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Notes Saim
Notes Saim
Introduction
Indian Stock Markets are one of the oldest in Asia. Its history dates back to nearly 200 years ago. The earliest records of
security dealings in India are meager and obscure. The East India Company was the dominant institution in those days
and business in its loan securities used to be transacted towards the close of the eighteenth century.
By 1830's business on corporate stocks and shares in Bank and Cotton presses took place in Bombay. Though the trading
list was broader in 1839, there were only half a dozen brokers recognized by banks and merchants during 1840 and 1850.
The 1850's witnessed a rapid development of commercial enterprise and brokerage business attracted many men into
the field and by 1860 the number of brokers increased into 60.
In 1860-61 the American Civil War broke out and cotton supply from United States of Europe was stopped; thus, the
'Share Mania' in India begun. The number of brokers increased to about 200 to 250. However, at the end of the American
Civil War, in 1865, a disastrous slump began (for example, Bank of Bombay Share which had touched Rs 2850 could only
be sold at Rs. 87).
At the end of the American Civil War, the brokers who thrived out of Civil War in 1874, found a place in a street (now
appropriately called as Dalal Street) where they would conveniently assemble and transact business. In 1887, they
formally established in Bombay, the "Native Share and Stock Brokers' Association" (which is alternatively known as " The
Stock Exchange "). In 1895, the Stock Exchange acquired a premise in the same street and it was inaugurated in 1899.
Thus, the Stock Exchange at Bombay was consolidated.
3. to invest money for short or long term periods with the aim of deriving profit.
5. price determination (demand and supply balancing, the continuous process of prices movements guarantees to
state correct price for each security so the market corrects mispriced securities)
6. informative function (market provides all participants with market information about participants and traded
instruments)
The Stock Exchange provide companies with the facility to raise capital for expansion through selling shares to
the investing public
When people draw their savings and invest in shares (through an IPO or the issuance of new company shares of
an already listed company), it usually leads to rational allocation of resources because funds, which could have
been consumed, or kept in idle deposits with banks, are mobilized and redirected to help companies'
management boards finance their organizations. This may promote business activity with benefits for several
economic sectors such as agriculture, commerce and industry, resulting in stronger economic growth and higher
productivity levels of firms. Sometimes it is very difficult for the stock investor to determine whether or not the
allocation of those funds is in good faith and will be able to generate long-term company growth, without
examination of a company's internal auditing.
Facilitating company growth
Companies view acquisitions as an opportunity to expand product lines, increase distribution channels, hedge
against volatility, increase its market share, or acquire other necessary business assets. A takeover bid or a
merger agreement through the stock market is one of the simplest and most common ways for a company to
grow by acquisition or fusion.
Profit sharing
Both casual and professional stock investors, as large as institutional investors or as small as an ordinary
middle-class family, through dividends and stock price increases that may result in capital gains, share in the
wealth of profitable businesses. Unprofitable and troubled businesses may result in capital losses for
shareholders.
Corporate governance
By having a wide and varied scope of owners, companies generally tend to improve management standards and
efficiency to satisfy the demands of these shareholders, and the more stringent rules for public corporations
imposed by public stock exchanges and the government. Consequently, it is alleged that public companies
(companies that are owned by shareholders who are members of the general public and trade shares on public
exchanges) tend to have better management records than privately held companies (those companies where
shares are not publicly traded, often owned by the company founders and/or their families and heirs, or
otherwise by a small group of investors).
Creating investment opportunities for small investors
As opposed to other businesses that require huge capital outlay, investing in shares is open to both the large and
small stock investors because a person buys the number of shares they can afford. Therefore the Stock
Exchange provides the opportunity for small investors to own shares of the same companies as large investors.
Primary market
The primary market s that part of the capital markets that deals with the issue of new securities. Companies,
governments or public sector institutions can obtain funding through the sale of a new stock or bond issue. This
is typically done through a syndicate of securities dealers. The process of selling new issues to investors is
called underwriting. In the case of a new stock issue, this sale is a public offering. Dealers earn a commission
that is built into the price of the security offering, though it can be found in the prospectus. Primary markets
creates long term instruments through which corporate entities borrow from capital market.
1. Origination- Deals with Origin of new Issue. The proposal is analyzed in terms of the nature of the security, the
size of the issue, time of the issue and floatation method of the issue.
2. Underwriting- Contract Between Issuing Company and Underwriter. Underwriter gives assurance that, in case
investor will not subscribe minimum number of share then they will subscribe. They also increases Investor
confidence.
3. Distribution-
• Public Placement
• Private Placement
• Right Issue
• Offer of Sale
1. The securities issued in the New Issue Market are invariably listed on a recognized stock exchange,
subsequent to their issue. This is of immense utility to potential investors who feel assured that should they
receive an allotment of new issues, they will subsequently be able to dispose them of at any time. The facilities
provided by the secondary markets, thus, widen the initial market for them.
2. Secondly, the stock exchanges exercise considerable control over the organisation of new issues. In terms of
the regulatory framework relating to dealings in securities, new issues, which seek stock exchange quotation
have to comply with statutory rules as well as regulations framed by the stock exchanges with the object of
ensuring fair dealings in them.
3. Fundamentally, the markets for new and old securities are, economically, an integral part of a single market
the industrial securities market. Thus they are susceptible to common influence and act and react upon each
other. Broadly, new issues increase when stock values are rising and vice versa.
Also, the quantitative predominance of old securities in the market usually ensures that it is these which set the
tone of the market as a whole and govern the prices and acceptability of new issues.
Thus, we see that the capital market, with particular reference to company scraps, performs two distinct
functions providing funds for trading in existing securities and funds for fresh issues of capital by the
companies either through public issue or right issue or by private placement.
While in many respects, the market mechanism for capital markets is the same as for commodities, there is a
fundamental difference that renders the former more complex, i.e. in the case of an ordinary commodity, it may
be bought or sold several times, but it is used up in consumption after some time. In the case of the capital
market nothing is consumed away.
Every year there is new supply and so the cumulative total of funds dealt with goes on rising and the New Issue
Market provides a common ground for facilitating this transfer process of funds from the suppliers (comprising
investors, individual, corporate and institutional) to the companies attempting to raise fresh capital.
The exact amount available for investment in a particular company, however, depends on macro factors like rate
of growth of the economy, total money supply, savings potential and the marginal propensity to save; and micro
factors like performance of a particular class of companies, facilities available for liquidation of investment and
the individual preference of an investor, etc.
Secondary Market
A stock exchange is a form of exchange which provides services for stock brokers and traders to trade stocks, bonds, and
other securities. Stock exchanges also provide facilities for issue and redemption of securities and other financial
instruments, and capital events including the payment of income and dividends. Securities traded on a stock exchange
include shares issued by companies, unit trusts, derivatives, pooled investment products and bonds.
To be able to trade a security on a certain stock exchange, it must be listed there. Usually, there is a central location at
least for record keeping, but trade is increasingly less linked to such a physical place, as modern markets are electronic
networks, which gives them advantages of increased speed and reduced cost of transactions. Trade on an exchange is by
members only.
The initial offering of stocks and bonds to investors is by definition done in the primary market and subsequent trading is
done in the secondary market. A stock exchange is often the most important component of a stock market. Supply and
demand in stock markets are driven by various factors that, as in all free markets, affect the price of stocks (see stock
valuation.
There is usually no compulsion to issue stock via the stock exchange itself, nor must stock be subsequently traded on the
exchange. Such trading is said to be off exchange or over-the-counter. This is the usual way that derivatives and bonds
are traded. Increasingly, stock exchanges are part of a global market for securities.
Two types of transactions can be carried out on the Indian stock exchanges: (a) spot delivery transactions "for delivery
and payment within the time or on the date stipulated when entering into the contract which shall not be more than 14
days following the date of the contract" : and (b) forward transactions "delivery and payment can be extended by further
period of 14 days each so that the overall period does not exceed 90 days from the date of the contract". The latter is
permitted only in the case of specified shares. The brokers who carry over the out standings pay carry over charges
which are usually determined by the rates of interest prevailing.
A member broker in an Indian stock exchange can act as an agent, buy and sell securities for his clients on a commission
basis and also can act as a trader or dealer as a principal, buy and sell securities on his own account and risk, in contrast
with the practice prevailing on New York and London Stock Exchanges, where a member can act as a jobber or a broker
only.
The nature of trading on Indian Stock Exchanges are that of age old conventional style of face-to-face trading with bids
and offers being made by open outcry. However, there is a great amount of effort to modernize the Indian stock
exchanges in the very recent times.
OTC has a unique feature of trading compared to other traditional exchanges. That is, certificates of listed securities and
initiated debentures are not traded at OTC. The original certificate will be safely with the custodian. But, a counter
receipt is generated out at the counter which substitutes the share certificate and is used for all transactions.
In the case of permitted securities, the system is similar to a traditional stock exchange. The difference is that the
delivery and payment procedure will be completed within 14 days.
Compared to the traditional Exchanges, OTC Exchange network has the following advantages:
• OTCEI has widely dispersed trading mechanism across the country which provides greater liquidity and lesser risk
of intermediary charges.
• Greater transparency and accuracy of prices is obtained due to the screen-based scripless trading.
• Since the exact price of the transaction is shown on the computer screen, the investor gets to know the exact
price at which s/he is trading.
• Faster settlement and transfer process compared to other exchanges.
• In the case of an OTC issue (new issue), the allotment procedure is completed in a month and trading
commences after a month of the issue closure, whereas it takes a longer period for the same with respect to
other exchanges.
Limitations
• Increasing accountability to public shareholders
• Need to maintain dividend and profit growth trends
• Chances of possible takeover and merger.
• Need to observe and adhere strictly to the rules and regulations by governing bodies
• Increasing costs in complying with higher level of reporting requirements
• Suffering a loss of privacy as a result of media interest
• Initially SEBI was a non statutory body without any statutory power. However in the year of 1995, the SEBI was
given additional statutory power by the Government of India through an amendment to the Securities and
Exchange Board of India Act 1992. In April, 1998 the SEBI was constituted as the regulator of capital markets in
India under a resolution of the Government of India.
• The SEBI is managed by its members, which consists of following: a) The chairman who is nominated by Union
Government of India. b) Two members, i.e. Officers from Union Finance Ministry. c) One member from The
Reserve Bank of India. d) The remaining 5 members are nominated by Union Government of India, out of them
at least 3 shall be whole-time members.
Objectives of Security and Exchange Board of India
• To promote and develop stock market
• To protect the interest of the investors in stock market.
• To regulate the stock market
Functions of Security and Exchange Board of India
In order to pursue the objectives SEBI has the following functions:
1. Regulate the working of the stock market.
2. Registration and licensing of the participants.
3. Registration and regulation of the collective investment schemes.
4. Promotion of self regulatory organization
5. Preventing unfair trade practices.
6. Promoting investor education.
7. Training of the intermediaries.
8. Preventing Insider trading, circular trading.
9. Regulating Mergers, takeovers, Amalgamations etc.
10. Undertaking Inspections, Calling for the information, audits of the stocks, seizure of the accounts.
The Security and Exchange Board of India Organization
• Primary Department- For Primary market Regulation
• Issue Management and Intermediary Department- For Intermediaries regulation
• Secondary Market Department- For secondary market regulation
• Institutional Department- For the regulation of Merger, takeovers, Amalgamations ets.
• Investigation Department- For Investigation purpose.
• Advisory Committee- For advice regarding regulation of primary and secondary market.
Unit-2
Concept of Risk
Risk is the potential of loss (an undesirable outcome, however not necessarily so) resulting from a
given action, activity and/or inaction. The notion implies that a choice having an influence on the
outcome sometimes exists (or existed). Potential losses themselves may also be called "risks". Any
human endeavor carries some risk, but some are much riskier than others.
where
N = the number of states,
pi = the probability of state i,
Ri = the return on the stock in state i, and
E[R] = the expected return on the stock.
The standard deviation is calculated as the positive square root of the variance.
Stock B
Although Stock B offers a higher expected return than Stock A, it also is riskier since its variance and standard
deviation are greater than Stock A's. This, however, is only part of the picture because most investors choose to
hold securities as part of a diversified portfolio.
Risk and Return Trade off
A fundamental investment concept is the tradeoff between risk and return. The concept is based on two realities
of investments and investment performance.
First, all investments carry some degree of risk – the reality that you could lose some or all of your money when
you buy stocks, bonds, mutual funds or other investments. Second, not only do different types of investments
carry different levels of risk, but the more risk you assume, the greater the investment return you are likely to
achieve.
Risk comes in many forms, but when talking about the risk-return tradeoff, the primary measure of risk is
volatility, or the degree to which an investment fluctuates in price. Different asset categories are subject to
different levels of price fluctuation. For instance, stocks can fluctuate widely from one year to the next (or even
from one day to the next), whereas the swing in bond prices tends to be less dramatic, and price fluctuations for
money market or so-called capital preservation investments are even lower.
Systematic Risk
Systematic risk is due to the influence of external factors on an organization. Such factors are normally
uncontrollable from an organization's point of view.
Systematic risk is a macro in nature as it affects a large number of organizations operating under a similar
stream or same domain. It cannot be planned by the organization.
Types of risk under the group of systematic risk are listed as follows:
1. Interest rate risk.
2. Market risk.
3. Purchasing power or Inflationary risk.
The types of risk grouped under systematic risk are depicted below.
Image Credits © Moon Rodriguez.
Now let's discuss each risk classified under the group of systematic risk.
Interest-rate risk arises due to variability in the interest rates from time to time. It particularly affects debt
securities as they carry the fixed rate of interest.
The interest-rate risk is further classified into following types.
1. Price risk.
2. Reinvestment rate risk.
The types of interest-rate risk are depicted below.
2. Market risk
Market risk is associated with consistent fluctuations seen in the trading price of any particular shares or
securities. That is, it is a risk that arises due to rise or fall in the trading price of listed shares or securities in the
stock market.
The market risk is further classified into following types.
1. Absolute risk.
2. Relative risk.
3. Directional risk.
4. Non-directional risk.
5. Basis risk.
6. Volatility risk.
The types of market risk are depicted in the following diagram.
Purchasing power risk is also known as inflation risk. It is so, since it emanates (originates) from the fact that it
affects a purchasing power adversely. It is not desirable to invest in securities during an inflationary period.
The purchasing power or inflationary risk is classified into following types.
1. Demand inflation risk.
2. Cost inflation risk.
The types of purchasing power or inflationary risk are depicted below.
Unsystematic risk is due to the influence of internal factors prevailing within an organization. Such factors are
normally controllable from an organization's point of view.
Unsystematic risk is a micro in nature as it affects only a particular organization. It can be planned, so that
necessary actions can be taken by the organization to mitigate (reduce the effect of) the risk.
The types of risk grouped under unsystematic risk are depicted below.
1. Business or liquidity risk.
2. Financial or credit risk.
3. Operational risk.
The types of risk grouped under unsystematic risk are depicted below.
Business risk is also known as liquidity risk. It is so, since it emanates (originates) from the sale and purchase of
securities affected by business cycles, technological changes, etc.
The business or liquidity risk is further classified into following types.
1. Asset liquidity risk.
2. Funding liquidity risk.
The types of business or liquidity risk are depicted and explained below.
Financial risk is also known as credit risk. This risk arises due to change in the capital structure of the
organization. The capital structure mainly comprises of three ways by which funds are sourced for the projects.
These are as follows:
1. Owned funds. For e.g. share capital.
2. Borrowed funds. For e.g. loan funds.
3. Retained earnings. For e.g. reserve and surplus.
The financial or credit risk is further classified into following types.
1. Exchange rate risk.
2. Recovery rate risk.
3. Credit event risk.
4. Non-Directional risk.
5. Sovereign risk.
6. Settlement risk.
The types of financial or credit risk are depicted and explained below.
3. Operational risk
Operational risks are the business process risks failing due to human errors. This risk will change from industry
to industry. It occurs due to breakdowns in the internal procedures, people, policies and systems.
The operational risk is further classified into following types.
1. Model risk.
2. People risk.
3. Legal risk.
4. Political risk.
The types of operational risk are depicted and explained below.
Image Credits © Moon Rodriguez.
Model risk is the risk involved in using various models to value financial securities. It is due to probability of
loss resulting from the weaknesses in the financial model used in assessing and managing a risk.
People risk arises when people do not follow the organization’s procedures, practices and/or rules. That is, they
deviate from their expected behavior.
Legal risk arises when parties are not lawfully competent to enter an agreement among themselves.
Furthermore, this relates to regulatory risk, where a transaction could conflict with a government policy or
particular legislation (law) might be amended in the future with retrospective effect.
Political risk is the risk that occurs due to changes in government policies. Such changes may have an
unfavorable impact on an investor. This risk is especially prevalent in the third-world countries.
The fundamental valuation is the valuation that people use to justify stock prices. The most common
example of this type of valuation methodology is P/E ratio, which stands for Price to Earnings Ratio.
This form of valuation is based on historic ratios and statistics and aims to assign value to a stock based
on measurable attributes. This form of valuation is typically what drives long-term stock prices.
The other way stocks are valued is based on supply and demand. The more people that want to buy the
stock, the higher its price will be. And conversely, the more people that want to sell the stock, the lower
the price will be. This form of valuation is very hard to understand or predict, and it often drives the
short-term stock market trends.
There are many different ways to value stocks. The key is to take each approach into account while
formulating an overall opinion of the stock. If the valuation of a company is lower or higher than other
similar stocks, then the next step would be to determine the reasons.
The EPS number that most analysts use is the pro forma EPS. To compute this number, use the net
income that excludes any one-time gains or losses and excludes any non-cash expenses like stock
options or amortization of goodwill. Then divide this number by the number of fully diluted shares
outstanding. Historical EPS figures and forecasts for the next 1–2 years can be found by visiting free
financial sites such as Yahoo Finance (enter the ticker and then click on "estimates").
Through fundamental investment research, one can determine their own EPS forecasts and apply other
valuation techniques below.
Forward P/Es reflect the future growth of the company into the figure. Forward P/Es are computed by
taking the current stock price divided by the sum of the EPS estimates for the next four quarters, or for
the EPS estimate for next calendar or fiscal year or two.
P/Es change constantly. If there is a large price change in a stock you are watching, or if the earnings
(EPS) estimates change, the ratio is recomputed.
1. P/E ratio indicates price per rupee of the share earning. This would help to compare the prices of stocks,
which have different EPS.
2. P/E ratio are helpful in analysing the stocks of the companies that do not pay dividend but have
earnings. It should be noted that when there is loss, P/E ratio analyses is difficult to use.
3. The variables used in P/E ratio model are easier to estimate than the variables in the discounting models.
With this ratio model the investor can only find the relative position of the different stocks. It does not
indicate what price is appropriate for a particular stock.
The expected return can be determined with the help of the following formula:
E(r)= Summation Pi * Ri
A bond’s price always moves in the opposite direction of its yield, as illustrated above. The key to
understanding this critical feature of the bond market is to recognize that a bond’s price reflects the value of
the income that it provides through its regular coupon interest payments. When prevailing interest rates fall –
notably rates on government bonds – older bonds of all types become more valuable because they were sold
in a higher interest-rate environment and therefore have higher coupons. Investors holding older bonds can
charge a “premium” to sell them in the secondary market. On the other hand, if interest rates rise, older bonds
may become less valuable because their coupons are relatively low, and older bonds therefore trade at a
“discount.”
Since governments began to issue bonds more frequently in the early twentieth century and gave rise to the
modern bond market, investors have purchased bonds for several reasons: capital preservation, income,
diversification and as a potential hedge against economic weakness or deflation. When the bond market
became larger and more diverse in the 1970s and 1980s, bonds began to undergo greater and more frequent
price changes and many investors began to trade bonds, taking advantage of another potential benefit: price,
or capital, appreciation.
Capital preservation: Unlike equities, bonds should repay principal at a specified date, or maturity. This makes
bonds appealing to investors who do not want to risk losing capital and to those who must meet a liability at a
particular time in the future. Bonds have the added benefit of offering interest at a set rate that is often higher
than short-term savings rates.
Income: Most bonds provide the investor with “fixed” income. On a set schedule, whether quarterly, twice a
year or annually, the bond issuer sends the bondholder an interest payment, which can be spent or reinvested
in other bonds. Stocks can also provide income through dividend payments, but dividends tend to be smaller
than bond coupon payments, and companies make dividend payments at their discretion, while bond issuers
are obligated to make coupon payments.
Capital appreciation: Bond prices can rise for several reasons, including a drop in interest rates and an
improvement in the credit standing of the issuer. If a bond is held to maturity, any price gains over the life of
the bond are not realized; instead, the bond’s price typically reverts to par (100) as it nears maturity and
repayment of the principal. However, by selling bonds after they have risen in price – and before maturity –
investors can realize price appreciation, also known as capital appreciation, on bonds. Capturing the capital
appreciation on bonds increases their total return, which is the combination of income and capital
appreciation. Investing for total return has become one of the most widely used bond strategies over the past
40 years. (For more, see “Bond Investment Strategies”.)
Diversification: Including bonds in an investment portfolio can help diversify the portfolio. Many investors
diversify among a wide variety of assets, from equities and bonds to commodities and alternative investments,
in an effort to reduce the risk of low, or even negative, returns on their portfolios.
Bond Risk
Interest Rate Risk
Variability in return from the debt to investors is caused by the changes is in the market interest rate.
Default Risk
The failure to pay the agreed amount of the debt instrument by the issuer in full, on time or both are default
risk.
Marketability Risk
Variability in return caused by the difficulty in selling the bonds quickly without having to make a substantial
concession is known as marketability risk.
Callability Risk
The uncertainty created in the investors return by the issuer ability to call the bonds at any time.
Bond Return:
Holding Period Return= (Price gain or Loss during the holding period + Coupon interest rate) / Price at the
beginning of the holding period
Yield To Maturity
YTM is the single discount factor that present value of the future cash flows from a bond equal to the current
price of the bond. We can also say that YTM is the rate of the return an investor can expect to earn if the bond
is held till maturity.
Assumption:
1. There should not be any default.
2. The investor hold the bond till maturity.
3. All the coupon should be reinvested immediately at the same time interest rate as the same time yield
to maturity of the bond.
The formula is :
Y = C + (P or D/ Year of Maturity)/ (Po + F)/ 2
Where
Y =YTM
C= Coupon Rate
P or D= Premium or Discount
Po= Present Value
F= Face Value
Theorem-2 : A decrease in interest rates raises bond prices by more than a corresponding increase in
rates lowers price
Lets assume 3 year 10% coupon paying bond for illustration
When YTM = 10% Price = 100
When YTM = 11% Price = 97.55 Change in price = -2.45%
When YTM = 9% Price = 102.53 Change in price = +2.53%
This the most important theorem of bond which says that price movement of bond with change is interest rate
either side is not equal. Price of the bond increases more than it declines when equal change in interest rate is
given. In above illustration you can clearly see that when yield declines by 1% price increases by 2.53% while
in case of increase in yield by 1%, price decline is 2.45%. As price curve of the bond is convex, you gain more
than you lose.
Theorem 3:
If the bond yields remain same then same over it’s life, the discount or premium depends on the
maturity period.
Example Bond A Bond B
Par Value Rs 1000 Rs 1000
Coupon Rate 10% 10%
Yield 15% 15%
Maturity Period 2 3
Market Price 918.71 885.86
This means, the bond with a short term to maturity sells at a lower discount than the bond with a
long term to maturity.
Theorem 4
If the bond yield remain constant over it’s life, the discount or premium amount will decrease at an
increasing rate as it’s life get’s shorter. Consider a bond with the face value Rs. 1000, and maturity
period of 5 years with yield to maturity 10% .
Years
The above example shows that rate declines when the bond approaches to maturity.
Theorem 5
A raise in the bond price for a decline in the bond yield is greater than the fall in bond price for a raise
in the yield . take a bond of 10% coupon rate, maturity period of 5 years with the face value of Rs
1000. If the yield declines by 2%, that is to 8% then the bond price will be 1079.87.
If, the yield increases by 2% then, the bond price will be Rs. 927.88.
= Rs. 100 (PVIFA 12%, 5 Years) + Rs.1000 (PVIF 12%, 5 Years)
=Rs. 100*3.6048 + Rs 1000*.05674
=Rs. 927.88
. Now the fall in the yield has resulted in a raise Rs 79.86 but the raise in the yield caused a variation of
Rs. 72.22 in the price.
Duration
Duration measures the time structure of the bond and the bond interest rate risk. The time structure of the
investment in bonds is expressed in two ways. The common way to state is how many years he has to wait until
the bond matures and the principles money is paid back. This is known as asset time to maturity or its years to
maturity. The other way is to measure the average time until all the interest coupons and the principle is
recovered. This is called Macaulay’s duration. Duration is defined as the weighted average of the time period to
the maturity, weights present values of the cash flow in each time period. The formula is.
D= C1/(1+r)/ P0 + C2/(1+r)2/P0+…………………………Ct/(1+r)t/P0*T
Duration =D
C= Cash flows
R = Current YTM
T= number of years
PV (C)= Present value of the cash flow
P0= Sum of the present value of the cash flows.
General Rules:
• Larger the coupon rate, lower the duration and less volatile the bond price.
• Longer the term to maturity, longer the duration and more the volatile bond.
• Higher the YTM, lower the bond duration and bond volatility, and vice versa.
• In a zero coupon bond, the bonds term to maturity and Duration are the same.
Importance of the duration:
The concept of the duration is important because it provide the length of a bond, helpful in evolving
immunization( the technique that make the bond portfolio holder to be relatively certain about the promised
stream of the cash flows.) strategies for the portfolio management and measures the sensitivity of the bond
price to changes in the interest rate.
Fundamental analysis
1. Economic Analysis
2. Industry analysis
3. Company Analysis
1. Economic Analysis
Economic Indicators
• GDP
• National Income
• Employment
• Inflation
Regression Model
2. Industry Analysis
• Growth
• Cost Structure and Profitability
• Nature of the Industry
• Nature of the Competition
• Government policy
• Labor market condition
Research and development
Technical Analysis
Technical tools:
1. Dow theory
2. Volume Trade
3. Moving Average
4. Odd Lot Trading
Dow theory
Based on Hypothesis
• No individual buyer or seller influence the major trend in market.
• Market discounts everything.
• It is not a tool to beat the market. It provide a way to understand it better.
According to this theory the trend are divided into primary, intermediate and short term trend. The primary trend
is upward or downward movement last for a year or two. The intermediate trends are corrective movements,
which may last for three weeks to three months. The short term refers to the day to day price movement. It is
also known as oscillators or fluctuations.
Technical Analysis
Primary Trends:
1. The security price trend may be either increasing or decreasing. When the market exhibit the increasing
trend it is called bull market. The bull market shows three clear cut peaks. Each peak is higher than the
previous one.. The bottoms are also higher then the previous ones.
• First Phase is Revival of the market
• Good corporate earning
• Speculation Phase
2. The reverse is also true with the bear market.
• Loss of hopes
• Recession phase
• Distress selling.
Secondary Trends:
The secondary trends are the Immediate trends moves against the main trends and leads to correction. In the
bull market the secondary trends would result in fall of about 33-66% of the earlier rise.
Intermediate trends correct the overbought and oversold condition. It provide the breathing condition to the
market. Compared to the primary trend, secondary trend is swift and quicker.
Minor Trend-
Minor trend or tertiary moves are called as random wriggles. They are simply the daily price fluctuations.
Minor trends tries to correct the secondary trend movement. It is better for the investors to concentrate on the
primary and secondary trends.
Technical Analysis
Volume of trade –
Dow gave special emphasis on volume. Volume expands along with the bull and bear market and narrows down
in the bear market. If the volume falls with the rise or vice versa, it is the matter of concern for the investors and
the trend may not persist for the longer time. Technical analyst used volume as an excellent method of
confirming the trend. The market is said to be bullish when small volume of trade and large volume trade follow
fall in price and the rise in price.
Large rise in price or large fall in price leads to large increase in volume . Large volume with rise in price
indicates that bull market and the large volume with fall in price indicates bear market.
If the volume declines for consecutive five days, then it will be continue for another four days and the same is
true in increasing volume.
Odd lot trading-
Shares are generally sold in lot of hundreds. Share which are sold in smaller lot fewer than 100 are called odd
lot. Such buyers and sellers are also called odd lotters. Odd lot purchase to odd lot sale (Purchase % sales) is
called as lot index. The increase in odd lot purchase results in an increase in the index. Relatively more selling
leads to fall in the index. It is generally considered that the professional investors is more informed and stronger
than odd lotters. When the professional investors dominate the market, the market is considered weak. The
notion behind is that odd lot purchase is concentrated at the top of the market cycle and selling at the bottom.
High odd lot purchase forecast fall in the market price and low purchase\sales ratio are presumed to occur
towards the end of bear market.
Moving average-
The market indices do not rise or fall in straight line. The upward and downward movements are interrupted by
the counter moves. The underlying trend can be studied by smoothing of the data. To smooth the data moving
average technique is used.
The word moving means that the body of the data moves ahead to include the recent observations. If it is five
day moving average, on the sixth day the body of the data moves to include the sixth day observation
eliminating the first day’s observation. Likewise it continues. In this method, closing price of the stock is used.
The moving average are used to study the movement of the market as well as the individual scrip prices. The
moving average indicates that the underlying trend in the scrip. The period of average determines the period of
the trend that is being identified. Fro underlying short term trend, a10 day or 30 day moving average are used.
In the case of medium term trend 50 day to 125 day are adopt. 200 day moving average is used to identify the
long term trend.
1. Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly
between two parties, without going through an exchange or other intermediary. Products such as swaps, forward
rate agreements, exotic options – and other exotic derivatives – are almost always traded in this way. The OTC
derivative market is the largest market for derivatives, and is largely unregulated with respect to disclosure of
information between the parties, since the OTC market is made up of banks and other highly sophisticated
parties, such as hedge funds. Reporting of OTC amounts is difficult because trades can occur in private, without
activity being visible on any exchange.
2.Exchange-traded derivatives (ETD) are those derivatives instruments that are traded via specialized
derivatives exchanges or other exchanges. A derivatives exchange is a market where individuals trade
standardized contracts that have been defined by the exchange. A derivatives exchange acts as an intermediary
to all related transactions, and takes initial margin from both sides of the trade to act as a guarantee.
Call options
The call option that gives the right to buy in its contract gives the particulars of the following:
1. The name of the company whose shares are to be purchased.
2. The number of the shares to be purchased.
3. The purchase price or the exercise price or the strike price of the shares to be bought.
4. The expiration date.
Example:
Let us A who owns 100 shares of Reliance Industries, which on 10 Dec, 2012 sold for Rs 119 Per share. He
could give (or sell) to B the right to buy that 100 shares at any time during the next 2 months at a price of Rs
125 per share. The price Rs125 is called the exercise price.. Now the seller of the option, A is the option seller
or write. For providing the option, A will charge premium from B. Let us assume the premium of Rs 3. In this
condition B has to pay Rs. 100*3= 300 as premium to A to make him sign the contract. When the exercise price
is less than the current market price of the underlying stock the option is in the money. For example the price of
the reliance share after 2 months is Rs130 it is said to be in the money. But if the price falls to the Rs 120 the
option is said to be out of the money. The advantage is that B has to pay only Rs. 300 and get more profit if the
price rise beyond Rs. 125.
Put options
The put option gives the right to sell an asset or security to someone else. It is not an obligation but an
option, in its contract gives the particulars of the following:
1. The name of the company whose shares are to be sold.
2. The number of the shares to be sold.
3. The purchase price or the exercise price or the strike price of the shares to be sold.
4. The expiration date.
Example:
Let us assume that A thinks that Reliance industries stock price can decline from its current level of Rs 119 per
share during the next two months. He could buy a put option to sell the 100 shares at Rs 125 which is the
striking price. A being the buyer of the option to sell the shares, has to pay premium in order to get the writer B
to sign the contract and to assume risk.
Let us take the premium as Rs 5 per share. Now A has to pay Rs 100*5=500 to B. If the price falls to Rs 115, A
stands gain because he can sell it at Rs 125 i.e. 100*125=12500. The gain is Rs. 12500-11500 (Present value)-
500 premium. At the same time if the price has increased to Rs 130 per share, A will not exercise the option and
his loss is only Rs. 500.
The Cox-Ross-Rubenstein model uses a risk-neutral valuation method. Its underlying principal
purports that when determining option prices, it can be assumed that the world is risk neutral and that
all individuals (and investors) are indifferent to risk. In a risk neutral environment, expected returns are
equal to the risk-free rate of interest.
The Cox-Ross-Rubenstein model makes certain assumptions, including:
The Cox-Ross-Rubenstein model is a two-state (or two-step) model in that it assumes the
underlying price can only either increase (up) or decrease (down) with time until expiration.
Valuation begins at each of the final nodes (at expiration) and iterations are performed
backwards through the binomial tree up to the first node (date of valuation). In very basic terms,
the model involves three steps:
• The creation of the binomial price tree
• Option value calculated at each final node
• Option value calculated at each preceding node
While the math behind the Cox-Ross-Rubenstein model is considered less complicated than the
Black-Scholes model (but still outside the scope of this tutorial), traders can again make use of online
calculators and trading platform-based analysis tools to determine option pricing values.
]
Futures
In finance, a futures contract (more colloquially, futures) is a standardized contract between two parties to buy
or sell a specified asset of standardized quantity and quality for a price agreed upon today (the futures price or
strike price) with delivery and payment occurring at a specified future date, the delivery date. The contracts are
negotiated at a futures exchange, which acts as an intermediary between the two parties. The party agreeing to
buy the underlying asset in the future, the "buyer" of the contract, is said to be "long", and the party agreeing to
sell the asset in the future, the "seller" of the contract, is said to be "short". The terminology reflects the
expectations of the parties—the buyer hopes or expects that the asset price is going to increase, while the seller
hopes or expects that it will decrease in near future.
In many cases, the underlying asset to a futures contract may not be traditional commodities at all – that
is, for financial futures the underlying item can be any financial instrument (also including currency, bonds, and
stocks); they can be also based on intangible assets or referenced items, such as stock indexes and interest rates.
Unlike an option both parties of a futures contract must fulfill the contract on the delivery date. The seller
delivers the underlying asset to the buyer, or, if it is a cash-settled futures contract, then cash is transferred from
the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the
settlement date, the holder of a futures position can close out its contract obligations by taking the opposite
position on another futures contract on the same asset and settlement date. The difference in futures prices is
then a profit or loss.
Marking to market-
While the futures contract specifies a trade taking place in the future, the purpose of the futures exchange
institution is to act as intermediary and minimize the risk of default by either party. Thus the exchange requires
both parties to put up an initial amount of cash, the margin. Additionally, since the futures price will generally
change daily, the difference in the prior agreed-upon price and the daily futures price is settled daily also
(variation margin). The exchange will draw money out of one party's margin account and put it into the other's
so that each party has the appropriate daily loss or profit. If the margin account goes below a certain value, then
a margin call is made and the account owner must replenish the margin account. This process is known as
marking to market. Thus on the delivery date, the amount exchanged is not the specified price on the contract
but the spot value (i.e. the original value agreed upon, since any gain or loss has already been previously settled
by marking to market).
Features OF Future
Futures contracts ensure their liquidity by being highly standardized, usually by specifying:
• The underlying asset or instrument. This could be anything from a barrel of crude oil to a short term
interest rate.
• The type of settlement, either cash settlement or physical settlement.
• The amount and units of the underlying asset per contract. This can be the notional amount of bonds, a
fixed number of barrels of oil, units of foreign currency, the notional amount of the deposit over which
the short term interest rate is traded, etc.
• The currency in which the futures contract is quoted.
• The grade of the deliverable. In the case of bonds, this specifies which bonds can be delivered. In the
case of physical commodities, this specifies not only the quality of the underlying goods but also the
manner and location of delivery.
• The delivery month.
• The last trading date.
• Other details such as the commodity tick, the minimum permissible price fluctuation.
Futures vs Options
Basis Futures Options
Obligation Both the parties are obliged to perform Both the parties are not obliged to perform.
the contract.
Premium No premium is paid The buyer paid premium to the seller.
Risk The holder of the contract is exposed to The buyer’s loss is restricted to the option
the entire spectrum of the risk. premium.
Exercise date. The parties of the contract must perform The buyer can exercise option any time prior
at the settlement date. to the expiary date.
Forward contract
In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy
or to sell an asset at a specified future time at a price agreed upon today. This is in contrast to a spot contract,
which is an agreement to buy or sell an asset today.
With a forward contract the transfer of the ownership takes place on the spot, but the delivery of the commodity
takes place does not occur until some future date.
Therefore in forward contract the parties agrees to do trade at some future date, at a stated price and quantity.
No money changes hands at the time deal is signed.
For example, a wheat farmer may wish to contract to sell their harvest at a future date to eliminate the risk of a
change in price by that date. Such transaction would take place through a forward market.
These are not traded on an stock exchange , they are buy and sold over the counter. These quantities of the
underlying asset and terms of the contracts are fully negotiable. The secondary market does not exist for the
forward contract and faces the problem of liquidity and negotiability.
A forward contract is an agreement between two parties A futures contract is a standardized contract, traded on a
Definition: to buy or sell an asset (which can be of any kind) at a futures exchange, to buy or sell a certain underlying
pre-agreed future point in time at a specified price. instrument at a certain date in the future, at a specified price.
Structure & Customized to customer needs. Usually no initial Standardized. Initial margin payment required. Usually used
Purpose: payment required. Usually used for hedging. for speculation.
Transaction
Negotiated directly by the buyer and seller Quoted and traded on the Exchange
method:
Institutional
The contracting parties Clearing House
guarantee:
Risk: High counterparty risk Low counterparty risk
No guarantee of settlement until the date of maturity Both parties must deposit an initial guarantee (margin).
Guarantees: only the forward price, based on the spot price of the The value of the operation is marked to market rates with
underlying asset is paid daily settlement of profits and losses.
Contract Forward contracts generally mature by delivering the Future contracts may not necessarily mature by delivery
Maturity: commodity. of commodity.
Expiry date: Depending on the transaction Standardized
Bullish strategies
• Bullish options strategies are employed when the options trader expects the underlying stock price to
move upwards. It is necessary to assess how high the stock price can go and the time frame in which the
rally will occur in order to select the optimum trading strategy.
• The most bullish of options trading strategies is the simple call buying strategy used by most novice
options traders.
• Stocks seldom go up by leaps and bounds. Moderately bullish options traders usually set a target price
for the bull run and utilize bull spreads to reduce cost. (It does not reduce risk because the options can
still expire worthless.) While maximum profit is capped for these strategies, they usually cost less to
employ for a given nominal amount of exposure. The bull call spread and the bull put spread are
common examples of moderately bullish strategies.
• Mildly bullish trading strategies are options strategies that make money as long as the underlying stock
price does not go down by the option's expiration date.
Bearish strategies
• Bearish options strategies are employed when the options trader expects the underlying stock price to
move downwards. It is necessary to assess how low the stock price can go and the time frame in which
the decline will happen in order to select the optimum trading strategy.
• The most bearish of options trading strategies is the simple put buying strategy utilized by most novice
options traders.
• Stock prices only occasionally make steep downward moves. Moderately bearish options traders usually
set a target price for the expected decline and utilize bear spreads to reduce cost. While maximum profit
is capped for these strategies, they usually cost less to employ. The bear call spread and the bear put
spread are common examples of moderately bearish strategies.
• Mildly bearish trading strategies are options strategies that make money as long as the underlying stock
price does not go up by the options expiration date. These strategies may provide a small upside
protection as well. In general, bearish strategies yield less profit with less risk of loss.
Option Greeks
In mathematical finance, the Greeks are the quantities representing the sensitivity of the price of derivatives
such as options to a change in underlying parameters on which the value of an instrument or portfolio of
financial instruments is dependent. The name is used because the most common of these sensitivities are often
denoted by Greek letters. Collectively these have also been called the risk sensitivities, risk measures or
hedge parameters.
The Greeks are vital tools in risk management. Each Greek measures the sensitivity of the value of a portfolio to
a small change in a given underlying parameter, so that component risks may be treated in isolation, and the
portfolio rebalanced accordingly to achieve a desired exposure; see for example delta hedging.
Delta
Delta,, measures the rate of change of option value with respect to changes in the underlying asset's price. Delta
is the first derivative of the value of the option with respect to the underlying instrument's price .
Vega
Vega measures sensitivity to volatility. Vega is the derivative of the option value with respect to the volatility of
the underlying asset.
Theta
Theta , measures the sensitivity of the value of the derivative to the passage of time (see Option time value): the
"time decay."
Rho
Rho measures sensitivity to the interest rate: it is the derivative of the option value with respect to the risk free
interest rate (for the relevant outstanding term).
Except under extreme circumstances, the value of an option is less sensitive to changes in the risk free interest
rate than to changes in other parameters. For this reason, rho is the least used of the first-order Greeks.
Lambda
Lambda, , omega, , or elasticity is the percentage change in option value per percentage change in the
underlying price, a measure of leverage sometimes called gearing.
Unit-4
Capital asset pricing model
The Capital Asset Pricing Model: An Overview
No matter how much we diversify our investments, it's impossible to get rid of all the risk. As investors,
we deserve a rate of return that compensates us for taking on risk. The capital asset pricing model (CAPM)
helps us to calculate investment risk and what return on investment we should expect.
The CAPM specifies that the expected return of an asset, E(Ri) is linearly related to its risk when risk is
measured in terms of the asset’s beta, βi
Birth of a Model
The capital asset pricing model was the work of financial economist (and, later, Nobel laureate in economics)
William Sharpe, set out in his 1970 book "Portfolio Theory And Capital Markets." His model starts with the
idea that individual investment contains two types of risk:
Systematic Risk - These are market risks that cannot be diversified away. Interest rates, recessions and wars are
examples of systematic risks.
Unsystematic Risk - Also known as "specific risk," this risk is specific to individual stocks and can be
diversified away as the investor increases the number of stocks in his or her portfolio.
Modern portfolio theory shows that specific risk can be removed through diversification. The trouble is that
diversification still doesn't solve the problem of systematic risk; even a portfolio of all the shares in the stock
market can't eliminate that risk. Therefore, when calculating a deserved return, systematic risk is what plagues
investors most. CAPM, therefore, evolved as a way to measure this systematic risk.
The Formula
Assumptions of CAPM
All investors:
• Aim to maximize economic utilities.
• Are rational and risk-averse.
• Are broadly diversified across a range of investments.
• Are price takers, i.e., they cannot influence prices.
• Can lend and borrow unlimited amounts under the risk free rate of interest.
• Trade without transaction or taxation costs.
• Deal with securities that are all highly divisible into small parcels.
• Assume all information is available at the same time to all investors.
E(Rm)
Rm-Rf
Rf
Beta
• If the realised return plots above the SML → Portfolio has overperformed
• If the realised return plots below the SML → Portfolio has underperformed
Problems of CAPM
1. The model assumes that the variance of returns is an adequate measurement of risk.
2. The model assumes that all active and potential shareholders have access to the same information and
agree about the risk and expected return of all assets (homogeneous expectations assumption).
3. The model does not appear to adequately explain the variation in stock returns. Empirical studies show
that low beta stocks may offer higher returns than the model would predict.
4. The model assumes that there are no taxes or transaction costs, although this assumption may be relaxed
with more complicated versions of the model.
5. Empirical tests show market anomalies like the size and value effect that cannot be explained by the
CAPM.
Portfolio
Portfolio is a financial term denoting a collection of investments held by an investment company, hedge fund,
financial institution or individual.
The term portfolio refers to any collection of financial assets such as stocks, bonds, and cash. Portfolios may be
held by individual investors and/or managed by financial professionals, hedge funds, banks and other financial
institutions. It is a generally accepted principle that a portfolio is designed according to the investor's risk
tolerance, time frame and investment objectives. The monetary value of each asset may influence the
risk/reward ratio of the portfolio and is referred to as the asset allocation of the portfolio
The Expected Return on a Portfolio is computed as the weighted average of the expected returns on the stocks
which comprise the portfolio. The weights reflect the proportion of the portfolio invested in the stocks. This can
be expressed as follows:
where
For a portfolio consisting of two assets, the above equation can be expressed as
Advantages of Beta
To followers of CAPM, beta is a useful measure. A stock's price variability is important to consider when assessing risk.
Indeed, if you think about risk as the possibility of a stock losing its value, beta has appeal as a proxy for risk.
Disadvantages of Beta
Another troubling factor is that past price movements are very poor predictors of the future. Betas are merely rear-view
mirrors, reflecting very little of what lies ahead.
Furthermore, the beta measure on a single stock tends to flip around over time, which makes it unreliable. Granted, for
traders looking to buy and sell stocks within short time periods, beta is a fairly good risk metric. However, for investors
with long-term horizons, it's less useful.
Interpretation of Beta
Movement of the asset is generally in the Volatile stock, such as a tech stock, or stocks
β>1 same direction as, but more than the which are very strongly influenced by
• Markowitz is a professor of finance at the Rady School of Management at the University of California, San Diego
(UCSD). He is best known for his pioneering work in Modern Portfolio Theory, studying the effects of asset risk,
return, correlation and diversification on probable investment portfolio returns.
Harry Markowitz put forward this model in 1952. It assists in the selection of the most efficient by analyzing various
possible portfolios of the given securities. By choosing securities that do not 'move' exactly together, the HM model
shows investors how to reduce their risk. The HM model is also called Mean-Variance Model due to the fact that it is
based on expected returns (mean) and the standard deviation (variance) of the various portfolios. Harry Markowitz made
the following assumptions while developing the HM model:
Assumptions
Risk of a portfolio is based on the variability of returns from the said portfolio.
4. The investor's utility function is concave and increasing, due to his risk aversion and consumption preference.
6. An investor either maximizes his portfolio return for a given level of risk or maximizes his return for the minimum risk.
To choose the best portfolio from a number of possible portfolios, each with different return and
risk, two separate decisions are to be made:
1. Determination of a set of efficient portfolios.
A portfolio that gives maximum return for a given risk, or minimum risk for given return is an efficient
portfolio. Thus, portfolios are selected as follows:
(a) From the portfolios that have the same return, the investor will prefer the portfolio with lower risk,
and
(b) From the portfolios that have the same risk level, an investor will prefer the portfolio with higher
rate of return.
• As the investor is rational, they would like to have higher return. And as he is risk averse, he
wants to have lower risk. In Figure in last slide, the shaded area PVWP includes all the possible
securities an investor can invest in. The efficient portfolios are the ones that lie on the boundary
of PQVW. For example, at risk level x2, there are three portfolios S, T, U. But portfolio S is
called the efficient portfolio as it has the highest return, y2, compared to T and U. All the
portfolios that lie on the boundary of PQVW are efficient portfolios for a given risk level.
• The boundary PQVW is called the Efficient Frontier. All portfolios that lie below the Efficient
Frontier are not good enough because the return would be lower for the given risk. Portfolios
that lie to the right of the Efficient Frontier would not be good enough, as there is higher risk for
a given rate of return. All portfolios lying on the boundary of PQVW are called Efficient
Portfolios. The Efficient Frontier is the same for all investors, as all investors want maximum
return with the lowest possible risk and they are risk averse.
Figure 2 shows the risk-return indifference curve for the investors. Indifference curves C1, C2 and C3
are shown. Each of the different points on a particular indifference curve shows a different combination
of risk and return, which provide the same satisfaction to the investors. Each curve to the left represents
higher utility or satisfaction. The goal of the investor would be to maximize his satisfaction by moving
to a curve that is higher. An investor might have satisfaction represented by C 2, but if his
satisfaction/utility increases, he/she then moves to curve C3 Thus, at any point of time, an investor will
be indifferent between combinations S1 and S2, or S5 and S6..
The investor's optimal portfolio is found at the point of tangency of the efficient frontier with the
indifference curve. This point marks the highest level of satisfaction the investor can obtain. This is
shown in Figure 3. R is the point where the efficient frontier is tangent to indifference curve C 3, and is
also an efficient portfolio. With this portfolio, the investor will get highest satisfaction as well as best
risk-return combination. Any other portfolio, say X, isn't the optimal portfolio even though it lies on the
same indifference curve as it is outside the efficient frontier. Portfolio Y is also not optimal as it does
not lie on the indifference curve, even though it lies in the portfolio region. Another investor having
other sets of indifference curves might have some different portfolio as his best/optimal portfolio.
Efficient market hypothesis
A market theory that evolved from a 1960's Ph.D. dissertation by Eugene Farma, the efficient market
hypothesis states that at any given time and in a liquid market, security prices fully reflect all available
information. The EMH exists in various degrees: weak, semi-strong and strong, which addresses the
inclusion of non-public information in market prices. This theory contends that since markets are
efficient and current prices reflect all information, attempts to outperform the market are essentially a
game of chance rather than one of skill.
• The weak form of EMH assumes that current stock prices fully reflect all currently available
security market information. It contends that past price and volume data have no relationship
with the future direction of security prices. It concludes that excess returns cannot be achieved
using technical analysis.
• The semi-strong form of EMH assumes that current stock prices adjust rapidly to the release of
all new public information. It contends that security prices have factored in available market and
non-market public information. It concludes that excess returns cannot be achieved using
fundamental analysis.
• The strong form of EMH assumes that current stock prices fully reflect all public and private
information. It contends that market, non-market and inside information is all factored into
security prices and that no one has monopolistic access to relevant information. It assumes a
perfect market and concludes that excess returns are impossible to achieve consistently.
The Elliott wave principle is a form of technical analysis that some traders use to analyze financial
market cycles and forecast market trends by identifying extremes in investor psychology, highs and
lows in prices, and other collective factors. Ralph Nelson Elliott (1871–1948), a professional
accountant, discovered the underlying social principles and developed the analytical tools in the 1930s.
He proposed that market prices unfold in specific patterns, which practitioners today call Elliott waves,
or simply waves. Elliott published his theory of market behavior in the book The Wave Principle in
1938, summarized it in a series of articles in Financial World magazine in 1939, and covered it most
comprehensively in his final major work, Nature’s Laws: The Secret of the Universe in 1946. Elliott
stated that "because man is subject to rhythmical procedure, calculations having to do with his
activities can be projected far into the future with a justification and certainty heretofore unattainable.“
The Elliott Wave Principle posits that collective investor psychology, or crowd psychology, moves
between optimism and pessimism in natural sequences. These mood swings create patterns evidenced
in the price movements of markets at every degree of trend or time scale.
In Elliott's model, market prices alternate between an impulsive, or motive phase, and a corrective
phase on all time scales of trend, as the illustration shows. Impulses are always subdivided into a set of
5 lower-degree waves, alternating again between motive and corrective character, so that waves 1, 3,
and 5 are impulses, and waves 2 and 4 are smaller retraces of waves 1 and 3. Corrective waves
subdivide into 3 smaller-degree waves starting with a five-wave counter-trend impulse, a retrace, and
another impulse. In a bear market the dominant trend is downward, so the pattern is reversed—five
waves down and three up. Motive waves always move with the trend, while corrective waves move
against it.
Five wave pattern (dominant trend) Three wave pattern (corrective trend)
Wave 1: Wave one is rarely obvious at its Wave A: Corrections are typically harder to identify
inception. When the first wave of a new bull
market begins, the fundamental news is almost than impulse moves. In wave A of a bear market,
universally negative. The previous trend is the fundamental news is usually still positive.
considered still strongly in force. Fundamental
analysts continue to revise their earnings Most analysts see the drop as a correction in a still-active
estimates lower; the economy probably does
not look strong bull market.
Wave 2: Wave two corrects wave one, but Wave B: Prices reverse higher, which many see as a
can never extend beyond the starting point
of wave one. Typically, the news is still resumption of the now long-gone bull market. The
bad. As prices retest the prior low, bearish volume during wave B should be lower than in wave A.
sentiment quickly builds, and "the crowd"
haughtily reminds all that the bear market By this point, fundamentals are probably no longer
is still deeply ensconced.
improving, but they most likely have not yet turned negative.
Wave 3: Wave three is usually the largest Wave C: Prices move impulsively lower in five waves.
and most powerful wave in a trend
Volume picks up, and by the third leg of wave C,
(although some research suggests that in
commodity markets, wave five is the almost everyone realizes that a bear market is
largest). The news is now positive and
fundamental analysts start to raise earnings firmly entrenched.
estimates. Prices rise quickly, corrections
are short-lived and shallow.
Arbitrage is a process of earning profit by taking advantage of differential pricing for the same asset. The process
generates riskless profit. On the security market, it is of selling security at a high price and the simultaneous purchase of
the same security at a relatively lower price. Since the profit earned through arbitrage is riskless, the investors have the
incentive to undertake this whenever an opportunity arises. In general, some investors indulge more in this type of
activities than others. However, the buying and selling activities of the arbitragers reduces and eliminates the profit
margin, bringing the market price to the equilibrium level.
The assumptions
where
is a constant for asset
is a systematic factor
is the sensitivity of the th asset to factor , also called factor loading,
and is the risky asset's idiosyncratic random shock with mean zero.
Idiosyncratic shocks are assumed to be uncorrelated across assets and uncorrelated with the factors.
The APT states that if asset returns follow a factor structure then the following relation exists between expected
returns and the factor sensitivities:
where
is the risk premium of the factor,
is the risk-free rate,
That is, the expected return of an asset j is a linear function of the asset's sensitivities to the n factors.
Note that there are some assumptions and requirements that have to be fulfilled for the latter to be correct: There
must be perfect competition in the market, and the total number of factors may never surpass the total number
of assets (in order to avoid the problem of matrix singularity),
Unit-5
Review the existing asset portfolio
Undertaking periodic evaluations of its asset portfolio, based on size and complexity, as part of its strategic
asset management helps an entity to confirm that its assets continue to be appropriate to meet its program
delivery requirements. As part of the evaluation of the existing asset portfolio the entity may consider:
using asset performance indicators to identify if existing assets are being appropriately used, maintained,
and are fit-for-purpose;
monitoring the performance of the asset portfolio in terms of laws, codes and benchmarks, and financial
performance; and
maintaining a detailed asset register, and accounting for the assets in accordance with Australian
Accounting Standards.
a) Sharpe’s Measure
b) Treynor’s Measure
c) Jensen’s Measure
Treynor measures-
The Treynor ratio (sometimes called the reward-to-volatility ratio or Treynor measure, named after Jack L.
Treynor, is a measurement of the returns earned in excess of that which could have been earned on an
investment that has no diversifiable risk (e.g., Treasury Bills or a completely diversified portfolio), per each unit
of market risk assumed.
The Treynor ratio relates excess return over the risk-free rate to the additional risk taken; however, systematic
risk is used instead of total risk. The higher the Treynor ratio, the better the performance of the portfolio under
analysis.
where:
Treynor ratio,
portfolio i's return,
risk free rate
portfolio i's beta
Limitations
Like the Sharpe ratio, the Treynor ratio (T) does not quantify the value added, if any, of active portfolio
management. It is a ranking criterion only. A ranking of portfolios based on the Treynor Ratio is only useful if
the portfolios under consideration are sub-portfolios of a broader, fully diversified portfolio. If this is not the
case, portfolios with identical systematic risk, but different total risk, will be rated the same. But the portfolio
with a higher total risk is less diversified and therefore has a higher unsystematic risk which is not priced in the
market.
An alternative method of ranking portfolio management is Jensen's alpha, which quantifies the added return as
the excess return above the security market line in the capital asset pricing model. As these two methods both
determine rankings based on systematic risk alone, they will rank portfolios identically.
Sharpe Ratio
Sharpe ratio evaluates the performance of a portfolio based on the total risk of a portfolio. It measures the
excess return generated by a portfolio over the risk free rate in relation to the total risk or standard deviation of a
portfolio.
Sharpe Ratio= (Rp - Rf)/s
Where, Rp=return on the portfolio, Rf= risk free rate and s= standard deviation of the return of the portfolio
Higher the Sharpe ratio, better is the fund.
Illustration: Consider two funds A and B. Let return of fund A be 30% and that of fund B be 25%. On the outset,
it appears that fund A has performed better than Fund B. Let us now incorporate the risk factor and find out the
Sharpe ratios for the funds. Let risk of Fund A and Fund B be 11% and 5% respectively. This means that the
standard deviation of returns - or the volatility of returns of Fund A is much higher than that of Fund B.
If risk free rate is assumed to be 8%,
Sharpe ratio for fund A= (30-8)/11=2% and
Sharpe ratio for fund B= (25-8)/5=3.4%
Higher the Sharpe Ratio, better is the fund on a risk adjusted return metric. Hence, our primary judgement based
solely on returns was erroneous. Fund B provides better risk adjusted returns than Fund A and hence is the
preferred investment. Producing healthy returns with low volatility is generally preferred by most investors to
high returns with high volatility. Sharpe ratio is a good tool to use to determine a fund that is suitable to such
investors.
Both Sharpe ratio and Treynor ratio measure risk adjusted returns. The difference lies in how risk is defined in
either case. In Sharpe ratio, risk is determined as the degree of volatility in returns - the variability in month-on-
month or period-on-period returns - which is expressed through the standard deviation of the stream of returns
numbers you are considering. In Treynor ratio, you look at the beta of the portfolio - the degree of "momentum"
that has been built into the portfolio by the fund manager in order to derive his excess returns. High momentum
- or high beta (where beta is > 1) implies that the portfolio will move faster (up as well as down) than the
market.
While Sharpe ratio measures total risk (as the degree of volatility in returns captures all elements of risk -
systematic as well as unsystemic), the Treynor ratio captures only the systematic risk in its computation.
When one has to evaluate the funds which are sector specific, Sharpe ratio would be more meaningful. This is
due to the fact that unsystematic risk would be present in sector specific funds. Hence, a truer measure of
evaluation would be to judge the returns based on the total risk.
On the contrary, if we consider diversified equity funds, the element of unsystematic risk would be very
negligible as these funds are expected to be well diversified by virtue of their nature. Hence, Treynor ratio
would me more apt here.
It is widely found that both ratios usually give similar rankings. This is based on the fact that most of the
portfolios are fully diversified. To summarize, we can say that when the fund is not fully diversified, Sharpe
ratio would be a better measure of performance and when the portfolio is fully diversified, Treynor ratio would
better justify the performance of a fund.
Portfolio Management
First let's understand the meaning of terms Portfolio and Management.
1. Portfolio is a group of financial assets such as shares, stocks, bonds, debt instruments, mutual funds,
cash equivalents, etc. A portfolio is planned to stabilize the risk of non-performance of various pools of
investment.
2. Management is the organization and coordination of the activities of an enterprise in accordance with
well-defined policies and in achievement of its pre-defined objectives.
Now let's comprehend the meaning of term Portfolio Management.
1. Portfolio Management (PM) guides the investor in a method of selecting the best available securities
that will provide the expected rate of return for any given degree of risk and also to mitigate (reduce) the
risks. It is a strategic decision which is addressed by the top-level managers.
For example, Consider Mr. John has $100,000 and wants to invest his money in the financial market other than
real estate investments. Here, the rational objective of the investor (Mr. John) is to earn a considerable rate of
return with less possible risk.
So, the ideal recommended portfolio for investor Mr. John can be as follows:-
PASSIVE MANAGEMENT
Passive management is an process is a holding a well diversified portfolio for a long term with the buy
and hold approach. Passive management refers to the investors attempt to construct a portfolio that
resembles the overall market returns. The simplest form of passive management is holding the index
fund that is designed to replicate a good and well defined index of the common stock such as BSE
sensex or NSE nifty. The fund manager buys every stock in the index in exact proportion of the stock
in that index. If reliance industry stock constitutes 5% of the index, the fund also invests 5% in reliance
industry stock.
ACTIVE MANAGMENT
Active management is holding securities based on the forecast about the future. The portfolio
managers vary their cash position or beta of the equity portion of the portfolio based on the
market forecast. The managers may indulge in group rotations. Here, group rotation means
changing the investment in different industries stocks depending on the assessed expectation
regarding their future performance.
The first introduction of a mutual fund in India occurred in 1963, when the Government of India launched Unit
Trust of India (UTI). Until 1987, UTI enjoyed a monopoly in the Indian mutual fund market. Then a host of
other government-controlled Indian financial companies came up with their own funds. These included State
Bank of India, Canara Bank, and Punjab National Bank. This market was made open to private players in 1993,
as a result of the historic constitutional amendments brought forward by the then Congress-led government
under the existing regime of Liberalization, Privatization and Globalization (LPG). The first private sector fund
to operate in India was Kothari Pioneer, which later merged with Franklin Templeton.
Despite being available in the market for over two decades now with assets under management equaling Rs
7,81,71,152 Lakhs (as of 28 February 2010) (Source: Association of Mutual Funds, India), less than 10% of
Indian households have invested in mutual funds. A recent report on Mutual Fund Investments in India
published by research and analytics firm, Boston Analytics, suggests investors are holding back from putting
their money into mutual funds due to their perceived high risk and a lack of information on how mutual funds
work. This report is based on a survey of approximately 10,000 respondents in 15 Indian cities and towns as of
March 2010. There are 43 Mutual Funds recently.
The primary reason for not investing appears to be correlated with city size. Among respondents with a high
savings rate, close to 40% of those who live in metros and Tier I cities considered such investments to be very
risky, whereas 33% of those in Tier II cities said they did not know how or where to invest in such assets.
Reasons for not investing in mutual funds in India
On the other hand, among those who invested, close to nine out of ten respondents did so because they felt these
assets were more professionally managed than other asset classes. Exhibit 2 lists some of the influencing factors
for investing in mutual funds. Interestingly, while non-investors cite "risk" as one of the primary reasons they do
not invest in mutual funds, those who do invest consider that they are "professionally managed" and "more
diverse" most often as their reasons to invest in mutual funds versus other investments.
A mutual fund is a type of professionally managed collective investment vehicle that pools money from many
investors to purchase securities.While there is no legal definition of the term "mutual fund", it is most
commonly applied only to those collective investment vehicles that are regulated and sold to the general public.
They are sometimes referred to as "investment companies" or "registered investment companies." Most mutual
funds are "open-ended," meaning investors can buy or sell shares of the fund at any time. Hedge funds are not
considered a type of mutual fund.
Advantages
Reduces the average cost per share and improves the possibility of gain over long period.
Takes away the pressure of timing the stock purchase from investors.
Applicable for both falling and rising market.
Disadvantages
Extra transaction cost with small and frequent purchase of shares
This does not indicate when to sell.
There is no indication of appropriate interval between the sales.
It is strictly for buying.
The plan enables the shift of investment from bonds to stocks and vice versa by maintain a constant amount invested
in the stock portion of the portfolio. The constant rupee plan starts with a fixed amount of money invested in selected
stocks and bonds. When the price of the stocks increases, the investor sells sufficient amount of stocks to return to the
original amount of the investment in stocks. By keeping the value of aggressive portfolio constant, remainder is
invested in the conservative portfolio..
The investors must choose action points or revaluation points. The action points are the times at which the investor
has to readjust the value of the stocks in the portfolio. Stocks values cannot be continuously the same and the investor
has to be watchful of the price movements. Stocks value in the portfolio can be allowed to fluctuate to a certain
extent. Percentage change in price like 5%, 10%, 20% can be fixed by the investor. Allowing only small percentage
change would result un an lot of transaction cost and would not be beneficial to the investor.