vertical axis. The percentage changes in the price
of the stock are regressed against the percentage change in the price of a market
index. Usually in the S&P 500 price index, Beta may be positive or negative.
Usually betas are found to be positive. We rarely find a negative beta which
reflects a movement contrary to the market. A .5 beta indicates that the market
index change of 1% was reflected by a .5% price change in stocks. Similarly a 1.5
betas would reflect that whenever the market index rose or fell by 1%, the stock
would rise and fall by 1.5%. Beta is referred to as systematic risk to the market
and a +E the unsystematic risk. Beta us useful piece of information both for
individual stock as well as portfolios, but as a measure of risk it is better used in
the analysis of portfolios. Also beta measures risk satisfactorily for diversified
efficient portfolios but not inefficient portfolios. In the present concept Beta is
satisfactory measure for portfolios because risk other than that reflected by beta
is diversified.
Beta has certain limitations within which it must be considered. While
calculating past betas, the length of time will affect beta size. When estimating
future betas, the markets expected return should also be estimated. If high beta
is accurately predicted and the market also goes up as predicted the relationship
will work. On the contrary high beta estimation and low market or downward
market will show that the beta will drop much faster than the market. Finally its
shortcomings as a measure for individual stock should be realized while
calculating stock. For the total portfolio beta is effective.

Alpha
The distance between the intersection and the horizontal axis called alpha

( ). The size of the alpha exhibits the stocks unsystematic return and its average
return independent of the markets return. If alpha gives a positive value, it is a
healthy sign but alphas expected value is zero. The belief of many of the investors is
that they find stocks with positive alphas and have a profitable return. It must be
recalled however that in an efficient market positive alphas cannot be predicted in
advance. The portfolio theory also maintains that the alphas of stock will average
out to 0 in a properly diversified portfolio. The third factor besides alpha and beta is
Rho

Rho ()

Rho () is the correlation coefficient which describes the dispersion of the


observations around the regression line. The correlation coefficient expresses
correlation between two stocks, for example i and j. The correlation coefficient would
be +1.0 if an upward movement in one security is accompanied by an upward
movement of another security. Conversely, downward movement of one security is
followed in the same direction, i.e downward by another security. If the movement of
two stocks is not in the same direction the coefficient correlation will be negative and
would show -1.0. if there was no relationship between the movements of the two
stocks the correlation coefficient would be 0. the correlation coefficient can be
calculated as follows
n
Pij
=
Rxi- Ri - Rxj - Rj
X=1

Rxi= xth possible return for security i.


Rxj = nth possible return for security j
Rij = expected return for i and j
Pxij = joint probability that Rxi and Rxj will occur simultaneously.
n= total number of joint possible returns.
The relationship or degree of correlation among securities indicates that if there is
perfect correlation diversification will not reduce portfolio risk below the lower of the
two individual security risks. If the securities are negatively correlated portfolio risk
can be greatly reduced. If the relationship is to be drawn between two security
returns the portfolio risk can be eliminated. When actual common stocks re analyzed
it will be found that usually these stocks are highly correlated but not perfectly
correlated. Correlation coefficients also help in determining the extent to which a
portfolio has eliminated unsystematic risk.

Co variance
While standard deviation is an excellent measure for calculation of risk of individual
stocks. It has its limitations as a measure of a total portfolio. With the correlation
the covariance approach should also be considered when there are two or three
stocks on the portfolio; co variance approach should also be considered when there
are two or three stocks on the portfolio. Co variance can be used to achieve the
highest portfolio expected return for a predetermined portfolio variance level or the
lowest portfolio return.
An individual securitys expected return and variance express return and risk for
portfolio of stocks the expected return on the individual securities. This is weighted
according to each securities rupee proportion in the portfolio. Since stocks tend to
cover or move together portfolio risk cannot be expressed for an individual stock. The
formulae for calculation of covariance of two stocks I and J and the covariance of
stocks with beta coefficients are
Cov. ij = p ij i j
P ij = joint probability that ij will move simultaneously
i = standard deviation of i
= standard deviation j

Investors Attitude towards Return and Risk


Understanding and measuring return and risk is fundamental to the investment
process and increased an awareness of the investment problem. Most investors are
risk averse. They must be aware of the risks in different investment whether they
are confronted with high, moderate or low risk and the kinds of risks investment are
exposed to before making their investment. To have a higher return the investor
should be able to accept the fact that he has to be faced with greater risks. In
commercial bank and life insurance savings, most of the risks are low but
purchasing power risk is high.

Most investors are risk averse and attempt to maximize their wealth at
the
minimum risk. Risk it is established can be reduced to a minimum but cannot be
completely erased or eliminated. Risk and return are related.

The study of investment is concerned with the purchase and sale of financial
assets and the attempt of the investor to make logical decisions about the various
alternatives in order to earn returns on them. The returns are further dependent on the
varying degrees of risk. A functional definition as defined by Amling is, Investment
may be defined as the purchase by an individual or institutional investor of a financial or
real asset that produces a return proportional to the risk assumed over some future
investment period.
Fisher and Jordan describe it in a similar manner An investment is a commitment of
funds made in the expectation of some positive rate of return. If the investment is
properly undertaken the return will be commensurate with the risk of the investor
assumes.
An investor takes a lot of decisions before he selects the right assets for making
investment. He considers the level of risk he can assume and the nature of assets
available. He has investment options like bonds, stocks, and real estates. Once he decides
the type of assets for instance common stock he has to decide which companys equity he
has to look for. He should possess large volume of funds to make investment on the stock
of companies like Reliance or Infosys. A part from that his decision should be based on
the return and risk associated with the assets.
The valuation does not pose much problems in the case of bond and preserved sotck as
the benefits are generally constant and certain. Equity valuation is difficult in the sense
the return on equity is not certain and high fluctuations are experienced frequently. Hence
the size of the return and risk determine the value of a share to an investor. An equity
manager performs three important activities viz deciding the equity to buy or sell, trading
of securities, and monitoring the performance of portfolio.
Basic valuation Models: Fundamental Approaches
Time value of money
The Basic Valuation Models are based on the idea that money has a time value. An
amount of Rs. 100 received today is worth more than a 100 rupee note two years later,
since Rs. 100 can be invested today at 6% interest. It will fetch then Rs. 106 in a year. For
different securities, future benefits may be received at different times. Even when the
amount of future payment is the same differences in the timing of receiving them will
create different values. The time value theory states that money received earlier is of
greater value then money received later even both are equal in amount and certainty
because money received earlier can be used for reinvestment to bring in greater returns
before the later returns can be received. The principle which works in time value of
money is interest. The technique used to find out the total value of money is
1. Compounding and
2. Discounting
1. Compounding

An initial investment or input will grow over a period of time. The terminal value can be
seen as
S = P (1+i)
S= Terminal value
i = Time Preference or interest rate
n = number of years
p = initial value

Valuation of Bonds or Debentures


The values of Bonds and Debentures are easy to determine. If there is no risk of default,
the expected return on a bond is made up of annual interest payments plus the principal
amount to be recovered at maturity.
Reasons for Issuing Bonds
Government has no choice but to borrow when they are unable to meet their expenses
from current revenue. Corporations, on the other hand have a wider choice in the matter
of financing their operations e.g retained earnings, new equity shares etc. but they still
prefer to go in for borrowing for the following reasons.
1. Reduce the cost of capital
2. To gain the benefit of leverage
3. To effect Tax savings
4. To widen the sources of funds
5. To preserve control
Features of bonds
1. indentures
2. Maturities
3. Interest payments
4. Call feature
Types of Bonds
1. Convertible and Non Convertible Bonds
2. Sinking fund Bonds
3. Serial Bonds
4. Mortgage or secured Bonds
5. Collateral Trust Bonds
6. Income Bonds
7. Adjustment Bonds
8. Assumed Bonds
9. Joint Bonds
10. Guaranteed Bonds
11. Redeemable and irredeemable Bonds
12. Participating Bonds

Bond prices, Yields and Interest Rate


There are a number of risks in bond investment. One is the business risk, that a decline in
earning power may impair the corporations ability to service debt. The second is the
purchasing power risk the prospect that a severe inflation may impair the purchasing
power of interest on debt as well as of the principal itself. The third is the so called
interest rate risk. If interest rate rises the market price of the security will decline until its
yields becomes competitive with the new higher interest rate. Usually near the peak of
the expansion when the boom seems about to top out, when the Central Bank authorities
are enforcing a tight money policy which has driven interest rates up and bonds prices
down, shrewd portfolio managers may switch from shares to high grade bonds. As
recession develops tight money will be eased; interest rates may fall; high grade bonds
rise. In fact the deeper the recession the higher will go the price of high grade bonds as
investment demand switches to favor them and bids up their prices.
The inflation and efforts to control it drive interest rates up. Borrowing corporations and
governmental bodies have to pay much higher interest on new issues and older
outstanding bonds with lower fall in price even in a recession period. To understand the
nature of the inverse relationship between price and yield it is necessary to know
something about the methods of yield calculations.
Current yield
The current yield on a bond is the annual interest due on it dividend by the bonds market
price. The current yield is a reliable measure of returns earned by perpetual bonds and or
almost any bond with a long time remaining to maturity.
Current yield = annual interest / market price
Thus a 15% interest bond selling at 90 has a current yield of
Current yield = 15/90x100 =16.16%.
Investor use the current yield to determine the rate of return earned on each invested
rupee but they know this yield has some handicaps. It means bond returns over an
indefinite time period. In theory the current yield assumes bonds are without a maturity
date when interest payments cease or that a bond will be sold at the same price as the
purchase price. The current yield in other words assumes interest will be paid forever or
that a bond will not appreciate or depreciate in price over a holding period.
The planning or holding period return
The current yield is based on the assumption that the stream of interest income from bond
investments will continue indefinitely while the holding period return confirms total
returns to a definite investment period. This planning or holding period can be any length
of time. The holding period yield for a bond is
HPYb = It +P/ po
t= the subscript t stands for time and refers to a holding period.
It = the bonds coupon interest payment during holding period t
Po = the bonds price at the beginning of holding period t
P= change in bond price over the period
The HPY can be broken down into an income yield measure and a percentage price
change measure.

Yield to maturity
The yield to measure most commonly used for bonds is not current yield but yield to
maturity (YTM) the percentage yield that will be earned on the bonds from purchase date
to maturity date. The yield to maturity puts bonds income into a common denominator
that permits investors to make yield comparisons. The yield to maturity need not consider
capital gains; bonds are redeemed at their face value at maturity. Indeed the yield to
maturity has several other virtues. It considers the time value of money market discounts
and premium and is the return earned over the remaining life of a bond issue.
The yield to maturity is a complex computation based upon a rather simple ides. It is the
discount rate that equals the present value of all cash flows from a bond to the cost
(current market prices).
n
t
n
Po = It/ (1+r) + Pt / (1+r)

t=1
Po= cost of bond
Pt = Terminal price or value
It = Annual interest in rupees
r= Discount rate which is the yield to maturity.
t= time period
To avoid these cumbersome calculations yields to maturity have been reduced to tables.
However bond tables are not complete. Complete table would show the net yield on
every amount invested at every possible rate of yield for every possible maturity. A large
assortment of tables is available with wide range in coupon rates, maturities and prices.
The more modern tables reflect the use of low and fractional coupon rates and provide
means by which prices and yields for maturities involving monthly periods can be
determined with a minimum of interpolation. Interpolation is a matter of proportion as it
is based upon the assumption that the changes in the bond values are proportionate. The
assumption is not absolutely correct but the degree of variance is too small too be serious.
The formula for approximating the YTM
Annual coupon interest + (Discount /Number of years to maturity)
(Current price+ Par value) / 2

Or
Annual coupon interest (premium/ number of years to maturity)
(Current price + par value) / 2

The yield to maturity calculation may not be an appropriate measure of the issues
expected rate of return if a bond is callable for refunding purposes. The corporation may
exercise the call privilege in case there is a significance chance that interest rates may fall
to level which makes refunding attractive to the issuer. Then the investment manger will
be faced with the necessity of reinvesting at lower rates if the quality not to be so
reduced. In addition to reinvesting at lower rates he will incur the annoyance and
expenses of having to make a new search for an acceptable issue. At offset against this
expenses will be the call premium which the issuer must pay in order to exercise the

call privilege. The end results of all these factors may be a realized yield that is
substantially different from the originally calculated yield to maturity.
Bond volatility
Price of bond changes according to the interest rate. Price changes in the bond are
generally called as bond volatility. The relationship between the duration of a bond and
the price volatility for a change in the market interest rate is given by the following
formula.
Percentage change in price = -MD [BP]
100
Where MD = modified Duration
BP = is the basis point which is 0.01% of 1%
Modified duration can be calculated as follows:
MD =
D
1+MY/I
D = duration
MY = market yield and
I = interest payment per year.
Immunization
Immunization is a technique which makes the bond holder t be certain of promised cash
flows. The changes in the market interest rate affect the bond interest rate. The coupon
rate and price bond thus get affected by market rate. However in the process of
immunization the coupon rate risk and the price risk are made to offset each other. When
there is an increase in market interest rate the prices of bonds fall. But at the same time
newly issued bonds fetch higher interest rates. The coupon can vary well be reinvested in
the bonds which offer higher interest rates and losses that occur due to fall in the price of
bond can be offset resulting in the immunization of portfolio. The money to be invested
in different bonds can be found by using the equation
Outflow of investment = (X1) (duration of bond 1) +(X2) (duration of bond 2)
Where X1 and X2 are the proportions of investment on bond 1 and bond 2
The process of immunization is criticized under the following grounds:
1. Immunization and duration are based on the assumption that change in interest
rates would occur before payments are received. However it may not be true
always. The change may occur even after the cash flow is received.
2. The assumption that the bonds have same yield may not hold good always.
3. The shift in the interest rate affects different bonds differently. This is in variation
with the assumption that the shift affects all the bonds equally.
4. The assumption that there will not be any call risk or default risk does not also
hold good.
Value of preference shares
Preference shares give a fixed rate of dividend but without a maturity date. They are
usually perpetuities but some times they have maturity dates also. The value of a
preference share as a perpetuity is calculated thus

V= D where
i
V= Value of preference shares
D= Annual dividend per preference share
i = Discount Rate on preference shares.
Yield on preference shares
The yield on preference shares is calculated as follows
i=D
V

Equity Valuation Model


The valuation of bonds and preference shares showed that the rate of dividend and
interest rate is constant and reasonably certain. Bonds represent constant income flows
with a finite measurable life and preference shares have constant return on their shares.
The valuation of common stocks is comparatively more difficult. The difficulty arises
because of two factors:
1. The amount of dividend and timing of cash flows expected by investors are
uncertain and
2. The earnings and dividends on common shares are generally expected to grow.
One year Holding period
Common stock valuation is easiest to start with when the expected holding period is one
year. To the investor the rewards from a common stock consist of dividends plus any
change in price during the holding period. The formula for calculating one year holding
period may be
Po = D1 + P1
1+r 1+r
Where D1 = Dividend to be received at the end of year one
r= Investors required rate of return or discount
P1 = selling price at the end of year one.
Po = selling price today
Multiple year holding periods
Suppose the buyer who purchases the share p holds it for 3 years and then sells it, the
value of the share to him today will be
P0= D1 + D2
+ Dn
(1+r) (1+r)2
(1+r)
Growth in dividends normal growth

Dividends cannot remain constant. The earnings and dividends of


most companys increases over time because of their retention
policies. The companies retain some portion of their earnings for
reinvestment in their own business. The policy would increase the

common shareholders equity as well as the firms earnings. Therefore


the earnings per share will also increase and would produce higher
dividends with the passage of time.
Share valuation

The following steps will indicate the value of a common stock


of a firm.
Step 1
Find out the present value of the share
Present value per share = cash dividends per share
Discount rate growth rate (required rate of
growth)
Step 2
Evaluate stock under changing risk conditions
Present value per share =
cash dividends
Discount rate growth rate
Step 3
Evaluate stock under changing growth conditions
Present value per share = cash dividends
Discount rate growth rate
Step 4
Calculate intrinsic value through fundamental analysis
Intrinsic value = earnings per share x price/earnings ratio
EPS = Net income after taxes
Number of shares outstanding
P/E = price per share
EPS
Step 6
Find out value earning ratio and compare it with P/E ratio
Value earning Ratio V/E = present value per share
EPS
Cash dividend - EPS
Discount rate-growth rate
Valuation of stock through price earning ratio

The investors make use of price earnings ratio to estimate value of


stocks and they find that the price earnings ratio models have the
following advantages over the discounting models
1. P/E ratio indicates price per rupee of share earnings, facilitating
comparison of price of stocks, having different earning per share.
2. Even the stocks of companies, which do not pay dividends but
having earnings, can be analysed by means of price earnings rations.
3. The variables used in P/E ratio models are easier to estimate.
However P/E ratio analysis is difficult to use when there is a loss.
Further one cannot find out the appropriate price for particular stock.
An investor can only find out relative positions of various stocks.
The constant growth model written in price earnings model takes the
form
P = d / r-g
By dividing both sides with E we can obtain P/E = d/e where d/e is
the payout
r-g
ratio. P/E ratio is now is the function of payout ratio, discount rate and
growth rate.
When r and g remain constant higher the payout
ration higher will be the price earning multiples. The growth rate is
also directly proportional to the P/E ratio. However the required rate
of return or the discount rate is inversely proportional to the value of
P/E ratio.
When growth rate is considered to be depending on the return of
equity(ROE).
P/E = d/e
r-ROE (1-d/e)
This makes the P/E ration depending on dividend payout ratio,
discount rate, and return on equity.

Derivatives Market
Assignment
Options
In the world of investments, an option is a type of a contract between two parties
when one person grants the other person the right to buy a specific asset at a specific
price within a specific time period. Alternatively the contract may grant the other
party the right to sell specific assets at a specific price within a specific time period.
The person who has received the right and thus has a decision to make is known as
the option buyer since he or she must pay for the right. The person who has sold the
right to the buyer and thus must respond to the buyers decision is known as the
option writer

Uses of options

There are number of reasons for being either a writer or a buyer of options. The
writer assures an uncertain amount of risk for a certain amount of money where as
the buyer assures an uncertain potential gain for a fixed cost, such a situation can
lead to a number of reasons for using options. However fundamental to either
writing or buying an option is mere promise that option is fairly valued in terms of
the possible outcomes. If the option is not fairly priced then of course an additional
source of profit or loss is introduced and the writer or buyer of such a contract may
be subject to an additional handicap that will reduce his or her return.
The reasons for writing option contract are varied but three of the most common are
to cash additional income on a securities portfolio, the fact that option buyers are not
as sophisticated as writers and to hedge along position. It is sometimes argued that
option writing is a source of additional income for the portfolio of an investor with a
large portfolio of securities. Such an approach assumes that the portfolio manager
can guess the direction of specific stock prices closely rough to make this strategy
worth while. What cannot be overlooked is that the writer gives up certain rights
when the option is written.
Second it is believed by some that the buyers of options are not as sophisticated as
the writers. The proponents of this view argue that option writers are the most
sophisticated participants in the securities market and view the option premiums
simply as additional income.

The third reason for writing options is to hedge a long term positions in a stock
portfolio. A typical situation would be where the portfolio manager is concerned that
a stock may decline if the stock is sold he or she will have to pay a capital gains tax.
Selling a option would involve a minimum risk of having the stock called away.
There are a number of reasons for buying options two of the most common are
leverage and changing the risk complexion of portfolio. The term leverage in
connection with options indicates buyer being able to control more securities than
could be done with realistic margin requirements. In other words with the use of
margins the buyer of securities can buyer more securities and hopefully make a
greater profit than could be done by taking a basic long position. Puts and calls can
be used in much the same fashion and perhaps provided higher return.

Another reason for buying options is to change the risk complexion of a portfolio of
securities. It should be noted that this benefit of options is available not only to the buyers
but also to writes. Therefore they permit the portfolio manager to undertake as much or as
little risk as he or she feels is appropriate at a point of time. They also give additional
flexibility insetting the amount of risk the portfolio manager is willing to accept with
respect to a specific portfoli

Types of option
There are two basic types of stock option, which can be used
separately or combined to derive two additional types of options.
Fundamentally the holder of an option merely possesses the right to
buy or sell a specific asset. The option contract specifies between the
period of time allowed to exercise this right and the price. The main
types of stock option are
1. Put option
A put is an option to sell. A put gives its holder the privilege of selling
or putting to a second party a fixed amount of some stock at a stated
price on or before a predetermined date.
2. Call option
A call is an option to purchase; its holders has the privilege of
purchasing or calling from a second party a fixed amount of some
stock at a stated price on or before a predetermined day. The standard
call contract is not by the individual originating the contract, but his
broker who by market practice must be a member firm of the stock
exchange. This endorsement guarantees that the contract will be
fulfilled and considerably enhances its status as a negotiable
instrument.
Therefore puts and calls are securities in end of them and can be
traded as any other security is traded. Puts and calls are almost written
on equities although occasionally preference shares, bonds and
warrants become the subject of options. Warrants are themselves a
kind of call option.
Puts and calls are the basic options forms. In addition there are other
kinds of options present in todays trading, which are combination of
puts and calls. These are
a. Spread
A spread consists of both a put and a call contract. The option price at
which the put or call is executed is specified in terms of a number of

rupees away from the market price of the stock at a time the option is
granted. The put may be exercised at a specified number of rupees
below the market and the call at the corresponding number of rupees
above the market. If the fluctuation is less than this spread either on
the upside or the downside the investment is valueless and results in a
complete loss to the purchaser.
b. Straddle
A straddle is similar to a spread except that the execution price of
either the put or call option is at the market price of stock at the time
of straddle is granted. In essence both the straddle and spread
accomplish the same thing.
Two recent additions to the family of options in current trading
are the strips and straps. A strip is a straddle with a second put
added to it having the same dimensions as the first put. A strap is a
straddle with a second call added to it. These combination options
appear for the most part on the supplying side of the put and the call
market.