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formulate buying and selling strategies. With the help of many indicators we can predict the
price volume and demand supply of the stocks.
Assumptions:
Dow theory
Based on Hypothesis
According to this theory the trend are divided into primary, intermediate and short term trend. The
primary trend is upward or downward movement last for a year or two. The intermediate trends are
corrective movements, which may last for three weeks to three months. The short term refers to the day to
day price movement. It is also known as oscillators or fluctuations.
Primary Trends:
1. The security price trend may be either increasing or decreasing. When the market exhibit the
increasing trend it is called bull market. The bull market shows three clear cut peaks. Each peak is
higher than the previous one.. The bottoms are also higher then the previous ones.
• Loss of hopes
• Recession phase
• Distress selling.
Secondary Trends:
The secondary trends are the Immediate trends moves against the main trends and leads to correction. In
the bull market the secondary trends would result in fall of about 33-66% of the earlier rise.
Intermediate trends correct the overbought and oversold condition. It provide the breathing condition to
the market. Compared to the primary trend, secondary trend is swift and quicker.
Minor Trend-
Minor trend or tertiary moves are called as random wriggles. They are simply the daily price fluctuations.
Minor trends tries to correct the secondary trend movement. It is better for the investors to concentrate
on the primary and secondary trends.
The efficient market hypothesis (EMH) is an investment theory that states it is impossible to
"beat the market" because stock market efficiency causes existing share prices to always
incorporate and reflect all relevant information. According to the EMH, stocks always trade at
their fair valueon stock exchanges, making it impossible for investors to either
purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible
to outperform the overall market through expert stock selection or market timing, and the only
way an investor can possibly obtain higher returns is by purchasing riskier investments.
1. Weak-Form EMH
The weak-form EMH implies that the market is efficient, reflecting all market information. This
hypothesis assumes that the rates of return on the market should be independent; past rates of
return have no effect on future rates. Given this assumption, rules such as the ones traders use to
buy or sell a stock, are invalid.
2. Semi-Strong EMH
The semi-strong form EMH implies that the market is efficient, reflecting all publicly available
information. This hypothesis assumes that stocks adjust quickly to absorb new information. The
semi-strong form EMH also incorporates the weak-form hypothesis. Given the assumption that
stock prices reflect all new available information and investors purchase stocks after this
information is released, an investor cannot benefit over and above the market by trading on new
information.
3. Strong-Form EMH
The strong-form EMH implies that the market is efficient: it reflects all information both public
and private, building and incorporating the weak-form EMH and the semi-strong form EMH.
Given the assumption that stock prices reflect all information (public as well as private) no
investor would be able to profit above the average investor even if he was given new
information.
CAPITAL ASSET PRICING MODEL-A model that describes the relationship between risk
and expected return and that is used in the pricing of risky securities.
The model was introduced by Jack Treynor, William Sharpe, John Lintner and Jan Mossin
independently, building on the earlier work of Harry Markowitz on diversification
and modern portfolio theory
The general idea behind CAPM is that investors need to be compensated in two ways: time value of
money and risk.
Assumptions-
Can lend and borrow unlimited amounts under the risk free rate of interest
Individuals seek to maximize the expected utility of their portfolios over a single period planning
horizon.
Assume all information is available at the same time to all investors
The market is perfect: there are no taxes; there are no transaction costs; securities are completely
divisible; the market is competitive.
Investors will always combine a risk free asset with a market portfolio of risky assets.Investors
will invest in risky assets in proportion to their market value..
Investors can expect returns from their investment according to the risk. This implies a liner
relationship between the asset’s expected return and its beta.
Investors will be compensated only for that risk which they cannot diversify. This is the market
related (systematic) risk.
CAPITAL MARKET LINE-Capital market line depicts the risk return relationship for efficient
portfolios. It serves two functions:
It shows that the appropriate measure of risk for an efficient portfolio is the standard deviation of
return on the portfolio.
SECURITY MARKET LINE- SML is the graphic depiction of CAPM and describes the market price of
risk in capital markets.SML shows the expected return and beta relationship and is depicted by the
following equation:
E(ri)= rf+B(rm-rf)
Expected return= Risk free return+ (Beta*Risk premium of market)
VALUE OF BETA- β= 1
β <1
β>1
For example, if a stock's beta is 1.2, it's theoretically 20% more volatile than the market.
The APT states that if asset returns follow a factor structure then the following relation exists
between expected returns and the factor sensitivities:
where
That is, the expected return of an asset j is a linear function of the asset's sensitivities to
the n factors.
In the APT context, arbitrage consists of trading in two assets – with at least one being mispriced.
The arbitrageur sells the asset which is relatively too expensive and uses the proceeds to buy one
which is relatively too cheap.
Under the APT, an asset is mispriced if its current price diverges from the price predicted by the
model. The asset price today should equal the sum of all future cash flows discounted at the APT
rate, where the expected return of the asset is a linear function of various factors, and sensitivity to
changes in each factor is represented by a factor-specific beta coefficient.
When the investor is long the asset and short the portfolio (or vice versa) he has created a position
which has a positive expected return (the difference between asset return and portfolio return) and
which has a net-zero exposure to any macroeconomic factor and is therefore risk free (other than for
firm specific risk). The arbitrageur is thus in a position to make a risk-free profit.