305 (Security Analysis and Portfolio Management)

SECURITY ANALYSIS
AND
PORTFOLIO MANAGEMENT
MCM - 205
Master of Commerce (M.Com.)

(Distance Mode)
Centre for Distance and Open Learning

Jamia Millia Islamia
New Delhi-110025
EXPERT COMMITTEE
Prof. Talat Ahmad Prof. M. Mujtaba Khan

Patron Officer on Special Duty, CDOL
Vice-Chancellor,
Prof. Mohammad Miyan Mr. Prashant Negi

Hony. Chief Advisor, CDOL, Hony. Jt. Director, CDOL
Founder Director, CDOL
Prof. Y.P. Singh Dr. Arvind Kumar

Department of Commerce, Hony. Jt. Director, CDOL
University of Delhi
Prof. K.V. Bhanu Murthy Dr. Pooja Talwar

Department of Commerce, Shaheed Bhagat Singh College,
University of Delhi University of Delhi
Prof. Attam Prakash Dr. Sunayana

Indian Institute of Foreign Trade Centre for Management Studies,
Dr. Ritu Sapra

Department of Commerce,
University of Delhi
PROGRAMME COORDINATOR
Mr Sarfaraz Nawaz Khan, CDOL, Jamia Millia Islamia
COURSE WRITERS
Prof. Arun Babbar, Head (Academics and Research), International College of Financial Planning
(ICoFP), New Delhi
(Unit 1)
Dr Punithavathy Pandian, Emeritus Professor-UGC, School of Business Studies, Madurai Kamaraj
University, Madurai
Units: (3.2, 4.1, 4.3-4.8, 5, 7.1, 7.3-7.8, 9, 10.1, 10.3-10.10, 11, 12, 13.4, 15, 16)
Paulomi M Jindal, Freelance Author
Units: (2, 3, 4.2, 6, 7.2, 8, 10.2, 13.1-13.3, 13.5-13.9, 14)
All rights reserved. Printed and published on behalf of the CDOL, Jamia Millia Islamia by Vikas® Publishing House, New Delhi
August, 2017
ISBN: 978-93-5259-430-6
All rights reserved. No part of this book may be reproduced in any form or by any means, electronic or mechanical, including
photocopying, recording or by any information storage or retrieval system, without permission in writing from the CDOL,
Jamia Millia Islamia, New Delhi.
Cover Credits: Anupama Kumari, Faculty of Fine Arts, Jamia Millia Islamia
SYLLABI-BOOK MAPPING TABLE
Security Analysis and Portfolio Management
Syllabi Mapping in Book
Block I An Overview of Investment Unit-1: Investment Analysis: Nature and Scope

(Pages 3-38);
Unit-2: Approaches to Investment Analysis
(Pages 39-54);
Unit-3: Concept of Return and Risk
(Pages 55-68);
Unit-4: Security and Risk Analysis
(Pages 69-94)
Block II Securities Market in India Unit-5: Functions and Methods of Selling

Securities in Primary and Secondary Market
(Pages 97-138);
Unit-6: Broker: Importance, Types and Role
(Pages 139-158);
Unit-7: Trading Mechanism and Listing of
Securities in Stock Exchange
(Pages 159-194)
Block III Analysis for Equity Investment Unit-8: Depository Act, 1996
(Pages 197-210);
Unit-9: Valuation of Securities: Bonds,
Debentures, Preference and Equity Shares
(Pages 211-232);
Unit-10: Fundamental Analysis
(Pages 233-262);
Unit-11: Technical Analysis
(Pages 263-296);
Unit-12: Efficient Market Hypothesis
(Pages 297-318)
Block IV Portfolio Theory Unit-13: Portfolio Analysis

(Pages 321-338);
Unit-14: Effects of Combination of Securities
(Pages 339-354);
Unit-15: Capital Market Theory
(Pages 355-378);
Unit-16: Portfolio Performance Evaluation
(Pages 379-396)
CONTENTS
BLOCK-I : AN OVERVIEW OF INVESTMENT
UNIT 1 INVESTMENT ANALYSIS: NATURE AND SCOPE 3-38

1.1 Introduction
1.2 Nature of Investment Management
1.3 Scope of Investments
1.4 Types of Investments
1.5 Summary
1.6 Key Words
1.7 Answers to ‘Check Your Progress’
1.8 Self-Assessment Questions
1.9 Further Readings
UNIT 2 APPROACHES TO INVESTMENT ANALYSIS 39-54

2.1 Introduction
2.2 Approaches to Investment Analysis: An Introduction
2.3 Methodologies of Investment Analysis
2.4 Summary
2.5 Key Words
UNIT 3 CONCEPT OF RETURN AND RISK 55-68

3.1 Introduction
3.2 Return and Risk
3.3 Diversification
3.4 Summary
3.5 Key Words
UNIT 4 SECURITY AND RISK ANALYSIS 69-94

4.1 Introduction
4.2 Security Analysis
4.3 Risk Analysis
4.4 Summary
4.5 Key Words
BLOCK-II : SECURITIES MARKET IN INDIA
UNIT 5 FUNCTIONS AND METHODS OF SELLING SECURITIES

IN PRIMARY AND SECONDARY MARKET 97-138
5.1 Introduction
5.2 Primary Market
5.3 Secondary Market
5.4 Summary
5.5 Key Words
UNIT 6 BROKER: IMPORTANCE, TYPES AND ROLE 139-158

6.1 Introduction
6.2 Understanding the Role Performed by Brokers
6.3 Stockbroker-Client Relation
6.4 Summary
6.5 Key Words
UNIT 7 TRADING MECHANISM AND LISTING OF SECURITIES IN

STOCK EXCHANGE 159-194
7.1 Introduction
7.2 Trading Mechanism
7.3 Listing of Securities in Stock Exchange
7.4 Summary
7.5 Key Words
BLOCK-III : ANALYSIS FOR EQUITY INVESTMENT
UNIT 8 DEPOSITORY ACT, 1996 197-210

8.1 Introduction
8.2 Need and Role of Depository Act
8.3 Dematerialisation Process
8.4 Summary
8.5 Key Word
UNIT 9 VALUATION OF SECURITIES: BONDS, DEBENTURES,
PREFERENCE AND EQUITY SHARES 211-232
9.1 Introduction
9.2 Bonds
9.3 Debentures
9.4 Preference Shares
9.5 Equity Shares
9.6 Summary
9.7 Key Words
UNIT 10 FUNDAMENTAL ANALYSIS 233-262

10.1 Introduction
10.2 Trends in Fundamental Analysis
10.3 Indicator
10.4 Indices
10.5 Moving Average
10.6 Summary
10.7 Key Words
UNIT 11 TECHNICAL ANALYSIS 263-296

11.1 Introduction
11.2 Technical Analysis: An Introduction
11.3 Candlestick Chart
11.4 Summary
11.5 Key Words
UNIT 12 EFFICIENT MARKET HYPOTHESIS 297-318

12.1 Introduction
12.2 Market Efficiency
12.3 Market Inefficiencies
12.4 Summary
12.5 Key Words
BLOCK-IV : PORTFOLIO THEORY
UNIT 13 PORTFOLIO ANALYSIS 321-338

13.1 Introduction
13.2 Simple Diversification
13.3 Markowitz Model: Estimating Rate of Return and Standard Deviation of Portfolio
13.4 Traditional and Modern Approach
13.5 Summary
13.6 Key Words
UNIT 14 EFFECTS OF COMBINATION OF SECURITIES 339-354

14.1 Introduction
14.2 Combination of Securities
14.3 Utility Analysis
14.4 Summary
14.5 Key Words
UNIT 15 CAPITAL MARKET THEORY 355-378

15.1 Introduction
15.2 Capital Asset Pricing Model (CAPM) Theory
15.3 Arbitrage Pricing Theory
15.4 Summary
15.5 Key Words
UNIT 16 PORTFOLIO PERFORMANCE EVALUATION 379-396

16.1 Introduction
16.2 Mutual Fund
16.3 Treynor’s Performance Index
16.4 Summary
16.5 Key Word
16.6 Answers to ‘Check Your Proress’
Investment Analysis:
Nature and Scope
BLOCK-I
AN OVERVIEW OF INVESTMENT
This block provides a basic introduction to the nature of investment management and its
various aspects. It also discusses the nature and scope of investment analysis, its various
approaches to investment analysis and the concept of return and risk.
The first unit provides an in-depth understanding of the nature of investment management.
The meaning of investment, the scope and types of investment are also further explained in
detail in the unit. This unit comprehensibly discusses the various aspects and features of
securities, commodities, real assets, contractual and intangible assets and currencies.
The second unit provides an introduction to the various approaches to investment analysis.
The unit assesses the methodologies involved in investment analysis such as top-down
approach and bottom-up approach. An overview of fundamental analysis, financial analysis,
ratio analysis, technical analysis is also discussed in the unit. It also gives a brief introduction
to random walk theories and Dow theory which will be discussed in detail in the coming
units.
The third unit analyses the concept of return and risk and elaborates on the risk return trade-
off. Diversification, concept of rupee cost averaging and technique of asset allocation are
also discussed.
The fourth unit presents an account of security analysis and risk analysis. It assesses the
measures and computation of systematic and unsystematic risk along with an elaborate
explanation of the different types of risks such as market risk, interest rate risk, business risk
and financial risk. The unit further elucidates risk measurement, standard deviation,
characteristic regression line and beta.
1
Nature and Scope
2
Nature and Scope
UNIT–1 INVESTMENT ANALYSIS: NATURE AND SCOPE
Objectives
After going through this unit, you will be able to:
 State the meaning of investment
 Discuss the nature of investment
 Summarize the scope of investment
 Give examples of different types of investments
Structure
1.1 Introduction
1.2 Nature of Investment Management
1.3 Scope of Investments
1.4 Types of Investments
1.5 Summary
1.6 Key Words
1.1 INTRODUCTION
Why must we invest? Investment is relatively painless, and its rewards are abundant.
You want to invest in order to create wealth. Investment is the best way to secure
your future. In this world, there are two ways to earn income; one is to exchange
your labour for money (offering your service to some person/organization) and the
other is to make use of the money you possess to earn more money (investing your
saved money). Investment means putting money to work to earn more money. By
investing, you will have a lot more money for leading a comfortable post-retirement
life, providing quality education to your children, fulfilling your social obligations, etc.
You could pass on your wealth to the next generation.
Almost all of us save a part of our earnings for the future. The money that we
earn with all the hard work should work even harder to make more money for us.
Our savings are invested in various ways, such as in banks, in shares, in bonds, in
metals, in land and properties and in insurance. The form of investment depends
upon the risk (there is always some risk involved when you invest) and return
3
Nature and Scope
associated with it and with the attitude of the investor/s. It also depends upon the
purpose for which such investments are made.
1.2 NATURE OF INVESTMENT MANAGEMENT
Investment is the employment of funds on assets with the aim of earning income or
capital appreciation. Investment has two attributes, namely time and risk. Present
consumption is sacrificed to get a return in the future. The sacrifice that has to be
borne is certain but the return in the future may be uncertain. This attribute of
investment indicates the risk factor. The risk is undertaken with a view to reap some
return from the investment. For a layman, investment means some monetary
commitment. For example, a person’s commitment to buy a flat or a house for his
personal use may be an investment from his point of view. This cannot be
considered as an actual investment as it involves sacrifice but does not yield any
financial return.
Meaning of Investment
Investments may be defined as a commitment of one’s money in one or more of
asset classes in anticipation of some gains while simultaneously bearing risk of
uncertainty. To the economist, investment is the net addition made to the nation’s
capital stock that consists of goods and services that are used in the production
process. A net addition to the capital stock means an increase in the buildings,
equipments or inventories. These capital stocks are used to produce other goods
and services.
Financial investment is the allocation of money to assets that are expected to
yield some gain over a period of time. It is an exchange of financial claims such as
stocks and bonds for money. They are expected to yield returns and experience
capital growth over the years.
The financial and economic meanings are related to each other because the
savings of the individual flow into the capital market as financial investments, to be
used in economic investment. Even though they are related to each other, we are
concerned only about the financial investment made on securities.
Secure investment, gambling and speculation

Following qualities are essential for a commitment to be known as a ‘secure
investment’:
4
Nature and Scope
 It expects gains while bearing associated risks.

 It is based upon thorough analysis.
 It has a high degree of security of returns and principal.
On the basis of aforementioned properties, you can differentiate gambling from
investing. Gambling would refer to a commitment when following properties exist:
 It expects gains while bearing associated risks
 It is not based upon analysis.
 It does not ensure any safety and surety of principal and return.
Similarly, there are speculative investments that can be termed as a commitment of
money when:
 There are expectations of gains while bearing associated risks.
 Thorough analysis is involved.
 There is no safety and surety of principal and return.
Example 1.1:
Categorize the following activities into secure investment, gambling and speculation.
1. Investment in a fixed coupon government security after thorough analysis
2. Investment in a bank’s fixed deposit after thorough analysis of bank’s
financials
3. Investment in gold bullion after thorough analysis
4. Investment in common equity stocks after thorough analysis
5. Investment in preference shares after thorough analysis
6. Investment in a residential or commercial real estate without thorough
analysis
7. Betting on horse racing
Solution:
1. Since it possesses qualities such as expectation of gain, safety and analysis,
it can be termed as secure investment.
2. Same as answer for 1.
3. This investment possesses properties such as expectation of returns and
risk; thorough analysis is involved; there is no safety of principal and
returns. Thus, it can be considered as a speculative investment.
5
Nature and Scope
4. Same as answer for 3.

5. Preference shares command reasonably high degree of safety in returns and
principal. Hence, they can be considered as secure investment.
6. Since there is no inherent safety of principal and no analysis is involved, it
can be considered as a ‘gambling’. Having said that, it does not mean that
there is no possibility of returns, there could be, but at the cost of high risk.
As per common experience, it can be inferred that most residential
investments fall in this category because investors either do not possess the
ability to analyse or turn a blind eye to it.
7. This action is surely considered a gambling activity. It depends on how
skilled the gambler is.
Analytical reference 1
Table 1.1 shows the average returns of investment classes, such as equities, gold and
government securities and short term bills in US markets over a fairly long period of time.
Table 1.1 Analysis of US Markets (1928 - 2011)
Time Average Chances of making a

Horizon Returns loss
1 Year 10.81% 29%
3 Year 11.04% 17%
5 Year 11.37% 12%
7 Year 11.52% 6%
10 Year 11.80% 5%
15 Year 12.25% 1%
20 Year 12.19% 0%
Observations
 Table 1.1 shows the returns attributable to time horizon and associated risk
of making a loss.
 Probability of making a loss with 1 year horizon was 29% whereas with 15
years horizon the same probability reduces to 1%.
 What is not so obvious is that average returns also increase with the time
horizon, though not so significantly.
Conclusions
 It can be concluded that investors having long term horizon in equity market
almost never suffered a loss in USA.
6
Nature and Scope
 A longer time horizon, while making investments, can reduce risk without
adversely affecting returns.
Analytical reference 2
The data of returns of four major asset classes in the US is given in Table 1.2.
Table 1.2 Analysis of Returns in USA 1968-2011
Treasury Government
Gold Equity Bills Securities
Geometric Mean Return (%) 10.35 8.26 5.02 6.68
Arithmetic Mean Returns (%) 11.49 10.76 5.43 8.03
Risk (%) 27.65 17.55 3.08 9.78
Source: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histret.html
Observations
 Gold and Equity are said to be riskier assets than T-Bills and G-Secs, the
same is being reflected here.
 As per data above Gold has been riskiest of all and T-Bills the safest.
 Risk and return are in perfect tandem with each other since the riskiest
asset (gold in this case) earned the highest returns and safest investment (T-
Bills in this case) earned the lowest returns.
Conclusions
 In long run, more risky asset classes are awarded with more returns and
vice versa.
Nature of Investments
Nature of an investment primarily depends on its type. However, there are some
standard characteristics always worth understanding before making an investment
decision.
1. Returns
Utility of an investment is calculated primarily on the basis of returns it generates.
Returns can accrue in any of the two forms, capital gains or income. Capital gains
refer to appreciation in prices of securities whereas income may comprise sources
such as dividends, interest or bonus etc.
Every investor is concerned about the future returns that he can expect during
the course of investment. Such returns are termed as expected returns from an
7
Nature and Scope
investment and are symbolized by E(R). It is very obvious that investors expect
higher returns from an asset that they perceive as more risky. Hence E(R) and risk
go hand in hand.
You might argue why E(R) is more important than past returns. Would you invest
money in an investment say ‘X’ that has generated phenomenal returns in past and is
likely to incur a loss in future, or investment say ‘Y’, that has generated loss in past
but is likely to generate phenomenal returns in future? Every rational investor would
choose Y if such crucial facts about future are already known.
In case of secure investments such as Bank Deposits, T-Bills or government
securities, it is very easy to estimate expected returns, as it is contractual and
mentioned well in advance. However in case of speculative investments such as
equity shares, commodities, or real estate etc., where expected return is not
guaranteed by issuer, it is not so easy to estimate it.
Return estimates made on the basis of rigorous amount of research and analysis
can provide a lot of guidance but these cannot be 100% accurate. The process is
still important and is considered as basic hygiene in the process of investment
making. Accuracy however depends upon the efficiency and experience of analyst.
2. Risk
In layman’s terms, the term ‘risk’ is the potential that a selected action or activity will
result in a loss. It is the likelihood of loss or less-than-expected returns. It is often
ignored trait of an investment. For example, in 2008, the world was swept by a
crisis called the ‘sub-prime crisis’, arising out of lending loans to borrowers who
were unqualified for the same or who did not have the capacity to repay. Similarly,
in the European Crisis of 2011-12, the countries of the continent are struggling since
2009 to repay the debts they have built up in recent decades. These crises are
classic examples of risk being ignored or at least underestimated.
Thus, in the present day financial world, it is important for an investment
manager to fairly assess various risk factors and their implications on the portfolio
returns.
There are various techniques of quantifying financial risk of a security, though we
shall talk about the most commonly accepted version, Standard Deviations in
returns of an asset. Before we further study this commonly heard term, let’s refer to
graphs below and comment which one looks to be more risky.
8
Nature and Scope
Meaning of standard deviation

A casual survey itself can reveal that a significant majority of people find stock
returns in chart-2 to be more risky than that of chart-1. It can be explained by the
fact that chart-2 is more volatile than chart-1, which means stock returns can easily
swing in any direction, including losses. The same essence of fluctuations is captured
in the statistics known as standard deviation.
Refer to another example. In both the charts that follow, a regression line is
drawn on the basis of past 30 year returns. You, as an analyst, are supposed to
predict the returns of the 40th return. In which case would you be more confident in
predicting future returns, chart-1 or chart-2?
Right answer should be chart-2, because the data points are more concentrated
around regression line, or in other words ‘standard deviation’ is lower.
Hence, it is important to study pattern of risk by studying standard deviations of
past returns.
3. Relationship with existing assets in investment portfolio

Many investors ignore this aspect of investment alternatives; however it is
mathematically proven as most important factor in determination of overall portfolio
9
Nature and Scope
risk. To put it in a simple manner, if new investment alternative is very different from
existing portfolio, it provides good diversification to portfolio. A diversified portfolio
is always safer because it is not dependent only upon one investment to generate
returns.
It can as well be mathematically expressed. If an investment is very different
from existing portfolio, it means that the correlation between the two is low or
even negative. In such cases the risk of the portfolio falls if risk is measured by
volatility in new portfolio returns.
Remember coefficient of correlation ranges from +1 to -1. Any correlation of
less than +1 between the returns two securities would simply mean that both
securities are presumably different from each other and diversification is possible.
However the extent of difference depends upon magnitude of correlation. A
correlation of -1 may imply that both securities are perfectly different from each
other. Such case is supposed to be the best case for portfolio diversification.
Remember correlations between any two securities would be obviously low if both
are affected by different economic set of factors or differently by same set of
economic factors.
Table 1.3 and Figure 1.1 elaborate upon this concept.
Table 1.3 Coefficient of Correlation
Correlation: Interpretation of Scope of Scope of

(between returns Relationship Diversification Risk
of two securities (between A and B) Reduction
A and B)
+1 Exact similarity NIL NIL
+0.70 to +0.99 Little Difference Little Little
+0.30 to +0.69 More Difference Good Good
0 to +0.29 Significant Difference Great Great
-0.50 to 0 . Little Opposite Excellent Excellent
-0.51 to -0.99 Quite Opposite Fantastic Fantastic
-1 Exact Opposite Perfection Maximum

Scope
Figure 1.1 shows graphically how two assets that are opposite of each other and
have perfectly negative correlation can reduce overall portfolio risk to zero.
10
Nature and Scope
Fig. 1.1 Pattern of Security Returns
In Figure 1.1, both securities, A and B, are perfectly negatively correlated. As a

result the returns of both securities move in opposite direction with respect to their
individual means. The straight line drawn between returns of A and B are their
respective mean returns. Note both assets are generating positive returns during the
whole period and yet bear a correlation of -1 solely due to pattern of returns.
An intelligent investment manager, who had foreseen such relationship, combined
both the assets in a proportion of 50:50 and created a portfolio called P. Portfolio P
has ZERO risk because there is no volatility in returns and investor can enjoy
consistent positive returns throughout.
One might argue that average return of portfolio P is lesser than security A, no
wonder it is a valid statement. An important question arises: how to decide whether
new asset should be added to the portfolio?
If the following condition is satisfied, you must add the new investment to the
portfolio:
(Sharpe Ratio of Existing Portfolio P) > (Sharpe ratio of new asset N) ×
(correlation (P,N))
Where:
 Sharpe Ratio = [ E(R)j – Risk Free Rate ] ÷ standard deviationj
o Risk Free rate = Return on risk free treasury bills
o E(R)j = Expected returns of security J
o Standard deviation j = Measure of volatility in returns of asset J. The
standard deviation term symbolizes the risk of asset J
11
Nature and Scope
4. Liquidity
Next important trait of an investment to be observed is ‘how easily an investment
can be converted into cash at prevailing market prices’ (also known as
conversion at fair value).
If an investment can be easily sold without causing its prices to significantly
change as a result, it is said to be liquid in nature. Example of the most liquid asset
is foreign currencies that have one of the most liquid markets of all other asset
classes.
However stock markets in general are considered to be liquid, it has got
limitations either when the order size is huge or there is a small unknown company
with thin trading at exchange. In both the situations, it will be difficult to convert a
stock in cash without causing the share prices to fall.
For example one might never find it difficult to liquidate shares worth ` 5 crores
in a company like TCS Ltd at prevailing market prices of ` 1264, however if it was
a trade of ` 200 crores, surely the prices would have crashed as a result of selling
pressure.
In certain cases liquidity is simply not there because there is a restriction on
selling the investment or a lock-in. For example, a close ended mutual fund could
not be redeemed before end of generally 3 years from the date of purchase.
Similarly, some companies issue shares to its key employees and restrict sales for a
particular period of time. A smart investor can protect herself from wild movement in
security’s prices even in such cases by simply using derivative contracts where you
can create a short position using futures/forwards or even options.
Example 1.2:
Categorize the following investment options in grades from A to E, A being most
liquid and E being least, on the basis of your common understanding about them:
1. Foreign Currencies
2. Small Cap Shares (shares of smaller companies)
3. Large Cap Shares (shares of bigger companies)
4. Gold
5. Privately held shares of unlisted companies (a.k.a. Private Equity)
6. Real Estate
7. Government Securities
12
Nature and Scope
Solution:
1. Foreign Currencies: A
2. Small Cap Shares: C
3. Large Cap Shares: A
4. Gold: A
5. Private Equity: E
6. Real Estate: D
7. Government Securities: A
5. Transaction costs
Some investment strategies completely fail because of very high transaction costs
involved. This is an important trait that cannot be ignored.
Transaction cost is any expense, paid directly or indirectly, for sale or
purchase of a security. It can be paid directly in the form of commissions,
brokerages, consultancy fee, recurring charges, transaction taxes etc. It can also be
paid indirectly, what many investors do not realize, in form of bid-ask spread,
market impact cost etc.
Before we understand Bid-Ask spread, let’s understand that bid is the buying
price and ask is the selling price of a security. Hence Bid-Ask spread refer to the
difference between price at which the same security can be bought and sold at the
same time.
Take an example of an auto dealer who buys and sells second hand vehicles.
Assume that you sold your 3 year old luxury car, after much negotiation, at ` 4 Lacs.
The next day you are passing by and observe that the dealer is selling the same car
at ` 6.5 Lacs. This difference of ` 2.5 lacs is essentially paid out of your pocket
only, in form of opportunity cost. It should be considered as part of transaction cost.
In the world of stock markets, bid-ask spread is specifically defined as the
difference between highest bid and lowest ask for a share.
Market Impact cost is another form of indirect transaction cost. It refers to the
change in price of a security solely because of your action of buy or sell of this
security. If price of a security falls because you are selling it or rises because you are
buying it, it is essentially increasing your cost, hence is referred to as transaction cost.
You would notice that transaction cost depends heavily on the fact that how
liquid a security is. A thinly traded security will lead to high bid-ask spread and
13
Nature and Scope
market impact cost and vice versa. Moreover, brokers charge more commission for
transacting an illiquid asset such as private equity, real estate etc.
6. Taxation
As discussed earlier, investments can generate returns in two forms, capital gains or
income. Investment returns in any form could be subject to taxes; however it is
generally observed that different countries treat either of capital gains and investment
more favourably than the other.
In India, it is generally the capital gains that get favourable tax treatment. For
example, long term capital gain is completely tax exempt in case of listed shares.
However interest on a 3 year FD for example, should be subject to taxation at
marginal tax rate as per current income tax laws.
Smart investment manager not just manages portfolio allocations, but also the tax
incidence within all legitimate boundaries. For example, one may choose to invest in
low dividend paying stocks if dividends were taxable (in India, dividends are tax free
in the hands of an investor) or that one may choose to defer selling an investment by
few more days or months in order to attract LTCG tax in place of STCG tax which
is higher.
Check Your Progress - 1
1. What is financial investment?

................................................................................................................
................................................................................................................
................................................................................................................
2. What are speculative investments?

................................................................................................................
................................................................................................................
................................................................................................................
3. What are transaction costs?

................................................................................................................
................................................................................................................
................................................................................................................
14
Nature and Scope
1.3 SCOPE OF INVESTMENTS
History of making investments traces back to human existence when it first

developed tools and equipment to hunt or survive. One of the most rewarding
investments in early stages was in lives stocks that had regular income generating
capacity.
In financial context, investments have enormous scope today and options range
from direct business investments, equities, and fixed income to structured derivatives
with highly innovative and customized pay off pattern.
Financial markets, recently, have witnessed a spur in creation of variety of
innovative instruments around the world. The main causes behind such a growth in
universe of financial instruments are economic growth, deregulation of financial
markets, spread of financial education and globalization of world economies.
However, the developing markets such as India lag in this race of financial
innovation and advancement primarily due to tight control over financial markets.
Lack of innovation and tight control is not a pure curse though; it has saved India
many times from the external global shocks. The 2008 financial crisis in US is also
attributed to innovative financial instruments that went bad in tough times.
India has still seen a steady and stable growth and innovation in markets for
financial instruments and various new products are being launched every year. One
reason behind such natural growth is the robust savings and investment rate that
India has. As we all know that investments are a vehicle that channelizes savings
into productive avenues, a high savings culture has led to high scope for
investments. Figure 1.2 compares India’s standing vis-a-vis other regions.
Fig. 1.2 Average Savings Rate in Major Countries since 2001

Source: data.worldbank.org
15
Nature and Scope
Scope of Investment Alternatives

Investments can have a really wide range of possible categories. Let us discuss some
perspectives to categorize the huge range of investment alternatives:
1. Tangibility Perspective (Real and Financial Investments)

Real investments are the tangible ones that can be touched and felt for example real
estate, commodities and gold, art collection etc. Apart from financial utility, that is,
return on investment, these investments can have a usage utility for investors. Such
as, a house can be used to live, gold can be used in creation of jewels and art can
be used in decoration.
Financial investments are generally intangible investments and have only a legal
existence. For example; common equity shares, preference shares, government
securities, bonds etc. Major attraction of investing in such assets is to generate higher
returns on investment.
It is worth noting that real investments always have a psychological edge over
financial investments because owner feels a tangible ownership. However such
mentality can at times lead to overpricing of real investments. Nevertheless, they offer
huge diversification to portfolio and help in mitigating risk.
2. Economic and Financial Investments perspective

Economics define investments as such commitments of money that further enhance
income generating capacity of an economy and examples typically include capital
goods such as roads, bridges, dams and other infrastructure investments. A direct
investment in business, IPO or any other primary market investment is also a part of
this definition.
Whereas financial investments additionally include the secondary market
investments that are merely an exchange of money from one hand to the other, such
as purchase of shares or bonds in secondary market.
3. Risk perspective (Fixed return vs Variable return)

Many investments have imbibed feature of guaranteed returns, such as fixed coupon
bonds, fix deposits and government securities.
Whereas others do not have such surety of returns, for example, variable coupon
bonds, shares, gold, real estate, etc.
You cannot interpret that fixed return investments are risk free in nature because
there could be a risk of default from the counter party that is guarantying such
16
Nature and Scope
returns, for example a bank might very well commit default when fixed deposits
mature if bank has suffered huge losses on the loans it granted further.
4. Return perspective (Growth vs Income)

As discussed earlier as well, returns to an investor can accrue in two ways,
appreciation of capital or income from investments.
Growth oriented investments are the ones that generate returns (or losses)
through appreciation (or depreciation) of prices. Gold, business investment or shares
of small companies are some of the examples.
Income oriented investments provide regular or random income to the investor in
form of interest, coupons dividends etc. Bonds, government securities and shares of
relatively mature companies are some examples of this category.
You would notice that most investments are hybrid property of generating
income and capital appreciation coexist simultaneously. Equity shares of large and
mature companies generally declare regular dividends and their prices appreciate
over time. Not so intuitive, but true that a bond that is generally known for its regular
income property can appreciate over time if its credit rating improves or if general
market’s interest rates fall.
Example 1.3:
Categorize the following investments as either growth oriented or income oriented or
hybrid:
1. Real Estate
2. Gold
3. Interest paying Fix Deposit scheme
4. Pension Fund
5. Preference shares
Solution:
1. Real Estate: Hybrid because of rental income as well as value
appreciation
2. Gold: Pure growth oriented since there is no income component
3. Interest paying Fix Deposit scheme: Pure income oriented since there
is no secondary market price
4. Pension Fund: Pure income oriented since there is no secondary market
price
5. Preference shares: Hybrid because it can appreciate in value and carries
a generally fixed dividend.
17
Nature and Scope
5. Time Horizon perspective (Short term vs Long term)

It’s a relatively simpler categorization, division on the basis of time horizon of an
investment. What is not so simple is to quantify short term and long term. There are
many notions that define time duration as being short or long. In reality it is a
subjective answer.
In case of a stock, for example, long term should be a period when negative and
positive outcomes, both have fair probability of having occurred. That means a
sufficiently large time period during which share can complete a full cycle of returns
that is ups and downs. Generally such time period would coincide with length of an
economic cycle, approximately ranging between 10 to 15 years.
Similarly for fixed income securities where returns are more or less known, long
term can be a time above 3 to 5 years. Short term would be generally less than
2 years. As said earlier, it’s a perception that what is long term or short term!
What is more important is to understand that riskier investments require longer
time horizon than safer ones. It pays off to hold riskier investments in long run as
shown in one of the analytical references earlier.
6. Mode of making investment perspective (Direct Investments vs Pooled

investments)
Direct investment, as the name itself suggests, refer to investment made by the
investor directly into the asset class.
Pooled investments, however, are not directly made by the end investor, but an
expert who invests on behalf of multiple small investors through a single vehicle.
Such instruments are known as pooled investments, for example mutual funds,
portfolio management services, REITs, ETFs etc.
Pooled investments have a major advantage that management of money lays in
expert hands but in trade of extra cost of managing them.
7. Activity perspective (Active style vs Passive style)

Investments management is said to be passive in following two cases:
 Buy and Hold Portfolio strategy: Commencing no changes in portfolio
even if markets change wildly.
 Tracking Portfolio strategy: In this case the manager tracks a
predetermined benchmark and only changes made in the portfolio are to
match changes in benchmark itself. Benchmarks can be a standard popular
18
Nature and Scope
index or a customized set of various assets decided well in advance. Some

examples are:
o Standard Popular Index: Nifty Fifty, BSE-500, S and P 500 BSE-
Greenex, BSE-Power, BSE-Auto, CNX Nifty Junior etc
o Custom created benchmark: 50% of Nifty Fifty and 50% of CNX Nifty
Junior
Investment strategy is said to be active when investment manager is free to the
composition of his portfolio and does not necessary have to follow any
predetermined benchmark.
Comparison between active and passive style

In case of a passive investment strategy, the manager is judged on basis of his
efficiency in perfectly following benchmark, and returns are just not a criterion.
Whereas in case of active investment strategy, the manager is judged on the basis of
excess returns (naively known as alpha) generated in comparison to the benchmark.
Followers of passive style believe that it’s better to follow the markets than to
try to outperform it because markets are way too efficient and cost of conducting
research and analysis on markets will be a pure wastage.
However followers of active investment strategy believe that markets are often
inefficient and leave enough room to outperform it. By conducting a thorough
research and analysis, one can generate more returns than overall average of
markets. Such strategist try to find stocks that are grossly undervalued or mispriced
that market participants at large did not notice.
Illustrative case
Mr A and Mr P, are analyzing Nifty Fifty and conclude that it is expected to deliver
a return of 18% over next one year. Mr A believes that there are many underpriced
securities with in Nifty Fifty but Mr P believes that amongst such intense hunt for
undervalued securities by many other analysts, it is impossible to find one.
Mr A decides to not to follow the index and develop a portfolio of securities that
he believe are undervalued at present market prices whereas Mr P builds a portfolio
of securities that exactly mirrors the composition of securities in his benchmark, Nifty
Fifty.
After one year it is observed that Nifty Fifty actually delivered 18% returns.
Since Mr P was following this benchmark to perfection, he obviously delivers 18%
19
Nature and Scope
returns in his portfolio. However it was interesting to look at the returns that Mr A
generated.
 If Mr. A generates 3% returns only: In this case it can be concluded that
Mr A had poor intuition and research skills to find out if stocks are
undervalued or not
 If Mr. A generates 17% returns: In this markets should have been too
efficient and despite superior research skills of Mr. A he could not generate
excess returns. The underperformance of 1% can be attributed to cost of
conducting research and analysis.
 If Mr. A generates 26% returns: In this case it can be safely concluded
that Mr. A was right that markets are inefficient and there is plenty of room
to outperform it. Moreover Mr. A possesses superior research skills to spot
undervalues stocks.
8. Authority to decide perspective (Discretionary and Nondiscretionary

Investments)
This categorization holds true where management of portfolio is outsourced to an
expert by the owner of money.
In case of discretionary investments, the manager has discretion of deciding
investment mix without ongoing approval of the investor. In such cases investor
entrusts the manager with all decision making authorities well in advance. Even in
discretionary investments, manager has to always act in good faith of the client and
be within boundaries defined in advance.
In case of non-discretionary investments, manager does not enjoy decision
making rights. Manager can take buying or selling decisions in the portfolio only after
explicit approval of the investor for every transaction. In such cases investors have
tight control over the portfolio and decision making is sluggish. Investment manager
primarily acts like an advisor in this case.
Mutual funds are an example of discretionary portfolio whereas portfolio
management services provided by banks or brokerage houses are example of a
nondiscretionary investment.
9. Perspective of Investment Frequency (Systematic Investments vs

Lump sum Investments)
An investment made by onetime outflow of money is known as a lump sum
investment, whereas a set of outflows in various recurring frequencies
(or instalments) is known as a systematic investment.
20
Nature and Scope
One can choose any of these modes in almost type of investments. However,
both modes of investing have their own merits and demerits.
Lump sum investing does not require a cash flow planning for future because no
future commitment towards investment is pending. But it puts the investor at market
timing risk, because markets could be grossly overvalued when this money is
invested and a subsequent fall can hurt the portfolio value.
Systematic investments on the other hand, take care of market timing risk
because money is invested at various market levels in staggered manner. A wild
swing in prices of securities would not affect the portfolio significantly because
investor would end up buying more units if prices fall and less units if prices rise. This
concept is also known as ‘rupee cost averaging’.
Analytical reference: Systematic vs Lump sum investment approach

(Risk and Return Implications)
Scenario A: If markets are volatile:
Table 1.4 Cash with Lump Sum Investment
Case with lump sum investment

Column A Column B Column Column
C=B÷ A D = [C×A]
Security Investment Units of Cumulative
Price Amount (`) security Portfolio Value
(`) bought (`)
100 1,134,000 11340.00 1134000

90 - 1020600
80 - - 907200
70 - - 793800
Maximum Loss
60 - - 680400
Point: –40%
75 - - 850500
100 - - 1134000
125 - - 1417500
Maximum Gain
150 - - 1701000
Point: +50%
TOTAL 1,134,000 11340.00 NA
21
Nature and Scope
Table 1.5 Cash with Systematic Investments: Rupee Cost Averaging
Case with Systematic Investments: Rupee Cost Averaging

Column A Column B Column Column D Column
C=B÷A E =  (C×A)
Security Investment Units of Total Cumulative
Price (`) Amount (`) security Number of Portfolio
bought units in Value (`)
possession
100 126,000 1260.00 1260.00
90 126,000 1400.00 2660.00
80 126,000 1575.00 4235.00
70 126,000 1800.00 6035.00
60 126,000 2100.00 8135.00 488100
75 126,000 1680.00 9815.00 Maximum Loss
100 126,000 1260.00 11075.00 Point: –22.5%
Note: gains are
125 126,000 1008.00 12083.00 higher & losses
150 126,000 840.00 12923.00 are lower than lum
Maximum sum strategy
TOTAL 1,134,000 12923.00 NA NA Gain
Point: +71%
Analysis of Scenario A
 Note, in both the cases principal invested is the same, only difference is in
the manner of investing money, i.e. Lump sum and systematic.
 It absolutely clear that systematic approach has lower risk but higher returns
than lump sum approach.
 Investor has higher net worth in case of systematic approach.
Scenario B: Upward trending market
Table 1.6 Case with Lump Sum Investment
Case with lump sum investment

Column Column Column Column
A B C=B÷A D =  (C×A)
Security Investment Units of Cumulative
Price Amount Security Portfolio
` ` Bought Value `
100 1,134,000 11340.00 1134000
110 - - 1247400
140 - - 1587600
170 - - 1927800
150 - - 1701000
190 - - 2154600
210 - - 2381400
240 - - 2721600 Maximum gain
250 - - 2835000 Point: +150%
TOTAL 1,134,000 11340.00 NA
22
Nature and Scope
Table 1.7 Case with Systematic Investments: Rupee Cost Averaging
Case with Systematic Investment:

Rupee Cost Averaging
Column Column Column Column Column
A B C = B÷A D E =  (C×A)
Security Investment Units of Total Cumulative
Price Amount security Number Portfolio
` ` Bought of Value
Units in `
possession
100 126,000 1260.00 1260.00 126000
110 126,000 1145.45 2405.00 264600
140 126,000 900.00 3305.45 462764
170 126,000 741.18 4046.63 687927
150 126,000 840.00 4886.63 732995
190 126,000 663.16 5549.79 1054460
210 126,000 600.00 6149.79 1291456
240 126,000 525.00 6674.79 1601949 Maximum Gain
250 126,000 504.00 7178.79 1794697 Point: + 58%
Total 1,134,000 7178.79 NA NA
Analysis of Scenario B
 In this case of an upward trending security prices, systematic investment
approach does not outperform the lump sum approach
Scenario C: Real market data of five major stocks (1st Sept, 2008 to
30th Aug, 2011)
When you observe the analysis of share prices of BHEL (Figure 1.3), HDFC
(Figure 1.4), NTPC (Figure 1.5), Hero Motocorp (Figure 1.6) and ONGC (Figure
1.7) for a period of three years, You will note that share price data has been
adjusted for impact of share splits. Moreover an imaginary interest rate @ 8% PA
has been added in calculation of systematic investment return on the amount not
invested during the process.
For detailed analysis of readers, a pattern of price movement is attached along
with the table showing comparison between lump sum approach and systematic
approach.
BHEL
Fig. 1.3 BHEL’s Price Movement

23
Nature and Scope
Fig. 1.4 HDFC Ltd’s Price Movement
Fig. 1.5 NTPC Ltd’s Price Movement
Fig. 1.6 Hero Motocorp Ltd’s Price Movement
24
Nature and Scope
Fig. 1.7 ONGC Ltd’s Price Movement
Analysis of Scenario C
 The analysis is summarized in Table 1.8.
 It shows systematic investment approach is generally better in case of
volatile, flat and trend less markets.
 Lump sum is best suited if share prices are consistently rising as in case of
Hero Motocorp Ltd.
Table 1.8 Stock Return Comparison
Systematic
Lump sum Pattern of
Company Investment
Return returns
Return
NTPC -2% 0% Flat
BHEL 5% 1% Rise then Fall
Hero Motocorp 139% 55% Uptrend
HDFC 42% 45% Fall then rise
ONGC -74% 49% Volatile and flat
Cells in green reflect better strategy
Source: BSE
1. What are growth oriented investments?

................................................................................................................
................................................................................................................
................................................................................................................
25
Nature and Scope
2. Differentiate between direct and pooled investments.

................................................................................................................
................................................................................................................
................................................................................................................
3. Differentiate between systematic investments and lump sum investments.

................................................................................................................
................................................................................................................
................................................................................................................
1.4 TYPES OF INVESTMENTS
Investments can be classified in five broad categories: securities, commodities, real

assets, contracts and currencies (Figure 1.8). It may be noted here that although
commodities have been classified separately from real assets below, commodities
are still a sub part of real assets.
Fig. 1.8 Classification of Investments
26
Nature and Scope
Securities
For an issuer, securities are a medium of raising money from the investors. Issuer can
be a government, an individual or a company. Securities include bonds, government
securities, treasury bills, commercial papers, certificate of deposits, equity shares,
preference shares, warrants, depository receipts and units of pooled investments
vehicles (PIV). These can be divided in three categories: Equity, Fixed Income and
units of PIVs.
Security transactions that directly take place between the issuers and investors
come under the purview of primary markets. Fresh issuance of equity shares (IPOs,
Right Issues), preference shares and debt securities are typical transactions in
primary markets.
Securities once issued in primary market can subsequently be traded amongst
other investors, traders or arbitrageurs; such transactions form part of secondary
markets.
Both forms of markets complement each other. In biological sense, securities
take birth in primary markets and are nurtured in secondary markets. Mind, it is only
the transactions in primary markets that directly help in building productive capacity
of an economy and count in national capital formation. Secondary markets on the
other hand provide liquidity, growth and incentives for investors of primary markets.
There are two more facets of security markets: Capital market and Money
Market. This division is created on the basis of time to maturity of the security.
Securities with time horizon of more than one year fall in category of capital markets
and instruments with time horizon of less than 1 year in money markets.
Figure 1.9 shows the various segments of security market.
Fig. 1.9 Segments of Security Market
27
Nature and Scope
Types of securities
There are three types of securities.
(i) Equity securities

The most commonly talked (however, generally the most commonly misunderstood)
category of investments is equity investments. Literal meaning of equity is ‘justice
and fairness’; however, in finance, the word equity represents the ownership in any
asset. Equity share, in a similar manner, represents ownership in a business.
Each share denominates certain ownership in the company. Promoters, who
wish to retain control over the company should retain majority of common shares as
well.
There are two types of equity shares: common stocks and preferred stocks
(Figure 1.10).
Fig. 1.10 Types of Equities
Difference between the two forms is significant, so much so that investors

virtually perceive only one of them as an equity share and the other as a debt
security. Let’s explore which one and why.
(a) Common stocks have residual rights because their claims on all benefits
and assets of the company are only after other capital provider’s claims have
been settled. They are entitled to dividends only after the interest and
28
Nature and Scope
preference share dividends have been paid to debt holders and preference
share holders. Similarly in case of liquidation of a company, first settlement is
done with debt holders, then comes preference shareholders and in the end
the common shareholders. Common stocks however carry the voting rights
that no other capital provider generally gets.
(b) Preferred stocks as the name itself suggests, are given preference over
common stock in case of payments of dividends or liquidation proceeds.
But preferred stocks usually do not carry voting rights. Preferred stocks
usually carry a fixed amount or a rate of dividends.
Due to such safety features, preferred stocks are virtually treated like a
debt security by investors.
(ii) Fixed income securities

Future cash flows are well defined in case of fixed income securities. Amount of
interest, its frequency, time to maturity and return of principal are some of such
clauses that are contractually defined well in advance.
Relative safety of interest and principal is the main motivation for investors into
these securities.
Fixed income securities can be further classified on the basis of their time to
maturity (Figure 1.11).
Fig. 1.11 Fixed Income Securities
29
Nature and Scope
(a) Money market securities: These instruments have maturity of less than
one year and their main utility is to enable short term parking of idle cash
lying with investors such as banks, companies, government and PIVs.
These markets are highly liquid and safe.
(b) Corporate bonds: The debt instruments issued by companies for a
maturity ranging between 1 to 10 years. While selecting a bond, it is
important to consider the credit profile of issuer. It is reflected in the credit
rating of the particular bond issue or issuer itself.
(c) Government securities (G-Secs): These are long term securities issued
by state or central government. When government issues securities
denominated in domestic currency, chances of default are almost nil.
However, due to long maturity periods, prices of these securities fluctuate
wildly in response to a change in market interest rates. This trait is also
known as interest rate risk or market risk or duration risk of government
securities.
Table 1.9 Money Market Instruments
(iii) Units of pooled investment vehicles (PIV)

Pooled investment vehicles are the instruments that collect investable money from
various investors and invest according to predetermined strategy. Investment
decision making is essentially outsourced by investors to an expert who vows to
manage money in best interest of investors within constraints defined in advance.
Unit of a PIV is like a share that represents ownership of in investor in collective
pool of assets held in a particular scheme. Value of every unit fluctuates exactly in
proportion with the value of collective pool of assets in a scheme. Value of an
individual unit is also often termed as net asset value (NAV).
Mutual Funds (MF), Portfolio Management Services (PMS), Exchange traded
funds (ETF), depositories, hedge funds, trusts are some examples of PIVs.
Commodities
In fact, commodities are one of the most conventional investments that have existed
with investors. For example, Indians have been heavily investing in gold since many
30
Nature and Scope
centuries in past. Commodities apart from gold are also finding growing space in
investor portfolios as it is getting easier gain exposure to them, thanks to
dematerialized facility.
Commodities are divided into four non-exhaustive categories:
1. Bullions or precious metals: It includes precious metals such as Gold and
Silver excluding their coin form
2. Agricultural products such as cereals, pulses etc.
3. Industrial metals such as copper, steel etc.
4. Energy products such crude oil
Commodities prices are linked to demand and supply factors which are different
for different commodities. Their value lies in their utility for end users.
Traditionally commodities are said to be a good hedge against inflation as their
returns have historically just beaten inflation. However investors seeking high
portfolio growth from commodities must have exceptional skills.
Commodities also enjoy low correlations with other financial investments and
hence provide a great deal of diversification and risk reduction in portfolio.
Real Assets
This is another conventional set of investments with really old investment history. This
group comprises real tangible assets with simultaneous usability value for the owner.
There is always a psychological advantage of holding these assets, which might not
necessarily result in higher returns. Some classifications of real investments are given
as follows:
1. Real Estate including land as well as buildings of residential or commercial
nature. Investments in real estate can be mad in direct form by directly
buying it or indirect form by buying securitized form of real estate such as
units of REIT Funds Real Estate Investment Trust) that are growing popular
in Indian financial markets.
2. Art and Collections such as antique cars, coins and paintings etc.
3. Machineries and Equipments: One can always invest in machines for usage
in business as well as leasing them out to generate regular income. Aircrafts
and ships are such examples.
4. Live Stock such as farm animals and poultry units.
31
Nature and Scope
Like any other investments, one can invest in real assets indirectly using PIVs.
Real assets are generally not linked to overall economy, hence are lowly correlated
with other financial assets. It makes them a viable choice for additional
diversification.
Contractual and Intangible Assets

A contract to buy or sell a particular asset on a future date at a predetermined price
itself is an investment. Just wonder that you commit a client, you will sell her 1000
share of Reliance Industries Ltd (RIL) after one month at a price of ` 920 per share.
When you enter in this contract, RIL is operating at ` 915 and you do not own
those stocks on the date of contract.
Imagine that you have already fixed the selling price without owning the security
and in order to honor the commitment you will have to buy 1000 RIL shares at
prevailing price any day before completion of one month. You will benefit if price of
RIL falls and your cost of buying RIL go down and conversely loose if price of RIL
rises.
You should see that economic value of this contract would fluctuate with the
prices of RIL which is the underlying asset of this contract. Such contracts are
popularly known as a derivative contract. It was the case of a forward contract
within derivative segment.
A derivative contract derives its value from the value of underlying asset.
Derivative contracts can be of the following categories:
1. Forward Contracts
2. Future Contracts
3. Options
4. Swaps
5. Others (Insurance, Corporate default swap, swaptions etc)
Intangibles, on the other hand, are investment options such as patents, R and D,
goodwill, franchise, copyrights, trademarks and brands. These assets are intangible
but can have huge potential of future returns. One of the richest men on the earth,
Bill Gates (Figure 1.12), the owner of Microsoft Corporation invested wisely in
creation of intangible assets that are fetching him regular royalty income. All these
investments could be possible only for a business during its operation. However
outside investors can also take an indirect exposure in these assets by buying some
ownership stake in the company itself.
32
Nature and Scope
Fig. 1.12 Bill Gates, Former Chairman Microsoft Corp
Currencies
Holding the currency of a nation is very much an investment in the fate of that
economy. One of the biggest investors in this category are the nations, China holds
foreign exchange reserves of approximately USD 3240 billion and India around
USD 290 billion on the date of writing this data.
Fig. 1.13 Forex Reserves of Important Countries (as on August, 2012)
Source: imf.org
Forex reserve however is not deliberate investment by a nation but a build up by
virtue of its economic activities with rest of the world. It is important to hold such
reserves especially for nations like India that depend heavily on essential imports.
Case with exporting or importing companies is quiet similar, they are exposed to
this asset simply by the virtue of their business operations outside India, for example
Infosys, TCS etc.
33
Nature and Scope
Other investor segments also invest in foreign currency in anticipation of gain. Price
of a currency, like every other asset, depends upon demand and supply situation.
Demand-supply analysis can be done by looking at balance of payment accounts of
a nation. If one expects that a nation would receive more of foreign investment inflows,
it is likely that currency will appreciate. Some of the major movement drivers in foreign
exchange rate of a currency are discussed here.
Table 1.10 Drivers of Movement in Exchange Rates
Cause (in domestic country) Eff ect on dom estic currency
Net Foreign investment inflow Appreciation
Growth in net exports Appreciation
Net Foreign investment outflow Depreciation
Growth in net imports Depreciation
Improvement in economic outlook Generally positive in long run
Improvement in credit rating Generally positive in long run
Increase in real interest rates* Appreciation
Low and Moderate domestic inflation Depreciation
Deterioration in economic outlook Generally negative in long run
Deterioration in credit rating Generally negative in long run
Decrease in real interest rates* Depreciation
High domestic inflation Depreciation
Note 1: List is not necessarily exhaustive.

Note 2: It is assumed that factors are constant in the nation of counter currency.
Note 3: *Real Interest Rate refers to interest rates net of inflation rates.
1. What are the five broad categories of investments?

................................................................................................................
................................................................................................................
................................................................................................................
34
Nature and Scope
2. What do you understand by government securities?

................................................................................................................
................................................................................................................
................................................................................................................
1.5 SUMMARY
 Investment is the employment of funds on assets with the aim of earning

income or capital appreciation. Investment has two attributes, namely time
and risk. Present consumption is sacrificed to get a return in the future.
 Investments may be defined as a commitment of one’s money in one or
more of asset classes in anticipation of some gains while simultaneously
bearing risk of uncertainty.
 Financial investment is the allocation of money to assets that are expected
to yield some gain over a period of time.
 The financial and economic meanings are related to each other because the
savings of the individual flow into the capital market as financial
investments, to be used in economic investment.
 Utility of an investment is calculated primarily on the basis of returns it
generates. Returns can accrue in any of the two forms, capital gains or
income. Capital gains refer to appreciation in prices of securities whereas
income may comprise sources such as dividends, interest or bonus, etc.
 If an investment is very different from existing portfolio, it means that the
correlation between the two is low or even negative. In such cases the risk
of the portfolio falls if risk is measured by volatility in new portfolio returns.
 If an investment can be easily sold without causing its prices to significantly
change as a result, it is said to be liquid in nature.
 Transaction cost is any expense, paid directly or indirectly, for sale or
purchase of a security. It can be paid directly in the form of commissions,
brokerages, consultancy fee, recurring charges, transaction taxes, etc.
 Market Impact cost is another form of indirect transaction cost. It refers to
the change in price of a security solely because of your action of buy or sell
of this security.
35
Nature and Scope
 Smart investment manager not just manages portfolio allocations, but also
the tax incidence within all legitimate boundaries.
 In financial context, investments have enormous scope today and options
range from direct business investments, equities, and fixed income to
structured derivatives with highly innovative and customized pay off pattern.
 Real investments are the tangible ones that can be touched and felt for
example real estate, commodities and gold, art collection, etc. Apart from
financial utility, that is, return on investment, these investments can have a
usage utility for investors.
 Economics define investments as such commitments of money that further
enhance income generating capacity of an economy and examples typically
include capital goods such as roads, bridges, dams and other infrastructure
investments.
 Growth oriented investments are the ones that generate returns (or losses)
through appreciation (or depreciation) of prices. Gold, business investment
or shares of small companies are some of the examples.
 An investment made by onetime outflow of money is known as a lump sum
investment, whereas a set of outflows in various recurring frequencies (or
instalments) is known as a systematic investment.
 For an issuer, securities are a medium of raising money from the investors.
Issuer can be a government, an individual or a company. Securities include
bonds, government securities, treasury bills, commercial papers, certificate
of deposits, equity shares, preference shares, warrants, depository receipts
and units of pooled investments vehicles (PIV).
 Investment decision making is essentially outsourced by investors to an
expert who vows to manage money in best interest of investors within
constraints defined in advance.
1.6 KEY WORDS
 Expected returns: The expected return (or expected gain) refers to the
value of a random variable one could expect if the process of finding the
random variable could be repeated an infinite number of times. Formally, it
gives the measure of the center of the distribution of the variable.
36
Nature and Scope
 Transaction costs: In economics and related disciplines, a transaction

cost is a cost incurred in making an economic exchange of some sort, or in
other words the cost of participating in a market.
 Fixed income security: It is an investment that pays regular income in the
form of a coupon payment, interest payment or preferred dividend.
1.7 ANSWERS TO ‘CHECK YOUR PROGRESS’

1. Financial investment is the allocation of money to assets that are expected
to yield some gain over a period of time. It is an exchange of financial
claims such as stocks and bonds for money. They are expected to yield
returns and experience capital growth over the years.
2. Speculative investments include investments like equity shares,
commodities, or real estate etc., where expected return is not guaranteed
by issuer and it is not so easy to estimate it.
3. Transaction cost is any expense, paid directly or indirectly, for sale or
purchase of a security. It can be paid directly in form of commissions,
brokerages, consultancy fee, recurring charges, transaction taxes etc. It can
also be paid indirectly, what many investors do not realize, in form of bid-
ask spread, market impact cost etc.

1. Growth oriented investments are the ones that generate returns (or losses)
through appreciation (or depreciation) of prices. Gold, business investment
or shares of small companies are some of the examples.
2. Direct investment, as the name suggests, refers to investment made by the
investor directly into the asset class. Pooled investments, however, are not
directly made by the end investor, but an expert who invests on behalf of
multiple small investors through a single vehicle. Such instruments are
known as pooled investments, for example mutual funds, portfolio
management services, REITs, ETFs etc.
3. An investment made by onetime outflow of money is known as a lump sum
investment, whereas a set of outflows in various recurring frequencies
(or instalments) is known as a systematic investment.
37
Nature and Scope

1. Investments can be classified in five broad categories: securities,
commodities, real assets, contracts and currencies.
2. Government securities are long term securities issued by state or central
government. When government issues securities denominated in domestic
currency, chances of default are almost nil. However due to long maturity
periods, prices of these securities fluctuate wildly in response to a change in
market interest rates.
1.8 SELF-ASSESSMENT QUESTIONS
1. With the help of charts state the meaning of standard deviation.

2. State some of the classifications of real investments.
3. What are the categories of derivative contracts?
4. State some of the drivers of movement in exchange rates.
5. Discuss the nature of financial investment.
6. Analyse the scope of investment alternatives.
7. Describe the different types of securities.
1.9 FURTHER READINGS
Bhole, L. M. 2004. Financial Institutions and Markets. New Delhi: Tata

McGraw-Hill.
Khan, M. Y. 2004. Financial Services. New Delhi: Tata McGraw-Hill.
Fischer, Donald E. and Ronald J. Jordan. 2002. Security Analysis and Portfolio
Management. New Jersey: Prentice-Hall.
Prasana, Chandra. 2002. Investment Analysis and Portfolio Management. New
Delhi: Tata McGraw-Hill.
Pandian, Punithavathy. 2008. Security Analysis and Portfolio Management. New
Delhi: Vikas Publishing.
38
Approaches to
Investment Analysis
UNIT–2 APPROACHES TO INVESTMENT ANALYSIS
Objectives
x Explain various approaches to investment analysis
x Discuss the key indicators used by technical analysis
x Describe random walk theories
Structure
2.1 Introduction
2.2 Approaches to Investment Analysis: An Introduction
2.3 Methodologies of Investment Analysis
2.4 Summary
2.5 Key Words
2.1 INTRODUCTION
Investment decisions are strategic decisions that require a thorough analysis of risk
as risk management is considered to be the basis of decision-making. The goal of
investment is not just profit in a certain period of time, but depending on the
preferences of the decision maker, there should be a compromise between
maximizing the expected return on investment and efforts to reduce the risk to a
minimum.
In this unit, you will study the different approaches to and methodologies of
investment analysis in detail.
2.2 APPROACHES TO INVESTMENT ANALYSIS:

AN INTRODUCTION
We can look at investment analysis as being the continuous evaluation of financial

assets allocation, current as well as potential, and selection of those allocations that
are the most suited to the goals and needs of the investor.
39
Approaches to
Investment Analysis
In investment analysis, the considerations to be made are of risk and growth

rate, and these are generally found to be directly proportionate for all investment
vehicles. In other words, investments that provide a high degree of certainty will
provide an extremely modest rate of return, and investments that come with a high
risk will provide extremely good returns even increasing manifolds within months.
With the help of investment analysis, it is for investors to look at what level of
risk they are willing to take and accordingly select where they will invest.
Besides just checking out an individual investment’s return, it is essential to
check out the involved taxes, transaction costs and opportunity costs which could
impact and diminish the net return. For example, it is possible that the taxes are
deferred or reduced according to the type of investment and the tax status of the
investor. Every tome that an investor buys or sells mutual funds, shares or stocks,
there might be a transaction cost to be paid. This fee is generally just a percentage
of the amount that is being transacted. The fees might sift 3-6 per cent or higher off
the initial investment and final return. One way it is possible to avoid these expenses
is through selecting no load mutual funds and dealing with discount brokers. It is the
opportunity cost that is way more nebulous. Opportunity cost is that which would
have been earned by the investment if it was deployed somewhere else. Opportunity
cost is largely the downside of investing too conservatively given one’s means and
circumstances. Risk as well as growth both factor into opportunity costs. One
example of this is that low risk will provide low returns, and possibly it is better to
lose the opportunity if a person with no current or future earnings is making the
investment from his savings.
Interest-bearing Investments and Treasuries

One of the investments that are of the lowest risk category (therefore lowest return)
is interest-bearing notes, like money market funds and certificates of deposit from
banks. They provide the investor a guaranteed periodic interest payment, or, in the
case of T-bills, a lump sum based on a guaranteed discount rate. To make a
selection in this type of investment, what needs to be considered is the comparative
interest rate and investment duration (term). Such investments are very liquid and
therefore quite popular. They are not subject to adverse timing effects and provide
an option that is nearly risk-free with certainty of return.
40
Approaches to
Investment Analysis
Mutual Funds
Mutual funds promise to provide returns like the stock-market and also low risk.
Mutual funds are easy to understand for even new investors. Such funds work with
pooling together the funds invested by the members in professionally managed
portfolios of stocks, bonds, and such investments. This enables them to make
available to individual investors that diversification of investment which otherwise
could only be achieved with a much higher investment by the individual and much
greater effort to review the many choices.
There is an investment objective associated with investments made in most funds
and with choices covering conservative, low risk funds which mirror a market index
to high-stakes aggressive growth funds that focus on small and unproven companies.
Selecting a mutual fund involves mostly the same considerations as for selecting
stocks.
Futures and Other Derivatives

Though investments such as futures and options have been considered to be riskiest
types of investment, the irony is that one of their key purposes of these market-
traded contracts is for hedging against adverse movements in cash markets. The
collective term for futures, options, and similar instruments is derivatives due to the
fact that they derive from price movements in other markets, including commodities,
currencies, and stocks. Several investors employ the use of derivatives for
speculation. Through their very nature, individual contracts are short-term
investments, although some investors, mainly corporations and other institutions,
maintain a regular portfolio of derivatives on underlying commodities or assets that
affect their business.
To analyze futures and options there has to be analysis of the expected direction
that the price of the underlying goods will take. Derivative analysis works with a
short-term (> 1 year) forecast for what could be the prices in the cash markets.
Error in forecasting by the investor will lead to heavy loses and accurate forecasting
will bring in huge gains. If one buys on margin (taking loan to have more money to
investment), it will lead to profit as well as loss getting multiplied.
Securities
We can look upon a security as being “a financial asset representing a claim on the
assets of the issuing firm and on the profits produced by the assets.” Security
analysis refers to the process applied for identifying the opportunities for investment
41
Approaches to
Investment Analysis
that are desirable, in such financial assets. With reference to corporate stocks and
bonds, the analysis flows from the interpretation of accounting and financial data
regarding operations, profitability, net worth, and so forth. The various basis for
identifying investment alternatives are: the investor’s risk/reward ratio, a specified
time horizon and current market prices.
Essentially, security analysts play the role of catalysts driving efficient market
hypothesis. In other words, “smart” money shall efficiently and logically so distribute
itself that all available information will be reflected in the price of the security. The
moment some new information comes up, it is assessed by the analysts and then
they recommend market price adjustments based on the price level changes which
are anticipated by them. It is the price adjustments’ cumulative impact which moves
the market to equilibrium and then every security’s price is approximately its true
investment value.
There are three areas in which security analysts operate and each area pertains
to a different set of objectives and goals. Brokerage firms and investment
banking deal with the “sell” side of security analysis. The clients that they have are
commission and fee paying investors, be they individual and institutional investors.
Security analysis is conducted by investment management organizations for the
portfolios managed by them. Due to the fact that securities are purchased by the
portfolio managers, they are considered as representing the “buy” side.
There are numerous investment publishing services which make available
security analysis for investors who subscribe to their reports.
1. State the investments that are of the lowest risk category.

................................................................................................................
................................................................................................................
................................................................................................................
2. State the role performed by security analysts.

................................................................................................................
................................................................................................................
................................................................................................................
42
Approaches to
Investment Analysis
2.3 METHODOLOGIES OF INVESTMENT ANALYSIS
The basic methodologies that are applied in analysis are: technical analysis and
fundamental analysis. In their own way, each approaches investment decisions from
the top-down and from the bottom-up.
The Top-down Approach

Top-down approach is a traditional methodology. In this approach, first the broader
perspective is considered and then slowly it keeps narrowing till it culminates at the
analysis of specific bonds and stocks. In this approach, first the macroeconomic
data is analyzed, filtered down to more specific sectors, and finally the results are
distilled on the basis of some specific security.
The important economic conditions and the forces at work and their potential
impact on the markets are determined by analysts. Also, they study corporate
profitability, the magnitude and path of export/import trends, migration, employment,
fiscal policy, money supply and interest rates so that they can evaluate what will be
the performance in future of individual economic sectors and of individual industries.
The top-down approach is also used by security analysts for allocating the funds
available to them within portfolios amongst long-term and short-term investments,
risk-free and risky securities, bonds and stocks. The market-to-market and sector-
to-sector comparisons that are made have the purpose of identifying where better
returns can be obtained by investors. The analysts provide suggestions for favorable
sectors and industries and even suggest specifically what to purchase.
Bottom-up Approach
While the top-down approach at times overlooks such stocks that are outside the
favourable sectors but offers significant investment opportunities, the bottom-up
approach is used to identify superior performers irrespective of industry.
The bottom-up approach seeks out investments that are advantageous on the
basis of financial and performance criteria, both applicable across sectors and
industries. They set up financial and performance financial benchmarks that must be
exceeded or at least met by companies if they want to be amongst the companies
under consideration. Criteria are also developed by analysts for separating the top
performers based on various degrees of risk, such as aggressive versus conservative.
43
Approaches to
Investment Analysis
Post filtering out the appropriate securities, the company’s fundamental analysis
is conducted by the analyst.
Fundamental Analysis
The role played by a fundamental analyst is seeking out superior returns from
securities which the market has mispriced. For this purpose, a fundamental analyst
will look at balance sheets and financial statements and forecast the future dividends
and earnings of the company being analysed, ‘the degree to which these exceed the
expected average for the industry, and the potential for the stock to move closer to
a correct or fair value.’ Fundamental analysts recommend that underpriced or
undervalued stocks should be bought.
There are various external conditions that affect the performance of a company.
Some of these are: demographic changes, economic conditions, government fiscal
policy and regulation, competition and vendors.
For the fundamental analyst, the important firm or industry specific
characteristics are: quality of management, research and development, physical
facilities, financial resources, product type, sales, and services, productivity, market
presence and profitability.
There are two ways in which the analyst approaches these indicators. These are:
trends within an industry and features of a particular firm. For this purpose, an analyst
employs a series of ratios constructed on the basis of the financial statements. These
ratios depict the percentage or decimal relationship of a number to another number.
With ratios, it becomes easy to make use of comparative financial statements that
carry important information regarding relationships and trends for the next few
years. A company’s ratios are compared by an analyst with the industry ratios, and
even cross-sectionally with those of other companies.
With structural analysis, analysts compare two financial statements on the basis
of the various items or groups of items for a specific period. Time series analysis is
used to correlate ratios over time, measured in years or by quarters.
With ratios being relative measures, they provide a common scale of
measurement which is used by analysts for the construction of historical averages. In
this way, analysts can make comparison between companies from different
industries, companies of varied sizes on the basis of their financial condition and
44
Approaches to
Investment Analysis
performance itself, through: (a) using trends to forecast future results (b) examining
averages and (c) establishing absolute standards. For the purpose of increasing
predictability, the impact that is felt on internal trends of external factors is also
considered by the analyst.
Financial Analysis
To know a company’s future value, it is essential to perform financial analysis. The
focus of financial analysis is on the condition of the financial statements: the income
statement, the balance sheet, the statement of changes in shareholders’ equity and
the funds flow statements. Based on these statements, the analyst finds out about the
outstanding claims on the income of the company.
A financial analyst will measure a company’s past performance, evaluate the
current conditions, and predict future performance. Such information is key for those
investors who seek superior returns. For creditors, it provides information on what
risk they will be taking if they extend credit.
Ratio Analysis
Financial ratio is the most common method that analysts employ. Composition ratios
are used for the purpose of comparing the size of the components of any accounting
category with the total of that category.
Composition ratios depict the size of each of the components in relation to their
total and to each other. They perform historic comparisons and trending and point
to the cause-and-effect relationships between the individual components and their
total.
Weaknesses of Financial Analysis

Financial analysis is dependent on financial reports’ data of a company for its
analysis; the findings of the analysis will be affected by “inflation, wild business
swings, changes in accounting practices, and undisclosed inner-workings of the
firm.” It is possible for management to have tweaked important key ratios through
inventory valuations, depreciation schedules and expense recognition practices.
Also, with the financial statements being static, there is no accounting for by the
analyst for the impact that seasonal variations will have. Then again, till performance
benchmarks are not used for comparison, the ratios have no meaning at all.
45
Approaches to
Investment Analysis
Technical Analysis
Technical analysis is used to study trends in stock prices so that future prices can be
predicted. It is believed by technical analysts “that all the relevant information about
economic fundamentals of an industry and of a stock are reflected in the direction
and volume of prices.” So, technical analysts study the past, since according to them
the markets are cyclical, form specific patterns, and over time these patterns are
repeated. Technical analysts are also of the belief that one must only compare short-
term and intermediate price movements with long-term trends for predicting the
direction that that market will take.
Technical analysis is based on two major techniques: study of key indicators and
charting market activity.
Here are some key indicators that are commonly used by technical analysts.
Trading volume
This is based on the supply-demand relationships and is an indicator of the
weakness/strength of the market. Generally, an uptrend can be seen in rising prices
with increased buying. Lowering of prices with rise in demand and rising prices with
falling volume, indicates downtrends. Trading volume is best applied in the short-
term, anywhere for 3 to 9 months.
Market breadth
This studies the activity of a broader range of securities than is examined by the
much publicized indices like Dow Jones Industrial Average. The breadth index is the
net daily advances or declines divided by the amount of securities traded. Breadth
analysis is concerned with change and not level for the purpose of evaluating the
dispersion of a general prices’ movement. The advance/decline line’s slope depicts
the breadth index’s trend. Breadth analysis points to the prime turning points in bull
and bear markets.
Confidence indices
It evaluates the bond investors’ trading patterns. Bond investors are seen to be
more sophisticated and much better informed than stock traders and even spot
trends faster. Of the several other confidence theories, some measure the sentiment
found among the analysts, the breadth trends in trading of futures and options, and
46
Approaches to
Investment Analysis
the confidence of the consumer. It is believed by analysts that these provide

predictive value for intermediate and near term.
Put-call ratio
This divides the volume of puts outstanding by the volume of calls outstanding.
Investors generally purchase the greatest number of puts around market bottoms when
their pessimism peaks, thus indicating a turnaround. Call volume is greatest around
market peaks, at the heights of investor enthusiasm—also indicating a market turn.
Cash position of funds

This provides information regarding what might be the potential demand. The
composition and volume of cash held by mutual funds, pension funds, institutional
investors and the like are examined by analysts. Due to the fact that fund managers
are performance driven, it is expected by analysts that they will search out higher
returns on large cash balances and, therefore, will invest more heavily in securities,
driving prices higher.
Short selling and bearish sentiment

Those analysts who believe in the same thing as short sellers will expect there to be
a downturn in the market. Analysts particularly watch the action of specialists who
make a market in a specific stock. In addition, analysts look at odd-lot short sellers
who indicate pessimism with increased activity. However, many technical analysts
express a “contrarian” view regarding short sales. These analysts believe short
sellers overreact and speculate because of the potential profits involved.
Furthermore, for closing their positions, short sellers will purchase the securities in
the future, thus putting upward pressure on prices. Month-to-month trends form the
basis for short selling analysis.
Odd-lot theory
This follows the trends of transactions that comprise less than round lots (>100
shares). This theory is based on small investors being right most of the time, and will
start to sell into an upward trend. Nevertheless, with the market continuing to rise,
the small investor re-enters the market as the sophisticated traders are bailing out in
anticipation of a top and a pull back. So, an increase in odd-lot trading is a signal
that there will be a market downturn.
47
Approaches to
Investment Analysis
Odd-lot indices divide (1) odd-lot purchases by odd-lot sales, (2) odd-lot short
sales by total odd-lot sales, and (3) total odd-lot volume (buys + sales) by round-
lot volume.
Charting
Charting proves useful for analysing market conditions and price behaviour of
individual securities. Such data provides trend of prices, insider sales, short sales and
trading volume over both long term and the intermediate duration. This data has also
been plotted by analysts to create charts, like bar, line and point-and-figure.
To interpret a chart one must have the ability to evaluate the meaning of the
resulting formations so that one can identify the ranges for selling and buying.
Charting aids in being sure of major market downturns, upturns, and trend reversals.
Moving averages are used by analysts for analyzing stock movements in the long
term and the intermediate duration. They make predictions about the prices by
studying the current price trends in relation to the long-term moving average. A
moving-average depicts the underlying direction and degree of change.
A stock price’s relative strength is a ratio of the average monthly stock price
compared to the monthly average index of the total market or the stock’s industry
group. It provides the analysts information regarding the relationship of specific price
movements to an industry or in general to the market. When specific industries or
stocks are being favoured by investors, these will be relatively strong. Such stocks
which outperform the trend of the market on the upside could retreat suddenly the
time when investors pull out for more paying prospects. Such stocks which
outperform in a declining market generally pull in other investors and stay strong.
When charts are created by analysts, specific trends begin to show. These
trends are characterized by a range of prices in which the stock trades.
Support base for the price is at the lower end of the range. This is the end where
the stock is a “good” buy and attracts additional investors, and thus forms a support
level. An increase in price could render a stock unattractive in comparison to other
stocks. Investors sell causing that upper limit to form a resistance level. Any
movement to occur beyond the resistance and support levels will need for a
fundamental change in the market and/or the stock
48
Approaches to
Investment Analysis
Random Walk Theories

These theorists don’t consider the market as having a cyclical nature. They also
work with the same data as is used by the chartists. According to the random walk
theory it is of no use to perform technical analysis due to the fact that past price and
volume statistics by themselves hold no information that bode well for success.
According to them, selecting securities at random will provide returns comparable
with those bought post fundamental and technical analysis.
All studies have shown that prices have no predictive value and the studies also
indicate randomness in price. Due to this reason the proponents of this hypothesis
have named it the random walk theory.
Random walkers make use of the time-series models to relate efficient
markets to the behaviour of stock prices and investment returns. According to them,
price changes are not linked with the entry of new information into the market, and
the price changes are distributed evenly all across the market. So, as this implies that
the distribution of price changes is constant from one period to the next, investors
cannot identify “mispriced” securities in any consistent manner. This assumption is
contradicted by empirical evidence and experience, and it is suggested that the
random walk properties of returns (or price changes) are highly restrictive.
Dow Theory
It has been theorized by Hamilton that the best gauge as far as financial and business
activity is concerned is the stock market since every relevant bit of information is
immediately discounted in the prices of stocks, as indexed by the Dow Jones
Industrial Average and the Dow Jones Transportation Average. In accordance with
this, it is essential for both averages to confirm market direction as the price trends
in the overall market are indicative of the termination of both bull and bear markets.
The following three movements simultaneously occur:
1. A primary bull or bearish trend, typically lasting 28 to 33 months.
2. A secondary trend goes counter to the primary trend, typically lasting
3 weeks to 3 months, and is reflective of a long-term primary movement.
3. Day-to-day activity making up the market’s first two movements,
confirming the direction taken by the long-term primary trend.
49
Approaches to
Investment Analysis
If the secondary trend’s effect has to be erased, it is important that the day-to-
day activity strongly support the primary trend, or else the market will start moving
in the opposite direction. In case the secondary trend is being supported by the day-
to-day activity, soon there will be a reverse in direction by the market and a new
primary trend will develop.
If over time there is an increase in the cyclical movements of the market
averages, and the successive lows become higher, there will be an upward trend in
the market. In case of the successive highs trending lower, and the successive low
trending lower, then there is a downward trend in the market.
1. What is the role played by a fundamental analyst?

................................................................................................................
................................................................................................................
................................................................................................................
2. As per the random walk theory why is technical analysis of no use?

................................................................................................................
................................................................................................................
................................................................................................................
2.4 SUMMARY
x One of the investments that are of the lowest risk category (therefore
lowest return) is interest-bearing notes, like money market funds and
certificates of deposit from banks. They provide the investor a guaranteed
periodic interest payment, or, in the case of T-bills, a lump sum based on a
guaranteed discount rate.
x Mutual funds promise to provide returns like the stock-market and also
low risk. Mutual funds are easy to understand for even new investors. Such
50
Approaches to
Investment Analysis
funds work with pooling together the funds invested by the members in
professionally managed portfolios of stocks, bonds, and such investments.
x Security analysis refers to the process applied for identifying the
opportunities for investment that are desirable, in such financial assets. With
reference to corporate stocks and bonds, the analysis flows from the
interpretation of accounting and financial data regarding operations,
profitability, net worth, and so forth.
x The basic methodologies that are applied in analysis are: technical analysis
and fundamental analysis. In their own way, each approaches investment
decisions from the top-down and from the bottom-up.
x The basic methodologies that are applied in analysis are: technical analysis
and fundamental analysis. In their own way, each approaches investment
decisions from the top-down and from the bottom-up.
x The bottom-up approach seeks out investments that are advantageous on
the basis of financial and performance criteria, both applicable across
sectors and industries.
x To know a company’s future value, it is essential to perform financial
analysis. The focus of financial analysis is on the condition of the financial
statements: the income statement, the balance sheet, the statement of
changes in shareholders’ equity and the funds flow statements.
x Technical analysis is used to study trends in stock prices so that future
prices can be predicted. Technical analysis is based on two major
techniques: study of key indicators and charting market activity.
x Charting proves useful for analysing market conditions and price behaviour
of individual securities. Such data provides trend of prices, insider sales,
short sales and trading volume over both long term and the intermediate
duration. This data has also been plotted by analysts to create charts, like
bar, line and point-and-figure.
x A stock price’s relative strength is a ratio of the average monthly stock
price compared to the monthly average index of the total market or the
51
Approaches to
Investment Analysis
stock’s industry group. It provides the analysts information regarding the

relationship of specific price movements to an industry or in general to the
market.
x Random walkers make use of the time-series models to relate efficient
markets to the behaviour of stock prices and investment returns. According
to them, price changes are not linked with the entry of new information into
the market, and the price changes are distributed evenly all across the
market. This assumption is contradicted by empirical evidence and
experience, and it is suggested that the random walk properties of returns
(or price changes) are highly restrictive.
x It has been theorized by Hamilton that the best gauge as far as financial and
business activity is concerned is the stock market since every relevant bit
of information is immediately discounted in the prices of stocks, as indexed
by the Dow Jones Industrial Average and the Dow Jones Transportation
Average.
2.5 KEY WORDS
x Stock price: It is the highest amount someone is willing to pay for the
stock, or the lowest amount that it can be bought for.
x Opportunity cost: It is the loss of other alternatives when one alternative
is chosen.
x Financial analyst: It is a person who performs financial analysis for
external or internal financial clients as a core part of the job.

1. One of the investments that are of the lowest risk category (therefore
lowest return) is interest-bearing notes, like money market funds and
52
Approaches to
Investment Analysis
certificates of deposit from banks. They provide the investor a guaranteed

periodic interest payment, or, in the case of T-bills, a lump sum based on a
guaranteed discount rate.
2. Essentially, security analysts play the role of catalysts driving efficient
market hypothesis. In other words, “smart” money shall efficiently and
logically so distribute itself that all available information will be reflected in
the price of the security. The moment some new information comes up, it is
assessed by the analysts and then they recommend market price
adjustments based on the price level changes which are anticipated by
them.

1. The role played by a fundamental analyst is seeking out superior returns
from securities which the market has mispriced. For this purpose, a
fundamental analyst will look at balance sheets and financial statements and
forecast the future dividends and earnings of the company being analysed,
‘the degree to which these exceed the expected average for the industry,
and the potential for the stock to move closer to a correct or fair value.’
2. According to the random walk theory it is of no use to perform technical
analysis due to the fact that past price and volume statistics by themselves
hold no information that bode well for success. According to them,
selecting securities at random will provide returns comparable with those
bought post fundamental and technical analysis.
1. Write a short note on mutual funds and securities.

2. Analyse the different approaches of investment analysis.
3. Write a short note on random walk theories.
53
Approaches to
Investment Analysis

McGraw-Hill.
54
Concept of Return
and Risk
UNIT–3 CONCEPT OF RETURN AND RISK
Objectives
x Discuss return analysis and risk analysis and their importance in investment
analysis
x Analyse the concept of return and risk
x Define diversification and its practices
x List the practices which ensure the best diversification
x Describe the technique of asset allocation
Structure
3.1 Introduction
3.2 Return and Risk
3.3 Diversification
3.4 Summary
3.5 Key Words
3.1 INTRODUCTION
Analysis and risk assessment is an integral part of any investment process, because
during the life of the investment project, there is a risk that the project will not
achieve desired result. There is no such situation in which it is known that all factors
that influence the choice and implementation of investment decisions and investors
are inevitably faced with certain risks. In order to reduce the risk to the lowest
possible level, the risk must be adequately considered, assessed, monitored and
avoided. In this way, management of the company try to quantify the potential risks
of investing by making rational decisions.
In financial planning, the investment goal must be considered in defining risk. If
your goal is to provide an acceptable amount of retirement income, you should
construct an investment portfolio to generate an expected return that is sufficient to
meet your investment goal. But because there is uncertainty that the portfolio will
earn its expected long-term return, the long-term realized return may fall short of the
55
Concept of Return
and Risk
expected return. This raises the possibility that available retirement funds fall short of
needs–that is, the investor might outlive the investment portfolio.
3.2 RETURN AND RISK
The two main aspects of investment analysis are return analysis and risk analysis.
The investor takes a number of decisions in the process of investment. He has to
decide about his risk tolerance level and the nature of assets to be bought, whether
they are stocks or bonds or real estates. Once he decides the nature of the asset, he
has to select it from the different alternatives. For example, the investor is faced with
many decisions while deciding about the investment to be made in the stock market.
There are blue chip companies that have a good record of earning profits over the
years and giving good return to the investors in terms of dividends, bonus, and price
appreciation. In the Bull Run of 2000-2006, the small companies and many penny
stocks gave good returns to the investors. The choice depends on the investors and
his risk-bearing capacity. The investor selects the stock on the basis of risk and
return analysis.
Rational investors, before investing their investible wealth in the stock, analyse
the risk associated with the particular stock. The actual return that can be earned
from a stock may vary and the risk is expressed in terms of variability of return. The
downside risk may be caused by several factors, either common to all stocks or
specific to a particular stock. Investors, in general would like to analyse the risk
factors and a thorough knowledge of the risk helps to plan the portfolio in such a
manner that minimizes the risk associated with the investment.
Establishing the value of bonds involves determining their fair price. This fair
price can be defined as the current value of the cash flows that can be generated.
This way bonds can be valued by discounting their current expected cash flow using
the correct rate of discount.
Investments involve undertaking a certain amount of risk and sacrifice in order to
earn more money using money. It also involves expected, and a certain amount of
unexpected, gains and losses. But this does not mean that investment decisions are
left to chance and fate. The risk involved and the expected rate of return influence all
investment decisions. All investments are futuristic. They represent hopes of
economic or material gains in the future. There are too many choices available to an
investor when it comes to investing.
56
Concept of Return
and Risk
Nature and Scope of Investment Analysis

Investment entails expectation of a future return. Therefore, the risk attached to
investment becomes important. Investment analysis focuses on the risk–return
relationship in the entire investment scenario. Investors need to decide on the return
they expect and the risk they are willing to take for the expected return. An investor
may invest in different avenues by creating a portfolio of investments with different
risk profiles.
The scope of investment covers various types of investments, their risk–return
character, the markets and the combined effect of all investments in the portfolio.
Investment analysis starts with the selection of investment avenues for a portfolio by
analysing the character of each investment and studying the market conditions and
their overall effect on the investment.
Elements of Investments
The main elements of investment are risk and return components. The other two
important elements of investment are tax shelter and markets or marketability.
Rate of return
The rate of return on an investment for a period of time is determined by the amount
of benefit or income and the principal amount of investment. It is normally referred
to as holding period returns.
Benefit or income + (Ending price of investment–Beginning price of investment)

Rate of return = Beginning price of investment
Return comprises income, which is referred to as the current yield earned by the
investment, and appreciation, which is referred to as capital gains.
Risk
The rate of return depends mainly on the type of investment selected. Risk is nothing
but the variability of return on an investment. Statistically, it is nothing but the
standard deviation of the normal return. Experts use different risk measures, such as
Variance, Standard deviation and Beta, for their study.
Variance is the square root of the deviations of the mean of individual returns. It
can be defined as the average of squared deviations of mean returns from individual
returns. Standard deviation is the square root of the variance. Beta is the movement
of stock returns in comparison to the market.
57
Concept of Return
and Risk
Return analysis
Investors want to maximize the return for their risk tolerance. Return is the motivating
factor that allows an investor to take risk. The investor considers both the realized
and expected returns. A realized return is the historical return which has already
happened, whereas na expected return is the return from the asset the investor
expects to earn over a future period. An expected return is normally forecast and
may or may not accrue.
Return on an investment consists of two components: interest or yield and capital
appreciation. In case of equity shares, the two components are dividends and the
changes in the stock prices between the date of purchase and sale. In the case of
long-term debt instruments, it is interest paid semi-annually and the price in the
market for the instrument if it is sold in the market before maturity or the redemption
value. Therefore,
Total return = Income + Price change (+/–)
Total return =
Return analysis: Arithmetic and Geometric Returns

It is customary to statistically use the arithmetic average, i.e., the sum of all
observations divided by the total number of values. This is given by the following
formula:
Where,
6x = sum of all observations
n = number of observations
Returns over a period of time, say one year of investment in any stock, can be
calculated on a daily or weekly or half-yearly basis. In such cases, arithmetic
average is used. When a different average over a multiple period is required,
geometric average is used. The geometric average return measures compound or
cumulative returns over time.
Where, R = total returns

n = number of periods
58
Concept of Return
and Risk
Tax shelter
Investments attract tax on their current income as well as on their capital gains.
However, some investments are exempted from tax on initial contribution and some
on their capital gains at the time of liquidation of investment. For example,
infrastructure bonds are exempted from tax on their initial investment.
Markets or marketability
An investment becomes worthy only when liquidity is high. The equity market
became more popular because it gave investors the most essential character of an
investment, i.e., liquidity. Markets allow shares to be freely traded for a desired
price. Equity markets are known for their Depth and Breadth. Depth refers to buy
or sell market orders for the same share and breadth refers to the volume of
transaction in the market.
The risk of investing and other aspects of security and risk analysis have been
dealt with in the next unit in detail.
Returns
The basic investment objectives may be summarized as safety, income and growth.
An investor who considers ‘safety’ as the primary objective will prefer fixed income
securities, especially government securities. Of course, returns from them tend to be
lower as compared to other types of securities, which, to a certain extent, can be
compensated by acquiring long-term fixed income securities. The overall risk in an
investor’s portfolio can be reduced by distributing risk over a wide variety of equity
shares in different industries. In satisfying the second objective, viz., ‘income’, fixed
income securities stand at the top. In the matter of meeting the third objective, viz.,
‘growth’, which implies capital appreciation, equity investment is the appropriate
choice.
Any investor, individual or group has to take into consideration several aspects
while investing the savings in ‘financial instruments’. One of them is: ‘how quickly
can the investment be converted in liquid cash if the need arises? Second, what is the
combination of investment to use so as to reduce the risk of loss and maximise
‘return’ over a period of time? For example, for older investors it is better to have a
combination of ‘fixed deposits, bonds and shares’. For the younger investor who
can take more risk, investment should be more in shares and less in fixed deposits.
This combination is known technically as ‘portfolio’. When different portfolio
decisions are taken for a group of investors or a large investor, they are termed as
‘strategy’.
59
Concept of Return
and Risk
In addition to the above primary objectives, there are two important secondary
objectives. They are ‘liquidity’ and ‘taxation’. An investment is liquid if it can be
converted into cash without loss at short notice. In this respect, money market funds
are very liquid. When an investor earns income from investments, the taxation aspect
of the income assumes importance. Different investment incomes attract different tax
treatments. A suitable investment strategy has to be chalked out bearing these
different tax treatments in mind in order to minimize the tax to be paid.
When an investor decides to invest, it is practically impossible to secure the
benefits arising from all the objectives mentioned above. This is because the
advantages associated with one objective will not generally result in the advantages
associated with another. For instance, where the objective of ‘growth’ is given
importance, the investor will be compelled to forego the advantages associated with
the objectives of ‘safety’ and ‘income’. As such, most portfolios will have to be
guided by one pre-eminent objective while the other objectives will have to be given
less weightage in the overall scheme. The investor need only be concerned with the
effort in finding, studying and deciding on the opportunities which match his/her
objectives. Asset allocation implies diversification of an investor’s asset portfolio
across all the different classes of assets. The aim of effective asset allocation is to
develop an appropriate mix of investments based on the investor’s specific
investment objectives which maximizes performance potential with an acceptable
level of investment risk. In short, chalking out clear investment objectives is a
necessary pre-requisite for developing a successful investment strategy.
Return on investment is a method that is used to determine how viable and
lucrative it is to make an investment and to compare the relative efficiency of
different investments. The rate of return is called holding period return because its
calculation is independent of the passages of the time. The result of the computation
of a return on investment is expressed in terms of a percentage or ratio. The
calculation of ‘return’ also depends upon who is doing so and for what purpose. For
instance, a marketeer may compare the return on investment of any two
commodities by dividing the gross profit earned on each product by the marketing
expenses incurred in connection with the concerned product. A financial analyst may
compare these products by using a different yardstick, i.e., by using a different
computation method. For example, an analyst may calculate the return on an
investment by dividing the net income generated by an investment by the net value of
all resources which have been used to produce and sell the commodity. Thus, return
60
Concept of Return
and Risk
on investment computations can easily be manipulated to suit the purpose of the user
and the result can be expressed in a variety of ways.
Risks
Risk can be defined as a chance that the actual outcome from an investment will
differ from the expected outcome. The dictionary meaning of risk is the possibility of
loss or injury; the degree or probability of such loss. In risk, the probable outcomes
of all the possible events are listed. Once the events are listed subjectively, the
derived probabilities can be assigned to the entire possible events. For example, the
investor can analyse and find out the possible range of returns from his investments.
He can assign some subjective probability to his returns, such as 50% of the time
there is a likelihood of getting ` 2 per share as dividend and 50% of the time the
possible dividend may be ` 3 per share. Often risk is interchangeably used with
uncertainty. In uncertainty, the possible events and probabilities of their occurrence
are not known. Hence, risk and uncertainty are different from each other.
The Risk Return trade-off

It is of prime importance to know about the extent of risk that you are willing to
indulge in even while still remaining comfortable with the investments you have made.
Risk can be defined as ‘the chance that an investment’s actual return will be
different than expected.’ This can technically be measured in statistical terms via the
use of standard deviation. In practical terms, risk is the possibility that the investor
could lose all or part of investment that was made originally.
Fig. 3.1 Risk/Return Tradeoff
When a person goes for low risk, he is also going for the potential returns on that
investment to be low. So, low risk is linked with low potential returns. Conversely,
61
Concept of Return
and Risk
high risks have been associated with high potential returns. With the risk return
trade-off, attempt is made to strike a balance between going for the lowest risk
possible and the highest return possible. The graphic given below represents the risk
return trade-off. If the standard deviation is high, the risk will also be high and so will
the possible return.
It is misunderstood that if there is a higher risk, the returns will also be higher. But
the fact is that the risk return trade-off depicts that higher risk provides a possibility
of higher returns not guaranteed higher returns. While risk means higher potential
returns, it also means higher potential losses.
On the risk scale’s lower end lies the scale of measure which is referred to as the
region of risk-free rate of return. The investment in this region is free from default or
non-payment of principal or interest by the person floating the investment. It is the
risk free rate in this region which is applied as reference for equity markets. The
overnight repo rate, on the other hand, is applied as reference for debt markets.
Consider that the current risk-free rate is 6 per cent, which would mean that without
taking any risk, virtually, it is possible to earn 6 per cent per year on money that is
invested.
Now, if index funds provide a return of average 13 per cent per year over the
long run (last five years), why will anyone be willing to settle for just 6 per cent per
annum? This is because the whole market which is represented by the index fund is
a place of risk, it carries immense risks as far as investments are concerned. It is not
that each year the return on index funds will be 13 per cent, but rather for example
it might be 8 on the first year and a 25 per cent in the very next year. An investor still
faces substantially greater risk and volatility to get an overall return that is higher than
a predictable government security. This is referred to as additional return, the risk
premium.
What can tell a person what is the correct risk level to work with? This is a
difficult question. From one person to another, the tolerance for risk will vary. The
need is dependent on the personal requirement, the income, current situation, and
other such factors. Therefore, each investor has to decide personal needs of
investment and the personal trade-off between risk and return, keeping in mind his
own investment objectives, life-stage and appetite for risk.
62
Concept of Return
and Risk
1. What are the two main aspects of investment analysis?

................................................................................................................
................................................................................................................
................................................................................................................
2. What are the basic investment objectives?

................................................................................................................
................................................................................................................
................................................................................................................
3. Define risk.
................................................................................................................
................................................................................................................
................................................................................................................
4. What is strategy?
................................................................................................................
................................................................................................................
................................................................................................................
5. When is an investment liquid?

................................................................................................................
................................................................................................................
................................................................................................................
3.3 DIVERSIFICATION
A technique for risk management, diversification works with a good mix of a variety
of investments within a portfolio so that it is possible to reduce and bring to minimum
the adverse effect of a single security on the overall performance of the portfolio.
63
Concept of Return
and Risk
With diversification, the risk of a portfolio is lowered. There are three main
practices that can help you ensure the best diversification:
x Spread the portfolio among multiple investment vehicles: Like mutual
funds, bonds, stocks and cash, a good idea would be to put purchase real
estate, too. Another way to go would be to purchase just mutual funds and
these must be of various different types. To take an example, approximately
30 per cent of the investment could be in equity schemes, about 40 per cent
in income/debt schemes and the remaining approximately 30 per cent could
be invested in money market schemes. One can also put money into
commodity funds, based on as and when SEBI permits them.
x Risk in the securities must be varied: In case the investment is made in
equity funds both small cap and large cap funds must be bought. If
investment is being made in debt, short-term as well as long-term debt must
be taken into account. The wise thing to do is to have investments in
varying levels of risk so that it is possible to offset any large loses with
investments made in other areas.
x Vary securities based on industry: Such a strategy helps to the impact
of specific risks of certain industries at a minimum.
All in all, it is diversification which is the key factor that will make it possible to
attain long-range financial goals with risk minimization. Investment always comes
with a risk and even diversification cannot cover all grounds.
Concept of Rupee Cost Averaging

It is considered that the most difficult task related to investment is timing the market.
In practice, to purchase at the lowest price and sell at the highest is next to
impossible. The use of rupee cost averaging (RCA) helps to reduce losses.
Rupee cost averaging is the process of putting in fixed amounts into a security/
stock/mutual fund at fixed points in time regardless of the prevailing price. So, more
units will be purchased of a security at lower prices, and fewer at higher prices. In
this way, there is an averaging out of the cost per unit/share over time. With RCA it
becomes possible to bring down the risk of making a big investment in a single
mutual fund/security at a wrong time.
The principle of RCA is an extremely powerful one and provides its best results
over long periods. The mutual funds’ based Systematic Investment Plans (SIPs) work
on the principle of RCA and is considered a good way to invest to reduce risks.
64
Concept of Return
and Risk
Technique of Asset Allocation

Asset allocation is an investment portfolio technique the goal of which is to strike a
balance between the risks and to create diversification by dividing assets among
major categories like cash, real estate, stocks and bonds. There is a different risk
level associated with each asset class, and due to this, the behaviour of each class
will vary over time. For example, while one asset in falling, the other will be rising in
value and another might be steadily holding the same position.
Asset allocation works on the basic principle that the older a person is, the
lower should be investment risks. For example, a retired person might have only
savings to fall back on and due to asset preservation being important, the investment
must be conservatively made.
1. What are the three main practices that can help ensure the best
diversification?
................................................................................................................
................................................................................................................
................................................................................................................
2. What do you understand by rupee cost averaging?

................................................................................................................
................................................................................................................
................................................................................................................
3.4 SUMMARY
x The two main aspects of investment analysis are return analysis and risk
analysis.
x Rational investors, before investing their investible wealth in the stock,
analyse the risk associated with the particular stock.
x The actual return that can be earned from a stock may vary and the risk is
expressed in terms of variability of return.
x Establishing the value of bonds involves determining their fair price. This fair
price can be defined as the current value of the cash flows that can be
generated.
65
Concept of Return
and Risk
x Investments involve undertaking a certain amount of risk and sacrifice in

order to earn more money using money. It also involves expected, and a
certain amount of unexpected, gains and losses.
x All investments are futuristic. They represent hopes of economic or material
gains in the future.
x The basic investment objectives may be summarized as safety, income and
growth. An investor who considers ‘safety’ as the primary objective will
prefer fixed income securities, especially government securities.
x The overall risk in an investor’s portfolio can be reduced by distributing risk
over a wide variety of equity shares in different industries.
x Any investor, individual or group has to take into consideration several
aspects while investing the savings in ‘financial instruments’.
x When different portfolio decisions are taken for a group of investors or a
large investor, they are termed as ‘strategy’.
x An investment is liquid if it can be converted into cash without loss at short
notice.
x Return on investment is a method that is used to determine how viable and
lucrative it is to make an investment and to compare the relative efficiency
of different investments.
x The rate of return is called holding period return, because its calculation is
independent of the passages of the time.
x Risk can be defined as a chance that the actual outcome from an investment
will differ from the expected outcome. In risk, the probable outcomes of all
the possible events are listed. It is ‘the chance that an investment’s actual
return will be different than expected.’
x With the risk return trade-off, attempt is made to strike a balance between
going for the lowest risk possible and the highest return possible.
x A technique for risk management, diversification works with a good mix of
a variety of investments within a portfolio so that it is possible to reduce
and bring to minimum the adverse effect of a single security on the overall
performance of the portfolio.
x With diversification the risk of a portfolio is lowered.
66
Concept of Return
and Risk
x It is considered that the most difficult task related to investment is timing the
market.
x Rupee cost averaging is the process of putting in fixed amounts into a
security/stock/mutual fund at fixed points in time regardless of the prevailing
price.
x The principle of RCA is an extremely powerful one and provides its best
results over long periods. The mutual funds’ based Systematic Investment
Plans (SIPs) work on the principle of RCA and is considered a good way
to invest to reduce risks.
x Asset allocation is an investment portfolio technique the goal of which is to
strike a balance between the risks and to create diversification by dividing
assets among major categories like cash, real estate, stocks and bonds.
3.5 KEY WORDS
x Rate of return: A rate of return is the gain or loss on an investment over

a specified time period, expressed as a percentage of the investment’s
cost.
x Investment analysis: It is the process of evaluating an investment for
profitability and risk, ultimately has the purpose of measuring how the given
investment is a good fit for a portfolio.

1. The two main aspects of investment analysis are return analysis and risk
analysis. The investor takes a number of decisions in the process of
investment. He has to decide about his risk tolerance level and the nature of
assets to be bought, whether they are stocks or bonds or real estates.
2. The basic investment objectives may be summarized as safety, income and
growth. An investor who considers ‘safety’ as the primary objective will
prefer fixed income securities, especially government securities.
3. Risk can be defined as a chance that the actual outcome from an investment
will differ from the expected outcome.
67
Concept of Return
and Risk
4. When different portfolio decisions are taken for a group of investors or a

large investor, they are termed as strategy.
5. An investment is liquid if it can be converted into cash without loss at short
notice.

1. The three main practices that can help ensure the best diversification are
spread the portfolio among multiple investment vehicles, risk in the
securities must be varied, and vary securities based on industry.
2. Rupee cost averaging is the process of putting in fixed amounts into a
security/stock/mutual fund at fixed points in time regardless of the prevailing
price. So, more units will be purchased of a security at lower prices, and
fewer at higher prices.
1. How does return analysis and risk analysis function as the two main aspects
of the investment analysis?
2. What do you understand by risk return trade-off?
3. With diversification, the risk of a portfolio is lowered. Discuss.

McGraw-Hill.
68
Security and Risk
Analysis
UNIT–4 SECURITY AND RISK ANALYSIS
Objectives
x Discuss the implications of security and risk analysis
x Assess and explain the measures and computations of systematic and
unsystematic risk
x Identify risk measurement tools
x Define characteristic regression line
Structure
4.1 Introduction
4.2 Security Analysis
4.3 Risk Analysis
4.4 Summary
4.5 Key Words
4.1 INTRODUCTION
In the previous units you studied about investment analysis and the concept of return
and risk.
Recapitulating the same, you learned that the two main aspects of investment
analysis are return analysis and risk analysis. Risk can be defined as a chance that
the actual outcome from an investment will differ from the expected outcome.
Whereas, return on investment is a method that is used to determine how viable and
lucrative it is to make an investment and to compare the relative efficiency of
different investments.
This unit will shed light on the topics pertaining to security analysis and risk
analysis along with their measures and computation.
69
Security and Risk
Analysis
4.2 SECURITY ANALYSIS
Analysis is a scientific method of study. We can look at analysis as being a careful

study of facts that are available. The study is conducted with the goal of arriving at
certain conclusions based on the facts under consideration on the basis of sound
logic and well as established principles. When analysis is applied to securities there
are pitfalls that come up due to the fact that by its very nature investment is not an
exact science.
Benjamin Graham and David Dodd in their book titled Security Analysis have
described three functions that are associated with security analysis: descriptive,
selective, and critical. Let us look at these functions:
1. Descriptive function
According to Benjamin Graham and David Dodd, ‘In its more obvious form,
descriptive analysis consists of marshalling the important facts relating to an issue and
presenting them in a coherent, readily intelligible manner. This function is adequately
performed for the entire range of marketable corporate securities …’
Analysis helps to reveal the weak and strong factors associated with the position
of an issue, helps to compare it with others that have a character which is similar,
and assess the factors that can impact the future performance of the issue.
This type of analysis can be applied to nearly every corporate issue.
2. Selective function
Security analysis, in the selective function provides its own specific judgements in this
function, security analysis tries to ascertain what should be done with an issue: buy,
sell, retain or exchanged for another.
3. Critical function
It is in the scope of security analysis that principles of investment finance and the
methods of corporation finance fall. One reaches an analytical judgment through the
application of standards to facts. So, the concern of the analyst is with the soundness
and practicability of the standards of selection. According to Benjamin Graham and
David Dodd, ‘He is also interested to see that securities, especially bonds and
preferred stocks, be issued with adequate protective provisions, and—more
important still—that proper methods of enforcement of these covenants be part of
accepted financial practice.’
70
Security and Risk
Analysis
The analyst wants the facts to be fairly presented, and for this he requires that he
should be extremely critical of the methods of accounting.
Also, the analyst must be aware of all corporate policies that can affect the
security owner. This is because the value of the issue that is being analysed by the
analyst is greatly dependent on the actions of the management.
1. What are the three functions associated with security analysis?

................................................................................................................
................................................................................................................
................................................................................................................
2. Describe descriptive analysis.
................................................................................................................
................................................................................................................
................................................................................................................
4.3 RISK ANALYSIS
We have already discussed the concept of risk in the previous unit. Risk consists of
two components, systematic risk and unsystematic risk. Systematic risk is caused by
factors external to the particular company and uncontrollable by the company. It
affects the market as a whole. In the case of unsystematic risk, the factors are
specific, unique and related to the particular industry or company.
Measures and Computation of Systematic Risk

Systematic risk affects the entire market. Often we read in newspapers that the
stock market is grappling in a bear hug or a bull grip. This indicates that the entire
market is moving in a particular direction, either downward or upward. Economic
conditions, political situations and sociological changes affect the security market.
The recession in the economy affects the profit prospect of the industry and the
stock market. The 1998 recession experienced by developed and developing
countries has affected the stock markets all over the world. The South East Asian
crisis has affected stock market worldwide. There the factors are beyond the control
of the corporate and the investor. They cannot be entirely avoided by the investor.
It drives home the point that systematic risk is unavoidable.
71
Security and Risk
Analysis
Systematic risk is further sub-divided into three parts:

x Market risk
x Interest rate risk
x Purchasing power risk
1. Market risk
Jack Clark Francis in his Journal ‘Statistical Analysis of Risk Surrogates for NYSE
stocks’, journal of financial and quantitative analysis, Vol 14 (5): 981-997: has
defined market risk as that portion of total variability of return caused by the
alternating forces of bull and bear markets. When the security index moves upward
haltingly for a significant period of time, it is known as bull market. In the bull market,
the index moves from a low level to the peak. Bear market is just a reverse to the
bull market; the index declines haltingly from the peak to a market low point called
trough for a significant period of time. During the bull and bear market more than 80
per cent of the securities’ prices rise or fall along with the stock market indices.
The forces that affect the stock market are tangible and intangible events. The
tangible events are real events such as earthquake, war, political uncertainty and fall
in the value of currency.
Fig. 4.1 Sensex Trend since Inception of the Series (1979) to 2013
Source: http://www.tradingeconomics.com/india/stock-market- 18th March, 2013.
SENSEX is the stock price index of the country computed and widely used
since its inception in 1979. First discernible bull-trend prevailed in early 1992, after
12 years of inception of the SENSEX series, only to be punctured by the Harshad
Mehta scam. Next bull trend took another 12 years from May 2004. The run lasted
72
Security and Risk
Analysis
for about 4 years to be punctured by American Melt down. But resilience of Indian
stock market was quick and as of March 2013 sensex hovers around 20000 points
or so.
It was on 8 January 2008 when the SENSEX touched an all time peak of
21078 before closing at 20873. The biggest crash in the history of Indian stock
market was on 18 May 2009 when the SENSEX increased by 2110.79 points from
the previous closing of 12174.42. This led to the suspension of trade for the whole
day. The reason was due to the victory of the UPA in the 15th general elections.
Trading was open for that day only for 55 seconds. Initially, in 25-30 seconds of
opening the market reached upper freeze limit twice in that day itself.
Thus, any untoward political or economic event would lead to a fall in the price
of the security which would be further accentuated by the over-reactions and the
herd-like behaviour of the investors. If some financial institutions start disposing the
stocks, the fear grips in and spreads to other investors. This results in a rush to sell
the stocks. The actions of the financial institutions would have a snowballing effect.
This type of over-reaction affects the market adversely and the prices of the scrips’
fall below their intrinsic values. This is beyond the control of the corporate.
2. Interest rate risk

Interest rate risk is the variation in the single period rates of return caused by the
fluctuations in the market interest rate. Most commonly, interest rate risk affects the
price of bonds, debentures and stocks. The fluctuations in the interest rates are
caused by changes in the government monetary policy and changes that occur in the
interest rates of treasury bills and the government bonds. The bonds issued by the
government and quasi-government are considered to be risk free. If higher interest
rates are offered, investor would like to switch his investments from private sector
bonds to public sector bonds. If the government to tide over the deficit in the budget
floats a new loan/bond of a higher rate of interest, there would be a definite shift in
the funds from low yielding bonds to high yielding bonds and from stocks to bonds.
Likewise, if the stock market is in a depressed condition, investors would like to
shift their money to the bond market to have an assured rate of return. The best
example is that in April 1996, most of the initial public offerings of many companies
remained undersubscribed but IDBI and IFC bonds were oversubscribed. The
assured rate of return attracted the investors from the stock market to the bond
market.
73
Security and Risk
Analysis
The rise or fall in the interest rate affects the cost of borrowing. When the call
money market rate changes, it affects the badla rate too. Most stock traders trade
in the stock market with the borrowed funds. The increase in the cost of margin
affects the profitability of the traders. This would dampen the spirit of the speculative
traders who use the borrowed funds. The fall in the demand for securities would
lead to a fall in the value of the stock index.
Interest rates not only affect the security traders but also the corporate bodies
who carry their business with borrowed funds. The cost of borrowing would
increase and a heavy outflow of profit would take place in the form of interest to the
capital borrowed. This would lead to a reduction in earnings per share and a
consequent fall in the price of share.
3. Purchasing power risk

Variations in the returns are caused also by the loss of purchasing power of currency.
Inflation is the reason behind the loss of purchasing power. The level of inflation
proceeds faster than the increase in capital value. Purchasing power risk is the
probable loss in the purchasing power of the returns to be received. The rise in price
penalises the returns to the investor and every potential rise in price is a risk to the
investor.
Inflation may be demand-pull or cost-push in nature. In the demand pull inflation,
the demand for goods and services are in excess of their supply. At full employment
level of factors of production, the economy would not be able to supply more goods
in the short run and the demand for products pushes the price upward. The supply
cannot be increased unless there is an expansion of labour force or machinery for
production. The equilibrium between demand and supply is attained at a higher price
level.
Cost-push inflation, as the name itself indicates, is inflation or rise in price caused
by an increase in cost. The increase in the cost of raw material, labour and
equipment makes the cost of production high and ends in high price level. The
producer tries to pass the higher cost of production to the consumer. Labourers or
the working force try to make the corporate to share the increase in the cost of living
by demanding higher wages. Thus, the cost push inflation has a spiralling effect on
price level.
The changes in the price levels are measured by the consumer price index for
industrial workers. This index uses a basket of goods used by the industrial
74
Security and Risk
Analysis
labourers in different parts of India. Wholesale price index is also used to measure
the inflation. The annual rate of inflation in terms of consumer price index of industrial
workers and wholesale price index are given in Table 4.1.
Table 4.1 Main Inflation Indicators
Years WPI CPI-IW

1997–98 4.4 6.8
1998–99 5.9 13.1
1999–00 3.3 3.4
2000–01 7.2 3.8
2001–02 3.6 4.3
2002–03 3.4 4.0
2007-08 4.7 6.2
2008-09 8.4 9.1
2010-11 9.56 10.45
2011-12 8.94 8.34
2012-13 7.55 10.00
(Source: RBI Bulletin)
Table 4.1 indicates the rate of growth of inflation in the Indian economy. The real
return of any investment could be calculated by using the following equation:
Nominal future value

Real future value =
1.0 + Inflation Rate (IR)
NIR – I
RIR = u 100
I
Where:
RIR = Real Interst Rate
NIR = Nominal Interest Rate effect on initial investment
I = Inflationary effect on initial investment
For example, if an investor gets a return of 12% on his investment and the
inflation rate is 6.8%, then the real value would be
1.0 + r
Real Rate of Return = – 1.0
1.0 + IR
75
Security and Risk
Analysis
1.0 .12
1
1.0 0.068
1.0486 1 .0486 4.86%
The example shows that his actual rate of return is only 4.86%. The purchasing
power has not increased by 12% according to his earnings. If, he really wants to
protect himself from the inflation and earn a 12% real rate of return, then his rate of
return should be 19.6 per cent.
1.0 + r
RR = -1
1.0 + IR
1 + r
0.12 +1 =
1.0 + 0.68
= 1.1961- 1 = .196 = 19.6%
If the investor has earned 5% return from his investment in stocks, even though
it gives an illusion of earning, his earning is actually negative. The following calculation
explains it.
1.0 + r
RR = –1
1.0 + IR
1.0 + .05
= – 1 = –.0169 = –1.69%
1.068
The investor’s income has increased by 5% but his real rate of return has
declined by 1.69 per cent. His investment has a negative real rate of return. Thus,
the changes that occur in the purchasing power also cause variations in the expected
return and the actual return. To tide over the purchasing power risk, the investor
should try to ensure that the nominal rate of return is greater than the inflation rate
prevailing in the economy. Thus, purchasing power risk affects returns from bonds,
debentures and stocks.
Measures and Computation of Unsystematic Risk

As already mentioned, unsystematic risk is unique and peculiar to a firm or an
industry. It stems from managerial inefficiency, technological change in the
production process, availability of raw material, changes in the consumer preference
and labour problems. The nature and magnitude of these factors differ from industry
to industry, and company to company. They have to be analysed separately for each
industry and firm. Changes in the consumer preference affect consumer products
like television sets, washing machines, refrigerators more than they affect the iron and
steel industry. Technological changes affect the information technology industry more
76
Security and Risk
Analysis
than that of consumer product industry. Thus, it differs from industry to industry.
Financial leverage of the companies that is debt-equity portion of the companies
differs from each other. The nature and mode of raising finance and paying back the
loans involve a risk element. All these factors form unsystematic risk and contribute
a portion in the total variability of the return. Broadly, unsystematic risk can be
classified into two sub-heading: Business and Financial Risks.
1. Business risk
Business risk is that portion of the unsystematic risk caused by the operating
environment of the business. Business risk arises from the inability of a firm to
maintain its competitive edge and the growth or stability of the earnings. Variation
that occurs in the operating environment is reflected on the operating income and
expected dividends. The variation in the expected operating income indicates the
business risk. Consider two companies—Anu and Vinu companies. In Anu
company, operating income could grow as much as 15 per cent and as low as 7 per
cent. In Vinu company, the operating income can be either 12 per cent or 9 per cent.
When both the companies are compared, Anu company’s business risk is higher
because of its high variability in operating income compared to Vinu company. Thus,
business risk is concerned with the difference between revenue and earnings before
interest and tax. Business risk can be divided into external business risk and internal
business risk.
(i) Internal business risk

Internal business risk is associated with the operational efficiency of the firm. The
operational efficiency differs from company to company. The efficiency of operation
is reflected on the company’s achievement of its pre-set goals and the fulfillment of
the promises to its investors.
x Fluctuations in sales: Sales level has to be maintained. It is common in
business to lose customers abruptly because of competition. Loss of
customers will lead to a loss in operational income. Hence, the company
has to build a wide customer base through various distribution channels.
Diversifed sales force may help to tide over this problem. Big corporate
bodies have long chain of distribution channel. Small firms often lack this
diversified customer base.
x Research and development (R&D): Sometimes the product may go out
of style or become obsolescent. It is the management that has to overcome
77
Security and Risk
Analysis
the problem of obsolescence by concentrating on the in-house research

and development program. For example, if Maruti Udyog has to survive
the competition, it has to keep its Research and Development section
active and introduce consumer oriented technological changes in the
automobile sector. This is often carried out by introducing sleekness,
seating comfort and break efficiency in their automobiles. New products
have to be produced to replace the old one. Reducing R&D budget for
short term advantage would be perilous for a company whose survival
depends on then products remaining continually competitive.
x Personnel management: Personnel management of the company also
contributes to the operational efficiency of the firm. Frequent strikes and
lock outs result in loss of production and high fixed capital cost. The labour
productivity also would suffer. The risk of labour management is present in
all the firms. It is up to the company to solve the problems at the table level
and provide adequate incentives to encourage the increase in labour
productivity. Encouragement given to the labourers at the floor level would
boost morale of the labour force and leads to higher productivity and less
wastage of raw materials and time.
x Fixed cost: Cost components also generate internal risk if the fixed cost is
higher in the cost component. During the period of recession or low
demand for product, the company cannot reduce the fixed cost. At the
same time in the boom period also the fixed factor cannot vary
immediately. Thus, the high fixed cost component in a firm would become
a burden to the firm. The fixed cost component has to be kept always in a
reasonable size, so that it may not affect the profitability of the company.
x Single product: The internal business risk is higher in the case of a firm
producing a single product. The fall in the demand for a single product
would be fatal for the firm. Further, some products are more vulnerable to
the business cycle while some products resist and grow against the tide.
Hence, the company has to diversify the products if it has to face the
competition and the business cycle successfully. Consider for instance,
Hindustan Lever Ltd., which produces a wide range of cosmetics has been
thriving in business. Even in diversification, diversifying the product in the
unknown path of the company may lead to an internal risk. Unwieldy
diversification is as dangerous as producing a single good.
78
Security and Risk
Analysis
(ii) External business risk

External risk is the result of operating conditions imposed on the firm by
circumstances beyond its control. The external environments in which it operates
exert some pressure on the firm. The external factors are social and regulatory
factors, monetary and fiscal policies of the government, business cycle and the
general economic environment within which a firm or an industry operates.
Government can promote a particular industry by giving tax holiday or by other
initiatives. As a consequence, the stock price of that industry will increase. For
instance, the sugar and fertilizer industry in India depend on external factors.
x Social and regulatory factors: Harsh regulatory climate and legislation
against the environmental degradation may impair the profitability of the
industry. Price control, volume control, import/export control and
environment control reduce the profitability of the firm. This risk is more in
industries related to public utility sectors such as telecom, banking and
transportation. The governments’ tariff policy of the telecom sector has a
direct bearing on its earnings. Likewise, the interest rates and the directions
given in the lending policies affect the profitability of the banks. CESC has
not been able to increase its power tariff due to the stiff resistance by the
West Bengal government. The Pollution Control Board has asked to close
most of the tanneries in Tamil Nadu, which has affected the leather industry.
x Political risk: Political risk arises out of the change in the government
policy. With a change in the ruling party, the policy also changes. When
Manmohan Singh was the finance minister, liberalization policy was
introduced. During the Bharathiya Janata Party government tenure, even
though efforts were taken to augment the foreign investment, more stress
was given to Swadeshi. Political risk arises mainly in the case of foreign
investment. The host government may change its rules and regulations
regarding the foreign investment. From the past, an example can be cited.
In 1977, the government decided that the multinationals must dilute their
equity and share their growth with the Indian investors. This forced many
multinationals to liquidate their holdings in the Indian companies.
x Business cycle: The fluctuations of the business cycle lead to fluctuations
in the earnings of the company. Recession in the economy leads to a drop
in the output of many industries. Steel and white consumer goods industries
tend to move in tandem with the business cycle. During the boom period,
there would be hectic demand for steel products and white consumer
79
Security and Risk
Analysis
goods. But at the same time, they would be hit much during the recession
period. At present, the information technology industry has resisted the
business cycle and moved counter cyclically during the recession period.
The effects of the business cycle vary from one company to another.
Sometimes, companies with inadequate capital and consumer base may be
forced to close down. In some other case, there may be a fall in the profit
and the growth rate may decline. This risk factor is external to the
corporate bodies and they may not be able to control it.
2. Financial Risk
Financial risk refers to the variability of the income to the equity capital due to the
debt capital. Financial risk in a company is associated with the capital structure of the
company. Capital structure of the company consists of equity funds and borrowed
funds. The presence of debt and preference capital results in a commitment of paying
interest or pre fixed rate of dividend. The residual income alone would be available
to the equity holders. The interest payment affects the payments that are due to the
equity investors. Debt financing increases the variability of the returns to the common
stock holders and affects their expectations regarding the return. The use of debt
with the owned funds to increase the return to the shareholders is known as financial
leverage.
Debt financing enables a corporate to have funds at a low cost and low financial
leverage to the shareholders. As long as the earnings of a company are higher than
the cost of borrowed funds, shareholders’ earnings are increased. At the same time
when the earnings are low, it may lead to bankruptcy to equity holders. This can be
illustrated with the help of the following example. Please note that no tax has been
assumed in order to simplify the concept.
Years
2006 2007 2008
Company A
Equity Capital 20,00,000 20,00,000 20,00,000
`10 per share
Debt fund 10,00,000 10,00,000 10,00,000
(10% interest)
Operating income 3,00,000 40,00,00 20,00,00
Earnings per share 1 1.5 0.5
Contd...
80
Security and Risk
Analysis
Company B
Equity Capital 10,00,000 10,00,000 10,00,000
`10 per share
Debt fund
(10% interest) 20,00,000 20,00,000 20,00,000
Operating income 3,00,000 4,00,000 2,00,000
Earnings per share 1.0 2.0 Nil
This example deals with three different situations. In 2006, both the companies
earned the same amount and the earnings per share were same. But, in 2007, there
was a 33.33 per cent hike in the earnings of the two companies. In company A,
33.33 per cent rise in operating income has resulted in a 50 per cent increase in
earnings per share. In company B, the effect of increase in operating income is
more. The earnings per share has increased by cent per cent i.e. from `1 to `2. This
is because the bond holders receive only the fixed interest whether the company
fared well or not. The increase in earnings per share would cause a change in the
capital appreciation in the shares of company B during a good year.
In 2008, the economic climate has changed and there is a fall in the operating
profit by 33.33 per cent for both the companies. This has caused 50 per cent fall in
earnings per share for company A compared to 2006. But company B,s earnings
per share has fallen to zero and the shareholders are affected adversly in the bad
year. If we assume another situation of negative earnings, the situation would be
worse in company B and the shareholders will be affected much. A few years of
persistent negative earnings will erode the shareholders’ equity. Fixed return on
borrowed capital either enhances or reduces the return to shareholders.
The financial risk considers the difference between EBIT and EBT (earnings
before tax). The business risk causes the variations between revenue and EBIT.
Payment of interest affects the eventual earnings of the company stock. Thus,
volatility in the rates of return on the stock is magnified by the borrowed money. The
variations in income caused by the borrowed funds in highly levered firms are greater
compared to the companies with low leverage. Financial leverage or financial risk is
avoidable because it is the management that has to decide how much to funding must
be equity capital how much should be borrowed capital.
Minimizing Risk Exposure

Every investor wants to guard himself from risk by understanding the nature of the
risk and by planning carefully. The following sections give an agenda for protecting
investors from the different types of risks.
81
Security and Risk
Analysis
1. Market risk protection

(i) The investor has to study the price behaviour of the stock. The stock that
shows a growth pattern may continue to do so for some more period. The
Indian stock market expects the growth pattern to continue for some more
time in information technology stock and depressing conditions to continue
in the textile related stock. Some stocks may be cyclical stocks and they
are avoided better.
(ii) The standard deviation and beta indicate the volatility of the stock. The
standard deviation and beta are available for the stocks that are included in
the indices. The National Stock Exchange News bulletin provides this
information. Looking at the beta values, the investor can gauge the risk
factor and make wise decision according to his risk tolerance.
(iii) Further, the investor should be prepared to hold the stock for a period of
time to reap the benefits of the rising trends in the market. He should be
careful in the timings of the purchase and sale of the stock. He should
purchase it at the lower level and sell at a higher level.
2. Protection against interest rate risk

(i) Often suggested solution for this is to hold the investment to maturity. If he
sells it in the middle due to fall in the interest rate, the capital invested
would experience a heavy loss.
(ii) The investors can also buy treasury bills and bonds of short maturity. The
portfolio manager can invest in the treasury bills and the money can be
reinvested in the market to suit the prevailing interest rate.
(iii) Another suggested solution is to invest in bonds with different maturity
dates. When the bonds mature in different dates, reinvestment can be done
according to the changes in the investment climate. Maturity diversification
can yield the best results.
3. Protection against inflation

(i) The general opinion is that the bonds or debentures with fixed return
cannot solve the problem. If the bond yield is 13 to 15 per cent with low
risk factor, they would provide hedge against the inflation.
(ii) Another way to avoid the risk is to have investment in short-term securities
and to avoid long-term investment. The rising consumer price index may
wipe off the real rate of interest in the long term.
82
Security and Risk
Analysis
(iii) Investment diversification can also solve this problem to a certain extent.
The investor has to diversify his investment in real estates, precious metals,
arts and antiques along with the investment in securities. One cannot assure
that different types of investments would provide a perfect hedge against
inflation. It can minimize the loss due to the fall in the purchasing power.
4. Protection against business and financial risk

(i) To guard against business risks, the investor has to analyse the strength and
weakness of the industry to which the company belongs. If weakness of
the industry is too much of government interference in the way of rules and
regulations, it is better to avoid it.
(ii) Analysing the profitability trend of the company is essential. The calculation
of standard deviation would yield the variability of the return. If there is
inconsistency in the earnings, it is better to avoid it. The investor has to
choose a stock of consistent track record.
(iii) The financial risk should be minimized by analysing the capital structure of
the company. If the debt equity ratio is higher, the investor should have a
sense of caution. Along with the capital structure analysis, he should also
take into account of the interest payment. In a boom period, the investor
can select a highly levered company but not in a recession.
1. What are the three subdivisions of systematic risk?

................................................................................................................
................................................................................................................
................................................................................................................
2. Define interest rate risk.
................................................................................................................
................................................................................................................
................................................................................................................
Risk Measurement
Understanding the nature of the risk is not adequate unless the investor or analyst is
capable of expressing it in some quantitative terms. Expressing the risk of a stock in
quantitative terms makes it comparable with other stocks. Measurements cannot be
83
Security and Risk
Analysis
assured of cent percent accuracy because risk is caused by social, political and
economic factors and managerial efficiency. Measurement provides an approximate
quantification of risk. The statistical tool often used to measure and used as a proxy for
risk is standard deviation.
Standard deviation
It is a measure of the values of the variables around its mean or it is the square root
of the sum of the squared deviations from the mean divided by the number of
observances. The arithmetic mean of the returns may be same for two companies
but the returns may vary widely. This can be illustrated with an example.
Now let us take two companies A and B to calculate the expected returns.
Company A Company B
(ri) (Pi) (Pi)(ri) (ri) (Pi) (Pi)(ri)
6 0.10 0.6 4 0.1 0.4
7 0.25 1.75 6 0.2 1.2
8 0.30 2.4 8 0.4 3.2
9 .25 2.25 10 0.2 2.0
10 .10 1.00 12 0.1 1.2
¦E (r) = 8.00 ¦E (r) = 8.00

In the example given here the expected means are the same in both the
companies. Company A return varies from 6% to 10% while company B’s return
varies from 4% to 12%. To find out the variation, the standard deviation technique
is applied.
N
σ= P [ri E ( r )]2
i 1
n
Varience (V2 ) ¦ P[r
i 1
i E(r)]2
hence V Variance (V 2 )
For company A
ri Pi r1-E(r) [r1- E(r)]2 P1[r1-E (r) ]2
6 0.10 –2 4 .4
7 0.25 –1 1 .25
8 0.30 0 0 0
9 0.25 +1 1 .25
10 0.10 +2 4 .40
1.30
84
Security and Risk
Analysis
N
V ¦ P[r E(r)]
i 1
i
2
V 1.30 1.14
For company B
ri Pi ri-E(r) [ri - E(r)]2 Pi [ri-E (r) ]2
4 0.1 –4 16 1.6
6 0.2 –2 4 .8
8 0.4 0 0 0
10 0.2 +2 4 .8
12 0.1 +4 16 1.6
——-
4.8
N
V ¦P
i 1
i [ri E(r)]2
V 4.80 2.19
The expected returns are same for companies A and B but the variations in expected
returns are different. Company A’s expected return is stable compared to company
B’s expected return. The standard deviation helps to measure the variability of
return. The variability in return includes both systematic and unsystematic risks.
Characteristic regression line (CRL)

Characteristic regression line (CRL) is a simple linear regression model estimated for
a particular stock against the market index return to measure risks. The model is:
Ri = Rf + E i Rm + e i
Ri = Return of the ith stock
Rf = Risk free rate of return
85
Security and Risk
Analysis
Ei = Slope of the ith stock

Rm = Return of the market index
e i = The error term
The security return is:
Today's price – Yesterday's price
Today's security return = ×100
Yesterday's price
Today's index – Yesterday's index
Today's market return = ×100
Yesterday's index
Like daily returns, weekly returns can be calculated by using this week’s and last
week’s prices instead of today’s and yesterday’s prices in the above mentioned
formula. Monthly returns also can be calculated.
Let us consider the daily prices of the Bajaj Auto stock and the NSE index for
the period 5th Oct 2008 to 16th Oct 2008. The objective of this example is only to
illustrate the computation of beta. Usually beta values have to be calculated from
data of a fairly long period to minimize the sampling error.
Date Bajaj Auto (Y)

October 5 597.80
October 6 570.80
October 7 582.95
October 8 559.85
October 9 554.60
October 12 545.10
October 13 519.15
October 14 560.70
October 15 560.95
October 16 597.40
To calculate the beta value, the returns have to be calculated. Then using the
formula, the beta and alpha coefficient can be calculated.
n¦ XY (¦ x)¦ y)
E 2
n¦ X (¦ X)2
D Υ E Χ
86
Security and Risk
Analysis
The calculations are given below.
Index X2 Bajaj Auto (Y)2 (XY)

Return X stock return Y
–6.54 42.77 –4.52 20.43 29.56
3.37 11.36 2.13 4.54 7.18
–3.01 9.06 –3.96 15.68 11.92
0.14 0.02 –0.94 00.88 –.13
–1.57 2.46 –1.71 2.92 2.68
–2.28 5.20 –4.76 22.66 10.85
3.28 10.76 8.00 64.00 26.24
–0.95 0.90 .04 .00 –00.04
0.47 0.22 6.50 42.25 3.06
–7.09 82.75 0.78 173.36 91.32
n ¦ XY ( ¦ x) ¦ y)
E
n ¦ x 2 ( ¦ x)2
9 u 91.32 (7.09) (.78)
9 u 82.75 (7.09)2
E 1.19
D Υ E Χ
.78
Υ .086
9
7.09
Χ .79
9
0.086 (1.19 u 0.79)
D 1.02
D = Rf = risk free return in the market (Normally, it is the interest rate on the T-
bills as they are considered the safest instruments).
The manual calculation seems to be laborious. At present beta can be calculated
with the help of hand calculators and computers very easily. When an investor has to
calculate for a long period computer would be of great use. Along with beta, other
information also can be got. Given below is the computer spread sheet for the
previous example. i.e. for Bajaj Auto stock return on NSE index return.
Ri D 1 Ei R m e i
D = 1.02, b = 1.19 standard error is 0.0266
1 1
Standard deviation of stock return : 4.39

Variance of stock return : 19.27
87
Security and Risk
Analysis
Standard deviation of Index return :3

Variance of the Index return :9
Correlation coefficient : 0.795
Beta
Beta is the slope of the characteristic regression line. Beta describes the relationship
between the stock’s return and the index returns. In the above example, beta
indicates that one per cent change in NSE index return would cause 1.19 per cent
change in the Bajaj Auto stock return.
1. Beta = + 1.0
One per cent change in market index return causes exactly one per cent
change in the stock return. It indicates that the stock moves in tandem with
the market.
2. Beta = + 0.5
One per cent change in market index return causes 0.5 per cent change in
the stock return. The stock is less volatile compared to the market.
3. Beta = + 2.0
One per cent change in market index return causes 2 per cent change in the
stock return. The stock return is more volatile. When there is a decline of
10 per cent in the market return, the stock with a beta of 2 would give a
negative return of 20 per cent. The stocks with more than 1 beta value is
considered to be risky.
4. Negative beta value indicates that the stock return moves in the opposite
direction to the market return. A stock with a negative beta of –1 would
provide a return of 10 per cent, if the market return declines by 10 per cent
and vice versa.
Stocks with negative beta resist the decline in the market return, but stocks with
negative returns are very rare.
Figure 4.2 (a, b, c) shows E= 1, E > 1 and E < 1 and the D.
88
Security and Risk
Analysis
Fig. 4.2(a) Systematic Market Risk
Fig. 4.2(b) High Systematic Risk Fig. 4.2(c) Low Systematic Risk
Alpha
The intercept of the characteristic regression line is alpha i.e. the distance between
the intersection and the horizontal axis. It indicates that the stock return is
independent of the market return. A positive value of alpha is a healthy sign. Positive
alpha values would yield profitable return.
Correlation
The correlation coefficient measures the nature and the extent of relationship
between the stock market index return and the stock return in a particular period.
n¦ XY ( ¦ X) ( ¦ Y)
r
2 2
n¦ X (¦ X)2 n¦ Y ( ¦ Y)2
9 u 91.32 ( 7.09 (.78)
9 u 82.75 (7.09)2 9 u 173.36 (.78)2
827.41
0.79
1040.73
89
Security and Risk
Analysis
The square of the correlation coefficient is the coefficient of determination. It

gives the percentage of variation in the stock’s return explained by the variation in the
market’s return. In our example,
r2 = (0.79)2 = 0.62
The interpretation is that 62 per cent of variations in stock’s return is explained
by the variations in the NSE index return.
1. What do you understand by standard mean?

................................................................................................................
................................................................................................................
................................................................................................................
2. What is a characteristic regression line?

................................................................................................................
................................................................................................................
................................................................................................................
4.4 SUMMARY
x Analysis is a scientific method of study. The study is conducted with the

goal of arriving at certain conclusions based on the facts under
consideration on the basis of sound logic and well as established principles.
x Benjamin Graham and David Dodd in their book titled Security Analysis
have described three functions that are associated with security analysis:
descriptive, selective, and critical.
x Risk consists of two components, systematic risk and unsystematic risk.
Systematic risk is caused by factors external to the particular company and
uncontrollable by the company.
x Economic conditions, political situations and sociological changes affect the
security market. The recession in the economy affects the profit prospect
of the industry and the stock market.
x When the security index moves upward haltingly for a significant period of
time, it is known as bull market.
90
Security and Risk
Analysis
x Interest rate risk is the variation in the single period rates of return caused
by the fluctuations in the market interest rate. Most commonly, interest rate
risk affects the price of bonds, debentures and stocks.
x The fluctuations in the interest rates are caused by changes in the
government monetary policy and changes that occur in the interest rates of
treasury bills and the government bonds.
x The rise or fall in the interest rate affects the cost of borrowing.
x Variations in the returns are caused also by the loss of purchasing power of
currency. Inflation is the reason behind the loss of purchasing power.
x Inflation may be demand-pull or cost-push in nature. In the demand pull
inflation, the demand for goods and services are in excess of their supply.
x Cost-push inflation, as the name itself indicates, is inflation or rise in price
caused by an increase in cost. The increase in the cost of raw material,
labour and equipment makes the cost of production high and ends in high
price level.
x Business risk is that portion of the unsystematic risk caused by the
operating environment of the business. Business risk arises from the inability
of a firm to maintain its competitive edge and the growth or stability of the
earnings.
x Internal business risk is associated with the operational efficiency of the
firm.
x External risk is the result of operating conditions imposed on the firm by
circumstances beyond its control.
x The fluctuations of the business cycle lead to fluctuations in the earnings of
the company. Recession in the economy leads to a drop in the output of
many industries.
x Financial risk refers to the variability of the income to the equity capital due
to the debt capital. Financial risk in a company is associated with the
capital structure of the company. Capital structure of the company consists
of equity funds and borrowed funds.
x The statistical tool often used to measure and used as a proxy for risk is
standard deviation. It is a measure of the values of the variables around its
mean or it is the square root of the sum of the squared deviations from the
mean divided by the number of observances.
91
Security and Risk
Analysis
x Characteristic regression line (CRL) is a simple linear regression model

estimated for a particular stock against the market index return to measure
risks.
x Beta is the slope of the characteristic regression line. Beta describes the
relationship between the stock’s return and the index returns.
x Negative beta value indicates that the stock return moves in the opposite
direction to the market return.
x Stocks with negative beta resist the decline in the market return, but stocks
with negative returns are very rare.
x The intercept of the characteristic regression line is alpha i.e. the distance
between the intersection and the horizontal axis. It indicates that the stock
return is independent of the market return.
x The correlation coefficient measures the nature and the extent of
relationship between the stock market index return and the stock return in
a particular period.
x The square of the correlation coefficient is the coefficient of determination.
It gives the percentage of variation in the stock’s return explained by the
variation in the market’s return.
4.5 KEY WORDS
x Interest rate risk: It is the variation in the single period rates of return
caused by the fluctuations in the market interest rate.
x Business risk: It is that portion of the unsystematic risk that is caused by
the operating environment of the business.
x Financial risk: It refers to the variability of the income to the equity capital
due to the debt capital.
x Standard deviation: It is a measure of the values of the variables around
its mean or it is the square root of the sum of the squared deviations from
the mean divided by the number of observances.
x Characteristic regression line: It is a simple linear regression model
risks.
92
Security and Risk
Analysis
x Alpha: The intercept of the characteristic regression line is alpha, i.e., the
distance between the intersection and the horizontal axis.

1. Benjamin Graham and David Dodd in their book titled Security Analysis
have described three functions that are associated with security analysis:
descriptive, selective, and critical.
2. Descriptive analysis consists of marshalling the important facts relating to an
issue and presenting them in a coherent, readily intelligible manner. This
function is adequately performed for the entire range of marketable
corporate securities.

1. Systematic risk is sub-divided into three parts:
x Market risk
x Interest rate risk
x Purchasing power risk
2. Interest rate risk is the variation in the single period rates of return caused
by the fluctuations in the market interest rate. Most commonly, interest rate
risk affects the price of bonds, debentures and stocks.

1. Standard mean is a measure of the values of the variables around its mean
or it is the square root of the sum of the squared deviations from the mean
divided by the number of observances.
2. Characteristic regression line (CRL) is a simple linear regression model
risks.
1. According to Benjamin Graham and David Dodd, three functions are

associated with security analysis. What are the three functions? Explain.
93
Security and Risk
Analysis
2. Analyse the measures and computation of unsystematic risk.

3. Write a descriptive note on characteristic regression line with the help of
graphs.
4. What is external business risk?
5. What is systematic risk? Explain its sub-divisions.
6. Explain political risk arising out of the change in the government policy.
7. How can an investor be protected from inflation?
8. How can risk be measured? Explain in detail.

McGraw-Hill.
94
Functions and Methods of
Selling Securities in Primary
and Secondary Market
BLOCK-II
SECURITIES MARKET IN INDIA
In this block, you will learn about the structure of the security market in India. The features
and functions of the primary and secondary market along with the method of selling securities
is explained in detail in this block. You will also analyse the importance, types and role of a
market broker along with the trading mechanism and the procedure of listing of securities in
stock exchange.
The fifth unit explains the functions and methods for issue of securities in primary and
secondary market. The concept of initial public offerings is also discussed in detail in the unit.
Further, the unit provides an account of the products of the secondary market such as equity
shares, government securities, debentures, and zero coupon bond and treasury bills.
The sixth unit gives an overview of the role performed by brokers in a market. The unit
provides a list of various types of brokers and elaborates on some of the important types for
example commercial broker, insurance broker and stock broker. The stock broker-client
relationship is also discussed in the unit.
The seventh unit provides an account of the trading mechanism as well as an explanation of
the varied kinds of trading that exist and their features such as that of online trading, day
trading and margin trading. The unit talks about the Bombay Stock Exchange (BSE) and
National Stock Exchange (NSE) and elucidates on topics as that of listing in BSE and NSE,
trading in BSE and NSE and investor interests and the BSE and the NSE. The listing
procedure, its merits and demerits and delisting are also discussed.
95
UNIT–5 FUNCTIONS AND METHODS OF SELLING

SECURITIES IN PRIMARY AND SECONDARY
MARKET
Objectives
x Differentiate between primary and secondary market
x Discuss the functions of primary and secondary market
x Describe the different products of the secondary market
x Describe the participants of the secondary market
Structure
5.1 Introduction
5.2 Primary Market
5.3 Secondary Market
5.4 Summary
5.5 Key Words
5.1 INTRODUCTION
The two segments of capital market are the primary and the secondary market. The
primary market deals with issue of new or fresh securities and is, thus, also known
as new issue market. The secondary market facilitates the purchase and sale of the
existing securities, and is often termed as stock market or stock exchange. It is
necessary for the investors to understand the working of these markets for an
informed decision-making.
In the primary market, new securities are issued while the secondary market
allows the trading of already issued securities. Due to huge value of investments,
individual players cannot invest in the money market. On the other hand, capital
market allows all to invest even with a modest amount.
97
5.2 PRIMARY MARKET
Primary market also called the new issue market, is the market for issuing new
securities. The main players of these markets are the private and public companies
that offer equity or debt based securities such as stocks and bonds in order to raise
money for their operations.
The features are as follows:
x It is a market for long-term capital where the securities are sold for the first
time. Hence, it is also called New Issue Market (NIM).
x Funds are collected and securities are issued directly by the company to the
investors.
x Primary issues are carried out by the companies for the purpose of
inception and functioning of business.
Benefits of Primary Market

The benefits are as follows:
x Company need not repay the money raised from the market.
x Money has to be repaid only in the case of winding up or buyback of
shares.
x There is no financial burden, because it does not involve interest payment.
If the company earns profit, dividend may be paid.
x Better performance of the company enhances the value for the
shareholders.
x It enables trading and listing of securities at stock exchanges.
x There is greater transparency in the corporate governance.
x If the company performs well; the image of the company brightens.
Disadvantages of the Public Issues

The disadvantages are as follows:
x It is a time consuming process involving the fulfilment of legal formalities.
x It is expensive and many intermediaries are involved in it. It necessitates
constant adherence to listing of agreements and legal requirements.
x Cornering of shares and hostile takeover may take place.
98
x Speculative trading of the company’s equity affects the reputation of the

company.
Types of Issues
Issues are classified into:
(a) Public issues
(b) Preferential issues (also known as private placements)
(c) Rights issues
Public Issue
When a company wants to raise capital by issuing shares to general investors, the
process is generally called public issue of shares or a primary market issue. Public
issues can be further classified as:
(i) Initial public offering
(ii) Follow-on public offering
(iii) Fast-track issue
Initial Public Offering

If the company is a new entrant to the capital markets, the issue made by such a
company is called Initial Public Offering (IPO). In other words, if the company
makes the public issue for the first time, it is an IPO. These issues are listed and
traded on stock exchanges as specified in the offer documents.
Follow on Public Offering (FPO)

If a company whose shares are already listed on a stock exchange, issues shares,
such an offering is called a further public offering. These are also called follow-on
public issues. Sometimes, the term IPO is interchangeably used with FPO. Listing or
continuous listing has to be satisfied by the FPO company. In 2006-2007, out of the
85 public issues, 77 were IPOs and the remaining were FPOs.
Fast-track Issue
The fast-track system introduced by SEBI in November 2007, was suggested by
the SEBI’s Primary Market Advisory Committee (PMAC). In the Fast-Track Issue
(FTI), well established and compliant listed companies need to make only
rationalized disclosures, rather than comprehensive ones, for follow-on public offers
and rights issues. The compliant company here means the company which complies
99
with the required rules and regulations. Provisions of the fast-track issue are on the
lines of the well-known seasoned issuers model of the US. This facility is available
to the companies that are listed on the Bombay Stock Exchange (BSE) or the
National Stock Exchange (NSE) for at least three years.
Companies eligible for a fast-track issue of shares must have an average market
capitalization of ` 10,000 crore of public shareholding for a period of one year. The
trading on the securities market should constitute at least 2 per cent of the total listed
shares of the last one year. No prosecution proceedings or show-cause notice issued
by SEBI should be pending against the company, its promoters or whole-time
directors.
Preferential Issue
Listed companies issue securities to a select group of persons under section 81 of
the Companies Act, 1956. The select group may be financial institutions, mutual
funds, or high net worth individuals. It is not a rights issue or a public issue. The
issuer company has to comply with the Companies Act and SEBI (Disclosures and
Investor Protection) guidelines regarding the preferential issue. This helps the
companies to raise capital quickly as compared to the public issue. The use of PAN
has been made mandatory for preferential allotment of shares, as in the case of most
of the transactions in the capital markets.
Rights Issue (RI)

It means an issue of capital to be offered by the company to its existing shareholders
through a Letter of Offer, under section 81(1) of the Companies Act, 1956. In
simple terms, a listed company issues fresh securities to its existing shareholders only.
The rights are offered in a specificied ratio to the number of securities held prior to
the issue by the shareholder. The ratio is fixed on the basis of the capital requirement
of the company. The stake of the existing shareholders is not diluted in the right issue.
When the right issue size is more than ` 50 lakh, the company has to file a draft offer
document with SEBI for observations. SEBI’s observation letter is valid for three
months.
Right issues are seen as a way to reward the company’s shareholders as the
issue of new shares is normally made at a price which is lower than the current
market price. Indian companies raised over ` 14085 crore through various right
issues in 2007. The Tata Group had announced a mega right issue of about ` 9,134
crore in November 2007.
100
Issuers
The listed and unlisted companies issue securities. Both of these have to fulfil
conditions laid down by the SEBI to issue equity shares.
Issue by Unlisted Company

According to SEBI Disclosure and Investor Protection Guidelines, an unlisted
company may make an initial public offering, only if it meets the following conditions:
x The company has net tangible assets of at least ` 3 crore in each of the
preceding three full years (of twelve months each), of which not more than
50 per cent is held in monetary assets.
x If more than 50 per cent of the net tangible assets are held in monetary
assets, the company has to make firm commitments to deploy such excess
monetary assets in its business/project.
x The company has a track record of distributable profits in terms of section
205 of the Companies Act, 1956, for at least three out of immediately
preceding five years.
x In case the company has changed its name within the last one year, at least
50 per cent of the revenue for the preceding one full year is earned by the
company from the activity suggested by the new name; and the aggregate
of the proposed issue and all the previous issues made in the same financial
year in terms of size (offer through offer document + firm allotment +
promoters’ contribution through the offer document), does not exceed five
times its pre-issue net worth as per the audited balance sheet of the last
financial year.
Issue by Listed Company

A listed company is eligible to make a public issue of equity shares or any other
security which may be converted into or exchanged with equity shares at a later
date, if it satisfies the following conditions:
x The aggregate of the proposed issue and all the previous issues made in the
same financial year in terms of size (offer through offer document + firm
allotment + promoters’ contribution through the offer document), issue size,
does not exceed five times its pre-issue net worth as per the audited
balance sheet of the last financial year.
101
x In case there is a change in the name of the issuer company within the last
one year (reckoned from the date of filing of the offer document), the
revenue accounted for by the activity suggested by the new name is not less
than 50 per cent of its total revenue in the preceding one full-year period.
Exemption from Eligibility Norms

Exemptions are provided to the following companies subject to certain conditions:
x Banking companies
x Infrastructure companies
x Listed companies
Investor
Primary markets attract a wide spectrum of investors. Different categories of
investors buy shares in the primary market. There may be reservations for retail
investors, non-institutional investors, Qualified Institutional Bidders (QIBs),
employees of the issuing company, existing shareholders of the issuing company, etc.
Investors are broadly categorized as:
x qualified institutional buyers
x non-institutional investors
x retail investors
Qualified Institutional Buyers

Mutual funds, banks, financial institutions like LIC and foreign investors, fall under
the category of QIBs. Earlier, QIBs were not required to submit any money along
with their bids and this had led to some manipulative practices. However, SEBI has
recently changed the provisions and now QIBs have to pay a margin, not the full
amount, at the time of bidding in the book building of an issue. The following are
specified as QIBs by the SEBI:
Public financial institutions as defined in section 4A of the Companies Act, 1956
x Scheduled Commercial Banks
x Mutual funds
x Foreign institutional investors registered with SEBI
x Multilateral and bilateral development financial institutions
x Venture capital funds registered with SEBI
102
x Foreign venture capital investors registered with SEBI

x State Industrial Development Corporations
x Insurance companies registered with the Insurance Regulatory and
Development Authority (IRDA)
x Provident funds with a minimum corpus of ` 25 crore
x Pension funds with a minimum corpus of ` 25 crore
Non-institutional Investors
Resident Indian individuals, HUF, companies, corporate bodies, NRIs, societies and
trusts whose application size in terms of value is more than ` 1 lakh also come under
this category. At least 15 per cent of the total issue has to be reserved for non-
institutional investors.
Retail Investors
They are defined in terms of the value of the primary issue applied by them. The
value of the applied shares should not exceed ` 1 lakh. According to the new
guidelines, the inclusion of PAN in application forms for public/rights issues has been
also made mandatory, irrespective of the value of application.
Thirty five per cent of the issue has to be reserved for them. Under this
category, only individuals, both resident and NRIs along with HUFs are allowed to
bid.
Companies making public issues can offer a discounted price to retail individual
investors, provided that the discount is not more than 10 per cent. State Bank of
India (SBI), the country’s largest lender, will be offering 10 per cent discount to
retail investors in its ` 16,742 crore rights issue.
Intermediaries
The companies take the assistance of many agencies for accessing the primary
market because of the complicated rules and regulations of the company and the
dynamic nature of the capital market. The intermediaries have to be registered with
SEBI and must have a valid certificate from SEBI to act as intermediaries. Following
are the intermediaries who are involved in the new issue market:
x Lead managers
x Registrars and share transfer agents
x Bankers to the issue
103
x Underwriters
x Stock brokers and sub-brokers and
x Depositories
The number of market intermediaries is given below
Table 5.1 The Intermediaries
Type of the Intermediary As on March

2006 2007 2008
Merchant Bankers 130 152 155
Registrar to the issue 83 82 76
Bankers to the issue 60 47 50
Underwriters 57 45 35
Depositories 02 02 02
Depository Participants 526 593 654
Lead Managers
Merchant bankers are appointed to manage the issue and are called lead managers
to the issue. Depending on the size of the issue, a company may appoint more than
one merchant banker. The pre-issue and post-issue responsibilities of the merchant
bankers are properly structured. The lead managers assist the company right from
the preparation of prospectus, to the listing of securities in stock exchanges. The
pre-issue and post-issue duties are given below.
Main pre-issue duties of the merchant bankers

x Preparation of the budget expense related to the issue
x Providing valuable suggestions about the appropriate timing of the public
issue
x Planning the draft and design of the offer documents, prospectus, statutory
advertisements and memorandums
x Offering advice to the company on the appointment of registrars to issue,
underwriters, brokers, bankers to the issue, advertising agents, etc.
x Giving direction to various agencies involved
x Maintaining due diligence of the company’s operations management/
business plans/legal matters, etc. The merchant banker should satisfy
himself about all the aspects of offering, veracity and adequacy of
disclosure in the offer documents. He issues a certificate to this effect to
SEBI.
104
x Completing all the formalities required by stock exchange, ROC, SEBI

x Paying requisite fee in accordance with SEBI while filing a draft offer with
it.
Main post-issue duties of the merchant bankers

x Management of escrow accounts, co-ordination of non-institutional
allocation
x Intimation of allocation and dispatch of refunds to bidders
x Finalization of trading, dealing of instruments, dispatch of certificates and
dematerialization of delivery of shares
x Submission of the post-issue monitoring reports as specified by SEBI within
three working days from the due date
x Submission of 50-day post-issue monitoring reports from the date of
closure of subscription of the issue
x Redressal of investor grievances arising from namely; allotment, refund and
dispatch
x Regularly monitoring and redressing investor grievances
Underwriters
Underwriting is an agreement with or without conditions to subscribe to the
securities of a body corporate in the event of non-subscription by the public. In other
words, if there is under-subscription (the amount received is less than the issue size),
the underwriters subscribe to the unsubscribed portion. The person who assures the
sum is called an underwriter. The underwriters are paid an underwriting commission.
A certificate of registration from SEBI has to be obtained by the agencies that wish
to carry out underwriting activities. After the selection of the underwriter, the issuing
company enters into an agreement with the underwriter. The agreement contains the
following details:
x The period during which the agreement will remain in force
x The amount of the underwriting obligation
x The maximum period within which the underwriter will have to subscribe to
the offer after the company’s intimation
x The rate and amount of commission or brokerage chargeable by the
underwriter
105
Bankers to the Issue

Banks, which accept application forms and money on behalf of the public are called
bankers to the issue. The collected money is transferred to the escrow accounts as
per the provisions of section 73(3) of the Companies Act, 1956. An escrow account
is a designated account, in which the funds can be utilized only for a specified
purpose. In other words, the bankers to the issue have to keep the funds in the
escrow account on behalf of the bidders. These funds are not available to the
company till the issue is completed and allocation is made. Commission is paid to
the bankers to the issue. Generally, the bankers:
x keep a proper record of applications and money received from the
investing public
x finalize the list of eligible allottees after deleting the invalid applications
x Determine the basis of allotment of securities
x Assist the finalization of allotment of securities
x Despatch refund orders as required
Registrar to the Issue

The company appoints the registrars to the issue in consultation with the lead
manager. Some merchant bankers carry on the activities of the registrars to an issue
as well as of the share transfer agents. Some carry on the activities of a registrar to
an issue or those of a share transfer agent. Quotations containing the details of the
various functions that they would perform along with the expected charges for the
functions are called for selection. Suitable ones are selected from the applications
received.
If the number of applications in a public issue is expected to be large, the issuer
company in consultation with the lead merchant banker can appoint one or more
registrars for the purpose of collecting the application forms at different centres and
forwarding the same to the designated registrar to the issue, as mentioned in the
offer document. The designated registrar to the issue shall be primarily and solely
responsible for all the activities as assigned to them for the issue management. His
main duties are to:
x receive all the application forms from the banks and acquire the relevant
data regarding the subscription of the issue, after the closure of the issue
106
x check the forms to ensure that all the required parameters are satisfied
x identify all other technical defects
x reconcile the application money as per the application forms with the actual
received by the bankers
x identify and keep aside the applications of dishonoured cheques
x prepare the basis of allotment in conjunction with the lead manager as per
the current guidelines
x submit the basis to the stock exchange for approval
x proceed with the allotment of shares and refunds within the prescribed time
limits, after getting the approval from the stock exchange and
x attend to all the complaints of post-allotment/listing and make efforts for its
speedy solution
The allotment process should be completed within fifteen days from the date of
closure of the issue. Normally is completed two days prior to the fifteen day
deadline, i.e., by the thirteenth day from the date of closure. In a fixed price issue, it
is thirty days from the date of closure (instead of fifteen days as in book built IPOs)
for obtaining the approval of basis of allotment, credit of the shares and dispatch/
credit of refund amounts The new shares have to be listed within seven working
days from the date of approval of the basis of allotment by the stock exchange.
Share Transfer Agents

They maintain the records of the holders of securities of the company for and on
behalf of the company. They also handle all matters related to transfer and
redemption of securities of the company.
Stock Brokers and Sub-Brokers

Appointing a broker is not compulsory, but approval of the stock exchange is
mandatory. The names and addresses of the brokers to the issue should be given in
the prospectus. The brokers enhance the sale of issue. Their other functions have
been given.
x use their contacts to invite the public for subscribing shares
x act as a connecting link between the prospective investors and the issue
x enhance the speedy subscription of the issue by the public
107
The issuing company pays brokerage according to the provisions in the

companies Act, and guidelines prescribed by the SEBI. Regarding the payment, an
agreement is made between the broker and the issuing company.
Depositories
They are the intermediaries who hold the securities in dematerialized form on behalf
of the shareholders. They enable transactions of securities by book entry. The
depository system links the issuers, depository participants, NSDL and Clearing
Corporation/houses of the stock exchanges. Transfers are affected by means of
account transfers.
Securities Exchange Board of India (SEBI)

Between 1987 and 1991, 12 per cent of household savings were invested in equity
and corporate debentures as compared to only 7 per cent between 1982 and 1985.
This signified the increasing number of retail investors in the stock market. Taking
advantage of the increasing interest of retail investors, many dubious companies that
did not have any real plans to do business, raised money by issuing shares, only to
vanish at a later date. These malpractices increased significantly and the grievances
of retail investors increased alarmingly. This led to the constitution of SEBI as a
supervisory body to regulate and promote security markets. However, the investors
are expected to know that SEBI does not recommend any issue. It also does not
take any responsibility for the:
x financial soundness of any scheme or project
x correctness of the statements made or opinions expressed in the offer
document for which the issue is proposed to be made
There is no requirement of filing any offer document/notice to SEBI in case of
preferential allotment and Qualified Institutional Placement (QIP). In QIP, the
merchant banker handling the issue has to file a copy of placement document with
SEBI after allotment for the purpose of record.
SEBI governs the primary issues. It issued disclosures and investor protection
guidelines in 1992 in accordance with the changes in the stock market. These
guidelines are commonly known as DIP guidelines. They provide comprehensive
guidelines for primary issuance. All the circulars issued by SEBI are compiled and
108
arranged in the form of chapters in the guidelines. Apart from these, the rules and
regulations relevant to the primary market are given below:
Rules
The following rules were laid down by SEBI.
· Securities and Exchange Board of India (Merchant Bankers) Rules, 1992
· Securities and Exchange Board of India (Registrars to an Issue and Share
Transfer Agents) Rules, 1993
· Securities and Exchange Board of India (Bankers to an Issue) Rules, 1994
· Securities and Exchange Board of India (Underwriters) Rules, 1993
· Securities and Exchange Board of India (Debenture Trustees) Rules, 1993
Regulations
Along with the above said rules, the following regulations were also stipulated by
SEBI.
· Securities and Exchange Board of India (Merchant Bankers) Regulations,
1992
· Securities and Exchange Board of India (Debenture Trustees) Regulations,
1993
· Securities and Exchange Board of India (Registrars to an Issue and Share
Transfer Agents) Regulations, 1993
· Securities and Exchange Board of India (Underwriters) Regulations, 1993
· Securities and Exchange Board of India (Bankers to an Issue) Regulations,
1994
· Securities and Exchange Board of India (Buyback of Securities)
Regulations
· SEBI (Credit Rating Agencies) Regulations, 1999
· Securities and Exchange Board of India (Debenture Trustees) Regulations
2003
Pricing
After the repeal of the Controller of Capital Issue Act, the companies can freely
price their equity shares in new issues. However, the price at which the security is
109
being offered to the applicants in firm allotment category should be higher than the
price at which securities are offered to the public.
In the face value of the shares of initial public offer by an unlisted company, if the
issue price is ` 500 or more, the issuer company shall have the discretion to fix the
face value below ` 10 per share, subject to the condition that the face value shall in
no case be less than one rupee per share. However, if the issue price is less than `
500 per share, the face value shall be ` 10 per share. The disclosure about the face
value of shares (including the statement about the issue price being ‘x’ times of the
face value) shall be made in the advertisement, offer documents and application
forms in a similar font size as that of issue price or price band.
The companies, which have already issued shares in the denomination of ` 10 or
` 100, may change the standard denomination of the shares by splitting or
consolidating the existing shares.
Placement of Issues
The placement of the issues may be through:
x Prospectus
x Offer of sale
x Private placement
x Book building
x Qualified institutions’ placement
Offer through Prospectus

In the offer through prospectus, subscription from the public is invited through issue
of the prospectus. The lead manager, after detailed discussions with the
management, auditors, legal advisors, etc., and examination of company records,
prepares a draft offer document or draft prospectus. The lead manager has to verify
and certify the facts stated in the draft prospectus and ensure that the company does
not make any false claims.
The draft prospectus is then filed with SEBI for its comments. On receipt of its
comments, the company makes changes to the draft prospectus, if required. The
comments from SEBI do not mean that it has approved the contents of the
prospectus. SEBI only makes some observations regarding the sufficiency of
information and disclosures. The company and the lead manager are responsible for
110
the contents of the prospectus. The prospectus is widely circulated among the
investors with help of the market intermediaries.
Prospectus
It is a document inviting offers from the public for the subscription or purchase of
any shares or debentures of a body corporate with all the information pertaining to
the company. It contains detailed information about the company, promoter/
directors, group companies, capital structures and terms of the mandatory
disclosures. The form and the contents of the prospectus are prescribed by part I of
Schedule II of the Companies Act and SEBI (Disclosure for Investor and
Protection) Guidelines, 2000.
The prospectus has to be filed through the lead manager and the company
cannot file it directly with SEBI. If the issue size is more than ` 20 crore, the
merchant bankers are required to file the prospectus at SEBI, Mumbai office. The
prospectus also has to be filed with the concerned stock exchanges along with the
application for listing its securities.
Contents of the Prospectus

The prospectus contains three parts.
Part I: This contains the general information like name and address of the
registered office of the company, opening and closing date of the issue, name of the
stock exchange where the issue is listed and addresses of the lead managers.
x Capital structure of the company in detail. Authorized, issued, subscribed
and paid up capital (number of instruments, description, and aggregate
nominal value). Size of the present issue, separately mentioning promoters’
contribution, firm allotment/reservation for specified categories and net offer
to public (number of instruments, description, aggregate nominal value and
issue amount shall be given in that order).
x Terms regarding the rights of the instrument holders and the mode of
application
x Particulars of the company management and projects undertaken
x Financial performance of the company which includes:
(a) Equity capital, research and borrowings
(b) Profit and loss including gross profit, net profit and dividend paid if any
(c) Any changes in the accounting policy
111
(d) Stock market information regarding the price of the company’s stock
for the monthly high/low price during the last six months
(e) Basis for issue price
(f) Outstanding litigation defaults, adverse events and material
developments
x Risk factors and management’s perception thereof
Part II: This contains the general information, financial information, statutory and
other information, main provisions of the Articles of Association of the company,
material contracts and documents for inspection.
Part III: contains the declaration by the directors that all the relevant provisions
of the companies Act, 1956 and the guidelines issued by the SEBI have been
complied with.
Abridged Prospectus
It was introduced by Companies (amendments) Act, 1988. It is a memorandum
containing the salient features of a prospectus. It is a brief version containing all the
important features of the prospectus. It can also carry application forms. It reduces
the expenses involved in the issue of shares.
Deemed Prospectus
It is the offer document issued by the issue houses on behalf of the company inviting
the public to subscribe to its equity or any other securities. This is known as
prospectus by implication.
Red Herring Prospectus

It does not have complete particulars on the pricing of the securities, the number of
shares to be issued or the amount of issue. This type of prospectus is adopted in the
book building route. It mentions the total number of shares to be issued and a price
band at which the prospective investors can bid. A listed company going for a further
issue need not mention the price band in the Red Herring Prospectus (RHP). It
needs to announce the price band only a day before the issue opening through a
separate advertisement.
The red herring prospectus should be filed with the Registrar of Companies at
least three days before the opening of the offer. It should also be filed with SEBI. Its
112
obligations and liabilities are the same as that of an ordinary prospectus. It should
provide all the details as by the Schedule II of the Companies Act. The directors or
constituted attorneys should put their signatures in the red herring prospectus. The
issuer company is required to disclose the assigned grade in the red herring
prospectus.
Statement in lieu of Prospectus

Statement in lieu of prospectus can be filed by a company which can raise necessary
capital without any public subscription or a company which cannot make any
allotment on account of its inability to obtain the minimum subscription. The model
form of a statement in lieu of prospectus is given in section 70 of the Schedule III of
the Companies Act.
Offer of Sale
This is the most common way of promoting a new issue, bringing a company to the
stock market and listing shares for the first time. Offer of sales means outright sale of
shares to intermediaries such as issuing houses or share brokers instead of offering
shares to the public. It is a bulk sale of shares at an agreed price to brokers or
merchant bankers, who in turn resell them to the investing public. The spread
between the purchase price and the offer price is the profit to the intermediaries.
Offer of sale of shares takes place in the case of existing shareholders purchasing
en bloc and then reselling them to the public. Similarly, foreign collaborators or
promoters may sell their shares to the Indian public through offer of sale which may
be through brokers or through prospectus. A prospectus containing the details of the
sale must be published in at least two national newspapers.
An offer for sale gives a chance to a large number of investors to invest in the
security offered. This means a wide distribution of shareholdings and holds out the
prospect of a good trading market in the shares when they have been issued. ICRA
Limited (‘ICRA’ or ‘Company’), made its public offering of equity shares through an
offer for sale by IFCI Limited, Administrator of the Specified Undertaking of the
Unit Trust of India and State Bank of India (‘selling shareholders’).
Private Placement
It is a direct private offering of securities to a limited number of sophisticated
investors. It is the opposite of a public offering. Investors are mainly financial
113
institutions, insurance companies, pension funds and high net worth individuals.
Securities issued as private placements include debt, equity and hybrid securities.
The private placement market in India has witnessed a very rapid growth in the
recent past with companies increasingly adopting the private route for funds
mobilization.
Steps in private placement

Collateral preparation: As a first step, the most effective capitalization strategy is
decided on the basis of the existing business profile of the companies. A complete
set of information is prepared to be presented to the potential investors. This would
enable the transaction to be carried out in a structured way.
Road show and investor short listing: In this phase, the lead manager helps the
issuer to decide the kind of private equity and investors. He holds initial discussions
with the investors helps the issuer have road shows by meeting the potential
investors and advises the issuer to prioritize among the investors to create a short list
of investors. He also helps the company to use its network of relationships to identify
the right investors.
Negotiation: The company and the lead manager analyse various offers from
the potential investors and drive deal negotiations with investors, which meets the
issuer’s strategic objectives. Finally, the most effective transaction suitable for the
issuers shareholders and employees is created.
Due diligence and closure: In this phase, the lead manager helps the client in
coordinating the overall due diligence process and negotiates on the final definitive
agreements with the potential investor. Thus, the deal is closed.
Advantages of private placement

The phenomenal growth of private placement of securities may be attributed to the
following reasons.
Convenience: Issues of smaller size can be privately placed whereas the public
issues market does not permit an issue below a certain minimum size.
Flexibility: The negotiation part of the private placement provides flexibility in
working out the terms of issue. For example, in a non-convertible debenture issue, a
discount may be given to institutional investors to make the issue attractive.
114
Less time: A private placement requires a lesser period, perhaps a month or

two, as the elaborate procedure followed in a public issue is not required.
Less issue costs: The issue cost for a private placement is considerably less as
compared to the public issue. The public issue involves several statutory and non-
statutory expenses associated with underwriting, brokerage, printing, mailing,
announcements, promotion and so on.
However, it should be remembered that:
x Private placement investors’ interest in a firm is limited to a short period
with the aim of maximizing their returns within a limited period of time. This
may lead to under-investment. It may be detrimental to the long-term
growth of the company.
x Private placements generally involve a few investors who have a higher
control over the policy decisions of the company. This could either act in
favour or against the interests of a firm.
Factors to be considered
Before participating in a private placement, the investors need to look into a number
of factors like:
x the track record of the company
x net worth of the company
x debt equity ratio
x debt redemption provisions
x profit before tax
x the asset cover
x the dividend record
x the percentage of unsecured deposits/borrowings
x the historical price of the company’s stock
Book Building
It is a process adopted in Initial Public Offer (IPO) for efficient price discovery.
During the offer period, the investor bids the offer either above or equal to the floor
115
price. Thus, in book building method, bids are collected from investors at various
prices. The offer price is determined only after the closure of the issue.
As per the SEBI guidelines, an issuer company can issue securities to the public
through a prospectus either by 100 per cent of the net offer to the public through
book building process or 75 per cent of the net offer to the public through book
building process and 25 per cent at the price determined through book building. The
fixed price portion is conducted like a normal public issue after the book built
portion, during which the issue price is determined.
The Process
The normal procedure is given below.
x The issuer appoints a lead merchant banker as a ‘book runner’ by the
issuer.
x The issuer decides the price or price band for the issue and the number of
securities to be issued.
x The issuer appoints the syndicate members after consulting the lead
merchant banker.
x The form for applying/bidding of shares is made available with all the
syndicate members, collection centers, brokers to the issue and bankers to
the issue.
x A book should remain open for a minimum of five days.
x Investors bid through the syndicate members. The syndicate members input
the investors’ orders into the electronic book.
x Bid has to be made for the minimum quantity specified by the issuer or in
multiples thereof.
x An investor can alter his bid, both price and quantity, anytime before the
close of the issue.
x Syndicate members aggregate and forward all offers to the book runner.
x After consulting the issuer, the book runner determines the issue price as a
weighted average of the offers received.
x Securities are allotted to the successful bidders.
116
Difference between the Fixed Price Process and Book Building Process
Difference between the fixed price process and book building process is as follows:
Table 5.2
Factors Fixed price process Book building process

Price Offer price of the securities is known Only an indicative price range is
in advance to the investor. given. Offer price of the
securities is not known in
advance to the investor.
Demand Demand for the issue is known only Demand for the securities offered
after the closure of the issue. is known everyday as the book is
built.
Payment Payment is made at the time of Payment is made only after
subscription. Refund is given after allocation.
allocation.
Information The spread of information may not be Before applying, all the investors
even. can see on an hourly basis how
the book is being built.
Therefore, there is no asymmetry
of information.
Green shoe option

If the issue is over-subscribed, the issuing companies can allocate up to 15 per cent
shares over and above the original issue size. The amount raised should be used to
operate a post-listing price stabilizing mechanism. Administered through an external
agency called a stabilizing agent, this scheme tries to minimize the post-listing price
volatility, if the stock turns weak.
It should be kept in mind that the stabilizing agent is not under any obligation to
keep the price above the issue price at all time. It is not mandatory to keep a green
shoe option. The details of a green shoe option should be disclosed in the
prospectus and should be made available for thirty days from the date of listing.
Qualified Institutions’ Placement (QIP)

SEBI vide its circular dated 8 May 2006, amended the SEBI (Disclosure and
Investor Protection) (DIP) Guidelines 2000, to introduce a new method of raising
funds from the market by companies in the form of ‘Qualified Institutions’
Placement’ (QIP). It is a form of private placement. It is an attempt by SEBI to
encourage Indian companies to raise money domestically rather than going outside
117
for Foreign Currency Convertible Bonds (FCCBs)/American Depository Receipts

(ADRs)/Global Depository Receipts (GDRs). Only those companies which are
listed on stock exchanges having nationwide trading terminals are allowed to raise
funds by selling their securities directly to Qualified Institutional Buyers (QIBs).
QIP Issue Structure

The placement size of QIPs shall not exceed five times the pre-issue net worth as
per the audited balance sheet of the previous financial year. Minimum of 10 per cent
of specified securities shall be allotted to mutual funds. If no mutual fund agrees to
take up the minimum portion or any part thereof, such portion may be allotted to
other QIBs. No allotment shall be made, directly or indirectly, to any QIBs being a
promoter or any person related to promoters. There should be at least two allottees
for an issue of size up to ` 250 crore and at least five allottees for an issue size in
excess of ` 250 crore. No single allotee shall be allotted more than 50 per cent of
the issue size.
Pricing and Lock-in

The pricing requirements shall be broadly at par with those for guidelines for
preferential issues as specified in the SEBI (DIP) guidelines. Minimum price is higher
than the average of the weekly high and low of the closing price quoted during the
six months or two weeks preceding the relevant date. There shall be an adjustment
of price in case of corporate actions, right issue, stock splits, etc. There will be no
lock-in period for the securities allotted under this route. However, there cannot be
off-market transactions in such securities for a period of one year from the date of
allotment.
Payment Terms
The specified securities allotted pursuant to QIP shall be made fully paid-up at the
time of their allotment.
IPO Grading
The Securities and Exchange Board of India has made IPO grading mandatory and
the new norm has been effective from 1 May 2007. Grading of IPOs is the
assessment of the ‘fundamentals’ of the issuer concerned on a relative grading scale.
The IPO grade assigned is the outcome of a detailed evaluation of qualitative and
quantitative factors of the concerned company. It is a comment on the fundamentals
118
of the company concerned and its growth prospects from a long-term perspective.
Generally, grades are assigned on a five-point scale, where IPO Grade 5 indicates
the highest grading and IPO Grade 1 indicates the lowest grading, i.e., a higher
score indicates stronger fundamentals. IPO grading represents an independent
opinion from an agency that is not connected with the placement of the issue. IPO
Grading is a one-time exercise, not subject to subsequent surveillance.
The Grading Process

It involves several steps. These are given below:
(a) The issuer company sends a formal request to the grading agency.
(b) The agency seeks information on the company’s existing operations as well
as proposed project(s) through a questionnaire.
(c) Site visits and discussions with the key operating personnel of the company
concerned are conducted by the rating agency.
(d) Apart from the officials of the company, the agency also meets its bankers,
auditors, merchant bankers and appraising authority (if any). If needed, the
opinion of independent expert agencies on critical issues like, the
technology proposed to be used is also obtained.
(e) Analysts of the agency present a detailed grading report to the rating
committee, which then assigns the grade. Usually, the assignment of grade
takes three to four weeks after all the necessary information has been
provided to ICRA.
(f) The issuer company is required to disclose the assigned grade and also
publish it in the red herring prospectus, which is filed with the Securities and
Exchange Board of India (SEBI) and other statutory authorities.
Grading Methodology
The grading methodology consists of analysing the:
x Industry prospects
x Competitive position
x Risks and prospects
x Financial performance
x Management quality
x Corporate governance
119
Industry prospects
Factors such as the growth prospects of the industry, the extent of cyclicality,
competitive intensity, vulnerability to technological changes and regulatory risks
inherent in the business differ from industry to industry. Regulatory risks inherent in
the pharmaceutical industry are higher than in the consumer good industry. Similarly,
vulnerability to technological changes is more in information technology industry.
Evaluating the prospects of the industry in which the company operates, helps to
understand the risks inherent in the business and the opportunities available.
Competitive Position
A company’s competitive position depends on its ability to increase/protect its
market share, command differential pricing and maintain margins at par with or
superior to its homogeneous products. Factors like brand equity, distribution
network, proximity to key markets and technological superiority are evaluated.
Operating efficiency
The operational efficiency highly relies on the cost structure, access to raw material
sources, superior technology, availability of skilled labour and so on. These factors
are analysed to find out if the company can attain the expected operational
efficiency.
Risks
Risk profile of the company is thoroughly studied. The ability of a company to
successfully execute the project that is being undertaken and the commissioning of
the project are assessed. A detailed risk assessment of the project with respect to
issues like availability of finances, technology tie-ups, ability to execute the project
without time or cost overrun, market risks arising from capacity additions and the
actions that are planned to counter those risks, is also carried out.
Financial Position and Prospects

The ability to generate earnings to shareholders is reflected by profitability margins.
Hence, the following factors are evaluated by the rating agency.
x Growth of earnings per share
x Return on Capital Employed (RoCE)
x Cost of capital and financial leverage
x Return on Net Worth (RoNW)
120
A comparative study of these factors for other leading companies operating in

the same industry helps in understanding the relative position of the respective
company.
Efficiency of the Management System

The profile of the top managerial personnel, the adequacy of the organization
structure, the management systems and its plans and policies towards earnings
growth and shareholder returns are evaluated. The management’s approach towards
risk and long term business plans is also analysed. Corporate governance practices,
apparent quality of independent directors, quality of accounting policies and the type
of transactions with subsidiaries and associates are also examined.
Grading Scale
The five-point grading scale has been shown next.
Grade 5: Strong fundamentals
Grade 4: Above-average fundamentals
Grade 3: Average fundamentals
Grade 2: Below-average fundamentals
Grade 1: Poor fundamentals
IPO grade is not:
x A recommendation to invest in the graded instrument
x A comment on the valuation or pricing of the IPO graded
x An indication of the likely listing price of the securities graded
x An assessment of the market risk associated with equity investments and
x An audit of the issuer
Factors to be Considered to Apply to an IPO

The various factors are as follows:
Prospectus of the issue

It gives the details of the issue. It has all the details about the company, the risk
factors and the company’s financials. It should be read carefully and the risk factors
given in the prospectus should be reviewed.
121
Issue price
When the market is buoyant, there is a chance for the issuers to over price the issue.
Investors need to decide if the issue is worth investing in at that price. Of the
thousands of IPOs and offers for sales made between 1994 and 1996, less than a
hundred were from companies with a track record. Even in this shortlist, only a few
managed to complete the planned projects and deliver value to the investors.
Price-Earnings (P/E)
The price earning ratio should be analysed. The P/E multiple is the ratio of the share
price to earnings per share (EPS which is given in the balance sheet). P/E of the
issue should be compared with the industry average and the other companies in that
sector.
Management of the issue

The lead managers for the issue have to be considered because pre-issue and post-
issue management rests heavily on the lead managers. Redressal of investors’
grievances also depends on them.
Market sentiment
It should also be considered along with the other factors. In a bear run, the prices
usually fall after the stock lists whereas in a bull run, the prices of the shares are
likely to zoom. Therefore, applying during the bear phase is the best way to get the
share at its cheapest rate. If the investment is for a long term purpose, altering
market sentiment has little impact. However, if it is for a short term, market has to be
considered.
Track record of the promoters

Investors should study the background and experience of the promoters, the
management team and their expertize, because they are responsible for the
profitability of the company. Analysing the track record of the promoters helps the
investors to avoid fly by night promoters and companies.
Promoters’ Holding
The percentage of promoter holding in a company is probably the most important
indicator of their commitment and confidence in the venture. The structure of their
holdings is also important. The transparent holding structure gives a clear view. Often
122
such holdings are through a complex web of investment companies which are difficult
to trace.
Nature of Investors
Presence of institutional investors, like venture capital funds, commercial banks,
private equity firms, etc., among the major shareholders of the company gives a
positive signal. Such firms are better equipped to analyse companies and generally
invest only after a detailed evaluation and confidence in the management. However,
they are not infallible and their presence in the shareholders’ list does not
automatically make the company investment-worthy.
Promoters and management

Promoters of the company should have a proven ability to run successful businesses.
Preferably, they should have sufficient experience in the same line of business. If they
are first time entrepreneurs, they must have held senior managerial positions in
companies engaged in the same business. Technical qualifications alone are not
sufficient, managerial experience is also essential.
Financial performance
This should be carefully analysed. The balance sheet of the company is a very
important document and the investors should study it carefully. The growth and focus
of the company can be understood through it.
Business analysis
The issue prospectus has a detailed analysis on the industry in which the company
operates and covers the current developments, future growth potential, competition,
government policy, etc. Studies conducted by industry bodies and associations
sometimes promote their interest and should not be taken as such. Projections have
to be verified with reliable data from sources like financial media, independent
research organizations, government departments, etc.
Government Policy
In a developing country like India, government policy can often build or break
industry fortunes. If the industry is prone to government intervention or is politically
sensitive, the company may face a lot of policy uncertainties. It may be wise to stay
away from politically sensitive businesses like agro-commodities, but to focus on
123
infrastructure related businesses where the government has no choice but to spend
more.
Industry Analysis
It gives a broader idea of the company which is operating. Analysis of its competitive
strengths as compared to other players in the industry is needed. If the company is
operating in a mature industry, there are other listed companies operating in the
same business. Analysing the operations of such companies helps to find out the logic
of the analysis provided by the issuing company.
Company’s Product
The analysis of the company’s products and services would focus on various
aspects like technology employed, design capabilities, geographic spread of the
market, market share in different segments, etc. If the company is using an untested
technology or production method, the risk increases. In cases where the company
operates in a mature industry and has established products or services, the following
aspects should be considered:
x product superiority
x technological innovation
x relative market share
x brand image
x distribution strength
1. State the features of primary market.

................................................................................................................
................................................................................................................
................................................................................................................
2. State the different types of investors of primary markets.

................................................................................................................
................................................................................................................
................................................................................................................
124
3. Name the intermediaries involved in the new issue market.

................................................................................................................
................................................................................................................
................................................................................................................
5.3 SECONDARY MARKET
Securities issued by a company for the first time are offered to the public in the
primary market. Once the IPO is done and the stock is listed, they are traded in the
secondary market. The main difference between the two is that in the primary
market, an investor gets securities directly from the company through IPOs, while in
the secondary market, one purchases securities from other investors willing to sell
the same.
The features of the secondary market are as follows:
x Trading of securities in the secondary market does not provide any funds to
the company.
x The investors as well as the speculators trade in securities.
x Securities of listed public limited companies are traded on a recognized
stock-exchange.
x Secondary market provides liquidity to the investors.
x The market prices in the secondary market reflect the investors’
perceptions of a company’s performance.
Market Segments
The secondary market has the following three segments.
(a) Capital Market (CM) segment where equity, preference shares and
warrants are traded.
(b) Wholesale Debt Market (WDM) segment where state and Central
Government securities, T-bills, PSU bonds, corporate debentures,
commercial papers, certificate of deposits, mutual funds etc., are traded.
(c) Futures and Options (F and O) segment where derivatives based on equity
and indices are traded. Index option, index futures stock options and stock
futures are bought and sold in this segment.
125
Participants
Participants of the secondary market mainly consist of:
x investors
x market intermediaries
x regulatory bodies
Investors
The investors can be broadly classified into:
x retail investors
x institutional investors
x foreign institutional investors
Retail Investors
They are individual investors with a limited access to funds. They park their surplus
funds in securities to earn returns. Equity investment is considered to be high risk
high return proposal as compared to other investment instruments like fixed deposits
and post-office savings schemes. The term ‘High Net worth Individual’ (HNI) is
used to refer to individuals and families who are affluent in their wealth holdings and
consequently have a higher risk profile. It is a relative term and its meaning is
different in different financial markets and regions.
Foreign Institutional Investors (FIIs)

They are venture capital funds, pension funds, hedge funds, mutual funds and other
institutions registered outside the country of the financial market in which they take
an investment exposure. They are allowed to invest in the primary and secondary
capital markets in India through the Portfolio Investment Scheme (PIS). Under this
scheme, FIIs can acquire shares/debentures of Indian companies through the stock
exchanges in India. They have to be registered with SEBI.
The ceiling for the overall investment for FIIs is 24 per cent of the paid up
capital of the Indian company. In the case of public sector banks, including the State
Bank of India, the limit is 20 per cent of the paid up capital. The ceiling of 24 per
cent for FIIs’ investment can be raised up to sectoral cap/statutory ceiling, subject to
the approval of the board and the general body of the company passing a special
resolution to that effect.
126
The number of FIIs registered with the Securities and Exchange Board of India
(SEBI) has doubled to 1,050 between March 2001 and June 2007. The Indian
capital market has attracted many global majors like HSBC, Citigroup, Merrill
Lynch, Crown Capital, Fidelity, Goldman Sachs, Morgan Stanley, UBS, Capital
International and ABN Amro. FIIs have gained a lot of importance as market
participants as they invest huge sums of money. They are often instrumental in giving
direction to the stock market movements in the short term.
Institutional Investors
Mutual funds, Unit Trust, insurance companies, banks and other large institutions
which invest their members’ money in shares and bonds, are known as institutional
investors. They have professional analysts and advisors who can usually analyse the
stock market trends much better than individual investors. They trade in large
volumes and play a major role in the stock market. Institutional investors often
account for the bulk of the trade done on the stock exchange, over a sustained
period.
Market Intermediaries
Intermediaries such as stockbrokers, depositories, depository participants and
banks facilitate the payment of money in share transactions. However, this section is
mainly concerned with:
(a) stock exchange members/ brokers and depositories
(b) depository participants
Stock Exchange Members/Brokers

A stock broker is a member of the stock exchange and he is permitted to trade on
the screen-based trading system of the stock exchange. The brokers have to register
with SEBI and should keep a registration certificate. A sub-broker is a person who
is affiliated to a member of a recognized stock exchange. He also has to register
himself with SEBI. Trading can be carried out only through the members. The
investors can enter into trade only through a brokers’ account. The broker enters
into trades either on his own account or on behalf of his clients in the stock
exchanges. The members can be:
x individuals
x firms
x corporate entities
127
The Ministry of Finance amended Rule 8 of the Securities Contracts Regulation

Act in 1957, to make provisions to admit specific corporations, companies or
institutions as members in the stock exchanges. These include IDBI, LIC, GIC,
UTI, ICICI and subsidiaries of any of the corporation or companies. Further, they
include any subsidiary of SBI or any other nationalized bank set up for providing
merchant banking services, buying, selling and other similar activities. After this
provision, a number of brokers, proprietary firms and partnership firms have
converted themselves into corporate entities. The general eligibility conditions are
specified below:
Table 5.3 Eligibility Conditions

Criteria Individuals Firms Corporate entities
Age Minimum age : 21 years Minimum age: 21 years Minimum age: 21 years
Maximum age : 60 years (applicable for partners) (applicable for directors)
Status Indian citizen Registered partnership Corporate registered

firm under Indian under Companies
Partnership Act,1932 Act, 1956 (Indian)
Education At least a graduate or Partner should be at Two directors should
equivalent least a graduate or be at least graduate
equivalent or equivalent
No person shall be admitted as a member/partner or director if:

x he has been adjudged bankrupt or a receiver order in bankruptcy has been
made against him or he has been proved to be an insolvent even though he
has obtained his final discharge
x he has compounded with his creditors for less than full discharge of debts
x he has been convicted of an offence involving a fraud or dishonesty
x he is engaged as a principal or employee in any business other than that of
securities, except as a broker or an agent not involving any personal
financial liability or for providing merchant banking, underwriting or
corporate or investment advisory services, unless he undertakes to severe
his connections with such business on admission, if admitted and
x he has been at any time, expelled or declared a defaulter by any other
stock exchange or has been debarred from trading in securities by any
regulatory authority like SEBI, RBI.
128
Experience
To become a member, he should have a minimum of two years experience in any
activity related to dealing in securities.
Capital Requirement
The stock exchanges shall have the Base Minimum Capital (BMC) requirements as
provided below:
Table 5.4 BMC Requirements
BSE, NSE and CSE ` 10 lakh

AhSE and DSE ` 7 lakh
Other Stock Exchanges ` 4 lakh
According to the present requirement, at least 50 per cent of the base minimum
capital should be in cash or in cash with an approved bank. The remaining 50 per
cent can be held by way of approved securities.
Fees
A stock broker has to pay a registration fee of ` 5000 for every financial year. After
the expiry of five years from the date of initial registration as broker, he has to pay
` 5000 for a block of five financial years. The exchange also collects transaction
charges from its trading members. If the annual turnover exceeds ` 1 crore during
any financial year, he has to pay additional charges. A NSE trading member is
required to pay ` 4 per lakh of his turnover. The brokers are allowed to have
multiple memberships in stock exchanges.
Brokerage Charges
The trading member can charge the following:
(a) brokerage charge
(b) penalties arising on a specific default on behalf of his/her client (investor),
(c) service tax as stipulated
(d) Securities Transaction Tax (STT) as prescribed
The maximum brokerage charge is fixed at 2.5 per cent of the contract price
inclusive of the amount charged by the sub-broker. However, it excludes the
statutory levies like turnover fee, service and stamp duty. The sub-broker’s charge
129
should not exceed 1.5 per cent of the contract price. Generally, brokerage charges
are as low as 0.15 per cent. Stamp duties are paid in accordance with the rate
prescribed by the respective state government.
In the contract note, the brokerage, service tax and STT are given separately.
Securities Transaction Tax (STT) is levied on transactions done on the stock
exchanges. The nature of STT and rates are prescribed by the Central Government
from time to time. STT came into effect from 1 October 2004.
x Brokers should also take insurance cover in respect of the Acts and
omission of the authorized assistants/clerks
x Sub-brokers are under the discipline of stock exchanges and members are
responsible and accountable for their dealings/acts/and omissions.
x Government of India also requires the stock exchanges to undertake audit
and inspection of any member broker and authorized assistants.
Depository
A depository is an organization, which maintains investors’ securities in electronic
form. In simple terms, a depository is a ‘bank’ for securities. National Securities
Depository Limited (NSDL) and Central Depository Services (India) Limited
(CDSL) are functioning as depositories in India. NSDL was first set up by NSE with
UTI and IDBI. CDSL is a depository managed by professionals and it was
promoted by the Bombay Stock Exchange (BSE) Limited along with a cross
section of several leading Indian and foreign banks.
The principal function of a depository is to dematerialize the securities and
enable their transactions in book-entry form. Dematerialization of securities occurs
when securities issued in physical form are destroyed and an equivalent number of
securities are credited into the beneficiary owner’s account. In a depository system,
the investors stand to gain by way of lower costs and lower risks of theft, forgery,
etc.
A depository established under the depositories Act can provide any service
connected with recording of allotment of securities or transfer of ownership of
securities in the record of a depository. A depository cannot directly open accounts
and provide services to clients. Any person who is willing to avail the services of the
depository can do so by entering into an agreement with the depository through any
of its depository participants.
130
Depository Participants
Agents to depository are called Depository Participants (DP). They are the
intermediaries between the depository and the investors. The relationship between
the DPs and the depository is governed by an agreement made between the two
under the Depositories Act. In a strictly legal sense, a DP is an entity who is
registered with SEBI under the provisions of the SEBI Act. As per the provisions of
this Act, a DP can offer depository related services only after obtaining a certificate
of registration from SEBI. SEBI (D and P) Regulations, 1996, prescribe a minimum
net worth of ` 50 lakh for stockbrokers, registrars, transfer agents and Non-
Banking Finance Companies (NBFCs), for granting them a certificate of registration
to act as DPs.
Benefits of Depository Services

The various benefits are as follows:
x The risk of bad deliveries and loss of certificates in transit are removed.
x There is saving in stamp duty.
x The cost of courier, notarization and the need for further follow-up is
eliminated. The liquidity of securities due to immediate transfer and
registration is increased.
x The brokerage charge for trading in dematerialized shares is low.
x Bonuses and rights are directly credited into the depository account.
x Interest charges are lower for loans taken against demat shares as
compared to physical shares.
x The limit of loans availed against demat shares is higher than the loans
borrowed against physical shares. It is ` 20 lakh per borrower against the
demat shares as collateral, but it is ` 10 lakh per borrower against physical
shares.
x The margin is 25 per cent for loans against demat shares. However, it is 50
per cent for loans against physical shares.
Depository Account Opening

Opening a depository account is just like opening a bank account.
x The investor can select any depository participant with whom he is
comfortable.
131
x The investor has to get the account opening form from the DP and fill it up.
x He has to sign a DP client agreement.
x The agreement specifies the rights and duties of the DP and the demat
account holder.
x The client identity proof along with the DP identity proof is given to the
account holder.
x To dematerialize the shares, the investor has to obtain the dematerialization
request form.
x The investor has to submit the filled up form along with the share certificate.
x The dematerialized shares are credited in the demat account within fifteen
days. In the case of directly purchasing dematerialized shares from the
broker, once the order is executed, the DP receives securities from the
broker’s clearing account.
Regulatory Authorities
The capital market is regulated by the:
x Ministry of Finance
x The Securities and Exchange Board of India (SEBI)
Ministry of Finance
In the Ministry of Finance, the capital market is regulated by the capital markets
division of the department of economic affairs. This division is responsible for
formulating the policies related to the orderly growth and development of the
securities markets, i.e., share, debt and derivatives, as well as protecting the
interests of the investors. In particular, it is responsible for:
x institutional reforms in the securities markets
x building regulatory and market institutions
x strengthening investor protection mechanism
x providing efficient legislative framework for securities markets.
Ministry of Finance administers legislations such as Securities and Exchange
Board of India Act, 1992 (SEBI Act 1992), Securities Contracts (Regulation) Act,
1956 and the Depositories Act, 1996.
132
The Securities and Exchange Board of India (SEBI)

The SEBI was established under the SEBI Act 1992, as a regulatory authority of
securities market with the objective to protect the interests of the investors in the
securities market and promote the development of the capital market. SEBI mainly:
x regulates business in stock exchanges
x supervises the working of stock brokers, share transfer agents, merchant
bankers, underwriters, etc.
x prohibits unfair trade practices in the securities market and
x administers mostly the Acts, rules and regulations related to the securities
market.
The following departments of the SEBI regulate the secondary market.
Market Intermediaries Registration and Supervision Department (MIRSD)

This department takes care of the registration of all market intermediaries related to
all segments of the market namely the equity and derivative segments. It also
supervises monitors and inspects all the intermediaries.
Market Regulation Department (MRD)

The main function of this department is to formulate new policies except relating to
derivatives for stock exchanges, their subsidiaries and market institutions such as
Clearing and Settlement Organizations and Depositories. It also supervises their
functioning and operations.
Derivatives and New Products Departments (DNPD)

The function of this department is mainly related to the supervision of derivatives
segments of the stock exchanges and introduction of new products to be traded. It
also takes care of the consequent policy changes.
1. State the three segments of secondary market.

................................................................................................................
................................................................................................................
................................................................................................................
133
2. What is a depository?
................................................................................................................
................................................................................................................
................................................................................................................
3. State the various benefits of depository services.

................................................................................................................
................................................................................................................
................................................................................................................
5.4 SUMMARY
x The primary market or the new issues market is concerned with the issue of
new securities.
x If the company is a new entrant to the capital markets, the issue is called an
Initial Public Offering or IPO.
x If a company whose shares are already listed on a stock exchange, issues
shares, it is called a Further Public Offering or FPO.
x In the Fast-Track Issue (FTI), established and compliant listed companies
need to make only rationalized disclosures, rather than comprehensive
ones, for follow-on public offers and rights issues.
x Investors are broadly categorized into: qualified institutional buyers, non-
institutional investors and retail investors.
x Lead managers to the issue manage the issue.
x Underwriters subscribe to the unsubscribed portion of the issue as per the
agreement.
x The registrar collects and finalizes the list of eligible allottees, ensures the
crediting of shares to the demat accounts of the applicants and the dispatch
of refund orders.
x Banks, which accept application form and money from the public on behalf
of the public are called bankers to the issue.
134
x The primary issuances are governed by SEBI in terms of SEBI

(Disclosures and Investor Protection) guidelines. SEBI framed its DIP
guidelines in 1992.
x In the offer through prospectus, subscription from the public is invited
through issue of the prospectus.
x Offer of sales means outright sale of shares to intermediaries such as issuing
houses or share brokers instead of offering shares to the public.
x A private placement is a direct private offering of securities to a limited
number of investors.
x Book building is a process adopted in IPO for efficient price discovery.
x Grading of IPOs is the assessment of the fundamentals’ of the issuer
concerned on a relative grading scale.
x Secondary market provides a platform for the sale of already issued and
listed securities.
x The secondary market has three segments namely the Capital Market
(CM) segment, Wholesale Debt Market (WDM) segment and Futures and
Options (F and O).
x A stock broker is a member of the stock exchange and is permitted to
carry out trades on the screen-based trading system of the stock exchange.
x Online trading means purchase and sale of stocks on the Internet.
x Depositor is the organization, which maintains the investors’ securities in the
electronic form.
5.5 KEY WORDS
x Primary market: It is a part of the capital market that deals with issuing of
new securities. Companies, governments or public sector institutions can
obtain funds through the sale of a new stock or bond issues
through primary market.
x Secondary market: It is a market where investors purchase securities or
assets from other investors, rather than from issuing companies themselves.
135
x Public issue: It refers to when new investors are given an issue/offer of

securities to join the family of the issuer as shareholders.

1. The features are as follows:
x It is a market for long-term capital where the securities are sold for the
first time. Hence, it is also called New Issue Market (NIM).
x Funds are collected and securities are issued directly by the company
to the investors.
x Primary issues are carried out by the companies for the purpose of
inception and functioning of business.
2. Investors of the primary market are broadly categorized as:
x Qualified institutional buyers
x Non-institutional investors
• Retail investors
3. The intermediaries involved in the new issue market are:
x Lead managers
x Registrars and share transfer agents
x Bankers to the issue
x Underwriters
x Stock brokers and sub-brokers and
x Depositories

1. The three segments of secondary market are:
x Capital Market (CM) segment where equity, preference shares and
warrants are traded.
x Wholesale Debt Market (WDM) segment where state and Central
Government securities, T-bills, PSU bonds, corporate debentures,
commercial papers, certificate of deposits, mutual funds etc., are
traded.
136
x Futures and Options (F and O) segment where derivatives based on

equity and indices are traded. Index option, index futures stock
options and stock futures are bought and sold in this segment.
2. A depository is an organization, which maintains investors’ securities in
electronic form. In simple terms, a depository is a ‘bank’ for securities.
National Securities Depository Limited (NSDL) and Central Depository
Services (India) Limited (CDSL) are functioning as depositories in India.
3. The various benefits of depository services are as follows:
x The risk of bad deliveries and loss of certificates in transit are
removed.
x There is saving in stamp duty.
x The cost of courier, notarization and the need for further follow-up is
eliminated. The liquidity of securities due to immediate transfer and
registration is increased.
x The brokerage charge for trading in dematerialized shares is low.
1. Explain the nature of issues to equity market.

2. Discuss the types of investors in the primary market.
3. Explain the role of market intermediaries.
4. Describe the role of lead managers.
5. Explain the functions of bankers to the issue and underwriters.
6. Discuss the role of SEBI in primary market.
7. Describe briefly the various kinds of prospectuses.
8. What is private placement? State reasons for companies preferring private
placement as the most appealing method of floatation of securities.
9. What is IPO grading?
10. Describe the market participants of the secondary market.
11. Who is a stock broker? What are the required eligibility conditions for a
stock broker?
137

McGraw-Hill.
138
Broker: Importance,
Types and Role
UNIT–6 BROKER: IMPORTANCE, TYPES AND ROLE
Objectives
x Discuss the different types of brokers
x Describe the SEBI rules regarding stockbrokers and sub-brokers
x Analyse the relationship between a stock-broker and the client
Structure
6.1 Introduction
6.2 Understanding the Role Performed by Brokers
6.3 Stockbroker-Client Relation
6.4 Summary
6.5 Key Words
6.1 INTRODUCTION
A stock broker is a member of the stock exchange, and he is permitted to trade on

the screen-based trading system of the stock exchange. Brokers have to register
with SEBI and should keep a registration certificate. A sub broker is a person who
is affiliated to a member of a recognised stock exchange. He too has to register with
SEBI. Trading can be carried out only through the members. Investors can enter into
trade only through brokers’ accounts. The broker enters into trade either on his own
account or on behalf of his clients in the stock exchanges.
This unit elaborates on the role and importance of the various types of brokers.
6.2 UNDERSTANDING THE ROLE PERFORMED BY BROKERS
Based on the Securities Contract (Regulation) Act, 1956, certain stock exchanges
have recognized as exclusive centres for securities’ trading. Majority of India’s stock
exchanges have been organized to be mutual and as far as compliance and tax
benefits are concerned, this is a beneficial move. The exchanges are managed and
139
Broker: Importance,
Types and Role
controlled by such trading members who are also broking services providers. An
exchange’s trading platform is only accessible to brokers. There is free entry and exit
of brokers with demutualised exchange. The broker enters into trades in exchanges
on own or client’s behalf. Brokers function in the secondary markets, selling and
purchasing securities, like bonds and stocks.
‘Broker’ as defined in the Concise Law Dictionary means a middleman or
agent who, for a commission on the value of the transmission, negotiates for others
the purchase or sale of stocks, bonds, commodities or property of any kind, or who
attends to the doing of something for another.
A broker is the one dealing in shares and his business also comprises the getting
of subscribers for shares. Basically, a broker is an intermediary in the secondary
market and acts as a middleman between the stock exchanges and investors. The
deal is reflected by a broker with the transfer of the shares and stocks. They take
funds from investors and bring them to the stock exchanges. Stockbrokers and sub
brokers are a category of intermediaries.
A broker is an individual or a firm who/that is employed by others for planning,
and organizing the sales or for negotiating contracts in return for a commission.
We can also say that a broker is an individual who arranges the transactions
between sellers and buyers on commission basis on execution of a deal. The broker
who functions also as a buyer or seller will be a principal party to the deal. The one
who acts on behalf of a principal is a distinguished agent.
The function of a broker is of arranging contracts for such property in which the
broker does not hold any personal concern or personal interest or possession of the
property. The broker is just a negotiator or intermediary for the contracting of
bargain of any kind, functioning as agent for those parties that want to sell/buy
services, commodities, personal property, real estate, bonds and/or stocks.
Generally, the rules that apply to agencies are also valid in majority of the
transactions where brokers are involved. While the client is the principal, the broker
is the agent for the client. Generally, the powers of the agent go beyond the powers
of a broker. A broker acts as a middleman and an agent does not. In the case where
a sale is arranged by a broker, the broker acts like the agent for both the parties
involved.
To ascertain if a person is playing the role of a broker in a deal, it becomes
important to examine the type of service that is being provided.
140
Broker: Importance,
Types and Role
An independent agent, the broker is extensively used in certain industries. The

key responsibility of a broker is to bring together buyers and sellers and in this
manner the broker becomes the third person facilitator between a seller and a buyer.
One example of this would be of a real estate broker who helps with a property’s
sale.
Brokers have the knowledge of and provide to their clients information
pertaining to the market that they are operating in. This information could be
associated with the market conditions, the products, the price and such other
information. Most of the times, nearly as high as 90% of the times, brokers are seen
to be representatives of the sellers and in about 10% of the times of the buyer. The
same broker cannot represent both the seller and the buyer associated in a
transaction. A major role is played by brokers in the sale of financial services, bonds,
stocks, etc.
Various advantages can be gained by including a broker in a transaction.
Foremost, brokers are well versed with the market and its behaviour. They already
have good relations with prospective accounts. The brokers possess resources and
tools that enable them to reach out to the largest possible buyer base. Brokers are
able to screen potential buyers in their buyer base on the basis of revenue that would
support the potential acquisition. Conversely, any individual producer, and certainly
the one new to the market, would possibly have lower customer access compared
to a broker. The issue of cost also makes it better to take on the services of a
broker as with smaller accounts, in smaller markets and with a narrow product line
they might fall cheaper.
Types of Brokers
There are various types of brokers, and each one of them deals in his own specific
type of transaction, such as ad (advertisement) broker, agri broker, aircraft broker,
arms broker, auto broker, auto transport broker, brokerage firm, broker-dealer,
business broker, cargo broker, commodity broker, customs broker, energy broker,
foreign exchange broker, information broker, insurance broker, intellectual property
broker, inversions, investment broker, joint venture broker, leasing broker, list
broker, marriage broker, mortgage broker, office broker, online broker, options
broker, pawnbroker, prime broker, real estate broker, retail broker, serviced office
broker, sharebroker, ship broker, sponsorship broker, stockbroker, truck broker,
website broker and yacht broker.
141
Broker: Importance,
Types and Role
Let us elaborate on some important types of brokers:

(i) Bill-and-note broker: The bill-and-note broker carries out negotiations
for the buying and selling of bills of exchange and of promissory notes.
(ii) Merchandise or commercial broker: A merchandise or commercial
broker is one who works with sellers and buyers by negotiating between
them the selling and purchasing of goods, while he himself does not have
the property’s personal custody. A commercial broker’s services are
offered on commission basis as sales representatives to manufacturers for
the products manufactured by them. A commercial broker neither has
possession of nor control over the product. The product is directly sent to
the buyer by the manufacturer while the broker is only the middleman and
third person facilitating the transaction.
(iii) Insurance broker: An insurance broker plays the role of the intermediary
facilitator acting between the prospective insured and the insurer. The
insurance broker is not the same as an insurance agent. An insurance agent
will be employed by the insurance company and will represent the
company. The insurance broker will only represent the insured. While the
rules and responsibilities of the company that has employed him bind the
insurance agent, the sole responsibility of the insurance broker is to provide
help to his client and has no obligation towards any company.
(iv) Real estate brokers: Real estate brokers work on a commission basis
and provide their services for selling, buying, renting and leasing of real
property. They also provide services for sale or purchase of lands, and
mortgage or acquisition for other persons. They even provide consultation
services to those looking to sell or purchase real estate.
(v) Stockbroker: In the Securities Exchange Act, 1934, a broker is defined
as ‘anyone, other than a bank, engaged in the business of effecting
securities transactions for the account of others.’ Based on this, brokers are
a sub-class of dealers and in this sub class are all those who are in the
business of effecting securities transactions as agents for others. A broker is
that intermediary who is registered under Section 12 of the SEBI Act,
1992 and is associated with the securities market. The various aspects of
stockbrokers and their functions are discussed ahead separately.
142
Broker: Importance,
Types and Role
(vi) Brokerage firm: A brokerage firm, or simply brokerage, is a financial

institution that facilitates the buying and selling of financial securities
between a buyer and a seller. Brokerage firms serve a clientele of investors
who trade public stocks and other securities, usually through
the firm’s agent stockbrokers. A traditional, or “full service”, brokerage firm
usually undertakes more than simply carrying out a stock or bond trade.
The staff of this type of brokerage firm is entrusted with the responsibility
of researching the markets to provide appropriate recommendations, and in
doing so they direct the actions of pension fund managers and portfolio
managers alike. These firms also offer margin loans for certain approved
clients to purchase investments on credit, subject to agreed terms and
conditions.
(vii) Broker-dealer: A broker-dealer is a person or firm in the business of
buying and selling securities, operating as both a broker and a dealer,
depending on the transaction. A brokerage acts as a broker (or agent)
when it executes orders on behalf of clients, whereas it acts as a dealer, or
principal, when it trades for its own account.
(viii) Commodity broker: A commodity broker is a firm or individual who
executes orders to buy or sell commodity contracts on behalf of clients and
charges them a commission. A firm or individual who trades for his own
account is called a trader. Commodity contracts include futures, options,
and similar financial derivatives. Clients who trade commodity contracts are
either hedgers using the derivatives markets to manage risk,
or speculators who are willing to assume that risk from hedgers in hopes of
a profit.
(ix) Futures Commission Merchant (FCM): A firm or individual that solicits
or accepts orders for commodity contracts traded on an exchange and
holds client funds to margin, similar to a securities broker-dealer.
(x) Introducing broker (IB): A firm or individual that solicits or accepts
orders for commodity contracts traded on an exchange. IBs do not actually
hold customer funds to margin.
(xi) Foreign Exchange (Forex) broker: It refers to a firm that provides
currency traders with access to a trading platform that allows them to buy
and sell foreign currencies. A currency trading broker, also known as a
143
Broker: Importance,
Types and Role
retail forex broker, or forex broker, handles a very small portion of the
volume of the overall foreign exchange market. Currency traders use these
brokers to access the 24-hour currency market. Forex brokers are usually
compensated through the bid-ask spread of a currency pair.
(xii) Investment broker: Investment brokers are individuals who bring
together buyers and sellers of investments. They usually are required to be
licensed to act on behalf of buyers and sellers of stock. They charge
a commission on trades that they execute on such instructions from buyers
and sellers.
(xiii) Leasing broker: The job of a leasing broker is to help business owners
lease the equipment they need to start, operate, and expand their
businesses, including everything from computers to machinery to heavy
equipment to specialized tools and lots more.
(xiv) List broker: A list broker acts as an agent for those who wish to
conduct direct marketing campaigns via direct mail, email or telemarketing.
List brokers provide lists that, minimally, contain a prospect’s name and
contact information. Additionally, lists may include additional demographic
information such as age, sex, etc.
(xv) Mortgage broker: A mortgage broker acts as an intermediary who
brokers mortgage loans on behalf of individuals or businesses. Mortgage
brokers exist to find a bank or a direct lender that will be willing to make
specific loan an individual is seeking.
(xvi) Options broker: Options brokers specialize in offering options trading,
research, education and other tools to individual investors. In addition to
common options trades like covered calls, option spreads, and straddles,
many options brokerages offer trading in products related to options,
including stocks, exchange-traded funds, mutual funds, and bonds (also
known as fixed income).
Stockbrokers: Meaning, Nature, Registration, Duties and Role

A stockbroker sells and buys shares in corporations and is associated with securities
and corporate stocks. The functions of a stockbroker cover a wider ground than
other brokers. A stockbroker is not just a negotiator. A stockbroker carries out a
purchase in personal name and generally pays the price of purchase. Oftentimes, the
stockbroker holds the responsibility of the possession of the securities which are
being dealt by him. On the other hand, and broker does not have possession or the
144
Broker: Importance,
Types and Role
title of the property which is issued, sold or bought. The scope of work and the
responsibilities of a stockbroker are much more than of an ordinary broker.
At times, a stockbroker could be entrusted with the possession of securities and
might go ahead and have them transferred with the name of the principal not being
there in the transaction. Oftentimes, a broker does advance payment and later takes
it from the client. In this way, a stockbroker plays the part of both an agent and a
bailee. It is required by SEBI that there be a written agreement between the investor
and his stockbroker, which should be executed on a minimum ` 20/- stamp paper.
The term ‘brokerage’ refers to a commission which is paid to a stockbroker,
bank or to any other marketing intermediary for placing shares on a best effort basis
or for inducing a broker’s clients or customers to subscribe for the company’s
shares or other securities and is lawful if reasonable in amount. Brokerage refers to
the commission or fee given to a broker or charged by him. Brokerage Commission
is the compensation paid by a property’s owner to the broker he employs to find a
purchaser for the property. Companies that are listed cannot pay brokerage
exceeding 5 per cent on private placement of capital. Expenses that the broker has
to undertake for getting subscribers are to be borne by the broker. Brokerage is
paid just for the services provided based on the contract with a company.
A stockbroker deals in stocks of moneyed corporations and in other types of
securities. A stockbroker facilitates the selling and purchasing of shares and stocks
on commission basis as well as Government or other securities, on behalf of and for
the accounts of his clients. Such a person would have made an application for
registration or would already be registered as sub-broker or stockbroker, in line
with the guideline laid down by SEBI Act, 1992. As has already been mentioned,
the functions of such a broker have a wider base than of other brokers due to his
being entrusted with the possession of the property for which he acts and may even
take and transfer it without the name of his principal appearing in the transactions.
No regularity body exists in India for brokers.
The role played by brokers and subbrokers in the secondary market is a vital
one. As capital market’s regulator, SEBI in recognition of the role has allowed the
broker and subbroker to function as underwriters and they do not need to register
with SEBI pursuant to SEBI (Underwriters) Rules & Regulations, 1993. For this,
they must possess a valid registration certificate issued by SEBI under SEBI
(Stockbrokers and Sub-Brokers) Rules & Regulations, 1992. Nevertheless, the
broker/sub-broker needs to work in compliance with every obligation stipulated
145
Broker: Importance,
Types and Role
thereunder and also must get permission from the concerned Stock Exchange of
which he is a member, which permits him to be an underwriter for every one of the
issues.
On a regular basis, brokers keep their clients informed (via newsletters, etc.) of
the position of the primary and secondary markets, specifically the new issues. The
information also carries recommendations made by the broker. Brokers and sub-
brokers get registered with leading merchant bankers who manage many public
issues.
The stockbroker makes investments for corporations and individuals in the
stock market. One has to be a member of the stock exchange to make transactions,
so corporations and individuals need the services of a brokerage house to sell and
purchase stocks. Oftentimes, Stockbrokers will give council and advice to their
clients on what to invest in, help them understand the basic functioning of the stock
exchange and gain knowledge of their clients’ requirements and financial ability, so
that they can provide them the most fitting investment. When the investment is
decided, the broker sends the order to the securities exchange’s floor via phone or
computer. Once the transaction is done, the broker apprises the client of the price.
Payment is made by the client and the title of the stock is transferred by the broker
to the client. The clearing and settlement procedure is performed for the transaction
to be fully completed.
It is under the Securities and Exchange Board of India (Stockbrokers and Sub-
Brokers) Regulations, 1992 that the law relating to Stockbrokers has been enacted
by the Central Government of India. According to the SEBI Rules, a ‘Stockbroker’
is a member of the stock exchange. He works as his client’s agent and deals with
securities on the client’s behalf. While in strict terms, a stockbroker is an agent, he is
considered to be a principal as far as the performance of the contract on his part
with the client and in the market is concerned. He has dual responsibility. He charges
his clients commission. While a broker executes transactions for investors, he also
provides value management or services. Stockbrokers are also governed by by-laws
of the respective stock exchanges.
To work as a stockbroker, apply for it in accordance with SEBI (Stockbrokers
and Sub-Brokers) Regulations, 1992. His registration has to be made under SEBI
Act, 1992. The broker must act according to the conditions specified by the
certificate of registration issued by SEBI as per the regulations framed on SEBI Act,
146
Broker: Importance,
Types and Role
1992, or else he cannot act as a broker dealing in securities market. A broker should
not have a pending enquiry against him for any malpractice in a stock exchange.
Persons indulging in manipulative activities are neither fit nor proper persons to
operate in the market.
A stockbroker has to abide by the code of conduct prescribed under SEBI
(Stockbrokers and Sub-Brokers) Regulations, 1992. The broker is expected to
keep high standard of integrity, exercising all care and skill to stay away from
malpractice and manipulation. These Rules are discussed ahead separately.
A broker needs to execute his client’s orders at the best price possible for the
client. A stock exchange’s member brokers must issue contract notes to their clients
for the securities bought and sold by them on for the clients. It must be specified in
the contract note that the brokerage taken from the client is not more than the stock
exchange fixed official scale. The broker is responsible for maintaining confidentially
of client transaction related information. Broker should only provide
recommendation to the client when he is certain of it being suitable for his client.
If an outside party has not honoured its business obligations to a broker, the
other brokers must not deal with this party. This requires that the stock exchange
members be made aware of defaulting parties.
In client dealing, a stockbroker needs to take some precautions to prevent
problems for the client and the market. Such precautions protect the stockbrokers’
interests, create discipline and transparency in client-broker dealings and add to the
secondary capital market’s healthy functioning.
Stock exchanges can report complaints against stockbrokers. A stock exchange
sends Monthly Status Report of Complaints that have been made against brokers,
rather than do it individually for each case as and when it happens.
Government of India: Stockbrokers and Sub-brokers Rules, 1992

Under the SEBI Act, the Central Government issued a notification on August 20,
1992, laying down rules relating to stockbroker and sub-brokers.
Definition of stockbroker
The rules define a stockbroker as a member of the stock exchange and the sub-
broker as any person who acts on behalf of the stockbroker as an agent or
otherwise, for assisting the investors in buying, selling or dealing in securities through
such brokers.
147
Broker: Importance,
Types and Role
Conditions for grant of certificate to stockbrokers

The rules stipulate that registration with the SEBI is necessary for acting as a broker
or a sub-broker. The conditions, for grant of a certificate or registration to act as
stockbroker are
(a) he holds the membership of a stock exchange;
(b) he shall abide by the rules and regulations and bye-laws of the stock
exchange of which he is a member;
(c) in case of any change in the status and constitution, the broker shall obtain
prior permission from the SEBI, to continue trading in securities;
(d) he shall pay the amount of fees for registration; and
(e) he shall take adequate steps for redressal of grievances of the investors
within one month of the date of receipt of complaint and keep the SEBI
informed about the number, nature and other particulars of the complaints
received from such investors.
Conditions for grant of certificate to sub-brokers

The conditions for the grant of a certificate to a sub-broker are:
(a) he is authorized in writing by a stockbroker, being a member of a stock
exchange for affiliating himself in buying, selling or dealing in securities;
(b) he shall pay the fees;
(c) he shall take adequate steps for the redressal of grievances of the investors,
within 1 month of the date of their receipt of the complaint and keep the
SEBI informed about the number, nature and other particulars of the
complaints received; and
(d) in case of any change in the status and constitution, the sub-broker shall
obtain prior permission from the SEBI to trade in securities.
SEBI: Stockbrokers and Sub-brokers Rules, 1992

The stockbrokers and sub-brokers regulations were issued by the SEBI through a
notification on October 23, 1992 with the prior approval of the Central
Government.
The regulations specify the procedure for registration of stockbrokers and sub-
brokers. The total number of registered brokers was 9192 as on March 31, 2000;
and sub-brokers, 5657.
148
Broker: Importance,
Types and Role
Registration of stockbrokers
The application for the grant of a certificate has to be made in Form A through the
stock exchange, of which he is a member. The application must be forwarded by the
exchange, within 30 days to the SEBI. SEBI may require the applicant to furnish
further information or clarification regarding the dealings in the securities and matters
connected. SEBI may also require personal representation.
While considering the application for registration, SEBI takes into account all
matters relating to buying, selling or dealing in securities. It also takes into
consideration the fact, whether the stockbroker is eligible to be admitted as a
member of the stock exchange, has the necessary infrastructure like adequate office
space, equipment and manpower to effectively discharge his activities, past
experience in securities business and is subjected to any disciplinary proceedings
under the rules, regulations and bye-laws of stock exchange with respect to his
business as a stockbroker, involving himself or any of his partners, directors or
employees. On being granted a certificate in Form D, the stockbroker has to abide
by the code of conduct. The code of conduct lays down general rules, duty to the
investors and towards dealing with the other stockbrokers.
General rules
A stockbroker is expected to maintain high standards of integrity, promptitude and
fairness in conducting his business. He is expected to exercise due skill, care,
diligence and comply with statutory requirements and not indulge in manipulation and
malpractices.
(i) Duty to the investor

A stockbroker shall execute orders at the best available market price and not refuse
to deal with small investors. He should promptly inform his clients about the
execution or non-execution of an order and make payment for sale and delivery of
the securities purchased. A contract note should be issued promptly. He is expected
to maintain confidentiality, about his clients investments. Stockbrokers should not
encourage sales or purchases of securities or furnish quotations, information and
advice to earn brokerage and commission. Stockbrokers are not expected to deal
with clients who are in default with other stockbrokers. Stockbrokers should also
disclose to the clients as to, whether he is acting as a principal or a broker and avoid
conflicts of interest. Investment advice should not be given unless required on the
basis of information given by the client about his financial situation, security holdings
149
Broker: Importance,
Types and Role
and investment objectives. Stockbrokers should render fair, prompt and competent
services to their clients.
(ii) Duties towards other Stockbrokers

A stockbroker should cooperate with the other brokers in comparing unmatched
transactions, replacing documents, declaring bad delivery, protection of client’s
interests and settlement of transactions. A stockbroker should not advertise his
business and induce through unfair means, clients from other brokers. Finally, a
stockbroker should not neglect or fail or refuse to submit the required returns to the
SEBI and stock exchange and not make false or misleading statements on any such
returns.
(iii) Registration Fees

Every stockbroker shall pay a registration fee of ` 5,000 for each financial year,
when the annual turnover does not exceed ` 1 crore; where the turnover exceeds `
1 crore, during any financial year, ` 5,000 plus 1/100 of one per cent of the turnover
in excess of ` 1 crore for each financial. After the expiry of 5 years, from the date
of initial registration, he shall pay a sum of ` 5,000 for a block of 5 years,
commencing from the sixth financial year, after the grant of initial registration to keep
his registration in the future.
General obligations and responsibilities

1. Every stockbroker should keep and maintain the following books of
accounts, records and documents: (a) Register of transaction (Sauda
Book); (b) clients ledger; (c) general ledger; (d) journals; (e) cash book; (f)
bank pass book; (g) documents, register of shares and securities received
and delivered; (h) members contract book, showing details of all the
contracts entered by him with the other members of the same exchange for
counterfoils of duplicates, or memos of confirmation issued to such other
members; (i) counterfoils or duplicates of contract notes issued to the
clients; (j) written consent of the clients with respect to the contracts
entered as principals; (k) margin deposit book; (l) register of accounts of
sub-brokers, and, (m) an agreement with the sub-broker specifying the
scope of authority and responsibilities of stockbrokers and each sub-
broker.
2. The stockbroker should inform the SEBI, the place where the books of
accounts, records and documents are maintained and kept.
150
Broker: Importance,
Types and Role
3. Stockbrokers should furnish with the SEBI after the closure of each
accounting period a copy of the audit report, balance sheet and profit and
loss accounts. The books of accounts, records and documents should be
preserved for a period of five years.
Inspection of accounts, records and documents by SEBI

Inspection of accounts, records and documents may be undertaken by the SEBI to
ensure that they are maintained in the manner required, and provisions of the SEBI
Act, rules and regulations and SE(R) Act and the rules made thereunder are
complied with, investigation into the complaints received from the investors, other
stockbrokers, sub-brokers or any person bearing on the activities of the
stockbroker and investigate suo moto in the interest of securities business or
investors’ interest into the affairs of the stockbrokers. SEBI can also appoint a
qualified auditor to investigate into the books of account or affairs of the
stockbroker.
The inspection may be undertaken after giving reasonable notice time or without
notice, if the investors or public interest requires. The stockbroker has to cooperate
by producing all the records and giving access to the premises. SEBI communicates
the findings of the inspection and gives the stockbroker an opportunity of being
heard before any action is taken.
Default
A stockbroker who fails to comply with any of the conditions of the registration,
contravenes any of the provisions of the SEBI Act, rules or regulations, contravenes
the provisions of the SE(R) Act or the rules made thereunder, contravenes the rules,
regulations of the stock exchange, is liable to suspension of registration after an
enquiry for a specified period of cancellation of registration.
Registration of sub-brokers
An application in Form B for registration to the SEBI, accompanied by a
recommendation letter from a stockbroker with whom he is affiliated, along with two
references including one from the banker, should be submitted to the stock exchange
of which the stockbroker, with whom he is to be affiliated, is a member. The stock
exchange has to verify the information and certify that the applicant is eligible for
registration. The stock exchange should forward the application within 30 days in the
case of an individual. The applicant should be 21 years of age, should not be
convicted of fraud or dishonesty and should have passed the 12th standard or an
151
Broker: Importance,
Types and Role
equivalent examination. If the SEBI is satisfied, the sub-broker is eligible for

registration, a certificate in Form E is made and the stock exchange is informed.
Fees
The sub-broker has to pay a fee of ` 1,000 for each financial year for an initial
period of 5 years. After the expiry of 5 years, the sub-broker should pay a fee of
`500 for each financial year, as long as the certificate remains in force.
The sub-broker should abide by the code of conduct. He should maintain, high
standards of integrity, promptitude and fairness in the conduct of investment business
and act with due skill, care and diligence.
(i) Duty to the investor

With regard to the investor, the sub-broker should execute orders at the best market
price and promptly finalize the transactions. Purchase or sale notes for all
transactions entered by him with his clients, should be issued promptly. Scrip-wise
split purchase or sale notes and similarly, bills and receipts showing brokerage
separately have to be issued. He can split the contract notes issued by the affiliated
brokers client-wise or scrip-wise into different denominations. A sub-broker should
not match the purchase and sale orders of his clients. They should be routed through
the member broker with whom the sub-broker is affiliated.
He should not commit breach of trust by disclosing confidential information about
his clients. He should not encourage sales or purchases to earn brokerage and
commission. A sub-broker is not expected to deal with defaulting clients. He should
disclose to his clients that he is acting as an agent and should avoid conflicts of
interest. Investment advice should not be given, unless found suitable on the basis of
information given, by the client about his financial situation, security holdings and
investment objectives. Sub-brokers should render fair, prompt and competent
services to their clients.
(ii) Duties towards stockbrokers

A sub-broker should cooperate with his broker in comparing unmatched
transactions, replacing documents declared as bad deliveries, protecting clients’
interests and settlement of his transactions with his broker. A legal agreement
specifying the rights and obligations of the sub-broker and the principal broker
should be executed. A sub-broker should not advertise his business and induce
through unfair means, clients from other brokers. Finally, a sub-broker shall not
152
Broker: Importance,
Types and Role
neglect or fail or refuse to submit the returns to the SEBI or the stock exchange and
not make false or misleading statements on any such returns.
1. Who is a commercial broker?

................................................................................................................
................................................................................................................
................................................................................................................
2. Define broker according to the Securities Exchange Act.

................................................................................................................
................................................................................................................
................................................................................................................
3. What does the term ‘brokerage’ refer to?

................................................................................................................
................................................................................................................
................................................................................................................
6.3 STOCKBROKER-CLIENT RELATION
The stockbroker-client is the same as a principal-agent relationship. According to

SEBI, there has to be a written agreement between a stockbroker and investor,
executed on a ` 20/-stamp paper. The nature of NSE and BSE trading makes a
stockbroker a del credere agent. A stockbroker and a client also have a bailor-
bailee relationship. By nature their relationship is also fiduciary. Nevertheless, the
SEBI Code of Conduct for Brokers requires that a broker exercise due diligence in
his functioning as ‘that of a stockbroker who would be required to perform his duties
towards his client using his skill with reasonable care’.
Shares have to be delivered by the investor to the stockbroker so that they can
be sold by the stockbroker in the stock exchange. All unsold shares need to be
returned by the stockbroker to the investor. In this way, the stockbroker is a bailee
holding specific bailee related responsibilities. The stockbroker-investor relationship
is by nature fiduciary, mature, based on trust, reliance, dependence or confidence
153
Broker: Importance,
Types and Role
rested by the investor in the reliability and faithfulness of the stockbroker who is in a
position of relative dominance and influence. A broker who betrays and is disloyal to
his investors/clients, is liable for damages. In case a broker misrepresents
information of a transaction or investment, the investor/client could pose a claim
against that broker for loss recovery.
A client who operates via a stock exchange, holds right to be provided the best
market price available at the time of his trade, and has the right to get the money or
shares on time, contract note from broker confirming the trade and indicating the
necessary details of the trade, good delivery and right to insist on rectification of bad
delivery.
A broker possesses several rights over his clients. When a broker completes the
provided instruction, he must get complete indemnity from the client as far as the
losses or liability incurred by him for making the transaction are concerned. He
should have complete freedom to close the contract in case the client fails to pay
him in two days from the issue of the contract note and sale/purchase of securities.
There are mandatory guidelines issued by SEBI for stockbrokers to be followed
prior to agreeing to act on clients’ behalf. One being that the broker cannot disclose
either personal or financial details of his clients to anyone. He must keep separate
accounts for his clients and regularly pay to them the accruing amounts. Clients must
be provided IDs so that they can be traced.
1. What does SEBI Code of Conduct for Brokers requires of a broker?

................................................................................................................
................................................................................................................
................................................................................................................
2. What are the rights that a broker possesses over his clients?
................................................................................................................
................................................................................................................
................................................................................................................
154
Broker: Importance,
Types and Role
6.4 SUMMARY
x Based on the Securities Contract (Regulation) Act, 1956, certain stock

exchanges have recognized as exclusive centres for securities’ trading.
x Majority of India’s stock exchanges have been organized to be mutual and
as far as compliance and tax benefits are concerned, this is a beneficial
move. The exchanges are managed and controlled by such trading
members who are also broking services providers.
x ‘Broker’ is defined as a middleman or agent who, for a commission on the
value of the transmission, negotiates for others the purchase or sale of
stocks, bonds, commodities or property of any kind, or who attends to the
doing of something for another.
x The function of a broker is of arranging contracts for such property in
which the broker does not hold any personal concern or personal interest
or possession of the property. The broker is just a negotiator or
intermediary for the contracting of bargain of any kind, functioning as agent
for those parties that want to sell/buy services, commodities, personal
property, real estate, bonds and/or stocks.
x An independent agent, the broker is extensively used in certain industries.
The key responsibility of a broker is to bring together buyers and sellers
and in this manner the broker becomes the third person facilitator between
a seller and a buyer.
x A stock broker deals in stocks of moneyed corporations and in other types
of securities. A stock broker facilitates the selling and purchasing of shares
and stocks on commission basis as well as Government or other securities,
on behalf of and for the accounts of his clients.
x The stock broker makes investments for corporations and individuals in the
stock market. One has to be a member of the stock exchange to make
transactions, so corporations and individuals need the services of a
brokerage house to sell and purchase stocks.
x On a regular basis, brokers keep their clients informed (via newsletters,
etc.) of the position of the primary and secondary markets, specifically the
new issues. The information also carries recommendations made by the
broker.
155
Broker: Importance,
Types and Role
x According to the SEBI Rules, a ‘Stockbroker’ is a member of the stock

exchange. He works as his client’s agent and deals with securities on the
client’s behalf. While in strict terms, a stockbroker is an agent, he is
considered to be a principal as far as the performance of the contract on his
part with the client and in the market is concerned.
x Stock exchanges can report complaints against stockbrokers. A stock
exchange sends Monthly Status Report of Complaints that have been made
against brokers, rather than do it individually for each case as and when it
happens.
x While considering the application for registration, SEBI takes into account
all matters relating to buying, selling or dealing in securities.
x A stockbroker who fails to comply with any of the conditions of the
registration, contravenes any of the provisions of the SEBI Act, rules or
regulations, contravenes the provisions of the SE(R) Act or the rules made
thereunder, contravenes the rules, regulations of the stock exchange, is
liable to suspension of registration after an enquiry for a specified period of
cancellation of registration.
x In client dealing, a stock broker needs to take some precautions to prevent
problems for the client and the market. Such precautions protect the stock
brokers’ interests, create discipline and transparency in client-broker
dealings and add to the secondary capital market’s healthy functioning.
x There are mandatory guidelines issued by SEBI for stock brokers to be
followed prior to agreeing to act on clients’ behalf. One being that the
broker cannot disclose either personal or financial details of his clients to
anyone. He must keep separate accounts for his clients and regularly pay to
them the accruing amounts.
6.5 KEY WORDS
x Broker: A middleman or agent who, for a commission on the value of the

transmission, negotiates for others the purchase or sale of stocks, bonds,
commodities or property of any kind, or who attends to the doing of
something for another.
x Bill-and-note broker: The bill-and-note broker carries out negotiations
for the buying and selling of bills of exchange and of promissory notes.
156
Broker: Importance,
Types and Role
x Brokerage firm: A brokerage firm, or simply brokerage, is a financial

institution that facilitates the buying and selling of financial securities
between a buyer and a seller.
x Broker-dealer: A broker-dealer is a person or firm in the business of
buying and selling securities, operating as both a broker and a dealer,
depending on the transaction.
x Commodity broker: A commodity broker is a firm or individual who
executes orders to buy or sell commodity contracts on behalf of clients and
charges them a commission.
x Leasing broker: The job of a leasing broker is to help business owners
lease the equipment they need to start, operate, and expand their
businesses, including everything from computers to machinery to heavy
equipment to specialized tools and lots more.
x List broker: A list broker acts as an agent for those who wish to
conduct direct marketing campaigns via direct mail, email or telemarketing.
x Mortgage broker: A mortgage broker acts as an intermediary who
brokers mortgage loans on behalf of individuals or businesses.
x Options broker: Options brokers specialize in offering options trading,
research, education and other tools to individual investors.

1. A merchandise or commercial broker is one who works with sellers and
buyers by negotiating between them the selling and purchasing of goods,
while he himself does not have the property’s personal custody. A
commercial broker’s services are offered on commission basis as sales
representatives to manufacturers for the products manufactured by them.
2. In the Securities Exchange Act, 1934, a broker is defined as ‘anyone, other
than a bank, engaged in the business of effecting securities transactions for
the account of others.’
3. The term ‘brokerage’ refers to a commission which is paid to a
stockbroker, bank or to any other marketing intermediary for placing
shares on a best effort basis or for inducing a broker’s clients or customers
157
Broker: Importance,
Types and Role
to subscribe for the company’s shares or other securities and is lawful if

reasonable in amount.

1. The SEBI Code of Conduct for Brokers requires that a broker exercise due
diligence in his functioning as ‘that of a stock broker who would be required
to perform his duties towards his client using his skill with reasonable care’.
2. A broker possesses several rights over his clients. When a broker
completes the provided instruction, he must get complete indemnity from
the client as far as the losses or liability incurred by him for making the
transaction are concerned. He should have complete freedom to close the
contract in case the client fails to pay him in two days from the issue of the
contract note and sale/purchase of securities.
1. Write a note on the role performed by brokers.

2. Discuss the different types of brokers.
3. What do you understand by brokerage?
4. What are the conditions for grant of certificate to stockbrokers?
5. Discuss the duties of a stockbroker towards the investers and other
stockbrokers.
6. Analyse the relationship between a stockbroker and a client.

McGraw-Hill.
158
Trading Mechanism and Listing
of Securities in Stock Exchange
UNIT–7 TRADING MECHANISM AND LISTING OF

SECURITIES IN STOCK EXCHANGE
Objectives
x Explain trading mechanism
x Describe trading in Bombay Stock Exchange
x Discuss the types of settlements
x Define online trading, day trading and margin trading
x State the procedure of listing of securities in stock exchange
Structure
7.1 Introduction
7.2 Trading Mechanism
7.3 Listing of Securities in Stock Exchange
7.4 Summary
7.5 Key Words
7.1 INTRODUCTION
In the previous units you studied about the role of a broker. A broker, as you know,
is an individual or a firm who/that is employed by others for planning, and organizing
the sales or for negotiating contracts in return for a commission.
This unit focuses on the trading mechanism and various types of trading. You will
also study merits and demerits of listing of securities in stock exchange. The stock
exchanges are a part of the securities market and play a primary role in channelizing
household savings to investments in productive enterprises. It is necessary to know
how stock exchanges and the securities market function, before placing surplus
funds in the stock market, so that investors can make informed decisions.
159
7.2 TRADING MECHANISM
Investors place, buy and sell orders with members of the stock exchanges in
different ways as given below:
x Limit orders: Orders are limited by a fixed price, for example, ‘Buy XXX
at `50’. Here, the order has clearly indicated the price at which it has to be
bought, and the investor is not willing to give more than `50.
x Best rate order: The buyer or seller gives the freedom to the broker to
execute the order at the best possible rate quoted on that date for buying.
It may be the lowest rate for buying and the highest rate for selling.
x Discretionary order: The investor gives the range of price for purchase and
sale. The broker can use his discretion to buy within the specified limit and fix
the price. The order stands as this: ‘Buy BRC 100 shares around `40’.
x Stop loss order: The orders are given to limit the loss due to unfavourable
price movements in the market. The order specifies a limited waiting period.
The seller authorizes brokers to sell shares if the price falls below the limit to
prevent further loss, e.g., ‘Sell BRC Ltd at `25, stop loss at `22’.
Online Trading
Online trading means the purchase and sale of stocks on the Internet. All stock
exchanges offer an e-trading facility. Earlier, trading took place in the trading hall.
Orders were placed with the stockbroker either verbally (personally or
telephonically) or in a written form (fax). In online trading, the investor accesses a
stockbroker’s website through his/her Internet-enabled personal computer and
places orders through the broker’s Internet-based order routing and trading engine.
These orders are routed to the stock exchange without manual interference and then
given effect. All the players in the securities market, viz., stockbrokers, stock
exchanges, clearing corporations, depositories, DPs, clearing banks, etc., are
electronically linked. The information flow happens in real time among them. The
orders are routed to the exchange in seconds.
Many securities trading agencies provide online trading facilities to their clients’
homes. Earlier, computer terminals at the brokers’ premises acted as the trading
platform but now it has been shifted to the homes of investors. This provides more
transparency in transactions. The investor knows exactly when and at what rate his
order was processed. Manipulation is difficult.
160
Procedure for online trading

Listed below are the main steps involved in online trading:
x An investor has to register with the online trading portals listed on the site.
x He has to open a bank account using the Internet, at the trading portals of
banking and depository service partners.
x He must be a registered iConnect user.
x On placing an order to buy or sell securities through the listed online trading
portal, he has to click on the ‘pay through’ bank listed on the online portal,
which will direct him to a login screen of the investor’s account.
x Once the login ID and password are entered, he has to verify the
transaction details and confirm the transaction by entering his transaction ID
and password.
x An email confirmation will follow giving the status of the transaction, once
the order has been executed.
x His account status is updated on a real-time basis. The securities’ status can
be viewed online after the day of settlement.
Day Trading
Holding the stock positions within the current trading day is known as day trading. In
other words, it means not holding any position overnight. In day trading, positions in
the markets are squared before the end of that day. This is the safest way to do day
trading because the trader is not exposed to the potential losses that can occur
overnight. The overnight news can affect the prices of the stock. Any news regarding
a company or any macroeconomic event that happens after the closure of the stock
exchange may affect the next day’s opening price of the stock. A day trader typically
trades (buys or sells) several times a day looking for fractions of a point to a few points
per trade, but closes out all his positions by day’s end. The goal of a day trader is to
capitalize on price movement within one trading day. Unlike investors, a day trader
may hold positions for only a few seconds or minutes and never overnight.
Types of Day Trading

Typically, day traders fall into the following two categories:
x Scalpers: This type of day trading involves the rapid and repeated buying
and selling of a large volume of stocks within seconds or minutes. The
objective is to earn a small percentage of profit per share on each
transaction while minimizing the risk.
161
x Momentum traders: The trader identifies the moving patterns of the stocks
during the day and buys stocks at bottoms and sell at tops within a day.
Advantages of Day Trading
Day trading offers the following advantages:
x No overnight risk: Positions are closed before the end of the trading day.
News and events that affect the next trading day’s opening prices do not
impact the trader’s portfolio.
x Leverage: Day traders have a greater leverage on their trading capital
because of low margin requirements as they close their trade on the same
market day. This increased leverage can increase the profits.
x Gains from market movement: Day trading often utilizes short selling to
take advantage of declining stock prices. The ability to lock in profits even
as markets fall throughout the trading day is extremely useful in a bear
market conditions.
Margin Trading
Trading with borrowed funds or securities is called margin trading. It helps investors
trade over and above their owned funds. It is a leveraging mechanism. SEBI
regulates margin trading by prescribing the eligibility conditions and procedures to be
followed. The stock exchanges disclose all brokers’ scrip-wise gross outstanding in
margin accounts. Disclosures regarding any day is available after trading hours the
following day.
Margin trading is subject to the following SEBI norms:
x The client can avail of the facility from only one broker at a time.
x Brokers with a net worth of `3 crore alone can provide margin trading.
x SEBI specifies a format for entering into an agreement with a client before
providing the margin trading facility.
x Margin trading facility is provided for securities in Group 1 and securities
that are offered in the initial public offer. These securities should satisfy the
requirements for trading in the derivatives segment.
x If the broker wants to borrow funds for offering margin trading facility, he
can borrow only from scheduled commercial banks or NBFCs regulated
by RBI and not from any other sources.
x If the broker uses borrowed funds, he has to disclose the name of the
lender and the amount borrowed.
162
x The broker’s total exposure in margin trading should not exceed the
borrowed funds. Further, it should not exceed 50 per cent of the broker’s
net worth.
x Single client-level exposure should not exceed 10 per cent of the total
exposure of the broker. Initial margin is usually set at 50 per cent, and the
maintenance margin at 40 per cent. These margins are subject to change.
x The broker has to disclose to the stock exchange details on the gross
exposure, including name of the client.
x Margin trading leads to a leveraged portfolio. The higher the leverage the
higher is the magnification effect. The client is likely to lose money or gain
money when he transacts on margin depending on the movement of the
market. Margin trading becomes risky if his portfolio has a few volatile
stocks. When an investor carries margin trading he faces the following
risks:
o He is exposed to the loss of more money than he has invested.
o A fall in the value of securities leads to the payment of additional funds
to avoid forced sale of the securities.
o The investor or client will have to deposit additional cash on short
notice to cover market losses.
Settlement
There are two types of settlements–fixed and rolling. A fixed cycle starts on a
particular day and ends after five days. For example, in the Mumbai Stock
Exchange the settlement cycle starts on Monday and ends on Friday. In the NSE, it
starts on Wednesday of one week and ends on Tuesday of the following week.
A rolling settlement is one in which trades outstanding at the end of the day have
to be settled at the end of the T+X time framework. T is the trade date and X is the
days as specified by SEBI. In this settlement, payments are made quicker than in the
weekly settlements. Thus, investors benefit from increased liquidity. On 15 January
1998, SEBI made T+5 rolling settlement mandatory for institutional investors,
namely, domestic financial institutions, banks, mutual funds, and foreign institutional
investors in respect of eight securities for which dematerialized trading was made
compulsory. On 24 April 1998, it added 22 more companies to the list of stocks
eligible for compulsory demat trading by institutions with effect from 1 June 1998.
The stocks were selected on the basis of five parameters—trading volume,
163
institutional holdings, extent of dematerialization, incidence of bad delivery problems

and the distribution of registrars.
SEBI decided to shorten the rolling settlement cycle from T+5 to T+3 to derive
benefits of increased efficiency of the rolling settlement and ensure speedier settlement.
The compulsory rolling settlement on T+3 basis commenced on 1 April 2002.
In the light of the experience gained with the working of T+5 and T+3
settlements, it was considered desirable to shorten the settlement period to T+2.
Under the new trading cycle, all transactions are closed in two trading days after the
deal is struck.
Risk Management
SEBI has taken several measures to minimize market, operational and systemic
risks. To enhance the level of protection provided to the investor, SEBI reviews its
policies continuously. In accordance with its review findings, it has drafted risk
management policies. To reduce the risk exposure of the investor SEBI stipulates the
following:
x Index-based market wide circuit breakers
x Mark-to-market margins
x Value at Risk (VaR)-based margin
x Intraday trading limits and gross exposure limits
x Time limits for payment of margin
x Collection of margin on T+1 basis
Further, the stock exchanges carry out real-time monitoring of intraday trading limits
and gross exposure limits.
Market Wide Circuit Breakers

Originally, circuit filters were imposed at individual scrip level to contain excessive
movements in stocks and indices. At present, there are no circuit filters on the scrips.
SEBI introduced the market wide circuit breakers (MWCB) to prevent large market
movements. These are imposed to contain large market movements. Circuit
breakers are applied at three stages – at 10 per cent, 15 per cent, and 20 per cent
– of the Sensex and Nifty’s upward or downward movements. If the Sensex or
Nifty breaches these levels, the circuit breakers are immediately triggered. Once the
circuit breakers are applied, trading in the equity and equity-based derivative
164
segment is halted. The trading halt is applied nationwide. The duration of the halt
depends on the index movement and timing of trade as described below:
x 10 per cent index movement either side before 1pm — 1-hour halt
x 10 per cent index movement either way between 1pm and 2.30 pm —
half-an-hour halt
x 10 per cent index movement either way after 2.30 pm — no halt, trading
will continue
x 15 per cent index movement either way before 2 pm — 2-hour halt
x 15 per cent index movement either way at or after 2 pm — trading
suspended
x 20 per cent index movement either way at any point of the trading session
— trading suspended
At the end of every quarter, the percentage variation of the closing price of the
index is translated into absolute points of index variation. In the case of Sensex, it is
rounded off to the nearest 25 per cent. At the end of each quarter, the percentage
and the absolute points are revised. The revised points are applicable for the next
quarter.
Mark to Market Margin

The mark-to-market margin (MTM) amount is collected on the outstanding
settlement obligations of the member. The gross open position is the outstanding
settlement obligation of a member. Mark to market loss is the notional difference
between the current market price and the contract price in respect of outstanding
trades. The closing price of the scrip is taken as the current price. The MTM is
calculated at individual client level.
The stock exchanges collect the MTM from the member or broker before the
start of trading the next day. The MTM margin is collected or adjusted from or
against the cash or cash equivalent component of the liquid net worth deposited with
the exchange. The margin so collected is released along with the pay-in and includes
early pay-in of securities.
Value at Risk (VaR) Margin

Value at risk margin covers potential losses for 99 per cent of the days. For the
purpose of VaR calculation, the stocks are divided into three categories, namely,
groups 1, 2, and 3 on the basis of their liquidity as illustrated in Table 7.1.
165
Table 7.1 Categories of Securities for VaR Calculation
For securities that have been listed for less than six months, the trading frequency
and impact cost are computed using the entire trading history of the scrip. For liquid
stocks, the VaR margins are based only on the volatility of the stock and the margin
covers one-day losses. For illiquid stocks, the volatility of the market index is also
used in the computation and it covers three-day losses so as to allow the clearing
corporation to liquidate the position over three days
Computation of the VaR margin requires an understanding of the following
definitions:
x Scrip V (sigma) means the volatility of the security computed as at the end
of the previous trading day. The computation uses the exponentially
weighted moving average method to daily returns.
x Scrip VaR means the highest of 7.5 per cent or 3.5 scrip V.
x Index V shows the daily volatility of the market index (S&P CNX Nifty or
BSE Sensex) computed as at the end of the previous trading day. The
computation uses the exponentially weighted moving average method to
daily returns.
x Index VaR means the higher of 5 per cent or 3 index sigmas. The higher of
the Sensex VaR or Nifty VaR would be used for this purpose.
Collection of VaR margin

The VaR margin is collected in the following manner:
x On an upfront basis by adjusting against the total liquid assets of the
member at the time of trade. Collection on T+1 day is not acceptable.
x On the gross open position of the member. The gross open position for this
purpose means the gross of all net positions across all the clients of a
member, including his proprietary position.
The VaR margin so collected shall be released along with the pay-in, including
early pay-in of securities.
166
Extreme Loss Margin

This margin covers the expected loss in situations that lie outside the coverage of the
VaR margins. The following points about extreme loss margin should be noted:
x The extreme loss margin for any stock should be higher than 5 per cent,
and one-and-a-half times the standard deviation of daily logarithmic returns
of the stock price in the past six months. This computation should be done
at the end of each month by taking the price data on a rolling basis for the
past six months, and the resulting value should be applicable for the next
month.
x The extreme loss margin is collected or adjusted against the total liquid
assets of the member on a real-time basis.
x The extreme loss margin is collected on the gross open position of the
member. The gross open position for this purpose means the gross of all
net positions across all the clients of a member.
Additional Margins
Exchanges or clearing corporations have the right to impose additional risk
containment measures over and above the risk containment system mandated by
SEBI. This is usually required only to deal with circumstances that cannot be
anticipated. Any additional margins that the exchanges may impose should be based
on objective criteria. It should not discriminate between members on the basis of
subjective criteria.
Margins from the Client

Members should protect themselves from client default. Margins are likely to be an
important element of such a system. The quantum of these margins, and the form and
mode of the collection are left to the discretion of the members. It should be well
documented and made accessible to the clients and the stock exchanges.
Investor Protection Fund (IPF)

Whenever a broker defaults in payment, the investor suffers. To avoid this, the stock
exchanges have set up an investor protection fund. The main objective of this fund is
to meet the legitimate claims of the clients of the defaulting members that are not
speculative in nature. SEBI has permitted the stock exchanges to fix suitable
compensation limits in consultation with the IPF Trust.
167
Bombay Stock Exchange (BSE)

The Bombay Stock Exchange Ltd is the oldest stock exchange in Asia. Popularly
known as BSE, it was established as ‘The Native Share and Stock Brokers
Association’ in 1875. It is the first stock exchange in the country to obtain
permanent recognition, which was granted in 1956 from the Government of India
under the SCRA. It was structured as a membership-based firm, an association of
persons. It is now a demutualized and corporatized entity. The demutualization of
BSE was completed in 2007.
The BSE shares were sold at `5,200 a piece. The 800-odd brokers in BSE
sold nearly half their shareholding, constituting 41 per cent of equity stake in the
exchange. This means these members would have collectively received `1,600 crore
through the stake sale. The list of investors includes six foreign entities, including
Germany’s Deutsche Boerse and Singapore Exchange Ltd (SGX), which bought 5
per cent each recently, paying `189 crore each. The other foreign investors in the
deal are US private equity fund Atticus Mauritius Ltd and Caldwell Asset
Management. Both bought 4 per cent in the Exchange. Besides these, Dubai
Financial and Katrel Investment Ltd, Cyprus, too took a stake. Together, these four
overseas investors picked up 16 per cent in BSE. The shares were sold to
corporate houses like Bajaj Auto, Bennett Coleman, and Mahindra & Mahindra and
high net worth individuals K Gopalakrishnan (Infosys CEO) and N S Raghavan.
Listing of Securities in BSE

A company has to submit a letter of application to the stock exchange before filing
the prospectus with the registrar of companies. The company enters into a listing
agreement with the BSE. This agreement requires the company to make certain
disclosures and perform certain acts. If the company fails, it may face some
disciplinary action, including suspension/delisting of securities. A listing agreement is
valuable. It is executed under the common seal of a company. Under it, a company
undertakes to do the following:
x To provide facilities for the prompt transfer, registration, sub-division, and
consolidation of securities.
x To give proper notice of closure of transfer books and record dates.
x To forward six copies of unabridged annual reports, balance sheets, and
profit and loss accounts to BSE, and to file shareholding patterns and
financial results on a quarterly basis.
168
x To intimate promptly to the exchange happenings that are likely to materially

affect the financial performance of the company and its stock prices.
x To comply with the conditions of corporate governance.
As per SEBI guidelines, an issuer company should list the securities within seven
working days after the finalization of the basis of allotment. Table 7.2 gives the listing
fee charges of the BSE.
Table 7.2 Securities other than Privately Placed Debt Securities and Mutual Funds*
Source: www.bseindia.com
Note: In case of debenture capital (not convertible into equity shares) the fees will be 75 per
cent of the above fees.
*Includes equity shares, preference shares, Indian depository receipts, fully convertible
debentures, partly convertible debentures, and any other security convertible into equity
shares.
Trading in BSE
Initially, BSE adopted open outcry trading like any other exchange the world over.
Fully automated computerized mode of trading known as BOLT (BSE Online
Trading) was introduced in 1995, to facilitate efficient processing of an order-driven
system. The exchange obtained permission from SEBI for expansion of the BOLT
network to locations outside Bombay. Earlier, members of the BSE were permitted
to open trading terminals only in Mumbai. The stock exchange admitted subsidiary
companies formed by 13 regional stock exchanges as members. The members of
these stock exchanges work as sub-brokers of the member brokers of BSE. Trading
is conducted between 9.15 a.m. and 3.30 p.m. from Monday to Friday.
169
Securities group
BSE has classified the scrips in the Equity Segment into ‘A’, ‘B’, ‘T’ and ‘Z’ groups
on the basis of qualitative and quantitative parameters. The ‘T’ Group represents
scrips which are settled on a trade-to-trade basis. The ‘G’ group is for trading in
government securities. The ‘Z’ group was introduced in July in 1999 and covers the
list of companies that fail to comply with listing requirements and resolve investor
complaints. In the equity segment, BSE provides a facility for online trading of odd-
lot securities in physical form in ‘A’, ‘B’, ‘T’ and ‘Z’ groups and in rights
renunciations in all groups of scrips.
IndoNext
The BSE and the Federation of Indian Stock Exchanges (FISE) (which represents
20 regional stock exchanges or RSEs) jointly created an alternate national platform
named BSE IndoNext, to enable old and new SMEs to raise equity and debt, and
facilitate trading in such companies. The RSEs are recording either nil or negligible
trading volumes. Investors and the companies, which are listed only on RSEs, are
affected severely. Investors in such SMEs are not able to find an exit route and get
fair market value for their investments. It is difficult for the existing companies and
new SMEs to raise fresh resources from the capital markets in the absence of
trading in the secondary market.
There are two groups in this segment. The ‘S’ group is for regular scrips of BSE
IndoNext and ‘TS’ group is for trade-to-trade settlement scrips.
Investors and the BSE

Investor interests in the BSE are protected in the following ways:
Investor protection fund (IPF) In 1987, the BSE set up an IPF to meet the claims
of investors against defaulter members. Trustees appointed by the exchange manage
the claim. For every `1 lakh of gross turnover, members contribute `0.15 to this
fund. Quarterly, the BSE contributes 2.5 per cent of the listing fees collected by it.
The maximum amount payable to an investor from this fund in the event of default by
a member is `15 lakh. The Defaulters Committee recommends the release of the
fund after scrutinizing the complaint for its genuineness.
Investors’ grievances against listed companies BSE forwards investors’
complaints to the companies concerned and a copy is sent to the investor. Investors
are advised to inform the BSE if the complaints are not resolved within 30 days. If
a company fails to redress the complaint within 30 days, the BSE sends a reminder
170
to the company. The BSE follows up with the companies to resolve the complaints.
When the total number of unresolved complaints is more than 25 and remains
unresolved by the company for more than 45 days, the BSE suspends trading in the
securities of such a company till the complaints are resolved. The BSE may also
transfer such scrips to the ‘Z’ group.
National Stock Exchange (NSE) of India Ltd

The NSE was set up in 1992 by leading financial institutions such as IDBI, LIC,
UTI, ICICI, SBI and others and started functioning as a stock exchange in April
1993. NSE was set up with the following objectives:
x To establish a nationwide trading facility for all types of securities
x To ensure equal access to all investors all over the country through an
appropriate communication network
x To provide a fair, efficient and transparent securities market using an
electronic trading system, enabling shorter settlement cycles and book entry
settlements
x To meet international benchmarks and standards
NSE was the first to offer screen-based trading all over India. Although the
impetus for its establishment came from policy makers, it was set up as a public
limited company. The NSE sold 26 per cent to a group of foreign investors, including
the New York Stock Exchange (NYSE).
The exchange was established as a purest form of a demutualized setup whereby
the ownership, management and trading rights are in the hands of three different sets
of people. This has completely eliminated any conflict of interest and helped the
NSE to aggressively pursue policies and practices within a public interest
framework. The framework is given in Table 7.3.
Table 7.3 Structure of the NSE
Source: ISMR Report 2007

171
Governing Body
A board of directors manages the exchange. The board delegates decisions relating
to market operations to an executive committee, which includes representatives from
the exchange’s trading members, the public and the management.
Besides, the exchange operates various committees to advise it on areas such as
good market practices, settlement procedures and risk containment systems.
Industry professionals, trading members and exchange staff constitute these
committees. The day-to-day management of the exchange is delegated to the
managing director, who is supported by a team of professionals.
Trading
The capital market segment offers a fully automated screen-based trading system,
known as the National Exchange for Automated Trading (NEAT) system. NEAT
operates on a strict price/time priority. Using NEAT technology, members across the
country can trade simultaneously with enormous ease and efficiency. There is a
uniform response time of less than 1.5 seconds for all the trades entered into the
NEAT system. The NSE Internet-based information system (NIBIS) provides
online dissemination of trading information over the Internet.
The exchange currently operates three market segments, namely, the capital
market segment (November 1994), wholesale debt market segment (June 1994)
and futures and options segment (June 2000). Trading on the equities segment takes
place from Monday through Friday. Trading does not take place on Saturdays,
Sundays and on holidays declared by the exchange in advance. The market opens at
9.15 a.m. and closes at 3.30 p.m. The closing session is conducted between
3.40 p.m. and 4 p.m. This is common for BSE and NSE.
Listing
As in the case of BSE, companies have to apply to the NSE and satisfy the norms
laid down by it. NSE charges listing fees based on the paid-up share capital of the
company. The listing fee applicable from
1 April 2011 is given in Table 7.4.
172
Table 7.4 NSE’s Listing Fee Structure
Source: nseindia.com
Companies which have a paid-up share, bond and/or debenture and/or debt
capital, etc., of more than `500 crore will have to pay a minimum fee of `5 lakh and
an additional listing fees of `3,400 for every increase of `5 crore or part thereof in
the paid-up share, bond and/or debenture and/or debt capital, etc.
Companies which have a paid-up share, bond and/or debenture and/or debt
capital, etc., of more than `1,000 crore will have to pay minimum fees of `8.5 lakh
and an additional listing fees of `3,700 for every increase of `5 crore or part thereof
in the paid-up share, bond and/or debenture and/or debt capital, etc.
Investor and the NSE

Investor interests are protected in the NSE in the following ways:
Investor protection fund (IPF): NSE has set up an investor protection fund to
compensate investors in the event of brokers’ defaults, and promote investor
education, awareness, and research. A registered IPF trust is created to administer
the fund. The trust acts on the recommendations of the defaulters’ committee to
satisfy investors’ claims against the defaulters. The maximum limit is `15 lakh per
investor per defaulter/expelled member.
Investor grievance cell (IGC): NSE has formed the IGC to resolve investor
complaints. A team of professionals who have experience in capital markets, and
173
company and legal affairs manages the cell. They are specially trained to identify
problems faced by investors and execute a solution at the earliest. The IGC attends
to the complaints of the investor against the trading members and listed companies.
Emails or complaint forms are used to report the complaints. A unique complaint
number is assigned to the valid complaints. Complaints are resolved within 45 days.
If the matter remains unresolved after exhausting all means, it is referred to
arbitration.
Over-the-counter Exchange of India

Over-the-Counter Exchange of India (OTCEI) was started in 1992 and modelled
after NASDAQ (National Association of Securities Dealers Automated Quotation)
and JASDAQ (Japanese Association of Securities Dealers Automated Quotation).
OTCEI’s main objective is to provide a market for the smaller companies.
They are not able to afford the listing fees of the large exchanges and fulfill the
minimum capital requirement for listing. It aims at creating a fully decentralized and
transparent market. Over-the-counter means trading across the counter in securities.
The counter refers to the location of the member or dealer of the OTCEI where the
deal or trade takes place. Every counter is treated like a trading floor for the OTCEI
where investors can buy and sell. The members or dealers of OTCEI counters are
linked to the central OTCEI computer. The member should have a computer and
telecommunication facilities.
Promoters
OTCEI is incorporated as a company under Section 25 of the Indian Companies
Act, 1956. As per the registration norms, OTCEI is obliged to plough back all its
profits and not allowed to declare dividends on its share capital. The promoters are
as follows:
Players in the OTCEI Market

The players on the OTCEI exchange are members and dealers whose roles are:
x To act as brokers, buying and selling securities as per the instructions of the
investors
174
x To act as market makers in securities, quoting the prices at which members

are willing to buy and sell the specified number of securities
Members can be public financial institutions, scheduled banks, mutual funds, SEBI
approved merchant bankers, banking subsidiaries, venture capital funds, and other
non-banking financial companies with minimum net worth of `2.5 crore. Members
pay a one-time non-refundable admission fee of `10 lakh and `5 lakh after one
year. The annual subscription fee is `1 lakh.
Dealers are individuals, partnership firms and corporate entities with a minimum
net worth of `5 lakh. They should have adequate office space and
telecommunication facilities. They have to pay a one-time non-refundable admission
fee of `2 lakh and annual subscription fee of `5,000. OTCEI may collect an
additional security deposit if it considers this necessary, depending upon the business
experience of the applicant.
Scrips to be Traded
As per the guidelines issued by the government for scrips to be traded in the
OTCEI, companies must satisfy the following conditions:
x The minimum capital requirement should be `3 crore, and should not
exceed `50 crore.
x For companies with an issued capital of more than `30 lakh but less than
`300 lakh, the minimum public offer should be 25 per cent of the issued
capital or `20 lakh worth of shares at face value, whichever is higher.
x Companies with issued capital of more than `30 crore must comply with
listing requirements and guidelines that are applicable to such companies in
other stock exchanges.
Revised listing norms The guidelines have been revised to broaden the
membership base of exchanges. The ministry now allows the following:
x Closely held existing corporate houses up to `100 crore
x New companies with a paid-up base of up to `50 crore
x All currently listed companies on various stock exchanges
Procedure for Listing of Scrips

An OCTEI listing involves the following steps:
x An OTCEI member is appointed as sponsor for the company’s issue. The
sponsor appraises the project or company from its technical, managerial,
175
commercial, economical, and financial aspects. The sponsor certifies the

appraisal.
x The sponsor determines the price of the shares offered to the public,
members, and dealers of the OTCEI.
x The sponsor gets all statutory consent and compliance with all SEBI
guidelines.
x The sponsor registers the issue with OTCEI and places the equity.
x The listing application has to be made to the OTCEI as per its rules and
regulations.
x The allotment is made after the approval is received.
Once the allotment is over, the equity is listed and trading commences. In a primary
issue, the sponsor manages the issue and is the sole underwriter for it. He can
subcontract his liability to a syndicate of members and dealers.
Trading System
The OTCEI has introduced certain new concepts in the Indian trading system.
x Screen-based nationwide trading known as OTCEI Automated Securities
Integrated System (OASIS)
x Market making
x Sponsorship of companies
x Trading in share certificates
x Short selling
x Demat trading through National Securities Depository Ltd for convenient
paperless trading
x Tie-up with National Securities Clearing Corporation Ltd for clearing
1. What are the two categories of day traders?

................................................................................................................
................................................................................................................
................................................................................................................
176
2. When was the Bombay Stock Exchange established?

................................................................................................................
................................................................................................................
................................................................................................................
3. State the main objective of over-the-counter exchange of India.

................................................................................................................
................................................................................................................
................................................................................................................
7.3 LISTING OF SECURITIES IN STOCK EXCHANGE
Listing refers to the admission of the security of a public limited company on a

recognised stock exchange for trading. Listing of securities is undertaken with the
primary objective of providing marketability, liquidity and transferability to securities.
After the promulgation of Companies (Amendment) Act 1988, listing of securities
offered to the public, became compulsory. The section 73, of the Companies Act
states that any company intending to offer shares or debentures to the public through
the issue of prospectus should make an application to one or more recognised stock
exchanges for permission to be traded in the respective stock exchange. After the
permission is granted, the company becomes eligible to list its securities in the stock
exchanges.
Merits of Listing
Let us discuss the different merits of listing:
x Liquidity: Listed shares can be sold at any recognised stock exchange and
converted into cash quickly. Finding out buyers would be easy in the
security market through brokers and screen based trading.
x Best prices: The price quotations and the volume traded regarding the
listed shares appear in the newspapers. According to the demand and
supply of the shares, prices are determined. This results in best price.
x Regular information: The transactions of the listed shares regularly
appear in the news paper, providing adequate information regarding the
current worth of the securities. Buying and selling activities can be decided
on the basis of the price quotations.
177
x Periodic reports: Listed companies have to provide periodic report to

the public. Half yearly financial reports should be published in the financial
newspapers or in any other newspapers. In 1985, it has been made
obligatory for all listed companies to submit unaudited financial results on a
half yearly basis within 2 months of the expiry of that half year. At present
quarterly reports have to be published.
x Transferability: Listing provides free transferability of securities. After the
incorporation of Section 22-A in the Securities Contract (Regulation) Act,
free transfer of shares has been ensured.
x Income tax benefit: Income-tax Act treats the listed companies as widely
held companies. The advantages available to a widely held company are
applicable to the listed company.
x Wide publicity: Since the prices are quoted in the newspaper, the listed
companies get wide publicity. This not only does good to the investor but
also to the corporate to attract the public for further issues.
Demerits of Listing
Let us discuss the demerits of listing.
x Listed companies are subjected to various regulatory measures of the stock
exchanges and SEBI.
x Essential information has to be submitted by the listed companies to the
stock exchanges.
x Annual General Meeting, Annual reports have to be sent to a large number
of shareholders. This creates large amount of unnecessary expenditure.
x Public offer itself is an expensive exercise. But, this is a pre-requisite for the
company’s shares to be listed.
Qualification for Listing

There are certain minimum requirements for a security to be listed in a stock
exchange. They are given below:
x Minimum issued capital: According to the regulation laid down by The
Ministry of Finance and Department of Economic affairs the minimum
issued capital should be `3 crores and the minimum public offer is `75
lakhs. In 1995 the Bombay Stock Exchange raised the limit from `3 Cr to
178
`5 Cr. In 1996, it has been further raised to `10 Cr. Some other stock
exchanges have also increased the limit to `5 Cr.
x Payment of excess application money: According to the direction given
by the SEBI, the amended listing agreement of Mumbai Stock Exchange
(1996) made the allotment of securities to be done within 30 days of the
closure of the public issue. The refund orders should be despatched within
the specified period. Beyond the period they shall be liable to pay an
interest rate of 15 p.a. Similar amendments are made in the Delhi Stock
Exchange agreement too.
x Listing on multiple exchanges: When the paid up capital of the company
is above `5 crores, it is obligatory for the company to seek listing on more
than one stock exchange.
x The number of shareholders: To ensure wide distribution of shares
among the general public and to prevent undue concentration of large
holdings with the company, minimum number of shareholders are
prescribed. For every `1 lakh of fresh issue of capital, there should be
atleast 10 shareholders. In the case of sale of existing capital of `1 lakh, it
should ensure atleast 20 public shareholders. In 1996, Bombay Stock
Exchange has reduced the above said numbers to 5 and 10 respectively. If
the number of shareholders falls below the prescribed number, then the
concerned company’s security would be delisted.
x Appointment of market maker: A company where the paid up capital is
`3 cr but not more than `5 cr and having a commercial operation for less
than two years should appoint a market maker. The market maker should
provide two way quotes for the concerned stock for a minimum period of
18 months from the date of trading on stock exchange. The difference
between quotations for the sale and purchase bid, ask spread should not
exceed 10 per cent. The market maker should have an inventory of 5 per
cent of the post issue capital as on the date of allotment.
x Articles of association: The articles of association of the company should
be in tune with the sound corporate practice. If veto power has been
provided to a director or a class of directors to over rule the majority
decision, the security of the company is not qualified for listing.
x Cost of public issue: To be listed, the company should adhere to the
ceiling in the expenditure of public issue as prescribed by the SEBI.
179
x Advertisement: The company should not advertise in newspapers that

‘issue over subscribed’ or ‘Thanks to the investing public for their
overwhelming response,’ etc during the subscription period. If the company
gives such an advertisement, listing will be refused by the stock exchange
after intimation to the stock exchange division of the Ministry of Finance.
x Minimum subscription: A minimum of `5,000 (500 shares of `10 each)
subscription has been fixed by SEBI. But, due to the slackness in the
primary market, it is reduced to `2000 of 200 shares of `10 each. This
should be given in the prospectus.
x Applying mode: The prospectus should provide information on how the
investor should apply. It should clearly state that the application must be
made in the prescribed form stating the number of shares applied for. It
should be applied in single name or joint names of not more than three.
Application can be made in the name of limited companies, corporations or
institutions and not in the name of a trust firm or partnership. The names
should be given in block letters in English. An individual can make only one
application.
x Public offer size: The size of the public offer and value of the share should
be stated in the first page of the prospectus. If the shares are issued at
premium, that also should be stated. Preferential allotment to the directors
and workers of the company and the reservation for allotment to the non-
resident Indians should be indicated clearly on the prospectus.
Listing Procedure
Obtaining the listing permission from stock exchanges involves various steps. The
steps are as follows:
x Preliminary discussion: The company desirous of getting its security
listed on the stock exchange should have detailed discussion with the stock
exchange authorities. The discussion enables it to understand the various
compliances to be complied with for listing its securities.
x Article of association approval: The articles of association will be
approved only if it fulfills certain requirements. They are:
1. Common form of transfer should be used.
2. Once the shares are fully paid, they should be free from all lien and in
the case of partly paid shares the company’s lien is restricted to the
call money alone.
180
3. The calls carried out in advance are entitled to interest rate but not for
dividends or any other declared profits.
4. The free dealings in company’s shares should not be restricted by any
provision.
5. The company should comply with the section 205-A of Companies
Act in the case of dividends.
If the company is not able to comply with any of the requirements of the Rule 19(2)
(a) of the Securities Contract Regulation Act, the company should give an
undertaking to make necessary amendments in the articles of association as required
in the next annual general meeting of the company. On the basis of the undertaking,
the security will be permitted to trade on the stock exchanges. If the article of
association provides veto powers to any director/or group of directors, the relevant
article should be amended to remove such powers to get the security listed.
Draft prospectus approval: Getting approval for the draft prospectus is the
essential pre-requisite for the security to be listed. Before finalising the draft
prospectus the company authority should hold a discussion with the stock exchange
authorities. While seeking approval, the prospectus should contain all the conditions
put by the stock exchange. The prospectus should clearly state the following:
1. The name of regional stock exchange and any other stock exchanges(s)
where it intends to enlist its securities.
2. It should specify the date of commencement of the subscription and the
date of closing of the subscription. It is essential to keep the subscription
list open for a minimum period of three working days. It may extend upto
10 working days at the discretion of the Board of Directors. The date of
closure of subscription list should be notified to the stock exchange where
listing is sought.
Listing Application
Any company when it intends to offer shares to the public through prospectus,
should make an application to the stock exchange or exchanges where the share is
to be listed. A formal application form should be filed before filing the prospectus
with the Registrar of Companies. A number of certificates have to be submitted with
the application. They are listed below:
1. Three certified copies of memorandum and articles of association and
debenture trust deed.
181
2. Copies of prospectus, offer for sale made during the last five years and
circulars and advertisement regarding the offer made during the last five
years.
3. Copy of every letter, report, balance sheet, valuation, contract, court order
or any other document that is given in the prospectus.
4. Certified copies of underwriting, brokerage, vendors, promoter’s selling
agents and sales managers agreement.
5. Certified copies of the service agreements of secretaries, treasures,
managing director, technical directors, general manager and manager.
6. Particulars regarding the material contract, technical advice and
collaboration, concessions and similar other documents.
7. Copies of agreements with the Industrial Finance Corporation, Industrial
Credit and Investment Corporation and such other bodies.
8. Details regarding the reorganisation, reconstruction, amalgamation and
details of the companies’ activities.
9. Specimen copies of the share certificate, debenture certificate, letters of
allotment, letters of acceptance, letters of renunciation, transfer receipts and
renewal receipts.
The above mentioned documents are ordinarily required by the listing application.
But sometime additional documents also may be called for.
The stock exchange generally acknowledges the receipt of the application and
gives instructions regarding various other formalities to be fulfilled before getting the
listing permission. Once the subscription list is closed, the process of allotment
should be closed within 30 days of the closure. Originally it was 10 weeks from the
closure of the subscription list. The allocation of shares should be intimated to the
stock exchange concerned.
Listing Agreement Regarding Projection of Profitability

Generally companies make projections regarding the profitability of the company at
the time of issue of capital and give an abridged statement of the balance sheet and
profit and loss account. Many times the projections are not met with. To provide
protection to the investors, SEBI amended the listing agreement by inserting a new
clause 43. Accordingly the company has to submit yearly statement showing the
variation between projections given in the prospectus and the actuals achieved. The
182
reasons for the variation in the profitability projections and actuals should be given.
If the projections are provided for five years, the company has to furnish explanation
for the unattained projected figures for all the five years. This information also should
be published in the news paper. The listed company has to give a copy of the
complete and full balance sheet, profit and loss account, and the directors’ report to
each shareholder.
Listing Agreement and Cash Flow Statement

The representatives of SEBI, the stock exchanges of Mumbai, Calcutta, Delhi,
Ahmedabad, National stock exchange and the Institute of Chartered Accountant of
India framed the norms for the inclusion cash flow statement in the annual reports.
The cash flow statement discloses the actual cash flow operations in the company.
This would provide better quality information to the shareholders. To comply with
the international standards this has been imposed as a part of listing agreement. The
company has to provide the cash flow statement along with the balance sheet profit
and loss account. The cash flow statement has to be prepared according to the
instructions given by the SEBI.
The cash flow statement helps the shareholders to analyse the pattern of
resources deployed and evaluate the changes in net assets of a company. It helps to
assess the ability of the company to generate cash and cash equivalents. Briefly, it is
useful to the shareholders to assess the liquidity, viability and financial adaptability of
the company.
Listing Fee
The stock exchange charges a fee from the company for permitting the company’s
scrip to be traded. The listing fee varies from major stock exchanges to regional
stock exchanges. The fees charged by the regional stock exchanges are
comparatively less than the major stock exchanges. The fee also differs according to
the equity base of the company. The following table gives the listing fee charged by
the NSE.
183
Table 7.5 Listing Fees of NSE (1999)
Particulars Amount `
1. Initial Listing Fees 7500

2. Annual Listing Fees
a) Companies with paid share and/ or debenture capital of 4200
`1 Cr
b) Above `1 Cr and up to `5 Cr 8400
c) Above `5 Cr and up to `10 Cr 14000
d) Above `10 Cr and up to `20 Cr 28000
e) Above `20 Cr and upto `50 Cr 42000
f) Above `50 Cr 70000
Companies that have a paid up capital of more than `50 Cr will pay additional listing
fees of `1400 for every increase of `5 Cr or part thereof in the paid up share or
debenture capital.
Listing of Right Shares

The formalities that have to be fulfilled in the case of right shares are given below:
1. The company should notify the stock exchange, the date of meeting of
Board of Directors at which the proposal of the right shares or debenture
is to be considered.
2. The company should inform the decision taken regarding the right issue to
the stock exchange immediately.
3. As per section 81 of the Companies Act 1956 the company should obtain
the consent of the shareholders by way of a special resolution in general
body meeting.
4. The record date for closure of register of members should be intimated to
the stock exchanges.
5. The letter of offer should give financial information before one month of the
date of letter of offer and from the date of company’s last balance sheet.
The working results regarding the sales/turnover and other income,
estimated gross profit/loss should be provided. The provisions made for
depreciation and taxes should be presented. Estimated amount of profit
and loss also should be given.
184
The current market price of the share, highest and lowest price of the equity
during the related period and the week end prices for the last four weeks
should be provided. The shareholders can renounce the rights in favour of
their nominees. The company has power to reject any nominee of whom it
does not approve. If the nominee is rejected, the shareholders have the
right to take up shares applied by the rejected nominee.
The shareholders are entitled to apply for additional shares. If the
shareholders have renounced their shares in whole or in parts in favour of
any other person, they cannot apply for additional shares. If the shares are
not quoted at premium this condition would be relaxed by the stock
exchanges.
6. The applications are accepted at all centres where recognised stock
exchanges are situated. If the company is not able to make such
arrangements at all centres, it can have the centres of its own choice
subject to the condition that bank commission and collection charges for
out station cheques would be borne by the company.
7. The letter of offer should be made within six weeks after the closure of the
transfer books.
8. The shareholders should be given reasonable time to record their interest or
exercise their rights. It should not be not less than four weeks.
9. The renunciation forms should be made available to the shareholders freely
on request.
10. The company should inform the stock exchange the last date fixed for
submission of rights application, split/renunciation application and
consolidated coupons.
11. The company should forward a specimen copy of the letter of offer and
application form for the rights issue to the stock exchange.
12. After despatching the allotment letters or share certificates the company
should apply for listing in the prescribed form. The company has to submit
the distribution, an analysis form and new issue statement forms.
13. After receiving the application form along with the required documents, the
stock exchange would permit the shares to be listed for official dealing by
its members.
185
The Securities and Exchange Board of India is taking steps to facilitate the
speedy disposal of right issues. It has directed all stock exchanges to
amend their listing rules. The appraisal of the rights issue is left with the
merchant bankers. The provisions relating to the fixing of record dates for
the purpose of right issue has been ignored. The companies can apply for
record date simultaneously with the filing of the letter of offer with SEBI.
High Powered Committee Recommendation

The High Powered Committee’s recommendations on Stock Exchanges on listing of
industries securities are given below
1. Once the completed listing application is submitted to the stock exchanges,
it should not take more than three working days for the admission of
securities for dealings.
2. Stock exchanges should set up guidance cells to provide required help to
the companies seeking enlistment. A uniform check list exhibiting the
standard set norms required by the stock exchanges for the admission of
the securities for trading should be prepared.
3. An updated brochure on matters related to listing should be prepared by
the stock exchanges. An annual review should be made regarding the
compliances of the provisions of listing agreement by the companies. It
should also publicise the names of the companies that have not complied
with the listing requirement and the Government also has to be informed.
These recommendations have been accepted by the Government.
Delisting
In December 1998, the Mumbai Stock Exchange has threatened to delist shares of
over 700 companies for non-payment of listing fee for 1997-98 by December
1998. Over the past years, several companies incurred loss and many of them were
unable to pay the listing fee. But many companies purposefully avoided paying the
listing fee. Delisting the company’s share prevents the public scrutiny of
performance. Many companies made public issue itself a business. Thus delisting
may be compulsory or voluntary. Some of the common causes for delisting are
given as:
186
Compulsory
(a) Non-payment of listing fee or violation of listing agreement.
(b) Thin/negligible trading or thin shareholding base.
(c) Non redressal of grievances.
(d) Unfair trade practices at the behest of promoters or managers, and
malpractice such as issuing of duplicate fake shares by management.
Voluntary
(a) Unable to pay the listing fee. Listing fee is prohibitive.
(b) Business sick/suspended/closed.
(c) Capital base is small.
(d) Mergers, demergers, amalgamations and takeovers.
Voluntary delisting is at present provided to the companies if three conditions are
satisfied.
(i) Company must have incurred losses in the preceding three years, with net
worth less than the paid-up capital.
(ii) Securities have been infrequently traded.
(iii) Securities remain listed at least on the regional stock exchange.
If these conditions are not fulfilled, Central Government approval would be needed.
The other ground under which voluntary delisting can be allowed by a stock
exchange is for thin public share holding.
Chandratre Committee Report (1997)

The committee studied the problem of delisting and felt that the listing process at
present does not have any degree of transparency. The committee felt that
disclosures should be made at every stage of the process. Advance public notice
should be given by the stock exchange on the proposed delisting.
(i) Intimation to other stock exchanges where the securities are listed.
(ii) Public notice of delisting should be given after the process is completed.
(iii) The annual report must contain details of delisting on any stock exchange
with reasons and justification.
187
(iv) An appeal made against the decision to delist would lie with the Central
Government.
(v) Dealing facility should be allowed for some time to provide a liquidity
window after delisting.
These detailed procedures must be made applicable even in the case of a
voluntary delisting too. As far as the voluntary delisting, the proposal is to
give public notice explaining the justification for delisting and requires a
special resolution authorising voluntary delisting.
Suggested framework: The contents of the Listing Agreement (LA) are to be
made part of the Conditions for Listing and Continued Listing under the rules of
SCRA. The LA is to have two parts: Part A to stipulate the minimum conditions for
listing to all stock exchanges (SE) and Part B to prescribe additional conditions by
any SE.
(i) Basic minimum listing norms for listing on any recognised SE must be
uniform; additional norms may be specified by SEs.
(ii) The LA may contain terms and conditions that serve investor interests
though the law may allow greater leeway to a company on a particular
issue.
(iii) Violation of the LA should be a punishable offense, with penalties of
`10,000 and `1,000 per day of continuing default.
(iv) SEs have to be empowered to prosecute a company and its directors/
officers for violation of LA.
(v) SEs have to strengthen their machinery for strict enforcement of LA and
institution of prosecution.
(vi) SEBI to be nodal authority for any amendments to the LA with due
consultation of SEs to ensure uniformity and avoid confusion.
(vii) Pre-listing scrutiny of draft offer documents to be made mandatory for all
stock exchanges before any SEs are cited in the final offer document as
SEs on which the securities would be listed.
(viii) Listing norms should be disclosed and well publicised to ensure desired
transparency in the pre-listing scrutiny of offer documents.
188
(ix) Compulsory listing on Regional Stock Exchanges has to be dispensed with.

SEs have to operate competitively and companies should have freedom of
choice in seeking listing on any SE.
(x) Recovery of listing fee from shareholders in case of default by the company
is not a feasible proposition though they may be the beneficiaries of the
SE’s services.
(xi) There is no need to bring uniformity in listing fee structure across SEs.
(xii) SEs should be free to decide the quantum of ‘listing fee’, manner of
payment and periodicity of payment.
(xiii) The listing fee should not be prohibitive and disproportionate to the
services offered by the SE.
(xiv) SEs must improve services to investors-especially redressal of investor
grievances and investor education.
Recent Developments
Share of the companies listed on exchanges other than the Bombay Stock Exchange
and seeking listing on it, will be required to have a minimum market capitalisation of
` 20 crores as against the previous criterion of ` 10 crores of issued capital.
The BSE board has decided that companies should have necessarily recorded
profits for the last three years, traded on at least half the total trading days with a
minimum of five trades and 500 shares on any given day and have 20 per cent of the
stock held with the public.
The board also decided to institute awards for investor friendly companies.
Categorised into three, companies would be awarded for best returns, being
proactive in servicing investor needs and corporate governance. Non friendly
companies are classified into ‘Z’ category, the exchange has identified 300 such
companies.
1. What are periodic reports?
................................................................................................................
................................................................................................................
................................................................................................................
189
2. State the conditions of voluntary delisting.
................................................................................................................
................................................................................................................
................................................................................................................
3. Write a short note on listing fee.
................................................................................................................
................................................................................................................
................................................................................................................
7.4 SUMMARY
x Investors place, buy and sell orders with members of the stock exchanges
in different ways like limit orders, best rate order, discretionary order, and
stock loss order.
x Online trading means the purchase and sale of stocks on the Internet.
x Holding the stock positions within the current trading day is known as day
trading. It means not holding any position overnight.
x A day trader typically trades (buys or sells) several times a day looking for
fractions of a point to a few points per trade, but closes out all his positions
by day’s end.
x Trading with borrowed funds or securities is called margin trading. It helps
investors trade over and above their owned funds.
x There are two types of settlements–fixed and rolling. A fixed cycle starts on
a particular day and ends after five days.
x A rolling settlement is one in which trades outstanding at the end of the day
have to be settled at the end of the T+X time framework. T is the trade
date and X is the days as specified by SEBI.
x SEBI has taken several measures to minimize market, operational and
systemic risks.
190
x SEBI introduced the market wide circuit breakers (MWCB) to prevent

large market movements.
x Initially BSE adopted open outcry trading like any other exchange the
world over. Fully automated computerized mode of trading known as
BOLT (BSE online Trading) was introduced in 1995, to facilitate efficient
processing of an order-driven system.
x NSE was the first to offer screen-based trading all over India.
x Listing refers to the admission of the security of a public limited company on
a recognised stock exchange for trading. Listing of securities is undertaken
with the primary objective of providing marketability, liquidity and
transferability to securities.
x Listed companies have to provide periodic report to the public. Half yearly
financial reports should be published in the financial newspapers or in any
other newspapers. In 1985, it has been made obligatory for all listed
companies to submit unaudited financial results on a half yearly basis within
2 months of the expiry of that half year. At present quarterly reports have
to be published.
x Listed companies are subjected to various regulatory measures of the stock
exchanges and SEBI.
x The articles of association of the company should be in tune with the sound
corporate practice. If veto power has been provided to a director or a
class of directors to overrule the majority decision, the security of the
company is not qualified for listing.
x Any company when it intends to offer shares to the public through
prospectus, should make an application to the stock exchange or
exchanges where the share is to be listed. A formal application form should
be filed before filing the prospectus with the Registrar of Companies.
x The representatives of SEBI, the stock exchanges of Mumbai, Calcutta,
Delhi, Ahmedabad, National stock exchange and the Institute of Chartered
Accountant of India framed the norms for the inclusion cash flow statement
in the annual reports.
x Delisting the company’s share prevents the public scrutiny of performance.
191
7.5 KEY WORDS
x Trading: It refers to the action or activity of buying and selling goods and
services.
x Online trading: It means the purchase and sale of stocks on the internet.
x Day trading: It means holding the stock positions within the current
trading day.
x Margin trading: Trading with borrowed funds or securities is called
marginal trading.
x Stock exchange: It is a market in which securities are bought and sold.
x Listing: It refers to the admission of the security of a public limited
company on a recognised stock exchange for trading.

1. The two categories of day traders are: scalpers and momentum traders.
2. The Bombay Stock Exchange was established as ‘The Native Share and
Stock Brokers Association’ in 1875.
3. OTCEI’s main objective is to provide a market for the smaller companies.
They are not able to afford the listing fees of the large exchanges and fulfill
the minimum capital requirement for listing.

1. Listed companies have to provide periodic report to the public. Half yearly
financial reports should be published in the financial newspapers or in any
other newspapers. In 1985, it has been made obligatory for all listed
companies to submit unaudited financial results on a half yearly basis within
2 months of the expiry of that half year. At present quarterly reports have
to be published.
192
2. Voluntary delisting is at present provided to the companies if three

conditions are satisfied.
x Company must have incurred losses in the preceding three years, with
net worth less than the paid-up capital.
x Securities have been infrequently traded.
x Securities remain listed at least on the regional stock exchange.
3. The stock exchange charges a fee from the company for permitting the
company’s scrip to be traded. The listing fee varies from major stock
exchanges to regional stock exchanges. The fees charged by the regional
stock exchanges are comparatively less than the major stock exchanges.
The fee also differs according to the equity base of the company.
1. What is the procedure for online trading?

2. Explain the types of settlements.
3. Write a short note on trading in Bombay Stock Exchange.
4. What are the merits and demerits of listing?
5. What are the new concepts introduced by OTCEI in the Indian trading
system?
6. State the process of compulsory and voluntary delisting.
7. Briefly explain the listing of right shares.
8. Discuss the listing application and agreement process.

McGraw-Hill.
193
194
Depository Act, 1996
BLOCK-III
ANALYSIS FOR EQUITY INVESTMENT
This block provides an in-depth understanding of the need and role of the Depositories Act
which has provisions for the regulation of depositories in securities and matters associated
with it. It explains the valuation of securities in terms of bonds, debentures, preference shares
and equity shares. The concepts of fundamental analysis, technical analysis and efficient
market hypothesis are also discussed in the subsequent units of the block.
The eighth unit describes the role of the Depository Act that was formed in 1996. It also
states the various stages involved in the dematerialisation process and assesses the benefits
of demat account. The concept of rematerialisation is also addressed in this unit.
The ninth unit explains the meaning and features of bonds, debentures, preference shares and
equity shares. Pros and cons of equity financing and public issue of equity are also discussed
thereafter.
The tenth unit presents and expansive explanation of fundamental analysis. It gives an
overview of this type of analysis wherein it sheds light on the trends and analytical models of
fundamental analysis. The two approaches, top-down- and bottom-up, that are associated
with fundamental analysis are also discussed. The unit further elaborates on the concepts of
indicator, indices and moving average.
The eleventh unit talks about a different type of analysis called technical analysis. It presents
an historical account of technical analysis and elucidates on the doctrine outlined by Charles
H. Dow which formed the basis for technical analysis. The unit analyses different kinds of
charts of technical analysis such as candlestick chart and its kinds and also explains the
concept of trend. The unit further discusses Elliott wave theory and provides an account of
similarities and dissimilarities between technical analysis and fundamental analysis.
The twelfth unit provides an understanding of the concept of market efficiency and
categorises efficient market hypothesis in the weak-form, semi-strong form and strong form.
It also elucidates on market inefficiencies as a contradiction to market efficiency.
195
UNIT–8 DEPOSITORY ACT, 1996
Objectives
x Assess the need and role of Depositories Act
x Explain the dematerialisation process
x Describe rematerialisation
Structure
8.1 Introduction
8.2 Need and Role of Depository Act
8.3 Dematerialisation Process
8.4 Summary
8.5 Key Words
8.1 INTRODUCTION
A depository is an organization that maintains investors’ securities in electronic form.

In simple terms, a depository is a ‘bank’ for securities. Agents to a depository are
called depository participants (DPs). They are the intermediaries between the
depository and the investors. The relationship between the DPs and the depository
is governed by an agreement between the two under the Depositories Act.
The Depositories Act, 1996 has provisions for the regulation of depositories in
securities and matters associated with it. This Act was enforced as an ordinance
which was the Depositories Ordinance, 1995, and this ordinance was created in a
manner that it would give a legal framework for the establishment of depositories for
recording of details of ownership in book entry form.
The initial form of the Indian stock exchanges’ settlement system was seen to be
extremely inefficient it was slow in handling the transfer of securities and thus, a more
efficient act was passed in 1996 called the Depositories Act. The purpose of the act
was to make sure there would be free transferability of securities and this would be
done with security, accuracy as well as speed.
This unit will discuss the Depository Act, 1996 in detail.
197
8.2 NEED AND ROLE OF DEPOSITORY ACT
The Depositories Act, 1996 has provisions for the regulation of depositories in
securities and matters associated with it. This Act was enforced as an ordinance
which was the Depositories Ordinance, 1995, and this ordinance was created in a
manner that it would give a legal framework for the establishment of depositories for
recording of details of ownership in book entry form.
Based on the act, consequential amendments were carried out in the Securities
and Exchange Board of India Act, 1992, in the Benami Transactions (Prohibition)
Act, 1988, Companies Act, 1956, the Income tax Act, 1961 and the Indian Stamp
Act, 1899.
A legal framework is provided by the Depositories Act, 1996 for the setting up
of depositories for the facilitation of holding of securities, even shares, in the
electronic or the demat form and to effect securities’ transfer via book entry.
With the Act, the depository system has been established in India since it
provides for the establishing of one or more depositories which will help the
investors hold securities in non-physical form which is referred to as the
dematerialized form, and affect the transfer of securities via book entries in accounts
that the depository maintains.
It is mandatory for each depository to get registered with the Securities and
Exchange Board of India (SEBI) and also obtain a Certificate allowing it to
commence business on fulfilling the set conditions.
Any investor who wants to enter the system has to obtain registration with at
least one participant, who must be an agent for the depository. The choice is
available to investors to continue with the existing securities certificates or switch
over to the depository mode. Thus, primary function performed by a depository is of
dematerializing securities and aiding in their transaction in the book entry form.
In its earliest form, the Indian stock exchanges’ settlement system was seen to be
extremely inefficient since it was not quick in handling the transfer of securities. This
system was prone to transaction delays, settlement delays, theft, forgery, mutilation
and bad deliveries and even to additional costs.
To overcome these problems, it was in 1996 that the Depositories Act was
passed. The purpose of the act was to make sure there would be free transferability
of securities and this would be done with security, accuracy as well as speed.
198
The act has managed to ensure the following:

Securities of public limited companies have been made freely transferable with a few
exceptions:
x Securities have been dematerialized in the depository mode
x The book entry form is implemented for maintaining ownership records
Two depositories have been set up for the purpose of fulfilling the provisions of
the Depositories Act, 1996. One is the National Securities Depository Limited
(NSDL) and the other is the Central Depository Service (India) Limited (CDSL).
Every Depository Participant (DP) needs to be registered under this depository
before it begins its operation or trade in the market.
NSDL is associated with the National Stock Exchange and CDSL is associated
with the Bombay Stock Exchange.
NSDL as well as CDSL has a network of Depository participants (DPs) who
are connected electronically with their own specific clients and these DPs are the link
which connects the clients with the depositories. A client is allowed to hold more
than one Demat Account.
Some of the functions of the Depository are, that it:
x Transfers without handling physical securities
x Transfers securities between accounts
x Holds securities in accounts
x Ensures the safekeeping of securities
All DPs are representatives (agents) of the investor in the depository system.
The DP of a client maintains his securities account balances and intimate the status of
the holding at regular intervals. The DPs help in immediate electronic transfer of
shares held in demat form through electronic book entry system.
SEBI has allowed financial institutions such as stockbrokers, custodians and
banks, to participate in the depository.
In the book entry system provided under the Act there is no physical transfer of
securities. A book entry is passed for the purpose of changing name/ownership
rights. With securities being fungible, this makes transfer easier.
Fungibility means that all the holdings of a particular security are identical and
inter-changeable and have no unique characteristic such as distinctive number,
certificate number, folio number, etc.
199
It is now also possible to give instructions in the application for providing new
shares in demat form when they are on offer at the time of the initial public issue. In
this approach, it is essential for the client to provide details of the bank account
number, name of the DP, DP ID and client ID. This facilitates transfer of securities.
Under the Companies Act 1956, public limited companies need to keep an
index of members where they have to maintain a record of the owners of the
company. Since dematerialization of securities and transfer of shares through book
entry system has been enforced, only NSDL and CDSL are the registered owners.
The process has been explained in the next section.
The depositories keep a track of all the clients through the depository
participants. While the registered owners are the depositories, beneficiary owners
are the people who are holding the securities at that time.
When a bonus issue is declared by a company, associated securities get
transferred to the two depositories who then further transfer them to the clients via
their DPs.
When a company declares cash dividends, the details of the investors’ holdings
are provided by the respective depository participants to the depository. These
details are passed on by the depository to the RTA (Registrar and Transfer Agents)
which facilitates the direct transfer of the amount to the bank account of the investor/
holder via Electronic Clearing System (ECS).
If a company wants its security in demat form, it must opt for it by registering
with at least one depository. This will require that the company transfers every one
of its shares to the depository. The company will be assigned an International
Securities Identification Number (ISIN) for its unique identification compared with
other companies.
Every one of the securities that are issued carries a unique ISIN which is issued
by the International Standards Organisation (ISO). SEBI has assigned the task of
issuing ISIN of various securities in India to NSDL. The Reserve Bank of India
handles the allocation of ISIN for Government securities. For every member
country, there is a different code assigned and this is based on ISIN Standard (ISO
6166).
India’s depository system is subject to and governed by the rules formulated by
SEBI, the market regulatory body in India. Based on SEBI (Depositories and
Participants) Regulations, 1996, the securities which are eligible for holding in
dematerialized form are as given follows:
200
x Shares, scrips, stocks, bonds, debentures, debenture stock or other

marketable securities of similar nature of any incorporated company or
other body corporate, including underlying shares of ADRs and GDRs.
x Units of mutual funds, rights under collective investment schemes and
venture capital funds, commercial paper, certificate of deposit, securitized
debt, money market instruments, government securities, national saving
certificates, kisan vikas patra and unlisted securities.
Important Provisions of the Act

Let us discuss the important provisions of the Depository Act.
1. Certificate of commencement of business
x No depository will act as a depository unless it obtains a certificate of
commencement of business from the Board.
x A certificate granted will be in such form as may be specified by the
regulations.
x The Board will not grant a certificate unless it is satisfied that the
depository has adequate systems and safeguards to prevent
manipulation of records and transactions: Provided that no certificate
will be refused unless the depository concerned has been given a
reasonable opportunity of being heard.
2. Rights and obligations of depositories, participants, issuers and beneficial
owners
x A depository will enter into an agreement with one or more
participants as its agent.
x Every agreement will be in such form as is specified by the bye-laws.
Any person, through a participant, enters into an agreement, in such
form as is specified by the bye-laws, with any depository for availing
its services.
x Any person who has entered into an agreement will surrender the
certificate of security, for which he seeks to avail the services of a
depository, to the issuer in such manner as is specified by the
regulations.
x The issuer, on receipt of certificate of security will cancel the certificate
of security and substitute in its records the name of the depository as
201
a registered owner in respect of that security and inform the

depository accordingly.
x A depository will, on receipt of information enter the name of the
person in its records, as the beneficial owner.
x Every depository will, on receipt of intimation from a participant,
register the transfer of security in the name of the transferee. If a
beneficial owner or a transferee of any security seeks to have custody
of such security, the depository will inform the issuer accordingly.
x Every person subscribing to securities offered by an issuer will have
the option either to receive the security certificates or hold securities
with a depository. Where a person opts to hold a security with a
depository, the issuer will intimate such depository the details of
allotment of the security, and on receipt of such information the
depository will enter in its records the name of the allottee as the
beneficial owner of that security. All securities held by a depository will
be dematerialised and will be in a fungible form.
x The beneficial owner will be entitled to all the rights and benefits and
be subjected to all the liabilities in respect of his securities held by a
depository.
x Every depository shall maintain a register and an index of beneficial
owners in the manner provided in section 150, 151 and 152 of the
Companies Act, 1956.
x Subject to such regulations and bye-laws, as may be made in this
behalf, a beneficial owner may with the previous approval of the
depository create a pledge or hypothecation in respect of a security
owned by him through a depository.
x Every beneficial owner will give intimation of such pledge or
hypothecation to the depository and such depository shall make
entries in its records accordingly.
x Every depository will furnish to the issuer information about the
transfer of securities in the name of beneficial owners at such intervals
and in such manner as is specified by the bye-laws.
x Every issuer will make available to the depository copies of the
relevant records in respect of securities held by such depository. If a
202
beneficial owner seeks to opt out of a depository in respect of any

security he will inform the depository accordingly.
x The depository will on receipt of intimation make appropriate entries
in its records and shall inform the issuer.
x Every issuer will, within thirty days of the receipt of intimation from the
depository and on fulfillment of such conditions and on payment of
such fees may be specified by the regulations, issue the certificate of
securities to the beneficial owner or the transferee according to the
case.
x The Bankers’ Books Evidence Act, 1891 will apply in relation to a
depository as if it were a bank.
x Without prejudice to the provisions of any other law for the time being
in force, any loss caused to the beneficial owner due to the negligence
of the depository or the participant, the depository will indemnify such
beneficial owner.
x Where the loss due to the negligence of the participant under sub-
section (1) is indemnified by the depository, the depository will have
the right to recover the same from such participant.
x Subject to the provisions of this Act, the rights and obligations of the
depositories, participants and the issuers whose securities are dealt
with by a depository will be specified by the regulations.
x The eligibility criteria for admission of securities into the depository is
specified by the regulations.
3. Penalty
x The one who contravenes or attempts to contravene or abets the
contravention of the provisions of this Act or any regulations or bye-
laws made thereunder shall be punishable with imprisonment for a
term which may extend to five years, or with fine, or with both.
x Where an offence under this Act has been committed by a company,
every person who at the time the offence was committed was in
charge of, and was responsible to, the company for the conduct of the
business of the company, as well as the company, will be deemed to
be guilty of the offence and will be liable to be proceeded against and
punished accordingly.
203
x Where an offence under 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 neglect on the part of, any
director, manager, secretary or other officer of the company, such
director, manager, secretary or other office will also be deemed to be
guilty of the offence and will be liable to be proceeded against and
punished accordingly.
1. State one role of Depository Act, 1996.

................................................................................................................
................................................................................................................
................................................................................................................
2. Name the two depositories that have been set up for the purpose of
fulfilling the provisions of the Depository Act, 1996.
................................................................................................................
................................................................................................................
................................................................................................................
8.3 DEMATERIALISATION PROCESS
Dematerialisation is the process by which a client can get physical certificates

converted into electronic balances.
An investor intending to dematerialise its securities needs to have an account
with a DP. The client has to deface and surrender the certificates registered in its
name to the DP. After intimating NSDL electronically, the DP sends the securities to
the concerned Issuer/ R&T agent. NSDL in turn informs the Issuer/ R&T agent
electronically, using NSDL Depository system, about the request for
dematerialisation. If the Issuer/ R&T agent finds the certificates in order, it registers
NSDL as the holder of the securities (the investor will be the beneficial owner) and
communicates to NSDL the confirmation of request electronically. On receiving such
confirmation, NSDL credits the securities in the depository account of the Investor
with the DP.
204
NSDL and Dematerialization
Features
x Holdings in only those securities that are admitted for dematerialisation by
NSDL can be dematerialised.
x Only those holdings that are registered in the name of the account holder
can be dematerialised.
x Names of the holders of the securities should match with the names given
for the demat account.
x If the same set of joint holders held securities in different sequence of names,
these joint holders by using ‘ Transposition cum Demat facility’ can
dematerialise the securities in the same account even though share certificates
are in different sequence of names. e.g., If there are two share certificates one
in the name of X first and Y second and another in the name of Y first and X
second, then these shares can be dematerialised in the depository account
which is in any name combination of X and Y i.e., either X first and Y second
or Y first and X second. Separate accounts need not be opened to demat
each share certificate. If shares are in the name combinations of X and Y, it
cannot be dematerialised into the account of either X or Y alone.
x Demat requests received from client (registered owner) with name not
matching exactly with the name appearing on the certificates merely on
account of initials not being spelt out fully or put after or prior to the
surname, can be processed, provided the signature of the client on the
Dematerialisation Request Form (DRF) tallies with the specimen signature
available with the Issuers or its R & T agent.
x A client may, in the normal course, receive demat confirmation in about 30
days from the date of submission of demat request to the DP.
x There are special processes for Securities issued by Government of India
and simultaneous transmission and demat.
Procedure
Let us now have a look at the various stages of the dematerialisation process.
Stage 1:
x Client/Investor submits the DRF (Demat Request Form) and physical
certificates (to be dematted) to the DP.
205
x DP checks if the submitted securities are available for demat.

x Client stamps ‘Surrendered for Dematerialisation’ to deface the
certificate.
x DP punches two holes on the name of the company and draws two parallel
lines across the face of the certificate. This ensures that the shares are not
lost in transit or misused till credit is received in the appropriate demat
account.
x The DP upon receipt of the shares and the DRF, issues the client an
acknowledgement and sends an electronic request to the company.
Stage 2:
x Demat request is entered by the DP in the system for sending to NSDL.
Stage 3:
x The physical certificates and the DRF are dispatched by the DP to the
R&T Agent.
Stage 4:
x Details of the electronic request are recorded by NSDL in the system.
x It is then forwarded to the R&T Agent.
Stage 5:
x R&T Agent receives the physical documents and the electronic request and
verifies them.
x On successful verification dematerialization of the concerned securities is
confirmed electronically to NSDL.
Stage 7:
x NSDL credits the dematerialised securities to the beneficiary account of the
investor.
x The DP is sent an electronic intimation.
Stage 8:
x A statement of transaction is sent to the client by the DP.
CDSL and Dematerialization

Second agency is CDSL - Central Depository Service (India) Limited. Main
functions of this agency are centralized database and accounting. Major participants
206
in CDSL are LIC, GIC and BSE. This agency is set up with the object to keep in
mind to accelerate growth of scripless trading, with major thrust of individual
participation and creating competitive environment, responsible to the user’s interests
and demands to enhance liquidity. CDSL aims to retain the entire data of the
investors in the central database of CDSL.
Demat Account: Benefits

Company shares trading falls in the compulsory demat segment. SEBI has made
demat mandatory for most traded scrips, and this means that the only way to trade
will be via electronic transaction and no stamp duty will apply on electronic transfer
of securities.
The payment mechanism in the electronic mode is the same as before, with
incurring of the usual charges for brokerage. Yet, once settlement has been done, the
pay in and pay out are on the same day for scripless trading so that both cash and
securities are obtained immediately.
Shares that are sold or bought get transferred the day following pay out. Postal/
courier charges that would be incurred for sending share certificates/transfer deeds
are eliminated. Facility exists for freezing/locking of investor accounts, which
enables making the account non-operational.
The facility to hypothecate and pledge securities exists in this format.
Rematerialisation
It is possible to change securities from the demat format to the physical format. For
such a conversion a Rematerialisation Request Form (RRF) has to be filled out and
submitted via the concerned DP and its process is the same as was for changing from
physical form to demat form. The request will be sent to the Depository by the
depository Participant post verification of the client holding the requisite securities in
balance. In turn, the Depository will intimate the Registrar and Transfer Agents of the
Company who will print and dispatch the share certificates for the number of shares
so rematerialized. The account of the beneficiary will be debited by the Depository
and that of the company will be credited.
It is not necessary that one gets the shares of the same folio number. The
Registrars and Transfer Agents will print new certificates with a new range of
certificate numbers. The investor will be allotted a new folio number; nevertheless if
one has an existing folio number, the same may be allotted.
207
1. What is the second stage of Dematerialisation Process?

................................................................................................................
................................................................................................................
................................................................................................................
2. State one benefit of a demat account.

................................................................................................................
................................................................................................................
................................................................................................................
8.4 SUMMARY
x The Depositories Act, 1996 has provisions for the regulation of

depositories in securities and matters associated with it. This Act was
enforced as an ordinance which was the Depositories Ordinance, 1995,
and this ordinance was created in a manner that it would give a legal
framework for the establishment of depositories for recording of details of
ownership in book entry form.
x Based on the act, consequential amendments were carried out in the
Securities and Exchange Board of India Act, 1992, in the Benami
Transactions (Prohibition) Act, 1988, Companies Act, 1956, the Income
tax Act, 1961 and the Indian Stamp Act, 1899.
x A legal framework is provided by the Depositories Act, 1996 for the setting
up of depositories for the facilitation of holding of securities, even shares, in
the electronic or the demat form and to effect securities’ transfer via book
entry.
x It is mandatory for each depository to get registered with the Securities and
Exchange Board of India (SEBI) and also obtain a Certificate allowing it to
commence business on fulfilling the set conditions.
x The primary function performed by a depository is of dematerializing
securities and aiding in their transaction in the book entry form.
208
x Two depositories have been set up for the purpose of fulfilling the
provisions of the Depositories Act, 1996. One is the National Securities
Depository Limited (NSDL) and the other is the Central Depository
Services (India) Limited (CDSL). Every Depository Participant (DP) needs
to be registered under this Depository before it begins its operation or trade
in the market.
x All DPs are representatives (agents) of the investor in the depository system.
x The DPs help in immediate electronic transfer of shares held in demat form
through electronic book entry system.
x Under the Companies Act 1956, public limited companies need to keep an
index of members where they have to maintain a record of the owners of
the company. Since dematerialization of securities and transfer of shares
through book entry system has been enforced, only NSDL and CDSL are
the registered owners.
x India’s depository system is subject to and governed by the rules
formulated by SEBI, the market regulatory body in India.
x Company shares trading falls in the compulsory demat segment. SEBI has
made demat mandatory for most traded scrips, and this means that the only
way to trade will be via electronic transaction and no stamp duty will apply
on electronic transfer of securities.
x The payment mechanism in the electronic mode is the same as before, with
incurring of the usual charges for brokerage. Yet, once settlement has been
done, the pay in and pay out are on the same day for scripless trading so
that both cash and securities are obtained immediately.
x It is possible to change securities from the demat format to the physical
format. For such a conversion a Rematerialisation Request Form (RRF) will
need to be filled out and submitted via the concerned DP and its process will
be the same as was for changing from physical form to demat form.
8.5 KEY WORDS
x Scrip: It refers to a provisional certificate of money subscribed to a bank

or company, entitling the holder to a formal certificate and dividends.
x Electronic clearing system: It is an electronic mode of transfer from one
bank account to another.
209

1. A legal framework is provided by the Depositories Act, 1996 for the setting
up of depositories for the facilitation of holding of securities, even shares, in
the electronic or the demat form and to effect securities’ transfer via book
entry.
2. National Securities Depository Limited (NSDL) which is associated with the
National Stock Exchange and Central Depository Services Limited (CDSL)
which is associated with the Bombay Stock Exchange have been set up for
the purpose of fulfilling the provisions of the Depository Act, 1996.

1. The second stage of Dematerialisation Process is that demat request is
entered by the Depository participant in the system for sending to NSDL.
2. The facility to hypothecate and pledge securities exists in this format.
1. State the role and need of Depository Act, 1996.

2. State the dematerialisation process in brief.
3. How is a demat account beneficial?
4. Explain rematerialisation.

McGraw-Hill.
210
Valuation of Securities: Bonds,
Debentures, Preference and
Equity Shares
UNIT–9 VALUATION OF SECURITIES: BONDS,

DEBENTURES, PREFERENCE AND EQUITY
SHARES
Objectives
x Define the terms–bonds, debentures, preference and equity shares
x State the main features of a bond
x Discuss the features and types of debentures
x Explain preference shares and equity shares
Structure
9.1 Introduction
9.2 Bonds
9.3 Debentures
9.4 Preference Shares
9.5 Equity Shares
9.6 Summary
9.7 Key Words
9.1 INTRODUCTION
Various types of securities are traded in the stock market. Broadly securities
represent evidence to property right. Security provides a claim on an asset and any
future cash flows the asset may generate. Commonly we think of securities as shares
and bonds.
According to the Securities Contracts Regulation Act 1956, securities include
shares, scrips, stocks, bonds, debentures or other marketable like securities of any
incorporated company or other body corporate, or government. Securities are
classified on the basis of return and the source of issue. On the basis of income they
may be classified as fixed or variable income securities. In the case of fixed income
security, the income is fixed at the time of issue itself. Bonds, debentures and
preference shares fall into this category. Sources of issue may be government,
211
Equity Shares
semi- government and corporate. The incomes of the variable securities vary from
year to year. Dividends of the equity shares of companies’ can be cited as an
example for this. Corporate sector generally raises funds through fixed and variable
income securities like equity shares, preference shares and debentures.
According to Companies Act 1956 ‘Debenture includes debenture stock, bonds
and any other securities of company, whether constituting a charge on the assets of
the company or not’. Debentures are generally issued by the private sector
companies as a long-term promissory note for raising loan capital. The company
promises to pay interest and principal as stipulated. Bond is an alternative form of
debenture in India. Public sector companies and financial institutions issue bonds.
Bond is a long term debt instrument that promises to pay a fixed annual sum as
interest for specified period of time.
All the financial dailies and investment related magazines publish the stock
market news. Separate News Bulletins are issued by BSE, NSE and OTCEI
providing information regarding the changes that take place in the stock market.
SEBI newsletter gives the changes in the rules and regulations regarding the activities
of the stock market. Reserve Bank of India Bulletin also carries the information
about the stock markets.
9.2 BONDS
A bond is a long-term debt instrument that promises to pay a fixed annual sum as
interest for a specified period of time. The basic features of the bonds are given
below:
x Bonds have face a value. This is known as par value. The bonds may be
issued at par, or at a discount.
x The interest rate is fixed. It may sometimes vary as in the case of a floating
rate bond. The interest is paid semi-annually or annually and is known as
the coupon rate. The interest rate is specified in the certificate.
x The maturity date of the bond is usually specified at the time of issue,
except in the case of perpetual bonds.
x The redemption value is also stated in the bonds. It may be at par value or
at a premium.
212
Equity Shares
x Bonds are traded in the stock market. When they are traded, the market
value may be at par, at a premium or discounted. The market value and
redemption value need not be the same.
Secured bonds and unsecured bonds: The secured bond is secured by the real
assets of the issuer. In case of the unsecured bond, the name and fame of an issuer
may be the only security.
Perpetual bonds and redeemable bonds: Bonds that do not mature or never
mature are called perpetual bonds. The interest alone would be paid. In redeemable
bonds, the bond is redeemed after a specific period of time. The redemption value
is specified by the issuer.
Fixed interest rate bonds and floating interest rate bonds: In fixed interest rate
bonds, the interest rate is fixed at the time of the issue, whereas in the floating interest
rate bonds, the interest rates change according to already fixed norms. For example,
in December 1993 the State Bank of India issued floating interest rate bonds worth
`500 crore, pegging the interest rate with its three and five years’ fixed deposit rates
to provide built-in yield flexibility to the investors.
Zero coupon bonds: These bonds sell at a discount and the face value is repaid at
maturity. The origin of this type of bond can be traced to the US Security Market
The high value of the US government security prevented investors from investing
their money in government security. Big brokerage companies like Merrill Lynch,
Pierce and others purchased government securities in large quantities and sold them
in smaller denominations—at a discounted rate. The difference between the
purchase cost and face value of the bond is the gain for the investor. Since the
investor does not receive any interest on the bond, the conversion price is suitably
arranged to protect the loss of interest to the investor. The discounted value is
calculated using the formula:
Face value of the bond

Present Value =
R = interest rate and n = number of years.

For example, a zero coupon bond with a face value of `50,000 that matures in
20 years’ time would be sold at `5,185 to give a return of 12 per cent per annum.
The merit of this bond is that the company does not have the burden of servicing
the debt during the execution period of the project. The repayment could be
213
Equity Shares
adjusted to fall after the completion of the project. This could result in considerable
cost savings for the company.
Deep discount bonds: A deep discount bond is another form of zero coupon bond.
The bonds are sold at a large discount on their nominal value and interest is not paid
on them. Also, they mature at par value. The difference between the maturity value
and the issue price serves as an interest return. The deep discount bonds’ maturity
period may range from three years to 25 years or more. IDBI first issued deep
discount bonds in India in 1992 with varying maturity period options. Later, ICICI
in 1997 issued deep discount bonds with four optional maturity periods. Early
redemption option is provided at the end of the 6th, 12th and 18th year.
Capital indexed bonds: In the capital indexed bond, the principal amount of the
bond is adjusted for inflation for every year. For example, an investment of `1000 in
inflation indexed bonds earns the investor a semi-annual interest income for a five-
years’ period. The re-selling of the principal amount is done semi-annually based on
the wholesale price index (WPI) movements. The principal amount of the bond is
adjusted for inflation for each of the years. A coupon rate of 6 per cent is worked on
the inflation-adjusted principal.
The bond is advantageous because it gives the investor more returns by taking
inflation into account. The investor enjoys the benefit of a return on his principal,
which is equal to the average inflation between the issue (purchase) and maturity
period of the instrument. The investor has to keep the instrument for the entire five-
year period, to avail the benefit of inflated principal amount.
If the investor wants to exit early, he can do it through the secondary market.
The value of the principal repayment is adjusted by the Index Rate (IR), which is
announced by the RBI two weeks prior to the repayment of the principal. The IR is
worked out as follows:
IR = Reference WPI as in Aug 2002/Base WPI
Financial institutions, banks, insurance companies or firm attorneys act as
trustees to the investors. In the indenture, the terms of agreement, description of
debentures, rights of debenture holders and of the issuing company, and
responsibilities of the company are specified clearly. Rates change according to
already fixed norms.
214
Equity Shares
1. What is a bond?
................................................................................................................
................................................................................................................
................................................................................................................
2. What are the basic features of a bond?

................................................................................................................
................................................................................................................
................................................................................................................
9.3 DEBENTURES
A debenture is a long-term debt security issued by a company. Basically, it is a long-

term loan raised by the company for a specified period with the date of maturity
predetermined. Debenture shows the interest rate as well as the security it carries.
Companies can issue secured as well as unsecured debentures.
From the view-point of investors, debentures offer an alternative mode of
investment, which carries a higher interest rate compared to bank deposits. Unlike
bank deposits, debentures can be transferred. Earlier, debentures were issued in
physical form only. Now, debentures are to be issued only in demat form which has
become a mandatory requirement from June 2011 under the Companies
(Dematerialization of Certificates) Rules, 2011.
Generally, debentures are less liquid as compared to PSU bonds and their
liquidity is inversely proportional to the residual maturity. In other words, debentures
become more liquid as their maturity date draws closer.
Types of Debentures
Debentures are divided into different categories on the basis of the convertibility of
the instrument and the security.
Debentures can be classified on the basis of convertibility into:
x Non-convertible debentures (NCD): These instruments retain the debt
character in a permanent manner and are not converted in to equity shares.
215
Equity Shares
x Partly convertible debentures (PCD): A part of these instruments is

converted into equity shares at a pre-determined future date and price in
the terms of the issue document. The issuer decides the ratio for
conversion. All the terms of conversion are decided at the time of the issue
itself.
x Fully convertible debentures (FCD): These are fully convertible into
equity shares. The ratio of conversion is decided by the issuer and spelt out
at the time of the issue itself. Upon conversion, the investors enjoy the same
status as equity shareholders of the company.
x Optionally convertible debentures (OCD): The investor has the option
to either convert these debentures into shares at a price decided by the
issuer at the time of the issue, or just retain it as a debenture, without
conversion, and collect the interest on the debentures. Conversion would
be exercised by the debenture holder depending on the prevailing market
price of the equity shares at the time of conversion. If the market price of
the converted equity share is not attractive, when the market price is lower
than the face value of the debenture, the debenture holder does not
exercise the option of conversion into equity shares as he is assured of
getting interest on the debentures.
Of these types of debentures, OCDs are a better instrument for the investor as
it gives the debenture holders a choice to opt out.
On the basis of security, debentures are classified into:
x Secured debentures: These instruments are secured by a charge on the
fixed assets of the issuer company. So, if the issuer fails payment of either
the principal or interest amount, assets charged can be sold to repay the
liability to the investors. Secured debentures are safe from the view-point
of repayment.
‘Secured’ refers to the security given by the issuer for the debenture. This
is usually in the form of a first mortgage or charge on the fixed assets of the
company on a pari passu basis with other first charge holders like financial
institutions, etc. Pari passu means ranking equally. When the same asset is
charged to the debenture holders as well financial institution, with pari pasu
clause, the benefit of asset charged is available equally to the financial
institution and debenture holders alike when assets are sold. Sometimes,
the charge can also be a second charge instead of a first charge. Most of
216
Equity Shares
the time, the charge is created by a trustee, specifically appointed for the
benefit of debenture holders.
x Unsecured debentures: These instruments are unsecured in the sense that
if the issuer defaults on payment of interest or principal amount, the investor
becomes unsecured creditor of the company. In the event of winding up of
the company, normally, the unsecured debenture holders do not get much
for the amount invested.
x Redeemable debentures: These debentures are redeemed after the
specified period. In case the debentures are repayable by instalments, on
payment of the last instalment, the rights of the debenture holders are
extinguished. On total repayment of the debentures, their life comes to a
close.
Difference between Debentures and Bonds

Both bonds and debentures are long-term debt instruments. Government sector
companies or public sector companies issue bonds—they do not issue debentures.
Private sector companies issue debentures as well as bonds. The similarity between
debentures and bonds is their long-term debt character. Certain bonds are RBI-
approved securities, which are eligible under the SLR limits of banks, while
debentures are not. Both bonds and debentures may be secured or unsecured. It is
desirable to check the terms of issue in respect of the security aspect, before
investing.
The following are the differences between debentures and bonds.
(a) Interest rate: In general, bonds are issued at a higher interest rate than
debentures. This avenue of financing through bonds is mainly availed of by
highly reputed corporate concerns and financial institutions. The issuing
entity has to offer a higher interest rate in respect of unsecured bonds;
otherwise investors would be few and far between.
(b) Security: Debentures are generally secured while bonds are unsecured.
(c) Issue: Typically, bonds are issued by public sector undertakings (PSUs),
public financial institutions and corporates. Debentures are issued by
companies.
(d) Statutory liquidity ratio: Certain categories of bonds qualify for statutory
liquidity ratio hence banks purchase them to maintain statutory liquidity ratio
while debentures do not qualify.
217
Equity Shares
(e) Stamp duty: Debentures in physical form, earlier, attracted stamp duty.
Stamp duty is a state subject and so there was no uniform stamp duty
throughout the country. Debentures attracted stamp duty twice, once at the
time of issue and also at the time of transfer. Now, debentures are to be
issued and transferred in electronic form only. Electronic transactions do
not attract any stamp duty, however each depository participant may levy a
transaction charge. Bonds are governed by the Indian Stamp Act 1899
(Central Act). A bond is transferable by endorsement and delivery and
does not require payment of stamp duty on transfer.
1. Define the term ‘debenture’.

................................................................................................................
................................................................................................................
................................................................................................................
2. What is the relationship between liquidity of debentures and residual

maturity?
................................................................................................................
................................................................................................................
................................................................................................................
3. Why are optionally convertible debentures (OCD) a better instrument for

the investor?
................................................................................................................
................................................................................................................
................................................................................................................
9.4 PREFERENCE SHARES
Preference share is often considered to be a hybrid security since it has many

features of both ordinary shares and debentures. It is similar to ordinary shares in a
way that (a) the non-payment of dividends does not force the company to
insolvency, (b) dividends are not deductible for tax purposes, and (c) in some cases,
218
Equity Shares
it has no fixed maturity date. On the other hand, it is similar to debentures in a way
that (a) dividend rate is fixed, (b) preference shareholders do not share in the
residual earnings, (c) preference shareholders have claims on income and assets
prior to ordinary shareholders, and (d) they usually do not have voting rights.
Preference shares may be issued in different forms, (a) Redeemable preference
shares maturity value, while irredeemable preference share is perpetual without a
maturity value (b) Cumulative preference share accumulates outstanding dividend
and is to be paid when the firm makes profit. On the other hand, non-cumulative
preference share foregoes outstanding dividend (c) Participative preference share
gives voting right to the preference shereholders. Preference shareholders do not
have voting rights in case of non-participative preference share (d) Convertibility
preference share entitles the preference shareholders to convert preference shares
into ordinary shares. Non-convertible preference share can not be converted into
ordinary share. (e) Convertible cumulative preferences share combines two features:
conversion into ordinary share and accumulation of dividend.
Features
Preference shares have several features. Some of them are common to all types of
preference shares while others are specific to some:
x Claims on income and assets: Preference share is a senior security as
compared to an ordinary share. It has a prior claim on the company’s
income in the sense that the company must first pay preference dividend
before paying ordinary dividend. It also has a prior claim on the company’s
assets in the event of liquidation. The preference share claim is honoured
after that of a debenture and before that of ordinary share. Thus, in terms
of risk, preference share is less risky than ordinary share. There is a cost
involved for the relative safety of preference investment. Preference
shareholders generally do not have voting rights and they cannot participate
in any extraordinary profits earned by the company. However, a company
can issue preference share with voting rights (called participative preference
shares).
x Fixed dividend: The dividend rate is fixed in the case of a preference
share, and preference dividends are not tax deductible. The preference
dividend rate is expressed as a percentage of the par value. The amount of
preference dividend will thus be equal to the dividend rate multiplied by the
par value. Preference share is called fixed-income security because it
219
Equity Shares
provides a constant income to investors. The payment of preference

dividend is not a legal obligation. Usually, a profitable company will honour
its commitment of paying preference dividend.
x Cumulative dividends: Most preference shares in India carry a
cumulative dividend feature, requiring that all past unpaid preference
dividend are to be paid before any ordinary dividends are paid. This
feature is a protective device for preference shareholders. The preference
dividends could be omitted or passed without the cumulative feature.
Preference shareholders do not have power to force company to pay
dividends; non-payment of preference dividend also does not result into
insolvency. Since preference share does not have the dividend enforcement
power, the cumulative feature is necessary to protect the rights of
preference shareholders.
x Redemption: Theoretically, both redeemable and perpetual (irredeemable)
preference shares can be issued. Perpetual or irredeemable preference
share does not have a maturity date. Redeemable preference share has a
specified maturity. In practice, redeemable preference shares in India are
often not retired in accordance with the stipulation since there are no
serious penalties for the violation of redemption feature.
x Sinking fund: Like in the case of debentures, a sinking fund provision may
be created to redeem preference share. The money set aside for this
purpose may be used either to purchase preference share in the open
market or to buy back (call) the preference share. Sinking funds for
preference shares are not common.
x Call feature: The call feature permits the company to buy back preference
shares at a stipulated buy-back or call price. The call price may be higher
than the par value. Usually, it decreases with the passage of time. The
difference between call price and par value of the preference share is called
call premium.
x Participation feature: Preference shares may, in some cases, have
participation feature which entitles the preference shareholders to
participate in extraordinary profit earned by the company. This means that
a preference shareholder may get dividend amount in excess of the fixed
dividend. The formula for determining extra dividend would differ. A
company may provide for extra dividend to preference shareholders equal
220
Equity Shares
to the amount of ordinary dividend that is in excess of the regular

preference dividend. Thus if the preference dividend rate is 10 per cent and
the company pays an ordinary dividend of 16 per cent, then preference
shareholders will receive extra dividend at 6 per cent (16 – 10 per cent).
Preference shareholders may also be entitled to participate in the residual
assets in the event of liquidation.
x Voting rights: Preference shareholders ordinarily do not have any voting
rights. They may be entitled to contingent or conditional voting rights. In
India, if a preference dividend is outstanding for two or more years in the
case of cumulative preference shares, or the preference dividend is
outstanding for two or more consecutive preceding years or for a period of
three or more years in the preceding six years, preference shareholders can
nominate a member on the board of the company.
x Convertibility: Preference shares may be convertible or non-convertible.
A convertible preference share allows preference shareholders to convert
their preference shares, fully or partly, into ordinary shares, at a specified
price, during a given period of time. Preference shares, particularly when
the preference dividend rate is low, may sometimes be converted into
debentures. For example, the Andhra Cement converted its preference
shares of `0.33 crore into debentures in 1985. To make preference shares,
attractive, the government of India has introduced convertible cumulative
preference share (CCPS). Unfortunately, companies in India have hardly
used this security to raise funds.
1. What is a preference share?

................................................................................................................
................................................................................................................
................................................................................................................
2. What is cumulative dividend?

................................................................................................................
................................................................................................................
................................................................................................................
221
Equity Shares
9.5 EQUITY SHARES
Two long-term securities that are available to a company for raising capital are
shares and debentures. Shares include ordinary (common) shares and preference
shares. Ordinary shares provide ownership rights to investors. Debentures or bonds
provide loan capital to the company, and investors get the status of lenders. Loan
capital is also directly available from the financial institutions to the companies. What
are the characteristics of loan capital and equity capital? What are their merits and
demerits?
Ordinary Shares or Equity

Ordinary shares (referred to as common shares in USA) represent the ownership
position in a company. The holders of ordinary shares or equity, called shareholders
(or stockholders in USA), are the legal owners of the company. Ordinary shares are
the source of permanent capital since they do not have a maturity date. For the
capital contributed by purchasing ordinary shares, the shareholders are entitled for
dividends. The amount or rate of dividend is not fixed; the company’s board of
directors decides it. An ordinary share is, therefore, known as a variable income
security. Being the owners of the company, shareholders bear the risk of ownership;
they are entitled to dividends after the income claims of others have been satisfied.
Similarly, when the company is wound up, they can exercise their claims on assets
after the claims of other suppliers of capital have been met.
Reporting of Ordinary Shares

The capital represented by ordinary shares is called share capital or equity capital. It
appears on the left-hand side of a firm’s account-form balance sheet or on the top
of sources of capital in the step-form balance sheet. Details about share capital are
generally contained in schedules attached to the balance sheet. Table 9.1 shows the
details of share capital for the Tata Motors Company Limited.
Shareholder’s equity includes both ordinary shares and preference shares (if
any). Tata Motors’ authorized capital includes convertible commulative preference
shares (CCPS) of `3,000 crore. The capital attributable to ordinary shares excludes
preference shares capital. In Tata Motors’ case, the ordinary shareholders’ equity
capital is: `19,134.84 (viz., paid up capital `638.07 plus reserves and surplus
`18,494.77) crore. Authorized share capital represents the maximum amount of
capital, which a company can raise from shareholders. A company can, however,
222
Equity Shares
change its authorized share capital by altering its Memorandum of Association

(a charter of the company). The alteration of the memorandum involves somewhat
complicated legal procedures. The portion of the authorized share capital, which has
been offered to shareholders, is called issued share capital. Subscribed share capital
represents that part of the issued share capital, which has been accepted by
shareholders. The amount of subscribed share capital, actually paid up by
shareholders to the company is called paid-up share capital. Often, subscribed and
paid-up share capital may be the same.
Table 9.1 Tata Motor’s Share Capital
as on 31 March 2013 (` crore)
The total paid-up share capital is equal to the issue price of an ordinary share
multiplied by the number of ordinary shares. The issue price may include two
components: the par value and the share premium. The par value is the price per
ordinary share stated in the Memorandum of Association. Generally, the par value of
an ordinary share is in the denomination of `100 or `10. Any amount in excess of
the par value is called the share premium. In the case of new companies, the par
value and the issue price may be the same. The existing, highly profitable companies
may issue ordinary shares at a premium. The paid-up share capital is stated at the
par value. The excess amount is separately shown as the share premium. The
company’s earnings, which have not been distributed to shareholders and have been
retained in the business, are called reserves and surplus. They belong to owners—
ordinary shareholders. Thus, the total shareholders’ equity is the sum of: (i) paid-up
share capital, (ii) share premium, and (iii) reserves and surplus. The total
shareholders’ equity or share capital is also called net worth.
223
Equity Shares
The book value per ordinary share is calculated as follows:
...(1)
For Tata Motors’, the book value per share as on 31 March 2013 is:
Note that the book value is based on historical figures in the balance sheet. It is
in no way related with the market value of an ordinary share. The market value of a
share is the price at which it trades in the stock market. It is generally based on
expectations about the performance of the economy, in general and the company, in
particular. Tata Motors’ market price per share on Bombay Stock Exchange has
generally been higher than its book value. For example, on 24 April 2009, the
market price of a Tata Motors’ share was ranging between `245 to `249. The
market prices of many companies’ shares trade at below their book values. Ordinary
shares of all companies may not be traded on stock markets. Therefore, the market
value of ordinary shares of all companies may not be available.
Features
Ordinary share has a number of special features which distinguishes it from other
securities. These features generally relate to the rights and claims of ordinary
shareholders.
x Claim on income: Ordinary shareholders have a residual ownership claim.
They have a claim to the residual income, which is, earnings available for
ordinary shareholders, after paying expenses, interest charges, taxes and
preference dividend, if any. This income may be split into two parts:
dividends and retained earnings. Dividends are immediate cash flows to
shareholders. Retained earnings are reinvested in the business, and
shareholders stand to benefit in future, in the form of the firm’s enhanced
value and earnings power and ultimately enhanced dividend and capital
gain. Thus, residual income is either directly distributed to shareholders in
the form of dividend or indirectly in the form of capital gains on the ordinary
shares held by them.
Payable dividends depend on the discretion of the company’s board of
directors. A company is not under a legal obligation to distribute dividends
224
Equity Shares
out of the available earnings. Capital gains depend on future market value
of ordinary shares. Thus, an ordinary share is a risky security from the
investor’s point of view. Dividends paid on ordinary shares are not tax
deductible for the company.
x Claim on assets: Ordinary shareholders also have a residual claim on the
company’s assets in the case of a liquidation. Liquidation can occur on
account of business failure or sale of business. Out of the realized value of
assets, first the claims of debt-holders and then preference shareholders are
satisfied, and the remaining balance, if any, is paid to ordinary shareholders.
In case of liquidation, the claims of ordinary shareholders may generally
remain unpaid.
x Right to control: Control in the context of a company means the power
to determine its policies. The board of directors approves the company’s
major policies and decisions while managers appointed by the board carry
out the day-to-day operations. Thus, control may be defined as the power
to appoint directors. Ordinary shareholders have the legal power to elect
directors on the board. If the board fails to protect their interests, then they
can replace directors. Ordinary shareholders are able to control the
management of the company through their voting rights and right to maintain
proportionate ownership.
x Voting rights: Ordinary shareholders are required to vote on a number of
important matters. The most significant proposals include: election of
directors and change in the memorandum of association. For example, if the
company wants to change its authorized share capital or objectives of
business, it requires ordinary shareholders’ approval. Directors are elected
at the Annual General Meeting (AGM) by the majority votes. Each ordinary
share carries one vote. Thus, an ordinary shareholder has votes equal to the
number of shares held by him. Shareholders may vote in person or by
proxy. A proxy gives a designated person right to vote on behalf of a
shareholder at the company’s annual general meeting. When management
takeovers are threatened, proxy fights—battles between rival groups for
proxy votes—occur. An earlier example in this regard was that of Gamon
India where both existing management and the Chhabrias fought for the
control of the company and put all efforts to collect proxy votes. The
existing management could continue its hold on the company with the help
of majority shareholders including the financial institutions.
225
Equity Shares
x Pre-emptive rights: The pre-emptive right entitles a shareholder to

maintain his proportionate share of ownership in the company. The law
grants shareholders the right to purchase new shares in the same proportion
as their current ownership. Thus, if a shareholder owns 1 per cent of the
company’s ordinary shares, he has pre-emptive right to buy 1 per cent of
new shares issued. A shareholder may decline to exercise this right. The
shareholders’ option to purchase a stated number of new shares at a
specified price during a given period is called rights. These rights can be
exercised at a subscription price, which is generally much below the share’s
current market price, or they can be allowed to expire, or they can be sold
in the stock market.
x Limited liability: Ordinary shareholders are the true owners of the
company, but their liability is limited to the amount of their investment in
shares. If a shareholder has already fully paid the issue price of shares
purchased, he has nothing more to contribute in the event of a financial
distress or liquidation. This position of shareholders is different from the
owners in the case of sole proprietary businesses or partnership firms
where they have unlimited liability. In the event of the insolvency of these
firms, owners are required to bring in additional capital from their personal
savings to pay claims of creditors. The limited liability feature of ordinary
share encourages otherwise unwilling investors to invest their funds in the
company. Thus, it helps companies to raise funds.
Pros and Cons of Equity Financing

Equity capital is the most important long-term source of financing. It offers the
following advantages to the company:
x Permanent capital: Since ordinary shares are not redeemable, the
company has no liability for cash outflow associated with its redemption. It
is a permanent capital, and is available for use as long as the company
goes.
x Borrowing base: The equity capital increases the company’s financial base,
and thus its borrowing limit. Lenders generally lend in proportion to the
company’s equity capital. By issuing ordinary shares, the company increases
its financial capability. It can borrow when it needs additional funds.
x Dividend payment discretion: A company is not legally obliged to pay
dividend. In times of financial difficulties, it can reduce or suspend payment
226
Equity Shares
of dividend. Thus, it can avoid cash outflow associated with ordinary

shares. In practice, dividend cuts are not very common or frequent. A
company tries to pay dividend regularly. It cuts dividend only when it
cannot manage cash to pay dividends. For example, in 1986 the Reliance
Industries Limited experienced a sharp drop in its profits and had a severe
liquidity problem. As a consequence, it had to cut its dividend rate from
50 per cent to 25 per cent. The company, however, increased the dividend
rate next year when its performance improved.
Equity capital has some disadvantages to the firm compared to other
sources of finance. They are as follows:
x Cost: Shares have a higher cost at least for two reasons: Dividends are not
tax deductible as are interest payments, and the flotation costs on ordinary
shares are higher than those on debt.
x Risk: Ordinary shares are riskier from investors’ point of view as there is
uncertainty regarding dividend and capital gains. Therefore, they require a
relatively higher rate of return. This makes equity capital as the highest cost
source of finance.
x Earnings dilution: The issue of new ordinary shares dilutes the existing
shareholders’ earnings per share if the profits do not increase immediately in
proportion to the increase in the number of ordinary shares.
x Ownership dilution: The issuance of new ordinary shares may dilute the
ownership and control of the existing shareholders. While the shareholders
have a pre-emptive right to retain their proportionate ownership, they may
not have funds to invest in additional shares. Dilution of ownership assumes
great significance in the case of closely held companies. The issuance of
ordinary shares can change the ownership.
Public Issue of Equity

Public issue of equity means raising of share capital directly from the public. For
example, Riga Sugar Company Limited a subsidiary of Belsund Sugar Limited made
a public issue of equity shares of `10 crore on 12 July 1994. The issue price per
share is `50—representing a premium of `40 over its par value. The issue price is
also higher than its book value of `26.35 per share. The company needs funds for
expansion and modernization of its plant as well as for diversification into the
manufacture of ethyl alcohol. The company expects to pay a dividend of 20 per cent
in 1993–94 and 1994–95 and 25 per cent in 1995–96.
227
Equity Shares
Consider another case, N.R. Agarwal Industries Limited is approaching the

public for the first time to raise `3.20 crore on 7 July 1994. Incorporated as a public
limited company in December 1993, the maiden issue of equity shares is intended to
part-finance its project for manufacturing industrial paper in Vapi, Gujarat. The share
is issued at par at `10.
Yet another example of public issue is the proposal to issue 95 lakh equity shares
of `10 each by CG Lifesciences. The issue price per share will be decided by the
book building process.
One recent example is the IPO (Initial Public Offering) by Wonderla Holidays
Limited. The company, incorporated in 2002, is a large operator of amusement
parks in India. The total income of the company in 2013 was `13,917 lakh and PAT
was `3,348 lakh. The purpose of the issue was to expand business in Hyderabad.
The issue size was about `166.75 – `181.25 crore. The par value of share was
`10, while the issue was in the range of `115 – `175.
As per the existing norms, a company with a track record is free to determine
the issue price for its shares. Thus, it can issue shares at a premium (as compared to
the par value).
Underwriting of Issues
It is legally obligatory to underwrite a public and a rights issue. In an underwriting,
the underwriters—generally banks, financial institution brokers, etc.—guarantee to
buy the shares if the issue is not fully subscribed by the public. The agreement may
provide for a firm buying by the underwriters. The company has to pay an
underwriting commission to the underwriter for their services.
Private Placement
Private placement involves sale of shares (or other securities) by the company to few
selected investors, particularly the institutional investors. Private placement has the
following advantages:
x Size: It is helpful to issue small amount of funds.
x Cost: It is less expensive. In the case of public issue of securities, the issue
costs, including both statutory and other costs, are quite high, ranging
between 10 to 20 per cent of the size of issue. A substantial part of these
costs can be avoided through private placement.
x Speed: It takes less time to raise funds through private placement, say, less
than 3 months. Public issues involve a number of requirements to be
fulfilled, and this requires a lot of time to raise capital.
228
Equity Shares
1. Define ordinary shares.

................................................................................................................
................................................................................................................
................................................................................................................
2. What is involved in private placement?

................................................................................................................
................................................................................................................
................................................................................................................
9.6 SUMMARY
x A bond is a long term debt instrument or security. Bonds issued by the

government do not have any risk of default. The government will always
honour obligations on its bonds. The private sector companies also issue
bonds which are called debentures in India.
x The principal of a redeemable bond or bond with a maturity is payable after
a specified period, called maturity period.
x It is relatively easy to determine the present value of a bond since its cash
flows and the discount rate can be determined without much difficulty. If
there is no risk of default, then there is no difficulty in estimating the cash
flows associated with a bond.
x Bonds may be classified into three categories: (a) bonds with maturity, (b)
pure discount bonds and (c) perpetual bonds.
x A debenture is a long-term promissory note for raising loan capital. The
firm promises to pay interest and principle as stipulated. The purchasers of
debentures are called debenture holders. It is a long-term, fixed income
financial security. Debenture holders are the creditors of a firm.
x The interest rate on a debenture is fixed and known. It is called the
contractual rate of interest. It indicates the percentage of the par value of
the debenture that will be paid out annually (or semi-annually or quarterly),
in the form of interest.
229
Equity Shares
x Debentures are either secured or unsecured. A secured debenture is

secured by a lien on the company’s specific assets.
x When debentures are not protected by any security, they are known as
unsecured or naked debentures.
x Credit rating of a bond/debenture shows the chances of timely payment of
interest and principal by a borrower.
x In India, the Credit Rating and Information Services of India Limited
(CRISIL) provides rating for bonds/debentures, fixed deposits and
commercial papers. Other rating companies include CARE and ICRA.
x Debentures may be straight debentures or convertible debentures. A
convertible debenture (CD) is one which can be converted, fully or partly,
into shares after a specified period of time.
x Non-convertible debentures (NCDs) NCDs are pure debentures without a
feature of conversion. They are repayable on maturity.
x Preference share is often considered to be a hybrid security since it has
many features of both ordinary shares and debentures. It may be issued in
different forms. Preference shares may be convertible or non-convertible.
When the preference dividend rate is low, a preference share may
sometimes be converted into debentures.
x Two long-term securities that are available to a company for raising capital
are shares and debentures.
x Shares include ordinary (common) shares and preference shares. Ordinary
shares provide ownership rights to investors. Debentures or bonds provide
loan capital to the company, and investors get the status of lenders.
x Ordinary shares (referred to as common shares in USA) represent the
ownership position in a company. The holders of ordinary shares or equity,
called shareholders (or stockholders in USA), are the legal owners of the
company.
x Public issue of equity means raising of share capital directly from the public.
x Private placement involves sale of shares by the company to few selected
investors, particularly the institutional investors.
230
Equity Shares
9.7 KEY WORDS
x Bond: It is a long-term debt instrument or security. Bonds issued by the

government do not have any risk of default.
x Debenture: It is a long term promissory note for raising loan capital. The
firm promises to pay interest and principal as stipulated.

1. Bond is a long term debt instrument that promises to pay a fixed annual sum
as interest for specified period of time.
2. The basic features of the bonds are that (i) bonds have face value, (ii) the
interest rate is fixed and known to bondholder, (iii) the maturity date of the
bond is usually specified at the time of issue, (iv) the redemption value is
stated in the bonds, and (v) bonds are traded in the stock market.

1. A debenture is a long-term debt security issued by a company. It is a long-
term loan raised by the company for a specified period with the date of
maturity predetermined.
2. The liquidity of debentures is inversely proportional to the residual maturity.
In other words, debentures become more liquid as their maturity date
draws closer.
3. Optionally convertible debentures (OCD) are a better instrument for the
investor as they give the debenture holders a choice to opt out.

1. Preference share is considered to be a hybrid security as it has many
features of both ordinary shares and debentures.
2. A cumulative dividend is a feature shared by most preference shares in
India which requires that all past unpaid preference dividends are to be
paid before any ordinary dividends are paid.
231
Equity Shares

1. Ordinary shares represent the ownership position in the company. The
holders of ordinary shares or equity, called shareholders are the legal
owners of the company.
2. Private placement involves sale of shares or other securities by the
company to few selected investors, particularly the institutional investors.
1. What is a debenture? State its classification and features.

2. Differentiate between debentures and bonds.
3. What are preference shares? How are they similar to ordinary shares?
4. Discuss the features of equity shares.
5. What are the features of loan capital and equity capital?

McGraw-Hill.
232
Fundamental
Analysis
UNIT–10 FUNDAMENTAL ANALYSIS
Objectives
x Elaborate the concept of fundamental analysis
x Explain the concepts of indicator, indices and moving average
Structure
10.1 Introduction
10.2 Trends in Fundamental Analysis
10.3 Indicator
10.4 Indices
10.5 Moving Average
10.6 Summary
10.7 Key Words
10.1 INTRODUCTION
The intrinsic value of an equity share depends on a multitude of factors. The earnings
of the company, the growth rate and the risk exposure of the company have a direct
bearing on the price of the share.
These factors in turn rely on the host of other factors like economic environment in
which they function, the industry they belong to, and finally companies’ own
performance. The fundamental school of thought appraised the intrinsic value of
shares through
x Economic Analysis
x Industry Analysis
x Company Analysis
Thus, fundamental analysis is a combination of economic, industry and company
analyses to obtain a stock’s current fair value and predict its future value.
233
Fundamental
Analysis
10.2 TRENDS IN FUNDAMENTAL ANALYSIS
In the disciplines of accounting and finance, fundamental analysis refers to the

analysis of a business’ financial statements (generally their analysis for the purpose of
assets, liabilities, and earnings of the business). It also encompasses the health of the
business, its markets and its competitors. When it is applied to forex and futures, it
will be looking at the economy’s overall state, and will take into account such factors
as management, manufacturing, housing, GDP, employment, earnings, production
and interest rates. While using fundamental analysis to analyzing currency, future
contracts or a stock, two different approaches can be adopted. These are bottom
up analysis and top down analysis. The terms are used to distinguish such analysis
from other types of investment analysis, like technical and quantitative.
For the purpose of making financial forecasts, it is possible to apply fundamental
analysis to current as well as historical data. A number of objectives exist:
x Perform a company stock valuation and predict the possible price evolution
x Make a projection on the company’s business performance
x Evaluate the company’s management and make internal business decisions
x Calculate the company’s credit risk.
Analytical Models
In the case where the analysis’ objective is determining of what stock to purchase
and at what price, investors have two methodologies to choose from:
x It is opined by fundamental analysis that a security might be mispriced by

the markets in the short run but eventually price correction will certainly
happen. It is possible to make profits through purchasing of mispriced
security and then waiting till the market sees the ‘mistake’ and the security
is re-priced.
x It is maintained by technical analysis that the price of the security already
reflects all information. Trends are analysed by technical analysts and this
form of analysis is of the opinion that sentiment changes predate and
predict trend changes. The emotional response of investors to the
movement of price causes price chart patterns that are recognizable. In
technical analysis, it is conducted on historical trends for the prediction of
movement of price in the future.
234
Fundamental
Analysis
For the purpose of stock picking, it is alright if investors employ both the
methods. To take an example, majority of the fundamental investors make use of
technicals to determine points of entry and exit. In the same way, there are technical
investors who make use of fundamentals to limit their universe of possible stock to
‘good’ companies.
The stock analysis to be used is based by investors on their own belief in the
different paradigms associated with ‘how the stock market works’.
Fundamental analysis comprises:
x Company analysis
x Economic analysis
x Industry analysis
On the basis of these three analyses, the shares’ intrinsic value is ascertained. It
is this value which is taken to be the share’s true value. In case of intrinsic value being
more than its market price, buying the share will be the judicious thing to do. In case
the intrinsic value and the market value are the same, the right thing to do will be to
hold on to the share. If the intrinsic value is lower than the market value, it is time to
sell off the share.
Fundamental analysis can be used by investors in varying portfolio management
styles.
The buy and hold variety of investors are of the opinion that going with good
businesses lets the assets of the investor grow as the business grows. With
fundamental analysis these investors are able to locate companies that will be good
for investment, and in this way they decrease their risk and also the probability of
wipe-out.
The value investors have eyes only for such companies that are under-valued.
They are of the opinion that ‘it’s hard to fall out of a ditch’. They use fundamental
analysis to arrive at the value and then decide companies based on that value.
It is essential for managers to employ the use of fundamental analysis for judging
the value of ‘good’ and ‘bad’ companies accurately. The stock price of bad
companies will finally fluctuate, leading to profit making opportunities.
It is also possible for managers to look at the economic cycle to ascertain
whether or not the circumstances are correct for purchasing of companies that are
suitable fundamentally.
235
Fundamental
Analysis
It is believed by contrarian investors, ‘In the short run, the market is a voting
machine, not a weighing machine’. With fundamental analysis it becomes possible for
a broker to make personal decision on value, and not to follow or even consider
what the market is saying.
Another use that managers can put to fundamental analysis is for determining the
future growth rates for purchasing of growth stocks that are priced high.
Also, managers could include together technical factors and fundamental factors
in computer models (quantitative analysis).
The Top-down and Bottom-up Approaches

There are two approaches associated with fundamental analysis i.e. top-down
approach and bottom-up approach.
Investors following the top-down approach begin analysis with global
economics, including both international and national economic indicators, like the
GDP growth rates, interest rates, inflation, productivity, exchange rates and energy
prices. Then they narrow down the search to industry/regional analysis for the total
sales, price levels, the effects of competing products, foreign competition and entry
or exit from the industry. After all of this work, they get down to zeroing in on the
best business in the area under scrutiny.
Investors following the bottom-up approach begin with specific businesses with
no regard to the region/industry. They follow an approach exactly reverse to the
top-down approach.
Procedures
The person analysing the health of a business begins with the analysis of the business’
financial statement which will also comprise financial ratios. Study is done of capital
financing new equity issues operating cash flow and dividends paid. Growth rate
projections and earnings estimates that are widely published (for example by
Thomson Reuters) could be looked upon as ‘fundamental’ or ‘technical’ based on
the investor’s perception of how valid they are.
Determined growth rates (of income and cash) and risk levels (for determining the
discount rate) are employed with various models of valuation. The most important of
these models is the discounted cash flow model used for calculating the current value
of the future Dividends received by the investor, along with the eventual sale price
(Gordon model):
236
Fundamental
Analysis
x Company’s earnings
x Company’s cash flows
The debt possessed by a company is one key consideration for knowing its
health. Its assessment can be done quickly with debt-to-equity ratio and the current
ratio (current liabilities/current assets).
The simple model which is applied commonly is price-to-earnings ratio (P/E
ratio). Implicit in this model of a perpetual annuity (time value of money) is that the
‘flip’ of the P/E is the discount rate appropriate to the risk of the business. The
multiple accepted is adjusted for expected growth since this does not come as part
of the model.
The PEG ratio has growth estimates incorporated into it. Its validity is based on
the time duration for that the analysts think that the growth will keep happening.
The stock prices are computer modeled now and this has replaced the
subjective interpretation of fundamental data (and technical data) throughout the
industry to a great extent. From around 2000, with computers capable of crunching
huge amounts of data, a new career has come up and the decisions that were made
by manager are now made by proprietary mathematical models.
Automation
The process of fundamental analysis has significantly declined over the past decade
or so. It is extremely time consuming to perform fundamental analysis and the new,
quick paced style of trading being used in the 21st century, with markets dominated
by day traders and HFT firms, such an analysis does not help in keeping pace with
the market. It is possible to reduce the time taken for analysis to screening services,
which could be paid ones or free ones. Screening services allow searching the entire
market for stocks that match the quantitative fields one is interested in. Such
software drastically reduces the time which otherwise would have gone into sifting
through SEC filings.
Fundamental Analysis: Strengths

Let us discuss the strengths of fundamental analysis.
x Long-term Trends: Use of fundamental analysis proves good in the case
of long-term investments that are based on very long-term trends. The
ability to identify and predict long-term consumer, technological,
demographic or economic trends could auger well for patient investors who
go for the right companies or group of industries.
237
Fundamental
Analysis
x Value Spotting: It is possible to use sound fundamental analysis for

identification of such companies which provide good value. John Neff,
Warren Buffett and Graham and Dodd are the savants of value investing.
With fundamental analysis it becomes easy to uncover companies that have
staying power, stable earnings, strong balance sheet and valuable assets.
x Business Acumen: An obvious but not a tangible incentive found in
fundamental analysis is the development of a thorough understanding of the
business. When an investor conducts such thorough analysis, he becomes
familiar with the key profit and revenue drivers of the company. With a
good understanding, it becomes possible for investors to identify those
companies which continue to deliver and which can succumb to shortfalls.
With fundamental analysis it becomes possible for investors to gain an
understanding of the key value drivers and companies in specific industries.
A company’s industry group greatly influences the price of its stock. By
studying such groups, it becomes easier for investors to be in a position to
spot opportunities that are income-oriented, cyclical, non-cyclical, value
driven, growth oriented, high-risk or low-risk.
x Understand Who’s Who: It is important to remember that it is as a group
that stocks move. When an investor understands the business of a
company, he is able to better categorize stocks within their relevant industry
group. It is possible for businesses to change really quickly and also a
company’s revenue mix. Being well aware of a company’s business and
knowing which group to place it in could make a major difference during
relative valuations.
Fundamental Analysis: Weaknesses

Let us discuss a few weaknesses associated with fundamental analysis.
x Time Constraints: Though it provides thorough insights, fundamental
analysis takes a lot of time. As it is time consuming, often it will provide
results that are not in line with the current prevailing facts.
x Company/Industry Specific: The techniques used for valuation will
depend on the industry group and each company’s specifics. Therefore,
there is need for a different technique and model for the various companies
and industries. Such an exercise could become time-consuming, causing the
research to be limited in scope.
238
Fundamental
Analysis
x Subjective: It can be safely said that it is on assumptions that fair value is

based. If there is a change in growth or multiplier assumptions there can be
a huge change in the final valuation. Awareness is generally there as far as
fundamental analysts are concerned which is why they employ sensitivity
analysis to present a base-case valuation, an average-case valuation and a
worst-case valuation. Nevertheless, even on a worst-case valuation, most
models are almost always bullish, the only question is how much so.
x Analyst Bias: Most information used for the analysis is the one that has
come from the company. Investor relations managers are employed by
companies for the specific task of releasing information and handling the
analyst community. Investor relations managers and CFOs are very adept
at presenting data and putting out information in a manner which will always
favour their company. It is just the buy-side analysts who manage to
venture past the company statistics and they are the ones working for
money managers and mutual funds managers. They work with the reports
made by the sell-side analysts who work for the big brokers. Such brokers
participate in investment banking and underwriting for the companies.
While restrictions exist for preventing any conflict of interest, brokers have
an ongoing relationship with the company under analysis. When working
with such reports, it is essential to keep in mind that there could be some
biases that the sell-side analyst may have had. On the other hand, the
company is being analysed by the buy-side analyst, only from the stand
point of investment for some portfolio manager. In case a relationship does
exist with a company, it is generally on different terms. Could be at times in
the form of a large shareholder.
x Definition of Fair Value: If market valuations extend beyond historical
norms, pressure is put for adjusting growth and multiplier assumptions to
compensate. Growth and multiplier assumptions, much like prices, are
subject to fluctuation.
With several companies having lost and still losing money, businesses are
now being valued as a multiple of its revenues. This would appear to be
accurate, but for the facts that for many stocks the PE was lower than the
stock’s multiple.
239
Fundamental
Analysis
1. Define fundamental analysis.

................................................................................................................
................................................................................................................
................................................................................................................
2. State the components of fundamental analysis.

................................................................................................................
................................................................................................................
................................................................................................................
10.3 INDICATOR
An indicator indicates the nature of market trends. A technical indicator is a set of

data points obtained by applying a formula to the price data of a stock or index.
Price data consists of open, high, low or close prices over a period. Some indicators
use only the closing prices, while others may use high and low prices. Certain
indicators use the volume of trade in their formulas. The volume of trade is
influenced by the behaviour of prices. An oscillator shows the stock price movement
between two points.
Technical indicators are used to find out the overall direction of the market. The
overall market movements affect individual share prices. Aggregate forecasting is
considered to be more reliable than individual forecasting. The usual indicators are
price and volume of trade. An indicator alerts the investor to study the price action
closely. If the momentum is weakening, it may warn the investor and trader to watch
for a break of support. If there is a large, positive divergence, it is a signal to the
investor to watch for a resistance break out. Some investors and traders use
indicators to predict the direction of future prices. Buy and sell signals should be used
along with other technical analysis tools. An indicator may give a sell signal, but if the
chart pattern shows an ascending triangle with a series of increasing peaks, it may be
a false signal.
240
Fundamental
Analysis
Volume of Trade
Dow gave special emphasis on volumes. Volume expands in a bull market and
narrows in a bear market. If the volume of trade falls with a rise in price or vice
versa, it is a matter of concern for the investor, and the trend may not persist for a
long time. Technical analysts see trading volume as an excellent method of confirming
trends. The market is said to be bullish when a small volume of trade and large
volume of trade follow a fall in price and a rise in price respectively. Specifically,
x A big rise or fall in price leads to a big change in volume.
x A large volume with a rise in price indicates a bull market and the large
volume with a fall in price indicates bear market.
x If volumes decline for five consecutive days, then it will continue for another
four days, and the same is true in the case of increasing volumes.
Significance of Volume
x Volumes confirm trends: Movements in either direction followed by high
volumes are a strong signal of trend reversals. If a stock price increases by
10 per cent after a long period of decline with a heavy volume of trade, it
signals a trend reversal. If a rise in price is not followed by heavy volume of
trade, it indicates that the market is not interested in the upward move. A
policy of watch and invest should be adopted.
x Volumes confirm chart patterns: Patterns such as an inverted ‘V’, head
and shoulders, triangles and rounded bottoms are confirmed with volume. If
the volume does not accord with the trend reversals indicated by the chart
pattern, the signal formed by the pattern is considered weak.
x Volumes lead price movements: Usually, volume changes precede price
changes. They give an idea about the upcoming trend reversals. If volumes
decline in an uptrend, it signals that the upward trend is about to end. Figure
10.1 provides an example of volume and price movements.
241
Fundamental
Analysis
Fig. 10.1 Volume and Price Movements for Reliance Industries
Breadth of the Market

The ‘breadth of the market’ is a term often used to refer to the advances and
declines that occur in the stock market. Advances refer to the number of shares
whose prices have increased from the previous day’s trading. Declines indicate the
number of shares whose prices have fallen from the previous day’s trading. This is an
indicator that is easy to plot and watch because data are available in all business
dailies.
The net difference between the number of stock advances and declines during
the same period is the breadth of the market. A cumulative index of net differences
measures the market breadth. Table 10.1 shows the breadth of the market.
Table 10.1 Breadth of the Market — National Stock Exchange
242
Fundamental
Analysis
The advance/decline can be drawn as a graph. The A/D line does not show
exactly when a reaction will occur, but it indicates that it will occur soon. The A/D line
is compared with the market index. In a bull market, a bearish signal is given when the
A/D line slopes down while the BSE Sensex is rising. In a bear market, a bullish signal
is given when the A/D line begins rising as the Sensex declines to a new low.
Harvey A Krow computed advances and declines as a ratio. He divided the
advances by the declines. Any number greater than 1 indicates advances are
exceeding decline. Values below 0.99 indicate declines are more than the advances.
Ten-day and 200-day moving averages of the A/D ratios are also computed. A ratio
of 0.75 signals a short-term buying opportunity and an intermediate rally at the
beginning of a bearish trend. In the later stages of a bear market, the ratio declines
below 0.5. Except in the first phase of a bull market, a rise above 1.25 indicates
selling opportunities.
Short sales
Short selling is a technical indicator known as short interest. The term ‘short sales’
refers to the selling of shares that are not owned. The bears are the short sellers who
sell now in the hope of purchasing at a lower price in future to make profits. The
short sellers have to cover their positions. Short positions of scrips are published in
the business newspapers. When demand for a particular share increases, the
outstanding short positions also increase, and it indicates a future rise in prices.
These indications cannot be absolutely correct, but they show the general situation.
Short sales of a particular month are selected and compared with the average
daily volume of the preceding month. This ratio shows how many days of trading it
would take to use up total short sales. If the ratio is less than 1, the market is said to
be weak or overbought, and a decline can be expected. A value between 1 and 0.5
shows a neutral market. Values above 1 indicate a bullish trend, and if it is above 2,
the market is said to be oversold. At market tops, short selling is high, and at market
bottoms, short selling is low.
1. What is a technical indicator?

................................................................................................................
................................................................................................................
................................................................................................................
243
Fundamental
Analysis
2. What do you understand by breadth of the market?

................................................................................................................
................................................................................................................
................................................................................................................
3. What is short selling?

................................................................................................................
................................................................................................................
................................................................................................................
10.4 INDICES
Stock market indices are useful for the following reasons:

x They help us recognize the broad trends in the market.
x They can be used as a benchmark for evaluating the investor’s portfolio.
x They function as a status report on the general economy as various
economic policies have an impact on the stock market.
x The investor can use the indices to allocate funds rationally among stocks.
To earn returns on par with market returns, he can choose stocks that
reflect the market movement.
x Index funds and futures are formulated with the help of the indices. Usually,
fund managers construct portfolios similar to any one of the major stock
market indices, for example, ICICI has floated ICICI index bonds. The
return of the bond is linked to the movement of the index.
x Technical analysts studying the past performance of the indices predict the
future movement of the stock market. The relationship between the
individual stock and the index helps to predict the individual share price
movement.
Computation of the Stock Index

A stock market index may either be a price index or a wealth index. The unweighted
price index is a simple arithmetical average of share prices with a base date. This
index gives an idea about the regular price movements of the constituents and
244
Fundamental
Analysis
reflects the total market. In a wealth index, the prices are weighted by market
capitalization. In such an index, the base period values are adjusted for subsequent
rights and bonus offers. This gives an idea about the real wealth created for
shareholders over a period. The following example shows how the wealth index is
calculated.
Let us consider an index constructed with three scrips X, Y, and Z.
Equity of company X: 100 (par value `10)
Equity of company Y: 200 (par value `10)
Equity of company Z: 250 (par value `10)
Market price of scrip X: `20
Market price of scrip Y: `30
Market price of scrip Z: `40
Market capitalization (MC) = Number of shares × Price of shares
X = 100 × `20 = `2,000
Y = 200 × `30 = `6,000
Z = 250 × `40 = `10,000
Aggregate market capitalization = `18,000
Index at period N = 100
Market price at N+1:
X share price = `25
Y share price = `40
Z share price = `50
Market capitalization:
X = 100 × `25 = `2,500
Y = 200 × `40 =`8,000
Z = 250 × `50 =`12,500
Aggregate market capitalization = `23,000
Index at period N + 1 = `23,000 × 100/18,000
N + 1 = 127.78
The weight used could be the trading volume of the particular scrip. When the
index uses the trading volume as weight, it shows the depth of the market in terms of
trading volumes and conditions. The all-India equity index of the Financial Express
with base year 1979 uses the trading volume of the scrip as the weight.
245
Fundamental
Analysis
The Business Line (BL)-250 (base 17 January 1994 = 100) – a comprehensive

index comprising 43 industry groups – is a wealth index and the weight used is the
market capitalization. If the index is broad-based, it can represent market
movements in a comprehensive manner. The impact of particular scrips is less in a
broad-based index. In the case of the unweighted price index, selected scrips’ price
average is calculated in relation to a base year. It shows just the price movement.
The Ordinary Share Price Index of the Economic Times with base year 1984-85 is
of this type.
Differences between the indices

The indices differ from one another to a certain extent. Sometimes, the Sensex may
go up by 100 points and NSE Nifty may go up only 40 points. The key factors that
distinguish one index from the other are given below:
x Number of component stocks
x Composition of the stocks
x Weights
x Base year
Number of Component Stocks

The number of stocks in an index influences the behaviour of the index. If the number
is high, it is a representative sample capable of reflecting the market movement.
The Sensex has 30 scrips, like the Dow Jones Industrial Average in the US. At
the same time, BSE-100 (National), BSE-200, the Dollex, (dollar equivalent of
BSE-200), the RBI index (338 stocks) and Nifty (50 stocks) are also widely used.
Private organizations construct their own indices, for example, CRISIL has its
CRISIL-500. From the above examples, it is clear that the number of scrips differs
from one index to another and hence their movements also vary. The BSE National
Index is considered to be more representative than Sensex because it has 100
stocks. Of these, 22 are quoted on the BSE, and the rest are listed on the BSE and
other exchanges.
Composition of the Stocks

The composition of the stocks in the index should reflect the market movement as
well as macroeconomic changes. The Centre for Monitoring the Indian Economy
maintains an index. It often changes the composition of the index to reflect market
movements in a better manner. Some of the scrips’ traded volumes may come
246
Fundamental
Analysis
down, and at the same time, some other stock may draw the market’s interest. In
such a case, the scrip that has lost market value should be dropped and others must
be added. Only then will the index become more representative. In 1993, the
Sensex dropped one company and added another. In August 1996, it was totally
revamped. Half the scrips were changed. The composition of the Nifty and Sensex
change continuously to suit the market. CRISIL-500 was changed in November
1996. In October 1998, the Nifty Junior Index composition was changed to reflect
the importance of information technology scrips.
Weights
The weight assigned to each company’s scrip also influences the movement of the
index. The indices may be weighted with the price or the value. The Dow Jones
Industrial Average and the Nikkei Stock Average of 225 scrips of the Tokyo Stock
Exchange are weighted with the price. A price weighted index is computed by
adding the current prices of the stocks in the stock exchange and dividing that by the
total number of stocks. In the sample given earlier, the high-priced stocks affect the
index more than the low-priced ones. The number of stocks is adjusted for any
stock splits, bonus and rights issues.
In the value weighted index, the total market value of the share (the number of
outstanding shares multiplied by the current market price) serves as the weight. Most
of the indices all over the world and in India, except the Economic Times Ordinary
Share Index, are weighted with the value. The scrip influences the index in
proportion to its importance in the market. The price changes that occur in the scrip
with substantial market capitalization dominate the changes that occur in the index.
The price changes caused by the bonus issue or rights issue of a scrip are reflected
in the index. With the bonus or rights issue, the number of outstanding shares and
their values are likely to change.
In an unweighted index, all stocks carry equal weights. The price or market
volume of the scrip does not affect the index. The movement of the price is based on
the percentage change in the average price of the stocks in the index. Here, the
assumption is that an equal amount of money is invested in each of the stocks in the
index. Value Line Average in the US is calculated without weights, and the geometric
mean, rather than the arithmetic mean, is used in its computation.
Base Year
The choice of base year also leads to variations among the indices. The base year is
different in different indices. The base year should be free of any unnatural
247
Fundamental
Analysis
fluctuations in the market. If the base year is close to the current year, the index
better reflects changes in the market movement. At the same time, when it is too
close, an investor cannot make historical comparisons.
The Sensex’s base year is 1978-79, and the next oldest one is the RBI Index of
Ordinary Shares, with 1980-81 as base year. Table 10.2 gives a summary of the
major stock market indices.
Table 10.2 Major Stock Market Indices
Indian indices Weighting basis No. of stocks Base Year
Economic Times Index of Ordinary Share Prices Unweighted 72 1984–85
BSE Sensex Market value 30 1978–79
BSE National Index Market value 100 1983–84
BSE–200 Market value 200 1989–90
Dollex Market value 200 1989–90
S & P Nifty (NSE–50) Market value 50 Nov 1995
S & P CNX Nifty Junior (NSE midcap) Market value 50 —
S & P CNX-500 Market value 500 1994
CNX Midcap-200 Market value 200 1994
CMIE Market value 72 June 1994
International indices
Dow Jones Industrial Average Price weighted 30 1928
Nikkei Dow Jones Average Price weighted 225 1949
S&P Composite Market value 500 1941–42
1. State the usefulness of stock market indices.

................................................................................................................
................................................................................................................
................................................................................................................
2. How does the number of stocks in an index influence its behaviour?

................................................................................................................
................................................................................................................
................................................................................................................
248
Fundamental
Analysis
10.5 MOVING AVERAGE
The market indices do not rise or fall in a straight line. The upward and downward
movements are interrupted by counter moves. The underlying trend can be studied
by smoothening the data. This is done by using the data moving average technique.
The word ‘moving’ here means that the body of data moves ahead to include
recent observations. If it is a five-day moving average, on the sixth day the body of
data moves to include the sixth day observation, eliminating the first day’s
observation, and so on. In the moving average calculation, the closing price of the
stock is used. Table 10.3 provides an illustration of a five-day moving average.
Table 10.3 Calculation of Five-day Moving Average for XXX Company Stock
Moving averages are used to study the movement of the market as well as the
individual scrip price. They show the underlying trend in the scrip. The period of the
average determines the period of the trend that is being identified. To identify a
short-term trend, 10–30 days moving averages are used. For the medium-term,
50–125 days averages are used, and for the long-term, 200-day moving averages
are used.
Index and stock price moving averages

Individual stock prices are compared with the stock market indices. The moving
average of the stock and the index are plotted on the same sheet and trends are
compared. If the NSE or BSE index lies above the stock’s moving average line, that
particular stock is seen as having a bullish trend. The price may go beyond the
market average. If the Sensex or Nifty is below the stock’s moving average, a
bearish market can be expected for that particular stock.
249
Fundamental
Analysis
If the moving average of the stock penetrates the stock market index from
above, it is a sell signal. Unfavourable market conditions prevail for the particular
scrip. If the stock line pushes up through the market average, it is a buy signal.
Stock price and moving averages

Buy and sell signals are provided by the moving averages. Moving averages are
used along with the price of the scrip. The stock price may intersect the moving
average at a particular point. Downward penetration of the rising average indicates
the possibility of a further fall. Hence a sell signal is generated as shown in Figure
10.2. Upward penetration of a falling average would indicate the possibility of the
further rise and indicates a buy signal. As the average indicates the underlying trend,
its violation may signal trend reversals, as shown in Figure 10.2.
Fig. 10.2 Moving Average and Stock Fig. 10.3 Moving Average and Stock
Prices – Buy Signal Prices – Sell Signal
Comparing two moving averages

When long-term and short-term moving averages are drawn, the intersection of the
two moving averages generates buy or sell signals. When the scrip price is falling and
the short-term average intersects the long-term moving average from above, it is a
signal to sell.
If the stock price is rising, and the short-term average intersects the long-term
average from below, it indicates a further rise in price. It gives a buy signal. Sell and
buy signals are shown in Figure 10.4 and Figure 10.5.
If the short-term average moves above the long-term average and the long-term
average falls, investor should treat an intersection with suspicion. The short-term
movement may not hold for long. Hence, the investor should wait for the long-term
250
Fundamental
Analysis
average to turn upwards before buying the scrip. Similarly, if the short-term average
moves below the long-term average before the long-term average has flattened out
or before it reverses its direction, the investor should wait for a fall in the long-term
average for a reversal of direction before moving out of the scrip.
Fig. 10.4 Moving Average and a Fig. 10.5 Moving Average and a
Buy Signal Sell Signal
Exponential Moving Average

An exponential moving average (EMA) is a weighted moving average. Recent prices
are given more weight than older prices. The concept behind this is that more recent
prices are considered more important than older prices. A 200-days long-term
simple average gives equal weightage to price data that are more than six months
old.
Calculation of the EMA is more complex than calculation of a simple moving
average. An EMA calculation first needs an exponent. The calculation of the
exponent is simple.
Where n = the number of days of the moving average. If it is 10 days, then the
exponent is as following
If 200-day EMA is calculated then
251
Fundamental
Analysis
The weight given for the shorter period is more than the weight given for the
longer period. The weighting declines by half when the moving average period
doubles.
EMA = (Current day’s close – Previous day EMA) × Exponent + Previous day
EMA
A rising exponential moving average indicates rising prices. A falling moving
average indicates declining trend. A rising long-term moving average shows a long-
term uptrend. A falling long-term moving average shows a long-term downtrend. Just
like the simple moving averages, they generate buy and sell signals. An illustration of
an exponential moving average is given in Figure 10.6.
Fig. 10.6 Exponential Moving Average
Average true range

J Welles Wilder developed the Average True Range (ATR) as an indicator that
measures volatility. Wilder’s book New Concepts in Technical Trading Systems
details the complete features of the ATR. The ATR is based on the value of true
range (TR). It is defined as the largest of the following:
x Current high price minus current low price
x Current high price minus the previous closing price (absolute value)
x Current low price minus the previous closing price (absolute value)
Absolute values are used so as to have positive numbers. Wilder was interested in
measuring the distance between two points, not the direction. The previous closing
price is used to measure the gap. Usually, the ATR is measured for 14 periods. It
252
Fundamental
Analysis
can be calculated for intraday, daily, weekly, or monthly periods. Wilder smoothened
the average using the following formula,
Indication of high ATR shows a high probability of trend changes. A low ATR
indicates low probability of trend changes. The following points should be noted
about ATR:
x The ATR indicator peaks before the market top and bottoms.
x A low ATR indicates the prevalence of a range in the market.
x The ATR peaks after a secondary rally.
x In the early stages of a fall, the ATR increases.
Figure 10.7 shows the ATR and TR.
Fig. 10.7 The Average True Range and True Range for Wipro
Oscillators
Oscillators indicate the market momentum or the scrips’ momentum. Oscillators
show the share price movement across a reference point from one extreme to
another. The momentum indicates:
253
Fundamental
Analysis
x Overbought and oversold conditions of the scrip or the market

x A possible trend reversal
x A rise or decline in the momentum
Generally, oscillators are analysed along with the price chart. They indicate trend
reversals that have to be confirmed with the price movement of the scrip. Changes
in the price should be correlated to changes in the momentum, only then buy and sell
signals can be generated. Actions have to be taken only when the price and
momentum agree with each other. Oscillators are built with the daily, weekly, or
monthly closing prices. For short-term trading, daily price oscillators are useful.
Moving average convergence and divergence (MACD)

Moving average convergence and divergence is the difference between two
exponential moving averages. It measures the convergence and divergence between
two exponential moving averages of varying periods. Short-term and long-term
exponential moving averages are calculated using the closing prices. The MACD
considers the difference between the short-term and long-term exponential moving
averages. Daily or weekly moving averages are also calculated. The 12-day and 26-
day exponential averages and 12-days and 48-days exponential moving averages
are common among traders.
The MACD is the short-term exponential moving average (SEMA) minus the
long-term exponential moving average (LEMA). If the value of SEMA is more than
that of LEMA, the MACD is positive and vice versa. If both values are equal, the
MACD will be zero.
MACD Line = 12-day EMA – 26-day EMA
Convergence takes place when moving averages move towards each other.
Divergence occurs when the shorter and longer moving averages move away from
each other. Usually, changes that occur in MACD are due to changes in the short-
term moving. Further, the SEMA changes faster than the LEMA (longer exponential
moving average). The longer moving average (26-day) is slow and less reactive to
price changes in the underlying stock or index.
x The zero contour is the centre line and MACD line oscillates above and
below this line.
x When the MACD crosses over the zero line, it shows that the SEMA has
crossed the LEMA.
254
Fundamental
Analysis
x The direction of the moving average crossover of the zero line shows the
direction of the price movement.
x The positive value of the MACD indicates that the SEMA is above the
LEMA and the rising price trend.
x The negative MACD values show that the SEMA is below the LEMA and
a declining trend.
MACD signal line: The signal line is a trigger line that signals buy or sell strategy.
When the MACD penetrates the signal line from below and moves above, it gives a
buy signal. Likewise, when it falls below the MACD signal line, it indicates a bearish
market.
Signal Line = 9-day EMA of MACD line.
x When the MACD crosses the signal line from below, it is a bullish
crossover.
x When the MACD crosses the signal line from above, it is a bearish
crossover.
x Depending on the strength of the movement, the crossovers may be for a
few days or a few weeks.
MACD histogram: The MACD-histogram is the difference between the MACD
value and the signal line (EMA) value. The changes in the MACD histogram occur
before changes occur in MACD. It shows trend changes earlier than the MACD
signal line. Sometimes, it may cause more false signals. Technical charts usually give
the MACD histogram along with the MACD indicator. The MACD histogram helps
to identify the centre line crossovers and divergences without difficulty.
MACD histogram = MACD line – Signal line
The following points about the MACD histogram should be noted:
x The MACD-histogram crosses the zero line when MACD crosses the
signal line (EMA).
x The value on the MACD-histogram is positive when the value of MACD is
greater than the value of the signal line.
x The value on the MACD-histogram is negative if the value of MACD is
less than the signal line value.
x When the MACD histogram is above the zero line, it is a buy signal.
255
Fundamental
Analysis
x When MACD histogram intersects the zero line downwards with negative
values, it is a sell signal.
Figure 10.8 shows the MACD, MACD signal line, MACD histogram and the
signals.
Fig. 10.8 MACD – Nifty
Relative strength index (RSI)

RSI was developed by Wells Wilder. It is an oscillator used to identify the inherent
technical strength and weakness of a particular scrip or market. RSI can be
calculated for a scrip by adopting the following formula,
The RSI can be calculated for any number of days depending on the wish of the
technical analyst and the time frame of trading adopted in a particular stock market.
RSI is calculated for 5, 7, 9 and 14 days. If the period considered is longer, the
256
Fundamental
Analysis
possibility of getting the wrong signals is reduced. Reactionary or sustained rise or

fall in the price of the scrip is foretold by the RSI.
Table 10.4 Calculation of 9-day RSI for XXX Company
The broad rule is, if the RSI crosses 70 there may be a downturn and it is time
to sell. If the RSI falls below 30, it is time to pick up the scrip. Figure 10.9 shows
buy and sell signals of an RSI chart.
Fig. 10.9 RSI Chart
If the share price is falling and RSI is rising, a divergence is said to have
occurred. Divergence indicates the turning point of the market. If the RSI is rising in
the overbought zone, it indicates a fall in prices. If RSI falls in the overbought zone,
it gives a clear sell signal. The term ‘overbought’ describes the price level at which
momentum can no longer be maintained, and the price has to go down. This
condition occurs after a sharp rise in price during a period of heavy buying. When
the RSI is in the oversold region, it generates a buy signal. The term ‘oversold’ is
used to describe a security or market that has declined to an unreasonably low level.
This condition is characterized by an increase in sales and excess of net declines.
257
Fundamental
Analysis
1. What is the purpose of data moving average technique?

................................................................................................................
................................................................................................................
................................................................................................................
2. What is ‘moving average convergence and divergence’ (MACD)?

................................................................................................................
................................................................................................................
................................................................................................................
10.6 SUMMARY
x In the disciplines of accounting and finance, Fundamental analysis refers to

the analysis of a business’ financial statements (generally their analysis for
the purpose of assets, liabilities, and earnings of the business). It also
encompasses the health of the business, its markets and its competitors.
x While using fundamental analysis to analyse currency, future contracts or a
stock, two different approaches can be adopted. These are bottom up
analysis and top down analysis. The terms are used to distinguish such
analysis from other types of investment analysis, like technical and
quantitative.
x As opined by fundamental analysis, a security might be mispriced by the
markets in the short run but eventually price correction will certainly
happen. It is possible to make profits through purchasing of mispriced
security and then waiting till the market sees the ‘mistake’ and the security
is re-priced.
x It is maintained by technical analysis that the price of the security already
reflects all information. Trends are analysed by technical analysts and this
form of analysis is of the opinion that sentiment changes predate and
predict trend changes.
x For the purpose of stock picking, it is alright if investors employ both the
methods .To take an example, majority of the fundamental investors make
258
Fundamental
Analysis
use of technicals to determine points of entry and exit. In the same way,
there are technical investors who make use of fundamentals to limit their
universe of possible stock to ‘good’ companies.
x Fundamental analysis comprises company analysis, economic analysis and
industry analysis. On the basis of these three analyses, the shares’ intrinsic
value is ascertained. It is this value which is taken to be the share’s true
value.
x The person analysing the health of a business begins with the analysis of the
business’ financial statement which will also comprise financial ratios. Study
is done of capital financing new equity issues operating cash flow and
dividends paid.
x Determined growth rates (of income and cash) and risk levels (for
determining the discount rate) are employed with various models of
valuation. The most important of these models is the discounted cash flow
model used for calculating the current value of the future
Dividends received by the investor, along with the eventual sale price
(Gordon model).
x The process of fundamental analysis has significantly declined over the past
decade or so. It is extremely time consuming to perform fundamental
analysis and the new, quick paced style of trading being used in the 21st
century, with markets dominated by day traders and HFT firms, such an
analysis does not help in keeping pace with the market.
x An obvious but not a tangible incentive found in fundamental analysis is the
development of a thorough understanding of the business.
x An indicator indicates the nature of market trends. A technical indicator is a
set of data points obtained by applying a formula to the price data of a
stock or index. Price data consists of open, high, low or close prices over
a period. Some indicators use only the closing prices, while others may use
high and low prices.
x Technical indicators are used to find out the overall direction of the market.
The overall market movements affect individual share prices.
x Aggregate forecasting is considered to be more reliable than individual
forecasting.
259
Fundamental
Analysis
x The ‘breadth of the market’ is a term often used to refer to the advances
and declines that occur in the stock market. Advances refer to the number
of shares whose prices have increased from the previous day’s trading.
Declines indicate the number of shares whose prices have fallen from the
previous day’s trading.
x Short selling is a technical indicator known as short interest.
x A stock market index may either be a price index or a wealth index.
x The number of stocks in an index influences the behaviour of the index. If
the number is high, it is a representative sample capable of reflecting the
market movement.
x The market indices do not rise or fall in a straight line. The upward and
downward movements are interrupted by counter moves. The underlying
trends can be studied by smoothening the data. This is done by using the
data moving average technique.
x Moving average convergence and divergence is the difference between two
exponential moving averages. It measures the convergence and divergence
between two exponential moving averages of varying periods.
10.7 KEY WORDS
x Trend: It refers to the direction of movement. The share prices can either
increase, fall or remain flat.
x Short sales: It refers to the selling of shares that are not owned.
x Base year: It refers to the year used for comparison for the level of a
particular economic index.

1. Fundamental analysis refers to the analysis of a business’ financial
statements (generally their analysis for the purpose of assets, liabilities, and
earnings of the business).
2. Fundamental analysis comprises of company analysis, economic analysis
and industry analysis.
260
Fundamental
Analysis

1. A technical indicator is a set of data points obtained by applying a formula
to the price data of a stock or index.
2. The breadth of the market is a term often used to refer to the advances and
declines that occur in the stock market.
3. Short selling is a technical indicator known as short interest. The term ‘short
sales’ refers to the selling of shares that are not owned.

1. Stock market indices help to recognize the broad trends in the market and
can be used as a benchmark for evaluating the investor’s portfolio.
2. If the number of stocks in an index is high, it is a representative sample
capable of reflecting the market movement.

1. The market indices do not rise or fall in a straight line. The upward and
downward movements are interrupted by counter moves. The underlying
trend can be studied by smoothening the data. This is done by using the
data moving average technique.
2. Moving average convergence and divergence is the difference between two
exponential moving averages. It measures the convergence and divergence
between two exponential moving averages of varying periods.
1. Define fundamental analysis. What are the strengths and weaknesses of

fundamental analysis?
2. What do you understand by an indicator?
3. Write a brief note on short sales.
4. Explain ‘moving average convergence and divergence’ in detail.

McGraw-Hill.
261
Fundamental
Analysis

262
Technical Analysis
UNIT–11 TECHNICAL ANALYSIS
Objectives
x Explain the assumptions of technical analysis
x Analyse different kinds of charts of technical analysis
x Compare technical and fundamental analysis
Structure
11.1 Introduction
11.2 Technical Analysis: An Introduction
11.3 Candlestick Chart
11.4 Summary
11.5 Key Words
11.1 INTRODUCTION
The share price movement is analysed broadly with two approaches, namely,
fundamental approach and the technical approach. Fundamental approach analyses
the share prices on the basis of economic, industry and company statistics. If the
price of the share is lower than its intrinsic value, investor buys it. But, if he finds the
price of the share higher than the intrinsic value he sells and gets profit. The technical
analyst mainly studies the stock price movement of the security market. If there is an
uptrend in the price movement investor may purchase the scrip. With the onset of fall
in price he may sell it and move from the scrip. Basically, technical analysts and the
fundamental analysts aim at good return on investment.
11.2 TECHNICAL ANALYSIS: AN INTRODUCTION
Technical Analysis is a process of identifying trend reversals at an early stage to

formulate the buying and selling strategies. Using several indicators, an investor
analyses the relationship between price–volume and supply–demand for the overall
market, as well as for the individual stock. During an upswing, the number of shares
263
Technical Analysis
traded is greater than before, and in a downswing, the number of shares traded
dwindles. If it is the other way around, trend reversals can be expected.
Assumptions
Technical analysis has the following assumptions:
x Interactions of supply and demand determine the market value of the scrip.
The market discounts everything. The price of the security quoted
represents the hopes, fears and inside information of the market players.
Inside information on the issue of bonus shares and right issues may
support the prices. The loss of earnings and information regarding
forthcoming labour problems may result in a fall in prices. These factors
may cause a shift in demand and supply, changing the direction of trends.
x The market always moves in a trend. Except for minor deviations, the stock
prices move in trends. The price may create definite patterns too. The trend
may be either increasing or decreasing. It continues for some time and then
reverses.
x It is said that history repeats itself and this is also true of the stock market. In
a rising market, the investors’ psychology is positive and they purchase shares
in greater volumes, driving the prices higher. In a downtrend, they may be
especially keen to get out of the market by selling the shares, thus plunging
share prices. Technical analysts believe that past prices predict the future.
History of Technical Analysis

The doctrine outlined by Charles H. Dow in 1884, in the Wall Street Journal, is the
basis for technical analysis. He wrote a series of articles in the journal. A. J. Nelson,
a close friend of Dow, formalized the Dow theory for economic forecasting. The
analysts used charts of individual stocks and moving averages in the early 1920s.
Later, with the advent of calculators and computers, sophisticated techniques came
into vogue.
Technical Tools
The most common technical tools used are Dow theory, volume of trading, short
selling, bar and candlestick charts, indicators and oscillators. This section analyses
some of these tools.
264
Technical Analysis
Dow theory
Dow developed his theory to explain the movement of the indices of Dow Jones
Averages. He developed it on the basis of certain hypotheses. The first hypothesis
was that no single individual or buyer can influence the market’s primary trend.
However, an individual investor can affect the daily price movements by buying or
selling large quantities of a scrip. The intermediate price movement can also be
affected to a lesser degree by an investor.
Dow’s second hypothesis was that the market discounts everything. Even
natural calamities such as an earthquake, plague or fire get quickly discounted in the
market. The global financial crisis of 2008 affected the share market for a while
before it returned to normalcy.
Dow’s third hypothesis was that the theory is not infallible. It is not a tool to beat
the market but provides a way to understand it better.
The Theory
The Dow theory sees a trend as primary, intermediate and short-term. The primary
trend may be a broad upwards or downwards movement that may last for a year or
two. The intermediate trends are corrective movements, which may last from three
weeks to three months. The primary trend may be interrupted by the intermediate
trend. The short-term trend refers to the day-to-day price movements. It refers to
the oscillations or fluctuations. These three types of trends can be compared to the
tide, waves and ripples in the sea.
Trend
Trend refers to the direction of movement. The share prices can either increase, fall
or remain flat. The three directions of share price movements are referred to as
rising, falling and flat trends. The point to be remembered is that share prices do not
rise or fall in a straight line. Every rise or fall in price is accompanied by a counter
move. If a share price is increasing, the counter move will be a fall in price and vice
versa. Share prices move in a zigzag manner.
Trend lines are straight lines drawn connecting either the tops or bottoms of the
share price movements. The technical analyst should have at least two tops or
bottoms to draw a trend line. Figure 11.1 shows trend lines.
265
Technical Analysis
Fig. 11.1 Trend Lines
Trend Reversal
The rise or fall in share prices cannot go on forever. The share price movement may
reverse its direction. Before the change of direction, certain patterns in price
movements emerge. Violation of the trend line shows the change in the direction of
the trend. Violation of the trend line means the penetration of the trend line by the
scrip’s price. If a scrip price cuts the rising trend line from above, it is a violation of
the trend line and signals the possibility of a fall in price. Likewise, if the scrip pierces
the trend line from below, it signals a rise in prices.
Primary Trend
The security price trend may be either increasing or decreasing. When the market
exhibits an increasing trend, it is referred to a bull market. The bull market shows
three clear-cut peaks. Each peak is higher than the previous one. The bottoms are
also higher than the previous bottoms. The reactions following the peak usually halt
before the previous bottoms. The phases leading to the three peaks are revival,
improvement in corporate profits, and speculation. The revival period encourages
more investors to buy scrips as their expectations about the future are high. In the
second phase, increased corporate profits result in a further price rise. In the third
phase, prices advance due to inflation and speculation. Figure 11.2 illustrates the
three phases of a bull market.
The reverse is true with the bear market. Here, the first phase of fall starts with
the abandonment of hope. The chances of prices moving back to the previous high
level appear to be low. This results in the sale of shares. In the second phase,
companies report lower profits and dividends. This leads to selling pressure. The
266
Technical Analysis
final phase is characterized by the distress sale of shares. During the bear phase in
the Bombay Stock Exchange, more than two-thirds of the stocks were inactive.
Most of the scrips were sold below their par values. Figure 11.2 illustrates the three
phases of a bear market. Here, the tops and bottoms are lower than the previous
ones. The bull and bear phases of the Indian stock market are given in Figure 11.2
and 11.3.
Fig. 11.2 Phases of a Bull Market
Fig. 11.3 Phases of a Bear Market
Secondary Trend
The secondary or intermediate trend moves against the main trend and leads to
correction. In a bull market, the secondary trend can result in the fall of about
267
Technical Analysis
33–66 per cent of the earlier rise. In a bear market, the secondary trend carries the
price upwards and corrects the main trend. The correction would be 33–66 per cent
of the earlier fall. The intermediate trend corrects the overbought and oversold
positions. It provides breathing space to the market. Compared to the time taken for
the primary trend, secondary trend is swift and quicker. Figure 11.4 shows the
secondary movement.
Fig. 11.4 Secondary Corrections
Fig. 11.5 Bull and Bear Markets—Sensex
268
Technical Analysis
Minor Trends
Minor trends or tertiary moves are the random wriggles that occur in price
movements. They are simply the daily fluctuations. Minor trends try to correct the
secondary trend movements. It is better for investors to concentrate on the primary
or secondary trends rather than on the minor trends. The chartist plots the scrip’s
price or the market index each day to trace the primary and secondary trends.
Support and Resistance Levels

Support and resistance levels are an integral part of technical analysis. A support
level exists at a price where considerable demand for that stock is expected to
prevent a further fall in the price level. The fall in the price may be halted for the time
being, or it may even result in a price reversal. In the support level, demand for the
scrip is expected to remain.
In the resistance level, the supply of scrip is greater than the demand and a
further rise in price is prevented. The selling pressure is greater, and the increase in
price is halted for the time being.
Support and resistance usually occur whenever the turnover of a large number of
shares tends to be concentrated at several price levels. When the stock touches a
certain level and then drops, this is called resistance, and if the stock goes down to
a certain level and then rises, there exists a support. The levels constantly switch
from one to the other, i.e., from support to resistance or from resistance to support.
Figures 11.6 (a) and 11.6 (b) show the support and resistance levels.
This can be explained numerically. For example, if a scrip price hovers around
`150 for some weeks, then it may rise and reach `210. At this point, the price halts
and then falls back. The scrip keeps on falling back to around its original price of
`150 and halts. Then it moves upwards. In this case, `150 becomes the support
level. At this point, the scrip is cheap, and investors buy it. Demand makes the price
move upwards. The price `210 becomes the resistance level, and selling pressure
results in a price decline.
269
Technical Analysis
Fig. 11.6 (a) Support Level Fig. 11.6 (b) Resistance Level
If the scrip price reverses the support level and moves downward, it means that
the selling pressure has overcome the potential buying pressure, signalling the
possibility of a further fall in the value of the scrip. It indicates the violation of the
support level and a bearish market.
If the scrip penetrates the previous top and moves above, it is a violation of the
resistance level. At this point, the buying pressure would be more than the selling
pressure. If the scrip moves above the double top or triple top formation, it indicates
a bullish market. The support and resistance levels need not be formed only on tops
or bottoms. They can be on the trend lines or gaps of the chart.
GAPS
Gaps are those points or price levels where the scrip has not changed hands. They
are formed in a rising or falling price level. If the prices are moving upwards and the
270
Technical Analysis
high of any day is lower than the next day’s low, a gap is said to have occurred. For
example, if the high price of Instant company’s scrip on 1 March is `200 and on 2
March, the low is `225, a gap occurs on the bar chart. This indicates that the stock
has not been traded between the levels `200 and `225. This gap indicates a further
rise in the price level. Likewise, in a falling price, a gap is formed if the low price on
day 1 is higher than the high price of day 2. Suppose the low price on Monday is
`150 and the high price on Tuesday is `130, a gap is said to have occurred.
It indicates that there was no transaction between the level of `150 and `130.
Figure 11.7 gives an illustration of such gaps.
Fig. 11.7 A Bull and Bear Gap: Cipla Ltd
Charts
Charts are a valuable and easiest of tools used in technical analysis. The graphic
presentation of data helps the investor to find out the trend of prices without any
difficulty. Charts also have the following uses:
x Help to spot current trends for buying and selling
x Indicate the probable future action of the market by projection
x Show historical movements
x Indicate the key areas of support and resistance
The charts do not lie but interpretation differs from analyst to analyst according to
one’s skills and experience. Leading analyst James Dines has said, ‘Charts are like
271
Technical Analysis
fire or electricity. They are brilliant tools if intelligently controlled and handled, but
dangerous to a novice.’
Point and Figure Charts

To predict the extent and direction of price movements of a stock or the stock market
indices, technical analysts use point and figure (PF) charts. These charts are one-
dimensional without any indication of time or volume. They show price changes in
relation to previous prices. The change in the direction of prices can be interpreted.
The charts are drawn on ruled paper. Figure 11.8 (a) shows the PF chart.
Fig. 11.8 (a) A Point and Figure Chart
The prices are given to the left of the figure as shown. The numbers represent the
price of the stock at two-point intervals. The interval of price changes can be
1,2,3,5 or 10 points. It depends on the analyst’s preference. Further, it depends
upon the stock price movement. Higher points are chosen for high-priced stocks
and vice versa. Only whole number prices are entered. In Figure 11.8 (a), the initial
price of 53 is entered in column 1 as X. The next mark X is made only if the stock
moves up to 55. As long as the price moves up, the Xs are drawn in the vertical
column. Here, the stock price has moved to 57. When the stock price declines by
two points or more, the chartist records the change by placing ‘0’ in the next
column. Then the movements are interpreted. The trend reversals can be spotted
easily. Figure 11.8 (b) shows the trend reversals in a point and figure chart.
Fig. 11.8(b) Trend Reversals in a Point and Figure Chart

272
Technical Analysis
As long as the price moves between points A and B, there is little indication of a
price rise. As the price penetrates the resistance level, it generates a buy signal. The
market may turn out to be bullish. Likewise, when the price pierces down the
support level C, it indicates that the stock should be sold, and the market may turn
bearish.
In spite of the simplicity in drawing PF charts, they have some inherent
disadvantages as listed below:
x They do not show the intra-day price movements.
x Only whole numbers are taken into consideration, which may result in loss
of information regarding minor fluctuations.
x Volumes are not mentioned in the chart. Both the volume and trend of
transactions are valuable guides to making investment decisions. In a bull
market, a price rise is accompanied by a high volume of trading. A bear
market is related to low volume of trading.
Bar Charts
The bar chart is the simplest and most commonly used tool of a technical analyst. To
build a bar, a dot is entered to represent the highest price at which the stock is
traded on that day, week or month. Then another dot is entered to indicate the
lowest price on that date. A line is drawn to connect these points. A horizontal nub
is drawn to mark the closing price. Line charts are used to show price movements.
The line chart is a simplification of the bar chart. Here, a line is drawn to connect the
successive closing prices.
Chart Patterns
Charts reveal certain patterns that are of predictive value. They are used as a
supplement to other information and as confirmation of signals provided by trend
lines. Some of the most widely used and easily recognizable chart patterns are
discussed here.
‘V’ formation
As the name indicates, in the ‘V’ formation, there is a long sharp decline and a fast
reversal. The ‘V’ pattern occurs mostly in popular stocks where the market interest
changes quickly from hope to fear and vice versa. In the case of an inverted ‘V’, first
the rise occurs and then the decline. There can also be extended ‘V’s. In it, the bottom
or top moves more slowly over a broader area. This is shown in Figure 11.9 (a).
273
Technical Analysis
Fig. 11.9 (a) A Chart with ‘V’ Formation
Fig. 11.9 (b) DLF Ltd – ‘V’ Shaped Reversal
Tops and bottoms

Top and bottom formation is fascinating to watch but what is more important is the
middle portion of it. The investor should buy after the upward trend has started and
exit before the top is reached. Tops and bottoms are formed at the beginning or end
of the new trends. The reversal from the tops and bottoms indicate sell and buy
signals.
Double top and bottom

This formation signals the end of one trend and the beginning of another. The double
top is formed when a stock price rises to a certain level, falls rapidly, rises again to
the same height or more, and turns down. Its pattern resembles the letter ‘M’. The
double top may indicate the onset of the bear market. The results should be
confirmed with share volumes and trends.
In a double bottom, the price of the stock falls to a certain level and increases
with diminishing activity. Then it falls again to the same or to a lower price and then
274
Technical Analysis
goes up to a higher level. The double bottom resembles the letter ‘W’. Technical
analysts view double bottom as a sign of a bull market. The double top formations
are shown in Figure 11.10 and the double bottom formations in Figure 11.11.
Fig. 11.10 (a) A Double Top Formation
Fig. 11.10 (b) Double Top – Exide Industries
Fig. 11.11(a) A Double Bottom Formation

275
Technical Analysis
Fig. 11.11 (b) Double Bottom – Bharti Telecom
Head and shoulders

This pattern is easy to identify and the signal generated by it is considered to be
reliable. In the head-and-shoulder pattern, there are three rallies resembling the left
shoulder, a head and a right shoulder. A neckline is drawn connecting the lows of the
tops. When the stock price cuts the neckline from above, it signals a bear market.
The upward movement of the price for some duration creates the left shoulder. At
the top of the left shoulder, people who bought during the upward trend begin to sell,
resulting in a dip. Near the bottom, there will be reaction and people who have not
bought in the first upward trend start buying at relatively low prices thus pushing the
price upwards. The alternating forces of demand and supply create new ups and
lows. This is shown in Figure 11.12.
Fig. 11.12 (a) A Heads and Shoulders Formation
276
Technical Analysis
Fig. 11.12 (b) Heads and Shoulders – Infosys Tech
Inverted head and shoulders

Here, the reverse of the previous pattern holds true. The price of stock falls and
rises, which make an inverted right shoulder. As the fall and rise in price continues,
the head and left shoulders are created. Connecting the tops of the inverted head
and shoulders gives the neckline. When the price pierces the neckline from below, it
indicates the end of a bear market and the beginning of a bull market. These patterns
have to be confirmed with the volume and trend of the market. This is illustrated in
Figure 11.13.
Fig. 11.13 (a) An Inverted Head and Shoulders Formation
277
Technical Analysis
Fig. 11.13 (b) Inverted Head and Shoulders – Bank of India
Rounding bottom
Rounding bottom formations give a bullish signal and indicate a possible reversal of
the downwards trend. They are normally elongated and U-shaped. Sometimes they
are called rounding turns, bowls or saucers. In order to show the trend reversal:
x The bottom low has to be a new low
x The low should not be too sharp and take a few weeks to form
x The decline and the rise should take more or less equal period
x The break out has to be higher than the beginning of the decline
x Volumes are high at the beginning of the decline, low at the end of the
decline, and increase during the advance
Figure 11.14 shows the formation of a rounding bottom.
Fig. 11.14 A Rounding Bottom Formation

278
Technical Analysis
Cup and handle

A cup and handle pattern marks the beginning of a bullish trend. In this pattern, the
upward trend pauses for a while and continues after confirmation of the pattern.
Figure 11.15 shows this pattern.
Fig. 11.15 Cup and Handle Formation: Spice Jet
This price pattern resembles a cup, and is followed by an upward trend. The
downwards or sideways movement of stock price forms a pattern like a handle.
When the price movement pierces the resistance lines in the handle, the upward
trend continues. The formation of the cup and handle pattern takes several months
or even a year or more.
Triangles
The triangle formation is easy to identify and popular in technical analysis. Triangles
can be symmetrical, ascending, descending, and inverted.
Fig. 11.16 (a) A Symmetrical Triangle Formation

279
Technical Analysis
Symmetrical triangle: This pattern is made up of a series of fluctuations, each of

which is smaller than the previous one. Tops do not attain the height of previous tops.
Likewise, bottoms are higher than the previous bottoms. Connecting the lower tops
that are slanting downwards gives a symmetrical triangle. Connecting the rising
bottoms, which is slanting upwards, becomes the lower trend line. It is not easy to
predict the breakaway either way. The symmetrical triangle does not have any bias
towards either bull or bear operators. It indicates the slowdown or temporary halt in
the direction of the original trend. There is always a chance that the original trend will
continue after the completion of the triangle. This is shown in Figures 11.16 (a) and (b).
Fig. 11.16 (b) Symmetrical Triangle: Cairn India
Ascending triangle: Here the upper trend line is almost a horizontal trend line
connecting the tops and the lower trend line is a rising trend line connecting the rising
bottoms. When the demand for the scrip exceeds the supply of it, there is a
breakout. The break will be in favour of a bullish trend. This pattern is spotted
during an upward move, and the probability of an upward move is high here. This is
shown in Figure 11.17.
Fig. 11.17 (a) An Ascending Triangle Formation

280
Technical Analysis
Fig. 11.17 (b) Ascending Triangle: Power Grid
Descending triangle: Here, the lower tops forms the upper trend line, which is a
falling one. The lower trend line would be almost horizontal connecting the bottoms.
It indicates the support level. The possibility of a downward breakout is high in this
pattern. The pattern indicates that the bear operators are more powerful than the bull
operators. This pattern is seen during a downtrend (Figure 11.18).
Fig. 11.18 (a) A Descending Triangle Formation
281
Technical Analysis
Fig. 11.18 (b) Descending Triangle: Axis Bank
Flags: A flag pattern is commonly seen on price charts. These patterns emerge
either before a fall or a rise in the value of the scrips. These patterns show the
market corrections of an over-bought or over-sold situation. These patterns form
quickly. Each rally and setback may last only three to four days. If the pattern is
wider, it may take three weeks to become complete.
Fig. 11.19(a) An Up Flag Formation Fig. 11.19(b) A Down Flag Formation
A flag resembles a parallelogram. A bullish flag is formed by two trend lines that
stoop downwards. A breakout would occur on the upper side of the trend line. In a
bearish flag, both the trend lines would be stooping upwards. The breakout occurs
in the downward trend line (Figure 11.19).
Pennant: A pennant looks like a symmetrical triangle. There can be bullish as well
as bearish pennants. In a bullish pennant, the lower tops form the upper trend line.
The lower trend line connects the rising bottoms. The bullish trend occurs when the
value of scrip moves above the upward trend line. Likewise, in the bearish pennant,
the upward trend line is a falling one and the lower trend line, a rising one
(Figure 11.20).
282
Technical Analysis
Fig. 11.20 (a) An Upward Pennant Formation Fig. 11.20 (b) A Downward Pennant Formation
1. What is technical analysis?

................................................................................................................
................................................................................................................
................................................................................................................
2. What is the role of an investor?

................................................................................................................
................................................................................................................
................................................................................................................
3. Define trends.
................................................................................................................
................................................................................................................
................................................................................................................
11.3 CANDLESTICK CHART
According to records, the candlestick chart is the oldest of price prediction charts.
In the 1700s, people used candlesticks to forecast rice prices. During this era in
Japan, use of candlestick charts helped Munehisa Homma, a rice merchant from
Sakata, make a fortune and become a prominent rice trader. The application of
candlesticks helped him execute more than 100 consecutive winning trades. To
283
Technical Analysis
create a candlestick chart, one needs four elements, namely, open, high, low and
closing prices for a given period. This is explained as follows:
When the candle body is white, it indicates the closing price is higher than the
opening price, and shows a bullish trend. A black body indicates that the closing
price is lower than the open price and shows a bearish trend. Figure 11.21 shows
the candlestick chart for NSE.
Fig. 11.21 Candlestick Chart for NSE – Nifty
Figure 11.21 shows different kinds of candlesticks with long and short shadows.
Some of them are explained below.
Kinds of Candlestick
x A white or black candlestick with a small body indicates not much price
movement and consolidation of stock price.
284
Technical Analysis
x A long white body in a candle shows that the closing price is higher than the
opening price, and a bullish trend. A long black body in a candle shows
that the closing price is lower than the opening price, and a bearish trend.
x A white candlestick with a long body and without shadow is a called a

‘White Marubozu’. This shows that the opening price is equal to the low
price, and the closing price is equal to the high price, and that there is
buying pressure in the market. It may lead to a bullish trend. A black
candlestick with a long body and without a shadow is a ‘Black Marubozu’.
This shows that the opening price is equal to the high price, and the closing
price is equal to the low price, and there is selling pressure in the market. It
may lead to a bearish trend.
x Spinning tops are candlesticks with a small real body and a long upper and
lower shadow. It represents indecision of the traders. The white or black
small real body shows little price movement from open to close. The long
shadows at both the ends indicate that both bulls and bears were active
during the trading session. If it appears after a long advance or long
white candlestick, it shows weak bulls and a probable change in trend.
Likewise, if it appears after a long decline or long black candlestick, it
indicates weak bears and a probable change in trend.
285
Technical Analysis
x The candlestick with a long lower shadow, small body, and no or very little
upper shadow is a hammer. The lower shadow must be at least twice the
length of the real body. This candlestick pattern must happen in the context
of a downtrend. This shows that the market is ‘hammering’ out a bottom.
Hammers at the bottom signal a bullish revival. A similar candlestick with a
black body is a hanging man. The hanging man indicates a bearish reversal
pattern that can occur at the top or resistant level. It signals that selling
pressure is beginning to increase. These patterns require confirmation.
Confirmation may be a downward gap or long black candlestick with
heavy volume.
x The inverted hammer, after a decline or downtrend, indicates a potential

trend reversal or support levels. After a decline, the long upper shadow
shows buying pressure during the trading session. An inverted hammer
followed by a bullish gap or long white candlestick with heavy volume gives
bullish confirmation. The formation of shooting star after an advance
indicates a bearish reversal pattern or resistance level. A downward gap or
long black candlestick with heavy volume gives a confirmation for bearish
trend.
286
Technical Analysis
x Doji appears when the closing price and opening price are equal to one
another. Dojies are neutral patterns and indications and are based on
preceding price and future confirmation. Doji is used both for the singular
and plural. Doji with a long upper shadow and short lower shadow signals
bearish trend, if it occurs in a bull market. Doji with a short upper and long
lower shadows signals bullish trend, if it appears in a bearish market.
x Dragonfly doji is a candlestick with a long, lower shadow, and no upper

shadow. It looks like a ‘T’. Dragonfly doji indicates trend reversals. If it
occurs after a long downtrend, a long black candlestick, or at the support
level, a dragonfly doji signals a potential bullish reversal. A gravestone doji
is a candlestick with open, low, and close prices equal and a long upper
shadow. If it appears after a long downtrend, a long black candlestick, or
at support, it shows a potential bullish reversal. When it occurs after a long
uptrend, long white candlestick or at resistance, it indicates a bearish
reversal.
287
Technical Analysis
x In harami position, a candlestick forms within the real body of the previous
candlestick. The Japanese meaning of harami is pregnant, and the second
candlestick is located inside the first. The first candlestick has a large real
body, and the second candlestick has a smaller real body than the first. Doji
and spinning tops, which have small real bodies, form harami. A white
candle followed by a black candle in the harami position indicates a bearish
market. A black candle followed by a white candle in the harami position
indicates a bullish trend.
x In star position, a candlestick forms a gap away from the previous

candlestick. The star position may be up or down. It appears separated
from the previous price action. As depicted, a candlestick in the star
position has a small real body and the first candle has a big real body. The
star position may occur in any combination of two white and black
candlesticks. Doji, hammers, shooting stars, and spinning tops, which have
small real bodies, form the star position. A white candle followed by a
black candle in the star position indicates a bearish market. A black candle
followed by a white candle in the star indicates a bullish trend.
Elliott Wave Theory

It was Ralph Nelson Elliott who gave the Elliott Wave theory in the late 1920s. He
discovered that even though stock behaves in a somewhat chaotic manner, trades
288
Technical Analysis
happen in repetitive cycles. His theory resembles the Dow theory, which says that
stock prices move in waves.
Fig. 11.22 (a) Elliott wave
Elliott discovered that the upward and downward swings in the market
always showed up in the same repetitive patterns. These patterns are divided and
termed as ‘waves’. The unique characteristics of the Elliott patterns are that they
consist of five waves indicating the main trend and three corrective waves. In
financial markets, every action creates an equal and opposite reaction. A 5–3 waves
complete a cycle. Five waves are within an impulsive wave. An impulsive wave
moves along with a main trend. According to the Elliott wave theory, a 5–3 pattern
remains constant, but the time span of each wave may differ. Figure 11.22 shows the
waves.
Fig. 11.22 (b) Elliott Wave Pattern

289
Technical Analysis
Figure 11.22 (a) shows five up (1–5) and three down waves (A–C). The waves
1, 3, and 5 are impulsive waves. They are in the direction of the trend. Waves 2, 4,
and – B are corrective waves. As A and C move along the trend, they are impulsive
waves.
Figure 11.22 (b) gives a detailed breakup of the Elliott wave. Wave 2 consists
of five short waves, i.e., three in the main direction and two in the correction mode.
Correction wave 4 consists of three sub-waves. Thus, Figure 11.22 shows trends
and counter-trends. The example given above is for a bullish market. For a bear
market, a downward trend of the same pattern can be shown. The theory divides
the wave into different categories such as:
x Grand super cycle x Super cycle
x Cycle x Primary
x Intermediate x Minor
x Minute x Minuette
x Sub-minuette
Figure 11.23 shows the Elliott wave pattern in the NSE-Nifty.
Fig. 11.23 Elliott Wave in the NSE-Nifty
Technical analysis vs fundamental analysis

The comparison between a technical analysis and a fundamental analysis can be
presented as follows:
x Fundamental analysts analyse the stock based on the goals of the investors.
They study the financial strength of corporation, growth of sales, earnings
290
Technical Analysis
and profitability. They also take into account the general industrial and
economic conditions. The technical analysts mainly focus attention on the
history of prices. Technical analysts choose to study two basic market
data–price and volume.
x Fundamental analysts estimate the intrinsic value of the shares and purchase
them when they are undervalued. They dispose of the shares when they are
overpriced and earn profits. They try to find out the long-term value of
shares. Compared to fundamental analysts, technical analysts mainly
predict the short-term price movements rather than long-term movements.
They are not committed to a buy-and-hold policy.
x Fundamentalists are of the opinion that supply and demand for stock
depend on underlying factors. The forecasts of supply and demand depend
on various factors. Analysts opine that they can forecast supply and
demand by studying the prices and volume of trading.
In both approaches, supply and demand factors are considered to be critical.
Business, economic, social, and political factors affect the supply and demand for
securities. These underlying factors in the form of supply and demand come together
in the securities’ market to determine security prices.
Excel Spreadsheet and Bar Charts

The required data are available at www.nseindia.com › Equities › Market
Information › Historical Data, or http://www.bseindia.com/stockinfo/stockprc.aspx.
The websites give the price history of the required company. Copy the data in
the excel spreadsheet. Arrange the data in the order of high price, low price, and
closing price against the dates.
x Click the ‘insert’ icon.tab in the menu bar.
x Select the high price, low price, and closing price in order from the
downloaded data.
x Click the ‘chart’ icon.
x Choose the stock bar chart and click it from the other charts icon.
x Now the stock bar chart is ready.
x To add the dates to the figure, right click on the axis and from the options,
click ‘select data’.
x From the dialogue box, click ‘edit from the horizontal (category) axis
labels’, choose the chart data range and select the dates.
x Now, the X-axis will have the dates.
291
Technical Analysis
x When you click the cursor inside the figure, the chart tools will open.
x Then click ‘Layout’. Labels and axes bar will appear. You can select the
relevant tool to fix the interval for data, name the axis and the chart. More
primary horizontal axis options in the Axes icon give the option to fix intervals.
x An example is given in Table 11.1.
Table 11.1 Downloaded Data for Example Bar Chart
Arrange the data as given below:

Table 11.2 Data for Bar Chart
292
Technical Analysis
Figure 11.24 shows the bar chart based on the above information.
Fig. 11.24 Bar Chart for Tata Power Stock
The candlestick chart can be drawn using the Excel spreadsheet. Here, instead of a
bar chart, the candlestick chart has to be chosen and other instructions are similar.
The order of the data should be as shown in Table 11.3. The Tata Power stock
price data are used.
Table 11.3 Tata Power Stock Data
1. State any two kinds of candlestick.

................................................................................................................
................................................................................................................
................................................................................................................
2. What are the unique characteristics of the Elliott patterns in the Elliott
Wave theory?
................................................................................................................
................................................................................................................
................................................................................................................
293
Technical Analysis
11.4 SUMMARY
x Technical analysis is a process of identifying trend reversals at an early

stage to formulate the buying and selling strategies.
x An investor analyses the relationship between price-volume and supply-
demand for the overall market as well as for the individual stock, using
several indicators. During an upswing, the number of shares traded is
greater than before, and in a downswing, the number of shares traded
dwindles.
x The doctrine outlined by Charles H Dow in 1884, in the Wall Street
Journal, is the basis for technical analysis.
x The most common technical tools used are Dow theory, volume of trading,
short selling, bar and candlestick charts, indicators and oscillators.
x The Dow theory sees a trend as primary, intermediate and short-term. The
primary trend may be a broad upwards or downwards movement that may
last for a year or two. The intermediate trends are corrective movements
which may last from three weeks to three months.
x Trend refers to the direction of movement. He share prices can either
increase, fall or remain the flat. The three directions of share prices are
referred to as rising, falling and flat trends. The point to be remembered is
the share prices do not rise or fall in a straight line.
x Trend lines are straight lines drawn connecting either the tops or bottoms of
the share price movements. The technical analyst should have at least two
tops or bottoms to draw a trend line.
x Violation of the trend line shows the change in the direction of the trend.
x The security price trend may be either increasing or decreasing. When the
market exhibits an increasing trend, it is referred to a bull market.
x The secondary or intermediate trend moves against the main trend and
leads to correction.
x Minor trends or tertiary moves are the random wriggles that occur in price
movements.
x Support and resistance levels are an integral part of technical analysis. A
support level exists at a price where considerable demand for that stock is
expected to prevent a further fall in the price level.
294
Technical Analysis
x Charts are valuable and easiest of tools used in technical analysis. The
graphic representation of data helps the investor to find out the trend of
prices without any difficulty.
x According to records, the candlestick chart is the oldest of price prediction
charts. In the 1700s, people used candlesticks to forecast rice prices.
x A white or black candlestick with a small body indicates not much price
movement and consolidation of stock price.
x The candlestick with a long lower shadow, small body, and no or very little
upper shadow is a hammer.
x It was Ralph Nelson Elliott who gave the Elliott Wave theory in the late
1920s.
x Elliott discovered that the upward and downward swings in the market
always showed up in the same repetitive patterns. These patterns are
divided and termed as ‘waves’. The unique characteristics of the Elliot
patterns are that they consist of five waves indicating the main trend and
three corrective waves.
11.5 KEY WORDS
x Bull market: It is a market in which share prices are rising, encouraging

buying.
x Bear market: It is a market in which share prices are falling, encouraging
selling.

1. Technical analysis is a process of identifying trend reversals at an early
stage to formulate the buying and selling strategies.
2. An investor analyses the relationship between price-volume and supply-
demand for the overall market as well as for the individual stock, using
several indicators.
3. Trend refers to the direction of movement. The share prices can either
increase, fall or remain flat.
295
Technical Analysis

1. The two kinds of candlestick are (a) a white or black candlestick with a
small body indicates not much price movement and consolidation of stock
price (b) a long body in a candle shows that the closing price is higher than
the opening price, and a bullish trend. A long black body in a candle shows
that the closing price is lower than the opening price, and a bearish trend.
2. The unique characteristics of the Elliot patterns are that they consist of five
waves indicating the main trend and three corrective waves.
1. Explain the concept of technical analysis and its assumptions.

2. Discuss the Dow theory. How is it similar to Elliott Wave theory?
3. What do you understand by trend?
4. Explain the different types of charts in technical analysis.
5. What is a candlestick chart? Explain different kinds of candlestick charts.

McGraw-Hill.
296
Efficient Market
Hypothesis
UNIT–12 EFFICIENT MARKET HYPOTHESIS
Objectives
x Understand the concept of market efficiency
x Categorise efficient market hypothesis
Structure
12.1 Introduction
12.2 Market Efficiency
12.3 Market Inefficiencies
12.4 Summary
12.5 Key Words
12.1 INTRODUCTION
In this unit, you will study the efficient market theory. The efficient market hypothesis
(EMH) asserts that financial markets are ‘informationally efficient’. It implies that you
cannot always achieve returns in excess of average market returns on a risk adjusted
basis, given the information available at the time you have made the investment.
There are three main versions of the hypothesis: ‘weak’, ‘semi-strong’ and ‘strong’.
The weak-form EMH claims that prices on traded assets, such as stocks and bonds,
already reflect all past publicly available information. The semi-strong form EMH
claims both, that prices reflect all publicly available information and that prices
instantly change to reflect new public information. The strong-form EMH additionally
claims that prices instantly reflect even hidden or ‘insider’ information.
12.2 MARKET EFFICIENCY
The expectations of investors regarding future cash flows are translated into or
reflected in share prices. Market efficiency is the accuracy and speed with which the
market translates the expectation into prices. There are two types of market
efficiencies:
297
Efficient Market
Hypothesis
x Operational efficiency
x Informational efficiency
Operational efficiency
Factors like the time taken to execute the order and the number of bad deliveries
measure the operational efficiency of a stock exchange. Operational efficiency of the
market is a matter of concern for the investors. The efficient market hypothesis
(EMH) does not take into account this efficiency.
Informational efficiency
It is a measure of swiftness with which the market reacts to new information. The
market frequently receives new information in the form of economic reports,
company analysis, political statements and notification of new industrial policy. How
does it react to this? Security prices adjust themselves rapidly and accurately. They
never take a long time to adjust to new information. For instance, a company’s
announcement of the issue of bonus shares can lead to a rise in the price of the
stock. Likewise, stock index movements reflect significant changes in the policy
decisions of the government.
Liquidity Traders
These traders’ investments and resale of shares depend upon their personal fortune.
Liquidity traders may sell their shares to pay their bills. They do not analyse before
they invest.
Information traders
Information traders base their buy or sell strategy on proper analyses. They estimate
the intrinsic value of shares. They enter the market on the basis of the deviation of the
market value of shares from the intrinsic value. They sell if the market value is higher
than the intrinsic value and vice versa. The buying and selling of shares triggered by
demand and supply forces brings the market price back to its intrinsic value.
The Random-Walk Theory

In 1900, French mathematician Louis Bachelier wrote an article suggesting that
security price fluctuations were random. In 1953, British statistician Maurice Kendall
reported that the stock price series is a wandering one. Each change is independent
of the previous one. In 1970, American economist Eugene Fama stated that efficient
markets fully reflect the available information. If markets are efficient, security prices
298
Efficient Market
Hypothesis
reflect normal returns for their level of risk. Fama suggested that the efficient market
hypothesis can be divided into three categories. They are the ‘weak form’, the
‘semi-strong form’ and the ‘strong form’. The level of information considered in the
market is the basis for this segregation. Figure 12.1 illustrates market efficiency.
Fig. 12.1 Levels of Information and the Markets
Weak Form of Efficient Market Hypothesis

Historical prices form the basis of information used in the weak form of efficient
market hypothesis (EMH). According to it, current prices reflect all the information
found in past prices and traded volumes. Future prices cannot be predicted by
analysing past prices. Everyone has access to past prices, even though some people
can get these more easily than others. Liquidity traders may sell their stocks without
considering the intrinsic value of the shares and cause price fluctuations. Buying and
selling activities of the information traders lead the market price to align itself with the
intrinsic value. Figure 12.2 shows a weakly efficient market.
Fig. 12.2 A Weakly Efficient Market

299
Efficient Market
Hypothesis
The dotted line in Figure 12.2 represents the intrinsic value. The intrinsic value
changes at times t and t + 1. In the weak form of market, the price of the stock and
its intrinsic value diverge significantly. The supply and demand for the stock or any
other asset has a tendency to move towards the equilibrium return. Supply and
demand match each other in the equilibrium return. Thus,
E(R) = Eq (R)
Where, E(R) is the expected return and Eq (R) is the equilibrium return.
The expected return is equal to the optimal forecast of return, which is F(R).
Then,
F(R) = Eq (R)
This indicates that the current price will be equal to the optimal forecast of a
stock’s return, which in turn is equal to the equilibrium return. The optimal forecast
uses all the available information in the market. Hence, EMH states that a security’s
price reflects all the available information.
In the weak form of efficient market, short-term traders may earn a positive
return. On average, short-term traders will not outperform the blindfolded investor
picking the stock with a dart. That is, traders may earn by the naive buy-and-hold
strategy and while some may incur a loss, the average buy-and-hold strategist
cannot be beaten by the chartist. Many studies by market analysts have proven the
weak form of EMH. Empirical tests of the weak form are presented here.
Filter rule: Investors use technical trading strategies based on historical prices to
earn returns. Filter rule is one such strategy. According to it, if the price of a security
rises by X per cent, an investor should buy and hold the stock until its price declines
by at least X per cent from a subsequent high. Short sellers can use the filter to earn
profits by liquidating their holdings when the price decreases from a peak level by X
per cent. They can take up short position as the price declines till the price reaches
a new low and then increases by X per cent. Different traders use different filter
rules. It ranges from as low as 0.5 per cent to as high as 50 per cent.
The filter rule can be explained with the help of an example. Take a hypothetical
company XY and assume the filter to be 10 per cent. The price fluctuates between
`20 and 30. Assume the starting point is `20. When there is an increase in the price
of the share to `22, i.e., a 10 per cent rise, one buys it. The rally may continue up
to `30 and decline. A fall in the price gives a sell signal at `27, i.e., 10 per cent of
300
Efficient Market
Hypothesis
`30, and the trader can take up a short position till it reaches its low level. When
there is an increase in price, the same exercise is followed.
Several studies have found that after commissions the average gains produced
by the filter rules are far below the gains of a naive buy-and-hold strategy adopted
by the investor.
A runs test finds out whether the series of price movements occurs by chance. A
run is an uninterrupted sequence of the same observation. Tossing a coin gives the
following sequence of occurrence.
HHTTTHHHTHH
Here, occurrence of H H is a run and T T is another run. When the sequence of
observations changes, it is counted as a run.
R = number of runs
n1 + n2 = number of observations in each category

= standard deviation
Z = standard normal variate
The following example explains the calculation of runs test. Table 12.1 gives the
Real company stock prices along with their runs.
301
Efficient Market
Hypothesis
Table 12.1 Real Company Stock Prices
The consecutive rise in prices would be counted as a positive run and the decline
would be counted as a negative run.
According to the probability theory, 95 per cent of the area under the normal
curve lies within +1.96 standard deviation of the mean. Since the calculated value of
minus 0.565 is less than minus 1.96, the runs have occurred by chance.
302
Efficient Market
Hypothesis
Published results of the studies using runs test suggest that runs in the price series
of stocks are not significantly different from the runs in the series of random numbers.
Serial correlation: The serial correlation technique tests the independence of
successive price changes. Serial correlation or autocorrelation measures the
correlation co-efficient in a series of numbers with the lagging values of the same
series. Price changes in period t + 1 (or t + any number) are correlated with the
price changes of the preceding period. Scatter diagrams can be used to find out the
correlation. If there is a correlation between the price of t and t + 1 period, the
points in the graph will form a straight line. If the price rise (or fall) in period t is
followed by price increase (or fall) in period t + 1, then the correlation co-efficient
will be +1. Many studies conducted on the security price changes have failed to
show any significant correlations. Fama computed serial correlations for 30 stocks
for the period 1958–62 with varying t periods from t + 1 to t + 10. The values of the
auto-correlations are usually insignificant with multiple values falling within the range
of 0.10 to minus 0.10. If there is little correlation between stock prices over time,
chart analyses cannot be of much use in predicting the future.
Predictability of Stock Returns

The National Stock Exchange has carried out research on the functioning of the
market. The research deals with the serial correlation factor in index returns.
This study looks at whether the Indian stock market is predictable by using
returns of S&P CNX Nifty index. Serial correlation with lag one is calculated. If
markets are informational efficient, the serial correlation will not be statistically
significant.
Table 12.2 shows the monthly serial correlation for three years 1995–96,
1996–97, and 1997–98. Logarithmic returns are used to check serial correlation at
lag one. Table 12.2 also gives the t-statistics, which help to determine if the
calculated correlation parameter is different from zero in the statistical sense.
303
Efficient Market
Hypothesis
Table 12.2 Predictability of Stock Returns
On the whole, out of the 36 months analysed, the correlation coefficients were
statistically different from zero in only four months. The results thus indicate that the
S&P CNX Nifty is an efficient index, and that the information assimilation and price
adjustment processes are quick.
Semi-Strong Form
The semi-strong form of the EMH states that the security price adjusts quickly to all
publicly available information. In semi-strong efficient markets, security prices fully
reflect all publicly available information. The prices not only reflect past prices, but
also the available information regarding the earnings of the corporation, dividend,
bonus issue, right issue, mergers, acquisitions, and so on. In the semi-strong efficient
market, a few insiders can earn a profit on short-run price changes rather than
investors who adopt the naive buy-and-hold policy.
In the case of a competitive market, supply and demand forces determine the
price. The price at the equilibrium level of supply and demand represents the
consensus opinion of the market. The intrinsic value of the stock and the equilibrium
price are the same. Whenever new information arrives in the market, supply and the
demand factors react to it. If the market processes the new information quickly, a
new price will come out of it. To be semi-strongly efficient, a market needs timely
and accurate dissemination of information and assimilation of news. Only then can
the market reflect all relevant information quickly. Studies show that stock markets
in the US strongly support the semi-strong hypothesis because the prices adjust
rapidly to new information.
304
Efficient Market
Hypothesis
Empirical evidence: Fama, Fisher, Jensen and Roll (1969) were the forerunners in
assessing the semi-strong form of EMH. They analysed the impact of stock split on
share prices. Their study was noteworthy because of the following reasons:
x It provided evidence of a semi-strong form of the market.
x It analysed if stock splits increase the wealth of the shareholders.
x It helped researchers develop a design to test market efficiency.
The authors developed a method to compute abnormal returns by using the
simple regression technique. Regressing the security return against the return of the
stock market index gives the normal return. The following equation shows it.
rit = D1 + ß1 rmt + eit
Where,
rit = realised return for the i the stock in the period t
rmt = realised return for index in period t
D1, ß1 = regression coefficients
eit = error term, or residual for the period t
The normal return for any period is as follows:
Normal return = D1 + ß1 rmt
Here, eit indicates the abnormal return.
For any period, ARit
eit = rit – (D1 + ß1 rmt)
eit = ARit
This method of estimating the abnormal return is called the residual analysis. The
regression equation represents normal return and eit represents abnormal return.
The Average Abnormal Return (AAR) can be obtained by adding the abnormal
returns over time and dividing it by n. The AAR can be measured around a date of
event or the announcement date of stock split or bonus issue.
CAAR = SAAR. Adding the AARit for each period gives the cumulative
Average Abnormal Return (CAAR). Period of study begins several weeks before
the event takes place and ends several weeks after the event. The CAAR provides
305
Efficient Market
Hypothesis
a snapshot of average price behaviour of securities over time. If the markets are
efficient, the CAAR should be close to zero.
The authors reviewed hundreds of cases of efficient corporations and
heterogeneous sample periods to study the effect of stock splits. They examined 940
stock splits from 1927 to 1959 in the New York Stock Exchange. The price
behaviour was analysed 29 months before and after the date of the stock split. They
found the CAAR for all 940 observations. They found the level of CAAR to be
insignificant and that it essentially fell from the date of announcement of the split.
According to them, the simple strategy of buying shares after a stock split did not
appear to generate abnormal returns. The study results provide evidence for the
semi-strong form of EMH.
Ball and Brown analysed the market’s ability to integrate the reported annual
earnings per share. Their study showed that the actual good price earnings were
higher than the predicted good price earnings and at the same time, the low price
earnings were lower than the predicted low price earnings. Ball and Brown found
that even before the announcement of a good report, the respective shares
experienced an increase in price. Likewise, even before the announcement of the
negative earnings report, the share prices decreased. Both the groups generated
only normal returns after the announcement providing support for the semi-strong
form.
Scholes, in his study found that the market is also efficient in identifying the seller.
He analysed the price effects of large secondary offerings. Usually, price tends to fall
before the secondary offering. This is mainly due to the information effect and not
due to selling pressures. If heavy selling is associated with the corporation’s
members and officers, the prices tend to fall at a faster rate. If it is sold by groups
other than these, the decrease in price is small.
Strong Form
The strong form EMH states that security prices fully reflect all information. It
represents an extreme hypothesis that most observers do not believe to be literally
true. This hypothesis maintains that not only is the publicly available information
useless to the investor or analyst, but that all information is useless. Information,
whether public or inside, cannot be used consistently to earn superior investor
returns in the strong form. This implies that security analysts and portfolio managers,
306
Efficient Market
Hypothesis
who have access to more information than ordinary investors, are not able to use it
to earn more profits.
Empirical evidence: Many of the tests of the strong form of EMH deal with mutual
fund performances. Financial analysts have studied the risk-adjusted rates of return
from hundreds of mutual funds and found that the professionally managed funds are
not able to outperform the naive -buy-hold strategists. Jensen studied 115 funds
over a decade. He concluded that even though the analysts have a wide range of
contacts and associations in both the business and financial committees, they are
unable to predict returns accurately enough to recover the research and transaction
costs. He holds this as a striking piece of evidence for the strong form of the efficient
market hypothesis.
Essence of the Theory

According to the theory, successive price changes or changes in return are
independent, and these successive price changes have a random distribution. The
random walk model argues that stock prices fully reflect all publicly available
information and further that the stock prices instantaneously adjust to the available
new information. The theory mainly deals with successive changes rather than the
price or return levels.
According to the theory, the market may have imperfections like transaction
costs and delays in disseminating relevant information to all market investors, but
these sources of inefficiency may not result in excess returns above the normal or
equilibrium returns. The equilibrium return is the return earned by the naive buy-and-
hold strategy.
Investors should note that the random theory says nothing about the relative
price changes that are occurring across the securities. Some securities may
outperform others. Again, it does not say anything about the decomposing of price
into market, industry or firm factors. All these factors consider relative prices but not
with the absolute price changes. The random walk hypothesis deals with the
absolute price changes and not with the relative prices.
The prices may change at random, but this does not imply that there would not
be any upward or downward trend in the price. The random walk hypothesis is
entirely consistent with the upward and downward movements of stock prices.
307
Efficient Market
Hypothesis
1. Define market efficiency.

................................................................................................................
................................................................................................................
................................................................................................................
2. What is informational efficiency?

................................................................................................................
................................................................................................................
................................................................................................................
3. What is residual analysis?

................................................................................................................
................................................................................................................
................................................................................................................
12.3 MARKET INEFFICIENCIES
Many studies have proven the prevalence of market efficiency. At the same time,
several studies also contradict the concept of market efficiency.
Overreactions of the market: Recent studies have shown that the market
overreacts to corporate news. If the corporation announces a reduction in the
earnings or closure of a unit, the market overreacts. The price of the stock may
decline. After the initial decline, it may take several weeks for the stock price to
reach the normal level. During this period, the investor may buy the stock when the
price is low and sell it once the normal level is reached. This strategy helps him to
earn an abnormal return, which goes against the efficient market hypothesis.
For example, take the studies conducted Joy, Litzenberger and McEnally (JLM)
over the period 1963–68, which gave different results. The authors examined the
quarterly earnings of the stock prices. The earnings of one quarter were compared
with the earnings of the same quarter of the previous year. If the current year’s
308
Efficient Market
Hypothesis
earnings were 40 per cent or higher than the earnings for the same quarter in the
previous year, the earnings were classified as better than anticipated. If the current
quarter’s earnings were below 40 per cent of the previous year’s earnings, they
were classified as worse than expected.
Then the abnormal returns were calculated from 13 weeks before the
announcement of earnings to 26 weeks after the announcement. The stocks whose
earnings were significantly greater than anticipated gave positive abnormal returns.
The stocks whose earnings were below the anticipated earnings generated negative
abnormal returns.
The authors’ main claim is that after the announcement of the earnings, stocks
that reported earnings substantially higher than that of the previous year continued to
generate positive abnormal returns. According to their study, investors could have
earned positive abnormal returns of around 6.5 per cent over the next 26 weeks
simply by buying stocks that reported earnings 40 per cent above the last quarterly
earnings. Meanwhile, for those stocks with earnings substantially below that of the
previous year, the cumulative average abnormal return remained relatively stable.
This shows evidence against the semi-strong market hypothesis because it states that
when the information is made public, the analyst could not earn abnormal profits. A
study by C P Jones and R S Rendleman for the period 1971–80 also gave results
similar to those of JLM.
Reversal to mean return: Some studies have found that stock returns have a
tendency to return to their average level. Stocks that currently yield low returns tend
to yield high returns in future. Likewise, the stocks that perform well at present may
not yield high returns in future. The returns may go back to the average level. This
gives an opportunity to predict the future price, which is contrary to the random
walk theory.
Delayed absorption of new information: Usually, stock prices react quickly to
information. Research has proved that stock prices tend to increase continuously for
some time after the announcement of good profits. Likewise, they continue to
decline for some time after the reporting of low profits.
Low P/E effect: Many studies have provided evidence that stocks with low price-
earnings ratios (P/Es) yield higher returns than stocks with higher P/Es. This is
known as the low PE effect. A study by Basu in 1977 looked at risk adjusted return
and even after the adjustment there was excess return in the low price-earnings
309
Efficient Market
Hypothesis
stocks. If historical information of P/E ratios can help investor to obtain superior
stock returns, it questions the validity of the semi-strong form of market hypothesis.
Basu stated that low P/E portfolio experienced superior returns relative to the
market, and high P/E portfolio performed in an inferior manner relative to the overall
market. Since his result directly contradicts the semi-strong form of efficient market
hypothesis, it is noteworthy.
Small firm effect: The theory of the small firm effect maintains that investing in small
firms (those with low capitalisation) provides superior risk adjusted returns. Banz
found the size of the firm to be highly correlated with returns. Banz examined
historical monthly returns of NYSE common stocks for the period 1931–75. He
formed portfolios consisting of the 10 smallest firms and the 10 largest firms and
computed the average return for these portfolios. The small firm portfolio
outperformed the large firm portfolio.
Several other studies have confirmed the existence of a small firm effect. The size
effect raised doubts about the risk associated with small firms. The risks associated
with them are underestimated, and they do not trade as frequently as the large firms.
The correct measurement of risk and return of small portfolios tends to eliminate at
least 50 per cent of the small firm effect.
The weekend effect French examined the returns generated by the S&P index
for each day of the week. Stock prices tend to rise all week, reaching a peak on
Fridays. Usually, stocks trade on Monday at low prices, before they begin the
week’s price increase. Buying on Monday and selling on Friday from 1953 to 1977
would have generated average annual return of 13.4 per cent while a simple buy-
and-hold would have yielded 5.5 per cent annual return. If the transaction costs are
taken into account, the naive buy-and-hold strategy would have provided higher
returns. The weekend effect knowledge is of value to investors. Purchases planned
on Thursday or Friday can be delayed until Monday, while sales planned for
Monday can be delayed until the end of the week. The weekend effect is a small but
significant deviation from perfectly random price movements and violates the weekly
efficient market hypothesis.
B Venkatesh of the BL Research Bureau stated that the Bombay Stock
Exchange reveals a clear pattern. Usually, Monday sees trading blues, and Friday,
310
Efficient Market
Hypothesis
frenzied activity. The Friday rush is related to speculators covering their open
position. If the short sellers fail to cover their position within this period, their open
positions results in the auction where prices are dear.
Efficient Markets and the Investor

Every theory is aimed at the benefit of the investor. A technical analysis helps the
investor to formulate his entry and exit strategy. The efficient market hypothesis also
has its message. But all the investment tips, investment advice or technical analysis
cannot guarantee an investor will earn abnormal profits. The publicly available
information too cannot help the investor to outperform the market. All this leads to
the conclusion that predictions about the market are inadequate. The constant
buying and selling of stocks will result in payment of commission to brokers. Instead,
the investor should pursue a buy-and-hold strategy with a careful selection of
stocks. Yet, the anomalies of an efficient market hypothesis suggest that a prudent
investor can earn higher with predictions than by following a buy-and-hold strategy.
Behavioural Finance
The anomalies of the efficient market hypothesis led to the evolution of behavioural
finance. According to Andre Sheifer, it borrows concepts from the social sciences
such anthropology sociology, and psychology to explain the behaviours of security
price.
Psychologists opine that investors are unhappy when loss occurs and happy with
the profit. This leads to the conclusion that investors are risk averse. The arbitrageurs
who make smart money reduce the profit opportunities. They borrow stocks from
the brokers and sell them. They hope to obtain the sold stock at a low price, and
give it back to the brokers. The drawback of this process is that stock prices may
go up. When stock prices rise, investors incur a loss. From the point of view of
psychologists, the investors are risk averse. Hence, this psychology limits the short
selling activity in the stock market. This leads to an overvaluation of stocks.
Psychologists also observe that investors are overconfident in their own
judgments. They act according to their beliefs. While one investor may feel that ‘X’
stock price is going to fall and it is better to get rid of it, another may judge it to be
a good investment at the prevailing price. Hence, the trading volume in the stock
market may be high. The efficient market hypothesis has no explanation for it.
311
Efficient Market
Hypothesis
Behaviour finance explains that the stock market bubbles are due to the social
contagion effect and overconfidence of the investor. The media and word-of-mouth
enthusiasm create stock market bubbles. Once the stock prices go up, the investor
feels it will rally in future. This leads to a positive feedback loop, and stock prices
continue to move up. This creates a speculative bubble without the backing of strong
fundamentals. This results in a stock market crash.
The efficient market hypothesis or EMH goes with the assumption that markets
are efficient.
There are three basic levels of EMH as given below, these have already been
discussed. Let us recapitulate.
x Weak Form EMH: Weak form of EMH is representative of an efficient
market which reflects all of the market information. This hypothesis is
based on the assumption that the rates of return prevailing in the market
need to be independent and that the rates that prevailed in the past will not
affect the rates that will be prevalent in the future. If this assumption is to be
taken as given, then the rules which are used by traders for selling and
buying of stocks and other similar rules will all become invalidated.
x Semi-Strong EMH: A semi-strong form of EMH is representative of an
efficient market which also reflects all information which is available
publicly. It is assumed in this hypotheses that there is quick adjustment by
stocks in keeping with the new information that has become available. In
the semi-strong form of EMH there is also the existence of weak-form of
hypothesis. If we go with the assumption that stock prices reflect each one
of the new available bits of information and stocks’ purchasing is done by
investors post release of this information, it is not possible for an investor to
benefit over and above the market with trading by using new information.
x Strong-Form EMH: The strong-form of EMH is representative of an
efficient market and is reflective of all information, be it private or public,
building and incorporating the weak-form of EMH and the semi-strong
form of EMH. Going with the assumption that stock prices reflect all
information (private and public, both) no investor would be able to get
profit above the average investor even if he was given new information.
312
Efficient Market
Hypothesis
Weak Form Tests

The tests of the weak form of the EMH can be categorized as:
x Statistical Tests for Independence: In the case of weak-form of EMH,
it is assumed that the rates of return on the market are independent. Based
upon this assumption, any of the tests that are applied for examining of the
weak form of the EMH test form an independent assumption. Examples of
these tests are the autocorrelation tests (returns are not significantly
correlated over time) and runs tests (stock price changes are independent
over time).
x Trading Tests: In the case of weak-form of EMH, past returns provide
no indication of future results, hence, the rules followed by the traders will
be invalid. One example of a trading test is the filter rule, which depicts that
post transaction costs, an abnormal return cannot be earned by an investor.
Semi-strong Form Tests

Going with the assumption that the semi-strong form implies that the market is
reflective of all publicly available information, the tests of the semi-strong form of the
EMH are:
x Event Tests: The semi-strong form goes with the assumption that all
information that is available publically is reflected by the market. With the
event test, it is possible to analyze the security, be it before or post some
event, like earnings. The thought behind the event test is that an investor will
not be able to reap an above average return by trading on an event.
x Regression/Time Series Tests: It is essential to know that the time
series forecast puts forth historical data. Therefore, an investor must never
get an abnormal return by employing this method.
Strong-Form Tests
Taking into consideration that the strong-form is indicative of the market being
reflective of all information, be it private or public, the tests for the strong-form
center around groups of investors with excess information. The investors will be:
x Insiders: Insiders to a company, for example the company’s senior
managers, will always have access to inside information. It is forbidden by
313
Efficient Market
Hypothesis
SEC regulations that insiders make use of such information for obtaining
returns that are abnormal.
x Exchange Specialists: An exchange specialist recalls runs on the orders
for a specific equity. However, it is seen that exchange specialists are able
to obtain higher than average returns due to this specific order information.
x Analysts: The equity analyst has been an interesting test. It analyzes
whether an analyst’s opinion can help an investor achieve above average
returns. Analysts do typically cause movements in the equities they focus
on.
x Institutional money managers: Institutional money managers who are
involved in the work of mutual funds, pensions and other types of
institutional accounts, are seen as not generally performing above the
overall market benchmark.
Check Your Progress-2
1. In market inefficiencies, what does market overreacts to?

................................................................................................................
................................................................................................................
................................................................................................................
2. What is small firm effect?

................................................................................................................
................................................................................................................
................................................................................................................
3. State the assumption on which the efficient market hypothesis function

upon.
................................................................................................................
................................................................................................................
................................................................................................................
314
Efficient Market
Hypothesis
12.4 SUMMARY
x Market efficiency is the accuracy and speed with which the market
translates the expectation into prices.
x There are two types of market efficiencies, namely, operational efficiency
and informational efficiency.
x Informational efficiency is a measure of swiftness with which the market
reacts to a new information. The market frequently receives new
information in the form of economic reports, company analysis, political
statements and notification of new industrial policy.
x Liquidity traders’ investments and resale of shares depend upon their
personal fortune.
x Information traders base their buy or sell strategy on proper analyses.
x In 1900, French mathematician, Louis Bachelier wrote an article suggesting
that security price fluctuations were random. In 1953, statistician Maurice
Kendall reported that the stock price series is a wandering one. In 1970,
American economist Eugene Fama stated that efficient markets fully reflect
the available information.
x Several studies have found that after commissions the average gains
produced by the filter rules are far below the gains of a naive buy-and-hold
strategy adopted by the investor.
x The National Stock exchange has carried out research on the functioning of
the market. The research deals with serial correlation factor in index
returns. This study looks at whether the Indian stock market is predictable
by using returns of S&P CNX Nifty index.
x The semi-strong form of the EMH states that the security price adjusts
quickly to all publicly available information. In semi-strong efficient
markets, security prices fully reflect all publicly available information.
x In the case of a competitive market, supply and demand forces determine
the price. The price at the equilibrium level of supply and demand
represents the consensus opinion of the market.
315
Efficient Market
Hypothesis
x The strong form EMH states that security prices fully reflect all information.
It represents an extreme hypothesis that most observers do not believe to
be literally true. This hypothesis maintains that not only is the publicly
available information useless to the investor or analyst, but that all
information is useless.
x The random walk hypothesis deals with the absolute price changes and not
with the relative prices.
x Recent studies have shown that the market overreacts to corporate news.
If the corporation announces a reduction in the earnings or closure of a unit,
the market overreacts. The price of the stock may decline. After the initial
decline, it may take several weeks for the stock price to reach the normal
level.
x Every theory is aimed at the benefit of the investor. A technical analysis
helps the investor to formulate his entry and exit strategy. The efficient
market hypothesis also has its message. But all the investment tips,
investment advice or technical analysis cannot guarantee an investor will
earn abnormal profits.
x The anomalies of the efficient market hypothesis led to the evolution of
behavioural finance. According to Andre Sheifer, it borrows concepts from
the social sciences such anthropology sociology, and psychology to explain
the behaviours of security price.
12.5 KEY WORDS
x Transaction cost: It is a cost incurred in making an economic exchange of

some sort, or in other words the cost of participating in a market.
x Abnormal returns: These are the differences between a single stock or
portfolio’s performance and the expected return over a set period of time.
316
Efficient Market
Hypothesis

1. Market efficiency is the accuracy and speed with which the market
translates the expectation into prices.
2. Informational efficiency is a measure of swiftness with which the market
reacts to a new information. The market frequently receives new
information in the form of economic reports, company analysis, political
statements and notification of new industrial policy.
3. The method of estimating the abnormal return is called the residual analysis.

1. The market overreacts to corporate news.
2. The theory of the small firm effect maintains that investing in small firms
(those with low capitalisation) provides superior risk adjusted returns.
3. The efficient market hypothesis or EMH goes with the assumption that
markets are efficient.
1. Explain different forms of efficient market hypothesis.

2. What are the causes of market inefficiencies? Discuss in detail.

McGraw-Hill.
317
Efficient Market
Hypothesis
318
Portfolio Analysis
BLOCK-IV
PORTFOLIO THEORY
In this block you will study portfolio analysis, effects of combination of securities, capital
market theory, and portfolio performance evaluation. The Markowitz model which analyses
the risk-and-return relationship is also discussed in the block.
The thirteenth unit gives the definition of simple diversification and helps in interpreting
Markowitz model which estimates the rate of return and the standard deviation of portfolio.
The assumptions of the model are also provided in order to make the concept easy to
comprehend. Correlation co-efficient is also explained in this unit.
The fourteenth unit provides an understanding of the concept of combination of securities and
explains the varying degrees of correlation. The unit also discusses Markowitz efficient
frontier. Utility analysis, and the efficient frontier and the indifference map are also described
in the unit.
The fifteenth unit provides an understanding of the two important theories, namely, the
capital asset pricing model and the arbitrage pricing theory. It also discusses the assumptions
that these models are based on. The concept of security market line is also elaborated in the
unit.
The sixteenth unit discusses the three performance index which are Sharpe’s performance
index, Treynor’s performance index and Jensen’s performance index. It also examines the
concept of mutual fund, Sortino ratio and upside potential ratio.
319
Portfolio Analysis
UNIT–13 PORTFOLIO ANALYSIS
Objectives
x Define simple diversification
x Interpret Markowitz model by estimating rate of return and standard
deviation of portfolio
x Discuss the traditional and modern approach of portfolio management
x Analyse the process of selection of portfolio
Structure
13.1 Introduction
13.2 Simple Diversification
13.3 Markowitz Model: Estimating Rate of Return and Standard Deviation of Portfolio
13.4 Traditional and Modern Approach
13.5 Summary
13.6 Key Words
13.1 INTRODUCTION
Traditional investment analysis, when applied to securities, emphasizes the projection

of prices and dividends. That is, the potential price of a firm’s common stock and the
future dividend stream are forecasted, then discounted back to the present. This
intrinsic value is then compared with the security’s current market price. If the
current market price is below the intrinsic value, a purchase is recommended, and if
the case is vice versa, sale is recommended. Although modern security analysis is
deeply rooted in the fundamental concepts just outlined, the emphasis has shifted.
The more modern approach to common portfolio analysis emphasizes return and
risk estimates rather than mere price and dividend estimates.
Harry Markowitz opened new vistas to modern portfolio selection in an article
in the ‘Journal of Finance’ in March 1952. His article indicated the importance of
correlation among the returns of different stocks in the construction of a stock
portfolio. Markowitz also showed that for a given level of expected return in a group
321
Portfolio Analysis
of securities one security would dominate the others. To find such security, the
knowledge of the correlation coefficients between all possible securities
combinations is required. After the publication of his paper, numerous investment
firms and portfolio managers developed ‘Markowitz algorithms’ to minimize portfolio
variance, i.e., risk. Even today the term ‘Markowitz diversification’ is used to refer
to the portfolio construction accomplished with the help of security covariance.
13.2 SIMPLE DIVERSIFICATION
Portfolio risk can be reduced by the simplest kind of diversification. Portfolio means
the group of assets an investor owns. These assets may vary from stocks to different
types of bonds. Sometimes, the portfolio may consist of securities from different
industries. When different assets are added to the portfolio, the total risk tends to
decrease. In the case of common stocks, diversification reduces the unsystematic
risk or unique risk. Analysts opine that if 15 stocks are added to the portfolio of an
investor, the unsystematic risk can be reduced to zero. But at the same time, if the
number exceeds 15, additional risk reduction cannot be ensured. However,
diversification cannot reduce systematic risk.
This naive kind of diversification is known as simple diversification. Here,
securities are selected at random and no analytical procedure is used. This sort of
diversification reduces risk only to a certain extent.
The total risk of the portfolio consists of systematic and unsystematic risks and
is measured by the variance of the rates of return over time. Many studies have
shown that systematic risk accounts for one quarter of the total risk.
A simple random diversification reduces the total risk. A portfolio with randomly
selected 10 securities has less risk than a portfolio with three securities. The reason
is that unsystematic price fluctuations are not correlated with the market’s systematic
fluctuations. Figure 13.1 shows how simple diversification reduces the risk. The
standard deviations of the portfolios are plotted on the Y-axis and the number of
randomly selected portfolio securities, on the X-axis.
The standard deviation for each portfolio is calculated and plotted. As the
portfolio size increases, the total risk line starts declining. It flattens out after a certain
point. Beyond that, risk cannot be reduced. This implies that spreading out assets
beyond a certain level cannot be expected to reduce the portfolio’s total risk below
the level of the undiversifiable risk.
322
Portfolio Analysis
Number of stocks
Fig. 13.1 Diversification and Portfolio Risk
Spreading the investment across too many assets can give rise to such problems as
the inclusion of poor performers, information inadequacy, high research, and high
transaction costs. These are discussed below:
x Poor performers: When numerous stocks are involved, the investor may
sometimes also buy stocks that will not yield adequate return.
x Information inadequacy: If there are too many securities in a portfolio, it
is difficult for the portfolio manager to have all information about their
individual performance. He has to be well-versed with the details of each
company’s performance. But access to such information, all at the same
time, can be quite difficult.
x High research costs: When a large number of stocks are included in a
portfolio, the returns and risks associated with individual stocks should be
analysed before their inclusion. For this, a lot of information has to be
gathered and kept and this involves high costs.
x High transaction costs: When small quantities of stocks are purchased
frequently, the investor has to incur higher transaction costs than for the
purchase of large blocks at less frequent intervals. In spite of all these
difficulties, big financial institutions purchase hundreds of different stocks.
Likewise, mutual funds also invest in many different stocks.
323
Portfolio Analysis
1. How is the total risk of the portfolio measured?

................................................................................................................
................................................................................................................
................................................................................................................
2. Mention the problems that arise in spreading the investment across too
many assets.
................................................................................................................
................................................................................................................
................................................................................................................
13.3 MARKOWITZ MODEL: ESTIMATING RATE OF RETURN

AND STANDARD DEVIATION OF PORTFOLIO
Commonly, there are two approaches in the construction of the portfolio of

securities viz. traditional approach and Markowitz efficient frontier approach. In the
traditional approach, (discussed in the next section) investor’s needs in terms of
income and capital appreciation are evaluated and appropriate securities are
selected to meet the needs of the investor. The common practice in the traditional
approach is to evaluate the entire financial plan of the individual. In the modern
approach (discussed in the next section), portfolios are constructed to maximise
the expected return for a given level of risk. It views portfolio construction in terms
of the expected return and the risk associated with obtaining the expected return.
Most people agree that holding two stocks is less risky than holding one. For
example, holding stocks of textile, banking, and electronic companies is better than
investing all the money in a textile company’s stock. But building up an optimal
portfolio is very difficult. Markowitz provides an answer by analysing the risk-and-
return relationship.
Assumptions of the model

The individual investor estimates risk on the basis of variability of returns, i.e., the
variance of returns. An investor’s decision is based solely on the expected return
and variance of returns.
324
Portfolio Analysis
For a given level of risk, an investor prefers higher return to lower returns.
Likewise, for a given level of return, an investor prefers lower risks to higher risks.
The Markowitz Concept

In developing his model, Markowitz gives up the single stock portfolio and
introduces diversification. The single security portfolio would be preferable if the
investor is perfectly certain that his expectation of highest return will be fulfilled. In
the world of uncertainty, most risk-averse investors would like to join Markowitz
rather than keep a single stock, because diversification reduces risk. This can be
shown with the help of example.
Take the stocks of ABC and XYZ company. The returns from each company
and their probabilities of occurrence, expected returns, and the variances are as
given in Table 13.1.
Table 13.1 Returns and Variances for ABC and XYZ Stock
ABC Expected return = 0.5 × 11 + 0.5 × 17 = 14

XYZ Expected return = 0.5 × 20 + 0.5 × 8 = 14
ABC variance = 0.5 (11–14)2 + 0.5 (17–14)2 = 9
XYZ variance = 0.5 (20–14)2 + 0.5 (8–14)2 = 36
ABC standard deviation = Variance =9 = 3
XYZ standard deviation = Variance = 36 = 6
The stocks of ABC and XYZ are expected to yield the same return of 9 per cent.
The XYZ stock is much more risky than the ABC stock, with the standard deviation
of the former being 6 and the latter 3. When the ABC return is high, the XYZ return
is low and vice-versa, i.e., when there is a 17 per cent return on ABC, there is an 8
per cent return from XYZ. Likewise, when the ABC return is 11 per cent, the XYZ
return is 20 per cent. If a particular investor holds only ABC or XYZ he stands to
lose at the time of bad performance.
325
Portfolio Analysis
Suppose the investor holds two-thirds of ABC and one-third of XYZ. The
return will be as follows:
N
Rp ¦ X1 R1
t 1
Rp = return on the portfolio
X1 = proportion of total portfolio invested in security 1.
RI = expected return of security 1
Let us calculate the expected return for both the possibilities
Possibility 1 = 2/3 × 11 + 1/3 × 20 = 14
Possibility 2 = 2/3 × 17 + 1/3 × 8 = 14
In both the situations, the investor stands to gain if the worst occurs, than by holding
either of the security individually. Holding two securities may reduce the portfolio risk
too. The portfolio risk can be calculated with the help of the following formula.
2 2 2 2
V = X V + X V + 2 X X (r V V )
p 1 1 2 2 1 2 12 1 2
V = portfolio standard deviation
p
X = percentage of total portfolio value in stock X
1 1
X = percentage of total portfolio value in stock X
2 2
V = standard deviation of stock X
1 1
V = standard deviation of stock X
2 2
r = correlation co-efficient of X and X
12 1 2
r = covariance of X12
12
V V
1 2
Using the same example given in the return analysis, the portfolio risk can be esti-
mated. Let us assume ABC as X1 and XYZ as X2. Now the covariance
is : X12
N
¦
1
Cov of X12 ( R1 R1 ) ( R2 R 2 )
N i 1
1
[(11 14 ) ( 20 14 ) (17 14 ) (18 14 )]
2
1 36
[( 18 ) ( 18 )] 18
2 2
covariance of X12 18
r 1
V 1V 2 3u6
326
Portfolio Analysis
The correlation co-efficient indicates the similarity or dissimilarity in the

behaviour of X1 and X2 stocks. In correlation, co-variance is not taken as an
absolute value but relative to the standard deviation of individual securities. It shows,
how much X and Y vary together as a proportion of their combined individual
variations measured by V1 and V2. In our example, the correlation co-efficient is –
1.0 which indicates that there is a perfect negative correlation and the returns move
in the opposite direction. If the correlation is 1, perfect positive correlation exists
between the securities and they tend to move in the same direction. If the correlation
co-efficient is zero, the securities’ returns are independent. Thus, the correlation
between two securities depends upon the covariance between the two securities and
the standard deviation of each security.
1. How does an individual investor estimate risk?

................................................................................................................
................................................................................................................
................................................................................................................
2. What is the use of Markowitz model?

................................................................................................................
................................................................................................................
................................................................................................................
13.4 TRADITIONAL AND MODERN APPROACH
The traditional approach basically deals with two major decisions. They are:
x Determining the objectives of the portfolio
x 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
327
Portfolio Analysis
relative portfolio weights are assigned to securities like bonds, stocks and
debentures and then diversification is carried out. Figure 13.2 explains this.
Analysis of constraints: The constraints normally discussed are: income
needs, liquidity, time horizon, safety, tax considerations and the temperament.
Income needs: The income needs depend on the need for income in constant
rupees and current rupees. The need for income in current rupees arises from the
investor’s need to meet all or part of the living expenses. At the same time inflation
may erode the purchasing power, the investor may like to offset the effect of the
inflation and so, needs income in constant rupees.
Analysis of constraints
Determination of Objectives
Selection of Portfolio
Bond and Common stock Bond Common stock
Assessment of risk and return
Diversification
Fig. 13.2 Portfolio Construction: Traditional Approach
328
Portfolio Analysis
x 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.
x 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.
Liquidity: Liquidity need of the investment is highly individualistic of the
investor. If the investor prefers to have high liquidity, then funds should be invested
in high quality short term debt maturity issues such as money market funds,
commercial papers and shares that are widely traded. Keeping the funds in shares
that are poorly traded or stocks in closely held business and real estate lack liquidity.
The investor should plan his cash drain and the need for net cash inflows during the
investment period.
Safety of the principal: Another serious constraint to be considered by the
investor is the safety of the principal value at the time of liquidation. Investing in
bonds and debentures is safer than investing in the stocks. Even among the stocks,
the money should be invested in regularly traded companies of longstanding.
Investing money in the unregistered finance companies may not provide adequate
safety.
Time horizon: Time horizon is the investment-planning period of the individuals.
This varies from individual to individual. Individual’s risk and return preferences are
often described in terms of his “life cycle”. The stages of the life cycle determine the
nature of investment. The first stage is the early career situation. At the career
starting point assets are lesser than their liabilities. More goods are purchased on
credit. His house might have been built with the help of housing loan scheme. His
major asset may be the house he owns. His priority towards investments may be in
the form of savings for liquidity purposes. He takes life insurance for protecting him
329
Portfolio Analysis
from unforeseen events like death and accidents and then he thinks of the
investments. The investor is young at this stage and has long horizon of life
expectancy with possibilities of growth in income, he can invest in high-risk and
growth oriented investments.
The other stage of the time horizon is the mid-career individual. At this stage, his
assets are larger than his liabilities. Potential pension benefits are available to him. By
this time he establishes his investment program. The time horizon before him is not as
long as the earlier stage and he wants to protect his capital investment. He may wish
to reduce the overall risk exposure of the portfolio but, he may continue to invest in
high risk and high return securities.
The final stage is the late career or the retirement stage. Here, the time horizon
of the investment is very much limited. He needs stable income and once he retires,
the size of income he needs from investment also increases. In this stage, most of his
loans are repaid by him and his assets far exceed the liabilities. His pension and life
insurance programmes are completed by him. He shifts his investment to low return
and low risk category investments, because safety of the principal is given priority.
Mostly he likes to have lower risk with high interest or dividend paying component
to be included in his portfolio. Thus, the time horizon puts restrictions on the
investment decisions.
Tax consideration: Investors in the income tax paying group consider the tax
concessions they could get from their investments. For all practical purpose, they
would like to reduce the taxes. For income tax purpose, interests and dividends are
taxed under the head “income from other sources”. The capital appreciation is taxed
under the head “capital gains” only when the investor sells the securities and realises
the gain. The tax is then at a concessional rate depending on the period for which the
asset has been held before being sold. From the tax point of view, the form in which
the income is received i. e. interest, dividend, short term capital gains and long term
capital gains are important. If the investor cannot avoid taxes, he can delay the taxes.
Investing in government bonds and NSC can avoid taxation. This constraint makes
the investor to include the items which will reduce the tax.
Temperament: The temperament of the investor himself poses a constraint on
framing his investment objectives. Some investors are risk lovers or takers who
would like to take up higher risk even for low return. While some investors are risk
averse, who may not be willing to undertake higher level of risk even for higher level
of return. The risk neutral investors match the return and the risk. For example, if a
330
Portfolio Analysis
stock is highly volatile in nature then the stock may be selling in a range of Rs.100-
200, and returns may fluctuate between Rs.00-100 in a year. Investors who are risk
averse would find it disturbing and do not have the temperament to invest in this
stock. Hence, the temperament of the investor plays an important role in setting the
objectives.
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:
x Current income
x Growth in income
x Capital appreciation
x 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.
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 maturity
period may not be a constraint.
331
Portfolio Analysis
Growth of income and asset mix: Here the investor requires a certain
percentage of growth in the income received from his investment. The investor’s
portfolio may consist of 60 to 100 percent equities and 0 to 40 percent debt
instrument. The debt portion of the portfolio may consist of concession regarding tax
exemption. Appreciation of principal amount is given third priority. For example
computer software, hardware and non-conventional energy producing company
shares provide good possibility of growth in dividend.
Capital appreciation and asset mix: Capital appreciation means that the
value of the original investment increases over the years. Investment in real estates
like land and house may provide a faster rate of capital appreciation but they lack
liquidity. In the capital market, the values of the shares are much higher than their
original issue prices. For example Satyam Computers, share value was Rs.306 in
April 1998 but in October 1999 the value was Rs.1658. Likewise, several examples
can be cited. The market capitalisation also has increased. Next to real assets, the
stock markets provide best opportunity for capital appreciation. If the investor’s
objective is capital appreciation, 90 to 100 per cent of his portfolio may consist of
equities and 0-10% of debts. The growth of income becomes the secondary
objective.
Safety of principal and asset mix: Usually, the risk averse investors are very
particular about the stability of principal. According to the life cycle theory, people in
the third stage of life also give more importance to the safety of the principal. All the
investors have this objective in their mind. No one like to lose his money invested in
different assets. But, the degree may differ. The investor’s portfolio may consist
more of debt instruments and within the debt portfolio more would be on short term
debts.
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
332
Portfolio Analysis
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.
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. In the stock portfolio, he has to adopt the
following steps which are shown in the following figure:
Fig. 13.3 Steps in Portfolio Diversification
The investor has to select the industries appropriate to his investment objectives.
Each industry corresponds to specific goals of the investor. The sales of some
industries like two wheelers and steel tend to move in tandem with the business
cycle, the housing industry sales move counter cyclically. If regular income is the
criterion then industries, which resist the trade cycle should be selected. Likewise,
the investor has to select one or two companies from each industry. The selection of
the company depends upon its growth, yield, expected earnings, past earnings,
expected price earning ratio, dividend and the amount spent on research and
development. Selecting the best company is widely followed by all the investors but
this depends upon the investors’ knowledge and perceptions regarding the company.
The final step in this process is to determine the number of shares of each stock to
333
Portfolio Analysis
be purchased. This involves determining the number of different stocks that is

required to give adequate diversification. Depending upon the size of the portfolio,
equal amount is allocated to each stock. The investor has to purchase round lots to
avoid transaction costs.
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. They are assumed to be indifferent
towards the form of return.
From the list of stocks quoted at the Bombay Stock Exchange or at any other
regional stock exchange, the investor selects roughly some group of shares say of 10
or 15 stocks. For these stocks’ expected return and risk would be calculated. The
investor is assumed to have the objective of maximising the expected return and
minimising the risk. Further, it is assumed that investors would take up risk in a
situation when adequately rewarded for it. This implies that individuals would prefer
the portfolio of highest expected return for a given level of risk.
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.
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
334
Portfolio Analysis
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.
1. What are the two major decisions of traditional approach?

................................................................................................................
................................................................................................................
................................................................................................................
2. What is time horizon?

................................................................................................................
................................................................................................................
................................................................................................................
13.5 SUMMARY
x Portfolio means the group of assets an investor owns. These assets may
vary from stocks to different types of bonds. Sometimes, the portfolio may
consist of securities from different industries.
x When different assets are added to the portfolio, the total risk tends to
decrease.
x In the case of common stocks, diversification reduces the unsystematic risk
or unique risk.
x The total risk of the portfolio consists of systematic and unsystematic risks
and is measured by the variance of the rates of return over time. Many
studies have shown that systematic risk accounts for the one quarter of the
total risk.
x Unsystematic price fluctuations are not correlated with the market’s
systematic fluctuations.
335
Portfolio Analysis
x The standard deviation for each portfolio is calculated and plotted. As the
portfolio size increases, the total risk line starts declining. It flattens out after
a certain point. Beyond that risk cannot be reduced. This implies that
spreading out assets beyond a certain level cannot be expected to reduce
the portfolio’s total risk below the level of the undiversifiable risk.
x When a large number of stocks are included in a portfolio, the returns and
risks associated with individual stocks should be analysed before their
inclusion. For this, a lot of information has to be gathered and kept and this
involves high costs.
x Most people agree that holding two stocks is less risky than holding one.
For example, holding stocks of textile, banking and electronic companies is
better than investing all the money in a textile company’s stock.
x The individual investor estimates risk on the basis of variability of returns,
i.e., the variance of returns. An investor’s decision is based solely on the
expected return and variance of returns.
x In developing his model, Markowitz gives up the single stock portfolio and
introduces diversification. The single security portfolio would be preferable
if the investor is perfectly certain that his expectation of higher return will be
fulfilled.
x In correlation, co-variance is not taken as an absolute value but relative to
the standard deviation of individual securities.
x The correlation between two securities depends upon the covariance
between the two securities and the standard deviation of each security.
13.6 KEY WORDS
x Portfolio: It means the group of assets an investor owns.

x Covariance: It is a statistical measure of how one investment moves in
relation to another.
x Correlation co-efficient: It measures the degree of correlation
336
Portfolio Analysis

1. The total risk of the portfolio is measured by the variance of the rates of
return over time.
2. The problems that arise in spreading the investment across too many assets
are inclusion of poor performers, information inadequacy, high research,
and high transaction costs.

1. An individual investor estimates risk on the basis of variability of returns i.e.
the variance of returns.
2. Holding two stocks is less risky than holding one but building up and
optimal portfolio is very difficult. Markowitz provides an answer by
analysing the risk and return relationship.

1. The traditional approach basically deals with two major decisions. They
are:
x Determining the objectives of the portfolio
x Selection of securities to be included in the portfolio
2. Time horizon is the investment-planning period of the individuals. This
varies from individual to individual. Individual’s risk and return preferences
are often described in terms of his “life cycle”.
1. What is simple diversification? Can it reduce total risk?

2. Define Markowitz diversification. Explain the statistical method used by
Markowitz to reduce risks.
3. Differentiate between the traditional and modern approach of portfolio
management.
337
Portfolio Analysis
4. Analyse the process of selection of a portfolio.

5. Explain the nature of portfolio risk if two securities are (a) perfectly
positively related (b) perfectly negatively correlated (c) have zero
correlation.

McGraw-Hill.
338
Effects of Combination
of Securities
UNIT–14 EFFECTS OF COMBINATION OF SECURITIES
Objectives
x Understand the concept of combination of securities
x Define utility analysis, indifference map and efficient frontier
Structure
14.1 Introduction
14.2 Combination of Securities
14.3 Utility Analysis
14.4 Summary
14.5 Key Words
14.1 INTRODUCTION
Portfolio risks can be calculated, like calculating the risk of single investments, by
taking the standard deviation of the variance of actual returns of the portfolio over
time. Most portfolios are diversified to protect against the risk of single securities or
class of securities. However, how rapidly risk declines depends on the covariance of
the assets composing the portfolio. Covariance is a statistical measure of how one
investment moves in relation to another. Because covariance numbers cover a wide
range, the covariance is normalized into the correlation coefficient, which measures
the degree of correlation, ranging from -1 for a perfectly negative correlation to +1
for a perfectly positive correlation.
14.2 COMBINATION OF SECURITIES
Combination of two securities reduces the risk factor if less degree of positive
correlation exists between them. In our case, the correlation coefficient is -1.
Vp = X12 V 1
2
+ X22 V 2
2
+ 2 X1 X2 (r12 V1 V2)
= ( 2/3)2 x 9+(1/3)2 x 36+2 x 2/3 x 1/3 (-1 x 3 x 6)
= 4 + 4 + (-8)
= 0
339
of Securities
The portfolio risk is nil if the securities are related negatively. This indicates that
the risk can be eliminated if the securities are perfectly negatively correlated. The
standard deviation of the portfolio is sensitive to (1) the proportions of funds devoted
to each stock (2) the standard deviation of each security and (3) co-variance
between two stocks.
The change in portfolio proportions can change the portfolio risk. Taking the
same example of ABC and XYZ stock, the portfolio standard deviation is calculated
for different proportions.
Stock ABC (X1) Stock XYZ (X2) Portfolio Standard
Deviation
100 0 3
66.66 33.3 0
50.0 50.0 1.5
0 100 6
By skillfull balancing of the investment proportions in different securities, the

portfolio risk can be brought down to zero. The proportion to be invested in each
security can be found out by:
X1 = V 1÷ ( V 1 + V2) the precondition is that the correlation co-efficient should
be –1.0.
Otherwise it is:
V 22 (r12 V1V2 )
X1
V12 V 22 (2r12 V1V 2 )
If the correlation co-efficient is less than the ratio of smaller standard deviation to
larger standard deviation, then the combination of two securities provides a lesser
standard deviation of return than when either of the security is taken alone. In our
example,
3
1 i . e . 1 .50
6
If the standard deviation ratio is 4/6 and the correlation co-efficient is + .8, the
combination of securities is not profitable because:
4
.8 ! i . e . .8 ! .66
6
340
of Securities
Varying Degrees of Correlation

In order to explain more about the relationship between securities, different degrees
of correlation co-efficients are analysed. Extreme cases like +1, -1, intermediate
values and no correlation are calculated for two securities namely X and Y. We
assume that the investor has specific amount of money to invest and that can be
allocated in any proportion between the securities. Security X has an expected rate
of return of 5% and a standard deviation of 4%. While for security Y, the expected
return is 8% and the standard deviation of return is 10%.
Let us first work out the expected return and the portfolio risk for different
values of correlation coefficients for varying proportions of the securities X and Y.
Portfolio return is calculated with the equation:
Rp = Xx Rx + Xy Ry
If there is 75% investment on X and 25% on Y, then Rp = .75 (5%) + 0.25 (8%)
= 5.75% then the Vp would be found out by using equation:
V p
= X2x V x2 + Xy2 Vy2 + 2Xx Xy (rxy Vx V y)
= 3/4 × 3/4 × 16 + 1/4 × 1/4 × 100 + 2 × 3/4 ×
1/4 (1 × 4 × 10)
= 5.5
Table 14.1 gives the values of Rp and Vp for varying degrees of correlation
co-efficients.
Table 14.1
Proportion of X Proportion of Y R s s s s
p p p p p
security in security in rxy rxy rxy rxy
portfolio portfolio
X1– X +1 –1 0 +.5
1.00 0.00 5.00 4.0 4.0 4.0 4.0

0.75 0.25 5.75 5.5 0.5 3.9 4.8
0.50 0.50 6.50 7.0 3.0 5.4 6.25
0.25 0.75 7.25 8.5 6.5 7.6 8.1
0.00 1.00 8.00 10.0 10.0 10.0 10.0
341
of Securities
The four figures 14.1 (a) (b) (c) and (d) indicate the relationship between risk
and return.
Risk and Return with Different Correlation
Fig. 14.1(a)
Fig. 14.1(b)
Fig. 14.1(c)
342
of Securities
Fig. 14.1(d)
All the graphs show the portfolio risks under varying levels of correlation co-
efficients. All the figures can be assembled together and placed in a single figure. The
following figure 14.2 expresses the relationship between expected returns and
standard deviations of returns for various correlation coefficients.
Fig. 14.2 Two Security Portfolio with Different Correlation Coefficients
In the figure 14.2, portfolio return is given on the vertical axis and portfolio risk
on the horizontal axis. Point A represents 100 per cent holdings of X and point B
represents 100 per cent holdings of Y. The intermediate points along the line segment
AB represent portfolios containing various combinations of two securities. The
straight line rx = +1 shows that the portfolio risk increases with the increase in
343
of Securities
portfolio return. Here, the combination of two securities could not reduce the
portfolio risk because of their positive correlation. Again, the ratio of smaller
standard deviation to larger deviation is less than the correlation coefficient.
1 > 4/10 = 1 >.4 which indicates that benefit cannot be derived by combining
both the securities. In this case if an investor wish to minimise his risk, it would be
better for him to invest all the money in security X where the risk is comparatively
lower.
The rxy = 0 line is a hyperbola. Along the line segment ACB, the rxy = 0. CB
contains portfolios that are superior to those along the line segment AC. Markowitz
says that all portfolios along the ACB line segment are feasible but some are more
efficient than others. The line segment ADB indicates (rxy = –1) perfect inverse
correlation and it is possible to reduce portfolio risk to zero. Portfolios on the line
segment DB provides superior returns than on the line segment AD. For example,
take two points on both the line segments K and J. The point K is superior to point
J because with the same level of risk the investor earns more return on point K than
on point J.
Thus, Markowitz diversification can lower the risk if the securities in the portfolio
have low correlation co-efficients.
Markowitz Efficient Frontier

The risk and return of all portfolios plotted in risk-return space would be dominated
by efficient portfolios. Portfolio may be constructed from available securities. All the
possible combination of expected return and risk compose the attainable set. The
following example shows the expected return and risk of different portfolios.
Table 14.2 Portfolio Risk and Return
Portfolio Expected Return (Rp) % Risk (Vp )
A 17 13
B 15 8
C 10 3
D 7 2
E 7 4
F 7 8
G 10 12
H 9 8
J 6 7.5
344
of Securities
The attainable set of portfolios are illustrated in figure 14.3. Each of the portfolio
along the line or within the line ABCDEFGJ is possible. It is not possible for the
investor to have portfolio outside of this perimeter because no combination of
expected return and risk exists there.
When the attainable sets are examined, some are more attractive than others.
Portfolio B is more attractive than portfolios F and H because B offers more return
on the same level of risk. Likewise, C is more attractive than portfolio G. even
though same level of return is achieved in both the points, the risk level is lower at
point C. In other words, any portfolio which gives more return for the same level of
risk or same return with lower risk is more preferable than any other portfolio.
Among all the portfolios, the portfolios which offer the highest return at particular
level of risk are called efficient portfolios. Here the efficient portfolios are A, B, C
and D, because at these points no other portfolio offer higher return. The ABCD line
is the efficient frontier along which all attainable and efficient portfolios are available.
Now the question raised is which portfolio the investor should choose? He would
choose a portfolio that maximizes his utility. For that utility analysis has to be done.
Fig. 14.3 Efficient Frontier
1. What is standard deviation of the portfolio sensitive to?

................................................................................................................
................................................................................................................
................................................................................................................
345
of Securities
2. On what condition will the combination of two securities provides a lesser

standard deviation of return than when either of the security is taken alone?
................................................................................................................
................................................................................................................
................................................................................................................
3. How can Markowitz diversification lower the portfolio risk?

................................................................................................................
................................................................................................................
................................................................................................................
14.3 UTILITY ANALYSIS
Utility is the satisfaction the investor enjoys from the portfolio return. An ordinary
investor is assumed to receive greater utility from higher return and vice-versa. The
investor gets more satisfaction or more utility in X + 1 rupees than from X rupee. If
he is allowed to choose between two certain investments, he would always like to
take the one with larger outcome. Thus, utility increases with increase in return.
The utility function makes certain assumptions about an investors’ taste for risk.
The investors are categorised into risk averse, risk neutral and risk seeking investor.
All the three types can be explained with the help of a fair gamble.
In a fair gamble which cost `1, the outcomes are A and B events. A event will
yield ` 2. Occurrence of B event is a dead loss i.e 0. The chance of occurrence of
both the events are 50% and 50%. The expected value of investment is (1/2) 2 +
1/2 (0) = `1. The expected value of the gamble is exactly equal to cost. Hence, it
is a fair gamble. The position of the investor may be improved or hurt by
undertaking the gamble.
Risk avertor rejects a fair gamble because the disutility of the loss is greater for
him than the utility of an equivalent gain. Risk neutral investor means that he is
indifferent to whether a fair gamble is undertaken or not. The risk seeking investor
would select a fair gamble i.e. he would choose to invest. The expected utility of
investment is higher than the expected utility of not investing. These three different
types of investors are shown in figure 14.4.
346
of Securities
Fig. 14.4 Marginal Utility and Return
The curves ABC are three different slopes of utility curves. The upward sloping
curve A shows increasing marginal utility. The straight line B shows constant utility,
and curve C shows diminishing marginal utility. A linear function means doubling of
returns would double the utility and it indicates risk neutral situation. The increasing
marginal utility suggests that the utility increases more than proportion to increase in
return and shows the risk seeking investor. The curve C shows risk averse investor.
The utility he gains from additional return declines gradually. The figures 14.5, 14.6
and 14.7 show the utility curves of the different investors.
Fig. 14.5 Indifference Curves of the Risk Fearing
347
of Securities
Fig. 14.6 Indifference Curves of the Risk Loving
Fig. 14.7 Indifference Curves of the Less Risk Fearing
Investors generally like to get more returns for additional risks assumed and the
lines would be positively sloped. The risk seeking investor’s utility curves are
negatively sloped and converge towards the origin. For the risk fearing, lower the
risk of the portfolio, happier he would be. The degree of the slope of indifference
curve indicates the degree of risk aversion. The conservative investor needs larger
return to undertake small increase in risk. The aggressive investor would be willing
to undertake greater risk for smaller return. Even though the investors dislike risk,
their trade off between risk and return differs.
348
of Securities
Indifference Map and the Efficient Frontier

Each investor has a series of indifference curves. His final choice out of the efficient
set depends on his attitude towards risk. Figure 14.8 shows the efficient frontier and
the indifference map.
Fig. 14.8 Indifference Curve and Efficient Frontier
The utility of the investor or portfolio manager increases when he moves up the
indifference map from I1 to I4. He can achieve higher expected return without an
increase in risk. In the figure 14.8 I22 touches the efficient frontier at point R. Even
though the points T and S are in the I2 curve, R is the only attainable portfolio which
maximises the utility of the investor. Thus, the point at which the efficient frontier
tangentially touches the highest indifference curve determines the most attractive
portfolio for the investor.
Leveraged Portfolios
In the above model, the investor is assumed to have a certain amount of money to
make investment for a fixed period of time. There is no borrowing and lending
opportunities. When the investor is not allowed to use the borrowed money, he is
denied the opportunity of having financial leverage.
Again, the investor is assumed to be investing only on the risky assets. Riskless
assets are not included in the portfolio. To have a leveraged portfolio, investor has to
consider not only risky assets but also risk free assets. Secondly, he should be able
to borrow and lend money at a given rate of interest.
349
of Securities
What is risk free asset?

The features of risk free asset are: (a) absence of default risk and interest risk and
(b) full payment of principal and interest amount. The return from the risk free asset
is certain and the standard deviation of the return is nil. The relationship between the
rate of return of the risk free asset and risky asset is zero. These types of assets are
usually fixed income securities. But fixed income securities issued by private
institutions have the chance of default. If the fixed income securities are from the
government, they do not possess the default risk and the return from them are
guaranteed. Further, the government issues securities of different maturity period to
match the length of investors holding period. The risk free assets may be government
securities, treasury bills and time deposits in banks.
Inclusion of risk free asset

Now, the risk free asset is introduced and the investor can invest part of his money
on risk free asset and the remaining amount on the risky asset. It is also assumed that
the investor would be able to borrow money at risk free rate of interest. When risk
free asset is included in the portfolio, the feasible efficient set of the portfolios is
altered. This can be explained in the Figure. 14.9.
Fig. 14.9 Efficient Frontier with Borrowing and Lending
In the figure 14.9, OP is gained with zero risk and the return is earned through
holding risk free asset. Now, the investor would attempt to maximise his expected
350
of Securities
return and risk relationship by purchasing various combinations of riskless asset and
risky assets. He would be moving on the line connecting attainable portfolio R and
risk free portfolio P i.e. the line PR. When he is on the PR, part of his money is
invested in fixed income securities i.e. he has lent some amount of money and
invested the rest in the risky asset within the point PR. He is depending upon his own
funds. But, if he moves beyond the point R to S he would be borrowing money.
Hence the portfolios located between the points RP are lending portfolios and
beyond the point R consists of borrowing portfolios. Holding portfolio in PR
segment with risk free securities would actually reduce risk more than the reduction
in return.
1. What are the features of risk free asset?

................................................................................................................
................................................................................................................
................................................................................................................
2. Define the term ‘utility’.

................................................................................................................
................................................................................................................
................................................................................................................
14.4 SUMMARY
x Combination of two securities reduces the risk factor if less degree of

positive correlation exists between them. The portfolio risk is nil if the
securities are related negatively. This indicates that the risk can be
eliminated if the securities are perfectly negatively correlated.
x The standard deviation of the portfolio is sensitive to (1) the proportions of
funds devoted to each stock (2) the standard deviation of each security and
(3) co-variance between two stocks.
351
of Securities
x The change in portfolio proportions can change the portfolio risk. By skill
full balancing of the investment proportions in different securities, the
portfolio risk can be brought down to zero.
x If the correlation co-efficient is less than the ratio of smaller standard
deviation to larger standard deviation, then the combination of two
securities provides a lesser standard deviation of return than when either of
the security is taken alone.
x In order to learn more about the relationship between securities, different
degrees of correlation coefficients are analysed.
x The risk and return of all portfolios plotted in risk-return space would be
dominated by efficient portfolios. Portfolio may be constructed from
available securities. All the possible combination of expected return and
risk compose the attainable set.
x Among all the portfolios, the portfolios which offer the highest return at
particular level of risk are called efficient portfolios.
x Utility is the satisfaction the investor enjoys from the portfolio return. An
ordinary investor is assumed to receive greater utility from higher return and
vice-versa.
x The utility function makes certain assumptions about an investors’ taste for
risk. The investors are categorised into risk averse, risk neutral and risk
seeking investor.
x When the investor is not allowed to use the borrowed money, he is denied
the opportunity of having financial leverage. Again, the investor is assumed
to be investing only on the risky assets. Riskless assets are not included in
the portfolio. To have a leveraged portfolio, investor has to consider not
only risky assets but also risk free assets. Secondly, he should be able to
borrow and lend money at a given rate of interest.
x The features of risk free asset are: (a) absence of default risk and interest
risk and (b) full payment of principal and interest amount. The return from
the risk free asset is certain and the standard deviation of the return is nil.
352
of Securities
The relationship between the rate of return of the risk free asset and risky
asset is zero. These types of assets are usually fixed income securities.
14.5 KEY WORDS
x Utility: It is the satisfaction the investor enjoys from the portfolio return.
x Indifference curve: It refers to a curve on a graph (the axes of which
represent quantities of two commodities) linking those combinations of
quantities which the consumer regards as of equal value.

1. The standard deviation of the portfolio is sensitive to the proportions of
funds devoted to each stock, the standard deviation of each security and
co-variance between two stocks.
2. If the correlation co-efficient is less than the ratio of smaller standard
deviation to larger standard deviation, then the combination of two
securities provides a lesser standard deviation of return than when either of
the security is taken alone.
3. Markowitz diversification can lower the risk if the securities in the portfolio
have low correlation co-efficients.

1. The features of risk free asset are absence of default risk and full payment
of principal and interest amount.
2. Utility is the satisfaction the investor enjoys from the portfolio return.
1. With the help of graphs explain the portfolio risks under varying levels of
correlation co-efficients.
353
of Securities
2. The utility function makes certain assumptions about an investors’ taste for
risk. Explain the types of investors.
3. Write a short note on risk free asset and its inclusion.

McGraw-Hill.
354
Capital Market
Theory
UNIT–15 CAPITAL MARKET THEORY
Objectives
x Explain capital asset pricing model
x Assess evaluation of securities
x Discuss the concept of arbitrage pricing theory
Structure
15.1 Introduction
15.2 Capital Asset Pricing Model (CAPM) Theory
15.3 Arbitrage Pricing Theory
15.4 Summary
15.5 Key Words
15.1 INTRODUCTION
Capital market theory is a generic term for the analysis of securities. It uses one or
the other mathematical model in order to explain and predict the progression of
financial and capital markets over time. Capital market theory is used as a model
that seeks to price assets, most commonly, shares in terms of trade-off between the
returns sought by investors and the inherent risks involved. Generally, a theory is
employed consciously or unconsciously whenever someone tries to formulate a
financial investment, or retirement plan. Several theories are used for these purposes
such as arbitrage pricing theory, capital asset pricing model, coherent market
hypothesis, efficient market hypothesis, fractal market hypothesis, or modern
portfolio theory.
However, the most popular model in capital market theory is the capital asset
pricing model. Capital market theory deals with issues like the role of the capital
markets, the major capital markets in the US, the initial public offerings and the role
of the venture capital in capital markets, financial innovation and markets in derivative
instruments, the role of securities and the exchange commission, the role of the
federal reserve system, role of the US Treasury and the regulatory requirements on
the capital market.
355
Capital Market
Theory
15.2 CAPITAL ASSET PRICING MODEL (CAPM) THEORY
Jack Treynor (1961), William Sharpe (1964), John Lintner (1965) and Jan Mossin
(1965) developed the asset pricing model independently. The theory was based on
the work of Harry Markowitz. It is a model of linear general equilibrium return. In
CAPM theory, the required rate of return of an asset has a linear relationship with an
asset’s beta value i.e., its un-diversifiable or systematic risk.
Assumptions of CAPM
CAPM is based on the following assumptions:
x An individual seller or buyer cannot affect the price of a stock. This is the
basic assumption of a perfectly competitive market.
x Investors make their decisions only on the basis of the expected returns,
standard deviations and covariances of all pairs of securities.
x Investors have homogenous expectations during the decision-making
period.
x An investor can lend or borrow any amount of funds at the risk-free rate of
interest. This rate of interest is the one offered for treasury bills or
government securities.
x Assets are infinitely divisible. Thus, an investor can buy shares in any
amount i.e., an investor can even buy `10 worth of Reliance Industry
shares.
x There is no transaction cost i.e., no cost is involved in the buying and selling
of stocks.
x There is no personal income tax. Hence, the investor is indifferent to the
form of return, whether it accrues as a capital gain or dividend.
x Unlimited quantum of short sales is allowed. An individual can sell any
amount of shares short.
Lending and borrowing

CAPM assumes that the investor can borrow or lend any amount of money at a
risk-free rate of interest. When this opportunity is given to investors, they can mix
risk-free assets with risky ones in a portfolio for the desired rate of risk-return
combination.
356
Capital Market
Theory
RP = portfolio return
Xf = proportion of funds invested in risk-free assets
1–Xf = proportion of funds invested in risky assets
Rf = risk-free rate of return
Rm = return on risky assets
The expected return on the combination of risky and risk-free assets is:
Rp = RfXf + Rm(1 – Xf)
This formula can be used to calculate the expected returns in different situations, like
mixing risk-free assets with risky ones, investing only in the risky asset, or using
borrowed money for the risky assets.
Now let us assume that borrowing and lending rates are 12.5% and the return
from the risky asset is 20%. There is a tradeoff between the expected return and
risk. If an investor invests in risk free assets and risky assets, his risk may be less
than what he invests in the risky asset alone. If he borrows to invest in risky assets,
his risk will increase more than he invests his own money in the risky assets. When
he borrows to invest, we call it financial leverage. If he invests 50% in risk-free
assets and 50% in risky assets, his expected return of the portfolio would be:
Rp = RfXf + Rm (1 – Xf)
= 12.5 × 0.5 + 20 (1 – 0.5)
= 6.25 + 10
= 16.25%
If there is zero investment in risk-free assets and 100% in risky ones, the return is
= 0 + 20%
= 20%
If –0.5 is in the risk-free asset, and 1.5 in the risky asset, the return is:
= (12.5 × –0.5) + 20 × 1.5
= –6.25 + 30
= 23.75
357
Capital Market
Theory
The variance of the above portfolio can be calculated by using the equation
V2p = V2f Xf2 + V2m (1 – Xf)2 + 2 CovfmXf (1 – xf)
The previous example can be taken for the calculation of the variance. The variance
of the risk-free asset is zero. The variance of the risky asset is assumed to be 15.
Since the variance of the risk-free asset is zero, the portfolio risk depends solely on
the portion of investment in the risky asset.
Table 15.1 A Sample Portfolio
The risk, at 22.5%, is more in the borrowing portfolio, but the return is also high. In
the portfolio with lending, the risk is 7.5%, but the return is also the lowest. The risk
premium is in proportion to the risk. The risk premium of a portfolio is the difference
between Rp and Rf i.e., the amount by which a risky rate of return exceeds the risk-
free rate of return.
Table 15.2 The Risk-Return Tradeoff
The risk-return proportionality ratio remains constant at 0.5. It shows that one unit
of risk premium is accompanied by 0.5 units of risk.
Basic Concept of CAPM

According to CAPM, all investors hold only a market portfolio and risk-free
securities. The market portfolio comprises all stocks in the market. Each asset is
held in proportion to its market value as compared to the total value of all risky
assets. For example, if Reliance shares represent 20 per cent of all risky assets, then
the market portfolio of the individual investor will have 20% of Reliance shares. At
this stage, the investor has the ability to borrow or lend any amount of money at the
risk-free rate of interest. The efficient frontier of the investor is given in Figure 15.1.
The investor prefers any point between B and C because with the same level of risk
358
Capital Market
Theory
that he faces on line BA, he can earn higher profits. The ABC line shows the
investor’s portfolio of risky assets. He can include risk-free assets either by lending
or borrowing. This is shown in Figure 15.2.
Fig. 15.1 Efficient Frontier
Fig. 15.2 Capital Market Line
The line RfS represents all possible combinations of risk-free and risky assets. The
S portfolio does not represent any risk-free asset, but the line RfS gives the
combination of both. The portfolio on the RfS line in Figure 15.2 is the lending
portfolio i.e., some money may be invested in the risk-free asset or may be
deposited in the bank for a fixed rate of interest. If it crosses the point S, it becomes
359
Capital Market
Theory
a borrowing portfolio. Money is borrowed and invested in the risky asset. The
straight line is called capital market line (CML). It represents the desirable set of
investment opportunities between risk-free and risky investments. The CML
represents a linear relationship between the required rates of return for efficient
portfolios and their standard deviations.
E(Rp) = portfolio’s expected rate of return

Rm = expected return on market portfolio
Vm = standard deviation of a market portfolio
Vp = standard deviation of the portfolio
For a portfolio on the capital market line, the expected rate of return in excess
of the risk-free rate is in proportion to the standard deviation of the market portfolio.
The price of the risk is given by the slope of the line. The slope equals the risk
premium for the market portfolio Rm– Rf divided by the risk or standard deviation of
the market portfolio. Thus, the expected return of an efficient portfolio is,
Expected return = Price of time + (Price of risk × Amount of risk)
Price of time is the risk-free rate of return. Price of risk is the premium amount
over and above the risk-free return.
Security Market Line (SML)

The risk-return relationship of an efficient portfolio is measured by the capital market
line. It does not show the risk-return tradeoff for other portfolios and individual
securities. Inefficient portfolios lie below the capital market line and the risk-return
relationship cannot be established with the help of the capital market line. Standard
deviation includes systematic and unsystematic risk. Unsystematic risk that can be
diversified is not related to the market. If the unsystematic risk is eliminated, then
systematic risk is alone of concern. This systematic risk can be measured by beta.
Beta analysis is useful for individual securities and portfolios whether efficient or
inefficient.
When a security is added to the market portfolio, risk is also added to it. The
variance of a portfolio is equal to the weighted sum of the covariances of the
individual securities in the portfolio. If we add a security to the market portfolio, its
marginal contribution to the variance of the market is the covariance between the
360
Capital Market
Theory
security’s return and a market portfolio’s return. If the security is included, the
covariance between the security and the market measures the risk. Covariance can
be standardized by dividing it by the standard deviation of a market portfolio (Covim/
Vm). This shows the systematic risk of the security. Then, the expected return of the
security is given by the equation:
This equation can be rewritten as follows.
The first term of the equation is nothing but the beta coefficient of the stock. The
beta coefficient of the equation of security market line (SML) is the same as the beta
of the market (single index) model. In equilibrium, all efficient and inefficient portfolios
lie along the security market line. The SML line helps to determine the expected return
for a given security beta. In other words, when betas are given, we can generate
expected returns for the given securities. This is explained in Figure 15.3.
Fig. 15.3 Security Market Line
If we assume the expected market risk premium to be 8 per cent and the risk-
free rate of return to be 7 per cent, we can calculate expected return for A, B, C
and D securities using the formula:
E (Ri) = Rf + Ei [E(Rm) – Rf]
If E =1
= 7 + 1 (8)
= 15%
361
Capital Market
Theory
Security A
Beta = 1.10
E (R) = 7 + 1.10(8)
= 15.8
Security B
Beta = 1.20
E (R) = 7 + 1.20(8)
= 16.6
Security C
Beta = 0.7
E (R) = 7 + 0.7(8)
= 12.6
The same can be found out easily from the Figure 15.3 too. All we have to do is
mark the beta on the horizontal axis and draw a vertical line from the relevant point
to touch the SML line. Then, from the intersection, draw another horizontal line to
touch the Y-axis. The expected return could be very easily read from the Y-axis. The
securities A and B are aggressive securities, because their beta values are greater
than one. When beta values are less than one, they are known as defensive
securities. In our example, security C has a beta value of less than one.
Evaluation of Securities
The relative attractiveness of a security can be found with the help of the security
market line. Stocks with a high risk factor are expected to yield more return and
vice-versa. The investor is interested in knowing whether the security offers a return
that is greater or less than proportional to its risk.
Figure 15.4 provides an explanation for the evaluation. There are nine points in the
diagram. A, B and C lie on the SML, R, S and T above it and U, V and W below
the SML. A, R and U have the same beta of 0.9. Likewise, beta values of S, B and
V are 1 and that of T, C and W is 1.1. The stocks lying above the SML yield higher
returns for the same level of risk. They are underpriced compared to their beta
values. We can prove that they are undervalued by using the simple rate of return
formula:
Ri
Po
362
Capital Market
Theory
Pi is the current price, Po, the purchase price and Div, the dividend. When the
purchase price is low, i.e., when the denominator value is low, the expected return
could be high. Applying the same principle, the stocks U, V and W can be classified
as overvalued securities and are expected to yield lower returns than stocks of
comparable risk. When the denominator value is high i.e., the purchase price is high,
the prices of these scrips may fall and lower the denominator. This will then increase
the securities’ returns.
Fig. 15.4 Evaluation of Securities with SML
The securities A, B and C are on the line. This means they are appropriately
valued. They offer returns in proportion to their risk. They have average stock
performance as they are neither undervalued nor overvalued.
Market Imperfections and SML

Information regarding the share price and market conditions may not be immediately
available to all investors. Imperfect information may affect the valuation of securities.
In a market with perfect information, all securities should lie on the SML. Market
imperfections would lead to a band of SML rather than a single line. They affect the
width of the SML band. If there are more imperfections, the width will also be more.
Figure 15.5 shows an SML in an imperfect market.
363
Capital Market
Theory
Fig. 15.5 SML in an Imperfect Market
Empirical Tests of the CAPM

In the CAPM, beta is used to estimate the systematic risk of a security and reflects
the future volatility of the stock in relation to the market. Future volatility of the stock
is estimated only through historical data. Historical data are used to plot the
regression line or the characteristic line and calculate the beta value. If historical
betas are stable over a period, they are a good proxy for their ex-ante or expected
risk.
Robert A Levy (1971), Marshall E Blume (1975) and others have studied the
question of beta stability intensively. Levy calculated betas for both individual
securities and portfolios. The main conclusions of his study were as follows:
x The betas of individual stocks are unstable; hence past betas are not good
estimators of future risk.
x The betas of portfolios of ten or more randomly selected stocks are
reasonably stable; hence, the betas of past portfolios are good estimators of
future portfolio volatility. This is because errors in the estimates of betas of
individual securities tend to offset one another in a portfolio.
Various researchers have attempted to find out the validity of the model by
calculating the beta and realized rate of return. They have attempted to test (1)
whether the intercept is equal to Rf, i.e., the risk-free rate of interest or the interest
rate offered for treasury bills and (2) whether the line is linear and passes through
beta = 1, which is the required rate of return of the market. In general, the studies
have produced the following results.
364
Capital Market
Theory
x A significant positive relationship between the expected return and

systematic risk. The slope of the relationship is usually less than that
predicted by the CAPM.
x The risk and return relationship appears to be linear. Empirical studies give
no evidence of significant curvature in the risk/return relationship.
x The CAPM theory implies that unsystematic risk is not relevant, but
unsystematic and systematic risks are positively related to security returns.
Higher returns are needed to compensate both the risks. Most of the
observed relationship reflects statistical problems rather than the true nature
of the capital market.
x According to Richard Roll (1977), the ambiguity of the market portfolio
leaves the CAPM untestable. The practice of using indices as proxies is
loaded with problems. Different indices yield different betas for the same
security.
x If the CAPM is completely valid, it should apply to all financial assets
including bonds. When bonds are introduced into the analysis, they do not
fall on the security market line.
Current Validity of CAPM

The CAPM is greatly appealing at an intellectual level, as it is logical and rational.
Although its basic assumptions raise some doubts in the minds of the investors,
investment analysts have been creative in adapting CAPM for their use. The
following points about CAPM should be noted:
x By focusing on the market risk, it makes the investors think about the
riskiness of assets in general. It provides the basic concepts and these are
of fundamental value.
x It is useful for the selection of securities and portfolios. Securities with
higher returns are considered to be undervalued and attractive buys.
Overvalued securities, whose returns are lower than the normal return, are
suitable for sale.
x In the CAPM, it is assumed that investors consider only the market risk.
Given the estimate of the risk-free rate, the beta of the firm and the
required market rate of return, one can find out the expected return for a
firm’s security. This expected return can be used as an estimate of the cost
of retained earnings.
365
Capital Market
Theory
x Even though CAPM is regarded as a useful tool for financial analysts, it has
its critics. They point out that when the model is ex-ante, the inputs also
should be ex-ante, i.e., based on the expectations of the future. Empirical
tests and analyses are ex-post, i.e., use only past data.
x Historical data regarding the market return, risk-free rate of return and
betas vary differently for different periods. The various methods used to
estimate these inputs also affect the beta value. Since the inputs cannot be
estimated precisely, the expected return determined through the CAPM
model is also subject to criticisms.
1. What is the basic assumption of a perfectly competitive market?

................................................................................................................
................................................................................................................
................................................................................................................
2. What is the purpose of beta in capital asset pricing model?

................................................................................................................
................................................................................................................
................................................................................................................
15.3 ARBITRAGE PRICING THEORY
Arbitrage pricing theory (APT) is one of the tools used by investors and portfolio
managers. Capital asset pricing theory explains the returns of the securities on the
basis of their respective betas. According to the models discussed earlier, an investor
chooses investments on the basis of the expected return and variance. The
alternative model in asset pricing developed by Stephen Ross is known as arbitrage
pricing theory. APT explains the nature of equilibrium in asset pricing in a less
complicated manner with fewer assumptions than CAPM.
Arbitrage
Arbitrage refers to the process of earning a profit by taking advantage of differential
pricing for the same asset. The process generates risk-free profit. In the security
market, it involves selling a security at a high price and the simultaneous purchase of
366
Capital Market
Theory
the same security at a relatively lower price. Since the profit earned through arbitrage
is risk-free, investors have the incentive to undertake this whenever an opportunity
arises. In general, some investors indulge more in this type of activity than others.
However, the buying and selling activities of the arbitrageur reduce and eliminate the
profit margin, bringing the market price to the equilibrium level.
APT is based on the following assumptions:
x Investors have homogenous expectations
x They are risk averse and utility maximizers
x Perfect competition prevails in the market, and there is no transaction cost
APT does not assume (1) a single period investment horizon (2) no taxes (3)
investors can borrow and lend at the risk-free rate of interest and (4) the selection
of the portfolio is based on the mean and variance analysis. These are the
assumptions of the CAPM theory.
Arbitrage Portfolio
According to APT, an investor tries to determine the possibility of an increase in the
returns from his portfolio without increasing the funds in it. He also likes to keep the
risk at the same level. For example, say the investor holds A, B and C securities and
wants to change the proportion of his investment in the securities without any
additional financial commitment. Let the change in the proportions be denoted by
XA, XB and XC. The investor can increase his investment in security A if he reduces
the proportions of his investments either in B or C, given that he tries to earn a higher
income without increasing his financial commitments. Thus, the changes in different
securities will add up to zero. This is the basic requirement of an arbitrage portfolio.
If X indicates the change in proportion,
'XA + XB + XC = 0
The factor sensitivity indicates the responsiveness of a security’s return to a
particular factor. The sensitiveness of the securities to any factor is the weighted
average of the sensitivities of the securities, with the weights being the changes made
in the proportion. For example, bA, bB and bC are the sensitivities; in an arbitrage
portfolio the sensitivities become zero.
bA 'XA + bB 'XB + bC 'XC = 0
An investor holds A, B and C stocks with the returns and sensitivity to changes
in industrial production is as follows. The total amount invested is `1,50,000.
367
Capital Market
Theory
Say the proportions change to:

'XA = 0.2
'XB = 0.025
'XC = –0.225
For an arbitrage portfolio:
'XA + XB + XC = 0
0.2 + 0.025 – 0.225 = 0
The sensitivities also become zero:
'XAbA + 'XBbB + 'XCbC = 0
0.2 × 0.45 + 0.025 × 1.35 – 0.225 × 0.55 = 0
In an arbitrage portfolio, the expected return should be greater than zero.
'XA RA + 'XBRB + 'XCRC > 0
=0.2 × 20 + 0.025 × 15 – 0.225 × 12
4.375 – 2.7 > 0
i.e., 1.675%
The investor would increase his investment in stock A and B by selling C. The new
compositions of weights would be:
'XA = 0.53
'XB = 0.355
'XC = 0.115
The portfolio allocation to stocks A, B and C is as follows:
= 1,50,000 × 0.53 + 1,50,000 × 0.355 + 1,50,000 × 0.115
= `(79,500 + 53,250 + 17,250)
= `1,50,000
The sensitivity of the new portfolio will be:
= 0.45 × 0.53 + 1.35 × 0.355 + 0.55 × 0.115
368
Capital Market
Theory
= 0.239 + 0.479 + 0.063

= 0.781
This is same as the old portfolio sensitivity:
i.e., 0.45 × 0.33 + 1.35 × 0.33 + 0.55 × 0.34 = 0.781
The return of the new portfolio is higher than that of the old portfolio.
Old portfolio return:
= 20 × 0.33 + 15× 0.33 + 12 × 0.34
= 6.6 + 4.95 + 4.08
= 15.63%
The new portfolio return:
= 20 × 0.53 + 15 × 0.355 + 12 × 0.115
= 10.6 + 5.325 + 1.38
= 17.305%
This is equivalent to the old portfolio return plus the return that occurred due to the
change in portfolio
= 15.63 +1.675 = 17.305%
The variance of the new portfolio’s change is only due to changes in its non-factor
risk. Hence, the change in the risk factor is negligible. From the analysis, it can be
concluded that:
x The return in the arbitrage portfolio is higher than that of the old portfolio.
x The arbitrage and old portfolio sensitivities remain the same.
x The non-factor risk is small enough to be ignored in an arbitrage portfolio.
Effect on the Price

To buy stock A and B the investor has to sell stock C. The buying pressure on stock
A and B would lead to an increase in their prices. Conversely, selling of stock C will
result in a fall in the price of stock C. At the lower price, there would be a rise in the
expected return of stock C. For example, if stock C at the price of `100 per share
earns 12 per cent return, at `80 per share the return would be 12/80 × 100 = 15%.
At the same time, return rates would decline in stock A and B with the rise in price.
This buying and selling activity will continue until all arbitrage possibilities are
eliminated. At this juncture, an approximate linear relationship arises between
expected returns and sensitivities.
369
Capital Market
Theory
The APT Model

According to Stephen Ross, the returns of the securities are influenced by a number
of macroeconomic factors. These are growth rates of industrial production, rate of
inflation, spread between long-term and short-term interest rates and spread
between low-grade and high-grade bonds. The arbitrage theory is represented by
the equation:
Ri = O0 + O1 bi1 + O2 bi2 + … + Oj bij
Ri = average expected return
O 1 = sensitivity of return to bi1
bi1 = beta co-efficient relevant to the particular factor
The equation is derived from the model
Ri = D1 + bi1 I1 + bi2 I2 + … + bijIj + ei
Let us take the two-factor model,
Ri = O0 +O 1 bi2 + bi2
If the portfolio is a well diversified one, unsystematic risk tends to be zero and
systematic risk is represented by bi1 and bi2 in the equation.
Let us assume the existence of three, well-diversified portfolios as shown here:
The equation Ri = O0 + O1 bi1 + O2 bi2 can be determined with the help of the
above-mentioned details. By solving the following equations,
12 = O0 + 1O1 + 0.5 O2
13.4 = O0 + 3O1 + 0.2O2
12 = O0 + 3O1 – 0.5O2
we can get
Ri = 10 + 1bi1 + 2 bi2
The expected return is
370
Capital Market
Theory
The risk is indicated by the sensitivities of the factors
All the portfolios constructed from portfolios A, B and C lie on the plane
described as A, B and C. Assume there exists a portfolio D with an expected return
of 14%, bi1 = 2.3 and bi2 = 0.066. This portfolio can be compared with portfolio E
having equal portion of A, B and C portfolios. Every portfolio would have a share of
33%. The portfolio bpj are:
bp1 = 1/3 × 1 + 1/3 × 3 + 1/3 × 3 = 2.33
bp2 = 0.5 × 1/3 + 0.2 × 1/3 + (–0.5 × 1/3) = 0.066
The risk for portfolio E is identical to the risk on portfolio D. The expected
return for portfolio E is:
1/3 (12) + 1/3 (13.4) + 1/3 (12)
= 12.46
Since portfolio E lies on the plane described above, the return could be obtained
from the equation of the plane.
R = 10 + 1 (2.33) + 2 (0.066)
= 12.46%
Portfolios D and E have the same risk but different returns. At this juncture, the
arbitrageur enters and buys portfolio D by selling portfolio E short. Thus, buying
portfolio D with the funds generated by selling E would provide riskfree profit with
no investment and no risk. Let us assume that the investor sells `1,000 worth of
portfolio E and buys `1,000 worth of portfolio D. The cash flow is as follows:
The arbitrage portfolio involves zero investment, has no systematic risk (bi1 and
bi2) and earns `15.4. Arbitrage would continue until portfolio D lies on the same
plane.
Arbitrage Pricing Equation

In a single factor model, the linear relationship between the return Ri and sensitivity
bi can be given in the following form.
Ri = OO + Oi bi
371
Capital Market
Theory
Ri = return from stock A

O o = risk-free rate of return
b i = sensitivity related to the factor
O i = slope of the arbitrage pricing line
The above model is known as a single factor model since only one factor is
considered. Here, only industrial production is considered. The APT one-factor
model is shown in Figure 15.6.
Fig. 15.6 APT One-Factor Model
Risk is measured along the horizontal axis and return on the vertical axis. Stocks A,
B and C stocks are considered to be in the same risk class. The arbitrage pricing line
intersects the Y axis on lO, which represents the risk-free rate of interest i.e., the
interest offered for the treasury bills. Here, the investments involve zero risk and it is
appealing to investors who are highly risk averse. li stands for the slope of the
arbitrage pricing line. It indicates the market price of risk and measures the risk-
return trade off in the securities market. bi is the sensitivity coefficient or factor beta
that shows the sensitivity of the asset or stock A to the corresponding risk factor.
The Constants of the APT Equation

The existence of a risk-free asset yields a risk-free rate of return that is a constant.
The asset does not have sensitivity to the factor, for example, industrial production.
If bi = 0,
Ri = O O + O i 0
Ri = O O
Ri = O O
372
Capital Market
Theory
In other words, OO is equal to the risk-free rate of return. If the single factor
portfolio’s sensitivity is equal to one i.e., bi = 1, then
Ri = OO + Oi1
This can be rewritten as:
Ri = O O + O i
Ri – O O = O i
Thus, li is the expected return in excess of the risk-free rate of return for a portfolio
with a unit sensitivity to the factor. The excess return is known as the risk premium.
Factors Affecting the Return

Many financial analysts have spelt out the factors affecting return. Chen, Roll and
Ross (1986) took four macroeconomic variables and tested them. According to
them, the factors are inflation, the term structure of interest rates, risk premia and
industrial production. Inflation affects the discount rate or the required rate of return
and the size of future cash flows. Short-term inflation is measured by monthly
percentage changes in the consumer price index. The interest rates on long-term
bonds and short-term bonds differ. This difference affects the value of payments in
the future relative to short-term payments. The difference between the return on
high-grade bonds and low-grade (more risky) ones indicates the market reaction to
risk. Industrial production represents the business cycle. Changes in industrial
production have an impact on the expectations and opportunities of the investor. The
real value of the cash flow is also affected by it.
Burmeister and McElroy (1988) have estimated the sensitivities with some other
factors. These are given below:
x Default risk
x Time premium
x Deflation
x Change in expected sales
x The market return not due to the first four variables
The default risk is measured by the difference between the return on long-term
government bonds and the return on long-term bonds issued by corporations plus
one-half of one per cent. Time premium is measured by the return on long-term
government bonds minus the one-month treasury bill rate of one month ahead.
Deflation is measured by the expected inflation at the beginning of the month minus
373
Capital Market
Theory
the actual inflation rate during the month. According to them, the first four factors
accounted for 25% of the variation in the Standard & Poor composite index and all
the four coefficients were significant.
Salomon brothers (1985) identified five factors in their fundamental factor
model. Inflation was the only factor they had in common with the others. Their
factors are given below:
x Growth rate in gross national product
x Rate of interest
x Rate of change in oil prices
x Rate of change in defence spending
All the three sets of factors have some common characteristics. They all affect
macroeconomic activities. Inflation and interest rate are identified as common
factors. Thus, the stock price is related to aggregate economic activity and the
discount rate of future cash flows.
APT and CAPM

The simplest form of the APT model is consistent with the simple form of the
CAPM model. When only one factor is taken into consideration, the APT can be
stated as:
Ri = OO + biOi
It is similar to the capital market line equation
Ri = Rf + bi (Rm – Rf), which is similar to the CAPM model.
APT is more general and less restrictive than CAPM. In APT, the investor has
no need to hold the market portfolio because it does not make use of the market
portfolio concept. The portfolios are constructed on the basis of the selected factors
to eliminate profits from arbitrage. APT is based on one price holding for all possible
portfolio combinations.
The APT model takes into account the impact of numerous factors on the
security. The macroeconomic factors are taken into consideration, and it is closer to
reality than CAPM.
The market portfolio is well defined conceptually. In the APT model, factors are
not well specified. Hence, the investor finds difficult to establish an equilibrium
relationship. The well-defined market portfolio is a significant advantage of the
CAPM and this has led to the wide use of this model in the stock market.
374
Capital Market
Theory
The factors that have an impact on one group of securities may not affect
another group of securities. There is a lack of consistency in the measurements of
the APT model.
Further, the influences of the factors are not independent of each other. It may
be difficult to identify the influence that corresponds exactly to each factor. Apart
from this, not all variables that exert an influence on a factor are measurable.
1. Define arbitrage.
................................................................................................................
................................................................................................................
................................................................................................................
2. How is risk measured on the graph?

................................................................................................................
................................................................................................................
................................................................................................................
15.4 SUMMARY
x Capital Asset Pricing Model (CAPM) theory was developed by Jack

Treynor (1961), John Lintner (1965) and Jan Mossin (1965). The theory
was based on the work of Harry Markowitz.
x CAPM is a model of general equilibrium return. In CAPM theory, the
required rate return of an asset has a linear relationship with an asset’s beta
value i.e. its un-diversifiable or systematic risk.
x The basic assumption of a perfectly competitive market is that the individual
seller or buyer cannot affect the price of a stock. CAPM assumes that the
investor can borrow or lend any amount of money at a risk-free rate of
interest.
x According to CAPM, all investors hold only a market portfolio and risk-
free securities. The market portfolio comprises all stocks in the market.
x For a portfolio on the capital market line, the expected rate of return in
excess of the risk-free rate is in proportion to the standard deviation of the
market portfolio.
375
Capital Market
Theory
x The expected return of an efficient portfolio is, Expected return = Price of

time + (Price of risk × Amount of risk)
x Price of time is the risk-free rate of return. Price of risk is the premium
amount over and above the risk-free return.
x The risk-return relationship of an efficient portfolio is measured by the
capital market line.
x Inefficient portfolios lie below the capital market line and the risk-return
relationship cannot be established with the help of the capital market line.
x Standard deviation includes systematic and unsystematic risk.
x In the CAPM, beta is used to estimate the systematic risk of a security and
reflects the future volatility of the stock in relation to the market. Future
volatility of the stock is estimated only through historical data. Historical
data is used to plot the regression line or the characteristic line and
calculate the beta value.
x The CAPM theory implies that unsystematic risk is not relevant, but
unsystematic and systematic risks are positively related to security returns.
Higher returns are needed to compensate both the risks. Most of the
observed relationship reflects statistical problems rather than the true nature
of the capital market.
x Arbitrage pricing theory (APT) is one of the tools used by investors and
portfolio managers. Capital asset pricing theory explains the returns of the
securities on the basis of their respective betas. According to the models
discussed earlier, an investor chooses investments on the basis of the
expected return and variance. The alternative model in asset pricing
developed by Stephen Ross is known as arbitrage pricing theory.
x Arbitrage refers to the process of earning a profit by taking advantage of
differential pricing for the same asset. The process generates risk-free
profit. In the security market, it involves selling a security at a high price
and the simultaneous purchase of the same security at a relatively lower
price.
x Many financial analysts have spelt out the factors affecting return. Chen,
Roll and Ross (1986) took four macroeconomic variables and tested them.
376
Capital Market
Theory
According to them, the factors are inflation, the term structure of interest
rates, risk premia and industrial production.
15.5 KEY WORDS
x Security market line: It measures the risk-return relationship of an

efficient portfolio.
x Market portfolio: It is a theoretical bundle of investments that includes
every type of asset available in the world financial market, with each asset
weighted in proportion to its total presence in the market.
x Arbitrage: It refers to the simultaneous buying and selling of securities,
currency, or commodities in different markets or in derivative forms in
order to take advantage of differing prices for the same asset.

1. An individual seller or buyer cannot affect the price of the stock. This is the
basic assumption of a perfectly competitive market.
2. In CAPM, beta is used to estimate the systematic risk of a security and
reflects the future volatility of the stock in relation to the market.

1. Arbitrage refers to the process of earning a profit by taking advantage of
differential pricing for the same asset.
2. Risk is measured along the horizontal axis on the graph.
1. State the assumptions of capital asset pricing model.

2. What is arbitrage pricing theory? Discuss in detail.
3. What do you understand by security market line?
377
Capital Market
Theory

McGraw-Hill.
378
Portfolio Performance
Evaluation
UNIT–16 PORTFOLIO PERFORMANCE EVALUATION
Objectives
x Define mutual fund
x Explain Sortino ratio and upside potential ratio
x Compare Sharpe’s, Treynor’s and Jensen’s performance index
Structure
16.1 Introduction
16.2 Mutual Fund
16.3 Treynor’s Performance Index
16.4 Summary
16.5 Key Word
16.6 Answers to ‘Check Your Proress’
16.1 INTRODUCTION
An investor can evaluate the performance of the funds using Sharpe’s and Treynor’s
indices. The Jenson measure will help him to determine the managerial efficiency of
the fund. The Sortino ratio will help him to examine the downside risk of a fund.
Portfolios are evaluated by portfolio managers, who can help identify a portfolio’s
strengths and weaknesses and based on its performance, develop a better
management strategy. Even though the evaluation of a portfolio’s performance is
considered the last stage of an investment process, it is an ongoing one. Managed
portfolios are commonly known as mutual funds. Different kinds of managed
portfolios are available in the capital market. The relative merits of the return and risk
criteria of the funds must be evaluated.
16.2 MUTUAL FUND
A mutual fund is an investment vehicle that pools funds from investors to invest in
stocks, bonds or other securities. An investor can participate in the mutual fund by
buying the units of the fund. Each unit is backed by a diversified pool of assets in
379
Evaluation
which the fund’s money has been invested. A closed-end fund has a fixed number of
units outstanding. It is open for a specific period to investors. The initial offer period
is terminated at the end of the pre-determined period. Closed-end schemes are
listed on stock exchanges. The investor can trade the units in the stock markets just
like other securities. The prices may be either quoted at a premium or at a discount.
In the open-end schemes, units are sold and bought continuously. Investors can
approach the fund managers directly to buy or sell the units. The price of the unit is
based on the net asset value (NAV) of the particular scheme. The NAV of the fund
is the value of the underlying securities of the scheme.
The gain or loss made by the mutual fund is passed on to investors after
deducting the administrative and investment management fees. The gains are
distributed to the unit holder in the form of dividend or reinvested to generate further
gains.
The mutual fund may be with or without a load factor. A commission or charge
paid by investors while purchasing or selling the mutual fund is known as a load
factor. Front-end load is charged when units are sold by the funds and back-end
load is charged when the units are repurchased by the funds. The front-end load
factor reduces the number of units when the investor buys it. The back-end load
reduces the investor’s proceeds when he sells the units. The load factor ranges
between one and six per cent of the NAV. Sometimes, the fund may not charge
either of the loads.
Net Asset Value (NAV)

Net asset value is the value of a fund’s assets minus its liabilities. NAV is typically
calculated on a per-unit basis.
NAV = (Market value of all securities held by the fund + Cash and
equivalent holdings – Fund liabilities) / Total fund units outstanding.
For example, if the mutual fund holds ` 205 lakh worth of securities and ` 30
lakh cash, and ` 6 lakh of liabilities and 20 lakh units outstanding at the close of a
trading day, then the value is computed as given below.
NAV = (205,00,000 + 30,00,000 – 600,000) / 20,00,000 = ` 11.45
Mutual funds calculate the NAV by themselves or through independent entities.
The NAV calculations for Reliance Mutual Fund and ABN Amro Mutual Fund are
done by Deutsche Bank. SEBI has laid down the regulations and guidelines with
regard to the valuation of funds’ investments. The valuations may be subject to audit
380
Evaluation
on an annual basis. The NAV changes in a trading day due to market fluctuations.
The NAVs of mutual funds are published in daily newspapers and on the funds’
websites. NAVs are important because of the following reasons:
x They help to determine the value of the investor’s current investment in that
mutual fund scheme.
x The NAV is the price at which new units of the schemes are bought and
sold.
x They provide a base for comparing the performance of various schemes.
Sharpe’s Performance Index

Sharpe’s performance index offers a single value to be used for the performance
ranking of different funds or portfolios. It is a reward to variability ratio. The Sharpe
index measures the risk premium of the portfolio in terms of its total risk. This risk
premium is the difference between the portfolio’s average rate of return and the risk-
free rate of return. The standard deviation of the portfolio indicates the risk. The
index assigns high values to assets that best support the risk-adjusted average rate of
return.
Rp R f
St
Vp
Portfolio average return Risk free rate of interest

Sharpe Index
Standard deviation of the portfolio return
The details of two hypothetical funds A and B are given below:

Table 16.1 Sharpe Index for Two Funds
The larger the St, the better the fund has performed. Thus, A is ranked as a
better fund because its index 0.457 > 0.427 even though portfolio B has a higher
return of 13.47 per cent. This is shown in Figure 16.1.
381
Evaluation
Fig. 16.1 Risk and Return for Funds A and B
The reason is that fund B’s managers took a great risk to earn the higher returns
and its risk-adjusted return is not profitable. The Sharpe index can be used to rank
the desirability of funds or portfolios, but not individual assets. An individual asset
carries unsystematic risk.
Sortino Ratio
The Sortino ratio, named after Frank A. Sortino, estimates the risk-adjusted return
of an asset or portfolio. It is a modification of the Sharpe ratio and evaluates return
per unit of risk on the downside. The Sharpe ratio takes equal account of both
upside and downside volatility. The Sortino ratio applies downside semi-variance in
the denominator. This is a measure of how much the return deviates from the minimal
acceptable rate. Thus, it differentiates negative volatility from positive volatility by
using downside deviation in the denominator. A large value of Sortino ratio points to
the low risk of significant losses occurring.
In the Russell Style Classification (RSC), the Sortino ratio is calculated as
follows:
Sortino ratio =
Where, r = average return

Where, rr = minimum acceptable return
V down = downside risk
This considers only returns that fall below a defined minimum acceptable return
(MAR) rather than the arithmetic mean. For example, if the MAR is seen as 12 per
382
Evaluation
cent, the downside deviation will measure the deviation of each period that falls
below 12 per cent.
Downside risk (Vdown)
=
N
Where
ri = Return for period i
N = Number of periods
rr = Minimum acceptable return
rd = (ri <rr)–rr
Upside Potential Ratio

This ratio, developed by Sortino, is a measure of excess return. Many investors
prefer funds that will yield the highest average return above their MAR. The upside
potential is the sum of returns in excess of the MAR divided by the total number of
observations. The upside potential ratio is the sum of upside deviations divided by
the downside risk. Downside deviation gives priority to larger deviations and is a
root mean square calculation. In upside potential, linear weighting is applied.
Upside potential =
N
ru = (ri > rr) – rr
Upside potential ratio =
= Sum of upside deviations ÷ downside risk

Downside deviation is calculated for at least 20 quarters or 36 months.
Sometimes, a fund’s returns for 24 months are used for calculation. To take an
example, the returns of 15 months are given in Table 16.1. The monthly minimum
acceptable return is assumed to be 0.8 per cent. The return, downside and upside
deviations are given in Table 16.2.
383
Evaluation
Table 16.2 Downside and Upside Deviations
Monthly downside risk (Vdown) = N
106.4
= 15
= 2.66
Annualized downside risk = Vdown × period of observation
Period of observation may be monthly or quarterly

= 2.66 × 12
= 9.21
Upside potential =
N
384
Evaluation
ru = (ri > 0.8) – 0.8

= 40.1 ÷ 15 = 2.67%
Downside potential =
N
= 20.8 ÷ 15
= 1.39
Upside potential ratio =
= 40.1 ÷ 9.21
= 4.35
Sortino ratio (monthly) =
= 2.09 – 0.8 ÷ 9.21

= 0.14
Sortino ratio (annualized) = 0.14 × 12
= 0.48
1. Define mutual fund.

................................................................................................................
................................................................................................................
................................................................................................................
2. What is Sharpe’s performance index?

................................................................................................................
................................................................................................................
................................................................................................................
385
Evaluation
3. Why is Sortino ratio used?

................................................................................................................
................................................................................................................
................................................................................................................
16.3 TREYNOR’S PERFORMANCE INDEX
To understand the Treynor index, an investor should know the concept of

characteristic line. The relationship between a given market return and the fund’s
return is given by the characteristic line. The fund’s performance is measured in
relation to the market performance. The ideal fund’s return rises at a faster rate than
the overall market performance when the market is moving upwards, and its rate of
return declines more slowly than the market return, in a decline. The ideal fund may
place its money in the treasury bills or short sell the stock during the decline and
make positive returns. The relationship between the ideal fund’s rate of return and
the market’s rate of return is shown in Figure 16.2.
Fig. 16.2 Fund’s Rate of Return
The horizontal axis shows the market return and the vertical axis, the fund’s rate
of return. The market return increases, while the fund’s return increases more than
proportional to the increase in market return and vice-versa. In Figure 16.3 the
fund’s rate of return is 20 per cent when the market’s rate of return is 10 per cent,
386
Evaluation
and when the market return is –10, the fund’s return is 10 per cent. The relationship
between the market return and fund’s return is assumed to be linear. This linear
relationship is shown by the characteristic line. Each fund establishes a performance
relationship with the market. The characteristic line can be drawn by plotting the
fund’s rate of return for a given period against the market’s return for the same
period. The slope of the line reflects the volatility of the fund’s return. A steep slope
would indicate that the fund is highly sensitive to the market’s performance. If the
fund is not so sensitive then the slope would be less.
All the funds have the same slope indicating the same level of risk. The investor
would prefer fund A because it offers a higher return than funds C and B for the
same level of risk exposure. This is shown in Figure 16.3.
Treynor measures the performance of the fund with the help of the characteristic
line. The slope of the line is estimated by:
Rp = D + (ERm + ep)
Where,
Rp = portfolio return
Rm = market return or index return
ep = error term or residual
D, E = coefficients to be estimated
Fig. 16.3 Market Return and Fund’s Return
The beta coefficient is treated as a measure of systematic risk, which cannot be

diversified.
387
Evaluation
of interest
Tn
Beta co-efficient of portfolio
Tn
Treynor’s risk premium of the portfolio is the difference between the average
return and the risk-free rate of return. The risk premium depends on the systematic
risk assumed in a portfolio. Let us analyse two hypothetical funds.
Table 16.3 Funds A and B
Fig. 16.4 Performance of funds A and B
Fund A is more valuable than B because it earns a higher risk premium per unit
of systematic risk (Tn of A 0.076 > 0.0678 of B).
Jensen’s Performance Index

The absolute risk-adjusted return measure was developed by Michael Jensen and is
commonly known as Jensen’s measure. It is mentioned as a measure of absolute
performance because performance is measured against a definite standard. This
standard is based on the manager’s predictive ability. Successful prediction of a
388
Evaluation
security price enables a manager to earn higher returns than the ordinary investor
expects to earn for a given level of risk. The basic Jensen model is as follows:
Rp = D + E (Rm – Rf)
Where,
Rp = average return of portfolio
Rf = risk-free rate of interest
D = the intercept
E = a measure of systematic risk
Rm = average market return
The return of the portfolio varies in the same proportion as the difference
between the market return and risk-free rate of interest. Beta is assumed to reflect
the systematic risk. If a fund’s portfolio is comprised of all market securities, its beta
will be equal to one. It will be greater than one if the fund’s portfolio consists of
securities that are riskier than a portfolio of all market securities. Figure 16.5 shows
the relationship between beta and fund’s return.
Fig. 16.5 Fund’s Beta and Return
Any professional manager would be expected to earn average portfolio return of

Rp = Rf + (Rm– Rf ). If his predictive ability is superior, he should earn more than
other funds at each level of risk. If the fund manager has consistently performed
better than the average Rp, there may be some constant factor that may make the
actual return higher than average Rp. This constant may be Dp that represents the
forecasting ability of the manager. Then the equation becomes
389
Evaluation
Rp – Rf = Dp + E(Rm – Rf)
or,
Rp = Dp + Rf + E(Rm – Rf)
By estimating this equation using regression techniques, Jensen claimed ap, the
constant, reflected the professional management’s ability to predict price
movements. A comparative analysis of three hypothetical funds A, B and C are given
in the Figure 16.6.
Fig. 16.6 Jensen’s Measure of Management Ability
Fund A’s Dp is equal to the risk-free rate of return. If no risk is undertaken, the
portfolio is expected to earn at least Rf. It is hypothesized that it takes no particular
professional managerial ability to increase the return Rp by increasing (Rm – Rf). In
fund C, the manager’s predictive ability earns him more than Rf. The fund manager
may be consistently performing better than the manager of fund A. If the
professional management does not improve, it will result in a negative Dp. This is
shown by the line B. Here, the Dp is even lower than the risk-free rate of interest.
Jensen, in his study of 115 funds, found that only 39 funds possessed positive Dp
and professional management had improved the expected return. On average, a
fund’s performance is worse than expected without professional management and if
any investor is to purchase such a fund’s shares, he must be selective in his
evaluation of management. Thus, Jensen’s evaluation of portfolio performance
involves two steps.
x Using the equation to calculate the expected return.
x Comparing the actual return with the expected return with the help of E, Rm
and Rf. If the actual return is greater than the expected return, the portfolio
390
Evaluation
is considered to be performing well. Table 16.4 gives the portfolio return

and the market return. Rank the performance.
Table 16.4 Portfolio Return and Market Return
Portfolio Rp E Rf
A 15 1.2 5%
B 12 0.8 5%
C 15 1.5 5%
Market Index 12 1.0 5%
The return can be calculated with the given information using the formula:
R = Rf + E (Rm – Rf)
Portfolio A = 5 + 1.2 (12–5) = 13.4
Portfolio B = 5 + 0.8 (12–5) = 10.6
Portfolio C = 5 + 1.5 (12–5) = 15.5
The difference between the actual and expected return is compared.
Portfolio A = 15 – 13.4 = 1.6
Portfolio B = 12 – 10.6 = 1.4
Portfolio C = 15 – 15.5 = –0.5
Among the risk-adjusted performance of the three portfolios, A is the best, B the
second best, with portfolio C in last position.
Excel Spreadsheet Application

Downside risk is calculated with the Excel spreadsheet. The example given inside the
lesson is used for calculation. The steps for calculation and the spreadsheet are
given.
Step 1: Enter the data in column A.
Step 2: For cell B2, write =IF(A2<0.8,A2–0.8). You will get the returns that are less
than 0.8. Drag and fill the cells.
Step 3: For cell C2, write =B2*B2. Drag and fill the cells.
Step 4: Choose cell A17. Click fx and select sum. Adopt the usual procedure for
the selection of data. Now you obtain the sum.
Step 5: Choose cell A18. Click fx and select average. Adopt the usual procedure of
selection of data. Now, you will obtain the average return.
Step 6: Choose cell C17. Click fx and select Sum. You will get the total of the
squared downside deviations
391
Evaluation
Step 7: Choose cell C18. Write =SQRT(C17/15) and press enter. Now, you obtain
the downside risk.
Annualized downside risk

Choose cell C19 and write =SQRT(12)*C18 and press enter.
Downside potential
Choose cell B17 and write = IMABS(SUM(B2:B16)) and press enter. You will get
the total of the absolute downside deviations.
Choose cell B18 and write = B17/15 and press enter. You will get the downside
potential.
Upside potential
Step 1: Choose cell 2 in Column D and write = IF(A2>0.8,A2–0.8). This gives
values higher than the minimum acceptable rate of return.
Step 2: Choose cell D17 and click fx, then sum.
Step 3: Choose cell D18 and write = D17/15 and press enter. You will get the
upside potential.
Upside potential ratio
Choose cell D19 and write = D17/C19, press enter, you will obtain upside potential
ratio.
Sortino ratio
Choose cell E2 and write = (A18-0.8) /C19 and press enter. Sortino ratio is there
for you.
Annualized Sortino ratio
Choose cell E3 and write = SQRT(12)*E2 and press enter. Annualized Sortino ratio
is ready.
Downside risk, upside potential and Sortino ratio in Excel spreadsheet
392
Evaluation
Check Your Progress- 2
1. What is a characteristic line?

................................................................................................................
................................................................................................................
................................................................................................................
2. Why is Jensen’s measure mentioned as a measure of absolute

performance?
................................................................................................................
................................................................................................................
................................................................................................................
16.4 SUMMARY
x A mutual fund is an investment vehicle that pools funds from investors to

invest in stocks, bonds or other securities. An investor can participate in the
mutual fund by buying the units of the fund. Each unit is backed by a
diversified pool of assets in which the fund’s money has been invested.
393
Evaluation
x A closed-end fund has a fixed number of units outstanding. It is open for a

specific period to investors. The initial offer period is terminated at the end
of the pre-determined period. Closed-end schemes are listed on stock
exchanges. The investor can trade the units in the stock markets just like
other securities. The prices may be either quoted at a premium or at a
discount.
x In the open-end schemes, units are sold and bought continuously. Investors
can approach the fund managers directly to buy or sell the units. The price
of the unit is based on the net asset value (NAV) of the particular scheme.
The NAV of the fund is the value of the underlying securities of the scheme.
x Net asset value is the value of a fund’s assets minus its liabilities. NAV is
typically calculated on a per-unit basis.
x Sharpe’s performance index offers a single value to be used for the
performance ranking of different funds or portfolios. It is a reward to
variability ratio. The Sharpe index measures the risk premium of the
portfolio in terms of its total risk.
x Risk premium is the difference between the portfolio’s average rate of
return and the risk-free rate of return. The standard deviation of the
portfolio indicates the risk. The index assigns high values to assets that best
support the risk-adjusted average rate of return.
x The Sortino ratio, named after Frank A. Sortino, estimates the risk-
adjusted return of an asset or portfolio. It is a modification of the Sharpe
ratio and evaluates return per unit of risk on the downside.
x The ratio, developed by Sortino, is a measure of excess return. Many
investors prefer funds that will yield the highest average return above their
MAR. The upside potential ratio is the sum of upside deviations divided by
the downside risk.
x Treynor measures the performance of the fund with the help of the
characteristic line.
x Treynor’s risk premium of the portfolio is the difference between the
average return and the risk-free rate of return. The risk premium depends
on the systematic risk assumed in a portfolio.
x The absolute risk-adjusted return measure was developed by Michael
Jensen and is commonly known as Jensen’s measure. It is mentioned as a
394
Evaluation
measure of absolute performance because performance is measured against

a definite standard.
x Downside risk is calculated with the Excel spreadsheet.
16.5 KEY WORD
x Net asset value (NAV): It is the value of a fund’s assets minus its
liabilities. NAV is typically calculated on a per-unit basis.

1. A mutual fund is an investment vehicle that pools funds from investors to
invest in stocks, bonds or other securities.
2. Sharpe’s performance index offers a single value to be used for the
performance ranking of different funds or portfolios. It is a reward to
variability ratio. The Sharpe index measures the risk premium of the
portfolio in terms of its total risk.
3. The Sortino ratio, named after Frank A. Sortino, estimates the risk-
adjusted return of an asset or portfolio. It is a modification of the Sharpe
ratio and evaluates return per unit of risk on the downside.

1. The relationship between a given market return and the fund’s return is
given by the characteristic line. It can be drawn by plotting the fund’s rate
of return for a given period against the market’s return for the same period.
2. Jensen’s measure is mentioned as a measure of absolute performance
because performance is measured against a definite standard.
1. What do you understand by mutual fund? Discuss with reference to NAV.

2. Compare and contrast Treynor’s performance index with that of Jensen’s.
3. Write short notes on Sortino ratio and upside potential ratio.
4. What is Sharpe’s performance index?
395
Evaluation

McGraw-Hill.
396

305 (Security Analysis and Portfolio Management)

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

305 (Security Analysis and Portfolio Management)

Uploaded by

Copyright:

Available Formats

SECURITY ANALYSIS

Master of Commerce (M.Com.)

Centre for Distance and Open Learning

Prof. Talat Ahmad Prof. M. Mujtaba Khan

Prof. Mohammad Miyan Mr. Prashant Negi

Prof. Y.P. Singh Dr. Arvind Kumar

Prof. K.V. Bhanu Murthy Dr. Pooja Talwar

Prof. Attam Prakash Dr. Sunayana

Dr. Ritu Sapra

Block I An Overview of Investment Unit-1: Investment Analysis: Nature and Scope

Block II Securities Market in India Unit-5: Functions and Methods of Selling

Block IV Portfolio Theory Unit-13: Portfolio Analysis

BLOCK-I : AN OVERVIEW OF INVESTMENT

UNIT 1 INVESTMENT ANALYSIS: NATURE AND SCOPE 3-38

UNIT 2 APPROACHES TO INVESTMENT ANALYSIS 39-54

UNIT 3 CONCEPT OF RETURN AND RISK 55-68

UNIT 4 SECURITY AND RISK ANALYSIS 69-94

UNIT 5 FUNCTIONS AND METHODS OF SELLING SECURITIES

UNIT 6 BROKER: IMPORTANCE, TYPES AND ROLE 139-158

UNIT 7 TRADING MECHANISM AND LISTING OF SECURITIES IN

BLOCK-III : ANALYSIS FOR EQUITY INVESTMENT

UNIT 8 DEPOSITORY ACT, 1996 197-210

UNIT 10 FUNDAMENTAL ANALYSIS 233-262

UNIT 11 TECHNICAL ANALYSIS 263-296

UNIT 12 EFFICIENT MARKET HYPOTHESIS 297-318

UNIT 13 PORTFOLIO ANALYSIS 321-338

UNIT 14 EFFECTS OF COMBINATION OF SECURITIES 339-354

UNIT 15 CAPITAL MARKET THEORY 355-378

UNIT 16 PORTFOLIO PERFORMANCE EVALUATION 379-396

UNIT–1 INVESTMENT ANALYSIS: NATURE AND SCOPE

1.2 NATURE OF INVESTMENT MANAGEMENT

Secure investment, gambling and speculation

 It expects gains while bearing associated risks.

4. Same as answer for 3.

Time Average Chances of making a

Meaning of standard deviation

3. Relationship with existing assets in investment portfolio

Correlation: Interpretation of Scope of Scope of

+0.70 to +0.99 Little Difference Little Little

+0.30 to +0.69 More Difference Good Good

0 to +0.29 Significant Difference Great Great

-0.50 to 0 . Little Opposite Excellent Excellent

-0.51 to -0.99 Quite Opposite Fantastic Fantastic

-1 Exact Opposite Perfection Maximum

Fig. 1.1 Pattern of Security Returns

In Figure 1.1, both securities, A and B, are perfectly negatively correlated. As a

Check Your Progress - 1

1. What is financial investment?

2. What are speculative investments?

3. What are transaction costs?

1.3 SCOPE OF INVESTMENTS

History of making investments traces back to human existence when it first

Fig. 1.2 Average Savings Rate in Major Countries since 2001

Scope of Investment Alternatives

1. Tangibility Perspective (Real and Financial Investments)

2. Economic and Financial Investments perspective

3. Risk perspective (Fixed return vs Variable return)

4. Return perspective (Growth vs Income)

5. Time Horizon perspective (Short term vs Long term)

6. Mode of making investment perspective (Direct Investments vs Pooled

7. Activity perspective (Active style vs Passive style)

index or a customized set of various assets decided well in advance. Some

Comparison between active and passive style