LECTURE NOTES

ON

SECURITY ANALYSIS AND

PORTFOLIO MANAGEMENT
MBA III semester R 16 syllabus

M RAMESH
Assistant Professor

MASTER OF BUSINESS ADMINISTRATION

INSTITUTE OF AERONAUTICAL ENGINEERING
(Autonomous)
DUNDIGAL- 500 043, HYDERABAD
 SYLLABUS

UNIT-I INVESTMENT AND SECURITY ANALYSIS

Investment environment in India, overview of Indian financial system securities trading in stock
markets, investment alternatives, the investment management process, Security analysis:
fundamental analysis, technical analysis, efficient market hypothesis.
UNIT-II PORTFOLIO ANALYSIS
The returns and risks from investing Markowitz portfolio theory, mean variance approach,
portfolio selection-efficient portfolios, the single index model capital asset pricing model,
arbitrage pricing theory.

UNIT-III BOND ANALYSIS & VALUATION & MANAGEMENT

Types of bonds, interest rates, term structure of interest rates, measuring bond yields, yield to
maturity, yield to call, yield to maturity, holding period return, bond pricing theorems, bond
duration, active and passive bond management strategies, bond immunization, bond volatility,
bond convexity.
UNIT-IV EQUITY VALUATION & DERIVATIVES
Equity analysis & valuation, balance sheet analysis equity valuation models, intrinsic value &
market price, the p/e ratio & earnings multiplier approach, price/book value, price/ sales ratio,
economic value added , overview of derivatives markets, option markets, option strategies and
option valuation forward & future markets, strategies. Stock index futures, interest rate futures,
swaps contracts.
UNIT-V MUTUAL FUNDS
Types of mutual funds schemes, structure, net asset value, risk and return, performance
evaluation models Sharpe model, trey nor model, Jensen model, fame’s decomposition. Trends
in Indian mutual funds.
Text Books:
1. William. F.Sharpe, Gordon j Alexander & Jeffery V Bailey, "Fundamentals of Investments", Prentice
Hall
2. Reilly, Brown, "Analysis of Investment and Management of Portfolios", 10th Edition, Cengage,
2012.
 Unit-I
INVESTMENTS AND SECURITY ANALYSIS
Introduction:
Security analysis is a pre-requisite for making investments. In the present day financial
markets, investment has become complicated. Investment may be defined as an activity that
commits funds in any financial/physical form in the present with an expectation of receiving
additional return in the future.
Types of investments
Investments may be classified as financial investments or economic investments. In the
financial sense, investment is the commitment of funds to derive future income in the form
of interest, dividend, premium, pension benefits, or appreciation in the value of the initial
investment. Economic investments are undertaken with an expectation of increasing the
current economy’s capital stock that consists of goods and services.
Objectives
The main objective of an investment process is to minimize risk while simultaneously
maximizing the expected returns from the investment and assuring safety and liquidity of
the invested assets.
Investment Vs Speculation
The capacity to bear risk distinguishes an investor from a speculator. An investor prefers
low risk investments, whereas a speculator is prepared to take higher risks for higher returns.
speculation is associated with buying low and selling high with the hope of making large
capital gains. Investors are careful while selecting securities for trading. Investments, in
most instances, expect an income in addition to the capital gains that may accrue when the
securities are traded in the market. Investment is long term in nature. An investor commits
funds for a longer period in the expectation of holding period gains. However, a speculator
trades frequently; hence, the holding period of securities is very short.

Investment Vs Gambling
Investment can also to be distinguished from gambling. Examples of gambling are horse
race, card games, lotteries, and so on. Gambling involves high risk not only for high returns
but also for the associated excitement. Gambling is unplanned and unscientific, without the
knowledge of the nature of the risk involved. It is surrounded by uncertainty and a gambling
decision is taken on unfounded market tips and rumors. In gambling, artificial and
unnecessary risks are
Created for increasing the returns. Investment is an attempt to carefully plan, evaluate, and
allocate funds to various investment outlets that offer safety of principal and expected
returns over a long period of time. Hence, gambling is quite the opposite of investment even
though the stock market has been euphemistically referred to as a “gambling den”.
Investment environment

Investment environment can be defined as the existing investment vehicles in the

market available for investor and the places for transactions with these investment vehicles.
Thus further in this subchapter the main types of investment vehicles and the types of
financial markets will be presented and described.

Investment vehicles
As it was presented in 1.1, in this course we are focused to the financial investments
that mean the object will be financial assets and the marketable securities in particular. But
even if further in this course only the investments in financial assets are discussed, for
deeper understanding the specifics of financial assets comparison of some important
characteristics of investment in this type of assets with the investment in physical assets is
presented.

Investment in financial assets differs from investment in physical assets in those

important aspects:
• Financial assets are divisible, whereas most physical assets are not. An asset is
divisible if investor can buy or sell small portion of it. In case of financial assets it
means, that investor, for example, can buy or sell a small fraction of the whole
company as investment object buying or selling a number of common stocks.
• Marketability (or Liquidity) is a characteristic of financial assets that is not
shared by physical assets, which usually have low liquidity. Marketability (or
liquidity) reflects the feasibility of converting of the asset into cash quickly and
without affecting its price significantly. Most of financial assets are easy to buy or to
sell in the financial markets.
 • The planned holding period of financial assets can be much shorter than the
holding period of most physical assets. The holding period for investments is

defined as the time between signing a purchasing order for asset and selling the
asset. Investors acquiring physical asset usually plan to hold it for a long period, but
investing in financial assets, such as securities, even for some months or a year can
be reasonable. Holding period for investing in financial assets vary in very wide
interval and depends on the investor’s goals and investment strategy.

The main types of financial investment vehicles are:

• Short term investment vehicles;
1. Fixed-income securities;
2. Common stock;
• Speculative investment vehicles;
• Other investment tools.

Short - term investment vehicles are all those which have a maturity of one year or
less. Short term investment vehicles often are defined as money-market instruments,
because they are traded in the money market which presents the financial market for short
term (up to one year of maturity) marketable financial assets. The risk as well as the return
on investments of short-term investment vehicles usually is lower than for other types of
investments. The main short term investment vehicles are:
• Certificates of deposit;
• Treasury bills;
• Commercial paper;
• Bankers’ acceptances;
• Repurchase agreements.
Certificate of deposit is debt instrument issued by bank that indicates a specified sum
of money has been deposited at the issuing depository institution. Certificate of deposit
bears a maturity date and specified interest rate and can be issued in any denomination. Most
certificates of deposit cannot be traded and they incur penalties for early withdrawal. For
large money-market investors financial institutions allow their large-denomination
certificates of deposits to be traded as negotiable certificates of deposits.

Treasury bills (also called T-bills) are securities representing financial obligations of
the government. Treasury bills have maturities of less than one year. They have the unique
feature of being issued at a discount from their nominal value and the difference between
nominal value and discount price is the only sum which is paid at the maturity for these
short term securities because the interest is not paid in cash, only accrued. The other
important feature of T-bills is that they are treated as risk-free securities ignoring inflation
and default of a government, which was rare in developed countries, the T -bill will pay the
fixed stated yield with certainty. But, of course, the yield on T-bills changes over time
influenced by changes in overall macroeconomic situation. T -bills are issued on an auction
basis. The issuer accepts competitive bids and allocates bills to those offering the highest
prices. Non-competitive bid is an offer to purchase the bills at a price that equals the average
of the

competitive bids. Bills can be traded before the maturity, while their market price is subject
to change with changes in the rate of interest. But because of the early maturity dates of T-
bills large interest changes are needed to move T-bills prices very far. Bills are thus regarded
as high liquid assets.

Commercial paper is a name for short-term unsecured promissory notes issued by

corporation. Commercial paper is a means of short-term borrowing by large corporations.
Large, well-established corporations have found that borrowing directly from investors
through commercial paper is cheaper than relying solely on bank loans. Commercial paper is
issued either directly from the firm to the investor or through an intermediary. Commercial
paper, like T-bills is issued at a discount. The most common maturity range of commercial
paper is 30 to 60 days or less. Commercial paper is riskier than T-bills, because there is a
larger risk that a corporation will default. Also, commercial paper is not easily bought and
sold after it is issued, because the issues are relatively small compared with T -bills and
hence their market is not liquid.
Banker‘s acceptances are the vehicles created to facilitate commercial trade
transactions. These vehicles are called bankers acceptances because a bank accepts the
responsibility to repay a loan to the holder of the vehicle in case the debtor fails to perform.
Banker‘s acceptances are short-term fixed-income securities that are created by non-
financial firm whose payment is guaranteed by a bank. This short-term loan contract
typically has a higher interest rate than similar short –term securities to compensate for the
default risk. Since bankers’ acceptances are not standardized, there is no active trading of
these securities.

Repurchase agreement (often referred to as a repo) is the sale of security with a

commitment by the seller to buy the security back from the purchaser at a specified price at
a designated future date. Basically, a repo is a collectivized short-term loan, where collateral
is a security. The collateral in a repo may be a Treasury security, other money-market
security. The difference between the purchase price and the sale price is the interest cost of
the loan, from which repo rate can be calculated. Because of concern about default risk, the
length of maturity of repo is usually very short. If the agreement is for a loan of funds for
one day, it is called overnight repo; if the term of the agreement is for more than one day, it
is called a term repo. A reverse repo is the opposite of a repo. In this transaction a
corporation buys the securities with an
agreement to sell them at a specified price and time. Using repos helps to increase the
liquidity in the money market.
Our focus in this course further will be not investment in short-term vehicles but it
is useful for investor to know that short term investment vehicles provide the possibility for
temporary investing of money/ funds and investors use these instruments managing their
investment portfolio.

Fixed-income securities are those which return is fixed, up to some redemption date
or indefinitely. The fixed amounts may be stated in money terms or indexed to some
measure of the price level. This type of financial investments is presented by two different
groups of securities:
• Long-term debt securities
• Preferred stocks.
Long-term debt securities can be described as long-term debt instruments
representing the issuer’s contractual obligation. Long term securities have maturity longer
than 1 year. The buyer (investor) of these securities is landing money to the issuer, who
undertake obligation periodically to pay interest on this loan and repay the principal at a
stated maturity date. Long-term debt securities are traded in the capital markets. From the
investor’s point of view these securities can be treated as a “safe” asset. But in reality the
safety of investment in fixed –income securities is strongly related with the default risk of an
issuer. The major representatives of long-term debt securities are bonds, but today there are
a big variety of different kinds of bonds, which differ not only by the different issuers
(governments, municipals, companies, agencies, etc.), but by different schemes of interest
payments which is a result of bringing financial innovations to the long-term debt securities
market. As demand for borrowing the funds from the capital markets is growing the long-
term debt securities today are prevailing in the global markets. And it is really become the
challenge for investor to pick long-term debt securities relevant to his/ her investment
expectations, including the safety of investment. We examine the different kinds of long-
term debt securities and their features important to understand for the investor in Chapter 5,
together with the other aspects in decision making investing in bonds.

Preferred stocks are equity security, which has infinitive life and pay dividends. But
preferred stock is attributed to the type of fixed-income securities, because the dividend for
preferred stock is fixed in amount and known in advance.

Though, this security provides for the investor the flow of income very similar to that of the
bond. The main difference between preferred stocks and bonds is that for preferred stock the
flows are for ever, if the stock is not callable. The preferred stockholders are paid after the
debt securities holders but before the common stock holders in terms of priorities in
payments of income and in case of liquidation of the company. If the issuer fails to pay the
dividend in any year, the unpaid dividends will have to be paid if the issue is cumulative. If
preferred stock is issued as noncumulative, dividends for the years with losses do not have
to be paid. Usually same rights to vote in general meetings for preferred stockholders are
suspended. Because of having the features attributed for both equity and fixed-income
securities preferred stocks is known as hybrid security. A most preferred stock is issued as
noncumulative and callable. In recent years the preferred stocks with option of convertibility
to common stock are proliferating.

The common stock is the other type of investment vehicles which is one of most popular
among investors with long-term horizon of their investments. Common stock represents the
ownership interest of corporations or the equity of the stock holders. Holders of common
stock are entitled to attend and vote at a general meeting of shareholders, to receive declared
dividends and to receive their share of the residual assets, if any, if the corporation is
bankrupt. The issuers of the common stock are the companies which seek to receive funds in
the market and though are “going public”. The issuing common stocks and selling them in
the market enables the company to raise additional equity capital more easily when using
other alternative sources. Thus many companies are issuing their common stocks which are
traded in financial markets and investors have wide possibilities for choosing this type of
securities for the investment.

Speculative investment vehicles following the term “speculation” (see p.8) could
be defined as investments with a high risk and high investment return. Using these
investment vehicles speculators try to buy low and to sell high, their primary concern is with
anticipating and profiting from the expected market fluctuations. The only gain from such
investments is the positive difference between selling and purchasing prices. Of course,
using short-term investment strategies investors can use for speculations other investment
vehicles, such as common stock, but here we try to

accentuate the specific types of investments which are more risky than other investment
vehicles because of their nature related with more uncertainty about the changes influencing
the their price in the future.
Speculative investment vehicles could be presented by these different vehicles:
• Options;
• Futures;
• Commodities, traded on the exchange (coffee, grain metals, other commodities);

Options are the derivative financial instruments. An options contract gives the
owner of the contract the right, but not the obligation, to buy or to sell a financial asset at a
specified price from or to another party. The buyer of the contract must pay a fee (option
price) for the seller. There is a big uncertainty about if the buyer of the option will take the
advantage of it and what option price would be relevant, as it depends not only on demand
and supply in the options market, but on the changes in the other market where the financial
asset included in the option contract are traded. Though, the option is a risky financial
instrument for those investors who use it for speculations instead of hedging.

Futures are the other type of derivatives. A future contract is an agreement between
two parties than they agree tom transact with the respect to some financial asset at a
predetermined price at a specified future date. One party agree to buy the financial asset, the
other agrees to sell the financial asset. It is very important, that in futures contract case both
parties are obligated to perform and neither party charges the fee.

There are two types of people who deal with options (and futures) contracts:
speculators and hedgers. Speculators buy and sell futures for the sole purpose of making a
profit by closing out their positions at a price that is better than the initial price. Such people
neither produce nor use the asset in the ordinary course of business. In contrary, hedgers buy
and sell futures to offset an otherwise risky position in the market.
Transactions using derivatives instruments are not limited to financial assets. There
are derivatives, involving different commodities (coffee, grain, precious metals,

and other commodities). But in this course the target is on derivatives where underlying
asset is a financial asset.
Other investment tools:
Various types of investment funds;
Investment life insurance;
Pension funds;
Hedge funds.

Investment companies/ investment funds. They receive money from investors with
the common objective of pooling the funds and then investing them in securities according
to a stated set of investment objectives. Two types of funds:
1. open-end funds (mutual funds) ,
2. closed-end funds (trusts).
Open-end funds have no pre-determined amount of stocks outstanding and they can
buy back or issue new shares at any point. Price of the share is not determined by demand,
but by an estimate of the current market value of the fund’s net assets per share (NAV) and a
commission.

Closed-end funds are publicly traded investment companies that have issued a
specified number of shares and can only issue additional shares through a new public issue.
Pricing of closed-end funds is different from the pricing of open-end funds: the market price
can differ from the NAV.

Insurance Companies are in the business of assuming the risks of adverse events
(such as fires, accidents, etc.) in exchange for a flow of insurance premiums. Insurance
companies are investing the accumulated funds in securities (treasury bonds, corporate
stocks and bonds), real estate. Three types of Insurance Companies: life insurance; non-life
insurance (also known as property-casualty insurance) and re-insurance. During recent years
investment life insurance became very popular investment alternative for individual
investors, because this hybrid investment product allows to buy the life insurance policy
together with possibility to invest accumulated life insurance payments or lump sum for a
long time selecting investment program relevant to investor‘s future expectations.
Pension Funds are an asset pools that accumulates over an employee’s working
years and pays retirement benefits during the employee’s nonworking years. Pension

funds are investing the funds according to a stated set of investment objectives in securities
(treasury bonds, corporate stocks and bonds), real estate.
Hedge funds are unregulated private investment partnerships, limited to institutions and
high-net-worth individuals, which seek to exploit various market opportunities and thereby
to earn larger returns than are ordinarily available. They require a substantial initial
investment from investors and usually have some restrictions on how quickly investor can
withdraw their funds. Hedge funds take concentrated speculative positions and can be very
risky. It could be noted that originally, the term “hedge” made some sense when applied to
these funds. They would by combining different types of investments, including derivatives,
try to hedge risk while seeking higher return. But today the word “hedge’ is misapplied to
these funds because they generally take an aggressive strategies investing in stock, bond and
other financial markets around the world and their level of risk is high

Financial markets
Financial markets are the other important component of investment environment.

Financial markets are designed to allow corporations and governments to raise new funds
and to allow investors to execute their buying and selling orders. In financial markets funds
are channeled from those with the surplus, who buy securities, to those, with shortage, who
issue new securities or sell existing securities. A financial market can be seen as a set of
arrangements that allows trading among its participants.
Financial market provides three important economic functions (Frank J. Fabozzi,
1999):
1. Financial market determines the prices of assets traded through the interactions
between buyers and sellers;
2. Financial market provides a liquidity of the financial assets;
3. Financial market reduces the cost of transactions by reducing explicit costs, such
as money spent to advertise the desire to buy or to sell a financial
asset.
Financial markets could be classified on the bases of those characteristics:
• Sequence of transactions for selling and buying securities;
• Term of circulation of financial assets traded in the market;
Economic nature of securities, traded in the market;
• From the perspective of a given country.

By sequence of transactions for selling and buying securities:

Primary market
Secondary market

All securities are first traded in the primary market, and the secondary market
provides liquidity for these securities.

Primary market is where corporate and government entities can raise capital and
where the first transactions with the new issued securities are performed. If a company’s
share is traded in the primary market for the first time this is referred to as an initial public
offering (IPO).
Investment banks play an important role in the primary market:
• Usually handle issues in the primary market;
• Among other things, act as underwriter of a new issue, guaranteeing the
proceeds to the issuer.

Secondary market - where previously issued securities are traded among investors.
Generally, individual investors do not have access to secondary markets. They use security
brokers to act as intermediaries for them. The broker delivers an orders received form
investors in securities to a market place, where these orders are executed. Finally, clearing
and settlement processes ensure that both sides to these transactions honor their
commitment. Types of brokers:
• Discount broker, who executes only trades in the secondary market;
• Full service broker, who provides a wide range of additional services to
clients (ex., advice to buy or sell);
• Online broker is a brokerage firm that allows investors to execute trades
electronically using Internet.
Types of secondary market places:
1. Organized security exchanges;
2. Over-the-counter markets;
3. Alternative trading system.
An organized security exchange provides the facility for the members to trade
securities, and only exchange members may trade there. The members include brokerage
firms, which offer their services to individual investors, charging commissions for executing
trades on their behalf. Other exchange members by or sell

for their own account, functioning as dealers or market makers who set prices at which they
are willing to buy and sell for their own account. Exchanges play very important role in the
modern economies by performing the following tasks:
a. Supervision of trading to ensure fairness and efficiency;

b. The authorization and regulation of market participants such as brokers and

market makers;
c. Creation of an environment in which securities’ prices are formed efficiently and
without distortion. This requires not only regulation of an orders and transaction
costs but also a liquid market in which there are many buyers and sellers,
allowing investors to buy or to sell their securities quickly;
d. Organization of the clearing and settlement of transactions;
e. The regulation of he admission of companies to be listed on the exchange and the
regulation of companies who are listed on the exchange;
 f. The dissemination of information (trading data, prices and announcements of
companies listed on the exchange). Investors are more willing to trade if

prompt and complete information about trades and prices in the market is
available.

The over-the-counter (OTC) market is not a formal exchange. It is organized

network of brokers and dealers who negotiate sales of securities. There are no membership
requirements and many brokers register as dealers on the OTC. At the same time there are
no listing requirements and thousands of securities are traded in the OTC market. OTC
stocks are usually considered as very risky because they are the stocks that are not
considered large or stable enough to trade on the major exchange.
An alternative trading system (ATS) is an electronic trading mechanism developed
independently from the established market places – security exchanges – and designed to
match buyers and sellers of securities on an agency basis. The brokers who use ATS are
acting on behalf of their clients and do not trade on their own account. The distinct
advantages of ATS in comparison with traditional markets are cost savings of transactions,
the short time of execution of transactions for liquid securities, extended hours for trading
and anonymity, often important for investors, trading large amounts.

Investment management process

Investment management process is the process of managing money or funds. The
investment management process describes how an investor should go about making
decisions.
Investment management process can be disclosed by five-step procedure, which
includes following stages:
1. Setting of investment policy.
2. Analysis and evaluation of investment vehicles.
3. Formation of diversified investment portfolio.
4. Portfolio revision
5. Measurement and evaluation of portfolio performance.

Setting of investment policy is the first and very important step in investment management
process. Investment policy includes setting of investment objectives. The investment policy
should have the specific objectives regarding the investment return requirement and risk
tolerance of the investor. For example, the investment policy may define that the target of
the investment average return should be 15 % and should avoid more than 10 % losses.
Identifying investor’s tolerance for risk is the most important objective, because it is
obvious that every investor would like to earn the highest return possible. But because there
is a positive relationship between risk and return, it is not appropriate for an investor to set
his/ her investment objectives as just “to make a lot of money”. Investment objectives
should be stated in terms of both risk and return.
The investment policy should also state other important constrains which could
influence the investment management. Constrains can include any liquidity needs for the
investor, projected investment horizon, as well as other unique needs and preferences of
investor. The investment horizon is the period of time for investments. Projected time
horizon may be short, long or even indefinite.

Setting of investment objectives for individual investors is based on the assessment

of their current and future financial objectives. The required rate of return for investment
depends on what sum today can be invested and how much investor needs to have at the end
of the investment horizon. Wishing to earn higher income on his / her investments investor
must assess the level of risk he /she should take and to decide if it is relevant for him or not.
The investment policy can include the tax status of the investor. This stage of investment
management concludes with the identification of the potential categories of financial assets
for inclusion in the investment portfolio. The identification of the potential categories is
based on the investment objectives, amount of investable funds, investment horizon and tax
status of the investor. From the section 1.3.1 we could see that various financial assets by
nature may be more or less risky and in general their ability to earn returns differs from one
type to the other. As an example, for the investor with low tolerance of risk common stock
will be not appropriate type of investment.

Analysis and evaluation of investment vehicles. When the investment policy is set
up, investor’s objectives defined and the potential categories of financial assets for inclusion
in the investment portfolio identified, the available investment types can be analyzed. This
step involves examining several relevant types of investment vehicles and the individual
vehicles inside these groups. For example, if the common stock was identified as investment
vehicle relevant for investor, the analysis will be concentrated to the common stock as an
investment. The one purpose of such analysis and evaluation is to identify those investment
vehicles that currently appear to be mispriced. There are many different approaches how to
make such analysis. Most frequently two forms of analysis are used: technical analysis and
fundamental analysis.
Technical analysis involves the analysis of market prices in an attempt to predict
future price movements for the particular financial asset traded on the market.
This analysis examines the trends of historical prices and is based on the assumption that
these trends or patterns repeat themselves in the future. Fundamental analysis in its simplest
form is focused on the evaluation of intrinsic value of the financial asset. This valuation is
based on the assumption that intrinsic value is the present value of future flows from
particular investment. By comparison of the intrinsic value and market value of the financial
assets those which are under priced or overpriced can be identified. Fundamental analysis
will be examined in Chapter 4.

This step involves identifying those specific financial assets in which to invest and
determining the proportions of these financial assets in the investment portfolio.
Formation of diversified investment portfolio is the next step in investment
management process. Investment portfolio is the set of investment vehicles, formed by the
investor seeking to realize its’ defined investment objectives. In the stage of portfolio
formation the issues of selectivity, timing and diversification need to be addressed by the
investor. Selectivity refers to micro forecasting and focuses on forecasting price movements
of individual assets. Timing involves macro forecasting of price movements of particular
type of financial asset relative to fixed-income securities in general. Diversification involves
forming the investor’s portfolio for decreasing or limiting risk of investment. 2 techniques of
diversification:

• random diversification, when several available financial assets are put to the
portfolio at random;
• objective diversification when financial assets are selected to the portfolio

following investment objectives and using appropriate techniques for analysis

and evaluation of each financial asset.

Investment management theory is focused on issues of objective portfolio diversification

and professional investors follow settled investment objectives then constructing and
managing their portfolios.

Portfolio revision. This step of the investment management process concerns the periodic
revision of the three previous stages. This is necessary, because over time investor with
long-term investment horizon may change his / her investment objectives and this, in turn
means that currently held investor’s portfolio may no longer be optimal and even contradict
with the new settled investment objectives. Investor should form the new portfolio by
selling some assets in his portfolio and buying the others that are not currently held. It could
be the other reasons for revising a given portfolio: over time the prices of the assets change,
meaning that some assets that were attractive at one time may be no longer be so. Thus
investor should sell one asset ant buy the other more attractive in this time according to his/
her evaluation. The decisions to perform changes in revising portfolio depend, upon other
things, in the transaction costs incurred in making these changes. For institutional investors
portfolio revision is continuing and very important part of their activity. But individual
investor managing portfolio must perform portfolio revision periodically as well. Periodic
re-evaluation of the investment objectives and portfolios based on them is necessary,
because financial markets change, tax laws and security regulations change, and other
events alter stated investment goals.

Measurement and evaluation of portfolio performance. This the last step in

investment management process involves determining periodically how the portfolio
performed, in terms of not only the return earned, but also the risk of the portfolio. For
evaluation of portfolio performance appropriate measures of return and risk and benchmarks
are needed. A benchmark is the performance of predetermined set of assets, obtained for
comparison purposes. The benchmark may be a popular index of appropriate assets – stock
index, bond index. The benchmarks are widely used by institutional investors evaluating the
performance of their portfolios.

It is important to point out that investment management process is continuing

process influenced by changes in investment environment and changes in investor’s
attitudes as well. Market globalization offers investors new possibilities, but at the same
time investment management become more and more complicated with growing
uncertainty.
Relationship between the primary and secondary Market

1. The primary/new issue market cannot function without the secondary market. The
secondary market or the stock market provides liquidity for the issued securities. The issued
securities
are traded in the secondary market offering liquidity to the stocks at a fair price.

2. The new issue market provides a direct link between the prospective investors and the
company. By providing liquidity and safety, the stock markets encourage the public to
subscribe to the new issues. The marketability and the capital appreciation provided in the
stock market are the major factors that attract the investing public towards the stock market.
Thus, it provides an indirect link between the savers and the company.

3. The stock exchanges through their listing requirements, exercise control over the primary
market. The company seeking for listing on the respective stock exchange has to comply
with all the rules and regulations given by the stock exchange.

4. Though the primary and secondary markets are complementary to each other, their
functions and the organisational set up are different from each other. The health of the
primary market depends on the secondary market and vice versa.

Underwriting
Origination do not guarantee that the issue will be successful, i.e., will get fully subscribed.
In case the issue is not well received in the market, the plans of the company/promoters
receive a setback and all expenses incurred in origination get wasted. To ensure success of
an issue the company/promoters get the issue underwritten. Underwriter guarantees that he
would buy the portion of issue not subscribed by the public. Such service is called
underwriting and is always rendered for a commission. Under-writing guarantees success of
the issue and benefits the issuing company, the investing public and capital market in
general.
Distribution
The success of an issue mainly depends on its subscription by the investing public. Sale of
securities to ultimate investors is called distribution. It is a specialised actively rendered by
brokers, subbrokers and dealers in securities.
Managers to the issue: Lead managers are appointed by the company to manage the public
issue programmes. Their main duties are (a) drafting of prospectus (b) preparing the budget
of expenses related to the issue (c) suggesting the appropriate timings of the public issue
(d) assisting in marketing the public issue successfully (e) advising the company in the
appointment of registrars to the issue, underwriters, brokers, bankers to the issue, advertising
agents etc. and (f) directing the various agencies involved in the public issue.
Registrar to the issue: In consultation with the lead manager, the Registrar to the issue is
appointed. Quotations containing the details of the various functions they would be
performing and charges for them are called for selection. Among them the most suitable one
is selected. It is always ensured that the registrar to the issue has the necessary infrastructure
like computer, internet and telephone.
Underwriters: Underwriter is a person/organisation who gives an assurance to the issuer to
the effect that the former would subscribe to the securities offered in the event of non-
subscription by the person to whom they were offered. They stand as back -up supporters
and underwriting is done for a commission.
Bankers to the issue: The responsibility of collecting the application money along with the
application form is on bankers to the issue. The bankers charge commission besides the
brokerage, if any. Depending upon the size of the public issue more than one banker to the
issue is appointed. When the size of the issue is large, three or four banks are appointed as
bankers to the issue. The number of collection centres is specified by the central
government. The bankers
to the issue should have branches in the specified collection centres.

The financial institutions: The function of underwriting is generally performed by

financial institutions. Therefore, normally they go through the draft of prospectus, study the
proposed programme for public issue and approve them. IDBI, IFCI, ICICI, LIC, GIC and
UTI are the some of the financial institutions that underwrite and give financial assistance.
The lead manager sends copy of the draft prospectus to the financial institutions and include
their comments,
if any in the revised draft.
Issue mechanism
New issues can be made in any of the following ways:
1. Public issue through prospectus,
2. Through offer for sale,
3. Through placement of securities— private placement and stock
exchange placing,
4. Issue of bonus shares,
5. Book-building, and
6. Stock option.
Margin Trading
Buying on margin is borrowing money from a broker to purchase stock. You can think of it
as a loan from your brokerage. Margin trading allows you to buy more stock than you'd be
able to normally. To trade on margin, you need a margin account. This is different from a
regular cash account, in which you trade using the money in the account. By law, your
broker is required to obtain your signature to open a margin account. The margin account
may be part of your standard account opening agreement or may be a completely separate
agreement. An initial investment of at least $2,000 is required for a margin account, though
some brokerages require more. This deposit is known as the minimum margin. Once the
account is opened and operational, you can borrow up to 50% of the purchase price of a
stock. This portion of the purchase price that you deposit is known as the initial margin. It's
essential to know that you don't have to margin all the way up to 50%.

SECURITY ANALYSIS

Security analysis is the analysis of tradable financial instruments called securities. These
are usually classified into debt securities, equities, or some hybrid of the two.
Tradable credit derivatives are also securities. Commodities or futures contracts are not
securities. They are distinguished from securities by the fact that their performance is not
dependent on the management or activities of an outside or third party. Options on these
contracts are however considered securities, since performance is now dependent on the
activities of a third party. The definition of what is and what is not a security comes directly
from the language of a United States Supreme Court decision in the case of SEC v. W. J.
Howey Co.. Security analysis is typically divided into fundamental analysis, which relies
upon the examination of fundamental business factors such as financial statements,
and technical analysis, which focuses upon price trends and momentum. Quantitative
analysis may use indicators from both areas.
Types of securities
1. Shares A share is an equity security. Its owner owns one part of the capital of the
company which has issued the shares in question. The shares enable the shareholder the
right to take part in the decision-making in the company. If the latter operates with profit,
the owners of shares may receive dividends. The amount of the dividend is decided upon
by the shareholders at a General Meeting of the Shareholders.
2. Bonds A bond is a debt security. When purchasing a bond, you have no right to
participate in the company's decision making but are entitled to the reimbursement of the
principal and the interest. There are several ways of repayment as the companies may
decide that the principal be paid in regular annual installments or on the maturity of
bonds. The interest may be refunded in a fixed amount or may be variable (inflation rate
or foreign currency). The issuers pay the interest once every year or once every half-year
(on the coupon maturity date).
3. Open-end funds An open-end fund stands for a diversified portfolio of securities and
similar investments, chosen and professionally managed by a fund management
company. Since the fund does not have fixed capital but is rather 'open ended', it grows
together with new investors joining and thus funding it. Open-end funds can invest in
domestic and international securities, in either shares, bonds or other investment vehicles.
Depending on the portfolio, the fund's risk and returns vary accordingly.
3.1. Trading in open-end funds Open-end funds do normally not trade on exchanges, and
there are indeed few exchanges worldwide where open-end fund shares can be bought;
but there are exceptions. Usually, open-end funds are bought through fund management
companies. Investors can invest into the fund via a postal or a standing order, being
charged with an entry fee upon each new purchase and with an exit fee when they decide
to sell their fund units. The other option, however, is to buy through a brokerage firm;
trading in open-end fund shares on an exchange involves no entry or exit fees for
investors, as they are only bound by broker's fees.
4. Index open-end funds With an index open-end fund, fund management companies allot
investors’ assets to a basket of securities making up a chosen index that thus tracks th e
 yield of the mentioned index. While the big investors may invest directly into a fund,
minor investors can only trade in fund shares on stock exchanges. Due to the possibility
of arbitrage, the market price of index open-end fund shares does usually not stray from
its NAV for more than 1%.
4.1. Trading in index open-end fund shares on primary market before purchasing
index open-end fund units, a declaration of accession must be signed. After
that, assets are transferred to a special fund account, open at a custodian
bank. Upon each purchase and sale, the fund charges appropriate entry and
exit fees (max 3% from purchase/sale). Fund investors are also charged a
management fee (0.5% of the average annual fund NAV) and the costs of
custodian services (0.1% of the average annual fund NAV). Each purchase or
sale within the fund on the primary market results in a changed number of
index open-end fund shares, which in turn affects the changes in the size of
fund's assets. Index open-end fund shares are purchased and sold at NAV, as
calculated by the management company.
4.2. Trading in index open-end fund shares on secondary market Minor investors
can buy index open-end fund shares on the exchange at the price that forms
on the market, without entry or exit fees, being charged solely brokerage
fees. Exchange trading of index open-end fund shares does not affect the size
of capital; while the owners of index open-end fund shares change, the fund’s
assets remain unaffected.
5. Close-end funds (ID) ID is a close-end investment fund investing its capital into securities
by other issuers. Investment company is managed by a management company (DZU)
which decides which securities to include in the fund's portfolio. The DZU is paid a
management fee by the investment company; it usually amounts to 1-2% per year in
Slovenia. The value of shares of the close-end funds is closely correlated to the value of
the company's
6. Investment certificates Investment certificates are debt securities issued by a bank, and
are designed to offer the investor an agreed yield under pre-defined conditions stipulated in
the prospectus. Issuers are mainly large banks, and an important criterion in selecting the
bank in whose investment certificates you would like to invest is its credit rating. Investment
certificates represent an investment directly linked to an index, share price, raw material
price, exchange rate, interest, industry, and other publicly available values. The holder of an
investment certificate does thereby not become an indirect owner of the assets underlying
the certificate. A certificate ensures the investor a guaranteed manner of payment.
Investment certificates are predictable and the investor can always anticipate their yield (or
loss) in a specific situation, which makes them a successful investment vehicle in times of
heavy market losses. There are different types of investment certificates – some guarantee
yields no matter what the situation on the market, while others yield profit only when the
prices fall, etc.
7. Warrants Warrants are options issued by a joint-stock company, which give holders the
right to purchase a certain quantity of the respective company’s shares at a pre-determined
price. After a certain period, the right to purchase shares terminates.
Fundamental Analysis:
Fundamental analysis is primarily concerned with determining the intrinsic value or the true
value of a security. For determining the security’s intrinsic value the details of all major
factors (GNP, industry sales, firm sales and expense etc) is collected or an estimates of
earnings per share may be multiplied by a justified or normal prices earnings ratio. After
making this determination, the intrinsic value is compared with the security’s current market
price. If the market price is substantially greater than the intrinsic value the security is said
to be overpriced. If the market price is substantially less than the intrinsic value, the security
is said to be under priced. However, fundamental analysis comprises:
1. Economic Analysis
2. Industry Analysis
3. Company Analysis

ECONOMIC ANALYSIS
For the security analyst or investor, the anticipated economic environment, and therefore the
economic forecast, is important for making decisions concerning both the timings of an
investment and the relative investment desirability among the various industries in the
economy. The key for the analyst is that overall economic activities manifest itself in the
behavior of the stocks in general. That is, the success of the economy will ultimately include
the success of the overall market.
INDUSTRY ANALYSIS
The mediocre firm in the growth industry usually out performs the best stocks in a stagnant
industry. Therefore, it is worthwhile for a security analyst to pinpoint growth industry,
which has good investment prospects. The past performance of an industry is not a good
predictor of the future- if one look very far into the future. Therefore, it is important to study
industry analysis. For an industry analyst- industry life cycle analysis, characteristics and
classification of industry is important.

INDUSTRY LIFE CYCLE ANALYSIS

Many industrial economists believe that the development of almost every industry may be
analyzed in terms of following stages
1. Pioneering stage: During this stage, the technology and product is relatively new. The
prospective demand for the product is promising in this industry. The demand for the
product attracts many producers to produce the particular product. This lead to severe
competition and only fittest companies survive in this stage. The producers try to develop
brand name, differentiate the product and create a product image. This would lead to non-
price competition too. The severe competition often leads to change of position of the firms
in terms of market share and profit.
2. Rapid growth stage: This stage starts with the appearance of surviving firms from the
pioneering stage. The companies that beat the competition grow strongly in sales, market
share and financial performance. The improved technology of production leads to low cost
and good quality of products. Companies with rapid growth in this stage, declare dividends
during this stage. It is always adisable to invest in these companies.
3. Maturity and stabilization stage: After enjoying above-average growth, the industry now
enters in maturity and stabilization stage. The symptoms of technology obsolescence may
appear. To keep going, technological innovation in the production process should be
introduced. A close monitoring at industries events are necessary at this stage.
4. Decline stage: The industry enters the growth stage with satiation of demand,
encroachment of new products, and change in consumer preferences. At this stage the
earnings of the industry are started declining. In this stage the growth of industry is low even
in boom period and decline at a higher rate during recession. It is always advisable not to
invest in the share of low growth industry.

CLASSIFICATION OF INDUSTRY
Industry means a group of productive or profit making enterprises or organizations that have
a similar technically substitute goods, services or source of income. Besides Standard
Industry Classification (SIC), industries can be classified on the basis of products and
business cycle i.e. classified according to their reactions to the different phases of the
business cycle.

These are classified as follows:

1. Growth Industries: These industries have special features of high rate of earnings and
growth in expansion, independent of the business cycle. The expansion of the
industry mainly depends on the technological change or an innovative way of doing
or selling something. For example-in present scenario the information technology
sector have higher growth rate. There is some growth in electronics, computers,
cellular phones, engineering, petro-chemicals, telecommunication, energy etc.
2. Cyclical Industries: The growth and profitability of the industry move along with the
business cycle. These are those industries which are most likely to benefit from a
period of economic prosperity and most likely to suffer from a period of economic
recession. These especially include consumer goods and durables whose purchase
can be postponed until persona; financial or general business conditions improve.
For example- Fast Moving Consumer Goods (FMCG) commands a good market in
the boom period and demand for them slackens during the recession.
3. Defensive Industries: Defensive industries are those, such as the food processing
industry, which hurt least in the period of economic downswing. For example- the
industries selling necessities of consumers withstands recession and depression. The
stock of defensive industries can be held by the investor for income earning purpose.
Consumer nondurable and services, which in large part are the items necessary for
existence, such as food and shelter, are products of defensive industry.
4. Cyclical-growth Industries: These possess characteristics of both a cyclical industry
and a growth industry. For example, the automobile industry experiences period of
stagnation, decline but they grow tremendously. The change in technology and
introduction of new models help the automobile industry to resume their growing
path.

CHARACTERISTICS OF AN INDUSTRY ANALYSIS

In an industry analysis, the following key characteristics should be considered by the
analyst. These are explained as below:
1. Post sales and Earnings performance: The two important factors which play an
important role in the success of the security investment are sales and earnings. The
historical performance of sales and earnings should be given due consideration, to
know how the industry have reacted in the past. With the knowledge and
understanding of the reasons of the past behavior, the investor can assess the relative
magnitude of performance in future. The cost structure of an industry is also an
important factor to look into. The higher the cost component, the higher the sales
volume necessary to achieve the firm’s break-even point, and vice-versa.
2. Nature of Competition: The numbers of the firms in the industry and the market
share of the top firms in the industry should be analyzed. One way to determine
competitive conditions is to observe whether any barriers to entry exist. The demand
of particular product, its profitability and price of concerned company scrip’s also
determine the nature of competition. The investor before investing in the scrip of a
company should analyze the market share of the particular company’s product and
should compare it with other companies. If too many firms are present in the
organized sector, the competition would be severe. This will lead to a decline in
price of the product.
3. Raw Material and Inputs: Here, we have to look into the industries, which are
dependent upon imports of scarce raw material, competition from other companies
and industries, barriers to entry of a new company, protection from foreign
competition, import and export restriction etc. An industry which has a limited
supply of materials domestically and where imports are restricted will have dim
 growth prospects. Labour is also an input and industries with labour problems may
have difficulties of growth.
4. Attitude of Government towards Industry: It is important for the analyst or
prospective investor to consider the probable role government will play in industry.
Will it provide financial support or otherwise? Or it will restrain the industry’s
development through restrictive legislation and legal enforcement? The government
policy with regard to granting of clearance, installed capacity and reservation of the
products for small industry etc. are also factors to be considered for industry
analysis.
5. Management: An industry with many problems may be well managed, if the
promoters and the management are efficient. The management likes Tatas, Birlas,
Ambanies etc. who have a reputation, built up their companies on strong
foundations. The management has to be assessed in terms of their capabilities,
popularity, honesty and integrity. In case of new industries no track record is
available and thus, investors have to carefully assess the project reports and the
assessment of financial institutions in this regard. A good management also ensures
that the future expansion plans are put on sound basis.
6. Labour Conditions and Other Industrial Problems: The labour scenario in a
particular industry is of great importance. If we are dealing with a labour intensive
production process or a very mechanized capital intensive process where labour
performs crucial operations, the possibility of strike looms as an important factor to
be reckoned with. Certain industries with problems of marketing like high storage
costs, high transport costs etc leads to poor growth potential and investors have to
careful in investing in such companies.
7. Nature of Product Line: The position of the industry in the life cycle of its growth-
initial stage, high growth stage and maturing stage are to be noted. It is also
necessary to know the industries with a high growth potential like computers,
electronics, chemicals, diamonds etc., and whether the industry is in the priority
sector of the key industry group or capital goods or consumer goods groups. The
importance attached by the government in their policy and of the Planning
Commission in their assessment of these industries is to be studied.
8. Capacity Installed and Utilized: The demand for industrial products in the economy
is estimated by the Planning Commission and the Government and the units are
given licensed capacity on the basis of these estimates. If the demand is rising as
expected and market is good for the products, the utilization of capacity will be
higher, leading to bright prospects and higher profitability. If the quality of the
product is poor, competition is high and there are other constraints to the availability
of inputs and there are labour problems, then the capacity utilization will be low and
profitability will be poor.
9. Industry Share Price Relative to Industry Earnings: While making investment the
current price of securities in the industry, their risk and returns they promise is
considered. If the price is very high relative to future earnings growth, the
investment in these securities is not wise. Conversely, if future prospects are dim but
prices are low relative to fairly level future patterns of earnings, the stocks in this
industry might be an attractive investment.
10. Research and Development: For any industry to survive in the national and
international markets, product and production process have to be technically
competitive. This depends upon the research and development in the particular
industry. Proper research and development activities help in obtaining economic of
scale and new market for product. While making investment in any industry the
percentage of expenditure made on research and development should also be
considered.
11. Pollution Standards: These are very high and restricted in the industrial sector.
These differ from industry to industry, for example, in leather, chemical and
pharmaceutical industries the industrial effluents are more.

COMPANY ANALYSIS:
THE STUDY OF FINANCIALS STATEMENTS
Financial statement means a statement or document which explains necessary financial
information. Financial statements express the financial position of a business at the end of
accounting period (Balance Sheet) and result of its operations performed during the year
(Profit and Loss Account). In order to determine whether the financial or operational
performance of company is satisfactory or not, the financial data are analyzed. Different
methods are used for this purpose. The main techniques of financial analysis are:
1. Comparative Financial Statements
2. Trend Analysis
3. Common Size Statement
4. Fund Flow Statement
5. Cash Flow Statement
6. Ratio Analysis
1) Comparative Financial Statements: In comparative financial statement, the financial
statements of two periods are kept by side so that they can be compared. By preparing
comparative statement the nature and quantum of change in different items can be calculated
and it also helps in future estimates. By comparing with the data of the previous years it can
be ascertained what type of changes in the different items of current year have taken place
and future trends of business can be estimated.
2) Trend Analysis: In order to compare the financial statements of various years trend
percentages are significant. Trend analysis helps in future forecast of various items on the
basis of the data of previous years. Under this method one year is taken as base year and on
its basis the ratios in percentage for other years are calculated. From the study of these ratios
the changes in that item are examined and trend is estimated. Sometimes sales may be
increasing continuously and the inventories may also be rising. This would indicate the loss
of market share of a particular company’s product. Likewise sales may have an increasing
trend but profit may remain the same. Here the investor has to look into the cost and
management efficiency of the company.
3) Common Size Statement: Common size financial statements are such statements in which
items of the financial statements are converted in percentage on the basis of common base.
In common size Income Statement, net sales may be considered as 100 percent. Other items
are converted as its proportion. Similarly, for the Balance sheet items total assets or total
liabilities may be taken as 100 percent and proportion of other items to this total can be
calculated in percentage.
4) Fund Flow Statement: Income Statement or Profit or Loss Account helps in ascertainment
of profit or loss for a fixed period. Balance Sheet shows the financial position of business on
a particular date at the close of year. Income statement does not fully explain funds from
operations of business because various non-fund items are shown in Profit or Loss Account.
Balance Sheet shows only static financial position of business and financial changes
occurred during a year can’t be known from the financial statement of a particular date.
Thus, Fund Flow Statement is prepared to find out financial changes between two dates. It is
a technique of analyzing financial statements. With the help of this statement, the amount of
change in the funds of a business between two dates and reasons thereof can be ascertained.
The investor could see clearly the amount of funds generated or lost in operations. These
reveal the real picture of the financial position of the company.
5) Cash Flow Statement: The investor is interested in knowing the cash inflow and outflow
of the enterprise. The cash flow statement expresses the reasons of change in cash balances
of company between two dates. It provides a summary of stocks of cash and uses of cash in
the organization. It shows the cash inflows and outflows. Inflows (sources) of cash result
from cash profit earned by the organization, issue of shares and debentures for cash,
borrowings, sale of assets or investments, etc. The outflows (uses) of cash results from
purchase of assets, investment redemption of debentures or preferences shares, repayment of
loans, payment of tax, dividend, interest etc. With the help of cash flow statement the
investor can review the cash movement over an operating cycle. The factors responsible for
the reduction of cash balances in spite of increase in profits or vice versa can be found out.
6) Ratio Analysis: Ratio is a relationship between two figures expressed mathematically. It is
quantitative relationship between two items for the purpose of comparison. Ratio analysis is
a technique of analyzing financial statements. It helps in estimating financial soundness or
weakness. Ratios present the relationships between items presented in profit and loss
account and balance sheet. It summaries the data for easy understanding, comparison and
interpretation.

Meaning of Technical Analysis

Technical analysis involves a study of market-generated data like prices and volumes to
determine the future direction of price movement. It is a process of identifying trend reversal
at an earlier stage to formulate the buying and selling strategy. With the help of several
indicators, the relationship between price –volume and supply-demand is analyzed for the
overall market and individual stocks. The basic premises, on which technical analysis is
formulated, are as follows:
1. The market value of the scrip is determined by the interaction of demand and supply.
2. Supply and demand is governed by numerous factors, both rational and irrational. These
factors include economic variables relied by the fundamental analysis as well as opinions,
moods and guesses.
3. The market discounts everything. The price of the security quoted represents the hope,
fears and inside information received by the market players. Insider information regarding
the issuance of bonus shares and right issues may support the prices. The loss of earnings
and information regarding the forthcoming labor problem may result in fall in price. These
factors may cause a shift in demand and supply, changing the direction of trends.
4. The market always moves in the trends except for minor deviations.
5. It is known fact that history repeats itself. It is true to stock market also. In the rising
market, investors’ psychology has upbeats and they purchase the shares in great volumes
driving the prices higher. At the same time in the down trend, they may be very eager to get
out of the market by selling them and thus plunging the share price further. The market
technicians assume that past prices predict the future.

Tools of Technical Analysis

Generally used technical tools to analyze the market data are as follows:

Dow theory

Originally proposed in the late nineteenth century by Charles H Dow, the editor of Wall
Street Journal, the Dow theory is perhaps the oldest and best-known theory of technical
analysis. Dow developed this theory on the basis of certain hypothesis, which are as follows:
a. No single individual or buyer or buyer can influence the major trends in the market.
However, an individual investor can affect the daily price movement by buying or selling
huge quantum of particular scrip.
b. The market discounts everything. Even natural calamities such as earth quake, plague and
fire also get quickly discounted in the market. The world trade center blast affected the share
market for a short while and then the market returned back to normalcy.
c. The theory is not infallible and it is not a tool to beat the market but provides a way to
understand the market. Explanation of the Theory Dow described stock prices as moving in
trends analogous to the movement of water.
He postulated three types of price movements over time:
(1) major trends that are like tide in ocean,
(2) intermediate trends that resemble waves,
(3) short run movements that are like ripples.
Followers of the Dow theory hope to detect the direction of the major price trend (tide)
known as primary trend, recognizing the intermediate movements (waves) or secondary
trends that may occasionally move in the opposite direction. They recognize that a primary
trend does not go straight up, but rather includes small price declines as some investors
decide to take profits. It means share prices don’t rise or fall in a straight t manner. Every
rise or fall in price experiences a counter move. If a share price is increasing, the counter
move will be a fall in price and vice-versa. The share prices move in a zigzag manner. The
trend lines are straight lines drawn connecting either the top or bottoms of the share price
movement. To draw a trend line, the analyst should have at least two tops or bottoms.
Primary Trend
The price trend may be either increasing or decreasing. When the market exhibits the
increasing trend, it is called bull market. The bull market shows three clear-cut peaks. Each
peak is higher than the previous peak and this price rise is accompanied by heavy trading
volume. Here, each profit taking reversal that is followed by an increased new peak has a
trough above the prior trough, with relatively light trading volume during the reversals,
indicating that there is limited interest in profit taking at these levels. And the phases leading
to the three peaks are revival, improvement in corporate profit and speculation. The revival
period encourages more and more investors to buy scrips, their expectations about the future
being high. In the second phase, increased profits of corporate would result in further price
rise. In the third phase, prices advance due to inflation and speculation.
Secondary Trend
The secondary trend moves against the main trends and leads to the correction. In the bull
market, the secondary trend would result in the fall of about 33-66 percent of the earlier rise.
In the bear market, the secondary trend carries the price upward and corrects the main trend.
Compared to the time taken for the primary trend, secondary trend is swift and quicker.
Minor Trends
Minor trends are just like the ripples in the market. They are simply the daily price
fluctuations. Minor trend tries to correct the secondary price movement. It is better for the
investor to concentrate on the primary or secondary trends than on the minor trends

The efficient market hypothesis (EMH)

Efficient market theory states that the price fluctuations are random and do not follow any
regular pattern. Fama suggested that efficient market hypothesis can be divided into three
categories.
They are: (1) the weak form,
(2) The semi strong form,
(3) The strong form.
The level of information being considered in the market is the basis for this segregation.
Weak form of EMH
The weak form hypothesis says that the current prices of stocks already fully reflect all the
information that is contained in the historical sequence of prices. Therefore, there is no
benefit in examining the historical sequence of prices forecasting the future. This weak form
of the efficient market hypothesis is popularly known as the random-walk theory. Clearly, if
this weak form of the efficient market hypothesis is true, it is a direct repudiation of
technical analysis. If there is no value in studying past prices and past price changes, there is
no value in technical analysis. As we saw in the preceding chapter, however, technicians
place considerable reliance on the charts of historical prices that they maintain even though
the efficient-market hypothesis refutes this practice.
Empirical tests of the weak form
Over the years an impressive literature has been developed describing empirical tests of
random walk (Paul H. Cootner, 1967). This research has been aimed at testing whether
successive or lagged price changes are independent. In this section we will review briefly
some of the major categories of statistical techniques that have been employed in this
research, and we will summarize their major conclusions. These techniques generally fall
into two categories: those that test for trends in stock prices and thus infer whether profitable
trading systems could be developed and those that test such mechanical systems directly.
Although certain of these studies were conducted many years ago, they are the basis upon
which research on the efficient-market theory has been based, and are included here to
provide the necessary conceptual basis for the theory and its evolution.
Semi strong form of EMH
The semi strong form of the efficient-market hypothesis says that current prices of stocks not
only reflect all informational content of historical prices but also reflect all publicly
available knowledge about the corporations being studied. Further-more, the semi strong
form says that efforts by analysts and investors to acquire and analyze public information
will not yield consistently superior returns to the analyst.
Examples of the type of public information that will not be of value on a consistent basis to
the analyst are corporate reports, corporate announcements, information relating to corporate
dividend policy, forthcoming stock splits, and so forth. In effect, the semi strong form of the
efficient market hypothesis maintains that as soon as information becomes publicly
available, it is absorbed and reflected in stock prices. Even if this adjustment is not the
correct one immediately, it will in a very short time be properly analyzed by the market.
Thus the analyst would have great difficulty trying to profit using fundamental analysis
Strong form of EMH
we have seen that the weak\ form of the efficient-market hypothesis maintains that past
prices and past price changes cannot be used to forecast future price changes and future
prices. Semi strong form of the efficient-market hypothesis says that publicly available
information cannot be used to earn consistently superior investment returns. Some studies
that tend to support the semi strong theory of the efficient-market hypothesis were cited.
Finally, the strong form of the efficient-market hypothesis maintains that not only is publicly
available information useless to the investor or analyst but all information is useless.
Specifically, no information that is available, be it public or ‘inside’, can be used to earn
consistently superior investment returns. The semi strong form of the efficient-market
hypothesis could only be tested indirectly- namely, by testing what happened to prices on
days surrounding announcements of various types, such as earnings announcements,
dividend announcements, and stock-split announcements. To test the strong form of
efficient-market hypothesis, even more indirect methods must be used. For the strong form,
as has already been mentioned, says that no information is useful. This implies that not even
security analysts and portfolio managers who have access to information more quickly than
the general investing public are able to use this information to earn superior returns.
Therefore, many of the tests of the strong form of the efficient market hypothesis deal with
tests of mutual-fund performance.
The efficient-market hypothesis and mutual-fund performance
It has often been said that large investors such as mutual funds perform better in the market
than the small investor does because they have access to better information. Therefore, it
would be interesting to observe if mutual funds earned above-average returns, where these
are defined as returns in excess of those that can be earned by a simple buy-and-hold
strategy. The results of such an investigation would have interesting implications for the
efficient market hypothesis.
Researchers have found that mutual funds do not seem to be able to earn greater net
returns (after sales expenses) than those that can be earned by investing randomly in a large
group of securities and holding them. Furthermore, these studies indicate, mutual funds are
not even able to earn gross returns (before sales expenses) superior to those of the native
buy-and-hold strategy. These results occur not only because of the difficulty in applying
fundamental analysis in a consistently superior manner to a large number of securities in an
efficient market but also because of portfolio over diversification and its attendant problems-
two of which are high book-keeping and administrative costs to monitor the investments,
and purchases of securities with less favorable risk-return characteristics. Therefore, it
would seem that the mutual-fund studies lend some credence to the efficient-market
hypothesis.
 Unit-II

PORTFOLIO ANALYSIS
Introduction
Portfolio is a combination of securities such as stocks, bonds and money market
instruments. The process of blending together the broad asset classes so as to obtain
optimum return with minimum risk is called portfolio construction. Individual securities
have riskreturn characteristics of their own. Portfolios may or may not take
on the aggregate characteristics of their individual parts.
Diversification of investment helps to spread risk over many assets. A diversification of
securities gives the assurance of obtaining the anticipated return on the portfolio. In a
diversified portfolio, some securities may not perform as expected, but others may exceed
the expectation and making the actual return of the portfolio reasonably close to the
anticipated one.
Approaches in portfolio construction
Commonly, there are two approaches in the construction of the portfolio of securities viz.
traditional approach and Markowitz efficient frontier approach
Traditional approach
The traditional approach basically deals with two major decisions. They are:
(a) Determining the objectives of the portfolio.
(b) Selection of securities to be included in the portfolio.
Normally, this is carried out in four to six steps. Before formulating the objectives, the
constraints of the investor should be analysed. Within the given framework of constraints,
objectives are formulated. Then based on the objectives, securities are selected. After that,
the risk and return of the securities should be studied. The investor has to assess the major
risk categories that he or she is trying to minimise. Compromise on risk and non-risk factors
has to be carried out. Finally relative portfolio weights are assigned to securities like bonds,
stocks and debentures and then diversification is carried out
Steps in traditional approach
(a) Need for current income: The investor should establish the income which the portfolio
should generate. The current income need depends upon the entire current financial plan of
the investor. The expenditure required to maintain a certain level
of standard of living and all the other income generating sources should be determined.
Once this information is arrived at, it is possible to decide how much income must be
provided for the portfolio of securities.
(b) Need for constant income: Inflation reduces the purchasing power of the money.
Hence, the investor estimates the impact of inflation on his estimated stream of income and
tries to build a portfolio which could offset the effect of inflation. Funds should be invested
in such securities where income from them might increase at a rate that would offset the
effect of inflation. The inflation or purchasing power risk must be recognised but this does
not pose a serious constraint on portfolio if growth stocks are selected.
2. Determination of objectives
Portfolios have the common objective of financing present and future expenditures from a
large pool of assets. The return that the investor requires and the degree of risk he is willing
to take depend upon the constraints. The objectives of portfolio range from income to capital
appreciation.
The common objectives are stated below:
 Current income
 Growth in income
 Capital appreciation
 Preservation of capital
The investor in general would like to achieve all the four objectives, nobody would like to
lose his investment. But, it is not possible to achieve all the four objectives simultaneously.
If the investor aims at capital appreciation, he should include risky securities where there is
an equal likelihood of losing the capital. Thus, there is a conflict among the objectives.
3. Selection of portfolio
The selection of portfolio depends on the various objectives of the investor. The selection of
portfolio under different objectives are dealt subsequently.
Objectives and asset mix- If the main objective is getting adequate amount of current
income, sixty per cent of the investment is made on debts and 40 per cent on equities. The
proportions of investments on debt and equity differ according to the individual’s
preferences. Money is invested in short term debt and fixed income securities. Here the
growth of income becomes the secondary objective and stability of principal amount may
become the third. Even within the debt portfolio, the funds invested in short term bonds
depends on the need for stability of principal amount in comparison with the
stability of income. If the appreciation of capital is given third priority, instead of short term
debt the investor opts for long term debt. The period may not be a constraint.
4. Risk and return analysis: The traditional approach to portfolio building has some basic
assumptions. First, the individual prefers larger to smaller returns from securities. To
achieve this goal, the investor has to take more risk. The ability to achieve higher returns is
dependent upon his ability to judge risk and his ability to take specific risks. The risks are
namely interest rate risk, purchasing power risk, financial risk and market risk. The investor
analyses the varying degrees of risk and constructs his portfolio. At first, he establishes the
minimum income that he must have to avoid hardships under
most adverse economic condition and then he decides risk of loss of income that can be
tolerated. The investor makes a series of compromises on risk and non-risk factors like
taxation and marketability after he has assessed the major risk categories, which he is trying
to minimise
5. Diversification: Once the asset mix is determined and the risk and return are analysed,
the final step is the diversification of portfolio. Financial risk can be minimised by
commitments to top-quality bonds, but these securities offer poor resistance to inflation.
Stocks provide better inflation protection than bonds but are more vulnerable to financial
risks. Good quality convertibles may balance the financial risk and purchasing power risk.
According to the investor’s need for income and
risk tolerance level portfolio is diversified. In the bond portfolio, the investor has to strike a
balance between the short term and long term bonds. Short term fixed income securities
offer more risk to income and long term fixed income securities offer
more risk to principal.
Modern approach:
the traditional approach is a comprehensive financial plan for the individual. It takes
into account the individual needs such as housing, life insurance and pension plans. But
these types of financial planning approaches are not done in the Markowitz approach.
Markowitz gives more attention to the process of selecting the portfolio. His planning can be
applied more in the selection of common stocks portfolio than the bond portfolio. The stocks
are not selected on the basis of need for income or appreciation. But the selection is based
on the risk and return analysis. Return includes the market return and dividend. The investor
needs return and it may be either in the form of market return or dividend
In the modern approach, the final step is asset allocation process that is to choose the
portfolio that meets the requirement of the investor. The risk taker i.e. who are willing to
accept a higher probability of risk for getting the expected return would choose high risk
portfolio. Investor with lower tolerance for risk would choose low
level risk portfolio. The risk neutral investor would choose the medium level risk portfolio

Portfolio risk/return
As mentioned earlier, an investment decision involves selection of a combination or group
of securities for investment. This group of securities is referred to as a portfolio. The
portfolio can be a combination of securities irrespective of their nature, maturity,
profitability, or risk characteristics. Investors, rather than looking at individual securities,
focus more on the performance of all securities together. While portfolio returns are the
weighted returns of all securities constituting the portfolio, the portfolio risk is not the
simple weighted average risk of all securities in the portfolio. Portfolio risk considers the
standard deviation together with the covariance between
securities. Co-variance measures the movement of assets together.
Markowitz Portfolio Selection
Markowitz Portfolio Selection Method identifies an investor’s unique risk-return
preferences, namely utilities. The Markowitz portfolio model has the following assumptions:
 Investors are risk averse
 Investors are utility maximisers than return maximisers
 All investors have the same time period as the investment horizon
 An investor who is a risk seeker would prefer high returns for a certain level of risk
and he is willing to accept portfolios with lower incremental returns for additional
risk levels.
 A risk averse investor would require a high incremental rate of return as
compensation for every small amount of increase in risk.
 A moderate risk taker would have utilities in between these two extremes.
 Markowitz H.M. (1952) introduced the term ‘risk penality’ to state the portfolio selection
rule. A security will be selected into a portfolio if the risk adjusted rate of return is high
compared to other available securities. This risk adjusted rate of return is computed as:
Risk adjusted return utility) = Expected return – Risk penality
Risk penalty is computed as:
Risk Penalty = Risk squared/Risk tolerance
Risk squared is the variance of the security return and risk tolerance is a number between 0
and 100. Risk tolerance of an investor is stated as a percentage point between these numbers
and a very high risk tolerance could be stated as 90 or above and a very low risk tolerance
level could be stated as between 0 and 20.
Markowitz portfolio theory
The author of the modern portfolio theory is Harry Markowitz who introduced the
analysis of the portfolios of investments in his article “Portfolio Selection” published in the
Journal of Finance in 1952. The new approach presented in this article included portfolio
formation by considering the expected rate of return and risk of individual stocks and,
crucially, their interrelationship as measured by correlation. Prior to this investors would
examine investments individually, build up portfolios of attractive stocks, and not consider
how they related to each other. Markowitz showed how it might be possible to better of
these simplistic portfolios by taking into account the correlation between the returns on
these stocks.

The diversification plays a very important role in the modern portfolio theory.
Markowitz approach is viewed as a single period approach: at the beginning of the period
the investor must make a decision in what particular securities to invest and hold these
securities until the end of the period. Because a portfolio is a collection of securities, this
decision is equivalent to selecting an optimal portfolio from a set of possible portfolios.
Essentiality of the Markowitz portfolio theory is the problem of
optimal portfolio selection.
The method that should be used in selecting the most desirable portfolio involves the use of
indifference curves. Indifference curves represent an investor’s preferences for risk and
return. These curves should be drawn, putting the investment return on the vertical axis and
the risk on the horizontal axis. Following Markowitz approach,the
measure for investment return is expected rate of return and a measure of risk is standard
deviation (these statistic measures we discussed in previous chapter, section 2.1). The
exemplified map of indifference curves for the individual risk-averse investor is presented in
Fig.3.1. Each indifference curve here (I 1, I2, I3 ) represents the most desirable investment or
investment portfolio for an individual investor. That means, that any of investments (or
portfolios) ploted on the indiference curves (A,B,C or D) are equally desirable to the
investor.
Features of indifference curves:
 All portfolios that lie on a given indifference curve are equally desirable
to the investor. An implication of this feature: indifference curves cannot
intersect.
 An investor has an infinitive number of indifference curves.
 Every investor can represent several indifference curves (for different
investment tools).
 Every investor has a map of the indifference curves representing his or
her preferences for expected returns and risk (standard deviations) for
each potential portfolio.
Two important fundamental assumptions than examining indifference curves
and applying them to Markowitz portfolio theory:
1. The investors are assumed to prefer higher levels of return to lower levels of
return, because the higher levels of return allow the investor to spend more on
consumption at the end of the investment period. Thus, given two portfolios with
the same standard deviation, the investor will choose the
portfolio with the higher expected return. This is called an assumption of
nonsatiation.
2. Investors are risk averse. It means that the investor when given the choise, will
choose the investment or investment portfolio with the smaller risk. This is called
assumption of risk aversion.
3. Efficient set of portfolios involves the portfolios that the investor will find optimal
 ones. These portfolios are lying on the “northwest boundary” of the feasible set and
is called an efficient frontier. The efficient frontier can be described by the
4. curve in the risk-return space with the highest expected rates of return for each level
of risk.
5.
6. Feasible set is opportunity set, from which the efficient set of portfolio can be
identified. The feasibility set represents all portfolios that could be formed from the
number of securities and lie either or or within the boundary of the feasible set.
7.
8. In Fig.3.3 feasible and efficient sets of portfolios are presented. Considering the
assumptions of nonsiation and risk aversion discussed earlier in this section, only
those portfolios lying between points A and B on the boundary of feasibility set
investor will find the optimal ones. All the other portfolios in the feasible set are are
inefficient portfolios. Furthermore, if a risk-free investment is introduced into the
universe of assets, the efficient frontier becomes the tagental line shown in Fig. 3.3
this line is called the Capital Market Line (CML) and the portfolio at the point at
which it is tangential (point M) is called the Market Portolio.
9. The Expected Rate of Return and Risk of Portfolio

Following Markowitz efficient set portfolios approach an investor should evaluate

alternative portfolios inside feasibility set on the basis of their expected returns and
standard deviations using indifference curves. Thus, the methods for calculating
expected rate of return and standard deviation of the portfolio must be discussed.
The expected rate of return of the portfolio can be calculated in some alternative
ways. The Markowitz focus was on the end-of-period wealth (terminal value) and using
these expected end-of-period values for each security in the portfolio the expected end-of-
period return for the whole portfolio can be calculated. But the portfolio really is the set of
the securities thus the expected rate of return of a portfolio should depend on the expected
rates of return of each security included in the portfolio (as was presented in Chapter 2,
formula 2.4). This alternative method for calculating the expected rate of return on the
portfolio (E(r)p) is the weighted average of the
expected returns on its component securities:
n

E(r)p = Σ wi * Ei (r) = E1(r) + w2 * E2(r) +…+ wn * En(r),

 i=1
here wi - the proportion of the portfolio’s initial value invested in security i;
Ei(r) - the expected rate of return of security I;
n - the number of securities in the portfolio.
Because a portfolio‘s expected return is a weighted average of the expected

returns of its securities, the contribution of each security to the portfolio‘s expected rate of
return depends on its expected return and its proportional share from the initial portfolio‘s
market value (weight). Nothing else is relevant. The conclusion here could be that the
investor who simply wants the highest posible expected rate of return must keep only one
security in his portfolio which has a highest expected rate of return. But why the majority of
investors don‘t do so and keep several different securities in their portfolios? Because they
try to diversify their portfolios aiming to reduce the investment portfolio risk.

Risk of the portfolio. As we know from chapter 2, the most often used measure for
the risk of investment is standard deviation, which shows the volatility of the securities
actual return from their expected return. If a portfolio‘s expected rate of return is a weighted
average of the expected rates of return of its securities, the calculation of standard deviation
for the portfolio can‘t simply use the same approach. The reason is that the relationship
between the securities in the same portfolio must be taken into account. As it was discussed
in section 2.2, the relationship between the assets can be estimated using the covariance and
coefficient of correlation. As covariance can range from “–” to “+” infinity, it is more useful
for identification of the direction of relationship (positive or negative), coefficients of
correlation always
lies between -1 and +1 and is the convenient measure of intensity and direction of the
relationship between the assets.
Risk of the portfolio, which consists of 2 securities (A ir B):

δp = (w²A . δ²A + w²B ²B + 2 wA . wB . kAB δA B) 1/2,

here: wA ir wB - the proportion of the portfolio’s initial value invested in security A

and B ( wA + wB = 1);
δA ir δB - standard deviation of security A and B;
 kAB - coefficient of coreliation between the returns of security A and B.

Sharpe’s Single Index Portfolio Selection Method

Sharpe W.E. (1964) justified that portfolio risk is to be identified with respect to their return
co-movement with the market and not necessarily with respect to within the security co-
movement in a portfolio. He therefore concluded that the desirability of a security for its
inclusion is directly related to its excess return to beta ratio,
i.e., R i- Rf/βi
Where
Ri = expected return on security i
Rf = return on a riskless security
I = beta of security i
This ranking order gives the best securities that are to be selected for the portfolio.

Cut-off Rate
The number of securities that are to be selected depends on the cutoff rate. The cut-off rate
is determined such that all securities with higher ratios are included into the portfolio.

Managing the portfolio

After establishing the asset allocation, the investor has to decide how to manage the
portfolio over time. He can adopt passive approach or active approach towards the
management of the portfolio. In the passive approach the investor would maintain the
percentage allocation for asset classes and keep the security holdings within its place over
the established holding period. In the active approach the investor continuously assess the
risk and return of the securities within the asset classes and changes them accordingly.
He would be studying the risks (1) market related (2) group related and (3) security
specific and changes the components of the portfolio to suit his objectives.

Portfolio performance measures

 Portfolio performance evaluation involves determining periodically how the
portfolio performed in terms of not only the return earned, but also the risk experienced by
the investor. For portfolio evaluation appropriate measures of return and risk as well as
relevant standards (or “benchmarks”) are needed.
In general, the market value of a portfolio at a point of time is determined by
adding the markets value of all the securities held at that particular time. The market value
of the portfolio at the end of the period is calculated in the same way, only using end-of-
period prices of the securities held in the portfolio.

The return on the portfolio (rp):

rp = (Ve - Vb) / Vb,

here: Ve - beginning value of the portfolio;

Vb - ending value of the portfolio.

The essential idea behind performance evaluation is to compare the returns which
were obtained on portfolio with the results that could be obtained if more appropriate
alternative portfolios had been chosen for the investment. Such comparison portfolios ar e
often referred to as benchmark portfolios. In selecting them investor should be certain that
they are relevant, feasible and known in advance. The benchmark should reflect the
objectives of the investor.
Relationship between risk and return
The expected rate of return and the variance or standard deviation provide investor with
information about the nature of the probability distribution associated with a single asset.
However all these numbers are only the characteristics of return and risk of the particular
asset. But how does one asset having some specific trade-off between return and risk
influence the other one with the different characteristics of return and risk in the same
portfolio? And what could be the influence of this relationship to the investor’s portfolio?
The answers to these questions are of great importance for the investor when forming his/
her diversified portfolio. The statistics that can provide the investor with the information to
answer these questions are covariance and correlation coefficient. Covariance and
correlation are related and they generally measure the same phenomenon – the relationship
between two variables. Both concepts are best understood by looking at the math behind
them.
Covariance
Two methods of covariance estimation can be used: the sample covariance and the
population covariance.
The sample covariance is estimated than the investor hasn‘t enough information
about the underlying probability distributions for the returns of two assets and then the
sample of historical returns is used.

Sample covariance between two assets - A and B is defined in

∑ [( rA,t - ŕA ) . ( rB,t - ŕB)]

t=1
Cov (ŕA, ŕB) = -----------------------------------------, (2.9)
n–1
here rA,t , rB,t - consequently, rate of return for assets A and B in the time period t, when t
varies from 1 to n;
ŕA, ŕB - sample mean of rate of returns for assets A and B consequently.
As can be understood from the formula, a number of sample covariance can range
from “–” to “+” infinity. Though, the covariance number doesn’t tell the investor much
about the relationship between the returns on the two assets if only this pair of assets in the
portfolio is analysed. It is difficult to conclud if the relationship between returns of two
assets (A and B) is strong or weak, taking into account the absolute number of the sample
variance. However, what is very important using the covariance for measuring relationship
between two assets – the identification of the direction of this relationship. Positive number
of covariance shows that rates of return of two assets are moving to the same direction:
when return on asset A is above its mean of return (positive), the other asset B is tend to be
the same (positive) and vice versa: when the rate of return of asset A is negative or bellow
its mean of return, the returns of other asset tend to be negative too. Negative number of
covariance shows that rates of return of two assets are moving in the contrariwise directions:
when return on asset A is above its mean of return (positive), the returns of the other asset -
B is tend to be the negative and vice versa. Though, in analyzing relationship between the
assets in the same portfolio using covariance for portfolio formation it is important to
identify which of the three possible outcomes exists:

positive covariance (“+”),

 negative covariance (“-”) or zero
covariance (“0”).

If the positive covariance between two assets is identified the common

recommendation for the investor would be not to put both of these assets to the same
portfolio, because their returns move in the same direction and the risk in portfolio will be
not diversified.
If the negative covariance between the pair of assets is identified the common
recommendation for the investor would be to include both of these assets to the
portfolio, because their returns move in the contrariwise directions and the risk in portfolio
could be diversified or decreased.

If the zero covariance between two assets is identified it means that there is no
relationship between the rates of return of two assets. The assets could be included in the
same portfolio, but it is rare case in practice and usually covariance tends to be positive or
negative.
For the investors using the sample covariance as one of the initial steps in analyzing
potential assets to put in the portfolio the graphical method instead of analytical one (using
formula 2.9) could be a good alternative. In figures 2.1, 2.2 and 2.3 the identification of
positive, negative and zero covariances is demonstrated in graphical way. In all these figures
the horizontal axis shows the rates of return on asset A and vertical axis shows the rates of
return on asset B. When the sample mean of return for both assets is calculated from
historical data given, the all area of possible historical rates of return can be divided into
four sections (I, II, III and IV) on the basis of the mean returns of two assets (ŕA, ŕB
consequently). In I section both asset A and asset B have the positive rates of returns above
their means of return; in section II the results are negative for asset A and positive for asset
B; in section III the results of both assets are negative – below their meansof return and in
section IV the results are positive for asset A and negative for asset B.

When the historical rates of return of two assets known for the investor are marked
in the area formed by axes ŕA, ŕB, it is very easy to identify what kind of relationship
between two assets exists simply by calculating the number of observations in each:
if the number of observations in sections I and III prevails over the number
of observations in sections II and IV, the covariance between two assets is
 positive (“+”);
if the number of observations in sections II and IV prevails over the
number of observations in sections I and III, the covariance between two assets
is negative(“-”);
if the number of observations in sections I and III equals the number of
observations in sections II and IV, there is the zero covariance between two
assets (“0”).
The population covariance is estimated when the investor has enough information
about the underlying probability distributions for the returns of two assets and can identify
the actual probabilities of various pairs of the returns for two assets at the same time.
Similar to using the sample covariance, in the population covariance case the
graphical method can be used for the identification of the direction of the relationship
between two assets. But the graphical presentation of data in this case is more complicated
because three dimensions must be used (including the probability). Despite of it, if investor
observes that more pairs of returns are in the sections I and III than in II and IV, the
population covariance will be positive, if the pairs of return in II and IV prevails over I and
III, the population covariance is negative.

2.2.2. Correlation and Coefficient of determination.

Correlation is the degree of relationship between two variables.

The correlation coefficient between two assets is closely related to their covariance.
The correlation coefficient between two assets A and B (kAB) can be
calculated using the next formula:
Cov(rA,rB)
kA,B = ------------------- ,
δ(rA) . δ(rB)

here δ (rA) and δ(rB) are standard deviation for asset A and B consequently.

Very important, that instead of covariance when the calculated number is

unbounded, the correlation coefficient can range only from -1,0 to +1,0. The more close the
absolute meaning of the correlation coefficient to 1,0, the stronger the relationship between
the returns of two assets. Two variables are perfectly positively correlated if correlation
coefficient is +1,0, that means that the returns of two assets have a perfect positive linear
relationship to each other , and perfectly negatively correlated if correlation coefficient is -
1,0, that means the asset returns have a perfect inverse linear relationship to each other . But
most often correlation between assets returns is imperfect . When correlation coefficient
equals 0, there is no linear relationship between the returns on the two assets .Combining
two assets with zero correlation with each other reduces the risk of the portfolio. While a
zero correlation between two assets returns is better than positive correlation, it does not
provide the risk reduction results of a negative correlation coefficient.
It can be useful to note, that when investor knows correlation coefficient, the
covariance between stocks A and B can be estimated, because standard deviations of the
assets’ rates of return will already are available:

Therefore, as it was pointed out earlier, the covariance primarily provides

information to the investor about whether the relationship between asset returns is positive,
negative or zero, because simply observing the number itself without any context with
which to compare the number, is not very useful. When the covariance is positive, the
correlation coefficient will be also positive, when the covariance is negative, the correlation
coefficient will be also negative. But using correlation coefficients instead of covariance
investor can immediately asses the degree of relationship between assets returns.
The coefficient of determination (Det.AB) is calculated as the square of
correlation coefficient:
Det.A, B = k²A,B (2.13)

The coefficient of determination shows how much variability in the returns of one
asset can be associated with variability in the returns of the other. For example, if correlation
coefficient between returns of two assets is estimated + 0,80, the coefficient of
determination will be 0,64. The interpretation of this number for the investor is that
approximately 64 percent of the variability in the returns of one asset can be explained by
the returns of the other asset. If the returns on two assets are perfect correlated, the
coefficient of determination will be equal to 100 %, and this means that in such a case if
investor knows what will be the changes in returns of one asset he / she could predict
exactly the return of the other asset.

Relationship between the returns on stock and market portfolio

 When picking the relevant assets to the investment portfolio on the basis of their
risk and return characteristics and the assessment of the relationship of their returns investor
must consider to the fact that these assets are traded in the market.
The characteristic line and the Beta factor
Before examining the relationship between a specific asset and the market portfolio
the concept of “market portfolio” needs to be defined. Theoretical interpretation of the
market portfolio is that it involves every single risky asset in the global economic system,
and contains each asset in proportion to the total market value of that asset relative to the
total value of all other assets (value weighted portfolio). But going from conceptual to
practical approach - how to measure the return of the market portfolio in such a broad its
understanding - the market index for this purpose can be used. Investors can think of the
market portfolio as the ultimate market index. And if the investor following his/her
investment policy makes the decision to invest, for example, only in stocks, the market
portfolio practically can be presented by one of the available representative indexes in
particular stock exchange.

The most often the relationship between the asset return and market portfolio return
is demonstrated and examined using the common stocks as assets, but the same concept can
be used analyzing bonds, or any other assets. With the given historical data about the returns
on the particular common stock (rJ) and market index return (rM) in the same periods of
time investor can draw the stock’s characteristic line
Stock’s characteristic line:
describes the relationship between the stock and the market;

shows the return investor expect the stock to produce, given that a particular
rate of return appears for the market;
helps to assess the risk characteristics of one stock relative to the market.
Stock’s characteristic line as a straight line can be described by its slope and
by point in which it crosses the vertical axis - intercept (point A in Fig. 2.8.).

The slope of the characteristic line is called the Beta factor. Beta factor for the
stock J and can be calculated using following formula:

Cov (rJ,rM)
βJ = ------------------- , (2.14)
 δ²(rM)

here: Cov(rJ,rM) – covariance between returns of stock J and the market portfolio;
δ²(rM) - variance of returns on market portfolio.

The Beta factor of the stock is an indicator of the degree to which the stock reacts to
the changes in the returns of the market portfolio. The Beta gives the answer to the investor
how much the stock return will change when the market return will change by 1 percent.
Further in Chapter 3 the use of Beta factor in developing capital
asset pricing model will be discussed.
Intercept AJ (the point where characteristic line passes through the vertical
axis) can be calculated using following formula:

AJ = rJ - βJ . rM, (2.15)

here: rJ - rate of return of stock J;

βJ - Beta factor for the stock J; rM -

rate of return of the market.

The intercept technically is a convenient point for drawing a characteristic line. The
interpretation of the intercept from the investor’s point of view is that it shows what would
be the rate of return of the stock, if the rate of return in the market is zero.

2.3.2. Residual variance

The characteristic line is a line-of-best-fit through some data points. A characteristic
line is what in statistics is called as time-series regression line. But in
reality the stock produce returns that deviate from the characteristic line (see Fig. 2.8). In
statistics this propensity is called the residual variance.

To calculate residual variance the residual in every period of observations must be

identified. Residual is the vertical distance between the point which reflect the pair of
returns (stock J and market) and the characteristic line of stock J.
It is useful for the interpretation of residual to investor to accentuate two
components in formula of residual
• Component 1 reflects the return actually generated by the stock J during period t;
• Component 2 (in the bracket) represents investor’s expectations for the
 stock’s return, given its characteristic line and market’s returns.
Note the difference between the variance and the residual variance:

The variance describes the deviation of the asset returns from its expected value ;
The residual variance describes the deviation of the asset returns from its
characteristic line.

Arbitrage Pricing Theory (APT)

APT was propsed ed by Stephen S.Rose and presented in his article „The arbitrage
theory of Capital Asset Pricing“, published in Journal of Economic Theory in
1976. Still there is a potential for it and it may sometimes displace the CAPM. In the CAPM
returns on individual assets are related to returns on the market as a whole. The key point
behind APT is the rational statement that the market return is determined by a number of
different factors. These factors can be fundamental factors or statistical. If these factors are
essential, there to be no arbitrage opportunities there must be restrictions on the investment
process. Here arbitrage we understand as the earning of riskless profit by taking advantage
of differential pricing for the same assets or security. Arbitrage is is widely applied
investment tactic.

APT states, that the expected rate of return of security J is the linear function from the
complex economic factors common to all securities and can be estimated
relating diversified portfolios, on assumption that the asset unsystematic (specific) risks are
negligable compared with the factor risks.
 Unit-III

BOND ANALYSIS AND VALUATION

AND MANAGEMENT
Introduction
Fixed income financial instruments which, traditionally, have been identified as a long-term
source of funds for a corporate enterprise are the cherished conduit for investor’s money. An
assured return and high interest rate are responsible for the preference of bonds over
equities. The year 1996-97 witnessed hectic trading in the debt market, as resource
mobilization reached a record level of almost Rs. 25,000 crores which was much above the
equity segment. In the first seven months of the fiscal year 1998-99, the funds mobilized by
ICICI (Four debt issues) and IDBI have accounted for 90 per cent of Rs. 3,175 Crores
mopped in the primary market. Financial institutions, banks and corporate bodies are
offering attractive bonds like retirement bonds, education bonds, deep discount bonds,
encash bonds, money multiplier bonds and index bonds. Knowing how to value fixed
income securities (bonds) is important both for investors
and managers. Such knowledge is helpful to the former in deciding whether they should buy
or sell or hold securities at prices prevailing in the market.

Bond valuation-Terminology
A bond or debenture is a debt instrument issued by the government or a government agency
or a business enterprise
Par Value- It is the value stated on the face of the bond. It represents the amount the firm
borrows and promises to repay at the time of maturity. Usually the par or face value of
bonds issued by business firms is Rs. 100. Sometimes it can be Rs. 1000.
Coupon Rate and Interest- A bond carries a specific interest rate which is called the coupon
rate. The interest payable to the bond holder is simply par value of the bond × coupon rate.
Most bonds pay interest semi-annually. For example, a GOI security which has a par value
of Rs. 1000 and a coupon rate of 11 per cent pays an interest of Rs. 55 every six months.
Maturity Period- Typically, bonds have a maturity period of 1-10 years; sometimes they
have a longer maturity. At the time of maturity the par (face) value plus perhaps a nominal
premium is payable to the bondholder.
The time value concept
The time value concept fo money is that the rupee received today is more valuable than a
rupee received tomorrow. The investor will postpone current consumption only if he could
earn more future consumption opportunities through investment. Individuals generally
prefer current consumption to future consumption. If there is inflation
in the economy, a rupee today will represent more purchasing power than a rupee at a future
date. Interest is the rent paid to the owners to part their money. The interest that the
borrower pays to the lender causes the money to have a future value different from its
present value. The time value of money makes the rupee invested today grow more than a
rupee in the future. To quantify this concept mathematically compounding and
discounting principles are used. The one period future time value of money is given by the
equation:
Future Value = present value (1 + interest rate). If hundred rupees are put in a savings bank
account in a bank for one year, the future value of money will be:
Future Value = Rs. 100 (1.0 + 6%)
= 100 × 1.06 = Rs. 106.
If the deposited money is allowed to cumulate for more than one time, the period exponent
is added to the previous equation.
Future value = (Present Value) (1 + interest rate)t
t- the number of time periods the deposited money accumulates as interest.
Suppose Rs. 100 is put for two years at the 6% rate of interest, money will grow to be Rs.
112.36.
Future Value = Present value (1 + interest rate)2
= 100 (1 + 0.06)2
= 100 (1.1236)
= 112.36.
Bonds classification by their key features:

By form of payment:

1 Nonintersecting bearing bonds - bonds issued at a discount. Throughout the bond’s

life its interest is not earned, however the bond is redeemed at maturity for face
value.
2 Regular serial bonds - serial bonds in which all periodic installments of principal
repayment are equal in amount.
3 Deferred –interest bonds –bonds paying interest at a later date;

4 Income bonds – bonds on which interest is paid when and only when earned by the
issuing firm;

5 Indexed bonds - bonds where the values of principal and the payout rise with
inflation or the value of the underlying commodity;

6 Optional payment bonds – bonds that give the holder the choice to receive payment
on interest or principal or both in the currency of one or more foreign countries, as
well as in domestic currency.

Coupon payment:
• Coupon bonds – bonds with interest coupons attached;

• Zero-coupon bonds – bonds sold at a deep discount from its face value and
redeemed at maturity for full face value. The difference between the cost of the bond
and its value when redeemed is the investor’s return. These securities provide no
interest payments to holders;
• Full coupon bonds – bonds with a coupon rate near or above current market interest
rate;

• Floating-rate bonds – debt instruments issued by large corporations and financial

organizations on which the interest rate is pegged to another rate, often the Treasury-
bill rate, and adjusted periodically at a specified amount over that rate.

Collateral:

9. Secured bonds – bonds secured by the pledge of assets (plant or equipment), the title
to which is transferred to bondholders in case of foreclosure;

• Unsecured bonds – bonds backed up by the faith and credit of the issuer instead of
the pledge of assets.

• Debenture bonds – bonds for which there is no any specific security set aside or
allocated for repayment of principal;

• Mortgage bonds (or mortgage-backed securities) – bonds that have as an underlying

security a mortgage on all properties of the issuing corporation;
 • Sinking fund bonds – bonds secured by the deposit of specified amounts. The
issuing corporation makes these deposits to secure the principal of the bonds, and it
is sometimes required that the funds be invested in other securities;
• Asset-Backed Securities (ABS) – similar to mortgage bonds, but they are backed by a
pool of bank loans, leases and other assets. The ABS are related with the new
market terminology – securitization which understood as the process of
transforming lending vehicles such as mortgages into marketable securities. The
main features of ABS for investor: relatively high yield, shorter maturities (3 -5
years) and monthly, rather than semiannual principal/ interest payments. From their
introducing to the market they were ranked as high credit quality instruments. But
the recent financial crises showed that these debt instruments could be extremely
risky investment when banks loans portfolios as a guarantee of ABS become
worthless causing banks’ insolvency problems.

• General obligation bonds – bonds, secured by the pledge of the issuer’s full faith
and credit, usually including unlimited tax-power;
• Guaranteed bonds – bonds which principal or income or both are guaranteed by
another corporation or parent company in case of default by the issuing corporation;
• Participating bonds – bonds which, following the receipt of a fixed rate of periodic
interest, also receive some of the profit generated by issuing business;
• Revenue bonds – bonds whose principal and interest are to be paid solely from
earnings.

1. Bond analysis: structure and contents

Similar to analysis when investing in stocks investor before buying bonds must
evaluate a wide range of the factors which could influence his/ her investment results. The
key factors are related with the results of the performance and the financial situation of the
firm which is issuer of the bonds. Various indicators are used for the evaluation of these
factors.
Bond analysis includes:
Quantitative analysis.
Qualitative analysis.
 7. Quantitative analysis.
Quantitative indicators – the financial ratios which allows assessing the financial
situation, debt capacity and credibility of the company –issuer of the bonds.

Since the bonds are debt instruments and the investor in bonds really becomes the
creditor the most important during analysis is the assessment of the credibility of the firm –
issuer of the bonds. Basically this analysis can be defined as the process of a ssessment the
issuer’s ability to undertake the liabilities in time. Similar to the performing of fundamental
analysis for common stock, bond analysis (or credit analysis) uses financial ratios. However
the analysis of bonds differs from the analysis of stock, because the holder of the regular
bonds has not any benefit of the fact that the income of the firm is growing in the future and
thus the dividends are growing – these things are important to the share holder. Instead of
this investor in bonds is more interested in the credibility of the firm, its financial stability.
Estimation of financial ratios based on the main financial statements of the firm (Balance
sheet; Profit/ loss statement; Cash flow statement, etc.) is one of the key instruments of
quantitative analysis. Some ratios used in bond analysis are the same as in the stock
analysis. But most important financial ratios for the bond analysis are:
1. Debt / Equity ratio;
2. Debt / Cash flow ratio;
3. Debt coverage ratio;
4. Cash flow / Debt service ratio.

Qualitative analysis
Qualitative indicators are those which measure the factors influencing the
credibility of the company and most of which are subjective in their nature and
valuation, are not quantifiable.
Although the financial ratios discussed above allows evaluating the credit situation of
the firm, but this evaluation is not complete. For the assessment of the credibility of the
firm necessary to analyze the factors which are not quantifiable. Unfortunately the
nature of the majority of these factors and their assessment are subjective wherefore it is
more difficult to manage these factors. However, this part of analysis in bonds based on
the qualitative indicators is important and very often is the dividing line between
effective and ineffective investment in bonds.
Groups of qualitative indicators/ dimensions:
 Economic fundamentals (the current economic climate – overall
economic and industry-wide factors);
Market position (market dominance and overall firm size: the larger firm
– the stronger is its credit rating);
Management capability (quality of the firm’s management team); Bond
market factors (term of maturity, financial sector, bond
quality, supply and demand for credit);
Bond ratings (relationship between bond yields and bond quality).

Analysis of Economic fundamentals is focused on the examining of business

cycle, the macroeconomic situation and the situation of particular sectors / industries in the
country’s economy. The main aim of the economic analysis is to examine how the firm
would be able to perform under the favorable and unfavorable conditions, because this is
extremely important for the investor, when he/ she is attempting to evaluate his/ her risk
buying the bonds of the firm.
Market position is described by the firm’s share in the market and by the size of the
firm. The other conditions being equal, the firm which share in the market is lager and
which is larger itself generally has credit rating higher. The predominance of

the firm in the market shows the power of the firm to set the prices for its goods and
services. Besides, the large firms are more effective because of the effect of the production
scale, their costs are lower and it is easier for such firms overcome the periods of falls in
prices. For the smaller firms when the prices are increasing they are performing well but
when the markets are slumping – they have the problems. Thus it is important for the
creditor to take it in mind.
Management capability reflects the performance of the management team of the
firm. It is often very difficult to assess the quality of the management team, but the result of
this part of analysis is important for the investor attempting to evaluate the quality of the
debt instruments of the firm. The investors seeking to buy only high quality (that means –
low risk) bonds most often are choosing only those firms managers of which follow the
conservative policy of the borrowing. Contrary, the risk-taking investors will search for the
firms which management uses the aggressive policy of borrowing and are running with the
high financial leverage. In general the majority of the holders of the bonds first of all are
want to know how the firm’s managers control the costs and what they are doing to control
and to strengthen the balance sheet of the firm (for this purpose the investor must analyze
the balance sheet for the period of 3-5 years and to examine the tendencies in changes of the
balance sheet main elements.

Bond market factors (term of maturity, financial sector, bond quality, supply and
demand for credit); The investor must understand which factors and conditions have the
influence on the yield and the prices of the bonds. The main factors to be mentioned are:
1. Term to maturity. Generally term to maturity and the interest rate (the yield) of
the bond are directly related; thus, the bonds with the longer term to maturity
have the higher yield than the bonds with shorter terms to maturity.
2. The sector in the economy which the issuer of the bonds represents. The yields
of the bonds vary in various sectors of the economy; for example, generally the
bonds issued by the utility sector firms generate higher yields to the investor than
bonds in any other sector or government bonds.
3. The quality of the bonds. The higher the quality of the bond, the lower the
yield. For the bonds with lower quality the yield is higher.

• The level of inflation; the inflation decreases the purchasing power of the future
income. Since the investors do not want to decrease their real yield generated
from the bonds cash flows, they require the premium to the interest rate to
compensate for their exposure related with the growing inflation. Thus the yield
of the bond increases (or decreases) with the changes in the level of inflation.
• The supply and the demand for the credit; The interest rate o the price of
borrowing money in the market depend on the supply and demand in the credit
market; When the economy is growing the demand for the funds is increasing
too and the interest rates generally are growing. Contrary, when the demand for
the credits is low, in the period of economic crises, the
interest rates are relatively low also.

Bond ratings. The ratings of the bonds sum up the majority of the factors which
were examined before. A bond rating is the grade given to bonds that indicates their credit
quality. Private independent rating services such as Standard & Poor's, Moody's and Fitch
provide these evaluations of a bond issuer's financial strength, or it’s the ability to pay a
bond's principal and interest in a timely fashion. Thus, the role of the ratings of the bonds as
the integrated indicator for the investor is important in the evaluation of yield and prices for
the bonds. The rating of the bond and the yield of the bond are inversely related: the higher
the rating, the lower the yield of the bond. Bond ratings are expressed as letters ranging from
'AAA', which is the highest grade, to 'C' ("junk"), which is the lowest grade. Different rating
services use the same letter grades, but use various combinations of upper- and lower-case
letters to differentiate themselves (see more information about the bond ratings in Annex 1
and the relevant websites of credit ratings agencies).

Market interest rates analysis

It s very important for the investor to the bonds to understand what causes the changes in the
interest rates in the market in the different periods of time. We could observe frequent
changes in the interest rates and the wide amplitude of it fluctuations during last decade,
thus the interest rates became the crucial factor in managing fixed income securities
portfolios as well as stock portfolios. The understanding of the macroeconomic processes
and the causality of the various economic factors with the interest rates helps the investors to
forecast the direction of the changes in interest
rates. At the macroeconomic level the relationship between the interest rate and the level of
savings and investments, changes in government spending, taxes, foreign trade balance is
identified.

Macroeconomic factors with positive influence to the interest rates (from the investors in
bonds position - increase in interest rates):
• Increase in investments;
• Decrease in savings level;
• Increase in export;
• Decrease in import;
• Increase in government spending;
• Decrease in Taxes.

Macroeconomic factors with negative influence to the interest rates (from the
investors in bonds position - decrease in interest rates):
 • Decrease in investments;
• Increase in savings level;
• Decrease in export;
• Increase in import;
• Decrease in government spending;
• Increase in Taxes.

By observing and examining macroeconomic indicators presented above the investors can
assess the situation in the credit securities market and to revise his/ her portfolio

Investment in bonds decision making process:

1. Selection of bond’s type according to the investor’s goals (expected income
and risk).
2. Bond analysis (quantitative and qualitative).
3. Bond valuation.
4. Investment decision making.

There are three widely used measures of the yield:

Current Yield
Yield-to-Maturity

Yield- to- Call

Current yield (CY) is the simples measure of bond‘s return and has a imitated
application because it measures only the interest return of the bond. The interpretation of
this measure to investor: current yield indicates the amount of current income a bond
provides relative to its market price. CY is estimated using formula:

CY = I / Pm ,

here: I - annual interest of the bond;

Pm - current market price of the bond
Yield- to- Maturity (YTM) is the most important and widely used measure of
the bonds returns and key measure in bond valuation process. YTM is the fully compounded
rate of return earned by an investor in bond over the life of the security, including inter est
income and price appreciation. YTM is also known as the promised-yield-to- maturity.
Yield-to-maturity can be calculated as an internal rate of return of the bond or the discount
rate, which equalizes present value of the future cash flows of the bond to its current market
price (value). Then YTM of the bond is calculated from this equation:

n
P = Σ Ct / (1 + YTM) t + Pn / (1 + YTM)ⁿ ,
t=1
here: P - current market price of the bond;
n - number of periods until maturity of the bond;
Ct - coupon payment each period;
YTM - yield-to-maturity of the bond;
Pn - face value of the bond.
As the callable bond gives the issuer the right to retire the bond prematurely,
so the issue may or may not remain outstanding to maturity. Thus the YTM may not always
be the appropriate measure of value. Instead, the effect of the bond called away prior to
maturity must be estimated. For the callable bonds the yield-to-call (YTC) is used. YTC
measures the yield on the bond if the issue remains outstanding not to maturity, but rather
until its specified call date. YTC can be calculated similar to YTM as an internal rate of
return of the bond or the discount rate, which equalizes present value of the future cash
flows of the bond to its current market price (value). Then
YTC of the bond is calculated from this equation:

P = Σ Ct / (1 + YTC) t + Pc / (1 + YTC) m,
t=1

here: P- current market price of the callable bond;

n - number of periods to call of the bond;
Ct - coupon payment each period before the call of the bond;
YTC - yield-to-call of the bond;
Pc - call price of the bond.
But the result from the estimation of the yields using the current market price
could be a relevant measure for investment decision making only for those investors
who believe that the bond market is efficient (see chapter 3.4). For the others who do not
believe that market is efficient, an important question is if the bond in the market is over
valuated or under valuated? To answer this question the investor need to estimate the
intrinsic value of the bond and then try to compare this value with the current market value.
Intrinsic value of the bond (V) can be calculated from this equation:

n
V = Σ C t / (1 + YTM*) t + Pn / (1 + YTM*)ⁿ,
t=1

here: YTM* - appropriate yield-to-maturity for the bond, which depends on the
investor’s analysis – what yield could be appropriate to him/ her on this
particular bond;
n - number of periods until maturity of the bond;
Ct - coupon payment each period;
Pn - face value of the bond.

The decision for investment in bond can be made on the bases of two alternative
approaches: (1) using the comparison of yield-to-maturity and appropriate yield-to-maturity
or (2) using the comparison of current market price and intrinsic value of the bond (similar
to decisions when investing in stocks). Both approaches are based on the capitalization of
income method of valuation.

(1) approach:
If YTM > YTM* - decision to buy or to keep the bond as it is under valuated;
If YTM < YTM * - decision to sell the bond as it is over valuated;

If YTM = YTM * - bond is valuated at the same range as in the market

and its current market price shows the intrinsic value.

(2) approach:
If P > V - decision to buy or to keep the bond as it is under valuated;
If P < V - decision to sell the bond as it is over valuated;
If P = V - bond is valuated at the same range as in the market and its
current market price shows the intrinsic value.
Strategies for investing in bonds. Immunization
Two types of strategies investing in bonds:
Passive management strategies;
Active management strategies.

Passive bond management strategies are based on the proposition that bond prices
are determined rationally, leaving risk as the portfolio variable to control. The
main features of the passive management strategies:
2. They are the expression of the little volatile in the investor’s forecasts
regarding interest rate and/ or bond price;
3. Have a lower expected return and risk than do active strategies;
4. The small transaction costs.

The passive bond management strategies include following two broad classes of
strategies:
Buy and hold strategies; Indexing strategies.

Buy and hold strategy is the most passive from all passive strategies. This is strategy
for any investor interested in nonactive investing and trading in the market. An important
part of this strategy is to choose the most promising bonds that meet the investor’s
requirements. Simply because an investor is following a buy-and-hold strategy does not
mean that the initial selection is unimportant. An investor forms the diversified portfolio of
bonds and does not attempt to trade them in search for the higher return. Following this
strategy, the investor has to make the investment decisions only in these cases:
• The bonds held by investor lost their rating, it decreases remarkably;
• The term to maturity ended;
The bonds were recalled by issuer before term to maturity

Using Indexing strategy the investor forms such a bond portfolio which is identical
to the well diversified bond market index. While indexing is a passive strategy, assuming
that bonds are priced fairly, it is by no means a simply strategy. Each of the broad bond
indexes contains thousands of individual bonds. The market indices are continually
rebalanced as newly issued bonds are added to the index and existing bonds are dropped
from the index as their maturity falls below the year. Information and transaction costs make
it practically impossible to purchase each bond in proportion to the index. Rather than
replicating the bond index exactly, indexing typically uses a stratified sampling approach.
The bond market is stratified into several subcategories based on maturity, industry or credit
quality. For every subcategory the percentage of bonds included in the market index that fall
in that subcategory is computed. The investor then constructs a bond portfolio with the
similar distribution across the subcategories.
There are various indexing methodologies developed to realize this passive strategy.
But for all indexing strategies the specific feature is that the return on bond portfolio
formed following this strategy is close to the average bond market return.

Active bond management strategies are based on the assumption that the bonds
market is not efficient and, hence, the excess returns can be achieved by forecasting future
interest rates and identifying over valuate bonds and under valuated bonds.
There are many different active bond management (speculative) strategies. The main
classes of active bond management strategies are:
The active reaction to the forecasted changes of interest rate;
Bonds swaps; Immunization.

The essentiality of the active reaction to the anticipated changes of interest rate
strategy: if the investor anticipates the decreasing in interest rates, he / she is attempting to
prolong the maturity of the bond portfolio or duration, because long-term bonds’ prices
influenced by decrease in interest rates will increase more than short-term bonds’ prices; if
the increase in interest rates is anticipated, investor attempts to shorten the maturity of the
bond portfolio or duration, by including more bonds with the shorter maturity of the
portfolio.

The essentiality of bond swaps strategies is the replacement of the bond which is in
the portfolio by the other bond which was not in the portfolio for the meantime. The aim of
such replacement - to increase the return on the bond portfolio based on the assumptions
about the tendencies of changes in interest rates. There are various types of swaps, but all
are designed to improve the investor’s portfolio position. The bond swaps can be:
1 Substitution swap;
 2 Interest rate anticipation swap;
3 Swaps when various bond market segments are used.
The essentiality of substitution swap: one bond in the portfolio is replaced by the
other bond which fully suits the changing bond by coupon rate, term to maturity, credit
rating, but suggests the higher return for the investor. The risk of substitution swap can be
determined by the incorrect rating of the bonds and the exchange of the unequal bonds
causing the loss of the investor.
Interest rate anticipation swap is based on one of the key features of the bond

– the inverse relationship between the market price and the interest rate (this means that
when the interest rates are growing, the bonds prices are decreasing and vice versa. The
investor using this strategy bases on his steady belief about the anticipated changes of
interest rates and attempts to change frequently the structure of his/ her bond portfolio
seeking to receive the abnormal return from the changes in bonds’ prices. This type of swaps
is very risky because of the inexact and unsubstantiated forecasts about the changes in the
interest rates.

Swaps when various bond market segments are used are based on the assessment
of differences of yield for the bonds in the segregated bond market segments.

The differences of the yields in the bond market are called yield spreads and their
existence can be explained by differences between
• Quality of bonds credit (ratings);
• Types of issuers of the bonds (government, company, etc.);
• The terms to maturity of the bonds (2 years, 5 years, etc.).

This strategy is less risky than the other swaps’ strategies; however the return for
such a portfolio is lower also.

Duration is the present value weighted average of the number of years over which investors
receive cash flow from the bond. It measures the economic life or the effective maturity of a
bond (or bond portfolio) rather than simply its time to maturity. Such concept, called
duration (or Macaulay's duration) was developed by Frederick Macaulay. Duration
measures the time structure of a bond and the bond’s interest rate risk. The time structure
ways. The common way to state is how many years until the bond matures and the principal
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 interest coupons and the principal is
recovered. This is called Macaulay’s duration. Duration is defined as the weighted average
of time periods to maturity, weights being present values of the cash flow in each time
period.
Duration and price changes-
The price of the bond changes according to the interest rate. Bond’s price changes are
commonly called bond volatility. Duration analysis helps to find out the bond price changes
as the yield to maturity changes. The relationship between the duration of a bond and its
price volatility for a change in the market

Immunization:
Immunization is a technique that makes the bond portfolio holder to be relatively certain
about the promised stream of cash flows. The bond interest rate risk arises from the changes
in the market interest rate. The market rate affects the coupon rate and the price of the bond.
In the immunization process, the coupon rate risk and the price risk can be made to offset
each other. Whenever there is an increase in the market interest rate, the prices of the bonds
fall. At the same time the newly issued bonds offer higher interest rate. The coupon can be
reinvested in the bonds offering higher interest rate and losses that occur due to the fall in
the price of bond can be offset and the portfolio is said to be immunized.
 Unit-IV
EQUITY VALUATION AND DERIVATIVES
Share valuation
Share valuation is the process of assigning a rupee value to a specific share. An ideal share
valuation technique would assign an accurate value to all shares. Share valuation is a
complex topic and no single valuation model can truly predict the intrinsic value of a share.
Likewise, no valuation model can predict with certainty how the price of a share will vary in
the future. However, valuation models can provide a basis to compare the relative merits of
two different shares. Common ways for equity valuations could be classified into the
following categories:
1. Earnings valuation
2. Cash flow valuation
3. Asset valuation
4. Dividend-discount model

Earnings valuation
Earnings (net income or net profit) is the money left after a company meets all its
expenditure. To allow for comparisons across companies and time, the measure of earnings
is stated as earnings per share (EPS). This figure is arrived at by dividing the earnings by the
total number of shares outstanding. Thus, if a company has one crore shares outstanding and
has earned Rs. 2 crore in the past 12 months, it has an EPS of Rs. 2.00. Rs.
20,000,000/10,000,000 shares = Rs. 2.00 earnings per share EPS alone would not be able to
measure if a company’s share in the market is undervalued or overalued. Another measure
used to arrive at investment valuation is the Price/Earnings (P/E) ratio that relates the market
price of a share with its earnings per share. The P/E ratio divides the share price by the EPS
of the last four quarters. For
example, if a company is currently trading at Rs. 150 per share with a EPS of Rs. 5 per
share, it would have a P/E of 30. The P/E ratio or multiplier has been used most often to
make an investment decision. A high P/E multiplier implies that the market has overvalued
the security and a low P/E multiplier gives the impression that the market has undervalued
the security. When the P/E multiple is low, it implies that the earnings per share is
comparatively higher than the prevailing market price. Hence, the
conclusion that the company has been ‘undervalued’ by the market. Assume a P/E multiplier
of 1.0. The implication is that the earnings per share is equal to the prevalent market price.
While market price is an expectation of the future worth of the firm, the earnings per share is
the current results of the firm. Hence, the notion that the firm has been ‘undervalued’ by the
market. On the other hand, a high P/E ratio would imply that the market is ‘overvaluing’ the
security for a given level of earnings.

Earnings forecast
Earnings can be forecast through the forecasts of the rates resulting in the earnings. The
variables that can be considered for forecasting earnings can be the future return on assets,
expected financial cost (interest cost), the forecasted leverage position (debt equity ratio),
and the future tax obligation of the company. The formula for
forecasting the earnings could be stated as follows:
Forecasted earnings (value) = (1-t)*[ROA + (ROA-I)*(D/E)]*E
Where,
ROA = Forecasted return on assets
I = Future interest rate
D = Total expected long term debt
E = Expected equity capital
t = Expected tax rate

Cash flows valuation

Cash flows indicate the net of inflows less outflows from operations. Cash flows differ from
book profits reported by companies since accounting profits identify expenses that are non-
cash items such as depreciation. Cash flows can also be used in the valuation of shares. It is
used for valuing public and private companies by investment
bankers. Cash flow is normally defined as earnings before depreciation, interest, taxes, and
other amortisation expenses (EBDIT). There are also valuation methods that use free cash
flows. Free cash flows is the money earned from operations that a business
can use without any constraints. Free cash flows are computed as cash from operations less
capital expenditures, which are invested in property, plant and machinery and so on.
EBDIT is relevant since interest income and expense, as well as taxes, are all ignored
because cash flow is designed to focus on the operating business and not secondary costs or
profits. Taxes especially depend on the legal rules and regulation of a given year and hence
can cause dramatic fluctuations in earning power. The company makes tax provisions in the
year in which the profits accrue while the real tax payments will be made the following year.
This is likely to overstate/ understate the profit of the current year.
Depreciation and amortisation, are called non-cash charges, as the company is not actually
spending any money on them. Rather, depreciation is an accounting allocation for tax
purposes that allows companies to save on capital expenditures as plant and equipment age
by the year or their use deteriorates in value as time goes by.
Amortisation is writing off a capital expenses from current year profit. Such amortised
expenses are also the setting aside of profit rather than involving real cash outflows.
Considering that they are not actual cash expenditures, rather than accounting profits, cash
profits will indicate the real strength of the company while evaluating its worth in the
market.
Cash flow is most commonly used to value industries that involve tremendous initial
project (capital) expenditures and hence have large amortisation burdens. These companies
take a longer time to recoup their initial investments and hence tend to report negative
earnings for years due to the huge capital expense, even though their cash flow has actually
grown in these years.

Asset valuation
Expectation of earnings, and cash flows alone may not be able to identify the correct
value of a company. This is because the intangibles such as brand names give credentials for
a business. In view of this, investors have begun to consider the valuation of equity through
the company’s assets.
Asset valuation is an accounting convention that includes a company’s liquid assets such
as cash, immovable assets such as real estate, as well as intangible assets. This is an overall
measure of how much liquidation value a company has if all of its assets were sold off. All
types of assets, irrespective of whether those assets are office buildings, desks, inventory in
the form of products for sale or raw materials and so on are considered for valuation.
Asset valuation gives the exact book value of the company. Book value is the value of a
company that can be found on the balance sheet. A company’s total asset value is divided by
the current number of shares outstanding to calculate the book value per share. This can also
be found through the following method- the value of the total
assets of a company less the long-term debt obligations divided by the current number of
share outstanding. The formulas for computing the book value of the share are given
below:
Book value = Equity worth (capital including reserves belonging to shareholders)/Number
of outstanding shares
Book value = (Total assets – Long-term debt)/Number of outstanding shares
Book value is a simple valuation model. If the investor can buy the shares from the
market at a value closer to the book value, it is most valuable to the investor since it is like
gaining the assets of the company at cost. However, the extent of revaluation reserve that
has been created in the books of the company may distract the true value
of assets. The revaluation reserve need not necessarily reflect the true book value of the
company; on the other hand, it might be depicting the market price of the assets better.

Dividend discount model

According to the dividend discount model, conceptually a very sound approach, the value
of an equity share is equal to the present value of dividends expected from its ownership
plus the present value of the sale price expected when the equity share is sold. For applying
the dividend discount model, we will make the following assumptions:
(i) dividends are paid annually- this seems to be a common practice for business
firms in India; and
(ii) the first dividend is received one year after the equity share is bought.
Single-period valuation model
Let us begin with the case where the investor expects to hold the equity share for one year.
The price of the equity share will be:

P0 =D/(1 + r) +P/(1 + r)

Where, P0 = current price of the equity share;

D1 = dividend expecteda year hence;
P1 = price of the share expected a year hence; and
r =rate of return required on the equity share.

Expected rate of return

In the preceding discussion we calculated the intrinsic value of an equity share, given
information about (i) the forecast values of dividend and share price, and (ii) the required
rate of return. Now we look at a different question: What rate of return can the investor
expect, given the current market price and forecast values of dividend and share price
The expected rate of return is equal to:
R = D1/P0 + g

Example. The expected dividend per share of Vaibhav Limited is Rs. 5.00. The dividend is
expected to grow at the rate of 6 per cent per year. If the price per share now is Rs. 50.00,
what is the expected rate of return?
Applying Equation, the expected rate of return is:
R = 5/50 + 0.06 = 16 per cent

Multi-period valuation Model

Since equity shares have no maturity period, they may be expected
to bring a dividend stream of infinite duration. Hence the value of an
equity share may be put as:
P0 =D/(1 + r)1+D/(1 + r)2+ ... +D/(1 + r)n+P/(1 + r)n
= Σn t=D/(1 + r)t+P/(1 + r) n

Zero Growth model

If we assume that the dividend per share remains constant year after year at a value of D
P0 =D/r

Constant growth model

One of the most popular dividend discount models assumes that the dividend per share
grows at a constant rate (g). The value of a share, under this assumption,

P0 =D/r - g

Two stage growth model

The simplest extension of the constant growth model assumes that extraordinary growth
(good or bad) will continue for a finite number of years and thereafter normal growth rate
will prevail indefinitely.

Impact of growth on price, returns, and P/E Ratio

The expected growth rates of companies differ widely. Some companies are expected to
remain virtually stagnant or grow slowly; other companies are expected to show normal
growth; still others are expected to achieve supernormal growth rate. Assu ming a constant
total required return, differing expected growth rates mean differing stock prices, dividend
yields, capital gains yields, and price-earnings ratios.

Multi-factor share valuation

Quantitative approaches convert a hypothetical relationship between numbers into a unique
set of equations. These equations mostly consider company-level data such as market
capitalisation, P/E ratio, book-to-price ratio, expectations in earnings, and so on.
Quantitative methods assume that these factors are associated with shares returns,
and that certain combinations of these factors can help in assessing the value and, further,
predict future values. When several factors are expected to influence share price, a multi-
factor model is applied in share valuation. The choice of the right combination of factors,
and how to weigh their relative importance (that is, predicting factor returns) may be
achieved through quantitative multivariate statistical tools. Many factors that have been
considered individually can be combined to arrive at a best-fit model for valuing equity
shares. Value factors such as price to book, price to sales, and P/E or growth factors such as
earnings estimates or earnings per share growth rates, can be used to develop the
quantitative model. These quantitative models
help to determine what factors best determine valuation during certain market periods.
These multifactor share valuation models can also be used to forecast future share values.

Factors influence risk: What makes financial assets risky. Traditionally, investors have
talked about several factors causing risk such as business failure, market fluctuations,
change in the interest rate inflation in the economy, fluctuations in exchange rates changes
in the political situation etc. Based on the factors affecting the risk the risk can be
understood in following manners-

Interest rate risk: The variability in a security return resulting from changes in the level of
interest rates is referred to as interest rate risk. Such changes generally affect securities
inversely, that is other things being equal, security price move inversely to interest rate.
Market risk: The variability in returns resulting from fluctuations in overall market that is,
the agree get stock market is referred to as market risk. Market risk includes a wide range of
factors exogenous to securities themselves, like recession, wars, structural changes in the
economy, and changes in consumer preference. The risk of going down with the market
movement is known as market risk.
Inflation risk: Inflation in the economy also influences the risk inherent in investment. It
may also result in the return from investment not matching the rate of increase in general
price level (inflation). The change in the inflation rate also changes the consumption pattern
and hence investment return carries an additional risk. This risk is related to interest rate
risk, since interest rate generally rises as inflation increases, because lenders demands
additional inflation premium to compensate for the loss of purchasing power.
Business risk: The changes that take place in an industry and the environment Causes risk
for the company in earning the operational revenue creates business risk. For example the
traditional telephone industry faces major changes today in the rapidly changing
telecommunication industry and the mobile phones. When a company fails to earn through
its operations due to changes in the business situations leading to erosion of capital, there by
faces the business risk.

Financial risk: The use of debt financing by the company to finance a larger proportion of
assets causes larger variability in returns to the investors in the faces of different business
situation. During prosperity the investors get higher return than the average return the
company earns, but during distress investors faces possibility of vary low return or in the
worst case erosion of capital which causes the financial risk. The larger the proportion of
assets finance by debt (as opposed to equity) the larger the variability of returns thus lager
the financial risk.

Liquidity risk: An investment that can be bought or sold quickly without significant price
concession is considered to be liquid. The more uncertainty about the time element and the
price concession the greater the liquidity risk. The liquidity risk is the risk associated with
the particular secondary market in which a security trades.

Exchange rate risk: The change in the exchange rate causes a change in the value of
foreign holdings, foreign trade, and the profitability of the firms, there by returns to the
investors. The exchange rate risk is applicable mainly to the companies who operate
oversees. The exchange rate risk is nothing but the variability in the return on security
caused by currencies fluctuation.

Political risk: Political risk also referred, as country risk is the risk caused due to change in
government policies that affects business prospects there by return to the investors. Pol icy
changes in the tax structure, concession and levy of duty to products, relaxation or
tightening of foreign trade relations etc. carry a risk component that changes the return
pattern of the business.

TYPES OF RISK
Thus far, our discussion has concerned the total risk of an asset, which is one important
consideration in investment analysis. However modern investment analysis categorizes the
traditional sources of risk identified previously as causing variability in returns into two
general types: those that are pervasive in nature, such as market risk or interest rate risk, and
those that are specific to a particular security issue, such as business or financial risk.
Dividing total risk in to its two components, a general (market) component and a specific
(issue ) component, we have systematic risk and unsystematic risk which are additive:
Total risk = general risk + specific risk
= market risk + issuer risk
= systematic risk + non systematic risk
Systematic risk: Variability in a securities total return that is directly associated with
overall moment in the general market or economy is called as systematic risk. This risk
cannot be avoided or eliminated by diversifying the investment. Normally diversification
eliminates a part of the total risk the left over after diversification is the non-diversifiable
portion of the total risk or market risk. Virtually all securities have some systematic risk
because systematic risk directly encompasses the interest rate, market and inflation risk. The
investor cannot escape this part of the risk, because no matter how well he or she diversifies,
the risk of the overall market cannot be avoided. If the stock market declines sharply, most
stock will be adversely affected, if it rises strongly, most stocks will appreciate in value.

Systematic risk: Variability in a securities total return that is directly associated with
overall moment in the general market or economy is called as systematic risk. This risk
cannot be avoided or eliminated by diversifying the investment. Normally diversification
eliminates a part of the total risk the left over after diversification is the non-diversifiable
portion of the total risk or market risk. Virtually all securities have some systematic risk
because systematic risk directly encompasses the interest rate, market and inflation risk. The
investor cannot escape this part of the risk, because no matter how well he or she diversifies,
the risk of the overall market cannot be avoided. If the stock market declines sharply, most
stock will be adversely affected, if it rises strongly, most stocks will appreciate in value.

Systematic risk: Variability in a securities total return that is directly associated with
overall moment in the general market or economy is called as systematic risk. This risk
cannot be avoided or eliminated by diversifying the investment. Normally diversification
eliminates a part of the total risk the left over after diversification is the non-diversifiable
portion of the total risk or market risk. Virtually all securities have some systematic risk
because systematic risk directly encompasses the interest rate, market and inflation risk. The
investor cannot escape this part of the risk, because no matter how well he or she diversifies,
the risk of the overall market cannot be avoided. If the stock market declines sharply, most
stock will be adversely affected, if it rises strongly, most stocks will appreciate in value.

Non-systematic risk: Variability in a security total return not related to overall market
variability is called un systematic (non market) risk. This risk is unique to a particular
security and is associated with such factors as business, and financial risk, as well as
liquidity risk. Although all securities tend to have some nonsystematic risk, it is generally
connected with common stocks.

The terms multiplier and price earnings ratio (P/E) are used interchangeably.
Thus:
Earnings multiplier = P/E ratio = Current market price/ Estimated earnings per share

DERIVATIVES:
The term ‘Derivative’ stands for a contract whose price is derived from or is dependent upon
an underlying asset. The underlying asset could be a financial asset such as currency, stock
and market index, an interest bearing security or a physical commodity. As Derivatives are
merely contracts between two or more parties, anything like weather data or amount of rain
can be used as underlying assets
Participants in Derivative markets
 • Hedgers use futures or options markets to reduce or eliminate the risk associated
with price of an asset.
• Speculators use futures and options contracts to get extra leverage in betting on
future movements in the price of an asset
• Arbitrageurs are in business to take advantage of a discrepancy between prices in
two different markets
BASIC TERMINOLOGIES,
• Spot Contract: An agreement to buy or sell an asset today.
• Spot Price: The price at which the asset changes hands on the spot date.
• Spot date: The normal settlement day for a transaction done today.
• Long position: The party agreeing to buy the underlying asset in the future assumes
a long position.
• Short position: The party agreeing to sell the asset in the future assumes a short
position
Delivery Price: The price agreed upon at the time the contract is entered into

FORWARD CONTRACT:
• Forward is a non-standardized contract between two parties to buy or sell an asset at
a specified future time at a price agreed today.
For Example: If A has to buy a share 6 months from now. and B has to sell a share worth
Rs.100. So they both agree to enter in a forward contract of Rs. 104. A is at “Long Position”
and B is at “Short Position” Suppose after 6 months the price of share is Rs.110. so, A
overall gained Rs. 4 but lost Rs. 6 while B made an overall profit of Rs. 6
FUTURES CONTRACT:
• Futures contract is a standardized contract between two parties to exchange a
specified asset of standardized quantity and quality for a price agreed today (the
futures price or the strike price) with delivery occurring at a specified future date,
the delivery date.
• Since such contract is traded through exchange, 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.
OPTIONS
• An option is a derivative financial instrument that specifies a contract between two
parties for a future transaction on an asset at a reference price.
• The buyer of the option gains the right, but not the obligation, to engage in that
transaction, while the seller incurs the corresponding obligation to fulfill the
transaction.
• Call Option: Right but not the obligation to buy
• Put Option: Right but not the obligation to sell
• Option Price: The amount per share that an option buyer pays to the seller
• Expiration Date: The day on which an option is no longer valid
• Strike Price: The reference price at which the underlying may be traded
• Long Position: Buyer of an option assumes long position
• Short Position: Seller of an option assumes short position

SWAP CONTRACT
The derivative in which counterparties exchange certain benefits of one party's
financial instrument for those of the other party's financial instrument. The benefits
in question depend on the type of financial instruments involved. The types of Swaps
are:
• Interest rate swaps
• Currency swaps
• Commodity swaps
• Equity Swap
• Credit default swaps
 Unit-V
MUTUAL FUNDS
 Meaning of Portfolio Revision:
A portfolio is a mix of securities selected from a vast universe of securities.
Two variables determine the composition of a portfolio; the first is the securities
included in the portfolio and the second is the proportion of total funds invested in
each security.

Portfolio revision involves changing the existing mix of securities. This may
be effected either by changing the securities currently included in the portfolio or by
altering the proportion of funds invested in the securities. New securities may be
added to the portfolio or some of the existing securities may be removed from the
portfolio. Portfolio revision thus leads to purchases and sales of securities. The
objective of portfolio revision is the same as the objective of portfolio selection, i.e.
maximising the return for a given level of risk or minimising the risk for a given
level of return. The ultimate aim of portfolio revision is maximisation of returns and
minimisation of risk.

Constraints in portfolio revision:

Portfolio revision is the process of adjusting the existing portfolio in
accordance with the changes in financial markets and the investor‘s position so as to
ensure maximum return from the portfolio with the minimum of risk. Portfolio
revision or adjustment necessitates purchase and sale of securities. The practice of
portfolio adjustment involving purchase and sale of securities gives rise to certain
problems which act as constraints in portfolio revision. Some of these are as under:

Transaction cost:

Buying and selling of securities involve transaction costs such as commission and
brokerage. Frequent buying and selling of securities for portfolio revision may push up
transaction costs thereby reducing the gains from portfolio revision. Hence, the transaction
costs involved in portfolio revision may act as a constraint to timely revision of portfolio

Taxes:
Tax is payable on the capital gains arising from sale of securities. Usually,
 long-term capital gains are taxed at a lower rate than short-term capital gains. To
qualify as long-term capital gain, a security must be held by an investor for a period
of not less than 12 months before sale. Frequent sales of securities in the course of
periodic portfolio revision or adjustment will result in short-term capital gains which
would be taxed at a higher rate compared to long-term capital gains. The higher tax
on short-term capital gains may act as a constraint to frequent portfolio revision.

Statutory stipulations:
The largest portfolios in every country are managed by investment
companies and mutual funds. These institutional investors are normally governed by
certain statutory stipulations regarding their investment activity. These stipulations
often act as constraints in timely portfolio revision.

Intrinsic difficulty:
Portfolio revision is a difficult and time consuming exercise. The
methodology to be followed for portfolio revision is also not clearly established.
Different approaches may be adopted for the purpose. The difficulty of carrying out
portfolio revision itself may act as a constraint to portfolio revision.

Portfolio revision strategies:

Two different strategies may be adopted for portfolio revision, namely an
active revision strategy and a passive revision strategy. The choice of the strategy
would depend on the investor‘s objectives, skill, resources and time.

Active revision strategy involves frequent and sometimes substantial adjustments to

the portfolio. Investors who undertake active revision strategy believe that security markets
are not continuously efficient. They believe that securities can be mispriced at times giving
an opportunity for earning excess returns through trading in them. Moreover, they believe
that different investors have divergent or heterogeneous expectations regarding the risk and
return of securities in the market. The practitioners of active revision strategy are confident
of developing better
Formula plans:
In the market, the prices of securities fluctuate. Ideally, investors should buy
when prices are low and sell when prices are high. If portfolio revision is done
according to this principle, investors would be able to benefit from the price
fluctuations in the securities market. But investors are hesitant to buy when prices are
low either expecting that prices will fall further lower or fearing that prices would
not move upwards again. Similarly, when prices are high, investors hesitate to sell
because they feel that prices may rise further and they may be able to realize larger
profits.
Constant Rupee value plan:
This is one of the most popular or commonly used formula plans. In this plan,
the investor constructs two portfolios, one aggressive, consisting of equity shares
and the other, defensive, consisting of bonds and debentures. The purpose of this
plan is to keep the value of the aggressive portfolio constant, i.e. at the original
amount invested in the aggressive portfolio.

As share prices fluctuate, the value of the aggressive portfolio keeps

changing. When share prices are increasing, the total value of the aggressive
portfolio increases. The investor has to sell some of the shares from his portfolio to
bring down the total value of the aggressive portfolio to the level of his original
Constant Ratio plan:
This is a variation of the constant rupee value plan. Here again the investor
would construct two portfolios, one aggressive and the other defensive with his
investment funds. The ratio between the investments in aggressive portfolio and the
defensive portfolio would be predetermined such as 1:1 or 1.5:1 etc. The purpose of
this plan is to keep this ratio constant by readjusting the two portfolios when share

prices fluctuate from time to time. For this purpose, a revision point will also have to
be predetermined.
Dollar cost averaging:
This is another method of passive portfolio revision. All formula plans
assume that stock prices fluctuate up and down in cycles. Dollar cost averaging
utilizes this cyclic movement in share prices to construct a portfolio at low cost.
PORTFOLIO EVALUATION:
Portfolio evaluation is the last step in the process of portfolio management. It
is the stage when we examine to what extent the objective has been achieved. It is
basically the study of the impact of investment decisions. Without portfolio
evaluation, portfolio management would be incomplete. It has evolved as an
important aspect of portfolio management over the last two decades.

Evaluation of mutual funds:

In India, at present, there are many mutual funds as also investment companies
operating both in the public sector as well as in the private sector. These compete
with each other for mobilising the investment funds with individual investors and
other organisations by offering attractive returns, minimum risk, high safety and
prompt liquidity. Investors and organisations desirous of placing their funds with
these mutual funds would like to know the comparative performance of each so as to
select the best mutual fund or investment company. For this, evaluation of the
performance of mutual funds and their portfolios becomes necessary.

Evaluation Perspective:
A portfolio comprises several individual securities. In the building up of the
portfolio several transactions of purchase and sale of securities take place. Thus,
several transactions in several securities are needed to create and revise a portfolio of
securities. Hence, the evaluation may be carried out from different perspectives or
viewpoints such a transactions view, security view or portfolio view.

Transaction view:
An investor may attempt to evaluate every transaction of purchase and sale of
securities. Whenever a security is bought or sold, the transaction is evaluated as
regards its correctness and profitability.

Security view:
Each security included in the portfolio has been purchased at a particular
price. At the end of the holding period, the market price of the security may be
higher or lower than its cost price or purchase price. Further, during the holding
period, interest or dividend might have been received in respect of the security. Thus,
it may be possible to evaluate the profitability of holding each security separately.
This is evaluation from the security viewpoint.

Portfolio view:
A portfolio is not a simple aggregation of a random group of securities. It is a
combination of carefully selected securities, combined in a specific way so as to
reduce the risk of investment to the minimum. An investor may attempt to evaluate
the performance of the portfolio as a whole without examining the performance of
individual securities within the portfolio. This is evaluation from the portfolio view.
Measuring Portfolio Return:
The first step in portfolio evaluation is calculation of the rate of return earned
over the holding period. Return may be defined to include changes in the value of the
portfolio over the holding period plus any income earned over the period. However,
in the case of mutual funds, during the holding period, cash inflows into the fund and
cash withdrawals from the fund may occur. The unit-value method may be used to
calculate return in this case.

Net Asset Value (NAV) Rp= (NAVt-NAVt-1)+ Dt+ Ct /NAVt-1

= Cash disbursements per unit during the holding period.

= Capital gains disbursements per unit during the holding period.

NAVt =NAV per unit at the end of the holding period.

NAVt-1= NAV per unit at the beginning of the holding period

Risk adjusted Returns:

One obvious method of adjusting for risk is to look at the reward per unit of
risk. We know that investment in shares is risky. Risk free rate of interest is the
return that an investor can earn on a riskless security, i.e. without bearing any risk.
The return earned over and above the risk free rate is the risk premium that is the
 reward for bearing risk. If this risk premium is divided by a measure of risk, we get
the risk premium per unit of risk. Thus, the reward per unit of risk for different
portfolios or mutual funds may be calculated and the funds may be ranked in
descending order of the ratio. A higher ratio indicates better performance.

Portfolio Beta can be used as an indication of the amount of market risk that the
portfolio had during the time interval. It can be compared directly with the betas of other
portfolios.
You cannot compare the ex post or the expected and the expected return of two
portfolios without adjusting for risk. To adjust the return for risk before comparison of
performance risk adjusted measures of performance can be used:
 Sharpe’s ratio;
 Treynor’s ratio;
 Jensen’s Alpha.

Sharpe’s ratio shows an excess a return over risk free rate, or risk premium, by unit
of total risk, measured by standard deviation:

Sharpe’s ratio = (řp– řf) / σp,

here: řp - the average return for portfolio p during some period of time;
řf - the average risk-free rate of return during the period;
σp - standard deviation of returns for portfolio p during the period.

Treynor’s ratio shows an excess actual return over risk free rate, or risk premium,
by unit of systematic risk, measured by Beta:

Treynor’s ratio = (řp –řf) / βp,

here: βp – Beta, measure of systematic risk for the portfolio p.

Jensen‘s Alpha shows excess actual return over required return and excess of
actual risk premium over required risk premium. This measure of the portfolio manager’s
performance is based on the CAPM
Jensen’s Alpha = (řp– řf) – βp (řm –řf),
here: řm - the average return on the market in period t;
(řm –řf) - the market risk premium during period t.
It is important to note, that if a portfolio is completely diversified, all of these

measures (Sharpe, Treynor’s ratios and Jensen’s alfa) will agree on the ranking of the
portfolios. The reason for this is that with the complete diversification total variance is equal
to systematic variance. When portfolios are not completely diversified, the Treynor’s and
Jensen’s measures can rank relatively undiversified portfolios much higher than the Sharpe
measure does. Since the Sharpe ratio uses total risk, both systematic and unsystematic
components are included.
Decomposition of Performance:
The performance measures access the overall performance of a portfolio or
fund. Eugene Fama has provided an analytical framework that allows a detailed
breakdown of a fund‘s performance into the source or components of performance.
This is known as the Fama decomposition of total return.

The total return on a portfolio can be firstly divided into two components,
namely risk free return and the excess return. Thus,

Total risk = Risk free return + Excess return

TRENDS IN INDIAN MUTUAL FUNDS

• Mutual funds in India began in 1964

• Unit Trust of India (UTI) was the first MF company
• Remains the market leader even today, Having about 68% of the market share
• Lost monopoly in 1987 With entry of public sector mutual funds Promoted by public
sector banks and insurance companies
• Industry was open to foreign institutions in 1993
• In 1963, finance minister Shri T. Krishnaswami gave the idea of mutual funds.
• The origin of mutual fund industry in India is with the introduction of the concept of
mutual fund by UTI in the year 1963.
• The first scheme launched by UTI was Unit Scheme in 1964.
 At the end of 1988 UTI had Rs.6,700 crores of assets under management
• Though the growth was slow, but it accelerated from the year 1987 when non-UTI
players entered the industry.
• SBI Mutual Fund was the first non- UTI Mutual Fund established in June 1987
– followed by:-
Punjab National Bank Mutual Fund (Aug 89),
Indian Bank Mutual Fund (Nov 89),
Bank of India (Jun 90),
Bank of Baroda Mutual Fund (Oct 92)
• The private sector entry to the MF rose the AUM to Rs. 470 bn in March 1993.
• The 1993 SEBI (Mutual Fund) Regulations were substituted by a more
comprehensive and revised Mutual Fund Regulations in 1996.
• The industry now functions under the SEBI (Mutual Fund) Regulations 1996.
• The number of mutual fund houses went on increasing, with many foreign mutual
funds setting up funds in India.
• The industry has also witnessed several mergers and acquisitions.
• At the end of January 2003, there were 33 mutual funds with total assets of Rs.
1,21,805 crores.
• The Unit Trust of India was having highest Rs.44,541 crores of assets under
management in year 2003.
• SEBI Removed Entry Load in MF on 1 August, 2009
• Introduction of Purchase/Sale facility through Stock Exchanges November, 2009
• National Stock Exchange (NSE) launched India's first Mutual Fund Service System
(MFSS) on November 30, 2009 through which an investor can subscribe or redeem
units of a mutual fund scheme

Meaning of Portfolio Revision: A portfolio is a mix of securities selected from a vast

universe of securities. Two variables determine the composition of a portfolio; the first is the
securities included in the portfolio and the second is the proportion of total funds invested in
each security. Portfolio revision involves changing the existing mix of securities. This may
be effected either by changing the securities currently included in the portfolio or by altering
the proportion of funds invested in the securities. New securities may be added to the
portfolio or some of the existing securities may be removed from the portfolio. Portfolio
revision thus leads to purchases and sales of securities. The objective of portfolio revision is
the same as the objective of portfolio selection, i.e. maximising the return for a given level
of risk or minimising the risk for a given level of return. The ultimate aim of portfolio
revision is maximisation of returns and minimisation of risk.

Portfolio revision strategies: Two different strategies may be adopted for portfolio
revision, namely an active revision strategy and a passive revision strategy. The choice of
the strategy would depend on the investor‘s objectives, skill, resources and time.
Active revision strategy involves frequent and sometimes substantial adjustments to the
portfolio. Investors who undertake active revision strategy believe that security markets are
not continuously efficient
Passive revision strategy, in contrast, involves only minor and infrequent adjustment to
the portfolio over time. The practitioners of passive revision strategy believe in market
efficiency and homogeneity of expectation among investors. They find little incentive for
actively trading and revising portfolios periodically. Under passive revision strategy,
adjustment to the portfolio is carried out according to certain predetermined rules and
procedures designated as formula plans. These formula plans help the investor to adjust his
portfolio according to changes in the securities market.

Prepared by
M.RAMESH, Assistant Professor
Department of MBA
 Nature and Scope of
UNIT 1 NATURE AND SCOPE OF Investment Decisions

INVESTMENT DECISIONS
Objectives
• After reading this unit, you should be able to :
• Explain the concept of investment in general
• Distinguish investment and speculation
• Discuss the process involved in investment decisions
• Explain investment environment, alternatives and markets.
Structure
1.1 Investment : An Introduction
12 Nature of Investment Decisions
1.3 The investment Decision Process
1.4 The Investment Environment
1.4.1 Financial Instruments
1.4.2 Financial Intermediaries
1.4.3 Financial Markets
1.5 Summary
1.6 Key Words
1.7 Self-Assessment Questions/Exercises
1.8 Further Readings

1.1 INVESTMENT : AN INTRODUCTION

Individuals like you invest money for various reasons. It could be that :
1. You or your family may be earning more than what is required for monthly
expenses and thus would like to keep the money in a safe place and also allow
the savings to earn a return during the period.
2. You may not have regular surplus but may get occasional one-time surplus
earnings such as annual bonus from your employer or sale of some family
property. You would like to keep such money for some time, when you don't
required, in some safe place and also allow such savings to earn a return during
the period.
We also invest money on education of our children like our parents did. Just as
individuals do, organizations too make investments. For example, you might have
read news items like Reliance Industries investing Rs. 1000 Cr. for expansion of its
petrochemical division.
The above examples underline the following characteristics of an `investment'
decision : One, it involves the commitment of funds available with you or that you
would be getting in the future. Two, the investment leads to acquisition of a plot,
house, or shares and debentures. Three, the physical or financial assets you have
acquired is expected to give certain benefits in the future periods. The benefits may
be in the form of regular revenue over a period of time like interest or dividend or
sales or appreciation after some point of time as normally happens in the case of
investments in land or precious metals.
The investment decisions being studied in this unit as well as the course MS-44,
relate to financial assets bulk of which comprise pieces of paper evidencing a claim
of the holder (i.e., investor) over the issuer (i.e., user of funds). For example, when
you buy shares of, say, Infosys or A.C.C., the share certificate that is handed over to
5
you is a piece of paper
An Overview
which testifies your ownership of the number of shares stated in the certificate. It
represents your financial claim (as a holder of the said shares) over Infosys or
A.C.C., (as issuers of the shares). The same can be said of units of UTI or any other
mutual fund scheme like the Mastershare or any security like a debenture, a warrant a
convertible, etc., of a company. Unlike promoters of companies, several buyers of
these securities hold them for limited period and then sell them. The reasons for
selling the financial assets could vary from person to person. If an investor needs
money for other expenditure like marriage or education, she or he could sell some of
the financial assets like shares/ bonds. Similarly, if an investor finds that his expected
return for the financial asset is realized, she or he can sell the same and use the
money to buy some other securities. It is also possible that some of these high-risk
takers speculate in financial securities. Investors of different kinds look out for
investments, which can be sold in organized markets with ease and at best obtainable
prices. Financial assets, which are tradeable with ease and at best prices in organized
markets, are known as `marketable securities'.
It may be appropriate at this juncture to define the term `investment' in a general
sense. Investment takes place when an investor postpones her/his consumption,
which is initially converted into savings and subsequently into investments. By not
spending the entire amount of your salary, you are saving a part of your salary
income for the future needs. Savings of this kind run into risk of loss of value
because of inflation. In order to prevent erosion of value of your savings, the amount
saved has to be invested at least by depositing the amount in savings bank account.
You have several options if the money you are saving is not required in the near
future and the number of options increases further, if you are willing to assume a bit
of risk in your investment. Remember without taking risk, it is not possible to expect
a higher return. Some of the investment options available to you are time deposit
(fixed deposit) of bank, bonds and debenture of financial institutions or companies,
mutual funds, futures, options, etc.
It is interesting to observe that all investment decisions arise from a 'trade-off'
between current and future consumption. An example would make this idea clear.
We can assume an individual who has Rs. 50,000, which he can either spend on
current consumption or invest, say, for one year at 11 per cent interest. This person's
current consumption (Co) can range from Rs. zero (when he invests the whole of Rs.
50,000) to Rs. 50,000 (when he does not invest a single rupee).

Figure 1.1: Trade-off between present and future consumption

Similarly, his future consumption (CI) can be as high as Rs. 55,500 (when he invests
the whole of Rs. 50,000 at 11 per cent per annum and ends up with a total wealth of
Rs. 50,000 + Rs. 5,500 = Rs. 55,500 at the end of the year, Rs. 5,500 being interest
earnings on Rs. 50,000 at 1 I per cent) to as low as Rs. zero (when he consumes the
whole of Rs. 50,000 right now).
In most such cases, individuals would consume a part and invest the rest. Such a
situation is called a 'trade-off between current and future possibilities for our
hypothetical individual on the trade-off function MN. Our investor is on point `X'
which suggests that he spends Rs. 30,000 today and invests the balance Rs. 20,000 to
6 get a total sum of Rs. 22,000, which includes interest of Rs. 2,000, at 11 per cent after
one year.
Having defined `investment' in terms of `postponed consumption' we must get ready Nature and Scope of
to answer an inescapable question viz., why should a person postpone his/her present Investment Decisions
consumption? This question acquires added significance because we know that
individual generally prefer current consumption to future consumption. And if they
are required to invest or postpone current consumption there must be commensurate
inducement. This underlines the need for a positive rate of return on all potential
investment without which a person would prefer to consume all his income today
rather than tomorrow. Such an investment /consumption behaviour is founded on an
important concept known as `time preference for money'. This concept signifies `a
rupee today is worth more than tomorrow'. The `tomorrow' must promise a larger
wealth to give incentive to forego current consumption. The next natural question is
how much the return should he larger to attract investment?
You will readily notice that a nominal rate of return may well be fully swallowed
away by the inflation. For example, if you earn an interest rate (nominal) of 11 per
cent for one year on your investment and face the threat of an 1 I per cent price rise
(inflation) too during that year, where do you stand in terms of purchasing power of
your money? What happens in a situation like this is that the I 1 per cent nominal
return is neutralized by 11 per cent inflation and you remain after one year where you
were a year ago. It is, therefore, natural that an investor would be induced to
postpone consumption today only if his command over goods and services does not
get diluted over time. Thus, if he gets 11 per cent nominal interest and 11 per cent is
the rate of inflation, his real rate of return would be zero. In the event of inflation
what induces investors to postpone current consumption is the real rate of return and
not just the monetary rate of return. There is yet another dimension to the rate of
return as an incentive to invest. For example, if a person buys, say, government
securities she/he is completely assured of all payments viz., interest and principal. In
such cases, a relatively lower rate of return is adequate as an incentive. But if the
avenue of investment is a company debenture, the probability of default does exist
even if the rate of interest and the repayment schedules are known in advance. The
investor here perceives some risk and would insist upon an additional compensation.
In other words, the investor requires a risk premium over and above the risk free rate.
This extra reward or risk premium would have to be substantially greater in the case
of shares of companies where the dividend rates are not ascertainable in advance and
where payment of such dividends and invested sums are not at all assured. What we
are trying to underline through these examples is the `risk' factor which effects the
expected rates of return by investors. In all these cases, investors demand a risk
premium. It would thus be seen that the investor's required rate of return would be an
aggregate of the risk-free real rate, expected rate of inflation, and risk premium.
Investments in securities on average offer adequate return to compensate the risk
assumed by the investors. But one has to wait for a longer period to realize such extra
return for the additional risk assumed particularly incase of investments in stocks. In
other words, if the holding period of an investment is short, then high-risk securities
may not offer adequate return to compensate the risk ,you have assumed. You might
have recognized the existence of `speculators' in the securities markets. They invest
in high risk securities for a short period and hence exposed to high level of risk.
Speculators may loose their entire wealth or become rich in a short period of time.
How are they different from that of normal investors? We can distinguish the two
operators as follows:
i) The time-horizon of a speculator is short while that of the investor is long.
ii) The investor expects a `good' return and a consistent performance over time but
the speculator expects abnormal returns earned quickly over short periods.
iii) The investor generally sticks to his investment, but the speculator makes rapid
shifts to greener pastures. He moves from one stock to other for a small profit.
iv) The investor is risk-averse but the speculator takes greater risks. Often,
speculators .take risk by entering into margin trading (i.e. use borrowed funds) to
increase the volume and his exposure in the market.
7
If speculation is high-risk game, why do exchanges allow such trading? They essentially
provide liquidity for the securities and often match the demand and supply of the market.
An Overview
For example, positive news on a firm may attract a large demand for the stock. In the
absence of any sellers, the price will shoot up. Some speculators may take a different
view and willing to sell the stock to meet the excess demand of the market. Similarly,
a mutual fund may wants to sell 1 lakhs shares of a company. If there are limited
buyers for the stock, the stock price would crash. Again, speculators would buy the
stock in anticipation of selling the same at a small profit once the demand for the
stock picks up in the market.

Activity-I

i) A young couple buys a flat for Rs 3 lakh with a 25 per cent down payment and
the balance in 100 equal monthly instalments. Would you consider the
investment a case of postponed consumption? Why?

……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………

ii) Distinguish between a speculator and an investor.

……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………

iii) You can make a visit to the nearest NSE Dealer and interview ten clients. Apply
above stated tests to find the number of investors who are investors and those
who are speculators. Find the turnover and holding period of the speculators and
investors. Don't be surprised if some of the speculators sell the stock within five
minutes of its purchase. They are called day-traders in the new computer-based
trading system.

……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………

1.2 NATURE OF INVESTMENT DECISIONS

You have seen in Section 1.1 that an individual invests `postpones consumption' only
in response to a rate of return, which must be suitably adjusted for inflation and risk.
This basic postulate, in fact, unfolds the nature of investment decisions. Let us
explain as follows:

Cash has an opportunity cost and when you decide to invest it you are deprived of this
opportunity to earn a return on that cash. Also, when the general price level rises the
purchasing power of cash declines - larger the increase in inflation, the greater the
depletion in the buying power of cash. This explains the reason why individuals require
a ‘real rate of return’ on their investments. Now, within the large body of investors,
some buy government securities or deposit their money in bank accounts that are
adequately secured. In contrast, some others prefer to buy, hold, and sell equity shares
even when they know that they get exposed to the risk of losing their much more than
those investing in government securities. You will find that this latter group of
investors is working towards the goal of getting larger returns than the first group and,
in the process, does not mind assuming greater risk. Investors, in general, want to earn
as large returns as possible subject, of course, to the level of risk they can possibly
8 bear.
The risk factor gets fully manifested in the purchase and sale of financial assets, Nature and Scope of
especially equity shares. It is common knowledge that some investors lose even when Investment Decisions
the securities markets boom. So there lies the risk.
You may understand risk, as the probability that the actual return on an investment
will be different from its expected return. Using this definition of risk, you may
classify various investments into risk categories.
Thus, government securities would be seen as risk-free investments because the
probability of actual return diverging from expected return is zero. In the case of
debentures of a company like TELCO or GRASIM, again the probability of the
actual return being different from the expected return would be very little because the
chance of the company defaulting on stipulated interest and principal repayments is
quite low. You would obviously put equity shares in the category of `high risk'
investment for the simple reason that the actual return has a great chance of differing
from the expected return over the holding period of the investor, which may range
from one day to a year or more.
Investment decisions are premised on an important assumption that investors are
rational and hence prefer certainty to uncertainty. They are risk-averse which implies
that they would be unwilling to take risk just for the sake of risk. They would assume
risk only if an adequate compensation is forthcoming. And the dictum of `rationality'
combined with the attitude of `risk aversion' imparts to investments their basic nature.
The question to be answered is: how best to enlarge returns with a given level of
risk? Or, how best to reduce risk for a given level of return? Obviously, there would
be several different levels of risks and different associated expectations of return. The
basic investment decision would be a trade-off between risk and return.
Figure 1.2 depicts the risk-return trade-off available to rational investors. The line
RF_M shows the risk-return function i.e., a trade-off between expected return and risk
that exists for all investors interested in financial assets. You may notice that the Ry
M line always slopes upward because it is plotted against expected return, which has
to increase as risk rises. No rational investor would assume additional risk unless
there is extra compensation for it. This is how his expectations are built. This is,
however, not the same thing as the actual return always rising in response to
increasing risk. The risk-return trade-off is figured on `expected or anticipated (i.e.,
ex-ante) return' and not on actual or realized (ex-post) return'. Actual return will also
be higher for high-risk securities, if you plot long-term return of these investments. It
is relatively easier to show evidence for this in debt instruments. For example,
Treasury Bills offers lowest return among the government securities because of their
short-term nature. Government bonds with a long-term maturity offer a return higher
than treasury bills because they are exposed to interest rate risk. We will discuss
more when we cover bond analysis. Corporate bonds offer a return more than
government bonds because of default risk. The return ranges from 12% to 18%
depending on the credit rating of the bond. The returns of all these securities are less
volatile compared to equity return. The long-term return of BSE Sensitive Index is
around 18%.

9
Figure 1.2: The Expected Return-Risk trade-off functions
An Overview
You may now look at Figure 1.2 to understand the relative positioning of different
financial assets on the risk-return map. The point RF is the expected return on
government securities where risk is zero and is recognized as the risk-free rate. As
you move on the RF_M line, you find successive points, which show the increase in
expected return as risk increase. Thus, equity shares, which carry lot more of risk
than government securities and company debentures are plotted higher on the line.
Company debentures are less risky than equity because of the mortgages and
assurances made available to the investor but more risky than government securities
where the default risk is zero because government generally does not fail. They are
placed between the two securities viz., government securities and equity shares.
Warrants, options and financial futures are other specialized financial assets ranked
in order of rising risk. We shall know more about these investments in a latter unit.
An important point deserves attention while interpreting the risk-return trade-off of
the type presented in Figure 1.2. It shows a simple fact. Financial securities are of
different types and they offer different risk-return combination. The risk and return
also move together. Thus, if an investor is not willing to assume any risk, she/he will
have to be satisfied with the risk-free rate i.e., RF by investing the wealth in
government securities. There are several options to investors. They can buy some
small savings (like NSC, PPF, Indira-Vikas Patra, etc.) or invest the amount in a
mutual funds scheme, which specializes in government securities. If you are not
happy with 8% or 9% return of government securities, you can move to next security
that offers higher return. But there is a cost associated with such higher return.
Investors in corporate bonds have to bear additional risk compared to investors of
government securities. One of the important sources of additional risk is default risk
since companies may fail to honour the interest and principal liability. As you move
on the ladder, you can expect a higher return but your risk also increases. Investors
need to strike a balance when they allocate their wealth under various investments. If
some one invests their entire savings only in government securities or only in high-
risk securities like equity or derivatives, it may not yield desired result. Investors
need to balance the investments by partly investing in equities and partly in
government securities. The proportion of investment can be changed depending on
the economic outlook. Allocation of wealth on different securities and periodical
revision should be an integral part of your investment strategy. We will discuss more
on this strategy in the next section as well as in a separate unit.
1.3 THE INVESTMENT DECISION PROCESS
In the last two sections, we emphasized two important issues namely the need for
converting savings into investments and a balanced approach in selection of
securities. Investment process gives you a methodology of achieving the above two
objectives. A lot of planning is required while investing your hard-earned money in
securities. Often investors lose money when they make investments without any
planning. They make hasty investment decision when the market and economy was at
its peak based on some recommendation. Some of you might have invested during
secondary market boom of 1992 and primary market boom of 1994-95. Many
investors of those times are yet to recover their losses. In the year 1999-2000,
investors of several software stocks, both in primary and secondary market, have lost
heavily. In all these cases, the problem is lack of planning and to an extend greed.
Both are not good for making a decent return on investment. A typical investment
decision undergoes a five-step procedure, which in turn forms the basis of the
investment process. These steps are:
1) Determine the investment objectives and policy
2) Undertake security analysis
3) Construct a portfolio
4) Review the portfolio
5) Evaluate the performance of the portfolio
You may note at the very outset that this five-step procedure is relevant not only for an
individual who is on the threshold of taking his own investment decisions but also for
individuals and institutions who have to aid and work out investment decisions for
10 others
i.e., for their clients. The investment process is a key-process entailing the whole body of Nature and Scope of
security analysis and portfolio management. Let us, now, discuss the steps involved in the Investment Decisions
investment process in detail:
1. Investment objectives and Policy
The investor will have to work out his investment objectives first and then evolve a
policy with the amount of investible wealth at his command. An investor might say that
his objective is to have `large money'. You will agree that this would be a wrong way of
stating the objective. You would recall that the pursuit of 'large-money' is not possible
without the risk of 'large losses'. The objective should be in clear and specific terms. It
can be expressed in terms of expected return or expected risk. Suppose, an investor can
aim to earn 12% return against the risk-free rate of 9%. It means the investor is willing to
assume some amount of risk while making investment. Alternatively, the investor can set
her or his preference on risk by stating that the risk of investment should be below market
risk. In specific terms, she or he can say that beta of the portfolio has to be 0.80. If the
investor defines one of the two parameters of investment (return or risk), it is possible to
find the other one because a definite relationship exists between the two in the market. It
may not be possible for you to define both return and risk because it may not be
achievable. For example, if you want to earn a return of 12% with zero risk when
government securities offer a return of 9%, it would not be possible to develop an
investment for you. Thus, it is desirable to set one of the two parameters (risk or return)
and find the other one from the market. If necessary, an investor can revise the objective
if sheik finds the risk is too high for her/him to bear a desired return. Though setting an
investment objective is good, many investors fail to do the same and blindly invest their
money without bothering the risk associated with such investments. Investments are
bound to fail if an investor ignores this point.
The next step in formulating the investment policy of an investor would be the
identification Of categories of financial assets he/she would be interested in. It is obvious
that this in turn, would depend on the objectives, amount of wealth and the tax status of
the investor. For example, a tax-exempt investor with large investible wealth like a
pension/provident fund would invest in anything but tax-exempt securities unless
compelled by law to do so. Some investors may entirely avoid derivatives because of
high risk associated with such investments. Some investors may invest more in equities to
earn higher return but use derivatives to reduce additional risk. As in consumer products,
financial products also come With different colours and flavors and one has to be highly
knowledgeable before selecting appropriate securities.
2. Security Analysis
After defining the investment objective and broadly setting the proportion of wealth to be
invested under different categories, the next step is selecting individual securities under
each category. For instance, if an investor sets 50% of her/his wealth to be invested in
government securities, the next question is which of the government securities that the
investments should be made. It should be noted that not all government securities are one
and the same. A long-term government bond is much riskier than short-term bonds.
Similarly, investment in equities requires identification of companies stocks, in Which
the investment can be made. Security analysis is often performed in two or three stages.
The first stage, called economic analysis, would be useful to set broad investment
objective. If the economy is expected to do well, investor can invest more in stocks. On
the other hand, if the economic slowdown is expected to continue, investor can invest less
in stocks and more in bonds. In stage two, investors typically examine the industries and
identify the industries, in which investment can be made. There are several classifications
of industry, which we will discuss in a separate unit. Investments need not be made in
any one specific industry because many of the stocks may be overpriced in a growth
industry. It is better to look for three to five industries and it depends on individual's
choice. The issue is an analysis of broad trends of industry and future outlook is essential
to proceed further on security analysis.
As the last step, one has to look into the fundamentals of specific companies and find
whether the stock is desirable for investment. At this stage, investors need to match the
risk-return objective she/he has set in the previous stage. Company specific analysis
includes examination of historical financial information as well as future outlook. Using 11
historical performance and future outlook, specifically the future cash flows are projected
An Overview
and discounted to present value. Through such analysis, analysts quantify the
intrinsic value of the stock and compare the same with current market price. If the
intrinsic value is greater than the current market price, the stock qualifies for
investment. For instance, if an investor based on her/his understanding and estimation
of cash flows finds the intrinsic value of Hindustan Lever is Rs. 300 against its
market price of Rs. 250, then the stock qualifies for investment.
Similar analysis has to be done for other stocks too. Since a large number of stocks
are traded in the market, it may be difficult to perform such analysis for all stocks.
Normally, investors use certain conditions to reduce the number of stocks for such
analysis. However, before investing in the stock, the investor would like to examine
whether the stock fits into the risk-return profile that was outlined earlier.
3. Portfolio Construction
In the previous stage, bonds and stocks, which fulfil certain conditions, are identified
for investments. Under portfolio construction stage, the investor has to allocate the
wealth to different stocks. A couple of principles guide such allocation of wealth.
Investors need to appreciate that the risk of portfolio comes down if the portfolio is
diversified. Diversification here doesn't mean more than one stock but stocks whose
future performance are not highly correlated. Further, too much diversification or too
many stocks may also create problem in terms of monitoring. For example, if the
investor decides to invest 10% of the wealth in software sector, it would be desirable
to restrict the investment in two or three stocks based on the amount of investment.
On the other hand, if she/he invests in 20 software stocks, the portfolio will become
too large and create practical problem of monitoring. While including stocks in the
portfolio, the investor has to watch its impact on the overall portfolio return and risk
and also examine whether it is consistent with the initial investment objective.
Portfolio construction is not done once for all. Since investors saving take place over
a period of time, portfolios are also constructed over a period of time. It is a
continuous exercise. Sometime, timing of investment may be critical. For instance, if
an investor saves Rs. 30,000 during the first quarter and the desired portfolio includes
both bonds and stocks, the issue before the investor is whether the amount has to be
used for bonds or stocks or both. It requires some further analysis at that point of
time. However, over the years, when the accumulated investments grow to certain
level, subsequent yearly investments as a proportion of total investments will become
smaller and hence the timing issue will become minor decision.
4. Portfolio Revision
Under portfolio construction, investor is matching the risk-return characteristics of
securities with the risk-return of investment objective. Under two conditions, the
securities, in which investment was made earlier, require liquidation and investing
the amount in a new security. The risk or expected return of the security might have
changed over a period of time when the business environment changes. For instance,
the software sector, which was showing 100% growth between 1995-2000 has
suddenly become risky after the U.S. slowdown. Many frontline companies have
revised their estimated earnings growth from 100% to 40%. The stock might also
become less risky but offer lower return. That is, when the risk-return characteristics
of securities change, it will affect the desired risk-return characteristics of portfolio
and hence calls for a revision of portfolio of stocks. Another reason for selling some
of the securities in the portfolio and buying a new one in its place is a change in
investment objective. For instance, when you are young and have less family
commitments, then your investment objective may aim for higher return even if it
amounts to higher risk. You may invest more of your savings in equity stocks and
derivatives. When your family grows, you might want to reduce the risk and change
the investment objective. Portfolio of securities has to be revised to reflect your new
investment objective. There is yet another reason for revision, which we discussed
earlier. When the macro-economic condition changes, you may want to shift part of
your investment from equity to debt or vice versa depending on the future economic
outlook.
5. Portfolio Performance Evaluation
The value of your investment changes over a period of time and it reflects the current
market value of the securities in the portfolio. For instance, if you have made some
12 investment in Hindustan Lever some 10 years back, when you first started investing, the
value of HLL today is several times more than its value some 10 years back. Few Nature and Scope of
stocks could have resulted in a loss and it would be difficult to construct a portfolio Investment Decisions
of stocks only with winner stocks. Portfolio return reflects the net impact of positive
and negative returns of individual securities in the portfolio. At the end of each
period, you may like to compute the portfolio return and risk and compare the same
with your investment objective as well as certain benchmark risk-return. The
objective of this exercise is to evaluate the efficiency in construction and
management of portfolio.
1.4 THE INVESTMENT ENVIRONMENT
A reading of the first three sections would have provided some understanding on the
basic principles of investment. Suppose you are able to frame your investment
objective and also identified securities that are to be purchased. Now you need to deal
with the market for the purchase and sale of securities. An understanding of the
operational details of the market would be useful. Investment decisions to buy/sell
securities taken by individuals and institutions are carried through a set of rules and
regulations. There are markets - money and capital - that function subject to such
rules and established procedures and are, in turn, regulated by legally constituted
authority. Then there are securities or financial instruments which are the objects of
purchase and sale. Finally, the mechanism, which expedites transfers from one owner
to another, comprises a host of intermediaries. All these elements comprise the
investment environment. Investors have to be fully aware of this environment for
making optimal investment decisions.
Discussion in the following paragraphs provides a brief overview of the three
elements of the investment environment viz., instruments, institutions, and markets:
1.4.1 Financial Instruments
Financial assets or instruments can be classified in a variety of ways. We will classify
them into creditorship and ownership securities on the basis of the nature of the
buyer's commitment. The description will then be split into public and private issues
differentiating the two major forms of issuance.
Creditorship Securities
Debt instruments furnish an evidence of indebtedness of the issuer to the buyer.
Periodic payments on such instruments are generally mandatory and all of them
provide for the eventual repayment at maturity of the principal amount. Securities
may also be sold at a price below the eventual redemption price, the difference
between the redemption price and the sale price constituting the interest. For
example, a buyer of a Rs. 100 bond/debenture may receive an interest at 6 per cent
for one year in one of the following ways:
a) he pays Rs. 100 at the time of investment and receives Rs. 106 at the end of one
year, or
b) he pays Rs. 94:30 at the beginning and receives Rs. 100 at maturity i.e., he
receives 6 per cent of Rs. 94.30 that is equal to the difference between Rs. 100
(redemption price) and Rs. 94.30 (issue price).
The latter arrangements are known as zero-interest bonds. The interest amount in
rupees measured as a percent of the par value of a debt instrument is known as
nominal or coupon `fate of interest. For example, Rs. 28 payable per year on a
debenture whose face/par value is Rs. 200 yields a coupon rate of 14 per cent per
annum.
Debt instruments can be issued by public bodies and governments and also by private
business firms.
Public Debt Instruments: Government issues debt instruments for long and short
periods. They are rated the best in terms of quality and are risk-free. A common term
used to designate them is 'gilt-edged-securities'. The 182-day treasury bills issued by
the Government of India are examples of short-term instruments. Government also
borrows, money for long-term and 11.5 percent Loan 2009 (V issue) of the
Government of India is an example of long-term instruments. State governments and
local bodies also issue series of loans and bonds. Banks, insurance, pension and 13
provident funds, and several other
An Overview
organizations buy government debt instruments in compliance with their statutory
obligations. Such debt instruments are usually over-subscribed. You can refer money
market page of any one of the financial dailies, where you can find the list of short-term
and long-term securities that were bought and sold on a particular day.
Private Debt Instruments: These are issued by private business firms, which are
incorporated as companies under the Companies Act, 1956. Generally these instruments
are secured by a mortgage on the fixed assets of a company. In addition to plain debt
instruments, there are several variations. A very popular variety of such debentures are
`convertible' whereby either the whole or a part of the par value of a debenture is
convertible (either automatically or at the option of investors) on the expiry of a
stipulated period after issue. The terms of conversion are stated in advance. There may be
a series of conversions and conversion price may differ from period to period.
Select Indian companies are now raising short-term funds by issuing a debt instrument
known as Commercial paper (CP). The Reserve Bank of India has issued detailed
guidelines in January 1990 in this regard. They are contained in "Non-Banking
Companies (Acceptance of Deposits through the Commercial Paper) Directives, 1989".
The eligibility for entering into the CP market is based on transparent norm, which
companies themselves, can readily assess. These conditions were relaxed in April 1990.
Special Debt Instruments : With a view to mop up resources and innovating the
spectrum of debt-instruments, two new debt instruments deserve a special mention viz.,
Public Sector Undertaking (PSU) Bonds (long-term) and Certificate of Deposit (short-
term).
The PSU bonds are issued to the general public and financial institutions by public sector
undertakings, usually with tax incentive. It is interesting to note that a large proportion of
PSU bonds is privately placed with banks, their subsidiaries, and financial institutions.
Certificates of Deposits (CDs) were introduced in June 1989. Commercial banks are
permitted to issue CDs within a ceiling equal to 2 per cent of their fortnightly average
outstanding aggregate deposits. The maturity of 3 months at the short-end and one-year at
the loner end was generally popular with investors. Interest rates for CDs are normally
higher than the interest rate offered by the bank for similar maturity period deposits.
Ownership Securities: These instruments are called `equities' because investors who
invest in them get a right to share residual profits. Equity investment may be acquired
indirectly or directly or even through a hybrid instrument known as preference shares.
They are discussed in this order.
Indirect Equities: The investor acquires special instruments of institutions, who take the
buy-sell decisions on behalf of investors. Such institutions are Unit Trust or Mutual
Funds. An individual who buys Unit gets a dividend from the income of the Trust/Mutual
Fund after meeting all expenses of management. The Units can be bought from and sold
to the institution at sale and repurchase prices announced from time to time (on a daily
basis). Many mutual funds schemes are also listed in stock exchanges and investors can
also sell and purchase the Units through secondary markets. The objective of Trusts and
Mutual Funds is to use their professional expertise in portfolio construction and pass on
the benefits to the small investor who cannot repeat such a performance if left alone to
subscribe to equity shares directly.
Direct Equities: The investor can subscribe directly to the equity issues placed on the
market by the new companies or by the existing companies. If she/he is already a
shareholder of an existing company, which enters the capital market for additional issue
of equity shares, such an investor would get a pro rata right to subscribe, on a pre-
emptive basis, to the new issue. Such offerings are known as ‘rights shares'. Established
companies' reward their shareholders in the form of ‘bonus shares' as well. They are
given out of the accumulated reserves and shareholders need not pay any cash
consideration as happens in the case of `right shares'. For example, a company may
announce a bonus issue on a one-for-one basis. This amounts to a 100 per cent bonus
issue (or, loosely stock dividend) so that the number of shares held by a shareholder after
the bonus would be doubled. The chances for an increase in the potential dividend
income become very bright and this would happen unless the company imposes a
proportionate cut in future dividends. Thus, a shareholder, who held 100 shares of Rs. 10
each in a company, got a dividend income of Rs. 200, the dividend announced being 20
14 per cent. His shareholding after a 100 per cent bonus now increases to 200. Now, if
the company maintaining the same rate of dividend as last year viz., 20 per cent, the
dividend income of the shareholder would go up to Rs. 400. He will, of course, get Nature and Scope of
only Rs. 200 even after the bonus if the company prunes the dividend to 10 per cent. Investment Decisions

Note: Figures compiled from various issues of Prime Annual Reports, Praxis
Consulting & Information Service, New Delhi. Figures exclude issues of exiting
companies and debt issues. Figures in bracket are number of issues.

15
An Overview
A less popular instrument is called `preference share'. It is neither full debt nor full
equity and is, therefore, recognized as a 'hybrid security'. Such a shareholder would
have certain preference over equity shareholder. They may relate to dividends,
redemption, participation, and conversion, etc. The most common is with regard to
dividends which, when not paid for any particular year, get accumulated and no
equity dividend would be payable in future until such accumulated areas of
preference dividend are cleared. The dividend rate on these shares is normally less
than the one on equity shares but greater than interest rate.

You may get an idea of the growth in issues of various kinds of instruments by public
limited companies in the non-government sector from Table 1.1

Activity-2

i) Study Table 1.1 and 1.2 and list out main trends and conclusions with regard to
the size and relative popularity of various instrument of finance.

…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………

ii) Note down top 20 stocks in term of trading volume in NSE yesterday from the
newspapers. Collect data with regard to the dividend and earnings record of
these companies.

…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………

1.4.2 Financial Intermediaries

Financial intermediaries perform the intermediation function i.e., they bring the users
of funds and the suppliers of funds together. Many of them issue financial claims
against themselves and use cash proceeds to purchase the financial assets of others.
The Unit Trust of India and other mutual funds belong to this category.

Most financial institutions underwrite issues of capital by non-governmental public

limited companies in addition to directly subscribing to such capital either under a
public issue or under a private placement. In 1992, SEBI required all equity issues
were to be underwritten fully but this requirement was withdrawn subsequently. The
percentage of underwriting has come down substantially after the withdrawal of this
requirement. While good issues require no underwriting, underwriters are not willing
to underwrite bad issues. Table 13 shows the changing trends in underwriting.

The financial institutions engaged in intermediary activities include the Industrial

Development Bank of India, Industrial Finance Corporation of India, Industrial
Credit and Investment Corporation of India, Unit Trust of India, Life Insurance
Corporation, and General Insurance Corporation. Two institutions, which have
broadened financial services activities in India, deserve a special mention. They are:
The Credit Rating Information Services of India Ltd., (CRIS1L) and other credit
rating agencies, and the Stockholding Corporation of India Ltd. (SHCIL).

16
 Table 1.3: Trend in Underwriting of Public Issues Nature and Scope of
Investment Decisions
(Rs. in crores)

Year (1) Total Issue Size (2) Amount Underwritten (3) (3) As % of (2)

1994-95 13312 10286 77.27%

1995-96 11822 3257 27.55%
1996-97 11648 912 7.83%
1997-98 3061 269 8.79%
1998-99 7911 158 2.00%
1999-00 7613 2159 28.36%

Source: The Primary Market Monitor, Prime Annual Reports, Praxis Consulting &
Information Service, New Delhi.
CRISIL, the first credit rating agency of the country, was set up jointly by ICICI, UTI,
LIC, GIC, and Asian Development Bank. It started operations in January 1988 and has
rated a large number of debt instruments and public deposits of companies. CRISIL
ratings provide a guide to investors as to the risk of timely payment of interest and
principal on a particular debt instruments and preference shares on receipt of request
from a company. Ratings relate to a specific instrument and not to the company as a
whole. They are based on factors like industry risk, market position and operating
efficiency of the company, track record of management, planning and control system,
accounting, quality and financial flexibility, profitability and financial position of the
company, and its liquidity management.
The SHCIL was sponsored by IDBI, IFCI, ICICI, UTI, LIC, GIC and IRBI to
introduce a book entry system for the transfie of shares and other types of scrips
replacing the present system that involves voluminous paper work. The corporation
commenced its operations in August 1988. Commencing its operations with UTI,
SHCII has now extended its operations to GIC, LIC mutual fund, and New India
Assurance Co. Ltd.
1.4.3 Financial Markets
Securities markets can be seen as primary and secondary. The primary market or the
new issues market is an informal forum with national and even international
boundaries. Anybody who has funds and the inclination to invest in securities would
be considered a part of this market. Individuals, trusts, banks, mutual funds, financial
institutions, pension funds, and for that matter any entity can participate in such
markets. Companies enter this market with initial and subsequent issues of capital.
They are required to follow the guideline prescribed by the regulating agencies like
SEBI from time to time unless they are expressly exempted from doing so. A
prospectus or a statement-in-lieu of prospectus is a necessary requirement because this
contains all material information on the basis of which the investor would form
judgement to put or not to put his money. Concealment and misrepresentations in
these documents have serious legal implications including the annulment of the issue.
Some companies would use the primary market by using their `in house' skill but most
of them would employ brokers, broking and underwriting firms, issue managers, lead
managers for planning and monitoring the new issue. New guidelines issued by the
Securities & Exchange Board of India (SEBI), now, require the compulsory
appointment of a registered merchant banker as issue manager where the amount of the
capital issue exceeds Rs.50 lakhs.
Secondary markets or stock exchanges are set up under the Securities Contracts
(Regulation) Act, 1956. They are known as recognized exchanges and operate within
precincts that possess networks of communication, automatic information scans, and
other mechanized systems. Members are admitted against purchase of a membership
17
card
An Overview
whose official prices vary according to the size and seniority of the exchange.
Membership cards generally command high unofficial premia because the number of
members is not easily expandable. Business was earlier transacted on the trading
floor within official working hours under the open bid system. Today, all exchanges
in India have introduced screen-based trading where the members of the exchange
transact the business (purchase and sale of securities) through computer terminals.
You can visit the nearest NSE broker's office to find yourself how trading takes
place. Methods of recording and settlement are laid down in advance and members
are obligated to follow them. Arbitration procedures exist for the resolution of
disputes. The regulatory mechanism relating to capital market has seen major
changes during the last ten years. The Securities and Exchange Board of India (SEBI)
is now responsible to monitor and control the stock market operations, new capital
issues, working of mutual funds, merchant bankers and other intermediaries. SEBI
has issued separate guidelines for each of the above entities and requires all the
intermediaries to register with the SEBI and periodically submit the reports on their
operations.

1.5 SUMMARY
Individuals save a part of their earnings to meet their future cash flow needs. Such
savings are often invested in securities since money has a time value. Investments
normally offer a positive return, which often is more than rate of inflation. Such a
positive return is an incentive for individuals to increase the level of savings and help
the country by creating new capital. Individuals before making investments need to
understand the basic principles of investments. While this course aims to give a
comprehensive input on investments, this unit gives an overview of the subject. Some
of the important issues covered in this unit are :

1. Securities are of different types and the expected return from such securities
differs considerably. Government securities offer lowest return but they are also risk-
free. Equities offer maximum return but they are too risky. Risk and return of
securities go together.

2. The starting point of investment process is clearly defining the investment

objectives. Investment objectives are expressed in terms of expected return or risk
and period of holding. Security analysis is performed to identify securities, which
qualify for investments. Following the principles of portfolio management, securities
are combined to achieve diversification. Portfolios are periodically revised and
performance of managing the portfolio is also periodically evaluated.

3. In addition to knowing the basic principles of investments, an investor is also

required to know the operations of securities market. Different types of securities are
traded in the market and they are broadly classified into debt and equity instruments.
They are bought and sold through a set of intermediaries, which include brokers,
stock exchanges, etc. All stock market intermediaries are regulated by the SEBI to
ensure orderly functioning of the market.

1.6 KEY WORDS

Ex ante: Before event or fact.

Expected return: Ex ante return on an investment. Ex post: After the event of fact.

Ex post return: Actual or realized return or an investment.

Financial Assets: Documentary evidence of financial claim of the holder, say of

shares on debentures, over the issuer.

Financial intermediation: A function, which brings the savers and users of funds
18 together, usually performed by specialized agencies and institutions like banks and
underwriters for art agreed/stipulated commission.
Investment: Commitment of funds for a period usually exceeding one year in Nature and Scope of
expectation of a required rate of return. Investment Decisions

Investment decision: The decision to acquire, hold, or dispose asset by rational and
risk-averse individuals/organizations.

Marketable securities: Financial claims, which are tradeable in organized markets at

the best prices.

Portfolio: A collection of two or more assets, generally employed in the context of

financial assets.

Portfolio construction: Building up a portfolio of financial assets with consideration

of selectivity, timing, and diversification or raising a portfolio with rational selection
criteria, at the right time, and in a way that the risk is reduced to the minimum for a
given level of expected return.

Portfolio revision: A review of an existing portfolio in the light of changes in risk-

return dimensions.

Portfolio evaluation: Assessing the performance of a portfolio on the basis of some

aptly developed norms or yardsticks.

Real assets: Physical assets held to perform an activity with an expected income/pay
off profile.

Realized return: The pay-off rate on an investment, which occurs after an event/fact
i.e., the actual return.

Risk: The probability that the realized return would be different from the anticipated
return of an investment.

Risk-averse investors: Rational individuals, who avoid risk and demand a

compensation for assuming risk.

Risk-free rate of return: The monetary rate of return obtainable on financial assets
with zero probability of default on principal and periodic payments, e.g. government
or gilt edged securities.

Risk-return trade-off: An approach to investment decision-making whereby the

utility/ welfare maximizing individuals acquire assets in a way that their returns are
maximized for given levels of risk or risk is minimized for given level of return.

Security analysis: A methodology whereby forecasts of financial variables like

earnings, dividends, cash flow are made for individual securities, (i.e. micro level) or
for securities as a homogeneous industry group (macro-level) using either past data
or a discounting approach.

Securities market: Organized and recognized trading centres, where financial claims
are bought and sold as per established rules and procedures.

Zero-interest bonds: Creditorship securities on which a coupon rate is not made

explicit but the compensation is provided through a discount on the purchase price or
a premium on redemption.

1.7 SELF-ASSESSMENT QUESTIONS/EXERCISES

1) Define investment.

2) Describe the steps involved in the investment process.

3) Briefly explain the problems of selectivity, timing, and diversification in

portfolio construction. 19
An Overview
4) Distinguish the following:
a) Financial asset and real asset
b) Risky investment and risk-free investment
c) Debt instruments and equities
5) Define the following terms:
a) Risk
b) Coupon rate
c) Zero-interest bonds
d) Credit Rating
e) Depository functions
6) State and explain the effect of changes in investment environment on investment
decisions.
7) Why should portfolio be continually evaluated?
8) Tick the correct alternative in the following:
a) All risk-averse investors crave for maximum wealth. (True/False)
b) Risk is the probability of actual return diverging from expected (True/False)
return.
(True/False)
c) A non-member cannot operate on the trading floor of
recognized stock exchange.
(True/False)
d) Preference shares are equities. (True/False)
e) All public sector bonds provide tax-free interest. (True/False)
f) CRISIL provides comprehensive financial consultancy to those
who approach it. (True/False)
g) Financial institutions do not directly subscribe to the shares and
debentures of companies. (True/False)

h) A registered merchant banker must be appointed as a manager (True/False)

for a new issue exceeding Rs. 50 lakhs.
i) An ex ante return is the return, which has been planned or (True/False)
expected.
J) Investment decisions are concerned only with financial assets. (True/False)
k) When an individual invests he commits his funds with an
(True/False)
expectation to obtain an adequate return
I) A rational investor maximizes his current and future wealth (True/False)
m) Investors do not care for the real rate of return and ignore
Inflation. (True/False)
n) All investors require an abnormal compensation even for low
levels of risk. (True/False)
o) Investible funds have an opportunity cost which influences the
investor's required return. (True/False)

p) Some investors will not accept any risk whatsoever but some (True/False)
others would be virtual dare-devils.
q) Equity shares are less risky than debentures. (True/False)

20
 Nature and Scope of
1.8 FURTHER READINGS Investment Decisions

D Ambrosio, Charles A., 1976, Principles of Modern Investments, Chicago : SRA,

Inc.
Jones, Charles P., Futtle, Donald L., and Heaton, Cheri!! P, 1977. Essentials of
Modem Investments, New York Ronald Press.
Fuller, Russell J., and Farrell, James L. 1987. Modern Investments and Security
Analysis, New York : McGraw-Hill Book Co.
Reilly, Frank K. 1979, Investment Analysis & Portfolio Management, Hinsdale,
Illinois : The Dryden Press.
Pandian Punithavathy, 2001, Security Analysis and Portfolio Management, Vikas
Publishing House Pvt. Ltd., New Delhi.
Kevin S., 2000, Portfolio Management, Prentice-Hall oflndia Pvt. Ltd., NewDelhi.

21
An Overview

UNIT 2 COMPONENTS OF INVESTMENT

RISK
Objectives

The objectives of this unit are to:

• Explain the concept of risk and genesis of total investment risk

• Distinguish between ‘systematic’ and ‘unsystematic’ risk
• Identify the factors that specially affect risk in investment in equity shares.
Structure
2.1 Concept of Investment Risk
2.2 Evolution of Risk Connotations
2.3 Interest Rate Risk
2.4 Market Risk
2.5 Inflation Risk
2.6 Default Risk
2.7 Business Risk
2.8 Financial Risk
2.9 Management Risk
2.10 Liquidity Risk
2.11 Summary
2.12 Key Words
2.13 Self-Assessment Questions/Exercises
2.14 Further Readings

2.1 CONCEPT OF INVESTMENT RISK

In Unit-1, while reading return-risk trade off function, you have come across terms
like `risky assets', `risk-averse investors', `risk-free rate' and so on but no formal input
on the term `risk' was given. In this Unit, the concept of risk is discussed in detail
because no investment decision can be taken without understanding the risk
associated with the investment. The importance of risk in investment decision can be
appreciated if you ask the investors why they invest one part of their savings in bonds
and the other part in equity. If risk is not a relevant factor in investment decision,
investor should bet all their savings only in equity stocks, which offer on average
higher return than debt instruments. Investors not only like return but they also
dislike risk. Many investors may be willing to take some amount of risk since it is the
only way to earn higher return but they need compensation for taking such additional
risk. Thus, investment decision not only requires an estimation of return but also an
assessment of risk to find whether the return from a risky asset is adequate for the
risk assumed by the investors.

The word `risk' is common vocabulary and is widely used in the world of
investments. In normal life, the term risk often means a negative outcome. If you say
that it is risky to drive vehicle in a particular road, you actually mean that driving in
that road may cause an accident. However, the term risk in investments has a
different meaning. It not only refers to a scope of negative occurrence but also
implies the chance of positive return. For example, we mentioned in Unit 1 that
22 investment in stocks is riskier than investments in bond.
It doesn't mean that investments in stocks will yield a negative return or it will be Components of
lower than bond return. It simply means that investments in stocks may offer a high Investment Risk
return or also a huge loss. Risk captures variation in expected return and such
uncertainty of return is invest in risky investments, the expected return needs to be
higher. When such higher expected return is used for discounting the future cash
flows, the security value moves downward. This way you can see a link between risk
and return. We will discuss more on this relationship as we move further on this
topic.
Since investment decisions are made based on the expected future outcome, we can
broadly classify our understanding and knowledge on future into four categories. At
one extreme, we have certain knowledge. If an investor invests in government
security, it is almost certain that the government pays interest and principal on the
due date. Only in extreme conditions, the government may fail to honour the
commitment. At the other extreme, we have no idea on the future and we can call this
as our ignorance. Suppose a company comes out with a public issue stating that they
will take up a research to develop a process that will convert iron into gold. Many of
us may not be able to judge the outcome because we may not have any idea on the
feasibility. No rational investment decision is feasible when we are ignorant of
possible outcome.
The third one is a situation where we know the possible outcomes and its range.
Suppose we are able to estimate that India Cement's earning will grow by 30% if the
economy does well and will decline by 10% if the economy fails. If we don't know
anything beyond that, then the situation is called as uncertain. It is again difficult to
take a rational investment decision in a situation of uncertainty. If we are able to
know the probability of the economy doing well or failing, then the situation is called
risky. In other words, a situation pertaining to future is considered as risky If we
know the range of outcome and its probability distribution. For example, in the above
India Cement's case, if we know the probability of economy doing well next year is
70% and the probability of economy failing is 30%, then we can estimate the India
Cement's earnings in a better way. Under this condition, the earnings of India
Cements will increase by 30% with 70% probability and decline by 10% with 30%
probability.
Two elements in the concept of risk as applied to the world of investment and finance
deserve attention. One, risk in the investment sense is associated with return. A
person buys a financial asset with expectations of a return. The investment decision
would be premised on an 'expected return', which may or may not actually be
realized. The chance of an `unexpected' or 'adverse' return would be the risk carried
by an investment decision. For example, you buy a share at Rs.370 expecting a
dividend of Rs. 6 per share in the coming year and expecting the price to rise to
Rs.450 in a year's time. You are basing your decision to buy on a return of
(450 - 370) + 6.0
= 23.2 percent.
370
Now, the price may rise only to Rs. 380 in which case the actual return downs to a
mere 4.2 percent, if the company comes out with a dividend of Rs. 6 per share on a
Rs. 10 equity share. Should the dividend be pruned to Rs. 4 per share, the return
would further fall to 3.3 per cent. The other point to be stressed about investment
risk is that it is generally considered synonymous with uncertainty. The investor is
most of the time dealing with uncertainty and yet figuring out his subjective
probabilities for the expected return. The risk-zone in which the investor moves is
characterized by 'stochastic knowledge' and his beliefs about the expected return
enable him to work out a probability distribution of possible outcomes. This is
illustrated in the paragraph that follows.
Assume that you are interested in buying 1000 equity shares of a company. The
market price as on October 1, 2001 of a ten-rupee share is Rs.200. The highest prices
were 1998-99: Rs. 135; 1999-2000: Rs. 146; and 2000-01: Rs.235. You expect the
price to go up to Rs. 250 within a year of your purchase. The company paid the
following dividends 1998-99: 23%; 1999-2000: 30% and 2000-01: 32%. There has
been a liberal record of five bonuses in the past, the last bonus being in 1997-98 in
the ratio of 1:1. This information enables you to figure an expected return of 26.6%
assuming that the company will maintain the dividend of 23
An Overview
32% in 2001-02 and that the price at the time of your sale will be Rs 250. The
expected return of 26.6% was derived as follows. The investor gets a dividend of Rs.
3.20 and a capital gain of Rs. 50 when she sells the stock at Rs. 250. The net gain of
Rs. 53.20 for an investment of Rs. 200 works out to 26.6%.
The figure you have estimated above is a single estimate of expected return. Since
future is uncertain, you may have to examine the probability of several other possible
returns. Thus, the expected return may be 20%, 30%, 35% or 10%. Now, you will
have to assign the chances of occurrence of these alternative possible returns on the
basis of your information and subjective beliefs. For example, you expect as follows:
Possible return (Xi) Probability Occurrence (P (Xi) )
10% 0.10
20% 0.20
26.6% 0.40
30% 0.20
35% 0.10
You are clearly now not working on a point estimate. The earlier estimate of 26.6% is
one of the five sets of outcomes you have generated. The table above is known as a
probability distribution and you can use it to have an insight into the riskiness of your
proposal to buy 1000 shares. The procedure would be as follows:
i) Estimate the expected value of the five possible outcomes. If the possible returns
are denoted by Xi and the related probabilities by P(Xi), the expected value (EV)
is
n
EV = ∑ XiP( Xi )
i =1

In other words, it is the sum of products of possible returns with their respective
probabilities.
ii) You will be in a position to have some idea of risk by estimating the variability
of possible outcomes from the expected value of outcomes that you have
estimated in (i) above. A statistical procedure used for the purpose is the
calculation of standard deviation which is given as follows:
n
σ= ∑ [(Xi − EV)2P(Xi)]
i=1

Where ‘ σ ’ denotes standard deviation and all other terms as in (i) above. The table
below provides the required calculations:
Possible Probability Products Deviations Deviation (Xi-EV)2
Return (Xi) (P (Xi)) (Xi-EV) Squared x P(Xi)

(1) (2) (3) = (1) x (2) (4) (5) = (4)2 (6)

10.0% 0.1 0.0100 -0.15 0.0229 0.0023

20.0% 0.2 0.0400 -0.05 0.0026 0.0005
26.6% 0.4 0.1064 0.01 0.0002 0.0001
30.0% 0.2 0.0600 0.05 0.0024 0.0005
35.0% 0.1 0.0350 0.10 0.0097 0.0010
EV 0.2514 σ2 0.0044

σ = 0.0044 = 0.0660
24
iii) The above calculations can be repeated for several stocks and if the investor's Components of
objective is to minimize risk, the one with minimum standard deviation can be Investment Risk
selected. Suppose there is another stock which offers same expected return if
25.14% but the standard deviation of return is lower than 0.0660. Then
investors will prefer the new stock, which offer lower risk with same return.
You may note that squared standard deviation (a2) is known as `variance' and is
an equally useful measure of risk.
Activity - 1
1. a) How many possible return outcomes could be estimated for a Government
security?
………………………………………………………………………………
b) What would be the probability of occurrence of the 'outcome(s)' in (a)
above?
………………………………………………………………………………
c) State how would you figure the one-period return on a risky security?
……………………………………………………………………………….
d) What does the standard deviation of possible return show?

……………………………………………………………………………….
e) Define risk.
……………………………………………………………………………
f) Can risk of an investment be considered without reference to return?
……………………………………………………………………………
2. Go through the illustration used above to explain the methodology of computing
expected return and risk. Perform a similar analysis for another stock, which
you are familiar with using the same methodology. Try to give justification of
the probability values that you are assigning though it will be difficult task but
worth to make an attempt.
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
…………………………………………………………………………………….

2.2 EVOLUTION OF RISK CONNOTATIONS

Section 2.1 had introduced you to a procedure of measuring investment risk, which
has emerged as a standard approach. It may be of interest for you to know that this
concept and its, later refinements have evolved over a time-period. In the early years
of the present century, analysts used financial statement data for evaluating the risk
of securities of a company. The broad indicators used by them were the amount of
debt employed by the firm. Their rule was: `the higher the amount of debt the greater
the, riskiness of security and G wham, Dodd and Cottle, who are considered pioneers
of `security analysis' as a discipline laid emphasis on `margin of safety' as a measure
of risk in the 1962 edition of their monumental work titled `Security Analysis'. They
were of the view that security analysis must calculate the `intrinsic value' of a
security independent of its market price. According to them, `intrinsic value of a
security would be a security analyst's own judgement based on its earning power and
financial characteristics and without reference to its market price. The difference
between `intrinsic value' and `market price' was called the `margin of safety' and the
rule used for assessment of risk was `the higher the margin of safety, the lower the
risk.' 25
An Overview
Graham and Dodd not only concentrated on the individual security but also
recognized the importance of its contribution to the risk of a well-diversified
portfolio. It must, however, be mentioned that what brought the concepts of risk for a
portfolio and a security under a clearer focus was the work of Markowitz and the
later development of the capital asset pricing model (CAPM). You will know more
about these developments in the area of investment risk in Block IV. In case you
liked to know about the original underpinnings of the work done by Markowitz, you
may refer to his classical article published in the March 1952 issue of the Journal of
Finance with the caption, "Portfolio Selection".
Several measures, other than the standard deviation discussed in the preceding
section, have been used to measure risk viz., range, semi-variance, and mean absolute
deviation. But standard deviation has been accepted in general because its knowledge
permits probability statements for most types of distributions. William Sharpe
observes as follows in support of the measure: "The standard deviation of a
portfolio's return can be determined from (among other things) the standard
deviations of the returns of its component securities, no matter what the distribution
is. No other relationship of comparable simplicity exists for most other variability
measures." (See: W. Sharpe, Investments, IInd ed. 1981, p.121). You may note that
the risk of a portfolio is not just the mathematical addition of the risk of each of the
individual securities that comprise. You may further note that where the portfolio is
well diversified, portfolio risk would be less than this mathematical total.
You would have also come across a statement in this unit that the standard deviation
measures the total risk of an investment. The later developments, in the theory of
investment risk decompose this `total' into several of its components. And this can be
done in two ways. One, dividing total risk into systematic and unsystematic risk and
two, dividing total risk into parts such that each of which has an origin in some causal
force. Obviously, the first part of the decomposition exercise is broad and has relation
to the market. The second part of the exercise relates to the factors or causes which
produce risk in investments.
The division of total risk into `systematic' and `unsystematic' or `non-systematic'
owes its origin to developments in the area of portfolio theory. Sources of risk that
cause variability of returns may be perceived as belonging to two general classes-
those that are pervasive and affect all securities though in varying degrees e.g.,
inflation, interest rates, market sentiment, etc., and those that are specific to a
particular security e.g., financial risk and business risk. When variability of returns
moves with the market, it is recognized as `systematic'. Firms cannot eliminate such a
risk and they are of major concern to the investor. For example, when prices rise, all
firms would be affected in terms of their costs and realizations, which in turn would
affect variability of returns. This will be a market phenomenon and would tend to
stay for all. The investor would demand compensation for this risk component in
figuring out his expected rate of return. On the other hand, when variability of returns
occurs because of firm-specific factors like the failure to obtain a prestigious
overseas contract, or a higher exposure to the risk of default in payment of interest
charges and debt obligations, the risk is termed `non-systematic'. Since this part of
risk can be reduced through a diversified portfolio, it is not considered while
computing the expected or required rate of return.
The two components of total risk are additive and hence total risk is equal to
Systematic risk plus Non-systematic risk. Systematic risk is normally measured by
comparing the stock's performance vis-a-vis market's performance under different
conditions. For example, in a good period, if the stock appreciates more than other
stocks in the market and in a bad period, it depreciates more than other stocks in the
market, the systematic risk of the stock is more than the market risk. The systematic
risk of the market (normally widespread market index like BSE-100 or NSE-50
index) is equal to 1 and systematic risk of all stocks is expressed in terms of
systematic risk of market index. This is done by measuring a value called `beta'. The
beta of the stock is equal to beta of the regression coefficient when stock's of returns
are regressed on return of market - index. If the beta of stock is 1.50, then the stock is
expected to show a price increase of 1.5 times of stock returns in a good period. At
the same time, if the market declines by some percentage in a bad period, the stock is.
26
expected to decline 1.5 times more than market's negative return.
For illustrative purpose, the weekly price and return data BSE-100 index, Hindustan Components of
Lever, Infosys and Reliance Industries are given in Appendix-1 of this Unit for a Investment Risk
period of six months (July, 2000 to June, 2001). Using the return data and regression,
the beta values of the three individual stocks are computed. As expected Hindustan
Lever's beta shows the lowest value and is 0.49. The stock is less volatile during the
period. The market as a whole (measured through BSE-100 index) has reported a net
loss of 32% during the six months period, whereas HLL has suffered a net loss of
27.60% during the same period. A week-to-week comparison shows that HLL
suffered less or posted profit when the market was reporting loss during the week. On
the other hand, Reliance Industries reported a gain of 8.30% against the market loss
of 32%. Again a week to week comparison shows the Reliance Industries weekly
return are closely moving in line with BSE-100 and hence got a beta value of 0.96,
which is close to market's beta of 1. Infosys showed wide variation during the period.
Against a market loss of 32%, Infosys reported a net loss of 54.79% and also showed
high volatility in the returns. The beta of 1.82 reflected the volatility. Thus, the
systematic risk of HLL is the lowest and Infosys is highest whereas Reliance
Industries has shown a moderate systematic risk. The unsystematic risk of the stock
is equal to total risk less systematic risk. It is computed as follows:
Unsystematic Risk = Variance of the stock - [Beta2 x Variance of the Market Index]
Sometime, the unsystematic risk is expressed as a standard deviation. For the three
illustrative stocks, the systematic and unsystematic measures are as follows:

BSE-100 HLL Infosys Reliance

Total Risk (variance) 0.0024 0.0029 0.0111 0.0037

Beta 1.0000 -0.0444 -0.8528 -0.1588

Systematic Risk (variance) 0.00024 0.0011 0.0043 0.0023
Unsystematic Risk (variance) 0 0.0017 0.0069 0.0014
Unsystematic Risk (SD) 0 4.13% 8.28% 3.73%
Activity-2
Indicate whether the following statements are True or False:
a) Margin of safety is the difference between intrinsic value and market price
…………………………………………….
b) Standard deviation is a better measure of risk because it can explain all
distributions…………………………………
c) Total investment risk cannot be calculated by absolute mean deviations
d) Systematic risk can be eliminated ........................................................................
e) A government security, a bond, and an equity share cannot form a
Portfolio…………………………
f) Inflation creates diversifiable risk .......................................................................
g) A diversified portfolio consists of securities, which yield maximum
returns…………………………...

2.3 INTEREST RATE RISK

In the previous section, we discussed that there are several reasons for the future
return varying from the expected return and we grouped them under two broad
categories. Our discussion was more on measuring different components of risk and
now we will discuss more on understanding different sources of risk. To start with,
we will discuss an important source of risk namely interest rate risk, which affects
every sector in the economy. Often
27
An Overview
government through RBI uses interest rates to push the economy forward or cool
down the heated economy. Interest rate risk arises from variations in such rates,
which cause changes in market prices. It can be seen that a rise in market interest
rates causes a decline in market prices of securities and vice versa. There are different
ways through which the interest rate affects the securities return. It affects the
expected or required rate of return because investors always compare risk-free return
with the expected return of an investment. An increase in interest rate will cause an
increase in expected or required rate of return of other investments.
Illustration
Assume a 14% secured non-convertible debenture of Rs. 200 for five years. As long
as the market interest rate remains at 14%, the value of debenture will be equal to Rs.
200. Suppose the interest rate in the market increases to 20%, it affects the prices of
debenture because an investor, who is willing to buy the debenture would expect a
return of 20% and hence discount the cash flows at 20%.
Solution

Year-end Cash Flow (Rs.) Present Value at 20%

1 28 23.33
2 28 19.44
3 28 16.20
4 28 13.50
5 228 91.63

Total 164.11

The debenture price will decline from Rs. 200 to 164.11.

Interest rate risk affects largely the securities with longer duration. For instance, if
there is another non-convertible debenture with 10 year maturity, its price would
decline to Rs. 149.69 from Rs. 200 if the interest rate increases from 14% to 20%.
The workings are as follows:

Year-end Cash Flow (Rs.) Present Value at 20%

1 28 23.33
2 28 19.44
3 28 16.20
4 28 13.50
5 28 11.25
6 28 9.38
7 28 7.81
8 28 6.51
9 28 5.43
10 228 36.82

Total 149.69

Now let us know, how the interest rate risk affects stock price? Since stocks have no
28 maturity, the interest rate changes affect the stock prices more than bonds. Secondly,
increase in interest rates also reduces the profit of the companies and hence securities
prices are negatively affected. It can now be stated that the market prices (or present Components of
values) of securities would be inversely related both to market interest rates (or yield Investment Risk
to maturity) and duration. You will recognize that the interest rate risk is the price
fluctuation risk, which the investor is likely to face when interest rates change.
With a view to avoid the interest rate and duration risk, the investor, may like to
invest in short-term securities. Rather than buying a 5-year debenture, he may buy a
one-year security every time the earlier one-year security matures. This strategy,
though successful in reducing the interest rate or the price fluctuation, would possibly
expose the investor to another risk. Even the coupon rates in successive short-term
securities may vary and the range of variation may be wide too. For instance, during
the last few years, interest rates are constantly coming down and bank and financial
institutions like IDBI and IFCI have reduced their interest rates. What the investor
would now encounter is the `coupon rate risk'. It will be the constant endeavour of
investor to weigh between the interest rate risk and the coupon rate risk while
keeping funds invested over his holding period.
You would have noticed in our discussion of financial instruments in Unit 1 that
interest payments on bonds and debentures are contractual payments and the
company can be sued for default. Cumulative preference dividends must also be paid
to avoid trouble from preference shareholders. Equity dividends can always be
skipped if the company is in deep financial trouble and a dividend payment would
hasten insolvency. In such a situation the cash dividend yield will be much more
risky than the coupon yield on debentures.
2.4 MARKET RISK
You would have observed that the market moves upward at some point of time and
then moves downward at some other point of time. Such movements may happen
despite the good or bad performance of the companies. Often, company management
and its employees will be puzzled why the market is behaving like this. Finance
Ministers and economic advisors have gone on record stating that they don't
understand the behavior of the market when it takes a beating after the presentation
of budget. Irrespective of our understanding, the reality is the market move in one of
the two directions (upward or downward) and once such trend starts, it exists for a
time. There are several reasons behind such movements. Changes in economy or
expectation about the future of the economy may cause such widespread movement.
Company specific news may also cause such movement and if the company is a
major one like Reliance or Infosys or Hindustan Lever, a positive or negative
development may generally affect several other stocks in the market. Similarly, a
shock in the U.S. market will have an impact on domestic stock prices.
Investors' psychology will also often contribute to the market risk. For instance,
negative news may create a panic in the market and everyone would like to sell the
stock without any buyer in the market. In this process, the market will decline more
than the desired level. Market risk is demonstrated by the increased variability of
investor returns due to alternating bouts to bull and bear phases. Efforts to minimize
this component of total investment risk require a fair anticipation of a particular
phase. This needs an understanding of the basic cause for the two market phases.
It has been found that business cycles are a major determinant of the timing and
extent of the bull and bear market phases. This would suggest that the ups and downs
in securities markets would follow the cycle of expansion and recession in the
economy. A bear market triggers pessimism and price falls on an extensive scale.
There is empirical evidence, which suggests that it is difficult for investors to avoid
losing in bear markets. Of course, there could be exceptions.
The question of protection against market risk naturally arises. Investors can protect
their portfolios by withdrawing invested funds before the onset of the bear market. A
simple rule to follow would be: `buy just before the security prices rise in a bull
market and sell just before the onset of the bear market', that is, buy low and sell
high. This is called good investment timing but often difficult to practice.
Market risk as pointed out earlier is also classified as systematic and non-systematic.
When combinations of systematic forces cause the majority of shares to rise during a
bull market and fall during a bear market, a situation called systematic market risk is 29
created. As
An Overview
already noted, a minority of securities would be negatively correlated to the
prevailing market trend. These unsystematic securities face diversifiable market risk.
For example, firms granted a valuable patent of obtaining a profitable additional
market share might find its share prices rising even when overall gloom prevails in
the market. Such unsystematic price fluctuations are diversifiable and the securities
facing them can be combined with some other shares so that the resulting diversified
portfolio offsets the non-systematic losses by gains from other -systematic securities.

2.5 INFLATION RISK

Inflation risk is the variability in the total purchasing power of an asset. It arises from
the rising general price level. The interest rate on bonds and debentures and dividend
rates on equity and preference shares are stated in money terms and if the general
price level rises during some future period, the buying power of the cash
interest/dividend income is likely to be received for that period would decline. And if
the rate of inflation is equal to the money rate of return, the investor does not add
anything to his existing wealth since he obtains a zero rate of return.

Many investors believe that if the market prices of their financial assets increase, they
are financially better off in spite of inflation. Their argument is `after all money is
increasing'. This is nothing but `money illusion'. Consider, for instance, a situation
when the market price of a security you are holding, doubles and the general price
level increases four-fold. Would you say that you are richer simply because your
command over money doubles by selling the security? True, you get more money
than what you had earlier but you can buy less with that money. You can't dismiss the
fact that your command over goods and services (which is the eventual objective of
all investment decisions) has declined due to a four-fold rise in prices in general.

The money illusion is partly rectified by obtaining real rates of return

(interest/dividend cash income + capital gains) that is equivalent to the inflation-
adjusted monetary or nominal rates of return. If the real rate of return is denoted by
Rr, inflation rate by q, coupon rate by `r' and nominal rate of return by R, then:

1.0 + r
Rr = -1
1.0 + q

For example, a Rs.500 debenture earns a coupon rate of 15% per annum. Inflation
rate expected in the coming one-year period is 12%. Then the real rate of return
would be :

1.15
Rr = - 1 = 1.027 - 1 = .027 or 2.7%
1.12

You may notice the drastic fall in the real rate of return to 2.27% from the coupon
rate of 15% due to inflation rate of 12%.

Again, an equity share of Rs. 10 promises a dividend of 20% and you expect the
price of the share to rise from the current level of Rs.60 to Rs. 80 in a year's time.
Inflation during the next year is estimated at 14%. The real rate of return would be :

(Rs. 80 - Rs. 60) + 2.0

Nominal rate {R} = = 36.7%
Rs. 60

1 + .367 1.367
= -1= -1
Real rate of Return (Rr) 1 + 1.4 1.14
= 1.199 - 1 = .199 or 19.9%

30 The above examples clearly highlight the effects of purchasing power risk on the
wealth and returns of an investor.
A question is sometimes asked about negative real rates of returns, that is, a situation Components of
where the inflation rate exceeds the nominal rate. Should an investor stop investing in Investment Risk
such situations? The answer would depend on what other alternatives the investor
would have in the event of not investing. If the money withheld from investment is
kept as idle cash with zero nominal return then investing even with negative real
returns, may be advisable because, as shown in the example below, non-investment
would yield a larger negative real return than investing. And even though normal
investment objectives would be to earn positive real rates, in abnormal situations like
the one stated above, the objective would be to reduce the negative real rate of return.

Assume that a security is expected to yield a nominal rate of return of 12% and the
rate of inflation is expected to be 15%. We have now to work out the choices of the
investor, further assuming that if he does not invest, his cash will have to remain idle.

Now, if our hypothetical investor decides to invest his real rate of return would be :

1+r 1.12
Rr = -1= - 1 = .974 - 1.0 = - 0.026
1+q 1.15

It works out to a negative 2.6% return. Should the investor decide to keep idle cash,
the real rate of return would be :

1 + 0.0 1.0
Rr = -1= − 1
1 + 15% 1.15
=.869 - 1.0 = - 0.131

It would be better to have a negative return of 2.6 than to end with a negative return
of 13.1% by keeping cash idle.

You have seen that the purchasing power risk arises even if the market prices of
assets rise. Likewise, this risk may emerge even if the asset prices do not fluctuate.
The reason for these relationships is that the purchasing power risk arises from
fluctuations in the purchasing power of real income and/or real price of assets and not
from fluctuations in buying power of their nominal income and/or nominal prices.

It has already been stated that investment assets are real assets like land, real estate,
gold, diamonds and financial or monetary assets like shares, bonds, and debentures. It
has been observed that prices of real assets move with inflation and are positively
correlated with it. In contrast, prices of monetary assets are relatively rigid and are
negatively correlated with inflation. In consequence, real assets do not lose
purchasing power, as do the monetary assets in periods of inflation. In other words,
real assets are good inflation hedges but monetary assets are not. Hence, monetary
assets cannot form part of a portfolio, which already has got a high degree of
purchasing power risk. Such a portfolio can be diversified with real assets.

Activity-3

I. Collect monthly data of movements in the BSE-100 Index for the last few
years. Refer Appendix-2 for the values form 1990 to 2001. Plot them on a
graph with months and years on the horizontal scale and Index levels on the
vertical scale. Read the resulting graph and point out.

a) No. of peaks

b) No. of troughs

c) Duration of all peaks and troughs

d) Average duration of all peaks and troughs.

31
An Overview
Also prepare a brief comment on the information of `bull' and `bear' markets
from the information that you obtained.

…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………

II. Tick the correct alternative in the following multiple-choice questions:

a) Market risk

(i) is an unimportant source of investor's total variability of returns

(ii) can be diversified away

(iii) arises primarily from the economy level cycle of recession and
expansion

b) The real rate of return is

(i) the inflation-adjusted rate of return

(ii) the rate at which an investor's purchasing power declines

(iii) both (i) & (ii) above

c) Interest rate risk is

(i) the variability of return that arises from fluctuations in market

interest rates

(ii) perfectly identical with unpredictability of future dividend rates

(iii) the difference between coupon rates on Government securities and

those on corporate debentures.

d) The interest rate risk on a government security

(i) is zero

(ii) is influenced by variations in market interest rates

(iii) is indicated by changes announced in coupon rates.

2.6 DEFAULT RISK

The default risk arises from a deterioration of financial strength of the company that
issues securities. Holders of such securities have to experience greater variability of
returns when financial strength begins to worsen. Since the basic parameter is
`financial health', default risk is also known as financial risk.
If not handled properly, the default episodes of a firm may as well finally end up in
bankruptcy. This would, however, not be quite a swift process and one may notice
warning signals before the final disaster strikes. For example, a company may begin
stopping payment of its bills, accumulate arrears of cumulative preference dividends
and accrued interest on loans, default on debenture interest, incur persistent losses,
slash the equity dividend, and finally skip it, and so on. In more objective terms,
adverse movements in financial ratios like the current ratio, the acid-test ratio, the
cash to operating expense ratio, the net-worth to total assets ratio and so on can be
32 put on the watch. The point is that bankruptcy will not be a bolt from the blue except
when an act of nature destroys all assets, which are not insured.
Firms operating in the financial services sector like CRISlL, CARE and ICRA Components of
undertake an ongoing exercise to provide quality-ratings to the debt instruments of Investment Risk
issuing companies. They are at present being solicited in India by companies who
want to raise funds from the capital market. In Western countries, the rating
programme is a voluntary and continual exercise performed by eminent firms like
Standard & Poor and Merin Lynch etc. Ratings as given by these agencies are a
significant aid to the investor in estimating the probabilities of default in a particular
debt issue.
When the first sign of a weakening financial health of a firm is noticed, market price
of its security react and take a deep dip. The price decline will be equal to the
estimated loss when the company goes into bankruptcy. The immediate target groups
would be lenders and loan creditors but ultimately even shareholders would suffer. In
fact, if the worst happens, losses of equity holders could be total and they may end up
with share prices nearly dropping to zero. Also, even at such abysmally low levels,
there may not be any takers.
As with other risk factors, there may be diversifiable and non-diversifiable
components of default risk. Thus, tight credit conditions created by Reserve Bank of
India would push up interest rates and financially weak companies may not be able to
borrow. Similarly, a recession may curtail order position of the firms and firms that
are already weak may start defaulting when their sales and income decline. These are
examples of systematic forces that affect all firms simultaneously and systematically
push them towards default. You should note that these are extraordinary
circumstances and would push up the normal default rate of firms. The systematic
element in default risk is more harmful to the investor than the
divcrsifia6!oe}cnoeo1. The latter can be anticipated and managed. For example, a
government security can be added to the portfolio unless securities exposed to normal
default risk themselves are yielding an average return that is very much in excess of
the default-free securities.
2.7 BUSINESS RISK
Firms operate in an environment, which often changes and such changes causes
variation in expected income. For example, a change in government policy on
fertilizer subsidy may affect a group of companies in the fertilizer industry. Similarly,
an action by a competitor, domestic or from outside may also affect other companies.
While the above changes in the environment are caused by certain entities, there are
several factors, which change the operating environment but can't be attributed to
anyone. For instance, many firms are exposed to business cycle and the income of
such firms significantly differs from period to period. Companies in steel, auto and
shipping industries are exposed to such business cycles. It is difficult to assess
whether the business risk is systematic or non-systematic. A diversified portfolio
consisting of securities of several industries can diversify such business risk to a great
extent. On the other hand, portfolios with few stocks or stock drawn from select
industries would be exposed to such business risk if all sectors of the portfolio were
affected by changes in the environment.
1.8 FINANCIAL RISK
Financial risk arises when the firm uses debt in its capital structure. Debt brings fixed
liability and hence increases the variability of income available to the equity
shareholders. Use of debt is not always bad. It will increase the profitability when the
company performs well and equity holders get a return more than what is available
otherwise. Debt creates problem in bad times because of the fixed liability. If the
company fails to meet the debt obligation, the managers need to spend a lot of time in
convincing the lenders to accept delayed payment and in meanwhile loose valuable
managerial time. Default easily spread bad words about the company and the
company faces problem from several fronts. It may not be able to get credit from
suppliers and some of the good workers may leave the company. Customers will also
prefer companies with sound financials to avoid uncertainty in supply.
The impact of financial risk upto a limit is restricted only to the equity holders. But
too much of debt creates problems even to existing debt security holders unless the
debt is fully secured. Even in such cases, it is difficult to take charge of the assets and
sell it to meet their liability in view of lengthy legal process. 33
An Overview
2.9 MANAGEMENT RISK
Management risk is that part of total variability of return which is caused by
managerial decisions in firms where owners are not managers. However qualified
and capable the management team, there are chances for judgmental errors and
wrong decisions. Owners-investors are rightly aggrieved when executives are paid
high salaries and perks and are allowed ego-bolstering non-income consumption like
luxury cars, lavishly furnished offices and yet they plunge the firm in severe
difficulties by their inept decisions.
Management errors are the main reasons, which give rise to management risk
component of total investor risk. The errors are so numerous that it is difficult to
either list them or even to classify them. Nevertheless, some potential areas of
management errors can be highlighted. The one great blunder that management might
commit is to ignore product obsolescence. In fact, adequate expenditure must be
made on R & D and alternative products are promoted before the life cycle of
existing ones comes to an end. Single product firms will be more exposed to this risk
than firms with diversified product lines. Another risk is the dependence of a firm on
a single large customer. Management must adequately diversify customer groups.
Many firms supplying military equipment have been found caught up in deep
financial distress when the Government announces cuts in military spending. Many
software companies are also facing this problem and making effort to diversify
customers as well as country exposure. Yet one more area of management errors
could be the wrong handling of a correct decision when it is subjected to unfair
criticism and is even fought out in a court. For example, an automobile manufacturer
develops a fuel-efficient small car much ahead of times. Some ardent consumer
protection group brings a lawsuit on the grounds of user-safety being threatened. The
firm then announces abandonment of the product, forcing investors to bear the loss of
investments and lost revenues in future. You should note that these cases are only
illustrative and the list may go to an infinite number of factors.
Agency Theory and Management Risk
A recent development in the area of explaining management risks is concerned with
research that seeks to explain the basic motivations of owners and managers. It has
been stated that owners work harder than managers, who do not have ownership
interest in a company. Moreover, non-owner managers have strong incentives to
consume non-pecuniary benefits since they are hired employees. The emerging
theory hypothesizes that owner-non-managers delegate all authority to non-owner-
managers, who then operate under a principal-agent relationship. Since ex-post
rewards and punishments are not perfect and just, hired executives may not make, as
much ex ante effort to generate profitable investment opportunities than they would if
they owned the firm. Thus, there is a conflict of interest between owners and
managers and the latter may abuse the authority delegated to them much to the
detriment of owners. In consequence, investors, who are rational individuals, would
pay a higher price for shares of owner-managed firms than for shares of employee-
managed firms. The difference between the two sets of prices has been termed as
`agency cost'. It must be observed that the theory has not gone without criticism but
the view is getting increasingly accepted.
Evaluating Management
Investors and security analysts must attempt to evaluate the management team of a
company for its strengths and deficiencies. The task, though difficult and highly
subjective, must be done using some vital checkpoints, which are briefly stated
below:
1) Age, health, and experience profile of executives
2) Growth-orientation and aggressiveness of management
3) Composition of Board of Directors and the number of outside directors;
Effectiveness of the Board.
4) Management depth of the firm i.e., extent of delegation and decentralization
and development of managers at all levels with a strong middle-management
34
team.
5) Dynamism and flexibility of management. Components of
Investment Risk
6) Dividend payout policy and cash dividend record
7) The depth and transparency of annual reports to shareholders (corporate
disclosure practices)
8) Compensation to managers including special arrangements like stock option
plans
9) Compliance record of environmental, consumer protection, and fair trade
practices
10) Extent of implementing corporate governance codes
Diversifiable and Non-diversifiable Elements
Management errors are instances of management weaknesses. During normal
periods, they go unnoticed but during periods of difficulty, not only are these errors
conspicuously observed but also the responses of weak management become very
poor.
Difficulties crop up when stresses are built up for all firms irrespective of the quality
of management. For example, a shortage of petroleum products or emergence of a
strong global competitor would aggravate problems and increase their number
manifold. Since all firms would be affected, the investor would have no choice to
diversify. Of course, he would sell off shares of firms with weaker management
because they would be more prone to committing management errors during such
stresses or systematic pressures. This would lower security prices of such firms and
investors would hold them only if higher rates of return are offered. But while this
may happen, there is no escape for the investor. If he moves from a weaker firm to a
firm that is not so weak, systematic pressures would still work. Hence, this
component of management risk is known as systematic or non-diversifiable risk.
It must be observed that even best managers can commit errors during normal
periods. This would be a case of diversifiable management risk. Normal management
errors occur randomly and investors can diversify by shifting their investments across
companies.

2.10 LIQUIDITY RISK

Liquidity risk of securities results from the inability of a seller to dispose them off
except by offering price discounts and commissions. It is easy to rank assets
according to liquidity. The currency unit of a country is immediately saleable at par
and no discount, etc., need be given. Government securities and blue chip shares are
the next highly liquid group of assets. Debt securities and equity shares of some small
and less known companies are less liquid or even illiquid. Lack of liquidity forces
investors to sell the securities at a price below to the existing price, particularly when
the quantity to be sold is large. Investors must consider the liquidity risk factor while
selecting securities.
Activity-4
I. Select a small and a medium-sized/large-sized company and visit their web
site. Write a note on your experience after browsing the web site. Are you
happy with the kind of information provided for investors in the web site? You
can also visit a web site of foreign company and compare the contents provided
in the web site of the company with Indian companies.
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
………………………………………………………………………………....
35
An Overview
II. You are given four pair of statements below. Indicate, for each pair, which
statement is true and which one is false.
1) a) Default risk is always the risk of bankruptcy
b) Default may end up in bankruptcy
2) a) Liquidity risk results from a situation when securities cannot be
sold except at a price discount.
b) Liquidity risk arises when the volume of trading is low
3) a) Being, absentee-owners, investors in general are more likely to
commit management errors.
b) Managers who do not own equity shares are prone to commit
management errors and magnify management risks.
4) a) The stronger among firms may be driven to a situation that it
makes default
b) Bankruptcy does not spare even the financially strong firms.

2.11 SUMMARY
Considerations of risk are vital for investments. A potential investor looks at some
expected return, which occurs in future. And what is certain about future is its
uncertainty. A decision today for a tomorrow, which is uncertain, is the kind of to
pography on which an investor has to walk. The path is rugged and the journey full of
risk. An intelligent investor would want to make his journey as smooth as possible.
He would attempt to anticipate the kind of risks she is likely to face and also the vast
number of factors that probably produce these risks. Even though she understands
that he task is highly subjective, she makes her best efforts to remain anchored to
cannons of rationality.
The two-step procedure that an investor follows in accomplishment of the objective
is to get some specific insights into the total investment risk and then to familiarize
with , various elements and factors that sum up to such total risk. For estimating the
total risk, the investor uses past experience and modifies it appropriately for the
expected changes, in the future and then develops a subjective probability
distribution of possible returns from the proposed investment. This probability
distribution is then employed to estimate the expected value of the return and its
variability. The `mean' gives the expected value and `variance' or `standard deviation'
gives the variability or the measure of risk. The widely used procedure for assessing
risk is known as the mean-variance approach.
The `variance' or `standard deviation' provides an overview of risk. It measures `total
risk'. In actual practice, various factors produce this total risk. A decomposition of
total risk would be necessary to gain knowledge of the influence of these factors
individually. Recognizing some recent developments in the theory of risk
measurement, especially the portfolio aspects, a first step in reaching out to the
components of total risk is to divide it into systematic or market-related risk and non-
systematic or diversifiable risk.
When it comes to specifying the factors influencing total risk, one may group them
into two broad classes, viz., factors, which produce non-diversifiable or systematic
risk and factors which cause non-systematic or diversifiable risk. The former
category comprises causes like interest rate variations, inflation, or market sentiment
(or bull-bear market) which would affect all firms and their measurement will be
useful in estimating required rate of return. The latter category would, on the other
hand, include causes like business environment, financial leverage, management
quality, liquidity, and chance of default. They affect some firms but no others. These
sources of risk are expected to have minimum impact on a diversified portfolio and
36 hence one need not be concerned with them too much.
 Components of
2.12 KEY WORDS Investment Risk
Agency Theory: Documents the view that managers have incentives to consume as
against owners who have motivation to work hard. The objective decision-making
process is based on delegation of authority to executives who manage on behalf of
owners. Agency theory postulates non-owner managers to be more susceptible to
management errors.
Agency Cost: The difference between the value of a firm managed by executive
delegates and the one managed by owners, the latter value being higher than the
former.
Bear Market: A period (measured generally in months) during which the market
indexes and prices of most shares decline in a given market. This phase is
characterized by pessimism and low volume.
Bull Market: A period during which the market indexes and prices of most shares
rise in value in a given market and when optimism prevails.
Coupon Rate Risk: The probability of the coupon rate of interest printed on the face
of a debt security as a percentage of its face value being changed in successive short
periods.
Diversifiable Risk: Variability of return caused by factors that are unique to one or a
few securities. Such variability is averaged out to zero in a diversified portfolio and
can, therefore, be eliminated.
Default Risk: The variability of returns to investors caused by changes in the
probability that the company issuing securities might default. Also known as
financial risk and/or bankruptcy risk.
Illiquid Assets: Assets including securities, which cannot be readily sold unless deep
price discounts and/or commissions are given.
Inflation Hedge: An asset whose market price rises as fast or even faster than the
rate of inflation so that the owner does not lose in terms of purchasing power.
Liquidity Risk: The probability that securities will not be sold out for cash without
price discounts and/or commission.
Management Depth: An organisation structure, which provides for adequate
decentralization, delegation, and opportunities for the development of managers at all
levels.
Management Evaluation: An assessment of a firm's management and its
aggressiveness, growth-orientation, research and development plans, utilization of
board of directors depth, flexibility, ability to earn profits and stay abreast of modern
developments, experience, education, and compensation plans.
Non-Diversifiable Risk: Variability in the investor's rates of return arising out of
common and macro-level factors like an economic downturn, general rise in prices..
Increase in interest rates, and bull/bear phases of the securities market. All returns of
securities are systematically affected by these factors. Hence, the risk is also known
as `systematic risk'.
Product Obsolescence: An old product suffering from reduced demand owing to
superior technology of competitors and/or shifts in consumer taste.
Quality Ratings: Quality grades developed by rating firms and agencies, which
indicate the relative probability that a security issue will default. These grades are
indicated by different combinations of alphabets.
Recession: A period during which general business activity declines for several
months or even a few years.
Trough: It occurs when general business activity has bottomed out at the end of a
recession. The usual timing of a trough is at the end of a recession and the beginning
of a recovery in business activity.
37
An Overview
2.13 SELF-ASSESSMENT QUESTIONS/EXERCISES
1) Which of the following concepts of `risk' would you consider better and why?
a) Margin of Safety
b) Debt Ratio
c) Standard deviation
2) Explain the following terms :
a) Diversifiable interest rate risk
b) Liquidity risk
c) Real rate of return
d) Peaks and troughs of business activity
e) Duration
3) Distinguish between
a) Financial risk and business risk
b) Diversifiable risk and Non-diversifiable risk
c) Nominal rate of return and Real rate of return
d) Market interest rate risk and coupon rate risk
e) Individual security risk and portfolio risk.
4) The following information is available fora hypothetical company:

Year Equity Share Price at end of year Dividends for the year

(Rs.) (Rs.)
1998 24.70 1.105
1999 27.20 1.26
2000 36.30 1.42
2001 35.75 1.58
2002 38.25 1.62

If the share was bought at the beginning of each year at the closing price of the
immediately preceding year and sold at the closing price of the year of purchase,
calculate holding period yields for each ofthe years 1998, 1999, 2000 and 2001.

5) Match the words and phrases listed below with the most appropriate definitions
or descriptions
Word or phrase Definition or description
1) Undiversifiable management risk a) The portion of an assets total
risk that is caused by discounts
and selling commission that be
given up to sell it.
2) Agency cost b) Variability of return caused by
changes in the price level.
38
 3) Undiversifiable market risk c) Difference in expenses at Components of
owner- and managed and Investment Risk
employee-managed firms.
4) Bull market d) Costly management errors that
occur systematically at the
worst times.
5) Purchasing power risk e) Variability of return caused by
simultaneous fluctuations in
the price of most securities.
6) Total risk f) Systematic price movements
that sweep most stocks along
in alternating bull and bear
market price swings.
7) Bull and bear market g) A period of prevailing
optimism that carries the price
of most securities to high
levels.
8) Liquidity risk h) The aggregate variability of
return an asset derives from all
its risk factors.
6) Indicate if the following statements are True or False:
a) Price fluctuations rises results from systematic changes in the prevailing
market interest rates. (True/False)
b) Most losses from default occur after the default. (True/False)
c) Price of a firm's share drop on the news of a little drop in earnings per
share because it is considered a forewarning to cut in dividends and
possible default and bankruptcy. (True/False)
d) A continual turnover of able executives hired into the firm from its
competitors suggest that the firm suffers from lack of management depth.
e) Consumption by top-level executives of excessive amounts of non-
pecuniary benefits such as expensive chauffeur-driven cars, private plane
services, luxurious meetings scheduled at glamour spots, and special
residences is all evidence of agency costs. (True/False)
f) About 70 per cent of the shares listed on the BSE declined in Price, on
average, during the recent bull market. (True/False)
g) An investor would earn real rate of return only when his portfolio rises
steadily. (True/False)
h) Purchasing power risk can be minimised by seeking securities with high
positive nominal rates of return. (True/False)

2.14 FURTHER READINGS

Curley, Anthony J., and Bear, Robert M., 1979, Investment Analysis and
Management, New York : Harper & Row.
Altman, Edward I., 1983, Corporate Financial Distress, New York : Wiley.
Harlow, J. Henemen, 1970, Reading in Financial Analysis, Ind. Ed. Homewood III
:Richard D. Irwin.
Henderson; Richard., 1980, Performance Appraisal., Reston, Va Reston Publishing.
Sprinckel, Bery W., 1964, Money and Stock Prices., Homewood III. : Richard D.
Irwin.
Fisher, Donald E., and Jordan, Ronald J., 1990, Security Analysis and Portfolio
Management, 4" Ed., New Delhi : Prentice Hall of India Pvt. Ltd 39
An Overview
Appendix 1: Computation of Beta (for illustrative purpose only)
Week BSE-100 HLL Infosys Reliance WEEKLY RETURN
BSE-100 HLL InfosysReliance
30-Jun-00 2397.06 283.64 8318.85 340.90
7-Jul-00 247720 278.50 8483.05 362.40 0.03 - 0.02 0.02 0.06
14-Jul-00 2432.76 294.50 7731.80 359.90 -0.02 0.06 -0.09 -0.01
21-Jul-00 2243.63 258.00 7267.10 341.95 - 0.08 - 0.13 - 0.06 - 0.05
28-Jul-00 2153.46 236.10 6954.05 340.80 -0.04 -0.09 -0.04 0.00
4-Aug-00 2075.15 255.35 6288.00 329.20 -0.04 0.08 -0.10 -0.03
11-Aug-00 2092.83 232.40 7255.45 328.85 0.01 - 0.09 0.14 0.00
18-Aug-00 2185.65 243.60 7966.65 336.50 0.04 0.05 0.09 0.02
25-Aug-00 2260.12 241.75 8079.25 333.75 0.03 - 0.01 0.01 - 0.01
1-Sep-00 2306.07 238.55 8373.15 337.05 0.02 - 0.01 0.04 0.01
8-Sep-00 2390.36 249.25 8555.30 373.95 0.04 0.04 0.02 0.10
15-Sep-00 2297.93 240.50 8507.90 364.90 -0.04 -0.04 -0.01 -0.02
22-Sep-00 2037.32 218.00 7018.80 334.75 - 0.12 - 0.10 - 0.19 - 0.09
29-Sep-00 2075.67 208.65 7343.60 342.60 0.02 - 0.04 0.05 0.02
6-Oct-00 2050.29 214.25 7389.65 340.20 -0.01 0.03 0.01 -0.01
13-Oct-00 1866.40 184.65 6479.75 317.55 - 0.09 - 0.15 - 0.13 - 0.07
20-Oct-00 1885.39 173.15 7099.45 295.85 0.0I - 0.06 0.09 - 0.07
27-Oct-00 1922.73 168.55 7200.75 304.15 0.02 -0.03 0.01 0.03
3-Nov-00 2009.27 184.45 7578.80 314.00 0.04 0.09 0.05 0.03
10-Nov-00 2014.02 187.00 7831.30 312.00 0.00 0.01 0.03 -0.01
17-Nov-00 2010.20 182.25 7637.20 310.20 0.00 - 0.03 - 0.03 - 0.01
24-Nov-00 2004.56 172.50 7442.20 313.20 0.00 -0.05 -0.03 0.01
1-Dec-00 2101.65 193.95 7264.75 328.40 0.05 0.12 -0.02 0.05
8-Dec-00 2185.11 192.25 7388.10 338.80 0.04 - 0.01 0.02 0.03
15-Dec-00 2144.12 192.50 7175.55 338.05 -0 02 0.00 -0.03 0.00
22-Dec-00 1981.98 200.60 5796.40 338.40 - 0.08 0.04 - 021 0.00
29-Dec-00 2032.20 206.35 5705.55 339.00 0.03 0.03 -0.02 0.00
5-Jan-01 2164.50 208.40 6381.50 364.65 0.06 0.01 0.11 0.07
12-Jan-01 2072.28 200.85 5797.95 354.30 - 0.04 - 0.04 - 0.10 - 0.03
19-Jan-01 2182.09 200.00 6778.90 368.75 0.05 0.00 0.16 0.04
26-Jan-01 2217.24 206.25 6777.80 381.45 0.02 0.03 0.00 0.03
2-Feb-01 2213.88 199.35 6860.20 394.35 0.00 -0.03 0.01 0.03
9-Feb-01 2266.38 213.50 6406.15 398.15 0.02 0.07 - 0.07 0.01
16-Feb-01 2219.68 216.25 6254.15 423.75 -0.02 0.01 -0.02 0.06
23-Feb-01 2083.91 21635 5598.55 409.70 - 0.06 0.00 - 0.11 - 0.03
2-Mar-01 2021.59 232.40 4939.85 417.45 -0.03 0.07 -0.13 0.02
9-Mar-01 1885.24 221.55 4817.50 405.55 -0.07 -0.05 -0.03 -0.03
16-Mar-01 1794,12 220.00 4694.20 384.40 - 0.05 - 001 - 0.03 - 0.05
23-Mar-01 1714.54 215.55 4220.40 379.10 - 0.05 - 0.02 - 0.11 - 0.01
30-Mar-01 1691.71 218.75 4082,90 390.90 -0.01 0.01 -0.03 0.03
6-Apr-O1 1658.60 219.95 4008.75 382.15 -0.02 0.01 -0.02 -0.02
13-Apr-01 1472.93 210.95 2849.85 295.85 - 0.12 - 0.04 - 0.34 - 0.26
20-Apr-01 1704.43 210 ""0 3840 360.00 0.15 0.04 0.30 0.20
27-Apr-01 1624.76 210.40 3236.50 347.85 - 0.05 - 0.04 - 0.17 - 0.03
4-May-01 1710.82 210.35 3813.50 342.70 0.05 0.00 0.16 - 0.01
11-May-01 1716.15 210.05 3902.40 356.15 0.00 0.00 0.02 0.04
18-May-01 1766.47 207.50 3942.05 373.90 0.03 - 0.01 0.01 0.05
25-May-01 1782.01 199.90 4177.35 394.70 0.01 - 0.04 0.06 0.05
1-Jun-01 1734.90 192.65 3746.90 380.05 - 0.03 - 0.04 - 0.11 - 0.04
8-Jun-01 . 1706.75 186.65 3954.00 370.30 - 0.02 - 0.03 0.05 - 0.03
15-Jun-01 1642.94 198.50 3401.90 357.65 -0.04 0.06 -0.15 -0.03
22-Jun-01 1620.20 204.70 3439.75 341.90 -0.01 0.03 0.01 -0.05
29-Jun-01 1630.02 205.35 3761.35 369.50 0.01 0.00 0.09 0.08
Beta 0.49 1.82 0.96

40
Appendix 2: BSE-100 Index Closing Prices from January 90 to September 2001 Components of
Investment Risk

41
An Overview

UNIT 3 VALUATION OF SECURITIES

Objectives

The objectives of this unit are to:

• explain the fundamentals of valuation as applied to securities
• discuss the relevance of the three-step valuation process as used traditionally
• familiarize you with the general approach to valuation as influenced by the
rules of market and different classes of investors
• analyze the specifics of fixed-income securities valuation
• examine valuation methodologies generally employed by preference and equity
investors
Structure
3.1 Introduction
3.2 The Three-step Valuation Process
3.2.1 Economy Analysis
3.2.2 Industry Analysis
3.2.3 Company Analysis
3.2.4 Empirical Support for the Valuation Sequence
3.3 The General Valuation Framework
3.3.1 The Basic Valuation Model
3.3.2 Value Price Relationship
3.3.3 The Cootner Hypothesis
3.3.4 The Dynamic Valuation Process
3.4 Valuation of Fixed-income Securities
3.4.1 Estimating Returns on Fixed Income Securities
3.5 Valuation of Preferences Shares
3.6 Valuation of Equity Shares
3.6.1 The Present Value of Expected Stream of Benefits from Equity Shares
3.6.2 Dividend Valuation Model
3.6.3 The P/E Approach to equity valuation
3.7 Summary
3.8 Key Words
3.9 Self-Assessment Questions/Exercises
3.10 Further Readings

3.1 INTRODUCTION
Investment is a commitment of funds for a period of time to derive a rate of return
that would compensate the investors for the time during which the funds are not
available for consumption, for the expected rate of inflation during the period of
investment and for the uncertainty involved. Since the objective of the investment is
to derive a rate of return, investors have to first specify the desired rate of return so
that an investment decision can be made if the expected rate of return is equal to or
greater than the desired or required rate of return. In the previous unit, it was
explained that the required return increases along with an increase in the risk level of
investment. Once the desired or required rate of return is
42
 Valuation of Securities
identified, the second step in investment decision is to find out the expected return of
investment. This is normally done by comparing the initial investment required to
buy the financial asset and periodic cash flows available from the asset. In some
cases, like savings bank account or investments in fixed deposits or corporate bond,
the estimation of expected return is fairly easy because the issuer of the security
clearly states the cash flows available from such assets. Thus decision on such
investments is relatively easier than investing in equity shares. Investment in equity
shares requires investors to estimate the cashflows based on the expected
performance of the firm during the investment period. This is the complex and most
challenging job in investment decision making process. In this Unit, we will discuss
how an investor can take up this challenging task of estimating future cash flows.
3.2 THE THREE-STEP VALUATION PROCESS
In the previous section, we explained that investment decision is made by comparing
the expected or estimated return with the required rate of return. This investment
decision process is similar to any purchasing decision you make in your day-to-day
life. For instance, when you visit a fruit shop to buy apples or automobile showroom
to buy a vehicle, you always compare the price with the value, which you are going
to receive by such purchases. There are two general approaches to the valuation
process when you make an investment decision: (1) the top-down, three-step
approach and (2) the bottom-up stock valuation, stock picking approach. The
difference between the approaches is the perceived importance of economy and
industry influence on individual firms and stocks. The three-step approach believes
that a firm's revenue is considerably affected by the performance of economy and
industry and thus, the first step in valuation of process is to examine the economy and
industry and their impact on the firm's cash flow. On the other hand, bottom-up
approach believes that it is possible to find stocks that offer superior returns
regardless of the market or industry outlook. In this unit, we will primarily be
discussing the three-step approach. Under this approach, the performance of
economy is first looked into to understand its impact on industries. Then the analysis
progress to industry level analysis to understand the likely performance of the
industries during the investment horizon. Once industries are picked up, the analysis
moves to individual stocks to examine the outlook of firms in the selected industries.
Thus, the three-step approach is also called economy-industry-company (E-I-C)
approach. Figure 3-1 illustrates the E-I-C approach.

Figure 3.1: The Investment Process (E-I-C Approach)

3.2.1 Economy Analysis
All firms are parts of the overall system known as the `general economy', which
witnesses ups and downs. It is logical to begin the valuation process with projections
of the `macro economy'. What you should grasp is the vast number of influences that
affect the `general economy'. To give only a few examples: Fiscal policy affects
spending both directly and through its multiplier effects. For example, tax cuts can
encourage spending whereas additional taxes on income or products can discourage
spending. Similarly an increase or decrease in government spending also influence
the economy. For example, increases in road building increases the demand for 43
earthmoving equipment and concrete materials.
An Overview
Employment created in road construction, earthmoving equipment manufacturing and
concrete materials manufacturing will in turn increase higher consumer spending. This
multiplier effect increase overall economic activity and thus many investors and
analysts consider government spending on plan expenditure is critical for industrial
activity.
Monetary policy affects the supply and cost of funds available to business units. For
instance, a restrictive monetary policy reduces money supply and thus reduces the
availability of working capital to business units. Such policy also increases interest
rates and thus increases the cost of funds to business units and also increases required
rate of return for the investors. Of course, it will also reduce inflation and thus reduces
the required rate of return. Monetary policy therefore affects all segments of the
economy and that economy's relationship with other economies.
In addition to fiscal and monetary polices, political uncertainty, war, balance of
payments crisis, exchange rates, monetary devaluations, world opinion, and several
other international. factors affect the performance of the economy. It is difficult to
conceive any industry or company that can avoid the impact of macroeconomic
developments that affect the total economy. A well-informed investor will first attempt
to project the future course of the economy. If his projections indicate conditions of
boom, the investor should select industries most likely to benefit from the expected
prosperity phase. On the other hand, if the outlook is not good or a recession is
expected, investor should defer investments in stocks or identify industries, called
defensive industry, which are less affected by the poor performance of the economy for
investment in equities. Investment in fixed income securities, particularly government
securities, is preferred in such scenario. Thus, the economic analysis helps investors
first to allocate available surplus amount between different types of securities (like
government bonds, corporate bonds and equities) and then select industries, which are
expected to do well in a given economic condition. Investors, like Foreign Institutional
Investors (FIIs) operating in several countries can use economic analysis to allocate
funds to different countries based on the economic outlook.
3.2.2 Industry Analysis
All industries are not influenced equally by changes in the economy nor they are
affected by business cycles at just one single point of time. For example, in an
international environment of peace-treaties and resolution of cold war, profits of
defence-related industries would wane. The upturn in construction industry generally
lags behind the economy. Similarly, a boom or expansion of the economy is not likely
to benefit industries subject to foreign competition of product obsolescence. The
equipment manufacturing industry will perform well towards the end of economic
cycle because the buyer firms typically increase capital expenditure when they are
operating at full capacity. On the other hand, cyclical industries such as steel and auto,
typically do much better than aggregate economy during expansion but suffer more
during contractions. In contrast, non-cyclical industries like food processing or drugs
would show neither substantial increase nor substantial decline during economic
expansion and contraction.
In general, an industry's prospects within a global business environment will determine
how well or poorly an individual firm will fare. Thus industry analysis should precede
company analysis. A weak firm in booming industry might prove more rewarding than
a leader in a weak or declining industry. Of course, the investor would continuously be
through a search process so that the best firms in strong industries are identified, and
narrow down the area of search for investment outlets. Industry analysis is also useful
for investors to allocate funds for different industries taking into account the future
potential and current valuation.
3.2.3 Company Analysis
After determining that an industry's outlook is good, an investor can analyze and
compare individual firms' performance within the entire industry. This involves
examining the historical performance of the company, the firm's standing in the
industry and future prospects. The last one is critical for estimation of cash flows and
hence value. It should be noted that a good Stock or Bond for investment need not
come from the best firm or market leader in the industry because the Stock or Bond of
such firms may be fully valued or overvalued and hence there is no scope for earning
additional return. Thus, investors always look for firms which
44
 Valuation of Securities
are undervalued for investments than looking for firms, which are best in respective
industries.
3.2.4 Empirical Support for the Valuation Sequence
You may at this stage, ask a question: "Why should the `company-level' be the last
stage in the valuation sequence?" The valuation sequence can be defended and your
question aptly answered if it could be shown that earnings, rates of return, prices, and
risk levels of a company bear relationships with the economy or with the market
which is used as a substitute factor for the `general economy'. Many studies are
available on the subject and it may not be out of place to provide an overview of their
basic findings.
Brown and Ball (1967):
This study selected 316 firms belonging to different industries. Earnings of each firm
were first related to earnings of all 316 firms (dummy for "economy") and then to
earnings of each of the firm belonging to its respective industry for the 1947-1965
period. It was found that 30-40 per cent of variability of each firm's earnings was
related to the variability of earnings of all firms, plus, 10-15 per cent of the firm's
earnings variability was related to the earnings variability of the industry. Also, larger
and more diversified firms were more closely related to the economy while the small
and specialized firms showed greater independence.
(For more details, you may see "Some preliminary findings on the Association
between the Earnings of a Firm, Its Industry and the Economy," Empirical Research
in Accounting; Selected Studies, 1967, Supplement to Vol. 5, Journal of Accounting
Research, pp 55-57).
King (1960):
This study examined the firm, industry, and economy relationships using the rate of
return as the base variable. The rate of return was defined as the monthly percentage
change in price. The exercise covered 63 stocks representing six industries for 403
months from June 1927 through December 1960. Fifty-two per cent of the variation
in stock prices was explained by variations in the prices of the whole market and
another ten per cent by industry variability. Even though the influence of the market
factor did decline over time, King's study confirms the valuation sequence being
discussed in this section.
(For more details, you may see Benjamin F. King, "Market and Industry Factors in
Stock Price Behaviour," Journal of Business, Vol. 39 No.1, Part-2, January 1960, pp
139-190).
Myers (1973):
Using King's methodology, this study enlarged the sample by adding 5 stocks from
each of the twelve industry groups and extended the sample period to December
1967. The market explained more than 55 per cent of the variance for individual
prices prior to 1944 but its explanatory power declined to less than 35 per cent during
the 1952-1967 period. The industry influence also weakened after 1952. The industry
influence was very weak when the industry was heterogeneous. Overall, the market
and industry need to be analyzed before looking at individual stocks.
(For more details, you may see Stephen L. Myers, "A Re-Examination of Market and
Industry Factors in Stock Price Behaviour," Journal of Finance, Vol 28, No. 3, June
1973, pp 695-705).
Blume (1971):
This study examined the influence of the market studying all the New York Stock
Exchange (NYSE) stocks for the period July 1926 through June 1968. Systematic
risk factor was computed with beta as the measure. The, influence of the market was
found to decline but still it explained about 30 per cent of the variance in individual
shares.
(For more details, you may see Marshall E. Blume, "On the Assessment of Risks,"
Journal of Finance Vol 26, No. 1, March, 1971 pp 1-10).
The results of these studies suggest strongly that a knowledgeable investor must first
project the state of the economy in view of its close relationship with the stock
market. And once an expansion is anticipated, serious common stock analysis would
be imperative.
45
An Overview
Activity -1
I. Based on the last economic survey presented one-day before the presentation of
Union Budget and last year Union Budget, how would you assess the economic
outlook for the country in the forthcoming year? Give any five important
reasons for you to believe that the economy will show good (or bad)
performance in the next year?
1. .......................................................................................................................
2. ………………………………………………………………………………
3. ………………………………………………………………………………
4. ………………………………………………………………………………
5. ………………………………………………………………………………
II. On a three-point scale (1=Good; 2=Average; 3=Poor), how would you rate the
outlook of the following industry for the coming one year.
(a) Cement Industry_____________________________________________
(b) Pharmaceutical Industry_______________________________________
(c) Machinery Manufacturing industry______________________________
(d) Software Industry____________________________________________
(e) Hotel Industry_______________________________________________

3.3 THE GENERAL VALUATION FRAMEWORK

Most investors look at price movements in securities markets. They perceive
opportunities of capital gains in such movements. All would wish if they could
successfully predict them and ensure their gains. Few, however, recognize that value
determines price and both changes randomly. It would be useful for an intelligent
investor to be aware of this process. The present section examines this process in
detail. We first present a brief outline of the basic valuation model and then proceed
to discuss the relationship of value with price via investor-market-action. We shall
also recall active and passive investment strategies and finally figure out the dynamic
valuation model.
3.3.1 The Basic Valuation Model
Value of an asset is equal to present value of its expected returns. This is true
particularly when you expect that the asset you own, provides a stream of returns
during the period of time. This definition of valuation also applies to value of
security. To covert this estimated stream of return to value a security, you must
discount the stream of cash flows at your required rate of return. This process of
estimation of value requires (a) the estimated stream of expected cash flows and (b)
the required rate of return on the investment. The required rate of return varies from
security to security on account of differences in risk level associated with securities.
Given a risk-adjusted discount rate and the future expected earnings flow of a
security in the form of interest, dividend earnings, or cash flow, you can always
determine the present value as follows:

CF1 CF2 CF3 CFn

PV= + 2
+ 3
+-----+
1+r (1+r) (1+r) (1+r) n
Where, PV = Present value
CF = Cash flow, interest, dividend, or earnings per time period upto `n'
number of periods.
46
 Valuation of Securities
r = risk-adjusted discount rate (generally the interest rate)
Expressed in the above manner, the model looks simple. But practical difficulties do
make the use of the model complicated. For instance, it may be quite difficult to
assume that every investor in the market exactly measure the value of cash flows and
risk adjusted required rate of return. Further, investors' expectation on compensation
for risk may also different between different types of investors. A small change in
these measures will also cause a change in the value. Thus, it may not be possible to
generate a single value. You will realize that market operations would become
tedious with a range of values. Secondly, return, risk, and value would tend to change
over time. Thus, security prices may rise or fall with buying and selling pressures
respectively (assuming supply of securities does not change) and this may affect
capital gains and hence returns expected. Consequently, estimates of future income
will have to be revised and values reworked. Similarly, the risk complexion of the
security may change over time. The firm may over borrow (and face financial risk) or
engage in a risky venture (and face operating risk). An increase in risk would raise
the discount rate and lower value. It would then seem to be a continuous exercise.
Every new information will affect values and the buying and selling pressures, which
keep prices in continuous motion, would drive them continuously close to new
values. The last part of this section portrays this dynamic valuation model with ever-
changing information inputs.
3.3.2 Value-Price Relationship
Present value, also known as intrinsic value or economic value, determines price. We
have said this in the preceding section. But how does it happen? Again, a hint to the
answer for this question has been stated in the foregoing paragraph. You should have
noted the role of `buying and selling pressures' which make prices more toward
value. Now, you would ask: `what these pressures are and how do they occur? You
will briefly understand that `investor action' in the wake of revisions of values spurs
such pressures.
You would recall that investment strategies can be `passive' or `active'. Following
this, investors and investment managers can also be broadly grouped in `passive' and
`active' categories. You should note that buying and selling pressures dominantly
originate with active investors. And they follow certain rules of the game which are
outlined below:
Rule 1: Buy when value is more than price. This underlines the fact that shares are
underpriced and it would be a bargain to buy now and sell when prices move up
toward value.
Rule 2: Sell when value is less than price. In a situation like this, shares would be
overpriced and it would be advantageous to sell them now and avoid less when price
later moves down to the level of the value.
Rule 3: Don't trade when value is equal to price. This is a state when the market price
is in equilibrium and is not expected to change.
3.3.3 The Cootner Hypothesis
Cootner adds one more dimension to the general view of investor action and buy-sell
pressures. He classifies active investors further into two groups viz., `professional
investors' and `unsophisticated investors’. The former are resourceful enough to
discover news and develop estimates of intrinsic value even before the
unsophisticated investors get the news. They will, therefore, be the first to commence
market action the moment a value-price mismatch is discovered. `Unsophisticated
investors' including hasty speculators who act on `hot tips' would not get any news
other than public news and will not have the skill to interpret even such public news.
They will however, act in the market but such an action would be incompatible with
true changes in intrinsic value. For instance, some of them might have got retirement
benefits and would desperately want to invest in shares and securities. And
unfortunately, such an action may come up at a time when price is more than value.
Likewise, some such investors may have to finance a marriage in the family and
would have to sell shares held by them even if price is already ruling at a level lower
than the intrinsic value. It is obvious that the action of unsophisticated investors
would cut against the trading pressures needed to rectify the disequilibrium between
value and price. 47
An Overview
It is only when their irrational action takes prices to substantial `highs' or `lows' that
the professional investors re-enter the scene and pocket enormous profits even while
attempting to realign the errant prices to intrinsic values.
Paul Samuelson has supplemented the Cootner formulation of the valuation model by
stressing the state of continuous equilibrium. Such a situation would be formed when
prices adjust at high speed to values. Instantaneously adjusting prices to `vibrating
values' would be known as perfectly efficient prices, which would be assumed to
reflect all information. A security with perfectly efficient prices would be in
continuous equilibrium.
3.3.4 The Dynamic Valuation Process
You should have by now understood the dynamic nature of valuation. Estimates of
present value, riskiness and discount rates, future income, and buy-sell action have to
be reviewed from time to time in response to new bits and sets of information. Figure
3.2 depicts the dynamic valuation process which is an ever continuing phenomenon.
The investors start with their estimates of intrinsic value using the present value
procedure. Working on the trading rules, they buy sell or don't trade. In the process,
buying and selling pressures are generated and prices either move up or down. In
either case, Future return will be influenced by the latest market price reacting to
buying/selling pressures. This will require present values to be reworked. The process
will thus go on.

Figure 3.2 : The Dynamic Valuation Model

Activity-2
I. Indicate if the following statements are True or False
a) Perfectly efficient prices reflect all information (True/False)
b) Continuous equilibrium is a state when action of the professional
investors brings prices closer to intrinsic value. (True/False)
c) The discount rate used to estimate present values is the risk adjustment
interest rate. (True/False)
II. In terms of Sales, Assets, and Profit, L&T and BHEL are close to each other
but the market price of these shares differs substantially. Can you list down any
three important reasons for the difference?
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
………………………………………………………………………………....
48
 Valuation of Securities
3.4 VALUATION OF FIXED INCOME SECURITIES
Debt securities issued by governments, government and quasi-government
organizations, and private business firms are fixed-income securities. Bonds and
debentures are the most common examples.

The intrinsic value of a bond or debenture is equal to the present value of its expected
cash flows. The coupon interest payments, and the principal repayment are known
and the present value is determined by discounting these future payments from the
issuer at an appropriate discount rate or market yield. The usual present value
calculations are made with the help of the following equation:
n
C TV
PV = ∑ (1+r) + (1+r)
i=1
1 n
(3.1)

Where PV = the present value of the security today (i.e., time period zero)

C = coupons or interest payments per time period `t'

TV = the terminal value repayable at maturity; this could be at part,

premium, or even at discount (in extraordinary cases)

r = the appropriate discount rate or market yield

n = the number of years of maturity

The valuation methodology implicit in the above equation can be illustrated.

Consider a bond (Bond-A) with a face value of Rs. 1,000 was issued with a maturity
of five years at par to yield 10%. Interest is paid annually and the bond is newly
issued. The value of the bond would be as follows:

Rs.100 Rs.100 Rs.100 Rs.100 Rs.100 + Rs.1000

PVA = + + + +
1+.10 (1+.10) (1+.10) (1+.10) 4
2 3
(1+.10)5
=100×.9091+100×.8264+100×.7513+100×.6830+1100×.6209
=90.91+82.64+75.13+68.30+682.99
= 999.97 or Rs. 1,000 approx.

You should recognize that the present value of the bond viz. Rs. 1,000 estimated
above is equal to the issue price because the bond has just been sold at par of Rs.
1,000.

Now, consider another bond (Bond-B) with a face value of Rs. 1,000 issued five
years ago at a coupon of 6%. The bond had a maturity period of ten years and as of
today, therefore, five more years are left for final repayment at par. The current
discount rate is 10 per cent as before. All other characteristics of bond-B are identical
with bond-A.

It is obvious that the present value of bond-B will not be Rs. 1,000 because investors
will not pay this price and agree to receive Rs. 60 per year as interest for the next five
years when bond-A with similar characteristics provides annual interest payments of
Rs. 100 for the next five years. The present value of bond-B will be determined as
follows:

Rs.60 Rs.60 Rs.60 Rs.60 Rs.60 + Rs.1000

PVB = + 2
+ 3
+ 4
+
1+.10 (1+.10) (1+.10) (1+.10) (1+.10)5
=60×.9091+60×.8264+60×.7513+60×.6830+1060×.6209
=54.55+48.59+45.08+40.98+658.15
= Rs. 847.35 49
An Overview
Any one, who buys the bond, will pay only Rs. 847.35. You will observe that the
numerator of the PV equation will be given at the time of issuance of the bond or the
debenture. The maturity period, timing of interest payments, and maturity value will
also be specified. What remains to be determined is the denominator of the equation
viz. the discount rate. You may notice that the discount rate is the current market
interest rate, which investors can earn on comparable investments such as new bonds
with the same features. In other words, it is an opportunity cost. Thus, the discount
rate incorporates the effect of interest rates and reflects the current market yield for
the issue.
Should interest payments be semi-annual, the PV equation will have to be modified
as follows: divide 'C', and `r' both by 2 and multiply `n' by 2. The resultant equation
will be:
2n
Ct / 2 TV
PV = ∑ + (3.2)
i =1 (1 + r / 2) (1 + r / 2) 2 n
t

Assuming semi-annual payments, present values of bonds A and B in the above

examples can be solved as under :
10
Rs.50 Rs.1,000
PVA = ∑ t
+
t=1 (1.05) (1.05)10
=Rs.999.98 or Rs. 1,000 approx.
10
Rs.30 Rs.1,000
PVB = ∑ t
+
t=1 (1.05) (1.05)10
=Rs.845.55

3.4.1 Estimating Returns on Fixed Income Securities

Several measures of returns on bonds are available. They are: the coupon rate, the
current yield, and the yield to maturity. The coupon rate is specified at the time of
issue and is all too obvious. The other two measures can be discussed.
Current yield: This is calculated as follows:

Stated (coupon) interest year

Current yield =
Current market price
For example, if a 15% Rs. 200 debenture is currently selling for Rs. 220 the annual
current yield would be:

Rs. 30
= 13.64%

You must notice that the 15% debenture with a face value Rs. 200 is currently selling
for Rs. 220 because interest rates subsequently declined and debenture/bond prices
move inversely with interest rates. The current yield having declined to 13.64% from
the coupon rate of 15% reflects this.
Current yield is a superior measure to coupon rate because it is based on the current
market price. However, it does not account for the difference between the purchase
price of the bond/debenture and its maturity value.
Yield-to-maturity (YTM): This is the most widely used measure of return on fixed
income securities. It may be defined as the indicated (promised) compounded rate of
return an investor will receive from a bond purchased at the current market price and
held to maturity. Computing YTM involves equating the current market price of a
bond with the discounted value of future interest payments and the terminal principal
repayment; thus YTM equates
50
 Valuation of Securities
the two values, viz., the market price and the present value of future payments
including the principal repayment. You may note that the compounding intervals may
be annual, semi-annual or quarterly. Equations 3(1) or 3(2), the latter being modified
for compounding intervals more frequent than one year, are generally used. If you are
familiar with concept called internal rate of return discussed in MS-4 course, the
YTM is IRR of initial investment (market price) and periodic payments including
principal amount received at the end of the period.
Assume that an investor purchases a 15%, Rs. 500 fully secured non-convertible
debentures at the current market price of Rs. 400. The debenture is to be repaid at the
end of five years from today. The yield-to-maturity can be estimated as follows:
n
Ct TV
MP = ∑ (1+YTM) + (1+YTM)
t=1
t n

5
Rs.75 Rs.500
or, Rs. 400 = ∑ (1+YTM) + (1+YTM)
t=1
t 5

What is required in this case is a value of YTM which equates Rs. 400 with the sum
of present values of Rs. 75 per year for 5 years and of Rs. 500 receivable at the end of
the fifth year. Clearly, a process of trial-and-error is indicated. Several values of
YTM can be tried till the equating value emerges. Trials can be started with the
coupon rate with the next trial rate increased if the present value of the preceding trial
exceeds the current market price and vice versa. Thus, trying at 15%, the following
present value of the right hand side cash flows is estimated.

PV15% = Rs. 75 per annum × PVIFa,5yrs.,15% +Rs.500 × PVIF15%. 5yrs.

= Rs.75 × 3.3522 + Rs. 500 × .4972 = Rs. 251.42 + 248.60
= Rs. 500.08
Since the PV of Rs. 500.08 exceeds Rs. 400, a higher discount rate must be tried.
The second trial may be made at 20%.

PV20% = Rs. 75 × 2.9906 + Rs.500 × .8333

= Rs. 224.295 + Rs. 200.95
= Rs. 425.245
Even the second trial has failed to equate the two values. Hence, you can $o over to
the third trial at, say, 24%.

PV24% = Rs. 75 × 2.7454 + Rs.500 × .3411

= Rs. 205.91 + Rs. 170.55
= Rs. 376.46
The third trial has lowered the present value to Rs. 376.46 which is less than Rs. 400.
Hence, the required YTM must lie between 20% and 24%. The estimate can be
obtained by interpolating, thus :

425.245-400.00 25.245
YTM = 20% + x(24%-20%) = 20% + x 4%
425.245-376.46 48.785
= 20% + 2.07% = 22.07%
You may now notice that YTM calculation is similar to calculating the internal rate
of return. Calculators and computers have made these calculations extremely easy.
For instance, if you are familiar with Microsoft Excel, then you can use = IRR ()
function to get this value. You may further note that the YTM is just a promised yield
and the investor cannot earn it unless the bond/debenture is held to maturity.
Secondly, the YTM concept is a compound 51
An Overview
interest concept with the investor earning interest-on-interest at YTM throughout the
holding period till maturity. You should understand that if intermediate cash flows
are not reinvested at YTM, the realized yield actually earned will differ from the
promised YTM. For instance after the purchase of the above bond, if the interest rates
decline in the market, then the interest received at the end of each year (Rs.75) can be
invested only at a lower rate and thus affect the YTM, which you have just now
calculated under the assumption that all interest received can be reinvested at the
same rate of YTM. At the same time, you may note that investors may not lose much
because the value of bond (market price) will increase and the bond will be attractive
for investment as it carries more interest rate than current interest rate available.

Investors must make specific assumption about future re-investment rates in order to
gain ideas about realized returns. Zero coupon bonds eliminate the reinvestment rate
risk because investors know at the time of purchase itself the YTM that will be
realized when the bond is held to maturity.

YTM can be approximated and tedious calculations be avoided using the following
formula:

Coupon Interest + [( MPn - MPt )] / N

Approximate YTM = ,where MPn is
[MPn + MPt ]/2

market price at maturity and MP, is market price (or cost) at beginning. In the above
example, the approximate YTM is

75 + [(500 - 400) / 5] 95
= = = 21.11%
(500 -+ 400) / 2 450

3.5 VALUATION OF PREFERENCE SHARES

Preference shares are a hybrid security. They have some features of bonds and some
of equity shares. Theoretically, preference shares are considered a perpetual security
but there are convertible, callable, redeemable and other similar features, which
enable issuers to terminate them within a finite time horizon. In the case of
redeemable preference shares, legal mandates require creation of redemption sinking
funds and their earmarked investments to ensure funds for repayment.

Preference dividends are specified like bonds. This has to be done because they rank
prior to equity shares for dividends. However, specification does not imply
obligation, failure to comply with which may amount to default. Several preference
issues are cumulative where dividends accumulate over time and equity dividends
require clearance of preference arrears first.

Preference shares are less risky than equity because their dividends are specified and
all arrears must be paid before equity holders get dividends. They are, however, more
risky than bonds because the latter enjoy priority in payment and in liquidation.
Bonds are secured also and enjoy protection of principal, which is ordinarily not
available to preference shares. Investors' required returns on preference shares are
more than those on bonds but less than on equity shares. In exceptional
circumstances when preference shares enjoy special tax-shields (like in U.S., inter-
corporate holdings of preference shares get exemption on 80% of preference
dividends) required returns on such shares may even be marginally below those on
bonds.

Since dividends from preference shares are assumed to be perpetual payments, the
intrinsic value of such shares will be estimated from the following equation valid for
perpetuities in general:

C C C
Vp = + + ............... =
(1 + K p ) (1 + K p ) 2
Kp
52
 Valuation of Securities
Where Vp = the value of a perpetuity today
C = the constant annual payment to be received
KP = the required rate of return appropriate for the perpetuity.
You have only to substitute preference dividend (D) for `C' and the appropriate
required return (KPs) for 'KP' and obtain the following equation for valuing preference
shares:

D
Vps =
K ps

You may note that `D' is perpetuity and is known and fixed forever. A perpetuity
does not involve present value calculations and the equation provides for computing
any of the three variables viz., value of the perpetuity (VPs), preference dividend (ID),
required rate of return (KP5) only if the remaining two variables are known. Thus, the
value of a preference share can be calculated if the dividend per share and the
required rate of return are known. Similarly, the required rate of return (or yield) can
be known if the value of the perpetuity and dividend per share are known.
A hypothetical example can be used to illustrate the valuation process of a preference
share. Consider Firm-A issuing preference shares of Rs. 100 each with a specified
dividend of Rs. 11.5 per share. Now, if the investors' required rate of return
corresponding to the risk-level of Firm-A is 10% the value today of the share would
be:

Rs.1.50
Vps = = Rs. 115.00
.10
If the required of return increases (say in the wake of rising interest rates, and in
consequence, the higher opportunity costs) to 12%, value will be :

Rs.11.50
Vps = = Rs. 95.83
.12
You may note that the value changes inversely to the required rate of return.
If you are an observer of market prices, you may notice the price of any preference
share on any day and calculate its yield on that day using the above formula. Thus, if
the current market price of the preference share in question is Rs. 125.00, then the
required rate of return or yield can be calculated as under:

D Rs.11.50
Vps = or, Rs. 125.00 =
K ps K ps
Rs.11.50
or, K ps = = 9.2%
125.00
Thus, the yield declines after issue of the shares by the Firm - `A'. May be, interest
rates declined or other factors changed to produce the downward shift in the yield.
You can observe price shifts over various ranges of time, say weeks, months, and
years and examine causes for shifts in yields of preference shares:
Activity-3
Examine and write a brief report on any one of the preference shares issues of a
public limited company? Also, contact a stockbroker and find out the reasons for low
popularity of preference shares in India.
………………………………………………………………………………
………………………………………………………………………………
……………………………………………………………………………… 53
……………………………………………………………………………….
An Overview
3.6 VALUATION OF EQUITY SHARES
You have known the basic features of equity shares in Unit 1. Unit 2 introduced the
risk-return complexion of such securities. Calculating total return for the holding
period on equity shares was also explained and illustrated in Unit 2. Factors affecting
the riskiness of equity shares and other securities were also discussed in Unit 2. This
section of the present unit will confine attention to valuation of equity shares using
present value principles. The three broad approaches to valuation viz., efficient
market, technical, and fundamental will be examined in detail in Block 3. However,
much of what would be said and analyzed here would relate to `fundamental
approach to valuation of equity shares'.
3.6.1 The Present Value of Expected Stream of Benefits from Equity Shares
Fundamental analysis is centred on presented value, which is computed as the
discounted value of future stream of benefits. In the case of equity shares, the future
stream of earnings poses two problems. One, it is neither specified (as in the case of
preference shares) nor perfectly known in advance as an obligation (as in the case of
bonds and debentures). Consequently, future benefits and their timing have both to be
estimated in a probabilistic framework. Two, there are at least three other variables
which are used as alternative measures of such benefits viz., dividends, cash flows,
and earnings.
Solution to the first problem is offered by past data, which is appropriately modified
for future projections. Of course, investors need to modify the past data by taking
into account the current reality and then measure the growth rate.
The second problem can also be viewed as a case of the three alternatives not really
conflicting with each other. The real question is: which cash flows are appropriate in
the valuation of equity shares? Now, if you buy equity shares and place them all in a
trust fund for your and your heir's perpetual benefit, what cash flows will be received
in the trust fund? The answer is `dividends' because this is the only cash distribution,
which a company makes to its shareholders. Even though earnings per share in any
year do belong to the shareholders, companies do not distribute them all.
Does it mean we should ignore earnings in valuation? Probably, No. All dividends
are paid out of earnings. Moreover, a popular approach to valuation of equity shares
known as P/E ratio uses earnings as its basis. Hence, earnings are important. Now, if
all earnings are paid out as dividends, they will be accounted for as dividends. In the
event of a part of earnings being retained and reinvested, the effect will be to increase
future earnings and finally future dividends also. Present value analysis should not
count earnings reinvested currently and paid later as dividends. It will lead to double
counting. In fact, the two can be properly defined and separated in which case the
two variables viz., earnings and dividends would produce the same results. Thus, it is
always correct to use dividends as the numerator of the present value equation used
to estimate the intrinsic value of equity shares. The present value model, which uses
dividends as its variable representing the cash flow stream, is known as the dividend
valuation model. This model is discussed below and is followed by a discussion of
the P/E approach to equity shares valuation.
3.6.2 Dividend Valuation Model
Under dividend valuation model, future dividends are discounted at the required rate
to get the value of share. There are three possible situations on future dividend.
a) Dividends do not grow in future i.e., the constant or zero growth assumption,
b) Dividends grow at a constant rate in future, i.e., the constant-growth
assumption,
c) Dividends grow at varying rates in future time periods i.e., multiple-growth
assumption.
The dividend valuation model is now discussed under the above three situations
a) The zero-growth Case : The growth rate of dividend D at time `t' will be
54 known by solving for `g' in the following:
 Valuation of Securities
Dt = Dt -1 (1 + g t ) …….(3.3)

Dt − Dt -1
or = gt ........(3.4)
Dt -1

You can easily see that when gt = 0, equation 3.3 will yield Dt = Dt-1 which means all
future dividends would be equal to be current dividend (i.e., the dividend of the
immediately preceding period available as one date).
Now, the present value of dividends for an infinite future period would be:
Dt Dt Dt
V= + 2
+ + ...........∞ …(3.5)
1+K (1 + K) (1 + K)3
∞
Dt
=∑
t =1 (1 + K)t
Since, Do = D1 = D2 = D3, under the zero-growth assumption, the numerator Dt in
equation 3.5 is replaced by Do to get
∞
D0
V=∑
t =1 (1 + K)t
Taking the uniform `Do' out of summation, we obtain:
∞ 1 
V=D0  ∑ t 
……..(3.6)
 t=1 (1 + K) 
You will appreciate that discounting cash flows over a very distant long future period
would, be meaningless. And mathematics tells us that if K>0 then the value of an
infinite series like
1
the one in equation (3.6) is reduced to ` ' so that equation (3.6) results in the
K
following :
1 D
V=D0   = 0 ……..(3.7)
 K  K0
and since Do = D1, equation 3.7 can also be written as
Dt
V= ……..(3.8)
K
You may recall that equation 3.8 was used for the valuation of preference shares.
This is one case for the application of the zero-growth assumption.
The calculation underlying the zero-growth model can be illustrated. Consider a
preference share on which the company expects to pay a cash dividend of Rs. 9 per
share for an indefinite future period. The required rate of return is 10% and the
current market price is Rs. 80.00. Would you buy the share at its current price?
This is zero-growth case because the dividend per share remains Rs. 9 for all future
time periods. You may find the intrinsic value of the share using equation 3.7 or 3.8
as follows:
Rs.9.00
V= = Rs..90
.10
Since the intrinsic value of Rs. 90 is more than the market price of Rs. 80, you would
consider buying the share.
b) The Constant Growth Case : When dividends grow in all future periods at a
uniform rate ‘g’,
D t = D0 (1 + g) t ……(3.9)
55
An Overview
Substituting ‘D0’ in equation 3.5 by the value of Dt in equation 3.9, we get

D0 (1 + g) t
∞
V= ∑ t
…….(3.10)
t=0 (1 + K)

Being a constant amount, `D0' can be written out of summation to obtain the
following equation :

 ∞ (1 + g) t 
V=D0  ∑ t 
…….(3.11)
 t=0 (1 + K) 
Using the mathematical properties of infinite series, if K>g, then it can be shown that
∞
(1 + g) t 1+g
∑
t=1 (1 + K)
t
=
K-g
…..(3.12)

Substituting equation 3.12 into equation 3.11 yields the valuation formula for
the constant growth situation as follows:
1+g 
V = D0   …….(3.13)
K -g
Equation 3.13 can be re-written as follows:
D0 (1 + g ) Dt
V= = …….(3.14)
K -g K-g
Example
Alfa Ltd., paid a dividend of Rs.2.00 per share for the year ending March 31, 2002. A
constant growth of 10% per annum has been forecast for an indefinite future period.
Investors required rate of return has been estimated to be 15%. You want to buy the
share at a market price of Rs. 60 quoted on July 1, 2002. What would be your
decision?
Solution
This is a case of constant-growth-rate situation. Equation 3.14 can be used to find out
the intrinsic value of the equity share as under :
D1 Rs. 2(1.10) Rs.2.20
V = = = = Rs.44.00
K - g .15 - .10 .05
The intrinsic value of Rs. 44 is less than the market price of Rs.60.00. Hence, the
share is overvalued and you would think before investing in the stock.
c) The Multiple-Growth Case : The multiple-growth assumption has to be made in
a vast number of practical situations. The infinite future time-period is viewed as
divisible into two or more different growth segments. The investor must forecast the
time `T' upto which growth would be variable and after which only the growth rate
would show a pattern and would be constant. This would mean that present value
calculations will have to be spread over two phases viz., one phase would last until
time ‘T’and the other would begin after `T' to infinity.
The present value of all dividends forecast upto and including time `T' VT(i)
would be: (3.15)
T
Dt
VT(i) = ∑ (1 + K)
t=1
t
…………(3.15)

The second phase present value is denoted by VT(2) and would be based on constant-
growth dividends forecast after time `T'. The position of the investor at time `T' after
which
56
 Valuation of Securities
the second phase commences can be viewed as a point in time when he is forecasting
a stream of dividends for time periods T+1, T+2, T+3, and so on which grow at a
constant rate. The second phase dividends would be :
DT+1 = DT (1 + g)
DT+2 = DT+1 (1 + g) = DT (1 + g) 2
DT+3 = DT+2 (1 + g) = DT (1 + g)3
And so on. The present value of the second phase stream of dividends can, therefore,
be estimated using equation 3.14 at time 'T':
 1 
VT = DT+1   …………(3.16)
K-g
You may note that `VT' given by equation 3.16 is the present value at time `T' of all
future expected dividends. Hence, when this value has to be viewed at time `zero', it
must be discounted to provide the present value at `zero' time for the second phase
present value. The latter can also be viewed at time `zero' as a series of cash
dividends that grow a constant rate as already stated. The resulting second phase
value VT(2) will be given by the following equation:
 1 
VT(2) = VT  T 
 (1 + K ) 

DT+1
= ………….(3.17)
(K - g)(1 + K)T

Now, the two present values of phase 1 and phase 2 can be added to estimate the
intrinsic value of an equity share that will pass through a multiple growth situation.
The following describes the summation procedure of the two phases:
V0 = VT(1) + VT(2)
T
Dt DT+1
= ∑ (1 + K)
t=1
t
+
(K - g)(1 + K)T
……(3.18)

Example
Cronecom Ltd., paid dividends amounting to Rs.0.75 per share during the last year.
The company is expected to pay Rs. 2.00 per share during the next year. Investors
forecast a dividend of Rs. 3.00 per share in the year after that. At this time, the
forecast is that dividends will grow at 10% per year into an indefinite future. Would
you buy/sell the share if the current price is Rs. 50.00? The required rate of return is
15%.
Solution
This is a case of multiple growth. The values VT(1) and VT(2) can be calculated as
follows:
Rs. 2.0 Rs. 3.0
VT(1) = + = Rs. 4.10
(1 + .15) (1 + .15) 2
1

Rs. 3.30
VT(2) = = Rs. 49.91
(.15 - .10)(1 + .15) 2
Since Vo = VT(1) + VT(2) , the two values can be summed to find the intrinsic value of a
Cromecon equity share at the time `zero'. This is given below:
Vo = Rs. 4.01 + Rs. 49.91 = Rs. 53.92
At the current price of Rs. 50.00, the share is under-priced and hence you will buy the
stock. 57
An Overview
3.6.3 The P/E Approach to Equity Valuation

Unlike dividend capitalization model, the PIE approach is fairly simple and widely
followed in the stock market. The first step under this model is estimating future
earnings per share. Next, the normal price-earnings ratio will be found. Product of
these two estimates will give the expected price. The most practical way of using PIE
model is first computing the industry average P/E or PIE of similar firm and then
multiplying the same with the expected or actual earning of the stock. P/E of an
industry is expected to be high when the industry is in high growth industry. P/E will
be low if the industry or firm is expected to show a low growth rate. PIE is also
affected by the risk associated with the earnings. The following table shows the
growth rate of sales, profit after tax and P/E ratio of few select companies.

T
hough growth rates and P/E ratio are not perfectly correlated, they give some idea
about the influence of fundamentals on P/E ratio. There are several other factors that
determine the P/E ratios.

3.7 SUMMARY
The basic objective of this unit is that the value of an asset is a function of future
expected cash flows from the asset. The general valuation model is discounting the
future cash flows at the required rate of return. This model applies to all assets
including financial assets. The model can be relatively easier to apply on fixed
income securities because there is some amount of certainty on the future cash flows.
Given a future interest and principal repayment, it is much easier to get the value of
bond. Since the market price is already available, valuation exercise is often reduced
to judging whether the asset is properly valued or not. In fixed income securities or
bonds, the general valuation model is also used to compute the yield to maturity
(YTM) to compare the same with the current yield of-similar securities to judge
under or over valuation of bonds.

The intrinsic value of a share at any point of time is the present value of a series of
cash dividends in future time periods with assumptions about varying growth levels
and situations being introduced to make calculations usable in practice. Dividend
valuation models with zero growth, constant growth, and super-normal growth
assumptions are found useful for the practicing security analysts and the investors.
The discount rate in all these models is the required rate of return of the investor
appropriately adjusted for the time value of money and riskiness of returns. This facet
of the problem will be examined in detail in the unit on Capital Asset Pricing Model
58 in Block4.
 Valuation of Securities
A much simplified and practical valuation model is price-earnings model. Under this
model, the stock price is the product of expected earnings and normal P/E ratio of the
stock. The normal PIE ratio is either the average of the industry or P/E ratio of
similar company in the market. Of course, the analysts can't use the P/E model and
for that matter even theoretically richer dividend discount model blindly because
there are several other factors which determine the value of the stock.

3.8 KEY WORDS

Active Investment Strategy : A form of investment management which involves
buying and selling financial assets with the objective of earning positive risk-adjusted
returns.
Constant Growth Model : A version of the dividend valuation model which
assumes that dividends are expected to grow at a constant rate overtime. It can be
used to solve the current price of a share.
Current Yield : The yield on a security1resulting from dividing interest payments or
dividends by the current market price of the security.
Dividend Valuation Model : A widely used model to value equity shares. The
model states that the current price of a share is equal to the discounted value of all
future dividends.
Earnings Multiplier : The P/E approach which states that the price of a share is
equal to the product of its earnings and a multiplier.
Expected Return : The ex ante return expected by investors over some future
holding period. The expected return often differs from the realised return.
Fundamental Analysis : A form of security analysis which seeks to determine the
intrinsic value of securities based on underlying economic factors. These intrinsic
values are compared to current market prices to estimate current levels of mispricing.
Holding Period Return : The total return from an investment for a given period of
time, including both yield and capital gain or loss.
Interest Rate Risk : The uncertainty in the return on a fixed-income security caused
by unanticipated fluctuations in the value of the asset due to changes in interest rates.
Multiple Growth Model : A type of dividend valuation model in which dividends
are assumed to grow at different rates over specifically defined time periods.
P/E Ratio : The ratio of share price to earnings using historical, current or estimated
data. This ratio is also referred to as multiplier.
Passive Investment Strategy: A strategy whereby investors do not actively seek out
trading possibilities in an attempt to out perform the market.
Promised Yield-to-Maturity: The yield-to-maturity on a bond calculated assuming
that all promised cash flows are received on a full and timely basis.
Security Analysis: A component of the investment process that involves determining
the prospective future benefits of a security, the conditions under which such benefits
will be received, and the likelihood of such conditions occurring.
Timing: An aspect of security analysis which entails forecasting the price
movements of asset classes relative to each other.
Top-down Forecasting: The valuation sequence in security which entails first
making forecasts for the economy, then for industries and finally for individual
companies. Each level of forecast is conditional on the previous level of forecasts
made.
Valuation Sequence : Same as top-down forecasting.
Yield-to-Maturity: The indicated (promised) compounded rate of return that an
investor will receive from a bond purchased at the current market price and held to
maturity.
59
An Overview
3.9 SELF-ASSESSMENT QUESTIONS/EXERCISES
1) Arun is considering investment in the equity shares of the industry leader,
TISCO, and has performed detailed analysis and research into the history and
performance of the company. To be on sound wickets, what other information
should be obtained before taking the final decision ?
2) A 5% Rs.1000 bond has 25 years remaining to maturity. What would be the
intrinsic value of the bond today if the current market yield is 6.5%. Interest is
payable on the bond semi-annually.
3) A 5% Rs. 1000 bond paying interest at annual intervals and having 25 years to
maturity is currently selling for Rs. 816. It is anticipated that the market yield is
likely to decline 5.5%. Estimate the intrinsic value of the bond two years
hence.
4) Indicate the correct alternative in the following :
a) The value of a security :
i) is synonymous with its price
ii) depends on the assessed value of the firm's physical assets
iii) equals the discounted present value of its future income.
b) An investor would be taking a rational decision if :
i) he buys when price is greater than value
ii) he does not trade when price is less than value
iii) he buys when price is less than value.
c) The Cootner hypothesis states that : prices and values both fluctuate
ii) prices fluctuate within upper and lower reflecting barriers that
bracket the consensus value estimate
iii) all of the above
d) The erratic price changes in securities markets are caused by :
i) the supply and demand conditions of primary issues
ii) the continuous arrival of new information
iii) the size of trading volume in the security
e) A perfectly efficient securities market is one where :
i) prices and values fluctuate
ii) prices equal values in a continuous equilibrium and they vibrate
together randomly
iii) all of the above
5) Match the following words and phrases with their correct definitions :
Word or Phrase Definition or Description
1) Price per share A) Present value of an equity share
based on all future dividends that
grow at different rates.
2) Passive investment Strategy B) Promised yield on a bond
purchased at current market price and
held to maturity.
3) Intrinsic value per share C) The correct decision when it is
under priced
60
 Valuation of Securities
4) Continuous equilibrium D) A value determined by market
processes that can sometimes be
irrational
5) Buy a security E) A buy-and-hold strategy with no
trading
6) Yield-to-maturity F) A value estimated by an
informed analyst
7) Multiple growth dividend valuation G) The value and price fluctuate
randomly together.

6) The equity share of Manjit Textiles Ltd., is currently selling at Rs. 55.00.
Earnings per share and dividends per share of the company over the past year
were Rs. 3.00 and Rs. 0.75 respectively. Fundamental analysts have worked out
the following forecasts of dividends, earnings, growth rates, and payout ratios for
the next two years.
Year1
D1 = Rs. 2.00 ; El = Rs. 5.00 ; gel = 67%; p1 =40%
Year 2
D2 = Rs. 3.00 ; E2= Rs. 6.00 ; ge2 = 20% ; p2 = 50%
It has been further forecast that earnings and dividend are expected to grow at a
constant rate of 10% after year 2. Consequently, the data for year 3 would be as
follows:
Year 3
D3= Rs. 3.30; E3 = Rs. 6.60; ge3 =10%; p = 50%
You are required to estimate the normal price-earnings ratio of Manjit Textiles if
the required rate of returns is 15%. Do you think that the Manjit Textiles equity
share is fairly valued?
7) Indicate if the following statements are True or False:
a) If the economic outlook suggests a recession that will have an impact on all
industries and all companies, investors would be advised to maintain high
portfolio liquidity.
b) Cyclical industries typically do much better than the aggregate economy
during downturns, but suffer more during upturns.
c) It is not really necessary to know the time pattern of returns from an
investment so that the income stream can be properly valued relative to
alternative investments.
d) Results of a study by King showed that about 62 per cent of the security's
price changes were explained by a combination of market and industry
components.
e) A bond promises interest payments every six months equal to one-half the
coupon rate times the face value of the bond and the payment of the principal
at its maturity.

3.10 FURTHER READINGS

Fuller, Russel J., and Farrell, Jr., James L. 1987, Modern vestments and Security
Analysis, New York : McGraw-Hill Book Company.
Gordon, Myron J., 1962, The Investment, Financing & Valuation of the Corporation,
Homewood III .: Irwin. 61
An Overview th
Graham, Bengamin, 1973, The Intelligent Investor, Harper & Row, New York. (5
ed.)

Juttle, Donald L., ed., 1983, The Revolution in Techniques for Mar,; Bing Bond
Portfolios, The Institute of Chartered Financial Analysis, Chulottesville.

Gup, Benton E., 1987, The Basics of Investing, John Wiley, 3'd ed., New York.

Lorie, James H., and Hamilton, Mar7y T., 1973, The Stock Market : T-aories a;
iEvidence, Homewood III : Richard D. Irwin.

Fischer, Donald E., and Jordan, Ronald J., 1990, Security Analysis and Portfolio
Management; 41" ed., Prentice Hall of India Private Ltd.

62
 Indian Stock Market :
UNIT 4 INDIAN STOCK MARKET : Organisation and
Functioning
ORGANISATION AND
FUNCTIONING
Objectives
The objectives of this unit are to:
• distinguish between primary market and secondary market
• highlight various types of traded securities, market players and trading
arrangements which exist in India
• to discuss organization and functioning of primary and secondary markets for
various types of securities in India
Structure
4.1 Introduction
4.2 Primary Markets
4.2.1 Principal Steps of a Public Issue
4.2.2 Eligibility for an IPO
4.2.3 Rights Issue
4.2.4 Private Placement
4.2.5 SEBI Guidelines for IPO's
4.3 Secondary Markets
4.4 Stock Market in India
4.4.1 Origin and Growth
4.4.2 Role and Functions
4.4.3 Membership, Organization and Management
4.4.4 Trading System
4.4.5 Stock Market Information System
4.5 Summary
4.6 Self-assessment Questions/Exercises
4.7 Further Readings
4.1 INTRODUCTION
Market is a place where buyers and sellers meet and exchange products. This
definition is universal and applies to all markets. In this course, we will discuss more
about the market called capital market. It is a place, where capital of different types is
exchanged. Often individuals, like you, are the lenders or the suppliers of capital.
Companies and various other institutions are the borrowers or the receivers of capital.
The market is organized or divided into different ways. At a very broad level, the
market is divided into (a) Short-term Capital Market (money market) and (b) Long-
term capital market (also, called stock market). Another way of classifying the
market is (a) Institutional Market and (b) Direct Market. As an investor you can deal
with the market in different ways. Let us understand the market from individual's
perspective.
If the surplus money you have can be spared only for a short period, you have to look
for savings of short-duration. Since the amount available is fairly small in such cases,
you have to look for some institutional support for such savings. In other words,
individuals don't directly deal with the money market, which specialize in short-term
capital. Often, individuals approach an institution for this purpose. You can save your
short-term surplus in a bank deposit or a mutual fund, which offer money market
schemes.
If the surplus money you have can be spared for a long-term, you have to look for
investments of longer duration. Again, you can go to an institution, which offers 5
long-
Securities Market term products or you can directly participate in the market. That is, you can deposit
in India your money in a long-term fixed deposit or invest in a mutual funds scheme or
directly buy securities in the market. When you intend to deal with the market on
your own, you can deal with the market in two ways. The markets are accordingly
classified into primary and secondary market. Primary market is the one in which the
company approaches investors to raise capital. They can approach for debt capital or
equity capital or combination of both. Dealing in primary market is fairly simple
today. Like fixed deposit opening, you have to take up an application form of the
issue and deposit the amount after filling up the form. Brokers and sub-brokers will
normally help you to get forms and guide you to fill up the forms. What is important
is you have to make sure that investments fit with your objective. Here too, financial
dailies and magazines publish analytical report on primary market issues for the help
of small investors. After your submission of application forms and if the company
accepts the same, you will get a certificate or credit in your depository. In the event
of too many people applying for the offer, the company may reject some applications.
In such cases, you will get refund of the money that you have invested initially.
Since the price is fixed in primary market, there will be competition for good issues.
The uncertainty of getting allotment forces many investors, who are directly willing
to deal with the market, to turn into secondary market. It is a place where an investor
sells to another investor. Since there are large number of sellers and buyers, the
market is dynamic. Securities prices change depending on the demand and supply of
the securities. Secondary market exists for different types of securities like debt,
equity and others. Investment in secondary market has also become easy, thanks to
developments in Information and Computing Technologies. You have to open an
account with the members of any stock exchanges of your choice. The procedure to
open an account is fairly simple and it is somewhat similar to opening a Savings
Bank Account with your banker. You can place your buying and selling orders over
phone and often you get immediate confirmation of your purchase or sale. Today, it
is also possible for you to buy and sell securities through internet. In this Unit, we
will discuss more on how the stock market is organized and how investors can
transact in buying and selling of securities in the market.

4.2 PRIMARY MARKETS

Primary market is the segment in which new issues are made whereas secondary
market is the segment in which outstanding issues are traded. It is for this reason that
the Primary Market is also called New Issues Market and the Secondary Market is
called Stock Market. In the primary market, new issues May be made in three ways,
namely, public issue, rights issue, and private placement. Public Issues involves sale
of securities to members of public. Rights issue involves sale of securities to the
existing shareholders/debenture holders. Private placement involves selling securities
privately to a selected group of investors. In the primary market, equity shares, fully
convertible debentures (FCD), partially convertible debentures (PCD), and non-
convertible debentures(NCD) are the securities commonly issued by non-government
public limited companies. Government companies issue equity shares and bonds.
Primary market has become very active in India after the abolition of Controller of
Capital Issue. You can refer Unit I (Tables 1.1 to 1.3) to find out the level of
activities in primary market during the last few years.
In the primary market, issues are made either 'at par' or `at premium'. Pricing the new
Issues is regulated under `Guidelines on Capital Issues' or what are also known as
"Guidelines for Disclosure and Investors Protection" issued by the Securities and
Exchange Board of India (SERI). The SEBI guidelines on Disclosure and Investor
Protection is now available in the SEBI website, www.sebi.gov.in. These are detailed
guidelines covering all issues relating to capital offerings. Prior to the promulgation
of the ordinance no.9 of 1992 by which the Capital Issues (Control) Act has been
repealed, the pricing of the new issues was regulated under the Controllers of Capital
Issues' (CO) pricing formula.
6 All Issues by a new company has to be made at par and for existing companies the
issue price should be justified as per Malegam Committee recommendations by
• The earnings per share (EPS) for the last three years and comparison of pre- Indian Stock Market :
Organisation and
issue price to earnings (P/E) ratio to the P/E ratio of the Industry. Functioning
• Latest Net Asset Value,
• Minimum return on increased networth to maintain pre-issue EPS. A company
may also raise finance from the international markets by issuing GDR's and
ADR's.
4.2.1 Principal steps of a Public Issue
A draft prospectus is prepared giving out details of the Company, promoters
background, Management, terms of the issue, project details, modes of financing,
past financial performance, projected profitability and others. Additionally a Venture
Capital Firm has to file the details of the terms subject to which funds are to be raised
in the proposed issue in a document called the `placement memorandum'.
Some of the steps involved in a public issue are
a) Appointment of underwriters: The underwriters are appointed who commit to
shoulder the liability and subscribe to the shortfall in case the issue is under-
subscribed. For this commitment they are entitled to a commission upto
maximum of 2.5 % on the amount underwritten.
b) Appointment of Bankers: Bankers along with their branch network act as the
collecting agencies and process the funds procured during the public issue.
The Banks provide temporary loans for the period between the issue date and
the date the issue proceeds becomes available after allotment, which is
referred to as a `bridge loan'.
c) Appointment of Registrars: Registrars process the application forms, tabulate
the amounts collected during the Issue and initiate the allotment procedures.
d) Appointment of the brokers to the Issue: Recognized members of the Stock
exchanges are appointed as brokers to the Issue for marketing the Issue. They
are eligible for a maximum brokerage of 1.5%.
e) Filing of prospectus with the Registrar of Companies: The draft prospectus
along with the copies of the agreements entered into with the Lead Manager,
Underwriters, Bankers, Registrars and Brokers to the issue is filed with the
Registrar of Companies of the state where the registered office of the
company is located.
f) Printing and dispatch of Application forms: The prospectus and application
forms are printed and dispatched to all the merchant bankers, underwriters,
brokers to the issue.
g) Filing of the initial listing application: A letter is sent to the Stock exchanges
where the issue is proposed to be listed giving the details and stating the intent
of getting the shares listed on the Exchange.
h) Statutory announcement: An abridged version of the prospectus and the Issue
start and close dates are published in major English dailies and vernacular
newspapers.
i) Processing of applications: After the close of the Public Issue all the
application forms are scrutinized, tabulated and then shares are allotted
against these applications.
j) Establishing the liability of the underwriter: In case the Issue is ;lot fully
subscribed to, then the liability for the subscription falls on the underwriters
who have to subscribe to the shortfall, in case they have not procured the
amount committed by them as per the Underwriting agreement.
k) Allotment of shares: after the Issue is subscribed to the minimum level, the
allotment procedure as prescribed by SERI is initiated.
l) Listing of the Issue: The shares after having been allotted have to be listed
compulsorily in the regional stock exchange and optionally at the other stock
exchanges. 7
Securities Market 4.2.2 Eligibility for an IPO
in India
An Indian Company is allowed to make an IPO if:

1) The company has a track record of dividend paying capability for 3 out of the
immediately preceding 5 years;

2) A public financial institution or scheduled commercial bank has appraised the

project to be financed through the proposed offer and the appraising agency
participates in the financing of the project to the extent of at least 10% of the
Project cost. Typically a new company has to compulsorily issue shares at par,
while the companies with a track record can issue shares at a premium.

4.2.3 Rights Issue

The rights Issue involves selling of securities to the existing shareholders in

proportion to their current holding. When a company issues additional equity capital,
it has to be offered in the first instance to the existing shareholders on a pro-rata basis
as per Section 81 of the Companies Act, 1956. The shareholders may by a special
resolution forfeit this right, partially or fully by a special resolution to enable the
company to issue additional capital to the public or alternatively by passing a simple
resolution and taking the permission of the Central Government. There is no
restriction on pricing of rights Issues.

4.2.4 Private Placement

A private placement results from the sale of securities by the company to one or few
investors. The issuers are normally the listed public limited companies or closely held
public or private limited companies which cannot access the primary market. The
securities are placed normally with the Institutional investors, Mutual funds or other
Financial Institutions. In a number of cases, Indian companies have also offered
shares to promoters under this route. SEBI has issued a separate guideline for pricing
of such preferential offers.

4.2.5 SEBI Guidelines for IPO’s

For complete details of SEBI guidelines on IPO, you have to visit www.sebi.gov.in,
where you can download the complete guideline on Disclosure and Investor
Protection) Guidelines, 2002. The salient features of these guidelines are given
below:

1. Promoters should contribute a minimum of 20% of the total issued capital , if

the company is an unlisted one. Promoter's contribution is subject to a lock-in
period of 3 years.

2. Net Offer to the General Public has to be at least 25% of the Total Issue size
for listing on a Stock Exchange.

3. Minimum of 50% of the Net offer to the Public has to be reserved for
Investors applying for 10 or less than 10 marketable lots of shares.

4. In an Issue of more than Rs. 100 crores the issuer is allowed to place the
whole issue by book-building.

5. There should be at-least 5 investors for every 1 lakh of equity offered.

6 Allotment has to be made within 30 days of the closure of the Public Issue
and 42 days in case of a Rights Issue.

7. All the listing formalities for a Public Issue has to be completed within 70
days from the date of closure of the subscription list.

8 8. Indian Development Financial Institutions and Mutual Funds can be allotted

securities upto 75% of the Issue Amount.
9. Allotment to categories of FII's and NRI's/OCB's is upto a maximum of 24% Indian Stock Market :
Organisation and
which can be further extended to 30% by an application to the RBI - Functioning
supported by a resolution passed in the General Meeting.
10. 10% individual ceiling for each category a) Permanent employees b)
Shareholding of the promoting companies
11. Securities issued to the promoter, his group companies by way of firm
allotment and reservation have a lock-in period of 3 years. However shares
allotted to FII’s and certain Indian and Multilateral Development Financial
Institutions and Indian Mutual Funds are not subject to Lock-in periods.
12. The minimum period for which a Public Issue has to be kept open is 3
working days and the maximum for which it can be kept open is 10 working
days. The minimum period for a Rights Issue is 15 working days and the
maximum is 60 working days.
13. A public issue is effected if the issue is able to procure 90% of the Total
issue size within 60 days from the date of earliest closure of the Public Issue.
In case of over-subscription the company may have the right to retain the
excess application money and allot shares more than the proposed Issue
which is referred to as the `green-shoe' option.
14. A Rights Issue has to procure 90% subscription in 60 days of the opening of
the Issue.

4.3 SECONDARY MARKETS

The secondary market is the segment in which outstanding issues are traded and thus
provide liquidity. Investors, who seek both profitability and liquidity, need both
primary and secondary markets. There is thus a direct and complementary interface
between the primary and secondary markets. Secondary market exists both for short-
term (money market) securities and long-term securities. It exists for debt, equity and
a variety of hybrid securities. While the secondary market activities in money market
securities are conducted over phone or through market makers, the trading is more
organized for long-term securities and conducted through stock exchanges. Buying
and selling securities in secondary market is fairly simple. Investors have to open an
account with a member of stock exchange and then place orders through the member.
For an orderly functioning of market, a set of institutions is required. The role of
institutions assumes importance in securities market because the market deals with
high value financial assets. Institutions connected with securities markets are Stock
Exchanges (http:// www.bseindia.com and http://www.bseindia.com), Members of
Stocks Exchanges (popularly called brokers), Clearing Corporation, Depository
(http://www.nsdl.co.in and http:// www.centraldepository.com) Transfer Agents and
Securities and Exchange Board of India (SEBI) (http://www.sebi.gov.in).
Technology has converted stock exchanges into a virtual institution. Earlier, there
was an importance for the physical location of stock exchange because it was a place
where brokers or their assistants negotiate the prices (outsiders can hear only some
noise but brokers understand the meaning) and enter into transactions on behalf of
their client-investors. Since the telecommunication was very poor in India, one or
two stock exchanges have been opened up in every state to cater to the needs of the
investors of the region. India is one of the few countries with a large number of stock
exchanges. Thanks to development in telecommunication and information
technology, the physical constraint was removed during the last few years. National
Stock Exchange today has its presence everywhere in the country. Bombay Stock
Exchange has also expanded its network. Many other stock exchanges are finding it
difficult to compete with these two principal stock exchanges and trying to come
together and create new business. This new development has improved transparency
of operations and brought down the cost. Today, stockbrokers are operating from
their office through computer network and investors can see the price at which the
transactions are settled. Internet based stock braking (http://www.icicidirect.com or
http:// www.5pnisa.com) allows investors to enter into transactions by themselves 9
without
Securities Market contacting their brokers directly. Competition has brought down the brokerage from
in India 2% to in India around 0.5% and today the brokerage rate in India is one of the
lowest in the world. This transformation has taken place in a matter of few months.
Members of stock exchanges, called stock brokers, are intermediary between buyers
and sellers. Buying and selling securities through members of stock exchange is
beneficial, legally and functionally. Entry of major institutions like ICICI, Kotak
Mahindra, into brokerage services and development in technology including intenet
based broking service have improved the quality of service. Many of these
brokerage houses offer a number of facilities to the investors at no extra cost.
Clearing corporation enables the members to settle the transactions entered among
themselves on behalf of their client-investors. It operates something similar to cheque
clearing service offered by RBI for the banks. Earlier when securities are traded in
physical form, a large number of securities have to be exchanged between members
and clearing corporation had a major work on this part. Today, after depository
facility was introduced, the workload of the clearing corporations has come down
significantly. Clearing corporation today facilitate the members to transfer (or
receive) securities to (or from) depositories and also settle monetary part of the
transactions. It is an institution exclusively serving the brokers.
Depository service is another major development in the Indian stock market. It
allows investors to hold securities in electronic form (like you are holding cash in
your bank account) and transfers electronically when they sell the shares. The
operation is fairly simple. Investors have to open a depository account with a member
of depository service provider (we have two depository service providers in India -
National Securities Depository Ltd and Central Depository Services (India) Limited).
Investors can give physical securities that they are holding for cancellation (provided
depository facility is available for the securities/company) and convert them in to
electronic holding. A large number of companies have depository holding facility and
SEBI has put it compulsory to trade certain stocks only under depository mode.
When an investor apply new shares next time in the primary market, they can ask the
issuer to credit the depository account in the event of successful allotment. Any new
purchases in the secondary market can also be credited in the depository account.
Investors will get periodical statement on their holding from the member with whom
the depository account is maintained. Many depository participants allow the
investors to see their account through Internet. There was some resistance from retail
investors for this change but today everyone started seeing the benefit of this service.
A significant part of volume traded today is settled through depository mode.
Apart from holding the stocks electronically, there are other benefits from depository
services.- There is no need to apply for transfer of shares after the purchase of shares.
If an investor buys securities in physical form and desire to transfer the shares in
her/his name, she/he has to fill-up the transfer deed, affix transfer fee (0.5% of
market value of stock) and then send the same to transfer agent. There is a cost, time
and uncertainty involved in the transfer. Under depository mode, the shares are
transferred in a short period of time without any further action from your side. For
more details about depository, visit one of the web sites (http://www.nsdl.co.in or
http://www.centraldepository.com) of depository service providers or the members of
depository service providers.
Transfer agents maintains the members register of the companies. On the
instructions of the company, they transfer the shares from the existing members to
new member. When an investor buys a share in a physical mode and intend to
transfer the share in her/his name, she/he has to send the transfer deed along with
share certificate to the Transfer Agent. There are many transfer agents like Karvy
Consultants Ltd (http://www.karvy.com) and MCS Ltd. After initial verification, they
will place the shares received for transfer for the approval of company's Board. The
shares are transferred in the name of investors after the approval of the Board and
investor will receive communication to this effect along with share certificates from
the Transfer Agent. Some companies perform this transfer of shares internally
whereas many leading companies have outsourced this service by appointing one of
10 these transfer agents. The process of verification and other formalities connected with
transfer has been simplified after the introduction of depository services.
Securities and Exchange Board of India (SEBI) regulates the Institutions and Indian Stock Market :
Organisation and
Intermediaries connected with the securities to protect the interest of investors, Functioning
Particularly the small investors. SERI is a government sponsored but independent
body. SEBI has prescribed detailed regulations and guidelines for various activities
related to transactions of securities market (See http://www.sebi.gov.in). Regulations
are primarily intended to protect small investors. Despite strong resistance, SEBI is
pushing several reforms connected with securities market. Some of the major
achievements of SEBI so far are bringing transparency in the securities market
operation, speeding up the technological progress and improving disclosure norms.
SERI is struggling hard to prevent insider trading and price rigging. Since regulation
is a complex task, it will take time to complete the process.

Activity -1

i) Write brief note on a recent public issue of a company. The note may include
the size of the issue, type of security offered, price, justification of premium,
registrar, banker to issue, underwriter, etc.

……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………….........

ii) Visit any one or more of the web sites and describe your additional learning on
the regulation of Primary and Secondary Markets.

……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
………………………………………………………………………………........

4.4 STOCK MARKET IN INDIA

From scattered and small beginnings in the 19th Century, India's stock market has
risen to great heights. By 1990, we had 19 Stock Exchanges in the country and by
2002 there were 23 Stock Exchanges as listed in the later sections of this unit. You
might be interested in knowing more about the origin and the growth of stock market
in India. What functions does it perform? What is the form of organization of stock
exchanges in India? How are these administered? We shall, now, address to these and
other questions.

4.4.1 Origin and Growth

Organizations and institutions, whether they are economic, social or political, are
products of historical events and exigencies. The events continually replace and/or
reform the existing organizations, so as to make them relevant and operational in
contemporary situations. It is, therefore, useful to briefly acquaint ourselves with the
origin and growth of the stock market in India.

Stock exchanges of India in a rudimentary form originated in 1800 and since that
time have developed through six broad stages.

1800-1865 : The East India Company and few commercial banks floated shares
sporadically, through a very small group of brokers. According to a newspaper in
1850, in Bombay during 1840-1850 there were only half a dozen recognised brokers.
The year 1850 marked a watershed. A wave of company flotations took over the
market ; the number of brokers spurted to 60. The backbone of industrial growth and
the resulting boom in share flotation was the legendary personality of the financial
world, Premchand Roychand. 11
Securities Market In 1860 the stock market created a unique history. The entire market was gripped by
in India what is known as ‘share mania’. The American Civil War created cotton famine.
Indian cotton manufacturers exploited this situation and exported large quantities of
cotton. The resulting increase in export earnings opened opportunities for share
investments. New companies started to come up. Excessive speculation and reckless
buying became the order of the day. This mania lasted upto 1865. It marks the end of
the first phase in the Indian stock exchange history because with the cessation of the
Civil War, demand for Indian cotton slumped abruptly. The share became worthless
pieces of paper. To be exact, on July 1, 1865 all shares ceased to exist because all
time bargains which had matured could not be fulfilled.
1866-1900: We find another distinct phase during 1866-1900. The mania effect
haunted the stock exchange of Bombay during these 25 years. Above everything else,
it led to foundation of a regular market for securities. Since the market was
established in Bombay, it soon became and still is the leading and the most organized
stock exchange in India. A number of stock brokers who geared up themselves, set
up a voluntary organization in 1887, called Native Share and Stockbrokers
Association. The brokers drew up codes of conduct for brokerage business and
mobilized private funds for industrial growth. It also mobilized funds for government
securities (gilt edged securities), especially of the Bombay Port Trust and the
Bombay Municipality. A similar organization was started at Ahmedabad in 1894.
1901-1913: Political developments gave a big fillip to share investment. The
Swadeshi Movement led by Mahatma Gandhi encouraged the indigeneous trading
and business class to start industrial enterprises. As a result, Calcutta became another
major centre of share trading. The trading was prompted by the coal boom of 1904-
1908. Thus the third stock exchange was started by Calcutta stock brokers. During
Inter-war years demand for industrial goods kept increasing due to British
involvement in the World Wars. Existing enterprises in steel and cotton textiles,
woolen textiles, tea and engineering goods expanded and new ventures were floated.
Yet another stock exchange was started at Madras in 1920.
The period 1935-1965 can be considered as the period of development of the
existing stock exchanges in India. In this period industrial development planning
played the pivotal role of expanding the industrial and commercial base of the
country. Two more stock exchanges were set up, at Hyderabad in 1943 and at Delhi
in 1947. At the time of Independence seven stock exchanges were functioning
located in the major cities of the country. Between 1946 and 1990, 12 more stock
exchanges were set up trading the shares of 4843 additional listed companies.
There are 23 stock exchanges in the country, 23 of them being regional ones with
allocated areas. Three others set up in the reforms era, viz., National Stock Exchange
(NSE), the Over the Counter Exchange of India Limited (OTCEI), and Inter-
connected Stock Exchange of India Limited (ISE) have mandate to nationwide
trading network. The ISE is promoted by 15 regional stock exchanges in the country
and has been set up at Mumbai. The ISE provides a member-broker of any of these
stock exchanges an access into the national market segment, which would be in
addition to the local trading segment available at present. The NSE and OCTEI, ISE
and majority of the regional stock exchanges have adopted the Screen Based Trading
System (SBTS) to provide automated and modern facilities for trading in a
transparent, fair and open manner with access to investors across the country. 9,877
companies were listed on the stock exchanges as on 31 March 1999, and the market
capitalization was 5,30,772 crore. The number of primary listed companies at various
stock exchanges in India was 9,644 as on end of March, 2002. The market
capitalisation at NSE was Rs. 6,36,861 crore by March 2002. The following are the
names of the various stock exchanges in India.
1. The Bombay Stock Exchange
2. The Ahmedabad Stock exchange Association
3. Bangalore Stock Exchange
4. The Calcutta Stock Exchange Association
12
5. Cochin Stock Exchange
6. The Delhi Stock Exchange Association Indian Stock Market :
Organisation and
7. The Guwahati Stock Exchange Functioning

8. The Hyderabad Stock Exchange

9. Jaipur Stock Exchange
10. Kanara Stock Exchange
11. The Ludhiana Stock Exchange Association
12. Madras stock Exchange
13. Madhya Pradesh Stock Exchange
14. The Magadh Stock Exchange
15. Mangalore Stock Exchange
16. Pune Stock Exchange
17. Saurashtra Kutch Stock Exchange
18. The Uttar Pradesh Stock Exchange Association
19. Vadodara Stock Exchange
20. Coimbatore Stock Exchange
21. Over The Counter Exchange of India
22. The National Stock Exchange of India
23. inter-connected Stock Exchange of India Limited
4.4.2 Role and Functions
The history of stock exchanges in foreign countries as well as in India shows that the
development of joint stock enterprise would never have reached its present stage but
for the facilities which the stock exchanges provided for dealing in securities. Stock
exchanges have a very important function to fulfil in the country's economy. In
Union of India vs. Allied International Products Ltd (1971) 41 Comp Cas 127 (SC) :
(1970) 3 SCC 5941], the Supreme Court of India has enunciated the role of the stock
exchanges in these words:

“A Stock Exchange fulfils a vital function in the economic development of a nation:

its main function is to `qualify' capital by enabling a person who has invested money
in, say a factory or a railway, to convert it into cash by disposing off his shares in the
enterprise to someone else. Investment in joint stock companies is attractive to the
public, because the value of the shares is announced day after day in the stock
exchanges, and shares quoted on the exchanges are capable of almost immediate
conversion into money. In modern days a company stands little chance of inducing
the public to subscribe to its capital, unless its shares are quoted in an approved stock
exchange. All public companies are anxious to inform the investing public that the
shares of the company will be quoted on the stock exchange”.

The stock exchange is really an essential pillar of the private sector corporate
economy. It discharges three essential functions in the process of capital formation
and in raising resources for the corporate sector. They are :

First, the stock exchange provides a market place for purchase and sale of securities
viz., shares, bonds, debentures, etc. It, therefore, ensures the free transferability of
securities which is the essential basis for the joint stock enterprise system. The
private sector economy cannot function without the assurance provided by the stock
exchange to the owners of shares and bonds that they can be sold in the market at any
time. At the same time those who wish to invest their surplus funds in securities for
long-term capital appreciation or for speculative gain can also buy stocks of their
choice in the market. 13
Securities Market Secondly, the stock exchange provides the linkage between the savings in the
in India household sector and the investment in corporate economy. It mobilizes savings,
channelises them as securities into those enterprises which are favoured by the
investors on the basis of such criteria as future growth prospects, good returns and
appreciation of prevalence on the Indian scene of such interventionist factors as
industrial licensing, provision of credit to private sector by public sector development
banks, price controls and foreign exchange regulations. The stock exchanges
discharge this function by laying down a number of regulations which have to be
complied with while making public issues e.g. offering at least the prescribed
percentage of capital of the public, keeping the subscription list open for a minimum
period of three days, making provisions for receiving applications at least at the
centres where there are recognised stock exchanges and allotting the shares against
applications on a fair and unconditional basis with the weightage being given to the
applications in lower categories, particularly those applying for shares worth Rs.500
or Rs.1,000, etc. Members of stock exchanges also assist in the floatation of new
issues by acting as managing brokers/official broker of new issue. In that capacity,
they, inter alia, try to sell these issues to investors spread all over the country. They
also act as under-writers to new issues. In this way, the broker community provides
an organic linkage between the primary and the secondary markets.
Thirdly, by providing a market quotation of the prices of shares and bonds, a sort of
collective judgement simultaneously reached by many buyers and sellers in the
market-the stock exchanges serves the role of a barometer, not only of the state of
health of individual companies, but also of the nation's economy as a whole. It is
often not realised that changes in share prices are brought about by a complex set of
factors, all operating on the markets simultaneously. Share values as a whole are
subject to secular trends set by the economic progress of the nation, and governed by
factors like general economic situation, financial and monetary policies, tax changes,
political environment, international economic and financial developments, etc. These
trends are influenced to some extent by periodical cycles of booms and depressions in
the free market economies. As against these long-term trends, the day-to-day prices
are influenced by another variety of factors notably, the buying or selling of major
operators, the buying and selling of shares by the investment financial institutions
such as the U.T.I. or L.I.C. which have in recent years emerged as the largest holders
of corporate securities, speeches and pronouncements by ministers and other
government spokesmen, statements by company chairmen at annual general meetings
and reports of bonus issues or good dividends by companies, etc., while these factors,
both long-term and short-term, act as macro influences on the corporate sector and
the level of stock prices as a whole, there is also a set of micro influences relating to
prospects of individual companies such as the reputation of the management, the state
of industrial relations in the enterprises, the volume of retained earnings and the
related prospects of capitalization of reserves, etc., which have a bearing on the level
of prices. In the complex interplay of all these forces, which leads to day-to-day
quotation of prices of all listed securities, speculation plays a crucial role. In the
absence of speculative operations, every purchase by an investor has to be matched
by a sale of the same security by an investor-seller, and this may lead to sharp
fluctuation in prices. With speculative sale and purchases taking place continuously,
actual sale and purchase by investors on a large scale are absorbed by the market with
small changes in prices. There are always some professional operators who are
hoping that the prices would rise. There are others predicting that prices will fall.
Both these groups acting on their respective assumption buy or sell continuously in
the market. Their operation helps to bring about an orderly adjustment of prices.
Without these speculative operations, a stock exchange can become a very
mechanical thing. However, excessive speculation endangers market equilibrium and
must be discouraged through appropriate safeguards. The regulatory authorities
should always take necessary precautionary measures to prevent and penalize
excessive speculation and to discipline trading.
A fact which needs to be emphasized is that the stock exchanges in India also serve
the joint sector units as also to some extent public sector enterprises. There is
substantial private participation in the share capital of a number of government
14
companies such as Balmer Lawrie, Andrew Yule, Gujarat State Fertilizers
Corporation, Gujarat Narmada Fertilizers Corporation, State Bank of India, ICICI, Indian Stock Market :
Organisation and
etc. In recent times some of the Central public sector companies have gone in for Functioning
public debentures through the stock exchanges. Also, there are some public sector
companies like VSNL which have made their share capital open for public
subscription.
Another important function that the stock exchanges in India discharge is of
providing a market for gilt-edged securities i.e. securities issued by the Central
Government, State government, Municipalities, Improvement Trusts and other public
bodies. These securities are automatically listed on the stock exchanges when they
are issued and transactions in these take place regularly on the stock exchanges.
4.4.3 Membership, Organisation and Management
By virtue of the century-old tradition, stock exchanges is a highly organized and
smooth functioning network in the world. The membership of stock exchanges
initially comprised of individuals and partnership firms. Later on companies were
also allowed to become members. A number of financial institutions are now
members of Indian stock exchanges. Over the years, stock exchanges have been
organized in various forms. For example, while the Bombay Stock Exchange,
Ahmedabad Stock Exchange and M.P. (Indore) Stock Exchange were organised as
voluntary non-profit making association of persons, the Calcutta Stock Exchange,
Delhi Stock Exchange, U.P. (Kanpur) Stock Exchange, Ludhiana Stock Exchange,
Cochin Stock Exchange, Gauhati Stock Exchange, Jaipur Stock Exchange, and
Kanara (Mangalore) Stock Exchange were organised as public limited companies.
Quite a few others have been organised as companies limited by guarantee.
The internal governance of every stock exchange rests in a Governing Board
Comprising Members of the Board and Executive Director/President. Members of the
Governing Board include brokers and non-brokers. Governing Bodies of stock
exchanges also have government nominees. The Executive Director/President is
expected to ensure strict compliance by all members of the exchange of rules/by
laws, margin regulations and trading restriction, etc. Subject to the previous approval
of SEBI, under the law, Governing Bodies of stock exchanges have wide powers to
make bye-laws. Governing Bodies can admit, punish, censure and also expel any
member, any partner, any remisier, and authorised clerk and employee. It has the
power to adjudicate disputes. Above all, it has the power to make, amend, suspend
and enforce rules, by-laws, regulations and supervise the entire functioning of a stock
exchange.
4.4.4 Trading System
Trading system differ from exchange to exchange. In the next few pages, the trading
system followed by the National stock Exchange is described. Students desire to
know more about the trading system of other exchanges in India as well as outside
India can visit respective web sites of stock exchanges.
NSE operates on the 'National Exchange for Automated Trading' (NEAT) system, a
fully automated screen based trading system, which adopts the principle of an order
driven market. NSE consciously opted in favour of an order driven system as
opposed to a quote driven system. This has helped reduce jobbing spreads not only
on NSE but in other exchanges as well, thus reducing transaction costs. Till the
advent of NSE, an investor wanting to transact in a security not traded on the nearest
exchange had to route orders through a series of correspondent brokers to the
appropriate exchange. This resulted in a great deal of uncertainty and high transaction
costs. NSE has made it possible for an investor to access the same market and order
book, irrespective of location, at the same price and at the same cost.
Market Types
The NEAT system has four types of market. They are :
Normal : All orders which are of regular lot size or multiples thereof are traded in
the Normal Market. For shares which are traded in the compulsory dematerialised
mode, the market lot is one share. Normal market consists of various book types
wherein orders are segregated as Regular lot orders, Special Term orders, Negotiated
15
Traded orders and Stop Loss orders depending on their order attributes.
Securities Market Odd Lot Market : All orders whose order size is less than the regular lot size are
in India traded in the odd-lot market. An order is called an odd lot order if the order size is
less than regular lot size. These orders do not have any special terms attributes
attached to them. In an odd-lot market, both the price and quantity of both the orders
(buy and sell) should exactly match for the trade to take place. Currently the odd lot
market facility is used for the Limited Physical Market as per the SEBI directives.
Spot Market : Spot orders are similar to the normal market orders except that spot
orders have different settlement periods vis-à-vis normal market. These orders do not
have any special terms attributes attached to them. Currently the Spot Market is being
used for the Automated Lending & Borrowing Mechanism (ALBM) session.
Auction Market : In the Auction Market, auctions are initiated by the Exchange on
behalf of trading members for settlement related reasons.
There are 3 participants in this market :
• Initiator : The party who initiates the auction process is called an initiator.
• Competitor : The party who enters orders on the same side as of the initiator is
called a Competitor.
• Solicitor : The party who enters orders on the opposite side as of the initiator is
called a Solicitor.
Order Books
The NSE trading system provides complete flexibility to members in the kinds of
orders that can be placed by them. Orders are first numbered and time-stamped on
receipt and then immediately processed for potential match. Every order has a
distinctive order number and a unique time stamp on it. If a match is not found, then
the orders are stored in different `books'. Orders are stored in price-time priority in
various books in the following sequence:
- Best Price
- Within Price, by time priority.
Price priority means that if two orders are entered into the system, the order having
the best price gets the higher priority. Time priority means if two orders having the
same price are entered, the order that is entered first gets the higher priority.
The Capital Market segment has following types of books:
Regular Lot Book : The Regular Lot Book contains all regular lot orders that have
none of the following attributes attached to them.
- All or None (AON)
- Minimum Fill (MF)
- Stop Loss (SL)
Special Terms Book : The Special Terms book contains all orders that have either of
the following terms attached:
- All or None (AON)
- Minimum Fill (MF)
(Note : Currently, special term orders i.e. AON and MF are not available on the
system as per the SEBI directives. )
Negotiated Trade Book : The Negotiated. Trade book contains all negotiated order
entries captured by the system before they have been matched against their
counterparty trade entries. These entries are matched with identical counterparty
entries only. It is to be noted that these entries contain a counterparty code in addition
to other order details.
Stop-Loss Book : Stop Loss orders are stored in this book till the trigger price
specified in the order is reached or surpassed. When the trigger price is reached or
surpassed, the order is released in the Regular lot book.
16
The stop loss condition is met under the following circumstances:
SELL ORDER - A sell order in the Stop loss book gets triggered when the last traded Indian Stock Market :
Organisation and
price in the normal market reaches or falls below the trigger price of the order. Functioning
BUY ORDER - A buy order in the Stop Loss book gets triggered when the last
traded price in the normal market reaches or exceeds the trigger price of the order.
Odd Lot Book : The Odd lot book contains all odd lot orders (orders with quantity
less than marketable lot) in the system. The system attempts to match an active odd
lot order against passive orders in the book. Currently, pursuant to a SEBI directive,
the Odd Lot Market is being used for orders which have a quantity less than or equal
to 500 (Qty more than the market lot) for trading. This is referred as the Limited
Physical Market (LPM).
Spot Book : The Spot lot book contains all spot orders (orders having only the
settlement period different) in the system. The system attempts to match an active
spot lot order against the passive orders in the book. Currently the Spot Market book
type is being used for conducting the Automated Lending & Borrowing Mechanism
(ALBM) session.
Auction Book : This book contains orders that are entered for all auctions. The
matching process for auction orders in this book is initiated only at the end of the
solicitor period.
Order Matching Rules
The best buy order is matched with the best sell order. An order may match partially
with another order resulting in multiple trades. For order matching, the best buy order
is the one with the highest price and the best sell order is the one with the lowest
price. This is because the system views all buy orders available from the point of
view of a seller and all sell orders from the point of view of the buyers in the market.
So, of all buy orders available in the market at any point of time, a seller would
obviously like to sell at the highest possible buy price that is offered. Hence, the best
buy order is the order with the highest price and the best sell order is the order with
the lowest price.
Members can proactively enter orders in the system which will be displayed in the
system till the full quantity is matched by one or more of counter-orders and result
into trade(s) or is cancelled by the member. Alternatively, members may be reactive
and put in orders that match with existing orders in the system. Orders lying
unmatched in the system are `passive' orders and orders that come in to match the
existing orders are called `active' orders. Orders are always matched at the passive
order price. This ensures that the earlier orders get priority over the orders that come
in later.
Order Conditions
A Trading Member can enter various types of orders depending upon his/her
requirements. These conditions are broadly classified into three categories: time
related conditions, price-related conditions and quantity related conditions.
Time Conditions
• DAY - A Day order, as the name suggests, is an order which is valid for the
day on which it is entered. If the order is not matched during the day, the
order gets cancelled automatically at the end of the trading day.
• GTC - A Good Till Cancelled (GTC) order is an order that remains in the
system until it is cancelled by the Trading Member. It will therefore be able
to span trading days if it does not get matched. The maximum number of
days a GTC order can remain in the system is notified by the Exchange from
time to time.
• GTD - A Good Till Days/Date (GTD) order allows the Trading Member to
specify the days/date up to which the order should stay in the system. At the
end of this period the order will get flushed from the system. Each day/date
counted is a 17
calendar day and inclusive of holidays. The days/date counted are inclusive
Securities Market of the day/date on which the order is placed. The maximum number of days a
in India GTD order can remain in the system is notified by the Exchange from time to
time.
• IOC - An Immediate or Cancel (IOC) order allows a Trading Member to buy
or sell a security as soon as the order is released into the market, failing
which the order will be removed from the market. Partial match is possible
for the order, and the unmatched portion of the order is cancelled
immediately.
Price Conditions
• Limit Price/Order - An order which allows the price to be specified while
entering the order into the system.
• Market Price/Order - An order to buy or sell securities at the best price
obtainable at the time of entering the order.
• Stop Loss (SL) Price/Order - The one which allows the Trading Member to
place an order which gets activated only when the market price of the
relevant security reaches or crosses a threshold price. Until then the order
does not enter the market.
SELL ORDER
A sell order in the Stop Loss book gets triggered when the last traded price in
the normal market reaches or falls below the trigger price of the order.
BUY ORDER
A buy order in the Stop Loss book gets triggered when the last traded price in
the normal market reaches or exceeds the trigger price of the order. e.g. If for
stop loss buy order, the trigger is Rs. 93.00, the limit price is Rs. 95.00 and
the market (last traded) price is Rs. 90.00, then this order is released into the
system once the market price reaches or exceeds Rs. 93.00. This order is
added to the regular lot book with time of triggering as the time stamp, as a
limit order of Rs. 95.00
Quantity Conditions
• Disclosed Quantity (DQ)- An order with a DQ condition allows the Trading
Member to disclose only a part of the order quantity to the market. For
example, an order of 1000 with a disclosed quantity condition of 200 will
mean that 200 is displayed to the market at a time. After this is traded,
another 200 is automatically released and so on till the full order is executed.
The Exchange may set a minimum disclosed quantity criteria from time to
time.
• MF - Minimum Fill (MF) orders allow the Trading Member to specify the
minimum quantity by which an order should be filled. For example, an order
of 1000 units with minimum fill 200 will require that each trade be for at
least 200 units. In other words, there will be a maximum of 5 trades of200
each or a single trade of 1000. The Exchange may lay down norms of MF
from time to time.
• AON - All or None orders allow a Trading Member to impose the condition
that only the full order should be matched against. This may be by way of
multiple trades. If the full order is not matched it will stay in the books till
matched or cancelled.
4.4.5 Stock Market Information System
Stock exchange quotations and indices published in daily newspapers are the main
source of information on stock exchange trades and turnover. Dailies like Economic
Times, Financial Express, Business Standard, Business Line, Times of India and
Hindustan Times publish daily quotations and indices. As for Bombay Stock
Exchange quotations published in Economic Times, information on equity shares,
starting from the first column, is presented in the following order: Company's name;
previous day's closing price in brackets; all the daily traded prices as published by the
BSE ; key financial parameters such as earnings per share (EPS), cash earnings per
share (CPS), cash P/E (price to earnings ratio), return on net worth (RN W) and gross
profit margin (GPM) etc. on different days; P/E ; and the high and low prices in the
18 preceding 52 weeks.
The first traded price is the day's opening price. If only one such price is recorded, it Indian Stock Market :
Organisation and
is also the day's closing price. If there are two prices, then the middle quote is either Functioning
the high or low price. If there are four prices, then one of the middle quotes is the
day's high and the other, the low. If there are no transactions in a company's share on
any day, the previous day's closing price is presented in brackets.
The EPS is the average net profit after tax per equity share and the CPS the average
cash profit (after adding back depreciation) per share. The cash P/E is the ratio of the
day's closing price to the cash earnings per share as distinct from the P/E ratio, which
relates price to the net profit per share. PE values are not printed when earnings are
either nil or negative.
The RNW is the net profit as a percentage of the net worth and measures the return
earned on the shareholders' fund i.e. equity capital plus reserves. The GPM is the
gross profit margin (before depreciation and tax) as a percentage of gross sales and
measures the company's profit margin which is available to absorb depreciation
charges arising from capital expenditure, tax payments, dividend distribution and
profit ploughback. All the figurers are taken from the latest available results (audited
/ unaudited) of the company.
The 52-week high and low prices of each share are worked out every day on the basis
of the highest and lowest points scaled during the immediately preceding 52 weeks.
The high and low prices are adjusted for bonus and rights issue of equity shares. If
any of the day's traded price is a yearly high or low, the entire line, including the
name of the company, is shown in bold types, with a 'H' attached to the high value or
`L' attached to the low value. Whenever there is a significant change in the day's
closing value as compared to the previous closing, it is shown in bold types with a
`plus' or `minus' sign as the case may be, after the closing value. For specified shares,
a three per cent change and for non-specified shares a 15 per cent change is treated as
significant. Whenever a share goes ex-divided or ex-bonus or ex-rights, it is indicated
by notation XD or XB or XR, as the case may be placed next to its closing price.
Symbol of face values other than Rs. 10. are also indicated along with the names.
Since Indian regulations allow stock splits, a number of firms have face value other
than Rs. 10.
For debentures, the information starting from the first column, is presented in the
following order: the nominal rate of interest on the face value, company name, face
value, previous day's closing price, the day's opening price, yield to maturity (YTM)
and yield (both annualized). The yield is nominal interest expressed in percentage
terms of closing value. The YTM adjusts the nominal return for the maturity period,
frequency of interest payments, manner of principal repayment, redemption
premium, if any, and thereby enables investors to compare different investment
options in debentures on a uniform scale. If there are no quotations for a company's
debenture on a day, the opening price is shown as nil, and the closing price the same
as the previous day's closing.
Besides these quotations share price indices are also published in different dailies.
Bombay Stock Exchange's 30- share ‘Sensex’ and 100 -share `National' indices are
quite popular. In addition, NSE-50 (Nifty) has also become popular with institutional
and retail investors in recent times. Besides these, there are other indices also which
include The Economic Times Index of Ordinary Share Price, Business Standard
Index of Ordinary Shares Price and a few others. Reserve Bank of India also
publishes Share Price Index.
Activity-2
1) Take a look at the Bombay Stock Exchange quotations published in Economic
Times and write out hereunder price quotations for five Shares and five
Debentures.
……………………………………………………………………………….......
...............................................................................................................................
............................................................................................................................... 19
...............................................................................................................................
Securities Market 2) Take a look at Economic Times or any other financial daily and compare and
in India contrast 30-share Sensex and 100-share National Index of Bombay Stock
Exchange and also NSE-50 Index.

…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………

3) Write out two sources of stock market information other than a newspaper.

…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
………………………………………………………………………………….

4.5 SUMMARY
In this Unit, we have discussed two segments of Indian securities market namely
primary market or new issues market and secondary market or stock market. We
have highlighted recent trends in the primary market and discussed various types of
market players and trading arrangements which exist in the Indian stock market.
Different aspects of the Indian stock market viz., origin and growth, role and
functions, membership, organisation and management, trading systems, and stock
market information system have been explained so that you as a student of this
course are able to clearly visualise the environment in which investment and portfolio
management decisions are made. In the following Unit we shall focus on the legal
frame of Indian securities market.

4.6 SELF-ASSESSMENT QUESTIONS/EXERCISES

1. What are the basic constituents of the securities market?

2. What are the different types of securities markets? What are their role and
functions?

3. What are different categories of players operating in primary and secondary

markets?

4. Write a brief note on the management of stock exchanges in India.

5. Briefly discuss recent trends in the development of the primary market in India.

6. What is OTCEI and NSE? How are they different from other stock exchanges ?

7. Critically evaluate stock market indices as indicators of the mood of the market
and health of the economy.

4.7 FURTHER READINGS

1. Bombay Stock Exchange Official Directory, Bombay Stock Exchange, Bombay

2. Gupta, L.C. 1992, Stock Exchange Trading in India-Agenda For Reform, Society
For Capital Market Research and Development, New Delhi.

3. SEBI Act and Regulations on various intermediaries and capital offerings

20
 Regulation

UNIT 5 REGULATION
Objectives
• The objectives of this unit are to:
• highlight history of regulation of securities of market in India
• discuss current status of regulation relating to securities market in India
• trace origin, functions, organization and activities of Securities and Exchange
Board of India
• indicate role of self-regulation vis-à-vis legislative regulation of securities
market.
Structure
5.1 Introduction
5.2 Types of Regulation
5.3 History of Securities Market Regulation
5.4 Securities Contracts (Regulation) Act, 1956
5.5 Securities and Exchange Board of India
5.5.1 Origin
5.5.2 Functions
5.5.3 Organization
5.5.4 Activities
5.6 Self-Regulation
5.7 Summary
5.8 Self-assessment Questions / Exercises
5.9 Further Readings
Appendix 5.1: Securities Contracts (Regulation) Act, 1956
Appendix 5.2 : SEBI Regulations on i) Stock Brokers and Sub-brokers, ii)
Insider Trading, and iii) Substantial Acquisition and Takeover.
5.1 INTRODUCTION
In Unit 4, you have seen how, from a scattered and small beginning in the 19th
century, India's securities market has risen to great heights by the beginning of the
decade of the 90s. The mobilization from primary market has exceeded Rs.27,000
crore in 1992. The market capitalization of outstanding issues have exceeded Rs.
1,00,000 crore. Starting their operations from under a Banyan Tree and Neem Tree,
the Bombay Stock Exchange in 1875 and Calcutta Stock Exchange in 1908
respectively, today we have 24 stock exchanges. The history of growth of primary and
secondary markets in India have witnessed spells of non-regulation, self-regulation,
half-hearted government regulation and close-set regulation. In this Unit we shall
discuss the legal framework of securities market in India. What has been the history of
securities market regulation in India? What are different Acts, Rules and Regulations
which affect securities market? What is the nature, role and functions of Securities and
Exchange Board of India? What is the international perspective on securities market
regulation? What promises does self-regulation hold in the present environment?
These are some of the questions we shall address one by one in the unit. Let us begin
by discussing the history of securities market regulation in India.

5.2 TYPES OF REGULATION

The regulatory framework relating to financial services can be broadly classified into
three main types. One set of regulations determine the types of activities that different
forms of institution are permitted to engage in. These regulations can be called as
21
structural regulations. For example, the Securities and Exchange Board of India
Securities market in (SEBI) insists that merchant bankers and stock broking institutions to separate all their
India fund-based activities. Similarly, the Reserve Bank of India (RBI) has prescribed the
activities that commercial banks can provide to the investors. Structural regulation
thus involves demarcation lines between the activities of financial institutions but
many of them have in fact been eroding in recent years. Banks are now providing
various services like leasing, term loan, credit cards, etc., in addition to their
traditional service of working capital lending. The rationale behind the expanding the
activities that can be provided by the financial service companies is the desire of
regulatory authorities to create greater competition.
There are regulations that cover the internal management of financial institutions and
other financial service organisations in relation to capital adequacy, liquidity and
solvency. The SEBI for instance has prescribed minimum net worth requirement for
various financial service firms that come under its jurisdiction. The objective of these
regulation is to restrict the firms without adequate resources enter into this field.
Recently, the RBI has regulated the non-banking finance companies in raising public
deposits. These regulations are known as prudential regulations as they aim to evolve
certain prudential norms for the operation of the industry.
There are number of investor protection regulations. All regulatory agencies in the
financial sector claim that the primary objective of the regulation by them is to protect
the interest of investors. It is generally perceived that investors are the weakest
participants of the financial markets and hence need protection from malpractice,
fraud and collapse. The information asymmetry between the investors and financial
intermediary or institution affects the investors and thus regulatory agencies step-in to
protect the interest of the investors. Thus, investor protection regulations are often in
the nature of demanding larger disclosure of information.
The regulations can also be classified on their scope. There are regulations which deal
with the macro aspects of the system. For example, legislation enacted in the
Parliament like Banking Regulation Act, Securities Contracts Regulation Act, etc., to
deal with the macro aspects of respective institutions. The regulatory authorities under
the legislation evolve rules, guidelines and regulations that govern the micro aspects
and operational issues. In addition to the regulations passed under formal statue and
regulators, there are self-regulations from the industry association. For example, the
foreign exchange dealers have their own self-regulation in addition to several other
statues and guidelines that govern their activities. Similarly, the merchant bankers
association is developing self-regulation that will govern their members in addition to
SEBI regulation. In the US and other developed markets, there are associations for
financial analysts which admit the members after they pass examination and evolve
code of conducts when they desire to practice as financial analyst.
The regulations in general aim to ensure the soundness and safety of financial
institutions, maintain the integrity of the transmission mechanism and protect the
consumers of financial services. The regulations also ensure freedom of operation to
improve the efficiency and provide adequate scope for innovation that benefit the
investors and other participants. The success of the regulation thus not only depends
on its ability to ensure investors protection but also determined by the level of
advancement and sophistication the system has achieved. In other words, regulation
should not block the development of financial service industry.
5.3 HISTORY OF SECURITIES MARKET REGULATION
The first legislative measure providing for regulation of stock exchanges was enacted
in 1925 namely, the Bombay Securities Contracts Control Act 1925. This Act was
enacted to regulate and control certain contracts for the purchase and sale of securities
in the city of Bombay and elsewhere in the Bombay Presidency. Indeed till then there
were no established trading rules. The public was not prohibited from entering the
trading floor, where clients often transacted business among themselves. The need for
regulation had arisen to check manipulation by brokers, which had resulted in two
severe market crashes between 1919 and 1925. In 1918-19 some brokers manipulated
the price of two highly traded stocks Standard Mill and Madhavji Mill resulting in a
crash. Fourteen brokers defaulted, forcing them to sell off their cards. The public
22 criticism that followed the manipulative
practices and the market slump of the early 1920s moved the Bombay Legislative
Council to set up a committee to look into the activities of the Bombay Stock Exchange
 Regulation
Sir wilfred Atlay, former chairman of the London Stock Exchange, was chosen to head
the committee. In its report the committee stated:
"The most sinister manifestation of speculation in Bombay is the recent occurrence of
corners in the market and the policy and practice of the Association with regard to
corners appears to us to constitute the head and front of their offending."
Even before the government of Bombay could consider action on the basis of the Atlay
Committee Report, the exchange experienced another crash in 1025. Later that year,
the Securities Contracts Control Act 1925 was passed by the government of Bombay.
Under that Act, "stock exchange" was defined as "any association, organization or body
of individuals, whether incorporated or not, established for the purpose of assisting,
regulating and controlling business in buying, selling and dealing in stocks, shares,
bonds, debentures, debenture stock and any other like securities". Section 4 of the Act
required a stock exchange had to submit rules for the regulation and control of
transactions in securities other than ready deliver contracts and furnish such
information in regard to such recognition as the Governor-in-Council might require.
Section 6 of the Act provided that every contract for the purchase or sale of securities,
other than a ready delivery contract, entered into after a date to be notified in this
behalf by the Governor-in-Council should be void unless the same was made subject to
and in accordance with the rules duly sanctioned under section 4 and every such
contract should be void unless the same was made between members or through a
member of a recognized stock exchange; and no claim should be allowed in any civil
court for the recovery of any commission, brokerage fee or reward in respect of any
such contract. But this Act defined "ready delivery contract" to mean "a contract of the
purchase or sale of securities for performance of which no time is specified and which
is to be performed immediately or within a reasonable time". It was also stated therein
by way of explanation that what was reasonable time was in each particular case a
question of fact. This Act did not achieve its purpose, for under section 6 thereof
contracts entered into in contravention to the provisions of that section were not made
illegal but only void with the result that even members of a stock exchange not
recognized under the Act were able to do business in that line. What is more, the
explanation to the definition of "ready delivery contract" which was excluded from the
operation of the Act was so elastic that in the name of ready delivery contracts,
unrecognized stock exchanges and individuals were able to carry on business in
forward contracts. Gambling in shares went on unchecked in Bombay as elsewhere. It
was, thus, found that the impact of this Act on the regulation of trading in securities
was not significant.
Huge losses suffered by the investing public during 1928 and 1938 brought forth public
criticism and the Government of Bombay appointed a committee called Morrison
Committee in 1936. Recommendations made by this committee were not found to be
useful. The Government of India appointed a committee in May, 1948, headed by Dr. P
J Thomas, Economic' Advisor to the Ministry of Finance, to submit a report on a
suitable law to regulate the stock exchanges in India. Under the constitution of India
`Stock Exchanges' is a central subject vide entry 48 in list (union list) in the seventh
schedule and therefore, the Union Government has exclusive authority to make laws on
the subjects. In 1952, a draft Bill on Stock exchange regulation was prepared by the
Government and this Bill was referred to an expert committee under the chairmanship
of A D Gorwala A Bill called the Securities Contracts (Regulation) Bill, prepared on
the lines of the draft recommended by the Gorwala Committee was introduced in
Parliament in 1954 and with some amendments Securities Contracts (Regulation) Act,
1956 was passed. The Securities Contracts (Regulation) Act ,1956 along with the
Securities Contracts (Regulation) Rules of 1957 have been the main laws regulating
securities market in India

5.4 SECURITIES CONTRACTS (REGULATION)

ACT, 1956
As noted above Securities Contracts (Regulation) Act 1956 and the rules made there
under, namely in Securities Contracts (Regulation) Rules, 1957 are the main laws 23
governing stock exchanges in India.
Securities market in The preamble to the Securities Contracts (Regulation) Act states that it is `an act to
India prevent undesirable transactions in securities by regulating the business of dealing
therein, by prohibiting options and by providing certain other matters connected
therewith". This Act provides for the direct and indirect control of virtually all aspects
of securities trading and the running of the stock exchanges. The Act makes every
transaction in securities in any notified State or area illegal and punishable by fine and
1 or imprisonment if it is not entered into between or with members of a recognized
stock exchange in the state or area. It also makes every such securities contracts void.
The Act thus prohibits the existence of other than recognized stock exchanges and
provides the mechanism of recognizing stock exchanges. Application to the Central
Government for recognition must include a copy of the rules relating, in general, to
the constitution of the stock exchange and in particular to, among other things, the
admission into the stock exchange of various classes of members, the exclusion,
suspension, expulsion and readmission of members, and the procedure for registration
of partnership as members. In determining whether to grant recognition, the Central
Government may make whatever inquiry is necessary and impose in the rules and
bye-laws of the stock exchanges whatever conditions are required to ensure "fair
dealing" and to "protect investors". These conditions concern, inter alia, the
qualifications for members, the manner in which contracts are to be entered into and
enforced, the representation of not more than three Central Government nominees on
the board of the stock exchange, and the maintenance of books and records by
members and their audit by chartered accountants. The Central Government has the
power to impose further conditions, other than in the rules, such as limiting the
number of members. Finally, the Central Government has the power unilaterally to
withdraw recognition.
After it recognizes a stock exchange, the Central Government exerts regulatory
control over it. Periodic reports are furnished to the Central Government. Certain
books and records are maintained for a period of five years. The Central Government
can make an inquiry itself, or through an appointed third party, into the affairs of a
stock exchange or any of its members. All officers, directors, members and others
who have had dealings in the matter under inquiry are required to produce requested
documents, statements, or information.
The Central Government retains control over the stock exchange's bye-laws and its
rule amendments. A stock exchange, subject to previous Central Government
approval, has the authority to make bye-laws for the regulation and control of
contracts and the regulation of trading. Similarly, no rule amendments have effect
until they are approved by the Central Government. The Central Government,
furthermore, has the power to direct stock exchange to amend its rules; and if it fails
to do so, the Government may directly amend such rules. The Securities Contract
(Regulation) Act grants the Central Government power to supercede governing body
of a recognized exchange. The suspension of business may be complete or subject to
conditions. Suspensions may not last more than seven days initially but may be
extended from time to time. The Central Government may supercede the governing
body of any exchange by declaration and then appoint any person or group of persons
to exercise and perform all the power and duties of the governing body.
Other powers granted to the Central Government include the ability to stop further
trading in specified securities for the purpose of preventing undesirable speculation,
and the power to compel a public company " in the interest of the trade or in the
public interest" to list its securities on any of the recognized exchanges.
Appendix 5.1 reproduces Securities Contracts (Regulation) Act, 1956.
Activity-1
i) What is a recognized stock exchange?
……………………………………………………………………………………
……………………………………………………………………………………
24 ……………………………………………………………………………………
……………………………………………………………………………………
 Regulation
ii) How many recognized stock exchanges are there now in India?

……………………………………………………………………………………
…………………………………………………………………………………….

iii) Name any three important reasons to have stock exchanges.

……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………

iv) Study some of the recent changes in SCRA relating to derivatives contracts.

…………………………………………………………………………………......
..................................................................................................................................
..................................................................................................................................
..................................................................................................................................

5.5 SECURITIES AND EXCHANGE BOARD OF INDIA

Many developed countries like U.K. and U.S.A. had long back created separate
Boards for the regulation of the securities market. While U.K. has the Securities and
Investment Board (SIB) and U.S. has the Securities and Exchange Commission
(SEC). The Indian Government's intention to set up a separate Board for the
regulation and orderly functioning of the capital market was first declared in the
Budget Speech by Shri Rajiv Gandhi, the then Prime Minister and Minister of
Finance, while presenting the Budget for the year 1987-88. He stated:

"The capital markets in India have shown tremendous growth in the last few years.
Approvals for capital issues have exceeded Rs. 5,000 crores in 1986-87. They were
only about Ra.5O0cnureuio108B'8 l. For a healthy growth of a capital markets,
investors must be fully protected. Trading malpracrices must be prevented.
Government have decided to set up a separate board for the regulation and orderly
functioning of Stock Exchange and the securities industry".

5.5.1 Origin

By a Notification issued on 12th April, 1988, Securities and Exchange Board of India
(SERI), was constituted as an interim administrative body to function under the over
all administrative control of the Ministry of Finance, Government of India.

In July 1988, the SEBI, constituted as aforesaid, published an approach paper on

comprehensive legislation for securities market.

In the Budget Speech for the year 1990-91, the then Finance Minister stated:

"The previous Government had announced the formation of the Securities and
Exchange Board of India (SEBI) in 1988. Three years have passed and the legislation
for giving statutory authority to 8BB{bam not been introduced. We will ensure that
this is done in this budget session".

In the Budget Speech for 1991-92, the Finance Minister said:

"While presenting the budget for 1987-80,our former Prime Minister the late Shri
Rajiv Gandhi had assured this House that for a healthy growth of capital markets, for
protecting the rights of investors and for preventing trading malpractices the
Government would set up a separate Board for the regulation and orderly functioning
of the stock exchanges and the securities industry. Although the Board was set up,
legislation to give the Board adequate powers was unfortunately not enacted. This
shall now be done forthwith and full statutory powers will be given to the Securities
and Exchange Board of India for administrating the relevant provisions of the 25
Securities contracts (Regulation) Act and the
Securities market in Companies Act. Transferring these powers from the Controller of Capital Issues and
India the Government to an independent body would enable it to effectively regulate,
promote and monitor the working of the stock exchanges in the country. A
comprehensive package of reforms relating to trading on the stock exchange,
including a system of national clearing and settlement and setting up of a central
depository, is also under active consideration".
Finally, in the budget Speech for 1992-93, the Finance Minister said:
"Financial sector reform also includes reform of the capital market, which will
increasingly play a vital role in mobilizing and allocating resources from the public.
Several initiatives announced in my budget speech last year have since been
implemented. The Securities and Exchange Board of India (SEBI), has now been
established on a statutory basis. As we gain experience, additional powers will be
given to SEBI to strengthen its capability."
The SEBI was given a statutory status on 30th January, 1992 by an Ordinance to
provide for the establishment of SEBI. A Bill to replace the Ordinance was introduced
rd
in Parliament on 3 March, 1992 and was passed by both houses of Parliament on 1st
April, 1992. The Bill became an Act on 4th April 1992 the date on which it received
the Presidents assent. However, as provided for in section (3), this Act is to be deemed
to have come into force on 30th January, 1992, i.e., the date on which the SEBI
Ordinance was promulgated.
5.5.2 Functions
Under Section 11 of the SEBI Act it is provided that subject to the provisions of this
Act, it shall be the duty of the Board to protect the interest of investors in securities
and to promote the development of and to regulate the securities market, by such
measures as it thinks fit. It is further provided that without prejudice to the generality
of the foregoing provisions, the measures referred to therein may provide for:
a) regulating the business in stock exchanges and any other securities markets;
b) registering and regulating the working of stock brokers, sub-brokers, share
transfer agents, bankers to an issue, trustees of trust deeds, registrars to an issue,
merchant bankers, underwriters, portfolio managers, investment advisers and
such other intermediaries who may be associated with securities markets in any
manner;
c) registering and regulating the working of collective investment schemes,
including mutual funds.
d) promoting and regulating self-regulatory organisations;
e) prohibiting fraudulent and unfair trade practice relating to securities markets.
f) promoting investors education and training of intermediaries of securities
markets;
g) prohibiting insider trading in securities;
h) regulating substantial acquisition of shares and take-over of companies;
i) calling for information from, undertaking inspection, conducting inquiries and
audit of the stock exchanges and intermediaries and self-regulatory
organisations in the securities market;
j) performing such functions and exercising such powers under the provisions of
the Capital Issue (Control) Act, 1947 (29 of 1947) and the Securities Contracts
(Regulation) Act, 1956 (42 of 1956), as may be delegated to it by the Central
Government.
k) levying fees or other charges for carrying out the purpose of this section;
1) conducting research for the above purpose;
m) performing such other functions as may be prescribed.
In sum and substance, Securities and Exchange Board of India has been constituted to
promote orderly and healthy development of the securities market and to provide
adequate investor protection. It aims to remove the unhealthy practices prevalent in
26
the Indian capital market and create an environment to facilitate mobilisation of
resources through the
 Regulation
securities market. Thus the Board plays a dual role by adopting regulatory functions
as well as playing an important developmental role. Its functions include :-
1) To deal with all matters relating to development and regulation of the securities
market.
2) To administer various legislations affecting securities market.
3) Regulation of the market intermediaries viz: stock exchanges, stock brokers,
merchant bankers, mutual funds, etc.
4) To provide adequate investor protection.
5.5.3 Organization
The management of SEBI vests in the Board which consists of the following
members, namely:-
a) a Chairman;
b) two Members from amongst the officials of the Ministries of the Central
Government dealing with Finance and Law;
c) one Member from amongst the officials of the Reserve Bank of India
d) two other Members , to be appointed by the Central Government.
The general superintendence, direction and management of the affairs of the SEBI
vests in a Board of Members, which may exercise all powers and do all acts and
things which may be exercised or done by the Board. Save as otherwise determined by
regulations, the Chairman shall also have powers of general superintendence and
direction of the affairs of the Board and may also exercise all powers and do all acts
and things which may be exercised or done by the Board.
The Chairman and the Members referred to at (a) and (d) above shall be appointed by
the Central Government and the members referred to at (b) and (c) above shall be
nominated by the Central Government and the Reserve Bank of India respectively.
For day to day functions the activities of SEBI have been divided into five operational
departments viz.,
1. Primary markets-policy, intermediaries, investor grievances and guidance, etc.
2. Issue Management & Intermediary department
3. Secondary market-policy, operations and exchange administration, new
investment products and insider trading, etc.
4. Secondary market-exchange administration, inspection and non-member
intermediaries, etc
5. Institutional investment-Mutual funds and FIIs, mergers and acquisitions, research
& publications and internal regulation.
Each department is headed by an Executive Director. Besides these five departments,
there are legal and investigation departments.
5.5.4 Activities
The first major activity undertaken by SEBI was the preparation of an Approach paper
on comprehensive legislation for Securities markets. Since inception, SEBI has issued
a number of guidelines, rules, draft regulations, consultative papers, etc., in order to
regulate and develop the securities market and protect investors interest. Some
important guidelines, etc. issued by SEBI include:
a) Rules regarding registration of intermediaries such as share transfer agents,
bankers to the issue, debenture trustees to the trust deeds, registrars to an
issue, underwriters, portfolio managers and investment advisors, stock
brokers and sub-brokers associated with the securities market. 27
Securities market in b) Guidelines for merchant bankers stating authorised activities of merchant
India bankers, the authorisation criteria and the terms of authorisation.
c) Code of conduct for merchant bankers, the violation, intentional or
otherwise, of which will make the merchant banker guilty of misconduct or
unprofessional conduct.
d) Categorization of merchant bankers, under which merchant bankers have
been categorized into three categories. Category 1 merchant bankers are
authorized to act in the capacity of lead manager/co-manager/advisor or
consultant to an issue, portfolio manager and underwriter to an issue as
mandatory required. Category 11 merchant bankers are authorized to act in
the capacity of co-manager/advisor or consultant to an issue or portfolio
manager. Category III merchant bankers are authorized to act only in the
capacity of advisor or consultant to an issue.
It is also prescribed that Category I merchant bankers must have a minimum
net worth of Rs. 1 crore, the category II merchant banker a minimum
networth of Rs. 50 lakh, and the Category' III merchant bankers a minimum
networth of Rs. 20 lakh. Initial authorization fee for categories I, II and III
will be Rs. 5 lakh, 3 lakh and Rs. 1 lakh respectively.
e) Circular regarding monitoring of merchant bankers where under penalty
points for non-compliance or defaults by merchant bankers would be
assigned which in turn would form the basis for suspension/cancellation of
authorisation of merchant bankers.
f) Guidelines on portfolio management services which cover such aspects as
portfolio management activities, client relationship, investment tenure fees
to be paid to the portfolio manager, client's money account, investment of
client fund, periodical reports to clients and administrative powers of the
SEBI in this regard.
g) Guidelines for lead managers for interse allocation of responsibilities which
require that wherever there are more than one lead manager to the issue
inter se allocation of the pre-issue and post-issue activities/sub-activities
will be properly made and information in this regard sent to SEBI.
h) Guidelines regarding purchase of non-convertible part of debentures
(khokhas) from the subscribers
i) Regulation for registrars and share transfer agents
j) Regulation on insider trading
k) Guidelines for mutual funds and asset management companies
l) Draft regulation for substantial acquisition of shares in listed companies
m) Consultative paper on free market pricing of capital issue
n) Guidelines on capital issues/Guidelines for Disclosure and Investor
Protection along with clarifications from time to time.
o) Guidelines on issue of securities by Development Financial Institutions
p) Formation of two advisory committees, one on primary market and the
other on secondary market comprising members from profession, academic
and investing public.
SEBI has brought out some Acts, Regulations and Guidelines during the last one
decade covering various activities relating to securities market and intermediaries
connected with securities market.
1. Depositories Act, 1996.
28 2. SEBI (Depositories and Participants) Regulations, 1996.
3. SEBI (Bankers to an Issue) Regulations, 1994.
 Regulation
4. SEBI (Custodian of Securities) Regulations, 1996.
5. SEBI (Debenture Trustees) Regulations, 1993.
6. SEB1 (Foreign Institutional investors) Regulations, 1995.
7. SEBI (Prohibition of Insider Trading) Regulation, 1992.
8. SEBI (Merchant Bankers) Regulations, 1992.
9. SEBI (Mutual Funds) Regulations, 1996.
10. SEBI (Portfolio Managers) Regulations, 1993.
11. SEBI (Registrars to an Issue and Share Transfer) Regulations, 1993.
12. SEBI (Stock Brokers and sub Brokers) Regulations, 1992.
13. SEBI (Substantial Acquisition and Takeover) Regulations, 1997.
14. SEBI (Buy-back of Securities) Regulations, 1998
15. SEBI (Underwriters) Regulations, 1993.
16. SEBI (Venture Capital Funds) Regulations, 1992.
17. SEBI (Central Lisiting Authority) Regulations, 2003
Some of the above Regulations are amended from time to time to include the
necessary changes from the practical experience. Some of the important guidelines are
given in the Appendix 5.2.

5.6 SELF REGULATION

In the foregone sections, we have discussed the regulatory framework applicable to
primary and secondary markets in India. The focus of discussion has been on what
may be called legislative regulation of securities market. In addition to legislative
regulation, self-regulation is equally important. Indeed in developed securities markets
like U.K. self-regulation plays an important role. There exist a number of self-
regulatory organizations (SROs) which really complement legislative regulation.
The spirit of self-regulation had been prevalent in the Indian securities market as well.
If one looks at the powers given to recognized stock exchanges in India to make and
enforce bye-law under the Securities Contracts (Regulation) Act, 1956, one tends to
conclude that Indian stock exchange have been envisaged as self-regulatory
organizations. Just to elaborate the point let us look at section 9 of the Securities
Contracts (Regulation) Act, 1956, which states as follows:
Any recognized stock exchange may, subject to the previous approval of the Central
Government (till 1991) and Securities and Exchange Board of India (since 1992)
make bye-laws for the regulation and control of contracts.
In particular, without prejudice to the generality of the foregoing power, such bye-
laws may provide for:
a) The opening and closing of markets and the regulation of the hours of trade;
b) A clearing house for the periodical settlement of contracts and difference
thereunder, the delivery of the payment for securities, the passing on of delivery
orders and the regulation and maintenance of such a clearing house;
c) The submission to the Central Government (till 1991) and Securities and
Exchange Board of India (since 1992) by the clearing house as soon as may be
after each periodical settlement of all or any of the following particulars as the
Central Government (till 1991) and Securities and Exchange Board of India (since 29
1992) may, from time to time to another,
Securities market in i) The total number of each category of security carried over from one
India settlement period to another;
ii) The total number of each category of security contracts which have been
squared up during the course of each settlement period;
iii) The total number of each category of security actually delivered each
clearing;
d) The publication by the clearing house of all or any of the particulars submitted
to the Central Government (till I991) and Securities and Exchange Board of
India (since 11992) under the clause © subject to the directions, if any, issued
by the Central Government (till 1991). Securities and Exchange Board of India
since 1992) in this behalf;
e) The regulation or prohibition of blank transfers;
f) The number and classes of contracts in respect of which settlements shall be
made or difference paid through the clearing house;
g) The regulation, or prohibition of badlas or carry-over facilities;
h) The fixing, altering or postponing of days for settlements;
i) The determination and declaration of market rates, including the opening,
closing, highest and lowest rates for securities;
j) The terms, conditions and incidents of contracts, including the prescription of
margin requirements, if any, and conditions relating thereto, and the forms of
contracts in writing;
k) The regulation of the entering into, making performance, recession and
termination, of contracts, including contracts between members or between a
member and his constituent or between a member and a person who is not a
member, and the consequences of default or insolvency on the part of a seller or
buyer or intermediary, the consequences of a breach by a seller or buyer, and
the responsibility of members who are not parties to such contracts;
l) The regulation of taravani business including the placing of limitations thereon;
m) The listing of securities on the stock exchange, the inclusion of any security for
the purpose of dealings and the suspension or withdrawal of any such securities,
and the suspension or prohibition of trading in any specified securities;
n) The method and procedure for the settlement of claims or disputes, including
settlement by arbitration;
o) The levy and recovery fees, fines and penalties;
p) The regulation of the course of business between parties to contracts in any
capacity;
q) The fixing of a scale of brokerage and other charges;
r) The making, comparing, settling and closing of bargains;
s) The emergencies in trade which may arise, whether as a result of pool or
syndicated operations or cornering or otherwise, and the exercise of powers in
such emergencies including the power to fix maximum and minimum prices for
securities;
t) The regulation of dealings by members for their own account;
u) The separation of the functions of jobbers and brokers;
v) The-limitations on the volume of trade done by any individual member in
exceptional circumstances;
w) The obligation of members to supply such information or explanation and to
produce such documents relating to the business as the governing body may
require.
3) The bye-laws made under this section may:
30 a) Specify the bye-laws, the contravention of which shall make a contract
entered into otherwise than in accordance with the bye-laws void under
sub-section (1) of section (14);
 Regulation
b) Provide that the contravention of any of the bye-laws shall render the
member concerned liable to one or more of the following: punishments,
namely:
i) Fine
ii) Expulsion from membership,
iii) Suspension from membership for a specified period,
iv) Any other penalty of a like nature not involving the payment of
money.
4) Any bye-laws made under this section shall be subject to such conditions in
regard to previous publications as may be prescribed, and, when approved by
the Central Government (till 1991) and Securities and Exchange Board of India
(since 1992) shall be published in the Gazette of India and also in the Official
Gazette of the State in which the principal office of the recognised stock
exchange is situated and shall have effect as from the date of its publication in
the Gazette of India:
Provided that if the Central Government (till 1991) and Securities and Exchange
Board of India (since 1992) is satisfied in any case that in the interest of the trade or in
the public interest any bye-laws should be made immediately, it may, by ordering in
writing, specifying the reasons thereof, dispense with the condition of previous
publication.
The foregone discussion clearly shows that Indian stock exchanges have been
envisaged as self-regulatory bodies. Of late, merchant banks and mutual funds have
also been envisaged as SROs. Unfortunately, the record of Indian stock exchanges as
SROs has been dismal. Despite various malpractices prevalent in stock exchanges,
hardly any disciplinary action had been initiated against any member of the stock
exchange. Recent inspection by SEBI of some of the stock exchanges have clearly
brought out that their bye-laws relating to margins, etc. have been observed more in
breach. Nevertheless it can't be denied that self-regulation is a necessary complement
to legislative regulation of securities market in any country.
Activity-2
i) What do the following stand for:
SEBI : ………………………………………………………………..
SIB : ………………………………………………………………..
SEC : ………………………………………………………………..
ii) List down any five important changes that SEBI has brought in the last five
years.
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
………………………………………………………………………………….…
iii) Briefly explain the need for self-regulation in monitoring security market
dealings.
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
…………………………………………………………………………………….

5.7 SUMMARY
In this Unit, we have discussed the legal and regulatory framework applicable to the
securities market in India. We have observed that while there are a host of Acts which
affect and regulate the securities market in India, the two most important were 31
Securities
Securities market in Contract (Regulation) Act, 1956 and set of Regulations and Guidelines issued by
India Security Exchange Board of India. In 1992, the Securities and Exchange Board of
India Act, 1992 was passed to create Securities and Exchange Board of India as a
statutory body to act as a nodal regulatory body for the regulation and development of
securities market in India and protect and promote investors interest. This unit has
also discussed the origin, functions, organization and activities of SEBI at some
length. After discussing the current status of regulations governing securities markets
in India, this unit has also highlighted the role of self-regulation vis-à-vis legislative
regulation. You are advised to study the Appendes given along with this unit and the
other regulation of SEBI which are available in SEBI's website in order to better
appreciate the legal and regulatory framework of the securities markets in India.

5.8 SELF-ASSESSMENT QUESTIONS/EXERCISES

1. Effective regulation is an essential condition for orderly growth of securities
market' Discuss.
2. Write a brief note on the history of regulation of securities market in India.
3. Between self-regulation and legislative regulation, which is more relevant for
India and why?
4. Discuss the objectives and functions of Securities and Exchange Board of India.
5. `SEBI is an independent Board.' Do you agree? Why?
6. Who can be a Member of a Stock Exchange in India?
7. In a short span of its existence, SEBI has been able to fully meet its objectives.'
Critically comment.
8. What measures have been adopted in India to protect investors' interest in the
securities market?

5.9 FURTHER READINGS

Casey, John L., Ethics in the Financial Market Place, New York: Scudder, Stevens &
Clark, 1990
Hammer, Richard M., Gilbert Simonetti Jr., and Charles T Crawford, eds. Investment
Regulation around the world, Somerset, N.J.: Ronald Press, 1983
Ramaiya, A, Guide to the Companies Act, Agra Wadwa & Co., (refer latest edition
and Volumes relating to SEBI Regulations)
Web Sites:
U.S. Security Exchange Commission: www.sec.gov
Financial Service Authority, UK: www.fsa.gov.uk
SEBI, India: www.sebi.gov.in

32
 Regulation
APPENDIX 5.1
THE SECURITIES CONTRACTS (REGULATION) ACT, 1956*
(ACT NO:42 OF 1956)
An Act to prevent undesirable transactions in securities by regulating the business of
dealing therein.[***]1 by providing for certain other matters connected therewith.
Be it enacted by Parliament in the Seventh Year of the Republic of India as follows:
CHAPTER I : PRELIMINARY
Short title, extent and commencement
1. (1) This Act may be called the Securities Contracts (Regulation) Act, 1956.
(2) It extends to the whole of India.
(3) It shall come into force on such date as the Central Government may, by
notification in the Official Gazette appoint.2
Definitions
2. In this Act, unless the context otherwise requires,-
(a) "contract" means a contract for or relating to the purchase or sale of
securities; (aa) "derivative" includes -
A. a security derived from a debt instrument, share. loam whether secured or
unsecured, risk instrument or contract for differences or any other form of
security;
B. a contract which derives its value from the prices, or index or prices, of
underlying securities;'
(b) "Government security" means a security created and issued. whether
before or after the commencement of this Act, by the Central
Government or a State Government for the purpose of raising a
public loan and having one of the forms specified in clause (2) of
section 2 of the Public Debt Act, 1944 (18 of 1944);
(c) "member" means a member of a recognised stock exchange:
(d) "option in securities" means a contract for the purchase or sale of a
right to buy or sell, or a right to buy and sell, securities in future, and
includes a teji, a mandi,a tezimandi, a galli, a put, a call or a put and
call in securities;
(e) "prescribed" means prescribed by rules made under this Act;
(f) "recognised stock exchange" means a stock exchange which is for the
time being recognised by the Central Government under section 4;
(g) "rules", with reference to the rules relating in general to the
constitution and management of a stock exchange, includes, in the
case of a stock exchange which is an incorporated association, its
memorandum and articles of association;
(ga) "Securities Appellate Tribunal" means a Securities Appellate
Tribunal established under sub-section (1) of section 15K of the
Securities and Exchange Board of India Act, 1992.4
1
The words "by prohibiting options and" omitted by the Securities Laws
(Amendment)Act, 1995, west: 25-3-1995.
2
The Act came into force on 20 February, 1957 vide Notification No.SRO '528,
dated 6 February, 1957 published in Gazette of India, Extraordinary, Part II. section
3, page 549, dated 16 February, 1957.
3
Inserted by Securities Laws ( Second Amendment ) Act,1999 vide Gazette
notification dated December 16, 1999.
1
I bid
*As Amended Upto 03/01/2000
33
Source: SEBI's Website
Securities market in (h) “Securities” include-
India
(i) shares, scrips, stocks, bonds, debentures, debenture stock or other
marketable securities of a like nature in or of any incorporated company
or other body corporate;
(ia) derivative;
(ib) units or any other instrument issued by any collective investment
scheme to the investors in such schemes,'
(ii) Government securities;
(iia) such other instruments as may be declared by the Central Government to
be securities; and
(iii) rights or interests in securities;
(i) spot delivery contract means a contract which provides for,-
(a) actual delivery of securities and the payment of a price therefor either on
the same day as the date of the contract or on the next day, the actual
period taken for the despatch of the securities or the remittance of money
therefor through the post being excluded from the computation of the
period aforesaid if the parties to the contract do not reside in the same
town or locality;
(b) transfer of the securities by the depository from the account of a
beneficial owner to the account of another beneficial owner when such
securities are dealt with by a depository;]'
(j) "stock exchange" means anybody of individuals, whether incorporated or not,
constituted for the purpose of assisting, regulating or controlling the
business of buying, selling or dealing in securities.
2A. Words and expressions used herein and not defined in this Act but defined in the
Companies Act, 1956 or the Securities and Exchange Board of India Act; 1992
or the Depositories Act, 1996 shall have the same meanings respectively
assigned to them in those Acts.'
5
Ibid
6
Substituted for "(ii) Government Securities; and" by the Securities and Exchange
Board of India Act, 1992, w.e.f. 30-1-1992.
7
Substituted for the following:
(i) "spot delivery contract" means a contract which provides for the actual
delivery of securities and the payment of a price therefor either on the same
day as the date of the contract or on the next day, the actual period taken for
the despatch of the securities or the remittance of money therefor through the
post being excluded from the computation of the period aforesaid if the parties
to the contract do not reside in the same town or locality;"
by the Depositories Act, 1996 (22 of 1996), w.e.f. 12-8- 1996.
8
supra n.3

34
 Regulation
CHAPTER II : RECOGNISED STOCK EXCHANGES
Application for recognition of stock exchanges
3. (1) Any stock exchange, which is desirous of being recognised for the purposes
of this Act may make an application in the prescribed manner to the Central
Government.
(2) Every application under sub-section (1) shall contain such particulars as
may be prescribed, and shall be accompanied by a copy of the bye- laws of
the stock exchange for the regulation and control of contracts and also a
copy of the rules relating in general to the constitution of the stock exchange
and in particular, to-
a. the governing body of such stock exchange, its constitution and powers
of management and the manner in which its business is to be
transacted;
b. the powers and duties of the office bearers of the stock exchange;
c. the admission into the stock exchange of various classes of members,
the qualifications, for membership, and the exclusion, suspension,
expulsion and readmission of members therefrom or thereinto;
d. the procedure for the registration of partnerships as members of the
stock exchange in cases where the rules provide for such membership;
and the nomination and appointment of authorised representatives and
clerks.
Grant of recognition to stock exchanges
4. (1) If the Central Government is satisfied, after making such inquiry as may be
necessary in this behalf and after obtaining such further information, if any,
as it may require:
(a) that the rules and bye-laws of a stock exchange applying for
registration arc in conformity with such conditions as may be
prescribed with a view to ensure fair dealing and to protect investors;
(b) that the stock exchange is willing to comply with any other conditions
(including conditions as to the number of members) which the Central
Government. after consultation with the governing body of the stock
exchange and having regard to the area served by the stock exchange
and its standing acid the nature of the securities dealt with by it, may
impose for the purpose of carrying out the objects of this Act; and
(c) that it would be in the interest of the trade and also in the public
interest to grant recognition to the stock exchange; it may grant
recognition to the stock exchange subject to the conditions imposed
upon it as aforesaid and in such form as may be prescribed.
(2) The conditions which the Central Government may prescribe under clause
(a) of sub-section (1) for the grant of recognition to the stock exchanges
may include, among other matters, conditions relating to -
(i) the qualifications for membership of stock exchanges;
(ii) the manner in which contracts shall be entered into and enforced as
between members;
(iii) the representation of the Central Government on each of the stock
exchanges by such number of persons not exceeding three as the
Central Government may nominate in this behalf; and
(iv) the maintenance of accounts of members and their audit by chartered
accountants whenever such audit is required by the Central
Government.
(3) Every grant of recognition to a stock exchange under this section shall be
published in the Gazette of India and also in the Official Gazette of the State
in which the principal office as of the stock exchange is situated, and such
recognition shall have effect as from the date of its publication in the
Gazette of India.
(4) No rules of a recognised stock exchange relating to any of the matters
specified in sub-section (2) of section 3 shall be amended except with the
approval of the Central Government. Withdrawal of recognition 5. If the
Central Government is of the opinion that the recognition granted to a stock 35
exchange under the provisions of this Act should, in
Securities market in the interest of the trade or in the public interest, be withdrawn, the Central
India Government is considering the withdrawal of the recognition for the
reasons stated in the notice and after giving an opportunity to the
governing body to be heard in the matter, the Central Government may
withdraw, by notification in the Official Gazette, the recognition granted to
the stock exchange:
Provided that no such withdrawal shall affect the validity of any contract entered into
or made before the date of the notification, and the Central Government may, after
consultation with the stock exchange, make such provision as it deems fit in the
notification of withdrawal or in any subsequent notification similarly published for the
due performance of any contracts outstanding on that date. Power of Central
Government to call for periodical returns or direct inquiries to be made 6. (1)
Every recognised stock exchange shall furnish to the [Securities and Exchange Board
of India] such periodical returns relating to its affairs as may be prescribed.
(2) Every recognised stock exchange and every member thereof shall maintain and
preserve for such periods not exceeding five years such books of account, and
other documents as the Central Government, after consultation with the stock
exchange concerned, may prescribe in the interest of the trade or in the public
interest, and such books of account. and other documents shall be subject to
inspection at all reasonable times by the [Securities and Exchange Board of
India].10
(3) Without prejudice to the provisions contained in sub-sections (1) and (2), the
[Securities and Exchange Board of India]11, if it is satisfied that it is in the
interest of the trade or in the public interest so to do, may, by order in writing-
a. call upon a recognised stock exchange or any member thereof to furnish in
writing such information or explanation relating to the stock exchange as
the [Securities and Exchange Board of India]12 may require; or
b. appoint one or more persons to make an inquiry in the prescribed manner in
relation to the affairs of any of the members of the stock exchange in
relation to the-stock exchange and submit a report of the result of such
inquiry to the [Securities and Exchange Board of India].13
(4) Where an inquiry in relation to the affairs of a recognised stock exchange or the
affairs of any of its members in relation to the stock exchange has been
undertaken under sub-section (3)-
(a) every director, manager, secretary or other officer of such stock exchange;
(b) every member of such stock exchange:
(c) if the member of the stock exchange is a firm, every partner, manager,
secretary or other officer of the firm; and
(d) every other person or body of persons who has had dealings in the course of
business with any of the persons mentioned in clauses (a), (b) and (c)
whether directly or indirectly; shall be bound to produce before the
authority making the inquiry all such books of account, and other
documents in his custody or power relating to or having a bearing on the
subject-matter of such inquiry and also to furnish the authorities within such
time as may be specified with any such statement or information relating
thereto as may be required of him.
Annual reports to be furnished to Central Government by stock exchanges 7.
Every recognised stock exchange shall furnish the Central Government with a copy of
the annual report, and such annual report shall contain such particulars as may be
prescribed. Power of recognised stock exchange to make rules restricting voting
rights, etc. 7A. (1) A recognised stock exchange may make rules or amend any rules
made by it to provide for all or any of the following matters, namely:
9
Substituted for "Central Government" by the Securities and Exchange Board of India
Act, 1992, w.e.f. 30-1-1992.
10
lbid
11
Ibid
12
36 lbid
13
lbid
 Regulation
(a) the restriction of voting rights to members only in respect of any matter placed before
the Regulation stock exchange at any meeting;
(b) the regulation of voting rights in respect of any matter placed before the stock
exchange at any meeting so that each member may be entitled to have one vote only,
irrespective of his share of the paid-up equity capital of the stock exchange;
(c) the restriction on the right of a member to appoint another person as his proxy to
attend and vote at a meeting of the stock exchange; and
(d) such incidental, consequential and supplementary matters as may be necessary to
give effect to any of the matters specified in clauses (a), (b) and (c).
(1) No rules of a recognised stock exchange made or amended in relation to any matter
referred to in clauses (a) to (d) of sub-section (1) shall have effect until they have
been approved by the Central Government and published by that Government in the
Official Gazette and, in approving the rules so made or amended, the Central
Government may make such modifications therein as it thinks fit, and on such
publication, the rules as provided by the Central Government shall be deemed to have
been validly made, notwithstanding anything to the contrary contained in the
Companies Act, 1956 (1 of 1956). Power of Central Government to direct rules to
be made or to make rules 8. (I) Where, after consultation with the governing bodies
of stock exchanges generally or with the governing body of any stock exchange in
particular, the Central Government is of the opinion that it is necessary or expedient
so to do, it may, by order in writing together with a statement of the reasons therefor,
direct recognised stock exchanges generally or any recognised stock exchange in
particular, as the case may be, to make any rules or to amend any rules already made
in respect of all or any of the matters specified in sub-section (2) of section 3 within a
period of [two months]14from the date of the order.
(2) If any recognised stock exchange fails or neglects to comply with any order made
under sub-section (1) within the period specified therein, the Central Government
may make the rules for, or amend the rules made by, the recognised stock exchange,
either in the form proposed in the order or with such modifications thereof as may be
agreed to between the stock exchange and the Central Government.
(3) Where in pursuance of this section any rules have been made or amended, the rules
so made or amended shall be published in the Gazette of India and also in the Official
Gazette or Gazettes of the State or States in which the principal office or offices of
the recognised stock exchange or exchanges is or are situate, and, on the publication
thereof in the Gazette of India, the rules so made or amended shall, notwithstanding
anything to the contrary contained in the Companies Act, 1956 (I of 1956), or in any
other law for the time being in force, have effect as it they had been made or
amended by the recognised stock exchange or stock exchanges, as the case may be.
Power of recognised stock exchange to make bye-laws 9. (1) Any recognised stock
exchange may, subject to the previous approval of the [Securities and Exchange
Board of India],15 make bye-laws for the regulation and control of contracts.
(4) In particular, and without prejudice to the generality of the foregoing power, such
bye-laws may provide for
(a) the opening and closing of markets and the regulation of the hours of-trade;
(b) a clearing house for the periodical settlement of contracts and differences
thereunder, the delivery of and payment for securities, the passing on of
delivery orders and the regulation and maintenance of such clearing house;
(c) the submission to the [Securities and Exchange Board of India]16 by the
clearing house as soon as may be after each periodical settlement of all or any
of the following particulars as the [Securities and Exchange Board of
India]17may, from time to time require, namely:
(i) the total number of each category of security carried over from one
settlement period to another.
14
Substituted by the Securities Laws (Amendment) Act, 1995, w.e.f 25-3-1995 for six
months .
15
Substituted for "Central Government" by the Securities and Exchange Board of India Act,
1992, w.e.f. 30-1-1992.
16
Ibid 37
17
Ibid
Securities market in (ii) the total number of each category of security, contracts in respect of
India which have been squared up during the course of each settlement period.
(iii) the total number of each category of security actually delivered at each
clearing;
(d) the publication by the clearing house of all or any of the particulars submitted to
the [Securities and Exchange Board of lndia]18 under clause (c) subject to the
directions, if any, issued by the [Securities and Exchange Board of India]19 in
this behalf;
(e) the regulation or prohibition of blank transfers;
(f) the number and classes of contracts in respect of which settlements shall be
made or differences paid through the clearing house;
(g) the regulation, or prohibition of badlas or carry-over facilities;
(h) the fixing, altering or postponing of days for settlements;
(i) the determination and declaration of market rates, including the opening,
closing, highest and lowest rates .for securities;
(j) the terms, conditions and incidents of contracts, including the prescription of
margin requirements, if any, and conditions relating thereto, and the forms of
contracts in writing;
(k) the regulation of the entering into, making, performance, rescission and
termination, of contracts, including contracts between members or between a
member and his constituent or between a member and a person who is not a
member, and the consequences of default or insolvency on the part of a seller or
buyer or intermediary, the consequences of a breach or omission by a seller or
buyer, and the responsibility of members who are not parties to such contracts;
(l) the regulation of taravani business including the placing of limitations thereon;
(m) the listing of securities on the stock exchange, the inclusion of any security for
the purpose of dealings and the suspension or withdrawal of any such securities,
and the suspension or prohibition of trading in any specified securities;
(n) the method and procedure for the settlement of claims or disputes, including
settlement by arbitration;
(o) the levy and recovery of fees, tines and penalties;
(p) the regulation of the course of business between parties to contracts in any
capacity;
(q) the fixing of a scale of brokerage and other charges;
(r) the emergencies in trade which may arise, whether as a result of pool or
syndicated operations or cornering or otherwise, and the exercise of powers in
such emergencies including the power to fix maximum and minimum prices for
securities;
(s) the regulation of dealings by members for their own account;
(t) the separation of the functions of jobbers and brokers;
(u) the limitations on the volume of trade done by any individual member in
exceptional circumstances;
(v) the obligation of members to supply such information or explanation and
to produce such documents relating to the business as the governing body
may require.
(3) The bye-laws made under this section may:
(a) specify the bye-laws, the contravention of which shall make a contract
entered into otherwise than in accordance with the bye- laws void under
sub-section (1) of section 14;
(b) provide that the contravention of any of the bye-laws shall render the
member concerned liable to one or more of the following punishments,
namely:
(i) fine,
(ii) expulsion from membership,
38 18
lbid
19
lbid
 Regulation
(iii) suspension from membership for a specified period,
(iv) any other penalty of a like nature not involving the payment of money.
(4) Any bye-laws made under this section shall be subject to such conditions in regard to
previous publication as may be prescribed, and, when approved by the [Securities and
Exchange Board of India]20 shall be published in the Gazette of India and also in the
Official Gazette of the State in which the principal office of the recognised stock exchange
is situate, and shall have effect as from the date of its publication in the Gazette of India:
Provided that if the [Securities and Exchange Board of India]21 is satisfied in any case that
in the interest of the trade or in the public interest any bye-laws should be made
immediately, it may, by order in writing specifying the reasons therefor, dispense with the
condition of previous publication. Power of [Securities and Exchange Board of 1ndia]22
to make or amend bye-laws of recognised stock exchanges 10. (1) The [Securities and
Exchange Board of India ]23 may, either on a request in writing received by it in this behalf
from the governing body of a recognised stock exchange or on its own motion, if it is
satisfied after consultation with the governing body of the stock exchange that it is
necessary or expedient so to do and after recording its reasons for so doing, make bye-laws,
for all or any of the matters specified in section 9 or amend any bye-laws made by such
stock exchange under that section.
(2) Where in pursuance of this section any bye-laws have been made or amended, the
bye-laws so made or amended shall be published in the Gazette of India and also in
the Official Gazette of the State in which the principal office of the recognised stock
exchange is situated, and on the publication thereof in the Gazette of India. the bye-
laws so made or amended shall have effect as if they had been made or amended by
the recognised stock exchange concerned.
(3) Notwithstanding anything contained in this section, where the governing body of a
recognised stock exchange objects to any bye-laws made or amended under this
section by the [Securities and Exchange Board of India]24 on its own motion, it may,
within [two months]25 of the publication thereof in the Gazette of India under sub-
section (2), apply to the [Securities and Exchange Board of India]26 for revision
thereof the [Securities and Exchange Board of India]27 may, after giving an
opportunity to the governing body of the stock exchange to be heard in the matter,
revise the bye-laws so made or amended, and where any bye-laws so made or
amended are revised as a result of any action taken under this sub- section, the bye-
laws so revised shall be published and shall become effective as provided in sub-
section (2).
(4) The making or the amendment or revision of any bye-laws under this section shall in
all cases be subject to the condition of previous publication:
Provided that if the [Securities and Exchange Board of India]28 is satisfied in
any case that in the interest of the trade or in the public interest any bye-laws should
be made, amended or revised immediately, it may, by order in writing specifying the
reasons therefor, dispense with the condition of previous publication. Power of
Central Government to supersede governing body of a recognised stock
exchange 11. (1) Without prejudice to any other powers vested in the Central
Government under this Act, where the Central Government is of the opinion that the
governing body of any recognised stock exchange should be superseded, then, not
withstanding anything contained in any other law for the time being in force, the
Central Government may serve on the governing body a written notice that the
Central Government is considering the supersession of the governing body for the
reasons specified in the notice and after giving an opportunity to the governing body
to be heard in the matter, it may, by notification in the Official Gazette declare the
governing body of such stock exchange to be superseded, and may appoint any
person or persons to exercise and perform all the powers and duties of the governing
body, and where more persons than one are appointed, may appoint one of such
persons to be the chairman and another to be the vice-chairman thereof.
20
lbid
21
lbid
22
lbid
23
Ibid
24
Ibid
25
Substituted by the Securities Laws (Amendment) Act, 1995, w.e.f. 25-1-1995 for "six months".
26
supra n.13
27
lbid 39
28
Ibid
Securities market in (2) On the publication of a notification in the Official Gazette under sub-section (1),
India the following consequences shall ensue, namely-
(a) the members of the governing body which has been superseded shall, as
from the date of the notification of supersession, cease to hold office as
such members;
(b) the person or persons appointed under sub-section (1) may exercise and
perform all the powers and duties of the governing body which has been
superseded;
(c) all such property of the recognised stock exchange as the person or
persons appointed under sub-section (1) may, by order in writing, specify
in this behalf as being necessary for the purpose of enabling him or them
to carry on the business of the stock exchange, shall vest in such person or
persons.
(3) Notwithstanding anything to the contrary contained in any law or the rules or
bye-laws of the recognised stock exchange the governing body of which is
superseded under sub-section (1), the person or persons appointed under that
sub-section shall hold office for such period a may be specified in the
notification published under that sub-section and, the Central Government may
from time to time, by like notification, vary such period.
(4) The Central Government may at any time before the determination of the period
of office of any person or persons appointed under this section call upon the
recognised stock exchange to reconstitute the governing body in accordance
with its rules and on such re-constitution all the property of the recognised stock
exchange which has vested in, or was in the possession of, the person or persons
appointed under sub-section (1), shall re-vest, as the case may be, in the
governing body so re-constituted:
Provided that until a governing body is so re-constituted, the person or persons
appointed under sub-section (1), shall continue to exercise and perform their powers
and duties. Power to suspend business of recognised stock exchanges 12. If in the
opinion of the Central Government an emergency has arisen and for the purpose of
meeting the emergency the Central Government considers it expedient so to do, it
may, by notification in the Official Gazette, for reasons to be set out therein, direct a
recognised stock exchange to suspend such of its business for such period not
exceeding seven days and subject to such conditions as may be specified in the
notification, and if, in the opinion of the Central Government, the interest of the trade
or the public interest requires that the period should be extended may, by like
notification extend the said period from time to time.
Provided that where the period of suspension is to be extended beyond the first period,
no notification extending the period of suspension shall be issued unless the governing
body of the recognised stock exchange has been given an opportunity of being heard
in the matter.

40
 Regulation
CHAPTER III : CONTRACTS AND OPTIONS IN
SECURITIES
Contracts in notified areas illegal in certain circumstances 13: If the Central Government is
satisfied, having regard to the nature or the volume of transactions in securities in any State or
area, that it is necessary so to do, it may, by notification in the Official Gazette, declare this
section to apply to such State or area, and thereupon every contract in such State or area which
is entered into after date of the notification otherwise than between members of a recognised
stock exchange in such State or area or through or with such member shall be illegal.
[Additional trading floor 13A. A stock exchange may establish additional trading floor
with the prior approval of the Securities and Exchange Board of India in accordance
with the terms and conditions stipulated by the said Board.]
Explanation: For the purposes of this section `additional trading floor' means a trading
ring or trading facility offered by a recognised stock exchange outside its area of operation
to enable the investors to buy and sell securities through such trading floor under the
regulatory framework of the stock exchange.]29 Contracts in notified areas to be void in
certain circumstances 14. (1) Any contract entered into in any State or area specified in the
notification under section 13 which is in contravention of any of the bye- laws specified in that
behalf under clause (a) of sub-section (3) of section 9 shall be void:
(i) as respects the rights of any member of the recognised stock exchange who has
entered into such contract in contravention of any such bye-laws, and also
(ii) as respects the rights of any other person who has knowingly participated in the
transaction entailing such contravention.
(2) Nothing in sub-section (1) shall be construed to affect the right of any person other than
a member of the recognised stock exchange to enforce any such contract or to recover
any sum under or in respect of such contract if such person had no knowledge that the
transaction was in contravention of any of the bye-laws specified in clause (a) of sub-
section (3) of section 9. Members may not act as principals in certain circumstances 15.
No member of a recognised stock exchange shall in respect of any securities enter into
any contract as a principal with any person other than a member of a recognised stock
exchange, unless he has secured the consent or authority of such person and discloses in
the note, memorandum or agreement of sale or purchase that he is acting as a principal:
Provided that where the member has secured the consent or authority of such person otherwise
than in writing he shall secure written confirmation by such person of such consent or
authority within three days from the date of the contract:
Provided further that no such written consent or authority of such person shall be necessary for
closing out any outstanding contract entered into by such person in accordance with the bye-
laws, if the member discloses in the note, memorandum or agreement of sale or purchase in
respect of such closing out that he is acting as a principal. Power to prohibit contracts in
certain cases 16.
(1) If the Central Government is of opinion that it is necessary to prevent undesirable
speculation in specified securities in any State or area, it may, by notification in the
Official Gazette, declare that no person in the State or area specified in the notification
shall, save with the permission of the Central Government, enter into any contract for
the sale or purchase of any security specified in the notification except to the extent and
in the manner, if any, specified therein.
(2) All contracts in contravention of the provisions of sub-section (1) entered into after the
date of the notification issued thereunder shall be illegal. Licensing of dealers in
securities in certain eases 17. (1) Subject to the provision of sub-section (3) and to the
other provisions contained in this Act, no person shall carry, on or purport to carry on,
whether on his own behalf or on behalf of any other person, the business of dealing in
securities in any State or area to which section 13 has not been declared to apply and to
which the Central Government may, by notification in the Official Gazette declare this
section to apply, except under the authority of a licence granted by the [Securities and
Exchange Board of lndia]30 in this behalf.
(3) No notification under sub-section (1) shall be issued with respect to any State or area
unless the Central Government is satisfied, having regard to the manner in which
securities are being dealt with in such State or area, that it is desirable or expedient in
the interest of the trade or in the public interest that such dealings should be regulated
by a system of licensing.
29
Inserted by the Securities Laws (Amendment) Act, 1995, w.e.f. 25-1-1995. 41
30
supra n. 9.
Securities market in (3) The restrictions imposed by sub-section (1) in relation to dealings in securities
India shall not apply to the doing of any thing by or on behalf of a member of any
recognised stock exchange. Exclusion of spot delivery contracts from sections
13, 14, 15 and 17 18. (1) Nothing contained in sections 13, 14, 15 and 17 shall
apply to spot delivery contracts.
(2) Notwithstanding anything contained in sub-section (1), if the Central
Government is of opinion that in the interest of the trade or in the public interest
it is expedient to regulate and control the business of dealing in spot delivery
contracts also in any State or are (whether section 13 has been declared to apply
to that State or area or not), it may. by notification in the Official Gazette,
declare that the provisions of section 17 shall also apply to such State or area in
respect of spot delivery contracts generally or in respect of spot delivery
contract for the sale or purchase of such securities as may be specified in the
notification, and may also specify the manner in which, and the extent to which,
the provision of that section shall so apply.
18A. Notwithstanding anything contained in any other law for the time being in
force, contracts are-
a. traded on a recognised stock exchange:
b. settled on the clearing house of the recognised stock exchange, in
accordance with the rules and bye-laws of such stock exchange.31
Stock exchanges other than recognised stock exchanges prohibited
19. (1) No person shall, except with the permission of the Central Government,
organise or assist in organising or be a member of any stock exchange
(other than a recognised stock exchange) for the purpose of assisting in,
entering into or performing any contracts in securities.
(2) This section shall come into force in any State or area on such date, as the
Central Government may, by notification in the Official Gazette, appoint.
[Prohibition of options in securities
20. Omitted by the Securities Laws (Amendment) Act, 1995, w.e.f. 25-1-1995]32
31
supra n. 3
32
Prior to omission it read as under: Prohibition of options in securities-
1. Notwithstanding anything contained in this Act or in any other law for die
time being in force, all options in securities entered into after the
commencement of this Act shall be illegal.
2. Any option in securities which has been entered into before such
commencement and which remains to be performed whether wholly or in part,
after such commencement, shall to that extent, become void.

42
 Regulation
CHAPTER IV : LISTING OF SECURITIES [****]33
[Conditions for listing
21. Where securities are listed on the application of any person in any recognized stock exchange,
such person shall comply with the conditions off the listing agreement with that stock exchange.]34
Right of appeal against refusal of stock exchanges to list securities of public companies
22. Where a recognised stock exchange acting in pursuance of any power given to it by its bye- laws,
refuses to list the securities of any public company or collective investment scheme,35 the company
or scheme 36shall be entitled to be furnished with reasons for such refusal, any may-
(a) within fifteen days from the date on which the reasons for such refusal are furnished to it, or
(b) where the stock exchange has omitted or failed to dispose of, within the time specified in
sub-section (1) of section 73 of the Companies Act, 1956 (1 of 1956) (hereafter in this
section referred to as the "specified time"), the application for permission for the shares or
debentures to be dealt with on the stock exchange, within fifteen days from the date of
expiry of the specified time or within such further period, not exceeding one month, as the
Central Government may, on sufficient cause being shown, allow, appeal to the Central
Government against such refusal, omission or failure, as the case may be, and thereupon the
Central Government may, after giving the Stock Exchange an opportunity of being heard-
(i) vary or set aside the decision of the stock exchange; or
(ii) where the stock exchange has omitted or failed to dispose of the application within
the specified time, grant or refuse the permission, and where the Central Government
sets aside the decision of the recognised stock exchange or grants the permission, the
stock exchange shall act in conformity with the orders of the Central Government.
Provided that no appeal shall be preferred against refusal, omission or failure, as the case may be,
under. this section on and after the commencement of the Securities Laws (Second Amendment) Act,
1999.37
Right of Appeal to Securities Appellate Tribunal against refusal of stock exchange to list securities
of public companies
22A. (1) Where a recognised stock exchange, acting in pursuance of any power given to it by its bye-
laws, refuses to list the securities of any public company, the company shall be entitled to be
furnished with reasons for such refusal, and may-
a. within fifteen days from the date on which the reasons for such refusal are furnished to
it, or
b. where the stock exchange has omitted or failed to dispose of, within the time specified
in sub-section (1) of section 73 of the Companies Act, 1956 (hereafter in this section
referred to as the "specified time"), the application for permission for the ,shares or
debentures to be dealt with on the stock exchange, within fifteen days from the date of
expiry of the specified time or within such further period, not exceeding one month, as
the Securities Appellate Tribunal may, on sufficient cause being shown, allow, appeal
to the Securities Appellate Tribunal having jurisdiction in the matter against such
refusal, omission or failure, as the case may be, and thereupon the Securities Appellate
Tribunal may, after giving the stock exchange, an opportunity of being heard-
33
"By public companies" omitted by Securities Laws (Second Amendment) Act, 1999 w.e.f
16.12.1999.
34
Substituted by the Securities Laws (Amendment) Act, 1995, w.e.f. 25-1-1995 for the following:
21. Power to compel listing of securities by public companies- Notwithstanding anything
contained in any other law for the time being in force, if the Securities and Exchange Board of
India is of opinion, having regard to the nature of the securities issued by any public company as
defined in the Companies Act, 1956 (1 of 1956), or to the dealings in them, that it is necessary or
expedient in the interest of the trade or in the public interest so to do, it may require the company,
after giving it an opportunity of being heard in the matter, to comply with such requirements as
may be prescribed with respect to the listing of its securities on any recognised stock exchange."
35
Supra n. 3.
36
Ibid.
37
Inserted by Securities Laws (Second Amendment) Act, 1999 vide Gazette Notification dated
43
December 16, 1999.
Securities market in i. vary or set aside the decision of the stock exchange; or
India
ii. where the stock exchange has omitted or failed to dispose of the application within
the specified time, grant or refuse the permission, and where the Securities Appellate
Tribunal sets aside the decision of the recognised stock exchange or grants the
permission, the stock exchange shall act in conformity with the orders of the
Securities Appellate Tribunal.
(2) Every appeal under sub-section (1) shall be in such form and be accompanied by such
fee as may be prescribed.
(3) The Securities Appellate Tribunal shall send copy of every order made by it to the
Board and parties to the appeal.
(4) The appeal filed before the Securities Appellate Tribunal under sub-section (I) shall
be dealt with by it as expeditiously as possible and endeavour shall be made by it to,
dispose of the appeal finally within six months from the date of receipt of the
appeal.38
Procedure and powers of Securities Appellate Tribunal
22B. (1) The Securities Appellate Tribunal shall not be guided by the principles of natural
justice and, subject to the other provisions of this Act and' of any rules, the
Securities Appellate Tribunal shall have powers to regulate their own procedure
including the places at which they shall have their sittings.
(2) The Securities Appellate Tribunal shall have for the purpose of discharging their
functions under this Act, the same powers as are vested in a civil court under the
Code of Civil Procedure, 1908, while trying a suit, in respect of the following
matters, namely:
a. summoning and enforcing the attendance of any person and examining him
on oath;
b. requiring the discovery and production of documents;
c. receiving evidence on affidavits;
d. issuing commissions for the examination of witnesses or documents;
e. reviewing its decisions;
f. dismissing an application for default or deciding it ex-parte;
g. setting aside any order of dismissal of any application for default or any order
passed by it ex-parte; and
h. any other matter which may be prescribed.
(3) Every proceeding before Securities Appellate Tribunal shall be deemed to be a
judicial proceeding, within the meaning of sections 193 and 228, and for the
purposes of section 196 of the Indian Penal Code and the Securities Appellate
Tribunal shall be deemed to be a civil court for all the purposes of section 195 and
Chapter XXVI of the Code of Criminal Procedure, 1973.39
Right to legal representations
22C. The appellant may either appear in person or authorise one or more chartered
accountants or company secretaries or cost accountants or legal practitioners or any of
its officers or present his or its case before the Securities Appellate Tribunal.
Explanation. - For the purposes of this section, -
a. "chartered accountant" means a chartered accountant as defined in clause (b) of
sub-section (1) of section 2 of the Chartered Accountants Act, 1949 and who has
obtained a certificate of practice under sub-section (1) of section 6 of that Act;
b. "company secretary" means a company secretary as defined in clause (c) of sub-
section (1) of section 2 of the Company Secretaries Act, 1980 and who has
obtained a certificate of practice under sub-section (1) of section 6 of that Act;
c. "cost accountant" means a cost accountant as defined in clause (b) of sub-section
(1) of section 2 of the Cost and Works Accountants Act, 1959 and who has
obtained a certificate of practice under sub-section (1) of section 6 of that Act;
38
Inserted by Securities Laws (Second Amendment) Act, 1999 vide Gazette Notification
dated December 16, 1999. Earlier provision read as under was omitted by the
Depositories Act, 1996,
39
44 Inserted by Securities Laws (Second Amendment ) Act, 1999 vide Gazette Notification
dated December 16, 1999.
d. "legal practitioner" means an advocate, vakil or an attorney of any High Court. and
 Regulation
includes a pleader in practice,
Limitation
22D. The provisions of the Limitation 'Act, 1963 shall as far as may be apply to an appeal
made to a Securities Appellate Tribunal.41
Civil court not to have jurisdiction
22E. No civil court shall have jurisdiction to entertain any suit or proceeding in respect of
any matter which a Securities Appellate Tribunal is empowered by or under this Act
to determine and no injunction shall be granted by any court or other authority in
respect of any action taken or to be taken in pursuance of any power conferred by or
under this Act.42
Appeal to High Court
22F. Any person aggrieved by any decision or order of the Securities Appellate Tribunal
may file an appeal to the High Court within sixty days from the date of
communication of the decision or order of the Securities Appellate Tribunal on any
question of fact or law arising out of such order;
Provided that the High Court may, if it is satisfied that the appellant was prevented by
sufficient cause from filing the appeal within the said period, allow it to be filed
within a further period not exceeding sixty days.43
22A. Free transferability and registration of transfers of listed securities of companies-
(1) In this section, unless the context otherwise requires-
(a) "company" means a company whose securities are listed on a recognised stock
exchange;
(b) "security" means security of a company, being a security listed on a recognised
stock exchange but not being a security which is not fully paid-up or on which
the company has a lien;
(c) all other words and expressions used in this section and not defined in this Act
but defined in the Companies Act, 1956 (1 of 1956), shall have the same
meanings as are assigned to them in that Act.
(2) Subject to the provisions of this section, securities of companies shall be freely
transferable.
(3) Notwithstanding anything contained in its articles or in section 82 or section 111 of the
Companies Act, 1956 (1 of 1956), but subject to the other provisions of this section, a
company may refuse to register the transfer of any of its securities in the name of the
transferee on any one or more the following grounds and on no other ground, namely:
(a) that the instrument of transfer is not proper or has not been duly stamped and
executed or that the certificate relating to the security has not been delivered to
the cone any or that any other requirement under the law relating to registration
of such transfer has not been complied with;
(b) that the transfer of the securities is in contravention of any law or rules made
thereunder or any administrative instructions or conditions of listing agreement
laid down in pursuance of such laws or rules;
(c) that the. transfer of the security is likely to result in such change in the
composition of the board of directors as would be prejudicial to the interests of
the company or to the public . interest; and
(d) that the transfer of the security is prohibited by any order of any court, tribunal
or other authority under any law for the time being in force.
(4) A company shall, before the expiry of two months from the date on which the instrument
of transfer of any of its securities is lodged with it for the purposes of registration of
such transfer, not only form, in good faith, its opinion as to whether such registration
ought not or ought to be refused on any of the grounds mentioned in sub-section (3) but
also-
40
Ibid
41
Ibid
42
Ibid
43
Ibid 45
Securities market in (a) if it has formed the opinion that such registration ought not to be so refused,
India effect such registration;
(b) if it has formed the opinion that such registration ought to be refused on the
ground mentioned in clause (a) of sub-section (3),intimate the transferor
and the transferee by notice in the prescribed form about the requirements
under the law which has or which have to be complied with for securing
such registration; and
(c) in any other case make a reference to the Company Law Board and forward
copies of such reference to the transferor and the transferee.
(5) Every reference under clause© of sub-section (4) shall be in the prescribed
form and contain the prescribed particulars and shall be accompanied by the
instrument of transfer of the securities to which it relates, the documentary
evidence, if any, furnished to the company along with the instrument of transfer,
and evidence of such other nature and such fees as may be prescribed.
(6) on receipt of a reference under sub-section(4), the Company Law Board shall,
after causing reasonable notice to be given to the company and also to the
transferor and the transferee concerned and giving them a reasonable
opportunity to make their representations, if any, in writing by order; direct
either that the transfer shall be registered by the company or that it need not be
registered by it.
(7) Where on a reference under sub-section (4), the Company Law Board directs
that the transfer of the securities to which it relates-
(a) shall be registered by the company, the company shall give effect to the
direction within ten days of the receipt of the order as if it were an order
made on appeal by the Company Law Board in exercise of the powers
under section III of the Companies Act, 1956 (I of 1956);
(b) need not be registered by the company, the company shall, within ten days
from the date of such direction, intimate the transferor and the transferee
accordingly.
(8) If default is made in complying with the provisions of this section, the company
and every officer of the company who is in default shall be punishable with fine
which may extend to five thousand rupees.
(9) If in any reference made under clause (c) of sub- section (4) of this section, any
person makes any statement-
(a) which is false in any material particular, knowing it to be false; or
(b) which omits any material fact knowing it to be material, he shall be
punishable with imprisonment for a term which may extend to three years
and shall also be liable to fine.
(10) For the removal of doubts, it is hereby provided that nothing in this section
shall apply in relation to any securities the instrument of transfer in respect
whereof has been lodged with the company before the commencement of the
Securities Contracts (Regulation) Amendment Act, 1995."

46
 Regulation
CHAPTER V : PENALTIES AND PROCEDURES
Penalties 23. (l) Any person who-

(a) without reasonable excuse (the burden of proving which shall be on him) fails to
comply with any requisition made under sub-section (4) of section 6; or

(b) enters into any contract in contravention of any of the provisions contained in section
13 or section 16; or

(c) contravenes the provisions contained in section 17 or section 19; or

(d) enters into any contract in derivative in contravention of section 18A or the rules
made under section 30.44

(e) owns or keeps a place other than that of a recognised stock exchange which is used
for the purpose of entering into or performing any contracts in contravention of any of
the provisions of this Act and knowingly permits such place to be used for such
purposes; or

(f) manages, controls, or assists in keeping any place other than that of a recognised
stock exchange which is used for the purpose of entering into or performing any
contracts in contravention of any of the provisions of this Act or at which contracts
are recorded or adjusted or rights or liabilities arising out of contracts are adjusted,
regulated or enforced in any manner whatsoever; or

(g) not being a member of a recognised stock exchange or his agent authorised as such
under the rules or bye- laws of such stock exchange or not being a dealer in securities
licensed under section 17.

(h) not being a member of a recognised stock exchange or his agent authorised as such
under the rules or bye- laws of such stock exchange or not being a dealer in securities
licensed under section 17, canvasses, advertises or touts in any manner either for
himself or on behalf of any other person for any business connected with contracts in
contravention of any of the provisions of this Act; or

(i) joins, gathers or assists in gathering at any place other than the place of business
specified in the bye-laws of a recognised stock exchange any person or persons for
making bids or offers or for entering into or performing any contracts in contravention
of any of the provisions of this Act; shall, on conviction, be punishable with
imprisonment for a term which may extend to one year, or with fine, or with both.

(2) Any person who enters into any contract in contravention of the provisions contained in
section 15 [or who fails to comply with the provisions of section 21 or with the orders
off s the Central Government under section 22 or with the orders of the Securities
Appellate Tribunal shall,46 on conviction, be punishable with fine which may extend to
one thousand rupees. Offences by companies 24. (1) Where an offence has been
committed by a company, every person who, at the time when the offence was
committed, was incharge of, and was responsible to, the company for the conduct of the
business of the company, as well as the company, shall be deemed to be guilty of the
offence, and shall be liable to be proceeded against and punished accordingly:

Provided that nothing contained in this sub-section shall render any such person liable to
any punishment provided in this Act, if he proves that the offence was committed
without his knowledge or that he exercised all due diligence to prevent the commission
of such offence.
44
Inserted by Securities Laws (Second Amendment) Act, 1999 vide Gazette Notification dated
December 16, 1999. Clause (d) was earlier omitted by the Securities Laws (Amendment)
Act, 1995, w.e.f. 25-1-1995. Prior to omission it read as under: "(d) enters into any option in
securities in contravention of the provisions contained in section 20; or" wilfully represents
to or induces any person to believe that contracts can be entered into or performed under this
Act through him; or
45
Substituted for "or who fails to comply with the orders of the Securities and Exchange Board
of India under section 21" by the Securities Laws (Amendment) Act, 1995, w.e.f. 25-1-1995.
46
Inserted by the Securities Laws ( Second Amendment) Act,1999 vide Gazette Notification 47
dated December 16, 1999.
Securities market in 2) Notwithstanding anything contained in sub-section (1), where an offence under
India this Act has been committed by a company and it is proved that the offence has
been committed with the consent or connivance of, or is attributable to any
gross negligence on the part of any director, manager, secretary or other officer
of the company, such director, manager, secretary or other officer of the
company, shall also be deemed to be guilty of that offence and shall be liable to
be proceeded against and punished accordingly.

Explanation:

For the purpose of this section-

(a) "company" means any body corporate and includes a firm or other association
of individuals. and

(b) "director", in relation to-

(i) a firm, means a partner in the firm;

(ii) any association of persons or a body of individuals, means any member

controlling the affairs thereof. 47

[(3) The provisions of this section shall be in addition to, and not in derogation
of, the provisions of section 22A].48

Certain offences to be cognizable 25. Notwithstanding anything contained in the

[Code of Criminal Procedure, 1898 (5 of 1898)],49 any offence punishable under sub-
section (1) of section 23, shall be deemed to be a cognizable offence within the
meaning of that Code. Jurisdiction to try offences under this Act 26. No court
inferior to that of a presidency magistrate or a magistrate of the first class shall take
cognizance of or try any offence punishable under this Act.
47
Substituted by the Securities Laws ( Second Amendment) Act,1999 vide Gazette
Notification dated December 16, 1999 for " (b) director , in relation to a firm, means
a partner in the firm".
48
Inserted by the Securities Contracts (Regulation) Amendment Act, 1985.
49
Now Code of Criminal Procedure, 1973.

48
 Regulation
CHAPTER VI : MISCELLANEOUS
Title to dividends 27. (1) It shall be lawful for the holder of any security whose name
appears on the books of the company issuing the said security to receive and retain any
dividend declared by the company in respect thereof for any year, notwithstanding that the
said security has already been transferred by him for consideration, unless the transferee
who claims the dividend from the transferor has lodged the security and all other
documents relating to the transfer which may be required by the company with the
company for being registered in his name within fifteen days of the date on which the
dividend became due.
Explanation
The period specified in this section shall be extended-
(i) in case of death of the transferee, by the actual period taken by his legal
representative to establish his claim to the dividend;
(ii) in case of loss of the transfer deed by theft or any other cause beyond the
control of the transferee, by the actual period taken for the replacement
thereof; and
(iii) in case of delay in the lodging of any security and other documents relating
to the transfer due to causes connected with the post, by the actual period of
the delay.
(2) Nothing contained in sub- section (1) shall affect-
a. the right of a company to pay any dividend which has become due to any
person whose name is for the time being registered in the books of the
company as the holder of the security in respect of which the dividend has
become due; or
b. the right of the transferee of any security to enforce against the transferor or
any other person his rights. if any, in relation to the transfer in any case where
the company has refused to register the transfer of the security in the name of
the transferee.
Right to receive income from collective investment scheme-
27A (1) It shall be lawful for the holder of any securities, being units or other
instruments issued by collective investment scheme, whose name appears on
the books of the collective investment scheme issuing the said security to
receive and retain any income in respect of units or other instruments issued by
the collective investment scheme declared by the collective investment scheme
in respect thereof for any year notwithstanding that the said security, being
units or other instruments issued by collective investment scheme, has already
been transferred by him for consideration, unless the transferee who claims the
income in respect of units or other instruments issued by collective investment
scheme from the transfer or has lodged the security and all other documents
relating to the transfer which may be required by the collective investment
scheme with the collective investment scheme for being registered in his name
within fifteen days of the date on which the income in respect of units or other
instruments issued by the collective investment scheme became due.
Explanation
The period specified in this section shall be extended-
(i) in case of death of the transferee, by the actual period taken by his legal
representative to establish his claim to the income in respect of units or
other instrument issued by collective investment scheme;
(ii) in case of loss of the transfer deed by theft or any other cause beyond the
control of the transferee, by the actual period taken for the replacement
thereof; and
(iii) in case of delay in the lodging of any security, being units or other
instruments issued by collective investment scheme, and other documents
relating to the transfer due to causes connected with the post. by the actual
period of the delay.
(2) Nothing contained in sub-section (1) shall affect-
a. the right of a collective investment scheme to pay any income from units or
other instruments issued by collective investment scheme which has
become due to any person whose name is for the time being registered in
the books of the collective investment scheme as the holder of the security 49
being units or other instruments issued by collective
Securities market in investment scheme in respect of which the income in respect of units or other
India instruments issued by collective scheme has become due; or
b. the right of transferee of any security, being units or other instruments issued by
collective investment scheme, to enforce against the transferor or any other
person his rights, if any, in relation to the transfer in any case where the company
has refused to register the transfer of the security being units or other instruments
issued by collective investment scheme in the name of the transferee.50
Act not to apply in certain cases 28. (1) The provisions of this Act shall not apply to-
(a) the Government, the Reserve Bank of Indio any local authority or any
corporation set up by a special law or any person who has effected any
transaction with or through the agency of any such authority as is referred to in
this clause;
(b) any convertible bond or share warrant or any option or right in relation thereto, in
so far as it entitles the person in whose favour any of the foregoing has been
issued to obtain at his option from the company or other body corporate, issuing
the same or from any of its shareholders or duly appointed agents, shares of the
company or other body corporate, whether by conversion of the bond or warrant
or otherwise, on the basis of the price agreed upon when the same was issued.
(2) Without prejudice to the provisions contained in sub-section (1), if the Central
Government is satisfied that in the interests of trade and commerce or the
economic development of the country it is necessary or expedient so to do, it
may, by notification in the Official Gazette, specify any class of contracts as
contracts to which this Act or any provision contained therein shall not apply, and
also the conditions, limitations or restrictions, if any, subject to which it shall not
so apply. Protection of action taken in good faith 29. No suit, prosecution or
other legal proceeding whatsoever shall lie in any court against the governing
body or any member, office bearer or servant of any recognised stock exchange
or against any person or persons appointed under sub-section (1) of section 11 for
anything which is in good faith done or intended to be done in pursuance of this
Act or of any rules or bye-laws made there under. Power to delegate 29A. The
Central Government may, by order published in the Official Gazette, direct that
the powers (except the power under section 30) exercisable by such conditions, if
any, as may be specified in the order, be exercisable also by the Securities and
Exchange Board of India or the Reserve Bank of India constituted under section 3
of the Reserve Bank of India Act, 1934.51 Power to make rules 30. (1) The
Central Government may, by notification in the Official Gazette, make rules for
the purpose of carrying into effect the objects of this Act.
(2) In particular, and without prejudice to the generality of the foregoing power, such rules
may provide for,
(a) the manner in which applications may be made, the particulars which they should
contain and the levy of a fee in respect of such applications;
(b) the manner in which any inquiry for the purpose of recognizing any stock exchange
may be made, the conditions which may be imposed for the grant of such
recognition, including conditions as to the admission of members if the stock
exchange concerned is to be the only recognised stock exchange in the area; and the
form in which such recognition shall be granted;
(c) the particulars which should be contained in the periodical returns and annual
reports to be furnished to the Central Government;
(d) the documents which should be maintained and preserved under section 6 and the
periods for which they should be preserved;
(e) the manner in which any inquiry by the governing body of a stock exchange shall
be made under section 6;
(f) the manner in which the bye-laws to be made or amended under this Act shall
before being so made or amended be published for criticism;
50
supra n. 3
51
Substituted by Securities Laws (Second Amendment) Act, 1999 vide Gazette Notification
dated December 16, 1999 for "The Central Government may, by order published in the
Official Gazette, direct that the powers exercisable by it under any provision of this Act
shall, in relation to such matters and subject to such conditions, if any, as may be specified in
50 the order, be exercisable also by the Securities and Exchange Board of India]" which was
inserted by Securities and Exchange Board of India Act, 1992, w.e.f 30.1.92.
 Regulation
(g) the manner in which applications may be made by dealers in securities for
licences under Regulation section 17, the fee payable in respect thereof and the
period of such licences, the conditions subject to which licences may be granted,
including conditions relating to the forms which may be used in making contracts,
the documents to be maintained by licensed dealers and the furnishing of
periodical information to such authority as may be specified and the revocation of
licences for breach of conditions-

(h) the requirements which shall be complied with-

(A) by public companies for the purpose of getting their securities listed on any
stock exchange;

(B) by collective investment scheme for the purpose of getting their units listed
on any stock exchange".52

(ha) the form in which an appeal may be tiled before the Securities Appellate
Tribunal under section 22A and the fees payable in respect of such appeal."

(i) any other matter which is to be or may be prescribed.

(3) Any rules made under this section [***]54 shall, as soon as may be, after their
publication in the Official Gazette, be laid before both Houses of Parliament.
Repeal 31. Repealed by the Repealing and Amending Act, 1960 (58 of 1960),
section 2 and Schedule 1.
52
Substituted by Securities Laws (Second Amendment) Act, 1999 vide Gazette
Notification dated December 16. 1999 for "the requirements which shall be
complied with by public companies for the purpose of getting their securities
listed on any stock exchange; [***]
53
Substituted by Securities Laws ( Second Amendment ) Act, 1999 vide Gazette
Notification dated December 16, 1999 for

[(ha) the form in which a notice referred to in sub-clause (b) of sub-section (4) of
section 22A shall be the particulars which such notice shall contain, the form in
which a reference under clause (c) of the said sub-section (d) shall be the
particulars which such reference shall contain, and the evidence and the, fees
which shall accompany such reference: and] which was inserted by Securities
Contracts (Regulation) Amendment Act,1985.
54
The words "shall be subject to the condition of previous publication and" deleted
by the Securities Laws.

51
Securities market in APPENDIX 5.2 (i)
India
SECURITIES AND EXCHANGE BOARD OF INDIA
(STOCK-BROKERS AND SUB-BROKERS) REGULATIONS, 1992
CHAPTER I : PRELIMINARY
Short title and commencement
1. (1) These regulations may be called the Securities and Exchange Board of
India (Stock- brokers and Sub-brokers) Regulations, 1992.
(2) These regulations shall come into force on the date of their publication in
the Official Gazette.
Definitions
2. In these regulations, unless the context otherwise requires-
1*[(a) 'clearing corporation or clearing house' means the clearing corporation
or clearing house of a recognised stock exchange to clear and settle trades
in securities."
(aa) `clearing member' means a member of a clearing corporation or
clearing house of the derivatives exchange or derivatives segment of
an exchange, who may clear and settle transactions in securities.]
2*[(aaa)] "enquiry officer" means any officer of the Board, or any other
person, having experience in dealing with the problems relating to the
securities market, who is appointed by the Board under Chapter VI];
(b) "form" means a form specified in Schedule I;
(c) "inspecting authority" means one or more persons appointed by the Board
to exercise powers conferred under Chapter V of these regulations;
(d) "regulations" means Securities and Exchange Board of India (Stock-
brokers and Sub-brokers) Regulations, 1992;
(e) "rules" means Securities and Exchange Board of India (Stock- brokers and
Sub-brokers) Rules, 1992;
(f) "Securities Contracts (Regulation) Act" means the Securities Contracts
(Regulation) Act. 1956 (42 of 1956);.
3*[( fa)"self clearing member" means a member of a clearing corporation]
(g) "small investor" means any investor buying or selling securities on a cash
transaction for a market value not exceeding rupees fifty thousand in
aggregate on any day as shown in a contract note issued by the stock-
broker.
4*[(ga) 'trading member' means a member of the derivatives exchange or
derivatives segment of a stock exchange and who settles the trade in the
clearing corporation or clearing house through a clearing member];
(h) All other words and expressions occurring in these regulations shall bear
the same meaning as in the Act and the rules.
1. "Clauses a & aa" inserted by the SEBI (Stock Brokers & Sub Brokers)
(Amendment) Regulations, 2000 published in the Official Gazette of India
dated 14.03.2000.
2. Clause (a) renumbered as (aaa) by the SEBI (Stock Brokers & Sub Brokers)
(Amendment) Regulations, 2000 published in the Official Gazette of India
dated 14.03.2000.
3. "Clause fa" inserted by the SEBI (Stock Brokers & Sub Brokers)
(Amendment) Regulations, 2001 published in the Official Gazette of India
dated 15.11.2001..
4. "Clause (ga)" inserted by the SEBI (Stock Brokers & Sub Brokers)
52 (Amendment) Regulations, 2000 published in the Official Gazette of India
dated 14.03.2000.
Source: SEBI’s Website
 Regulation
CHAPTER II : REGISTRATION OF STOCK BROKERS
Application for registration of stock broker
3. (1) An application by a stock-broker for grant of a certificate shall be made in
Form A through the stock exchange or stock exchanges, as the case may be,
of which he is admitted as a member.
(2) The stock exchange shall forward the application form to the Board as early
as possible but not later than thirty days from the date of its receipt.
(3) Notwithstanding anything contained in sub-regulation (I), any application
made by a stock- broker prior to coming into force of these regulations
containing such particulars or as near thereto as mentioned in the Form A
shall be treated as an application if made in pursuance of sub-regulation (I)
and dealt with accordingly:
Provided that the requirement of the payment of fees shall be the same as is
referred to in sub-regulation (I) of regulation 10.
Furnishing information, clarification, etc.
4. (1) The Board may require the applicant to furnish such further information or
clarifications, regarding the dealings in securities and matters connected
thereto to consider the application for grant of a certificate.
(2) The applicant or, its principal officer shall, if so required, appear before the
Board for personal representation.
Consideration application
5. The Board shall take into account for considering the grant of a certificate all
matters relating to buying, selling, or dealing in securities and in particular the
following, namely, whether the stock broker-
(a) is eligible to be admitted as a member of a stock exchange;
(b) has the necessary infrastructure like adequate office space, equipments and
man power to effectively discharge his activities;
(c) has any past experience in the business of buying, selling or dealing in
securities;
(d) is subjected to disciplinary proceedings under the rules, regulations and bye-
laws of a stock exchange with respect to his business as a stock-broker
involving either himself or any of his partners, directors or employees;
5*["(e) is a fit and proper person"]
Procedure for registration
6. The Board on being satisfied that the stock-broker is eligible, shall grant a
certificate in Form D to the stock-broker and send an intimation to that effect to the
stock exchange or stock exchanges as the case may be.
Stock-Brokers to abide. by Code of Conduct, etc.
7. The stock-broker holding a certificate shall at all times abide by the Code of
Conduct as specified at Schedule II.
Procedure where registration is not granted
8. (1) Where an application for grant of a certificate under regulation 3, does not
fulfil the requirements mentioned in. regulation 5, the Board may reject the
application after giving a reasonable opportunity of being heard.
(2) The refusal to grant the registration certificate shall be communicated by the
Board within thirty days of such refusal to the concerned stock exchange and
to the applicant stating therein the grounds on which the application has been
rejected.
5. "Clause e" inserted by the Securities and Exchange Board of India (Stock Brokers
& Sub Brokers) (Amendment) Regulations, 1998 published in the Official Gazette
53
of India dated 05.01.1998.
Securities market in (3) An applicant may, being aggrieved by the decision of the Board under
India sub- regulation (2) apply within a period of thirty days from the date of
receipt of such intimation, to the Board for reconsideration of its decision.

(4) The Board shall reconsider an application made under sub- regulation (3)
and communicate its decision as soon as possible in writing to the
applicant and to the concerned stock-exchange.

Effect of refusal of certificate of registration

9. A stock-broker, whose application for grant of a certificate has been refused by

the Board, shall not, on and from the date of the receipt of the communication
under the sub-regulation (2) of regulation 8, buy, sell, or deal in securities as a
stock-broker.

Payment of fees and the consequences of failure to pay fees

10. (1) Every applicant eligible for grant of a certificate shall pay such fees and in
such manner as specified in Schedule Ill:

Provided that the Board may on sufficient cause being shown permit the
stock-broker to pay such fees at any time before the expiry of six months
front the date for which such fees become due.

(2) Where a stock-broker fails to pay the fees as provided in regulation 10, the
Board may suspend the registration certificate, whereupon the stock- broker
shall cease to buy, sell or deal in securities as a stock- broker].

54
 Regulation
CHAPTER III : REGISTRATION OF SUB-BROKERS
Application for registration of sub-broker
11. (1) An application by a sub- broker for the grant of a certificate shall be made
in Form B.
(2) The application for registration under sub-regulation (1) above, shall be
accompanied by a recommendation letter from a stock-broker of a
recognised stock exchange with whom he is to be affiliated along with two
references including one from his banker.
(3) The application form shall be submitted to the stock exchange of which the
stock- broker with whom he is to be affiliated is a member.
(4) The stock exchange on receipt of an application under sub-regulation (3)
shall verify the information contained therein and shall also certify that the
applicant is eligible for registration as per criteria specified in sub-
regulation (5).
(5) The eligibility criteria for registration as a sub-broker shall be as follows,
namely:
(i) in the case of an individual;
(a) the applicant is not less than 21 years of age;
(b) the applicant has not been convicted of any offence involving
fraud or dishonesty;
(c) the-applicant has at least passed 12th standard equivalent
examination from an institution recognised by the Government;
6*["(d) the applicant is a fit and proper person"].
Provided that the Board may relax the educational qualifications on
merits having regard to the applicant's experience.
(ii) In the case of partnership firm or a body corporate the partners or
directors, as the case may be, shall comply with the requirements
contained in clauses (a) to (c) of sub-regulation (i).
(6) The stock exchange shall forward the application form of such applicants
who comply with all the requirements specified in sub-regulations (1) to (5)
to the Board as early as possible, but not later than thirty days from the date
of its receipt.
Procedure for registration
12. (1) The Board on being satisfied that the sub-broker is eligible, shall grant a
certificate in Form E to the sub-broker and send an intimation to that effect
to the stock exchange or stock exchanges as the case may be.
(2) The Board may grant a certificate of registration to the appellant subject to
the terms and conditions as stated in rule 5.
Procedure where registration is not granted
13. (1) Where an application for grant of a certificate under regulation l1, does not
fulfil the requirements mentioned in regulation 11, the Board may reject the
application after giving a reasonable opportunity of being heard.
(2) The refusal to grant the certificate shall be communicated by the Board
within thirty days of such refusal to the concerned stock exchange and to
the applicant stating therein the grounds on which the application has been
rejected.
(3) An applicant being aggrieved by the decision of the Board under sub-
regulation (2) may within a period of thirty days from the date of receipt of
such intimation, apply to the Board for reconsideration of its decision.

6. "Clause" inserted by the SEBI (Stock Brokers & Sub Brokers) (Amendment) 55
Regulations, 1998 published in the Official Gazette of India dated 05.01.1998.
Securities market in (4) The Board shall reconsider an application made under sub-regulation (3)
India and communicate its decision as soon as possible in writing to the applicant
and to the concerned stock exchange.

Effect of refusal

14. A person whose application for grant of a certificate has been refused by the
Board shall, on and from the date of the communication of refusal under
regulation 13 cease to carry on any activities as a sub-broker.

General Obligations and Inspection

15. (1) The sub-broker shall-

(a) pay the fees as specified in Schedule III;

(b) abide by the Code of Conduct specified in Schedule 11;

(c) enter into an agreement with the stock broker for specifying the
scope of his authority and responsibilities.

(2) The sub-broker shall keep and maintain the books and documents,
specified in regulation 17 except for the books and documents referred to
in clauses (h), (i), (j), (k), (1) and (m) of sub regulation (1) of regulation
17.

Application of Chapter IV, V & VI

16. The provisions of Chapters IY V and VI of these regulations shall apply to a sub-
broker as they apply in case of a stock broker.

56
 Regulation
7*[CHAPTER III A : REGISTRATION OF TRADING
AND CLEARING MEMBERS
Application for registration of Trading member or Clearing member
16A (1) An application for grant of certificate of registration by a trading member of a
derivatives exchange or derivatives segment of a stock exchange shall be made in
Form AA of Schedule I, through the concerned derivatives exchange or derivative
segment of a stock exchange of which he is a member.
(2) An application for grant of certificate of registration by a clearing member 8*[or self
clearing member] of the clearing corporation or clearing house of a derivatives
exchange or derivatives segment of a stock exchange, shall be made in Form AA of
Schedule I, through the concerned clearing corporation or clearing house of which
he is a member.
Provided that a trading member who also seeks to act as a clearing member 9*[or
self clearing member] shall make separate applications for each activity in Form AA
of Schedule I.
(3) The derivatives exchange or segment or clearing house or corporation as the case
may be shall forward the application to the Board as early as possible but not later
than thirty days from the date of its receipt.
Furnishing of Information, Clarification, etc.
16B (1) The Board may require the applicant or the concerned stock exchange or segment
or clearing house or corporation to furnish such other information or clarifications,
regarding the trading and settlement in derivatives and matters connected thereto, to
consider the application for grant of a certificate.
(2) The applicant or its principal officer shall, if so required, appear before the Board
for personal representation.
Consideration of Application
16C (1) The Board shall take into account for considering the grant of a certificate all
matters relating to dealing and settlement in derivatives and in particular the
following, namely, whether the applicant-
(a) is eligible to be admitted as a trading member of a derivative exchange and /
or a clearing member of a derivatives exchange or derivatives segment of a
stock exchange or clearing corporation or house;
(b) has the necessary infrastructure like adequate office place, equipments and
manpower to effectively undertake his activities;
(c) is 'subjected to disciplinary proceedings under the rules, regulations and bye-
laws of any stock exchange with respect to his business as a stock broker or
member of derivatives exchange or segment or member of clearing house or
corporation involving either himself or any of his partners, directors or
employees.
10*[(d) has any financial liability which is due and payable to the Board under
these regulations].
(2) An applicant who desires to act as a trading member, in addition to complying
with the requirements of sub-regulation (I), shall have a net-worth as may be
specified by the derivative exchange or segment from time to time and the
approved user and sales personnel of the .trading member have passed a
certification programme approved by the Board;
(3) An applicant who desires to act as a clearing member, in addition to complying
with the requirements of sub-regulation (1), shall have a minimum net worth of
Rs. 300 lacs and
7. "Chapter III A" inserted by the SEBI (Stock Brokers & Sub Brokers)(Amendment )
Regulations, 2000 published in the Official Gazette of India dated 14.3.2000.
8. "or self clearing member" inserted by the SEBI (Stock Brokers & Sub Brokers)
(Amendment) Regulations, 2001, published in the Official Gazette of India dated
15.11.2001.
9. "or self clearing member" inserted by the SEBI (Stock Brokers & Sub Brokers)
(Amendment) Regulations, 2001, published in the Official Gazette of India dated
15.11.2001.
10. "Clause d" inserted by the SEBI (Stock Brokers & Sub Brokers) (Amendment) 57
Regulations, 2002 published in the Official Gazette of India dated 20.02.2002.
Securities market in shall deposit at least a sum of Rs. 50 lacs or higher amount with the clearing corporation
India or clearing house of the derivatives exchange or derivatives segment in the form
specified from time to time.
11*[(4) An applicant who desires to act as a clearing member, in addition to complying
with the requirements of sub-regulation (1), shall have a minimum net worth of
Rs.100 lacs and shall deposit at least a sum of Rs. 50 lacs or higher amount with the
clearing corporation or clearing house of the derivatives exchange or derivatives
segment in the form specified from time to time].
Explanation
For the purpose of 12*[sub-regulations (2), (3) and (4)] the expression `net worth' shall mean
paid up capital and free reserves and other securities approved by the Board from time to time
(but does not include fixed assets, pledged securities, value of member's card, non-allowable
securities (unlisted securities), bad deliveries, doubtful debts and advances (debts or advances
overdue for more than three months or debts or advances given to the associate persons of the
member), prepaid expenses, losses, intangible assets and 30% value of marketable securities).
Procedure for registration :
16D. The Board on being satisfied that the applicant is eligible, shall grant a certificate in
Form DA of Schedule I, to the applicant and send an intimation to that effect to the
derivatives segment of the stock exchange or derivatives exchange or clearing
corporation or clearing house, as the case may be.
Procedure where registration is not granted
16E (1) Where an application for the grant of a certificate under regulation 16A does not
fulfil the requirements specified in 16C of the regulations, the Board may reject the
application of the applicant after giving a reasonable opportunity of being heard.
(2) The refusal to grant the certificate of registration shall be communicated by the
Board within 30 days of such refusal to the concerned segment of the stock
exchange, or clearing house or corporation and to the applicant stating therein the
grounds on which the application has been rejected.
(3) An applicant may, if aggrieved by the decision of the Board under sub-regulation
(2) apply within a period of thirty days from the date of receipt of such information
to the Board for reconsideration of its decision.
(4) The Board shall reconsider an application made under sub-regulation (3) and
communicate its decision as soon as possible in writing to the applicant and to the
concerned segment of the stock exchange or clearing house or corporation.
Effect of refusal of certificate of registration
16F. An applicant, whose application for the grant of a certificate of registration has been
refused by the Board, shall not, on and from the date of receipt of the communication
under sub-regulation (2) or sub-regulation (4) of regulation 16E, deal in or settle the
derivatives contracts as a member of the derivatives exchange or derivatives segment or
clearing corporation or clearing house.
Payment of fees and consequences of failure to pay fees
16 G (1) Every applicant eligible for grant of a certificate as a trading or clearing member
""[or self-clearing member] shall pay such fee and in such manner as specified in
Schedule IV
(2) Where a trading or clearing member ""[or self clearing member] fails to pay the
fees as provided in sub-regulation (I), the Board may suspend or cancel the
registration certificate after giving an opportunity of being heard, whereupon the
trading and clearing member 14'[or self clearing member] shall cease to deal in or
settle the derivatives contract as a member of the derivatives segment of the
exchange or derivatives exchange or clearing corporation or clearinghouse'.
11. "sub-regulation 4" inserted by the SEBI (Stock Brokers & Sub Brokers) (Amendment)
Regulations, 2001, published in the Official Gazette of India dated 15.11.2001.
12. Substituted for "(2) and (3)" by the SEBI (Stock Brokers & Sub Brokers) (Amendment)
Regulations, 2001, published in the Official Gazette of India dated 15.11.2001.
13. "or self-clearing member" inserted by the SEBI (Stock Brokers & Sub Brokers)
(Amendment) Regulations, 2001, published in the Official Gazette of India dated
15.11.2001.
58 14. or self-clearing member" inserted by the SEBI (Stock Brokers & Sub Brokers)
(Amendment) Regulations, 2001, published in' the Official Gazette of India dated
15.11.2001.
 Regulation
Trading member / Clearing member15*[or self clearing member] to abide by the
Code of Conduct, etc.

16H (1) The code of conduct specified for the stock brokers as stipulated in Schedule II,
shall be applicable mutatis mutandis to the trading member, clearing member
and such members shall at all times abide by the same.
(2) The trading member and clearing member shall abide by the code of conduct as
specified in the rules, bye-laws and regulations of the derivatives exchange or
derivatives segment of the exchange.

(3) The trading members shall obtain details of the prospective clients in ‘Know
Your Client’ format as specified by the Board before executing an order on
behalf of such client.

(4) The trading member shall mandatorily furnish 'Risk Disclosure Document'
disclosing the risk inherent in trading in derivatives to the prospective clients in
the form specified by the derivatives exchange or derivatives segment.

(5) The trading or clearing member shall deposit margin or any other deposit and
shall maintain position or exposure limit as specified by the Board or the
concerned exchange or segment or clearing corporation or clearing house from
time to time.

16*[(6) The provisions of sub regulations (1) to (5) shall be applicable mutatis
mutandis to a self clearing member].

Chapter IV, V and VI applicable

16 I (1) The provision of Chapter IV, V and VI shall be applicable mutatis mutandis to a
trading member and a clearing member 17*[or self clearing member] and such
members shall abide by the provisions of the said Chapters.
(2) In the chapters referred to in sub-regulation (1), the word `stock broker' shall
refer to trading member or clearing member18*[or self clearing member] and
the word 'stock exchange' shall refer to 'derivatives exchange or derivatives
segment of an exchange or clearing corporation or clearing house.'
(3) The Board may issue such directions under section 11B of the Act to the
trading member or clearing member 19*[or self clearing member] as may be
deemed appropriate and such member shall abide by such directions.
(4) In case of violation of any regulation, the trading or the clearing member 20*[or
self-clearing member] shall be liable to penalty as specified in regulation 26.)

15. "or self-clearing member" inserted by the SEBI (Stock Brokers & Sub Brokers)
(Amendment) Regulations, 2001. published in the Official Gazette of India dated
15.11.2001.
16. "Sub-regulation 6" inserted by the SEBI (Stock Brokers & Sub Brokers)
(Amendment) Regulations, 2001, published in the Official Gazette of India dated
15.11.2001.
17. "or self-clearing member" inserted by the SEBI (Stock Brokers & Sub Brokers)
(Amendment) Regulations, 2001, published in the Official Gazette of India dated
15.11.2001.
18. "or self-clearing member" inserted by the SEBI (Stock Brokers & Sub Brokers)
(Amendment) Regulations, 2001, published in the Official Gazette of India dated
15.11.2001.
19. "or self-clearing member" inserted by the SEBI (Stock Brokers & Sub Brokers)
(Amendment) Regulations, 2001, published in the Official Gazette of India dated
15.11.2001.
20. "or self-clearing member" inserted by the SERI (Stock Brokers & Sub Brokers)
(Amendment) Regulations, 2001, published in the Official Gazette of India dated
59
15.11.2001.
Securities market in
India
CHAPTER IV : GENERAL OBLIGATIONS AND
RESPONSIBILITIES
To maintain proper books of accounts, records etc.
17. (1) Every stock-broker shall keep and maintain the following books of
accounts, records and documents namely:
(a) Register of transactions (Sauda Book);
(b) Clients ledger;
(c) General ledger;
(d) Journals;
(e) Cash book;
(f) Bank pass book:
(g) Documents register should include particulars of shares and securities
received and delivered;
(h) Members' contract books showing details of all contracts entered into
by him with other members of the same exchange or counterfoils or
duplicates of memos of confirmation issued to such other member:
(i) Counterfoils or duplicates of contract notes issued to clients;
(j) Written consent of clients in respect of contracts entered into as
principals;
(k) Margin deposit book:
(l) Registers of accounts of sub-brokers;
(m) An agreement with a sub-broker specifying the scope of authority and
responsibilities of the Stock-Broker and such sub- broker.
(2) Every stock-broker shall intimate to the Board the place where the books of
accounts. records and documents are maintained.
(3) Without prejudice to sub-regulation (I), every stock- broker shall, after the
close of each accounting period furnish to the Board if so required as soon as
possible but not later than six months from the close of the said period a copy
of the audited balance sheet and profit and loss account, as at the end of the
said accounting period:
Provided that, if it is not possible to furnish the above documents within the
time specified, the stock-broker shall keep the Board informed of the same
together with the reasons for the delay and the period of time by which such
documents would be furnished.
Maintenance of books of accounts and records
18. Every stock broker shall preserve the books of account and other records
maintained under regulation 17 for a minimum period of live years.
21
*[Appointment of compliance officer
18A (1) Every stock broker shall appoint a compliance officer who shall be
responsible for monitoring the compliance of the Act, rules and
regulations, notifications, guidelines instructions, etc, issued by the Board
or the Central Government and for redressal of investors grievances.
(2) The compliance officer shall immediately and independently report the
Board any non-compliance observed by him].
21. Regulation i8x inserted by the SEB/ (Investment Advice by Intermediaries)
(Amendment) Regulations 2001, published in the Official Gazette of India dated
60
29.05.2001.
 Regulation
CHAPTER V : PROCEDURE FOR INSPECTION
Board's right to inspect
19 (1) Where it appears to the Board so to do, it may appoint one or more persons as inspecting
authority to undertake inspection of the books of accounts, other records and documents of
the stock-brokers for any of the purposes specified in sub-regulation (2).
(2) The purposes referred to in sub-regulation (1) shall be as follows, namely:
(a) to ensure that the books of accounts and other books are being maintained in the
manner required;
(b) that the provisions of the Act, rules, regulations and the provisions of the Securities
Contracts (Regulation) Act and the rules made thereunder are being complied with;
(c) to investigate into the complaints received from investors, other stock brokers, sub-
brokers or any other person on any matter having a bearing on the activities of the
stock- brokers; and
(d) to investigate suo-moto, in the interest of securities business or investors' interest, into
the affairs of the stock-broker.
Procedure for inspection
20. (1) Before undertaking any inspection under regulation 19, the Board shall give a reasonable
notice to the stock- broker for that purpose.
(2) Notwithstanding anything contained in sub-regulation (1), where the Board is satisfied that
in the interest of the investors or in public interest no such notice should be given, it may by
an order in writing direct that the inspection of the affairs of the stock broker be taken up
without such notice.
(3) On being empowered by the Board, the inspecting authority shall undertake the inspection
and the stock-broker against whom an inspection is being carried out shall be bound to
discharge his obligations as provided under regulation 21.
Obligations of stock-broker on inspection by the Board
21. (1) It shall be the duty of broker on inspection by the Board every director, proprietor, partner,
officer and employee of the stock-broker, who is being inspected, to produce to the
inspecting authority such books, accounts and other documents in his custody or control and
furnish him with the statements and information relating to the transactions in securities
market within such time as the said officer may require.
(2) The stock-broker shall allow the inspecting authority to have reasonable access to the
premises occupied by such stock- broker or by any other person on his behalf and also
extend reasonable facility for examining any books, records, documents and computer data
in the possession of the stock- broker or any other person and also provide copies of
documents or other materials which, in the opinion of the inspecting authority arc relevant.
(3) The inspecting authority, in the course of inspection, shall be entitled to examine or record
statements of any member, director, partner, proprietor and employee of the stock- broker.
(4) It shall be the duty of every director proprietor, partner, officer and employee of the stock
broker to give to the inspecting authority all assistance in connection with the inspection,
which the stock broker may be reasonably expected to give.
Submission of Report to the Board
22. The inspecting authority shall, as soon as may be possible submit an inspection report to the
Board.
Communication of Findings etc.
23. (1) The Board shall after consideration off the inspection report communicate the findings to
the stock-broker to give him an opportunity of being heard before any action is taken by
the Board on the findings of the inspecting authority.
(2) On receipt of the explanation, if any, from the stock-broker, the Board may call upon the
stock-broker to take such measures as the Board may deem fit in the interest of the
securities market and for due compliance with the provisions of the Act, rules and
regulations.
Appointment of Auditor
24. Notwithstanding anything contained above, the Board may appoint a qualified auditor to
investigate into the books of account or the affairs of the stock-broker:
Provided that, the auditor so appointed shall have the same powers of the inspecting authority as
mentioned in regulation 19 and the obligations of the stock- broker in regulation 21 shall be 61
applicable to the investigation under this regulation.
Securities market in
India
CHAPTER VI : PROCEDURE FOR ACTION IN
CASE OF DEFAULT
Liability for action in case of default
25. (1) A stock-broker who
(a) fails to comply with any conditions subject to which registration has been
granted;
(b) contravenes any of the provisions of the Act, rules or regulations;
(c) contravenes the provisions of the Securities Contracts (Regulation) Act or the
rules made thereunder;
(d) contravenes the rules, regulations or bye-laws of the stock exchange; shall be
liable to any of the penalties specified in sub- regulation (2).
(2) The penalties referred to in sub-regulation (1) may be either -
(a) suspension of registration, after the inquiry, for a specified period; or
(b) cancellation of registration.
Suspension, cancellation of registration, etc.
26. (1) A penalty of suspension of registration of a stock-broker may be imposed if-
(i) the stock-broker violates the provisions of the Act, rules and regulations;
(ii) the stock-broker does not follow the code of conduct annexed at Schedule IL
(iii) the stock-broker-
(a) fails to furnish any information related to his transactions in securities as required by the
Board;
(b) furnishes wrong or false information,
(c) does not submit periodical returns as required by the Board;
(d) does not co-operate in any enquiry conducted by the Board;
(iv) the stock-broker fails to resolve the complaints of the investors or fails to give a
satisfactory reply to the Board in this behalf:
(v) the stock-broker indulges in manipulating or price rigging or cornering activities in the
market;
(vi) the stock-broker is guilty of misconduct or improper or unbusinesslike or unprofessional
conduct;
(vii) the financial position of the stock broker deteriorates to such an extent that the Boar( is
of the opinion that his continuance in securities business is not in the interest of
investors and other stock-brokers;
(viii) the stock-broker fails to pay the fees;
(ix) the stock-broker violates the conditions of registration:
(x) the membership of the stock-broker is suspended by the stock exchange:
Provided that the Board for reasons to he recorded in writing may in case of repeated defaults
of the type mentioned above impose a penalty of cancellation of registration of the stock-
broker.

(2) A penalty of cancellation of registration of a stock-broker may be imposed if-

(i) the stock-broker violates any provisions of insider trading regulations or take-over
regulations;
62 (ii) the stock-broker is guilty of fraud, or is convicted of a criminal offence; and
(iii) cancellation of membership of the stock-broker by the stock exchange.
 Regulation
Manner of order of suspension or cancellation
27. No order of penalty of suspension and cancellation shall be imposed except
after holding an enquiry in accordance with the procedure specified in regulation 28.
22
*[Provided that the holding of such an enquiry shall not be necessary in cases where
the stock broker:
(a) ceases to be a member of a recognised stock exchange; or
(b) is declared defaulter by the stock exchange and is not readmitted to the
membership of the exchange within a period of six months from such declaration
;or
(c) surrenders the membership of the stock exchange; or
(d) is declared insolvent by a Court; or
(e) fails to pay the registration or annual fees to the Board in the manner specified in
the regulations; or
(f) voluntarily surrenders certificate to the Board; or
(g) is wound up by an order passed by the Court.
"Provided further that no action shall be taken against the stock broker without giving
an opportunity of hearing to the stock broker].
Manner of holding enquiry
28. (1) For the purpose of holding an enquiry under regulation 27, the Board may
appoint an enquiry officer.
(2) The enquiry officer shall issue to the stock-broker a notice at the registered
office or the principal place of business of the stock-broker.
(3) The stock-broker may, within thirty days from the date of receipt of such
notice, furnish to the enquiry officer a reply together with copies of
documentary or other evidence relied on by him or sought by the Board from
him.
(4) The enquiry officer shall, give a reasonable opportunity of hearing to the
stock-broker to enable him to make submissions in support of his reply made
under sub-regulation (3).
(5) Before the enquiry officer, the stock-broker may either appear in person or
through any person duly authorised on his behalf:
Provided that no lawyer or advocate shall be permitted to represent the stock-broker at
the enquiry:
Provided further that where a lawyer or an advocate has been appointed by the Board
as a presenting officer under sub-regulation (6), it shall be lawful for the stock-broker
to present his case through a lawyer or advocate.
(6) If it is considered necessary, the enquiry officer may request the Board to
appoint a presenting officer to present its case.
(7) The enquiry officer shall, after taking into account all relevant facts and
submissions made by the stock-broker, submit a report to the Board and
recommend the penalty to be awarded as also on the, justification of the penalty
proposed in the notice.
Show-cause notice and order
29. (1) On receipt of the report from the enquiry officer, the Board shall consider the
same and issue a show-cause notice as to why the penalty as it considers
appropriate should not be imposed.
(2) The stock-broker shall within twenty-one days of the date of the receipt of the
show-cause send a reply to the Board.
22 Proviso inserted by the SEBI (Stock Brokers and Sub-Brokers) (Amendment)
Regulations, 1999 published in the Official Gazette of India dated 06.07.1999. 63
Securities market in (3) The Board after considering the reply to the show-cause notice, if received,
India shall as soon as possible but not later than thirty days from the receipt of
the reply, if any, pass such order as it deems fit.
(4) Every order passed under sub-regulation (3) shall be self-contained and
give reasons for the conclusions stated therein including justification of the
penalty imposed by that order.
(5) The Board shall send a copy of the order under sub-regulation (3) to the
stock- broker, stock exchange of which the stock-broker is the member,
23
*[***].
Effect of suspension and cancellation of registration of stock-the stock-broker
30. (1) On and from the date of the suspension of broker he shall cease to buy, sell
or deal in securities as a stock-broker during the period of suspension.
(2) On and from the date of cancellation, the stock-broker shall with immediate
effect cease to buy sell or deal in securities as a stock-broker.
Publication of order of suspension
31. The order of suspension or cancellation of certificate passed in sub-regulation (3)
of regulation 29 shall be published in at least two daily newspapers by the Board
be published in at least two daily newspapers by the Board.
Appeal to the Securities Appellate Tribunal
24
*32. [Any person aggrieved by an order of the Board made, on and after the
commencement of the Securities Laws (Second Amendment) Act, 1999, (i.e.,
after 16th December 1999), under these regulations may prefer an appeal to a
Securities Appellate Tribunal having jurisdiction in the matter].

23. and to the Central Government" omitted by the Securities and Exchange Board
of India (Stock Brokers and Sub-brokers) Amendment Regulations, 1999 published in
the Official Gazette of India dated 06.07.1999.
24. Substituted for the following provision by the SEBI (Appeal to the Securities
Appellate Tribunal) (Amendments) Regulations, 2000 published in the Official
64 Gazette of India dated 28.03.2000.
APPENDIX 5.2 (ii)
 Regulation
SECURITIES AND EXCHANGE BOARD OF INDIA
(1*[PROHIBITION OF] INSIDER TRADING) REGULATIONS, 1992 *
No. LE/6308/92 In exercise of the powers conferred by section 30 of The Securities and
Exchange Board of India, Act 1992 (15 of 1992), the Board with the previous approval of the
Central Government hereby makes the following regulations, namely:
CHAPTER I : PRELIMINARY
Short title and commencement
1. (1) These regulations may be called the Securities and Exchange Board of India
("[Prohibition of] Insider Trading) Regulations, 1992.
(2) These regulations shall come into force on the date of the publication in the Official
Gazette.
Definitions
2. In these regulations, unless the context otherwise requires-
(a) "Act" means the Securities and Exchange Board of India Act, 1992 (15 of 1992);
(b) "body corporate" means a body corporate as defined under section 2 of the
Companies Act, 1956 (1 of 1956);
(c) "connected person" means any person who-
(i) is a director, as defined in clause (13) of' section 2 of the Companies Act,
1956 (1 of 1956) of a company, or is deemed to be a director of that company
by virtue of sub-clause (10) of section 307 of that Act or
(ii) occupies the position as an officer or an employee of the company or holds a
position involving a professional or business relationship between himself and
the company 3*[whether temporary of permanent] and who may reasonably be
expected to have an access to unpublished price sensitive information in
relation to that company;
4
*[Explanation: For the purpose of clause (c), the words "connected person"
shall 5*[mean] any person who is a connected person six months prior to an
act of insider trading.
(d) "dealing in securities" means an act of 6*[subscribing] buying, selling or agreeing
"[subscribe] to buy, sell or deal in any securities by any person either as principal or
agent;
(e) "insider" means any person who, is or was connected with the company or is
deemed to have been connected with the company, and who is reasonably expected
to have access, 8*[***] connection, to unpublished price sensitive information in
respect of securities of"[a] company, or who has received or has had access to such
unpublished - price sensitive information;
1. "Prohibition of" inserted by the SEBI (insider Trading) (Amendment) Regulations, 2002
published in the Official Gazette of India dated 20.02.2002.
2. "Prohibition of" inserted by the SEBI (Insider Trading) (Amendment) Regulations, 2002
published in the Official Gazette of India dated 20.02.2002.
3. "Whether temporary of permanent" inserted by the SEBI (Insider Trading)
(Amendment) Regulations, 2002 published in the Official Gazette of India dated
20.02.2002.
4. Explanation inserted by the SEBI (insider Trading) (Amendment) Regulations, 2002
published in the Official Gazette of India dated 20.02.2002.
5. Substituted for "include" by the SEBI (Prohibition of Insider Trading) (Second
Amendment) Regulations, 2002 in the Official Gazette of India dated 29.11.2002 vide
S.O. 1245(E).
6. "Subscribing" inserted by the SEBI (Insider Trading) (Amendment) Regulations, 2002
published in the Official Gazette of India dated 20.02.2002.
7. "subscribe" inserted by the SEBI (Insider Trading) (Amendment) Regulations, 2002
published in the Official Gazette of India dated 20.02.2002.
8. “by virtue of such connection” omitted by the SEBI (Insider Trading) (Amendment)
Regulations, 2002 published in the Official Gazette of India dated 20.02.2002.
9. Substituted for “the” by the SEBI (Insider Trading) (Amendment) Regulations, 2002
published in the Official Gazette of India dated 20.02.2002.
*As amended upto 16-12-2002.
65
Source: SEBI's Website.
Securities market in (f) "investigating authority" means any officer of the Board or any other person. not being a
India firm. body corporate or an association of persons, having experience in dealing with the
problems relating to the securities market and who is authorised by the Board under Chapter
III;

(g) "officer of a company" means any person as defined in clause (30) of section 2 of the ,
Companies Act, 1956 (1 of 1956) including an auditor of the company;

(h) "person is deemed to be a connected person" if such person-

(i) is a company under the same management or group or any subsidiary company
thereof within the meaning of section (113) of section 370, or sub-section (11) of
section 372, of the Companies Act, 1956 (1 of 1956) or sub-clause (g) of section 2 of
the Monopolies and Restrictive Trade Practices Act, 1969 (54 of 1969) as the case
may be; or
10
*[(ii) is an intermediary as specified in section 12 of the Act, Investment company,
Trustee Company, Asset Management Company or an employee or director
thereof or an official of a stock exchange or of clearing house or corporation].

(iii) is a merchant banker, share transfer agent, registrar to an issue, debenture trustee,
broker, portfolio manager, Investment Advisor, sub-broker, Investment Company or
an employee thereof, or, is a member of the Board of Trustees of a mutual fund or a
member of the Board of Directors of the Asset Management Company of a mutual
fund or is an employee thereof who have a fiduciary relationship with the company:

(iv) is a member of the Board of Directors, or an employee, of a public financial

institution as defined in Section 4A of the Companies Act, 1956; or

(v) is an official or an employee of a self Regulatory Organisation recognised or

authorised by the Board of a regulatory body; or

(vi) is a relative of any of the aforementioned persons:

(vii) is a banker of the company.

11
*(viii) relatives of the connected person;
12
*[(ix) is a concern, firm, trust, Hindu Undivided family, company or association of
persons wherein any of the connected persons mentioned in sub-clause (1) of
clause (c), of this regulation or any of the persons mentioned in sub-clauses (vi),
(vii) or (viii) of this clause have more than 10% of the holding or interest].
13
*[(ha) `price sensitive information' means any information which relates directly or
indirectly to a company and which if published is likely to materially affect the
price of securities of company;

Explanation: The following shall be deemed to be price sensitive information-

(i) periodical financial results of the company;

(ii) intended declaration of dividends (both interim and final);

10. Substituted for the following clause by the SEBI (insider Trading) (Amendment) Regulations,
2002 published in the Official Gazette of India dated 20.02.2002
"is an official or a member of a stock exchange or of a clearing house of that stock
exchange, or a dealer in securities within the meaning of clause (c) of section 2, and
section 17 of the Securities Contracts (Regulation) Act, 1956 (42 of 1956)
respectively or any employee of such member or dealer of a stock-exchange;"
11. Clauses "viii and ix" inserted by the SEBI (Insider Trading) (Amendment) Regulations, 2002
published in the Official Gazette of India dated 20.02.2002.
12. Substituted for the following clause by the SEBI (Prohibition of Insider Trading) (Second
Amendment) Regulations,2002 published in the Official Gazette of India dated 29.11.2002
vide S.O. 1245(E).
"a concern, firm, trust, Hindu Undivided Family, Company, Association of Persons
wherein the relatives of persons mentioned in sub-clauses (vi), (vii) or (viii) has
more than 10% of the holding or interest."
66 13. Clause "ha" inserted by the SEBI (Insider Trading) (Amendment) Regulations, 2002
published in the Official Gazette of India dated 20.02.2002.
 Regulation
(iii) issue of securities or buy-back of securities;
(iv) any major expansion plans or execution of new projects:
(v) amalgamation, mergers or takeovers:
(vi) disposal of the whole or substantial part of the undertaking;
(vii) any significant changes in policies, plans or operations of the company].
(i) "relative" means a person, as defined in section 6 of the Companies Act, 1956 (1
of 1956);
(j) "stock exchange" means a stock exchange which is recognised by the Central
Government 14*[or Securities and Exchange Board of India] under section 4 of
Securities Contracts (Regulation) Act, 1956 (42 of 1956);
15
*[(k) Unpublished means information which is not published by the company or its
agents and is not specific in nature.
Explanation: Speculative reports in print or electronic media shall not be considered
as published information:-
(i) periodical financial results of the company;
(ii) intended declaration of dividends (both interim and final);
(iii) issue of securities or buy-back of securities;
(iv) any major expansion plans or execution of new projects;
(v) amalgamation, mergers or takeovers;
(vi) disposal of the whole or substantial part of the undertaking;
(vii) any significant changes in policies, plans or operations of the company.]
(i) “relative” means a person, as defined in section 6 of the Companies Act,
1956(1 of 1956);
(j) “stock exchange” means a stock exchange which is recognized by the Central
Government 14*[or Securities and Exchange Board of India] under section 4 of
Securities Contracts (Regulation) Act, 1956 (42 of 1956);
14
*[(k) Unpublished means information which is not published by the company or its
agents and is not specific in nature.
Explanation : Speculative reports in print or electronic media shall not be considered
as published information.]
14. “or Securities and Exchange Board of India" inserted by the SEBI (Insider
Trading) (Amendment) Regulations, 2002 published in the Official Gazette of
India dated 20.02.2002.
15. Substituted for the following sub-regulation (k) by the SEBI (Insider Trading)
(Amendment) Regulations, 2002 published in the Official Gazette of India dated
20,02.2002
"unpublished price sensitive information" means any information which relates
to the following matters or is of concern, directly or indirectly, to a company,
and is not generally known or published by such company for general
information, but which if published or known, is likely to materially affect the
price of securities of that company in the market
(i) financial results (both half-yearly and annual) of the company:
(ii) intended declaration of dividends (both interim and final);
(iii) issue of shares by way of public rights, bonus, etc.;
(iv) any major expansion plans or execution of new projects;
(v) amalgamation, mergers and takeovers;
(vi) disposal of the whole or substantially the whole of the undertaking;
(vii) such other information as may affect the earnings of the company.
(viii) Any changes in policies, plans or operations of the company.
67
CHAPTER II : PROHIBITION ON DEALING,
Securities market in
India
COMMUNICATING OR COUNSELLING
Prohibition on dealing communication or counselling on matters relating to inside
trading
3. No insider shall -
(i) either on his own behalf or on behalf of any other person, deal in securities of a
company; listed on any stock exchange 16* [when in possession on any unpublished
price sensitive information; or
17
*[(ii) Communicate, counsel or procure, directly or indirectly, any unpublished price
18
*[sensitive] information to any person who while in possession of such unpublished
price sensitive information shall not deal in securities.
Provided that nothing contained above shall be applicable to any communication required in
the ordinary course of business 19*[or profession or employment] or under any law]
20
*[***]
21
*[3A. No company shall deal in the securities of another company or associate of that other
company while in possession of any unpublished price sensitive information].
22
*[Regulation 3A not to apply in certain cases:
3B(1)-In a proceeding against a company in respect of regulation 3A, it shall be a defence to
prove that it entered into a transaction in the securities of a listed company when the
unpublished price sensitive information was in the possession of an officer or employee
of the company, if;
(a) the decision to enter into the transaction or agreement was taken on its behalf by a person
or persons other than that officer or employee; and
(b) such company has put in place such systems and procedures which demarcate the
activities of the company in such a way that the person who enters into transaction in
securities on behalf of the company cannot have access to information which is in
possession of other officer or employee of the company; and
(c) it had in operation at that time, arrangements that could reasonably be expected to
ensure that the information was not communicated to the person or persons who made
the decision and that no advice with respect to the transactions or agreement was given
to that person or any of those persons by that officer or employee; and
(d) the information was not so communicated and no such advice was so given.
16. Substituted "on the basis of' by the SEBI (Insider Trading) (Amendment) Regulations,
2002 published in the Official Gazette of India dated 20.02.2002.
17. Substituted for the following clause (ii) by the SEBI (Insider Trading) (Amendment)
Regulations, 2002 published in the Official Gazette of India dated 20.02.2002
"(ii) communicate any unpublished price sensitive information to any person, with or
without his request for such information, except as required in the ordinary course of
business or under any law or"
18. Substituted for 'sinsitive" by the SEBI (Prohibition of Insider Trading) (Second
Amendment) Regulations, 2002 published in the Official Gazette of India dated
29.11.2002 vide S.O. 1245(E).
19. "or profession or employment" inserted by the SEBI (Prohibition of Insider Trading)
(Second Amendment) Regulations, 2002 published in the Official Gazette of India dated
29.11.2002 vide S.O. 1245(E).
20. Following clause (iii) deleted by the SEBI (Insider Trading) (Amendment) Regulations,
2002 published in the Official Gazette of India dated 20.02.2002.
"(iii) counsel or procure any other person to deal in securities of any company on the
basis of unpublished price sensitive information."
21. "Regulations 3A" inserted by the SEBI (Insider Trading) (Amendment) Regulations,
2002 published in the Official Gazette of India dated 20.02.2002.
22. Regulation 3B Inserted. by the SEBI (Prohibition of Insider Trading) (Second
68 Amendment) Regulations, 2002 published in the Official Gazette of India dated
29.11.2002 vide S.O. 1245(E)..
 Regulation
(2) In a proceeding against a company in respect of regulations 3A which is in
possession of unpublished price sensitive information, it shall be defence to
prove that acquisition of shares of a listed company was as per the Securities
and Exchange Board of India (Substantial Acquisition of Shares and Takeovers)
Regulations, 1997"].

Violation of provisions relating to insider trading

5. Any insider, who deals in securities 23[***] in contravention of the provisions of

regulation 3 24*[or 3A] shall be guilty of Insider trading.

23. "or communicate any information or counsels any person dealing in securities"
deleted by the SEBI (Insider Trading) (Amendment) Regulations, 2002 published
in the Official Gazette of India dated 20.02.2002.

24. "or 3A" inserted by the SEBI (Insider Trading) (Amendment) Regulations, 2002
published in the Official Gazette of India dated 20 02.2002. 69
Securities market in
India
CHAPTER III : INVESTIGATION
25
*[Power to make inquiries and inspection
4A(1) If the Board suspects that any person has violated any provision of 26* [these]
regulations, it may make inquiries with such persons or any other person as
mentioned in clause (i) of sub-section (2) of Section 11 as deemed fit, to form a prima
facie opinion as to whether there is any violation of these regulations.
(2) The Board may appoint one or more officers to inspect the books and records of
insider(s) or any other persons as mentioned in clause (i) of sub-section (2) of Section
11 for the purpose of sub-regulation (1).
Board's right to investigate
5. (1) Where the Board, 27*[is of prima facie opinion,] that it is necessary to investigate and
inspect the books of account, other records and documents of an insider 28* [or any
other person mentioned in clause (i) of sub-section (1) of section II of the Act] for any
of the purposes specified in sub-regulation (2), it may appoint an investigating
authority for the said purpose.
(2) The purposes referred to in sub-regulation (1) may be as follows:
(a) To investigate into the complaints received from investors, intermediaries or any
other person on any matter having a bearing on the allegations of insider trading;
and
(b) To investigate suo-moto upon its own knowledge or information in its possession
to protect the interest of investors in securities against breach of these regulations.
Procedure for investigation
6. (1) Before undertaking an investigation under regulation 5 the Board shall give a
reasonable notice to insider for that purpose.
(2) Notwithstanding anything contained in sub-regulation (1), where the Board is
satisfied that in the interest of investors or in public interest no such notice should be
given, it may by an order in writing direct that the investigation be taken up without
such notice.
(3) On being empowered by the Board, the investigating authority shall undertake the
investigation and inspection of books of accounts and insider 29*[an insider or any
other person mentioned in clause (i) of sub-section (1) of section 11 of the Act]
against whom an investigation is being carried out shall be bound to discharge his
obligations as provided in regulation 7.
Obligations of insider on investigation by the Board
7. (1) It shall be the duty of every insider, who is being investigated, "''[or any other person
mentioned in clause (i) of sub-section (1) of section 11 of the Act] to produce to the
investigating authority such books, accounts and other documents in his custody or
control and furnish the authority with the statements and information relating to the
transactions in securities market within such time as the said authority may require.
25. "Regulation 4A" inserted by the SEDI (Insider Trading) (Amendment) Regulations. 2002
published in the Official Gazette of India. dated 20.02.2002:
26. Substituted for "thede" by the SEBI (Prohibition of Insider Trading) (Second Amendment)
Regulations, 2002 published in the Official Gazette of India dated 29.11.2002 vide S.O.
1245(E).
27. Substituted for "on the basis of written information in its possession is of the opinion" by
the SEBI (Insider Trading) (Amendment) Regulations, 2002 published in the Official
Gazette of India, dated 20.02.2002.
28. "an insider or any other person mentioned in clause (i) of sub-section (ii) of section 11 of
the Act" inserted by the SEBI (Insider Trading) (Amendment) Regulations, 2002
published in the Official Gazette of India, dated 20.02.2002.
29. "an insider or any other person mentioned in clause (i) of sub-section (ii) of section 11 of
the Act" inserted by the SEBI (Insider Trading) (Amendment) Regulations, 2002
published in the Official Gazette of India, dated 20.02.2002.
30. "or any other person mentioned in clause (i) of sub-section (i) of section 11 of the Act"
70 inserted by the SEBI (Insider Trading) (Amendment) Regulations, 2002 published in the
Official Gazette at India, dated 20.02.2002.
 Regulation
(2) The insider 31*[or any other person mentioned 32*[in] clause (i) of sub-section (1) of section 11 of
the Act] shall allow the investigating authority to have reasonable access to the premises occupied
by such insider and also extend reasonable facility for examining any books, records, documents
and computer data in his possession of the stock- broker or any other person and also provide
copies of documents or other materials which, in the opinion of the investigating authority are
relevant.
(3) The investigating authority, in the course of investigation, shall be entitled to examine or record
statements of any member, director, partner proprietor and employee of the insider 33*[or any
other person mentioned in clause (i) of sub-section (1) of section 11 of the Act.]
(4) It shall be the duty of every director, proprietor, partner, officer and employee of the insider to
give to the investigating authority all assistance in connection with the investigation, which the
insider 34*[or any other person mentioned in clause (1) of sub-section 1 of section 11 of the Act]
may be reasonably expected to give.
Submission of Report to the Board
8. The investigating authority shall, within 35* [reasonable time] of the conclusion of the investigation
submit an investigation report to the Board.
Communication of Findings, etc.
36
*[9 (1) The Board shall, after consideration of the investigation report communicate the findings
to the person suspected to be involved in insider trading or violation of these regulations.
(2) The person to whom such findings has been communicated shall reply to the same within
21 days; and
(3) On receipt of such a reply or explanation, if any, from such person, the Board may take
such measures as it deems fit to protect the interests of the investors and in the interests of
the securities market and for the due compliance of the 37* [provisions] of the Act, the
Regulations made thereunder including the issue of directions under regulation 11.
Appointment of Auditor
10. Notwithstanding anything contained in 38*[regulation 4A and] regulation 5, the Board may
appoint a qualified auditor to investigate into the books of account or the affairs of the insider
39
*[or any other person mentioned in clause (1) of sub-section 1 of section 11 of the Act];

31. "or any other person mentioned in clause (1) of sub-section 11 of section ii of the Act" by the SEBI
(Insider Trading) (Amendment) Regulations, 2002 published in the Official Gazette of India, dated
20.02.2002.
32. `in' inserted by the SEBI (Prohibition of Insider Trading) (Second Amendment) Regulations, 2002
published in the Official Gazette of India dated 29.11.2002 vide S.O. I 245(E).
33. "or any other person mentioned in clause (1) of sub-section 11 of section ii of the Act" inserted by
the SEBI (Insider Trading) (Amendment) Regulations, 2002 published in the Official Gazette of
India, dated 20.02.2002.
34. "or any other person mentioned in clause (1) of sub-section 1 of section 11 of the Act" inserted by
the SEBI (Insider Trading) (Amendment) Regulations, 2002 published in the Official Gazette of
India, dated 20.02.2002.
35. Substituted for "One month" by the SEBI (Insider Trading) (Amendment) Regulations, 2002
published in the Official Gazette of India, dated 20.02.2002
36. Substituted for the following regulation 9 by the SEBI (Insider Trading) (Amendment) Regulations,
2002 published in the Official Gazette of India, dated 20.02.2002
"(1) The Board shall after consideration of the investigation report communicate the findings to
the insider and he shall be given an opportunity of being heard before any action is taken by
the Board on the findings of the investigating authority.
(2) On receipt of the explanation; if any, from the insider, the Board may call upon the insider to
take such measures as the Board may deem fit to protect the interest of investors and in the
interest of the securities, market and for due compliance with the provisions of the Act, rules
made thereunder and these regulations."
37. Substituted for "province" by the SEBI (Prohibition of Insider Trading) (Second Amendment)
Regulations, 2002 published in the Official Gazette of India dated 29.11.2002 vide S.O.1245(E).
38. "regulation 4A and" inserted by the SEBI (Insider Trading) (Amendment) Regulations, 2002
published in the Official Gazette of India, dated 20.02.2002.
39. "or any other person mentioned in clause (1) of sub-section 1 of section 11 of the Act" inserted by
the SEBI (Insider Trading) (Amendment) Regulations, 2002 published in the Official Gazette of
India, dated 20.02.2002. 71
Securities market in Provided that, the auditor so appointed shall have the same powers of the inspecting
India authority as stated in regulation 5 and the insider shall have the obligations specified
in regulation 7.

Directions by the Board

40
*[11 - The Board may without prejudice to its right to initiate criminal prosecution
under section 24 or any action under Chapter VIA of the Act, to protect the interests
of investors and in the interests of the securities market and for due compliance with
the provisions of the Act, Regulations made thereunder issue any or all of the
following order, namely:-

(a) directing the insider or such person as mentioned in clause (i) of sub-section (2)
of section 11 of the Act not to deal in securities in any particular manner;

(b) prohibiting the insider or such person as mentioned in clause (i) of sub-section
(2) of section 11 of the Act from disposing of any of the securities acquired in
violation of these Regulations;

(c) restraining the insider to communicate or counsel any person to deal n

securities;

(d) declaring the transaction(s) in securities as null and void;

(e) directing the person who acquired the securities in violation of these regulations
to deliver the securities back to the seller;

Provided that in case the buyer is not in a position to deliver such securities.
the market price prevailing at the time of issuing of such directions or at the
time of transactions which ever is higher, shall be paid to the seller.

(f) directing the person who has dealt in securities in violation of these regulations
to transfer an amount or proceeds equivalent to the cost price or market price of
securities, whichever is higher to the investor protection fund of a Recognised
Stock Exchange.]

“11. On receipt of the explanation, if any, from the insider under sub-regulation (2)
of regulation 9, the Board may without prejudice to its right to initiate criminal
prosecution under section 24 of the Act, give such directions to protect the
interest of investors and in the interest of the securities market and for due
compliance with the provisions of the Act, rules made thereunder and these
regulations, as it deems fit for all or any of the following purposes, namely:-

(a) directing the insider not to deal in securities in any particular manner;

(b) prohibiting the insider from disposing of any of the securities acquired in
violation of these regulations;

(c) restraining the insider to communicate or counsel any person to deal in

securities."

40. Substituted for the following regulation 11 by the SEBI (Insider Trading)
(Amendment) Regulations, 2002 published in the Official Gazette of India, dated
72 20.02.2002.
 Regulation
41
*CHAPTER IV : POLICY ON DISCLOSURES AND
INTERNAL PROCEDURE FOR
PREVENTION OF INSIDER TRADING
Code of internal procedures and conduct for listed companies and other entities
12. (1) All listed companies and organisations associated with securities markets
including:
(a) the intermediaries as mentioned in section 12 of the Act, asset
management company and trustees of mutual funds;
(b) the self regulatory organisations recognised or authorised by the Board;
(c) the recognised stock exchanges and clearing house or corporations;
(d) the public financial institutions as defined in Section 4A of the
Companies Act, 1956; and
(e) the professional fines such as auditors, accountancy firms, law firms,
analysts, consultants, etc., assisting or advising listed companies, shall
frame a code of internal procedures and conduct as near there to the
Model Code specified in Schedule 1 of these Regulations.
(2) The entities mentioned in sub-regulation (1), shall abide by the Code of
Corporate Disclosure Practices as specified in Schedule 11 of' these
Regulations.
(3) All entities mentioned in sub-regulation (1), shall adopt appropriate
mechanisms and procedures to enforce the codes specified under sub -
regulations (1) and (2).
(4) Action taken by the entities mentioned in sub-regulation (I) against any
person for violation of the code under sub-regulation (3) shall not preclude the
Board from initiating proceedings for violation of these Regulations.
Disclosure of interest or holding by directors and officers and substantial
shareholders in a listed companies-
13. Initial Disclosure:
(1) Any person who holds more than 5% shares or voting rights in any listed
company shall disclose to the company, the number of shares or voting rights
held by such person, on becoming such holder, within 4 working days of:-
(a) the receipt of intimation of allotment of shares; or
(b) the acquisition of shares or voting rights, as the case may be.
(2) Any person who is a director or officer of a listed company, shall disclose to the
company, the number of shares or voting rights held by such person, within 4
working days of becoming a director or officer of the company.
Continual Disclosure
(3) Any person who holds more than 5% shares or voting rights in any listed
company shall disclose to the company the number of shares or voting rights
held and change in shareholding or voting rights, even if such change results in
shareholding falling below 5%, if there has been change in such holdings from
the last disclosure made under sub-regulation (1) or under this sub-regulation;
and such change exceeds 2% of total shareholding or voting rights in the
company.
(4) Any person who is a director or officer of a listed company, shall disclose to the
company, the total number of shares or voting rights held and change in
shareholding
41. "Chapter IV" inserted by the SERI (Insider Trading) (Amendment) Regulations,
2002 published in the Official Gazette of India, dated 20.02.2002. 73
Securities market in or voting rights, if there has been a change in such holdings from the last
India disclosure made under sub-regulation (2) or under this sub-regulation, and the
change exceeds Rupees 5 lac in value or42* [25000] shares or 43*[1 %] of total
shareholding or voting rights, whichever is lower.
(5) The disclosure mentioned in sub-regulations (3) and (4) shall be made within 4
working days of;
a) the receipt of intimation of allotment of shares, or
b) the acquisition or sale of shares or voting rights, as the case may be.
Disclosure by company to stock exchanges
(6) Every listed company, within five days of receipt, shall disclose to all stock
exchanges on which the company is listed, the information received under sub-
regulations (1), (2), (3) and (4).
Violation of provision relating to disclosure
14. (1) A person who violates provisions of regulation 12 shall be liable for action
under Section 11 or 11 B and/or Section 24 of the Act.
(2) A person who violates provisions of regulation 13 shall be liable for action as
specified in regulation 11 or Sections II, 11 B or action under Chapter VIA or
section 24 of the Act.)
Appeal to the Securities Appellate Tribunal
44
*[45* (15) Any person aggrieved by an order of the Board made, on and after the
commencement of the Securities Laws (Second Amendment) Act, 1999, (i.e.,
after 16th December 1999), under these regulations may prefer an appeal to a
Securities Appellate Tribunal having jurisdiction in the matter].

42. Substituted for “5000”by the SEBI (Prohibition of Insider Trading) (Second
Amendment) Regulations, 2002 published in the Official Gazette of India dated
29.11.2002 vide S.0.1245(E).
43. Substituted for "1%" by the SEBI (Prohibition of Insider Trading) (Second
Amendment) Regulations, 2002 published in the Official Gazette of India dated
29.11.2002 vide S.0.1245(E).
44. Substituted for the following by the SEBI (Appeal to the Securities Appellate
Tribunal) (Amendment) Regulations, 2000 published in the Official Gazette of
India, dated 28.03.2000.
"Any person aggrieved by an order of the Board under these regulations may
prefer an appeal to the Central Government."
74 45. Regulation 12 renumbered as 15 by the SEBI (Insider Trading) (Amendment)
Regulations. 2002 published in the Official Gazette of India, dated 20.02.2002.
 Regulation
APPENDIX 5.2 (III)
SECURITIES AND EXCHANGE BOARD OF INDIA
(SUBSTANTIAL ACQUISITION OF SHARES AND TAKEOVERS)
REGULATIONS, 1997*
S. O. No 124(E) - In the exercise of the powers conferred by section 30 of the Securities and
Exchange Board of India Act, 1992 (15 of 1992), the Board hereby makes the following
Regulations namely: -

CHAPTER I : PRELIMINARY
Short title and commencement
1 (1) These Regulations shall be called the Securities and Exchange Board of India
(Substantial Acquisition of Shares and Takeovers) Regulations, 1997.
(2) These Regulations shall come into force on the date of their publication in the
Official Gazette.
Definitions
2 (1) In these Regulations, unless the context otherwise requires:-
(a) "Act" means the Securities and Exchange Board of India Act, 1992 (15 of
1992);
(b)"acquirer" means any person who, directly or indirectly, acquires or agrees to
acquire shares or voting rights in the target company, or acquires or agrees to
acquire control over the target company, either by himself or with any person
acting in concert with the acquirer;
(c) "control" shall include the right to appoint majority of the directors or to
control the management or policy decisions exercisable by a person or
persons acting individually or in concert, directly or indirectly, including by
virtue of their shareholding or management rights or shareholders
agreements or voting agreements or in any other manner;
1
["Explanation: (i) Where there are two or more persons in control over
the target company, the cesser of any one of such persons from such
control shall not be deemed to be a change in control of management
nor shall any change in the nature and quantum of control amongst
them constitute change in control of management.
Provided that the transfer from joint control to sole control is effected in
accordance with clause (e) of sub - regulation (1) of regulation 3.
(ii) If consequent upon change in control of the target company in
accordance with regulation 3, the control acquired is equal to or less
than the control exercised by person (s) prior to such acquisition of
control, such control shall not be deemed to be a change in control".
2
*[(cc) "disinvestment" means the sale by the Central Government 3[or by
the State Government as the case may be] of its shares or voting rights and
/ or control in a listed Public Sector Undertaking;]
(d) "investigating officer" means any person appointed by the Board under
Regulation 38;
(e) "person acting in concert" comprises, -
(1) persons who, for a common objective or purpose of substantial acquisition of shares or
voting rights or gaining control over the target company, pursuant to an agreement or
understanding (formal or informal), directly or indirectly co-operate by acquiring or
agreeing to acquire shares or voting rights in the target company or control over the
target company.
1
Explanation Inserted vide SERI (Substantial Acquisition of Shares and Takeovers) (Second
Amendment) Regulations, 2002 dated 9th September, 2002.
2
Sub-regulation (cc) inserted by SEBI (Substantial Acquisition of Shares and Takeovers)
(Amendment) Regulations, 2001 published in the official Gazette of India dated 17.8.2001.
* As amended upto 1/10/2002. 75
Source: SEBI’s Website
Securities market in (2) Without prejudice to the generality of this definition, the following persons will be in India
India deemed to be persons acting in concert with other persons in the same category, unless the
contrary is established :
(i) a company, its holding company, or subsidiary of such company or company under
the same management either individually or together with each other;
(ii) a company with any of its directors, or any person entrusted with the management of
the funds of the company;
(iii) directors of companies referred to in sub-clause (i) of clause (2) and their associates
(iv) mutual fund with sponsor or trustee or asset management company;
(v) foreign institutional investors with sub account(s);
(vi) merchant bankers with their client(s) as acquirer;
(vii) portfolio managers with their client(s) as acquirer;
(viii) venture capital funds with sponsors;
(ix) banks with financial advisers, stockbrokers of the acquirer, or any company which i a
holding company, subsidiary or relative of the acquirer.
Provided that sub-clause (ix) shall not apply to a bank whose sole relationship with
the acquirer or with any company, which is a holding company or a subsidiary of the
acquirer or with a relative of the acquirer, is by way of providing normal commercial
banking services or such activities in connection with the offer such as confirming
availability of funds, handling acceptances and other registration work.
(x) any investment company with any person who has an interest as director, fund
manager, trustee, or as a shareholder having not less than 2% of the paid-up capital of
that company or with any other investment company in which such person or hi
associate holds not less than 2% of the paid up capital of the latter company.
Note: For the purposes of this clause 'associate' means:
(a) any relative of that person within the meaning of section 6 of the Companies Act, 1956 (1 of
1956); and
(b) family trusts and Hindu Undivided Families.
(f) “4[offer period' means the period between the date of entering into Memorandum of
Understanding or the public announcement, as the case may be and the date of completion
of offer formalities relating to the offer made under these regulations.];
(g) "panel" means a panel constituted by the Board for the purpose of Regulation 4;
(h) “5[promoter" means -
(i) the person or persons who are in control of the company, directly or indirectly
whether as a shareholder, director or otherwise; or
3
Inserted vide SEBI (Substantial Acquisition of Shares and Takeovers) (Second Amendment)
Regulations, 2002 dated 9th September, 2002.
4
Earlier Definition read as [(0 offer period" means the period between the date of public announcement of
the first offer and the date of closure of that offer] Substituted vide SEBI (Substantial Acquisition of
Shares and Takeovers) (Second Amendment) Regulations, 2002 dated 9th September, 2002.
5
[(h) "promoter" means
(1) (i) the person or persons who are in control of the company, or
(ii) person or persons named in any offer document as promoters;
(2) a relative of the promoter within the meaning of section 6 of the Companies Act, 1956 (1 of
1956);and
(3) in case of a corporate body,
(i) a subsidiary or holding company of that body, or
(ii) any company in which the `Promoter' holds 10% or more of the equity capital or which
holds 10% or more of the equity capital of the Promoter, or
(iii) any corporate body in which a group of individuals or corporate bodies or combinations
thereof who hold 20% or more of the equity capital in that company also hold 20% or more
of the equity capital of the `Promoter'; and
(4) in case of an individual,
(i) any company in which 10% or more of the share capital is held by the 'Promoter' or a
relative of the `Promoter' or a firm or Hindu undivided family in which the
'Promoter' or his relative is a partner or co-parcener or a combination thereof,
(ii) any company in which a company specified in (i) above, holds 10% or more of the share
capital or
76 (iii) any HUF or firm in which the aggregate share of the Promoter and his relatives is equal to
or more than 10% of the total.] Substituted vide SEBI (Substantial Acquisition of Shares
and Takeovers) (Second Amendment) Regulations, 2002 dated 9th September, 2002.
 Regulation
(ii) person or persons named as promoters in any document of offer of
securities to Regulation the public or existing shareholders,
and includes,
(a) where the promoter is an individual,-
(1) a relative of the promoter within the meaning of section 6 of the
Companies Act, 1956 (l of 1956);
(2) any firm or company, directly or indirectly, controlled by the
promoter or a relative of the promoter or a firm or Hindu undivided
family in which the promoter or his relative is a partner or a
coparcener or a combination thereof:
Provided that, in case of a partnership firm, the share of the promoter
or his relative, as the case may be, in such firm should not be less than
50%,";
(b) where the promoter is a body corporate, -
(1) a subsidiary or holding company of that body; or
(2) any firm or company, directly or indirectly, controlled by the
promoter of that body corporate or by his relative or a firm or Hindu
undivided family in which the promoter or his relative is a partner or
coparcener or a combination thereof:
Provided that, in case of a partnership firm, the share of such
promoter or his relative, as the case may be, in such firm should not be
less than 50%1.
(i) "public financial institution- means a public financial institution as defined in
Section 4A of the Companies Act, 1956.
6
*[(ii) "Public Sector Undertaking" means a company in which the Central
Government 7[or a State Government] holds 50% or more of its equity capital
or is in control ()lithe company;]
(j) "public shareholding "means shareholding in the hands of person(s) other than
the acquirer and persons acting in concert with him;
(k) "shares" means shares in the share capital of a company carrying voting rights
and includes any security which would entitle the holder to receive shares with
voting rights 8[but shall not include preference shares].
(l) "sick industrial company" shall have the same meaning assigned to it in clause
(o) of sub-section (1) of Section 3 of the Sick Industrial Companies (Special
Provisions) Act, 1985 ( I of 1986) or any statutory re-enactment thereof.
(m) "state level financial institution" means a state financial corporation established
under Section 3 of the State Financial Institutions Act, 1951 and includes
development corporation established as a company by a State Government with
the object of development of industries or agricultural activities in the state;
(n) "stock exchange" means a stock exchange which has been granted recognition
under Section 4 of the Securities Contracts (Regulation) Act, 1956 (42 of 1956);
(o) "target company" means a listed company whose shares or voting rights
or control is directly or indirectly acquired or is being acquired;
9
[(p) "working days" shall mean the working days of the Board."]
(2) All other expressions unless defined herein shall have the same meaning as have
been assigned to them under the Act or the Securities Contracts (Regulation)
Act, 1956, or the Companies Act, 1956, or any statutory modification or
reenactment thereto, as the case may be.
6
Sub-regulation (ii) inserted by SERI (Substantial Acquisition of Shares and
Takeovers) (Amendment) Regulations, 2001 published in the official Gazette of
India dated 17.8.2001.
7
Inserted vide SEBI (Substantial Acquisition of Shares and Takeovers) (Second
Amendment) Regulations, 2002 dated 9th September, 2002.
8
Inserted vide SEBI (Substantial Acquisition of Shares and Takeovers) (Second
Amendment) Regulations, 2002 dated 9th September, 2002.
9
Clause (p) inserted vide SEBI (Substantial Acquisition of Shares and Takeovers)
(Second Amendment) Regulations. 2002 dated 9th September, 2002. 77
Applicability of the Regulation
Securities market in 3 (1) Nothing contained in Regulations 10, Regulation 11 and Regulation 12 of these regulations
India shall apply to:

(a) allotment in pursuance of an application made to a public issue.

Provided that if such an allotment is made pursuant to a firm allotment in the p issues,
such allotment shall be exempt only if full disclosures are made in the prospectus
about the identity of the acquirer who has agreed to acquire the shares the purpose of
acquisition, consequential changes in voting rights, shareholding pattern of the
company and in the Board of Directors of the Company, if any, whether such
allotment would result in change in control over the company.

(b) allotment pursuant to an application made by the shareholder for rights issue,

(i) to the extent of his entitlement; and

(ii) upto the percentage specified in Regulation 11:

Provided that the limit mentioned in sub-clause (ii) will not apply to the acquisition
by any person presently in control of the company and who hi the rights letter of offer
made disclosures that they intend to acquire additional, shares beyond their
entitlement if the issue is undersubscribed.

Provided further that this exemption shall not be available in case the acquisition of
securities results in the change of control of management;
10
*[(c)]

(d) allotment to the underwriters pursuant to any underwriting agreement;

(e) inter se transfer of shares amongst :-

11
[(i) group coming within the definition of group as defined in the Monopolies Restrictive
Trade Practices Act, 1969 (54 of 1969) where persons constituter such group have
been shown as group in the last published Annual Report the target company I;

(ii) relatives within the meaning of Section 6 of the Companies Act, 1956 (1 of 1956;

(iii) (a) Indian promoters and foreign collaborators who are shareholders;

(b) Promoters:
12
[ Provided that the transferor(s) as well as the transferee(s) have been holding shares in
the target company for a period of at least three years prior to the proposed acquisition.]
10
[(c) preferential allotment, made in pursuance of a resolution, passed under Section 81 (IA) of the
Companies Act, 1956 (1 of 1956).

Provided that,-

(i) board Resolution in respect of the proposed preferential allotment is sent to all the steel
exchanges on which the shares of the company are listed for being notified on the notice
board;

(ii) full disclosures of the identity of the class of the proposed allottee (s) is made, and if any
the proposed allottee (s) is to be allotted such number of shares as would increase his hold
to 5% or more of the post issued capital, then in such cases, the price at which the afloat is
proposed, the identity of such person(s), the purpose of and reason for such allotment,
consequential changes, if any, in the board of directors of the company and in voting right
the shareholding pattern of the company, and whether such allotment would result in chat
in control over the company are all disclosed in the notice of the General Meeting called
the purpose of consideration of the preferential allotment;]Omitted vide SEBI (Substanti1
Acquisition of Shares and Takeovers) (Second Amendment) Regulations, 2002 dated 9th
September, 2002.
11
The earlier definition [(i) group companies, coming within the definition of group as defined in the
Monopolies and Restrictive Trade Practices Act, 1969 (25 of 1969) ;] Substituted vide SEBI
(Substantial Acquisition of Shares and Takeovers) (Second Amendment) Regulations, 2002 dated 9t
September, 2002.
12
The proviso read as [Provided that the transferor(s) as well as the transferees) in sub-clauses (a) and
have been holding individually or collectively not less than 5%shares in the target company for a
78 period of at least three years prior to the proposed acquisition;] Substituted vide SEBI (Substantial
Acquisition of Shares and Takeovers) (Second Amendment) Regulations, 2002 dated 9th September,
2002.
 13 Regulation
[(iv) the acquirer and persons acting in concert with him, where such transfer
of shares takes place three years after the date of closure of the public offer
made by them under these Regulations.]
14
[Explanation .- (1) The exemption under sub-clauses (iii) and (iv) shall not be
available if inter se transfer of shares is at a price exceeding 25% of the price
as determined in terms of sub-regulations (4) and (5) of regulation 20.";
2. The benefit of availing exemption under this clause, from applicability of the
Regulations for increasing shareholding or inter se transfer of shareholding shall be
subject to such transferor(s) and transferee(s) having complied with Regulation 6,
Regulation 7 and Regulation 8.1
(f) acquisition of shares in the ordinary course of business by,-
(i) a registered stock-broker of a stock exchange on behalf of clients;
(ii) a registered market maker of a stock exchange in respect of shares for which he
is the market maker, during the course of market making;
(iii) by Public Financial Institutions on their own account;
(iv) by banks and public financial institutions as pledgees;
15
[(v) the International Finance Corporation, Asian Development Bank,
International Bank for Reconstruction and Development, Commonwealth
Development Corporation and such other international financial
institutions,
(vi) a merchant banker or a promoter of the target company pursuant to a
scheme of safety net under the provisions of the Securities and Exchange Board of
India (Disclosure and Investor Protection) Guidelines, 2000 in excess of limit
specified in sub-regulation (1) of Regulation 11.]
16
[(ff) acquisition of shares by a person in exchange of shares received under a
public offer made under these Regulations.]
(g) acquisition of shares by way of transmission on succession or inheritance;
(h) acquisition of shares by government companies within the meaning of Section 617 of the
Companies Act, 1956 (1 of 1956) and statutory corporations;
17
[Provided that this exemption shall not be applicable if a Government company acquires
shares or voting rights or control of a listed Public Sector Undertaking through the
competitive bidding process of the Central Government 18[or the State Government as
the case may be] for the purpose of disinvestment."]
(i) transfer of shares from state level financial institutions, including their subsidiaries, to co--
promoter(s) of the company 19[or their successors or assignee(s) or an acquirer who
has substituted an erstwhile promoter] pursuant to an agreement between such financial
institution and such co-promoter(s);
13
Inserted vide SEBI (Substantial Acquisition of Shares and Takeovers) (Second Amendment)
Regulations, 2002 dated 9th September, 2002.
14
[Explanation: The benefit of availing of exemption from applicability of Regulations for
increasing shareholding or inter se transfer of shareholding among group companies, relatives and
promoters shall be subject to such group companies or relatives or promoters filing statements
concerning group and individual shareholding as required under Regulations 6, Regulation 7 and
Regulation 8.] Substituted vide SEBI (Substantial Acquisition of' Shares and Takeovers) (Second
Amendment) Regulations, 2002 dated 9th September, 2002.
15
Inserted vide SEBI (Substantial Acquisition of Shares and Takeovers) (Second Amendment)
Regulations, 2002 dated 9th September, 2002.
16
Inserted vide SEBI (Substantial Acquisition of Shares and Takeovers) (Second Amendment)
Regulations, 2002 dated 9th September, 2002.
17
Proviso inserted by SEBI (Substantial Acquisition of Shares and Takeovers) (Amendment)
Regulations, 2002 published in the official .Gazette of India dated 29.1.2002.
18
Inserted vide SEBI (Substantial Acquisition of Shares and Takeovers) (Second Amendment)
Regulations, 2002 dated 9th September, 2002.
19
Inserted vide SEBI (Substantial Acquisition of Shares and Takeovers) (Second Amendment) 79
Regulations. 2002 dated 9th September, 2002.
 20
Securities market in [(ia) transfer of shares from venture capital funds or foreign venture capital investors
India registered with the Board to promoters of a venture capital undertaking or venture capital
undertaking pursuant to an agreement between such venture capital fund or foreign venture
capital investors with such promoters ea venture capital undertaking];
(j) pursuant to a scheme -
(i) framed under Section 18 of the Sick Industrial Companies (Special Provisions) Act,
l9R5;
(ii) of arrangement or reconstruction including amalgamation or merger or demerger
under any law or regulation, Indian or foreign.
(k) acquisition of shares in companies whose shares are not listed on any stock
exchange;
Explanation: The exemption under clause (k) above shall not be applicable if by
virtue of acquisition or change of control of any unlisted company, whether in India
or abroad, the acquirer acquires shares or voting rights or control over a listed
company.
21
(1) [*] other cases as may be exempted from the applicability of Chapter III by the Board
under Regulation 4.
(2) Nothing contained in Chapter III of the Regulations shall apply to the acquisition of
Global Depository Receipts or American Depository Receipts so long as they are not
converted into shares carrying voting rights.
(3) in respect of acquisitions under clauses 22[*](e).(h) and (i) of sub-regulation (1), the
stock exchanges where the shares of the company are listed shall, for information of the
public, be notified of the details of the proposed transactions at least 4 working days in
advance of the date of the proposed acquisition, in case of acquisition exceeding 23[5%]
of the voting share capital of the company.
(4) In respect of acquisitions under clauses (a),(b),24[*],(e) and (i) of sub-regulation (1), the
acquirer shall. within 21 days of the date of acquisition, submit a report along with
supporting documents to the Board giving all details in respect of acquisitions which
(taken together with shares or voting rights, if any, held by him or by persons acting in
concert with him) would entitle such person to exercise 25*[15%] or more of the voting
rights in a company.
26
[Explanation - For the purposes of sub-regulations (3) and (4), the relevant date in
case of securities which arc convertible into shares shall be the clate of conversion of
such securities].
(5) The acquirer shall, along with the report referred to under sub-regulation (4), pay a fee
of Rs. 1 0, 000/- to the Board, either by a bankers cheque or demand draft in favour of
the Securities and Exchange Board of India, payable at Mumbai.
The Takeover Panel
4. (1) The Board shall for the purposes of this Regulation constitute a Panel of majority of
independent persons from within the categories mentioned in sub-section (5) of
Section 4 of the Act.
(2) For seeking exemption under clause (1) of sub-regulation (1) of Regulation (3), the
acquirer shall file an application 27[supported by a duly sworn affidavit] with the
Board, given: details of the proposed acquisition and the grounds on which the
exemption has been sought [Format of application].
20
Sub-regulation (la) inserted by SEBI (Substantial Acquisition of Shares and Takeovers)
(Amendment) Regulations, 2000 published in the official Gazette of India dated 30.12.2000.
2l
The word [such] Omitted vide SEBI (Substantial Acquisition of Shares and Takeovers)
(Second Amendment) Regulations, 2002 dated 9th September, 2002.
22
The brackets and the word c Omitted vide SEBI( (Substantial Acquisition of Shares
and Takeovers) (Second Amendment) Regulations, 2002 dated 9th September, 2002.
23
Substituted for “2%” by the SEBI (Substantial Acquisition of Shares and Takeovers
(Amendment) Regulations, 1998 published in the official Gazette of India dated 28.10.1990.
24
The brackets and the word[(c)] Omitted vide SEBI (Substantial Acquisition of Shares and
Takeovers) (Second Amendment) Regulations, 2002 dated 9th September, 2002.
25
Substituted for “10%” by the SEBI (Substantial Acquisition of Shares and Takeovers)
(Amendment) Regulations, 1998 published in the official Gazette of India dated 28.10.1998.
26
Explanation Inserted vide SEBI (Substantial Acquisition of Shares and Takeovers) (Second
80 Amendment) Regulations, 2002 dated 9th September, 2002.
27
Inserted vide SEBI (Substantial Acquisition of Shares and Takeovers) (Second
Amendment) Regulations, 2002 dated 9th September, 2002.
 Regulation
(3) The acquirer shall, along with the application referred to under sub-regulation
(2), pay a fee of Rs. 25, 000/- to the Board, either by a bankers cheque or
demand draft in favour of the Securities and Exchange Board of India,
payable at Mumbai.
(4) The Board shall within 5 days of the receipt of an application under sub-
regulation (2) forward the application to the Panel.
(5) The Panel shall within 15 days from the date of receipt of application make a
recommendation on the application to the Board.
(6) The Board shall after affording reasonable opportunity to the concerned
parties and after considering all the relevant facts including the
recommendations, if any, pass a reasoned order on the application under sub-
regulation (2) within 30 days thereof.
(7) The order of the Board under sub-regulation (6) shall be published by the
Board.
Power of the Board to grant exemption
5. In order to remove any difficulties in the interpretation or application of the
provisions of these Regulations, the Board shall have the power to issue
directions through guidance notes or circulars:
Provided that where any direction is issued by the Board in a specific case
relating to interpretation or application of any provision of these Regulations, it
shall be done only after affording a reasonable opportunity to the concerned
parties and after recording reasons for the direction.

81
Securities market in
India
CHAPTER II : DISCLOSURES OF SHAREHOLDING
AND CONTROL IN A LISTED
COMPANY
Transitional provision
6. (1) Any person, who holds more than five percent shares or voting rights in any
company, shall within two months of notification of these Regulations disclose his
aggregate shareholding in that company, to the company.
(2) Every company whose shares are held by the persons referred to in sub-regulation
(1) shall, within three months from the date of notification of these Regulations,
disclose to all the stock exchanges on which the shares of the company are listed,
the aggregate number of shares held by each person.
(3) A promoter or any person having control over a company shall within two months
of notification of these Regulations disclose the number and percentage of shares or
voting rights held by him and by person(s) acting in concert with him in that
company, to the company.
(4) Every company, whose shares are listed on a stock exchange, shall within three
months of notification of these Regulations, disclose to all the stock exchanges on
which the shares of the company are listed, the names and addresses of promoters
and, or person(s) having control over the company, and number and percentage of
shares or voting rights held by each such person.
Acquisition of 5% and more shares of a company
28
[7. (1) Any acquirer, who acquires shares or voting rights which (taken together with shares
or voting rights, if any, held by him) would entitle him to more than five per cent or ten per
cent or fourteen per cent shares or voting rights in a company, in any manner whatsoever,
shall disclose at every stage the aggregate of his shareholding or voting rights in that
company to the company and to the stock exchanges where shares of the target company are
listed].
29
[(1A) Any acquirer who has acquired shares or voting rights of a company under sub-
regulation (1) of regulation 11, shall disclose purchase or sale aggregating two per cent. or
more of the share capital of the target company to the target company, and the stock
exchanges where shares of the target company are listed within two days of such purchase or
sale alongwith the aggregate shareholding after such acquisition or sale].
30
[Explanation - for the purposes of sub-regulations (1) and (1A), the term 'acquirer' shall
include a pledgee, other than a bank or a financial institution and such pledgee shall make
disclosure to the target company and the stock exchange within two days of creation of
pledge.]
(2) The disclosures mentioned in 31*[sub-regulations(1) and (1A)] shall be made within 32[two
days], -
(a) the receipt of intimation of allotment of shares; or
(b) the acquisition of shares or voting rights, as the case may be.
28
The earlier sub-regulation read as [(1) Any acquirer, who acquires shares or voting rights
which (taken together with shares or voting rights, if any, held by him) would entitle him to
more than five percent shares or voting rights in a company, in any manner whatsoever, shall
disclose the aggregate of his shareholding or voting rights in that company, to the company.]
Substituted vide SEBI (Substantial Acquisition of Shares and Takeovers) (Second
Amendment) Regulations, 2002 dated 9th September, 2002.
29
The earlier provision which read as follows [(1 A) Any acquirer who has acquired shares or
voting rights of a company under sub-regulation (1) of regulation 11, shall disclose purchase
or sale aggregating two per cent or more of the share capital of the target company to the
target company, and the stock exchanges where shares of the target company are listed
within two days of such purchase or sale along with the aggregate shareholding after such
acquisition or sale.] Substituted vide SEBI (Substantial Acquisition of Shares and
Takeovers) (Second Amendment) Regulations, 2002 dated 9th September, 2002.
30
Explanation inserted vide SEBI (Substantial Acquisition of Shares and Takeovers) (Second
Amendment) Regulations, 2002 dated 9th September, 2002.
31
Substituted for "sub-regulation (1)" by SEBI (Substantial Acquisition of Shares and
Takeovers) (Third Amendment) Regulations, 2001 published in the official Gazette of India
82 dated 24.10.2001
32
The words [four working days of] substituted vide SEBI (Substantial Acquisition of Shares
and Takeovers) (Second Amendment) Regulations, 2002 dated 9th September, 2002.
33 Regulation
[“(2A) The stock exchange shall immediately display the information received from
the acquirer under sub-regulations (1) and (1A) on the trading screen, the notice board
and also on its website].
(3) Every company, whose shares are acquired in a manner referred to in 34*[sub-
regulation(1)) and (1A)] shall disclose to all the stock exchanges on which the
shares of the said company are listed the aggregate number of shares held by
each of such persons referred above within seven days of receipt of information
under 35*[sub-regulations (1) and (1A)].
Continual disclosures
8. (1) Every person, including a person mentioned in Regulation 6 who holds
more than 36*[fifteen] per cent shares or voting rights in any company,
shall, within 21 days from the financial year ending March 31, make yearly
disclosures to the company, in respect of his holdings as on 31st March.
(2) A promoter or every person having control over a company shall, within 21
days from the financial year ending March 31, as well as the record date of
the company for the purposes of declaration of dividend, disclose the
number and percentage of shares or voting rights held by him and by
persons acting in concert with him, in that company to the company.
(3) Every company whose shares are listed on a stock exchange, shall within 30
days from the financial year ending March 31, as well as the record date of
the company for the purposes of declaration of dividend, make yearly
disclosures to all the stock exchanges on which the shares of the company
are listed, the changes, if any, in respect of the holdings of the persons
referred to under sub-regulation (1) and also holdings of promoters or
person(s) having control over the company as on 31st March.
(4) Every company whose shares are listed on a stock exchange shall maintain
a register in the specified format to record the information received under
sub-regulation (3) of Regulation 6, sub-regulation (1) of Regulation 7 and
sub-regulation (2) of Regulation 8.
Power to call for information
10. The stock exchanges and the company shall furnish to the Board
information with regard to the disclosures made under
Regulations 6, Regulation 7 and Regulation 8 as and when
required by the Board.
33
Sub Regulation (2A) inserted vide SEBI (Substantial Acquisition of Shares and
Takeovers) (Second Amendment) Regulations, 2002 dated 9th September, 2002.
34
Substituted for "sub-regulation (1)" by SEBI (Substantial Acquisition of Shares and
Takeovers) (Third Amendment) Regulations, 2001 published in the official Gazette of
India dated 24.10.2001.
35
Substituted for "sub-regulation (1)" by SEBI (Substantial Acquisition of Shares and
Takeovers) (Third Amendment) Regulations, 2001 published in the official Gazette of
India dated 24.10.2001.
36
Substituted for "ten" by the SERI (Substantial Acquisition of Shares and Takeovers)
(Amendment) Regulations, 1998 published in the official Gazette of India dated
28.10.1998.

83
Securities market in
India
CHAPTER III : SUBSTANTIAL ACQUISITION OF
SHARES VOTING RIGHTS IN AN OF
ACQUISITION CONTROL OVER A
LISTED COMPANY
Acquisition of 37*[fifteen] or more of the shares or voting rights of any company,
10. No acquirer shall acquire shares or voting rights which (taken together with shares or
voting rights if any, held by him or by persons acting in concert with him), entitle such
acquirer to exercise 37* [ fifteen ] percent or more of the voting rights in a company, unless
such acquirer makes a public announcement to acquire shares of such company in accordance
with the Regulations.
Consolidation of holdings
11. (1) No acquirer who, together with persons acting in concert with him, has acquired, in
accordance with the provisions of law,38*[15 per cent or more but less than 75 per
cent the shares or voting rights in a company, shall acquire, either by himself or
through or 1 persons acting in concert with him, additional shares or voting rights
entitling him to exercise more than 39*[40[5%]] of the voting rights,41 [in any
financial year ending on 31 March], unless such acquirer makes a public
announcement to acquire shares in accords with the Regulations.
42*[(2) No acquirer, who together with persons acting in concert with him has acquired , in
accordance with the provisions of law, 75% of the shares or voting rights in a
company shall acquire either by himself or through persons acting in concert with
him any additional shares or voting rights, unless such acquirer makes a public
announcement to acquire shares in accordance with the regulations]
43*[(3) Notwithstanding anything contained in Regulations 10, 11 and 12, in case of
disinvestment of a Public Sector Undertaking , an acquirer who together with
persons acting in concert with him, has made a public announcement, shall not be
required to make another public announcement at the subsequent stage of further
acquisition of shares or voting rights or control of the Public Sector Undertaking
provided:-
(i) both the acquirer and the seller are the same at all the stages of acquisition, and
(ii) disclosures regarding all the stages of acquisition, if any, are made in the letter
of c issued in terms of Regulation 18 and in the first public announcement].
Explanation:- For the purposes of Regulation 10 and Regulation 11, acquisition shall mean and
include,-
37
Substituted for "10%" by the SEBI (Substantial Acquisition of Shares and Takeovers)
(Amendment) Regulations, 1998 published in the official Gazette of India dated 28.10.1998.
38
Substituted for "[not less than 10% but not more than 51%]" by the SEBI (Substantial
Acquisition of Shares and Takeovers) (Amendment) Regulations, 1998 published in the
official Gazette of India dated 28.10.98.
39
Substituted for "5%" by the SEBI (Substantial Acquisition of Shares and Takeovers) (Third
Amendment Regulations, 2001, published in the official Gazette of India dated 24.10.2001.
Earlier it was substituted for "2" by the SEBI (Substantial Acquisition of Shares and
Takeovers) (Amendment) Regulations, 1 published in the official Gazette of India dated
28.10.98.
40
The word and figures ["10% of the voting rights"] substituted vide SEBI (Substantial
Acquisition of Shares and Takeovers) (Second Amendment) Regulations, 2002 dated 9th
September, 2002.
41
The word and figures ["in any period of 12 months with" in any financial year ending on 31st
Mar Substituted vide SEB1 (Substantial Acquisition of Shares and Takeovers) (Second
Amendment) Regulations, 2002 dated 9th September, 2002.
42
Substituted for "No acquirer shall acquire shares or voting rights which (taken together with
shares or voting rights, if any, held by him or by persons acting in concert with him), entitle
such acquirer to exercise more than 51% of the voting rights in a company, unless such
acquirer makes a public announcement to acquire share of such company in accordance with
the Regulations" by the SEBI (Substantial Acquisition of Shares and Takeovers)
(Amendment) Regulations, 1998 published in the official Gazette of India dated 28.10.1998.
84 43
Sub-regulation (3) inserted by the SEB1 (Substantial Acquisition of Shares and Takeovers)
(Amendment Regulations, 2001 published in the official Gazette of India dated 17.08.2001.
 Regulation
(a) direct acquisition in a listed company to which the Regulations apply;

(b) indirect acquisition by virtue of acquisition of 44[*] companies, whether listed or unlisted,
whether in India or abroad.

Acquisition of control over a company

12. Irrespective of whether or not there has been any acquisition of shares or voting rights in a
company, no acquirer shall acquire control over the target company, unless such person
makes a public announcement to acquire shares and acquires such shares in accordance with
the Regulations.

Provided that nothing contained herein shall apply to any change in control which takes
place in pursuance to a 45[special resolution] passed by the shareholders in a general meeting.
46
[“Provided further that for passing of the special resolution facility of voting through postal ballot
as specified under the Companies (Passing of the Resolutions by Postal Ballot) Rules, 2001 shall
also be provided].

Explanation:
47
[For the purposes of this Regulation, acquisition shall include direct or indirect acquisition
of control of target company by virtue of acquisition of companies, whether listed or
unlisted and whether in India or abroad].

Appointment of a Merchant Banker

13. Before making any public announcement of offer referred to in Regulation 10 or Regulation
11 or Regulation 12, the acquirer shall appoint a merchant banker in Category-I holding a
certificate of registration granted by the Board, who is not associate of or group of the
acquirer or the target company.

Timing of the Public Announcement of Offer

14. (1) The public announcement referred to in Regulation 10 or Regulation 11 shall be made by
the merchant banker not later than four working days of entering into an agreement for
acquisition of shares or voting rights or deciding to acquire shares or voting rights
exceeding the respective percentage specified therein:
48
*[Provided that in case of disinvestment of a Public Sector Undertaking, the public
announcement shall be made by the merchant banker not later than 4 working days of the
acquirer executing the Share Purchase Agreement or Shareholders Agreement with the
44
The word [holding] Omitted vide SEBI (Substantial Acquisition of Shares and Takeovers)
(Second Amendment) Regulations, 2002 dated 9th September, 2002.
45
Substituted for the word [resolution] vide SEBI (Substantial Acquisition of Shares and Takeovers)
(Second Amendment) Regulations, 2002 dated 9th September, 2002.
46
Inserted vide SEBI (Substantial Acquisition of Shares and Takeovers) (Second Amendment)
Regulations, 2002 dated 9th September, 2002.
47
[Explanation:
(i) For the purposes of this Regulation where there are two or more persons in control
over the target company, the cessor of any one such person from such control shall
not be deemed to be a change in control of management nor shall any change in the
nature and quantum of -control amongst them constitute change in control of
management.
Provided however that if the transfer of joint control to sole control is through sale at
less than the market value of the shares, a shareholders meeting of the target company
shall be convened to determine mode of disposal of the shares of the outgoing
shareholder, by a letter of offer or by block-transfer to the existing shareholders in
control in accordance with the decision passed by a special resolution. Market value
in such cases shall be determined in accordance with Regulation 20.
(ii) where any person or persons are given joint control, such control shall not be deemed
to be a change in control so long as the control given is equal to or less than the
control exercised by person(s) presently having control over the company.]
Substituted vide SEBI (Substantial Acquisition of Shares and Takeovers) (Second
Amendment) Regulations, 2002 dated 9th September, 2002.
48
Proviso inserted by the SEBI (Substantial Acquisition of Shares and Takeovers) 85
(Amendment) Regulations, 2001 published in the official Gazette of India dated
17.08.2001.
Securities market in Central Government 49[or the State Government as the case may be] for the
India acquisition shares or voting rights exceeding the percentage of share holding referred
to in Regulation 10 or Regulation 11 or the transfer of control over a target Public
Sector Undertaking:
(2)
In case of an acquirer acquiring securities, including Global Depositories
Receipts or American Depository Receipts which, when taken together with the
voting right any already held by him or persons acting in concert with him,
would entitle hi voting rights, exceeding the percentage specified in Regulation
10 or Regulation the public announcement referred to in sub-regulation (1) shall
be made not late than four working days before he acquires voting rights on
such securities upon conversion, or exercise of option, as the case may be.
(3) The public announcement referred to in Regulation 12 shall be made by the
merchant banker not later than four working days after any such change or
changes are deg to be made as would result in the acquisition of control over the
target company by the acquirer.
50
[(4) In case of indirect acquisition or change in control, a public announcement
be made by the acquirer within three months of consummation of such
acquisition change in control or restructuring of the parent or the company
holding shares c control over the target company in India].
Public Announcement of Offer
15. (1) The public announcement to be made under Regulations 10 or Regulation 11 or
Regulation 12 shall be made in all editions of one English national daily with wide
circulation, on Hindi national daily with wide circulation and a regional language
daily with wide circulation at the place where the registered office of the target
company is situated al the place of the stock exchange where the shares of the target
company are most frequently traded.
51
[2) Simultaneously with publication of the public announcement in the newspaper in
terms of sub-regulation (1), a copy of the public announcement shall be,
(i) submitted to the Board through the merchant banker,
(ii) sent to all the stock exchanges on which the shares of the company are listed
for being notified on the notice board,
(iii) sent to the target company at its registered office for being placed before the Be
of Directors of the company.]
52
[(3)]
(3) Simultaneous with the submission of the public announcement to the Board, the
public announcement shall also be sent to all the stock exchanges, on which the shares
of the company are listed for being notified on the notice board, and to the target
company a registered office for being placed before the board of directors of the
Company.
(4) The offer under these Regulations shall be deemed to have been made on the date on
is the public announcement has appeared in any of the newspapers referred to in sub-
regulation (1).
49
[or the State Government as the case may be] inserted vide SEBI (Substantial Acquisition of
Shares Takeovers) (Second Amendment) Regulations, 2002 dated 9th September, 2002.
50
Inserted vide SEBI (Substantial Acquisition of Shares and Takeovers) (Second Amendment)
Regular 2002 dated 9th September, 2002.
51
[(2) A copy of the public announcement to be made under Regulations 10 or Regulation 11 or
Regulation 12 shall be submitted to the Board through the merchant banker at least two
working days before its issuance]Substituted vide SERI (Substantial Acquisition of Shares and
Takeovers) (Second Amendment Regulations, 2002 dated 9th September, 2002.
52
The sub-regulation (3) which read as [(3) Simultaneous with the submission of the public
announcement to the Board, the public announcement shall also be sent to all the stock
exchanges on which the shay the company are listed for being notified on the notice board, and
to the target company at its registered office for being placed before the board of directors of
86 the Company]. Omitted vide SEBI (Substantial Acquisition of Shares and Takeovers) (Second
Amendment) Regulations, 2002 dated 9th September,2002.
 Regulation
Contents of the Public Announcement of Offer

16. The public announcement referred to in Regulations 10 or Regulation 11 or Regulation 12

shall contain the following particulars, namely : -

(i) the paid up share capital of the target company, the number of fully paid up and
partly paid up shares;
(ii) the total number and percentage of shares proposed to be acquired from the public,
subject to a minimum as specified in sub-regulation (1) of Regulation 21;
(iii) the minimum offer price for each fully paid up or partly paid up share;
(iv) mode of payment of consideration;
(v) the identity of the acquirer(s) and in case the acquirer is a company or companies,
the identity of the promoters and, or the persons having control over such
company(ies) and the group, if any, to which the company(ies) belong:
(vi) the existing holding, if any, of the acquirer in the shares of the target company,
including holdings of persons acting in concert with him;
(vii) salient features of the agreement, if any, such as the date, the name of the seller, the
price at which the shares are being acquired, the manner of payment of the
consideration and the number and percentage of shares in respect of which he
acquirer has entered into the agreement to acquire the shares or the consideration,
monetary or otherwise, for the acquisition of control over the target company, as the
case may be;
(viii) the highest and the average price paid by the acquirer or persons acting in concert
with him for acquisition, if any, of shares of the target company made by him during
the twelve month period prior to the date of public announcement;
(ix) object and purpose of the acquisition of the shares and future plans, if any, of the
acquirer for the target company, including disclosures whether the acquirer proposes
to dispose of or otherwise encumber any assets of the target company in the
succeeding two years, except in the ordinary course of business of the target
company.
Provided that where the future plans are set out , the public announcement shall
also set out how the acquirers propose to implement such future plans.
53
[“Provided further that the acquirer shall not sell, dispose of or otherwise
encumber any substantial asset of the target company except with the prior approval
of the shareholders.
(ixa) an undertaking that the acquirer shall not sell, dispose of or otherwise encumber any
substantial asset of the target company except with the prior approval of the
shareholders].
(x) the 'specified date' as mentioned in Regulation 19;
(xi) the date by which individual letters of offer would be posted to each of the
shareholders;
(xii) the date of opening and closure of the offer and the manner in which and the date by
which the acceptance or rejection of the offer would be communicated to the
shareholders;
(xiii) the date by which the payment of consideration would be made for the shares in
respect of which the offer has been accepted;
(xiv) disclosure to the effect that firm arrangement for financial resources required to
implement the offer is already in place, including details regarding the sources of
the funds whether domestic i.e from banks, financial institutions, or otherwise or
foreign i.e., from Non-Resident Indians or otherwise.
(xv) provision for acceptance of the offer by person(s) who own the shares but are not
the registered holders of such shares;
(xvi) statutory approvals, if any, required to be obtained for the purpose of acquiring the
shares under the Companies Act, 1956 (1 of 1956), the Monopolies and Restrictive
Trade Practices Act, 1969 (54 of 1969), The Foreign Exchange Regulation Act,
1973, (46 of 1973) and/or any other applicable laws;
(xvii) approvals of banks or financial institutions required, if any; whether the offer is
subject to a minimum level of acceptance from the shareholders; and
53
Inserted vide SEBI (Substantial Acquisition of Shares and Takeovers) (Second
Amendment). Regulations, 2002 dated 9th September, 2002. 87
(xviii) such other information as is essential for the shareholders to make an informed
Securities market in decision in regard to the offer.
India
Brochures, advertising material etc.
17. The public announcement of the offer or any other advertisement, circular, brochure,
publicity material or letter of offer issued in relation to the acquisition of shares shall not
contain any misleading information.
Submission of Letter of offer to the Board
18. (1) Within fourteen days from the date of public announcement made under Regulation 10,
Regulation 11 or Regulation 12 as the case may be, the acquirer shall, through its
merchant banker, file with the Board, the draft of the letter of offer, containing
disclosures as specified by the Board.
(2) The letter of offer shall be dispatched to the shareholders not earlier than 21 days
from its submission to the Board under sub-regulation (1).
Provided that if, within 21 days from the date of submission of the letter of offer, the
Board specifies changes, if any, in the letter of offer, (without being under any
obligation to do so) the merchant banker and the acquirer shall carry out such changes
before the letter of offer is dispatched to the shareholders.
54
[Provided further that if the disclosures in the draft letter of offer are inadequate or
the Board has received any complaint or has initiated any enquiry or investigation in
respect of the public offer, the Board may call for revised letter of offer with or
without rescheduling the date of opening or closing of the offer and may offer its
comments to the revised letter of offer within seven working days of filing of such
revised letter of offer.]
(3) The acquirer shall, along with the draft letter of offer referred to in sub-regulation (1),
pa: a fee of Rs. 50, 000/- to the Board, either by a banker's cheque or demand draft in
favour of the Securities and Exchange Board of India, payable at Mumbai.
Specified date
19. The public announcement shall specify a date, which shall be the 'specified date' for the
purpose of determining the names of the shareholders to whom the letter of offer should
be set
Provided that such specified date shall not be later than the thirtieth day from the date of
the public announcement.
55
[Offer price.
20. (1) The offer to acquire shares under regulations 10, 11 or 12 shall be made at a price not
low than the price determined as per sub-regulations (4) and (5).
(2) The offer price shall be payable -
(a) in cash ;
(b) by issue, exchange and, or transfer of shares (other than preference shares) of
acquirer company, if the person seeking to acquire the shares is a listed body
corporate; or
(c) by issue, exchange and, or transfer of secured instruments of acquirer company
with a minimum `A' grade rating from a credit rating agency registered with
the Board;
(d) a combination of clause (a), (b) or (c) :
Provided that where the payment has been made in cash to any class of
shareholders for acquiring their shares under any agreement or pursuant to any
acquisition in the open market or in any other manner during the immediately
preceding twelve months from the date of public announcement, the letter of
offer shall provide an option to the shareholders to accept payment either in
cash or by exchange of shares or other secured instruments referred to above:
54
Inserted vide SEBI (Substantial Acquisition of Shares and Takeovers) (Second Amendment)
Regulations 2002 dated 9th September, 2002.
55
[Minimum offer price
20. (1) The offer to acquire the shares under Regulations 10, Regulation 11 or Regulation
12 shall be made at a minimum offer price which shall be payable -
(a) in cash; or
88 (b) by exchange and, or transfer of shares of acquirer company, if the person
seeking to acquire the shares is a listed body corporate; or
Provided further that the mode of payment of consideration may be altered in
 Regulation
case of revision in offer price or size subject to the condition that the amount to be
paid in cash as mentioned in any announcement or the letter of offer is not reduced.
(3) In case the offer price consists of consideration payable in the form of securities issuance
of which requires approval of the shareholders, such approval shall be obtained by the
acquirer within twenty one days from the date of closure of the offer:
Provided that in case the requisite approval is not obtained, the acquirer shall pay the
entire consideration in cash.
(4) For the purposes of sub-regulation (1), the offer price shall be the highest of-
(a) the negotiated price under the agreement referred to in sub-regulation (1) of
regulation 14;
(b) price paid by the acquirer or persons acting in concert with him for acquisition,
if any, including by way of allotment in a public or rights or preferential issue
during the twenty six week period prior to the date of public announcement,
whichever is higher:
(c) the average of the weekly high and low of the closing prices of the shares of
the target company as quoted on the stock exchange where the shares of the
company are most frequently traded during the twenty six weeks or the average
of the daily high and low of the closing prices of the shares as quoted on the
stock exchange where the shares of the company are most frequently traded
during the two weeks preceding the date of public announcement, whichever is
higher.
Explanation:
In case of disinvestment of a Public Sector Undertaking, the relevant date for the calculation of the
55
[contd........... ]
(c) by exchange and/or transfer of secured instruments with a minimum of grade rating
from a credit rating agency;
(d) a combination of clauses (a), (b) or (c).
Provided that where payment has been made in cash to any class of shareholders for acquiring their
shares under any agreement or pursuant to any acquisition in the open market or in any other manner
during the preceding 12 months from the date of public announcement, the offer document shall provide
that the shareholders have the option to accept payment either in cash or by exchange of shares or other
secured instruments referred to above.
(2) For the purposes of sub-regulation (I), the minimum offer price shall be the highest of
(a) the negotiated price under the agreement referred to in sub-regulation (1) of Regulation
I4;
(b) highest price paid by the acquirer or persons acting in concert with him for any
acquisitions, including by way of allotment in a public or rights issue, if any, during the
26 week period prior to the date of public announcement:
(c) the price paid by the acquirer under a preferential allotment made to him or to persons
acting in concert with him, at any time during the twelve month period upto the date of
closure of the offer;
(d) the average of the weekly high and low of the closing prices of the shares of the target
company as quoted on the stock exchange where the shares of the company are most
frequently traded during the 26 weeks preceding the date of public announcement.
[Explanation: In case of disinvestment of Public Sector Undertaking, the relevant date for the calculation
of the average of the weekly high and low of the closing prices of the shares of the Public Sector
Undertaking, as quoted on the stock exchange where its shares are most frequently traded, shall be the
date preceding the date when the Central Government (opens the financial bid)].
(3) Where the shares of the target company are infrequently traded, the offer price shall be
determined by the issuer and the merchant banker taking into account the following factors:
(a) the negotiated price under the agreement referred to in sub-regulation (1) of
Regulation 14;
(b) highest price paid by the acquirer or persons acting in concert with him for acquisitions
including by way of allotment in a public or rights issue, if any, during the twenty six
week period prior to the date of public announcement;
(c) the price paid by the acquirer under a preferential allotment made to him or to
persons acting in concert with him, at any time during the twelve month period upto
the date of closure of the offer; and
(d) other parameters including return on networth, book value of the shares of the target
company, earning per share, price earning multiple vis-à-vis the industry average.
Explanation:
(h) For the purpose of this clause, shares will be deemed to be infrequently traded if
on the stock exchange, the annualized trading turnover in that share during the
preceding 6 calendar months prior to the month in which the public
announcement is made is less than two percent (by number of shares) of the
listed shares. For this purpose, the weighted average number of shares listed
during the said six months period may he taken. 89
average of the weekly or daily high and low of the closing prices of the shares of the Public Sector
Securities market in Undertaking, as quoted on the stock exchange where its shares are most frequently traded, shall be
India the date preceding the date when the Central Government or the State Government opens the
financial bid.
(5) Where the shares of the target company are infrequently traded, the offer price shall be
determined by the acquirer and the merchant banker taking into account the following
factors:
(a) the negotiated price under the agreement referred to in sub-regulation (1) of regulation
14;
(b) the highest price paid by the acquirer or persons acting in concert with him for
acquisitions, if any, including by way of allotment in a public or rights or preferential
issue during the twenty six week period prior to the date of public announcement;
(c) other parameters including return on networth, book value of the shares of the target
company, earning per share, price earning multiple vis-à-vis the industry average:
Provided that where considered necessary, the Board may require valuation of such
55
[cont…………]
[(ia) In case of, disinvestment of Public Sector Undertaking, the shares of such an
undertaking shall be deemed to be infrequently traded if on the stock
exchange the annualized trading turnover in the shares during the preceding
six calendar months prior to the month, in which the Central Government
(opens the financial bid) is less than two per cent (by the number of shares)
of the listed shares. For this purpose the weighted average number of shares
listed during the six months period may be taken].
(ii) In case of shares, which have been listed within six months proceeding the
public announcement, the trading turnover may be annualised with reference
to the actual number of days for which the share has been listed.
[(3A) Notwithstanding anything contained in sub-regulation (3), in case of disinvestment of
Public Sector Undertaking, whose shares are infrequently traded, the minimum offer
price shall be the price paid by the successful bidder to the Central Government,
arrived at after the process of competitive bidding of the Central Government for the
purpose of disinvestment'''.
(4) Notwithstanding the provisions of sub-regulations (1), (2) and (3) above, where the
acquirer has acquired shares in the open market or through negotiation or otherwise,
after the date of public announcement at a price higher than the minim um offer
price stated in the' letter of offer, then the highest price paid for such acquisition
shall be payable for all acceptances received under the offer.
[Provided that no such acquisition shall be made by the acquirer during the last
seven working days prior to the closure of the offer].
(5) In case where shares or secured instruments of the, acquirer company are offered in lieu
of cash payment, the value of such shares or secured instruments shall be determined
in the same manner as mentioned in sub-regulations (2) and (3) above to the extent
applicable, as duly certified by an independent Category I Merchant Banker (other
than the managers to the offer) or an independent Chartered Accountant of 10 years
standing.
(6) The letter of offer shall contain justification on the basis on which the price has been
determined.
Explanation (1) The highest price under clause (h) or the average price under clause (d) of sub-
regulation (2) may be adjusted for quotations, if any, on cum-rights or cum-
bonus (or cum-dividend) basis during the said period.
(2) Where the public announcement of offer is pursuant to acquisition by way of
firm allotment in a public issue or preferential allotment, the average price
under clause (d) of sub-regulation 2 shall be calculated with reference to the 26
week period preceding the date of the board resolution which authorised the
firm, preferential allotment.
(3) Where the shareholders have been provided with an option to accept payment
either in cash or by way of exchange of security then subject to the provisions
of Regulation 20, the pricing for the cash offer could be different from that of a
share exchange offer or offer for exchange with secured instruments, provided
that the disclosures in the offer document contains suitable justification for such
differential pricing.
(4) Where the offer is subject to a minimum level of acceptances, the acquirer may
subject to the provision of Regulation 20, indicate a lower price for the minimum
acceptance of 20%, should the offer not receive full acceptance. ] Substituted
90 vide SEBI (Substantial Acquisition of Shares and Takeovers) (Second
Amendment) Regulations, 2002 dated 9th September, 2002.
 Regulation
infrequently traded shares by an independent merchant banker (other than
the manager to the offer) or an independent chartered accountant of
minimum ten years' standing or a public financial institution.
Explanation
(i) For the purpose of sub-regulation (5), shares shall be deemed to be
infrequently traded if on the stock exchange, the annualised trading turnover
in that share during the preceding six calendar months prior to the month in
which the public announcement is made is less than five per cent. (by
number of shares) of the listed shares. For this purpose, the weighted average
number of shares listed during the said six months period may be taken.
(ii) In case of disinvestment of a Public Sector Undertaking, the shares of such
an undertaking shall be deemed to be infrequently traded, if on the stock
exchange, the annualised trading turnover in the shares during the preceding
six calendar months prior to the month, in which the Central Government or
the State Government as the case may be opens the financial bid, is less than
five per cent. (by the number of shares) of the listed shares. For this purpose,
the weighted average number of shares listed during the six months period
may be taken.
(iii) In case of shares which have been listed within six months preceding the
public announcement, the trading turnover may be annualised with reference
to the actual number of days for which the shares have been listed.
(6) Notwithstanding anything contained in sub-regulation (5), in case of disinvestment of a
Public Sector Undertaking, whose shares are infrequently traded, the minimum offer
price shall be the price paid by the successful bidder to the Central Government or the
State Government, arrived at after the process of competitive bidding of the Central
Government or the State Government for the purpose of disinvestment.
(7) Notwithstanding anything contained in the provisions of sub-regulations (2), (4), (5)
and (6), where the acquirer has acquired shares in the open market or through
negotiation or otherwise, after the date of public announcement at a price higher than
the offer price stated in the letter of offer, then, the highest price paid for such
acquisition shall be payable for all acceptances received under the offer:
Provided that no such acquisition shall be made by the acquirer during the last seven
working days prior to the closure of the offer.
(8) Any payment made to the persons other than the target company in respect of non
compete agreement in excess of twenty five per cent of the offer price arrived at under
sub-regulations (4) or (5) or (6) shall be added to the offer price.
(9) In case where shares or secured instruments of the acquirer company are offered in lieu
of cash payment, the value of such shares or secured instruments shall be determined in
the same manner as specified in sub-regulation (4) or sub-regulation (5) to the extent
applicable, as duly certified by an independent merchant banker (other than the manager
to the offer) or an independent chartered accountant of a minimum ten years standing or
a public financial institution.
(10) The offer price for partly paid up shares shall be calculated as the difference between
the offer price and the amount due towards calls-in-arrears or calls remaining unpaid
together with interest, if any, payable on the amount called up but remaining unpaid.
(11) The letter of offer shall contain justification or the basis on which the price has been
determined.
Explanation:
(i) The highest price under clause (b) or the average price under clause (c) of sub-
regulation (4) may be adjusted for quotations, if any, on cum-rights or cum-bonus
or cum-dividend basis during the said period.
(ii) Where the public announcement of offer is pursuant to acquisition by way of firm
allotment in a public issue or preferential allotment, the average price under
clause (c) of sub-regulation (4) shall be calculated with reference to twenty six
week period preceding the date of the board resolution which authorised the firm 91
allotment or preferential allotment.
Securities market in (iii) Where the shareholders have been provided with an option to accept payment either
India in cash or by way of exchange of security, the pricing for the cash offer could be
different from that of a share exchange offer or offer for exchange with secured
instruments provided that the disclosures in the letter of offer contains suitable
justification for such differential pricing and the pricing is subject to other provisions
of this regulation.
(iv) Where the offer is subject to a minimum level of acceptance, the acquirer may,
subject t the other provisions of this regulation, indicate a lower price for the
minimum acceptance upto twenty per cent should the offer not receive full
acceptance.
(12) The offer price for indirect acquisition or control shall be determined with reference to the date
of the public announcement for the parent company and the date of the public announcement
for acquisition of shares of the target company, whichever is higher, in accordance with sub-
regulation (4) or sub-regulation (5)].
56
[Acquisition price under creeping acquisition.
“20A. (1) An acquirer who has made a public offer and seeks to acquire further shares under sub-
regulation (1) of regulation 11 shall not acquire such shares during the period of 6
month from the date of closure of the public offer at a price higher than the offer price.
(2) Sub-regulation (1) shall not apply where the acquisition is made through the stock
exchanges].
Minimum number of shares to be acquired
57
[21. (1) The public offer made by the acquirer to the shareholders of the target company shall I for
a minimum twenty per cent of the voting capital of the company].
58
[(2)].
(3) If the public offer results in the public shareholding being reduced to 10% or less of the
voting capital of the company, or if the public offer is in respect of a company which hi
public shareholding of less than 10% of the voting capital of the company, the acquirer
shall either,
59
[(a) make an offer to buy the outstanding shares remaining with the shareholders in
accordance with the Guidelines specified by the Board in respect of Delisting of
Securities; or]
(b) undertake to disinvest through an offer for sale or by a fresh issue of capital to
the public, which shall open within a period of 6 months from the date of closure
of the public offer, such number of shares so as to satisfy the listing
requirements.
(4) The letter of offer shall state clearly the option available to the acquirer under sub-regulation
(.
(5) For the purpose of computing the percentage referred to sub-regulation (1), (2) and (3) the
voting rights as at the expiration of 30 days after the closure of the public offer shall be
reckoned.
(6) Where the number of shares offered for sale by the shareholders are more than the shares
ogre to be acquired by the person making the offer, such person shall, accept the offers
received from
56
Inserted vide SEBI (Substantial Acquisition of Shares and Takeovers) (Second Amendment)
Regulation 2002 dated 9th September, 2002.
57
The sub-regulation (I) and proviso which read as [(1) The public offer shall be made to the
shareholder of the target company to acquire from them an aggregate minimum of 20% of the
voting capital of I company. Provided that where the open offer is made in pursuance to sub-
regulation (2) of Regulation 11, the public offer shall be for such percentage of the voting capital
of the company as may be decided by the acquirer]. Substituted vide SEBI (Substantial
Acquisition of Shares and Takeovers) (Second Amendment) Regulations, 2002 dated 9th
September, 2002.
58
The earlier sub-regulation [(2) Where the offer is conditional upon minimum level of acceptances
from the shareholders as provided for in clause (xviii) of Regulation 16, the provisions of sub-
regulation (I this regulation shall not be applicable, if the acquirer has deposited in the escrow
account in cash a sum of 50% of the consideration payable under the public offer]. Omitted vide
SEBI (Substantial Acquisition of Shares and Takeovers) (Second Amendment) Regulations, 2002
dated 9th September, 2002.
59
The earlier clause [(a) within a period of 3 months from the date of closure of the public offer,
make an offer to buy out the outstanding shares remaining with the shareholders at the same offer
92 price, which may result in de-listing of the target company; or] Substituted vide SEBI
(Substantial Acquisition of Shares and Takeovers) (Second Amendment) Regulations, 2002 dated
9th September, 2002.
 Regulation
the shareholders on a proportional basis, in consultation with the merchant banker,
taking care to ensure that the basis of acceptance is decided in a fair and equitable
manner and does not result in non-marketable lots.
Provided that acquisition of shares from a shareholder shall not be less than the
minimum marketable lot or the entire holding if it is less than the marketable lot.
60
[Offer conditional upon level of acceptance.
2IA. (1) Subject to the provisions of sub-regulation (8) of regulation 22, an acquirer
or any person acting in concert with him may make an offer conditional as
to the level of acceptance which may be less than twenty per cent:
Provided that where the public offer is in pursuance of a Memorandum of
Understanding, the Memorandum of Understanding shall contain a
condition to the effect that in case the desired level of acceptance is not
received the acquirer shall not acquire any shares under the Memorandum
of Understanding and shall rescind the offer].
General Obligations of the acquirer
22. (1) The public announcement of offer to acquire the shares of the target company
shall be made only when the acquirer is able to implement the offer.
(2) Within 14 days of the public announcement of the offer, the acquirer shall
send a copy of the draft letter of offer to the target company at its registered
office address, for being placed before the board of directors and to all the
stock exchanges where the shares of the company are listed.
(3) The acquirer shall ensure that the letter of offer is sent to all the shareholders
(including non-resident Indians) of the target company, whose names appear
on the register of members of the company as on the specified date
mentioned in the public announcement. so as to reach them within 45 days
from the date of public announcement.
Provided that where the public announcement is made pursuant to an
agreement to acquire shares or control over the target company, the letter of
offer shall be sent to shareholders other than the parties to the agreement.
Explanation (i) A copy of the letter of offer shall also be sent to the
Custodians of Global Depository Receipts or American
Depository Receipts to enable such persons to participate in
the open offer, if they are entitled to do so.
(ii) A copy of the letter of offer shall also be sent to warrant
holders or convertible debenture holders, where the period of
exercise of option or conversion falls within the offer period.
(4) The date of opening of the offer shall be not later than the sixtieth day from the
date of public announcement.
(5) The offer to acquire shares from the shareholders shall remain open for a period
of 30 days.
61
[(5A) The shareholder shall have the option to withdraw acceptance tendered
by him upto three working days prior to the date of closure of the offer].
(6) In case the acquirer is a company, the public announcement of offer, brochure,
circular, letter of offer or any other advertisement or publicity material issued to
shareholders in connection with the offer must state that the directors accept the
responsibility for the information contained in such documents.
Provided that if any of the directors desires to exempt himself from responsibility
for the information in such document, such director shall issue a statement to that
effect, together with reasons thereof for such statement.
(7) During the offer period, the acquirer or persons acting in concert with him shall
not be entitled to be appointed on the board of directors of the target company.
60
Inserted vide SEB1 (Substantial Acquisition of Shares and Takeovers) (Second
Amendment) Regulations, 2002 dated 9th September, 2002.
61
Inserted vide SEBI (Substantial Acquisition of Shares and Takeovers) (Second
Amendment) Regulations, 2002 dated 9th September, 2002. 93
 62
Securities market in *[Provided that in case of acquisition of shares or voting rights or control of a Public
India Sect( Undertaking pursuant to a public announcement made under the proviso to
sub-regulation Regulation 14, the provisions of sub-regulation (8) of Regulation 23
shall be applicable].
63
[Provided further that where the acquirer, other than the acquirer who has made an
offer under regulation 21 A, after assuming full acceptances, has deposited in the
escrow account hundred per cent of the consideration payable in cash where the
consideration payable is in cash am the form of securities where the consideration
payable is by way of issue, exchange or trans of securities or combination thereof,
he may be entitled to be appointed on the Board of Directors of the target company
after a period of twenty one days from the date of public announcement].
(8) Where an offer is made conditional upon minimum level of acceptances, the acquirer
or any person acting in concert with him -
(i) shall, irrespective of whether or not the offer received response to the minimum
level of acceptances, acquire shares from the public to the extent of the minimum
percentage specified in sub-regulation (1) of Regulation 21.
Provided that the provisions of this clause shall not be applicable in case the
acquirer has deposited in the escrow account, in cash, 50% of the consideration
payable under the public offer.
(ii) shall not acquire, during the offer period, any shares in the target company, except
by way of fresh issue of shares of the target company, as provided for under
Regulation 3:
(iii) shall be liable for penalty of forfeiture of entire escrow amount, for the non-
fulfilment of obligations under the Regulations;
(9) If any of the persons representing or having interest in the acquirer is already a
director on the ( board of the target company or is an "insider" within the meaning of
Securities and Exchange Board of India (Insider Trading) Regulations, 1992, he shall
recluse himself and not participate in any matter(s) concerning or 'relating' to the
offer including any preparatory steps leading to the offer.
(10) On or before the date of issue of public announcement of offer, the acquirer shall
create an escrow account as provided under Regulation 28.
(11) The acquirer shall ensure that firm financial arrangements has been made for
fulfilling the obligations under the public offer and suitable disclosures in this regard
shall be made in the public announcement of offer.
(12) The acquirer shall, within a period of 30 days from the date of the closure of the
offer, complete procedures relating to the offer including payment of consideration to
the shareholders who ha accepted the offer and for the purpose open a special
account as provided under Regulation 2;
Provided that where the acquirer is unable to make the payment to the shareholders
who have accepted the offer before the said period of 30 days due to non-receipt of
requisite statutory approvals, the Board may, if satisfied that non-receipt of requisite
statutory approvals was not due to any wilful default or neglect of the acquirer or
failure of the acquirer to diligently purse( the applications for such approvals, grant
extension of time for the purpose, subject to the acquirer agreeing to pay interest to
the shareholders for delay beyond 30 days, as may be specified by the Board from
time to time.
(12) Where the acquirer fails to obtain the requisite statutory approvals in time on account
of wilful default or neglect or inaction or non-action on his part, the amount lying in
the escrow account shall be liable to be forfeited and dealt with in the manner
provided in clause (e) of sub regulation 12 of Regulation 28, apart from the acquirer
being liable for penalty as provided in t Regulations.
(14) In the event of withdrawal of offer in terms of the Regulations, the acquirer shall not
make any offer for acquisition of shares of the target company for a period of six
months from the date o public announcement of withdrawal of offer.
62
Proviso inserted by the SEBI (Substantial Acquisition of Shares and Takeovers) (Second
Amendment) Regulations, 2001 published in the official Gazette of India dated
12.09.2001.
94 63
Inserted vide SEBI (Substantial Acquisition of Shares and Takeovers) (Second
Amendment) Regulations 2002 dated 9th September, 2002.
 Regulation
(15) In the event of non-fulfilment of obligations under Chapter III or Chapter IV of the
Regulations, the acquirer shall not make any offer for acquisition of shares of any listed
company for a period of twelve months from the date of closure of offer.
(16) If the acquirer, in pursuance to an agreement, acquires shards which along with his
existing holding, if any, increases his share holding beyond 64*[15%], then such an
agreement for sale of shares shall contain a clause to the effect that in case of non-
compliance of any provisions of this regulation, the agreement for such sale shall not be
acted upon by the seller or the acquirer.
65
*[Provided that in case of acquisition of shares of a Public Sector Undertaking pursuant
to a public announcement made under the Regulations, the provisions of sub-regulation
(8) of Regulation 23 shall be applicable].
66
[(17) Where the acquirer or persons acting in concert with him has acquired any shares in
terms of sub-regulation (7) of regulation 20 at a price equal to or less or more than the
offer price, he shall disclose the number, percentage, price and the mode of acquisition of
such shares to the stock exchanges on which the shares of the target company are listed
and to the merchant banker within 24 hours of such acquisition and the stock exchanges
shall forthwith disseminate such information to the public].
(18) Where the acquirer has not either, in the public announcement, and, or in the letter of
offer, stated his intention to dispose of or otherwise encumber any assets of the target
company except in the ordinary course of business of the target company, the acquirer,
where he has acquired control over the target company shall be debarred from disposing
of or otherwise encumbering the assets of the target company for a period of 2 years from
the date of closure of the public offer.
67
[(19) The acquirer and the persons acting in concert with him shall be jointly and severally
responsible for fulfilment of obligations under these Regulations].
General Obligations of the board of directors of the target company
23. (1) Unless the approval of the general body of shareholders is obtained after the date of
the public announcement of offer, the board of directors of the target company shall
not, during the offer period, -
(a) sell, transfer, encumber or otherwise dispose of or enter into an agreement for
sale, transfer, encumbrance or for disposal of assets otherwise, not being sale or
disposal of assets in the ordinary course of business, of the company or its
subsidiaries; or
(b) issue 68[or allot] any authorised but unissued securities carrying voting rights
during the offer period; or
(c) enter into any material contracts.
69
[Explanation : Restriction on issue of securities under clause (b) of sub-
regulation (1) shall not affect
(i) the right of the target company to issue or allot shares carrying voting
rights upon conversion of debentures already issued or upon exercise of
option
64
Substituted for "10" by SEBI (Substantial Acquisition of Shares and Takeovers)
(Amendment) Regulations, 1998 published in the official Gazette of India dated 28.10.98.
65
Proviso inserted by the SEBI (Substantial Acquisition of Shares and Takeovers)
(Amendment) Regulations, 2001 published in the official Gazette of India dated 17.08.2001.
66
Earlier sub-regulation 17 which read as [(17) Where the acquirer or persons acting in concert
with him has acquired any shares 27*[in terms of sub- regulation (4) of regulation 20] he,
shall disclose the number, percentage, price and the mode of acquisition of such shares to the
stock exchanges on which the shares of the target company are listed and to the merchant
banker, within 24 hours of such acquisition. Substituted vide SEBI (Substantial Acquisition
of Shares and Takeovers) (Second Amendment) Regulations, 2002 dated 9th September,
2002.
67
Inserted vide SEBI (Substantial Acquisition of Shares and Takeovers) (Second Amendment)
Regulations, 2002 dated 9th. September, 2002.
68
Inserted vide SEBI (Substantial Acquisition of Shares and Takeovers) (Second Amendment)
Regulations, 2002 dated 9th September, 2002.
69
The earlier Explanation read as [Explanation: Restriction on issue of securities under clause
(h) of sub-regulation (1) shall not affect the right of the target company to issue and allot
shares carrying voting rights upon conversion of debentures already issued or upon exercise
of option against warrants, as per pre-determined terms of conversion/ exercise of option]. 95
Substituted vide SEBI (Substantial Acquisition of Shares and Takeovers) (Second
Amendment) Regulations, 2002 dated 9th September, 2002.
Securities market in against warrants, as per pre-determined terms of conversion or exercise of in India
India option.
(ii) issue or allotment of shares pursuant to public or rights issue in respect of
which the offer document has already been filed with the Registrar of
Companies or Stock Exchanges, as the case may be].
(2) The target company shall furnish to the acquirer, within 7 days of the request of the
acquirer of within 7 days from the specified date, whichever is later, a list of
shareholders or warrant holders or convertible debenture holders as are eligible for
participation under Explanation (ii) to sub-regulation (3) of Regulation 22 containing
names, addresses, shareholding and folio number and of those persons whose
applications for registration of transfer of shares are pending with the company.
(3) Once the public announcement has been made, the board of directors of the target
company shall not,
(a) appoint as additional director or fill in any casual vacancy on the board of directors,
by. an. person(s) representing or having interest in the acquirer, till the date of
certification by the merchant banker as provided under sub-regulation (6) below.
Provided that upon closure of the offer and the full amount of consideration payable
to the shareholders being deposited in the special account, changes as would give
the acquirer representation on the Board or control over the company, can be made
by the target company.
(b) allow any person or persons representing or having interest in the acquirer, if he is
already a director on the board of the target company before the date of the public
announcement, to participate in any matter relating to the offer, including any
preparatory steps leading thereto.
(4) The board of directors of the target company may, if they so desire, send their unbiased
comments and recommendations on the offer(s) to the shareholders, keeping in mind the
fiduciary responsibility of the directors to the shareholders and for the purpose seek the
opinion of an independent merchant banker or a Committee of Independent Directors;
Provided that for any misstatement or for concealment of material information, the
directors shall be liable for action in terms of these Regulations and the Act.
(5) The board of directors of the target company shall facilitate the acquirer in verification of
securities tendered for acceptances.
(6) Upon fulfilment of all obligations by the acquirers under the Regulations as certified by
the merchant banker, the board of directors of the target company shall transfer the
securities acquired by the acquirer, whether under the agreement or from open market
purchases, in the name of the acquirer and, or allow such changes in the board of directors
as would give the acquirer representation on the board or control over the company.
(7) The obligations provided for in sub-regulation (16) of regulation 22 shall be complied
with by the company in the circumstances specified therein.
70
*[(8) The restrictions
(a) for appointment of directors on :he Board of a target company by the acquirer under
sub-regulation (7) of Regulation 22.
(b) for acting on agreement for under sub-regulation (16) of Regulation 22;
(c) for appointment of directors by the target company under clause (a) of sub-
regulation 3 of this Regulation; and
70
Sub-regulation 8 inserted by the SEBI (Substantial Acquisition of Shares and Takeovers)
(Second Amendment) Regulations, 2001 published in the official Gazette of India dated
12.09.2001.
“(8) The obligations provided for in the proviso to clause (a) of sub-regulation (3) and
sub-regulation (6) of this regulation, shall not be applicable where the agreement to
sell shares of a Public Sector Undertaking contains a clause to the effect that in case
of non-compliance of any of the provisions of the Regulations, the shares or the
control of the Public Sector Undertaking shall revert back to the Central Government
and the acquirers shall be liable to such penalty as may be imposed by the Central
Government."
The above sub-regulation (8) was inserted by the SEBI (Substantial Acquisition of
96 Shares and Takeovers) (Amendment) Regulations, 2001 published in the official
Gazette of India dated 17.08.2001.
 Regulation
(d) for on transfer of securities or changes in the Board of Directors of the target
company under sub-regulation (6) of this Regulation, shall not be applicable, in case
of sale of shares of a Public Sector Undertaking by the Central Government 71[or the
State Government], and the agreement to sell contains a clause to the effect that in
case of non-compliance of any of the provisions of the Regulations by the acquirer,
transfer of shares or change of management or control of Public Sector Undertaking
shall vest back with the Central Government 71[or the State Government] and the
acquirer shall be liable to such penalty as may be imposed by the Central Government
71
[or the State Government]. ]
General obligations of the merchant banker
24. (1) Before the public announcement of offer is made, the merchant banker shall ensure
that-
(a) the acquirer is able to implement the offer;
(b) the provision relating to escrow account referred to in Regulation 28 has been
made;
(c) firm arrangements for funds and money for payment through verifiable means to
fulfil the obligations under the offer are in place;
(d) the public announcement of offer is made in terms of the Regulations.
(2) The merchant banker shall furnish to the Board a due diligence certificate which shall
accompany the draft letter of offer.
(3) The merchant banker shall ensure that the 72[*] public announcement and the letter of
offer is filed with the Board, target company and also sent to all the stock exchanges
on which the shares of the target company are listed in accordance with the
Regulations.
(4) The merchant banker shall ensure that the contents of the public announcement of
offer as well as the letter of offer are true, fair and adequate and based on reliable
sources, quoting the source wherever necessary.
(5) The merchant banker shall ensure compliance of the Regulations and any other laws
or rules as may be applicable in this regard.
(6) Upon fulfilment of all obligations by the acquirers under the Regulations, the
merchant banker shall cause the bank with whom the escrow amount has been
deposited to release the balance amount to the acquirers.
(7) The merchant banker shall send a final report to the Board within 45 days from the
date of closure of the offer
Competitive bid
25. (1) Any person, other than the acquirer who has made the first public announcement, who
is desirous of making any offer shall, within 21 days of the public announcement of
the first offer, make a public announcement of his offer for acquisition of the shares
of the same target company.
Explanation: An offer made under sub-regulation (1) shall be deemed to be a
competitive bid.
(2) No public announcement for an offer or competitive bid shall be made after
21 days from the date of public announcement of the first offer.
73
*[ (2A)No public announcement for a competitive bid shall be made after
an acquirer has already made the public announcement under the proviso to
sub-regulation (1) of
71
The words [or the State Government] inserted vide SEBI (Substantial Acquisition of Shares
and Takeovers) (Second Amendment) Regulations, 2002 dated 9th September, 2002.
72
The word [draft] omitted vide SEBI (Substantial Acquisition of Shares and Takeovers)
(Second Amendment) Regulations, 2002 dated 9th September, 2002.
73
Substituted for the following by the SEBI Substantial Acquisition of Shares and Takeovers)
(Second Amendment) Regulations, 2001 published in the official Gazette of India dated
12.09.2001.
“(2A) No public announcement for a competitive bid shall be made after an acquirer
has already made the public announcement under the proviso to sub-regulation (1) of
Regulation 14 pursuant to entering into a Share Purchase or Shareholders' Agreement
with the Central Government for acquisition of shares or voting rights or control of a
Public Sector Undertaking."
The above sub-regulation (2A) was inserted by the SEBI (Substantial Acquisition of Shares 97
and Takeovers) (Amendment) Regulations, 2001 published in the official Gazette of India
dated 17.08.2001.
Securities market in Regulation 14 pursuant to entering into a Share Purchase or Shareholders Agreement with the
India Central Government 74[or the State Government as the case may be], for acquisition shares or
voting rights or control of a Public Sector Undertaking].
(3) Any competitive offer by an acquirer shall be for such number of shares which, when
taken together with shares held by him along with persons acting in concert with him,
shall be 75[at least equal to the holding of the first bidder including the number of shares
for which the present offer by the first bidder has been made].
(4) Upon the public announcement of a competitive bid or bids, the acquirer(s) who had
made the public announcement(s) of the earlier offer(s), shall have the option to 76[make
an announcement revising the offer].
Provided that if no such announcement is made within fourteen days of the
announcement of the competitive bid(s), the earlier offer(s) on the original terms shall
continue to be valid and binding on the acquirer(s) who had made the offer(s) except
that the date of closing t the offer shall stand extended to the date of closure of the
public offer under the last subsisting competitive bid.
(5) The provisions of these Regulations shall mutatis mutandis apply to the competitive
bid(s) made under sub-regulation (1).
(6) The acquirers who have made the public announcement of offer(s) including the public
announcement of competitive bid(s) 77[*] shall have the option to make upward
revisions in his offer(s), in respect to the price and the number of shares to be acquired,
at any time upto seven working days prior to the date of closure of the offer:
Provided that the acquirer shall not have the option to change any other terms and
condition of their offer 78[except the mode of payment following an upward revision in
offer].
Provided further that any such upward revision shall be made only upon the acquirer,
-
(a) making a public announcement in respect of such changes or amendments in
all the newspapers in which the original public announcement was made;
(b) simultaneously with the issue of public announcement referred in clause (a),
informing the Board, all the stock exchanges on which the shares of the
company are listed, and the target company at its registered office;
(c) increasing the value of the escrow account as provided under sub-regulation
(9) of Regulation 28.
(7) Where there is a competitive bid, the date of closure of the original bid as also the
date of closure of all the subsequent competitive bids shall be the date of closure of
public offer under the last subsisting competitive bid and the public offers under all
the subsisting bids shall close on the same date.
Upward Revision of Offer
26. Irrespective of whether or not there is a competitive bid, the acquirer who has made the
public announcement of offer, may make upward revisions in his offer in respect to the
price and the number of shares to be acquired, at anytime upto seven working days prior
to the date of the closure of the offer.
Provided that any such upward revision of offer shall be made only upon the acquirer -
74
The words [or the State Government as the case may be] inserted vide SEBI (Substantial
Acquisition of Shares and Takeovers) (Second Amendment) Regulations, 2002 dated 9th
September, 2002.
75
Substituted for the words ["at least equal to the number of shares for which the first public
announcement has been made"] vide SEBI (Substantial Acquisition of Shares and
Takeovers) (Second Amendment) Regulations, 2002 dated 9th September, 2002.
76
[make an announcement:-
(a) revising the offer; or
(b) withdrawing the offer, with the prior approval of the Board]. Substituted vide SEBI
(Substantial Acquisition of Shares and Takeovers) (Second Amendment) Regulations, 2002
dated 9th September, 2002.
77
The words [but have not withdrawn the offer in terms of sub-regulation (4)] Omitted vide
SEBI (Substantial Acquisition of Shares and Takeovers) (Second Amendment) Regulations,
98 2002 dated 9th September, 2002.
78
Inserted vide SEBI (Substantial Acquisition of Shares and Takeovers) (Second Amendment)
Regulations, 2002 dated 9th September, 2002.
 Regulation
(a) making a public announcement in respect of such changes or amendments
in all the newspapers in which the original public announcement was made;
(b) simultaneously with the issue of such public announcement, informing the
Board, all the stock exchanges on which the shares of the company are
listed, and the target company at its registered office.
(c) increasing the value of the escrow account as provided under sub-
regulation (9) of Regulation 28.
Withdrawal of Offer
27. (1) No public offer, once made, shall be withdrawn except under the following
circumstances:-
79
[(a)]
(b) the statutory approval(s) required have been refused;
(c) the sole acquirer, being a natural person, has died;
(d) such circumstances as in the opinion of the Board merits withdrawal.
(2) In the event of withdrawal of the offer under any of the circumstances specified
under sub-regulation (1), the acquirer or the merchant banker shall:
(a) make a public announcement in the same newspapers in which the
public announcement of offer was published, indicating reasons for
withdrawal of the offer.
(b) simultaneously with the issue of such public announcement, inform -
(i) the Board;
(ii) all the stock exchanges on which the shares of the company are
listed; and
(iii) the target company at its registered office.
Provision of Escrow
28. (1) The acquirer shall as and by way of security for performance of his
obligations under the Regulations, deposit in an escrow account such sum
as specified in sub-regulation (2).
(2) The escrow amount shall be calculated in the following manner, -
(a) For consideration payable under the public offer, - upto and
including Rs.100 crores - 25%; exceeding Rs.100 crores - 25% upto
Rs.100 crores and 10% thereafter.
(b) For offers which are subject to a minimum level of acceptance, and
the acquirer does not want to acquire a minimum of 20%, then 50%
of the consideration payable under the public offer in cash shall be
deposited in the escrow amount.
(3) The total consideration payable under the public offer shall be calculated
assuming full acceptances and at the highest price if the offer is subject to
differential pricing, irrespective of whether the consideration for the offer
is payable in cash or otherwise.
(4) The escrow account referred in sub-regulation (1) shall consist of, -
(a) cash deposited with a scheduled commercial bank ; or
(b) bank guarantee in favour of the merchant banker; or
(c) deposit of acceptable securities with appropriate margin, with the
merchant banker; or
(d) cash, deposited with a scheduled commercial bank in case of clause
(b) of sub-regulation (2) of this Regulation.
79
The earlier clause which read as [(a) the withdrawal is consequent upon any
competitive bid; Omitted vide SEBI (Substantial Acquisition of Shares and 99
Takeovers) (Second Amendment) Regulations, 2002 dated 9th September, 2002.
Securities market in (5) Where the escrow account consists of deposit with a scheduled commercial bank, the
India acquirer shall, while opening the account, empower the merchant banker appointed
for offer to instruct the bank to issue a banker's cheque or demand draft for the
amount lying to the credit of the escrow account, as provided in the Regulations.
(6) Where the escrow account consists of bank guarantee, such bank guarantee shall be
in favour of the merchant banker and shall be valid atleast for a period commencing
from date of public announcement until 30 days after the closure of the offer.
(7) The acquirer shall, in case the escrow account consists of securities empower the
mere banker to realise the value of such escrow account by sale or otherwise
provided that is there is any deficit on realisation of the value of the securities, the
merchant banker shall liable to make good any such deficit.
(8) In case the escrow account consists of bank guarantee or approved securities, these
shall not be returned by the merchant banker till after completion of all obligations
under the Regulations.
(9) In case there is any upward revision of offer, consequent upon a competitive bid or
otherwise, the value of the escrow account shall be increased to equal at least 10% of
the consideration payable upon such revision.
(10) Where the escrow account consist of bank guarantee or deposit of approved
securities, acquirer shall also deposit with the bank a sum of at least 1% of the total
consideration payable, as and by way of security for fulfilment of the obligations
under the Regulation by the acquirers.
(11) The Board shall in case of non-fulfilment of obligations under the Regulations by the
acquirer forfeit the escrow account either in full or in part.
80
[( 11A) In case of failure by the acquirer to obtain shareholders' approval required
under sub-regulation (3) of regulation 20, the amount in escrow account may be
forfeited].
(12) The escrow account deposited with the bank in cash shall be released only in the
follow( manner,
(a) the entire amount to the acquirer upon withdrawal of offer in terms of
Regulation upon certification by the merchant banker;
(b) for transfer to the special account opened in terms of sub-regulation (1) of
Regulation 29.
Provided the amount so transferred shall not exceed 90% of the cash deposit
made under clause (a) of sub-regulation (2) of this regulation.
(c) to the acquirer, the balance of 10 per cent of the cash deposit made under
clause (a) of sub-Regulation (2) of this Regulation or the cash deposit made
under sub-Regulation 81[(10)] of this Regulation, on completion of all
obligations under the Regulations, and upon certification by the merchant
banker;
(d) the entire amount to the acquirer upon completion of all obligations under the
Regulations, upon certification by the merchant banker, where the offer is for
exchange of shares or other secured instruments;
(e) the entire amount to the merchant banker, in the event of forfeiture for non-
fulfilment of any of the obligations under the Regulations, for distribution
among the target company, the regional stock exchange and to the
shareholders who had accepted the offer in the following manner, after
deduction of expenses, if any, of the merchant banker and the registrars to the
offer, -
(i) one third of the amount to the target company;
(ii) one third of the amount to the regional stock exchange for credit of the
investor protection fund or any other similar fund for investor education,
research, grievance redressal and similar such purposes as may be
specified by the Boat from time to time;
80
Inserted vide SEBI (Substantial Acquisition of Shares and Takeovers) (Second Amendment)
Regulation 2002 date 9th September, 2002,
100
81
'The earlier bracket and figure [(8)] Substituted vide SE131 (Substantial Acquisition of
Shares and Takeovers) (Second Amendment) Regulations, 2002 dated 9th September, 2002.
 Regulation
(iii) residual one third to be distributed pro-rata among the shareholders who
have accepted the offer.
(13) In the event of non-fulfilment of obligations by the acquirer, the merchant
banker shall ensure realisation of escrow amount by way of foreclosure of
deposit, invocation of bank guarantee or sale of securities and credit proceeds
thereof to the regional stock exchange of the target company, for the credit of
the Investor Protection Fund or any other similar fund.
Payment of consideration
29. (1) For the amount of consideration payable in cash, the acquirer shall, within a
period of 21 days from the date of closure of the offer, open a special account
with a Bankers to an Issue registered with the Board and deposit therein, such
sum as would, together with 90% of the amount lying in the escrow account,
if any, make up the entire sum due and payable to the shareholders as
consideration for acceptances received and accepted in terms of these
Regulations and for this purpose, transfer the funds from the escrow account.
(2) The unclaimed balance lying to the credit of the account referred in sub-
regulation (1) at the end of 3 years from the date of deposit thereof shall be
transferred to the investor protection fund of the regional stock exchange of
the target company.
(3) In respect of consideration payable by way of exchange of securities, the
acquirer shall ensure that the securities are actually issued and despatched to
the shareholders.

101
Securities market in
India
CHAPTER IV : BAIL OUT TAKEOVERS
Bail out takeovers

30. (1) The provisions of this Chapter shall apply to a substantial acquisition of shares in a
financially weak company not being a sick industrial company, in pursuance to a
scheme of rehabilitation approved by a public financial institution or a scheduled
bank; (hereinafter referred to as lead institution).
(2) The lead institution shall be responsible for ensuring compliance with the provisions
this Chapter.
(3) The lead institution shall appraise the financially weak company taking into account
financial viability, and assess the requirement of funds for revival and draw up the
rehabilitation package on the principle of protection of interests of minority
shareholder good management, effective revival and transparency.
(4) The rehabilitation scheme shall also specifically provide the details of any change in
management.
(5) The scheme may provide for acquisition of shares in the financially weak company
in of the following manner:
(a) outright purchase of shares, or
(b) exchange of shares, or
(c) combination of both.
Provided that the scheme as far as possible may ensure that after the proposed
acquisition the erstwhile promoters do not own any shares in case such acquisition is
made by the new promoters pursuant to such scheme.
Explanation: For the purpose of this chapter, the expression "financially weak
company” means a company, which has at the end of the previous financial year
accumulated fosse which has resulted in erosion of more than 50% but less than
100% of its networth as at the beginning of the previous financial year, that is to say,
of the sum total of the paid-up capital and free reserves.
Manner of acquisition of shares
31. (1) Before giving effect to any scheme of rehabilitation the lead institution shall invite
offers for acquisition of shares from atleast three parties.
(2) After receipt of the offers under sub-regulation (1), the lead institution shall select
one o the parties having regard to the managerial competence, adequacy of financial
resources and technical capability of the person acquiring shares to rehabilitate the
financially weal company.
(3) The lead institution shall provide necessary information to any person intending to
make an offer to acquire shares about the financially weak company and particularly
in relation to its present management, technology, range of products manufactured,
shareholding pattern, financial holding and performance and assets and liabilities of
such company for period covering five years from the date of the offer as also the
minimum financial and other commitments expected of from the person acquiring
shares for such rehabilitation.
Manner of evaluation of bids
32. (1) The lead institution shall evaluate the bids received with respect to the purchase
price or exchange of shares, track record, financial resources, reputation of the
management of the person acquiring shares and ensure fairness and transparency in
the process.
(2) After making evaluation as provided in sub-regulation (1), the offers received shall
be listed in order of preference and after consultation with the persons in the affairs
of the management of the financially weak company accept one of the bids.
Person acquiring shares to make an offer

33. The person acquiring shares who has been identified by the lead institution under sub-
regulation (2) of Regulation 32, shall on receipt of a communication in this behalf from
the lead institution make a formal offer to acquire shares from the promoters or persons in
102 charge of the affairs of the management of the financially weak company, financial
institutions and also other shareholders of the company at a price determined by mutual
negotiation between the person acquiring the shares and the lead institution.
 Regulation
Explanation: Nothing in this regulation shall prohibit the lead institution offering the
shareholdings held by it in the financially weak company as part of the scheme of
rehabilitation.
Person acquiring shares to make public announcement
34. (1) The person acquiring shares from the promoters or the persons in charge of the
management of the affairs of the financially weak company or the financial institution
shall make a public announcement of his intention for acquisition of shares from the
other shareholders of the company.
(2) Such public announcement shall contain relevant details about the offer including the
information about the identity and background of the person acquiring shares, number
and percentage of shares proposed to be acquired, offer price, the specified date, the
date of opening of the offer and the period for which the offer shall be kept open and
such other particulars as may be required by the board.
(3) The letter of offer shall be forwarded to each of the shareholders other than the
promoters or the persons in charge of management of the financially weak company
and the financial institutions.
(4) If the offer referred to in sub-regulation (1) results in the public shareholding being
reduced to 10% or less of the voting capital of the company, the acquirer shall either
(a) within a period of three months from the date of closure of the public offer,
make an offer to buy out the outstanding shares remaining with the
shareholders at the same offer price, which may have the effect of delisting the
target company; OR
(b) undertake to disinvest through an offer for sale or by a fresh issue of capital to
the public which shall open within a period of 6 months from the date of
closure of public offer, such number of shares so as to satisfy the listing
requirements.
(5) The letter of offer shall state clearly the option available to the acquirer under sub-
regulation (4).
(6) For the purposes of computing the percentage referred to in the sub-
regulation (4), the voting rights as at the expiration of thirty days after the
closure of the public offer shall be reckoned.
(7) While accepting the offer from the shareholders other than the promoters or
persons in charge of the financially weak company or the financial
institutions, the person acquiring shares shall offer to acquire from the
individual shareholder his entire holdings if such holding is upto hundred
shares of the face value of rupees ten each or ten shares of the face value of
rupees hundred each.
Competitive Bid
35. No person shall make a competitive bid for acquisition of shares of the financially weak
company once ,the lead institution has evaluated the bid and accepted the bid of the
acquirer who has made the public announcement of offer for acquisition of shares from
the shareholders other than the promoters or the persons in charge of the management of
the financially weak company.
Exemption from the operations of Chapter III
36. (1) Every offer which has been made in pursuance of Regulation 30 shall be accompanied
with an application to the Board for exempting such acquisitions from the provisions
of Chapter III of these Regulations.
(2) For considering such request the Board may call for such information from the
company as also from the lead institution, in relation to the manner of vetting the
offers, evaluation of such offers and similar other matters.
(3) Notwithstanding grant of exemption by the board, the lead institution or the acquirer
as far as may be possible, shall adhere to the time limits specified for various
activities for public offer specified in Chapter III.
Acquisition of shares by a state level public financial institution
37. Where proposals for acquisition of shares in respect of a financially weak company is
made by a state level public financial institution, the provisions of these Regulations in so
far as they relate to scheme of rehabilitation prepared by a public financial institution,
shall apply except that in such a case the Industrial Development Bank of India, a
corporation established under the Industrial Development Bank of India Act, 1964 shall be
the agency for ensuring the compliance of these Regulations for acquisition of shares in 103
the financially weak company.
Securities market in
India
CHAPTER V : INVESTIGATION AND ACTION BY THE
BOARD
Board's right to investigate
38. The Board may appoint one or more persons as investigating officer to undertake
investigation for any of the following purposes, namely:
(a) to investigate into the complaints received from the investors, the
intermediaries or any other person on any matter having a bearing on the
allegations of substantial acquisition of shares and takeovers;
(b) to investigate suo-moto upon its own knowledge or information, in the
interest of securities market or investors interests, for any breach of the
Regulations ;
(c) to ascertain whether the provisions of the Act and the Regulations are
being compile, with.
Notice before investigation
39. (1) Before ordering an investigation under Regulation 38, the Board shall give
not less than 10 days notice to the acquirer, the seller, the target company, the
merchant banker, as. the case may be.
(2) Notwithstanding anything contained in sub-regulation (1), where the Board is
satisfied that in the interest of the investors no such notice should be given, it
may be an order in writing direct that such investigation be taken up without
such notice.
(3) During the course of an investigation, the acquirer, the seller, the target
company, the merchant banker, against whom the investigation is being
carried out shall be bound to discharge his obligation as provided in
Regulation 40.
Obligations on investigation by the Board
40. (1) It shall be the duty of the acquirer, the seller, the target company, the merchant
banker whose affairs are being investigated and of every director, officer and
employee thereof, to produce to the investigating officer such books,
securities, accounts, records and other documents in its custody or control and
furnish him with such statements and information relating to his activities as
the investigating officer may require, within such reasonable period as the
investigating officer may specify.
(2) The acquirer, the seller, the target company, the merchant banker and the
persons being investigated shall allow the investigating officer to have
reasonable access to the premises occupied by him or by any other person on
his behalf and also extend reasonable facility for examining any books,
records, documents and computer data the possession of the acquirer, the
seller, the target company, the merchant banker or such other person and also
provide copies of documents or other materials which, in the opinion of the
investigating officer are relevant for the purposes of the investigation.
(3) The investigating officer, in the course of investigation, shall be entitled to
examine or to record the statements of any director, officer or employee of the
acquirer, the seller the target company, the merchant banker.
(4) It shall be the duty of every director, officer or employee of the acquirer, the
seller, the target company, the merchant banker to give to the investigating
officer all assistance in connection with the investigation, which the
investigating officer may reasonably require.
Submission of Report to the Board
41. The investigating officer shall, as soon as possible, on completion of the
104 investigation, submit a report to the Board: Provided that if directed to do so by
the Board, he may submit interim reports.
 Regulation
Communication of findings
42. (1) The Board shall, after consideration of the investigation report referred to in
Regulation 41, communicate the findings of the investigating officer to the
acquirer, the seller, the target company, the merchant banker, as the case may
be, and give him an opportunity of being heard.
(2) On receipt of the reply if any, from the acquirer, the seller, the target company,
the merchant banker, as the case may be, the Board may call upon him to take
such measures as the Board may deem fit in the interest of the securities
market and for due compliance with the provisions of the Act and the
Regulations.
Appointment of Auditor
43. Notwithstanding anything contained in this Regulation, the Board may appoint a
qualified auditor to investigate into the books of account or the affairs of the
person concerned: Provided that the auditor so appointed shall have the same
powers of the investigating authority as stated in Regulation 38 and the
obligations of the person concerned in Regulation 40 shall be applicable to the
investigation under this Regulation.
Directions by the Board
82 “
[ 44. Without prejudice to its right to initiate action under Chapter VIA and section
24 of the Act, the Board may, in the interest of securities market or for protection of
interest of investors, issue such directions as it deems fit including
(a) directing appointment of a merchant banker for the-purpose of causing
disinvestment of shares acquired in breach of regulations 10, 11 or 12
either through public auction or market mechanism, in its entirety or in
small lots or through offer for sale;
(b) directing transfer of any proceeds or securities to the investors protection
Fund of a recognised stock exchange;
(c) directing the target company or depository to cancel the shares where an
acquisition of shares pursuant to an allotment is in breach of regulations
10,11 or 12;
(d) directing the target company or the depository not to give effect to
transfer or further freeze the transfer of any such shares and not to permit
the acquirer or any nominee or any proxy of the acquirer to exercise any
voting or other rights attached to such shares acquired in violation of
regulations 10, 11 or 12;
(e) debarring any person concerned from accessing the capital market or
dealing in securities for such period as may be determined by the Board;
(f) directing the person concerned to make public offer to the shareholders of
the target company to acquire such number of shares at such offer price as
determined by the Board;
82
The earlier regulation 44 which read as follows:

[Directions by the Board.

44. The Board may, in the interests of the securities market, without prejudice to its
right to initiate action including criminal prosecution under section 24 of the
Act give such directions as it deems fit including:
(a) directing the person concerned not to further deal in securities;
(b) prohibiting the person concerned from disposing of any of the securities
acquired in violation of these Regulations;
(c) directing the person concerned to sell the shares acquired in violation of
the provisions of these Regulations;
(d) taking action against the person concerned.] Substituted vide SEBI
105
(Substantial Acquisition of Shares and Takeovers) (Second Amendment)
Regulations, 2002 dated 9th September, 2002.
Securities market in (g) directing disinvestment of such shares as are in excess of the percentage of
India the shareholding or voting rights specified for disclosure requirement under
the regulation 6,7 or 8:
(h) directing the person concerned not to dispose of assets of the target company
contra to the undertaking given in the letter of offer;
(i) directing the person concerned, who has failed to make a public offer or
delayed the making of a public offer in terms of these Regulations, to pay to
the shareholders, whose shares have been accepted in the public offer made
after the delay, the consideration amount along with interest at the rate not
less than the applicable rate of interest payable by banks on fixed deposits].
Penalties for non-compliance
45. (1) Any person violating any provisions of the Regulations shall be liable for action
in terms of the Regulations and the Act.
(2) If the acquirer or any person acting in concert with him, fails to carry out the
obligation under the Regulations, the entire or part of the sum in the escrow
amount shall be liable to be forfeited and the acquirer or such a person shall also
be liable for action in terms the Regulations and the Act.
(3) The board of directors of the target company failing to carry out the obligations
under the Regulations shall be liable for action in terms of the Regulations and
Act.
(4) The Board may, for failure to carry out the requirements of the Regulations by an
intermediary, initiate action for suspension or cancellation of registration of an
intermediary holding a certificate of registration under section 12 of the Act.
Provided that no such certificate of registration shall be suspended or cancelled
unless the procedure specified in the Regulations applicable to such intermediary
is complied with.
(5) For any mis-statement to the shareholders or for concealment of material
information required to be disclosed to the shareholders, the acquirers or the
directors where he acquirer is a body corporate, the directors of the target
company. the merchant banker 1 the public offer and the merchant banker
engaged by the target company for independence advice would be liable for
action in terms of the Regulations and the Act.
(6) The penalties referred to in sub-regulation (1) to (5) may include -
(a) criminal prosecution under section 24 of the Act;
(b) monetary penalties under section 15 II of the Act;
(c) directions under the provisions of Section 11B of the Act.
Appeal to the Securities Appellate Tribunal
83
46. *[Any person aggrieved by an order of the Board made, on and after the
commencement of the Securities Laws (Second Amendment) Act, 1999, (i.e..
after 16th December 1999), under the regulations may prefer an appeal to a
Securities Appellate Tribunal having jurisdiction in the matter].

Repeal and Saving

47. (1) The Securities and Board of India (Substantial Acquisition of Shares and
Takeovers) Regulations, 84*[1994] are hereby repealed.
83
Substituted for the following by SEBI (Appeal to the Securities Appellate Tribundal)
(Amendment) Regulations, 2000, published in the official Gazette of India dated
28.03.2000.
“Appeal to Central Government
Any person being aggrieved by an order of the Board may prefer an appeal to the Central
Government
84
106 Substituted for "1993" by a corrigendum published in the Gazette of India, Extra-
Oridinary on 06.02.1998.
 Regulation
(2) Notwithstanding such repeal :-
(a) Anything done or any action taken or purported to have been done or
taken including approval of letter of offer, exemption granted, fees
collected any adjudication, enquiry or investigation commenced or show
cause notice issued under the said regulations shall be deemed to have
been done or taken under the corresponding provisions of these
regulations;
(b) Any application made to the Board under the said regulations and pending
before it shall be deemed to have been made under the corresponding
provisions of these regulations.
(c) Any appeals preferred to the Central Government under the said
regulations and pending before it shall be deemed to have been preferred
under the corresponding provisions of these regulations.

107
 Economy and Industry
Analyses
UNIT6 ECONOMY AND
INDUSTRY ANALYSES
Objectives

The objectives of this unit are to:

• Explain the relevance of economy and industry analyses for equity investment
decision
• Discuss the usefulness of these analyses in an efficient market setup
• Highlight a framework of analysis of economy-industry-company
• Suggest steps that could form part of the economy and industry analyses
• Discuss various techniques to evaluate different economy and industry related
factors.

Structure
6.1 Security Analysis and Investment Decision
6.2 Fundamental Analysis
6.3 Fundamental Analysis and Efficient Market
6.4 Economy-Industry-Company Analysis: A Framework
6.5 Economy Analysis
6.6 Measures of Economic Activity
6.7 Economic forecasting
6.7.1 Anticipatory Surveys
6.7,2 Barometric or Indicator Approach
6.7.3 Economic Model Building Approach
6.8 Industry Analysis
6.8.1 Techniques of industry Analysis
6.9 Summary
6.10 Self-assessment Question/Exercises
6.11 Further Readings

6.1 SECURITY ANALYSIS AND INVESTMENT

DECISION
In Unit 3 of Block I, we briefly reviewed the need for economy and industry analyses
in investment decision, It was emphasized that the starting point of any investment
decision is evaluation of future economic performance. There is no point in investing
in stocks or any other form of risky investments when the future performance of the
economy is not expected to be good. For instance, stock market all over the world
suffered major loss during the year 2000 and 2001 when the U.S. economy reported
slowdown in the economic growth. Stock prices have crashed more than fifty percent
during this period. Economy analysis also assumes importance for allocation of
capital between equity investments and government securities. Many of us would like
to invest in government securities or schemes of government, which are not exposed
to price variation risk during the period of economic downtrend. In this unit, we will
discuss more on techniques used in evaluating future economic performance. Another
critical factor taken by the investors while investing
5
Securities Market in is the outlook of different industries. While economic performance in general influence
India the outlook of industries, its impact on industries differs from industries and industries.
For instance, some industries are affected more adversely when the economy is doing
badly whereas few other industries do well during the second half of the economic
recovery. The price and return of such stocks are also affected accordingly. Investors
would normally distribute their wealth to different industries based on expected return
and current price of stocks in the industry. It may not be always profitable to buy stocks
of industries, which are expected to do well in the near future. On the other hand,
investors may receive more benefit by investing in stocks of industries, which are not
doing well currently but likely to perform well once the economy picks up well. Such
stocks may be available at much lower price compared to stocks of industries, which
are presently doing well. In this unit, we will discuss different classifications of
industries based on the relationship between economic performance and performance
of industries. We will also discuss different phases of industries and their impact on
valuation. In addition, the sources of information to perform economic and industry
analyses will be covered. We will begin our discussion with a broader framework of
these analyses called fundamental analysis.
6.2 FUNDAMENTAL ANALYSIS
Investment decision-making being continuous in nature should be attempted
systematically. Broadly, two approaches are suggested in the literature. These are: (i)
Fundamental Analysis, and (ii) Technical Analysis. In the first approach, the investor
attempts to look at fundamental factors that affect risk return characteristic of the
security. In the second approach, the investor tries to identify the price trends, which
reflect these characteristics. The technical analysis concentrates on demand and supply
of security and prevalent trend in share price measured by various market indices in the
stock market.
Economic and industry analyses are part of fundamental analysis. In the fundamental
approach, various fundamental or basic factors that affect the risk-return of the
securities are examined. Effort, here, is to identify those securities, which are perceived
to be mispriced in the stock market. The assumption in this case is that the `market
price' of the security and the price as justified by its fundamental factors called
`intrinsic value' are different and the market place provides an opportunity for a
discerning investor to detect such discrepancy. The moment such a discrepancy is
identified the decision to invest or disinvest is taken. The decision rule under this
approach is as follows:
If the price of a security at the market place is higher than the one, which is justified by
the security's fundamentals, sell that security. This is because, it is expected that the
market will sooner or later realise its mistake and reduce its price. Therefore, before the
market realise its mistake and price that security properly, a deal to sell this security
should be struck in order to reap the profits. But, if the price of that security is lower
than what it should be based on its fundamental, it should be bought before the market
corrects its mistake by increasing the price of security in question. The price prevailing
in the market is called `market price' (MP) and the one justified by its fundamental is
called `intrinsic value' (IV).
Decision Rule Recommendation

(1) If IV > MP, Buy the Security

(2) If IV < MP, Sell the Security
(3) If IV = MP, No action
The fundamental factors mentioned above may relate to the economy or industry or
company or all/some of them. Thus, economy fundamentals, industry fundamentals
and company fundamentals are considered while analysing the security for taking
investment decision. In fact the economy-industry-company framework forms an
integral part of this approach. As explained earlier, the analysis requires collection of
large amount of data relating to economy, industry and company for any meaningful
analysis. This framework can be properly utilized by suitable adjustments in a particular
context. For instance, a fund manager of a large mutual fund can move from economy
to industry and then company analysis whereas a small investor can spend more time
6 on fundamental analysis. Such analysis helps the investors to take an informed and
considered investment decision.
 Economy and Industry
6.3 FUNDAMENTAL ANALYSIS AND EFFICIENT Analyses
MARKET
Fundamental analysis is not free from criticism. It is pertinent to mention that doubts
are expressed about the utility of this approach in the context of efficient stock
market, which already incorporates the information about the economy, industry and
company in the share price. It is claimed that stock market incorporates such
information in the share price rather instantaneously. The result of this assumption is
that price prevailing at the market place can be taken to represent the price of the
share justified by its fundamental i.e., intrinsic value (IV). The equality of MP and IV
makes the fundamental analysis or any other analysis useless or redundant. The above
given view about share market efficiency implies that no one would be able to make
abnormal gains given such a set up. Some research studies in the literature also
support the above view. Practitioners, however, do not agree to such conclusions of
empirical nature. We will discuss more on efficient market hypothesis and its impact
on security valuation in Unit 9.
Once again let us clear at this stage that the truth lies in between these two extreme
position-denouncing security analysis as totally redundant to the one that would bring
us profits. In fact, stock market is not efficient to the extent the researchers proclaim.
There are many operational inefficiencies and structural deficiencies in stock market.
Though the market is fairly efficient in the long run in a sense that only information
leads price changes, operational and structural inefficiencies cause time lag between
arrival of information and its impact on the security prices. In this context, analysis still
has an important role to play. It is paradoxical but correct to say that one has to assume
that stock market is inefficient to make it efficient. It is only then the processing of
information relating to economy-industry company would take place that would allow
the stock market to reflect the information in the price quickly if not instantaneously. It
is a fact of life that earning abnormal profits is not the only and final goal for most of
the investors. Rather, it has been observed that earning the normal returns, (i.e., the
return commensurate with risk prevalent in the market) is a worthwhile objective to
pursue, which most of the investors are not even able to achieve. In nutshell,
fundamental analysis has an important role to play for making investment decisions
in an efficient set up, too.
6.4 ECONOMY-INDUSTRY-COMPANY ANALYSIS : A
FRAMEWORK
The analysis of economy, industry and company fundamental as mentioned above is
the main ingredient of fundamental approach. The analysis should take into account
all the three constituents which form different but crucial steps in making investment
decision. These can be looked at as different stage in the investment decision, making
process and are depicted graphically with three concentric circles as shown in Fig 6.1
below. The process of investment analysis starts with an evaluation of economic
outlook. After getting some confidence on economic outlook, the analysis is moved
to industry specific to identify industries, which are worth for further analysis to pick
up good stocks. The last stage is identifying specific stocks from selected industry.
Operationally, to base the investment decision on various fundamentals, all the three
stages must be taken into account. In this unit, we will concentrate on economy and
industry analyses while in the next Unit, we will focus on the company level analysis.

7
Figure 6.1 : Investment Decision making process.
Securities Market in
India
6.5 ECONOMY ANALYSIS
All investment decisions are made within the economic environment after taking into
account the economic prospect of the country. This environment varies as the
economy goes through stages of prosperity. Why economy fails to have prosperity
forever? There are several reasons. Often, when the economy is booming, companies
over invest in projects and create excess capacity and thus lead-to slow down of the
economy. Further, government policies and external pressures also create
complications to the economy. For instance, increase in oil prices on account of gulf
war or war with neighboring countries creates pressures to the domestic economy.
Government also can create problems to the economy by following wrong policies or
failure to adopt right policies like failure in meeting disinvestment target. Different
stages of economic prosperity are also referred to as the business cycle. The term
cycle doesn't mean that there is some orderliness in the economic sequence such as
the seasons of the year. The economy doesn't follow a regularly repeated sequence of
events. It simply means how economic output and growth moves from period one to
next periods. If the initial period is a period of rabid growth, it peaks out at some
point of time and a recession sets in subsequently. After some point of slow growth,
the economy bottoms out but by then, new demand accrues and fresh activities
emerge. The economy now sets into recovery mode and then gets into expansion. The
cycle moves on without any definite length of time between the stages because
government and other agencies would like to extend the expansion stage while trying
to cut down the recession or speed up the recovery phase. Figure 6.2 illustrates the
common characteristics that are applicable to different business cycles.

Figure 6.2 : Phases of the Business Cycle

Starting from a point of neutrality (t 1 ), the economy expands and reaches peak (t2).
The economy then declines, reaching a trough at t3 and subsequently starts to rebound
to repeat the pattern. As mentioned earlier, economists all over the world have
developed a fair amount of understanding on factors leading to different phases of the
economy and also developed necessary monetary and fiscal policies to speed up the
process of recovery and extend the period of expansion. Despite such efforts, the
government fails to achieve desired results because of new factors emerging in the
economy and ever-changing social arid political events.

6.6 MEASURES OF ECONOMIC ACTIVITY

The critical issue before investors is to assess the future of economic activity so that
she or he can take an investment decision. It is possible by forecasting a few widely
used economic measures. A discussion on such economic measures will be useful
8 before discussing the forecasting techniques.
 Economy and Industry
Gross Domestic Product : Economic activity is measured by aggregate indicators Analyses
such as the level of production and national output. The most widely and commonly
quoted measure is Gross Domestic Product (GDP), which is the total value of all final
good and services newly produced within the country's boundaries with domestic
factors of production. Cars made within the country by companies like Hundai are
included in the GDP A similar measure is Gross National Product, which measures
the total value of all final goods and services newly produced by an economy and
includes income generated abroad. GDP or GNP and particularly the growth rate of
GDP or GNP are relevant for investment for two reasons. One, a good GDP growth
means continuous income for individuals and hence surplus money can be deployed
for investments. Two, corporate growth is directly influenced by the GDP growth. In
Table 6.1 and 6.2, the GDP values along with several other important economic
indicators are given. The growth rate of GDP at factor cost from year 1951-52 to
2000-01 is given in Figure 6.3. The growth rate is showing high level of volatility
reflecting economic cycles. Against the average growth rate of 11.41%, the standard
deviation is 5.90%. After the initiation of economic reforms in 1992, the growth rate has
picked up initially but subsequently declined on account of competition from external
market.

Table 6.1 : Macro-Economic Aggregates

(At current prices)
New Series (Base : 1993-94) (Rupees in crore)
Year Population GDP at Consump Indirect GDP at Net factor
(million) factor of tion of Taxes less market Income
cost fixed capital subsidies pries abroad
1 2 3 4 6 7 9
1950-51 359 9547 364 387 9934 -41
1951-52 365 10080 411 486 10566 -35
1952-53 372 9941 442 425 10366 -25
1953-54 379 10824 465 458 11282 -19
1954-55 386 10168 511 510 10678 -29
1955-56 393 10332 546 541 10873 -10
1956-57 401 12334 611 617 12951 -17
1957-58 409 12610 662 739 13349 -20
1958-59 418 14106 772 768 14874 -35
1959-60 426 14816 843 859 15675 -57
1960-61 434 16220 944 947 17167 -72
1961-62 444 17116 1058 1080 18196 -98
1962-63 454 18302 1164 1264 19566 -108
1963-64 464 20916 1313 1566 22482 -112
1964-65 474 24436 1477 1784 26220 -145
1965-66 485 25586 1671 2082 27668 -164
1966-67 495 29123 1975 2182 31305 -230
1967-68 506 34225 2222 2424 36649 -258 9
1968-69 518 36092 2416 2731 38823 -255
Securities Market in Year Populati GDP at Consump Indirect GDP at Net
India on(milli factor of tion Taxes less market factor
on) cost Fixed subsidies prices income
capital abroad
1 2 3 4 6 7 9
1969-70 529 39691 2678 3'059 42750 -271
1970-71 541 42222 2970 3455 45677 -284
1971-72 554 44923 3292 4009 48932 -291
1972-73 567 49415 2721 4532 53947 -302
1973-74 580 60560 4339 5053 65613 -325
1974-75 593 71283 5560 6196 77479 -291
1975-76 607 75709 6449 7560 83269 -255
1976-77 620 81381 6907 8358 89739 -233
1977-78 634 92881 7497 8716 101597. -233
1978-79 648 99823 8573 10310 110133 -156
1979-80 664 108927 10449 11914 120841 153
1980-81 679 130176 12288 13586 143762 345
1981-82 692 152056 14708 16544 168600 40
1982-83 708 169525 17175 18737 188262 -634
1983-84 723 198630 19565 20866 219496 -944
1984-85 739 222705 22487 22810 245515 -1424
1985-86 755 249547 26717 28444 277991 -1429
1986-87 771 278258 30389 32919 3111.77 -1805
1987-88 788 315993 33974 38350 354343 -2619
1988-89 805 378491 39693. 43076 421567 -4496
1989-90 822 438020 46560 48159 486179 -5731
1990-91 839 510954 53264 57720 568674 -7545
1991-92 856 589086 64402 64031 653117 -10077
1992-93 872 673221 74512 '75146 748367 -11645
1993-94 891 781345 83353 77875 859220 -12080
1994-95 908 917058 97994 95712 1012770 -13083
1995-96 927 1073271 117926 114741 1188012. -13484
1996-97 943 1243546 136503. 124662 1368208 -13082
1997-98 959 1390042 152050 132399 1522441 -13205
1998-99 P 975 1616033 166609 142243 1758276 -14968
1999-00 QE 991 1786459 180727 170538 1956997 -15431
2000-01 RE 1007 1978042

Source: RBI website: www.rbi.org.in

Table 6.2 : Macro-Economic
Aggregates
(At current prices)
New Series (Base : 1993-94)
(Rupees in crore)
Year GNP GNP Per capita Private Govt. Personal-
at at GNP at final con- final con- disposable
factor market factor cost sumption sumption income#
cost prices (Rupees) expen- expen -
diturediture
(PFCE)(GFCE)
1 10 11 12 13 14 15
1950-51 9506 9893 265 . 592 8876
1951-52 10045 10531 275 . 621 9325
1952-53 9916 10341 267 . 643 9275
1953-54 10805 11263 285 . 679 10137
1954-55 10139 10649 263 . 708 9402
1955-56 10322 10863 263 . 759 9574
1956-57 12317 12934 307 . 837 11435
1957-58 12590 13329 308 . 978 11691
1958-59 14071 14839 337 . 1049 13049
10 1959-60 14759 15618 346 . 1105 13660
 Economy and Industry
Year GNP GNP Per Privat Govt. Personal Analyses
at at capita final con-final con- disposab
factor market GNP sumption sumption le
cost prices factor expen- expen - income#
cost at diture diture
(Rupees) (PFCE (GFCE)
1 10 11 12 14 15
1960-61 16148 17095 372 16166 1206 14638
1961-62 17018 18098 383 16905 1336 15358
1962-63 18194 19458 401 17804 1620 16320
1963-64 20804 22370 448 19766 2088 18552
1964-65 24291 26075 512 23269 2240 21936
1965-66 25422 27504 524 24562 2570 22975
1966-67 28893 31075 584 28606 2808 26260
1967-68 33967 36391 671 34090 3126 31137
1968-69 35837 38568 692 34106 3428 32716
1969-70 39420 42479 745 36893 3847 35775
1970-71 41938 45393 775 39141 4289 37891
1971-72 44632 48641 806 42215 4982 40126
1972-73 49113 53645 866 46529 5283 44431
1973-74 60235 65288 1039 56091 5765 54741
1974-75 70992 77188 1197 67957 6995 63642
1975-76 75454 83014 1243 69498 8265 67810
1976-77 81148 89506 1309 72256 9192 72330 ,
1977-78 92648 101364 1461 83205 9780 83635
1978-79 99667 109977 1538 90492 10852 89680
1979-80 109080 120994 1643 98264 12481 97634
1980-81 130521 144107 1922 119024 14492 120642
1981-82 152096 168640 2198 137220 17075 138869
1982-83 168891 187628 2385 147625 20135 153126
1983-84 197686 218552 2734 174386 232I6 181359
1984-85 221281 244091 2994 191619 26631 202245
1985-86 248118 276562 3286 209890 31734 224371
1986-87 276453 309372 3586 232958 37507 250920
1987-88 313374 351724 3977 260195 43990 286328
1988-89 373995 417071 4646 299255 50673 340292
1989-90 432289 480448 5259 338750 57909 392223
1990-91 503409 561129 6000 387137 66030 461192
1991-92 579009 643040 6764 446262 74285 527018
1992-93 661576 736722 7587 500980 83957 611390
1993-94 769265 847140 8634 574772 97725 707692
1994-95 903975 999687 9956 664157 108639 834764
1995-96 1059787 1174528 11432 765797 128816 949191
1996-97 1230464 1355126 13048 903653 145725 1127541
1997-98 1376837 1509236 14357 974795 172189 1249877
1998-99 P 1601065 1743308 16421 1141207 211770 1480283
1999-00 QE 1771028 1941566 17871 1265432 251516 1649228
2000-01 RE 1961279 19476 --
Source: RBI website: www.rbi.org.in
Measures of Consumer Confidence: This type of survey is not available
unfortunately in India at this stage. Consumer confidence index is one of the strong
short-term economic indicators used by the investors to assess whether there is any
change of direction in the economy. Consumer confidence affects spending, which
has an impact on corporate profit and levels of employment. A positive change in the
consumer confidence index or consumer sentiment index in the U.S. indicates a strong
impact on the profitability of firms in general and in particular for firms dealing with
consumer items. There is yet another index in the U.S., which captures the
confidence level of purchase managers of firms in the U.S. Since such surveys are
not conducted in India, what is useful is estimate of personal disposable income.
Figure 6.4 shows the growth rate of personal disposal income during the period. A
correlation analysis between GDP growth rate and Personal Disposal Income shows a
strong correlation of 98. 11
Securities Market in
India

Inflation or Consumer Price Index: In addition to aggregate measures of economic

activity and leading indicators, measures of inflation can have an important impact on
investors' behavior. Inflation in general denotes a general change in the price levels and
measured in terms of index. Two commonly used indexes are Consumer price index
(CPI) and the Wholesale price index (WPI). You can see the weekly measures of WPI
on every Monday in any economic dailies with a commentary. Table 6.3 shows the
WPI and CPI values since 1970-71. You may observe after a high level of inflation till
1998-99, the inflation has come under control. What is the impact of inflation on stock
market. Inflation in general is not bad as long as it comes along with the growth of the
economy. When the economy is expanding fast, it is natural that money supply also
increases along with disposable personal income of individuals and thus cause an
increase in prices. Under this condition, stock market is favorably affected on account
of increase in profitability of firms. Nevertheless, inflation affects interest rates and
hence adversely affects the stock prices. An increase in rate of inflation will cause an
increase in rate of interest of all kinds of securities. An increase in interest rate affects
the value of stock as well as other securities in two ways. One, it affects' adversely the
profitability of firms because of higher outflow on interest cost. Two, it also increases
the expected rate of return of investors and directly affects the discount rate. An
increase in discount rate has an adverse impact on value of securities of different types.
Such an adverse impact may ultimately lead to a recession and hence governments and
central banks are concerned with inflation. A typical reaction from the central banks (in
our case Reserve Bank of India) is controlling money supply through appropriate
monetary policies. A reduction in money supply through increase in CRR or SLR or
increasing bank rate will reduce the heat of the economy and thus cool down the prices.
After reaching necessary correction, the central bank of the country relaxes the norms
so that the economic activity continues without any break.
Table 6.3: Wholesale and Consumer Price Index
Year WPI CPI

Base 1970-71

1970-71 100.00 186.00

1971-72 105.60 192.00
1972-73 116.20 207.00
1973-74 139.70 250.00
1974-75 174.90 317.00
1975-76 173.00 313.00
1976-77 176.60 301.00
1977-78 185.80 324.00
1978-79 185.80 331.00
1979-80 217.60 360.00
1980-81 257.30 401.00
12 1981-82 281.30 451.00
 Economy and Industry
Analyses

Source: www.rbi.org.in # Base 1981-82=100

Interest Rates : The level of interest rates is perhaps the most important macro
economic factor to consider in one’s invest analysis. Forcasts of interest rates
directly affect the forecast of returns in the fixed income market. Suppose you expect
the interest rates to decline in the near future. Under this situation, you will shy away
from investing in long-term debt instruments. Thus, a superior technique to forecast
rates would be immerse value to an investor attempting to determine the best asset
allocation for his or her portfolio. The following factors would help investors in
forcasting the future direction of the interest rates:
1. The supply of funds from savers, primarily households.
2. The demand for funds from businesses to be used to finance physical
investments in plant, equipment, and inventories.
3. The monetary policy of the Reserve Bank of India
4. The expected rate of inflation.
There is a close linkage between the above variables. For instances, the supply of
funds from savers depends on the level of economic growth. The same economic
growth determines the demand for funds from businesses. The monetary policy of
RBI is the outcome of inflation and inflation of the country is influenced by monetary
policy as well as economic performance. The Government and the Central Bank
influence the interest rates significantly. For example, an increase in the
government’s budget deficit increases the government borrowings. An increase in the
demand for funds pushes the interest rates. The Central Bank can reduce the impact
of government borrowing by increasing the supply of money through monetary
policy. While this will temporarily arrest an increase in the interest rates, increased
money supply pushes the inflation, which in turn increases the interest rates. Many
times, the Central Bank also uses interest rates directly to control the economy. For
instance, the U.S. Federal Reserve during the period 2000-2001 has cut down the
bank rate several times in order to boost the economy. Many countries including
Reserve Bank of India has reduced the interest rate during this period. Table 6.5
shows the interest rate prevailing in the Indian economy during the period of 1970-71 13
to 2000-01. Though an
Securities Market in increase in interest rate should have an adverse effect on the market and vice versa,
India the impact of interest rate changes on stock prices in the real world is difficult to
forecast. For instance, interest rates were high during the period of 1991-93 period but
the stock market reached the peak during the same period. Though interest rates have
declined significantly during the last two years, the market remained depressed.
Table 6.4: Prime Lending Rate of IDBI and Advance Rate of SBI
Year Prime Lending Rate Advance Rate
IDBI SBI
1970-71 8.50 7.00-8.50
1971-72 8.50 8.50
1972-73 8.50 8.50
1973-74 9.00 8.50-9.00
1974-75 10.25 9.00-13.50
1975-76 11.00 14.00
1976-77 11.00 14.00
1977-78 11.00 13.00
1978-79 11.00 13.00
1979-80 11.00 16.50
1980-81 14.00 16.50
1981-82 14.00 16.50
1982-83 14.00 16.50
1983-84 14.00 16.50
1984-85 14.00 16.50
1985-86 14.00 16.50
1986-87 14.00 16.50
1987-88 14.00 16.50
1988-89 14.00 16.50
1989-90 14.00 16.50
1990-91 14.00-15.00 16.50
1991-92 18.00-20.00 16.50
1992-93 17.00-19.00 19.00
1993-94 14.50-17.50 19.00
1994-95 15.00 15.00
1995-96 16.00-19.00 16.50
1996-97 16.20 14.50
1997-98 13.30 14.00
1998-99 13.50 12.00-14.00
1999-00 13.60-17.10 12.00
2000-01 14.00 11.50
2000-01 12.00 11.50

Source: www.rbi.org.in
Government Policy: The government has two broad classes of macro economic tools -
those that affect the demand for goods and services and those that affect their supply.
For most of postwar history, demand-side policy has been of primary interest. The
focus has been on government spending, tax levels, and monetary policy. Since
1980s, however, increasing attention has been focussed on supply-side economics.
Broadly interpreted, supply-side concerns have to do with enhancing the productive
capacity of the economy, rather than increasing the demand for the goods and
services the economy can produce. In practice, supply-side economists have focussed
on the appropriateness of the incentives to work, innovate, and take risks that result
from the system of taxation. The thrust is creating infrastructure and skills among
people to increase the economic activity. Such polices may have little impact in the
short run but they produce sustainable long-run growth in the economy.
Fiscal Policy: Fiscal policy refers to the government's spending and tax action and is
part of demand-side management. It is the most direct way to influence the economy.
For instance, when the government increases spending, it creates more demand in the
economy and similarly, when the government reduces spending, it causes slow down
14 in the economy. It must be noted that government is a major' direct buyer of several
core sector products. The
 Economy and Industry
government can also increase or decrease t h e demand for the products by reducing Analyses
or increasing the tax rates. Changes in tax rates directly increase or decrease the
disposable income of the public. Though fiscal policy has a direct and immediate
impact on the economy, it takes a long time to frame such policies on account of
political compulsion. For instance, it took several years for the Indian policy makers
to reduce tax rates and fiscal deficit.
Monetary Policy: Monetary policy, in the form of changing CRR and SLR i s also
demand-side management of economy. T h e Central Bank changes the money
supply (rather adjust the growth rate of money supply) through variety of polices and
thus influence the economy. One of the reasons for inflation being under control
during the last two years is slow down in the growth of money supply. Table 6.5
provides money supply in the economy and bank rate prevailing at various point of
time. If it increases the money supply, it will fuel the growth in the short-run but
causes inflation and higher interest rate in the long-run. Similarly, the Central Bank
by reducing the money supply can slow down the growth and prevent the economy to
create over capacity in several industries. However, monetary policy affects the
economy in more roundabout way than fiscal policy.
Table 6.5: Money Supply and Bank Rate in the economy

Rs. in crones

15
Source : RBI Website
Securities Market in
India
6.7 ECONOMIC FORECASTING
In order to perform economic analysis, it is essential to forecast economic performance
with the help of some of the economic factors discussed in the previous section.
Depending upon the duration, forecasting can be made for short term, intermediate and
long term. Short term refers to a period up to three years. Sometimes, it can also refer
to much shorter period, such as quarter or a few quarters. Intermediate period refers to
a period of three to five year period. Long term forecasting refers to the forecasting
made for more than five years. This may mean a period of ten years or more. We will
discuss some short term forecasting techniques in the following sections:

6.7.1 Anticipatory Surveys

This is a very simple method through which investor can form their opinion]
expectations with respect to the future state of the economy. As is generally
understood, this is the survey of expert opinions of those who are prominent in the
government, business, trade and industry. Generally, it incorporates expert opinion
with regard to construction activities, plant and machinery expenditures, level of
inventory, etc, which have important bearing on the economic activities. Anticipatory
surveys can also incorporate the opinion or future plan of consumer with regard to
their spending. So long as people plan and budget their expenditure and implement
their plans accordingly such surveys should provide valuable input as a starting point.
Despite the valuable inputs provided by this method, care must be exercised in using
the information generated through this method. Precautions are needed because:
1. Survey results can not be regarded as forecasts per se. A consensus of opinion
may be used by the investor in forming his own forecasts.
2. There is no guarantee that the intentions of surveys would certainly materialize.
To this extent, the investors can not rely solely on these.

6.7.2 Barometric or Indicator Approach

In this approach, various types of indicators are studied to find out how the economy
is likely to perform in the future. For meaningful interpretations, these indicators are
classified into leading, roughly coincidental, and lagging indicators.
Leading Indicators: As the name suggests, these are indicators that lead the economic
activity in terms of their outcome. That is, these are those time series data of the
variables that reach their high points as well as their low points in advance of the
economic activity.
Roughly Coincidental Indicators: These are the indicators that reach their peaks and
the troughs at approximately the same time as the economy.
Lagging. Indicators: These are time series data of variables that lag behind in their
consequence vis-a-vis the economy. That is, these reach their turning points after
economy has already reached its own.
Indicator approach is quite useful in suggesting the direction of a change in the
aggregate economic activity. However, it tells nothing about the magnitude of
change. In developed countries, data relating to various indicators are published at
short intervals For example, U.S. Department of Commerce publishes data regarding
various indicators in each of the following categories:
Leading Indicators
• Average weekly hours of manufacturing production workers.
• Average weekly initial unemployment claims
• Contracts and orders for plant and machinery
• Index of S&P stock prices
16 • Money supply (M2)
 Economy and Industry
• Change in sensitive material prices Analyses
• Change in manufacturer's unfilled orders ( durable goods industries) • Index
of consumer expectations
Coincidental Indicators:
• Index of industrial production
• Manufacturing and trade sales
• Employment on non-agricultural payrolls
• Personal income less transfer payments
Lagging Indicators
• Average duration of unemployment
• Ratio of manufacturing and trade inventories to sales
• Average prime rate
• Commercial and industrial loans outstanding
• Chang in consumer price index for service.
The above list is not exhaustive. It is only illustrative of various indicators used by
investors. A word of caution would not be out of place here as forecasting based
solely on leading indicators in hazardous business. One should be quite careful in
using them. In any case, there are practical difficulties in operationalizing it as data
collection is not done well in advance. There is always a delay in it, with the result
that interpretation even if correctly performed can not be fruitfully utilized. Further,
problems with regards to their interpretation as well exits. Various indicators under
broad category of leading indicators, its various measuring may give conflicting
signals in terms of future direction of the economy.

To overcome these limitations, the use of diffusion index or composite index had
been suggested. This takes care of the problems by combining several indicators into
one index in order to measure the strength or weaknesses in the movement of a
particular kind of indicators. Care has to be exercised even in this case because
diffusion indices are not without problems either. Apart from the fact that its
computations are difficulties, it does not eliminate the irregular movements in the
series. Despite these limitations, indicators approach/ diffusion index can be a useful
tool in the hands of a skillful forecaster.

Money and Stock price

It is widely recognized that money supply in the economy plays a crucial part in the
investment decision making. The rate of change in the money supply in the economy
affects the GNP, corporate profits, interest rates and stock prices. Accordingly,
monetarists argue that total money supply in the economy and its rate of change play
an important part in influencing that stock price. Too much money in the economy, it
is argued, fuels the inflation. And as investment in the stock is considered as hedge
against inflation, stock price increases during inflationary times. The relevance of
economy analysis and some economic indicators is well illustrated in a newspaper
report as reproduced in Box 6.1.

6.7.3 Econometric Model Building Approach

This is another approach in determining the precise relationship between the
dependent and the Independent variables. In fact, econometrics is a discipline where
in application of mathematics and statistical techniques is made to economic theory.
It presupposes the precise and clear relationship between the dependent and
independent variables. One of such well-defined relationship with its attendant
assumptions rest with analyst. Thus by using econometrics, the analyst is able to
forecast a variable more precisely than by any other approach. But forecasts thus
derived would be as good as the data inputs used and assumptions made. 17
Securities Market in Opportunistic Model Building or GNP Model Building or Sectional Analysis is
India frequently used in practice and is most eclectic method. It borrows from the methods
discussed earlier. It uses national accounting framework in order to achieve short-term
forecasts. Various steps while using this approach are:
1) Hypothesize the total demand in the economy as measured by its total income
(GNP) based on likely scenarios in the country like war, peace, political
instability, economic changes level and rate of inflation, etc.
2) Forecast the GNP figure by estimating the levels of its various components like:
Consumption expenditure
• Gross private domestic investment
• Government purchases of goods and services.
• Net exports.
3) After forecasting the individual components of GNP, the analyst adds them up
and get a figure of the forecasted GNP.
4) The analyst compares total of GNP so arrived with an independently arrived at, a
priori. Forecast of GNP and test, the overall forecast for internal consistency.
This is done to ensure that both his total forecast and subcomponents' forecast
make sense and fit together in reasonable manner.
Thus opportunistic model building involves all the details described above with a vast
amount of judgment and inequity.

Activity-1

a) Distinguish between leading and lagging indicators.

…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
………………………………………………………………………………….

b) List out six indicators, which you consider useful to know the future direction
of Indian economy. Also, classify them, into leading, coincidental and lagging
indicators.

…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
………………………………………………………………………………....

c) Examine Table 6.1 to 6.5 and Figure 6.1 to 6.3. Updated the table with the
current values. Based on this examination, how do you assess the future
outlook of the economy?

…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
18 ………………………………………………………………………………….
 Economy and Industry
Box 6.1 Analyses
ECOMONY WITNESS BULLISH TRENDS
Mudar Patherya
After having been a devout pessimist for the last two years. I must confess that I
am shedding my ideology. I am turning a bull. The reasons for this
metamorphosis are to be found more in the fundamentals of the economy than in
the stock market. Take the sales of automobiles in the first quarter of the current
financial year as a yardstick. Maruti Udyog has reported sales of 33680 vehicles
in the domestic market in the first three months of 1993-94. "We are going at full
stretch now." Says R.C.Bahargave, managing director of Maruti Udyog. We sold
around 1.28 lakh vehicles in the last financial year and our target of the current
year is in excess of 1.50 lakh vehicles. After years of plateauing out, and our target
to be a substantial jump in sales for the current financial year. The demand for cars
is a good indicator of the economy land by this index. I can say that the economy
has turned around. In fact, Maruti hardly has any inventory and even if the
company has an additional in built capacity of 20per cent, we would have been
able to clean out our inventory without a problem. In fact, today we do not even
need to push sales of the vehicles. The vehicles are moving themselves".
Maruti's turnaround is not an isolated instance. Hindustan motor is also talking in
terms of a negligible inventory. A Calcutta based dealer said recently: "When the
company, announced that it would be raising its monthly target to 1900 vehicles
in March, no one took the company seriously. When the company announced
that it would be raising its output to 2100 for April, a number of people took them
sceptically. Today, Hind Motors has a monthly output of 2600 vehicles, there is
no inventory with the company or the dealers, there is a premium on the cars and
there is two months waiting list. In fact, we are having to go to the company with a
request for a additional five cars per month".
BULLISH: If the turnover was only in automobiles, the theory of the country's
economic turnaround could still have been debated. However industries are also
turning strongly bullish. Take polyester yam for example. Over the last few
months there has been a strong increase in the off take of fabric which, in turn, has
resulted in demand overtaking supply of yam. As a result of this imbalance, yarn
prices have been strengthening consistently over the last few months, the latest
being of Rs. 4 per kilo increase in early August. Not surprisingly companies like
Sanghi Polyester, DCL, Polyester and Haryana Petro have become the fancied
darlings of the stock market.
Or take the case of fibers for example. For long written off a leper industry due
to the mounting losses sustained by it as well as the poor capacity utilization
levels. Negligible additional capacity was created in the country for
manufacturing polyester staple fibers. Because of the increase in the domestic
consumption and export of blended fabrics and blended yarn (Poly viscose and
Poly cotton) fiber demand had ballooned and even reached a stage when users are
being told that there will be no supplies for the next couple of months. Suddenly,
the cash turnaround of companies like Orissa Synthetic and India Polyfibers has
became a reality.
Or lastly come to colour picture tubes. Samtel colour reported a loss of Rs 8.91
Crores in 1992-93 (8 months) but faces the prospects of sharply revived 1993-
94. The basis is a projected increase in the consumption of colour picture tubes
form 8.3 lakh numbers in 1992-93 to around 11 lakh numbers in the current
financial year. What is interesting is that this is indicative of the turnaround in the
electronic industry as a whole, leading to improved prospects for a number of
related companies. What has accounted for this suddenly-revived economy? One
of the answers is definitely the cut in customs duties and corresponding
reduction in excise which has helped to reduced the cost structure of a number of
products. This has made a number of products cheaper in the domestic market
and expanded the base for them in the process.
FUTURE SCENARIO: What of the future? The scenario could emerge strongly
bullish if the cut in import duty in the finished product is accompanied by a cut in 19
the import tariff for the raw material as well,
Securities Market in
India Besides, the excise component would have to be lowered as well, resulting in an
expansion of demand within the country. Once this transpires. More goods will be
sold, the recession will be history and if installed capacities fall short of meeting the
demand, we could even have a temporary shortage in certain areas on our hands.

Given this is scenario, only the stubborn would continue to be bearish. It is the
times perhaps to cover our shorts on the sensex and place all our big chips on the
shares of Polyester companies. Stock of DCL polyester, Sanghi Polyester and
Harayan Petro look cheap when viewed against projected 1993-94 earning. With the
festive season round the bend, the buoyancy in yam prices is expected to continue,
giving investors a sharp turn around for the first half of the current financial year.

Source: TOI, August 9, 1993

6.8 INDUSTRY ANALYSIS

After conducting analysis of the economy and identifying the direction it is likely to
take in the short, intermediate and long term, the analyst must look into various sectors
of the economy in terms of various industries. An industry is a homogenous group of
companies. That is, companies with the similar characteristic can be grouped into one
industrial group. There are many other bases on which grouping of companies can be
done. For example, traditional classification is generally done product wise like
pharmaceutical, cotton, textile, synthetic fiber industry, etc. Such a classification
though useful does not help much in investment decision making. Some of the more
useful bases for classifying industries from the investment decision point of view are as
follows:
Growth industry: This is the industry, which is expected to grow persistently and its
growth is likely to exceed the average growth of the economy.
Cyclical industry: In this category of the industry, the firms included are those which
move closely with that rate of industrial growth of the economy and fluctuate cyclically
as the economy fluctuates.
Defensive industry: It is a grouping that includes firms which move steadily with the
economy and decline less than the average decline of the economy in a cyclical
downturn.
Declining industry: This is that category of firms, which either generally decline
absolutely or grow less than the average growth of the economy.
Another useful criterion to classify industries is the various stages of their development.
Industries with different stages of their life cycle development exhibit different
characteristics. In fact, each development stage is unique. Grouping firms with similar
characteristics of development helps investors to properly evaluate different investment
opportunities in the companies. Basing on the stage in the life cycle, industries may be
classified as follows:
Pioneer's Stage: This is the first stage in the industrial life cycle of a new industry.
Being the first stage, the technology and its products are relatively new and have not
reached a stage of perfection. Experimentation is the order both in product and
technology. However, there is a demand for its products in the market, thereby, the
profit opportunities are in plenty. This is a stage where the venture capitalists take a lot
of interest and enter the industry and sometimes organize the business. At this stage,
the risk of many firms being out of the industry is also more; hence, mortality rate is
very high in the industry, with the result that if an industry withstands the risk of being
out of the market, the investors would reap the rewards substantially or else substantial
risk of loss of investment exist. A very pertinent example of this stage of industry in
India was leasing industry which was trying to come-up during mid eighties. There was
a mushroom growth of companies in this period. Hundreds of companies came into
existence. Initially, lease rental charged by them was very high. But as the competition
grew among firms, lease rental reduced and come down to a level where it became
difficult for a number of companies to survive. This period saw many companies that
could not survive the onslaught of competition. Only those which tolerate this
20 onslaught of price war could remain in the industry. Leasing industry today in India is
much pruned compared to mid-eighties.
 Economy and Industry
Fast growing stage: This is the second stage when the chaotic competition and Analyses
growth that were the hallmark of the first stage is more or less over. Firms that could
not survive this onslaught have already died down. The surviving large firms now
dominate the industry. The demand for its products still grows faster in the market
leading to an increase in profits to the companies. This is the stage where companies
grow orderly and rapidly. These companies provide a good investment opportunity to
the investors. In fact, as the firms during this stage of development grow faster, they
sometimes break the records in various areas like payments of dividends, etc, thus
becoming more and more attractive for investments.

Maturity and stabilization stage: This third stage where industries grow roughly at the
rate of the economy and are fully developed to reach a stage of stabilization. Looked
at differently, this is a stage where the ability of the industry to grow appears to have
more or less lost. As compared to the competitive industries, rate of growth in the
industry in slower. Sales may still be rising, but at a lower rate. It is at this stage that
the industry is facing the problem of what Grodinsky called "latent obsolescence" a
term used to describe a situation where earliest signs of decline has emerged.
Investors have to be very cautions to examine and interpret these signs before it is too
late.

Relative Decline stage: The fourth stage of industrial life cycle development is the
relative decline stage. Industry at this stage has grown old. New products and new
technology have come in the market. Customers have changed their habits, styles,
liking, etc. Its products are not much in demand as was in the earlier stages. Still, the
industry can continue to exist for some more time. Consequently, the industry would
grow less than the average growth of the economy during the best of the times of the
economy. But as it expected, the industry would decline much faster than the decline
of the economy in the worst of times.

The specific characteristics of different stages of life cycle development of industries

have a number of implications for investment decision. For example, Pioneering
stage is very risky stage. As you know that risk and returns are positively correlated,
investment at this .stage is quite rewarding. However, for an investor looking for
steady long-term returns with risk aversion, it is suggested that he should in general
avoid investing at this stage. These are good for venture capitalists. But if he is still
keen to invest, he should try to diversify or disperse his investment in companies that
are in the second stage of development i.e., fast growth. This probably explains the
prevalent higher stock prices of the companies of this industry.

From the investment point of view, selection of the industries at the third stage of
development is quite crucial as it is the future growth of the industry that is relevant
and not its past performance. There are a number of examples where the share prices
of companies in a decline industry have been artificially hiked up in the market. This
is justified on the basis of good record of its performance. But the fact of the matter is
that a company in a declining industry would sooner or later feel the pinch of its
features and an investor investing in companies at this stage would experience
reduction in the value of his investment in due course.

After having discussed various investment implications, it may be pointed out that
one should be careful while using this classification. This is because the above
discussion assumes that the investor would be able to identify various stages in the
industry life cycle. In practice, it is a very difficult proposition to detect which stage
of development an industry is at a given point of time. Needless to say, it is only a
general framework that is presented above and he can use it for meaningful analysis
with suitable modifications. In order to strengthen the analysis further, it is essential
to study the unique feature of the industry in detail. Due to its unique characteristics,
unless the specifi. industry is studied properly and in depth with regard to these, it
will be very difficult to form an opinion for profitable investment opportunities.
Given below are some of the features that could be considered for a detailed
investigation while selecting an industry for investment. These features broadly relate 21
to the operational and structural aspects of the industry.
Securities Market in i) State of Competition in the industry
India
Competition is a way of life that increases, as barriers to enter the industry are
loosened/ removed. It is an important input in investment decision making. Knowing
about the state of competition in a particular industry, therefore, is a must. Questions
those are relevant in this context are:
• Which firm in the industry plays a leadership role and how firms compete
among themselves?
• How is the competition among domestic and foreign firms both in the
domestic and the foreign markets? How do the domestic firms perform there?
• Which type of products are manufactured in this industry? Are these
homogenous in nature or highly differentiated?
• What is the nature and prospect of demand for the industry? This may also
incorporate the analysis of classifying major markets of its products:
customer-wise and geographical area-wise, identifying various determinants
of the demands of its products, and assessing the likely demand scenarios in
the short, intermediate and long run.
• Which type of industry is it: growth, cyclical, defensive or relative decline
industry?
ii) Cost conditions and profitability
The worth of a share depends on its return and the return depends on profitability of
the company. Interestingly growth is an essential variable but its mere presence does
not guarantee profitability. Profitability depends upon the state of competition
prevalent in the industry, cost control measure adopted by its constituent units and the
growth in demand for its products. While conducting an analysis from the point of
view of cost and profitability, some relevant aspects to be investigated are:
• How is the cost allocation done among various heads like raw materials,
wages and overheads?
Knowledge about the distribution of costs under various heads is very essential
as this gives an idea to the investors about the controllability of costs. Some
industries have overhead costs much higher than others. Likewise, labour
cost is another area that requires close scrutiny. This is because finally
whether labour is cheap or expansive depends on the wage level and labour
productivity is taken into account.
• Price of the product of the industry.
• Capacity of production-installed, used, unused, etc.
• Level of capital expenditure required to maintain or increase the productive
efficiency of the industry.
Profitability is another area that calls for a thorough analysis on the part of investors.
This requires a thorough analysis on the part of investors. No industry can survive in
the long run if is not making profits. This requires a thorough investigation into various
aspects of profitability. However, such an analysis can being by having a bird's eye
view of the situation. In this context ratio has been found quite useful. Some of the
important ratios often used are:
• Gross Profit Margin ratio
• Operation Profit Margin ratio
• Rate of Return on Equity
• Rate of Return of Total Capital

22 Ratios are not an end in themselves. But they do indicate possible areas for further
investigation.
 Economy and Industry
iii) Technology and Research Analyses
Due to increase in competition in general, technology and research play a crucial part
in the growth and survival of a particular industry. However, technology itself is
subject to change; sometimes, very fast, leading to obsolescence. Thus only those
industries which are updating themselves in the field of technology could have a
competitive advantage over others in terms of the quality, pricing of products, etc.
The relevant questions to be probed further by the analyst in the respect could include
the following:
• What is the nature and type of technology used in the industry?
• Are there any expected changes in the technology in terms of offering new
products in the market leading to increase in sales?
• What has been the relationship of capital expenditure and the sales over
time? Whether more capital expenditure has led to increase in sales or not?
• What has been the amount of money spent on the research and development
activities of the firm? Does the amount on the research and development in
the industry relate to its redundancy and long run?
• What is the assessment of this industry in terms of its sales and profitability
in the short, intermediate and long run.
The impact of all these factors have to be finally translated in terms of two most
crucial numbers i.e., sales and profitability - their level and expected rate of change
during short, intermediate and long run.
6.8.1 Techniques of industry analysis
Up till now, we have discussed about various factors that are to be taken into account
while conducting industry analysis. Now we turn our attention to various techniques
that helps us evaluate that factors mentioned above:
End Use and Regression Analysis: It is the process whereby the analysis or investor
attempts to diagnose the factors that determine the demand for the output of the
industry. This is also known as end-use or product-demand analysis. In this process,
the investor hopes to uncover the factors that explain the demand. Some of the factors
found to be powerful in explaining the demand for the industry are: GNP, disposable
income, per capita, consumption, price elasticity techniques like regression analysis
and correlation have been often used. These help to identify the important
factors/variables. However, one should be aware of their limitations.
Inputs Output Analysis: This analysis helps us understand demand analysis in
greater detail. Input output analysis is very useful technique that reflects the flow of
good and services through the economy. This analysis includes intermediate steps in
the production process as the good proceed from the raw material stage through final
consumption. This information is reflected in the input-output table reflects the
pattern of consumption at all stages- not just at the final stage of consumption of final
goods. This is done to detect any changing pattern or trends that might indicate the
growth or decline of industries.
Activity-2
Tick the right answer:
1. Cyclical industry is cyclical in divided payout. True / False
2. Defensive industry is like automobile industry. True / False
3. A profitable investment opportunity lies in a matured and stable industry.
True / False
4. Competition exists in all walks of life. Investments is no exception,
so why bother about it. True / False
5. Anticipatory surveys being simple technique can be relied solely for
forecasting industry variables. True / False 23
Securities Market in Table 6.6: Index Numbers of Industrial Production
India
Year Mining Manufacturing Electricity General
& Quarrying
Base : 1980-81=100
Weight 11.46 77.11 11.43 100.00
1981-82 117.7 107.9 110.2 109.3
1982-83 132.3 109.4 116.5 112.8
1983-84 147.8 115.6 125.4 120.4
1984-85 160.9 124.8 140.4 130.7
1985-86 167.5 136.9 152.4 142.1
1986-87 177.9 149.7 168.1 155.1
1987-88 184.6 161.5 181.0 166.4
1988-89 199.1 175.6 198.2 180.9
1989-90 211.6 190.7 219.7 196.4
1990-91 221.2 207.8 236.8 212.6
1991-92 222.5 206.2 257.0 213.9
1992-93 223.7 210.7 269.9 218.9
1993-94 231.5 223.5 290.0 232.0
1994-95 248.8 245.4 314.6 253.7
1995-96 267.3 278.8 340.1 284.5
1996-97 268.4 302.8 353.4 304.6
1997-98 281.5 313.7 377.6 317.3
Base : 1993-94=100
Weight 10.47 79.36 10.17 100.00
1997-98 126.4 142.5 130.0 139.5
1998-99 125.4 148.8 138.4 145.2
1999-00 126.7 159.4 148.5 154.9
2000-01 131.4 167.9 154.4 162.7

6.9 SUMMARY
In this Unit, we have discussed the relevance of economy and industry analysis for
equity investment decision and introduced the economy-industry-company framework
of fundamental analysis. We have also noted the usefulness of fundamental analysis in
efficient market set up. This Unit also explains that nature of economy analysis and
discusses economic forecasting techniques viz., anticipatory surveys, barometric or
indicators approach and the econometric model building approach. As part of industry
analysis, it is pointed out that more than product wise classification, life cycle stage-
wise classification of industries is more useful for equity investment decisions making.
This Unit concludes by introducing techniques of industry analysis viz., end or
regression analysis and input-output analysis. In the next Unit, we will move forward to
discuss company specific analysis to give a complete understanding on fundamental
approach.

6.10 SELF-ASSESSMENT QUESTIONS/EXERCISES

1) Define `Fundamental Analysis'. Bring out its relevance for equity investment
decision.

2) Discuss the relevance of fundamental analysis in efficient market set up.

`
3) Economic-Industry-Company (EIC) framework provides a useful approach to
equity investments decision'. Explain and illustrate.

4) `Economic forecasting is the heart of economy analysis'. Comment and briefly

24 explain various techniques of economic forecasting.
 Economy and Industry
5) Define `industry analysis' and bring out its relevance for selecting equity shares Analyses
for investments.
6) `Fundamental analysis is application only in the hands of institutional
investors. Individual investors would find it too time taking and costly to adopt'
- Critically examine the above statement.
7) Please read `Economy witness bullish trends' as given in the Unit and answer
the following questions:
a) What are the indicators of bullish trends?
b) How would you classify these indicators?
c) Do you agree with recommendation made by the author of this unit?
8) Write short notes on the following:
(a) Economy Analysis
(b) Industry Analysis
(c) Techniques of Economic Forecasting
(d) Anticipatory Surveys.
(e) Econometric Model Building Approach.
6.11 FURTHER READINGS
Amling, f., 1984, Investment -An Introduction to Analysis and Management, 5th ed.
PHI. New Delhi.
Fischer, D.E. and RJ Jordan 1995, Security Analysis and Portfolio Management, 6th
ed. PHI, New Delhi.

25
Securities Market in
India
UNIT 7 COMPANY LEVEL
ANALYSIS
Objectives

The objectives of this unit are to:

• Highlight the need for and importance of company analysis

• Explain the process of estimation of equity -ice
• Discuss and illustrate quantitative and qualitative methods to value equity
• Discuss methods of forecasting earnings per share
Structure
7.1 Need for Company Analysis
7.2 Different Measures of Value
7.3 Holding Period Yield
7.4 Quantitative Analysis
7.4.1 Dividend Discounted Method
7.4.2 Price-Earnings Approach
7.5 Forecasting Earnings Per Share
7.6 Traditional Methods of Forecasting EPS
7.6.1 ROI Approach
7.6.2 Market Share Approach
7.6.3 Independent Estimates Approach
7.7 Modern Methods of Forecasting EPS
7.7.1 Regression and Correlation Ananlysis
7.7.2 Trend Analysis
7.7.3 Decision Tree Analysis
7.8 Qualitative Analysis
7.9 Summary
7.10 Self-assessment Questions/Exercises
7.11 Further Readings

7.1 NEED FOR COMPANY ANALYSIS

In the previous unit, we have discussed the relevance of economy and industry
analysis and how it can be conducted. In this Unit, we will discuss the company
level analysis. In order to provide a proper perspective of this analysis, let us begin
by discussing the way investor takes the investment decision given his goal of return
maximization. For earning profits, investors apply a simple and common sense
decision rule. That is,
• Buy the share at a low price, and
• Sell the share at a high price
The above decision rule is very simple to understand but difficult to apply in actual
practice. Despite this, efforts are generally made to operationalize it by using proper
formal and analytical framework. To begin with, the problems faced by the investor
are:
How to find out whether the price of a company's share is high or low?
26 Which benchmark to use to compare the price of the share?
 Company Level
The first question becomes easier if some benchmark is agreed upon with which the Analysis
prevailing market price can be compared. Fundamental analysis in fact helps the
investor in this respect by providing a benchmark in terms of intrinsic value. This
value is dependent upon economy, industry and company fundamentals. Out of these
three, company level analysis provides a direct link between investor's action and his
investment goal in operational terms. This is because an investor buys the equity
share of company and not that of industry and economy. Industry and economy
framework indeed provide him with proper background against which he buys the
shares of a particular company. This setting is nevertheless very important, but for
action to take place it is the company that provides investors actual key settings. A
careful examination of the company with its quantitative and qualitative
fundamentals is, therefore, very essential. As Fischer and Jordan have aptly put it, "A
good economic analysis inform the investor about the propriety of a current stock
purchase, regardless of the industry in which he might invest. If the economic
outlook suggests purchase at this time, the economic analysis along with the industry
analysis will aid the investor in selecting their proper industry in which to invest.
Nonetheless, knowing when to invest and in which industry is not enough. It is also
necessary to know which companies in which industries should be selected".

7.2 DIFFERENT MEASURES OF VALUE

A common valuation measure is Book Value, which is the networth of a company as
shown hi the balance sheet. Book value can be expressed on per share basis and in
such a case, the book value per share is equal to net worth divided by the number of
shares outstanding. Book value per share of few actively traded companies is given in
Table 7.1. The book value is derived based on certain accounting assumptions. An
important assumption is related to valuation of assets. Assets are valued after
deducting the depreciation value from the acquisition cost. Depreciation amount of
an asset for a period is computed based on the initial estimated life of the machine.
There is no guarantee that the amount provided as depreciation is equal to loss in the
value of the asset and it may be either more or less than the actual loss in the value of
the asset. The market price of a stock takes into account the market value of the asset.
Nevertheless, book value is a starting point in any valuation exercise and unless there
is a window-dressing in accounting, the intrinsic value of an asset is at least equal to
the book value of the asset. Table 7.1 also shows the market value per share and in
many cases, the market value is greater than book value.

Another measure close to book value is liquidation value per share. This represents
the amount of money that could be realized by breaking the firm, selling its assets,
repaying debt and then distributing remainder to the shareholders. If there is an active
takeover market, the price of the stock should be at least equal to liquidation value.
Otherwise, corporate raiders would find it profitable to acquire the firm and then take
up liquidation.

Value of a firm can also be measured by computing the replacement cost of

the asset less debt. Replacement cost can be measured if you could find out
what is the current cost of putting up a similar plant. For many industries, the
cost per unit of capacity (like cost of I million ton of cement plant) is
available. If the market price is below to this replacement cost level, then firms
intending to expand will find it easier to acquire the firm than putting up one
more plant.

All the above measures fail to look into the earning capability of the firm by using
the assets. It is quiet possible that firms can use the assets and earn superior return
because of several other advantages or skills available within the firm. On the other
hand, market value of the firm takes into account such future income arising out of
the use of assets. The ratio of market price to replacement cost popularly called
Tobin's q, after the Nobel Prize-winning economist James Tobin, is another popular 27
value measure among the economists.
Securities Market in Table 7.1: Book Value, Market Price and P/B Ratio as on March 31, 20XX
India
Company Name Book ValueMarket Price P/B Ratio HPY(%)
Wipro 38.94 1334.25 34.26 -76%
Infosys Technologies 168.43 4082.90 24.24 -54%
Hindustan Lever 11.30 218.75 19.36 -91%
Nestle India 26.75 506.10 18.92 35%
Digital Global soft 36.39 416.10 11.43 -42%
Satyam Computer Services 21.7 233.90 10.78 -95%
Cipla 109.25 998.80 9.14 -11%
Britannia Industries 79.45 690.15 8.69 11%
Dr. Reddy'S Laboratories 154.72 1247.25 8.06 -23%
Castrol India 31.89 229.85 7.21 -25%
GlaxosmithklinePharmaceutical 60.99 427.40 7.01 -5%
Sun Pharmaceutical Inds. 81.04 541.20 6.68 -15%
H D F C Bank 34.66 230.00 6.64 -10%
Colgate-Palmolive 24.36 154.50 6.34 6%
ITC 132.14 814.40 6.16 11%
P&G 111.88 566.40 5.06 -3%
Dabur India 12.25 60.90 4.97 -93%
Hero Honda Motors 28.49 140.35 4.93 -86%
NIIT 160.00 716.25 4.48 -65%
Smithkline Beecham 82.53 369.40 4.48 -8%
Ranbaxy Laboratories 136.56 576.95 4.22 -18%
Asian Paints 63.32 246.20 3.89 -42%
Reliance Industries 122.44 390.90 3.19 24%
Reliance Petroleum 15.91 48.55 3.05 -20%
HDFC. 194.16 544.85 2.81 43%
I C I C I Bank 61.97 165.40 2.67 -36%
Asea Brown Boveri 91.48 237.60 2.60 11%
Novartis India 109.72 269.75 2.46 -70%
Associated Cement Cos. 64.91 129.80 2.00 -8%
Gujarat Ambuja Cements 99.52 154.10 1.55 -28%
Tata Tea 160.96 233.95 1.45 -39%
Larsen & Toubro 155.10 221.30 1.43 -23%
Hindalco Industries 554.55 771.45 1.39 5%
Zee Telefilms 97.75 121.60 1.24 -88%
Indian Hotels Co. 217.73 254.70 1.17 5%
BSES 176.22 187.85 1.07 -21%
MTNL 125.98 132.30 1.05 -44%
Tata Iron & Steel Co. 125.76 122.35 0.97 6%
Bharat Heavy Electricals 147.60 142.00 0.96 14%
Tata Power 109.14 99.15 0.91 47%
Hindustan Petroleum 182.58 160.60 0.88 22%
1CICI 109.08 87.95 0.81 -36%.
State Bank Of India 250.35 200.25 0.80 0%
Grasim Industries 317.20 249.10 0.79 -18%
Bajaj Auto 331.62 257.65 0.78 -33%
Mahindra & Mahindra 190.75 120.15 0.63 -63%
Oriental Bank Of Commerce 82.25 39.95 0.49 9%
TELCO 137.64 65.05 0.47 -52%
Indian Petrochemicals Corpn. 127.24 54.05 0.42 -11%
Tata Chemicals 96.10 38.05 0.40 -28%

28
 Company Level
Though the above measures give a fair estimation on the value of the stock, it is Analysis
necessary to take into account the future cash flows for a better estimate of the firm's
value as a going concern. We will examine a few models used in valuation that takes
into the future value.
7.3 HOLDING PERIOD YIELD
Before attempting to discuss the approach that can be adopted for company level
analysis, let us be clear about the objective of investor and how it can be quantified?
It is to reiterate the proposition that an investor looks for increasing his returns from
the investment. These returns are composed of capital gains and stream of income in
the form of dividends. Assuming that he wanted to hold equity shares for a period of
one year only (known as holding period), i.e, he sells it at the end of the year, the total
returns received by him would equal to capital gains plus dividends received at the
end of the year, i.e.
R t = (Pt - Pt-1 ) + D t
Where Pt = Price of the share at the end of the year
Pt-1 = Price of the share at the beginning of the year
Dt = Dividend received at the end of the year.
Rt = Return for the holding period, t.
In order to calculate the return received by him on his original investment (i.e.
purchase price), total returns should be divided by Pt-1. These are expressed in
percentage terms and known as holding period yield (HPY). Thus,
(Pt - Pt-1 ) + D t
HPY(%) = × 100
Pt-1
Table 7.1 also gives the holding period yield for NSE-50 Index stocks for the year
20XX-XI and you can observe that HYP is negative in many cases. Investors would
not invest in stocks to earn negative return and hence the HPY computation has to be
prospective to give meaningful input in valuation. For instance, the buyer of stocks in
April 20XX would have estimated positive HPY for the stocks. In actual practice,
however, the investor would know the beginning price of the share (called purchase
price) as this is the price he or she has paid to buy the shares but the price at the end
of the year (i.e., selling price) as well as dividend income to be received would have
to be estimated. This is where the problem lies. How to estimate the future price of
the share as well as dividends? is the main challenge. Time series data relating to
dividends paid by companies provide us useful clues in estimating the dividends
likely to be declared by companies. There is, it seems, a stable dividend policy
followed by most firms in general. Thus, an investor would be able to estimate
dividend receipts at the end of the year with reasonable degree of accuracy under
normal circumstances. It has been found that company management is very
conservative in increasing the amount of dividend paid to shareholders. Management
does not increase the dividend unless this increase is sustainable in the long run. But
the opposite is true in case of a dividend cut. They seem to be liberal in case dividend
cut is to be made. This is to avoid further cuts if need arises. Amount of dividend, in
actual practice, does not form a large part of the total returns of the investor. This is
true particularly in many profitable companies. Nevertheless, it is an important
constituent as indicated above.
Estimation of future price of the share that contributes a major portion in the total
returns of the investor is much more problematic and is discussed in detail in the
following section. In order to estimate future price of share, you may adopt two
approaches, namely, Quantitative analysis and Qualitative analysis. Let us elaborate
each of the two approaches.
7.4 QUANTITATIVE ANALYSIS
This approach helps us to provide a measure of future value of equity share based on
quantitative factors. The two method commonly used under this approach are:
• Dividend discounted method, and 29
• Price-earnings ratio method
Securities Market in 7.4.1 Dividend Discounted Method
India
The dividend discount method is based on the premise that the value of an investment
is the present value of its future cash dividends. The present value (PV) is calculated by
discounting the future cash dividend at cost of equity. The formula, thus, is
D1 D2 Dn
PV = + 2
+ .......... +
(1 + K) (1 + K) (1 + K)n
If the dividend grows at a constant rate and the term "n" approaches infinity, then the
above equation can be rewritten as under:
D1
PV =
k-g
Where, k = discount rate or cost of equity
g = growth rate of dividend
D1 = expected dividend
Example: Varun Shipping has declared a dividend of 15% for the year ending March
2002. If the dividend will show a growth rate of 10% and cost of equity is 20%, what is
the value of the stock as of March 2002?
Expected Dividend for the year 2003: 15 x (1+10%) =16.5%
Expected Dividend per share (Face Value Rs. 10) = Rs. 1.65
Growth Rate of Dividend = 10% or 0.10
Cost of Equity = 20% or 0.20
Value as per constant DDM = 1.65/(0.20-0.10)
= Rs. 16.50
The price of the stock as on March 31, 2002 was Rs. 12.35 against its value of Rs.
16.50. Hence, one can say that the stock was underpriced provided the assumptions on
dividend growth rate and cost of equity are correct.
Dividend discount model assumes that the growth rate of future dividend is mainly
arising out of retained earnings. That is if the firm grows because of retained earnings,
it will have additional earnings, which in turn leads to higher dividend. This is basic
assumption of constant dividend growth model. If the dividend growth is fueled by
other reasons like cost reduction or increase in productivity or increase in market price,
etc., the model may not reflect the correct value. Another reason for the failure of the
model is when the growth rate is more than discounting rate.
Though it looks that the value of shares can be increased by increasing dividend, it may
not have the desired impact since an increase in payout will reduce the growth rate
arising out of retained earning and thus negatively affect the value. In fact, the growth
rate of dividend under constant growth model is equal to Return on Investment (ROI)
times the ratio of retained earnings to net profit. For example, if the ROI of the
company is 20% and the company retains 60% of the profit earned (i.e., the payout
ratio is 40%), the dividend growth rate is expected to be 12%. If the company increases
the dividend by paying 60% of its earnings, then the growth rate will be 8% (i.e. 20%
multiplied by 40% of retained earnings). Thus any increase in the numerator of the
valuation equation will be offset by an increase in the value of denominator and one
can't expect the value to increase because of a mere increase in dividend rate or
dividend payout ratio. Of course one has to look into cost of equity also. If cost of
equity is equal to ROI, then changes in payout or retained earnings ratio will have no
impact on the price. On the other hand, if the cost of equity is less than ROI, then an
increase in payout ratio will adversely affect the value. If the cost of equity is higher
than ROI, then value is positively affected if there is an increase in payout ratio. In
Table 7.2, the dividend, earnings per share, payout ratio, growth of dividend, value as
determined by the constant growth DDM and market price of the stock of select
companies are given. For the purpose of maintaining simplicity, the cost of capital is
30 assumed at 20%.
 Company Level
It may give you an idea about the extent of variation one can get between the values Analysis
based on DDM and current market price and such variation can be either attributed to
under or over pricing or absence of assumption of constant growth rate. You may
note that market price as on March 31, 2001 is considerably higher than the value
determined by the dividend discount model except in Tata chemicals, where the
actual market price is marginally lower than the value computed under DDM.

Table 7.2: Comparison of Value under DDM and Actual Market Price
Company Name EPS DPS Dividend AveragePrice MP Variatio
Growth Payout DDM (31/03/2001)
ABB 13.04 5.0 7% 40% 42.24 237.60 462%
Asian Paints 17.02 7.00 10% 47% 80.50 246.20 206%
ACC -3.41 2.0 4% 55% 12.70 129.80 922%
BSES 22.09 4.0 7% 23% 33.22 187.85- 465%
Bajaj Auto 49.48 8.0 13% 23% 139.13 257.65 85%
BHEL 6.9 3.0 9% 15% 29.66 142.00 379%
Britannia 23.66 550 9% 35% 55.44 690.15 1145%
Castrol 10.88 7.5 9% 73% 78.02 229.85 195%
Cipla 28.87 4.5 19% 13% 791.89 998.80 26%
Colgate-Palmolive 438 825 0% 101% 40.65 154.50 280%
Dabur India 2.6 1.0 10% 30% 11.41 60.90 434%
Dr. Reddy' S 31.17 4.0 11% 18% 49.89 1247.25 2400%
Glaxosmithkline 11. 5.0 13% 54% 79.62 427.40 437%
Grasim 29.09 8.0 8% 27% 71.28 249.10 249%
GA Cement 25. 4.0 9% 32% 39.99 154.10 285%
Hero Honda 12.67 3.0 22% 21% -153.47 14035 -191%
Hindalco 89.86 12.00 15% 10% 259.70 771.45 197°/8
Hindustan Lever 6.0 3.5 9% 66% 33.99 218.75 544%
HPCL 3035 10.00 11% 24% 117.11 160.60 37%
HDFC 37.78 1230 8% 37% 111.42 544.85 389%
ICICI 15.13 550 5% 51% 3934 87.95 124%
ITC 38.88 10.00 18% 26% 497.76 814.40 64%
Indian Hotels 22.01 10.00 11% 34% 12131 254.70 110%
IPCL 9.0 3.0 7% 40% 2427 54.05 123%
Infosys 81.71 10.00 27% 12% -170.67 4082.90 -2492%
L&T 8.8 630 4% 43% 41.68 22130 431%
MTNL 3134 450 10% 17% 49.81 13230 166%
M&M 14.96 550 8% 32% 51.63 120.15 133%
60.92 430 25% 14% -117.52 71625 -709%
Nestle India 123 14.00 2% 91% 7829 506.10 546%
Novartis India 17.18 15.00 10% 49% 16930 269.75 59%
Oriental Bank 11.23 350 6% 31% 25.56 39.95 56%
Procter & Gamble 38.99 7.5 7% 59% 60.71 566.40 833%
Ranbaxy 15.58 750 7% 39% 63.48 576.95 809%
Reliance Industries 24.11 425 8% 22% 37.89 390.90 932%
Satyam Computer 14.81 0.8 20% 21% 202.49 233.90 16%
SmithklineBeecham 24.68 6.3 24% 34% -191.70 369.40 -293%
State Bank Of India 41.97 5.0 6%. 17% 36.81 20025 444%
Tata Chemicals 132 5.0 7% 55% 41.34 38.05 -8%
Tata Iron & Steel 14.43 5.0 4% 43% 33.48 122.35 265%
Tata Power Co. 2035 5.0 10% 27% 53.57 99.15 85%
Tata Tea 19.74 9.0 8% 54% 80.29 233.95 191%
Wipro 23.12 0.50 16% 6% 16.13 1334.25 8173%
Zee Telefilms 2.7 0.55 14% 25% 10.34 121.60 1077%

Note: Negative value in Price under DDM is on account of growth rate of dividend
being more than assumed cost of capital of 20%
31
Growth rate of dividend is based on the average R01 of last five years times 1-
payout ratio of last five years time.
Securities Market in On the basis of the above model, the following inferences can be drawn:
India
1. If the return on investment is equal to discounting rate, changes in payout ratio fail
to have an impact on the value of the firm.
2. If the return on investment is greater than discounting rate, then value is positively
affected if the company cuts the payout ratio.
3. If the return on investment is less than discounting rate, then value is positively
affected if the company increases the payout ratio.
While applying this approach, one has to be careful about using the discount rate, K.
A higher value of discount rate would unnecessarily reduce the value of an equity while
a lower value would unreasonably increase it, that will have implications to invest/
disinvest the shares. A discount rate is based on the risk free rate and risk premium.
That is,
Discount Rate = Risk Free Rate + Risk Premium
K = Rf + RP
Thus, higher the risk free interest rate with Rp remaining the same would increase the
discount rate, which in turn would decrease the value of the equity. In the same way,
higher risk premium with Rf remaining the same would increase the overall discount rat
and thus decrease the value of the equity. The risk premium is computed by applying
cap 1 asset pricing model, which we will discuss in Unit 12, You might have briefly
covered this topic of computing cost of equity or cost of capital in your basic finance
course.
One of the critical assumption in the above model is dividend shows a constant
growth. In reality some companies like software companies in India may show a
superior return but it may not be sustainable in the long run. For instance, if you
expect that dividend to show a growth rate of 40% during the next 5 years and there
after it will stabilize around 10%, then you can use DDM with a slight modification.
This model is called multi-period dividend discount model. Under this model, it is
first necessary to compute the dividend receivable upto sixth year. The first five year
dividends are discounted to present value. Dividend received from sixth year to
infinity can be used to value the stock at the end of fifth year using constant DDM.
The value of the stock at the end of fifth year can be discounted further to get the
present value of the stock today and added with the discounted value of first five
years.
A numerical example will be useful. Suppose the expected dividend from a software
company for the next year is Rs. 10 per share. It is expected to show a growth rate of
40% in the next five years. That is dividend for year 2 to year 5 will be Rs.14, Rs. 9.6,
Rs. 27.44, and Rs.38.42 respectively. Thereafter the dividend is expected to show a
growth rate of 10% and it means the dividend for the sixth year will be Rs. 42.26. The
present value of first five-year dividends discounted at 20% is equal to Rs. 58.07. The
value of the stock at the end of fifth year is Rs, 422.58. The present value of Rs. 422.58
is Rs.169.82. Together, the value of the firm is Rs. 227.89.

Year Dividend Amount (Rs) PV of Dividend (Rs.) Rs. P

1 10.00 8.33
2 14.00 9.72
3 19.60 11.34
4 27.44 13.23
5 38.42 15.44
PV of first 5 year dividend 58.07
6 42.26
Value of share at the end of fifth year 422.58
PV of value of share 169.82
Total value of share 227.89
32
 Company Level
7.4.2 Price-Earnings Approach Analysis

According to this method, the future price of an equity is calculated by multiplying

the P/E ratio by the expected EPS. Thus,
P = EPS x P/E ratio
The P/E ratio or multiple is an important ratio frequently used by analyst in
determining the value of a share. It is frequently reported in the financial press and
widely quoted in the investment community. In India too, you could verify its
popularity by looking at various financial magazines/newspapers. The P/E ratio
essentially reflects the amount that the shareholders are willing to pay for every
Rupee of earnings. As such it should reflect the risk associated with the earnings. For
instance, if the P/E ratio is 5 for a company and 10 for another company, then
investors perceive that risk associated with the earnings of first company is relatively
higher than risk associated with the earnings of second company. That is the reason, if
you examine the P/E of firms in the market, you will observe that P/E of multinational
companies are much higher than the Indian firms. From the Market Price and EPS
values given in Table 7.2, you can compute the P/E ratio of sample companies and
compare the results. You can also examine the correlation between P/E and volatility
in earnings to get a broad idea why investors give more P/E for some companies.
The inverse of P/E is equal to capitalization rate. For instance, if the P/E is 5, it
means that the market is willing to capitalize the earnings by 20%. As in DDM, the P/E
model also fails to consider the future potential of earnings of the company since
growth rate of earnings is not deducted from the capitalization rate to get the value of
the firm. For instance, in the above example, we find that the EPS is discounted at
20% to get the value without considering any growth rate in the earnings. If the EPS
is expected to grow at 5% in the future, the discounting rate should be 15% but there
is no provision for such adjustment under the P/E model.
This approach seems to be quite straight and simple. There are, however, important
problems with respect to the calculation of both P/E ratio and EPS. Pertinent
questions often asked are:
• How to calculate the P/E ratio?
• What is the normal P/E ratio?
• What determines P/E ratio?
• How to relate company P/E ratio to market P/E ratio?
The problems often confronted in calculating this ratio are: which of the earnings-
past, present or future to be taken into account in the denominator of this ratio? Like
wise, which price should be put in the numerator of this ratio? These questions need
to be answered while using this method.
You will appreciate that the usefulness of the above model lies in understanding the
various factors that determine P/E ratio. P/E ratio is broadly determined by:
• Dividend pay out
• Growth
• Risk free rate
• Business risk
• Financial risk
Thus, other things remaining the same,
1 Higher would be the P/E ratio, if higher is the growth rate or dividend payout
or both.
2 Lower would be P/E ratio, if higher is
a) Risk free rate,
b) Business risk, 33
c) Financial risk.
Securities Market in The foregoing presentation helps us provide a quantitative measure of the value of an
India equity share. However, there still remains the problem of estimating earning per
share, which has been used in both the methods discussed above. This is a key
number, which is being quoted, reported and used most often by company
management, investors, analysts, financial press, etc. It is this number every body is
attempting to forecast. The starting point to forecast earnings per share, however, is
to understand the chemistry of earnings as described in the previous unit. We shall
describe various approaches to forecast earnings per share in the following section:

Activity -1

I. you have the fo llo win g i n fo r ma tio n :

Expected Earnings per share : Rs. 10 Current Payout Ratio : 40%

Expected Dividend per share : Rs. 4 Return on Investments (ROI) : 20%

Cost of Equity : 20%

Growth rate of dividend : 12% [ROl (20%) x Retained Earnings (60%* )]

Value per share

(based on constant DDM) : Rs. 50

(a) Using the DDM equation given above and assuming a R0I of 20%, find the equity
value for the following combinations of payout ratio and cost of capital.

Cost of Capital Payout Ratio

20% 40% 60%
16%
20% Rs. 50*
24%
* This value was already computed. Fill up the remaining cells.

(b) Briefly write your understanding on the impact of changes in payout ratio
and cost of capital on the value of stock.

…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………

II. A) Define Company Analysis

…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………

B) A Compare and contrast 'Dividend Discounted Method' and the 'P/E Ratio
method' of estimating price of an equity share.

…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
34 …………………………………………………………………………………
 Company Level
7.5 FORECASTING EARNINGS PER SHARE Analysis

Earnings is the most important number in valuing the stock. The most important and
the principle source of getting information about the earnings of the company is its
financial statements. Out of the two statements, namely, Balance Sheet and Income
Statement, it is the income statement that is more often used in order to assess the
future state of the firm. The income statement of the past few years shows the kind of
growth that the company is witnessing on sales and earnings. A comparison of
income statement of the company vis-à-vis income statement of the industry shows
the market share of the firm. While the historical data culled out from the income
statement is useful for estimating the earnings, one has to look into the current and
future prospects. For instance, quarterly information will be extremely useful in this
context. In addition, analysts can develop techniques linking company's fortune with a
few other economic variables. Now-a-days, it is possible to get investment analysts
expected information and they are published in several web sites and newspaper.
There are various methods employed to assess the future outlook of the revenue,
expenses and earnings of the firm given the economic and industry outlook. These
methods can be broadly classified into two categories, namely, traditional and modern.
Under the traditional approach, the forecaster obtains the estimate of single value of
the variable. While in the case of modem approach, he gets the range of values with
the probability of each occurrence. Let us discuss these two approaches in detail.
7.6 TRADITIONAL METHODS OF FORECASTING EPS
Under the traditional approach the following methods of forecasting are adopted:
• ROI approach
• Market share approach
• Independent estimates approach
Before starting the discussion on the forecasting techniques, it will not be out of place
to briefly mention the way the earnings per share is measured from the financial
statements. This will provide us an understanding of its changes. Broadly, changes in
earnings are affected by operating and financing decisions. Both these decisions are,
however, interdependent. But attempts are generally made to separate the two
decisions so that the effect of each is studied separately. Given below is the format
which analysts use to calculate the earnings per share.
Income Statement for the year ended.........................
(1) Sales Revenue
(2) Less: Operating Expenses
(3) Earnings Before Interest and Tax (EBIT)
(4) Less: Interest Expenses
(5) Earnings Before Tax (EBT)
(6) Less: Taxes
(7) Earnings After Tax (EAT)
(8) Number of Shares Outstanding
(9) EPS = EAT/Number of Shares Outstanding

Let us now explain the R01 approach to forecast earnings per share.

7.6.1 ROI Approach

Under this approach, attempts are made to relate the productivity of assets with the
earnings. That is, returns earned on the total investment (assets) are calculated and
estimates regarding earning per share are made. Simply stated,
35
Return on Assets = EBIT/Assets
Securities Market in Return on assets (ROA) is a function of the two important variables viz., turnover of
India assets, and margin of profit. In other words,
Return on Assets = Assets Turnover x Profit Margin
where, Asset Turnover = Sales/Assets
Profit Margin = EBIT/Sales
Therefore, ROA = (Sales/Assets) x (EBIT/Sales),
ROA is thus a function of (1) number of times the asset base is utilised and converted
into sales (asset turnover) and (2) profits earned on the sales (Profit margin). This is a
simple but crucial relationship. The above two equations can be further decomposed.
For instance, the asset turnover ratio can be decomposed further to fixed asset
turnover and current assets turnover. Profit margin can be further decomposed to
expenses ratio. Such kind of decomposing helps the analysts to forecast the earning
more accurately. For instance, asset turnover ratio of the firm can be forecasted if we
are able to get some idea about the growth rate of the industry. Profit margin can be
forecasted by looking into the cost structure and the impact of recent changes in the
prices of critical raw materials. Once an analyst or investor forecast the individual
components of ratio, it is possible to forecast the ROA. ROA will be useful to
forecast the EBIT. EBIT requires a minor adjustment before getting earnings per
share. The adjustment is on account of debt used by the firms.
Leverage is the use of borrowed funds in the enterprise with a fixed cost. The more is
the use of such funds, the higher is said to be the leverage. As borrowed funds are of a
fixed rate/cost and if the firm is earning profits, it is profitable to use more of borrowed
funds. However, there is limit beyond which use of borrowed funds can increase the
risk associated with the earnings per share and in certain cases may also reduce the
earnings per share. It is often said that as borrowed funds increase in relation to
equity funds in the total financing mix, borrowing costs would not only increase; but
increase more rapidly than the amounts borrowed. This happens because the
suppliers of funds now perceive the business more risky when borrowed funds are
utilised beyond a certain point. The relationship between Return On Equity (ROE),
ROA and debt can be explained as follows:
Rate of Return on Equity = R + (R-I)L/E
Where, R = Return on Assets
I = Effective interest rate
L/E = Total outside liabilities/equity
If we multiply the above equation with equity capital, we can find out the earnings
before taxes.
Thus, EBT = (R+(R-I)L/E)E, and
As forecasting of earnings is the central theme in the company level analysis, it requires
an understanding of the earnings formation process. The ROI approach provides a
framework for analysing the effects and interaction between the return a firm earns
on its assets and the manner it is financed. Once this return generating power is
understood by the analyst, he can forecast the key variables in the model and
substitute the forecasted values into the model and forecast Earnings After Tax
(EAT).
Based on the chemistry of earnings, the analyst can further use the following equations
to calculate the earnings per share:
[(1-T){R+(R-I)L/E}E]
EPS =
Number of shares outstanding
The above model is quite simple but its importance will be realised if we keep the
variables in the functional forms as shown below:
36
 Company Level
Earnings per share and its changes are a function of: Analysis

1. Utilisation of asset base

2. Productivity of sales (Profit Margin)

Interest expenses
3. Effective cost of borrowed funds (I) =
(effective rate of interest) Total outside liabilities

4. Debt equity ratio (L/E) = Total outside liabilites/equity

5. Equity base (E)

6. Effective tax rate (T) = Tax expenses / EBT

7. Return on assets = EBIT/Assets

The model can be used to forecast earnings in the future holding period. For this
purpose, the analyst has to collect the information relating to the following variables:
1 Net sales 6 Taxes
2 Other Incomes 7 EAT
3 Cost of Sales 8 Average Shares Outstanding
4 EBIT 9 Earnings per share (EPS)
5 Interest Expenses 10 Dividend per share (DPS)
Other relevant information with regard to the financial position is as follows:
1. Total Assets
2. Current Debt
3. Long term Debt
4. Equity shares
5. Total Debt and Equity
After collecting the above information, it can be summarised and the following key
variables can be calculated and arranged in the tabular form for the purpose of
analysis. The following table gives the picture relating to the information as required
for the application of this model:
Summary Table
1 Earning per Share
2 Return on Assets
3 Profit Margin
4 Asset Turnover
5 Effective Interest Rate
6 Total Equity/Outside Liabilities
7 Number of Shares Outstanding
8 Effective Rate of Interest
9 Earning per Share
10 Dividend per Share
11 Retention Rate (1-10)
12 Cost of Equity
13 Growth rate of Dividend (2) x (11 }
14 Value per share
The intrinsic value of the share can be computed with the help of Dividend Discount 37
Model (DDM) explained earlier by using the key variables.
Securities Market in 7.6.2 Market Share Approach
India
This approach emanates from the industry analysis. Once the estimate about the
future prospects of the industry is completed, the analyst would then look into the
firms, which are the leaders and pacesetters in the industry and would then find out
the market share of the firm to be analysed. The following steps can be adopted to
implement this method:
1. Estimate the industry's total sales
2. Estimate the firm's share in the total sales in industry i.e. market share
3. Estimate the profit margin
4. Multiply sales by profit margin to get total earnings
5. Divide earnings by number of shares outstanding to get EPS.
6. Multiply EPS by P/E ratio.
In order to estimate the profit margin under this approach, the analyst has to
understand the mark up and behaviour of cost and prices during the relevant range of
activity. This calls for having an understanding of profit-volume relationship of the
firm. The analyst should look into various component of costs like:
1. Fixed and variable cost (or operating leverage), and
2. The level of sales volume the firm is likely to attain during the forecast period.
7.6.3 Independent Estimates Approach
Under this approach, each and every item of revenue and expense is estimated
separately and summed up to arrive at the future EPS. All the three approaches are
traditionally utilised by security analysts. However, these are not mutually exclusive
approaches. But one important and common limitation of these approaches is that
they indicate point estimate of EPS and HPY and therefore, attach 100% probability
of outcome.

7.7 MODERN METHODS OF FORECASTING EPS

Under modern approaches to forecasting earnings of a company, statistical
techniques ate used. The following techniques are generally included in this category:

• Use of regression and correlation analyses

• Use of trend analysis

• Decision tree analysis

Let us briefly discuss each of these.
7.7.1 Regression and Correlation Analyses
In order to find out the interrelationships of relevant variables, the techniques of
regression and correlation analyses are used. When the inter-relationship covers two
variables, simple regression is used and for more than two variables, multiple
regression technique is used. Using this approach, security analysts may find out the
inter-relationship between the variables belonging to the economy, industry and the
company. For instance, if the analyst believes that the sales of the firm depends on
GDP growth rate, monsoon, and population growth rate, then it is possible to set a
relationship between sales and other independent variables by collecting the data
pertaining to sales and other variables for the last few years, say20 years. Once the
data is ready, a regression model can be set out to find the relationship and can be
used to predict the sales. Major advantages in its application relate to deriving the
38 forecasted value as well as testing the reliability of the estimates.
 Company Level
7.7.2 Trend Analysis Analysis

While using this technique, the relationship of only one variable is tested over time
using the regression technique. In a way, it is the simple regression technique where
the inter-relationship of a particular variable is tested vis-à-vis time. That is why the
name trend analysis. It is quite useful to understand the historical behaviour of the
variable for the purpose of the security analysis.
7.7.3 Decision Tree Analysis
The above two methods are considered superior to the traditional methods employed
to forecast the value of earnings per share. However, an important limitation remains.
Both these methods provide only point estimate of the forecast value. In order to
improve decision making process, information relating to the probability of
occurrence of the forecast value is quite useful. Thus a range of values of the variable
with the probabilities of occurrence of each value will go a long way to improve
decision by the investor. To overcome these limitations, decision tree and simulation
techniques are used. Under the decision tree analysis the decision is assumed to be
taken sequentially with probability of each sequence. Thus, in order to find out the
probability of the final outcome, given various sequential decisions along with
probabilities, the probabilities of each sequence is to be multiplied and summed up.
In practice, whenever security analyst attempts to use decision tree analysis in
conducting analysis of the securities, he starts with estimating the sales. The
application of the decision tree analysis is illustrated below by taking a simple
example.
1. Sales(Rs. Lakhs) Probability
10.0 .3
12.0 .5
11.0 .2
2. Expenses Probability
6.0 .6
7.0 .4
3. P/E ratio Probability
10 .4
20 .3
25 .3
4. Number of shares outstanding is one lakh.
A) Estimation of EPS by Decision Tree Approach

39
Securities Market in B) Estimation of Share Price
India
Estimated EPS(Rs.) P/E Ratio Probability Estimated Share
Price (Rs.)
10 0.40 2xl0x0.40= 8
=
2 20 0.30 2x20x0.30 12
=
25 030 2x25x0.30 15
Total 35
The above approach provide us the information with a range of values with the
probabilities of their occurrence instead of a point estimate. This is quite helpful in
forming expectations with regard to the likelihood of the events to improve the
decision making process.
Activity-2
a) List out traditional methods of forecasting EPS.
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
b) Compare and contrast traditional method of forecasting EPS with modern
methods.
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………

7.8 QUALITATIVE ANALYSIS

As mentioned earlier, the quantitative approach helps us to provide a quantitative
measure of the value of an equity. Various methods/models discussed above are quite
useful. But caution is required to base one's decision only on the figure derived by
such analysis. Analyst is also required to bear in mind qualitative/subjective factors.
An alert analyst would be able to gather such information from the following sources:
1. Company's financial statements
2. Financial Press, magazines etc.
3. Company's officials
This information may relate to the following factors:
i) Availability of infrastructure
ii) Inventory-size, value, risk
iii) Order book position
iv) Product risk
v) Marketing and distribution
vi) Components of cost-fixed and variable
vii) Availability of raw material inputs
viii) Cost of inputs
ix) Quality of personnel
x) Quality of management
xi) Future plans
With the qualitative factors in mind, an investor/analyst can judge whether the
quantitatively derived measure of value of an equity is reasonable or not and
accordingly take informed risk while taking the decision to invest or disinvest shares
40 of a company.
 Company Level
Of all the qualitative factors, quality of management is most important. As one Analysis
successful investor quipped `I don't invest in products; I invest in management'; What
he meant was that more than considering product, he analyses management of the
company. Needless to say, the assessment of quality and competence of management
is perhaps most difficult. J.C. Francis (1983) suggested a list of forty four questions
to be probed and answered in order to assess management of a company. These
questions have been given in appendix 7.1 at the end to this Unit.
On going through these questions, you will notice that finding good answers to many
of these questions is not easy. The security analyst who tries to find good answers to
these questions must do some ingenuous' detective work, possess a high degree of
sensitivity and spend hours of hard research. We may however point out here some
critical aspects of company management, which every investor must carefully probe.
These are commitment and competence, future orientation, image building,
investor friendliness and government relation building.
As far as commitment is concerned, the investors must look up the past record .of
management to particularly see that it did not indulge in premature diversion of funds
from one company to another. The competence of the management may be viewed in
terms of the composition of the board, professional qualifications and experience of
the members of board and the chief executive. The future orientation of a company
management can be gauged through research and development expenditure,
managerial development and training expenses and unexhausted fund-raising
capacity of the company.
It is also important to undertake sufficient image building activities for a company.
The image building activities of a management will be reflect in its community
development activities and management of relations with the press and media. The
investor friendliness of the management can be assessed from its dividend policies,
i.e. payment of dividend in cash or kind and issue of bonus shares. Management of
shareholder grievances can give fair idea about the investor friendliness of company
management.
Another aspect of company management, which is particularly important in a country
like India, characterised by high degree of government regulation, is its track record
of managing relations with the government. How many capacity renewals/expansions
could it win from the government? And in how much time? The answers to these
questions can be fairly insightful about the capability of the company management to
manage government relation, which holds very high significance particularly in an
economy characterised by widespread government regulation of business and
industry.
We may conclude by stating that management, though most difficult to evaluate,
holds the real key to the quality of equity investment decision. As part of
fundamental analysis, company management must be evaluated for its commitment,
competence and capacity to manage operations of the company and shareholder,
community and government relations. Past track record of the management in this
regard can come handy. The problem is particularly challenging where it is a new
management, without having past track record. Such a situation would perhaps
demand venture capitalist skills.
Activity-3
a) Take recent financial statements of any company and calculate the value of
its equity share using the dividend discounted method and P/E ratio
approach.
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
b) Compare the values calculated by the above methods with the market price
of its share? Are these the same? If there is any difference, give possible
reasons.
……………………………………………………………………………………
…………………………………………………………………………………… 41
……………………………………………………..……………………………..
Securities Market in
India
7.9 SUMMARY
The analysis of a company is important as it is in the shares of a company that an
investor invests. This requires forecasting both future price of the share as well as
dividends. Future price of the share can be calculated using two approaches:
discounted dividend model and WE ratio approach. Earnings per share is the most
important and widely used variable in valuing equity share. Forecasting EPS is very
crucial for investment decision making. There are traditional as well as modem
methods of forecasting EPS. Traditional methods are ROI approach, Market share
approach, and independent estimation approach. These methods provide a point
estimate of the forecasted variable. Modern forecasting methods are: regression and
correlation analysis, trend analysis, decision tree analysis and simulation. Decision
tree and simulation methods provide a range of values with probability of their
outcomes. Such information are quite useful in making investment decisions.
However, this calls for generating information regarding probabilities of occurrence
of various outcomes. The common limitation of these approaches is that these are
quantitative in nature. Investor must try to find the reasonableness of the value of the
share by taking into account the qualitative factors. Company management
constitutes most difficult, Yet most critical, qualitative factor to be analysed by the
investor or investment analyst. Past track record of the company management would
come handy here. However to analyze a new management, without having past track
record, perhaps the skills of the venture capitalist are needed.

7.10 SELF-ASSESSMENT QUESTIONS/EXERCISES

1. Why do you think company analysis is important for equity investment
decision?
2. `Estimation of equity price is the main challenge in the entire process of equity
investment decision'. Comment.
3. What are different methods of quantitative analysis used for equity investment
decision? How do they differ from qualitative analysis?
4. What are different methods of forecasting EPS? Which one do you consider the
best and why?
5. Using imaginary data explain and illustrate decision tree analysis for
forecasting EPS.
6. `Evaluation of management is the main challenge in company analysis.'
Comment, and explain how would you go about it.
7. Write short notes on the following?
a) Dividend Discounted Method
b) Price-Earnings Approach
c) ROI Approach
d) Market Share Approach
e) Independent Estimates Approach
8. Three months after learning of the death of his uncle, Mahesh got letter from
Digpaul & Associates, attornies at law, that read in part as follows:
“ .........and therefore, you will receive from your uncle's estate the following
securities.
200 Shipping Industry Debendutes
Par value: Rs, 100
Coupon: 11.5 percent, compounded semiannually
Maturity: December 31, 2007
42 Current yield: 13.8
 Company Level
250 Ferros metal Industry bonds Analysis
Par value Rs. 100
Coupon: 12 percent, compounded semiannually Maturity: June 30, 2006
Current yield: 13 percent
300 Shares, Ferros metal Preferred stock
Par value: Rs. 10
Indicated dividend: 1 I percent Maturity: None
Crrent yield: 15 percent
These securities may be picked up by you or your representative at our office at any
time after December 31, 2002."
Mahesh was very pleased to be remembered in his uncle's will but was less than
pleased with a portfolio consisting of fixed income securities. Being a young man
with family responsibilities, Mahesh decided that he was more interested in capital
growth than fixed income. He called Lal and Co., his broker, and asked for some
advice. In response he received the following letter:
"I am delighted to hear of your good fortune and of your desire to invest in
high quality securities. May I suggest that you invest in Maharashtra Cement
and Hind Petro, two fine companies with excellent prospects for their
common stocks. I enclose our recent write-ups on each company. If you
decide to invest in common stock, let me know and I would be pleased to
liquidate your fixed income holdings."
After looking over the prospects for the two companies, Mahesh has decided that
either company would suit his needs, provided it offered 24 percent before tax return
on his investment in the common stock. He has decided to liquidate his current
portfolio and invest in the firm whose stock is most realistically priced, if the stock also
offers a return of at least 24 percent.
Required
1 What is the current value of Mahesh's portfolio?
2 What are the intrinsic values of the common stock of Maharashtra and Hind?
3 Which stock is the best buy? Why?

43
Securities Market in
India

7.11 FURTHER READINGS

Amling, F. 1984, Investment - An Introduction to Analysis and management, ed., PHI;
New Delhi.

Fischer, D.E., and R.J. Jordan, 1995, Security Analysis and Portfolio Management, ed.
PHI, New Delhi.

Francis J.C., 1983, Management o f Investment, McGraw-Hill (International Student

Edition)

44
 Company Level
Appendix - 7.1 Analysis
J.C. Francis, in his book, Management of Investment (1983) suggested the
following list of questions which may be used to evaluate the management of a
company.
1. Is management aggressive and growth oriented?
2. Is management looking ahead or resting on its part accomplishment?
3. Does the firm plan ahead, or is it managed by crisis?
4. Does the firms executives appear to have energy and good leadership
instincts? Or, are the executives tired, dull , educationally deficient unable
to answer questions satisfactorily too young, too old or experienced?
5. Is the firm well diversified?
6. Does one customer provide most of the firm sales?
7. Does one product line provide most of the firm's sales?
8. Does the firm use only one marketing channel for its sales?
9. Is the firm a timebomb that is about to explode like lockhead was in early
1969? (Witnessing significant drop in sale).
10. Does the firm appear to have an adequate R & D program?
11. Is the industry in which the firm is located experiencing an
increasing or decreasing sales trend?
12. If the trend is downward does the firm have a product that is becoming
obsolete?
13. If this is the case, is the firm pouring all available funds into new
product development while also seekings growing firm with which to
merge?
14. Even if the company is profitable and is enjoying sales growth,
does it nevertheless retain some of its current earnings for R&D
expenditure?
15. Does the firm properly utilises its board of directors?
16. Does the board have many of the firm's own executives on it or does the
board largely consist of component executives from outside the firm, as
it should?
17. Does the board of directors have access to information it needs to
properly oversee and direct the firm?
18. Does management satisfactorily respond to vigorous questioning by the
board at regular intervals?
19. Does the firm have management depth?
20. Is it firm run by someone whose ego won't permit other competent
managers to develop, or does the firm have an established chain of
command?
21. Are authority and responsibility delegated are decentralised?
22. Does the firm have a good team of middle managers being groomed to
take over some day?
23. Are junior executives being developed properly?
24. Is management dynamic and flexible?
25. Do the firm's managers have the foresight and self-confidence needed to
make the decisions essential to earnings high rates of profit?
26. Is the company profitable? 45
Securities Market in
India 27. Is each product line profitable or at least potentially profitable?

28. Is each of the firm subsidiaries making its fair contribution to the
parent corporation?
29. How high are the firm's profits margins compared with those of its competitors?
30. How does the firm's rate of return on equity compare to the returns
available in equally risky industries?
31. Does the firm maintain or even augments its cash dividend payouts?
32. Is the firm keeping up with business development?
33. Are computers being used as they should be within the firm?
34. Is the company cleaning up its own messes or might the Environment
Protection Agency sue the firm in order to force compliance with the
pollution laws?
35. Does the firm hire fairly from among groups that have suffered the
effects of discrimination?
36. Does the firm use inflation adjusted accounting statements?
37. Are the annual reports to shareholders informative or are they just pretty
pictures and stories that flatter the firm's management?
38. Are managers properly compensated?
39. Do top executives have their initiative stifled by fixed salaries or are bonuses,
stock options and other incentives used to motivate top managers?
40. Does the management team have enough experience?
41. Does the firm promote people too quickly or too slowly?
42. Are too many or too few outsiders hired into top management slots?
43. Are executives fired so frequently as to make the remaining executives
nervous about their own job security?
44. At the other extreme are top management job used as retirement positions for
old and sometimes incompetent executives?

46
 Technical Analysis

UNIT 8 TECHNICAL ANALYSIS

Objectives
The objectives of this Unit are to:
• Explain the meaning of technical analysis and distinguish it from fundamental
analysis
• Discuss the origin and development of technical analysis
• Pinpoint the Dow Theory and its basic tenets and explain and illustrate
classical
• formations and the related rules
• Explain and illustrate modern technical analysis
• Highlight market indicators, as different from individual stock indicators.
Structure
8.1 Introduction
8.2 Meaning of Technical Analysis
83 Fundamental Analysis vs. Technical Analysis
8.4 Origin and Development of Technical Analysis
8.4.1 Dow Theory and its Basic Tenets
8.4.2 Types of Charts
8.5 Methods of Technical Analysis
8.5.1 Analysis of Price Patterns and Trends
8.5.2 Analysis of Oscillators or Price Indicators
8.6 Market Indicators
8.7 Limitations of Technical Analysis
8.8 Summary
8.9 Self-assessment Questions/Exercises
8.10 Further Readings

8.1 INTRODUCTION
Investors can use broadly two approaches, namely, Fundamental Approach or
Technical Approach in taking investment decision. Fundamental approach or analysis
involves detailed examination of data pertaining to the company, industry and
economy. It requires considerable skill of the analysts to examine such massive data
to get a value for the firm and then compare the value with the market price to take
investment decision. If the, value is more than the market price, the investor buys the
Stock. An alternative approach called technical approach or analysis, ignores all data
other than data generated in the stock market. Technical analysts believe that there
are enough number of investors and analysts in the market, who constantly examine
the stocks and derive the price. There is no point in doing or repeating such exercise.
It is adequate to watch them because whatever superior analytical techniques such
investors have, they have to come to the market ultimately to cash their efforts.
Technical analysis is thus reading the minds and activities of the major players in the
market by observing their behavior in the market place through price, volume and
several other market data. Technical analysis typically involves charting the market
data and using a number of oscillators. With the easy accessibility of computers and 47
internet, technical analysis is now become much easier since several web sites offer
free charting facilities.
Securities Market in
India
8.2 MEANING OF TECHNICAL ANALYSIS
Technical Analysis is concerned with a critical study of the daily or weekly price and
volume data of the Index comprising several shares, like Bombay Stock Exchange
Sensitive Index (SENSEX), or of a particular Stock, like Infosys or Hindustan Lever.
The objective of the technical analysis is to predict or forecast the short, intermediate
and long term price movements. It uses only the data generated from the market.
Such market generated data includes price, volume, number of trades, 52-week high
or low price, intra-day spread, dealers buy-sell quote spread, number of advances and
declines, number of Stocks hitting the new high and low, open interest, etc. Some of
the basic assumptions of the technical analysis are:
1. Market value is determined solely by the interaction of supply and demand.
2. Supply and demand are governed by numerous factors, both rational and
irrational.
3. Stock prices tend to move in trends, which persists for an appreciable length of
time.
4. Changes in trend are caused by shifts in demand and supply.
5. Shifts in demand and supply can be detected through chart analysis and some
chart patterns repeat themselves.
To appreciate technical analysis, one has to understand the above assumptions
clearly. Technical analysis assumes that there is a sufficient lag between the arrival of
information and its ultimate impact on the Stock prices. The analysis fails if the
information never incorporated in the prices (inefficient market) or instantaneously
reflected in the prices (efficient market). The perfect set up is temporarily inefficient
such that initially a few investors or analysts are able to understand the impact of
information on prices and entering into the Stock. Subsequently, more and more
people are entering into the Stock. Technical analysts believe that charts will give
them a clue about entry of more and more investors into the Stock and hence they can
also enter into the Stock without doing such analysis. They are primarily moving with
the crowd and exit from the market the moment the Stock prices started moving down.
As such they are no long-term investors in a particular Stock though they invest in the
market for a longer period. They move from one security to another security.
8.3 FUNDAMENTAL ANALYSIS Vs TECHNICAL
ANALYSIS
The price of most of the Indices and the Stocks keep on varying in a seemingly
erratic fashion, so much so that the difference between the high and the low during a
year may exceed by a ratio of two or more, even though the fundamentals do not
change much. For instance, in spite of the daily variation of price, the earnings of the
company do not vary during the year, the book value, the loans, the profit margin, the
taxes and other charges, depreciation, etc. may not change from one annual report to
the other. Hence the fundamentals dictate the price horizon of the shares of a
company, but are not able to say what would be the price at a particular point of time.
Technical analysis incorporates techniques to determine when 'an equity is
overbought, or is oversold so that they can sell and buy the stocks at such levels.
According to a firm offering technical analysis services, the technical analyst or
technician believes that the price movements, whatever their cause, once in force
persist for some period of time and form a particular pattern which can be detected. He
further believes that by critical study of these patterns of price and volume of trading,
he can predict whether price are moving higher or lower and even by how much. In
sum and substance, technician believes that the forces of supply and demand, guided
by logical as well as emotional factors, reflect in the price and volume movements
and by carefully examining the pattern of these movements, future price of stock can
be reliably predicted. And the whole process involves much less time and data
analysis, compared with fundamental analysis, it facilitates timely decision.
Timing of Trade is the Important Thing
Investment analysts following fundamental. analysis advise to invest in a
fundamentally strong company i.e., one, which has high reserves, large profits, low
48 debt, and pays high
 Technical Analysis
dividends. But if you buy such a share at the wrong time and then the price moves
down, you lose your wealth in spite of the strong fundamentals. Technical analysis
can be used to avoid this pitfall because it tells the appropriate time to buy a share and
the appropriate time to sell the same. Many investors thus use technical analysis as
supplement to fundamental analysis.
There are few basic differences between technical and fundamental analysis, which are
listed below:
Technical Analysis Fundamental Analysis
Focus on timing and likely price Focus on valuation of intrinsic value
changes; and
Not bothered about the intrinsic through such value, identifying
Focuses on internal factors - factors Focus on external factors - factors
that that are
are available in the market (price, outside the market (annual reports,
l
Focus is generally on near (short) iFocus
d i expected
is on long-term i
term price.
changes in the prices though Typically follows buy-hold-sell
intermediate strategy
Focus is more on price direction than Focus is on price target; not
price generally
target or forecast bothered for short-term price
changes
Easier and faster Requires considerable time for
voluminous data. analyzing
Simultaneously applied to many Difficult to apply for a large number
stocks of stocks unless a big analysts team
is set up
Technical analysis is often criticized as a blind and irrational method of investment
whereas fundamental analysis is more scientific and systematic. In a way, it is true
that there is no strong theoretical basis for technical analysis. It doesn't mean that it is
irrational. It uses a simple philosophy that the market is a place where a large number
of investors of different kind buy and sell securities and it believes that it is possible
to find some pattern in their trading and can be exploited for buying and selling stocks.
Thus, it is difficult for any one to read a textbook on technical analysis and then start
doing it. It requires considerable exposure to market and understanding of how a
typical crowd behaves when an important information about the company is released.
They also read the type of price reaction when the insiders enter into the stock.
Technical analysts on the contrary never complain against fundamental analysts.
They simply believe that is time consuming and too costly affair.

Activity-1
a) What is technical analysis?
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
b) List out two points of difference between fundamental analysis and technical
analysis.
……………………………………………………………………………………
……………………………………………………………………………………
…………………………………………………………………………………….
c) Why should technical analysis confirm findings based on fundamental analysis?

………………………………………………………………………………….....
................................................................................................................................. 49
.................................................................................................................................
Securities Market in
India
8.4 ORIGIN AND DEVELOPMENT OF TECHNICAL
ANALYSIS
Technical Analysis evolved in 1900-1902 when Charles H. Dow presented the
celebrated `Dow Theory' in a series of editorials in the Wall Street Journal in USA. The
Classical Technical Analysis evolved gradually in the early part of the 20th century,
and deals with a detailed study of price bar charts of the indices as well as the
individual stocks.
8.4.1 Dow Theory and its Basic Tenets
To start with, the Dow's Theory put forward six basic tenets as follows:
1. THE AVERAGES DISCOUNT EVERYTHING: Daily prices reflect the
aggregate judgement and emotions of all stock market participants. This process
discounts (takes into account) everything known and predicable that can affect
the demand-supply relationship of the stocks.
2. THE MARKET HAS THREE MOVEMENTS: Primary movements, secondary
reactions, and minor movements. The primary movement is the long range cycle
that carries the entire market up or down. The secondary reactions act as a
restraining force on the primary movement and tends to correct deviations from
it. Secondary reactions usually last from several weeks to several months in
length. The minor movements are the day-to-day fluctuations in the market.
Minor movements have little analytic value because of their short duration and
variations in amplitude.
3. PRICE BAR CHARTS INDICATE MOVEMENTS.
4. PRICE/VOLUME RELATIONSHIPS PROVIDE BACKGROUND.
5. PRICE ACTION DETERMINES THE TREND.
6. THE AVERAGES MUST CONFIRM: The movement of two different market
indices must confirm each other to confirm the trend.
8.4.2 Types of Charts
Charting represents a key activity for the technical analyst. The two oldest and most
widely used charting procedures are point-and-figure (P&F) charting and bar charting.
The major features of P&F charting are that (1) it has no time dimension, (2) it
disregards small changes in the stock price and (3) it requires a stock to reverse
direction a predetermined number of points before a change in direction is recorded on
the chart. P&F charts were used earlier because it is easier to graph manually because it
considers only prices on days when there is a major change and in that process, it uses
roughly about 20% of total number of prices. With good computer facility and special
packages for graphing, there are only very few users of P&F charts.
On the other hand, bar chart contains measures on both axis - price on the vertical axis
and time on the horizontal axis. On the bar charts, rather than just plotting a point on
the graph, the analyst plots a vertical line to represent the range of prices of the stock
during the period. The length of the bar represents high and low price of the day
whereas the open and close prices are shown as a small ticker on both sides of the bar.

50
 Technical Analysis
Generally, bar charts also show at the bottom volume information for the period of which
price information is depicted.
The third and most popular type of chart in recent days is candle stick charts. It uses bar
chart as a basis but put a small box using open and closer ticker of the bar charts. In order
to distinguish whether close is higher or lower. than opening price, the body of the candle
stick is colored. Normally, a black color indicates a bearish candle stick, meaning the
closing price of the day is less than opening price of the day. On the other hand, a white
candle indicates, bullish candle meaning closing price is higher than opening price. For the
Infosys stock, the candle stick chart is show below:
Candle Stick Chart Infosys Technologies Ltd.

There is yet another simple charting method, where only one of the four prices (open, high,
low and close) is used. It is a line chart where you can witness some continuity in the price
line.
8.5 METHODS OF TECHNICAL ANALYSIS
Technical analysts broadly use two methods to analyze the stocks to find whether it is
worth to buy the stock or sell the stock or hold the stock. In the first analysis, the analyst
uses the price chart as it is to find trends and patterns. In the second approach, the
analysts converts the market information into certain statistical figures and draw
conclusion. We will first discuss the pattern before moving into statistical analysis.
8.5.1 Analysis of Price Patterns and Trends
As mentioned in the previous sections, the analysts use the charts made up of historical
price, volume and other market generated data to understand the minds of major players in
the market and the demand and supply positions of the stock. It is also assumed that the
prices react to the news but the reaction is not instantaneous but takes some time to fully
reflect the value of the information on the prices. Though the time and speed of the
adjustment process differ depending on the type of the information and its availability to
the investors, they could be broadly classified into certain patterns and this knowledge
could be used subsequently to predict the future behaviour of the prices. The analysis of
patterns is the first principle in the technical analysis and the success of this method of
analysis of stock prices depends on the ability of the user in recognizing the patterns.
There are three basic patterns in the stock price movements. They are: uptrend,
downtrend and sideways patterns.
The uptrend pattern is recognized the moment the stock prices form a new high
(ascending top) and some times it is also preferred to wait for the formation of ascending
bottom. The uptrend pattern once emerged will continue till the time a downtrend pattern
is seen in the prices. The downtrend pattern is recognized once the price fails to create a
new high and some times it may be preferred to wait for the formation of descending
bottoms. The purchase decision can be effected once the uptrend pattern is seen and
stocks could be hold till the time the downward pattern is noticed. The investor can also
go short in the downward pattern. The duration of these two trends for many stocks in the
Indian market is fairly long and consistent investment decision on the basis of pattern
recognition offers a substantial gain to the investors. The weekly chart of Sensex shows
four major uptrend pattern during the last six year (since 1991) and three downward
patterns. Of the four uptrend patterns, the appreciation in the values o f the index on two 51
occasions was more than 100% whereas on the other two occasions, the index showed a
net gain of nearly 80%.
Securities Market in The technical analysts also usually draw lines by connecting the bottoms and tops of
India uptrend and downtrend respectively. These lines are used to get early warning signal for
the reversal of the trend. For instance, an upward trendline is drawn by connecting two
descending bottoms and the line is extended further. It is presumed that the price of the
stock which is moving upward will see periodic corrections and during the correction
phase, the price will come closer to the trendline and get support from the trendline. If this
support fails to take place, it is the first signal for the reversal of the uptrend. In the
subsequent days, the price may not reach a new high giving a clear bearish pattern but the
confirmation may be delayed. Similarly, bearish trendlines are drawn by connecting two
descending tops and extending the line further downward. Against the normal expectation
of resistance, if the price line penetrated the trendline, it is an indication for the reversal
of the downtrend.
There are several variations in trendline pattern. Typically, analysts use more than one
trendline to draw such new patterns like Head and shoulders, triangles, double tops or
bottoms,

Head and shoulders : The formation is encountered when a bar chart forms a hump
followed by a peak, and then another hump. A line joining the lowest points of the humps
and the peaks products a resistance line which foresees a bearish market. A reversed head
and shoulders formation is the opposite of this, and depicts an on coming bullish
tendency.
Triangles : These are formed when the peak point of descending tops fall on a line, as well
as the ascending bottoms fall on a different line, and both the lines join up at a point in
the future. If the prices break out of this triangle Upwards, it indicates bullishness, and if
the prices break out on the downside, it indicates bearishness. The odds are that the new
move will proceed in the same direction as the one prior to the triangle's formation.
Flags and Pennants : These are forms when, in the midst of a big bull run, the price chart
indicates a halt and the boundaries of this consolidation form a flag (parallel lines) or
pennant (lines sloping down and up to meet at a point in future). These are formed almost
exactly half-way between the bottom and the top, signaling bullish conditions.
A few other important patterns like `rounding tops and bottoms', `triangle' and `double
and triple tops and bottoms' are also useful in investment decision making.
Rounding tops and bottoms : Shows a gradual reversal of the trend from downtrend to
uptrend or uptrend to downtrend. The pattern which looks like a Bowl or Saucer moves
forward with higher momentum after the formation of pattern. Though a safe pattern in
view of availability of sufficient time to recognise and initiate action, they are less
frequent in actively traded stocks. Actively traded stocks change trend without moving
sideways. However, this pattern can be seen in weekly charts and charts of small value
stocks.
Double and triple tops and bottoms : Pattern is a horizontal pattern that forewarns reversal
in the trend. A `double or triple tops' pattern is formed when the uptrend in a stock is
resisted at a particular level. In a normal market, this pattern shows that a group of traders
who had earlier accumulated stocks at lower levels is waiting to liquidate their position
once the price reaches the specific level. If the supply at that level is of small quantity and
the underlying demand is sufficient, then the stock will easily break the resistance and
create a new peak above the previous one. The absence of this break in the resistance
level gives way to the formation of double or triple tops pattern and stock price moves
downward on the formation of this pattern. The double or triple bottoms pattern indicates
52 strong demand at a particular level and the stock bottoms out at this level.
 Technical Analysis
8.5.2 Analysis of Oscillators or Price Indicators
The modern technical analysis deals with indicators, such as moving averages,
exponential moving averages, weighted moving averages, moving averages cross
over, various types of bands around the moving averages like the bands in terms of
standard deviations, Bollinger bands, etc, and the rate of change, etc. Several
oscillators are also used, like stochastic, relative strength index (RSI), strength
relative to a market index, moving average conversance divergence (MACD)
technique. The basic difference between price trends and oscillators is, price trends
are often difficult to interpret and what action has to be followed is not defined
clearly. On the other hand, oscillators clearly define the investment decision rule. For
instance, if you use Moving average, the simple decision rule is buy the stock, the
moment the stock price crosses the moving averages. We will discuss some of the
important oscillators.
a) Moving Average
An average is the sum of prices of a share over some weekly periods divided by the
number of weeks. This point is marked on the latest date for which a price bar has
been plotted. This process is repeated for the previous dates. The points thus obtained
are connected together to give the Moving Average line.
An example of the calculatiion of a 5-week Moving Average is given in Table 8.1
Table 8.1: Calculation of Five Week Moving Average

There is another type of moving average called exponential moving average. In an

Exponential Moving Average, more weight is given on the most recent data and less
weight is given to the older data. Moving Averages smoothen out the apparent erratic
movement of share prices and highlight the underlying trend. Moving averages are
fairly simple to interpret. The decision rule is:
Buy: When the price line crosses the pre-determined moving averages from bottom,
buy the stock and hold it as long as the price line is above the moving average line
Sell: When the price line crosses the pre-determined moving averages from the top,
sell the stock. If short selling is allowed, take short position and hold it as long as
price line is below moving averages.
Moving Average Analysis : Reliance Industries

53
Securities Market in Applying the above decision rule, you will buy Reliance sometime in December 2000
India around Rs. 320 and sell at Rs. 400 sometime in March 2001. The profit during the
four months period is Rs. 80 or 25% for an investment of Rs. 320. In the above
analysis, 50-day moving averages is used. The time period of moving averages
depends on the purpose of using the moving averages. For long-term analysis,
normally 200 or 100-day moving average is used. For intermediate term, 100 or 50
day moving average is used. For short-term, analysts use 10-day to 50-day moving
averages. Moving averages are used for intra-day trading (popularly called day
trading) and in such cases, one has to use minute-to-minute charts and moving
average period will be 5 minutes or 10 minutes moving averages.
Though moving averages helps investors to take such decision, one has to experiment
with different moving averages to find which is suitable for the stock and do lot of
mock trading before started using them in the real world. This warning is given
because some of you might get tempted to invest in the stocks based on such simple
tools.
Activity-2
i) What do the following formations signify?
a) Triple Top
…………………………………………………………………………
…………………………………………………………………………
…………………………………………………………………………
b) Head and Shoulder
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………..
c) Flag and Pennats
…………………………………………………………………………
…………………………………………………………………………
…………………………………………………………………………
ii) What do the following stand for?
a) RSI ……………………………………………………………………
b) ROC……………………………………………………………………
c) MACD…………………………………………………………………
b) Moving Average Convergence Divergence (MACD) Indicator
MACD is also based on moving averages and used normally for intermediate trend
analysis. The MACD is the difference between a 26-day and 12-day exponential
moving average. A 9-day exponential moving average, called the "signal" (or
"trigger") line is plotted on top of the MACD to show buy/sell opportunities. The
MACD proves most effective in wide-swinging trading markets. There are three
popular ways to use the MACD: crossovers, overbought/oversold, and divergences.
Crossovers: The basic MACD trading rule is to sell when the MACD falls below its
signal line. Similarly, a buy signal occurs when the MACD rises above its signal line.
It is also popular to buy/sell when the MACD goes above/below zero.
Overbought/Oversold Conditions: The MACD is also useful as an
overbought/oversold indicator. When the shorter moving average pulls away
dramatically from the longer moving average (i.e., the MACD rises), it is likely that
the security price is overextending and will soon return to more realistic levels.
MACD overbought and oversold conditions exist vary from security to security.
Divergences: An indication that an end to the current trend may be near occurs when
the MACD diverges from the security. A bearish divergence occurs when the MACD
is making new lows while prices fail to reach new lows. A bullish divergence occurs
when the MACD is making new highs while prices fail to reach new highs. Both of
these divergences are most significant when they occur at relatively
verbought/oversold levels.
54
 Technical Analysis

MACD is equally efficient indicator for those who don't want to buy and sell stocks
frequently. For instance, a person who follows MACD may have to buy and sell
stocks around four to five times in a normal year.
c) Relative Strength Index
This index emphasizes market moves before they occur. When the price of a stock
advances, the closing price is higher than the closing price of the previous day. When
the price of the stock declines, the closing price is lower than the closing price of the
previous day. However, the rise or fall of a market is not smooth. During the rising
phase, the price falls several times, while during the falling phase, the price rises
several times. Relative Strength Index tells us whether the net difference between the
closing prices is increasing or decreasing.
During the rising phase of the market, the prices move up fast, and the differences
between the recent close and the previous close are large. When the market reaches
the top, these differences reduce. When the market declines, the difference again
become large. RSI is computed either on 14-days or 14-week basis.
The formula for 14 - week Relative Strength Index (RSI) is given Below:
RSI = 100- [100 / (1 + RS)]
Average of 14 weeks' up closing prices
Where RS =
Average of 14 weeks' down closing prices
This is a powerful indicator and pinpoints buying and selling opportunities ahead of
the market. It ranges in value from 0 to 100. Values above 70 are considered to
denote overbought conditions, and values below 30 are considered to denote
oversold conditions.
RSI Analysis : ITC Ltd.

55
Securities Market in If the RSI has crossed the 30 lines from below to above and is rising, a buying
India opportunity is indicated. If it has crossed the 70 lines from above to below indicates a
selling opportunity. Note these signals in the above chart and examine whether such
decision rule gives you profit.
There are several other indicators available in the market. Some of the popular
indicators are listed below:
1. Accumulation/Distribution
2. Momentum
3. On Balance Volume
4. Price Patterns
5. Price ROC
6. Stochastic Osciallator
7. Volume
8. Volume Oscillator

8.6 MARKET INDICATORS

Technical indicators help not only to predict individual stock price behaviour but also
the trend of the market. Some important Price, Volume and other indicators of market
are highlighted below:
Price Advances vs. Declines : By comparing number of shares which advanced and
those declined during a certain period of time, one may know what the market is really
doing. The difference between the advances and declines is called `breadth of the
market'. The technician is generally more interested in change in breadth than in
absolute level. Further, breadth may be compared with a stock-market index.
Normally, breadth and the stock market index will move in unison. However, when
they diverge, a key signal occurs. During a bull market if breadth declines to new lows
while the stock market index makes new highs a peak in the average is suggested. The
peak will be followed by major downturn in stock prices generally.
High-low Differential or index can be used as a supplementary measure to `breadth of
the market' to predict market. In theory, a rising market will generally be
accompanied by an expanding number of stocks attaining new highs and a dwindling
number of new lows. The reverse will hold true for a bearish market.
The volume of short selling which refers to selling shares that are not owned, can be
useful indicator of the market as well as for individual stocks. Short selling, or as it is
called short interest also, can be related to average daily volume. The short interest
for a period say a month, divided by average daily gives a ratio. This ratio indicates for
many days of trading it would take to use up total short interest. Historically, on the
New York Stock Exchange (NYSE) and the American Stock Exchange (AMEX), the
ratio has varied between one-third of a day and four days. In general when the ratio is
less than 1.0, the market is considered weak or weakening. It is common to say that
the market is overbought. A decline should follow sooner or later. The zone between
1.0 and 1.5 is considered a neutral indicator. Values above 1.5 indicate bullish
territory with 2.0 and above highly favorable. This market is said to be `oversold'. A
rise should follow sooner or later as `oversold' state will lead to buying pressure (to
cover short position) in the market.
Odd-lot trading which can be measured by constructing an odd-lot index by relating
odd-lot purchase to odd-lot sales (Purchase + Sales), can indicate the direction of the
market, as technicians feel that the odd lotters are inclined to do the wrong thing at
critical turns in the market. Rising index indicates rising market and falling index
indicates falling market which, in effect, mean selling proportionately less at or near
the market peak and selling proportionately more before a rise in the market.
Mutual-funds Cash as a Percentage of Net Assets on a daily or weekly or monthly
basis has been a popular market indicator. The theory is that a low cash ratio, say
56 about 5%
 Technical Analysis
would indicate a reasonably fully invested position leaving negligible buying power
indicating that the market is due for climb down. High cash ratio indicates
possibilities of market climb up.
In the U.S. two confidence indicators have been quite popular with market analyst.
One is Barron's ratio of higher-to lower grade bond yield. The second is Standard
and Poor's low priced and high grade common stocks. A rise in Barron's ratio
indicates narrowing of the spread between high and low grade bonds which is
considered indicative of the rising markets. A fall in the ratio would indicate
declining markets.
The S&P confidence indicator relates low-priced (speculative) stocks. to the high-
grade (quality) stocks. A rise in the ratio (low priced/high grade) indicates rising
market, while a fall in the ratio is indicative of declining market.
General Motors Theory is that as General Motors goes so goes the market.
Indeed, the number of indicators technicians use to predict changes in the direction of
the overall market is almost limitless. In the foregone discussion, we have tried to
capture the essence o f some such indicators.
8.7 LIMITATIONS OF TECHNICAL ANALYSIS
The Dow's theory serves only as a starter so far as Indian conditions are concerned.
Let us review each of the basic tenets of Dow theory, one by one.
THE AVERAGES DISCOUNT EVERYTHING: This is valid even in India. The
most popular depictions of averages are simple moving average (average of close,
high or low price of a given period) and exponential moving averages (which extend
the average over the entire record, assigning more weight to the most recent data).
Moving averages of 30 days or 5 weeks depict short-term trend and moving averages
of 200 days or 14 to 40 weeks depict long term trend. The crossovers of two averages
indicate that the trend is changing direction. For instance, if the 5-weeks moving
average crosses the 14-week moving average from below to above, it indicates
beginning of bullish phase, and may define buying opportunities. The reverse is true
if crossing is from above to below.
THE MARKET HAS THREE MOVEMENTS: Primary, Secondary and Minor.
Elliot Ware Theory is the most popular depiction of this principle. It states that the
market moves up in five waves i.e., five up or down, eg., three moves up and two
down, while it moves down in three to five waves. These waves are primary,
secondary and tertiary superposed on each other, and it takes experience to separate
the three movements. For instance, an upward movement of a primary wave
comprises five secondary waves, and so o n . This applies well to stocks in USA
where the market movement is free from all constraints, and the public takes part
freely in investment as well as options trading. However, in India the market suffers
frequent upheavals because of the frequent changes in the government policy, as well
as speculative activity indulged in by brokers, and it is not unusual to see the market
gain by 25% post-budget, and the individual stocks may jump up or down by 50%
within a few weeks due to speculation. Hence in India it is not clear to what extent
this theory applies, though some analysts persist in trying to fit the market
movements to this theory.
PRICE BAR CHARTS INDICATE MOVEMENT: This is true, but moving
averages remote the daily or weekly fluctuations and bring out the trend more
reliably.
PRICE/VOLUME RELATIONSHEPS PROVIDE BACKGROUND:
Unfortunately volume data are not reported in India, and the volume data of specified
group shares, where in forward trading is allowed by the exchanges, is published
after delay of several weeks. Since forward trading is no indicator of the actual
market activity, these relationships are of little value in India.
PRICE ACTION DETERMINES THE TREND: This is true in India as well.
THE AVERAGES MUST CONFIRM: This is based on the premise that if one
group of activity, say manufacturing, does not trend in the direction of another group, 57
say transportation, it indicates an oncoming change of trend of the market. In USA
data about
Securities Market in different activities is regularly published, for instance, utilities average and
India transportation average. The Mumbai Stock Exchange and National Stock Exchange
have started offering indices of different industries and hence it is possible now to
make such comparison. However, in practice, there is no widespread acceptance to
such analysis and typically the focus is on individual stocks.
Insider manipulations are rampant in the Indian Stock Market. Such manipulations
are encountered in USA also, but they are few in numbers and the culprits are caught
and punished. In the Indian Stock Market, it is not unusual to find that the price of a
share doubled in few days, and fall back to its original value a few days later. All these
malpractice leave their mark on the prices of stocks. Thus one can suspect whether
the charts represent the true balance of the demand and the supply forces. Hence, it is
possible that some of the technical analysis techniques suitable in other market may
not be suitable in India and indicators evolved for American conditions may lead to
erroneous conclusions. It is always desirable to do extensive research and experience
before taking up technical analysis based investment decision. Alternatively, one can
subscribe some of the technical analysis services offered by experts in the field.

Activity - 3

a) List out three market indicators.

…………………………………………………………………………………
…………………………………………………………………………………
………………………………………………………………………………….

b) List out two reasons for which all the techniques of technical analysis as
developed and applicable in USA are not applicable in India.

…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………

8.8 SUMMARY
In this Unit, we have discussed the technical analysis approach to predicting share
price behaviour. This approach differs from fundamental approach in as much as it is
based on the analysis of movements of price and volume of stocks, while
fundamental analysis is focused on economy, industry and company variables
affecting share price. The two approaches are, however, complementary to each other
rather than substitutes. In this Unit, we have also explained the origin and
development of technical analysis. The Dow Theory, which takes its name from Dow-
The originator of technical analysis, dated 1902-04, and its basic tenets have been
discussed and classical charting techniques viz. Point and figure chart and bar chart
and classical formations viz, triple top, , head and shoulder, triangle, flag and pennant
and support and resistance, etc., have been explained and illustrated. The techniques
of modern technical analysis viz., price bar charts, moving average, exponential
moving average, oscillators, Rate of Change (ROC), Relative Strength Index (RSI)
and Moving Average Convergence Divergence (MACD) techniques have been
explained and illustrated. Market indicators, as different from individual stock
indicators, have also been highlighted. The Unit concludes with a brief description of
the limitations of technical analysis, as evolved and developed in USA in our
conditions.

8.9 SELF-ASSESSMENT QUESTIONS/EXERCISES

1) Define `Technical Analysis' and `Fundamental Analysis'. Between the two
which one do you consider superior and why?
2) Write a brief note on the origin and development of technical analysis.
58 3) Compare and contrast fundamental and technical analysis.
 Technical Analysis
4) Compare and contrast `Point-and-Figure-Charting' and the `Bar-Charting'.
Which one do you consider superior and why?

5) `Technical analysis is useful for predicting individual share price as well as the
direction of the market as a whole'. Elaborate and illustrate.

6) `Technical analysis, as evolved and developed in USA. requires various

modifications for useful application in India'. Comment, bring out the
rationale for and nature of modifications, if any, required.

7) Write short notes on the following:

(a) Technical Analysis

(b) Dow Theory

(c) Charting

(d) Market indicators

8) Distinguish between the following:

(a) Moving Average and Exponential Moving Average

(b) Oscillator and Momentum

(c) Relative Strength Index and Moving Average Convergence

Divergence Signal.

8.10 FURTHER READINGS

Clifford, P., 1992, Technical Analysis, vision Books, New Delhi.

Charles Le Beau and Gavid W Lucas, Technical Traders Guide to Computer Analysis of
the Futures Market, Business-Irwin, Illinois, USA.

Fischer, D.E and RJ Jordan, 1995, Security Analysis and Portfolio Management, 6'" ed.
PHI, New Delhi.

Martin, J., 1985, Technical Analysis, McGraw Hill.

Murphy J., 1986, Technical Analysis of the Futures Market, Prentice Hall, New
Delhi.

59
Securities Market in
India
UNIT 9 EFFICIENT MARKET
HYPOTHESIS
Objectives

After reading this Unit, you should be able to:

• Explain the concept of market efficiency

• Differentiate various forms/degrees of market efficiency
• Undertake various empirical tests of market efficiency
• Pinpoint implications of Efficient Market Hypothesis (EMH) for security
analysis and portfolio management.
Structure
9.1 Introduction
9.2 Definitions of Market Efficiency
93 Forms of Market Efficiency
9.4 Empirical Tests of EMH
9.4.1 Tests of Weak Form
9.4.2 Tests of Semi-strong Form
9.4.3 Tests of Strong Form
9.5 Anomalies in EMH
9.6 Indian Studies on Market Efficiency
9.7 Implications of EMH for Security Analysis
9.8 Implications of EMH for Portfolio Management
9.9 Summary
9.10 Self-assessment Questions/Exercises
9.11 Further Readings

9.1 INTRODUCTION
In the last three units, we have discussed two different approaches namely, the
Fundamental Analysis and the Technical Analysis that are used by the investors in
taking investment decisions. These approaches were used under the assumption that
the current market prices are different from its intrinsic value and such analyses will
help investors in finding under-priced and over-priced stocks. The validity of the
assumption that the market price is not equal to the intrinsic value is questionable. The
third approach, called `Efficient Market Hypothesis', is based on the premise that
current market price is a true reflection of the value of the securities (stocks) and
hence it is futile to expect that fundamental or technical analysis will yield a superior
return by identifying under-priced or over-priced stocks. Under efficient market
hypothesis, investors can expect a return commensurate with the risk associated with
such investments.
Efficient Market Hypothesis was an issue that was the subject of intense debate
among Academics and Finance Professionals during the last four decades. The
Efficient Market Hypothesis states that at any given time, security prices fully reflect
all available information. The implications of the efficient market hypothesis are
truly profound. Most individuals who buy and sell securities (stocks in particular), do
60 so under the assumption that the securities they are buying are worth more than the
price that they are paying, while
 Efficient Market
securities that they are selling are worth less than the selling price. But if markets are Hypothesis
efficient and current prices fully reflect all information, then buying and selling
securities in an attempt to outperform the market will effectively be a game of chance
rather than skill.
Under efficient investors can not outperform the market since there are numerous
knowledgeable analysts and investors who would not allow the market price to
deviate from the intrinsic value due to their active buying and selling. The current
market price therefore reflects the intrinsic value at all time and hence, there is no
need for fundamental analysis or technical analysis. Empirically also market prices
have been observed to move randomly or independently. A net outcome of all this
had been a good deal of confused surroundings of the efficient market model or
random walk model. It is perhaps for the same reason that we still talk of efficient
market hypothesis and not efficient market approach to equity investment decision.
In this Unit, you will get introduced with the concepts and forms of market efficiency,
some empirical tests of EMH and also the anomalies in EMH. Efforts have also been
put to enlighten you on some of the Indian studies on market efficiency and to a
certain extent on the implications of EMH for security analysis and portfolio
management.
9.2 DEFINITIONS OF MARKET EFFICIENCY
The efficient market theory was discovered by chance, in 1953, by Maurice Kende1Lu
distinguished statistician. Kendell had been looking for regular price cycles, but to his
surprise he could not find any. He came to a finding that there exists no pattern in the
movement of share prices and that the change in prices is a random event. To quote
Maurice Kendell himself "As if once a week the demon of chance drew a random
number and added it to the current price to determine the next weeks price." Initially,
this result disturbed many economists because they interpreted the random behaviour
of stock prices as an outcome of erratic market psychology and it follows no logical
rules. However, over a period of time, they started appreciating that in a well
functioning or efficient market, prices will indeed change randomly reflecting the
impact of new information.
The Efficient Market Hypothesis slowly evolved in the 1960s from the Ph.D.
dissertation of Eugene Fama. Fama persuasively made the argument that in an active
market that includes many well-informed and intelligent investors, securities will be
appropriately priced and reflect all available information. If a market is efficient, no
information or analysis can be expected to result in out performance of an appropriate
benchmark.
An efficient market is defined as a market where there are large numbers of
rational, profit-maximizers actively competing, with each trying to predict future
market values of individual securities, and where important current information is
almost freely available to all participants. In an efficient market, competition among
the many intelligent participants leads to a situation where, at any point in time,
actual prices of individual securities already reflect the effects of information based
both on events that have already occurred and on events which, as of now, the market
expects to take place in the future. In other words, in an efficient market at any point
in time the actual price of a security will be a good estimate of its intrinsic value.
William Sharpe stated that "a perfectly efficient market is one in which every security
price equal its market value at all times". An efficient capital market is a market that is
efficient in processing information. The prices of securities observed at any time are
based on "correct" evaluation of all information available at that time. In an efficient
market, prices fully reflect all available information. Substantial evidence has been
presented by empirical studies regarding the validity of EMH. Conclusion of these
studies is not that superior performance is impossible, but that consistently superior
performance for a given risk level is extremely rare.
The random walk theory asserts that price movements will not follow any patterns or
trends and that past price movements cannot be used to predict future price
movements. Much of the theory on these subjects can be traced to French
mathematician Louis Bachelier whose Ph.D. dissertation titled "The Theory of
Speculation" (1900) included some remarkably insights and commentary. Bachelier 61
came to the conclusion that “ The mathematical
Securities Market in
India expectation of the speculator is zero" and he described this condition as a "fair
game." Unfortunately, his insights were so far ahead of the times that they went
largely unnoticed for over 50 years until his paper was rediscovered and eventually
translated into English and published in 1964
Market efficiency has implications for corporate managers as well as for investors.
This takes a lot of the "gamesmanship" out of corporate management. If a market is
efficient, it is difficult to fool the public for long. For instance, only genuine "news"
can move the stock price. It is hard to pump-up the stock price by claims that are not
verifiable by investors. "Fake" news will not move the price, or if it does, the price
will quickly revert to the pre-announcement value when the news proves hollow.
Publicly available information is probably already impounded in the price. This is
hard for some managers to believe. An example is the Sears' attempt to sell the Sears
Tower in Chicago in the late 1950's. The company believed that since it carried the
property on its balance sheet at greatly depreciated values, the public did not credit
the company with the full market price of the building and thus Sears's stock was
underpriced. This proved to be false. In fact, it seems that Sears was overestimating
the value of the building and the stock price was relatively efficient!
Another lesson: accounting tricks don't fool anybody. Don't worry about timing
accounting charges and don't worry about whether information is revealed in the
footnotes or in the statements. An efficient market will quickly figure out the
meaning of the information, once it is made public.
Rationale investors seek to maximize returns at a given level of risk. If a security is
underpriced, investors will quickly identify it and rush to pick it up. Competition for
the underpriced security drives the price up. Hence it would be difficult to
consistently achieve superior performance. Most securities are correctly priced and it
should be possible to earn a normal return by randomly choosing securities of a given
risk level.
Notion of financial market efficiency is in fact akin to the concept of profit in a
perfectly competitive market. Abnormal or excess profits, in such a market are
competed away. In an efficient market new information is discounted as it arrives.
Price instantaneously adjusts to a new and correct level. An investor cannot
consistently earn abnormal profits by undertaking fundamental analysis (to identify
undervalued/overvalued securities) or by studying the behaviour of share prices with
a view to discerning definite patterns. Isolated instance of windfall gains from the
stock market does not negate the theory that markets are efficient.
Paradox of the efficient market is that it is efficient because of the organized and
systematic efforts of thousands of analyst to evaluate intrinsic values. It ceases to be
efficient the moment such efforts are abandoned by the investing community and
analyst firms. Market prices will promptly and fully reflect what is known about the
companies whose shares are traded only if investors seek superior returns and
analyze information promptly and.. perceptively. If the efforts were abandoned, the
efficiency of the market would diminish rapidly. In order for EMH to be true, it is
necessary for many investors to disbelieve it!

9.3 FORMS OF MARKET EFFICIENCY

Eugene Fama gave three flavours to market efficiency and subsequently all empirical
testing has proceeded on these lines. These three forms have been discussed in detail.
a) Weak form of Efficiency
The weak form means that the current prices of stock already fully reflect all the
information that is contained in the historical sequence of prices. Hence abnormal
profits cannot be earned by studying the past behaviour of share prices. In other
words, weak form of efficiency implies that you can't make excess profits by trading
on past trends. You may be surprised to note that a lot of people do exactly just that.
They are called technical analysts, or chartists. By implication, technical analysis that
relies on charts of prices, moving averages and momentum and volume of trading is
not a meaningful analysis for making abnormal trading profits if the markets are
62 efficient in weak form. What would you do if you
 Efficient Market
notice that every time the market went up by 1%, the next day on average, it went up Hypothesis
again by 1/2 %? What would you do if you notice that every time the market went
down by 1%, the next day on average, it went down again by 1/2 %? If your answer
is that you would buy on an up day and sell on a down day, you have the makings of
an active technical trader and you are using a trading rule.
Academics have been testing trading rules like this for forty years, and traders have
been exploiting them for even longer. The concept behind the simple rule described
above is momentum. Although it is a widely used concept for technical investing,
there is no evidence that any short-term market-timing rule actually makes money. The
reason for this is the following: What if everyone followed the same strategy?
Wouldn't the opportunity go away? Further, you have to buy and sell stocks every
day, and in doing so, you have to pay brokerage fees. Thus, while major patterns in
stock prices should not exist, weak patterns that are too costly to arbitrage may
persist. If these simple trends are arbitraged away, then the market will follow a
random walk, i.e. past deviation from expected returns tell you nothing about future
deviations from expected returns.
A weak-form efficient market is one in which past security prices are impounded into
current prices. Since past prices are deemed public information, weak form of
efficiency implies semi-strong form of efficiency and semi-strong form efficiency
implies strong form efficiency.
b) Semi-Strong form of Efficiency
How about all public information? That is, all information available in annual reports,
news clippings, gossip columns and so on? If the market price impounds all of this
information, the market is then called Semi-Strong Form Efficient. Most people
believe that the U.S. equity markets by and large reflect publicly available
information. But one has to consider certain things. Whether the information put on
the Internet public? Are government files available under the freedom of information
act public? There must be subtle shades of semi-strong market efficiency, but they are
not typically differentiated. Each new piece of information an analyst gathers should
be carefully considered with regard to whether it is already impounded in the stock
price. The easier it was to get, the more likely it is to have already been traded upon.
Semi-strong form strikes at the very heart of the analyst profession. Tests of semi-
strong have dealt with the speed at which market participants react to public releases
of new information. Empirical evidence generally supports the contention that the
public reacts quickly to information; but there is also some evidence that the market
does not always digest new information correctly.
c) Strong Form of Efficiency
This represents the extreme case of market efficiency. What kind of information is
impounded in the stock price? It turns out that there are lots of different levels of
market efficiency, depending upon the source or the information being impounded.
The best way to illustrate this is through example. Suppose you had a hyper-efficient
market that impounded a l l private information. This means that even a personal
note passed between the CEO and the CFO regarding a major financial decision would
suddenly impact the stock price! If so, this is called Strong-Form Efficiency. Few
people believe that the market is strong-form efficient, but it is nice to have this
benchmark!
To test the strong form three groups of investors having potential access to private
information have been examined. These are:
a) Corporate Insiders
b) Stock Exchange Specialists
c) Mutual Funds
9.4 EMPIRICAL TESTS OF EMH
What is the degree of efficiency witnessed in, the stock market? Is it efficient of the
weak form or semi-strong form or strong form? In order to be able to answer these
questions, certain empirical tests have been devised. This section would discuss in
63
detail some of the tests used:
Securities Market in
India 9.4.1 Tests of Weak Form
Weak form efficiency should be the simplest type of efficiency to prove, and for a time
it was widely accepted that the U.S. stock market was at least weak form efficient. Recall
that weak form efficiency only requires that you cannot make money using past price
history of a stock (or index) to make excess profits. Recall the intuition that, if people
know the price will rise tomorrow, then they will bid the price up today in order to
capture the profit. Researchers have been testing weak form of efficiency using daily
information since the 1950's and typically they have found some daily price patterns,
e.g. momentum. However, it appears difficult to exploit these short-term patterns to
make money. Interestingly, as you increase the horizon of the return, there seems to be
evidence of profits through trading. Buying stocks that went down over the last two
weeks and shorting those that went up appears to have been profitable. When you
really increase the horizons, stock returns look even more predictable. Eugene Fama
and Ken French for instance, found some evidence that 4-year returns tend to revert
towards the mean. Unfortunately, this is a difficult rule to trade on with any confidence,
since the cycles are so long that in fact, they are as long as the patterns conjectured by
Charles Henry Dow some 100 years ago!
Does this all lend credence to the chartists, who look for cryptic patterns in security
prices - perhaps. But in all likelihood there is no easy money in charting, either. Prices
for widely trades securities are pretty close to a random walk, and if they were not, then
they would quickly become so, as arbitrageurs moved in to buy the stock when it is
underpriced and short (sell) it when it is overpriced. But who knows. May be a retired
rocket scientist playing around with fractal geometry and artificial intelligence will hit
upon something. Of course, if he or she did, it wouldn't become common knowledge, at
least for a while! There have been empirical tests of weak-form market efficiency for
equities, bonds and futures contracts. Random walk hypothesis suggests that even bond
price changes should be essentially random or unpredictable.
Tests of Weak form efficiency
Two groups of tests have been formulated by researchers to test the weak form of
EMH. One approach looks for statistically significant patterns in security price
changes. Another approach searches for profitable short-term trading rules. Serial
independence, filter rules, run tests and distribution pattern test for weak form are
described below:
a) Statistical tests of independence
EMH contends that security returns over time should be independent of one another
because new information comes to market in a random, independent fashion and
security prices adjust rapidly to this new information. Does return of day t correlate with
day t-1, t-n? Two major statistical tests have been used to verify this independence. One
is the Autocorrelation test and the other is the Run test.
(i) Serial Independence (Autocorrelation): Autocorrelation measures the
significance of the positive or negative correlation in return over time. Does the rate of
return on day correlate with the rate of return on day t- 1 or t-2 or t-3. If the capital
market is believed to be efficient then one should expect insignificant correlation for all
combinations. Randomness in stock price movements can be tested by calculating the
correlation between price changes in one period and changes for the same stock in
another period.
If the autocorrelation is close to zero, the price changes are said to be serially
independent. This is tested for over-short periods (1 to 4 days, even 9-16 days). Fama,
for instance, calculated the autocorrelation for the period 1958-1962 for US stock
prices. The autocorrelation was found to be insignificant. A similar analysis is done for
the BSE Sensitive Index (Sensex) and few other stocks for the period from April 1997 to
March 2001 using the daily index value and the results are reported in Table 9.1. The
results show that the serial or auto correlation values between the returns of various
lags are very low and statistically insignificant except in a few cases. A very low
autocorrelation provides some evidence that Indian market is also showing efficiency at
weak form and hence any analysis on historical price data is of little use. One of main
reasons for achieving weak form of efficiency is creating an environment for active
64 trading and reducing the transaction cost. These two actions will attract a large number
of investors to trade and bring some level of efficiency in the market.
 Efficient Market
Table 9.1: Serial Correlation (Autocorrelation) of select securities Hypothesis
Days Lag Sensex HLL Infosys Reliance Telco Tisco
1 0.0332 0.0751 0.1796 0.0359 0.1014 0.0300
2 0.0052 -0.0123 0.0312 0.0167 0.0178 0.0153
3 -0.0018 -0.0582 -0.0173 0.0381 0.0153 0.0309
4 0.0250 0.0097 -0.0548 0.0180 0.0181 0.0450
5 -0.0237 -0.1045 -0.0295 -0.0076 0.0058 -0.0126
6 -0.0366 -0.0647 -0.0384 -0.0136 -0.0541 -0.0518
7 -0.0060 -0.0403 -0.1144 0.0351 -0.0514 -0.0125
8 0.0228 -0.0129 -0.0241 0.0133 -0.0196 -0.0070
9 0.1076 0.0255 0.0622 0.0431 0.0984 0.0469
10 0.0142 -0.0130 0.0248 0.0213 -0.0194 0.0668
(ii) Runs tests confirm efficiency: Price changes may be random most of the time,
but occasionally become serially correlated for varying period of time. Further serial
correlation coefficients can be affected by extreme values. To overcome these
problems, the run test is used. Run tests ignore the absolute values of the numbers in
the series and observe only their signs. Given a series of price changes, each price
change is either designated a plus (+) if it is an increase in price or a minus (-) if it is
a decrease in price. The result is a set of pluses and minuses just like this - + + + - + -
+ + + - + - + + . A run occurs when two consecutive price changes are the same, two
or more consecutive positive or negative price changes constitute one run. For
example + + + - - +- + - has three runs. When the price changes in a different
direction then, such as a negative price change is followed by a positive price change,
the run ends and a new run begins.
The actual number of runs observed is compared with the number that are expected
from a series of randomly generated price changes. If no significant differences are
found, then price changes are random in character. Studies that have examined the
stock price runs have confirmed the independence of stock price changes over time.
The actual number of runs for stock price series consistently fell over the range
expected for a random series.
(iii) Distribution Pattern: The sum or the distribution of random occurrences
will statistically conform to a normal distribution. If proportionate price changes are
randomly generated events, then their distribution should be approximately normal.
Fama has tested for normal distribution and found only slight difference from the
normal. Studies have also been undertaken on technical trading strategies based on
information other than historical prices, such as odd-lot figures, volume of short
sales, advance-decline ratios, chart pattern, etc. The general conclusion is that such
strategies have failed to outperform a naive buy-and-hold strategy.
b) Tests of Trading Rules
The statistical tests of independence were too rigid to identify the intricate price
patterns examined by technical analysis. Technical analysis do not accept a set
number of positive or negative price changes as a signal of a move to a new
equilibrium in the market. They typically look for a general consistency in the price
and volume trends over time. Such a trend might include both positive and negative
changes. For this reason technical analysts felt that their trading rules were too
sophisticated and complicated to be simulated by rigid statistical tests. Advocates of
EMH, hypothesized that investors could not derive profit above a buy and hold
policy or abnormal profits using any trading rule that depended solely on any past
market information about factors such as price, volume, odd lot shares or specialist
activity.
Filters can be prescribed for trading as follows:
A share price is increasing and a 20 per cent filter has been set. Suppose it starts
declining and when it reaches a level 20 per cent below its peak, it is a sell signal.
Similarly, if the share is declining in price and it reverses its trend and level, then it is
a buy signal. By using such buy and sell signals, using filters ranging from 1 to 50
per cent several studies found that it was not possible to earn abnormal returns. 65
Securities Market in
India Studies of this trading rule have a range of filters from 0.5 percent to 50 percent. The
results indicated that small filters would yield above average profits before taking
account of trading commissions. However some filters generate numerous trades and
therefore substantial trading costs. When these trading commissions were considered
all the trading profits turned to losses. Alternatively, larger filters did not yield returns
above those of a simple buy and hold strategy (Fama and Blume, 1966).
On a before transaction cost basis these trading rules do appear to work, but there is no
evidence that you can profitably trade on this - when transaction costs are included the
profitability disappears.
Researchers have generated other trading rules that used past market data other than
stock prices. Trading rules have been devised that use odd-lot figures, advanced-
decline ratios, short sales, short positions and specialist activities. These simulation
tests have generated mixed results. Most of the early studies suggested that these
trading rules generally would not outperform a buy and hold policy on a risk-adjusted
basis after taking account of commissions (George Pinches, 1970), while a couple of
studies have indicated support for the specific trading rules (Brush, 1986 and Proitt
and White, 1988). Therefore most evidence from simulation of specific trading rules
indicate that these trading rules have not been able to beat a buy and hold policy.
These results support the weak form of EMH.
9.4.2 Tests of Semi-Strong Form
Semi-Strong form contends that all public information is fully reflected in security
prices. Public information includes company financial statements, earnings and
dividends, bonus announcements and macro-economic data.
The most obvious indication that the market is not always and everywhere semi-
strong form efficient is that money managers frequently use public information to
take positions in stocks. While there is no evidence that they beat the market on a
risk-adjusted basis, it is hard to believe that an entire industry of information
production and analysis is for naught. It seems likely that there is value to publicly
available information, however there are probably degrees to which information
really is public knowledge. What is surprising is that recent studies have shown some
evidence that excess returns can be made by trading upon very public information.
These tests usually take the form of "backtesting" trading strategies. That is, you play
a "what-if' game with past stock prices, and pretend you followed some rule, using
information available only at the time of the pretend trade. One common rule that
seems to perform well historically is to buy stocks when the dividend yield is high.
This apparently has made money in the past, even though the information about
which of the stocks have high yields and which of them have low yields is widely
available. Another rule that generates positive excess returns in back-tests is to buy
stocks when the earnings announcement is higher than expected. This seems simple,
since current announcements and even forecasts are widely available as well.
Does this mean that it is easy to become rich in stock market? Hardly! The profitability
of these simple trading rules depends upon the liquidity of the stocks involved and
trading costs ("frictions"). Sometimes the costs outweigh the benefits. While many
investment managers explain that they pursue a strategy of buying "Value" stocks
(such as low PIE firms) few of these managers have consistently superior track
records.
The assumption of semi-strong form efficiency is a good first approximation for a
market with as many sharp traders and with as much publicly available information
as the U.S. equity market. Fama, Fischer, Jensen and Roll have tested the speed of the
market's reaction to a company's announcements of a stock split and with respect to a
change in dividend policy. They estimated the abnormal returns using `residual
analysis". Security returns were regressed against the returns on a market index and
the error term in the following linear equation represented the residual or abnormal
return.
Fama, Fischer, Jensen and Roll examined 940 Stock Splits on the New York Stock
Exchange from 1927 to 1959. Price of the Stocks was examined for a period of 29
months before the date of the split and 20 months after the split. The actual act of
66 splitting did not have any impact on the wealth of shareholders. Further, buying
stocks after a stock split did not appear to produce abnormal returns.
 Efficient Market
Ball and Brown did an analysis of the stock market's ability to absorb the Hypothesis
informational content of reported annual earnings per share. They found that those
companies which reported "good" earnings experienced price increases and those
with "bad" earnings reports experienced price declines. Nearly 85 per cent of the
informational content of the earnings announcements was reflected in stock price
movements, prior to the release of the actual figure.
9.4.3 Tests of Strong Form
Strong form argues that all information is fully reflected in security prices. The top
management has access to corporate and financing strategies. In the same way
specialists have access to the book limit orders for any share. Knowledge of the price
and quantities of th e limit order represent private information. Professional portfolio
managers who have large research database and also access to top management may
also have access to such private. Merchant banking firms, for example, may have
private information on a new company that has not yet been disclosed to the public.
To disprove strong form EMH, one has to find an insider who has profited from
inside information.
The strong form of EMH is of two types:
a) Super-strong form which includes insiders and specialists (who possess
monopolistic information)
b) Near-strong form which includes private estimates developed by (who possess
information) financial analysts, portfolio managers, etc.
In USA, corporate managers or say one who owns more than 10 per cent of an issue
of securities are deemed to be "insiders" under the Securities and Exchange Acts of
1933 and 1944. Insiders are required to report their transactions within 10 days to the
Securities and Exchange Commission. Such insider trading information is published
in the SECs Official Summary of Securities Transactions and Holdings. Nearly 2
months elapse before information on insider transactions becomes publicly available.
Several studies have found that insiders and specialists in USA use such monopolistic
information to advantage and earn positive abnormal returns. Hence the super-strong
form of EMH was by and large not valid.
Under the Insiders Trading Regulation, 1992, the Securities and Exchange Board of
India defined an, insider as "a person who, is or was connected with the company or
is deemed to have been connected with the company, and who is reasonably expected
to have access, by virtue of such connection, to unpublished price sensitive
information in respect of securities of the company, or who has received or has had
access to such unpublished price sensitive information". Hence an insider could be
the company promoter, director, executive, auditor, a lawyer, stock broker, a fund
manager or even a newspaper correspondent who may be privy to a certain critical
development in the company which could affect the company's share prices, before
the general public come to know of the development.
The regulation has also given an illustrative list of information that may be construed
upon as price sensitive information. It includes financial results (both half yearly and
annual), declaration of dividends (both half yearly and annual), issue of shares by
way of public, rights or bonus, any major expansion or execution of new projects,
amalgamation, mergers and takeovers, taxation charges, extra-ordinary events like
strikes, etc.
Further the regulation say that a person guilty of insider trading based on reports
submitted by the inspection of SEBI is liable to be punished with a civic penalty not
exceeding three times of the profit gained or loss avoided as a result of dealing,
subject to a minimum of Rs. 5,00,000 or punishable with rigorous imprisonment not
exceeding two years, or a fine not exceeding Rs. 5 lakhs or both as the court may
decide. (More information on the regulation could be obtained from the SEBI web
site: www.sebi.gov.in). With the implementation of the regulation to curb insider
trading, it is hoped that stock market would become more efficient and devoid of
malpractice.
Even studies in USA that rejected the superstrong form of EMH did not report
exceedingly large returns. Insiders have been able to earn abnormal returns of the
order of 4-5 per cent over a period of 8 months before transaction costs. Between
1968 and 1977, the performance
67
Securities Market in
India of more than 83 per cent of all mutual funds in USA was worse than S&P 500 index.
The fact that mutual funds did not outperform randomly selected portfolio probably
means that mutual fund managers compete in an efficient market with other portfolio
managers of equal competence.
A simple test for Strong Form of Efficiency is based upon price changes close to an
event Acts of nature may move prices, but if private information release does not, then
we know that the information is already in the stock price. For example, consider a
merger between two firms. Normally, a merger or an acquisition is known about by an
"inner circle" of lawyers, investment bankers and the firm managers before the public
release of the information. When these insiders violate the law by trading on this private
information, they may make money. They also make it to the SEC's wall of shame.

Unfortunately, stock prices typically move up before a merger, indicating that someone
is acting dishonestly. The early move indicates that the market has a tendency towards
strong-form of efficiency, i.e. even private information is incorporated into prices.
However, the public announcement of a merger is typically met with a large price
response, suggesting that the market it not strong-form efficient. Leakage, even if
illegal, does occur, but it is not fully impounded in stock price. By the way, until
recently, insider trading was legal in Switzerland.

The efficient market theory is a first and good approximation for characterizing how
price is a liquid and free market react to the disclosure of information. In a word,
"Quickly!" If they did not, then the market is lacking in the opportunism we have come
to expect from an economy with arbitrageurs constantly collecting, processing and
trading upon information about individual firms. The fact that information is
impounded quickly in stock prices and that the windows of investment opportunity are
fleeting, is one of the best arguments for keeping the markets free of excessive trading
costs, and for removing the penalties for honest speculation. Speculators keep market
prices close to economic values, and this is good, not bad.

Activity-1

a) List out three forms of market efficiency.

…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
68 …………………………………………………………………………………
…………………………………………………………………………………
 Efficient Market
b) List out four test of weak form of market efficiency and point out which of the Hypothesis
four are statistical in nature?
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
9.5 ANAMOLIES IN EMH
Securities markets are flooded with thousands of intelligent, well-paid, and well-
educated investors seeking under and over-valued securities to buy and sell. The
more participants and the faster the dissemination of information, the more efficient a
market should be. The debate about efficient markets has resulted in hundreds and
thousands of empirical studies attempting to determine whether specific markets are
in fact "efficient" and if so to what degree. Many novice investors are surprised to
learn that a tremendous amount of evidence supports the efficient market hypothesis.
Early tests of the EMH focused on technical analysis and it is chartists whose very
existence seems most challenged by the EMH. And in fact, the vast majority of
studies of technical theories have found the strategies to be completely useless in
predicting securities prices. However, researchers have documented some technical
anomalies that may offer some hope for technicians, although transaction costs may
reduce or eliminate the advantage.
a) Technical Anomalies
A question that has been subject to extensive research and debate is whether past
prices and charts can be used to predict future prices. "Technical Analysis" is a
general term for a number of investing techniques that attempt to forecast securities
prices by studying past prices and related statistics. Common techniques include
strategies based on relative strength, moving averages, as w e l l as support and
resistance.. The majority of researchers that have tested technical trading systems (and
the weak-form efficient market hypothesis) have found that prices adjust rapidly to
stock market information and that technical analysis techniques are not likely to
provide any advantage to investors who use them. However others argue that there is
validity to some technical strategies. In particular, an excerpt from the sixth edition of
Malkiel's book goes like this - "The central proposition of charting is absolutely false,
and investors who follow its precepts will accomplish nothing but increasing
substantially the brokerage charges they pay. There has been a remarkable uniformity
in the conclusions of studies done on all forms of technical analysis. Not one has
consistently outperformed the placebo of a buy-and-hold strategy."
Ball and Brown analyzed annual earnings, Joy, Litzenberger and McEnally tested the
impact of quarterly earnings announcement on stock prices. They found that
favorable information published in quarterly reports is not instantaneously reflected
in stock prices. Researchers have also uncovered numerous other stock market
anomalies that seem to contradict the EMH. The search for anomalies is effectively
the search for systems or patterns that can be used to outperform passive and/or buy-
and-hold strategies. Theoretically though, once an anomaly is discovered, investors
attempting to profit by exploiting the inefficiency should result its disappearance. In
fact, numerous anomalies that have been documented via back testing have
subsequently disappeared or proven to be impossible to exploit because of
transactions costs.
b) Stock Market Anomalies
The stock market related anomalies include-
(i) Fundamental anomalies:
Value investing is probably the most publicized anomaly of the fundamental anomalies
and is frequently touted as the best strategy for investing. There is a large body of
evidence documenting the fact that historically, investors mistakenly overestimate the
prospects of growth companies and underestimate value companies. S. Basu in a well-
researched article tested for the informational content of the price earnings multiple.
His study inquired into whether low price earnings multiple tended to outperform
stocks with high P/E ratios. His study indicates that low P/E portfolio experienced
69
superior returns relative to the market.
Securities Market in
India Over 20 different studies of market reaction to earnings announcements reported post-
announcement excess returns.
(ii) Calendar Anomalies:
These includes anomalies like the January effect, turn of the month effect, the Monday
effect and Year ending in 5 effect.
January Effect: According to Robert Haugen and Philippe Jorion, "The January
effect is, perhaps the best-known example of anomalous behaviour in security
markets throughout the world." The January Effect is particularly intriguing because
it doesn't appear to be diminishing despite being well known and publicized for nearly
two decades. Theoretically an anomaly should disappear as traders attempt to take
advantage of it in advance. The bottom line is that January has historically been the
best month to be invested in stocks.
The effect is usually attributed to small stocks rebounding following year-end tax
selling. Individual stocks depressed near year-end are more likely to be sold for tax-
loss recognition while stocks that have run up are often held until after the new year.
Many believe the January effect has moved into November and December as a result
of mutual funds being required to report holdings at the end of October and from
investors buying in anticipation of gains in January. Some studies of foreign
countries have found that returns in January were greater than the average return for
the whole year. Interestingly, the January effect has also been observed in many
foreign countries including some (Great Britain and Australia) that don't use
December 31 as the tax year-end. This implies that there is more to the January effect
than just tax effects.
Empirical study has also established that over one-half of the small firm effect occurs
in January and most of the abnormal return associated with January takes place during
the first 5 days of trading.
Turn of the Month Effect: Stocks consistently show higher returns on the last day
and first four days of the month. Chris R. Hensel and William T. Ziemba presented
the theory that the effect results from cash flows at the end of the month (salaries,
interest payments, etc.). The authors found returns for the turn of the month were
significantly above average from 1928 through 1993 and "that the total return from
the S&P 500 over this sixty-five-year period was received mostly during the turn of
the month." The study implies that investors making regular purchases may benefit
by scheduling to make those purchases prior to the turn of the month.
The Monday Effect: Monday tends to be the worst day to be invested in stocks. The
first study documenting a weekend effect was by M. J. Fields in 1931 in the Journal
of Business at a time when stocks traded on Saturdays. Fields had also found in a
1934 study that the DJIA commonly advanced the day before holidays. Several
studies have shown that returns on Monday are worse than other days of the week.
Interestingly, Lawrence Harris has studied intraday trading and found that the
weekend effect tends to occur in the first 45 minutes of trading as prices fall but on
all other days prices rise during the first 45 minutes. This anomaly presents the
interesting question: Could the effect be caused by the moods of market participants?
People are generally in better moods on Fridays and before holidays, but are
generally grumpy on Mondays (in fact, suicides are more common on Monday than
on any other day). Investors should however, keep in mind that the difference is
small and virtually impossible to take advantage of because of trading costs.
Year ending in 5
In its existence, the DJIA has never had a down year in any year ending in 5. Of course,
this may be purely coincidental. Unfortunately we have to wait till 2005 to see if the
streak will continue.
c) Other Anomalies
The Size Effect: Some studies have shown that small firms (capitalization or assets)
tend to outperform. The small stock affect was first documented by Rolf W. Banz. He
divided the stocks on the NYSE into quintiles based on market capitalization. The
returns from 1926 to 1980 for the smallest quintile outperformed the other quintiles
70 and other indexes. Others have argued that it is 'not size that matters, it is the
attention and the number of analysts that follow the stock.
 Efficient Market
Announcement Based Effects: Price changes tend to persist after initial Hypothesis
announcements. Stocks with positive surprises tend to drift upward, those with
negative surprises tend to drift downward. Some refer to the likelihood of positive
earnings surprises to be followed by several more earnings surprises as the
"cockroach" theory because when you find one, there are likely to be more in hiding.
Robert Haugen in his book The New Finance: The Case Against Efficient Markets
argued that the evidence implies investors initially underestimate firms showing
strong performance and then overreact. Haugen concluded that "The market
overreacts-with a lag" and that " we apparently have a market that is slow to
overreact."
IPOs, Seasoned Equity Offerings, and Stock Buybacks: Numerous studies have
concluded that Initial Public Offerings (IPOs) in aggregate underperform the market
and there is also evidence that secondary offerings also underperform. Several recent
studies have also documented arguably related market inefficiencies. Bala Dharan
and David Ikenberry found that firms listing their stock on the NYSE and AMEX for
the first time subsequently underperform. Tim Loughran and Anand M. Vijh recently
found that acquiring firms that complete stock mergers underperform, while firms that
complete cash tender offers outperform. The study implies that acquirers who use
their stock to effect transactions may believe the stock is overvalued.
Stock repurchases, on the other hand, can be viewed as the opposite of stock issues,
and studies have shown that firms announcing stock repurchases outperform in the
following years (David et al. 1995). This evidence seems to confirm the theory that
managers tend to have inside information regarding the value of their company's
stock and their decisions whether to issue or buy back their stock may signal over or
undervaluation. The implication of these studies seems to be that investors may do
better buying stocks of firms that are repurchasing their own stock rather than from
firms that are selling or issuing more of their own stock.
Insider transactions: There have been many studies that have documented a
relationship between transactions by executives and directors in their firm's stock and
the stock's performance. Insider buying by more than one insider is considered by
many to be a signal that the insiders believe the stock is significantly undervalued and
their belief that the stock will outperform accordingly in the future. However, many
researchers question whether the gains are significant and whether they will occur in
the future.
The S&P Game: "The S&P Game" involves buying stocks that will be added to the
S&P 500 index (after the announcement but before the stock is added several days
later). The fact that stocks rise immediately after being added to S&P 500 was
originally documented by Andrei Shleifer as well as Lawrence Harris and Eitan Gurel
in 1986 (Also see Messod D. Beneish and Robert E. Whaley). Opportunities may also
exist with other indexes.
9.6 INDIAN STUDIES ON MARKET EFFICIENCY
There have been numerous empirical studies on testing the different forms of market
efficiency in the developed markets. Though the empirical work is not comparable to
the quantity of work in the developed markets, Indian literature on this is not a
neglected subject. For instance a study on weak form of efficiency by Ramasastri
(2001) tested the efficiency of the Indian capital market for the period from 1996
through 1998 using a powerful technique called the Spectral Analysis. As per his
findings, autocorrelation for different lags were found to be statistically insignificant.
Further correlogram, based on Sensex, established that Indian stock market has been
efficient. Spectral analysis revealed that there is a presence of periodic cycles in the
movement of share prices. Yet confirms market efficiency as power function flattens
at higher frequencies. Other studies that validated the Weak form of efficiency
include Studies by Rao and Mukherjee (1971) Sharma and Kennedy (1977) SK
Barua (1980), OP Gupta (1985) and YB Yalawar (1985)
Abhijit Dutta (2001) tested the semi strong form of market efficiency. He attempted
to analyze the behaviour of Indian individual investor's reaction to the good and bad
news and their effect on the stock market. The statistical inferences were based on three
major factors namely, the individual investors confidence in the market, Indian
individuals reaction to the market and their portfolio decision. The findings revealed
that the Indian 71
Securities Market in
India individuals have high confidence in themselves and are not guided by the market
discounted asymmetric information. However, since their number is less, their
influence is not felt.
A study by Rao and Nageshwara (1997) on the BSE index shows that market react to
totality and specifically administered prices react the sharpest in the context.
Similarly Arora and Natarajan (1997) concluded that if equilibrium with regard to
investment had to be reached then priority assignments amid the goals are to be rather
discouraged.
Maiti (1997) had observed the various aspects of shareholding pattern and concluded
that institutional investors showed loyalty to blue chip companies leading to an
asymmetry in market information as regards investment in stocks. J Ramachandran had
studied the impact of bonus issues on share prices and found the market to be efficient
in semi-strong form.0ther Indian Studies by Desai M (1965), Ojha PR (1976),
Prasanna Chandra (1975) and Ramachandran G (1989) showed the dividends have a
positive influence on share price behaviour. There has been no empirical study
validating the strong form of EMH in India.
9.7 IMPLICATIONS OF EMH FOR SECURITY
ANALYSIS
There are three reasons why security analysis remains relevant even in a generally
efficient market. In an efficient but less than perfect market, there is a time lag between
the arrival of information and its subsequent reflection in price. During the interval,
security analysis provides an opportunity to adjust portfolios profitably. Such rewards
are captured by institutional investors, who have the capacity to process large amounts
of data quickly and efficiently.
Competition of information, which ensures market efficiency, limits the opportunity to
earn above average return. The legitimate function of security analysis is to discover
information before competitors get it. Security analysis is critical to the investment
process even in the case of instantaneous price response. Correct pricing of assets in
an efficient market (but less than perfect) does not imply investors' indifference to the
choice of assets held in a portfolio. As price of security responds to new information,
reflecting change in risk and returns, portfolio adjustment takes place. Security
analysis and portfolio management are complimentary to an efficient capital market.
9.8 IMPLICATIONS OF EMH FOR PORTFOLIO
MANAGEMENT
Since you are now a lot familiar with the subject could I pose the question "Is it
possible to outperform the market?" This is one of the most important questions any
investor should ask. This question is relevant for you as an investor and also for the
fund managers, who invest in securities promising the naive investors to pay a
handsome return on their investment. This they could do only by outperforming the
market. If your answer is no and if you believe the market is efficient, then passive
investing or indexing - buying diversified portfolios of all the securities in an asset
class - is probably the way to go. The arguments for such an approach include
reduced costs, tax efficiency and the fact that, historically, passive funds have
outperformed the majority of active funds
But if your answer is yes, it is possible to beat the market, then you should pursue
active portfolio management. Among the arguments for this approach are the
possibility that there are a variety of anomalies in securities markets (that we have
discussed in the earlier sections) that can be exploited to outperform passive
investments the likelihood that some companies can be pressured by investors to
improve their performance and the fact that many investors and managers have
outperformed passive investing for long periods of time.
But the active investor must still face the challenge of outperforming a passive
strategy. Essentially, there are two sets of decisions. The first is asset allocation,
where you carve up your portfolio into different proportions of equities, bonds and
72 other instruments decisions, often referred to as market timing as investors try to
reallocate between equities and bonds
 Efficient Market
in response to their expectations of better relative returns in the two markets, tend to Hypothesis
require macro forecasts of broad-based market movements. The second set of
decisions includes security selection - picking particular stocks or bonds. These
decisions require micro forecasts of individual securities underpriced by the market
and hence offering the opportunity for better than average returns.
Active investing involves being 'overweight' in securities and sectors that you believe
to be undervalued and `underweight' in assets you believe to be overvalued. Buying a
stock, for example, is effectively an active investment that can be measured against
the performance of the overall market. Compared to passive investing in a stock index,
buying an individual stock combines an asset allocation to stocks and an active
investment in that stock in the belief that it will outperform the stock index. In both
market timing and security selection decisions, investors may use either technical or
fundamental analysis and growth investing. And you can be right in your asset
allocation and wrong in your active security selection and vice versa.

There could be two important implications of EMH for portfolio selection. These are:

1. Even simple random selection leads to portfolio, which approximates the market
very closely when 15-20 stocks are held.

2. Index Funds are an outgrowth of the increasing awareness and acknowledgement

of market efficiency.

Nobel Laureate William Sharpe makes a simple yet powerful case against active
management in his article 'The Arithmetic of Active Management': "If active and
passive management styles are defined in sensible ways, it must be the case that: (1)
before costs, the return on the average actively managed dollar will equal the return
on the average passively managed dollar; and (2) after costs, the return on the average
actively managed dollar will be less than the return on the average passively managed
dollar These assertions will hold for any time period".

Ambitious investors and investment managers almost all want to beat the market, but
it is worth asking why should they want to beat it for you. Why should precious
insights into the nature of the market be available for sale to the general public, either
directly through a fund or indirectly, perhaps through a book advocating a particular
investment technique as the route to out-performance? If an investment technique is so
good, it would seem to make more sense to keep its secrets to yourself.

Activity-2

a) Distinguish between active and passive management of portfolio? Briefly

explain the process involved in the active management of the portfolios.

……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………

b) List out the implications of EMH for security analysis and portfolio
management in India.

……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………

9.9 SUMMARY
In this Unit, we have discussed various dimensions of the hypothesis that the stock
markets are efficient. We have highlighted the concept and forms of market
efficiently viz., weak form, semi-strong form. and strong form. We have also
described various empirical tests of EMH. Indian studies on market efficiency are
briefly indicated and the anomalies in EMH 73
Securities Market in
India are pointed out. The Unit closes by highlighting the implications of EMH for security
analysis and portfolio management, "Investing by dart" can still not be recommended
as superior equity investment strategy in the context of most of the stock markets of the
world. Most of the world stock markets are still less than efficient and hold scope for
abnormal returns by following active security analysis and portfolio management
strategies.

9.10 SELF-ASSESSMENT QUESTIONS/EXERCISES

1. What do you mean by capital markets are efficient? And why capital market
should be efficient?
2. Define market efficiency?
3. Describe the differences in various forms of market efficiency.
4. Describe the different tests of the weak form of EMH.
5. What are the implications of EMH for technical analysis?
6. What factors can act as signaling devices for stock price movements? Explain,
how these factors would affect market efficiency?
7. Distinguish between active and passive portfolio management strategies. Why
did Index funds become popular in USA?
8. What are some of the anomalies in efficient market hypothesis?
9. What are the implications of EMH for security analysis and portfolio
management?

9.11 FURTHER READINGS

Ball R and P Brown. "An Empirical Evaluation of Accounting Income Numbers",
Journal of Accounting Research, Autumn, 1968.
S Brown and J Warner "Measuring Security Price Performance" Journal of Financial
Economics, September 1980.
S. Basu, "Investment Performance of Common Stocks in Relation to their Price-
Earnings Ratios: A Test of the Efficient Market Hypothesis", Journal of Finance, June
1977.
Eugene F. Fama, "Random Walks in Stock Market Prices," Financial Analysts
Journal, September/October 1965 (reprinted January-February 1995).
E. Fama, "Efficient Capital Markets: A Review of Theory and Empirical Work". Journal
of Finance, May 1970.
E.F. Fama, L. Fisher, M Jensen and R. Roll, "The Adjustment of Stock Prices to New
Information", International Economic Review, February 1969.
K.K. French "Stock Returns and the Weekend Effect" Journal of Financial Economics,
March 1980.
Robert Haugen and Philippe Jorion, "The January Effect: Still There after All These
Years," Financial Analysts Journal, January-February 1996.
Chris R. Hensel and William T. Ziemba, "Investment Results from Exploiting Turn-of-
the-Month Effects," Journal of Portfolio Management, Spring 1996.
Lawrence Harris, "A Transaction Data Study of Weekly and Intradaily Patterns in Stock
Returns, "Journal of Financial Economics, June 1986
Rolf W. Banz, "The Relationship Between Market Value and Return of Common
74 Stocks," Journal of Financial Economics, November 1981.
 Efficient Market
Bala Dharan and David Ikenberry, "The Long-Run Negative Drift of Post-Listing Stock Hypothesis
Returns," Journal of Finance, December 1995.

David Ikenberry, Josef Lakonishok, and Theo Vermaelen, "Market Underreaction to

Open Market Share Repurchases," Journal of Financial Economics, October 1995.

Lawrence Harris and Eitan Gurel, "Price and Volume Effects Associated with Changes
in the, S&P 500 List: New Evidence for the Existence of Price Pressures." Journal of
Finance, September 1986.

Messod D. Beneish and Robert E. Whaley "An Anatomy of the S&P Game: The Effects
of Changing the Rules" Journal of Finance, December 1996.

William F. Sharpe (1991), "The Arithmetic ofActive Asset Management' Financial

Analysis Journal 47 (1), January / February.

Albright, Christian S. (1987), Statistics for Business and Economics, New York,
Macmillan Publishing, 515-517..

Hagerman, Robert K. and Richmond, Richard D. (1973), "Random Walks, Martingales

and the OTC", Journal of Finance 28 (4), September, 897-909.

Fama, Eugene and Blume, Marshal (1966), "Filter Rules and Stock Market Trading
Rules", Journal of Finance 39 (1), (January): 226-241.

Pinches, George (1970), "The Random Walk Hypotheses and Technical Analysis",
Financial Analysts Journal 26 (2), (March - April): 104-110.

Brush, John S. (1986), "Eight Relative Strength Models Compared" Journal of Portfolio
Management 13 (1), (Fall): 21-28.

Pruitt, Stephen W. and White, Richard E. (1988), "Who Says Technical Analysis Can't
Beat the Market", Journal of Portfolio Management 14 (3), (Spring): 55-58.

Ramasastri, A. S. (2001), "Stock Market Efficiency - Spectral Analysis" Finance India

15 (3), (September): 885-990.

Arora, R. and Natarajan P. (1997), "Social Dynamics Influences Towards

Equilibrium Decisions as regards Investment Opportunities in the Light of Multiple
Goals" Finance India 10: 941-950.

Maiti, M. H. (1997), "Indian Capital Market: Some Emerging Trends" Finance India
11: 609-618.

Rao, S. V. D. and Nageswara (1997), "Response of Stock Price to Macro Events"

Finance India 10: 881-918.

Abhijit Duna (2001), "Investors Reaction to Good and Bad News in Secondary Market:
A Study Relating to Investor's Behaviour" Finance India 15 (2), (June): 567-576.

75
 Portfolio Analysis
UNIT 10 PORTFOLIO ANALYSIS
Objectives

The objectives of this Unit are to:

• explain and illustrate the concepts and measures of return and risk as they
apply to individual assets as well as portfolio of assets
• highlight the concept of diversification of risk
• discuss the portfolio selection problem and the process.
Structure
10.1 Introduction
10.2 Inputs to Portfolio Analysis
10.2.1 Return and Risk Characteristics of Individual Assets
10.2.2 Expected Return and Risk of a Portfolio
10.2.3 Diversification of Risk
10.3 Portfolio Analysis and Selection
10.3.1 Portfolio Risk Selection Problem
10.3.2 Selection of Optimal Portfolio
10.4 Summary
10.5 Key Words
10.6 Self-Assessment Questions/Exercises
10.7 Further Readings

10.1 INTRODUCTION
Suppose you believe that investments in stocks offer an expected return of 20% while
the expected return from bonds is around 10%. Would you invest all your money in
stocks because stocks offer two times of return of bonds? Probably not; because you
may be aware of an axiom that `putting all eggs in a basket is not desirable'. You
would prefer a portfolio of securities rather than investing all your savings in a single
security or group of securities belonging to same category. In this book, we will
discuss more about how one should go about in constructing a portfolio that suits
specific objectives of the investment. In this unit, we will address some of the basic
issues measuring return and risk of the portfolio before addressing the main issue of
selecting optimal portfolio.

The term `portfolio' generally means a collection or combination and in the context of
investment management, it means a collection or combination of financial assets (or
securities) such as shares, debentures and government securities. However, in a more
wider context the term `portfolio' may be used synonymously with the expression
`collection of assets', which can even include physical assets (gold, silver, real estate,
etc.). What is to be borne in mind is that, in the portfolio context, assets are held for
`investment' purposes and not for `consumption' purposes.

We will begin with the analysis of return-risk characteristics of individual assets, and
then proceed to examine how individual assets combine into a portfolio to determine
its return and risk attributes. Having done so, our next logical step would be to
consider the question; how can an investor make a choice when facing an infinite
number of possible portfolios? Or, more precisely, how can the investor decide which
assets to hold and how much to invest in each? Quite obviously, the ultimate choice
of a portfolio will hinge on the investor's attitude towards risk and return. 5
Portfolio Theory
10.2 INPUTS TO PORTFOLIO ANALYSIS
Portfolio analysis builds on the estimates of future return and risk of holding various
combinations of assets. As we know, individual assets have risk return characteristics
of their own. Portfolios, on the other hand, may or may not take on the aggregate
characteristics of their individual parts. In this section, we will reflect on the
assessment of return-risk attributes of individual assets and portfolios.
10.2.1 Return and Risk Characteristics of Individual Assets
Any investment decision requires an estimate of return and risk associated with the
investment. However the most difficult task of investment decision is estimation of
return and risk. We spent the whole of Block III in discussing how should one
estimate the future value of the asset so that return can be measured. If we are able to
estimate a range of expected return, then it is possible to estimate the probabilities
associated with the range of expected return to get the risk measure. In practice,
however, the return and risk of the securities are estimated based on the historical
return and risk of securities. A stock's single period basic return is:
Dividend + (Market Price t - Market Price t-1 )
Total Return t =
Market Price t-1
There are different measures of historical return. The most elementary form of return
measure is holding period yield or return. Here, the dividend received during the
holding period is added along with the capital gain and divided by the purchase price.
If the holding period is more or less than one year, normally the holding period return
is stated for one-year period. This measure is not much useful if one wants to
measure the risk associated with the security. There are two other measures of return
by which one can measure risk.
a) Arithmetic Average: The arithmetic average return is equal to sum of returns
of period and divided by `n'. For instance, if the stock has offered a holding
period return of 11% in period 1, 12% in period 2 and 16% in period 3, then the
arithmetic average return is equal to 13%. Though it is better than holding
period return, this measure suffers because of its failure in considering time
value of money. Another problem of this measure is differential treatment of
positive and negative return. For instance if a stock price increases from Rs. 10
to Rs. 20 in period 1 and declines back to Rs. 10 in period 2, the Arithmetic
average return is still positive value of 25% (Period I return is 100% and Period
2 return is -50%; Total return is 50% and hence average return is 25%).
b) Geometric Average: The geometric average return is based on the compound
value and is also called time-weighted average return. It addresses the problem
of differential treatment of positive and negative return described above. The
geometric average return is computed as follows:
GMR = [(1 + R1 ) x (1 + R 2 ) x (1 + R 3 ).....x (1 + R n )]1/n − 1
Illustration: Five years back, you have applied and was allotted 100 shares of a
company at the rate of Rs. 50 per share (Face Value Rs. 10). The price at the end of
each year along with annual dividend per share received from the stock are as
follows:
Year 1 2 3 4 5
Dividend per share (Rs.) 1 1.5 1.5 2 2
Market Price (Rs.) 40 55 70 77 91
Find the Holding Period Return (HPR), Arithmetic Average and Geometric Average
return of the stock.
HPR : [Dividend (Rs. 8) + Capital Appreciation (Rs. 41)] / Investment (Rs. 50)
: 49/50 = 98% for five years or 19.60% per year
AA Return : [R1 (-18%) + R2 (41.25%) + R3 (30%) + R4 (12.86%) + R5(20.78%)]/5
17.38%
6 Note: R1 is equal to [(41-50)/50], R2 is equal to [(56.5 - 40)/40], etc.
GA Return : [(1+R1)x(1+R2)x(1+R3)x(1+R4)x(1+R5)]1/5 – 1 Portfolio Analysis
: [(.82)x(1.41)x(1.30)x l.13)x(1.21%)]1/5-1
: 15.47%
As you may observe, for the same set of data, we get different values of return. HPR
is the highest and GAR is the lowest. The Geometric Return is lower than other two
returns because of compounding. In Table 10.1, the different measures of return of
NSE-50 companies are given based on last ten years data. The list contains only for
the companies, which have 10-year listed life.
In addition to the above two types of return, a foreign investor or foreign fund would
compute dollar-weighted return to adjust differences in the foreign exchanges
between the point of investment and sale. For example, if a foreign fund purchased a
stock at Rs. 50 today when the US Dollar - Rupee rate is Rs. 50 per US Dollar and sold
the stock at Rs. 55 at the end of one year, the holding period return in Rupee term is
10% [(55-50)/50]. However, if the Rupee depreciates during this period and quotes
Rs. 56 per US Dollar, the foreign fund incurs a loss because it can get less than one
Dollar with the sale value of the stock. The loss is equal to 1.79% [$1- $(55/56)].
While historical return gives a fair idea about the future return, they are often used to
measure the risk. It is true that it is more relevant to use expected risk by measuring
the probability associated with various returns, often such measure is, not used in
practice. Historical data is generally used to measure the risk. The risk associated
with an investment in. stocks is measured using variance or standard deviation of the
historical return. Table 10.1 also shows the standard deviation of stock return along
with different return measures. A question with variance as a measure of risk is: why
count `happy' surprises (those above the average historical return or expected return)
at all in a measure of risk? Why not just consider the deviations below the average
historical return or expected return (i.e. the downside danger)? Measures to do so
have m u c h to recommend them. But if a distribution is symmetric, such as the
normal distribution, the result will be the same. Because, left side of a symmetric
distribution is a mirror image of the right side. Although distributions of historical or
forecasted returns are often not normal, analysts generally assume normality to
simplify their analysis.
Table 10.1: Return and Risk Measures of select stocks of NSE-50

7
Portfolio Theory

In Block 1 of this course, we had discussed how to compute mean and variance (or
standard deviation), so we need not reiterate the procedure here. You may, however,
look up appendix at the end of this unit to quickly revise the concepts of portfolio
return and risk. We may now refer to Figure 10.1 that depicts the distribution of
returns that might be expected for two investments, A and B.
Figure 10.1 : Possible Outcomes of two Independent Investments

Expected Rate of Return

The mean or expected return, at the vertical dotted line, is the same for both
investments. But, investment B is more risky. With investment A, the distribution of
returns (or possible outcomes) is more closely grouped about the mean value. In
other words, the variance is smaller than that of investment B. Consequently, it can
be said with greater degree of accuracy that our forecast will be close to the actual
return from investment A.
When we move from evaluating a single asset in isolation to evaluating a portfolio,
our return-risk analysis changes. Return is still the expected return, but for a portfolio
the return will be the average return from all the assets held in the portfolio. Risk is
still the variance (or standard deviation) of the expected returns from the portfolio.
The investor is still concerned with upside potential and downside danger. However,
the risk of a combination of assets is very different from a simple average of the risk
of individual assets. Most dramatically, the variance of a portfolio of two assets may
be less than the variance of either of the assets themselves. We will examine all these
aspects in the discussion that follows.
10.2.2 Expected Return and Risk of a Portfolio
The return on a portfolio of assets is simply a weighted average of the return on the
individual assets. The weight applied to each return is the fraction of the portfolio
invested in that asset. Thus,
n

8
R (p) = ∑x R
i=1
i i (10.1)
Where Portfolio Analysis
R(p) = the expected return of the portfolio;
Xi = the proportion of the portfolio's initial fund invested in
asset ‘i’
Ri = the expected return of asset `i'; and
n = the number of assets in the portfolio.
To illustrate the application of the above formula, let us consider a portfolio of two
equity shares A and B. The expected return on A is, say, 15 per cent and that on B is
20 per cent. Further assume that we have invested 40 per cent of our fund in share A
and the remaining in B. Then, the expected portfolio return will be
0.40 x 15 + 0.60 x 20 = 18 per cent.
It may be noted here that portfolio weight can be either positive or negative. In case
of securities, the weight will be negative when investor enters into `short sales'.
Usually, the investors buy securities first and sell them later. But with a `short sale'
this process is reversed; the investors sell first the securities that they do not possess,
and buy them later to cover the sales. Since institutional investors in our country do
not enter into such short sales, we will ignore the situation of short sales in the
present discussion as well as in our dealing with the subject matter in subsequent
units.
Having discussed the computation of expected portfolio return, we now turn to the
measurement of variance of portfolio's return (i.e., the risk of the portfolio). As
mentioned earlier, assets when combined may have a greater or lesser risk than the
sum of their component risks. This fact arises from the degree to which the returns of
individual assets move together or interact. It is vital, therefore, to consider
covariance of returns in estimating portfolio variance.
Let us intuitively understand why the risk of portfolio of stocks is lower than the sum
of the risk of the individual stocks. Suppose you have invested your wealth in two
securities. Assume the securities prices move in opposite direction such that when
one security gains, the other security incurs loss. For instance, if one security reports a
gain of 10% in a period, the other one reports a loss of 5%. In the next period, the
security, which lost 5% shows a gain of 12% but the other one lost 7%. Though the
two securities individually has a variance, an investment of equal amount in these
two securities will have a constant return of 5% during the period. In other words, the
variance of the portfolio return is zero.
We may not find assets that move in opposite direction in the real life because the same
set of factors affect the performance of several assets. At the same time, assets are
also not perfectly affected by the factors and hence there is a scope for reduction in the
variance of portfolio of assets. We will explain the same with the help of portfolio of
investments in three stocks. Three equity shares with the following return-risk
characteristics are considered for this purpose:
Monthly Average Standard Proportion
Return (%) Deviation (%) Invested (%)
ACC 8.89 19.55 33
Century Textiles 5.12 7.99 33
Hindustan Lever 3.42 6.18 34
Monthly returns here represent average appreciation of share prices estimated on the
basis of price movements over 26 monthly intervals during the period 1989 to
February 1991. A weighted average of standard deviation of each share returns works
out to (.33 x 19.55 + .33 x 7.99 + .34 x 6.18) 11.18 per cent. However, a direct
estimation of standard deviation of historical portfolio returns yields a figure of 9.61
per cent. Thus, the portfolio risk, as measured by standard deviation, is less than the
sum of component risks. The lower portfolio risk in this case is due to the fact that
the returns of the select scrips have not exhibited greater tendency to move together.
In fact, the correlation co-efficient of returns (we will discuss about covariance and
correlation co-efficient after a while) between ACC and Hindustan Lever and that
between ACC and Century Textiles were found to be low (.3 and 4 respectively)
9
during the period under consideration.
Portfolio Theory The computation of the portfolio variance in the above example is based on the
following formula:
n n
σ 2 (p) = ∑ ∑x x σ
i=1 j=1
i j ij

where ‘ σ ij ’ denotes the covariance of returns between asset i and asset j. An

explanation of the formula is now in order.
We start off with the most important element of this formula, namely, covariance. It
is a statistical measure of how two random variables, such as the returns on asset
and `move together'. A positive value for covariance indicates that the assets
returns tend to go together. For example, a better-than-expected return for one is
likely to occur along with a better-than-expected return for the other. A negative
covariance indicates a tendency for the returns to offset one anther. For example, a
better-than-expected return for one asset is likely to occur along with a worse-than -
expected return for the other. A relatively small or zero value for the covariance
indicates that there is little or no relationship between the returns for two assets.
Closely related to covariance is the statistical measure known as correlation. The
relationship is given by
σij = ρij σ i σ j
where ρij denotes the correlation coefficient between the return on asset `i' and that
on ‘j’. The correlation coefficient simply rescales the covariance to facilitate
comparison with corresponding values for other pairs of random variables. The
coefficient ranges from - 1 (perfect negative correlation) to + 1 (perfect positive
correlation). A co-efficient of 0 indicates that returns are totally unrelated.
Given an understanding of covariance and correlation, next logical step is to know
how the double summation of equation (10.2) is performed. The easiest way to
understand equation (10.2) is form a n x n table. Suppose there are three stocks in the
portfolio, then the equation 10.2 is equal to
Given an understanding of covariance and correlation, next logical step is to know
how the double summation of equation (10.2) is performed. The easiest. way to
understand equation (10.2) is f o r m a n x n table. Suppose there are three stocks in
the portfolio, then the equation 10.2 is equal to

The above table has to be expanded if the number of securities are more than three.
For example, if the number of stocks are 5, then we have to frame 5 x 5 table. The
variance of the portfolio is equal to sum of the values in the above cells. In the
above table, Wx, Wy and Wz are proportions of investments made in security X, Y
and Z. The variance of the security X, Y and Z appears in the diagonal cells as
σ xx , σ yy, and σ zz . The covariance between the securities appears in non-diagonal
cells as σ xx , σ yy, and σ zz . You may also note, the covariance of σ xy is equal to
covariance of σ yx . Thus, if the number of assets in the portfolio is three, then the
portfolio variance can be expressed as follows:

σ 2 (p) = w x 2 σ xx + w y 2 σ yy + w z 2 σ zz + 2w x w y σ xy + 2w x wzσ xz + 2w y wzσ yz

The variance of the portfolio used for the computation of portfolio return can be
computed as follows. To explain this computation, we have used weekly price
returns of three well-know stocks of Indian market namely, Hindustan Lever
(HLL), Infosys and Tisco from January 1997 to December 2001. We need the
10 following details:
 Weekly Return, Variance and Standard Deviation of HLL, Infosys and Tisco Portfolio Analysis

HLL Infosys Tisco

Mean 0.38% 0.64% -0.25%
Variance 0.0029 0.0133 0.0048
Standard Deviation 5.37% 11.55% 6.93%
Variance and Co-variance Matrix of HLL, Infosys and Tisco
Covariance between HLL Infosys Tisco
HLL 0.0029 0.0001 0.0011
Infosys 0.0001 0.0133 0.0016
Tisco 0.0011 0.0016 0.0048
Note: The values of diagonal elements are variance.
The variance of the portfolio is equal to:
Stocks Proportion HLL Infosys Tisco
of 50% 30% 20%
HLL 50% . 5 x . 5 x.0029 . 3 x . 5 x . 0 0 0 1 .2x.5x.0011
Infosys 30% .5 x .3 x .0001 .3 x .3 x .0133 .2 x .3 x .0016

Tisco 20% .5 x .2 x .0011 .3 x .2 x.0016 .2 x .2 x .0048

The sum of the cells is equal to 0.002538, which is equal to the variance or risk of the
portfolio. The risk of the portfolio can also be expressed in terms of standard
deviation. In such case, the portfolio risk is equal to:
σ 2 (p) = .002538

σ ( p ) = .002538 = 0.050375 or 5.03%

The return of the portfolio is 0.33% per week. It may be noted that the risk of the
portfolio that we computed is much lower than the weighted average variance or risk
of the individual securities in the portfolio. The reduction portfolio risk is mainly on
account of diversification and less than perfect correlation between the three stocks.

10.2.3 Diversification of Risk

Efforts to spread and minimize portfolio risk take the form of diversification. Most
investors prefer to hold several assets rather than putting all their eggs into one
basket, with the hope that if one goes bad, the others will provide some protection
from extreme loss. Surely enough, there is merit in this approach; although some
investors hold a contrary view point that recommends putting all eggs into one basket
and then keeping a sharp eye on the basket.

It is not difficult to understand that adding more assets in the portfolio can reduce the
overall portfolio risk. Consider the table drawn earlier to compute the portfolio risk
and look into the diagonal cells. The diagonal cells contain the variance of securities
in the portfolio. In that example, we assumed that an equal investment is made in
three stocks. The sum of the diagonal cells is equal to sum of the variance of three
securities multiplied by (1/3)2. Suppose, we add one more stock in the portfolio and
revise our weights to 0.25 for each stock. The values of diagonal cells is now equal to
sum of the variance of four securities multiplied by (1/4)2. We know (1/4)2 < (1 /3)2.
Suppose, if the number of securities in the portfolio is increased to 20, then the value
of the diagonal cells is equal to sum of the variance of individual securities multiplied
by (1/20)2. The value of (1/20)2 is equal to .0025 and close to zero. Since the
multiplier is now close to zero, the sum of the diagonal cells will
11
Portfolio Theory reach close to zero. Thus, when a security is added to the portfolio, the value of
diagonal cells is close to zero and thus reduced the variance of the portfolio. However,
there is a limitation in adding securities to reduce the risk because the diagonal cells
value can not be reduced below zero (i.e. negative) to reduce the portfolio risk further.
Thus, beyond a level, diversification fails to yield further benefit by way of reducing
the risk. This is being illustrated in Figure 10.2.

Figure 10.2 : Diversification of Risk Risk

Number of Securities

It may be noted that beyond certain portfolio size, the reduction in risk is marginal and
insignificant.

We will discuss more about diversifiable and non-diversifiable risk in Unit 12.A word
of caution may, however, be urged here. The above discussion would appear to suggest
that the overall portfolio risk can be reduced by only increasing number of assets in the
portfolio. This is not true. Several empirical studies have indicated that a portfolio
comprising a few assets selected carefully for their risk-diversifying characteristics (i.e.
nature. and degree of variance and covariance), would be less risky than a portfolio of
considerably greater size with assets being selected without regard to risk. Thus, -what
matters in diversification is not the number of assets per se, but right kinds.

Activity 1

a) Define the following terms.

i) Portfolio Risk.

…………………………………………………………………………………
…………………………………………………………………………………
……………………………………………………………………………….....
.................................................................................................................................

ii) Variance-Covariance Matrix.

…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………

b) What is the major point illustrated through Figure 10.2.

…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
………………………………………………………………………………….
12
 Portfolio Analysis
10.3 PORTFOLIO ANALYSIS AND SELECTION
In the previous section, we have discussed how portfolio risk is measured. Let us
summarise important points before discussing how an investor can use the concept in
selection of the portfolio. Risk associated with investments can be reduced through
diversification and such diversification helps the investors to reduce the risk of the
portfolio. Investments in individual securities, risk (variance) associated with
individual securities and the relationships (covariance) between the securities are the
three variables that affect the risk of the portfolio. While diversification reduces the
unsystematic risk of the portfolio, the number of securities required to minimize the
portfolio risk is not very large. Finally more than the number of securities, what
matters in reducing the risk of the portfolio is the kind of securities included in the
portfolio. The last observation is stressed in this section.
10.3.1 Correlation between Securities and its Impact on Portfolio Risk
We have discussed that risk is reduced when the portfolio includes one stock in the
portfolio. The above observation is not universal in a sense that if the new stock is
perfectly correlated with other securities in the portfolio: In other words, the job of
investment analysts or any other persons responsible in constructing the portfolio is
to identify stocks or securities that are less related with each other for portfolio
construction. The risk of the portfolio can be reduced to zero if the correlation
between the assets included in the portfolio is equal to minus 1. However, such
securities are difficult to identify in the market. If two securities are perfectly
correlated, then there is no diversification benefit and such combination will not
reduce the risk of the portfolio. There are only very few securities in the market
whose correlation is equal to minus one. What is more prevalent in the market is
securities whose return are correlated between minus 1 to plus 1. Depending on the
level of correlation, diversification reduces the risk of the portfolios. The relationship
between the assets and its impact on portfolio risk is explained below in Figure 10.3
with the help of two securities.
Figure 10.3: Correlation and Portfolio Risk

(a)Correlation = - 1 (b) Correlation = +1 (c) Correlation = 0.72

Figure 10.3 (c) is more relevant for our discussion since the correlation between the
securities is often less than 1 and greater than zero. In such a situation, when an
investor combine such securities, the risk of the security is initially reduced. We will
show you with a real life example in the following Table:
Figure 10.3 (c) is more relevant for our discussion since the correlation between the
securities is often less than 1 and greater than zero. In such a situation, when an
investor combine such securities, the risk of the security is initially reduced. We will
show you with a real life example in the following Table:
SI.No. Proportion of Investment in Portfolio Portfolio Risk
Hindustan Lever Infosys Return (Variance)
1 100% 0% 0.38% 0.00289
2 80% 20% 0.43% 0.00240
3 60% 40% 0.48% 0.00320
4 40% 60% 0.54% 0.00529
5 20% 80% 0.59% 0.00867
6 0% 100% 0.64% 0.01334
Note: Correlation between Hindustan Lever Ltd. and Infosys is .0087 13
Portfolio Theory The risk and return of the portfolio is plotted below to show how the graph looks
similar to one shown in Figure 10.3 (C)
Figure 10.4: Risk and Return of Portfolios of HLL and Infosys

If there are 10 securities in the market, it is possible to draw the diagrams of the above
for a number of combination of two-securities.

10.3.2 Portfolio Selection

In the above section, we have shown that combination of securities normally reduces
the risk. Often, it also leads to an increase in return, which is good for investors. That
is, you are able to achieve higher return and also lower risk through diversification. The
problem is if there are large number of securities in the market, how to determine the
optimum portfolio, which reduces the risk while keeping the return constant or
increasing the return. We first provide an intuitive understanding of the concept. If
there are large number of securities in the market and if you are able to form a two-
security portfolio and find the portfolio return and risk for various combinations as
discussed above, then you will have a large number of graphs as in Figure - 10.3 (C).

Figure 10.5: Risk and Return of Two-Stock Portfolios

Return

Risk

In the above Figure 10.5 we have shown six combinations. Now the issue is how to
select a portfolio, which is good in terms of minimizing risk and maximizing return. Now
carefully look into the above Figure particularly on the dashed line. There are five
portfolios offering same risk but different returns. Consider the two extreme Portfolios
- Portfolio X and Portfolio Y. While X offers lowest return, Y offers highest return for
the same level of risk. Now, we can say all four portfolios below Y are inefficient in a
sense that you would not buy such portfolio with the same risk level to earn lower
return. If we eliminate all such inefficient portfolios, we will get a smooth curve, which
connects the left extreme values of the curves. Such an efficient set of the portfolios is
shown in Figure 10.6.

The new curve A and B connects all left-extreme values of earlier portfolios and
become efficient set of portfolios. For instance, we don't have any portfolios above this
curve to show better return for a given level of risk. All portfolios below this curve of
A and B are inefficient and hence no one prefer such combination of stocks. All points
in the curve are efficient because it is not possible to evaluate two points in the curve
14 and conclude one is
better than the other. They are all efficient portfolios because for a higher risk, the Portfolio Analysis
expected return is also high. Depending on the investors risk and return expectation,
they can pick up any combination. If an investor like to have low risk, then she or he
will select a combination of stocks close to point A. On the other hand, if an investor
likes to assumes more risk, she or he will prefer a portfolio close to point B.
Figure 10.6: Efficient Set of Portfolios

If the above understanding is clear intuitively, we can now proceed to learn how to
find an optimal portfolio. This requires an application of quadratic programming.
n n
Minimize Variance of Portfolio Z : ∑ ∑ Cov w w
i=1 j=i
ij
i j

Subject to : ∑ x E(R ) - E* = 0
i i

∑x - 1 = 0
i

Combining the above three equations, we get an optimization equation to minimize the
risk:
Z = (∑ ∑ Covij w i w j )+(λ1 ∑ X i E(R i )-E*)+(λ 2 ∑ X i -1)
For a three securities portfolio, the optimization equation is as follows.

Z = X12σ 11 + X 2σ 22 2 + X 32σ 33 + 2X1 X 2σ 12 + 2X1 X 3σ 13 + 2X 2 X 3σ 23 + λ1 (X1E1 + X 2 E 2 +

X 3 E 3 -E*) + λ 2 (X1 + X 2 + X 3 - 1)
Setting partial derivatives of Z with respect to all variables equal to zero (dz /dx1, dz
/dx2, dz/dx3, dλ1 and dz/ dλ 2 ), we get a set of five equations and solving the five
linear equations for the unknowns X1 X2 and X3, the proportion of investment to be
made in each of the stocks to get the desired return. The above quadratic
programming results will be in the form of three equations in the form of
X1= a+b1E (R)
X2 = a+b2E (R)
X3=a+b3E (R)
Where `a' and `b,' are known and one has to substitute the expected rate of return to
know the investment to be made in the three stocks.
The portfolio selection process as described above is not something new; the model
was presented by Harry Markowitz briefly in 1952 and later in a complete book
entitled Portfolio Selection-Efficient Diversification of Investments (1959). One
important concept that Markowitz emphasized for the first time was that some
measure of risk, and not just the expected rate of return, should be considered when
dealing with investment decision. Markowitz's approach to portfolio analysis and
selection attracted a number of academicians and practitioners, who subsequently
began to adjust the basic framework so that practical application could be more
readily considered. Another interesting thing happened. Following the presentation of
the model, there had been a wide spread realisation of how computers could be
utilized in investment decision making. Markowitz's own solution to portfolio
selection problem necessitates, as we will see in the next unit, 15
Portfolio Theory application of computers. As a final remark, we may mention that Markowitz's work
marks the beginnings of what is today known as modern portfolio theory.
Activity 2

1) List out four basic steps of portfolio selection process.

…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………

2) Whose work marked the beginning of modern portfolio theory?

…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………

10.4 SUMMARY
The unit describes the basic components of portfolio selection process. Beginning
with the estimation of a portfolio's expected return and risk, which in turn involves
estimation of such input data as expected return, variance and covariance for each of
the assets contained in the portfolio, we have explained why an investor should
consider only the `efficient set' out of the feasible set of portfolios. Once the efficient
portfolios are delineated, the investor will next `select the `optimal' portfolio depending
upon his or her `trade-off' between return and risk. In terms of graphical analysis such
optimal portfolio will be located at the point where indifference curve that
summarises the investors risk-return trade-off, is tangent to the efficient set. In this
kind of approach to portfolio selection, it is assumed that rational investors are risk
averse and prefer more return or loss. Finally, the portfolio selection approach
presented here epitomises the Markowitz's model developed in early 1950s.

10.5 KEY WORDS

Portfolio refers t o collection of assets (financial or physical or both).

Portfolio weight refers to the fraction of available fund that is being invested in a
particular asset in a particular asset in the portfolio.

Expected rate of return is the return on an asset (or portfolio) over a holding period
that an investor anticipates to receive.

Standard deviation is a measure of the dispersion of possible outcomes around the

expected outcome of a random variable.

Variance is the squared value of the standard deviation.

Covariance is a statistical measure of the relationship between two random

variables.

Correlation coefficient is a statistical measure similar to covariance in,that it measures

the degree mutual variation between two random variables. The correlation coefficient
re-scales covariance to facilitate comparison among pairs of random variables. The
correlation coefficient is bounded by the values - 1 and +I.

Variance-covariance matrix is a table, which symmetrically arrays the covariance

between a number of random variables. Variances of the random variables lie on,the
16 diagonal of the matrix, w h i l e covariance between the random variables lie above or
below the diagonal.
Diversification means the spreading of investments over more than one asset with a Portfolio Analysis
view to reduce the portfolio's risk (i.e., the variability of expected portfolio returns).
Feasible set (or opportunity set) represents the set of all portfolios that can be formed
by an investors, given a population of assets.
Efficient set (Efficient frontier) is the set of portfolios of a given population of assets
which offer the maximum possible expected return for a given level of risk.
Optimal portfolio means the feasible portfolio that offers an investor the maximum
level of satisfaction, given his or her own preference for return and risk. This
portfolio is located at the point of tangency between the efficient set and an
indifference curve of the investor.

10.6 SELF-ASSESSMENT QUESTIONS/EXERCISES

1) The following forecasts have been made for investments A and B.
Investments A Investments B
Return (%) Probability Return (%) Probability
10 .05 2 .05
15 .20 12 .25
20 .50 20 .40
25 .20 28 .25
30 .05 38 .05

Calculate the expected rate of return and standard deviation. Which

investment has more upside potential and downside danger?
2) If a portfolio's expected return is always equal to the weighted average of the
expected return of the component assets, why is not portfolio risk always
equal to the weighted average of the component assets' variances? Explain.
3) Suppose an analysts has provided you with the following estimates in respect
of equity shares of Century Textiles, Escorts and Hoechst:
Century Escorts Hoechst
Expected monthly Return (%) 5 4 9
Standard Deviation (%) 8 7 17
Correlation coefficients of Returns
Between
Century and Escorts 0.4
Century and Hoechst 0.6
Escorts and Hoechst 0.3

Assuming that equal amounts of the available funds will be invested in the three
scrips, estimate the portfolio's mean return and standard deviation.
4) Consider two securities with the following characteristics:
A B

Expected Return 12 02
Standard Deviation 08 10
Assuming no correlation between the returns on two securities, calculated expected
return and standard deviation for each of the following portfolios:
Portfolio Weights (XA)
Security A 1.0 .75 .50 25 0.0

17
Portfolio Theory Plot these portfolios with expected portfolio returns on x-axis and standard deviation
on y-axis. Locate the efficient frontier' and the portfolio with least risk or standard
deviation.
Can you precisely determine XA corresponding to the portfolio with minimum standard
deviation? (Hint: Obtain the equation for σ p with zero correlation between returns on
two securities. To find XA for which σ p is minimum, set the first order derivative of
σ p with respect to XA equal to zero, and then solve for XA).
5) Explain the following in your own words and using graphs:
a) diversification of risk
b) indifference curves
c) selection of optimal portfolio
6) For a portfolio with the following characteristics, calculate the rate of return and
the standard deviation of the rate of return (r1 and σ p ):

7) Consider the data given below:

a) Form all possible portfolios consisting of two securities each, calculate the rate
of return and standard deviation of rate of return for each one of these
portfolios. You may assume that each portfolio has equal proportions of the
two securities.
b) Out of the set of portfolios formed in Q. 7a, identify the efficient portfolio (s)
8) Refer to the following observations for securities X and Y:

a) Compute the sample mean returns for X and Y.

b) Compute sample standard deviations for X & Y
18 c) Compute the sample correlation co-efficient between the returns on X&Y.
 Portfolio Analysis
10.7 FURTHER READINGS
Elton, Edwin J. and Gruber, Matin J., 1987 Modern Portfolio Theory and Investment
Analysis, John Wiley 84 Sons.

Alexander, Gordon J., Sharpe, William F., and Jeffery V. Baibey Fundamentals of
Investments, (3rd ed.) Prentice-Hall, Inc.

Answers to select Self-Assessment Questions

6) rt = 13.13%

σp = 1.77%

7a) rAB = 12.5%

σ AB = .63%

rAC = 27.5%

σ AC = .06%

rBC = 20%

σ BC = .62%

7b) Portfolio constituted by securities A and C because it has the highest rate of
return and the lowest standard deviation.

8. a) rX = 011; rY = .0625

b) σ XY = -.0017

c) ρ XY = -.798

19
Portfolio Theory Appendix
Rate of return of a portfolio
The rate of return from a portfolio is computed as:
n
R (P) = ∑X R
i=1
i it

where
R(p) = rate of return of portfolio during period t
Xi = proportion, in terms of value, of security i in the portfolio
Rit = rate of return of security i during period t
N = number of securities comprising the portfolio
Rit, rate of return of security i during t is in turn computed as follows
Pit = (Pit-1 - Pit + Iit )/Pit
where
Pit+1 = market price of security `i' at beginning of period d t+1 (or
alternatively at the end of period t)
Pit = market price of security `i' at beginning of period `t'
Iit = income in the form of dividends/interest etc. received from
holding security `i' during period `t'
To illustrate the concept, let us take an example of a portfolio comprising three securities A, B
and C. The relevant data is given below:
Security Price No. held beg. Price Dividend
beg 1990 1990 end 1990 recd 1990
A . Rs.25/ share 100 Rs.28/ share Rs. 2/ share
B Rs.50/ share 30 Rs.49/ share Rs. 4.5/ share
C Rs.60/ share 100 Rs.65/ share Rs. 1/ share
Now, from the above data, we can compute XA, XB, and Xc as follows:
XA = (25 x 100)/[(25 x 100) + (50 x 30) + (60 x 100)]
= 2500/(2500 + 1500 + 6000)
= 2500/10000
= 0.25
XB = (50 x 30)/[(25 x 100) + (50 x 30) + (60 x 100)]
= 1500/(2500 + 1500 + 6000)
= 1500/10000
= 0.15
XC = (60 x 100)/[(25 x 100) + (50 x 30) + (60 x 100)]
= 6500/(2500 + 1500 + 6000)
= 6000/10000
= 0.6
Similarly, we can compute rA1990 , rB1990 , rC1990 as follows:

rA1990 = (28 – 25 + 2)/25

= 5/25
20
= 0.2 or (20%)
 rB1990 = (48 - 50 + 4.5)/50 Portfolio Analysis

= 2.5/25
= .05 or (5%)
rC1990 = (65 -60 + 1)/60
= 6/60
= 0.1 or (10%)
Now we can compute the rate of return from the portfolio as follows:
rP1990 = ∑x r i it

= ( . 2 5 x . 2 ) + ( . 1 5 x.05) +.6 x .1)

= .05 +.0075 + .06
= 0.1175 (11.75%)
From the above illustration we can see that the rate of return from a portfolio is a
function of the rate of returns from individual securities comprising the portfolio.
Risk of a portfolio
The most commonly used measure of variability of returns from a portfolio is the
standard deviation of the returns of the portfolio and this is computed as follows:
n n
σ 2 (p) = ∑ ∑x xσ
i=1 j=1
i j ij (10.2)

where
σ2p = Variance of returns of the portfolio

Xi = Proportion (in terms of value) of security ` i' in the

portfolio.
Xj = Proportion (in terms of value) of security `j' in the
portfolio.
σij = Co-variance between the security ‘i' and security ‘j’
Where
σ ij = ρijσ iσ j
σi = Standard deviation of returns from security `i'

σj = Standard deviation of returns from security `j'

ρij = coefficient of correlation between the rates of return of

securities `i' and ‘j’
n = the number of securities in the portfolio
To illustrate the concept, let us take the example considered in the earlier section,
with some additional data provided as follows:
Security Xi σi
(as computed above) (as computed above)

A 025 0.1
B 0.15 0.1
C 0.60 02
The correlation matrix (between the rates of return of securities A, B and C) is given
below:
A B C
A 1.0 +.1 +.8
B +.1 1.0 -.6
C +.8 - .6 1.0
21
Portfolio Theory Given this data op is computed as:
σp = (2.5) 2 + (.1) 2 + (.15)2 + (.1) 2 + (.6)2 + (.2) 2
+ (2 x .25 x .15 x .1 x .1 x .1) + (2 x .25 x .6 x .8 x .1 x .2)
+ (2 x .15 x .6 x (-.6) x .1 x .2)
= .00625 + .000225 + .0145 + .0075 + .000075 + .0048
= .025465
= 2.5%
From the above formula it is apparent that the risk of a portfolio which has a high
degree of correlation between the returns from its constituent securities would be
higher than the risk of a portfolio which has a low degree of correlation between the
returns from its constituent securities. Herein lies the crux of portfolio management in
order to reduce the risk of a portfolio, a portfolio manager would have to pick and
choose a diversified basket of securities such that the degree of co-movement between
their returns is very low.
Though the standard deviation of returns is a well-accepted measure of the risk
associated with a security, modem portfolio theories believe that a better index of risk
would be the "beta" value of a security. While the standard deviation measures the
total variability in returns from the security, the beta value is an index of that portion
of the variation, which can be attributed to market level factors, which are not unique
to the firm. Modem portfolio theorists argue that the risk, which arises from factors
unique to the firm are not that important because they can be eliminated through
diversification. The beta value of a portfolio indicates the degree of sensitivity of
returns from the portfolio to changes in the returns from the market as a whole and is
computed as follows
n
βp = ∑x β
i=1
i i

j
erin
h
W
Where
β p = beta of the portfolio
Xi = proportion (in terms of value) of security in the portfolio.
βi = beta value for security i
n = number of securities comprising the portfolio.
The beta value of individual securities (which indicates the degree of sensitivity of
returns from the security to changes in the returns from the market as a whole) is in
turn got as follows:
Cov22(ri , rm )
βi =
Var(rm )
Where:
βi = beta value of security `i’
Cov (ri, rm) = covariance between the returns from security `i' and returns
from the market
Var (rm ) = variance of returns from the market
From the above discussion on the beta value of a portfolio, it becomes clear that if we
use the beta value as an indicator of the risk associated with the returns from a
portfolio and if we wish to minimize this risk, we would have to pick and choose
securities which have very low beta values. In other words, in order to reduce the risk
of a portfolio we have to choose securities whose returns are fairly insensitive to
22 changes in the returns from the market as a whole.
 Portfolio Selection
UNIT 11 PORTFOLIO SELECTION
Objectives

The objectives of this unit are to:

• explain and illustrate the Markowitz's approach to delineating efficient set

• discuss the basic tenets of Sharpe's single-index model and how the model
simplifies selection process
• describe other portfolio selection models.
Structure
11.1 Introduction
11.2 Finding the Efficient Set
11.2.1 Constrained Minimisation Problem
11.2.2 Lagrange Multipliers Technique
11.2.3 Tracing the Efficient Frontier
11.2.4 Limitation of Markowitz Approach
11.3 Single-Index Model
11.3.1 The Assumptions and the Model
11.3.2 Systematic Risk and Diversifiable (or Residual) Risk and
Covariance of Returns
11.3.3 Variance of Portfolio Returns
11.3.4 Estimating Beta and the Diversifiable Risk Component
11.4 Other Portfolio Selection Models
11.5 Summary
11.6 Key Words
11.7 Self-Assessment Questions/Exercises
11.8 Further Readings

11.1 INTRODUCTION
In the previous unit, we noted that an investor's opportunity set of investments or
portfolios will be defined by the `efficient set'. But we left the question of actually
finding the efficient set unanswered. This unit will first provide a logical approach to
delineating efficient set. We will then discuss some of the practical problems of
implementing this approach, and present another model, known as `single-index
model', that simplifies the portfolio selection process to a great extent. Finally, we
will indicate some other portfolio selection techniques.
11.2 FINDING THE EFFICIENT SET
We may recall that an efficient set is a continuous curve (see Figure 10.3 in Unit 10)
which, in turn, means that there are infinite number of efficient portfolios. This poses
a typical problem to the investors. How can one determine the composition (i.e.,
combination of assets and portfolio weights) of each of an infinite number of efficient
portfolios? Markowitz did contemplate this problem and, in a major breakthrough,
presented a solution algorithm based on `quadratic programming' technique. While a
complete description of the algorithm, which is referred to as Markowitz's `critical
line method', is beyond the scope of this unit, we may give you a rough idea of what
is being accomplished by it:
11.2.1 Constrained Minimization Problem
As we know, an efficient set can be determined by minimising portfolio risk (i.e.,
return variance) for any level of expected return. If we specify the return at some level
and minimize
23
Portfolio Theory risk, we have one point (i.e., a portfolio) on the efficient frontier. Thus, we need to
solve the following constrained minimisation problem:
n n
Minimise variance( σ 2 p ) = ∑ ∑x x σ
i=1 j=1
i j ij

Subjet to the constraints:

1) Expected return (Rp) is equal to some predetermined level R p
2) The sum of the portfolio weights for all assets in the portfolio must be equal
to 1; ( ∑xi = 1 )
i=1

3) The portfolio weight assigned to any asset should be positive

(xi ≥ 0, i = 1, ..., n). In other words, short sales are not allowed.
This is a quadratic programming problem because of the presence of terms like x2j , and
xi , xj in the objective function.
11.2.2 Lagrange Multipliers Technique
The above kind of non-linear minimization problem can be solved by applying
Lagrange Multipliers Technique. We will explain the procedure with a three-assets
case and using the following example data:
Equity Shares Monthly Expected Standard Deviation
Return (%) (%)
Ashok Leyland 3.5 11
ACC 9.0 20
Grasim 4.5 12
Variance-Covariance Matrix
Ashok Leyland ACC Grasim

Ashok Leyland .012 .009 .007

ACC .009 .040 .014
Grasim .007 .014 .014
Let us suppose that x1, x2 and x3 are the portfolio weights corresponding to the equity
shares of Ashok Leylend, ACC and Grasim respectively. The portfolio weights must
add up to 1, i.e.,
xi+x2+x3= 1
Let us further assume that our target expected rate of return (Rp) is 5 per cent. With
these assumptions, we have:
a) expected rate of return equation (i.e., the return constraint):
0.05 =.035 x1 +.09x2+.045 (1-x1 - x 2)
which on simplification yields
.1 x1-.045x2+.005=0
b) returns-variance of the portfolio:
2 2 2
σ 2(p) = [x1 * 0.012] + [x2 * 0.04]+ [(1-x1-x2) 0.014]+ [2 * .009 x1 x2]+ [2
* 0.007 x1 (1-x1-x2)] + [2 * 0.014 x2 (1-x1-x2)]
which on simplification can be written as
2 2
σ 2 (p) = [0.012 x1 ] + [0.04 x2 ] + [0.014 x1 ]+ [.004 x1 x2] + 0.014

24
Following the Lagrange Multipliers method, we now write the objective function as Portfolio Selection
Minimise Z = σ 2 (p) + λ[R p * - R p ]

or, Minimise Z = [0.012 x12] + [0.04 x22]+ [0.014x1]+ [.004 x1 x2]+0.014+ λ [.01x1 -
0.45 x2+.005]
where λ is known as the `Lagrangain multiplier'. The expression within the bracket
ensures that the return constraint will be always satisfied while minimizing the
variance.
Thus values of x1, x2 and λ for which Z will be minimum, can be obtained by setting
the partial derivatives equal to zero, and then solving the equations simultaneously.
This is shown below:
δz/δx1 = .024x1 + .004x1 + .01 λ -.014 = 0

δz/δx 2 = .004x1 + .052x2 - .045 = 0

δz/δy = .0 l x1 - .045x2 - .005 = 0
Solving the above set of equations, we get
X1= .445
X2=.210
X3 = .345
λ = .248
Thus, for a target expected rate of return of 5 per cent, the `minimum variance' set or
`efficient portfolio' will correspond to an allocation by 44.5 per cent of the fund to
Ashok Leyland, 21 per cent to ACC, and the remaining to Grasim. If we plug the
portfolio weights into the objective function, we find
σ 2 (p) = .0117
or σ p = .1089
So, our minimum-risk portfolio will have a standard deviation of returns of 10.8 per
cent.
The value of λ in our solution indicates the incremental change in the value of
objective function (i.e., the variance) that one might expect as a result of an
infinitesimally small change in the constraint (in this instance, the target expected
return), Since the objection function is nonlinear, its slope changes continuously and
so should λ .
11.2.3 Tracing the Efficient Frontier
The process discussed above can be repeated to find as many points as desired on the
efficient frontier, each time starting with a specified target expected rate-of return. In
actual practice, standard computer packages are available which can find solutions
quickly and accurately. For our example case of three equity shares. Table 11.1
shows ten efficient portfolios identified by the application of such a package.
Table 11.1: Ten Efficient Portfolios
Portfolio 1* 2 3* * 4 5
Expected Return (%) 3.9 4.5 5.0 5.6 6.2
Standard Deviation (%) 9.9 10.2 10.8 11.7 12.8
Composition (%):
Ashok Leyland 58.6 50.4 44.5 37.7 31.3
ACC 0.0 10.7 21.0 33.0 44.2
Grasim 41.4 38.9 34.5 29.3 24.5 25
Portfolio Theory

Portfolio No. 6 7 8 9 10
Expected Return (%) 6.7 7.3 7.9 8.4 9.0
Standard Deviation (%) 14.1 15.4 16.9 18.4 20.0

Composition (%): 24.9 18.5 12.2 5.8 0.0

Ashok Leyland
ACC 55.3 66.4 77.6 88.7 100.0
Grasim 19.8 15.1 10.2 5.5 0.0

* This is the `global minimum variance' efficient portfolio. No other portfolio

offers lower level of risk than this.
** We have already illustrated the determination of this portfolio through the
application of Lagrange Multipliers Technique.
Once sufficient number of efficient portfolios are determined, it is a simple matter for
the computer, using its capability for graphics, to draw the graph of the efficient set.
Figure 11.1 shows the graph drawn by the computer package.
Figure 11.1: Efficient Frontier

Risk
In this context, it would be interesting to know the concepts of `corner portfolios' as
introduced by Markowitz. Any set of efficient portfolios can be described in terms of
still a smaller sub-set of efficient portfolios, which Markowitz termed as `corner
portfolios'. The distinguishing feature of two adjacent corner portfolios is that: (a) one
portfolio will contain either all the assets which appear in the other, plus one additional
asset, or (b) all but one of the assets which appear in the other. Thus, while moving
along the efficient frontier curve from one corner portfolio to the next, portfolio weights
will vary until either one asset drops out of the portfolio or another enters. The point (or
the portfolio) at which .a change in the composition of assets takes place marks a new
corner portfolio. For instance, portfolios numbered 1 and 4 in Table 11.1, may be
considered as corner portfolios.
An important property of corner portfolios is that any combination of two adjacent
corner portfolios will result in a portfolio that lies on the efficient set between the two
corner portfolios. For example, if an investor puts 30 per cent of his or her available
funds in the portfolio numbered 1 and 70 per cent in the portfolio numbered 4 (see Table
11.1), then the resulting portfolio of the following composition (or portfolio weights)
will be another efficient portfolio lying between the corner portfolios 1 and 4.
Ashok Leyland : .30 x 58.6 +.70 x 37.7 =44.0%
ACC : .30 x 0.0 + .70 x 33.0 = 23.1%
Grasim : .30 x 41.4 + .70 x 29.3 = 32.9

26
Thus, a computer algorithm may be developed which first determines some Portfolio Selection
successive corner portfolios, and proceeds next to delineate a set of efficient
portfolios lying between every two adjacent corner portfolios. Each of these
portfolios will correspond to a dot in the return-risk space, which can be finally
connected to draw the graph of the efficient set.

11.2.5 Limitations of Markowitz's Approach

It is easy to see that the Markowitz's approach to trace efficient set is extremely
demanding i n its input data needs and computation requirements. This has been
probably best expressed by Markowitz himself : "...it is reasonable to ask security
analysts to summarize their researches in 100 carefully considered variances of
returns. It is not reasonable, however, to ask for almost 5000 carefully and
individually considered covariances". Indeed, while analysts and portfolio managers
are accustomed to thinking about expected rates of return, they are much less
comfortable in assessing the possible ranges of variation in their expectations, and are
usually, not at all accustomed to estimating covariance of returns among assets.

The problem is made more complex by the number of estimates of covariance (or
correlation) required. For a set of 200 shares, for example, we need to compute [200
(200-1)/ 2] = 19,900 covariance. It is unlikely that the analysts will be able to directly
estimate such a staggering number of inputs. Obviously, what we need is an alternate
formula for portfolio variance, that lends itself to easy computation even when we are
dealing with a large set of assets. However, an understanding of Markowitz process
would sharpen your understanding on the portfolio theory and management though
you may not use in your day to day life Markowitz method of portfolio construction
for stocks.

Activity 1

Define the following

i) Efficient set

…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………

ii) Lagrange Multipliers Technique

…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………

iii) Diversifiable Risk

…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………

11.3 SINGLE-INDEX MODEL

We get such a capability with the `single-index model' developed by a student of
Markowitz named William Sharpe (1963). In the 1950s, after techniques for
estimating the required inputs to this model were perfected, packaged, and marketed
as computer software, modern portfolio really took off in terms of practical
applications. Now the single-index model is widely employed to allocate investments
iii the portfolio between individual equity shares, while the original more general
model of Markowitz is widely used to allocate investments between types of assets,
such as bonds, shares, and real estate. In the discussion that follows, we present the
basic tenets of the `single-index model', with reference to investment in equity shares. 27
Portfolio Theory 11.3.1 The Assumptions and the Model
Essentially, the single-index model assumes that the returns of various securities are
related only through common relationships with some basic underlying factor. In the
words of Sharpe, this factor "may be the level of the stock market as a whole, the gross
national product, some price index, or any other factor thought to be the most important
single influence on the returns from securities". A casual observation of share-price
movements, at least, tends to support this line of argument. There is considerable
evidence that when the stock market goes down, most shares tend to decrease in price.
For instance, on the date of budget, several stocks move in the same direction
depending on the assessment of the budget on the economy and industry. It appears,
therefore, that one reason share returns might be correlated is because of a common
response to market changes as measured by the movements in, say, share price index.
To understand the above assumption of the single-index model more precisely,
consider Figure 11.2, where we have related the returns of a hypothetical share to the
returns on the market index.
Figure 11.2: ACC Return vs. Sensex Return

The line running through the scatter points is the 'line of best fit', or an estimate of what
is known as a share's `characteristic line'. Algebraically, the characteristic line can be
defined as
Ri = a i + βi R m (11.1)
where
Ri = the return of security i
ai = the components of share i's return that is independent of the market's
performance-a random variable;
Rm = the rate of return on market index-a random variable; and
βi (beta) = the slope. of the characteristic line that measures the expected change
in R, given a change in Rm
It is useful to break the term Ri , in two components:
1. α i (alpha), the expected value of ai ; and
2. ei, the random element with a Mean value of zero.
In terms of graphical presentation (see Figure 11.2) e 1 (or residuals, a s they are
frequently referred to) measure vertical deviations from the characteristic line. With
this, equation (11.1) can now be written as
R i = α i + β i R m + ei (11.2)

where Rm and ei , (both random variables) are conveniently assumed to be not correlated
with each other.

28
It is further assumed that the residuals are not correlated across shares of different Portfolio Selection
companies; that is, ei, is independent of ej for all values of i and j. This is an important
assumption; it implies that the only reason shares vary together, systematically, is
because of a common co-movement with the market. Thus, single-index model assumes
away all other possible effects on shares' returns, such as industry effects.
11.3.2 Systematic Risk and Diversifiable (or Residual) Risk and Covariance of
Returns
With some manipulations of equation (11.2), we get the following important results:
(a) the expected return, R i = α j + β i R m
(b) the variance of share's return, σ 2i = β 2iσ 2 m + σ 2ei where σ 2 m and σ 2ei are
variances of the distribution of Rm and ei, respectively; and
(c) covariance of returns between shares i and j, σ ij = β iβ jσ 2 m
It is apparent from (a) above that the expected return has two components: a unique or
non-market part, a, and market related part, βi Rm. Even though shares have many
common characteristics and, as a result, tend to move together, their numerous individual
and distinguishing properties cause shares to co-move with the market at different rates.
Accordingly, how sensitive a share's price is to changes in the overall market i.e. the
value of its `beta' is of great significance in determining the expected return.
Like the expected return, we can always split the variance of share's returns into two
parts, as shown in (b) above. The first component β 2iσ 2 m , is called the `systematic risk' or
`market risk' of the investment. Since σ 2 m is the same for all shares, systematic risks will
differ among different shares accordingly to the magnitudes of their `betas', βi . Simply
stated, beta measures sensitivity of a share's price movements compared with those of the
market index. Shares having betas less than 1 can be said to be `defensive'. One per cent
increase (decrease) in the market return is likely to be accompanied by a less than one per
cent increase (decrease) in the shares' rate of return. The investors are thus defended to
some extent against the occurrence of major down fall in the market return. On the other
hand, shares with individual beta values greater than one are considered to be more
`aggressive' or more risky, as one per cent increase (decrease) in the market return is
likely to be accompanied by an even greater increase (decrease) in the shares' rates of
return. A beta of one implies `average' riskiness; every one per cent return on the market
is associated with one per cent opportunity return on the share. Beta can be negative as
well, reflecting that share prices can rise when the market falls and vice versa; but this is
normally unusual.
The systematic risk is caused by macro events like oil crisis, an unexpected change in rate
of inflation, etc. The macro events are broad and affect nearly all shares to one degree or
another, and they may have an impact on the general level of stock market. Thus, one
cannot reduce systematic risk by diversifying investment across different shares. That is
why the systematic risk is often called `non-diversifiable' risk.
The second component of variance of share's returns, σ 2 ei , is known as `residual
variance' or `unsystematic risk' or `diversifiable risk'. The source of this kind of risk is
`micro' events, which have impact on individual shares but no sweeping impact on other
shares. Examples include the introduction of a new product(s) or the sudden obsolescence
of an old one. They might also include labour strike lockout or the resignation or death of
a key person in the firm, or splitting up of a business family. Since micro events affect
only the individual shares under consideration, their impact can be reduced to a great
extent by holding a diversifiable portfolio. We will explain how diversification of risk
takes place after a while.
At this point, we may recall that under Markowitz model we are required to compute
covariance of returns for every pair of assets comprising the portfolio. We have also
observed that without having estimates of covariance, one cannot compute the variance of
portfolio returns. However, if the single-index model is a valid description of the process
generating shares returns, there is no need for direct estimates of the covariance. All that
we need to know are the values of share betas and variance of returns on market index;
the covariance between any two shares i and j can next be obtained easily by employing
the
29
Portfolio Theory relationship as noted above. Needless to say that the relationship is much less
demanding in terms of estimation procedure and computation time.
What is more amazing to note here is that the single-index model does not require even
the indirect estimates of covariance of returns between shares. The model provides a
still simpler formula for computing variance of portfolio returns. We will now
explain this.
11.3.3 Variance of Portfolio Returns
We begin by restating that the total risk or variance of returns on share `i' is given by
σ 2i = βiσ 2 m + σ 2 ei (11.3)
Total variance = Systematic Risk + Residual variance
This equation holds-for a portfolio of shares as well. Rewriting the equation for a
portfolio, we get
σ 2i = β 2 p σ 2 m + σ 2 ep (11.4)
Total Portfolio variance = Portfolio Systematic Risk + Portfolio residual variance
Where the subscript `p' denotes a portfolio.
It can be further shown that
n
βp = ∑xβ
i=1
i i

Portfolio Beta = Weighted average of individual share betas

and,
n
σ 2 ep = ∑x
i=1
2
i σ 2 ei

Portfolio residual variance = Weighted average of individual residual variances where

weights are squared.
To illustrate the above formula of portfolio variance, let us consider the following two
shares:
Share Beta Residual Variance
Ashok Leyland 0.54 98.2

Grasim 1.13 62.7

Suppose, an investor is planning to put equal amounts of his investible fund in these
two shares. Then we have
βp = 0.54 x.50+1.13 x -.50=0.56

σ 2 ep = [98.2 x (.5)2] + [62.7 x (.5)2] = 40.2

If σ 2 m is equal to 81.0 per cent, the variance of the returns of the portfolio under
consideration will be given by
σ2p = (.56)2x 81.0 +40.2 =65.6
σp = 8.1%

Let us now add one more share to the above portfolio, say, the share of ACC with a
beta of 1.63 and residual variance of 179.6 per cent. Suppose, the investor decides
once again to invest equal amount. This time σ p will work out to be 11.7 percent,
whereas σ 2 ep , will be 37.8 per cent.
It is interesting to note that while the portfolio's systematic risk component ( β p ) has
increased due to the addition of a more risky share, its non-market related risk
component has declined. Given the single-index model's assumption that residuals
(ei's) of different shares are not correlated (we have already explained this assumption),
it is not difficult to
30
appreciate how a portfolio's residual variance begins to diminish as the number of Portfolio Selection
shares (n) in the portfolio is increased. Assume for a moment that an investor forms a
portfolio by placing equal amounts of his funds into each of n shares. Equation (11.6)
then becomes
n
σ 2 ep = [ 1 ] ∑ [ 1 ] σ 2ei
n i=1 n
where the term within the bracket denotes average residual variance of the shares
comprising the portfolio. As the number of shares in the portfolio gets large,
portfolio's average residual variance falls so rapidly that most of it is effectively
eliminated even for moderately sized portfolios.
At this stage, it would be appropriate to contrast the procedure for computing
portfolio variance as outlined above with that of the Markowitz model. We have
mentioned earlier that for a portfolio of 200 shares, Markowitz model requires 19,900
estimates of covariance. Under the single-index model we need, however, only 200
estimates of beta, 200 estimates of residual variance, and one estimate for the variance
of returns on market index. Indeed, this is a dramatic reduction in the input data for
computing portfolio variance.
But how accurate is the portfolio variance estimate as provided by the single-index
model's simplified formula? If it is the Markowitz formula, we know that the
variance number of perfectly accurate, given, of course, the accuracy of the
covariance estimates. Besides, the formula makes no assumptions regarding the
return generating process. On the other hand, the single-index model assumes that the
market factor solely determines the shares' returns and residuals. are not correlated
across different shares. Thus, the accuracy of the single-index model's formula for
portfolio variance is as good as the accuracy of underlying assumptions. Quite
obviously, the assumptions are not strictly accurate. Many researchers have found
that there are influences beyond the market that cause shares to move together. In
addition, empirical evidence suggests that residuals are correlated to some degree,
which is not altogether unexpected. After all, if something (good or bad) happens to a
company, some other companies, such as its suppliers and competitors, would be
affected simultaneously. The residuals that appear for the shares of these other
company would not, therefore, be independent of each other. However, one can
always expect that the degree of correlation would not be large enough to impair the
relative efficiency with which the single-index model estimate the portfolio variance.
11.3.4 Estimating Beta and the Diversifiable Risk Component
The estimation of beta and the diversifiable risk component of a share involves fitting
a `characteristic line' as shown in Figure 11.2, such that the vertical deviations of the
scatter points from the fitted line are minimized. The statistical procedure for
obtaining a line of best fit is known as `simple linear regression' or `ordinary least
squares method (OLS)'. The beta can be computed manually or using computers.
Today, analysts generally use computers to get beta value. For instance if you have
the monthly returns of a Market Index (like BSE Sensex) and an individual stock's
return (say Grasim) in the Microsoft Excel sheet, you can easily compute the beta
using a function called =SLOPE(Range of Stock Return, Range of Market Return).
At the end of the Unit, the computation of beta is illustrated.
Although the above estimation procedure looks quite straight forward, it is fraught
with several practical problems. For instance, what should be the length of beta
estimation period-two years, three years or more? Or, should we base our calculation
on annual return data? There are many shares which are not regularly traded on the
stock exchange; accordingly, their price quotations remain unchanged even the case
of ill-traded shares? No doubt, the literature on the subject provides some answers to
all such questions, but they need be verified empirically in our context. Unfortunately,
there is dearth of empirical studies with the Indian shares' data. Even if we obtain
satisfactory estimates of historical data, we still face the problem of estimating future
(or ex ante) beta. What is of concern to us is betas for future holding period, and not
the historical betas.
Since large-scale expectational data on returns of individual shares as well as of market
index are not available, one cannot directly estimate future betas by fitting regression 31
Portfolio Theory lines. So, the historical beta must be estimated first and then we can make some
adjustments to it for deriving the future beta.
Activity 1

i) List out two major points of difference between Markowitz's approach and
Sharpe's single-Index Model of selecting optimal portfolio.

………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………

ii) List out relevant data for computing beta of an equity share.

………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………

iii) Try, to compute beta of an equity share of your choice.

………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
……………………………………………………………………………….

11.4 OTHER PORTFOLIO SELECTION MODELS

So far we have considered investment in risky assets like equities. However, an
investor can also invest in `risk-free assets such as `treasury bills' or `government
securities'. Besides, in our analysis the investor is not allowed to use borrowed money
to invest in a portfolio of assets. This means that the investor is not allowed to use
financial leverage. If we take into account these new opportunities to the investor, we
will notice a major impact on the shape and location of the efficient set. We shall
discuss this situation in the next Unit on Capital Market Theory.

We now take a note of some other portfolio selection models that seem to hold great
promises to practical applications. One such model is the `multi-index model'. There
are different variants of this model and each of them is developed to capture some of
the non-market influences that cause shares to move together (recall that single-index
model accounts for only market related influences). The non-market influences, in
essence, include a set of economic factors or industry characteristics that account for
common movement in share prices. While it is easy to find a set of indices that are
associated with non-market effects over any period of time, it is quite another matter
to find a set that is successful in predicting covariance that are not market related.
There is still a great deal of work to be done before multi-index models consistently
outperform the simpler one.

Another model that takes into account a wide spectrum of practical considerations in
portfolio selection is the goal-programming model. In real life, an investor's goals
and desires transcend. the notion of a trade-off between only risk and return. For
example, an investor may prefer to invest some minimum amount in several different
shares, but at the same time he or she may not like individual investment to exceed a
specified limit. Additionally, he or she may prefer dividend income to capital
appreciation. There may also be a desire not to allow the portfolio beta to be either
above or below a predetermined level. Apart from holding such diverse goals and
desires, the investor may even set the order of

32
their priorities. In this kind of investment problem situation, the goal-programming Portfolio Selection
model is ideally suited to provide an optimal solution. Further goal programming
solution can be easily obtained by available computer packages.

11.5 SUMMARY
This unit has provided some insights into Markowitz's approach to trace the efficient
set. The application of Markowitz's model requires estimation of large number of
covariance. And without having estimates of covariance, one cannot compute the
variance of portfolio returns. This makes the task of delineating efficient set
extremely difficult. However, William Sharpe's `single-index model' simplifies the
task to a great extent. Even with a large population of assets from which to select
portfolios, the number of required estimates are amazingly less than what are
required in Markowitz's model. But how accurate is the portfolio variance estimate as
provided by the single-index model's simplified formula? While the Markowitz's
model makes no assumption regarding the source of the covariance, the single-index
model does. Obviously, the accuracy of the latter model's formula for portfolio
variance is as good as the accuracy of its underlying assumption.
In passing, we have also mentioned in this unit other portfolio selection models, such
as `multi-index model' and `goal programming model' which have high intuitive
appeal but would require much more work before they outperform the simple ones.

11.6 KEY WORDS

Lagrange Multipliers Technique is a technique of solving non-linear optimization
problems.
Corner Portfolio is an efficient portfolio with the following property: any
combination of two adjacent corner portfolios will result in a portfolio that lies on the
efficient set between the two corner portfolios.
Single-Index Model purports to explain the covariance, which exist between the
returns on different assets on the basis of the relationship between the returns and a
single index, usually the market index.
Market-Index (or Market Portfolio) refers to the ultimate market index, containing a
common fraction of the total market value of every capital investment in the economic
system.
Characteristic Line shows the linear relationship between the return on any asset
and the return on the market index.
Systematic (or Market Portfolio) risk is that part of an asset's total risk whch is
related to moves in the market index and, hence, cannot be diversified away.
Beta Coefficient refers to relative measure of sensitivity of an asset's return to
change in the return on the market index. Mathematically, the beta of an asset is the
asset's covariance with the market index divided by the variance ofthe market index.
Unsystematic (or Diversifiable) Risk is that part of an asset's total risk which arises
out of factors unique to the asset. Such risk can be diversified away through portfolio
investment.
Simple Linear Regression (or Ordinary Least Squares) refers to a statistical model
of the relationship between two random variables in which one variable is
hypothesized to be linearly related to the other. This relationship is depicted by a
regression line which is a straight line fitted to pairs of values of the two variables, so
that the sum of the squared random error terms is minimized.
Multi-Index Model purports to explain the covariance that exist between assets on the
basis of changes over time in two or more indices, such as the market, GDP, or the
money supply.
33
Portfolio Theory Goal Programming is a technique to solve optimization problems with multiple
goals. When no feasible solution exists, the goal-programming model permits attaining
the goals as closely as possible.

11.7 SELF-ASSESSMENT QUESTIONS/EXERCISES

1) Explain in your own words the following:
a) Significance of corner portfolios'
b) Major limitations of Markowitz's model
c) Key assumptions of the Single-Index model
d) How a portfolio's residual variance begins to diminish as the number
of assets in the portfolio is increased.
2) Consider the data pertaining to the three-assets case used in this Unit to
explain the application of Largrange Multipliers Technique. Assuming a
target expected rate of return (Rp) of 6 percent, determine the minimum-
variance portfolio (specify the proportion of funds to be allocated to each
share). What is the standard deviation of portfolio return?
3) Monthly return (excluding dividend) data are presented below for each of the
three shares and BSE National Index (1983-84 =100) for an 18-month period
(Oct. 1990-March 1992). Compute the return and standard deviation of a
portfolio constructed by placing one third of your funds in each share, using
(a) the single-index model
(b) the direct method (as is considered under Markowitz's model)
Do the answers in (a) and (b) above differ? why?
Month ITC Tata Steel Britania B SE National Index
1 9.43 45.57 5.98 7.41
2 0.00 -14.78 -9.68 -5.33
3 -4.31 -5.10 -8.93 -7.35
4 -18.92 -19.35 -13.73 -14.64
5 -6.67 1.67 13.64 1.58
6 28.57 10.66 12.00 15.19
7 20.00 3.11 2.68 5.11
8 2.93 10.92 -0.87 0.76
9 5.25 -6.74 -2.63 -0.97
10 21.45 20.56 17.12 10.44
11 23.13 13.36 15.38 17.47
12 32.83 -3.66 1.33 6.42
13 1.52 -6.33 1.32 -3.13
14 11.99 2.70 16.88 5.42
15 -23.08 7.46 5.56 -2.08
16 6.00 23.27 9.47 10.06
17 44.26 5.63 4.81 17.68
18 56.82 27.74 76.15 29.59

11.8 FURTHER READINGS

Haugen. Robet A. 1990 Modern Investment Theory, 5th Edn., Prentice-Hall
International, Inc.
Alexander, Gordon J. and Sharpe, William F., and Jeffery V. Bailay, Fundamentals of
Investments, 3rd Edn., Prentice-Hall. Inc.

34
 Appendix Portfolio Selection
Table 11.1: Monthly Return of Sensex and Select Stocks and Beta Computation
Month End Sensex Castro! Colgate Infosys
30-Jan-1997 7.65% -0.12% 6.98% 0.03%
27-Feb-1997 -2.34% 0.18% 11.88% 14.83%
27-Mar-1997 8.98% 5.35% 10.53% 15.27%
5-Apr-1997 2.41% -4.64% -1.73% 19.97%
27-May-1997 -3.48% -2.63% -7.21% 10.62%
27-Jun-1997 11.93% 18.46% -1.47% 23 .79%
25-Jul-1997 1.37% 31.21% 7.45% 12.42%
27-Aug-1997 -2.20% 5.11% 5.14% 30.34%
26-Sep-1997 -4.21% -6.44% -8.84% 21.17%
27-Oct-1997 0.23% -1.27% -0.85% -13.59%
27-Nov-1997 -7.78% 12.78% -6.78% 3.81%
26-Dec-1997 0.15% 3.35% -8.47% -17.87%
27-Jan-1998 -9.83% -7.55% -6.04% -2.68%
27-Feb-1998 10.56% 0.65% 7.79% 22.36%
27-Mar-1998 7.91% -0.36% 8.46% 20.00%
27-Apr-1998 4.46% 0.40% 1.83% 26.28%
27-May-1998 -7.49% -7.15% -11.87% 17.17%
26-Jun-1998 -16.11% -11.72% -9.59% -11.16%
27-Jul-1998 -2.64% -9.72% 12.78% 12.21%
27-Aug-1998 -3.58% 7.03% -19.58% 6.69%
25-Sep-1998 8.36% 9.97% -5.18% -5.18%
27-Oct-1998 -10.I7% 3.87% -12.86% -2.76%
27-Nov-1998 -3.89% -1.15% 0.96% -3.66%
24-Dec-1998 6.48% 12.36% 13.60% 24.04%
27-Jan-1999 13.18% 19.18% 7.72% 59.68%
27-Feb-1999 1.36% -1.80% -14.19% 25.65%
26-Mar-1999 5.82% 0.24% -2.61% -7.42%
26-Apr-1999 -9.79% -5.48% 1.17% -4.39%
27-May-1999 19.02% 8.25% 18.86% 23.61%
25-Jun-1999 6.45% -1.19% -1.02% 14.02%
27-Jul-1999 11.71% 4.82% 27.70% 23.33%
27-Aug-1999 6.04% 2.97% 8.43% 24.44%
27-Sep-1999 -3.18% -14.02% -5.01% 25.43%
27-Oct-1999 0.86% -5.09% -2.35% 6.92%
26-Nov-1999 -1.08% -3.83% -14.41% 28.03%
27-Dec-1999 2.41% -10.10% -2.34% 31.66%
27-Jan-2000 11.43% 13.61% 0.00% 15.45%
25-Feb-2000 4.73% -13.93% -27.40% 19.54%
27-Mar-2000 -8.48% 1.70% -5.97% 19.53%
27-Apr-2000 -9.07% -4.66% -3.01% -23.70%
26-May-2000 -12.71% -3.87% 12.41% -24.82%
27-Jun-2000 14.74% 5.92% 7.36% 36.20%
27-Jul-2000 -8.66% -14.00% 10.91% -16.87%
25-Aug-2000 3.17% 0.57% -16.67% 19.13%
27-Sep-2000 -5.72% -8.96% -0.87% -7.70%
27-Oct-2000 -10.45% -19.15% -3.46% -3.44%
27-Nov-2000 6.44% 24.56% 6.36% 5.3 7%
27-Dec-2000 -2.31% 12.42% -0.61% -27.45%
25-Jan-2001 11.67% -5.00% -10.24% 23.12%
27-Feb-2001 -6.02% 1.74% -1.05% -15.97%
27-Mar-2001 -9.21% -8.86% -12.10% -18.29%
27-Apr-2001 -7.36% -6.28% 10.45% -30.45%
25-May-2001 6.93% 4.79% 0.43% 29.07%
27-Jun-2001 -6.78% -6,06% -7.07% -15.31%
27-Jul-2001 -4.69% -3.64% -0.53% 2,35%
27-Aug-2001 2.05% 23 .55% 2.67% 7.93%
27-Sep-200 -18.17% -2.74% -4.21% -39.81%
25-Oct-2001 11.29% -1.64% 2.21% 28.41%
27-Nov-2001 8.78% -22.79% 0.56% 24.69%
27-Dec-2001 -4.74% -4.79% 1.32% 4.02%
25-Jan-2002 6.40% 3.84% -5.16% -2.33%
Beta 1.0000 0.49735 0.4392 1.5338

35
Portfolio Theory

UNIT 12 CAPITAL MARKET THEORY

Objectives
After studying this Unit you should be able to:
• pinpoint basic tenets and assumptions of Capital Asset Pricing Model (CAPM)
define risk free asset, risk free lending, risk free borrowing and leveraged
portfolio
• discuss and illustrate the implications of leveraged portfolio for efficient set
and Capital Market Line (CML)
• explain and illustrate `beta' measure of systematic risk and the Security Market
Line (SML) that relates the expected return for an asset to its beta
• highlight limitations of CAPM and describe alternative theory namely
Arbitrage Pricing Theory (APT) Structure.
Structure
12.1 Introduction
12.2 Concepts of Risk-free Asset, Risk-free Lending and Risk-free Borrowing
12.3 Efficient Set with Risk Free Lending and Borrowing
12.3.1 Leveraged Portfolio
12.3.2 Market Portfolio
12.3.3 Capital Market Line
12.4 The CAPM
12.4.1 Assumptions
12.4.2 Security Market Line
12.4.3 Limitations
12.5 Arbitrage Pricing Theory (APT)
12.6 Summary
12.7 Self-Assessment Questions/Exercises
12.8 Further Readings

12.1 INTRODUCTION
Capital Market Theory sets the environment in which securities analysis is
preformed. Without a well-constructed view of modem capital markets, securities
analysis may be a futile activity. A great debate, and great divide, separates the
academics, with their efficient market hypothesis, and the practitioners, with their
views of market inefficiency. Although the debate appears surreal and unimportant at
times, its resolution is immensely critical for conducting effective securities analysis
and investing successfully.
The CAPM is commonly confused with portfolio theory. Portfolio theory is simply the
use of statistical and mathematical programming techniques to derive optimal tradeoffs
between risk and return. Under very restrictive assumptions (rarely found in financial
markets), the CAPM is a highly specialized subset of portfolio theory. Even so, the
CAPM has become very popular as it provides a logical, common sense tradeoff
between risk and return.
In this unit, our endeavor will be to extend the portfolio theory described in the
previous two units, to the capital market theory that is concerned with pricing risky
assets. In particular, we would like to know if two assets differ with respect to their
risk, how will they differ in terms of the price investors are willing to pay or the rate
of return investors expect to get from them?
The major implication of the capital market theory is that the expected return of an
asset will be related to a measure of risk for that asset, known as `beta'. The exact
36 manner in which
expected return and beta are related is specified by the Capital Asset Pricing Model or Capital market Theory
CAPM, which was developed in mid-1960s. The model has generally been attributed to
Williams Sharpe, but similar independent derivations were, made to by John Linter and Jan
Mossin. Consequently, the model is often referred to as Sharpe-Linter-Mossin (SLM)
Capital Asset Pricing Model. Although the model has been extensively examined,
modified and extended in the literature, the original SLM version of the CAPM still
remains the central theme in capital market theory as well as in current practices of
investment management.

12.2 CONCEPTS OF RISK-FREE ASSET, RISK-EREE

LENDING AND BORROWING
Following the development of Markowitz portfolio model, institutional investors and others
started realizing the need for considering the relationship between the stocks in
constructing the portfolios. Many of these investors started using sophisticated
mathematical models to derive optimal portfolio but always found it difficult to measure the
same in view of large number of assets traded in the market. CAPM resolves this problem
to an extent by considering investments in risk-free asset. As we will see in this Unit,
giving investors these new opportunities will have major impact in the shape and
allocation of the efficient set and subsequent portfolio selection. But before we proceed to
discuss this aspect, let us get acquainted with the terms like `risk-free asset', `risk-free
lending' and 'risk-free borrowing'.
Risk-free Asset
Risk-free asset is an asset, which has a certain future return. In other words, a risk-free asset
is one for which there is no uncertainty regarding the future returns; that is, the investor
knows exactly what the value of the asset will be at the end of the holding period. Thus,
variance of returns of a risk-free asset is equal to zero. A good example of such asset is
government bonds.
Whether all types of government bonds are risk-free asset? It is difficult to say because
long-term government bonds are exposed to certain types of risk like interest rate risk and
inflation risk. For instance, if the maturity period of a government security is (say) 15
years, while the investment horizon (or the holding period) of an investor is (say) three-
months, then the investor does not really know at what market price he will be able to
sell the security at the end of his holding period. Any change in interest-rate structure
during the holding period will-influence the market price of the security. To give an idea,
upward revision of interest rate will have a tendency to lower the market price, such that
yield-to-maturity at market-price-based acquisition of the security of given maturity period
compares well with the yield-to-maturity of new issue with similar maturity period. This
is an example of what is termed as `interest-rate-risk'. Thus, normally, the short-term
government securities like Treasury Bills are called risk-free securities. Can corporate
debentures be treated as risk-free asset? Certainly not, because risk of default is
associated with them in addition to interest rate risk and inflation risk. In fact, corporate
bonds have more risk like liquidity risk. However, in relative term, they are better than
equity on risk.
What is the co-movement of returns of risk-free asset and risky asset (or portfolio of risky
assets)? Interestingly, it is always zero. We may recall that covariance between returns of
two-assets ‘i’ and ‘j’ are given by
σ ij = ρij σ iσ j
where ρij , σ i , σ j are the correlation co-efficient and standard deviation of returns on
assets i' and `j' respectively. If one of the assets is risk-free asset, say asset `i', then by
definition returns on risk-free asset are certain such that the standard deviation ( σ i ) is
zero and hence the co-variance ( σ ij ) is also zero.

As we will see later, these two characteristics of risk-free asset, namely, (a) variance = 0;
and (b) covariance of returns with any other asset = 0, are quite significant in determining
the shape of efficient frontier. 37
Portfolio Theory
Risk-Free Lending and Borrowing
Investing in a risk-free asset is frequently referred to as `risk-free lending', since
investment in such assets tantamount to giving loan directly to the government. An
investor does not have to depend solely on his own wealth to decide how much to
invest in assets. She/he can borrow and invest, i.e., the investor can use financial
leverage. However, investor will have to pay interest on borrowed funds and such
borrowing is also assumed to have same risk-free interest rate and hence deemed as
"risk-free borrowing". Though it may not be practical for an ordinary investor to
borrow at risk-free interest rate, it is quiet possible for large funds to borrow at a rate
close to risk-free rate.
Activity 1
What do the following stand for:
CAPM …………………………………………………………………………………
CML ………………………….………………………………………………………..
SML ……………………..……………………………………………………………..
SLM ………………………..…………………………………………………………..
APT ……………………………………………………………………………………

12.3 EFFICIENT SET WITH RISK-FREE LEADING AND

BORROWING
Recall efficient frontier (set of efficient portfolios) we have drawn in Figure 10.5 of
Unit 10. The efficient frontier consists of only risky securities. What happens to the
average rate of return and standard deviation of returns when a risk-free asset is
combined with a portfolio of risky assets such as exists on the Markowitz efficient
frontier?
The expected portfolio return (RP is given by
RP = XRf +(1- x)Ri (12.1)
where,
x = the proportion of the portfolio invested in a risk
free asset;
Rf = risk-free rate of return; and
Ri = expected return on risky portfolio `i' .
Recalling equation (10.2), variance of returns for two-asset portfolio ( σ 2 p ) is as
follows:
σ 2 = [x 2σ 2 f ]+[(1-x)2σ 2i ]+[2x(1-x)σ if ] (12.2a)

Where, σ 2 f and σ 2i are the return variances of risk-free asset and risky portfolio
respectively, and σ if is the covariance of returns between risk-free asset and portfolio
of risky assets i.
As we have noted earlier, for risk-free asset variance and covariance terms are Zero,
i.e., σ 2 f = 0 and σ if = 0; and so equation (12.2a) retains only the middle terns and
reduces to
σ 2p = (1-x) 2σ 2i

σp = (1-x)σ i (12.2b)

As the equations (12.1) and (12.2b) are both linear, the returns-risk graph for portfolio
possibilities, combining the risk-free asset and risky portfolios on Markowitz efficient
38 frontier, is represented by a straight line. Figure 12.1 illustrates the position.
Figure 12.1: Efficient Set of Portfolios with Risk-Free Asset Capital market Theory
Return

Risk
The set of efficient portfolios marked in the curve A, B, M, C, and D are set of
portfolios consisting of risky assets. Suppose there is a risk-free asset offering a
return of Rf Now compare an investment in the portfolio of A (consisting of risky
assets) and investment in risk-free security. Investment in risk-free security offers a
return higher than A but without any risk. Thus, investment in risk-free security is
superior to investments in A and in that process A become inefficient portfolio. A
tangent line drawn from Rf through the curve A-B-M-C-D is now become efficient
portfolio. You may note that only one portfolio marked `M', which consists of risky
assets falls under the new efficient frontier. Such portfolio is called `market portfolio'
which consists of all risky assets. Investors can now earn any return they like on the
efficient frontier by investing a part of money in M, and the rest in Rf For instance, an
investor, who is willing to take maximum risk, will invest entire wealth in M whereas
an investor, who dislike risk invest the entire wealth in Rf An investor with moderate
risk preference will invest 50% in Rf and the balance 50% in M. An investor, who
want to go beyond M has to borrow at risk-free rate of interest and invest the amount
in M and capture the difference between M and Rf to increase the return.
12.3.1 Leveraged Portfolio
In the foregoing analysis it has been tacitly assumed that investors holding portfolios
by combining risk-free asset and risky portfolio M, do so with their own funds. This
is not a realistic assumption. In the real world, investors often purchase assets with
borrowed funds. We now explore the implications of borrowing.
Assume that an investor is, of course, ready to accept higher level of risk, i.e., the
investor is willing to hold portfolio with expected standard deviation of returns σ p
greater than σ m . One alternative would be to choose a portfolio of risky assets on
Markowitz efficient frontier beyond M, such as the one at point C. A second
alternative is to borrow money (i.e., add financial leverage) at risk-free rate and
invest the same in the risky asset portfolio at M. By doing so, the investor can move
from point M to, say, point Q along the extension of Rf to M line. And as is evident
from Figure 12.1, such portfolios as at Q dominate all portfolios below the line,
including the portfolio at C.
To illustrate the point, let us assume that investors can borrow, whatever amount he
wants, at a risk-free rate. In other words, we are assuming that risk-free lending and
risk-free borrowing rates are the same (we will see the implication of relaxing this
assumption later). We may further note that investors would not desire to
simultaneously invest in risk-free asset and borrow money at risk-free rate. Now,
suppose that an investor borrows an amount equal to 50 per cent of his original
wealth of, say, Rs. 10,000. So he has total of Rs. 15,000 which he proposes to invest
in portfolio M. What is the proportion of fund being invested in M? It is given by
1 - x = 15,000/10,000= 1.5
However, the sum of proportions being invested in risk-free assets and M must still
equal one, which means that 39
Portfolio Theory
x =-5,000/10,000=-0.5
The negative sign indicates borrowing, on which there will be interest payment at Rf.
Thus, restating equation (12.1), we have
RP = -0.5Rf + 1.5Rm
Assuming that Rf = 8% and Rm = 20%, the return on the leveraged portfolio will be
= - 0.5 (.08) + 1.5 (0.20) = 0.26 or 26 per cent
which is significantly higher than Rm , the expected return of 20 per cent on risky
portfolio M. Using equation (12.2b), the standard deviation of returns from leveraged
portfolio works out to

σ p =(1-(-.5))σ m = 1.5 σ m

Thus, our investor could increase return along the line Rf - M - Q. Herein lies the
advantage of owning a `leveraged' portfolio. However, leveraging also involves a
trade-off; the risk of a leveraged portfolio is always higher than that of tangency
portfolio, M (in the instant case it is 1.5 times).
12.3.2 Market Portfolio
In this unit you will learn more about the portfolio M. The discussion may look a bit
abstract but necessary to get complete understanding on capital market theory. The
portfolio M represents `optimal combination of risky assets' and is referred to as
"market portfolio". It may be explained as follows.
If all investors have homogenous expectations and they all face the same risk-free
lending and borrowing rate (Rf), each one of them will generate the same risk-return
graph as depicted in figure 12.1. Everyone would obtain the same tangency portfolio
M, and invest in this portfolio in conjunction with risk-free lending or borrowing to
achieve a personally preferred overall combination of risk and return. An aggressive
investor may prefer a leveraged portfolio, which would have a higher risk and return
than portfolio M. In contrast, a conservative investor might prefer a lending portfolio,
which would have lower risk and return than the portfolio M. The decision to hold a
leveraged or lending portfolio is purely a "financial decision" on an investor's risk
preference. It has nothing to do with the decision about holding the combination of
risky asset (i.e., investment decision) corresponding to the portfolio M. In other
words, the composition of risky portfolio M and its inclusion in every investor's
portfolio is independent of his or her risk-return preference; this aspect is known as
`separation theorem', introduced by James Tobin in 1958.
Another important feature of the portfolio M is that it represents a `market portfolio -
a portfolio that is comprised of all risky assets, where the proportion to be invested in
each asset corresponds to its relative market value. Why must the portfolio M include
some investment in every risky asset? If a risky asset was not in this portfolio, it
would mean that nobody is investing in that asset; obviously, the market price of the
asset must fall, which in turn would cause the expected return to rise, until it is being
included in the portfolio M. In the market portfolio, the asset is held in the proportion
that the market value of that asset represents of the total market value of all risky
assets. If, for example, there is a higher proportion of an asset than is justified by its
market value, the excess demand for this asset will result in increase in its price until
its value becomes consistent with the proportion. Thus, when all the price adjustments
are over, i.e., market is brought into equilibrium, tangency portfolio M becomes the
market portfolio. Besides, it is the most diversified portfolio, since it contains all the
risky assets.
12.3.3 Capital Market Line (CML)
With the identification of M as market portfolio, we may define the straight line from Rf
through M, as `capital market line' (CML). This line represents the risk premium as a
40 40 result of taking on extra risk. James Tobin added the notion of leverage to Modern
Portfolio Theory by incorporating into the analysis an asset, which pays a risk-free Capital market Theory
rate of return. By combining a risk-free asset with risky assets, it is possible to
construct portfolios whose risk-return profiles are superior to those of portfolios on
the efficient frontier. Consider the diagram below:
Figure 12.2: Capital Market Line

Risk (Return Volatility)

The capital market line is the tangent line to the efficient frontier that passes
through the risk free rate on the expected return axis.
The risk-free rate is assumed to be 5%, and a tangent line-called the capital market
line-has been drawn to the efficient frontier passing through the risk-free rate. The
point of tangency corresponds to a portfolio on the efficient frontier. That portfolio is
called the "super efficient" portfolio. The Capital Asset Pricing Model demonstrates
that, given certain simplifying assumptions, the super-efficient portfolio must be the
market portfolio.
Using the risk-free asset, investors who hold the super-efficient portfolio may:

• Leverage their position by shorting the risk-free asset and investing the
proceeds in additional holdings in the super-efficient portfolio, or

• Deleverage their position by selling some of their holdings in the super-

efficient portfolio and investing the proceeds in the risk-free asset.
All types of investors, whether aggressive or conservative, will achieve their desired
risk-return levels by combining market portfolio with risk-free lending or borrowing
along the CML. Let us re-examine the equation (12.3) of the capital market line to
make a few more observations at this stage. The term (r m - rm ) / σ m , the slope of
capital market line, can be thought of as the market price of risk for all efficient
portfolios. It is extra return that can be gained by increasing the level of risk
(standard deviation) on an efficient portfolio by one unit. Thus, the entire second
term of equation (12.3) represents that element of expected portfolio return that
compensates for the risk level accepted. The first term, risk-free rate (or the intercept
of CML), is often referred to as the reward for waiting or the return required for
delaying potential consumption for one period.
With these two terms, CML sets the expected return on an efficient portfolio as (Price
of time) + [(Price of risk) x (Amount of risk)]
When Risk-Free Rates are different
In the foregoing discussion we assumed that risk-free rates of lending and borrowing
are the same. We now relax this assumption, and consider that where the additional
subscripts B and L refer to borrowing and lending respectively.
Figure 12.3 shows the modified efficient set; it consists of three distinct but
connected segments, RfL - ML - MB - B 41
Portfolio Theory
Figure 1 2 3 : Efficient Set of Portfolios with different Risk-free rates

The construction of this efficient set can be explained as follows: If RfL = RfB, then the
resulting efficient set will be given by the straight line from RfL through ML. On the
other hand, if risk-free lending and borrowings rates are the same, but the rate is set
at a higher level equal to RfB, then the efficient set of portfolios will lie on the straight
line from RfB through MB. We may note that MB is at a higher level than ML on
Markowitz's efficient set, since it corresponds to a tangency point associated with
higher risk-free rate, RfB
Now, since the investor cannot borrow at RfL, that part of the line emanating from RfL
that extends past ML is not available to the investors (shown in Figure 12.3 by dotted
lines) and can be removed from our consideration. Again, since the investors cannot
invest in a risk-free asset that earns a rate equal to RfB, that part of the line from RfB
and going through MB, but lying to the left of MB, is not available to the investors; and,
hence, can be ignored. On the whole, RfL - ML - MB - B becomes the relevant efficient
set to investors who can lend at RfL and borrow at RfB

12.4 The CAPM

In this section, we turn to the basic Capital Asset Pricing Model developed by Sharpe,
Linter and Mossin. We present here a descriptive model of how assets are priced.
The CAPM model describes the relationship between risk and expected return, and
serves as a model for the pricing of risky securities. CAPM says that the expected
return of a security or a portfolio equals the rate on a risk-free security plus a risk
premium. If this expected return does not meet or beat required return then the
investment should not be undertaken.
The CAPM builds upon the Markowitz portfolio model and capital market line.
Obviously, it pre-supposes all the assumptions stated earlier at appropriate places
(including those stated in the previous two Units). Besides, the model itself adds few
more assumptions. So, let us begin our discussion of the CAPM by putting together
all the assumptions of the model at one place.
12.4.1 Assumptions
1. Investors evaluate portfolios by looking at expected returns and standard
deviations of those portfolios over a one-period horizon.
2. Investors, when given a choice, between two otherwise identical portfolios, will
choose the one with higher expected return.
3. Investors, when given a choice, between two otherwise identical portfolios,
will choose the one with the lower standard deviation or risk.
4. Individual assets are infinitely divisible, meaning that an investor can buy a
42 fraction of a share if he or she so desires.
5. There is a risk-free rate at which an investor may either lend money or borrow Capital market Theory
money.
6. Taxes and transaction costs are irrelevant.
7. All investors have the same one-period horizon.
8. The risk-free rate is the same for all investors.
9. Information is freely and instantly available to all investors.
10. Investors have homogeneous expectations, meaning that they have the same
perceptions in regard to the expected returns, standard deviations and
covariance of returns between any two assets.
Needless to say, many of these assumptions are unrealistic, and one may very well
wonder how useful a model can be that is based on them. But, then assumptions are
necessary in building a model, and we should not be so much concerned about the
assumptions as we should be about how well the model explains the relationships that
exist in the real world. In fact, several authors have shown that many of the above
assumptions can be relaxed with minor impact on the CAPM and no change in the
overall concept of the model.
12.4.2 Security Market Line (SML)
Given the capital market line (CML) and the dominance of the market portfolio, the
relevant risk measure for an individual risky asset is its covariance with the market
portfolio (Covi,M), or what is known as its `systematic risk'. When this covariance is
standardized by the covariance for the market portfolio, we obtain the well-known
`beta' measure. of systematic risk and a security market line (SML) that relates the
expected return for an asset to its beta. Under the CAPM, the postulated relationship
is such that higher an asset's beta, the higher its expected return.
To understand the CAPM and computation of beta, let us examine the whole issue
intuitively. If the concept of CML is clear, you will agree that it is not possible for
any stock to offer a risk-return relationship below or above the CML. If it is below
the CML, such stocks are known as overpriced stocks (meaning they offer lower
return for a given level of risk and there is an alternative portfolio on the line of
CML, which offer higher return) and investors will start selling the stock until its
return increases to the level of CML. The same applies if there is a stock above CML
in terms of risk and return and investors will buy such stocks by offering higher price
until its return declines to CML. In CML, you can observe only two points namely Rf
and M. Since M is an efficient portfolio, we assume that the risk associated with the
M is the least. Further it is also a diversified portfolio and hence one can expect no
unsystematic risk (Recall the discussion in Unit 9 on how diversification beyond a
point fails to yield further results in reducing the risk). Suppose a stock lies beyond
M in the CML line and it means that the stock's risk is higher and hence offer higher
return. Now, it is possible to quantify how much that the stock is riskier than M and
such a measure is called beta of the stock. If the stock falls on the CML line, it's
return (Rs) should satisfy the following equation.
Rs = R f + βs (R m - R f )
where βs = σ sm / σ 2 m
The term β s , representing covariance of returns between asset `s' and the market
portfolio divided by return variance of market portfolio, is known as "beta co-
efficient" or simply "beta" for asset. The above equation is the most often written
form of the CAPM. If the beta and expected return of stocks are plotted, the line that
shows the risk and return of all stocks in the market is called security market line
(SLM). Let us now examine some properties of beta.
Beta is a means of measuring the volatility of a security or portfolio of securities in
comparison with the market as a whole. Beta is calculated using regression analysis.
Beta of 1 indicates that the security's price will move with the market. Beta of greater
than 1 indicates that the security's price will be more volatile than the market. Beta
43
less than 1 means that it will be less volatile than the market.
Portfolio Theory
Many Utilities stocks have a beta of less than 1. Conversely most high-tech stocks
have a beta greater than one, they offer a higher rate of return but they are also very
risky. For example, if a stock's beta is 1.2, it's 20% more volatile than the market.
Beta is a good indicator of how risky a stock is. Beta is the sensitivity of a stock's
returns in comparision to the returns on some market index (e.g., BSE Sensex, NSE-
50 or BSE-100).
Beta values can be roughly characterized as follows:
1. β less than 0
Negative beta is possible but not likely. People thought gold should have
negative betas but that hasn't been true.
2. β equal to 0
Cash under your mattress, assuming no inflation or any investments with a
guaranteed constant return.
3. β between 0 and 1
Low-volatility investments (e.g., Utility stocks)
4. β equal to 1
Matching the index (e.g., any index fund offered by mutual funds)
5. β greater than 1
Anything more volatile than the index (e.g., small cap. funds)
6. β much greater than 1 (tending toward infinity)
Impossible, because the stock would be expected to go to zero on any market decline.
Beta of 2-3 is probably as high as you will get.
More interesting is the idea that securities may have different betas in up and down
markets.
Here is an example showing the inner details of the beta calculation process: Suppose
we collected end-of-the-month prices and any dividends for a stock and the BSE
sensitive index for 61 months (0 to 60). We need n + 1 price observations to calculate n
holding period returns, so since we would like to index the returns as 1 to 60, the prices
are indexed 0 to 60. Also, professional beta services use monthly data over a five-year
period.
Now, calculate monthly holding period returns using the prices and dividends. For
example, the return for month 2 will be calculated as:
R2 = (P2-P1+D2) / P1
Here R denotes return, P denotes price, and D denotes dividend.
The following table of monthly data may help in visualizing the process. (Monthly data
is preferred in the profession because investors' horizons are said to be monthly.)
Si. No. Date Price Dividend' Return
0 31/12/96 45.20 0.00
1 31/01/97 47.00 0.00 0.0398
2 28/02/97 46.75 0.30 0.0011
.... ...... ....... ..... .....
59 30/11/01 46.75 0.30 0.0011
60 31/12/01 48.00 0.00 0.0267
Note: (*) Dividend refers to the dividend paid during the period. They are assumed
to be paid on the date. For example, the dividend of 0.30 could have been
paid between 01/02/87 and 28/02/87, but is assumed to be paid on
28.02.87.

44
So now we'll have a series of 60 returns on the stock and the index (1 to 61). Plot the Capital market Theory
returns on a graph and fit the best-fit line (visually or using least squares process). In
Figure 12.4, you can see the monthly return of BSE Sensex and ITC over 60 months
period (January 1997 - December 2001). In Table 12.1, the beta of stocks forming
part of BSE Sensex along with return and total risk measures are listed. You may
observe that many new economy stocks like Satyam, Zee Tele have high beta whereas
multinational companies like Nestle, Castrol, HLL, Colgate have shown low beta. You
may also observe that returns of the new economy stocks were also high compared to
other low beta stocks. You may have to periodically revise the beta values since the
risk of the stock changes over time based on changes in the economy and industry
characteristics.

Table 12.1: Return, Variance, SD and Beta of BSE Sensex Stocks

Stock Return Variance SD Beta
BSE Sensex 0.10 16.99 4.12 1.00
Satyam 2.25 132.18 11.50 1.70
Infosys 1.67 97.61 9.88 1.44
Zee Tele 1.65 138.74 11.78 1.39
MTNL 0.08 61.20 7.82 1.25
L&T 0.18 50.86 7.13 1.18
BHEL 0.10 59.48 7.71 1.17
Telco -0.18 66.10 8.13 1.16
RIL 0.47 58.62 7.66 1.15
ACC 0.34 60.15 7.76 1.13
ICICI 0.33 80.74 8.99 1.10
NET 0.64 101.07 10.05 1.10
SBI 0.14 47.16 6.87 1.08
M&M. -0.24 61.47 7.84 1.07
Tisco -0.02 49.57 7.04 1.03
ITC 0.53 45.90 6.78 0.92
Ranbaxy 0.56 44.92 6.70 0.90
Grasim 0.16 73.30 8.56 0.88
BSES 0.20 45.36 6.74 0.82
Dr. Reddy 1.17 53.77 .7.33 0.82
GA Cement 0.38 39.25 .6.26 0.78
Cipla 1.00 55.28 7.44 0.77
RPL 0.59 44.55 6.67 0.73
Glaxo 0.23 34.16 5.84 0.70
HPCL 0.29 60.29 7.76 0.68
Hindalco 0.19 41.01 6.40 0.67
HLL 0.53 29.88 5.47 0.67
Colgate 0.03 26.21 5.12 0.65
Bajaj Auto -0.14 33.87 5.82 0.60
Castrol 0.08 22.78 4.77 0.53
Nestle 0.48 29.28 5.41 0.51

Note: Returns represent weekly return of the stock for a period of 1997-2001

If you had a portfolio of beta 1.2, and decided to add a stock with beta 1.5, then you
know that you are slightly increasing the riskiness (and average return) of your
portfolio. This conclusion is reached by merely comparing two numbers (1.2 and
1.5). That parsimony of computation is the major contribution of the notion of "beta". 45
Conversely if you got cold
Portfolio Theory
feet about the variability of your beta = 1.2 portfolio, you could augment it with a
few companies with beta less than 1. If you had wished to figure such conclusions
without the notion of beta, you would have had to deal with large covariance matrices
and nontrivial computations.

Figure 12.4: Monthly Return of BSE Sensex vs. ITC (1997 - 2001)

Hence, beta is the relevant measure of risk for an asset; it measures what is termed as
`systematic or market risk'. It can be shown that the `total risk' of the asset, as
measured by variance of its return, is of the following form

σ 2i = β 2iσ 2 m + σ 2ei (12.8)

where σ 2 ei , is the variance of return for the asset that is not related to the market
portfolio. It is also said to measure `unsystematic or unique risk'. We know that
unique or unsystematic risk can be eliminated in a completely diversified portfolio
such as the market portfolio. (Recall our discussion in this regard from the previous
Unit). So, unsystematic risk is not relevant to investors, and they should not expect to
receive added returns for assuming this risk. It is only in the case of assets with
greater market risk or betas that investors should expect higher return.

Second, beta of a portfolio is simply a weighted average of the betas of its component
assets (n) where the proportions invested in the assets ( x i ) are the weights. Thus,
portfolio beta ( β p ) is given by
n
β p = ∑ x iβ i
i=1

we may illustrate this point by taking a stock portfolio comprising seven stocks with
their betas and portfolio proportions given as follows:
(1) (2) (3) (4)
Company Beta PORTFOLIO WEIGHTED
PROPORTIONS BETA
A 1.50 11.7 .175
B 1.36 22.2 .302
C 1.37 15.7 .215
D 1.07 5.3 .056
E 1.17 26.2 .306
F 1.73 13.9 .240
G 1.09 5.1 .055
100.0 1.349
The beta of this stock portfolio is 1.35, which is obtained by summing up the
multiproduct of (2) and (3) above and shown under (4). It is easy to see the central role
played by the beta in the determination of expected return and risk for stocks as well as
46 portfolio and thus in stock selection and portfolio creation and revision.
12.4.3 Limitations Capital market Theory

You may be now interested in knowing whether security returns is in fact directly
related to beta, as the CAPM asserts. Research results suggest that the CAPM does
not reflect the world well at least when tested using ex-post data. Critics have pointed
out that the inadequacy of the model is due to its austerity. The market, in principle
includes all stocks, a variety of other financial instruments, and even non-marketable
assets such as an individual's investment in education; to which no market index like
the SP 500 Index in US or Bombay Stock Exchange National Index (or any other
index used to represent the market) can be a perfect proxy. And when we measure
market risk using an imperfect proxy, we may obtain a quite imperfect estimate of
market sensitivity. Secondly, the CAPM asserts that only a single number- market
return - is required to measure risk. The actual returns depend upon a variety of
anticipated an unanticipated events. Thus, while systematic factors are the major
sources of risk in portfolio return, different portfolios have different sensitivities to
these factors. It is the recognition of this phenomenon which lies at the core of an
alternative-pricing model called Arbitrage Pricing Theory (APT). Let us briefly
discuss APT in the following section.

12.5 ARBITRAGE PRICING THEORY (APT)

As noted above, at the core of APT is the recognition that several systematic factors
affect security returns. It is possible to see that the actual return, R, on any security or
portfolio may be broken down into three constituent parts, as follows:

R=E+bf+e

where:

E = expected return on the security

b = security's sensitivity to change in the systematic factor

f = the actual return on the systematic factor

e = returns on the unsystematic factors

The above Equation merely states that the actual return equals the expected return,
plus factor sensitivity times factor movement, plus residual risk. The subtler rationale
and mathematics of APT are left out here. The empirical work suggests that a three or
four - factor model adequately captures the influence of systematic factors on stock -
market returns. The APT Equation may thus be expanded to :

R = E + (b1) (f1) + (b2) (f2) + (b 3 ) (f 3 ) + (b4) (f4) + e

Each of the four middle terms in this equation is the product of the returns on a
particular economic factor and the given stock's sensitivity to that factor. What are
these factors and separating unanticipated from anticipated factor movements in the
measurement of sensitivities is perhaps the biggest problem in APT. Some of the
factors empirically found to be useful in measuring risk are:

• Changes in expected inflation, unanticipated changes in inflation, industrial

production, default-risk premium and term structure of interest rates (Roll &
Ross, J FE, Mar 77)

• Default risk, term structure of interest rates, inflation, long term expected growth
rate of profits for the economy, and residual market risk (Berry, FAJ, Mar-Apr
88)

It may be noted that CAPM and APT are different variants of the true equilibrium
pricing model. Both are, therefore, useful in supplying intuition into the way security
47
prices and equilibrium returns are established.
Portfolio Theory
Activity 2

Define the following terms:

a) Leveraged Portfolio.
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
b) Capital Market line.
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
c) Market Portfolio.
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
d) Security Market line.
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………

12.6 SUMMARY
In this Unit, we have discussed the basic levels and assumptions of Capital Asset
Pricing Model (CAPM). The Concepts of risk free asset, risk free lending, risk free
borrowing, leveraged portfolio, market Portfolio, Capital Market Line (CML), Security
Market Line (SML) and beta have been explained and illustrated at length. This Unit
also pinpoints the limitations CAPM and introduces arbitrage pricing theory (APT) and
concludes that till concrete research results become available to the contrary, both
CAPM and APT could be regarded useful, at least intuitively, to guide investors and
portfolio managers for pricing the risky assets like equities.

12.7 SELF-ASSESSMENT QUESTIONS/EXERCISES

1) Define risk free asset. List out two risk free assets.

2) Compare and contrast Capital Market Line (CML) and Security Market Line
(SML).

3) What are the basic assumptions underlying Capital Asset Pricing Model?

4) Define efficient frontier. What happens to the Capital Market Line and the choice
of an optimal portfolio if borrowing rate is allowed to exceed the lending rate?

5) Define leveraged portfolio and bring out its implications for capital market line.

6) Compare and contrast CAPM and APT. Which of the two is a better model for
pricing risky assets and why?

7) Assume the SML is given as Ri = 0.05 + .06 β and the estimated below on two
stocks are β x = .04 and β γ = 1.5. What must be the expected return on two
securities in order for one to feel that they are a good purchase?

8) What specifically should a `true believer' in the CAPM do with her money if
she seeks to hold a portfolio with a beta of 1.5?
48
9) The following data are available to you as a portfolio manager: Capital market Theory

a) Draw a security market line. In terms of the security market line, which of
the securities listed above are undervalued? Why?

b) Assuming that a portfolio is constructed using equal proportions of the

five stocks listed above, calculate the expected return and risk of such a
portfolio.

10. Compare and contrast standard deviation and beta as measure of stock and
portfolio risks.

12.8 FURTHER READINGS

Fischer, Donald E, and Ronald J. Jordon 1995, Security Analysis and Portfolio
Management, 6th ed., PHI, New Delhi

Nancy, Efficient? Chaotic? What is the New Finance? Harvard Business Review,
March-April, 1993.

49
Portfolio Theory
UNIT 13 PORTFOLIO REVISION
Objectives

The objectives of this unit are to:

• understand need for Portfolio Revision

• contrast `active' and `passive' portfolio revision strategies
• highlight portfolio revision practices and the constraints in portfolio revision
• discuss and illustrate formula plans for portfolio revision.
Structure
13.1 Meaning of Portfolio Revision
13.2 Need for Portfolio Revision
13.3 Portfolio Revision Strategies
13.4 Portfolio Revision Practices
13.5 Constraints in Portfolio Revision
13.6 Formula Plans
13.6.1 Basic Assumptions and Ground Rules
13.6.2 Constant-Dollar-Value Plan
13.6.3 Constant -Ratio Plan
13.6.4 Variable-Ratio Plan
13.6.5 Limitations
13.7 Dollar (or Rupee) Cost and Share Averaging
13.8 Summary
13.9 Self-Assessment Questions/Exercises
13.10 Further Readings

13.1 MEANING OF PORTFOLIO REVISION

Most investors are comfortable with buying securities but spend little effort in
revising portfolio or selling stocks. In that process they lose opportunities to earn
good return. In the entire process of portfolio management, portfolio revision is as
important as portfolio analysis and selection. Keeping in mind the risk-return
objective, an investor selects a mix of securities from the given investment universe.
In a dynamic world of investment, it is only natural that the portfolio may not
perform as desired or opportunities might arise turning the desired into less than
desired. Further, some of the risk and return estimation might change over a period of
time. In every such situation, a portfolio revision is warranted. Portfolio revision
involves changing the existing mix of securities. The objective of portfolio revision is
similar to the objective of portfolio selection i.e., maximizing the return for a given
level of risk or minimising the risk for a given level of return. The process of
portfolio revision is also similar to the process of portfolio selection. This is
particularly true where active portfolio revision strategy is followed. It calls for
reallocation of funds between bond and stock market through economic analysis,
reallocation of funds among different industries through industry analysis and finally
selling and buying of stocks within the industry through company analysis. Where
passive portfolio revision strategy is followed, use of mechanical formula plans may
be made. What are these formula plans? We shall discuss these and other aspects of
portfolio revision in this Unit. Let us begin by highlighting the need for portfolio
50 revision.
 Portfolio Revision
13.2 NEED FOR PORTFOLIO REVISION
No plan can be perfect to the extent that it would not need revision sooner or later.
Investment Plans are certainly not. In the context of portfolio management the need
for revision is even more because the financial markets are continually changing.
Thus the need for portfolio revision might simply arise because market witnessed
some significant changes since the creation of the portfolio. Further, the need for
portfolio revision may arise because of some investor-related factors such as (i)
availability of additional wealth, (ii) change in the risk attitude and the utility
function of the investor, (iii) change in the investment goals of the investors and (iv)
the need to liquidate a part of the portfolio to provide funds for some alternative uses.
The other valid reasons for portfolio revision such as short-term price fluctuations in
the market do also exist. There are thus numerous factors, which may be broadly
called market related and investor related.

13.3 PORTFOLIO REVISION STRATEGIES

Broadly speaking investors may, depending on their investment objectives skill and
resources, follow `active' or `passive' strategies for portfolio revision. Active strategy
of portfolio revision involves a process similar to portfolio analysis and selection as
described in Units 10 and 11, which is based on an analysis of fundamental factors
covering economy, industries and companies as well as technical factors as described
in Units 6, 7 and 8. As against this, under passive strategy some kind of formula
plans are followed for revision. Some popular formula plans are described under
section 13.6

Active revision strategy seeks `beating the market by anticipating' or reacting to the
perceived events or information. Passive revision strategy, on the other hand, seeks
`performing as the market'. The followers of active revision strategy are found among
believers in the "market inefficiency" whereas passive revision strategy is the choice
of believers in the `market efficiency'. However, some of the formula strategies are
on the premise of market inefficiency. The frequency of trading transactions, as is
obvious, will be more under active revision strategy than under passive revision
strategy and so will be the time, money and resources required for implementing
active revision strategy than for passive revision strategy. In other words, active and
passive revision strategies differ in terms of purpose, process and cost involved. The
choice between the two strategies is certainly not very straight forward. One has to
compare relevant costs and benefits. On the face of it, active revision strategy might
appear quite appealing but in actual practice, there exist a number of constraints in
undertaking portfolio revision itself. Some significant constraints are discussed under
Section 13.5.

Activity 1

a) Define Portfolio Revision.

…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………

b) Name two broad sets of factors which may motivate portfolio revision.

…………………………………………………………………………………
…………………………………………………………………………………
……………………………………………………………………………........

c) Distinguish `active' and `passive' strategies of portfolio revision.

…………………………………………………………………………………
…………………………………………………………………………………
……………………………………………………………………………….... 51
Portfolio Theory
13.4 PORTFOLIO REVISION PRACTICES
Investors follow both active and passive portfolio revision strategies. Studies about
portfolio revision strategies show that the efficient market hypothesis is slowly but
continuously gaining and investors revise their portfolio much less often than they
were doing previously because of their rising faith in market efficiency. Institutional
investors on the other hand have shown definite tendency in the recent past for active
revision of their portfolios and most often to correct their past mistakes. For instance,
Morgan Stanely mutual funds in India has made major revision in the last few years to
reduce the size of the portfolio since the fund invested initially in about 500 stocks. In
a volatile market, many funds feel that without such revision, it would be difficult to
show better performance. This is said to be motivated by their desire to achieve
superior performance by frequent trading to take advantage of their supposedly
superior investment skills.
Some research studies undertaken in U.S. about the market timing and portfolio
revision suggested as follows:
• F. Black (1973) found that `monthly and weekly revision could be a
rewarding strategy though when transactions costs were considered the results
were less impressive, but, of course, still significantly positive.
• H.A. Latane, et. Al. (1974) concluded that complete portfolio revision every
six months would have been a rewarding strategy.
• Sharpe (1975) contradicts some of the earlier notions on active portfolio
revision. According to Sharpe, a manager, who attempts to time the market
must be right roughly three times out of four, in order to outperform the buy-
and-hold portfolio. If the manager is right less often, the relative performance
will be inferior because of transaction costs and the manager will often have
funds in cash equivalents when they could be earning the higher returns
available from common stock.
Many private sector mutual funds in Indian market have become very active in
portfolio revision.

13.5 CONSTRAINTS IN PORTFOLIO REVISION

A look into the portfolio revision practices as discussed above highlight that there are
number of constraints in portfolio revision, in general, and active portfolio revision, in
particular. Let us indicate some common constraints in portfolio revision as follows:
Transaction Cost: As you know buying and selling of securities involve transaction
cost including brokers' fee. Frequent buying and selling for portfolio revision may
push up transaction costs beyond gainful limits.
Taxes: In most of the countries, capital gains are taxed at concessional rates. But for
any income to qualify as capital gains, it should be earned after lapse of a certain
period. To qualify such concessional rate of 10% tax, investors today need to wait for
one year after the purchase. The minimum period required to qualify for long-term
capital gain is one year for financial assets. Frequent selling for portfolio revision may
mean foregoing capital gains tax concession. Higher the tax differential (between rates
of tax for income and capital gains), higher the constraint. Even for tax switches,
which means that one stock is sold to establish a tax loss and a comparable security is
purchased to replace it in the investor's portfolio, one must wait for a minimum period
after selling a stock and before repurchasing it, to be able to declare the gain or loss. If
the stock is repurchased before the minimum fixed period, it is considered a wash
sale, and no gain or loss can be claimed for tax purpose.
Statutory Stipulations: In many countries including India, statutory stipulations have been
made as to the percentage of investible funds that can be invested by investment
companies/mutual funds in the shares/debentures of a company or industry. In such a
situation, the initiative to revise portfolio is most likely to get stifled under the burden of
52 various stipulations. Government owned investment companies and mutual funds are quite
 Portfolio Revision
often called upon to support sagging markets (albeit counters) or cool down heated
markets, which puts limit on the active portfolio revision by these companies.
No Single Formula: Portfolio revision is no exact science. Even today there does not
exist clear cut answer to the overall question of whether, when and how to revise a
portfolio. The entire process is fairly cumbersome and time-consuming. The
investment literature do provide some formula plans, which we shall discuss in the
following section, but they have their own assumptions and limitations.

Activity 2

a) List out three constraints in portfolio revision.

…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………

b) Define the following :

Wash sale.

…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
……………………………………………………………………………….......
..............................................................................................................................

Tax switches.

…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
………………………………………………………………………………….

(c) Examine four quarterly disclosure of any mutual fund scheme. Examine the
portfolio held by the fund at the end of each quarter and find out the extent of
revision that the fund has made during the four quarters.

…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………

13.6 FORMULA PLANS

As noticed above, the problem of portfolio revision essentially boils down to timing
the buying and selling the securities. Ideally, investors should buy when prices are
low, and then sell these securities when their prices are high. But as stock prices
fluctuate, the natural tendencies of investors often cause them to react in a way
opposite to one that would enable them to benefit from these fluctuations. Investors
are hesitant to buy when prices are low for fear that prices will fall further lower, or for
fear that prices won't move upward again. When pries are high, investors are hesitant
to sell because they feel that prices may rise further and they may realise larger
profits. It requires skill and discipline to
53
Portfolio Theory buy when stock prices are low and pessimism abounds and to sell when stock prices
are high and optimism prevails. Mechanical portfolio revision techniques have been
developed to ease the problem of whether and when to revise to achieve the benefits
of buying stocks when prices are low and selling stocks when prices are high. These
techniques are referred to as formula plans. There are three popular formula plans
namely, Constant-Dollar-Value Plan, Constant Ratio Plan and Variable Ratio Plan.
Before discussing each one of these, let us understand the basic assumptions and
ground rules of formula plans.
13.6.1 Basic Assumptions and Ground Rules
The formula plans are based on the following assumptions:
l. The stock prices move up and down in cycles.
2. The stock prices and the high grade bond prices move in the opposite
directions.
3. The investors cannot or are not inclined to forecast direction of the next
fluctuation in stock prices which may be due to lack of skill and resources or
their belief in market efficiency or both.
The use of formula plans call for the investor to divide his investment funds into two
portfolios, one aggressive and the other conservative or defensive. The aggressive
portfolio usually consists of stocks while conservative portfolio consists of bonds.
The formula plans specify pre-designated rules for the transfer of funds from the
aggressive into the conservative and vice-versa such that it automatically causes the
investor to sell stocks when their prices are rising and buy stocks when their prices
are falling. Let us now discuss, one by one, the three formula plans.
13.6.2 Consant-Dollar-Value Plan
The Plan (CDVP) asserts that the dollar value (or Rupee Value in Indian Context) of
the stock portion of the portfolio will remain constant. This, in operational terms,
would mean that as the value of the stocks rises, the investor must automatically sell
some of the shares to keep the value of his aggressive portfolio constant. If, on the
other hand, the prices of the stocks fall, the investor must buy additional stocks to
keep the value of the aggressive portfolio constant. By specifying that the aggressive
portfolio will remain constant in dollar value, the plan implies that the remainder of the
total fund will be invested in the conservative fund. In order to implement this plan,
an important question to answer is what will be the action points? Or, in other words,
when will the investor make the transfer called for to keep the dollar value of the
aggressive portfolio constant? Will it be made with every change in the prices of the
stocks comprising the aggressive portfolio? Or, will it be set according to pre-
specified periods of time or percentage change in some economic or market index or
percentage change in the value of the aggressive portfolio?
The investor must choose pre-determined action points, also called revaluation points,
very carefully. The action points can have significant effect on the returns of the
investor. . Action points placed at every change or too close would cause excessive
transaction costs that reduce return and the action points placed too far apart may
cause the loss of opportunity to profit from fluctuations that take place between them.
Let us take an example to clarify the working of constant-dollar-value-plan.
Assume an investor has Rs. 20,000 and she divides the investments in two equal parts
of Rs. 10,000 each. The first part was invested in bonds and the second one was
invested in equity shares. She watches price movements of stocks and bonds
regularly and decides to sell the shares if the equity portfolio wealth appreciated more
than 20% of initial investment of Rs. 10,000 (i.e. Rs. 12,000) and invest the sale
proceeds in bonds. Similarly, if the equity portfolio depreciates by 20% of initial
wealth of Rs. 10,000 (i.e. Rs. 8,000), she will transfer Rs. 2,000 from bonds (by selling
bonds) to equity and by buying equity so that the equity part will be brought back to
Rs. 10,000. In other words, the action point is when the equity portfolio appreciates
or depreciates by 20%. In Table 13.1, for an assumed stock price, we have illustrated
the portfolio revision strategy. Note all formula plans will offer a desired results over
54 a longer period of time.
 Portfolio Revision
Table 13.1: Example of a Constant-Dollar-Value Formula Plan
Constant-Dollar-Value Formula
1 2 6 7
3 4 5
Stock Value of Action Total No. of
Value of Value of Total
Price Buy- Points shares in
Conservati Aggressive value
Index and-hold & Actions Formula
ve Portfolio (Col. 3
Strategy Plan
Portfolio (Col. + Col.
(Rs.)
(Col.5- 7xCol. I) 4)
(800 shares
Col.4) (Rs.) (Rs.)
x col.l)
(Rs.)
(Rs.)
25 20,000 10,000 10,000 20,000 400
22 17,600 10,000 8,800 18,800 400
20 16,000 10,000 8,000 18,000 400
Buy 100
20 16,000 8,000 10,000 18,000 shares at 500
Rs.20*
22 17,600 8,000 11,000 19,000 500
24 19,200 8,000 12,000 20,000 500
24 19,200 10,000 10,000 20,000 Sell 83.3 416.7
shares at
Rs. 24
26 20,800 10,000 10,830 20,830 416.7
28.8 23,040 10,000 12,000 22,000 416.7
28.8 23,080 12,000 10,000 22,000 Sell Rs. 347.2
69.5 shares
at Rs. 28.8
25 20,000 12,000 87,00 20,700 347.2

*To restore the stock portfolio to Rs.10,000, Rs.2,000 is transferred from the
conservative ' portfolio and used to purchase 100 shares at Rs.20 per share.
In our example, an investor with Rs.20,000 for investment decides that the constant
dollar (Rupee) value of her aggressive portfolio will be Rs.10,000. The balance of
Rs.10,000 will make up her conservative portfolio at the beginning. She purchases 400
shares selling at Rs.25 per share. She also determines that she will take action to
transfer funds from aggressive portfolio to conservative portfolio or vice-versa each
time the value of her aggressive portfolio reaches 20 per cent above or below the
constant value of Rs. 10,000. Table 13.1 shows the positions and actions of the
investor during the complete cycle of the price fluctuations of stocks comprising the
portfolio. Although the example refers to the investment in one stock, the concepts
are identical for a portfolio of stocks, as the value change will be for the total
portfolio. In this example, we have used fractional shares and have ignored
transaction costs to simply the example. In order to highlight the revaluation actions
of our investor, we have shown them `boxed' in Table 13.1. The value of the buy-
and-hold strategy is shown in column (2) to enable comparison with the total value of
our investors' portfolio [column (5)] as per constant-dollar-value plan of portfolio
revision. Notice the revaluation actions (represented by boxed areas in Table 13.1)
taken when the price fluctuated to Rs.20, 24, and 28.8, since the value of the
aggressive fund become 20 per ' cent greater or less than the constant value of
Rs.10,000. Notice also that the investor using the constant-dollar-value formula plan
has increased the total value of his fund to Rs.20,700 after the complete cycle while
the buy-and-hold strategy yielded only Rs.20,000. Let us now illustrate another
formula plan, namely, constant-ratio-plan.
13.6.3 Constant-Ratio-Plan
The constant-ratio plan specifies that the value of the aggressive portfolio to the value
of the conservative portfolio will be held constant at the pre-determined ratio. This
plan automatically forces the investor to sell stocks as their prices rise, in order to
keep the ratio of the value of their aggressive portfolio to the value of the
conservative portfolio constant. 55
Portfolio Theory Table 13.2: Example of Constant-Ratio Formula Plan
1 2 Value of Constant-Ratio Plan 6 7
Stock Price Value of 3 4 5 Ratio Total No.
Buy- of
Index and-hold Value of Value of Total & Actions shares in
Strategy Conservati Aggressive value Formula
(Rs.) ve Plan
(800 shares Portfolio Portfolio (Col. 3
x coal) (Col. 5- (Col. + Col.
(Rs.) Co1.4) 8xCol.1) 4)
(Rs) (Rs.) (Rs.)
25 20,000 10,000 10,000 20,000 1.00 400
23 18,400 10,000 9,200 19,200 0.92 400
22.5 18,000 10,000 9,000 19,000 0.90 400
1.00
22.5 16,200 9,500 9,500 19,000 Buy 22.2 422.2
at Rs 22 5*
20.25 16,200 9,500 8,540 18,040 0.90 422.2
1.00
20.25 16,000 9,020 9,020 18,040 Buy 23.7 445.9
at Rs.20.25
20 17,920 9,020 8,910 17,930 0.99 445.9
22.4 17,920 9,020 9,920 18,940 1.10 445.9
1.00
22.4 19,920 9,470 9,470 18,940 Sell 20.1 425.8
at Rs. 22.4
24.6 23,080 9,470 10,430 19,900 1.10 425.8
*To restore the ratio from .90 to 1.00, total value of the fund, Rs.19,000, is simply split in
two equal segments ofRs.9,500, and Rs.9500/9,500=1.00. The Rs.500 transferred from
the conservative portfolio will buy 22.2 Shares at the prevailing price of Rs.22.50.
Likewise, the investor is forced to transfer funds from conservative portfolio to
aggressive portfolio as the price of stocks fall. We may clarify the operation of this
plan with the help of an example. For the sake of our example, the starting point and
other information are the same as in the previous example. The desired ratio is 1:1. The
initial fund of Rs.20,000 is thus divided into equal portfolios of Rs.10,000 each. The
action points are pre-determined at ± .10 from the desired ratio of 1.00. Table 13.2
shows, in boxes, the actions taken by our investor to readjust the value of the two
portfolios to reobtain the desired ratio.
You may notice that the constant-ratio plan calls for more transactions than the
constant -dollar-value plan did, but the actions triggered by this plan are less
aggressive. This plan yielded an increase in total value at the end of the cycle compared
with the total value yielded under constant-dollar-value plan. It did, however,
outperform the buy-and-hold strategy. Let us now explain and illustrate variable-ratio
plan.
13.6.4 Variable-Ratio Plan
Variable-ratio plan is a more flexible variation of constant ratio plan. Under the variable
ratio plan, it is provided that if the value of aggressive portfolio changes by certain
percentage or more, the initial ratio between the aggressive portfolio and conservative
portfolio will be allowed to change as per the pre-determined schedule. Some
variations of this plan provide for the ratios to vary according to economic or market
indices rather than the value of the aggressive portfolio. Still others use moving
averages of indicators. In order to illustrate the working of variable ratio plan let us
continue with the previous example with the following modifications:
The variable-ratio plan states that if the value of the aggressive portfolio rises by 20 per
cent or more from the present price of Rs.25, the appropriate ratio of the aggressive
portfolio will be 3:7 instead of the initial ratio of 1:1 Likewise, if the value of the
aggressive portfolio decreases by 20 per cent or more from the present price of Rs.25,
the appropriate percentage of aggressive portfolio to conservative portfolio will be 7:3.
Table 13.3 presents, in boxes, the actions taken by our investor to readjust the value of
the aggressive portfolio as per variable-ratio plan.
56
 Portfolio Revision
Table 13.3: Example of Variable-Ratio Formula Plan
1 2 3 4 5 6 7 8
Stock
Price
Index Value of Value of Total No.
Buy- of
and-hold Value of Value of Total Stock as Shares in
Strategy Conservati Aggressiv value of Total Agressive
(Rs.) ve e
(800 Portfolio Portfolio (Col. 3 Fund (Col. Revaluati Portfolio
shares (Col.5- (Col.8xCol + Col. 4 + Col, 5) on
x coal) Col.4) .l) 4) Action
(Rs.) (Rs.) (Rs.) (Rs.)
.
25 20,000 10,000 10,000 20,000 50% 400
22 17,600 10,000 8,800 18,800 47% 400
20 16,000 10,000 8,000 18,000 44.5% 400
70% Buy 230
20 16,000 5,400 12,600 18,000 shares 630
at Rs.20
22 17,600 5,400 13,860 19,260 72% 630
25 20,000 5,400 15,760 21,160 74.5% 630
50% Sell 207
25 20,000 10,580 10,580 21160 shares 423
at Rs.25
26 20,800 10,580 11,000 20,580 53% 423
28.8 23,040 10,580 12,180 22,760 54% 423
25 20,000 10,580 10,580 21,160 50% 423
You may notice that the increase in the total value of the portfolio after the complete
cycle under this plan is Rs. 1,160, which is greater than the increase registered under
the other two formula plans. The revaluation actions/transactions undertaken are also
fewer under this plan compared to other two plans. Variable ratio plan may thus be
more profitable compared to constant-dollar-value plan and the constant-ratio plan.
But, as is obvious, variable ratio plan demands more forecasting than the other
formula plans. You must have observed, the variable ratio plan requires forecasting
of the range of fluctuations both above and below the initial price (or say median
price) to establish the varying ratios at different levels of portfolio values. Beyond a
point, it might become questionable as to whether the variable ratio plan is less
complicated than the extensive analysis and forecasting that it was supposed to
replace.
13.6.5 Limitations
Indeed, none of the formula plans are a royal road to riches, First, as an effort to
provide mechanical rules for portfolio revision, they make no provision for what
securities should be selected for investment. Second formula plans by their nature are
inflexibility makes it difficult to know if and when to adjust the plan to new
conditions emerging in the investment environment. Finally, in the absence of much
faith in the market efficiency, particularly in the development stock markets, there
may not be many followers of formula plans for portfolio revision
Activity 2
a) What is the total value of the portfolios at the end of the complete cycle
under Constant . Dollar Value Plan, Constant Ratio Plan and Variable Ratio
Plan in the examples given above.
…………………………………………………………………………………
…………………………………………………………………………………
………………………………………………………………………………....
b) Comment on the differences, if any?
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
57
Portfolio Theory
13.7 DOLLAR (OR RUPEE) COST AND SHARE
AVERAGING
In the formula plans discussed above, investors have to create two portfolios and
switch the investment from one to another depending the market condition. An
alternative to this approach is investing only in stocks and building a portfolio over a
period of time while reducing the cost of acquisition. Often investors get into the
problem of bad investment by betting the entire wealth on stocks. Such mistakes can
be avoided by investing regularly over a period of time and thus getting an average
price of the market. Since stocks have always the tendency of moving upward and
downward, it would be difficult to exactly buy at low and sell at top. These averaging
methods allow the investors to participate in both bull and bear markets. They are
discussed below:
13.7.1 Dollar (or Rupee) Cost Averaging
Under this method, an investor will invest a constant amount every period (say
monthly) in single or group of stocks or invest in index funds. In that process, if the
stock price is low, the investor would be in a position to buy more stocks (or more
units in the case of mutual funds investments) and if the prices are high, then the
investor will purchase less number of stocks or units. Since the amount invested is
same irrespective of the market conditions, this technique is referred to as Dollar or
Rupee cost averaging. Over a period of time (after couple of bull and bear markets),
you can expect the average cost of holding per share will be considerably less than
the current market price. Note one has to wait for a minimum period to see the impact
of such plans.
13.7.2 Share Averaging
Under this method, the investor will buy the same quantity of stock every period (say
month) irrespective of the market price. That is when the market is bullish, the
investor will invest more money and when the market is bearish, she or he will invest
less money. In that process, it automatically allows the investors to save more in
bonds when the market is not doing well and invest more in stocks when the market
is doing well.
The following Tables (13.4 and 13.5) illustrate how these two plans work using
Reliance Industries as an example. We are using quarterly prices of last 5 years to
show the workings.
Table 13.4 Rupee Cost Averaging Plan
Month Closing No of Stocks Wealth as Investment Net Gain
Price Purchased Cumulative on date
31-Dec-1996 109.00 4.59 4.59 500.00 500 0.00
31-Mar-1997 128.38 3.89 8.48 1088.90 1000 88.90
30-Jun-1997 185.88 2.69 11.17 2076.61 1500 576.61
30-Sep-1997 180.13 2.78 13.95 2512.37 2000 512.37
31-Dec-1997 165.50 3.02 16.97 2808.32 2500 308.32
31-Mar-1998 176.90 2.83 19.80 3501.76 3000 501.76
30-Jun-1998 143.30 3.49 23.28 3336.64 3500 -163.36
30-Sep-1998 118.80 4.21 27.49 3266.18 4000 -733.82
31-Dec-1998 119.80 4.17 31.67 3793.67 4500 -706.33
31-Mar-1999 130.40 3.83 35.50 4629.34 5000 -370.66
30-Jun-1999 176.70 2.83 38.33 6773.03 5500 1273.03
30-Sep-1999 236.50 2.11 40.44 9565.21 6000 3565.21
30-Dec-1999 233.70 2.14 42.58 9951.96 6500 3451.96
31-Mar-2000 314.50 1.59 44.17 13892.78 7000 6892.78
30-Jun-2000 340.90 1.47 45.64 15558.98 7500 8058.98
29-Sep-2000 342.60 1.46 47.10 16136.57 8000 8136.57
29-Dec-2000 339.00 1.47 48.58 16467.01 8500 7967.01
0-Mar-2001 390.90 1.28 49.85 19488.06 9000 10488.06
9-Jun-2001 369.50 1.35 51.21 18921.18 9500 9421.18
28-Sep-2001 265.85 1.88 53.09 14113.52 10000 4113.52
31-Dec-2001 305.15 1.64 54.73 16699.89 10500 6199.89

58
 Portfolio Revision
The above Table was prepared based on the assumption that an investor invests Rs.
500 (you can add more zeros to make the purchases realistic) every quarter
irrespective of the price. Column 2 shows the market price at the time of purchase.
Column 3 shows the number of stocks that can be. purchased with Rs. 500. Column 4
gives the cumulative number of shares and column 5 gives the value of such
cumulative stocks on that date (if the investor sells, this much amount will be
available). Column 6 shows the amount invested in such plans and the last column
shows the difference between the wealth and investments as on 31.12.2001. At the
end of five years, for an investment of Rs. 10,500, the investor could have purchased
54.73 stocks whose wealth on that day is Rs. 16,700. It gives a net appreciation of Rs.
6,200. The average cost per share works out to Rs. 191.86 against the market price of
Rs. 305 as on 31.12.2001. The investor incurring loss in this stock is unlikely given
the difference between the average cost of acquisition and current market price. The
investment offers an average return of 4.4% per quarter, which will move upward
once the stock price moves forward. To succeed this plan, one has to wait more time
and increase the frequency of investment, say from quarterly to monthly.
If an investor followed the share average plan, she would have got the following
returns.
Table 13.5 Share Average Plan
Month Closing No of Stocks Wealth as Invest Net Gain
Price on date ment
Purchased Cumulative
31-Dec-1996 109.00 2.00 2.00 218.00 218.00 0.00
31-Mar-1997 128.38 2.00 4.00 513.52 474.76 38.76
30-Jun-1997 185.88 2.00 6.00 1115.28 846.52 268.76
30-Sep-1997 180.13 2.00 8.00 1441.04 1206.78 234.26
31-Dec-1997 165.50 2.00 10.00 1655.00 1537.78 117.22
31-Mar-1998 176.90 2.00 12.00 2122.80 1891.58 231.22
30-Jun-1998 143.30 2.00 14.00 2006.20 2178.18 -171.98
30-Sep-1998 118.80 2.00 16.00 1900.80 2415.78 -514.98
31-Dec-1998 119.80 2.00 18.00 2156.40 2655.38 -498.98
31-Mar-1999 130.40 2.00 20.00 2608.00 2916.18 -308.18
30-Jun-1999 176.70 2.00 22.00 3887.40 3269.58 617.82
30-Sep-1999 236.50 2.00 24.00 5676.00 3742.58 1933.42
30-Dec-1999 233.70 2.00 26.00 6076.20 4209.98 1866.22
31-Mar-2000 314.50 2.00 28.00 8806.00 4838.98 3967.02
30-Jun-2000 340.90 2.00 30.00 10227.00 5520.78 4706.22
29-Sep-2000 342:60 2.00 32.00 10963.20 6205.98 4757.22
29-Dec-2000 339.00 2.00 34.00 11526.00 6883.98 4642.02
30-Mar-2001 390.90 2.00 36.00 14072.40 7665.78 6406.62
9-Jun-2001 369.50 2.00 38.00 14041.00 8404.78 5636.22
28-Sep-2001 265.85 2.00 40.00 10634.00 8936.48 1697.52
31-Dec-2001 305.15 2.00 42.00 12816.30 9546.78 3269.52
Under this plan, the investor purchases 2 shares per quarter and in that process, he
would have purchased 42 stock by investing an amount of Rs. 9546.78. The average
cost of acquisition is Rs. 227.30 against the current market rate of Rs. 305.15 as on
31.12.2001. This investment plan offers a return of 3.6% per quarter.
On comparison, when the market prices are volatile, the constant dollar or Rupee cost
averaging is better than share averaging. On the other hand, if the market is on the
uptrend for a long period of time, share averaging will yield better returns. Further
share averaging may demand more investment if the prices have gone up too high. In
dollar cost averaging, the amount is held constant and one can plan for such periodic
investment in portfolio of stocks. Depending on the investors' willingness to invest
money and availability of money and also their forecast on the future, they can
choose one of the two methods. 59
Portfolio Theory
13.8 SUMMARY
In this Unit, we have noticed that in the entire process of portfolio management,
portfolio revision, which involves changing the existing mix of securities, is as
important as portfolio analysis and selection. The portfolio revision strategies adopted
by investors can be broadly classified as `active' and `passive' revision strategies.
This Unit also points out that while both `active and `passive' revision strategies are
followed by believers of market efficiency or those, who lack portfolio analysis and
selection skills and resources. Major constraints, which come in the way of portfolio
revision, are transaction costs, taxes, statutory stipulations and lack of ideal formula.
This Unit also discusses and illustrates three formula plans of portfolio revision,
namely, constant-dollar-value plan, constant-ratio plan, and variable-ratio plan. Before
closing the discussion about formula plans, it was also noted that these formula plans
are not a royal road to riches. They have their own limitations. The choice of
portfolio revision strategy or plan is thus no simple question. The choice will involve
cost and benefit analysis.

13.9 SELF-ASSESSMENT QUESTIONS/EXERCISES

1) ‘In the Indian Context, buy-and-hold is a better strategy compare to any of the
portfolio revision strategies,' Comment.

2) Compare and contrast constant-dollar-value plan, constant-ratio plan and

variable-ratio plan. You may use imaginary data.

3) ‘Formula plans are hardly useful in the Indian Context.’ Comment.

4) Define the following:

a) Aggressive portfolio

b) Conservative portfolio

c) Action points

5) `Formula plans are good because they aid the investor in overcoming his
emotional involvement with the timing of the purchase and sale of stock.'
Comment.

6) Critically evaluate the three formula plans and suggest modification, if any, to
make them useful for investors in Indian Stock market.

7) `Formula plans aid the investor in selecting appropriate securities.' Comment.

8) What are the ground rules to be followed by an investor who wants to adopt
formula plans?

9) Critically examine the basic assumptions of formula plans and comment on

their validity in the Indian Context.

10) Why does the need arise for portfolio revision? What are the constraints in
portfolio revision?

13.10 FURTHER READINGS

Fischer, Bonald E, and Ronald J. Jordon, 1995, Security Analysis and Portfolio
Management, 6th PHI, New Delhi.

Frederick Amling, Investments: An Introduction to Analysis and Management, 5 th Ed.,

60 Prentice Hall, N.J.
 Performance Evaluation
UNIT 14 PERFORMANCE EVALUATION of Managed Portfolio

OF MANAGED PORTFOLIO
Objectives

The objectives of this Unit are to:

• discuss the various concepts and methods of computing portfolio return viz.
• distinguish between Performance Measurement and Performance Evaluation
and the primary components of performance.
• highlight the concept of benchmark portfolio for comparison and evaluation.
• explain why a portfolio earned a certain return over a particular time period,
also known as performance attribution; and
• pinpoint the problems encountered in performance evaluation.
Structure
14.1 Introduction
14.2 Methods of Computing Portfolio Return
14.2.1 Dollar or Value Weighted Rate of Return
14.2.2 Time-Weighted Rate of Return
14.2.3 Risk Adjusted Return
14.3 Components of Investment Performance
14.3.1 Stock Selection
14.3.2 Risk Taking
14.3.3 Market Timing
14.4 Problems with Risk Adjusted Measure
14.5 Benchmark Portfolios for Performance Evaluation
14.6 Summary
14.7 Self-Assessment Questions/Exercises
14.8 Further Readings
14.1 INTRODUCTION
Quite frequently small investors feel insecure in managing their own investment in
securities because they consider themselves inadequate to perform this delicate task
successfully. Often, they feel that they lack education, background, time, foresight,
resources and the temperament to carry out the proper handling of their portfolio. The
logical step they then take is to turn the job over to a professional portfolio manager.
Most often, the portfolio manager chosen takes the form of a mutual fund or
Investment Company. The main reasons for selecting a mutual fund or investment
company involves the management, diversification and liquidity aspects. Managers
trained in the techniques of security analysis devote their full time for meeting the
funds' investment objectives. This permits a constant monitoring of the securities
comprising the portfolio. Furthermore, large amounts of money entrusted to the fund
is invested in securities of different industries and thereby enabling diversification
which otherwise is not possible for an average investor with limited funds. This
diversification evolves as a result of stated objectives of the Fund. Further, these
institutions are also able to obtain lower brokerage commissions than that of an
individual small investor. The small investors opt for a fund whose objectives are
mostly in line with his/her own. Since many funds with various objectives are
competing to acquire the funds of investors, it is necessary to evaluate the
performance of the fund managers. 5
Institutional and
Managed portfolios Though historical performance is not an indicator for future performance, it given a
f i r understanding on how the fund manager performs in different market. For
instance, some fund managers perform better than others when the market was in
uptrend whereas some others focus on reducing volatility and they show better
performance when the market was not doing well.
This Unit discusses various methods of computing portfolio returns and components
of investment performance. And pinpoint the difficulties in risk-adjusted measures of
portfolio performance. Further, we shall also explain the concept and method of
construction of benchmark portfolio for performance evaluation of a managed
portfolio. Let us begin by distinguishing performance measurement and performance
evaluation and explaining methods of computing portfolio return.
14.2 METHODS OF COMPUTING PORTFOLIO RETURN
Performance measurement is just an accounting function, which attempts to reconcile
the end of period with the beginning period values. Performance evaluation on the
other hand, addresses the issues of whether:
• The past performance was superior or inferior
• Such performance was due to skill or luck
• Future performance will be similar or not.
Portfolio performance is generally evaluated over a time interval of at least four
years, with returns for a number of sub-periods within the interval-like monthly or
quarterly, so that there is a fairly adequate number of observations for statistical
evaluation. The calculation of portfolio return is fairly simple when there are no
deposits or withdrawals of money from a portfolio during a time period. In that case,
the market value of the portfolio in the beginning and at the end of the period are
determined for computing the portfolio return. The three steps involved in the
computation of the return are illustrated in Table 14.1.
Table 14.1 Measuring Portfolio Return

6
Performance measurement becomes difficult when a client adds or withdrawals money from Performance Evaluation
the portfolio. The per cent change in the market value of the portfolio as computed above of Managed Portfolio
may not be an accurate measurement of the portfolio's return in that case. For example, if
the beginning value of the portfolio is Rs.50,000 and the value at the end of October is
Rs.70,000 and the client deposits Rs.30,000 in cash in early November, the value at the end
of the year would be Rs.1,00,000. The portfolio return in this case will be
1,00,000 - 50,000
= 100%
50,000
However, the entire return was not due to the investment manager. A more accurate measure
would be:
(1,00,000 - 50,000) - 50,000
= 40%
50,000
14.2.1 Dollar or Value-Weighted Rate of Return
It is also called as the internal rate of return. The interest rate that equates the initial
contribution and the cash flows that occur during the period with the ending value of the
fund is the dollar-weighted rate of return. Mathematically, this measure of return is the
dollar-weighted average of sub-period returns with the dollar weights equal to the sum of
the initial contribution and all the cash flows upto the time of the sub-period return. Note,
we don't need to make any adjustment for Rupee investment since the dollar actually means
value.
For example, a portfolio has market value of Rs. 100 lakhs. In the middle of the quarter, the
client deposits Rs.5 lakhs and at the end of the quarter the value of the portfolio is Rs. 103
lakhs. The dollar-weighted return would be calculated by solving the following equation for
r.
-5 103
100 = +
(1 + r) (1 + r) 2
r = - .98% which is a semi-quarterly rate of return.
This can be converted into quarterly return with the help of the following equation.
[1 + (- 0.0098)]2 - 1 = - 1 . 9 5 % per quarter
14.2.2 Time-Weighted Rate of Return
The time-weighted rate of return is the weighted average of the internal rates of return for
the sub-periods between the cash flows and it is weighted by the length of the sub-periods.
In other words, the geometric (compounded) return measured on the basis of periodic
market valuations of assets is time-weighted return. The equation for time-weighted rate of
return for 4 sub-periods is
1/ 4
Annual Return = [(1 +r1)(1+r2)(1+r3)(1+r4)] -1
Let us now make a quick comparison of Dollar-Weighted and Time-Weighted Returns. A
portfolio of Rs. 50 lakhs declines to Rs. 25 lakhs in the middle of the quarter at which point,
the client deposits Rs. 25 lakhs with the portfolio management firm. Note before the
investment of additional investment, the investor lost 50% of the return. At the end of the
quarter, the portfolio has a market value of Rs. 100 lakhs. Now the investor during the
second period has gained 100% return. The semi-quarterly dollar-weighted return for this
port-folio would be:
-25 100
50 = +
(1 + r) (1 + r) 2
r = 18.6 %
Quarterly dollar-weighted return = (1.186)2 - 1 = 40.66 %. However, its quarterly time-
1/2
weighted return would be [(1 - 0.5) (1 + 1)] - 1 = 0 per cent. There is a lot of difference in
7
Institutional and
Managed portfolios returns. Each rupee lost half its value in the first half and the remaining half doubled
in value in the second half. Thus assuming that a rupee at the beginning was worth a
rupee at the end of the quarter, a time-weighted return is a more accurate measure
than the dollar-weighted return. A dollar-weighted return is strongly influenced by
the size and the timing of the cash flows (that is deposits or withdrawals) over which
the investment manager has no control.
If the return in the first, second, their and fourth quarters are given by r1, r2 r3 and r4,
annual return can be calculated by adding 1 to each quarterly return, then multiplying
the four figures, taking the nth route of the product and finally subtracting 1 from the
resulting product. Thus,

Annual Return = [(1 + r1 )(1 + r2 )(1 + r3 )(1 + r4 )]1/4 − 1

This method assumes the reinvestment of both the capital and the earnings at the end
of each quarter.

The performance of a mutual fund can be evaluated by using the beginning and the
end period net asset values as follows:

(NAVt - NAVt-1 ) + D t + C t
Rp =
NAVt-1

The one period rate of return for a mutual fund (Rp) is defined as the change in net
asset value (NAV) plus its cash disbursement (D) and capital gains disbursements
(C). Net asset values of the fund are adjusted for bonus and rights. Table 14.2 (given
at the end of this Unit) shows the rate of return earned by selected mutual funds
during the last few years. The return on BSE Sensex is also given in the Table to
provide a benchmark for performance evaluation. The funds are ranked in the order of
performance. The differential return earned could have been due to differential risk
exposures of the funds. Hence, the returns have to be adjusted for risk before making
any comparison. Risk-adjusted return gives an idea of whether the return earned is
commensurate with the risk incurred.

Activity 1

1. Between performance measurement and performance evaluation, which one is

just an accounting function?

…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
………………………………………………………………………………….

2. Between Dollar-Weighted Return and Time-Weighted Return, which method

considers the market value of the portfolio just before each cash flow occurs?

…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………

3. In order to evaluate the performance of a mutual fund besides the beginning

there d periods net asset values, which other financial variables are relevant?

…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
8
14.2.3 Risk Adjusted Rate of Returns Performance Evaluation
of Managed Portfolio
It is a measure of how much risk a fund or portfolio assumed to earn its returns. This
is usually expressed as a number or a rating. The performance of a fund should be
assessed in terms of return per unit of risk. The more return per unit of risk, the
better. The funds that provide the highest return per unit of risk would be considered
the best performer. For well-diversified portfolios in all asset categories, the standard
deviation is the relevant measure of risk. When evaluating individual stocks and not
so well diversified portfolios, the relevant measure of risk is the systematic or market
risk, which can be assessed using the beta co-efficient ( β ). Beta, as you would recall
from Unit 12, signifies the relationship between covariance (stock, market) and
variance of market. Two well-known measures of risk adjusted return are used for
the purpose, one is the Sharpe ratio and the other is the Treynor ratio.
Sharpe Ratio
Sharpe ratio is the ratio developed by Bill Sharpe and is calculated by subtracting the
risk free rate from the rate of return for a portfolio and dividing it by the standard
deviation of the portfolio returns. It tells us whether the returns of the portfolio were
because of smart investment decisions or by excess risk.
Sharpe ratio = (Portfolio return - risk free return) / Portfolio Standard Deviation
Or
[rp - rf ] / σ p

i.e., realized return on the portfolio ( rp ) in excess of risk- free rate (rf) divided by the
standard deviation of the portfolio ( σ p ).

For example, let's assume that we look at a one-year period of time where an index
fund returned 11% and Treasury bills earned 6%. If the standard deviation of the
index fund was 20%, then the Sharpe Ratio is computed as follows:
Sharpe ratio = [11- 6] / 0.20 = 25
The Sharpe ratio is an appropriate measure of performance for an overall portfolio .
particularly when it is compared to another portfolio or another index such as BSE
Sensex, BSE 100, NSE-50, etc.
Treynor Ratio (Reward to Variability ratio)
Treynor Ratio measures the returns earned in excess of those that could have been
earned on a riskless investment, per unit of market risk assumed. This ratio is similar
to Sharpe Ratio except it uses beta instead of standard deviation. It is the ratio of a
fund's average excess return to the fund's beta.
T = Return of Portfolio - Return of Risk Free Investment / Beta of Portfolio
Or
[rp - rf ] / β p

i.e. realised portfolio return ( rp ) in excess of risk-free rate (rf) divided by the beta of the
portfolio ( β p ).

The absolute risk adjusted return is the Treynor ratio + the risk free rate.
For instance, assume two portfolios A and B. The respective returns are 12% and 14%
with a beta of 0.7 and 1.2 respectively. If the Risk Free Rate = 9%, then the Treynor's
ratio is computed as follows:
T(A)=[12-9] / 0.7 = 4.25
Risk adjusted rate of return of Portfolio A = 4.25 + 9 = 13.25%
T ( B ) = [1 4 - 9 ]/ 1.2 = 4.17
Risk adjusted rate of return of Portfolio B =4.17 + 9 = 13.17% 9
Institutional and
Managed portfolios Without any analysis of risk, if you ask any investor what is the better number (12%
or 14%) almost universally they might say 14%.. However, when you point out the
risk-adjusted rate of return, many adjust their thinking.
Both these measures provide a way of ranking the relative performance of various
portfolios on a risk-adjusted basis. For investors whose portfolio is a predominant
representation in a particular asset class, the total variability of return as measured by
standard deviation is the relevant risk measure.
The calculation of Sharpe and Treynor ratios for two hypothetical Funds are given
below:
Fund Return Risk- Excess SD Beta Sharpe Treynor
Return Return Ratio Ratio
1 20 10 10 8 0.80 L25 12.50
2 30 10 20 15 1.10 1.33 18.18
The ranking on both these measures will be identical when both the funds are well
diversified. A poorly diversified fund will rank lower according to the Sharpe measure
than the Treynor ratio. The less diversified fund will have greater risk when using
standard deviation is used.
Differential Return (Jensen Measure)
Jensen's measure is an absolute measure of performance, adjusted for risk. This
measure assesses the portfolio manager's predictive ability. The objective is to
calculate the return that should be expected for the fund, given the risk level and
comparing it with the actual return realised over the period.
The model used is;
R jt − R ft = a i + β j (R mt - R ft ) + e
The variables are expressed in terms of return and risk.
R jt = Average return on portfolio for period t
Rft = Risk-free rate of interest for period t
ai = Intercept that measures the forecasting ability of the portfolio manager
β j = A measure of systematic risk

R m t = Average return on the market portfolio

e = Error term
In both Sharpe and Treynor models, it is assumed that the intercept is at the origin. In
the Jensen model, the intercept can be at any point, including the origin.
If the intercept is al and has a positive value, it indicates that the superior return has
been earned due to superior management skills. On the other hand if the intercept is
zero, it indicates neutral performance. This manager has done as well as an unmanaged
randomly selected portfolio with a buy-and-hold strategy. If the intercept is negative,
then the managed portfolio did not do as well as an unmanaged portfolio of equal
systematic risk.
Jensen's measure is illustrated below:

Actual Returns and Risk

Rft Rjt R mt Beta

Fund A 5 12 15 0.50
Fund B 5 20 15 1.50
Fund C 5. 14 15 1.10

10
From Jensen's equation, the return on the portfolio (assuming c = 0 and the intercept Performance Evaluation
(ai) is at the origin) is : of Managed Portfolio

R jt = R ft + β j (R mt - R ft )

Fund A

R jt = 5 + 0.5 (15 - 5) = 10

a = 12 - 10 = 2% (Excess Positive Return)

Fund B
= 5 + 1.5 ( 1 5 - 5 ) = 20
a = 20 - 20 = 0% (Neutral Performance).
Fund C
= 5 + 1.10 (15 -5 ) = 16
a = 14 - 16 = - 2% (Negative Return)
Jensen measure not only calculates the differential between actual and expected
earnings, but also enables an analyst to determine whether the differential return
could have occurred by chance or whether it is significantly different from zero in a
statistical sense. The (alpha value) value of the equation can be tested to s e e if it is
significantly different from zero by using a `t statistic'. When the (alpha value) value
is high and the error in the regression is low, the statistic will be high.
A low (alpha value) value and high regression error results in low t-statistic. At-
statistic of 2 is significant in a statistical sense. It implies that the probability of the
performance due to chance is very low. A t-statistic of - 1 indicates that the
performance occurred due to chance.
The R2 for regression of the fund returns with the market returns indicates the degree
of diversification of the fund. Higher the R2, the more the fund is correlated with the
market index; and less the unsystematic risk, the better diversified is the fund.
Activity 2
Fund January 98 - July 2001

Return Beta SD R2
Scheme X 39.90 0.81 7.30 96%
Scheme Y 32.70 0.91 930 78%

Between Scheme X and Scheme Y, which one is more diversified? Which one is
having greater unsystematic risk in the portfolio?

14.3 COMPONENTS OF INVESTMENT

PERFORMANCE
Portfolio Managers need a clear and relevant method of attributing returns to various
activities that comprises the investment management process viz. investment policy or
risk taking, market timing and stock selection.
14.3.1 Stock Selection
The most important decision as part o f investment strategy is asset allocation. This
involves deciding about what percentage o f the portfolio should be in stocks, bonds,
cash, etc., based on the goals and funds available with the portfolio manager, and also
taking in view
11
Institutional and
Managed portfolios the current and anticipated market conditions? Once he makes that decision, he has to
select suitable investments within the selected asset classes.
For that portion of the portfolio that the portfolio manager allocates to equities (or if
the fund is equity based fund), he should strive to buy shares in excellent businesses
at prices that make business sense. Search for opportunities that offer the highest
predictable annual compounding rate of return possible, where the risk is reasonable
in light of the potential reward.
Further, he should make long-term investments in the common stock of great
businesses at prices that make economic sense given the business's intrinsic value.
The intrinsic value of an investment is the projected annual compounding rate of
return the investment will produce. Focus on the predictability of future earnings of a
business in order to project future value, and make long-term investments in
businesses whose future earnings are predictable to a satisfactory degree of certainty.
Moreover he should make only those investments where he is able to do so at fair or
bargain prices. The price he pays determines the rate of return.
Various methods have been developed to decompose total portfolio returns and
attribute it to each component. Eugene Fama has provided a framework for
performance attribution. We will use one example to show how this decomposition is
feasible.
Example: A mutual fund scheme has offered a return of 15% during a period when the
market index (like Sensex or Nifty) reported a return of 8%. The risk-free rate during
the period was 6%. The standard deviation of returns of the market index and the
portfolio are 12% and 10% respectively. The beta of the portfolio is 0.75. The scheme
has reported an excess return of 9% (15% - 6%) over and above the risk-free return
and we need to find out the sources of such excess returns with the help of the
information given.
Since the beta of the stock is 0.75, the expected return of the fund as per CAPM is
E(R) = Rf+ beta (Rm-Rf) = 6% + 0.75 (8% - 6%) = 7.5%
Against this expected return 7.5%, the fund has offered a return of 15%. The
difference of 7.50% can be attributed to selectivity or ability of the fund managers in
selecting the stocks. The balance 1.5% represents the premium for risk.
14.3.2 Risk Taking
To earn excess return, portfolio managers bear additional risk. By using the Capital
Market Line (CML) we can determine the return commensurate with risk as
measured by the standard deviation of return. The normal return for Fund A, using
total risk would be:
R f + [(R m - Rrf ) (σ p / σ m )]
i.e. 6%+[ (8% - 6%) (10% / 12%)] = 7.67%
The difference between this normal return of 7.67% and the expected normal return
computed earlier (7.50%) is 0.17. This additional expected return is on account of
diversification risk.
The fund offered a return of 15% against the expected return of 7.50% and the excess
return is attributed to selectivity. However, selectivity increases diversification risk,
which was quantified as 0.17%. If we remove the compensation required for bearing
diversification risk, the net return attributed to selectivity is 7.33%
The overall performance of a Fund can be thus decomposed into (i) due to selectivity
and (ii) due to risk taking.
14.3.3 Market Timing
Portfolio Managers can also achieve superior performance by picking u p high beta
s t o c k s during a market upswing and moving out of equities and into cash in declining
markets. To study market timing ability, one could calculate the quarterly returns for a
Fund and for the market index like Bombay Stock Exchange's National Index of a 5
year period and plot them on a scatter diagram. Then a characteristic line can be
12 fitted.
 Performance Evaluation
of Managed Portfolio

Fig. 14.2 (a, b) : Fund return vs. market return for (a) superior stock selection
and (b) superior market timing. [Source: J.L. Treynor and K.
Mazuy, Can Mutual Funds outguess the Market?" Harvard
Business Review (July-August 1966), pp. 131-136.].
Figures 14.2 (a) and 14.2(b) give the excess return of the fund on the Y-axis and the
excess return of the market index on the X-axis. Both figures reveal positive ex-post
alphas. The scatter diagram in Figure 14.2(a) shows that all the point cluster close to
the regression line indicating that the relationship between portfolio excess return and
market excess return is linear. The average beta of the portfolio is fairly constant or
the beta of the portfolio was roughly the same at all times. Since alpha is positive, it
appears that the excess return is due to his stock selection abilities.
In Figure 14.2(b), the points in the middle lie below the regression line and those at
the ends lie above the regression line. This suggests that the portfolio consisted of
high beta securities when market return was high and low beta securities when the
market return was low.
To describe this relationship, we can fit a curve to the points plotted by adding a
quadratic term to the simple linear relationship.
rp = a + brm + cr2m, where
2
r m = return on the market index squared
rP = return on the fund (portfolio),
a, b, c = values to be estimated by regression analysis.
The Figure indicates that the curve becomes steeper as one moves to the right of the
diagram. The Fund movements are amplified on the upside and vice versa. This
implies that the Fund manager was anticipating market changes correctly and that the
superior performance of the Fund manager was anticipating market changes correctly
and that the superior performance of the fund can be attributed to skill in timing.
The performance of 37 mutual funds was studied by Jack L. Treynor and Kay Mazuy
over the period 1953 through 1962. Only one of the funds had a fitted quadratic term
that was significantly different from zero, indicating market-timing skills. The fitted
relationships for other funds evidenced no curvilinearity, indicating that the funds did
not demonstrate any 'skills in market timing. This entire period was one of rising
market.
James Farrel covered market prices in both rising and falling markets (1957-1975) and
came to the conclusion that Funds as a group do not make substantial shifts in asset
positioning to take advantage of market timing.

14.4 PROBLEMS WITH RISK-ADJUSTED MEASURES

In 1997, Modigliani and Modigliani developed the risk-adjusted performance
measure (RAP) often called M-squared, which is by now widely accepted in theory
and practice. Two-years later Lobosco showed that Modigliani's measure can be
combined with 13
Institutional and
Managed portfolios Sharpe style analysis to take investment style into consideration. Both the measures
have increased the investor awareness of risk adjusted performance measures.
However these measures use the standard deviation as the measure of risk and hence
it is relevant only for investors who invest the whole of their savings into the fund. It
is pertinent to note here the other problems of using the risk-adjusted performance
measures.
• Use of Market Surrogate. All measures other than reward to variability ratio
(Treynor ratio) requires the identification of a market portfolio. Whatever
Surrogate is used for market portfolio (say a market index like the ET Index) it
can be criticised as being inadequate. By making slight changes in the
surrogate, performance ranking can vary.
• Choice of Risk-Free Rate. The choice of a risk-free rate has to be appropriate.
If the risk-free rate is too low, then the benchmark portfolio based on it may give
too high a return, making it difficult for the portfolio to show superior
performance against the benchmark.
• Validity of CAPM. reward to volatility measure and differential return
measure involves beta, using the Capital Asset Pricing Model. But CAPM may
not be the correct asset-pricing model in all circumstances. Other asset pricing
models are being developed where the risk would incorporate many other
factors apart from market related risk.

14.5 BENCHMARK PORTFOLIOS FOR

PERFORMANCE EVALUATION
Benchmark portfolio is a tool for the meaningful evaluation of the performance of a
portfolio manager. The more the benchmark reflects the manager's stated style, the
more accurately the performance of the manager's skill can be assessed. Specialised
benchmarks are called `normal portfolios'. They are especially constructed by mutual
consent of the client and the manager to reflect the client's needs and the manager's
style. Some management firms develop a normal portfolio, which they can use for all
clients, and some develop it separately for each type of client.
When benchmarks are designed in advance, the portfolio managers know what the
specific objectives are and tailor the portfolio accordingly. The benchmark should
reflect the appropriate investment universe in which the manager works. Without a
yardstick for proper comparison, it becomes difficult to distinguish between active
management skills and random results.
Rather than using a market index like the Bombay Stock Exchange's Sensitive Index
or the Economic Times Index, a benchmark portfolio would use a portfolio with
predominantly value-oriented shares for a value manager, growth-oriented shares for
a growth manager and small capitalization shares for a small-cap (size) manager. It is
quite possible for an investment manager to perform better than the benchmark,
though the benchmark may itself under-perform in relation to a market index.
The process of constructing a benchmark portfolio involves:
a) Defining the universe of stock to be used for the benchmark portfolio, and
b) Defining the weightage of the stocks in the universe.
An investment manager's month-end portfolio can be examined for the last five years to
get an idea of the average exposure of the manager to various factors (industry,
capitalisation, P/E etc.). For example, if an investment manager tends to invest in
securities in high capitalisation, low PE, low growth stocks, higher weights can be
assigned to these in the benchmark. The more stable the exposure and the investment
style, the easier it should be to build benchmarks with appropriate weights.
Performance attribution analysis, as mentioned earlier, is a means of evaluating an
investment manager's performance, the return and the sources of return relative to a
benchmark portfolio. This analysis looks to an investment manager's total 'excess'
return, or `Active Management Return' (AMR) relative to its benchmark over the
14 given
period. It also looks at the components of AMR stock selection, industry selection Performance Evaluation
and market timing. of Managed Portfolio

The benchmark portfolio return is a `buy-and-hold' return on a predetermined

portfolio tailored to a manager's style. The cumulative excess return or cumulative
AMR is the difference between actual portfolio return and the benchmark return over
the evaluation period.

14.6 SUMMARY
In this unit we have discussed various concepts and methods of computing portfolio
return viz. Dollar-Weighted Return, Value-Weighted Return, and Risk-adjusted Rate of
Return. We have also distinguished between performance measurement and
performance evaluation and highlighted the primary components of performance
namely stock selection and market timing and also the concept and method of
construction of a benchmark portfolio for comparison and evaluation with a managed
portfolio. The problems faced in using risk-adjusted measures for portfolio evaluation
have also been briefly pointed out in this Unit. In the following two units, we shall
learn about portfolio management practices in investment companies and mutual
funds in India.

14.7 SELF-ASSESSMENT QUESTIONS/EXERCISES

1. Distinguish between performance measurement and performance evaluation of
an investment portfolio.

2. Distinguish between Dollar-Weighted and Time-Weighted Return.

3. Describe the Sharpe, Treynor and the Jensen measures of portfolio returns.

4. How are the returns on managed portfolio attributed to stock selection and
market timing? Discuss and illustrate.

5. What are benchmark portfolios? How are they used to evaluate the performance
of a portfolio manager? Discuss with suitable examples.

14.8 FURTHER READINGS

G.P. Brinson, JJ Diermier and GG Schlarbaum "A Composite Portfolio Benchmark for
Pension Plans" - Financial Analyst Journal, March/April 1986.

Eugene Fama, "Components of Investment Performance", Journal ofFinance, June

1972.

Michael Murphy, "Why No One Can Tell Who's Winning", Financial Analysts
Journal, May - June 1980.

Jack L Treynor, "How to Rate Management of Investment Funds", Harvard Business

Review, January - February 1965.

William F Sharpe "Mutual Fund Performance", Journal of Business, January 1996.

15
Institutional and
Managed portfolios Table 14.2: Performance of Mutual Funds Schemes as on March 2002
Rank Scheme Name 3 year 6 month 1 year
Sensex 3.91 17.80 -12.14
Nifty 7.94 17.32 -11.20
1 JM Basic Fund 51.38 132.31 55.15
2 Zurich India Taxsaver - Growth 41.82 43.05 21.59
3 Zurich India Taxsaver - Dividend 41.55 42.64 19.61
4 Alliance Capital Tax Relief 96 35.83 59.39 11.18
5 Pioneer ITI Infotech Fund - Dividend 30.71 100.00 -0.58
6 Alliance Equity Fund - Dividend 24.09 47.19 6.67
7 Zurich India Equity - Dividend 23.70 54.19 27.55
8 Prudential ICICI Growth Plan - Dividend 22.55 41.71 8.48
9 Tata Pure Equity Fund 22.24 31.16 -3.33
10 Templeton India Growth Fund 21.76 41.61 13.83
11 Zurich India Equity - Growth 21.59 54.26 28.06
12 Pioneer ITI Bluechip - Growth 19.23 53.76 9.63
13 Pioneer ITI Prima Plus - Growth 19.10 55.41 21.20
14 Alliance Equity Fund - Growth 17.30 50.39 2.69
15 Pioneer ITI Prima Plus Dividend 15.42 34.72 5.01
16 Pioneer ITI Bluechip - Dividend 15.09 41.48 0.95
17 Pioneer ITI Prima Fund - Growth 14.97 87.52 39.12
18 Reliance Growth - Dividend 14.95 49.21 20.15
19, Birla Advantage Fund - Dividend 13.59 32.09 3.14
20 Birla Advantage Fund - Growth 13.59 32.09 3.14
21 Reliance Vision 13.46 60.79 30.90
22 Pioneer ITI Infotech Fund - Growth 12.35 100.00 -0.60
23 Prudential ICICI Growth Plan - 12.07 41.36 8.24
24 GIC Growth Plus II 10.97 38.16 -3.53
25 Pioneer ITI Prima Fund - Dividend 10.68 53.32 13.75
26 Sundaram Growth Fund 10.15 42.53 10.03
27 SUN F&C Value - Dividend 9.41 40.83 -0.58
28 Zurich India Top 200 - Dividend 8.26 44.68 14.98
29 Zurich India Top 200 - Growth 7.14 44.53 13.51
30 Reliance Growth - Growth 7.08 49.35 20.21
31 KM K 30 Unit Scheme 6.65 36.63 -3.17
32 UTI Primary Equity Fund 6.16 33.37 11.92
33 Chola a Freedom Technology - Dividend 4.92 40.00 0.33
34 GIC Fortune 94 2.97 66.24 22.20
35 DSP ML Equity Fund 1.91 35.00 ,7.81
36 UTI Grandmaster - 1993 1.17 35.77 20.01
37 UTI Mastergain 92 0.29 38.97 -0.10
38 Zurich India Capital Builder - Dividend 0.11 31.35 6.76
39 SBI Magnum Equity Fund -0.05 31.24 -9.20
40 UTI Master Index Fund -1.74 35.71 -5.12
41 Zurich India Capital Builder - Growth -2.02 31.20 6.76
42 UTI Masterplus Unit Scheme 91 -2.33 41.08 -2.44
43 JM Equity - Dividend -2.50 21.10 -7.33
44 SUN F&C Value - Growth -4.82 40.57 -1.35
45 SBI Magnum Multiplier Plus 93 -5.84 30.04 -16.34
46 Chola Freedom Technology - Cumulative -7.41 39.97 0.31
47 LIC Dhanvikas (1) -9.98 39.47 5.08
48 JM Equity - Growth -15.78 26.03 -8.24
Source: www.mutualfundsindia.com. See the notes given below for workings.
16
Notes Performance Evaluation
of Managed Portfolio
Performances of all schemes are calculated for periods specified, as the absolute
appreciation in the NAV values between the dates, after adjustment for dividends and
bonuses. This method gives the due weightage for the dividends and bonuses paid in
the scheme and also on the time when these were paid. The dividends paid are not
considered to be re-invested in the same scheme but are inflated by the rate of risk
free interest in the economy and adjusted. The reinvestment of dividend will mean
the return equal to growth option. We have given weightage to the time value of
money and taken the risk free rate of 8.5 per cent for calculations. This method is the
most appropriate method for dividend adjustment.
Performance for a period less than a year is reported in absolute and that for a period
more than a year is annualized. The actual calculation is explained-below
Let us consider
Nc = NAV for the current date;
Nc’ = Present NAV after adjustment for dividend and bonuses;
Np = NAV of the day since when return has to be calculated;
D = dividend in percentage, announced between the period specified;
B= bonus announced between the period specified;
t = no. of days between the period of dividend announcement and current date;
Fv = Face Value of the scheme;
R = rate of risk free return (presently we are considering 8.5% as the rate of risk free
returns as provided by RBI Relief Bonds )
Dividend adjustment
Nc' =Nc + [ {D * Fv/100} *(1 + r/( 100*365) ^ (t))]
Bonus adjustment
Let the bonus payment be represented in the form `a: b' i.e. `a' number of units for
every ‘b’ units held.
Then, Nc' = Nc * {b/(a+b)}
Return
Return = {(Nc’ - Np) * 100} / Np
Note: The adjustment is done in the order of announcement from the present day to
the date of announcement going in the reverse direction from present to past.

17
Institutional and Managed
Portfolio
UNIT 15 INVESTMENT COMPANIES
Objectives
The objectives of this Unit are to:
• highlight different types of Investment Companies
• discuss the role of Insurance Companies and Pension Funds in the capital
markets
• describe some of the major products offered by the insurance companies and
pension funds.
Structure
15.1 Introduction
15.2 Insurance Companies
15.2.1 Life Insurance Corporation of India
15.2.2 General Insurance Companies
15.3 Pension Funds
1.5.3.1 Pension Plans in India
15.4 Summary
15.5 Self-assessment Questions/Exercises
15.6 Further Readings

15.1 INTRODUCTION
Individuals have the option to invest on their own or through some institutions, which
specialise in such activities. In the U.S. and many other developed nations, investors
normally prefer to invest through mutual funds and pension funds. Indian investors
are also increasingly investing through such specialised funds. Funds, which
specialise in investments on behalf of their Investors are called Investment
Companies. An investment company is a pool of funds belonging to many
individuals that is used to acquire a collection of individual investments such as
stocks, bonds and other publicly traded securities. While some of the investment
companies offer these services indirectly, others offer such services directly. In this
unit, we will discuss more on investment companies, which offer such indirect
services to investors. Investment companies, which offer direct services, often called
as mutual funds which will be discussed in detail in the next Unit. For the limited
purpose of this Unit, let us call companies belonging to former group as investment
companies and second group of companies as mutual funds.
Investment companies typically offer some service not directly related to investing
the money in securities but the amount collected against such services are invested in
securities and income earned out of that are shared with the customers of service. To
give an example, suppose if you have taken a life insurance policy from Life
Insurance Corporation of India or any, other newly formed private sector insurance
company, you are actually getting an insurance product or service. Insurance policies
invariably have two components namely risk cover and savings. Such insurance
companies in addition to protecting the family of policyholders in the event of loss of
policyholders' life also offer a return on the savings part in the form of bonus. In
order to reward the policy older with such return, insurance companies invest money
in securities of different types. Another example is pension funds, which also collect
regularly some amount from the subscribers and reward the subscribers by providing
pension for the subscribers as well as her/his family. Specialised Pension Funds are
yet to take off in India but LIC, UTI and ITI-Pioneer Mutual Fund have already
floated pension funds schemes. Many mutual funds and private life insurance
companies are in the process of bringing such schemes to investors.
In contrast with investment companies, the mutual funds are not offering any other
services other than investment services to investors. Mutual funds collect money
18 from investors and
 Investment Companies
simply invest the amount in securities as per the scheme. At the end of the scheme or
periodically, the return earned from the scheme is distributed to the holders of mutual
funds units after deducting management fees. We will discuss more on mutual funds
in the next Unit. In this unit our discussion is mainly restricted to insurance and
pension companies.
15.2 INSURANCE COMPANIES
Insurance industry is one of the several industries, which was earlier under the
monopoly of the government, opened up for competition. Today, in addition to Life
Insurance Corporation of India and General Insurance Corporation of India and its
Associates, there are large number of private players like HDFC Standard Life,
ICICI-Prudential, etc., have entered into the market. The following table shows some
of the major private sector companies registered with Insurance Regulatory and
Development Authority (IRDA) and the list is growing.
Table 15.1 Insurance Companies in the Private Sector
Life Insurance Companies General Insurance Companies
HDFC Standard Life Insurance Co. Royal Sundaram Alliance Insurance Co
Max New York Life Insurance Co Reliance General Insurance Company
Om Kotak Mahindra Life Insurance IFFCO Tokio General Insurance Co.
Tata AIG Life Insurance Company TATA AIG General Insurance Company
ING Vysya Life Insurance Company Bajaj Allianz General Insurance Co
Metlife India Insurance Company ICICI Lombard General Insurance Co.
ICICI Prudential Life Insurance Co.
Birla Sun Life Insurance Company
SBI Life Insurance Company
Allianz Bajaj Life Insurance Company

15.2.1 Life Insurance Corporation of India

The LIC of India was established by an Act of Parliament in 1956. The corporation
central office is located in Mumbai and there are seven zonal offices one each at
Mumbai, Kolkata, Delhi, Kanpur, and Chennai. The corporation has 100 divisional
offices and 2048 branches and 6,28,301 agents.
Some of the objectives that the Corporation pursues are listed below:
• Spread Life Insurance much more widely and in particular to the rural areas and
to the socially and economically backward classes with a view to reaching all
insurable persons in the country and providing them adequate financial cover
against death at a reasonable cost.
• Maximize mobilization of people's savings by making insurance-linked savings
adequately attractive.
• Deploy the funds to the best advantage of the investors as well as the community
as a whole, keeping in view national priorities and obligations of attractive
return.
• • Act as trustees of the insured public in their individual and collective capacities.
• Meet the various life insurance needs of the community that would arise in the
changing social and economic environment.
During the last five decades, the Corporation has grown huge size in terms of
collecting the savings and also investing the same in the market. Table 15.2, 15.3 and
15.4 will give you an idea on the role of LIC in Indian capital market. LIC has
crossed the 2 crore landmark by underwriting 2.25 crore policies during the year
2001-2002. The sum assured against these policies was Rs. 192784.96 crores. During
the year 2001-02 LIC has settled in all 85.27 lakh claims both maturity and death.

19
Institutional and Managed
Portfolio

Table 15.3 : New Business Individual Insurance (excluding Annuities)

New Business in India New Business Out of Total New Business
Year No. of Sum Annual No. of Sum Annu No. of Sum Annual
Polici Assured Premiu Policie Assure al Policie Assured Premiu
es(in (Rs. In m(Rs. s d Premi s (Rs. in m
lakhs crores) In (Rs. in um crores) (Rs. in
) crores) crores (Rs. crores)
) in
crores
(1) (2) (3) (4) (5) (6) ) (7) (8) (9) (10)
1996-97 122.68 56740.50 3345.39 12,296 253.44 15.39 122.81 56,993.94 3360.78

1997-98 133.11 63617.69 3841.12 13,904 310.14 18.07 133.25 63,927.83 3859.19
1998-99 148.44 75316.28 4863.41 13,356 289.98 17.11 148.57 75,606.26 4880.52
1999-00 169.77 91214.25 6008.28 12,648 276.69 17.74 169.89 91,490.94 6026.02
2000-01 196.57 124771.62 8851.89 7,911 179.01 11.46 196.65 1,24,950.63 8863.35
2001-02 224.91 192572.27 16009.44 8,695 212.69 1 2 . 5 7 224.99 192784.96 16022.01

Source: Website of LIC : 45th Chairman's Review

20
 Investment Companies
Table 15.4: LIC's Investments - Some Highlights

Note : 1) Item 1 & 2 are shown as at Book Value as on 31.3.02.

2) Item 3 to 12 are Gross investment made so far.
Source : Web site of LIC

LIC offers a number of plans, which can be broadly classified as plans for
individuals, group scheme and pension plans. The various schemes offered by LIC as
on 5.5.03 are :
(a) Plans For individuals
Whole life schemes Endowment schemes
Term assurance plan Periodic money-back plans
Capital market linked plans Medical benefits linked
insurance
Plans for the benefits of handicapped Plans to cover housing loans
Joint life plan Plans for children’s needs
Investment plans
(b) Group Schemes
Group Term Insurance Schemes
Group Gratuity Scheme
Group Superannuation Scheme
Group Leave Encashment Scheme
Group Insurance Scheme in view of EDLI
Janashree Bima Yojana
Group Savings Linked Insurance Scheme
Krishi Shramik Samaj ik Suraksha Yojana 2001
Shiksha Sahayog Yojana

(b) Pension Plans

New Jeevan Akshay I
New Jeevan Dhara I
21
New Jeevan Suraksha I
Institutional and Managed Since you are studying a course on investments, it will be useful to think about LIC
Portfolio as a part of your portfolio of investments. Some of the reasons on why should an
individual has to take insurance policy are listed below:
Protection: Savings through life insurance guarantee full protection against risk of
death of the saver. In life insurance, on death, the full sum assured is payable (with
bonuses wherever applicable) whereas in other savings schemes, only the amount
saved (with interest) is payable.
Aid to thrift: Life insurance encourages `thrift'. Long term saving can be made in a
relatively `painless' manner because of the `easy instalment' facility built into the
scheme (method of paying premium either monthly, quarterly, half yearly or yearly).
Take, for example, Salary Saving Scheme popularly known as SSS. This scheme
provides a convenient method of paying premium each month by deduction from
one's salary. The deducted premium is remitted by the employer to the LIC. The Salary
Saving Scheme can be introduced in an institution or establishment subject to
specified terms and conditions.
Liquidity: Loans can be raised on the sole security of a policy, which has acquired
loan value. Besides, a life insurance policy is also generally accepted as security for
even a commercial loan.
Tax Relief: Tax relief in Income Tax and Wealth Tax is available for amounts paid by
way of premium for life insurance subject to Income Tax rates in force. Assesses can
avail themselves of provisions in the law for tax relief. In such cases the assured in
effect pays a lower premium for his insurance than she/he would have to pay
otherwise.
Money when you need it: A suitable insurance plan or a combination of different
plans can be taken out to meet specific needs that are likely to arise in future, such as
children's education, start-in-life or marriage provision or even periodical needs for
cash over a stretch of time. Alternatively, policy moneys can be so arranged to be made
available at the time of one's retirement from service to be used for any specific
purpose, such as for the purchase of a house or for other investments. Subject to
certain conditions, loans are granted to policyholders for house building or for
purchase of flats.
Investments through Life Insurance offer attractive return. Table 15.5 shows bonus
paid by LIC during the last few years.
Statutory Regulations Governing LIC Investments
The investment policy of LIC is subject to regulations under the provisions contained
in the Life Insurance Corporation Act, 1956. It stipulates that LIC’s funds shall be
invested as under:
i) In Central Government marketable securities:
Not less than 25 per cent
ii) In Central Government, State Government Securities including securities in
(i) above:
Not less than 50 per cent
iii) In. socially-oriented sectors, including the public sector, co-operatives plus
(ii) above:
Not less than 75 per cent
Of the balance 25 per cent, about eight per cent would be set aside for loans against
policies, about two per cent may be invested in immovable properties and about 10 per
22 cent may be invested in the private corporate sector.
 Investment Companies
Table 15.5 : Rates of Bonus declared by LIC of India
(Rates of Bonus per annum per Rs.1000 Sum Assured)
Valua tio n as at Whole Life Policies (Rs.) Endowment Policies (Rs.)
31.12.1957 16.00 12.80
31.12.1959 16.00 12.80
31.12.1961 16.00 12.80
31.03.1963 17.50 14.00
31.03.1965 20.00 16.00
31.03.1967 20.00 16.00
31.03.1969 22.00 17.60
31.03.1971 22.00 17.60
31.03.1973 22.00 17.60
31.03.1975 22.00 17.60
31.03.1977 25.00 20.00
31.03.1979 31.00 24.80
31.03.1981 35.00 28.00
31.03.1983 42.50 34.00
31.03.1985. 55.00 44.00
31.03.1986 65.00 52.00
31.03.1987 72.50 58.00
31.03.1988 77.50 62.00
31.03.1989 80.00 64.00
31.03.1990 82.50 66.00
31.03.1991 84.00 67.00
31.03.1992 84.00 67.00
31.03.1993 84.00 67.00
31.03.1994 84.00 67.00
31.03.1995 86.00 67.00-69.00
31.03.1996 86.00 67.00-69.00
31.03.1997 88.00 64.00-71.00
31.03.1998 91.00 62.00-74.00
31.03.1999 93.00 53.00-76.00
31.03.2000 95.00 53.00-80.00
31.03.2001 95.00 53.00-80.00
31.03.2002 100.00 49.00-65.00
Source : Website of LIC of India
15.2.2 General Insurance Companies
Unlike Life Insurance, there is no saving under general insurance. Policyholders take
the policy and get an insurance cover for their machine, office, house, health, etc.
Though no income is distributed back to policyholders, the general insurance
companies are major investors in the market. For instance, the value of investments
in the capital market by General Insurance Corporation of India as on March 2000 is
close to Rs. 1860 cr.
Activity 1
1. Assume that you want to take an LIC policy for yourself or someone in your
family. List down the needs of such policies.
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
23
Institutional and Managed 2. Contact a Insurance Agent of LIC of India and a private insurance company.
Portfolio Ask them to suggest three plans and compare whether such plans meet your
requirements.

…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………

15.3 PENSION FUNDS

Private pension funds are yet to pick up in India but many private insurance
companies have plans to launch the pension fund products to Indian investors. The
employees of organized sector in India, particularly Government employees are
covered by pension scheme sponsored by the Government. On the other hand, several
individuals without a government job have no planned scheme to protect their
retirement life and hence the potential of pension fund in India is high. In the U.S.
and Europe, pension funds have grown rapidly to become the primary vehicle of
retirement savings. A pension plan is an agreement to provide income to participants
upon their retirement. These funds are mostly tax deductible and investment income of
the fund is also not taxed. Distributions from the fund whether to the employer or
employee are taxed as ordinary income. There are two types of pension plans.

A) Defined contribution: Here a formula specifies the contributions but not

benefit payments. Contribution rules are usually specified as a predetermined
fraction of salary although that fraction need not be constant and can be changed
over the course of employees' career. Pension benefits are not specified other
than at retirement the employee applies that the total accumulated value of
contributions and earnings on those contributions to purchase an annuity. The
employee often has a choice over both the level of contribution and the way the
account is invested:

B) Defined benefit: Here a formula specifies benefits but not the manner,
including contributions, in which these benefits are funded. The benefit formula
typically takes into account years of service of the employer and levels of wages
or salary. The employer or an insurance company hired by the sponsor
guarantees the benefits and thus absorbs the investment risk. The obligation of
the plan sponsor to pay the promised benefits is like a long-term liability of the
employer.

In the United States, the first pension fund was established towards the end of the
nineteenth century by the railroads, the nation's first larger employer. By 1929, there
were 397 plans sponsored by employers and another 13 sponsored by labour union.
They covered nearly 4 million workers. Since there is no guaranteed return and funds
raised were invested in securities, many pension funds have failed during the great
depression. Pension fund industry gained substantial expansion during the World War
II because many employers were motivating labour force to join their service by
offering pension benefit. By 1945, private pension plans covered 6.40 million
workers, a 50% increase over 1940. The growth of pension plans has continued at
rapid space since World War II and half of the private employees in the U.S. are
covered by the pension funds. Contribution of pension funds account nearly 24% of
the net personal savings of the employees. Pension funds in the U.S. today control
more than $3000 billion worth of assets. Defined pension plans are today insured by
Pension Benefit Guarantee Corporation (Penny Benny) and in the event a plan
defaults or is terminated, the Penny Benny guarantees pension benefit up to certain
limit.
24
 Investment Companies
15.3.1 Pension Plans in India
1 JEEVAN AKSHAY-I OF LIC OF INDIA
Salient Features:
Minimum age at entry : 40 Last Birthday.
Maximum Age at entry : 79 Last Birthday.
Minimum Purchase Price : Rs.25,000/-.
Minimum Annuity Installment : Rs. 250/-.
Type of Annuities Available:
• Annuity for Life
• Annuity certain for 5,10,15,20 years and for life thereafter
• Annuity with return of purchase price
• Annuity for Life increasing at a simple rate of 3 % per annum.
• Annuity for Life with a provision for 50 % of the annuity to the spouse of the
annuitant for life on death of the annuitant.
Modes of Annuity Payments:
Annuity can be paid in yearly, half-yearly, quarterly or monthly installments, subject
to a minimum annuity of Rs. 250/-.If the annuity payable under a particular mode is
less than Rs. 250/-, then the allowable mode should be so altered such that the
minimum annuity payable is Rs.250/-.
• No Loan will be given by the Corporation to the policy holders under this plan.
• No Surrender value will be available under this plan.
2 NEW JEE VAN SURAKSHA -I/NEW JEEVAN DHARA-I
Salient Features
• Minimum Age at entry : 18 years last birthday.
• Maximum age at entry : 65 years last birthday.
• Minimum vesting age : 50 years last birthday.
• Maximum vesting age : 79 years last birthday.
• Minimum deferment period : 2 years.
• Minimum Notional Cash option : Rs. 50,000 for regular premium policies
• Minimum Single Premium : Rs. 10,000/-
• Minimum amount of Annual Premium : Rs. 2500
• Maximum deferment period : 35 years.
• Age Proof : Standard Age Proof required.
Benefits
a) On vesting
The Notional Cash Option together with Reversionary Bonuses and Final additional
Bonuses (if any) with or without 25% commutation will be compulsorily converted
into annuity having following options:
25
Institutional and Managed • Annuity for life.
Portfolio
• Annuity for life with guaranteed period of 5, 10, 15, 20 years.
• Joint life and last survivor annuity to the annuitant and his/her spouse under
which annuity payable to the spouse on death of the purchaser will be 50% of
that payable to the annuitant.
• Life annuity with return of purchase price.
• Life annuity with annuities increasing at a simple rate of 3% per annum.
b) During Deferment
A term rider option will be available. On the death of the policy holder who has opted
for the term Assurance rider (provided the policy is in-force), the Term Assurance
Sum Assured along with all premiums ( excluding term Assurance premium and extra
premium if any) paid up to the date of death accumulated at the rate of 5% p.a.
compounding or at such rates as decided by the Corporation from time to time will be
paid to the nominee. When the policy is not in-force, only return of premiums with
interest as stated above will be available.
For those not opting for the Term Assurance Rider, in respect of policies which are in-
force or in a paid up condition, all premium accumulated at 5% p.a. compounding or at
such rates as decided by the Corporation from time to time, will be paid to the
nominee.
c) Paid up, Guaranteed and Special Surrender Value
• For Annual Premium Plans: The Guaranteed Surrender Value will be
equal to 90% of all premiums paid excluding the first year premium, all
Term Assurance premium and extra premium ( i f any). This will be
allowed after at least two full years' premiums have been paid and will be
available after two full years have been completed from the date of
commencement. However, the policy can not be surrendered after the
annuity vests.
• For Single Premium Plan: The Guaranteed Surrender Value will be
90% of the single premium paid. Surrender will be allowed 2 years after
the commencement of the policy.
• Special Surrender Value: For Annual premium policy this will be
available at least two years after date of commencement and during
deferment period if at least two full years' premium have been paid.
d) Non-forfeiture regulations
If, after at least two full years premiums are paid in respect of this policy, any
subsequent premium be not duly paid, the policy shall not be wholly void, but the
amount of Notional Cash Option shall be reduced to such a sum as shall bear same
ratio to the original, as the number of premiums actually paid shall bear to the total
number of premiums originally stipulated for in the policy. The policy so reduced
will thereafter be free from all liabilities for payment of the within mentioned
premiums but shall not be entitled to participate in future profits. The existing vested
Bonus additions will attach to the reduced paid up policy and this will determine the
reduced annuity payable on vesting. The option of commutation of 25% pension will
also be available on the vesting age. If however the annuity payable is less than the
minimum of Rs. 250/-, the Corporation will have the right to change the mode of
payment of annuity to yearly, half-yearly or quarterly or to pay a lump sum subject to
deduction of tax if any, at source as per the prevailing taxation rules. In the event of
non-payment of the premiums within the days of grace the life cover will cease.
i) For Term Assurance Option
• Maximum Term Assurance Sum Assured would be equal to twice the
Notional Cash Option subject to a maximum of Rs. 25,00,000 (overall
limit on riders on all plans).
26
 Investment Companies
• Minimum Term Assurance Sum Assured : Rs. 1,00,000
• Maximum age at entry 50
• Minimum Term 10 years.
• Maximum Term 35 years.
Note: Term Assurance Rider cover ceases at age 60 years.
Income Tax Provisions Under New Jeevan Suraksha -I Plan
1. New Jeevan Suraksha-I is a scheme approved by IRDA as envisaged in Section
10(23 AAB) of the Act.
2. The income of the fund maintained under this pension scheme is totally exempt
from income tax being a fund maintained under section 10(23 AAB) of the Act.
3. The deduction under Section 80CCC is available up to a sum of Rs.10,000/- to
the assessee, who is an individual in respect of any sum deposited by him into
the above plan.
3 PIONEER ITI MUTUAL FUND - PENSION SCHEME
a) Investment Focus
Saving for retirement is of paramount importance to all of us. Pioneer ITI Pension Plan,
India's first pension fund in the private sector helps you save for your retirement in a
convenient and flexible manner. Pension Plan invests in a mix of high quality debt
instruments and equities to ensure relative stability of your investment and to deliver
superior returns in comparison to traditional tax-saving instruments.
b) Fund Suitability
For investors seeking tax rebate plus the returns and safety of fixed income
investments as well as those saving for retirement. Ideal for a time horizon of 3 years
plus.
c) Highlights
• Tax rebate of20% for investments upto Rs.60,000 under Sec 88 (xiiic)
• Premature withdrawal after 3 years at a nominal charge on the NAV
• Choice oft plans - Dividend Scheme & Growth Scheme
• Convenience of investing amounts as low as Rs.500
• Income tax benefits under Sec. 48 & 112
Activity 2
1. Examine the Pension Plan offered by the LIC and find out whether it is suitable
to you.
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
…………………………………………………………………………………….
2. Examine how LIC Pension Fund differs from private sector pension fund like
Pioneer ITI Pension Fund. You may contact the agents of both companies ask
them to explain the features of the products.
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………. 27
Institutional and Managed
Portfolio
15.4 SUMMARY
Many investors find it difficult to manage their investments due to lack of knowledge
or expertise and lack of time for constant monitoring of the investment position.
Investment companies offer their services to such investors and manage their fund on
their behalf. Investment companies can be broadly grouped under two categories.
Those which offer portfolio services and those which offer other services along with
investment services. In this Unit, we have discussed Life Insurance Companies and
Pension Funds, who also invest the investors' money but their principal services are
providing insurance cover and retirement benefit respectively. To an individual
investor, these investments are critical than other investments because she or he has to
protect the family members in the event of death of the bread-winner of the family and
secondly, investors should also look into post-retirement needs. They can think about
other forms of investments only after meeting these two basic needs. In the next Unit,
we will discuss mutual funds in detail.

15.5 SELF-ASSESSMENT QUESTIONS/EXERCISES

1) Why is there a need for investment companies? What are the functions of an
investment company?

2) How can investment companies be classified?

3) Discuss some of the popular schemes of insurance companies and their suitability
to different types of investors.

4) Assuming you have taken an LIC policy some 10 years back, find out the tax-
adjusted return you will get using the LIC's bonus figures given the text.

5) Discuss the role of pension funds for Indian investors. Why it takes so many
years in developing pension funds whereas mutual funds have picked up well in
India?

15.6 FURTHER READINGS

Kohn, Meir. 1999, Financial Institutions and Markets (chapter 15), Tata McGraw Hill.
Francis, J.C., 1988, Management of Investments : McGraw Hill, N.Y

Reilly, F K and Brown, C.K. 2000 Investment Analysis and Portfolio Management,
The Dryden Press, Orlando.

28
 Mutual Funds

UNIT 16 MUTUAL FUNDS

Objectives

The objectives of this unit are to:

• highlight the purpose and the concept of Mutual Fund

• pinpoint the organisational structure and the different activities involved in
floating a Mutual Fund
• point out the basic investment objectives of Mutual Funds.
• explain the process of creating, managing and revising portfolios of securities
in terms of laid down objectives of Mutual Funds.
Structure
16.1 Introduction
16.2 Concept and Advantages of Investing in Mutual Funds
16.3 Organisation of Mutual Funds
16.4 Types of Mutual Funds
16.5 History of Mutual Funds
16.6 Mutual Fund Investment Process
16.6.1 Creation of a Portfolio
16.6.2 Regulatory Environment Relating to Creation of Portfolio of Various Securities
16.7 Portfolio Revision
16.8 Systems and Controls
16.9 Summary
16.10 Key Words
16.11 Self-Assessment Questions/Exercises
16.12 Further Readings

16.1 INTRODUCTION
In the previous Unit, we discussed one type of Investment Companies which along
with providing a facility of savings also help the investors to get certain special
services like life insurance and pension. In this Unit, we will discuss another popular
investment company namely mutual funds. A Mutual Fund is a trust that pools the
savings of a number of investors, who share a common financial goal. Mutual funds
make investments in the stock and debt markets on behalf of investors joining the
scheme and thus offers two special services namely expertise in investments and
diversification. A small investor with a surplus funds of say Rs. 10,000 per year may
not be in a position to get such expert advice or diversification without mutual funds.
Investors thus not only share a common financial goal but also share the cost
associated with expert advice and diversification. Some of the objectives that mutual
funds pursue on behalf of their investors are attractive yields, capital appreciation,
holding the safety and liquidity as prime parameters. The rest of the Unit will get you
introduced with the concepts of mutual funds, the advantages of investing in Mutual
Funds, the history of mutual funds, the organisation of mutual funds and the mutual
fund investment process.

29

Content Digitized by eGyanKosh, IGNOU

Institutional and
Managed Portfolios
16.2 CONCEPTS AND ADVANTAGES OF INVESTING IN
MUTUAL FUNDS
As stated earlier mutual funds pool the funds from small investors and invest in
shares and bonds of companies. The income earned through these investments and
the capital appreciation realized are shared by its unit holders in proportion to the
number of units owned by them. Thus a Mutual Fund is the most suitable investment
for the common man as it offers an opportunity to invest in a diversified,
professionally managed basket of securities at a relatively low cost.
The flow chart below describes broadly the working of a mutual fund:
Figure 1: Mutual Fund Operation Flow Chart

By investing in various Mutual Fund Schemes, small investors or middle income

investors seek the following advantages compared to other types of investments:
i) Professional Management: No impulsive decision making regarding purchase
or sale of share/securities, since the funds are managed by expert, professional
fund managers who have access to latest and detailed information regarding
the stock market and individual scrips
i) Diversification: Investment variety and spread in different industries
iii) Convenient Administration : Freedom from paper work
iv) Return Potential: Even the smallest dividend or capital gain gets reinvested,
thus enhancing the effective return.
v) Low Costs
vi) Liquidity: Liquidity through buy back arrangements of the mutual fund or
listing on some stock exchanges after a certain lock-in period
vii) Transparency
viii) Flexibility
ix) Choice of schemes
x) Tax benefits: Tax benefits on invested amounts/returns or dividends/capital
gains
xi) Well regulated
xii) Capital appreciation: Without having to watch the upward or downward
performance curves of different scripts.

16.3 ORGANISATION OF MUTUAL FUNDS

A Mutual fund can be constituted either as a corporate entity or as a trust. In India,
Unit Trust of India (UTI) was set up as a corporation under an Act of Parliament in
30 1964. SEBI regulation on Mutual Funds requires a mutual fund be constituted in the
form of a trust. The
Content Digitized by eGyanKosh, IGNOU
 Mutual Funds
instrument of trust shall be in the form of a deed, duly registered under the provisions
of Mutual Funds the Indian Registration Act, 1908 (16 of 1908) executed by the
sponsor in favour of the trustees named in such an instrument. While Mutual Funds
registered as trust floats schemes and collects money, the actual investment is made
by a different entity called Asset Management Company (AMC). AMC is typically
constituted as a company registered under Companies Act, 1956. The mutual fund set
up is slightly complex because of involvement of different entities and the following
diagram shows the relationship between the entities.
Figure 2: Organisation of a Mutual Fund

Mutual funds are to be sponsored by an individual or group of individuals or

companies. Sponsors also appoint Trustees who will manage the mutual funds.
Sponsors or Trustees also appoint AMC and enter into an agreement with them for the
management of funds. In practice, sponsors also promote an AMC for the mutual
funds. Transfer Agent maintains the records of unit holders and make changes when
investors buy or sell Units. Custodian keeps the 'securities purchased by the fund. We
will discuss each of the entities and the role they played in mutual funds industry.
Asset Management Companies
As per guidelines, AMC shall be authorized for business by SEBI on the basis of
certain criteria and the Memorandum and Articles of Association of the AMC would
have to be approved by SEBI. Accordingly, no company can register as an AMC
under the Companies Act 1956 without the Memorandum and Articles of Association
being approved by SEBI.
Transfer Agents
Their major responsibilities include:
i) Receiving and processing the application form of investors
ii) Issuing of Unit/Share Certificates on behalf of Mutual Fund
iii) Maintain detailed records of Unit holders transactions
iv) Purchasing, selling, transferring and redeeming the Unit/Share Certificates
v) Issuing of income/dividend Warrants, Cheques etc.
vi) Creating security interest on Units/Certificates for allowing loans against them
Advertiser
Major responsibilities of an advertiser include:
i) Helping mutual funds organizers to prepare a media plan for marketing the
fund
ii) Issuing/buying the space in the space in newspapers and other electronic media
for advertising the various features of a fund
iii) Arranging for hoardings at public places 31

Content Digitized by eGyanKosh, IGNOU

Institutional and Advisor/manager
Managed Portfolios
It is generally a corporate entity who does the following jobs:
i) Professional advice on the Fund's investments.
ii) Advice on Asset Management Services.
Trustees
Trustees provide the overall management services and charge management fee
Custodian
A custodian, which is again a corporate body does the following functions: Holds
securities
ii) Receives and delivers securities whenever investors sells and buys Units.
iii) Collects income/interest/dividends on the securities
iv) Holds and processes cash
Besides the above, other players who are involved in the Mutual Fund activities are as
under:
i) Fund Administrator;
ii) Fund Accounting Services;
iii) Legal Advisors;
iv) Fund Officers;
v) Underwriters/Distributors;
vi) Legal Advisors
The basis of payment to various players for their services in organizing a mutual fund
is given in Table 16.1. The SEBI regulation on mutual funds also to an extent
governs the service charges and management fee. Considering the importance of
mutual funds and large amount of public money being vested with such funds, the
SEBI has brought out a detailed guideline. The Securities and Exchange Board of
India (Mutual Funds) Regulations, 1996 are given in Appendix. Since the mutual
funds are typically promoted by an existing financial service company or leading
industrial group, the SEBI regulation put various restrictions while investing the
mutual funds money. It also required a kind of arm-length relationship between the
sponsors or their companies and the management of the mutual funds.

Table 16.1:: Basis for Service Charges to Intermediaries Associated with Mutual Fund

SERVICES COST BASIS

i) Registrar & Registrar & Number of Unit-holders/
Transfer Agents Transfer Agents fee Certificate holder accounts
Service fee; Number of
transactions; Standard outputs
and standing charges for
maintaining records
ii) Advertiser Advertiser service Percentage of the total budget
fees of advertisement
iii) Custodian Custodian fee Number of transactions in
terms
of amount
iv) Trustee Management fee Average net assets.
v) Advisor Advisory fee Average net assets.
vi) Underwriters Underwriters fee Total offering
vii) Legal Advisor Legal fees Actuals
viii) Auditors Audit fees Actuals
32 ix) Fund Officers Fund Officer's fees Actuals

Content Digitized by eGyanKosh, IGNOU

 Mutual Funds
16.4 TYPES OF MUTUAL FUNDS
Mutual funds could be classified in many ways based on structure, objectives of
investment, pattern 'of investments and returns, etc.
Based on structure, mutual funds could be classified as:
1) Open - Ended Schemes
2) Close-Ended Schemes
3) Interval Schemes
Based on the investment objective, the classification could be:
a) Growth Funds
b) Income Funds
c) Balanced Schemes
d) Money Market Schemes
e) Other Special Schemes
Open-Ended Funds
Under open-ended scheme, the mutual fund will announce daily purchase and sale,
price of the Units of the scheme. If you want to buy the Units today, you can buy the
same at the sale price. May be, after six months, if you decide to sell the units, you
can sell at the purchase price announced by the mutual fund on that date. Thus, the
mutual fund offers instant liquidity for your investment under open-ended scheme by
taking responsibility of purchasing back the Units. There is no limit to the size of the
funds. Investors can invest as and when they like. The purchase price is determined
on the basis of Net Asset Value (NAV). NAV is the market value of the fund's assets
divided by the number of outstanding Shares/Units of the fund.
An open-ended funds is one that is available for subscription all through the year.
These do not have a fixed maturity. Investors can conveniently buy and sell Units at
Net Asset Value ("NAV") related prices. The key feature of open-ended schemes is
liquidity
Close-Ended Funds
Under close-ended schemes, there is no repurchase facility. However, the Units are
listed in the stock market and investors can sell and buy Units like any other
securities in the market. The scheme has a `specific life (say 10 years or 5 years) and at
the end of the period, the mutual fund sells securities bought under the scheme and
disburses the proceeds to Unit holders. When the stock market was doing well, many
of the schemes have attracted investors and there was also active secondary market.
But they lost the fancy of the investors after couple of stock market failures. Today,
the close-ended scheme is virtually dead and only a very few schemes of this nature
floated during the last few months. These funds are fixed in size as regards the crops
of the fund and the number of shares. In close-ended funds, no- fresh Units are
created after the original offer of the scheme expires. The Shares/Units of these funds
are not redeemable at their NAV during their life as are in the case of open-ended
funds. The Shares of such funds are traded in the secondary .market on stock
exchanges at market prices that may be above or below their NAV.
Interval Funds
Interval funds combine the features of open-ended and close-ended schemes. They
are open for sale or redemption during pre-determined intervals at NAV related
prices.
The classification of Mutual Funds on the basis of investment objectives are:
Growth Funds
The aim of growth funds is to provide capital appreciation over the medium to long-
term. Such schemes normally invest a majority of their corpus in equities. It has been
33
proven that

Content Digitized by eGyanKosh, IGNOU

Institutional and returns from stocks, have out performed most other kind of investments held over the
Managed Portfolios long term. Growth schemes are ideal for investors having a long-term outlook
seeking growth over a period of time.
Income Funds
The aim of income funds is to provide regular and steady income to investors. Such
schemes generally invest in fixed income securities such as bonds, corporate
debentures and Government securities. Income Funds are ideal for capital stability and
regular income.
Balanced Funds
The aim of balanced funds is to provide both growth and regular income. Such
schemes periodically distribute a part of their earning and invest both in equities and
fixed income securities in the proportion indicated in their offer documents. In a
rising stock market, the NAV of these schemes may not normally keep pace, or fall
equally when the market falls. These are ideal for investors looking for a combination
of income and moderate growth.
Money Market Funds
The aim of money market funds is to provide easy liquidity, preservation of capital
and moderate income. These schemes generally invest in safer short-term instruments
such as treasury bills, certificates of deposit, commercial paper and inter-bank call
money. Returns on these schemes may fluctuate depending upon the interest rates
prevailing in the market. These are ideal for Corporate and individual investors as a
means to park their surplus funds for short periods.
Load Funds
A Load Fund is one that charges a commission for entry or exit. That is, each time you
buy or sell Units in the fund, a commission will be payable. Typically entry and exit
loads range from 1% to 2%. It could be worth paying the load, if the fund has a good
performance history.
No-Load Funds
A No-Load Fund is one that does not charge a commission for entry or exit. That is,
no commission is payable on purchase or sale of Units in the fund. The advantage of
a no load fund is that the entire corpus is put to work.
Tax Saving Schemes
These schemes offer tax rebates to the investors under specific provisions of the
Indian Income Tax laws as the Government offers tax incentives for investment in
specified avenues. Investments made in Equity Linked Savings Schemes (ELSS) and
Pension Schemes are allowed as deduction u/s 88 of the Income Tax Act, 1961.
Special Schemes
Industry Specific Schemes
Industry Specific Schemes invest only in the industries specified in the offer document.
The investment of these funds is limited to specific industries like InfoTech, FMCG,
Pharmaceuticals, etc.
Index Schemes
Index Funds attempt to replicate the performance of a particular index such as the BSE
Sensex or the NSE 50.
Sectored Schemes
Sectoral Funds are those, which invest exclusively in a specified industry (like Pharma
34 fund or IT fund) or a group of industries or various segments such as `A' Group
shares or initial public offerings.

Content Digitized by eGyanKosh, IGNOU

 Mutual Funds
Activity 1
The mutual fund industry in India has seen tremendous growth during the last few
years. The number of mutual funds and schemes offered by them are very large. Visit a
website of a mutual fund (say Alliance Capital or DSP Merrill Lynch) and go through
the schemes and their objectives. Based on the assessment, list down the schemes and
the broad head under which you would like to classify the schemes in the following
table format.
No. Scheme Name Classification Classification Based on
Based on Structure Investment Objective
1
2
.
.
.
.
N

16.5 HISTORY OF MUTUAL FUNDS

Mutual Funds as a concept first originated in the Britain in the 19th century but
developed in the U.S. in the late 19th and early 20th century at the principal money
centres of North East. These funds were primarily close-ended and used to finance
growth in U.S.A. after the Civil War. However, the crash of stock markets in 1929
led to the demise of these close-ended funds. In 1940, U.S. had about 68 funds;
currently there are several thousands of schemes. More significantly, in the year 1965
there were only 2 to 3% of U.S. households who owned fund shares. Nearly one-
fourth of all U.S. households invest today in Mutual Funds. In 1965, U.S. Mutual
Fund annual sales were $ 4.4 billion; in today's terms, its monthly sales are twice that
level. U.S. Mutual Funds now deal with over five crore shareholder accounts. The
secret behind the U.S. success story is that their fund managers have developed
mutual funds for all economic conditions and for every investment need. However,
not only the U.S. but some other countries of the world also saw the unprecedented
growth in this industry. Italy's Mutual Fund Industry witnessed a growth of 2000%,
Japan 600%, U.K. 350% and Germany 330%. Countries like Canada, Australia,
Mexico and many South American countries too recorded enormous growth during
the decade. The mutual fund industry in India was under monopoly for a long time
and hence the growth was not very much during the initial period. However, after
they are opened up for private sector, the industry has witnessed tremendous growth.
The Indian Mutual Funds Industry has recorded a tremendous growth in size during
the last 10 years with cumulative resources mobilized rising from Rs. 4,563 Cr. in
1986 to over Rs. 102, 000 Cr. of late. The Indian mutual fund industry began with the
formation of Unit Trust o f India (UTI) in 1963 with the introduction of its first
biggest scheme Unit Scheme '64. The VTI then introduced several schemes aimed at
different sections of people. The public sector monolith operated under monopoly
conditions and in an over regulated economy till the mid-eighties. In 1987, the
commercial banks and the insurance companies were also permitted to launch
schemes. Their schemes were received with enthusiasm and more than Rs.6000 Cr.
were raised in 1988-89. The nationalized banks sold their schemes like any other
traditional banking deposit. Assured returns were offered in some schemes and this
created a perception that mutual funds are as safe as nationalized bank deposits. The
boom continued into the nineties with the liberalization evoking positive response
from the investors and acting as an additional catalyst for growth. In 1991-92 mutual
funds mobilized a record Rs. 14000 Cr.
The concept of Mutual Fund is gaining practical relevance in India, and a large
number of funds have been floated in the recent past. The impetus to this growth has
basically come from the following factors:
(i) banks were earlier unable to tap the capital market for funds, or to invest their
35
deposits in the market;

Content Digitized by eGyanKosh, IGNOU

Institutional and (ii) individual investors, lacking risk bearing capacity and unsure of the capital
Managed Portfolios market behaviour, were not keen on investing any substantial amount directly
in the market instruments;
(iii) banks working under Reserve Bank of India (RBI) guidelines could not
provide growth with better yields to the investing public and were losing out
in the competition with innovative new market instruments which had better
yields compared with savings and fixed deposit interest rates. Table 16.2
presents a profile and status of Mutual Funds in India as on 28th February,
2002..
Table 16.2:Assets under Management of Indian Mutual Funds as on 28th February 2002
(Rs. in crores)
No. of [ Open- Close- Assured Total
Schemes ended ended Return
Income 136 33819 4565 17966 56350
Growth 108 86494 4618 13312
Balanced 34 17126 231 - 17357
Liquid/Money Market 29 13445 - - 13445
Gilt 28 4208 - - 4208
EMS 63 412 1730 - 2142
Total 398 77704 11144 17966 106814
Note: Assets under UTI management is Rs. 51.944 cr. as on February 2002.
16.6 MUTUAL FUND INVESTMENT PROCESS
16.6.1 Creation of a Portfolio
The portfolio of a mutual fund depends on the objectives of each scheme/fund floated
by a mutual fund. For example, the objective of an income-oriented scheme is to
provide regular monthly income to its shareholders. The portfolio of such a fund
should consist of fixed income bearing securities so that the fund can achieve its
objective. It has been learnt from Indian experience that the portfolio of such a fund
consists of mainly the following securities:
Non Convertible Debentures (NCD's) - 75 to 90%
Call Money - 1 0 to 25%
A portfolio of income cum growth oriented fund consists of mainly NCD's upto 70% of
the portfolio, approximately 25% of equities and 5% of money market instruments. On
the other hand, a pure growth or equity fund creates a portfolio of share/stock of growth
or blue-chip companies.
The fund manager of a mutual fund is the person responsible for buying these
securities in such a way that the fund is able to achieve its objectives. A fund
manager tries to create a well diversified portfolio of securities so that unsystematic
risk is reduced significantly and returns expected on individual securities and on
portfolio is directly related to `mark risk' or systematic risk. A fund manager has the
following investment options in terms of buying securities from the Indian market :

36

Content Digitized by eGyanKosh, IGNOU

 Mutual Funds
Depending on the objective of the scheme and target return, fund managers form a
portfolio based on the expected return of the above securities. While buying these
securities, the fund manager takes into consideration the following norms for each
kind of security.
Non-convertible Debentures
i) Asset Cover or Security Cover : A company must maintain a minimum asset
cover. This cover is calculated on the basis of secured borrowings and
debentures charged to fixed assets, whereby fixed assets should be in general
more than one time of the total such existing borrowings and debentures
secured by equitable mortgage on fixed assets. The movable fixed assets are
generally excluded from the calculations.
ii) Interest Cover : PBIDT (profit before interest, depreciation and taxes) should
be around two times the existing interest liability plus the interest liability on
the proposed debentures so as to protect the payment of interest on the
debentures. This cover is to be calculated on the basis of the average of the
proceeding three years profit figures.
iii) Company must have paid dividend for the last three or minimum two
preceding years.
iv) Networth of the company should be around Rs. One Crore.
Small variations in the above norms are accepted provided the company is otherwise
very sound and the rate of return is higher than normal.
Equity Shares (Common Norms for Primary as well as Secondary Market):
Management: First and foremost emphasis is placed on quality of management
because unless the management is efficient and professional even a good project can
fail.
Industry: The industry in general should be growth oriented, expanding and
modernising, etc. Mutual Funds avoid seasonal and declining industries.
Government Policy: A fund manager constantly studies the economic and fiscal
policies of the government and analyses their impact on the companies.
Analytical Studies: A fund manager studies the full details of the past performance
of companies including turnover, profitability, earnings, track record and financial
strength. He also compares it with the industry. in which the company falls. He works
out projections based on news reports and discussions to assess the future prospects.
He studies the expansion, diversification and other plans of the companies to assess
their future outlook ' and potential.
Market Study: Fund managers also assess the standing of the company, its general
reputation, its market share and the competition it is likely to face. Besides, factors like
the demand and supply of the product and import and export policy which have a
bearing on the growth prospects of the company are also looked into.
Studies on Industries: A mutual fund undertakes the studies of the industries to find
out the outlook as well as the problems and faced by the industries and in turn the
units in the said industries.
Besides studying the above fundamental factors, for both primary and secondary
market operations, a fund manager uses the following additional tools to decide the
timing for entering into secondary market operations. However, this is not a rigid
formula.
a) ‘PE’ Ratio (Price Earning Ratio)
i) Average `PE' ratio for the industry.
ii) Average `PE' ratio of the company based on the last three years.
iii) Earnings per share of last year x Average `PE' ratio of the company.
b) High and Low Price
A fund manager is also aware that the market fluctuates as a normal pattern 3 - 4
times in a year and these movements are watched for proper opportunities. For
this purpose, a chart showing the trends in price movements for the previous 37
year is prepared.
Content Digitized by eGyanKosh, IGNOU
Institutional and c) Book Value
Managed Portfolios
A mutual fund calculates the book value (less revaluation reserves) and
compares it with the market price. If the market price is twice or thrice the book
value, the share is over priced and if the market price is less or equal, the share
is called under priced.
16.6.2 Regulatory Environment Relating to Creation of Portfolio of various
Securities*
We have discussed that a Fund Manager creates a diversified portfolio of securities
whereby unsystematic risk is almost eliminated and systematic risk is analysed to
provide optimum return: However, to protect general investors' interest the Securities
and Exchange Board of India has placed certain restrictions on the investment by
mutual funds in India as follows:
1) No individual scheme of the Mutual Fund should invest more than 5 per cent of
its corpus in any one company's shares.
2) No Mutual Fund under all its schemes should own more than 5 per cent of any
company's paid up capital carrying voting rights.
3) No Mutual Fund under all its schemes taken together should invest more than
10 per cent of its funds in the shares or debentures or other securities of a
single company.
4) No Mutual Fund under its schemes taken together should invest more than 15
per cent of its funds in shares and debentures of any specific industry (such as
cotton textiles, tea, tyres etc.) except where a scheme has been floated for
investments in one or more specified industries.
5) Privately placed debentures, securitised debt and other unquoted debt
instruments holdings shall not exceed 10 per cent in case of growth funds and
40 per cent in case of income funds.

16.7 PORTFOLIO REVISION

There are two broad aspects of portfolio management, namely, effective investment
planning, and constant review and revision of Investment. While we have already
discussed the first aspect under section 16.6, let us discuss the second aspect
hereunder.
Constant review and revision of investment requires:
i) Continuous monitoring of the quality of management of the companies in
which investment has already been made.
ii) Continuous financial analysis and trend analysis of the companies' balance
sheets/ profit & loss accounts to choose sound companies and off-load
investment made in companies where the performance is lacking.
iii) Continuous analysis of the securities market trends.
Whereas a Funds Manager takes into consideration all fundamental and technical
analyses while making initial purchases of securities, continuous monitoring jobs are
done generally by a research cell of the mutual funds in India. The research cell
undertakes on a continuous basis all kinds of analysis of securities existing in the
portfolio and does further analysis of newer securities in all classes of securities and
compares them with the existing securities and suggests changes in the portfolio for
maintaining good returns or higher returns with the same risk as perceived in the
existing portfolio. Thus measurement of risk involved in the expected rate of return is
very essential before diversification of any portfolio can be undertaken by a mutual
fund. A research executive measures the risk by taking variance and standard
deviation of return. A large variation around the average would indicate great
uncertainty regarding the expected return.
38 *For the current investment norms, refer SEBI regulations and circulars.

Content Digitized by eGyanKosh, IGNOU

 Mutual Funds
16.8 SYSTEMS AND CONTROL
For managing a portfolio, it is not only the creation, re-creation and regrouping of
various securities which is important for achieving the desired rate of return, but
various kinds of systems and controls are needed. A Mutual Fund generally provides
the desired controls through its accounting and custodian system. We shall discuss
each of them and how these help to manage a portfolio.
Accounting System
As accounting. system must clearly disclose:
.
i) The policy in respect of recognition of revenue and income from investment.
ii) The policies relating to valuation of investments.
iii) The aggregate carrying value and market value of non performing assets under
each type of investment.
iv) Provision to be made for depreciation/loss in the value of non performing
investment
v) Per unit Net Asset Value (NAV) at various intervals and at the end of the
accounting year.
All the above accounting policies if pursued consistently help to maintain a clear
picture about all investments in a portfolio and thus provide the true picture of the
portfolio.
Custodian System
A custodian system should provide/ensure:
i) Timely receipt and delivery of cash and securities;
ii) Delivery of securities only upon receipt of payment and payment only upon
receipt of securities;
iii) Timely resolution of discrepancies and failures;
iv) Segregation of assets by the custodian and regular inventory verification;
v) Regular reconciliation of assets to accounting records;
vi) Securities are properly registered;
vii) Proper nomination and record of declared dividend and other corporate actions.
All the above accounting policies and custodian system if pursued by Mutual Funds
help them to maintain a clear picture of all investment and their performance in a
portfolio.

16.9 SUMMARY
The history of Mutual Funds in India is not very old. It started with the establishment
of the Unit Trust of India in the year 1964. However, the real take off started when
public sector banks entered into this area in the year 1987. Experience of the other
countries shows that with the development of the capital market more and more
household savings are expected to be channeled into the secondary market through
institutions like mutual funds. This is quite visible from the growing popularity of
mutual funds in India. Mutual Funds have proved to be an attractive investment for
many investors, the world over, since they give them a mixture of liquidity, return
and safety in accordance with their performance. Further, the investor gets these
benefits without having to directly invest in a large number of scrips. Only by
investing in one fund she/he gets the benefits of a diversified portfolio which is
handled by specialists. With the kind of innovative schemes available-in the market
today, mutual funds serve the needs of various investors. An analysis of performance
of many private sector funds also shows that they have done reasonably well
compared to market performance.
39

Content Digitized by eGyanKosh, IGNOU

Institutional and
Managed Portfolios
16.10 KEY WORDS
Asked or Offering Price : The price at which a mutual fund's shares can be
purchased. The asked or offering price means the current net asset value (NAV) per
share plus sales charge, if any. For a no-load fund, the asked price is the same as the
NAV.
Asset Allocation Fund : A fund that spreads its portfolio among a wide variety of
investments, including domestic and foreign stocks and bonds, government
securities, gold bullion and real estate stocks. This gives small investors fir more
diversification than they could get allocating money on their own. Some of these
funds keep the proportions allocated between different sectors relatively constant,
while others alter the mix as market conditions change.
Balanced Fund : A mutual fund that maintains a balanced portfolio, generally 60%
bonds or preferred stocks and 40% common stocks.
Bid or Sell Price : The price at which a mutual fund's shares are redeemed (bought
back) by the fund. The bid or redemption price means the current net asset value per
share, less any redemption fee or back-end load.
Bond Fund : A mutual fund whose portfolio consists primarily of corporate or
Government bonds. These funds generally emphasize income rather than growth.
Bond Rating : System of evaluating the probability of whether a bond issuer will
default. Various firms analyze the financial stability of both corporate and government
bond issuers. Ratings range from AAA or Aaa (extremely unlikely to default) to D
(currently in default). Bonds rated BBB or below are not considered to be of
investment grade. Mutual funds generally restrict their bond purchases to issues of
certain quality ratings, which are specified in their prospectuses.
Capital Appreciation Fund : A mutual fund that seeks maximum capital appreciation
through the use of investment techniques involving greater than ordinary risk, such as
borrowing money in order to provide leverage, short-selling and high portfolio
turnover.
Capital Growth : A rise in market value of a mutual fund's securities, reflected in its
net asset value per share. This is a specific long-term objective of many mutual funds.
Certificate of Deposit : Interest-bearing, short-term debt instrument issued by banks
and thrifts.
Common Stock Fund : An open-end investment company whose holdings consist
mainly of common stocks and usually emphasize growth.
Confirm Date : The date the fund processed your transaction, typically the same day
or the day after your trade date.
Custodian : The bank or trust company that maintains a mutual fund's assets,
including its portfolio of securities or some record of them. Provides safekeeping of
securities but has no role in portfolio management.
Daily Dividend Fund : This term applies to funds that declare their income dividends
on a daily basis and reinvest or distribute monthly.
Deferred Compensation Plan : A tax-sheltered investment plan to which employees
of state and local governments can defer a percentage of their salary.
Rupee-Cost Averaging : The technique of investing a fixed sum at regular intervals
regardless of stock market movements. This reduces average share costs to the
investor, who acquires more shares in periods of lower securities prices and fewer
shares in periods of high prices. In this way, investing risk is spread over time.
Exchange Privilege (or switching privilege) : The right to transfer investments from
40 one fund into another, generally within the same fund group, at nominal cost.

Content Digitized by eGyanKosh, IGNOU

 Mutual Funds
Ex-Dividend Date : The date on which a fund's Net Asset Value (NAV) will fall by
an amount equal to the dividend and/or capital gains distribution (although market
movements may alter the fund's closing NAV somewhat). Most publications which
list closing NAVs place an "X" after a fund' name on its ex-dividend date.
Expense Ratio : The ratio of total expenses to net assets of the fund. Expenses
include management fees, the cost of shareholder mailings and other administrative
expenses. The ratio is listed in a fund's prospectus. Expense ratios may be a function
of a fund's size rather than of its success in controlling expenses.
Fiscal Year : An accounting period consisting of 12 consecutive months. Global
Fund A fund that invests in both Indian. and foreign securities.
Growth Fund : A mutual fund whose primary investment objective is long-term
growth of capital. It invests principally in common stocks with significant growth
potential.
Income Dividend : Payment of interest and dividends earned on the fund's portfolio
securities after operating expenses are deducted.
Income Fund : A mutual fund that primarily seeks current income rather than
growth of capital. It will tend to invest in stocks and bonds that normally pay high
dividends and interest.
Index Fund : A mutual fund that seeks to mirror general stock-market performance by
matching its portfolio to a broad-based index, most often the S&P CNX Nifty index.
Junk Bond : A speculative bond rated BB or below. "junk bonds" are generally
issued by corporations of questionable financial strength or without proven track
records. They tend to be more volatile and higher yielding than bonds with superior
quality ratings. "Junk bond funds" emphasize diversified investments in these low-
rated, high-yielding debt issues.
Load Fund : A mutual fund that levies a sales charge up to 6%, which is included in
the offering price of its shares, and is sold by a broker or salesman. A front-end load
is the fee charged when buying into a fund; a back-end load is the fee charged when
getting out of a fund.
Management Fee : The amount a mutual fund pays to its investment adviser for
services rendered, including management of the fund's portfolio. in general, this fee
ranges from .5% to I% of the fund's asset value.
Money Market Fund : A mutual fund that aims to pay money market interest rates.
This is accomplished by investing in safe, highly liquid securities, including bank
certificates of deposit, commercial paper, government securities and repurchase
agreements. Money Market funds make these high interest securities available to the
average investor seeking immediate income and high investment safety.
Net Asset Value Per Share : The current market worth of a mutual fund share.
Calculated daily by taking the funds total assets securities, cash and any accrued -
earnings deducting liabilities, and dividing the remainder by the number of shares
outstanding.
No-Load Fund : A commission-free mutual fund that sells its shares at net asset
value, either directly to the public or through an affiliated distributor, without the
addition of a sales charge.
Payable Date : The date on which distributions are paid to shareholders who do not
want to reinvest them. This date can be anywhere from one week to one month after
the Record Date.
Payroll Deduction Plan : An arrangement between an employer and a mutual fund,
authorized by the employee, through which a specified sum is deducted from an
employee's salary to buy shares in the fund.
Redemption Fee : A fee charged by a limited number of funds for redeeming, or 41
buying back, fund shares.
Content Digitized by eGyanKosh, IGNOU
Institutional and Redemption Price : The price at which a mutual fund's shares are redeemed (bought
Managed Portfolios back) by the less expensive fund. The redemption price is usually equal to the current
net asset value per share.
Sector Fund : A fund that operates several specialized industry sector portfolios under
one umbrella. Transfers between the various portfolios can usually be executed by
telephone at little or no cost.
Short Selling : The sale of a security which is not owned by the seller. The "short
seller" borrows stock for delivery to the buyer, and must eventually purchase the
security for return to the lender.
Specialty Fund : A mutual fund specializing in the securities of a particular industry
or group of industries or special types of securities.
Systematic Withdrawal Plans : Many mutual funds offer withdrawal programs
whereby shareholders receive payments from their investments. These payments are
usually drawn from the fund's dividend income and capital gain distributions, if any,
and from principal only when necessary.
Variable Annuity : A type of insurance contract that guarantees future payments to the
holder, or annuitant, usually at retirement. The annuity's value varies with that of the
underlying portfolio securities, which may include mutual fund shares. All monies held
in the annuity accumulate tax-deferred.
Voluntary Plan : A flexible plan for capital accumulation, involving no specified time
frame or total sum to be invested.
Yield : Income or return received from an investment, usually expressed as a
percentage of market price, over a designated period. For a mutual fund, yield is
interest or dividend before any gain or loss in the price per share.
Zero Coupon Bond : Bond sold at a fraction of its face value. It appreciates gradually,
but no periodic interest payments are made. Earnings accumulate until maturity,
when the bond is redeemable at full face value. Nonetheless, interest is taxable as it
accrues.

16.11 SELF-ASSESSMENT QUESTIONS/EXERCISES

1) Discuss briefly the concept of mutual fund and explain how far mutual funds
have been successful in India.

2) Describe various types of schemes issued by various Mutual Funds in India.

3) Discuss the role of the Registrar, Transfer Agents, Custodian and the Fund
Manager in a Mutual Fund.

4) Why Indian Mutual Funds in general guarantee a minimum return to investors

whereas this is not the practice in US and other countries?

5) Discuss major variables that a Fund Manager considers before buying fixed
income securities, say NCD's.

6) When the co-relation coefficient of two securities is (-1), what does it tell to the
Fund Manager?

7) Consider Stock B, which has possible returns + 50%, 0% and - 50%. The three
possible returns are equally probable. What is the expected return and standard
deviation for Stock B.

8) Systems and Controls are as important as creation of portfolio of securities in

managing a; portfolio by a Mutual Fund. Discuss this statement and bring out
42 the role played by accounting and custodian system in portfolio management
by a mutual fund.

Content Digitized by eGyanKosh, IGNOU

 Mutual Funds
16.12 FURTHER REDINGS
Anderson, Carle E. and James B. Ross. 1988 Modern Mutual Fund families and
variable life: Tools for investment growth and tax benefits. Dow Jones - Irwin
Lucile Tomlinson (ed) 1971. Flow to Start, Operate and Manage Mutual Funds,
Presidents Pub. House, New York.
Michael D. Hirsch 1987, Multifund Investing: How to Build a High Performance
Portfolio of Mutual Funds. Dow Jones - Irwin.
Richard C. Dorf, 1988, The Mutual Fund Portfolio Planner: A Guide for Selecting
the Best Funds for you in today's Market. Probus Pub.

43

Content Digitized by eGyanKosh, IGNOU

Institutional and APPENDIX 16.1
Managed Portfolios

SECURITIES AND EXCHANGE BOARD OF INDIA

(MUTUAL FUNDS) REGULATIONS, 19
S.O.No.856 (E) In exercise of the powers conferred by section 30 read with clause (c)
of sub-section (2) of section 11 of the Securities and Exchange Board of India Act,
1992, (15 of 1992) the Securities and Exchange Board of India hereby makes the
following regulations.
CHAPTER I : PRELIMINARY
Short title, application and commencement
1. (1) These regulations may be called the Securities and Exchange Board of
India (Mutual Funds) Regulations, 1996.
(2) They shall come into force on the date of their publication in the Official
Gazette.
Definitions
2. In these regulations, unless the context otherwise requires:
(a) "Act" means the Securities and Exchange Board of India Act, 1992 (15
of 1992);
(b) "advertisement" includes every form of advertising, whether in a
publication, by display of notices, signs, labels or by means of circulars,
catalogues or other documents, by an exhibition of pictures or
photographic films, by way of sound broadcasting or television, or in any
other manner;
(c) "associate" includes a person:
(i) who directly or indirectly, by himself, or in combination with
relatives, exercises control over the asset management company or
the trustee as the case may be, or
(ii) in respect of whom the asset management company or the trustee,
directly or indirectly, by itself, or in combination with other persons
exercises a control, or
(iii) whose director, officer or employee is a director, officer or
employee of the asset management company;
(d) "asset management company" means a company formed and registered
under the Companies Act, 1956 (1 of 1956) and approved as such by the
Board under sub-regulation (2) of regulation 21;
(e) "broker" means a stock broker as defined in Securities and Exchange
Board of India (Stock Broker) Rules, 1992;
(f) "close-ended scheme" means any scheme of a mutual fund in which the
period of maturity of the scheme is specified;
(g) "control" means:
(i) in case of a company any person or combination of persons who
directly or indirectly own, control or hold shares carrying not less
than 10% of the voting rights of such company; or
(ii) as between two companies, if the same person or combination of
persons directly or indirectly, own, control or hold shares carrying
not less than 10% of the voting rights of each of the two companies;
or
(iii) majority of the directors of any company who are in a position to
exercise control over the asset management company.
(h) "custodian" means a person who has been granted a certificate of
registration to carry on the business of custodian of securities under the
Securities and Exchange Board of India (Custodian of Securities)
Regulations, 1996:
(i) "depository" means a body corporate as defined in the Depositories Act,
1996 (22 of 1996);
44
Source : SEBI's Website
Content Digitized by eGyanKosh, IGNOU
 Mutual Funds
(j) "economic offence" means an offence to which the Economic Offences
(Limitation of Prosecution) Act, 1974 (12 of 1974) applies for the time-
being;
(k) "enquiry officer" means any person appointed as such by the Board
under Chapter IX, (1) "form" means any of the forms specified as such in
the First Schedule;
(m) "fraud", for the purpose of these regulations has the same meaning as is
assigned to it in section 17 of the Indian Contract Act, 1872 (9 of 1872);
''[(mm) "group" means a group as defined in clause (et) of section 2 of
the Monopolies and Restrictive Trade Practices Act, 1969 (54 of 1969)];
(n) "inspecting officer" means any person appointed as such by the Board
under Chapter VIII;
(o) "money market instruments" includes commercial papers, commercial
bills, treasury bills, Government securities having an unexpired maturity
upto one year, call or notice money, certificate of deposit, usance bills,
and any other like instruments as specified by the Reserve Bank of India
from time to time;
(p) "money market mutual fund" means a scheme of a mutual fund which
has been set up with the objective of investing exclusively in money
market instruments;
(q) "mutual fund" means a fund established in the form of a trust to raise
monies through the sale of units to the public or a section of the public
under one or more schemes for investing in securities, including money
market instruments;
(r) "offer document" means any document by which a mutual fund invites
public for subscription of units of a scheme:
(s) "open-ended scheme" means a scheme of a mutual fund which offers
units for sale without specifying any duration for redemption;
(t) "relative" means a person as defined in section 6 of the Companies Act,
1956 (1 of 1956);
(u) "scheme" means a scheme of a mutual fund launched under Chapter V;
(v) "schedule" means any of the schedules annexed to these regulations;
(w) "securities laws" means the Securities and Exchange Board of India Act,
1992 (15 of 1992), the Securities Contracts (Regulation) Act, 1956 (42 of
1956) and the Depositories Act, 1996 (22 of 1996) including their
amendments and such other laws as may be enacted from time to time;
(x) "sponsor" means any person who, acting alone or in combination with
another body corporate, establishes a mutual fund;
2*
[(y) "trustee" means the Board of Trustees or the Trustee Company who
holds the property of the Mutual Fund in trust for the benefit of the unit-
holders.]
(z) "unit" means the interest of the unit-holders in a scheme, which consists
of each unit representing one undivided share in the assets of a scheme;
(z) (i) "unit-holder" means a person holding unit in a scheme of a mutual
fund.

1. Clause "mm" inserted by the SEBI (Mutual Fund) (Amendment) Regulations, 1998,
published in the Official Gazette of India dated 12.01.1998.
2. Substituted for the following by the SEBI (Mutual Fund) (Amendment) Regulations, 1999
published in the Official Gazette of India dated 08.12.1999.
"trustee" means a person who holds the property of the mutual fund in trust for the
benefit of the unit-holders and includes a trustee company and the directors of 45
the trustee company"

Content Digitized by eGyanKosh, IGNOU

Institutional and
Managed Portfolios
CHAPTER II : REGISTRATION OF MUTUAL FUND
Application for registration
3. An application for registration of a mutual fund shall be made to the Board in
Form-A by the sponsor.
Application fee to accompany the application
4. Every application for registration under regulation 3 shall be accompanied by
non-refundable application fee as specified in the Second Schedule.
Application to conform to the requirements
5. An application, which is not complete in all respects shall be liable to be
rejected.
Provided that, before rejecting any such application, the applicant shall be given
an opportunity to complete such formalities within such time as may be
specified by the Board.
Furnishing information
6. The Board may require the sponsor to furnish such further information or
clarification as may be required by it.
Eligibility criteria
7. For the purpose of grant of a certificate of registration, the applicant has to fulfil
the following, namely:
(a) the sponsor should have a sound track record and general reputation of
fairness and integrity in all his business transactions;'
Explanation: For the purposes of this clause "sound track record" shall
mean the sponsor should:
(i) be carrying on business in financial services for a period of not less
than five years; and
(ii) the networth is positive in all the immediately preceding five years;
and
(iii) the networth in the immediately preceding year is more than the
capital contribution of the sponsor in the asset management
company; and
(iv) the sponsor has profits after providing for depreciation, interest and
tax in three out of the immediately preceding five years, including
the fifth year.
3*
[(aa) the applicant is a fit and proper person]
(b) in the case of an existing mutual fund, such fund is in the form of a trust
and the trust deed has been approved by the Board;
(c) the sponsor has contributed or contributes atleast 40% to the net worth of
the asset management company;
Provided that any person who holds 40% or more of the net worth of an
asset management company shall be deemed to be a sponsor and will be
required to fulfil the eligibility criteria specified in these regulations;
(d) the sponsor or any of its directors or the principal officer to be employed
by the mutual fund should not have been guilty of fraud or has not been
convicted of an offense involving moral turpitude or has not been found
guilty of any economic offence.
(e) appointment of trustees to act as trustees for the mutual fund in
accordance with the provisions of the regulations;
(f) appointment of asset management company to manage the mutual fund
and operate the scheme of such funds in accordance with the provisions
of these regulations;
(g) appointment of a custodian in order to keep custody of the securities and
carry out the custodian activities as may be authorised by the trustees.

46 3. Clause "aa" inserted by the SEBI (Mutual Fund) (Amendment) Regulations, 1998,
published in the Official Gazette of India dated 12.01.1998.

Content Digitized by eGyanKosh, IGNOU

 Mutual Funds
Consideration of application
8. The Board, may on receipt of all information decide the application.
Grant of Certificate of Registration
9. The Board may register the mutual fund and grant a certificate in Form-B on
the applicant paying the registration fee as specified in Second Schedule.
Terms and conditions of registration
10. The registration granted to a mutual fund under regulation 9, shall be subject to
the following terms and conditions:
(a) the trustees, the sponsor, the asset management company and the
custodian shall comply with the provisions of these regulations;
(b) the mutual fund shall forthwith inform the Board, if any information or
particulars previously submitted to the Board was misleading or false in
any material respect;
(c) the mutual-fund shall forthwith inform the Board, of any material change
in the information or particulars previously furnished, which have a bearing
on the registration granted by it;
(d) payment of fees as specified in the regulations and the Second Schedule.
Rejection of application
11. Where the sponsor does not satisfy the eligibility criteria mentioned in-
regulation 7, the Board may reject the application and inform the applicant of
the same.
Payment of service fee
12. A mutual fund shall pay before the 15th April each year a service fee as
specified in the Second Schedule for every financial year from the year
following the year of registration.
Provided that the Board may, on being satisfied with the reasons for the delay
permit the mutual fund to pay the service fee at any time before the expiry of
two months from the commencement of the financial year to which such fee
relates.
Failure to pay service fee
13. The Board may not permit a mutual fund who has not paid service fee to
launch any scheme.

47

Content Digitized by eGyanKosh, IGNOU

Institutional and
Managed Portfolios
CHAPTER III : CONSTITUTION AND MANAGEMENT
OF MUTUAL FUND AND OPERATION
OF TRUSTEES, ETC
Trust Deed to be registered under the Registration Act
14. A mutual fund shall be constituted in the form of a trust and the instrument of
trust shall be in the form of a deed, duly registered under the provisions of the
Indian Registration Act, 1908 (16 of 1908) executed by the sponsor in favour
of the trustees named in such an instrument.
Contents of trust deed
15. (1) The trust deed shall contain such clauses as are mentioned in the Third
Schedule and such other clauses which are necessary for safeguarding
the interests of the unit holders.
(2) No trust deed shall contain a clause which has the effect of:
(i) limiting or extinguishing the obligations and liabilities of the trust
in relation to any mutual fund or the unit holders; or
(ii) indemnifying the trustees or the asset management company for
loss or damage caused to the unit holders by their acts of
negligence or acts of commissions or omissions.
Disqualification from being appointed as trustees
16. (1) A mutual fund shall appoint trustees in accordance with these
regulations.
(2) No person shall be eligible to be appointed as a trustee unless:
(a) he is, a person of ability, integrity and standing; and
(b) has not been found guilty of moral turpitude; and
(c) has not been convicted of any economic offence or violation of any
securities laws; and
(d) has furnished particulars as specified in Form-C.
(3) An asset management company or any of its officers or employees shall
not be eligible to act as a trustee of any mutual fund.
(4) No person who is appointed as a trustee of a mutual fund can be
appointed as a trustee of any other mutual fund unless:
(a) such a person is an independent trustee referred to in sub-
regulation (5); and
(b) prior approval of the mutual fund of which he is a trustee has been
obtained for such an appointment.
4*
[(5) Two thirds of the trustees shall be independent persons and shall not be
associated with the sponsors or be associated with them in any manner
whatsoever]
(6) In case a company is appointed as a trustee then its directors can act as
trustees of any other trust provided that the object of the trust is not in
conflict with the object of the mutual fund.
Approval of the Board for appointment of trustee
17. (1) No trustee shall initially or any time thereafter be appointed without prior
approval of the Board.
5*
[***]
4. Substituted for the following by the SEBI (Mutual Fund) (Amendment)
Regulations, 1998, published in the Official Gazette of India dated 12.01.1998.
"At least 50 % of the trustees shall be independent persons and no such trustees
shall be an associate or a subsidiary or associated in any manner with the
sponsor."
5. Following proviso deleted by the SEBI (Mutual Fund) (Amendment)
Regulations, 1998, published in the Official Gazette of India dated 12.01.1998.
48 "Provided further if any trustee resigns or retires a new trustee shall be appointed
within a period of three months with the prior approval of the Board."

Content Digitized by eGyanKosh, IGNOU

 Mutual Funds
(2) The existing trustees of any mutual fund may form a trustee company to
act as a trustee with the prior approval of the Board.
Rights and obligations of the trustees
18. (1) The trustees and the asset management company shall with the prior
approval of the Board enter into an investment management agreement.
(2) The investment management agreement shall contain such clauses as are
mentioned in the Fourth Schedule and such other clauses as are necessary
for the purpose of making investments.
(3) The trustees shall have a right to obtain from the asset management
company such information as is considered necessary by the trustees.
(4) The trustees shall ensure before the launch of any scheme that the asset
management company has:
(a) systems in place for its back office, dealing room and accounting;
(b) appointed all key personnel including fund manager(s) for the
scheme(s) and submitted their bio-data which shall contain the
educational qualifications, past experience in the securities market
with the trustees, within 15 days of their appointment;
(c) appointed auditors to audit its accounts;
6*
[(d) appointed a compliance officer who shall be responsible for
monitoring the compliance of the Act, rules and regulations,
notifications, guidelines, instructions etc. issued by the Board or the
Central Government and for redressal of investors' grievances;]
(e) appointed registrars and laid down parameters for their supervision;
(f) prepared a compliance manual and designed internal control
mechanisms including internal audit systems;
(g) specified norms for empanelment of brokers and marketing agents.
7*
[(4a) The compliance officer appointed under clause (d) of sub-
regulation (4) shall immediately and independently report to the
Board any non-compliance observed by him.]
(5) The trustees shall ensure that an asset management company has been
diligent in empanelling the brokers, in monitoring securities transactions
with brokers and avoiding undue concentration of business with any
broker.
(6) The trustees shall ensure that the asset management company has not
given any undue or unfair advantage to any associates or dealt with any
of the associates of the asset management company in any manner
detrimental to interest of the unit-holders.
(7) The trustees shall ensure that the transactions entered into by the asset
management company are in accordance with these regulations and the
scheme.
(8) The trustees shall ensure that the asset management company has been
managing the mutual fund schemes independently of other activities and
have taken adequate steps to ensure that the interest of investors of one
scheme are not being compromised with those of any other scheme or of
other activities of the asset management company.
(9) The trustees shall ensure that all the activities of the asset management
company are in accordance with the provisions of these regulations.
(10) Where the trustees have reason to believe that the conduct of business of
the mutual fund is not in accordance with these regulations and the
scheme they shall forthwith take such remedial steps as are necessary by
them and shall immediately inform the Board of the violation and the
action taken by them.
6. Substituted for the following by the SEBI (Investment Advise by Intermediaries)
(Amendment) Regulations, 2001, published in the Official Gazette of India dated
29.05.2001
"appointed a compliance officer to comply with regulatory requirement and to
redress investor grievances."
7. Clause "4a" inserted by the SERI (Investment Advise by Intermediaries)
(Amendment) Regulations, 2001, published in the Official Gazette of India 49
dated 29.05.2001.
Content Digitized by eGyanKosh, IGNOU
Institutional and 8*
[(11) Each trustee shall file the details of his transactions of dealing in securities with the
Managed Portfolios
Mutual Fund on a quarterly basis.]
(12) The trustees shall be accountable for, and be the custodian of, the funds and property
of the respective schemes and shall hold the same in trust for the benefit of the unit
holders in accordance with these regulations and the provisions of trust deed.
(13) The trustees shall take steps to ensure that the transactions of the mutual fund are in
accordance with the provisions of the trust deed.
(14) The trustees shall be responsible for the calculation of any income due to be paid to
the mutual fund and also of any income received in the mutual fund for the holders of
the units of any scheme in accordance with these regulations and the trust deed.
(15) The trustees shall obtain the consent of the unit-holders:
(a) whenever required to do so by the Board in the interest of the unit-
holders; or
(b) whenever required to do so on the requisition made by three-fourths of the
unit holders of any scheme; or
(c) when the majority of the trustees decide to wind up or prematurely
redeem the units; or
9*
[***]
10*
[15A. The trustees shall ensure that no change in the fundamental attributes of any
scheme or the trust or fees and expenses payable or any other change which.
would modify the scheme and affects the interest of unitholders, shall be carried
out unless:
(i) a written communication about the proposed change is sent to each unit-
holder and an advertisement is given in one English daily newspaper having
nationwide circulation as well as in a newspaper published in the language of
the region where the Head Office of the mutual fund is situated; and
(ii) the unit-holders are given an option to exit at the prevailing Net Asset Value
without any exit load.]
8. Substituted for the following by the SEBI (Mutual Fund) (Amendment) Regulations,
1999 published in the Official Gazette of India dated 08.12.1999.
"Each trustee shall file the details of his holdings in securities on a half yearly basis
with the trust."
9. Following clause (d) along with proviso deleted by the SEBI (Mutual Funds)
(Second Amendment) Regulations, 2000 published in the Official Gazette of India
dated 22.05.2000. Clause (d) along with proviso was inserted by the SEBI (Mutual
Fund) (Amendment) Regulations, 1999 published in the Official Gazette of India
dated 08.12.1999.
"(d) when any change in the fundamental attributes of any scheme or the trust or
fees and expenses payable or any other change which would modify the scheme or
affect the interest of the unit-holders is proposed to be carried out unless the consent
of not less than three-fourths of the unit-holders is obtained:
9a*
[Provided that no such change shall be carried out unless three fourths of the unit-
holders have given 'their consent and the unit-holders who do not give their consent
are allowed to redeem their holdings in the scheme.
Provided further that in case of an open ended scheme, the consent of the unit-
holders shall not be necessary if:
(i) the change in fundamental attribute is carried out after one year from the date
of allotment of units.
(ii) the unit-holders are informed about the proposed change in fundamental
attribute by sending individual communication and an advertisement is given
in English daily newspaper having nationwide circulation and in a newspaper
published in the language of the region where the head office of the mutual
fund is situated.
(iii) the unit-holders are given an option to exit at the prevailing Net Asset Value
without any exit load]
Explanation: For the purposes of this clause "fundamental attributes" means the
investment objective and terms of a scheme."
10. "Clause 15A" inserted by the SEBI (Mutual Fund) (Second Amendment) Regulations,
50 2000 published in the Official Gazette of India dated 22.05.2000.

Content Digitized by eGyanKosh, IGNOU

 Mutual Funds
(16) The trustees shall call for the details of transactions in securities by the
key personnel of the asset management company in his own name or on
behalf of the asset management company and shall report to the Board,
as and when required.
(17) The trustees shall quarterly review all transactions carried out between
the mutual funds, asset management company and its associates.
11*
(18) The trustees shall [quarterly] review the networth of the asset
management company and in case of any shortfall, ensure that the asset
management company make up for the shortfall as per clause (f) of sub-
regulation (1) of regulation 21.
(19) The trustees shall periodically review all service contracts such as
custody arrangements, transfer agency of the securities and satisfy itself
that such contracts are executed in the interest of the unit-holders.
(20) The trustees shall ensure that there is no conflict of interest between the
manner of deployment of its networth by the asset management company
and the interest of the unit-holders.
(21) The trustees shall periodically review the investor complaints received
and the redressal of the same by the asset management company.
(22) The trustees shall abide by the Code of Conduct as specified in the Fifth
Schedule.
(23) The trustees shall furnish to the Board on a half yearly basis:
(a) a report on the activities of the mutual fund;
(b) a certificate stating that the trustees have satisfied themselves that
there have been no instances of self dealing or front running by any
of the trustees, directors and key personnel of the asset management
company;
(c) a certificate to the effect that the asset management company has
been managing the schemes independently of any other activities and
in case any activities of the nature 'referred to in sub-regulation (2)
of regulation 24 have been undertaken by the asset management
company and has taken adequate steps to ensure that the interest of
the unit-holders are protected.
12*
[(24) The independent trustees referred to in sub-regulation (5) of regulation
16 shall give their comments on the report received from the asset
management company regarding the investments by the mutual fund in the
securities of group companies of the sponsor.]
13*
[(25) Trustees shall exercise due diligence as under:
A. General Due Diligence:
(i) The Trustees shall be discerning in the appointment of the directors
on the Board of the asset management company.
(ii) Trustees shall review the desirability of continuance of the asset
management company if substantial irregularities are observed in any
of the schemes and shall not allow the asset management company
to float new schemes.
(iii) The trustee shall ensure that the trust property is properly protected,
held and administered by proper persons and by a proper number of
such persons.
(iv) The trustee shall ensure that all service providers are holding
appropriate registrations .from the Board or concerned regulatory
authority. .
(v) The Trustees shall arrange for test checks of service contracts.
(vi) Trustees shall immediately report to Board of any special
developments in the mutual fund.
11. Substituted for "continuously" by the SEBI (Mutual Fund) (Amendment)
Regulations, 1998 published in the Official Gazette of India dated 12.01.1998.
12. "Clause 24" inserted by the SERI (Mutual Fund) (Amendment) Regulations,
1998 published in the Official Gazette of India dated 12.01.1998
13. "Clause 25" inserted by the SEBI (Mutual Fund) (Amendment) Regulations,
1999 published in the Official Gazette of India dated 08.12.1999 51

Content Digitized by eGyanKosh, IGNOU

Institutional and B. Specific Due Diligence:
Managed Portfolios The Trustees shall:
(i) obtain internal audit reports at regular intervals from independent
auditors appointed by the Trustees.
(ii) obtain compliance certificates at regular intervals from the asset
management company.
(iii) hold meeting of trustees more frequently.
(iv) consider the reports of the independent auditor and compliance
reports of asset management company at the meetings of trustees for
appropriate action.
(v) maintain records of the decisions of the Trustees at their meetings and
of the minutes of the meetings.
(vi) prescribe and adhere to a code of ethics by the Trustees, asset
management company and its personnel.
(vii) communicate in writing to the asset management company of the
deficiencies and checking on the rectification of deficiencies.
(26) Notwithstanding anything contained in sub-regulations (I) to (25), the trustees
shall not be held liable for acts done in good faith if they have exercised
adequate due diligence honestly.
(27) The independent directors of the trustees or asset management company shall
pay specific attention to the following, as may be applicable, namely:
(i) the Investment Management Agreement and the compensation paid
under the agreement.
(ii) service contracts with affiliates-whether the asset management
company has charged higher fees than outside contractors for the
same services.
(iii) selection of the asset management company's independent directors.
(iv) securities transactions involving affiliates to the extent such
transactions are permitted.
(v) selecting and nominating individuals to fill independent directors
vacancies.
(vi) code of ethics must be designed to prevent fraudulent, deceptive or
manipulative practices by insiders in connection with personal
securities transactions.
(vii) the reasonableness of fees paid to sponsors, asset management
company and any others for services provided.
(viii) principal underwriting contracts and their renewals.
any service contract with the associates of the asset management company.]

52

Content Digitized by eGyanKosh, IGNOU

 Mutual Funds
CHAPTER IV : CONSTITUTION AND MANAGEMENT OF
ASSET MANAGEMENT COMPANY AND
CUSTODIAN
Application by an asset management company
19. (1) The application for the approval of the asset management company shall be made
in Form D.
(2) The provisions of regulations 5, 6 and 8 shall, so far as may be, apply to the
application made under sub-regulation (1) as they apply to the application for
registration of a mutual fund.
Appointment of an asset management company
20. (1) The sponsor or, if so authorised by the trust deed, the trustee shall, appoint an
asset management company, which has been approved by the Board under sub-
regulation (2) of regulation 21.
(2) The appointment of an asset management company can be terminated by
majority of the trustees or by seventy five per cent of the unit-holders of the
scheme.
(3) Any change in the appointment of the asset management company shall be
subject to prior approval of the Board and the unit-holders.
Eligibility criteria for appointment of asset management company
21. (1) For grant of approval of the asset management company the applicant has to fulfil
the following:
(a) in case the asset management company is an existing asset management
company it has a sound track record, general reputation and fairness in
transactions;
Explanation: For the purpose of this clause sound track record shall mean
the net worth and the profitability of the asset management company.
14*
[(aa) the asset management company is a fit and proper person.]
(b) the directors of the asset management company are persons having
adequate professional experience in finance and financial services related
field and not found guilty of moral turpitude or convicted of any economic
offence or violation of any securities laws; .
15*
(c) the key personal of the asset management company [have not been
found guilty of moral turpitude or convicted of economic offence or
16*
violation of securities laws] [or worked] for any asset management
17*
company or mutual fund or any intermediary [during the period when
its] registration has been suspended or cancelled at any time by the Board;
(d) the board of directors of such asset management company has at least fifty
per cent directors, who are not associate of, or associated in any manner
with, the sponsor or any of its subsidiaries or the trustees;
(e) the Chairman of the asset management company is not a trustee of any
mutual fund;
(f) the asset management company has a networth of not less than mines ten
crores:
Provided that an asset management company already granted approval
under the provisions of Securities and Exchange Board of India (Mutual
Funds) Regulations, 1993 shall within a period of twelve months from the
date of notification of these regulations increase its networth to rupees ten
crores.
14. Clause "aa" inserted by the SEBI (Mutual Fund) (Amendment) Regulations, 1998,
published in the Official Gazette of India dated 12.01.1998.
15. "have not been found guilty of moral turpitude or convicted of economic offence or
violation of securities laws" inserted by the SEW (Mutual Fund) (Amendment)
Regulations, '1998, published in the Official Gazette of India dated 12.01.1998.
16. Substituted for "has not been working" by the SEBI (Mutual Fund) (Amendment)
Regulations, 1998, published in the Official Gazette of India dated 12.01.1998.
17. Substituted for "whose" by the SEBI (Mutual Fund) (Amendment)
Regulations, 1998, published in the Official Gazette of India dated
12.01.1998. 53

Content Digitized by eGyanKosh, IGNOU

Institutional and 18*
[Provided that the period specified in the first proviso may be extended in
Managed Portfolios
appropriate cases by the Board up to three years for reasons to be recorded in
writing.
Provided further that no new schemes shall be allowed to be launched or managed by
such asset management company till the net worth has been raised to Rupees ten
crores.]
19*
[Explanation: For the purposes of this clause, "net worth" means the aggregate of
the paid up capital and free reserves of the asset management company after
deducting there from miscellaneous expenditure to the extent not written off or
adjusted or deferred revenue expenditure, intangible assets and accumulated losses.]
(2) The Board may, after considering an application with reference to the matters
specified in sub-regulation (1), grant approval to the asset management company.
Terms and conditions to be complied with
22. The approval granted under sub-regulation (2) of regulation 21 shall be subject to the
following conditions, namely:
(a) any director of the asset management company shall not hold the office of the
director in another asset management company unless such person is an
independent director referred to in clause (d) of sub-regulation (I) of regulation
21 and approval of the board of asset management company of which such
person is a director, has been obtained;
(b) the asset management company shall forthwith inform the Board of any material
change in the information or particulars previously furnished, which have a
bearing on the approval granted by it:
(c) no appointment of a director of an asset management company shall be made
without, prior approval of the trustees;
(d) the asset management company undertakes to comply with these
regulations;
20*
[(e) no change in the controlling interest of the asset management
company shall be made unless:
(i) prior approval of the trustees and the Board is obtained;
(ii) a written communication about the proposed change is sent to
each unit-holder and an advertisement is given in one English
daily newspaper having nationwide circulation and in a
newspaper published in the language of the region where the
Head Office of the mutual fund is situated; and
(iii) the unit-holders are given an option to exit on the prevailing Net
Asset Value without any exit load]
18. Proviso inserted by the SEBI (Mutual Fund) (Amendment) Regulations, 1998,
published in the Official Gazette of India dated 12.01.1998.
19. Substituted for the following Explanation by the SEBI (Mutual Fund) (Amendment)
Regulations, 1999 published in the Official Gazette of India dated 08.12.1999.
"Explanation for the purposes of this clause, "networth" means the paid up capital and
free reserves of the company"
20. Substituted for the following clause (e) by the SEBI (Mutual Fund) (Second
Amendment) Regulations, 2000 published in the Official Gazette of India dated
22.05.2000. Clause (e) was inserted by the SEBI (Mutual Fund) (Amendment)
Regulations, 1999 published in the Official Gazette of India dated 08.12.1999
"(e) any change in controlling interest of the asset management company shall be only
with prior approval of trustees, the Board and the unit holders.
[Provided that in case of an open ended scheme, the consent of the unit-holders shall not
be necessary if:
(i) the change in control takes place after one year from the date of allotment of
units.
(ii) the unit-holders are informed about the proposed change in the controlling
interest of asset management company by sending individual communication and
an advertisement is given in one English daily newspaper having nationwide
circulation and in a newspaper published in the language of the region where the
head office of the mutual fund is situated.
54 (iii) the unit-holders are given an option to exit at the prevailing Net Asset
Value without any exit load
Content Digitized by eGyanKosh, IGNOU
 21* Mutual Funds
[Provided that in case of an open ended scheme, the consent of the unit holders
shall not be necessary if:
(i) the change in control takes place after one year from the date of allotment of
units
(ii) the unit-holders are informed about the proposed change in the controlling
interest of asset management company by sending individual communication
and an advertisement is given in one English daily newspaper having
nationwide circulation and in a newspaper published in the language of the
region where the head office of the mutual fund is situated.
(iii) the unit-holders are given an option to exit at the prevailing Net Asset
Value without any exit load."
(f) The asset management company shall furnish such information and documents to
the trustees as and when required by the trustees.
Procedure where approval is not granted
23. Where an application made under regulation 19 for grant of approval does not
satisfy the eligibility criteria laid down in regulation 21, the Board may reject the
application.
Restrictions on business activities of the asset management company
24. The asset management company shall:
(1) not act as a trustee of any mutual fund;
(2) not undertake any other business activities except activities in the nature o f
22*
[portfolio management services] management and advisory services to
offshore funds, pension funds, provident funds, venture capital funds,
management of insurance funds, financial consultancy and exchange of
research on commercial basis if any of such activities are not in conflict with
the activities of the mutual fund;
Provided that the asset management company may itself or through its
subsidiaries undertake such activities if it satisfies the Board that the key
personnel of the asset management company, the systems, back office, bank
and securities accounts are segregated activity wise and there exist systems to
prohibit access to inside information of various activities.
Provided further that asset management company shall meet capital adequacy
requirements, if any, separately for each such activity and obtain separate
approval, if necessary under the relevant regulations.]
(3) the asset management company shall not invest in any of its schemes unless
full disclosure of its intention to invest has been made in the offer documents
23*
[in case of schemes launched after the notification of these regulations.]
Provided that an asset management company shall not be entitled to charge
any fees on its investment in that scheme.
Asset Management Company and its obligations
25. (1) The asset management company shall take all reasonable steps and exercise
due diligence to ensure that the investment of funds pertaining to any scheme
is not contrary to the provisions of these regulations and the trust deed.
(2) The asset management company shall exercise due diligence and care in all its
investment decisions as would be exercised by other persons engaged in the
same business.
(3) The asset management company shall be responsible for the acts of
commissions or omissions by its employees or the persons whose services
have been procured by the asset management company.
(4) The asset management company shall submit to the trustees quarterly
reports of each year on its activities and the compliance with these
regulations.
21. Proviso inserted by the SEBI (Mutual Fund) (Amendment) Regulations, 1999
published in the Official Gazette dated 08.12.1999.
22. "portfolio management services" inserted by the SEBI (Mutual Fund)
(Amendment) Regulations, 1999 published in the Official Gazette dated 08.12.1999.
23. "in case of schemes launched after the notification of these regulations"
inserted by the SEBI (Mutual Fund) (Amendment) Regulations, 1998, published
in the Official Gazette dated 12.01.1998. 55

Content Digitized by eGyanKosh, IGNOU

Institutional and (5) The trustees at the request of the asset management company may terminate the
Managed Portfolios assignment of the asset management company at any time:
Provided that such termination shall become effective only after the trustees have
accepted the termination of assignment and communicated their decision in
writing to the asset management company.
(6) Notwithstanding anything contained in any contract or agreement or termination,
the asset management company or its directors or other officers shall not be
absolved of liability to the mutual fund for their acts of commission or omissions,
while holding such position or office.
24*
(7) (a) An asset management company shall not through any broker associated with
the sponsor, purchase or sell securities. which is average of 5% or more of the
aggregate purchases and sale of securities made by the mutual fund in all its
schemes.
Provided that for the purpose of this cub-regulation, aggregate purchase and
sale of securities shall exclude sale and distribution of units issued by the
mutual fund.
Provided further that the aforesaid limit of 5% shall apply for a block of any
three months.
(b) An asset management company shall not purchase or sell securities through
any broker [other than a broker referred to in clause (a) of sub-regulation
(7)] which is average of 5% or more of the aggregate purchases and sale of
securities made by the mutual fund in all its schemes, unless the asset
management company has recorded in writing the justification for exceeding
the limit of 5% and reports of all such investments are sent to the trustees on
a quarterly basis.
Provided that the aforesaid limit shall apply for a block of three months.
(8) An asset management company shall not utilise the services of the sponsor or any
of its associates, employees or their relatives, for the purpose of any securities
transaction and distribution and sale of securities:
Provided that an asset management company may utilise such services if
disclosure to that effect is made to the unit-holders and the brokerage or
commission paid is also disclosed in the half yearly annual accounts of the mutual
fund.
25*
[Provided further that the mutual funds shall disclose at the time of declaring
half-yearly and yearly results;
(i) any underwriting obligations undertaken by the schemes of the mutual funds
with respect to issue of securities associate companies,
(ii) devolvement, if any,
(iii) subscription by the schemes in the issues lead managed by associate
companies
(iv) subscription to any issue of equity or debt on private placement basis where
the sponsor or its associate companies have acted as arranger or manager].
(9) The asset management company shall file with the trustees the details of
transactions in securities by the key personnel of the asset management company in
their own name or on behalf of the asset management company and shall also
report to the Board, as and when required by the Board.
(10) In case the asset management company enters into any securities transactions with
26*
any of its associates a report to that effect shall be sent to the trustees [ * * * ]
27*
[at its next meeting].
24. Substituted for the following sub regulation (7) by the SERI (Mutual Fund) (Amendment)
Regulations, 1998, published in the Official Gazette dated 12.01.1998 .
"No asset management company sh311 deal in securities through any broker associated with the
sponsor or a firm which is an associate of a sponsor beyond 5% of the. daily gross business of the
mutual fund."
25. Proviso inserted by the SEB1 (Mutual Fund) (Amerdmeitt) Regulations, 1999 published in
the Official Gazette dated 08.12.1999.
26. "immediately" omitted by the SEBI (Mutual Fund) (Amendment) Regulations, 1998,
published in the Official Gazette dated 12.01.1998.
56 27. at its next meeting„ inserted by the SEBI (Mutual Fund) (Amendment) Regulations, 1998,
published in the Official Gazette dated 12.01.1998.

Content Digitized by eGyanKosh, IGNOU

 Mutual Funds
(11) In case any company has invested more than 5 per cent of the net asset
value of a scheme, the investment made by that scheme or by any other
scheme of the same mutual fund in that company or its subsidiaries shall
be brought to the notice of the trustees by the asset management company
and be disclosed in the half yearly and annual accounts of the respective
schemes with justification for such investment 2K" [provided the latter
investment has been made within one year of the date of the former
investment calculated on either side.]
(12) The asset management company shall file with the trustees and the Board:
(a) detailed bio-data of all its directors along with their interest in
other companies within fifteen days of their appointment; and
(b) any change in the interests of directors every six months.
29*
[(c) a quarterly report to the trustees giving details and adequate
justification about the purchase and sale of the securities of the group
companies of the sponsor or the asset management company as the
case may be, by the mutual fund during the said quarter.]
30*
[(13) Each director of the Asset Management Company shall file the details
of his transactions of dealing in securities with the trustees on a
quarterly basis in accordance with the guidelines issued by the
Board.]
(14) The asset management company shall not appoint any person as key
personnel who has been found guilty of any economic offence or
involved in violation of securities laws.
(15) The asset management company shall appoint registrars and share
transfer agents who are registered with the Board.
Provided if the work relating to the transfer of units is processed in-
house, the charges at competitive market rates may be debited to the
scheme and for rates higher than the competitive market rates, prior
approval of the trustees shall be obtained and reasons for charging
higher rates shall be disclosed in the annual accounts.
(16) The asset management company shall abide by the Code of Conduct
as specified in the Fifth Schedule.
Appointment of Custodian
26. (1) The mutual fund shall appoint a custodian to carry' out the custodial
services for the schemes of the fund and sent intimation of the same to
the Board within fifteen days of the appointment of the custodian.
(2) No custodian in which the sponsor or its associates hold 50% or more
of the voting rights of the share capital of the custodian or where 50%
or more of the directors of the custodian represent the interest of the
sponsor or its associates shall act as custodian for a mutual fund
constituted by the same sponsor or any of its associate or subsidiary
company.
Agreement with Custodian
27. The mutual fund shall enter into a custodian agreement with the custodian,
which shall contain the clauses which are necessary for the efficient and
orderly conduct of the affairs of the custodian.
Provided that the agreement, the service contract, terms and appointment of
the custodian shall be entered into with the prior approval of the trustees.
28. Proviso inserted by the SEBI (Mutual Fund) (Amendment) Regulations,
1998, published in the Official Gazette dated 12.01.1998.
29. Clause (c) inserted by the SEBI (Mutual Fund) (Amendment) Regulations,
1998, published in the Official Gazette dated 12.01.1998.
30. Substituted for the following by the SEBI (Mutual Funds) (Second
Amendment) Regulations, 2001, published in the Official Gazette dated
23.07.2001
"A statement of holdings in securities of the directors of the asset management
company shall be filed with the trustees with the dates of acquisition of such
securities at the end of each financial year".
57

Content Digitized by eGyanKosh, IGNOU

Institutional and
Managed Portfolios
CHAPTER V : SCHEMES OF MUTUAL FUND
Procedure for launching of schemes
28. (1) No scheme shall he launched by the asset management company unless
such scheme is approved by the trustees and a copy of the offer document
has been filed with the Board.
(2) Every mutual fund shall along with the offer document of each scheme pay
filing fees as specified in the Second Schedule.
Disclosures in the offer document
29. (1) The offer document shall contain disclosures which are adequate in order
to enable the investors to make informed investment decision [including
the disclosure on maximum investments proposed to be made by the
scheme in the listed securities of the group companies of the sponsor].
(2) The Board may in the interest of investors require the asset management
company to carry out such modifications in the offer document as it deems
fit.
(3) In case no modifications are suggested by the Board in the offer document
32*
within 21 [working] days from the date of filing, the asset management
company may issue the offer document.
33*
[(4) No one shall issue any form of application for units of a mutual
fund unless the form is accompanied by the memorandum containing such
information as may be specified by the Board.]
34*
[Nomination
29A (1) The asset management company shall provide an option to the
unit-holder to nominate, in the manner specified in Fourth
Schedule, a person in whom the units held by him shall vest in
the event of his death.
(2) Where the units are held by more than one person jointly, the
joint unit-holders may together nominate a person in whom all
the tights in the units shall vest in the event of death of all the
joint unit holders.]
Advertisement material
30. (1) Advertisements in respect of every scheme shall be in conformity with the
Advertisement Code as specified in the Sixth Schedule and shall be
submitted to the Board within 7 days from the date of issue.
(2) The advertisement for each scheme shall disclose 35* [investment objective
for each scheme]
Misleading statements
31. The offer document and advertisement materials shall not be misleading or
contain any statement or opinion which are incorrect or false.
Listing of close ended schemes
32. Every close ended scheme shall be listed in a recognized stock exchange within
six months from the closure of the subscription.
Provided that listing of close ended scheme shall not be mandatory:
(a) if the said scheme provides for periodic repurchase facility to all the unit-
holders with restriction, if any, on the extent of such repurchase; or
31. "including the disclosure on maximum investments proposed to be made by the
scheme in the listed securities of the group companies of the sponsor" inserted by
the SEBI (Mutual Fund) (Amendment) Regulations, 1998, published in the
Official Gazette of India dated 12.01.1998.
32. "working" inserted by the SEBI (Mutual Fund) (Amendment) Regulations,
1998, published in the Official Gazette dated 12.01.1998.
33. Sub-regulation (4) inserted by the SEBI (Mutual Fund) Amendment
Regulations,' 1998, published in the Official Gazette of India dated 12.01.1998.
34. Regulation 29A inserted by the SEBI (Mutual Fund) Amendment Regulations,
1998, published in the Official Gazette of India dated 11.06.2002.
35. Substituted for "in addition to the investment objective, the method and
periodicity or valuation of the investment, the method and periodicity of sales
58 and repurchases" by the SEBI (Mutual Fund) (Amendment) Regulations, 1998,
published in the Official Gazette of India dated 12.01.1998.
Content Digitized by eGyanKosh, IGNOU
 Mutual Funds
(b) if the said scheme provides for monthly income or caters to special classes of
persons like senior citizens, women, children, widows or physically
handicapped or any special class of persons providing for repurchase of units
at regular intervals; or
(c) if the details of such repurchase facility are clearly disclosed in the offer
document; or
(d) if the said scheme opens for repurchase within a period of six months from
the closure of subscription.
Repurchase of close ended schemes
33. (1) The asset management company may at its option repurchase or reissue the
repurchased units of a close ended scheme.
(2) The units of close ended schemes referred to in the proviso to regulation 32
may be open for sale or redemption at fixed pre-determined intervals if the
maximum and minimum amount of sale or redemption of the units and the
periodicity of such sale or redemption have been disclosed in the offer
36*
document [***].
(3) The units of close ended scheme may be converted into open ended scheme:
(a) if the offer document of such scheme discloses the option and the
period of such conversion; or
37*
[(b) the unit-holders are provided with an option to redeem their units in
full.]
(4) A close ended scheme shall be fully redeemed at the end of the maturity
38*
period [***].
39*
[Provided that a close ended scheme may be allowed to be rolled over if
the purpose, period and other terms of the roll over and all other material
details of the scheme including the likely composition of assets immediately
before the roll over; the net assets and net asset value of the scheme, are
disclosed to the unit-holders and a copy of the same has been filed with the
Board.
Provided further, that such roll over will be permitted only in case of those
unit-holders who express their consent in writing and the unit-holders who do
not opt for the roll over or have not given written consent shall be allowed to
redeem their holdings in full at net asset value based price.]
Offering Period
40*
34. No scheme of a mutual fund other than the [initial] offering period of any
equity linked savings schemes shall be open for subscription for more than 45
days.
Allotment of Units and refunds of moneys
35. (1) The asset management company shall specify in the offer document:
(a) the minimum subscription amount it seeks to raise under the scheme;
and
(b) in case of over subscription the extent of subscription it may retain.
Provided that where the asset management company retains the over
subscription referred to in clause (b), all the applicants applying up to
five thousand units shall be given full allotment subject to the
oversubscription mentioned in clause (b).
36. "without listing" deleted by the SEBI (Mutual Fund) (Amendment) Regulations,
1998, published in the Official Gazette of India dated 12.01.1998.
37. Substituted for the following clause (b) by the SEBI (Mutual Fund) (Amendment)
Regulations, 1998, published in the Official Gazette of India dated 12.01.1998.
"The majority of the unitholders gives a consent to that effect."
38. "unless a majority of the unitholders otherwise decide for its rollover by passing a
resolution" omitted by the SEBI (Mutual Fund) (Amendment) Regulations, 1998,
published in the Official Gazette of India dated 12.01.1998.
39. Substituted for the following provoiso by the SEBI (Mutual Fund) (Amendment)
Regulations, 1998, published in the Official Gazette of India dated 12.01.1998.
"Provided the unitholders not opting for the rollover shall be allowed to redeem
their holdings in the scheme."
40. "initial" inserted by the SEBI (Mutual Fund) (Amendment) Regulations, 59
1998, published in the Official Gazette of India dated 12.01.1998.
Content Digitized by eGyanKosh, IGNOU
Institutional and (2) The mutual fund, and asset management company shall be liable to
Managed Portfolios refund the application money to the applicants:
(i) if the mutual fund fails to receive the minimum subscription
amount referred to in clause (a) of sub-regulation (1);
(ii) if the moneys received from the applicants for units are in
excess of subscription as referred to in clause (b) of sub-
regulation (1).
(3) Any amount refundable under sub-regulation (2) shall be refunded
within a period of six weeks from the date of closure of subscription list,
by Registered AD and by cheque or demand draft marked "A/C Payee"
to the applicants.
(4) In the event of failure to refund the amounts within the period specified
in sub-regulation (3), the asset management company shall be liable to
pay interest to the applicants at a rate of fifteen per cent per annum on
the expiry of six weeks from the date of closure of the subscription list.
Unit certificates or Statement of Accounts
36. The asset management company shall issue to the applicant whose application
has been accepted, unit certificates or a statement of accounts specifying the
number of units allotted to the applicant as soon as possible but not later than six
41*
weeks from the date of closure of the [initial subscription list and or from the
date of receipt of the request from the unit-holders in any open ended scheme].
Provided that if an applicant so desires, the asset management company shall
issue the unit certificates to the applicant within six weeks of the receipt of
request for the certificate.
Transfer of units
37. (1) An unit certificate unless otherwise restricted or prohibited under the scheme,
shall be freely transferable by act of parties or by operation of law.
(2) The asset management company shall, on production of instrument of
transfer together with relevant unit certificates, register the transfer and
return the unit certificate to the transferee within thirty days from the date of
such production.
Provided that if the units are with the depository such units will be
transferable in accordance with the provisions of the Securities and Exchange
Board of India (Depositories and Participants) Regulations, 1996.
Guaranteed returns
38. No guaranteed return shall be provided in a scheme:
(a) unless such returns are fully guaranteed by the sponsor or the asset
management company;
(b) unless a statement indicating the name of the person who will
guarantee the return, is made in the offer document;
(c) the manner in which the guarantee to be met has been stated in the
offer document.
Winding up
39. (1) A close-ended scheme shall be wound up on the expiry of duration fixed in
the scheme on the redemption of the units unless it is rolled-over for a further
period under sub-regulation (4) of regulation 33.
(2) A scheme of a mutual fund may be wound up, after repaying the amount due
to the unit-holders:
(a) on the happening of any event which, in the opinion of the trustees,
requires the scheme to be wound up; or
(b) if seventy five per cent of the unit-holders of a scheme pass a
resolution that the scheme be wound up; or
(c) if the Board so directs in the interest of the unit-holders.
41. Substituted for "subscription list" by the SEBI (Mutual Fund) (Amendment)
60 Regulations, 1998, 60 published in the Official Gazette of India dated 12.01.1998.

Content Digitized by eGyanKosh, IGNOU

 42* Mutual Funds
(3) Where a scheme is to be wound up under [***] sub-regulation (2), the
trustees shall give notice disclosing the circumstances leading to the
winding up of the scheme:
(a) to the Board; and
(b) in two daily newspapers having circulation all over India, a vernacular
newspaper circulating at the place where the mutual fund is formed.
Effect of winding up
40. On and from the date of the publication of notice under clause (b) of sub-
regulation (3) of regulation 39, the trustee or the asset management company as
the case may be, shall:
(a) cease to carry on any business activities in respect of the scheme so
wound up;
(b) cease to create or cancel units in the scheme;
(c) cease to issue or redeem units in the scheme.
Procedure and Manner of winding up
41. (1) The trustee shall call a meeting of the unit-holders to approve by simple
majority of the unit-holders present and voting at the meeting resolution for
authorising the trustees or any other person to take steps for winding up of
the scheme.
Provided that a meeting of the unit-holders shall not be necessary if the
scheme is wound up at the end of maturity period of the scheme.
(2) (a) The trustee or the person authorised under sub-regulation (1) shall
dispose of the assets of the scheme concerned in the best interest of the
unit-holders of that scheme.
(b) The proceeds of sale realised under clause (a), shall be first utilised
towards discharge of such liabilities as are due and payable under the
scheme and after making appropriate provision for meeting the
expenses connected with such winding up, the balance shall be paid to
the unit-holders in proportion to their respective interest in the assets of
the scheme as on the date when the decision for winding up was taken.
(3) On the completion of the winding up, the trustee shall forward to the Board
and the unit-holders a report on the winding up containing particulars such as
circumstances leading to the winding up, the steps taken for disposal of
assets of the fund before winding up, expenses of the fund for winding up,
net assets available for distribution to the unit-holders and a certificate from
the auditors of the fund.
(4) Notwithstanding anything contained in this regulation, the provisions of
these regulations in respect of disclosures of half yearly reports and annual
43*
reports shall continue to be applicable [until winding up is completed or
the scheme ceases to exist.]
Winding up of the scheme
42. After the receipt of the report under sub-regulation (3) of regulation 41, if the
Board. is satisfied that all measures for winding up of the scheme .have been
complied with, the scheme shall cease to exist.
42. "sub-regulation (1) or" deleted by the SEBI (Mutual Fund) (Amendment)
Regulations, 1998, published in the Official Gazette of India dated 12.01.1998.
43. "initial subscription list and or from the date of receipt of the request from the
unit holders in any open ended scheme" inserted by the SEBI (Mutual Fund)
(Amendment) Regulations, 1998, published in the Official Gazette of India dated
12.01.1998.

61

Content Digitized by eGyanKosh, IGNOU

Institutional and
Managed Portfolios
CHAPTER VI : INVESTMENT OBJECTIVES AND
VALUATION POLICIES
Investment objective
43. The moneys collected under any scheme of a mutual fund shall be invested only
in transferable securities in the money market or in the capital market or in
privately placed debentures or securitised debts.
Provided that moneys collected under any money market scheme of a mutual
fund shall be invested only in money market instruments in accordance with
directions issued by the Reserve Bank of India:
Provided further that in case of securitised debts such fund may invest in asset
44*
backed securities [and] mortgaged backed securities.
Investment, borrowing, restriction, etc.
44. (1) Any investments to be made under r e g u l a t i o n 4 3 shall be invested
subject to the investment restriction specified in the Seventh Schedule.
45*
(1A) The mutual fund having an aggregate of securities which are worth
Rs.10 crores or more, as on the latest balance sheet date, shall subject to such
instructions as may be issued from time to time by the Board settle their
transactions entered on or after January 15, 1998 only through dematerialised
securities.]
(2) The mutual fund shall not borrow except to meet temporary liquidity needs of
the mutual funds for the purpose of repurchase, redemption of units or
payment of interest or dividend to the unit-holders.
Provided that the mutual fund shall not borrow more than 20% of the net
asset of the scheme and the duration of such a borrowing shall not exceed a
period of six months.
(3) The mutual fund shall not advance any loans for any purpose.
46*
[(4) The mutual fund may lend securities in accordance with the Stock Lending
Scheme of the Board.]
Option Trading, etc.
45. The funds of a scheme shall not in any manner be used in option trading or in
short selling or carry forward transactions.
47*
[Provided that mutual funds shall enter into derivatives transactions in a
recognised stock exchange for the purpose of hedging and portfolio balancing, in
accordance with the guidelines issued by the Board].
Underwriting of Securities
46. Mutual funds may enter into underwriting agreement after obtaining a
certificate of registration in terms of the Securities and Exchange Board of
India (Underwriters) Rules and Securities and Exchange Board of India
(Underwriters) Regulations, 1993 authorising it to carry on' activities as
underwriters.
Explanation: (1) For the purpose of these regulations. the underwriting
obligation will be deemed as if investments are made in such securities.
(2) The capital adequacy norms for the purpose of underwriting shall be the
net asset of the scheme.
Provided that the underwriting obligation of a mutual fund shall not at any time
exceed the total net asset value of the scheme.
44. Substituted f o r the word "excluding" by the SEBI (Mutual Fund) (Second
Amendment) Regulations, 2000, published in the Official Gazette of India dated
22.05.2000.
45. "Sub-regulation IA" inserted by the SEBI (Mutual Fund) (Amendment)
Regulations„ 1998, published in the Official Gazette of India dated 12.01.1998.
46. Sub-regulation (4) inserted by the SEBI (Mutual Fund) (Amendment) Regulations,
1998, published in the Official Gazette of India dated 12.01.1998.
62 47. Proviso inserted by the SEBI (Mutual Fund) (Amendment) Regulations, 1999
published in the Official Gazette of India dated 08.12.1999

Content Digitized by eGyanKosh, IGNOU

 Mutual Funds
Method of valuation of investments
47. Every mutual fund shall compute and carry out valuation of its investments in
its portfolio and publish the same in accordance with the valuation norms
specified in Eighth Schedule.
Computation of Net Asset Value
48. (1) Every mutual fund shall compute the Net Asset Value of each scheme by
dividing the net assets of the scheme by the number of units outstanding on
the valuation date.
(2) The Net Asset Value of the scheme shall be calculated and published at
least in two daily newspapers at intervals of not exceeding one week:
Provided that the Net Asset Value of any scheme for special target segment or
any monthly income scheme which are not mandatorily required to be listed in
any stock exchange under Regulation 32, may publish the Net Asset Value at
monthly or quarterly intervals as may be permitted by the Board.
Pricing of Units
49. (1) The price at which the units may be subscribed or sold and the price at
which such units may at any time be repurchased by the mutual fund shall
be made available to the investors.
(2) The mutual fund, in case of open ended scheme, shall at least once a week
publish in a daily newspaper of all India circulation, the sale and
repurchase price of units.
(3) While determining the prices of the units, the mutual fund shall ensure that
the repurchase price is not lower than 93% of the Net Asset Value and the
sale price is not higher than 107% of the Net Asset Value.
Provided that the repurchase price of the units of a close ended scheme shall not
be lower than 95% of the Net Asset Value:
Provided further that the difference between the repurchase price and the sale
price of the unit shall not exceed 7% calculated on the sale price.
(4) The price of units shall be determined with reference to the last
determined Net Asset Value as mentioned in sub-regulation (3) unless:
(a) the scheme announces the Net Asset Value on a daily basis; and
48*
[(b) the sale price is determined with or without a fixed premium added to
the future net asset value which is declared in advance.]

48. Substituted for the following clause (b) by the SEBI (Mutual Fund) (Amendment)
Regulations, 1998, published in the Official Gazette of India dated 12.01.1998.
"the sale price is determined by adding to the future Net Asset Value a fixed
premium which is declared in advance"
63

Content Digitized by eGyanKosh, IGNOU

Institutional and
Managed Portfolios
CHAPTER VII : GENERAL OBLIGATIONS
To maintain proper books of accounts and records, etc.
50. (1) Every asset management company for each scheme shall keep and maintain
proper books of accounts, records and documents, for each scheme so as to
explain its transactions and to disclose at any point of time the financial
position of each scheme and in particular give a true and fair view of the
state of affairs of the fund and intimate to the Board the place where such
books of accounts, records and documents are maintained.
(2) Every asset management company shall maintain and preserve for a period
49*
of [eight] years its books of accounts, records and documents.
(3) The asset management company shall follow the accounting policies and
standards as specified in Ninth Schedule so as to provide appropriate details
of the schemewise disposition of the assets of the fund at the relevant
accounting date and the performance during that period together with
information regarding distribution or accumulation of income accruing to the
unit holder in a fair and true manner.
Financial year
51. The financial year for all the schemes shall end as of March 31 of each year.
Provided that, for a new scheme commenced during a financial year, the
disclosure and reporting requirements would apply for the period beginning from
the date of its commencement and ending on March 31st of the 50" [that financial
year].
Limitation on fees and expenses on issue of schemes
52. (1) All expenses should be clearly identified and appropriated in the individual
schemes.
(2) The Asset Management Company may charge the mutual fund with
investment and advisory fees which are fully disclosed in the offer document
subject to the following namely:-
(i) One and a quarter of one per cent of the weekly average net assets
outstanding in each accounting year for the scheme concerned, as long
as the net assets do not exceed Rs. 100 crores, and
(ii) One per cent of the excess amount over Rs. 100 crores, where net assets
so calculated exceed Rs. 100 crores. .
(3) For schemes launched on a no load basis, the asset management company
shall be entitled to collect an additional management fee not exceeding 1% of
the weekly average net assets outstanding in each financial year.
(4) In addition to the fees mentioned in sub-regulation (2), the asset management
company may charge the mutual fund with the following expenses namely:-
(a) initial expenses of launching schemes.
(b) recurring expenses including:-
(i) marketing and selling expenses including agents' commission, if
any;
(ii) brokerage and transaction cost;
(iii) registrar services for transfer of units sold or redeemed;
(iv) fees and expenses of trustees;
(v) audit fees;
(vi) custodian fees; and
51*
(vii) costs related to investor communication;
(viii) costs of fund transfer from location to location;
49. Substituted for "ten years" by the SEBI (Mutual Fund) (Amendment)
Regulations, 1998, published in the Official Gazette dated 12.01.1998.
50. Substituted for "following year" by the SEBI (Mutual Fund) (Amendment)
Regulations, 1998, published in the Official Gazette dated 12.01.1998.
64 51. Clauses (vii) to (xii) inserted by the SEBI (Mutual Fund) (Amendment)
Regulations, 1998, or trustee or sponsors dated 12.01.1998.

Content Digitized by eGyanKosh, IGNOU

 Mutual Funds
(ix) cost of providing account statements and dividend/redemption
cheques and warrants;
(x) insurance premium paid by the fund;
(xi) winding up costs for terminating a fund or a scheme;
(xii) costs of statutory advertisements;]
52*
[(xiii) such other costs as may be approved by the Board.]
(5) Any expense other than those specified in sub-regulation (2) and (4) shall be borne
53*
by the asset management company [or trustee or sponsors].
Provided that initial expenses of floating the scheme shall not exceed six percent of
the initial resources raised under that scheme and such expenses shall be accounted
in the books of accounts of the scheme as specified in the Tenth Schedule. .
54*
[Provided further that any excess over the 6% initial issue expense shall be
borne by the asset management company].
(6) The total expenses of the scheme excluding issue or redemption expenses, whether
initially borne by the mutual fund or by the asset management company, but
including the investment management and advisory fee shall be subject to the
following limits:-
(i) On the first Rs. 100 crores of the average weekly net assets 2.5%
(ii) On the next Rs. 300 crores of the average weekly net assets 2.25%
(iii) On the next Rs. 300 crores of the average weekly net assets 2.0%
(iv) On the balance on the assets 1.75%
Provided that such recurring expenses shall be lesser by at least 0.25% of the
weekly average net assets outstanding in each financial year in respect of a
scheme investing in bonds.
(7) Any expenditure in excess of the limits specified in sub-regulation (6) shall be
55*
borne by the asset management company [or by the trustee or sponsors].
(8) The provisions of sub-regulations (3) (4), (5) and (6) will come into effect
56*
[from 1st April, 1997] for those schemes of mutual funds which have been
launched prior to notification of these regulations.
Dispatch of warrants and proceeds
53. Every mutual fund and asset management company shall,
(a) dispatch to the unitholders the dividend warrants within S7'[30 days] of the
declaration of the dividend.
(b) dispatch the redemption or repurchase proceeds within 10 working days
from the date of redemption or repurchase.
58*
[(c) In the event of failure to dispatch the redemption or repurchase proceeds
within the period specified in sub-clause (b), the asset management
company shall be liable to pay interest to the unitholders at such rate as
may be specified by Board for the period of such delay.
(d) Notwithstanding payment of such interest to the unitholders under sub-
clause (c), the asset management company may be liable for penalty for
failure to dispatch the redemption or repurchase proceeds within the
stipulated time.]
52. Clause (vii) renumbered as sub clause (xiii) by the SEBI (Mutual Fund)
(Amendment) Regulations, 1998, published in the Official Gazette dated
12.01.1998.
53. "or trustee or sponsors" inserted by the SEBI (Mutual Fund) (Amendment)
Regulations, 1998, published in the Official Gazette dated 12.01.1998.
54. Proviso inserted by the SEBI (Mutual Fund) (Amendment) Regulations, 1998,
published in the Official Gazette dated 12.01.1998.
55. "or by the trustee or sponsors" inserted by the SEBI (Mutual Fund) (Amendment)
Regulations, 1998, published in the Official Gazette dated 12.01:1998.
56. Substituted for "after three months from the date of notification of these
regulations" by the SEBI (Mutual Fund) Amendment Regulations, 1997, published
in the Official Gazette dated 15.04.1997.
57. Substituted for "45 days" by the SEBI (Mutual Fund) Amendment Regulations,
2001, published in the Official Gazette dated 23.07.2001,
58. Clauses (c) and (d) inserted by the SEBI (Mutual Fund) Amendment Regulations,
2000, published in the Official Gazette dated 14.03.2000.es t as: 65

Content Digitized by eGyanKosh, IGNOU

Institutional and Annual Report
Managed Portfolios 54. Every mutual fund or the asset management company shall prepare in respect of
each financial year an annual report and annual statement of accounts of the
schemes and the fund as specified in Eleventh Schedule.
Auditor's Report
55. (1) Every mutual fund shall have the annual statement of accounts audited by an
auditor who is not in any way associated with the auditor of the asset
management company.
Explanation: For the purposes of this sub-regulation and regulation 66 "auditor"
means a person who is qualified to audit the accounts of a company under
section 224 of the Companies Act, 1956 . ( 1 of 1956).
(2) An auditor shall be appointed by the trustees.
(3) The auditor shall forward his report to the trustees and such report shall
form part of the Annual Report of the mutual fund.
(4) The auditor's report shall comprise of the following:
(a) a certificate to the effect that:
(i) he has obtained all information and explanations which, to the
best of his knowledge and belief, were necessary for the
purpose of the audit;
(ii) the balance sheet and the revenue account give a fair and true
view of the scheme, state of affairs and surplus or deficit in
the Fund for the accounting period to which the Balance
Sheet or, as the case may be the Revenue Account relates;
(iii) the statement of account has been prepared in accordance with
accounting policies and standards as specified in the Ninth
Schedule.
59*
[Mailing] of Annual Report and summary thereof
56. (1) The schemewise Annual Report of a mutual fund or an abridged summary
60* 61*
thereof [* * * (***) shall be mailed to all unit-holders] as soon as may be
possible but not later than six months from the date of closure of the relevant
accounts year.
(2) The Annual Report and abridged summary thereof shall contain details as
specified in the Eleventh Schedule and such other details as are necessary for the
purpose of providing a true and fair view of the operations of the mutual fund.
62*
[Provided that the abridged scheme wise annual report mailed to unit-holders need not
contain full portfolio disclosure but must contain details on group company investments
such as the name to the company, the amount of investment made in each company of the
group by each scheme and the aggregate investments made by all schemes in the group
companies of the sponsor.
59. Substituted for "Publication" inserted by the SEBI (Mutual Fund) (Amendment)
Regulations, 1998, published in the Official Gazette of India dated 19.02.2002.
60. The sub-regulation (1) of regulation 56 as in SERI (Mutual Fund) Regulations,
1996. read as follows
"(1) .The schemewise Annual Report of a mutual fund or an abridged summary
thereof shall be published through an advertisement as soon as may be possible
but not later than six months from the date of closure of the relevant accounts
year.
"and an abridged schemewise annual report shall be mailed to all unitholders" was
inserted by the SEBI (Mutual Fund) Amendment Regulations, 1998, published in
the Official Gazette dated 12.01.1998. After which the regulation read as follows
"(1) The schemewise Annual Report of a mutual fund or an abridged
summary thereof shall be published through an advertisement and an
abridged schemewise annual report shall be mailed to all unitholders as
soon as may be possible but not later than six months from the date of
closure of the relevant accounts year.
61. "shall be published through an advertisement and an abridged scheme wise annual
report" was deleted by the SEBI (Mutual Fund) Amendment Regulations, 2002,
published in the Official Gazette of India dated 19.02.2002.
66 62. Proviso inserted by the SEBI (Mutual Fund) Amendment Regulations, 1998,
published in the Official Gazette of India dated 12.01.1998.
Content Digitized by eGyanKosh, IGNOU
63* Mutual Funds
(***)]
64*
(3) The report if [mailed in abridged summary form as per sub regulation (1)] shall
carry a note that 65* [for unit-holders of a scheme] full Annual Report shall be
available for inspection at the Head Office of the mutual fund and a copy thereof shall
be made available to the unit-holder on payment of such nominal fees as may be
specified by the mutual fund.
Annual Report to be forwarded to the Board
66*
57. Every mutual fund [***] shall within six months from the date of closure of each
financial year forward to the Board a copy of the Annual Report and other information
including details of investments and deposits held by the mutual fund so that the entire
schemewise portfolio of the mutual funds is disclosed to the Board.
Periodic and continual disclosures
58. (1) The mutual fund, the asset management company, the trustee, custodian, sponsor
of the mutual fund shall make such disclosures or submit such documents as they
may be called upon to do so by the Board.
(2) Without prejudice to the generality of sub-regulation (1), the mutual fund
67*
[***] shall furnish the following periodic reports to the Board namely:
(a) copies of the duly audited annual statements of accounts including the
balance sheet and the profit and loss account for the fund and in respect of
each scheme, once a year;
(b) a copy of six monthly unaudited accounts;
(c) a quarterly statement of movements in net assets for each of the schemes
of the fund;
(d) a quarterly portfolio statement, including changes from the previous
periods, for each scheme.
(3) No sale of units of any scheme of a mutual fund shall be made by the trustees or
an asset management company unless accompanied by documents which contain
information which is adequate for the investors to take an informed decision.
Half Yearly disclosures
68*
59. A mutual fund and asset management company shall before the expiry of [one
month] from the close of each half year that is on 31st March and on 30th September,
publish its unaudited financial results in one English daily newspaper circulating in
the whole of India and in a newspaper published in the language of the region where
69*
the Head Office of the mutual fund is situated. [The half-yearly results must be
printed in at least 7 point Times Roman font with proper spacing for easy reading.]
Provided that the half-yearly unaudited report referred in this sub-regulation shall
contain details as specified in Twelfth Schedule and such other details as are necessary
for the purpose of providing a true and fair view of the operations of the mutual fund.
63. Following part of the proviso deleted by the SEBI (Mutual Funds) (Amendment)
Regulations, 2002 published in the Official Gazette of India dated 19.02.2002.
"provided further that full portfolio disclosure is not required if the full accounts are
published in newspapers"
64. Substituted for "if published in summary form", by the SEBI (Mutual Funds)
(Amendment) Regulations, 2002 published in Official Gazette of India dated
20.02.2002
65. "for unitholders of a scheme" inserted by the SEBI (Mutual Fund) (Amendment)
Regulations, 1998, published in Official Gazette of India dated 12.01.1998.
66. "and asset management company" deleted by the SEBI (Mutual Fund) (Amendment)
Regulations, 1998, published in Official Gazette of India dated 12.01.1998.
67. "and asset management company" deleted by the SEBI (Mutual Fund) (Amendment)
Regulations, 1998, published in Official Gazette of India dated 12.01.1998.
68. Substituted for "two months" by the SEBI (Mutual Funds) (Second Amendment)
Regulations, 2001 published in Official Gazette of India dated 23.07.2001
69. "The half-yearly results must be printed in at least 7 point Times Roman font with
proper spacing for easy reading" inserted by the SEBI (Mutual Fund) (Amendment)
67
Regulations, 1998, published in Official Gazette of India dated 20.02.2002.

Content Digitized by eGyanKosh, IGNOU

Institutional and 70*
[59A. A mutual fund shall before the expiry of one month from the close of each
Managed Portfolios
half year (i.e., 31st March and 30th September), send to all unit-holders a complete
statement of its scheme portfolio.

Provided that statement of scheme portfolio may not be sent to the unit-holders, if the
statement is published, by way of an advertisement, in one English daily circulating
in the whole of India and in a newspaper published in the language of the region
where the head office of the mutual fund is situated.]

Disclosures to the investors

60. The trustees shall be bound to make such disclosures to the unit-holders as are
essential in order to keep them informed about any information which may have
an adverse bearing on their investments.

68

Content Digitized by eGyanKosh, IGNOU

 Mutual Funds
70. Regulation 59A inserted by the SEBI (Mutual Fund) (Amendment) Regulations, 2000,
published in the Official Gazette of India dated 14.03.2000.

CHAPTER VIII : INSPECTION AND AUDIT

Board's right to inspect and investigation
61. (1) The Board may appoint one or more persons as inspecting officer to undertake
the inspection of the books of accounts, records, documents and infrastructure,
systems and procedures or to investigate the affairs of a mutual fund, the
trustees and asset management company for any of the following purposes,
namely:
(a) to ensure that the books of accounts are being maintained by the mutual
fund, the trustees and asset management company in the manner specified
in these regulations;
(b) to ascertain whether the provisions of the Act and these regulations are
being complied with by the mutual fund, the trustees and asset
management company;
(c) to ascertain whether the systems, procedures and safeguards followed ray
the mutual fund are adequate;
(d) to ascertain whether the provisions of the Act or any rules or regulations
made thereunder have been violated;
(e) to investigate into the complaints received from the investors or any other
person on any matter having a bearing on the activities of the mutual funds,
trustees and asset management company;
(f) to suo-motu ensure that the affairs of the mutual fund, trustees or asset
management company are being conducted in a manner which are in the
interest of the investors or the securities market.
Notice before inspection and investigation
62. (1) Before ordering an inspection or investigation under regulation 61 the Board
shall give not less than ten days notice to the mutual fund, asset management
company or trustees as the case may be.
(2) Notwithstanding anything contained in sub-regulation (1), where the Board is
satisfied that in the interest of the investors no such notice should be given, it
may, by an order in writing direct that such inspection or investigation be taken
up without such notice.
(3) During the course of inspection or investigation, the mutual fund, trustees or
asset management company against whom the inspection or investigation is
being carried out shall be bound to discharge his obligations as provided in
regulation 63.
Obligations on inspection and investigation
63. (1) It shall be the duty of the mutual fund, trustees or asset management company
whose affairs are being inspected or investigated, and of every director, officer
and employee thereof, to produce to the inspecting officer such books, accounts,
records, and other documents in its custody or control and furnish him such
statements and information relating to the activities as mutual funds, trustees or
asset management company, as the inspecting officer may require, within such
reasonable period as the inspecting officer may specify.
(2) The mutual fund, trustees or asset management company shall allow the
inspecting officer to have a reasonable access to the premises occupied by it or
by any other person on its behalf and also extend reasonable facility for
examining any books, records, documents, and computer data in the possession
of the mutual fund, trustees and asset management company or such other
person and also provide copies of documents or other materials which in the
opinion of the inspecting officer are relevant for the purpose of the inspection.
(3) The inspecting officer, in the course Of inspection or investigation, shall be
entitled to examine or record the statements of any director, officer, or
employee of the mutual fund, trustees and asset management company.
(4) It shall be the duty of every director, officer, or employee of the mutual fund,
asset management company or trustee to give to the inspecting officer all
assistance in connection with the inspection or investigation, which the
69
inspecting officer may reasonably require.

Content Digitized by eGyanKosh, IGNOU

Institutional and Submission of report to the Board
Managed Portfolios
64. The inspecting officer shall, as soon as possible, on completion of the inspection
or investigation submit a report to the Board:

Provided that if directed to do so by the Board, he may submit interim reports.

Communications of findings, etc.

65. (1) The Board shall, after consideration of the inspection report or
investigation report referred to in regulation 64, communicate the findings
of the inspecting officer to the mutual fund, trustees or asset management
company as the case may be, and give him an opportunity of being heard:

Provided that if any proceedings under Chapter VIII are. initiated the
procedure under Chapter VIII shall be followed.

(2) On receipt of the reply if any, from the mutual fund, trustees or asset
management company, as the case may be, the Board may call upon the
trustees or asset management company to take such measures as the Board
may deem fit in the interest of the investors, securities market and for due
compliance with the provisions of these regulations.

Appointment of Auditor

66. Without prejudice to the provisions of regulation 55, the Board shall have the
power to appoint an auditor to inspect or investigate, as the case may be, into
the books of accounts or the affairs of the mutual fund, trustee or asset
management company:

Provided that the Auditor so appointed shall have the same powers of the
inspecting officer as stated in regulation 61 and the obligation of the mutual
fund, asset management company, trustee, and their respective employees in
regulation 63, shall be applicable to the investigation under this regulation.

Payment of inspection fees to the Board

67. The Board shall be entitled to recover such expenses including fees paid to the
auditors as may be incurred by it for the purposes of inspecting the books of
accounts, records and documents of the mutual fund, the trustees and the asset
management company.

70

Content Digitized by eGyanKosh, IGNOU

 Mutual Funds
CHAPTER IX : PROCEDURE FOR ACTION IN CASE OF
DEFAULT
Suspension of certificate
68. The Board may suspend a certificate granted to a mutual fund if such mutual
fund:
(a) contravenes any of the provisions of the Act and these regulations;
(b) fails to furnish any information or furnishes wrong information relating
to its activity as a mutual fund as required under these regulations;
(c) fails to submit periodical returns as required under these regulations;
(d) does not co-operate in any inquiry or inspection conducted by the Board;
(e) fails to comply with any directions of the Board issued under the
provisions of the Act or the regulations;
(f) fails to resolve the complaints of the investors or fails to give a
satisfactory reply to the Board in this behalf;
(g) indulges in unfair trade practices in securities;
Explanation: For the purpose of this clause "unfair trade practices" has
the same meaning as in Securities and Exchange Board of India
(Fraudulent and Unfair Trade Practices in Securities Market)
Regulations, 1995;
(h) is guilty of misconduct or improper or unbusinesslike or unprofessional
conduct which is not in accordance with the Code of Conduct specified
in the Fifth Schedule;
(i) asset management company fails to maintain the networth in accordance
with the provisions of regulation 21;
(j) fails to pay any fees;
(k) violates the conditions of registration;
(l) mutual fund, asset management company or trustees of that mutual fund
does not carry out its obligations as specified in these regulations.
Cancellation of certificate
69. The Board may cancel the certificate of registration granted to a mutual fund, if
such mutual fund
(a) is guilty of fraud, or has been convicted of an economic offence;
(b) has been guilty of repeated defaults of the nature specified in regulation
68;
(c) the mutual fund, asset management company, trustee of that mutual fund
indulges in price manipulation or price rigging or cornering activities
affecting the securities market and the investors interest;
(d) the financial position of the mutual fund deteriorates to such an extent
that the Board is of the opinion that its continuance is not in the interest
of unit-holders and other mutual funds.
Manner of making order of cancellation or suspension
70. No order of suspension or cancellation of certificate or the approval, as the case
may be, shall be made by the Board against a mutual fund, trustees, asset
management company except after holding an enquiry in accordance with the
procedure specified in regulation 71.
Manner of holding enquiry before suspension or cancellation
71. (1) For the purpose of holding an enquiry, under regulation 70 the Board
may appoint one or more enquiry officers.
(2) The enquiry officer shall issue to the mutual fund, asset management
company or the trustee, as the case may be, at its registered office or the
principal place of its business, a notice setting out the grounds on which
action is proposed to be taken against it and calling upon it to show
cause against such action within a period of fourteen days from the date 71
of receipt of the notice.
Content Digitized by eGyanKosh, IGNOU
Institutional and (3) The mutual fund, asset management company or trustee shall within fourteen
Managed Portfolios days of the date of receipt of such notice, furnish to the enquiry officer a written
reply, together with copies of documentary or other evidence relied on by it or
sought by the Board from the mutual fund, trustees, or asset management
company.
(4) The enquiry officer shall give a reasonable opportunity of hearing to the mutual
fund, trustees, or asset management company, to enable it to make submissions
in support of its reply made under sub-regulation (3).
(5) Before the enquiry officer, the mutual fund, trustees or asset management
company may either appear in person or through any person duly authorised by
the mutual fund, trustees or asset management company.
Provided that no lawyer or advocate shall be permitted to represent the mutual
fund, trustees or asset management company at the enquiry:
Provided further that where a lawyer or an advocate has been appointed by the
Board as a presenting officer under sub-regulation (6), it shall be lawful for the
mutual fund, asset management company or trustee to present its case through a
lawyer or advocate.
(6) The enquiry officer may if he considers it necessary, ask the Board to appoint a
presenting officer to present its case.
(7) The enquiry officer shall, after taking into account all relevant facts and
submissions made by the mutual fund, trustees or asset management company
submit a report to the Board and recommend the action, if any, to be taken
against the mutual fund, trustees or asset management company as also the
grounds on which the penal action is justified.
Show cause notice and order
72. (1) On receipt of the report from the enquiry officer, the Board shall consider the
same and issue to the mutual fund, trustees or asset management company, a
show-cause notice.
(2) The mutual fund, asset management company or trustee, shall within fourteen
days of the date of the receipt of the show-cause notice, send a reply to the
Board.
(3) The Board, after considering the reply of the mutual fund, trustees or asset
management company, if any, shall as soon as possible pass such order as it
deems fit.
(4) The Board shall send to the mutual fund, trustees, or asset management company,
a copy of the order made under sub-regulation (3).
Effect of suspension or cancellation of certificate of registration
73. (1) On and from the date of the suspension of the certificate or the approval, as the
case may be, the mutual fund, trustees or asset management company, shall
cease to carry on any activity as a mutual fund, trustee or asset management
company, during the period of suspension, and shall be subject to the directions
of the Board with regard to any records, documents, or securities that may be in
its custody or control, relating to its activities as mutual fund, trustees or asset
management company.
(2) On and from the date of cancellation of the certificate or the approval, as the
case may be, the mutual fund, trustees or asset management company shall with
immediate effect, cease to carry on any activity as mutual fund, trustees or asset
management company, as the case may be.
(3) The Board may in the interest of the unit-holders issue directions with regard to
the transfer of any records, documents or securities that may be in its custody or
control, relating to its activities as mutual fund, trustees or asset management
company.
(4) The Board may in order to protect the interest of the unit-holders order the
transfer of records, document, securities, etc. to any person specifically
appointed for the purpose or to any other trustee or asset management company.
Provided that the Board shall while appointing such a person determine the
terms and conditions of such an appointment.
Publication of order of suspension or cancellation
72 74. The order of suspension or cancellation passed under sub-regulation (3) of regulation 72,
may be published by the Board in two newspapers.

Content Digitized by eGyanKosh, IGNOU

 Mutual Funds
Action against intermediaries Mutual Funds
75. The Board may initiate action for suspension or cancellation of registration of an
intermediary holding a certificate of registration under section 12 of the Act who
fails to exercise due diligence or to comply with the obligations under these
regulations:
Provided that no such certificate of registration shall be suspended or cancelled
unless the procedure specified in the regulations applicable to such intermediary
is complied with.
Adjudication, etc.
76. (1) The Board may for the offences specified in sections 15 A to 15 E of the
Act initiate action under section 15 I of the Act and in case of violation of
any of the provisions of the Act or the regulations, initiate action under
sections 11, 11B or section 24 of the Act.
(2) The Board may in addition to suspension or cancellation of certificate,
order suspension of launching of any scheme of a mutual fund for a period
not exceeding one year for violation of any of the provisions of these
regulations after following procedure under this Chapter.
(3) The Board may during the pendency of any proceeding of suspension or
cancellation under this Chapter also order suspension for launching of any
scheme not exceeding three months without following procedure under
this Chapter.
Provided that no order shall be passed without giving an opportunity of hearing.

73

Content Digitized by eGyanKosh, IGNOU

Institutional and
Managed Portfolios
CHAPTER X : MISCELLANEOUS
Power of the Board to issue clarifications

77. In order to remove any difficulties in the application or interpretation of these

regulations, the Board shall have the power to issue clarifications and guidelines
in the form of notes or circulars, which shall be binding on the sponsor, mutual
funds, trustees, asset management companies and custodians.

Repeal and Saving

78. (1) The Securities and Exchange Board of India (Mutual Funds) Regulations,
1993 are hereby repealed.

(2) Notwithstanding such repeal:

(a) anything done or any action taken or purported to have been done
or taken, including registration or approval granted, fees collected,
scheme announced, registration or approval, suspended or
cancelled, any inquiry or investigation commenced under the said
regulations, shall be deemed to have been done or taken under the
corresponding provisions of these regulations;

(b) any application made to the Board under the said regulations and
pending before it shall be deemed to have been made under the
corresponding provisions of these regulations;

(c) any appeals preferred to the Central Government under the said
regulations and pending before it shall be deemed to have been
preferred under the corresponding provisions of these regulations.

74

Content Digitized by eGyanKosh, IGNOU

Q1. What is EMH (EFFICIENT MARKET HYPOTHESIS )?

Ans. An efficient market is defined as a market where there are large numbers
of rational, profit-maximizers actively competing, with each trying to predict
future market values of individual securities, and where important current
information is almost freely available to all participants.

 Investors use two different approaches namely, the fundamental analysis

and the technical analysis that are used by the investors in taking
investment decisions.
 These approaches were used under the assumption that the current market
prices are different from its intrinsic value and such analyses will help
investors in finding under-priced and over-priced stocks.
 The validity of the assumption that the market price is not equal to the
intrinsic value is questionable.
 The third approach, called `EFFICIENT MARKET HYPOTHESIS', is
based on the premise that current market price is a true reflection of the
value of the securities (stocks) and hence it is futile to expect that
fundamental or technical analysis will yield a superior return by
identifying under-priced or over-priced stocks.
 Under efficient market hypothesis, investors can expect a return
commensurate with the risk associated with such investments.
 The efficient market hypothesis (emh) is one of the main reasons some
investors may choose a passive investing strategy. It helps to explain the
valid rationale of buying these passive mutual funds and exchange-traded
funds (etfs).
 The Efficient Market Hypothesis states that at any given time, security
prices fully reflect all available information.

CONCLUSION
The efficient market hypothesis (EMH)
Efficient market theory states that the price fluctuations are random and do not
follow any regular pattern. Fama suggested that efficient market hypothesis can
be divided into three categories.
They are: (1) the weak form,
(2) The semi strong form,
(3) The strong form.

The level of information being considered in the market is the basis for this
segregation.

Q2.Compare And Contrast Between Fundamental Analysis And Technical

Analysis ?

Ans. Stock prices change every minute, and so every investor is keen to know the
future price trends of the stocks of a company, so as to make investment decisions
rationally. For this purpose fundamental analysis and technical analysis are used
to research and forecast price trend of the stock in future.

Fundamental Analysis studies all those factors which have an impact on the
stock price of the company in future, such as financial statement, management
process, industry, etc. It analyzes the intrinsic value of the firm to identify whether
the stock is under-priced or over-priced. On the other hand, technical
analysis uses past charts, patterns and trends to forecast the price movements of
the entity in the coming tim

Content: Fundamental Vs Technical Analysis

BASIS FOR FUNDAMENTAL

TECHNICAL ANALYSIS
COMPARISON ANALYSIS

Meaning Fundamental Analysis is a Technical analysis is a

practice of analyzing securities method of determining the
BASIS FOR FUNDAMENTAL
TECHNICAL ANALYSIS
COMPARISON ANALYSIS

by determining the intrinsic future price of the stock using

value of the stock. charts to identify the patterns
and trends.

Relevant for Long term investments Short term investments

Function Investing Trading

Objective To identify the intrinsic value To identify the right time to

of the stock. enter or exit the market.

Decision making Decisions are based on the Decisions are based on

information available and market trends and prices of
statistic evaluated. stock.

Focuses on Both Past and Present data. Past data only.

Form of data Economic reports, news events Chart Analysis

and industry statistics.

Future prices Predicted on the basis of past Predicted on the basis of

and present performance and charts and indicators.
profitability of the company.

Type of trader Long term position trader. Swing trader and short term
day trader.
Definition of Fundamental Analysis

 Fundamental Analysis refers to the detailed examination of the basic

factors which influence the interest of the economy, industry and company.
 It is meant to gauge the actual intrinsic value of a share, by measuring the
economic, financial and other factors (both qualitative and quantitative) to
identify the opportunities where the value of share varies from its current
market price.
 The fundamental analysis assesses all the factors that have the capability
of influencing the value of the security (including macroeconomic factors
and organization-specific factors), called as fundamentals, which are
nothing but the financial statements, management, competition, business
concept, etc. It aims at analysing the economy as a whole, the industry to
which it belongs, business environment and the firm itself.
  It relies on the assumption that there is some sort of delay in influencing
the share prices by these fundamentals. So, in the short run, the prices of
stocks do not match its value, but in the long run, it adjusts itself. It is a
three-phase analysis of:

 The Economy: To analyse the general economic status and condition of

the country. It is analysed through economic indicators.
 The Industry: To determine the prospects of various industry
classification, with the help of competitive analysis of industries and
industry life cycle analysis.
 The Company: To ascertain the financial and non-financial characteristics
of the firm to find out whether to buy, sell or hold the shares of the
company. For this purpose, sales, profitability, EPS, are analysed along
with management, corporate image and product quality.

Definition of Technical Analysis

 Technical Analysis is used to forecast the price of a share, which says that
the price of a share of the company is based on the interaction of demand
and supply forces, operating in the marketplace.
 It is used to forecast the future market price of the stock, as per the past
performance statistics of the share. For this purpose, first of all, the changes
in the price of the stock are ascertained, to know how the price will change
in future.

The price at which the buyer and seller of the share, decides to settle the deal, is
one such value which combines, weighs and expresses all the factors, and is the
only value which matters. In other words, technical analysis gives you a clear and
comprehensive view of the reason for changes in prices of a security. It is based
on the premise that the price of share move in trends, i.e. upward or downward,
relying upon the attitude, psychology and emotion of the traders.
Tools used for Technical Analysis

 Prices: The change in the price of securities is represented in the change in

the attitude of the investor and the demand and supply of securities.
 Time: The degree of price movement is a function of time, i.e. the time
taken in the reversal of trend will determine the change in price.
 Volume: The magnitude of price changes can be seen in the transaction
volume that characterizes the change. Suppose there is a change in the price
of shares, but there is a small change in the transaction volume, then it can
be said that the change is not very powerful.
 Width: The quality of change in price, is gauged by ascertaining if the
change in trend is dispersed across many industries or it is specific to a few
securities only. It reflects the degree to which changes in the price of
securities have taken place in the market as per the overall trend.

Key Differences Between Fundamental and Technical Analysis

The difference between fundamental and technical analysis can be drawn clearly
on the following grounds:

1. Fundamental Analysis is a method of examining security so as to identify

its intrinsic value for long term investment opportunities. As against,
Technical Analysis is a method of evaluating and forecasting the price
of a security in future, on the basis of price movement and volume of
transaction. It identifies what a stock will do in future.
2. In fundamental analysis, longer periods are used to analyse stocks as
compared to technical analysis. Hence, fundamental analysis is employed
by those investors who want to invest in stocks whose value will increase
in several years. On the contrary, technical analysis is used when the trade
is for short term only.
3. The time difference between the two analysis is not only experienced in

their approach but in their objective too, wherein the technical analysis is

concerned with trading, fundamental analysis talks about investment. As

most of the investors use fundamental analysis to buy or hold stocks of the

company, whereas traders rely on the technical analysis, to make short term

profits.

4. While fundamental analysis aims at ascertaining the true intrinsic value of

the stock, technical analysis is used to identify the right time to enter or
exit the market.
5. In fundamental analysis, decision making is based on the information
available and statistic evaluated. On the contrary, in technical analysis,
decision making is based on market trends and the stock price.
6. In fundamental analysis, both past and present data are considered,
whereas, in technical analysis, only past data is considered.
 7. Fundamental Analysis is based on financial statements, whereas technical
analysis is based on charts with price movements.
8. In fundamental Analysis the intrinsic value of the stock can be
ascertained by analysing an income statement, balance sheet, cash flow
statement, profit margin, return on equity, price to earnings ratio, etc.
However, technical analysts rely on the chart patterns (such as
continuation pattern and reverse patterns), price actions, technical
indicator, resistance and support, to analyse the future price trends. Here
resistance is the point where the investor is of the view that price will not
rise further and is ready to sell, and support is a point where the investor is
of the view that price will not fall further and is ready to buy.
9. In fundamental analysis, the future price of the security is decided upon the
past and present performance and profitability of the company. As
opposed, in technical analysis the future prices are on the basis of charts
and indicators.
10.Fundamental analysis is done by long term position trader, while technical
analysis is done by swing trader and short term day trader.

CONCLUSION

In fundamental analysis, the stock is bought by the investor when the market price
of the stock is less than the intrinsic value of the stock. As against, in technical
analysis, the stock is bought by the traders, when they expect that it can be sold
at a relatively higher price.

Q3. Why should technical analysis confirm findings based on fundamental

analysis?

 Technical analysis is a trading discipline employed to

evaluate investments and identify trading opportunities in price trends and
patterns seen on charts.
  Technical analysts believe past trading activity and price changes of a
security can be valuable indicators of the security's future price
movements.
 Technical analysis may be contrasted with fundamental analysis, which
focuses on a company's financials rather than historical price patterns or
stock trends.

Fundamental analysis is most useful for long term investments, while technical
analysis is more useful for short term trading and market timing. Both can also
be combined to plan and execute investments over the medium and long term.

Q4.Explain The Different Avenues Of Investment?

Ans. Investment avenues are the different ways that a person can invest his
money. It also called investment alternatives or investment schemes.
Investment alternatives in India

 Non marketable financial assets:

These are such financial assets which gives
moderately high return but can not be traded in market.
* Bank Deposits
* Post Office Schemes
* Company FDs
* PPF
 Equity shares:
These are shares of company and can be traded in secondary market.
Investors get benefit by change in price of share and dividend given by
companies.
Equity shares represent ownership capital. As an equity shareholder, a person has
an
ownership stake in the company. This essentially means that the person has a
residual
interest in income and wealth of the company. These can be classified into
following
broad categories as per stock market:
* Blue chip shares
* Growth shares
* Income shares
* Cyclic shares
* Speculative shares
 Bonds:
Bonds are the instruments that are considered as a relatively safer investment
avenues.
* G sec bonds
* GOI relief funds
* Govt. agency funds
* PSU Bonds
* RBI BOND
* Debenture of private sector co.

 Money market instrument:

By convention, the term "money market" refers to the
market for short-term requirement and deployment of funds. Money market
instruments
are those instruments, which have a maturity period of less than one year.
* T-Bills
* Certificate of Deposit
* Commercial Paper

 Mutual Funds-
A mutual fund is a trust that pools together the savings of a number of
investors who share a common financial goal. The fund manager invests this pool
of
money in securities, ranging from shares, debentures to money market
instruments or in a
mixture of equity and debt, depending upon the objective of the scheme. The
different
types of schemes are
* Balanced Funds
* Index Funds
* Sector Fund
* Equity Oriented Funds

 Life insurance:
Now-a-days life insurance is also being considered as an investment
avenue. Insurance premiums represent the sacrifice and the assured sum the
benefit.
Under it different schemes are:
* Endowment assurance policy
* Money back policy
* Whole life policy
* Term assurance policy
 Real estate:
One of the most important assets in portfolio of investors is a residential
house. In addition to a residential house, the more affluent investors are likely to
be
interested in the following types of real estate:
* Agricultural land
* Semi urban land
* Farm House
 Precious objects: Investors can also invest in the objects which have value.
These
comprises of:
* Gold
* Silver
* Precious stones
* Art objects
 Financial Derivatives: These are such instruments which derive their value
from some
other underlying assets. It may be viewed as a side bet on the asset. The most
important
financial derivatives from the point of view of investors are:
* Options
* Futures

Q5. Define Investment state the objective of investment ?

Investment objectives are related to what the client wants to achieve with the
portfolio of investments. Objectives define the purpose of setting the portfolio.
Generally, the objectives are concerned with return and risk considerations. These
two objectives are interdependent as the risk objective defines how high the client
can place the return objective

Objectives

 Risk objective.

To determine a risk objective, there are several steps:

o Specify a risk measure (or measures) such as standard deviation.

o Determine the investor's willingness to take risk.
 o Synthesize the investor's willingness and ability into the investor's
risk tolerance. Risk tolerance is affected by an individual's
psychological makeup, current insurance coverage, cash reserves,
family situation, age, current net worth and income expectations, etc.
Investment firms survey clients to gauge their risk tolerance.
o Specify an objective using the measure(s) in the first step above.
 Return objective.

To determine a return objective, there are several steps:

o Specify the return measure such as total nominal return.

o Determine the investor's stated return desire.
o Determine the investor's required rate of return.
o Specify an objective in terms of the return measure in the first step
above.

Constraints
The investor's risk and return objectives are set within the context of several
constraints.

 Liquidity.

Liquidity in the investment sense is the ability to quickly convert

investments into cash at a price close to their market value. Investors may
need some cash in excess of the contribution rate or the savings rate, but
they don't want to sell assets at unfavorable terms. This requirement may
stem from current income needs or from non-recurring needs and can be
met by cash-equivalents or by converting other assets into cash.

 Time horizon.

This is the time between making an investment and needing the funds.
Investment objectives and associated time horizons may be short-term,
long-term, or a combination of these two. There is a relationship between
an investor's time horizon, asset allocation, liquidity needs and the ability
to handle risk. Investors with long investment horizons generally require
less liquidity and can tolerate greater portfolio risk, and losses are harder
to overcome during a short time frame for investors with short investment
horizons.

 Tax concerns.

Investment planning is complicated by the tax code. For example, income

from dividends, interests and rents is taxable at the investor's marginal tax
 rate. Capital gains are only taxable after the asset has been sold for a price
higher than its cost or basis, but unrealized capital gains are not taxable at
all (the tax liability can be deferred indefinitely). Sometimes we have to
make a trade-off between taxes and diversification needs. Other factors,
such as tax deductible IRA contributions and 401(k) plans also complicate
this issue.

 Legal and regulatory factors.

Individual investors are generally not affected by regulations, but

professional and institutional investors need to be aware of regulations. For
example, a government agency may limit the uses of certain asset classes
in retirement portfolios.

 Unique needs and preferences.

There may be a number of unusual considerations that affects the investor's

risk-return profile. For example, investment requirements may depend on
goal spending. Thus, individuals will require adequate funds to be set aside
to meet known spending demands. Moreover, many investors may want to
exclude certain investments from the portfolio based on personal
preferences. For example, investors may specify that no investments in
their portfolio be affiliated with the manufacture or distribution of alcohol,
pornography, tobacco or environmental harmful products.

Q6.How do Bollinger bands work?

Bollinger Bands shows the levels of different highs and lows that a security price
has reached in a particular duration and also its relative strength, where highs are
near to the upper line and lows are near to lower line. In other words, the price
points near the edges of the ‘envelope’ formed can help us recognise a pattern at
a particular moment. The bandwidth widens and narrows depending on volatility.
If it’s high, the band would widen and if the volatility decreases, then the band
would narrow. These bands show oversold and overbought conditions in relation
to a selected time period moving average.

Bollinger Bands use W patterns to identify W-Bottoms when the second low is
lower than the first low but holds above the lower band. It occurs when a reaction
low forms close to or below the lower band. The price then pulls back towards
the middle band or higher and creates a new price low that holds the lower band.
Example of Required Rate of Return (RRR) Using the Dividend Discount Model
(DDM)
A company is expected to pay an annual dividend of $3 next year, and its stock
is currently trading at $100 a share. The company has been steadily raising its
dividend each year at a 4% growth rate.

 RRR = 7% or (($3 expected dividend / $100 per share) + 4% growth

rate)

Example of Required Rate of Return Using the Capital Asset Pricing Model
(CAPM)
In the capital asset pricing model (CAPM), RRR can be calculated using the beta
of a security, or risk coefficient, as well as the excess return that investing in the
stock pays over a risk-free rate (called the equity risk premium).

Assume the following:

 The current risk-free rate is 2% on a short-term U.S. Treasury.

 The long-term average rate of return for the market is 10%.

Let's say Company A has a beta of 1.50, meaning that it is riskier than the overall
market (which has a beta of 1).

To invest in Company A, RRR = 14% or (2% + 1.50 X (10% - 2%))

Company B has a beta of 0.50, which implies that it is less risky than the overall
market.

To invest in Company B, RRR = 6% or (2% + 0.50 X (10% - 2%))

Thus, an investor evaluating the merits of investing in Company A versus

Company B would require a significantly higher rate of return from Company A
because of its much higher beta.
 Preparation Platform for the Three
Levels of the CFA® Exam

3,000 Practice Questions for the CFA®

Exam – QBank, Mock Exams, and
Study Notes
August 13, 2020 in CFA® Program, FRM

Search
Sharpe Ratio, Treynor Ratio and Jensen’s Alpha
(Calculations for CFA® and FRM® Exams) Search...

Portfolio Performance Measures

Portfolio management involves a trade-off between risk and return. Most amateur Recent Posts
investors mistakenly focus only on the return aspect and lose sight of the risk taken
Tips to Make the Most of
to achieve the return. The portfolio performance measures are intended as metrics Your 300 Hours of CFA®
to compare different portfolios quickly. Like any financial ratio, these are not Exam Preparation
intended to be a one-stop answer to decide on a portfolio and should instead be used
in conjunction with other data points. The Best Study Strategies to
Get a CFA® Charter while
The measure themselves are quite different from one another in the way that they Working Full-time

measure the trade-off and how they define risk.

Use CFA® Mock test to
Sharpe Ratio Prepare for Your Exam

The Sharpe Ratio is defined as the portfolio risk premium divided by the portfolio
risk: What are the differences
between the Three Levels of
Return on the portfolio– Return on the risk-free rate
Rp – R
f
the CFA® Exam?
Sharpe ratio = =
Standard deviation of the portfolio σp

What is the CFA

The Sharpe ratio, or reward-to-variability ratio, is the slope of the capital allocation Institute Calculator
policy?
line (CAL). The greater the slope (higher number) the better the asset.

FRM® Study Platform

Note that the risk being used is the total risk of the portfolio, not its systematic risk,
which is a limitation of the measure. The portfolio with the highest Sharpe ratio has
the best performance, but the Sharpe ratio by itself is not informative. In order to
rank portfolios, the Sharpe ratio for each portfolio must be computed.

A further limitation occurs when the numerators are negative. In this instance, the
Sharpe ratio will be less negative for a riskier portfolio resulting in incorrect
rankings.
3,000 FRM® Practice Questions –
QBank, Mock Exams, and Study Notes
Example: Calculating the Sharpe Ratio     
A client has three portfolio choices, each with the following characteristics:
Video Series – Level I of the CFA®
Exam

Expected Return Volatility Beta

Introduction to the Level I CF
Portfolio A 15% 12% 10%

Portfolio B 18% 14% 11% 00:00 08:55

Portfolio C 12% 9% 5% Click here to access 40 hours of video

lectures.

The efficient market portfolio has an expected return of 20% and a standard FRM® Part 1 Video Series
deviation of 12%, and the risk-free rate of interest is 5%.
Risk Management: A Helicop
Based on the Sharpe ratio for each portfolio, the client should choose:

A. Portfolio A
00:00 37:06

B. Portfolio B

Click here to access 40 hours of FRM

C. Portfolio C
video lectures.

Solution
Preparation Platform for the Three
Levels of the CFA® Exam
The correct answer is B.

Rp –R
Return on the portfolio–Return on the risk-free rate f
Sharpe ratio = =
Standard deviation of the portfolio σp

15%−5%
Portfolio A’s Sharpe Ratio = = 0.83
12%

18%−5%
Portfolio B’s Sharpe Ratio = = 0.93
14%

12%−5%
Portfolio C Sharpe Ratio = = 0.77
9%

3,000 Practice Questions for the CFA®

The client should choose portfolio B as it gives the highest Sharpe ratio. Exam – QBank, Mock Exams, and
Study Notes

Type of Risks
The Sharpe Ratio defines the risk in terms of standard deviation, which is a measure
of total risk. Hence, it includes both systematic as well as unsystematic risk. The
next measures that we look at – Treynor Ratio and Jensen’s Alpha – define the risk
in a narrower way. In order to understand the applicability of the measure, we first
need to understand the different types of risks.

CAPM suggests that investors should hold the market portfolio and a risk-free asset.
The true market portfolio consists of a large number of securities, and it may not be
practical for an investor to own them all. Much of the non-systematic risk can be
diversified away by holding 30 or more individual securities. However, these
securities should be randomly selected from multiple asset classes. An index may
serve as the best method of creating diversification.

It is important to note that only non-systematic risk can be eliminated through the
addition of different securities into the portfolio. Systematic risk – the risk inherent
to the entire market – cannot be diversified away.

The systematic risk of a portfolio is denoted by Beta:

Covariance  between the security and the market Cov(Ri , Rm )

β = =
i
Variance of the Market 2
σ
m

Example: Calculating the Expected Return of a Security

Assume the risk-free rate is 2%, security has a correlation of 0.8 with the market
index and a standard deviation of 16% while the standard deviation of the market is
12%. If the market expected return is 8%, what is the expected return of the security?

A. 10.56%

B. 5.60%

C. 8.42%

Solution

The correct answer is C.

E(Ri ) = R + βi [E(Rm )– R ]
f f

Where

E(R )
i
 = the expected return of asset i over the holding period.
R
f
  = rate of return on the risk-free asset.

Rm = Expected market return over the holding period.

ꞵi = the Beta factor of the asset i.

Note that (Rm − Rf ) is the expected return per unit risk (beta) and ꞵi (Rm − Rf ) is
the expected return above the risk-free rate of return.

Step 1: Find the Beta

0.8×0.16×0.12
ꞵi = = 1.07
2
0.12

Step 2: Find the expected return

E(Ri ) = 2% + 1.07 × (8%– 2%) = 8.42%

Treynor Ratio
The Treynor ratio is an extension of the Sharpe ratio that, instead of using total risk,
uses beta or systematic risk in the denominator. As such, this is better suited to
investors who hold diversified portfolios.

Rp – R
Return on the portfolio– Risk-free rate f
Treynor ratio = =
Beta of the portfolio Bp

As with the Sharpe ratio, the Treynor ratio requires positive numerators to give
meaningful comparative results and, the Treynor ratio does not work for negative
beta assets. Also, while both the Sharpe and Treynor ratios can rank portfolios, they
do not provide information on whether the portfolios are better than the market
portfolio or information about the degree of superiority of a higher ratio portfolio
over a lower ratio portfolio.

Example: Calculating Treynor’s Ratio

A portfolio manager earned an average annual return of 12%. The beta of the
portfolio is 0.9, and the volatility of returns is 25%. The average annual return for
the market index was 14%, and the standard deviation of the market returns is 30%.
The risk-free rate is 5%. Calculate the Treynor measure for the portfolio.

A. 10.0%

B. 5.6%

C. 7.8%

Solution

The correct answer is C:

Formula:
 Rp – R
f

Bp

12% − 5%
= = 7.8
9%

Jensen’s Alpha
Jensen’s Alpha is based on systematic risk. The daily returns of the portfolio are
regressed against the daily returns of the market in order to compute a measure of
this systematic risk in the same manner as the CAPM. The difference between the
actual return of the portfolio and the calculated or modeled risk-adjusted return is a
measure of performance relative to the market.

¯ ¯ ¯ ¯
α = Rp − ( R + β (Rm − R ))
P f p f

If αp is positive, the portfolio has outperformed the market, whereas a negative
value indicates underperformance. The values of Alpha can also be used to rank
portfolios or the managers of those portfolios, with the Alpha being a
representation of the maximum an investor should pay for the active management
of that portfolio.

Example: Calculating Jensen’s Alpha

Two portfolios have the following characteristics:

Portfolio Return Beta

A 8% 0.7

B 7% 1.1

Given a market return of 10% and a risk-free rate of 4%, calculate Jensen’s Alpha for
both portfolios and comment which portfolio has performed better.

A. -0.2%  and -3.6% respectively; Portfolio A has performed better than Portfolio B.

B. -0.2% and -3.6% respectively; Portfolio B has performed better than Portfolio A.

C. 0.2% and 3.6% respectively; Portfolio B has performed better than Portfolio A.

Solution

The correct answer is A.

¯ ¯ ¯ ¯
Jensen’s alpha (αP ) = Rp − (R + βp (Rm − R ))
f f

Jensen’s Alpha for Portfolio A = 0.08– [0.04 + 0.7(0.1– 0.04)] = −0.002

Jensen’s Alpha for Portfolio B = 0.07– [0.04 + 1.1(0.1– 0.04)] = −0.036

Jensen’s Alpha is -0.2% and -3.6% for portfolios A  and B, respectively. A higher
Jensen’s Alpha (-0.2% in this case) indicates that a portfolio has performed better.
Also note that both portfolio managers have been unable to create Alpha, but the
manager of portfolio A has been not as bad as portfolio B’s manager.

Share:

Related Posts

November 30, 2018 in FRM by Mathieu

October 6, 2020 in CFA® Program by
Mathieu Valois
2021 CFA® Exams – New Exam Dates
and Registration Fees
Whether affected or infected, it is
indisputable that the COVID-19 brought with
it...
Valois
Central Counterparties
Central counterparties, also known as CCPs,
protect market participants from counterparty
/credit/default risk...

AnalystPrep
 

Trusted by thousands of CFA and FRM candidates each year

Products Company Resouces

CFA Level I About Us Exam P Study Notes

CFA Level II FRM Study Notes

 y
Contact Us
CFA Level III CFA Study Notes
FAQ
FRM Part I AnalystPrep Login
Privacy
FRM Part II GARP
Terms
SOA – Exam P CFA Institute

©AnalystPrep. All Rights Reserved

CFA Institute does not endorse, promote or warrant the accuracy or quality of AnalystPrep. CFA® and Chartered Financial Analyst® are
registered trademarks owned by CFA Institute.