FMP End Term

Fixed Income Products:
Securitization
1
Agenda
Concept of Securitization
ABS / MBS
CMO
CDO/CLO
Indian Experience
2
What is Securitization
Process of pooling / repackaging non-marketable,
illiquid assets into tradable securities
Involves true sale of the underlying assets
Additional support provided by the originator/ issuer
to enhance rating of the securitized paper
Investors’ recourse restricted to proceeds from the
underlying assets and the credit enhancement
Securitization transforms the risk-return characteristics of an
asset to meet demands of the transaction participants
3
Classes of securitised paper
Asset backed securitisation (ABS)
Auto pool securitisation
Mortgage backed securitisation
CDO/CLO : Collateralized debt/loan obligations
Lease rentals securitisation
Future flow securitisation (FFS)
Securitisation of receivables to be generated in future
Road toll securitisation
Telecom receivables securitisation
Credit card receivables securitisation
4
Typical transaction structure
Originator Credit Enhancement Liquidity Facility
Providers Providers
Sale of
Purchase
Loans Issue of securities (PTCs)
consideration
Original
Servicing
Loan SPV Investors
Obligors of securities
Receivables Subscription to securities

Collection
Agency Rating
Agreement Arranger
Collection
Agent Rating Agency
Contracts
Ongoing cash flows
Initial cash flows
5
Parties to a securitisation
Initial owner of the assets
Originator Sells its asset to the SPV
Contractual debtor to Originator

Obligor Pays cashflows that are securitised
Set up specifically for transaction

SPV Purchases assets from Originator
Company/Trust/ Mutual Fund
Subscribe to securities
Investors issued by SPV
6
Parties to a securitisation (contd.)
Collects monies from Obligors,
Servicer
monitors and maintains assets
Banker for the deal. Manages

Receiving &
inflows& outflows, invests interim
Paying Agent funds, accesses cash collateral
Credit Provides credit enhancement

enhancement by way of swaps, hedges,
provider guarantees, insurance etc.
As structurer for designing &

Merchant executing the transaction and
banker as arranger for the securities
7
Parties to a securitisation (contd.)
Provides a rating for the deal
Credit Rating
based on structure, rating of
Agency parties, legal and tax opinion etc
Legal & Tax Provide key opinions on the

Counsel structure & underlying contracts
Appointed for conducting due

Auditor diligence both initial and
during tenor of deal
Appointed for safe custody of the

Custodian
underlying documents and
R&T Agents registration/ transfer of securities
8
Conventional business model
Traditional bank / FI
Origination Servicing
Originate and hold till maturity
Funding
9
Classical Financial Model
Bank's ability to lend restricted by:
⚫ The capital it could raise through traditional
borrowing (deposits)
⚫ Geographical concentrations
⚫ Nature (tenure) of liabilities raised
Posed a systemic challenge of failure to the banking model
Investors’ appetite restricted by:
⚫ Low availability of highest credit paper
⚫ Assets to match the liabilities raised
⚫ Lack of dissemination channels available to Mutual
Funds, Insurance Companies etc.
Need an evolution of markets to address these issues
10
Changing business model
Securitization leads to..
NBFCs / Banks NBFCs / Banks /

Specialized servicers
Funding
Funding
Banks, MFs, Insurance

companies, individuals
11
…unbundling of roles
Institutions with good distribution arms can concentrate
on origination without holding to maturity
Can expand lending as constraint on capital removed
Servicing expertise improves operational efficiency of the
sector
Disaggregate, repackage and distribute assets to different
parties - able and willing to accept them
Realize benefits from specialization and economies of scale
Enabling banks to achieve higher RoA and RoCE
Investors get customised investment solutions from the
originators
12
Securitization – Transcending the
barriers
Loans, origination and HTM, static book
Credit • PTCs
• STRIPS
• Trading
Credit market • Credit views
• Dynamic
portfolio
management
Markets
Bonds, debentures, trading, interest rate views
13
Essential for capital market evolution
Helps banks access funds for onward lending in infrastructure,
retail sector
Diversifies risk in the economy by reducing concentrations
Gives transparency to the way lending is priced by marrying
demand with supply
Improves internal monitoring of asset portfolio to take stock of
actual risk levels on the balance sheet
Brings out operational efficiency and robust risk management
through the involvement of external rating agencies on
internal portfolio
With increasing development, leads to standardization of
lending and borrowing operations and servicing capabilities
14
Benefits of Securitization …
⚫ Managing portfolio concentrations through
Portfolio
investment in diverse pools of assets and
management
reducing heavy exposures
⚫ For banks with limited disbursement capabilities,

it enables them to inorganically build
incremental asset book during slowdown in
Asset Liability credit off take
Management ⚫ Corrects mismatch between asset liability
growth; overall growth higher of the two
⚫ Can look at originating specific to market
demands
15
Benefits of Securitization …
⚫ Generates AAA credit to match the market

demand for it
⚫ Enables banks with a limited distribution channel
to also have AAA exposure
⚫ High yields at lower risks; yield pickup since
Investment structures usually priced at a premium
options ⚫ Paper to suit different risk appetites based on
time tranching and subordination
⚫ Lower volatility of rating (S&P study in 2001 for
the US Securitization Markets revealed less than
1% default ratio out of 13,538 classes)
16
Securitisation – Evaluation
Parameters
Ability to borrow
High leverage restricts on-balance sheet funding
Securitisation reduces leverage
Rating of originator
Poor rating inhibits borrowing
Securitisation ensures higher rating through
cherry-picking
credit-enhancements
17
Securitisation – Evaluation
Parameters (contd.)
Cost of borrowing
Securitisation allows lower cost borrowing
Rating of borrower does not impact transaction
rating
Reduction in leverage
Tenure of borrowing
Long-term funds available
Matching of borrowing with assets
18
Illustration #1 – Medium-sized
NBFC
Background
Player in auto-loan segment
Small capital base/high leverage leading to:
Low rating/ high cost of borrowing
Capital is a constraint for business expansion
Solution – Securitize auto-loans
Lower cost of funding
Ability to raise fresh assets
Improved return on capital
19
Illustration #2 – Large-sized Bank
Background
Large bank – present in all asset classes
Aggressive size and profit targets need:
Constant funding for asset creation
Increased margins without affecting volumes
Solution – Securitize auto/mortgage/corporate loans

Aggressive asset-growth possible
Lower servicing costs on higher base
Improved profit margins/return on capital
20
International Experience
Global structured finance issuance in 2021 was $1.53
trillion that is expected to grow to $3.14 by 2027.
Mortgage related issuances outstanding UPB, Unpaid
Principal Balance) in the US markets alone is at $ 7.7
trillion from around 1 million issues
This market represents maximum depth and width
where the entire range of credits (from AAA to BB) is
traded
Investors in sub-investment grade credits include
hedge funds and private equity funds
21
22
23
Indian Market
1991: First auto ABS issuance by Citibank
Issue size – INR 231 mn (USD 8 mn)
1991 – 1997: Sporadic issuances

13 auto ABS issuances and four other transactions
Cumulative issuance amount = INR 5 bn (USD 109 mn)
Average issue size under INR 500 mn (USD 11 mn)
Issuances restricted to Car and CV loans categories
Limited issuers: mainly NBFCs and a few foreign banks
1998 – 2000: Dormant market

Recession in India
Underperformance by NBFCs
Tightening of fiscal regulations
24
Indian Market
Fiscal 2021-22 witnessed the securitization market
in India grow to Rs. 1.35 trillion compared Rs. 0.9
trillion in the previous year.
In 2019 and 20, the size was Rs. 1.9 trillion.
First half of 2022-23 saw 0.75 trillion worth of
securitization deals.
Mortgage-backed securitization (MBS) loans remain
the largest segment among asset classes,
accounting for ~40% of market volume, followed
by commercial vehicle (CV) loans (30%) and
microfinance loans (13%). In comparison,
property-backed and CV loans had accounted for
45% and 21% respectively, in the first half of last
fiscal.
25
Indian Market (contd.) ..
Simple issue structures
Pass Through Certificates
Single senior tranch
Premium transfer
Direct assignment
Single Obligor issues
Introduction of new asset categories
Mortgage loans, Personal loans and multi obligor CDOs
Till FY 01: Small issuances; since then markets have
picked up
26
Indian Market (contd.) ..
Increased market penetration
Originator Side
Entry and dominance of private banks as issuers
Foreign banks and their financing outfits followed
NBFCs reduced to marginal role
Investor side
Banks and insurance companies participate on the
long end of tenure
Mutual Funds participate at the short end
27
28
Mortgage-backed securities
Mortgage-backed securities are securities backed
by a pool of mortgage loans.
1. Mortgage passthrough securities;
2. Collateralized mortgage obligations;
3. Stripped mortgage-backed securities.
The last two types are called derivative
mortgage-backed securities since they are
created from the first type.
29
MBS versus fixed income investments
• Virtually no default risk since the mortgages in a pool
are guaranteed by a government related agency, such
as GNMA (Government National Mortgage
Association) or FNMA (Federal National Mortgage
Association).
• Originating a mortgage loan is like writing a coupon
bearing bond, except that the par is repaid in
amortized amount periodically.
• Prepayment risk – like the call right of a bond issuer
Prepayment privileges given to the householder to put
the mortgage back to the lender at its face value.
30
Mortgage passthrough securities
• A mortgage passthrough security is a security created when
one or more holders of mortgages form a pool of mortgages
and sell shares or participation certificates in the pool.
• The cash flows consist of monthly mortgage payments
representing interest, scheduled repayment of principal,
and any prepayments.
• Payments are made to security holders each month. The
monthly cash flows for a passthrough are less than the
monthly cash flows of the underlying mortgages by an
amount equal to servicing and other fees.
• Not all of the mortgages included in the pool that are
securitized have the same mortgage rate and the same
maturity. A weighted average coupon rate and a weighted
average maturity are determined.
31
Prepayment
One of the biggest problems facing MBS is the
prepayment risk.
Payments made in excess of the scheduled
principal repayments. The amount and timing
of the cash flows from the repayments are not
known with certainty.
• Sale of a home
• Market rates fall below the contract rate
• Failure to meet the mortgage obligations
32
Factors affecting prepayment behaviors
1. Prevailing mortgage rate – the current level of mortgage
rates relative to the borrower’s contract rate.
The spread should be wide enough to cover the refinancing costs
2. Path history of rate spread is important
depends on whether there have been prior opportunities to
refinance since the underlying mortgages were originated.
3. Presence of prepayment penalty.
4. Macroeconomic factors e.g. growing economy results in a
rise in personal income and opportunities for worker
migration.
5. Seasonal factor: Home buying increases in the Spring and
reaches a peak in the late Summer. Since there are delays
in passing through prepayments, the peak may not be
observed until early Fall.
33
Prepayment models
Describes the expected prepayments on the underlying
pool of mortgages at time t in terms of the yield curve
at time t and other relevant variables.
− predicted from an analysis of historical data.
Example
Weekly report “Spread Talk” published by the Prudential
Securities
provides 6-month, 1-year and long-term prepayment
projections assuming different amounts of shift in
interest rates.
34
Collateralized Mortgage Obligations
A collateralized mortgage obligation is a debt instrument
collateralized by mortgage passthrough certificates. The
cash flows (interest and principal) are directed to different
bond classes, called tranches so as to mitigate different
forms of prepayment risk.
• The creation of a CMO cannot eliminate prepayment risk. It
can only redistribute prepayment risk among different
classes of bond holders.
• CMO class has a different coupon rate from that for the
underlying collateral, resulting in instruments that have
varying risk-return characteristics that fit the needs of
fixed-income investors.
• Assume that investors have different preferred maturities
and so they should be willing to pay different prices for
securities of different expected maturities.
35
Sequential-pay tranches
Divide the prepayment into tranches. All principal
payments are used to pay down the nearest remaining
tranche.
Uncertainty in maturity: Tranche A has the shortest
maturity.
Total par value of $400 million
Tranche Par amount coupon rate (%)
A $194,500,000.00 7.5
B $36,000,000.00 7.5
C $96,500,000.00 7.5
D $73,000,000.00 7.5
$400,000,000.00
36
Sequential-pay tranches
Rule Tranche A receives all the principal
payments until the entire principal amount
owed to that bond class, $194,500,000 is paid
off; then tranche B begins to receive principal
and continues to do so until it is paid the entire
$36,000,000.
- As part of the principal is repaid in Tranche A,
future interest payments to Tranche A are
reduced.
37
Five-Tranche Sequential-Pay Structure
with Floater, Inverse Floater, and Accrual Bond Classes
Tranche Par Amount Coupon Rate (%)
A $194,500,000.00 7.50
B $36,000,000.00 7.50
FL $72,375,000.00 1-month LIBOR + 0.50
IFL $24,125,000.00 28.50 − 3 × (1-month LIBOR)
Z (accrual) $73,000,000.00 7.50
$400,000,000.00
The interest for the accrual tranche would accrue and be added
to the principal balance (like zero-coupon bond). The interest
that would have been paid to the accrual bond class is used to
speed up pay down of the principal balance of earlier bond
classes.
Z bonds are highly risky since
(i) they have long effective maturities
(ii) there is uncertainty about the timing of prepayment.
38
Payment rules
For disbursement of principal payments:
Disburse principal payments to tranche A until it is paid off
completely.
After tranche A is paid off completely, disburse principal
payments to tranche B until it is paid off completely.
After tranche B is paid off completely, disburse principal
payments to tranches FL and IFL until they are paid off
completely.
The principal payments between tranches FL and IFL should be
made in the following way: 75% to tranche FL and 25% to
tranche IFL.
After tranches FL and IFL are paid off completely, disburse
principal payments to tranche Z until the original principal
balance plus accrued interest is paid off completely.
39
Payment rules
For payment of periodic coupon interest:
• Disburse periodic coupon interest to tranches A, B, FL,
and IFL on the basis of the amount of principal
outstanding at the beginning of the period.
• For tranche Z, accrue the interest based on the principal
plus accrued interest in the preceding period.
• The interest for tranche Z is to be paid to the earlier
tranches as a principal paydown.
• There is a cap on FL and a floor on IFL. The maximum
coupon rate for FL is 10% ; the minimum coupon rate
for IFL is 0%. The factor 3 in IFL is called the coupon
leverage.
40
Why CMO are popular?
1. The CMO converts a long-term monthly payment
instrument into a series of semi-annual payments, which
are bond-like securities with short, intermediate and long
maturities.
2. The multiple-maturity structure reduces the degree of
uncertainty of cash flows for any particular maturity
class, and provides the longer maturity classes with
limited call protection. This is because shorter tranches
absorb the initial burden of excess principal repayments.
3. Investors are attracted by the broader range of
investment maturities made possible by the CMO
structure. For example, insurance companies purchase
heavily in the 4-6 year life tranche. Pension funds have
been active in the longer tranche sector.
41
Why CMO are popular?
4. Credit quality
The high quality of the collateral (GNMA etc.) along
with the protective structure of the trust, enables these
securities to generally carry the highest investment
grade credit rating.
5. Yield
Offer investors attractive yield premiums over Treasury
and even some corporate bonds.
6. Event risk
CMO are essentially free from default risk. They are also
free from events that cause price fluctuations in the
corporate world.
42
Valuation of the tranches
CMO is the unbundling of traditional mortgage-backed
securities into short tranche cash flows and long
tranche cash flows.
• Steeper yield curves (wider spread between the long-
term and short-term interest rates) and greater
prepayment risk enhance the value of of the CMO
security relative to the comparable GNMA
(Government National Mortgage Association) pass-
through.
• Each 100 basis points increase in the steepness of the
yield curve is found to provide 14 basis points
increase in CMO’s weighted yield
43
Stripped mortgage backed securities
They are created by altering the distribution of principal
and interest from a pro rata distribution to an unequal
distribution. For example, all the interest is allocated
to the IO class (interest only) and all the principal to
the PO class (principal only).
• PO securities are purchased at a substantial discount
from par value. The faster the prepayments, the higher
the yield the investor will realize.
• IO investors want prepayments to be slow. This is
because when prepayments are made, the outstanding
principal declines, and less dollar interest is received.
44
Impact of mortgage rates
Falling interest rate – faster prepayment
• Principal payments are received sooner and discounted at
a lower interest rate, the value of POs rises.
• Earlier principal payments reduce interest payments to
IOs. These interest payments are discounted at a lower
interest rate, partially offsetting the decline in payments.
Rising interest rate – slower prepayment
• For POs, principal payments are deferred and discounted
at higher interest rates, the value of POs drops.
• For IOs, interest received is higher than anticipated,
though discounted at a higher interest rate. IOs can
increase in value unless interest rates increase sharply.
45
Valuing MBS using Monte Carlo
simulation
• Generate random interest rate paths by taking as input
today’s term structure of interest rates and a volatility
assumption.
• Prepayments are projected by feeding the refinancing
rate and loan characteristics into a prepayment model.
Given the projected prepayments, the cash flow along
an interest rate path can be determined.
The simulation works by generating many scenarios of
future interest rate paths. An estimate of the value of
the MBS is the average of the sample values over
many simulation trials.
46
Definition of CDO
A collateralized debt obligation (CDO) is an asset-
backed security (e.g. corporate bonds, mortgage-
backed securities, bank loans).
The funds to purchase the underlying assets (called
collateral assets) are obtained from the issuance of
debt obligations (also referred as tranches).
It is a special purpose vehicle that invests in a pool of
assets – high-yield bonds, loans, emerging market
debts, asset-backed securities, investment-grade bonds
etc.
CBO (assets are bonds)
CDO
CLO (assets are loans)
47
Growth of markets for CDOs
Notional amount of CDO’s as rated by Moody’s
Investors Services
$1 billion in 1995 to $131 billion in 2021 and projected
to be at $171 billion by 2028.
Regulatory wedge – what market requires (economic
capital)
and what regulators require (regulatory capital)?
Loans are 100% risk weight items and capital charges of
8% are levied on them.
• Active management of credit risk:
•To reduce industry-specific and geographical-specific
concentrations.
48
Motivation of sponsors
Arbitrage transaction
Sponsors want to earn the spread between the yield
offered on the collateral assets and the payments made
to various tranches in the structure.
Balance sheet transaction – synthetic CDO
1. Sponsors want to remove debt instruments (loans)
from its balance sheet.
2. Banks and insurance companies seek to reduce their
capital requirements by removing loans due to their
higher risk-based requirements.
3. Freeing of capital: Banks are better for originating and
servicing loans.
49
Motivations of investors
Attractive yield opportunity for investors seeking a yield
premium over the more traditional investment
alternatives.
Allow investors to participate indirectly in a diversified
high-yield or investment grade portfolio with a
collateral manager of their choice.
Example
Investment-grade investors are able to participate in the
high-yield market through the purchase of a senior
note of a high-yield CBO.
50
Differences between CDO and MBS
MBSs are backed by a fixed pool of real estate
mortgages.
CDOs permit trading of the underlying collateral
within established parameters relating to the
characteristics of such underlying collateral.
(i) geographic and industry concentration limits
(ii) minimum over-collateralization and debt
service coverage requirements.
51
Differences between CDO and MBS
1. For diversification, CDO criteria often encourage
investment in a variety of asset types.
2. At closing, the CDO issuer will commonly purchase
only a portion of the underlying collateral and will
employ a ramp up period (3-month to a year) to
acquire the remainder of the portfolio.
3. CDO structures permit the reinvestment of principal
distributions on the underlying collateral in new assets
during a preset reinvestment period.
52
Rating of Tranches
1. Relocate the risk of the underlying assets to
different tranches.
2. Rating of each tranche is determined primarily
through the priority in the cash flows generated
by the collateral.
Senior notes (rated AAA, AA or A) – highest
priority on the cash flows.
53
Rating of Tranches
Mezzanine tranches (rated BBB to B) – claim on cash
flows that is subordinate to the senior notes.
Equity in the CDO (subordinated notes) is the residual –
represent the first-loss position [may require a cushion
to be in place to safeguard the higher-rated tranches in
future years].
Three key inputs to cash flow CDO ratings
• Collateral diversification
• Likelihood of default
• Recovery rates
54
Equity in a CDO
The lowest credit tranche – subordinated note.
It will absorb the first loss of the portfolio
(similar to insurance deductible).
It has the highest credit risk.
The only tranche without investment grade
rating.
55
High Yield Bonds
High Yield Bonds, Junk Bonds, Speculative Grade
Bond, Distress Assets etc. are names used for
investing in sub-investment grade assets.
20% of corporate bonds
Originally issued by “Fallen Angels”
Boom in the market with increase in Leveraged Buyouts
One famous example is the $31 billion LBO of RJR
Nabisco by private equity sponsor Kohlberg Kravis &
Roberts (KKR) in 1989. The financing backing the
deal included five high-yield issues that raised $4
billion.
56
High Yield Bonds
Mike Milken and Drexel Burnham Lambert
Junk Bond King
Den of Thieves
Greenmailing
Credit Derivatives
Investors – Mutual Funds, Insurance Companies,
Pension Funds etc.
57
High Yield Bonds
58
Structuring - A Simple
Example
59
Citibank HongKong
The Story
A-rated financial institution:
funding cost T+40, comfortable with AA- rated
out to maturity 5 years, yield on 5 year AA
bond from Korean Development Bank (KDB)
T+60.
20 bps pick up is insufficient.
Citibank, cost of capital is T+5, but wouldn’t
like AA risk.
60
Citibank HongKong
The idea
Asset sale at par on Default
FI Citibank
Premium (y bps)
Citi buys asset and will be able to receive par value in

case of default. In return Citi pays “y” bps annually.
What should be “y”?
61
Citibank HongKong
Before After
Investor
Revenue T+60
Funding cost -(T+40)
Net takings 20 bps
Premium: swap “y” bps
CITIBANK
Revenue T+60
Funding cost -(T+5)
Net takings -y bps
Premium: swap 55-y bps
62
Citibank HongKong
y must be more than 20

y cannot be greater than 55
y should be between 25 and 40
Final number a function of bargaining power
of parties.
Loss will occur only if both A FI and AA
bond defaults.
Probability for this is very small.
63
Active vs. Passive
Investments
1
Active Investment Management
Supported by security analysis and portfolio
management techniques
Security Selection
Timing
Diversification
Benchmarking
High cost and effort
Evidence that most managers doesn’t outperform
broad market benchmarks
2
Passive Investment Management
No research, no views on the market movement, low
cost
Index Funds
Mimic a known index
Tracking error
ETF
Existing index or an index created for the purpose
Factor models
Smart Beta
3
Stock Indices
Market-cap weighted
Market-cap weighted – Float adjusted
Equal weighted
Rebalancing
Annual
Semi-annual
Quarterly
Dynamic
4
Index Fund vs. ETF
Index fund is a mutual fund mimicking a known
index
It invest in the index stocks in the same weights
Provide NAV on a daily basis at the end of the
day, like any open ended mutual fund
ETF also mimics a standard index or custom made
index
It get traded continuously in the market like any
other equity
Have liquidity facilitators like market makers.
5
Indian Mutual Fund Size
As of Oct 2022, Indian mutual funds have Rs.39.53
Trillion of assets under management
Of which, Index funds accounted for 1.09 Trillion,
Gold ETFs 0.2 Trillion and ETFs 4.67 Trillion
Until 2014, Gold ETFs were the important segment,
and later equity ETF grew faster
Currently equity ETFs are 12% of total MF Aum,
while Index Funds, and all ETFs together account
for around 15%.
6
The first ETF was launched in India in December
2001 and was linked to Nifty 50.
ETFs based on Nifty 50 has crossed AUM of Rs. 2
Trillion
The asset base of ETFs surged from Rs 52,368 crore
as on March 2017 to Rs 4.99 lakh crore as on
March 2022.
The number of ETFs climbed from 84 to 228 as on
March during the same period.
7
8
India Largest ETFs Size
Largest ETFs - AUM (Rs. Crore)

BHARAT Bond ETF - April 2025
Nippon India ETF Nifty 50 BeES
CPSE ETF
UTI-S&P BSE Sensex ETF
UTI-Nifty 50 ETF
SBI S&P BSE SENSEX ETF
SBI Nifty 50 ETF
0 20,000 40,000 60,000 80,000 1,00,000 1,20,000 1,40,000 1,60,000
9
Global Largest ETFs Size
Assets Under Management - Largest ETFs ($ Billion)
iShares Core U.S. Aggregate Bond ETF
Vanguard Total Bond Market ETF
iShares Core MSCI EAFE ETF
Vanguard FTSE Developed Markets ETF
Vanguard Value ETF
Invesco QQQ Trust
Vanguard Total Stock Market ETF
Vanguard S&P 500 ETF
iShares Core S&P 500 ETF
SPDR S&P 500 ETF Trust
0.00 50.00 100.00 150.00 200.00 250.00 300.00 350.00 400.00
10
Performance of Indian Markets
Large
Midcap Midcap Midcap Smallcap Smallcap Midcap Midcap
Year Nifty Next 50 100 200 500 150 50 100 250 100 250 15
2012 27.70 48.08 30.60 31.64 31.84 44.28 35.14 47.26 38.19 36.23 36.82 57.04
2013 6.76 4.81 6.46 4.44 3.61 -3.01 -2.82 -6.13 -8.14 -10.06 1.67 -11.83
2014 31.39 44.42 33.17 35.53 37.82 60.26 46.06 57.49 69.57 65.90 46.18 55.96
2015 -4.06 6.96 -2.41 -1.90 -0.72 8.41 1.54 8.35 10.20 5.55 2.80 -6.17
2016 103.01 107.07 103.60 103.70 103.84 105.41 107.24 107.07 100.36 101.19 104.70 103.35
2017 28.65 44.76 31.05 33.43 35.91 54.34 51.28 47.26 57.28 57.30 42.43 52.42
2018 3.15 -9.00 1.14 -1.01 -3.38 -13.33 -11.00 -15.42 -26.80 -29.08 -6.21 -10.21
2019 12.02 0.46 10.42 8.68 7.66 -0.28 -4.66 -4.32 -8.27 -9.53 4.89 -1.85
2020 14.90 14.84 14.86 15.62 16.67 24.38 24.92 21.87 25.09 21.47 19.67 27.29
2021 24.12 29.87 25.04 27.47 30.19 46.81 43.22 46.06 61.94 59.28 35.65 39.96
2022 5.13 0.60 4.48 4.20 3.42 1.90 2.06 2.06 -4.93 -14.61 3.24 5.16
11
Fin Private PSU

Auto Bank Energy Service FMCG IT Media Metal Pharma Bank Bank Realty
42.47 56.54 13.77 51.96 48.53 -1.86 58.67 17.68 31.88 67.00 40.63 52.71
9.41 -8.73 0.43 -7.32 12.18 57.97 1.50 -14.26 26.51 -2.99 -30.44 -34.38
56.69 64.57 8.54 57.34 18.22 17.84 33.02 7.02 43.42 67.87 67.07 10.02
-0.32 -9.68 -0.66 -5.41 0.33 -0.03 10.30 -31.35 9.26 -3.27 -32.91 -15.02
110.75 107.42 119.66 104.93 102.78 92.75 99.15 145.20 85.82 107.33 104.11 95.80
31.37 40.50 38.73 41.42 29.38 12.18 32.69 48.54 -6.30 40.79 24.10 109.80
-23.10 6.35 0.60 10.60 13.65 23.78 -25.92 -19.94 -7.81 8.15 -16.55 -33.02
-10.69 18.41 10.98 25.65 -1.29 8.39 -29.72 -11.20 -9.34 16.19 -18.25 28.49
11.46 -2.79 6.38 4.47 13.46 54.94 -8.57 16.18 60.64 -2.90 -30.57 5.12
18.96 13.49 33.74 13.96 9.96 59.58 34.56 69.66 10.12 4.58 44.37 54.26
16.54 19.66 15.10 9.48 16.70 -23.91 -9.50 16.79 -9.75 19.52 56.83 -9.59
12
India
Comm Consu ESG Servic Value 50 Low High Alpha
odities mption CPSE 100 Infra MNC PSE es 50 Futures Vol 50 Beta 50 50
19.33 37.47 11.32 33.35 21.65 28.29 8.95 26.87 28.93 31.61 32.23 44.51 50.64
-8.64 9.55 -6.13 9.14 -4.16 7.74 -8.60 8.77 -16.10 9.24 3.43 -20.32 2.92
16.67 29.70 39.99 31.95 22.71 42.47 34.58 37.81 75.49 33.63 43.30 39.79 68.00
-9.54 7.99 -17.03 -2.18 -8.91 7.45 -11.94 -3.23 -9.23 -2.70 8.79 -17.85 14.72
124.74 97.53 112.89 103.16 97.95 101.15 117.92 101.02 122.57 105.03 103.65 97.30 89.83
34.75 45.13 14.36 31.64 34.11 53.10 16.53 31.94 42.36 32.94 30.21 59.47 67.03
-16.07 -2.26 -23.05 3.96 -12.71 -5.81 -21.24 8.70 -28.57 7.43 -0.52 -28.39 -14.49
0.03 -0.65 -6.25 10.99 2.52 -1.10 -4.80 16.86 -15.61 13.43 5.06 -18.52 7.22
10.74 19.29 -15.87 21.57 12.15 13.52 -13.31 12.45 6.33 18.28 23.96 9.11 51.75
46.83 19.26 38.98 30.72 35.58 22.82 37.12 24.31 51.74 24.57 22.42 35.50 74.45
4.81 9.14 23.94 -3.18 6.31 3.38 11.75 3.17 12.51 7.65 0.34 6.73 -12.80
13
Performance of Indian Markets-
Indices
Large
Midcap Midcap Midcap Smallcap Smallcap Midcap Midcap
Year Nifty Next 50 100 200 500 150 50 100 250 100 250 15
2012 27.70 48.08 30.60 31.64 31.84 44.28 35.14 47.26 38.19 36.23 36.82 57.04
2013 6.76 4.81 6.46 4.44 3.61 -3.01 -2.82 -6.13 -8.14 -10.06 1.67 -11.83
2014 31.39 44.42 33.17 35.53 37.82 60.26 46.06 57.49 69.57 65.90 46.18 55.96
2015 -4.06 6.96 -2.41 -1.90 -0.72 8.41 1.54 8.35 10.20 5.55 2.80 -6.17
2016 103.01 107.07 103.60 103.70 103.84 105.41 107.24 107.07 100.36 101.19 104.70 103.35
2017 28.65 44.76 31.05 33.43 35.91 54.34 51.28 47.26 57.28 57.30 42.43 52.42
2018 3.15 -9.00 1.14 -1.01 -3.38 -13.33 -11.00 -15.42 -26.80 -29.08 -6.21 -10.21
2019 12.02 0.46 10.42 8.68 7.66 -0.28 -4.66 -4.32 -8.27 -9.53 4.89 -1.85
2020 14.90 14.84 14.86 15.62 16.67 24.38 24.92 21.87 25.09 21.47 19.67 27.29
2021 24.12 29.87 25.04 27.47 30.19 46.81 43.22 46.06 61.94 59.28 35.65 39.96
2022 5.13 0.60 4.48 4.20 3.42 1.90 2.06 2.06 -4.93 -14.61 3.24 5.16
14
Performance of Indian Markets -
Sectors
Fin Private PSU
Year Auto Bank Service FMCG IT Media Metal Pharma Bank Bank Realty Energy
2012 42.47 56.54 51.96 48.53 -1.86 58.67 17.68 31.88 67.00 40.63 52.71 13.77
2013 9.41 -8.73 -7.32 12.18 57.97 1.50 -14.26 26.51 -2.99 -30.44 -34.38 0.43
2014 56.69 64.57 57.34 18.22 17.84 33.02 7.02 43.42 67.87 67.07 10.02 8.54
2015 -0.32 -9.68 -5.41 0.33 -0.03 10.30 -31.35 9.26 -3.27 -32.91 -15.02 -0.66
2016 110.75 107.42 104.93 102.78 92.75 99.15 145.20 85.82 107.33 104.11 95.80 119.66
2017 31.37 40.50 41.42 29.38 12.18 32.69 48.54 -6.30 40.79 24.10 109.80 38.73
2018 -23.10 6.35 10.60 13.65 23.78 -25.92 -19.94 -7.81 8.15 -16.55 -33.02 0.60
2019 -10.69 18.41 25.65 -1.29 8.39 -29.72 -11.20 -9.34 16.19 -18.25 28.49 10.98
2020 11.46 -2.79 4.47 13.46 54.94 -8.57 16.18 60.64 -2.90 -30.57 5.12 6.38
2021 18.96 13.49 13.96 9.96 59.58 34.56 69.66 10.12 4.58 44.37 54.26 33.74
2022 16.54 19.66 9.48 16.70 -23.91 -9.50 16.79 -9.75 19.52 56.83 -9.59 15.10
15
Performance of Indian Markets -
Strategy
India
Comm Consu ESG Servic Value 50 Low High Alpha
Year odities mption CPSE 100 Infra MNC PSE es 50 Futures Vol 50 Beta 50 50
2012 19.33 37.47 11.32 33.35 21.65 28.29 8.95 26.87 28.93 31.61 32.23 44.51 50.64
2013 -8.64 9.55 -6.13 9.14 -4.16 7.74 -8.60 8.77 -16.10 9.24 3.43 -20.32 2.92
2014 16.67 29.70 39.99 31.95 22.71 42.47 34.58 37.81 75.49 33.63 43.30 39.79 68.00
2015 -9.54 7.99 -17.03 -2.18 -8.91 7.45 -11.94 -3.23 -9.23 -2.70 8.79 -17.85 14.72
2016 124.74 97.53 112.89 103.16 97.95 101.15 117.92 101.02 122.57 105.03 103.65 97.30 89.83
2017 34.75 45.13 14.36 31.64 34.11 53.10 16.53 31.94 42.36 32.94 30.21 59.47 67.03
2018 -16.07 -2.26 -23.05 3.96 -12.71 -5.81 -21.24 8.70 -28.57 7.43 -0.52 -28.39 -14.49
2019 0.03 -0.65 -6.25 10.99 2.52 -1.10 -4.80 16.86 -15.61 13.43 5.06 -18.52 7.22
2020 10.74 19.29 -15.87 21.57 12.15 13.52 -13.31 12.45 6.33 18.28 23.96 9.11 51.75
2021 46.83 19.26 38.98 30.72 35.58 22.82 37.12 24.31 51.74 24.57 22.42 35.50 74.45
2022 4.81 9.14 23.94 -3.18 6.31 3.38 11.75 3.17 12.51 7.65 0.34 6.73 -12.80
16
An overview of
Multi-Factor ETF investing
17
Multi-factor ETFs - Evolution
1896 – First price weighted index

1923 – First Market Cap weighted index
1975 – First Index Mutual Fund
1993 – First ETF
2000 – First single factor smart Beta ETF
2003 – First 2 & 3 factor Smart Beta ETF
2014 – First 4-Factor Smart Beta ETF
18
Overview of ETF Markets
ETF Market trends
Since the launch of the first exchange-traded fund (ETF) in
1993, ETFs have become one of the most popular
investment vehicles for both institutional and individual
investors
▪ Global ETF assets at year-end 2014 stood at $2.6 trillion
with U.S. accounting for 73% of total assets
▪ The value of assets manged by ETFs globally is currently
at $10.02 trillion with US accounting for $7.19 trillion
▪ Number of ETFs – 8,552, out of which US account for
2,632.
▪ SPDR S&P 500 is the largest ETF in the world with a
market capitalization of $369.5 billion
▪ Total assets of ETFs listed in Europe is $1.5 trillion, and
the number of ETFs is at 1,926
20
ETF Market trends
Global ETF assets and net flows
3,000 Assets ($ billion) Net flows ($ billion) 2,661

2,500 2,263
2,000 1,771
$ billion
1,500 1,314 1,370

1,049
1,000 693
500 237 236 257 323
148 162 161
0
2008 2009 2010 2011 2012 2013 2014
# of ETFs 1,269 1,681 2,141 2,618 3,038 3,463 4,006
21
Active vs. passive investing
In 10 years, there is a visible shift towards passive investments
2003 Passi 2013
Active
ve,
, 32%
37%
Passi
Active ve,
, 63% 68%
Active Investments Passive Investments

▪ Fund manager conducts rigorous research ▪ Track a pre-determined index with minimum
▪ Aim to beat the market based on manager’s monitoring from the fund manager
ability for selection and timing of investments ▪ Aim to replicate the performance of a market
▪ Maximize gains and minimize losses
▪ Potential to underperform index ▪ Less scope for outperformance

▪ Generally higher fees ▪ No proactive or corrective action
▪ Typically less tax-efficient when Index is underperforming
▪ Buy/sell decisions based on index,
not research
These limitations have led to the

Limitations emergence of a third alternative – Limitations
Smart Beta
22
Drawbacks of market-Cap weighted
Indexes
As of 2014, nearly 83% of the global ETF assets were invested in
market-cap weighted ETFs
But there are limitations to market-cap weighted indexes…..
▪ Concentration: More than 63% of market-cap weighted index assets are held by the top
20% largest names!
▪ Potential problem of overweighting overvalued securities while underweighting
undervalued stocks
▪ Underweight's exposure to other rewarded risks like value and size, etc.
Excessive risk concentration

100%
80%
Top 20%
63% 68% 66% 65%
60% constituents by
weight
40% Bottom 80%
constituents by
20% 37% 34% 35% weight
32%
0%
S&P 500 Index STOXX Europe 600 FTSE Japan Index FTSE Asia ex-
Index Japan Index
23
The Smart Beta Revolution
Introduction to Smart Beta
Smart Beta strategies attempt to deliver better performance, reduced risk, or
both, compared to conventional market-cap weighted indexes by using
alternative weighting schemes or selection criteria for index components
Smart Beta ETFs: The Intersection

of Active and Passive Investments
Systematic
Generally low cost and more Beta
transparent than active funds Advanced
Traditional Beta
Index
Can be a source of incremental Smart
Beta also Strategic
returns or a way to manage risks known as
like traditional active funds Beta
Alternative
Provide broad market Beta
exposure
Can potentially help achieve a Enhanced

Traditional desired outcome such as Beta
Active
dampening the impact of
market volatility or pursuing
higher income
25
Evolution of Smart Beta
Yesterday’s “Alpha” Is Today’s Beta
Alpha Alpha
Alpha
Strategy Beta
(Unexplained returns) Smart
Alternative Beta Factor Beta
Beta
Portfolio Return
Regional Beta
Beta
Beta Country Beta Market
(Market returns) Beta
Sector Beta
1960s 1970s 1990s 2000s
In 1960, the capital Jack Clifton Bogle Fama and French Further return
asset pricing model (1975) launches the first (1992) show that three components that until
(“CAPM”) starts to index fund, making factors – market risk, recently were
describe the relationship market beta investable small cap (size) and considered alpha are
between risks and value – explain over being recognized as
expected returns 90% of portfolio returns sources of systematic
returns or “risk factors”
Academic research has provided a more robust explanation of equity return components, which
can be accessed in a transparent, liquid and cost-effective manner using systematic strategies.
26
Growth of U.S. Smart Beta ETFs
▪ U.S. ETF assets in Smart Beta strategies grew fourfold since 2009
▪ In 2014, $61 billion (25%) of the $239 billion of inflows into ETFs went
into Smart Beta funds. This has increased to $1.6 trillion
U.S. Smart vs. Non-Smart Beta ETF Asset Growth

1,800 240
Net flows (in $billion)

1,600
Assets (in $billion)
1,400 180
1,200
1,000
120
800
600
400 60
200
0 0
2008 2009 2010 2011 2012 2013 2014
U.S. Non-Smart Beta ETF Assets U.S. Smart Beta ETF Assets
U.S. Non-Smart Beta ETF Net flows U.S. Smart Beta ETF Net flows
Year 2008 2009 2010 2011 2012 2013 2014

# of Non-Smart Beta ETF launches 83 92 113 99 101 96 138
# of Smart Beta ETF launches 9 7 17 35 34 37 43
27
Growth of U.S. Smart Beta ETFs
Assets Under Management - Largest Smart Beta

iShares S&P 500 Growth ETF
ETFs ($ Billion)
iShares MSCI USA Min Vol Factor ETF
Invesco S&P 500® Equal Weight ETF
Schwab US Dividend Equity ETF
Vanguard High Dividend Yield Index ETF
iShares Russell 1000 Value ETF
iShares Russell 1000 Growth ETF
Vanguard Dividend Appreciation ETF
Vanguard Growth ETF
Vanguard Value ETF
0 20 40 60 80 100 120
28
Time Diversification
29
Time Diversification
Holding equities for long periods time reduces risk,
compared to holding for short periods
Below average returns get offset by above average
returns over long time
So, if your investment horizon is long term, you
could increase the equity holding
This is against the glide path suggested for risk
taking abilities
This is typical practitioner view
30
Term Structure of Volatility
31
Term Structure of Returns
32
Term Structure of Sharpe Ratios
33
Risk-Return Trade-off
34
35
36
37
Smart Beta
Smart Beta = Active + Passive Strategies
Active Passive
Active Strategies Smart Beta Strategies Passive Strategies
▪ Aim to provide returns ▪ Aim to generate higher

▪ Aim to deliver returns in
Objectives higher than the returns or lower risk
line with the benchmark
benchmark than the benchmark
▪ Provide exposure to
▪ Provide exposure to various ▪ Provide exposure to
either a single factor or
equity premia factors such as market weighted
How they multiple factors such as
momentum and value benchmark components
work size and momentum
▪ Manager’s discretion is a key ▪ Employ rules-based
component in stock selection ▪ Employ rules-based
methodology
methodology
Portfolio
▪ Flexible ▪ Relatively Static ▪ Relatively Static
composition
▪ Have the potential to

▪ Use fundamental insights
deliver out performance by ▪ Are cost-effective
driven by research
Advantages harvesting returns ▪ Deliver equity risk
▪ Have the potential to associated with risk factors premium
deliver alpha
▪ Are cost-effective
39
Types of Risk Factors
A factor can be any characteristic relating a group of securities that is
important in explaining their returns and risk. Factor premia is the
compensation for investors for taking the particular factor risk.
Implementation in strategy
based on
Factor What it is
Selection Weighting
scheme scheme
▪ Refers to market capitalization of the
stock. Historically, small cap stocks have Mid and small-
Size Equal weight
delivered excess returns over large cap cap stocks
stocks
▪ Is a measure of stocks that trade at lower

Value Value stocks Economic size
valuations than average
▪ Ranks securities to its peers, utilizing the

relative strength methodology to identify High
Momentum -
the strongest and weakest investment momentum
trends
▪ Utilize volatility rankings of the stocks in Efficient
Low volatility the portfolio to minimize the effects of Low volatility minimum
market fluctuations volatility
40
Decoding risk factors
The existence of the factor premia could also be explained by investors’
making systematic errors owing to behavioral biases
Factor Behavioral explanation Risk premia explanation

▪ Small stocks are more sensitive to
▪ Investors tend to invest in "big
economic shocks, such as recessions.
Size companies" which are considered
Moreover, they are less liquid, with a
safe
higher downside risk
▪ Investors’ overreaction to bad news

▪ Value stocks are cyclical and more
Value and short term trends pulls down
leveraged
stock prices below fair value
▪ Investor overconfidence and self- ▪ High expected growth firms are more
Momentum attribution bias leads to returns sensitive to shocks which hinders their
continuation in the short term performance
▪ Investors’ preference for stocks with ▪ Low beta stocks will likely fail to
Low
lottery like payoffs can lead to perform in turbulent markets as betas
volatility
overpricing of high beta stocks converge to one
41
Factor Strategies Outperform Traditional
Indexing
Historically, the single factor strategies have outperformed market-cap
weighted strategies…
MSCI single factor indexes vs. MSCI World Index performance since 2000
300
MSCI World Index (3.2% p.a.)
MSCI World Value Index (4.1% p.a.)
MSCI World Momentum Index (5.2% p.a.)
250
MSCI World Minimum Volatility Index (6.2% p.a.)
MSCI World Mid Cap Equal Weighted Index (6.8% p.a.)
200
150
100
50
0
Jan-00 Oct-01 Jul-03 Mar-05 Dec-06 Aug-08 May-10 Jan-12 Oct-13 Jun-15
42
Risk factors during business CYCLE
Downturn Recession Recovery Boom
Positive Negative Negative Positive
Economic Economic Economic Economic
Economic Growth but Growth but Growth but Growth and
Growth Slowing Slowing Improving Improving
Business Cycle
Size – – + +
Value  – ++ +
Momentum  –  +
Low
+ ++ –– –
volatility
43
no single factor outperforms consistently
Timing factors is hard…
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Top
performer Low Moment Moment Low Low Moment Low
Size Size Value Size Size Value
Volatility um um Volatility Volatility um Volatility
45.1% 23.7% 25.1% 41.5% 20.0% 15.5%
-10.1% 27.8% 19.4% -29.7% 7.3% 29.7% 11.4%
Moment Low Moment Moment

Size Value Size Size Value Moment Size Size Moment
um Volatility um um
-13.5% 38.1% 16.8% 24.8% 26.7% um 4.2% 15.4% 26.7% um 6.5%
20.9% 5.5% -40.2% 16.1%
Moment Moment Low Low Low Low Moment

Value Size Value Value Value Value
um um Volatility Volatility Volatility Volatility um
9.6% 4.6% -40.4% -5.6% 26.6% 3.7%
-14.8% 25.4% 20.0% 20.5% 16.4% 12.0% 14.1%
Low Low Moment Moment Low Low

Value Value Value Size Value Size Size
Bottom -19.9%
Volatility
18.5%
Volatility um
3.4% -41.5%
um
9.0% -9.9%
Volatility Volatility
2.4%
performer 25.2% 7.7% 18.7% 14.2% 8.1% 18.6%
Difference between top and bottom performing Smart Beta factors
9.8% 19.9% 5.2% 20.1% 6.4% 16.0% 11.8% 27.3% 11.0% 17.2% 7.4% 11.1% 9.0%
44
Drawbacks of single-factor strategies
These strategies focus on one factor and can produce highly concentrated
Concentration portfolios that take significant (and sometimes unintended) sector or factor
risk risk. Such an emphasis on a factor can create greater than- expected risk
for the portfolio
Despite the historical long term outperformance of each of these factors,

Timing the
their short term performance can be unpredictable, leading to periods of
factor
either outperformance or underperformance
These strategies tend to tilt towards a single risk factors and can increase
Tracking error
the tracking error in the portfolio
45
The Movement to Multi-Factor
Multi-factor Smart Beta
Multi-factor Strategies involve the use of a combination of factor strategies.
These strategies seek to incorporate a number of different return premiums,
as opposed to just one type and thus play a dual role in reducing risk and
enhancing portfolio returns
Multi-factor Smart Beta strategies

Momen potentially offer
Size
Low tum
Volatility ▪ Improved risk-adjusted
performance
▪ Superior diversification
Value
▪ Reduced volatility impact of
business cycles
Multi-factor Smart
Beta
47
US Multi-Factor Smart Beta growth
▪ Assets of U.S. Multi-factor Smart Beta ETFs grew fivefold in five years
▪ In 2014, U.S. Multi-factor Smart Beta ETF flows increased to $6.4 billion
from $1.5 billion in 2010
U.S. Multi-factor Smart Beta ETF Asset Growth and Flows
25 7.0
Net Flows (in $billion)

Net Flows Assets 6.0
20
Assets (in $billion)
5.0
15 4.0
10 3.0
2.0
5
1.0
0 0.0
2010 2011 2012 2013 2014
Year 2010 2011 2012 2013 2014
# of U.S. Multi-factor Smart Beta ETFs 31 45 54 57 72
48
Multi-factor strategy: risk & return
Multi-factor S&P 500 Index
Low High
Mid-cap Value strategy (ERC (Market-cap
volatility momentum
Allocation) weighted)
Annual. returns 11.2% 10.6% 9.8% 10.8% 10.7% 7.9%
Annual. volatility 19.4% 16.3% 19.3% 19.7% 18.4% 19.5%
Sharpe ratio 0.5 0.6 0.4 0.5 0.3 0.5
Annual. tracking
4.4% 5.0% 5.3% 3.5% 3.3% -
error
Information ratio 0.7 0.5 0.4 0.9 0.8 -
Multi-factor strategy performance during bull and bear markets
Bull markets Bear markets

Annual. Informati Annual. Informati
U.S. Long Term Annual. Sharpe Annual. Sharpe
volatilit on volatilit on
(1974 to 2014) returns ratio returns ratio
y ratio y ratio
Mid-cap 21.5% 13.8% 0.2 1.5 -7.2% 29.1% 0.1 -0.3
Low volatility 18.1% 11.3% -0.1 1.5 -5.3% 24.7% 0.1 -0.2
High momentum 19.9% 13.9% 0.1 1.4 -7.4% 28.8% 0.0 -0.3
Value 20.7% 13.8% 0.1 1.4 -6.8% 29.7% 0.1 -0.2
Multi-factor
strategy (ERC 20.0% 13.0% 0.1 1.5 -6.6% 27.6% 0.1 -0.3
Allocation)
S&P 500 Index 19.0% 13.6% - 1.3 -8.6% 29.5% - -0.3 49
Building Efficient Portfolios with Multi-
Factor strategies
Multi-factor Smart Beta allocations can improve risk-adjusted returns
12.0%
25% Fixed 100% Multi-
income factor Smart
75% Multi- Beta
50% Fixed
10.0%
income factor Smart
75% Fixed 50% Multi- Beta
income factor Smart
8.0% 90% Fixed 25% Multi- Beta
factor Smart
Return
income
10% Multi- Beta
factor Smart
6.0% Beta 25% Fixed 100% Equity
50% Fixed income
75% Fixed 75% Equity
income
income
50% Equity
4.0% 25% Equity
100% Fixed
income
2.0%
2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
Volatility
50
Reducing risk with Multi-factors
Correlation across factors
U.S. Long Term
Mid-cap Momentum Low volatility Value
(1974 to 2014)
Mid-cap 1.00 0.67 0.63 0.86
Momentum - 1.00 0.61 0.64
Low volatility - - 1.00 0.70
Value - - - 1.00
Historically, individual factors have displayed less than one correlation to each
other. Hence, grouping multiple factors together can reduce the overall risk of
the portfolio
Combining factors can provide improved risk adjusted performance
51
Looking Forward
reasons for using Smart Beta ETFs
Primary reasons for using / not using Smart Beta ETFs by
institutional investors
Reasons for using Reasons for not using
Performance / returns Lack of familiarity
Reduce volatility / beta Lack of history / track record
Exposure to specific assets Prefer active management
Decision makers have not

Diversification recommended
Better asset risk return Conservative approach
Alternative weighting of assets

vs. Haven't found a product that meets
my needs
Low cost Satisfied with current strategies
Rules based / not subjective Lack value
Only 4%
Tax efficient Don't think they work believe this
Alternative strategy Not cost efficient
53
Future of Smart Beta
Global Smart Beta ETF assets Expected change in the next 3 years2
Historical Current
as of 12/31/2008 as of 12/31/2014
Smart Beta
62% 36% 2%
ETFs
11% 17%
Market-cap
weighted ETFs 54% 37% 9%
89% 83%
Actively
Non-Smart Beta ETFs
managed ETFs 41% 49% 10%
Smart Beta ETFs
Leveraged/
Inverse ETFs 21% 69% 10%
Since 2008, Smart Beta ETF
Increase Remain the same Decrease
assets have grown, at an
annualized rate of 34%, to over
$439 billion, and now to $1.6
trillion
54
Key takeaways
Passive Passive investing has become popular as investors have
investing
moved away from more expensive active managers to
cheaper exposures
Smart
Beta
Smart Beta strategies can provide exposure to market
risk factors that are not accessed by using traditional cap-
Multi-
factor weighted index strategies. Potentially resulting in active-
Smart Beta like outperformance
Multi-factor Smart Beta strategies are the next frontier in

ETF portfolio construction, by combining multiple factor
exposures to diversify risk and harvest multiple risk
premia
55
Trading Strategies
Involving Options
1
Three Alternative Strategies
Take a position in the option & the
underlying
Take a position in 2 or more options of
the same type (A spread)
Combination: Take a position in a
mixture of calls & puts (A
combination)
2
Strategies Involving a Single
Option and a Stock
Writing a Covered Call
Long in Stock and Short in Option.
Buying a Covered Call
Long in Option and Short in Stock.
Buying a Covered Put (or Protective Put)
Long Put and Long Stock.
Writing a Covered Put
Short Stock and Short Put Option.
3
Option Strategy
Assume you hold 1000 shares of Adani
Enterprises. You are not sure what way
market will move and want to protect the
value of your holding. What will you do?
Which option will you choose? On Nov 30,
the price is Rs.3,917.90
Put Options
Ex. Price 3800 3850 3900 3950 4000 4050 4100
Premium 93.25 113.05 133.35 158.95 185.55 218.40 250.70
4
Protective Put Buying
Profit (Rs.)
Purchased
share
Combined
Stock Price
at Expiration
3700 3750 3800 3850 3900 3950 4000 4050 4100 4150 4200
Purchased
put
5
Portfolio Insurance
Hedging strategy that provides a minimum

return on the portfolio while keeping upside
potential
Buy protective put that provides the minimum
return
Generally done with stock index options
Put exercise price greater or less than the current
portfolio value?
Problems in matching risk with contracts
6
Portfolio Insurance
Profit (Rs.)
Portfolio Value
Combined
Index value
at Expiration
18500 18550 18600 18650 18700 18750 18800 18850 19000
Purchased
put
7
Option Strategy
Assume you hold 1000 shares of Adani
Enterprises. You expect the market to come
down. What will you do?
You can sell the stock OR You can Write a
Call Option.
Ex. Price 3800 3850 3900 3950 4000 4050 4100

Premium 236.65 204.80 177.70 152.10 129.45 109.95 92.35
8
Covered Call Writing
Profit (Rs.)
Purchased
share Combined
Stock Price
at Expiration
3700 3750 3800 3850 3900 3950 4000 4050 4100 4150 4200
Written call
9
Positions in an Option & the
Underlying
Profit Profit
X
X ST ST
(a)
(b)
Profit Profit
X
ST X ST
(c) (d)
10
Spreads
A Spread trading strategies involve taking a position in
two or more options of the same type.
Bull Spread
Buying a Call option with a certain strike price and selling
a call option with a higher striking price. Both the
options have the same expiration date. Since Call price
decreases as the strike price increases, the value of
option sold is always lower than the value of option
bought. Thus, a Bull Spread, created from Call options,
will have an initial investment.
11
Bull Spreads
Example: An investor buys a Call for Rs.85.65 with a
strike price of Rs.2700 and write for Rs.37.75 a call
with a strike price of Rs.2800 of Reliance share on Nov
30, 2022, which is maturing on 29-Dec.
The payoff from this Bull Spread strategy is Rs.100 if the
stock price is above Rs.2800 and zero when it is below
Rs.2700.
If the stock price is between Rs.2700 and Rs.2800, the
payoff is the amount by which the stock price exceeds
Rs.2700.
The cost of the strategy is Rs.85.65 – Rs.37.75 = Rs.47.9.
The net profit lies between -47.9 and 52.1.
12
Bull Spread Using Calls
Profit
X1 X2 ST
13
Bull Spreads
Bull spreads can be created by Buying a Put with
a low strike price and Selling a Put with a high
strike price. This strategy involves a positive
cashflow to the investor up front. The final
payoffs from bull spreads created using puts
are lower than from those created using calls.
14
Bull Spreads with Puts
On Nov 30, you buy Reliance 2700 Put for Rs.40.7 and
write a Put 2800 for Rs.91.15. This creates an up
front inflow of Rs.50.45.
You keep this Rs.50.45 if the stock price is above
Rs.2800 and end up paying 100-50.45 =
Rs.49.55,when it is below Rs.2700.
If the stock price is between Rs.2700 and Rs.2800, the
payoff is the difference between Rs.50.45 and the
amount by which the stock price is below Rs.2800.
15
Bull Spread Using Puts
Profit
X1 X2 ST
16
Bear Spreads
When the investor expects stock price to

decline, bear spread is used. This involves
buying a call at higher strike and selling a call
at lower strike. Thus, the bear spread created
from calls gives an initial cash inflow.
17
Bear Spreads
Example: An investor write a Call for Rs.85.65 with a
strike price of Rs.2700 and buy for Rs.37.75 a call with
a strike price of Rs.2800 of Reliance share on Nov 30,
2022, which is maturing on 29-Dec. The payoff from
this Bear Spread strategy is -Rs.100 if the stock price is
above Rs.2800 and zero when it is below Rs.2700. If the
stock price is between Rs.2700 and Rs.2800, the payoff
is a loss of the amount by which the price is above
Rs.2700. The investment generates Rs.85.65 – Rs.37.75
= Rs.47.9 up front. The net profit lies between -100 and
47.9.
18
Bear Spread Using Calls
Profit
X1 X2 ST
19
Bear Spreads
To create a Bear Spread using Puts instead of

Calls, the investor buys a Put with a high
strike price and sells a Put with a low strike
price. Thus, the bear spread created by puts
require an initial investment.
20
Bear Spread Using Puts
Profit
X1 X2 ST
21
Butterfly Spreads
A Butterfly spread involves positions in options with three
different strike prices. It can be created by buying a call
option with a relatively low strike price, X1; buying a call
option with relatively high strike price, X3; and selling two
call options with a strike price, X2, halfway between X1
and X3. Generally, X2 is close to the current stock price.
A Butterfly spread leads to a profit if the stock price stays
close to X2 but gives rise to a small loss if there is a
significant stock price move in either direction. The
strategy requires a small investment initially.
22
Butterfly Spreads
Example: Reliance stock is trading at Rs.2731.35
on Nov 30. An investor feels that it is unlikely
to have significant price move in the next one
month. The market price of 29-Dec calls are as
follows:
Strike Price Call Price
2680 98.95
2740 63.80
2800 37.75
23
Butterfly Spreads
The investor could create a Butterfly spread by buying
one call with Rs.2680 strike price, buying a call with
Rs.2800 strike price, and writing two calls with
strike price of Rs.2740. It costs Rs.98.95 + Rs.37.75
– (2 x Rs.63.8) = Rs.9.1 to create the spread. If the
stock price in one month is less than Rs.2680 or
greater than Rs.2820, there is no payoff, and the
investor makes a net loss of Rs.9.1. If the stock
price is between Rs.2680 and Rs.2820, a profit is
made. The maximum profit of Rs.50.9 is made
when the stock price is Rs.2740.
24
Butterfly Spread Using Calls
Profit
X1 X2 X3 ST
25
Butterfly Spreads
Butterfly spread can be created using Put options.
The investor buys a put with a low strike price,
buy a put with a high strike price, and sells two
puts with an intermediate strike price.
A Butterfly spread can be sold or shorted by
following the reverse strategy. Options are sold
with strike prices X1 and X3, and two options
with intermediate strike price X2 are purchased.
This strategy produces a modest profit, if there is
a significant price movement.
26
Butterfly Spread Using Puts
Profit
X1 X2 X3 ST
27
Calendar Spreads
A Calendar spread can be created by Selling a Call
option with a certain strike price and buying a
longer-maturity call option with the same strike
price. The longer the maturity, the costlier the
call option, and hence, this strategy will require
an initial investment. The investor makes a
profit if the stock price at the expiration of the
short-maturity option is close to the strike price.
A loss is made when the stock price is
significantly above or below the strike price.
28
Calendar Spread Using Calls
Profit
ST
X
29
Calendar Spreads
In a Neutral Calendar Spread, a strike price
close to the current stock price is chosen.
A Bullish Calendar Spread would involve a

higher strike price than the current price.
A Bearish Calendar Spread would involve a

lower strike price.
30
Calendar Spreads
Calendar Spreads can be created by using Put options as well
as Call options. The investor buys a long-maturity put
option and sells a short-maturity put option. The payoff
pattern is same as that of the call option case.
A Reverse Calendar Spread is the opposite of what we have
discussed. The investor buys a short-maturity option and
sells a long-maturity option. This creates a small profit if
the stock price at the expiration of the short-maturity option
is well above or below the strike price. It leads to a loss if it
is close to the strike price.
31
Calendar Spread Using Puts
Profit
ST
X
32
Diagonal Spreads
Bull, Bear, and Calendar spreads can all be
created from a long position in one call and a
short position in another call. In the case of
Bull and Bear spreads, the calls have different
strike prices and the same expiration date.
Calendar spreads have the same strike price and
different expiration dates. A Diagonal spread
is a spread in which both strike price as well as
expiration dates are different.
33
Combinations
A combination is an option strategy that involves
taking a position in both calls and puts.
Straddle
This involves buying a call and a put with the same
strike price and expiration date. If the stock
price is close to the strike price at expiration of
the options, this leads to a loss. If there is a
large movement in the stock price in either
direction, a significant profit will result.
34
A Straddle Combination
Profit
X ST
35
Straddle Example
Consider options on Adani Enterprise stock.
On Nov 30, the stock price is Rs.3917.9 and
options are trading as,
29-Dec Call 4000 109.95
29-Dec Put 4000 185.55
You could sell both call and put and receive
Rs.295.5 as premium. You will make a loss
only if the price goes above Rs.4295.5 or
goes below Rs. 3704.5.
36
Strips and Straps
A Strip consists of a long position in one call and
two puts with the same strike price and
expiration date.
A Strap consists of a long position in two calls and
one put with the same strike price and expiration
date.
In a strip, the investor is betting that there will be
big stock price move, and the decrease is more
likely than an increase. In a strap the investor
assumes an increase to be more likely than a fall.
37
Strip & Strap
Profit Profit
X ST X ST
Strip Strap
38
Strangles
In a strangle, an investor buys a put and a call with
the same expiration date, but different strike
prices. The call strike price is higher than the
put strike price.
A strangle is a similar strategy to a straddle. The

downside risk if the stock price ends up at a
central value is less for strangles than straddles.
39
A Strangle Combination
Profit
X1 X2
ST
40
Strangle Example
On Nov 30, options on Adani Enterprise trade
at
29-Dec Call 4100 92.35
29-Dec Put 3800 93.25
You could sell both call and put and receive
Rs.185.6 as premium. You will make a loss
only if the price goes above Rs.4185.6 or
goes below Rs. 3614.4.
41
Box Spreads
Definition: bull call spread plus bear put spread.
Risk-free payoff if options are European
Construction:
Buy call with strike X1, sell call with strike X2
Buy put with strike X2, sell put with strike X1
Profit equation: P = Max(0,ST - X1) - C1 - Max(0,ST -
X2) + C2 + Max(0,X2 - ST) - P2 - Max(0,X1 - ST) + P1
P = X2 - X1 - C1 + C2 - P2 + P1 if ST  X1 < X2
P = X2 - X1 - C1 + C2 - P2 + P1 if X1 < ST  X2
P = X2 - X1 - C1 + C2 - P2 + P1 if X1 < X2 < ST
42
Box Spreads (continued)
Evaluate by determining net present value (NPV)
NPV = (X2 - X1)(1 + r)-T - C1 + C2 - P2 + P1
This determines whether present value of risk-free
payoff exceeds initial value of transaction.
If NPV > 0, do it. If NPV < 0, do the reverse.
Box spread is also difference between two put-
call parities.
Early exercise a problem only on short box
spread
Transaction costs high
43
Condors
A condor is a less risky version of the
strangle, with four different striking
prices
There are various ways to construct a long
condor
The condor buyer hopes that stock prices
remain in the range between the middle
two striking prices
44
Buying a Condor
Construction:
Buy call with strike X1, sell call with strike
X2
Buy put with strike X4, sell put with strike
X3
X1 < X2 < X3 < X4
45
Buying a Condor (cont’d)
Long condor
3 3/8
75 80 85 90
Stock price at
0 option expiration
76 5/8 88 3/8
1 5/8
46
Writing a Condor
The condor writer makes money when
prices move sharply in either direction
The maximum gain is limited to the

premium
47
Writing a Condor (cont’d)
Short condor
1 5/8
80 85
Stock price at
0 option expiration
75 90
3 3/8 88 3/8
76 5/8
48
CHAPTER 8: TECHNICAL ANALYSIS1
Introduction
The current market price of a stock is certain but its future value (price) is uncertain. The
rewards for those who can read the future value correctly are enormous. This high
reward attracts some of the best brains from all walks of life to the profession of
forecasting the stock prices. Though the approaches to forecasting differ, there is a
common underlying assumption. It is believed that stocks like any other commodity have
a present and future value and there is a broad understanding among existing and
prospective investors about these values. This assumption is not peculiar to stocks but is
present in almost all commodities that are publicly traded in the markets. Analysts use
different approaches to measure the value of the stocks. If a detailed analysis is
performed on the basis of the financial and non-financial details of the company, it is
called fundamental analysis. If an analyst restricts the input to data generated from the
market, the method is known as technical analysis. Since the technical analysts plot the
market data in different charts, this approach is also known as chart analysis or
‘chartism.’
Chartism
Chartism or Technical Analysis is an art (some experts call it science) of recording

historical stock price and volume data, usually in graphic form to forecast future trend.
Analysts use this approach on individual stocks, market indices, or both. While one
section of analysts believes in this approach, academic community has built up huge
evidence to disprove the utility of technical analysis. The critics have examined the
relationship between historical stock price and future price to show that there is no
relationship between the two. Nevertheless, technical analysis is widely followed by
investors and the analysis is performed on equity, bonds, forex and commodities. In a
competitive market, where a large number of investors and analysts are present, the
market price of a stock shall reflect all the publicly available information on the company
including its future plans. In other words, market discounts everything. What is really
being measured is the earnings flow of the company. There is a consensus on this
number in the world of certainty. Many companies have started indicating their future
performance through various public statements. There are analysts who also predict and
publicize earnings of actively traded stocks.
The forecasted earning is based on a number of assumptions, a few of them relating to

factors within (e.g., assumptions of no break down, strike, lockouts, etc.) and a few to
events outside the company (e.g. price rise of raw material, good monsoon, etc.). The
current stock price reflects the forecasted earnings and when assumption changes, the
forecast also changes. In a dynamic economic and business environment, assumptions
change constantly, and stock prices follow suit. While this is rationalist reasoning for
1
Prepared by Prof. M S Narasimhan, IIMB. For private circulation only
price changes, at times, stock prices might change on account of irrational behavior of
market participants. Whether rational or irrational, the technical analysts believe that the
behaviour of the stocks could be studied through historical prices.
Suppose an analyst tells you that a particular stock is underpriced, and it is a good buy at
current price based on some news that is already available in the market. That means the
market has not fully reflected the news. In such a situation, you have two options. First,
you can watch the counter for some time till someone to locate the scrip and start
accumulating it. When the prices start moving up, you can also buy the stock on the
assumption that a few more people will also join you. The price appreciation under this
strategy is faster and the waiting period is shorter. The second option is to enter into the
scrip right now and take the lead. The first option is simple and less risky. Technical
analysts watch the price movements daily to get an earlier indication for price
appreciation or depreciation. In that process, they also try to read the minds of other
players in the market including fundamental analysts, major institutional investors,
insiders, and speculators. The assumption is that all these participants need to come to
the market to realize the benefit of their analysis and market reflect their knowledge as
well as emotion. A number of tools and indicators have been developed to understand
the market trends and corrections. Though many technical indicators are simple and easy
to interpret, there is no assurance that trades based on technical analysis always result in
positive return. It should be noted that reading the market is not a simple task and it
requires a considerable amount of understanding on its behavior.
Here is an example to relate how technical analysts read the minds of millions of
investors in the market. Assume you are waiting for a train in Mumbai suburban station.
The platform is densely crowded, and everyone is waiting for the arrival of the train. If
you happen to overhear the conversation of some passengers, they will talk about the
train and its arrival. Some curious passengers would go to the edge of the platform and
try to see as far as possible to check whether the train is arriving. The platform dynamic
changes once the train is spotted at distance. You don’t have to do anything to know
whether the train is coming or not. You just need to observe the crowd to know how it
will typically behave once the crowd spots the train. Technical analysts observe similarly
and use price charts and trends to predict the future of the market.
Basics of Technical Analysis
The objective of technical analysis is to predict future price changes or movement in the
short, intermediate and long-term. Here, analysts do not predict the future price of the
stock but only the price change. Suppose a stock is currently quoting at Rs. 520, a
fundamental analyst may be able to say that the true value of the stock is Rs. 650 and
eventually, it will appreciate to that level. On the other hand, a technical analyst may not
be able to give a price forecast but say that the stock is on the uptrend and the price will
continue to increase. There is no way to measure where the uptrend will terminate using
technical analysis. If any technical analyst tries to give such forecast, they are simply
making a guess based on the trend.
Technical analysts use data that is generated in the market place. This data includes open,
high, low and closing price of the stock, volume, number of trades, average bid-ask
spread, etc. If the stock is traded in the derivative segment, analysts also have additional
market data like open interest, cost of carry, and implied volatility. Technical analysts
don’t use any data other than that generated in the market place. In fact, they don’t have
to know anything about the company, its location, industry, promoter or management,
etc. On a lighter note, it is often said that technical analysts will sit in a closed room
where even the rays of the sun are not allowed to enter and take investment decisions
based on market data. This indicates that their decisions are purely based on charts and
are not influenced by any other factors or input.
The basic philosophy of the technical analysis is that stock prices move in trends and,
hence, historical prices can be used to understand the future behaviour of the market.
Analysts use the charts made up of historical price, volume and other market generated
data to understand the minds of major players in the market and the demand and supply
positions of the stock. It is also assumed that the prices react to news but the reaction is
not instantaneous and takes time to fully reflect on the prices. Though the time and speed
of the adjustment process differ depending on the type of the information and its
availability to the investors, they can be broadly classified into certain patterns and this
knowledge can be used subsequently to predict the future behavior of the prices. The
analysis of patterns is the first principle in the technical analysis and the success of this
method depends on the ability of the user in recognizing the patterns.
Stock prices are determined solely by the demand and supply, which in turn, are
governed by numerous factors. It is immaterial whether such factors are rational or
irrational. An important assumption in technical analysis is stock prices tend to move in
trends which persists for an appreciable length of time. Changes in stock prices or trends
are caused by shifts in demand and supply. Technical analysts believe that these shifts
can be detected through chart analysis and that some chart patterns repeat themselves.
Types of Charts
Technical analysts draw charts using price, volume and other market-generated data to
assess the underlying market trend. Four different types of charts are drawn in practice.
The most common type is the line chart where the technical analysts normally use the
closing price of daily or weekly or monthly frequency to draw the chart. The next most
common chart type is the bar chart which is based on open, high, low and closing price.
The high and low prices determine the length of the bar and open and close prices are
incorporated on the left and right side of the bar, respectively, using a small dot on the
bar.
The Candle Stick chart uses the same open, high, low and close data like the bar chart
but creates a box using the open and close price. The box or body is coloured to show
that closing price is lower than the opening price. If the closing price is more than the
opening price, then the body will remain white. The volume data is generally shown
below the candle stick and on the lower portion of the graph.
The fourth and last chart type which is unique to the stock market is Point and Figure
chart. Unlike the other three charts, every day data is not used to draw the point and
figure chart. If the price change for the day is small, it is not considered for charting.
The chart is drawn using the prices of the days when the change is large. A few decades
back, when there was no computer facility, charts were prepared manually and so it was
not an easy task to prepare and update charts on daily basis and that too for so many
companies. The Point and Figure chart was used to simplify the process of maintaining
the charts by entering only relevant values. You need to specify the points which you
are interested in. For example, while preparing such chart for NIFTY, you can say unless
the NIFTY changes its value by 50 points on either side, you will not be interested in
tracking those values in the chart. That is, if today’s NIFTY is 10000 and tomorrow it
moves to 10020 or 9960, you will not enter that value in your chart. If the NIFTY moves
to 10070 or 9945 day after tomorrow, you will enter the values in the chart. Values are
entered using crosses (X) and Zeros (0) or squares to show the movement of the prices.
The period is tracked by changing the symbol into the month value, like 1, 2, 3… 12 for
each month.
The Point and Figure chart is useful when it is difficult to maintain the line or bar chart.
If there is a reversal in the trend, the values are entered in the next column. Of the 250
data points in a year, P&F will use only about 50 data points because for the remaining
days, the price change may be lower than 50 points. That way, it is easy to maintain the
chart manually. The interpretation of the chart is similar to the other charts. You can
draw a line connecting the edges of each bar to get a sense of the market movement.
There are technical analysts who develop additional trading rules using the Point and
Figure chart but there is no consensus and wide following of such rules. One such
interpretation is that if the length of bar is too long, there will be a reversal in the near
future and such reversal will be at least one-third of the length of the bar. Unfortunately,
there is no decision in such rule, and it is only an expectation of what is likely to happen.
Investors know that there will be periodical correction in the market but no one knows
when it is going to happen. In today’s computerized world, there is no difficulty in
generating other types of charts and hence, we rarely see the Point and Figure chart in
popular press and television channel visuals.
Trend Formation
In a market where information is available to all participants who are capable of

processing information quickly and are able to see its impact on stock prices, there will
not be any trend in the prices. On the other hand, if there is a delay in distributing
information or market participants take time to process information, stock prices move on
a trend to reach the destination. Technical analysts’ explanation for the delay is
interesting. They believe that information is generally available first to the insiders, who
accumulate the stocks initially which, in turn, makes the price moves upward. When
insiders stop buying the stock, the prices start declining. These insiders will now want
others to know the information to create additional demand and hence spread the positive
news. Lower price and insider information reaching out to select people attracts
additional demand and as a result, price starts moving upward and in the process, the
stock creates a new peak, which is an important event for technical analysts. They
believe that this new demand should be strong enough for the market to create a peak.
Stock prices continue to move forward as long as the information is reaching new set of
people who in turn enter into the market with fresh demand. Investors have self-interest
in spreading the positive news to other investors after their purchase. This upward trend
will not continue for a long time. At some point of time, insiders will start moving out
slowly when stock price reaches its fair value. As investors slowly start moving out, the
stock creates a new bottom. Technical analysts see the new bottom as an indication of
bearish trend. Next uptrend takes place when insiders get new positive information.
There are three basic patterns in the stock price movements: uptrend, downtrend and
sideways patterns. The uptrend pattern is recognized the moment the stock prices form a
new high and create successive tops. The uptrend pattern once it emerges will continue
till the time a downtrend pattern is seen in the prices. The downtrend pattern is
recognized once the price fails to create a new high. Technical analysts buy the stock
when it creates a new peak or during the uptrend. They hold the stock as long as the
uptrend continues. They get the sell signal when the stock fails to create a new peak in
an uptrend. They get signal for short-selling when the stock creates a new bottom. The
stock or market moves into the sideways pattern when it fails to create successive peaks
and bottoms but moves sideways. Technical analysts buy on seeing new peak, sell when
the stock fails to create a new peak and short-sell when it creates a new bottom. The
sideways pattern is an aberration in the trend formation and is an undecided phase of the
stock market.
The above weekly chart of NIFTY shows major uptrend, downtrend and sideways
pattern. The patterns are generally visible in weekly and monthly chart. Daily chart and
intra-day chart show volatility and patterns are generally not visible. Within each uptrend
or downtrend, one can see several reversals. Therefore, the charting and labelling trends
are more to show that some trends are in force at any given point of time in the stock
market and you need to understand such trend and accordingly take investment decisions.
Labelling itself is not going to lead to any action point.
NIFTY - January 2000 to June 2018 (Monthly)

12000.00
10000.00
nd
tre
8000.00
Up
Dow
6000.00
ntre
nd
nd
4000.00
tre
Up Sideways
2000.00
0.00
200001
200008
200103
200110
200205
200212
200307
200402
200409
200504
200511
200606
200701
200708
200803
200810
200905
200912
201007
201102
201109
201204
201211
201306
201401
201408
201503
201510
201605
201612
201707
201802
Though the market follows certain pattern and trends are seen, there is no perfect
similarity among them. Both duration and the gain or loss are different for different
trends. In other words, it is difficult to predict when the trend is going to end and how
much gain or loss the market is going to achieve during the period. Technical analysts
move with the trend (buying during the uptrend and selling during the downtrend) and
believe that in the long-run, the approach offers superior return. Here is an example.
Suppose a stock moves from Rs. 90 to Rs. 160, declines to 110 and then moves to Rs.
180. An investor who bought the stock at Rs. 90 can sell at Rs. 180 and earn 100%
return. Suppose a technical analyst bought the stock at Rs. 100 on getting buy signal,
sold it at Rs. 150 on getting sell signal and bought the stock again at Rs. 120 on getting
buy signal. Since the investor is having a cash of Rs. 150, she can now buy 1.25 units of
the stock when the price is Rs. 120. When the investor exits at Rs. 180, she gets Rs. 225
(1.25 units of stock @ Rs. 180 per share). This investor who followed technical analysis
earns 125% return during the same period on the same stock.
The downtrend patterns are generally sharp and investors who recognize the trend could
have avoided all the losses. In contrast, uptrend takes long time to reach its destination.
It is something similar to trekking. We take long time to reach the peak of hill while
trekking whereas it will not take much time to return from the peak to the base. Another
analogy is taking the staircase to reach the fifth floor of a building and returning to the
ground floor after the completion of the work. You need a lot of energy to climb upward.
Similarly, the market requires lot of support in moving forward whereas when negative
news quickly spreads, we see a fall in the stock prices. The sideways patterns emerge at
the end of the major trends. They are at times consolidation of the earlier pattern and
hence the trend may continue in the same direction after the sideways pattern.
Alternatively, it may reverse after the consolidation period. Therefore, it is difficult to
predict the trend that follows sideways trend.
The chart alone will not help in taking investment decisions. You need some additional
objective decision tools to initiate actions based on the outcome of the tool. Technical
analysts have developed a large number of tools over the years and these are popularly
called ‘indicators’ or ‘oscillators’. Indicators convert the raw market data (price and
volume) into an actionable output using some statistical process. You can measure
whether the tool offers any superior return or not over the years through back testing.
While day traders use such tools for active trading, long-term investors are more
interested in tools which help to enter and exit from the market at the right time.
Technical analysts have developed tools for different types of investors.
They usually draw lines by connecting the bottoms and tops of uptrend and downtrend,
respectively. These lines are used to get early warning signals for the reversal of the
trend. For instance, an upward trendline is drawn by connecting two descending bottoms
and this line is extended further. It is presumed that the price of the stock which is
moving upward will see periodic corrections, and during the correction phase, the price
will come closer to the trendline and get support from it. Therefore, such an upward
trendline is also called the support line. At some point of time, the stock fails to take
support from the upward trendline and breaks out. The break-out in the support line is
an action point where the sell decision is taken based on this break-out. Similarly, bearish
trendlines are drawn by connecting two descending tops and extending the line further
downward. Against the normal expectation of resistance, if the price line penetrates the
trendline, it is an indication for the reversal of the downtrend. Again, this break-out calls
for an action of buying the stock.
The logic behind the upward and downward pattern and trendlines is simple. When the
price initially moves upward, it is an indication that the demand is more than the supply.
When the price moves upward, a part of the demand gets fulfilled while a part is
extinguished. In other words, at higher price level, the demand declines whereas the
supply increases. At some point of time, the demand and supply are equal and then
demand is lower than the supply. At this point, the price starts falling. If the supply is
very strong, the price will continue to fall. On the other hand, if the lower price attracts
fresh demand, the stock starts moving upward. The uptrend will terminate before the
previous top if the underlying demand is weak. If the stock hits a new high, it is an
indication of strong underlying demand and it is expected that the uptrend will continue
for considerable length of time with periodic minor corrections. The same but the reverse
logic works for the downtrend. Since the underlying assumption of the trend pattern is
the emergence of the fresh demand (supply) after a minor decline (increase) in the price
levels, the trendlines fix the maximum limit with in which such demand and supply
emerge.
The trend pattern and trendlines are two simple but most useful tools in analyzing the
future trend. The rewards are good for those who consistently follow these two methods.
That is, buy on seeing new peak and sell when the stock fails to create a new peak; short-
sell when the stock creates a bottom and cover the position when the stock fails to create
a new bottom. The basic limitation of these tools is their long-term orientation. It
captures the long-term cycles of the market. The tool is not useful for short-term traders.
Stock prices move in trends and such trends take different shapes. Some of them are
simple patterns like the uptrend line or the downtrend line. The trend could also take
triangle or other shapes. There are trends which are curved ones.
The primary objective of analyzing the historical prices of stocks and other market data in
the technical analysis is to recognize a pattern and then compare it to similar patterns that
have occurred in the past. It is believed that the forces that enabled the market to form a
pattern earlier are also present now and the outcome is also similar to the outcome of the
earlier pattern. There are three basic patterns in the stock prices namely, bullish, bearish,
and sideways or neutral. These basic patterns are identified normally by drawing
trendlines. While trendlines are fairly simple and have been discussed earlier there are
several other complex patterns which are useful in identifying trading opportunities.
The Head-and-Shoulders pattern is one of the reliable major reversal patterns. The ‘left-
shoulder’ is first formed with a strong rally supported by high trading volume followed
by a decline in the prices with considerably reduced volume. The ‘head’ is formed
immediately after the left shoulder in the same manner of the left shoulder but this time
the rally takes the price above the top of the left shoulder. The decline that follows the
rally brings down the price below the top of the left shoulder but closes at or above the
bottom. The ‘right shoulder’ is formed again with a rally but without any increase in the
volume. The rally fails to reach the top of the head. At this stage, it is possible to draw a
line known as Neckline which connects the bottoms of the left shoulder and the right
shoulder.
The downtrend after the rally which forms the right-shoulder is expected to move below
the neckline before showing a minor rally. This minor rally is expected to end at the
neckline and the downtrend that follows is a major bearish phase of the market. While
this kind of pattern is seen in a bull market to give a trend reversal, the inverted Head-
and-Shoulders pattern is formed in a bear market. Though a reversal signal is available
immediately on drawing the neckline, the pattern completes only when the price line
penetrates the neckline and the neckline resists the minor rally after the penetration.
Further, the volume changes should also be exactly as described earlier to give a precise
signal for the trend change.
The rationale behind the head-and-shoulders reversal pattern can be seen from the
behavior of the bull and bear operators at the time of liquidating their positions. For
instance, in an uptrend, the bull operators want to take maximum profit when the price
reaches the target. But this operation of distribution of their holdings requires even more
patient and skillful handling than the accumulation. They first start selling their holdings
in small quantity to see the price reaction. Since any decline in the price will affect their
profit, they respond by first ceasing their selling and even support the stock by making
fresh purchases. With the supply temporarily held up, the decline halts and the advances
resume. They allow the price to rise to a comfortable level before resuming their selling.
But this time, they will get a good average price even though the price will decline in
response to their selling. When this distribution is completed, there is no one in the
market even to lend temporary support and the stock moves into a long bearish market.
While the head-and-shoulders pattern indicates reversal, it is not necessary that in all
major reversals, this particular pattern should be present. Further, the pattern may also
occasionally fail if any of the conditions, such as lack of volume or failure for the price to
reach the neckline. However, this pattern clearly gives a warning signal to the analysts
for a possible major price reversal.
Investment in securities requires the investors to take two important decisions namely
‘buying’ and ‘selling’. Profit from an investment decision (either buying or short selling
a security) is realized after the sale (or purchase in the event of short selling) of securities.
The right time to sell (purchase) securities is once the downtrend (uptrend) is confirmed.
Often investors find it difficult to take the second decision and in the process of delay,
they lose significant part of the profit. When an investment starts giving a negative return,
investors hold their positions and wait for the target. But it may take several weeks for
the stock to reach it. The decision of taking reverse position assumes importance and
technical analysis is found extremely useful in this context irrespective of the
methodology adopted in taking the first investment decision. The head-and-shoulders
pattern discussed earlier is one of the several reversal patterns that will help investors in
taking a selling decision. A few other important patterns like ‘rounding tops and
bottoms’, ‘triangle’ and ‘double and triple tops and bottoms’ are also useful in taking buy
or sell decisions.
Rounding tops and bottoms shows a gradual reversal of the trend from downtrend to
uptrend or vice versa. The pattern which looks like a Bowl or Saucer moves forward
with higher momentum after the formation. Though it is a safe pattern in view of the
availability of sufficient time to recognize and initiate action, they are less frequent in
actively traded stocks. Actively traded stocks change trend without moving sideways.
However, this pattern can be seen in weekly charts and charts of small value stocks. The
‘bowl’ or ‘saucer’ pattern gives a buy signal.
Bowl or Saucer Pattern (Illustration)
Horizontal or sideway patterns come in many shapes. The ‘double and triple tops and
bottoms’ pattern is a horizontal pattern that forewarns reversal in the trend. A ‘double or
triple tops’ pattern is formed when the uptrend in a stock is resisted at a particular level.
In a normal market, this pattern shows that a group of traders who had earlier
accumulated stocks at lower levels is waiting to liquidate their position once the price
reaches the specific level. If the supply at that level is of small quantity and the
underlying demand is sufficient, then the stock will easily break the resistance and create
a new peak above the previous one. The absence of this break-out at the resistance level
gives way to the formation of double or triple tops pattern and the stock price moves
downward on the formation of this pattern. The ‘double or triple bottoms’ pattern
indicates strong demand at a particular level and the stock bottoms out at this level.
While the double or triple top in an uptrend is an indication of bearing trend, double or
triple bottom in the downtrend is an indication of a bullish trend. There is no signal if the
double top is observed during the downtrend and double bottom is observed in an
uptrend.
Double Top
Another important sideways pattern is the ‘triangle’. If the price movements in a stock
gives an uptrend and downtrend simultaneously, then a ‘symmetrical triangle’ pattern is
formed. The pattern is also referred to as a ‘coil’ pattern. The ascending bottoms and
descending tops are the process of contraction or coiling in the prices and the pattern has
to see a break at the end. The pattern emerges when the battle between the bulls and
bears to support and resist the price gets stronger and one group must give way to the
other. The volume remains low as the pattern moves forward due to the withdrawal of
many from the fray. On break out, the stock immediately explodes in the direction in
which the pattern breaks out. Thus, it is difficult to forecast the direction though reversal
in the trend often takes place. The impact of explosion depends on the length of the
pattern. Normally, to give a reasonable impact, it requires a minimum of three ascending
tops and descending bottoms. Another triangle, which is difficult to interpret, is the
‘expanding triangle’ where we see successive ascending tops and descending bottoms.
This pattern can’t continue for a long and has to open up. It shows volatility of the
market and one needs to be careful. In all triangles and for that matter any trend analysis,
the decision point is the break-out of the pattern. We draw and recognize the patterns but
look out for their break-out to take an investment decision.
While symmetrical triangles fail to give advance notice about the future trend, another
triangle pattern, namely, the ‘right angle triangle’ pattern indicates the direction of
change in the prices. This triangle is of two types, viz., ascending triangle and
descending triangle. In an ascending triangle, the bottoms are ascending whereas the tops
are equal. As the name of the pattern indicates, the stock will move upward at the end of
the pattern. The descending triangle, on the other hand, gives a bearish note which is
formed when tops are descending whereas the bottom is a flat line.
Moving Averages
The primary idea of technical analysis is to understand the underlying trend of the
market. Since the daily prices have noises, we need a tool to remove them to see the
underlying trend. Moving averages are useful in this context. Moving average is
computed by considering the data of the last few days to start with and on the next day,
one recent additional day data is taken while dropping the oldest one to recompute the
average for the next day. This process of adding new data and dropping the old one
continues. Moving averages are plotted along with price line for interpretation and
decisions. The table given below shows five-day moving average of NIFTY.
Compared to price line, moving averages are smooth lines with less volatility.
Date NIFTY 5-day MA Date NIFTY 5-day MA

01/06/18 10,696.20 11/06/18 10,786.95 10,720.15
04/06/18 10,628.50 12/06/18 10,842.85 10,770.09
05/06/18 10,593.15 13/06/18 10,856.70 10,804.50
06/06/18 10,684.65 14/06/18 10,808.05 10,812.44
07/06/18 10,768.35 10,674.17 15/06/18 10,817.70 10,822.45
08/06/18 10,767.65 10,688.46 18/06/18 10,799.85 10,825.03
21/06/18 10,741.10 10,768.23 19/06/18 10,710.45 10,798.55
22/06/18 10,821.85 10,769.06 20/06/18 10,772.05 10,781.62
25/06/18 10,762.45 10,761.58 03/07/18 10,699.90 10,666.40
26/06/18 10,769.15 10,773.32 04/07/18 10,769.90 10,686.10
27/06/18 10,671.40 10,753.19 05/07/18 10,749.75 10,718.23
28/06/18 10,589.10 10,722.79 06/07/18 10,772.65 10,729.90
29/06/18 10,714.30 10,701.28 09/07/18 10,852.90 10,769.02
02/07/18 10,657.30 10,680.25 10/07/18 10,947.25 10,818.49
NIFTY 2018 and 5-day Moving Average

11,000.00
10,900.00
10,800.00
10,700.00
10,600.00
10,500.00
10,400.00
01/06/18
03/06/18
05/06/18
07/06/18
09/06/18
11/06/18
13/06/18
15/06/18
17/06/18
19/06/18
21/06/18
23/06/18
25/06/18
27/06/18
29/06/18
01/07/18
03/07/18
05/07/18
07/07/18
09/07/18
11/07/18
NIFT Y 5-day MA
We may not see much of the smoothness in this 5-day moving average but if we take the
moving average of a longer period, we will find a smooth line. Normally, 50-day, 100-
day and 200-day moving averages are used by the technical analysts. There is no specific
preference for the period and the choice depends on how many times one wants to trade
(buy and sell) in a year. If an investor is willing to do five to ten trades in a year, they
can use the 50-day moving average. The 100-day moving average will result in about
three to five trades in a year and 200-day moving average will result in one or two trades
per year. Here, each trade refers to one buy and one sell or one sell and one buy
transaction. If we reduce the moving average days to 25-days, then the number of round
trades will increase to ten to fifteen trades per year.
The interpretation and action point of moving average are simple. If the price line cuts
the moving average from bottom while on uptrend, it is a buy signal. The signal is
exactly at a point where the price line cuts the moving average or just after the
penetration. Similarly, technical analysts get a sell signal, when the price line cuts the
moving average from the top in a downward trend. Since the moving average removes
the noises in the price, an uptrend is a clear bullish signal. When the price lines cuts the
moving average, it shows a strong underlying demand for the stock in the market and
investors are willing to buy it even at a high price. Moving averages act as hurdle or
resistance level in the market and if the price line breaks through, it means the trend has
adequate strength to break the hurdle and, hence, we can expect continuation of uptrend.
The 25-50-100 day moving averages can be used together for taking buy and sell
decisions in a phased manner. For example, if an investor has Rs. 10 lakhs for
investment, they can first invest the amount in a bond market mutual fund scheme. Let
us assume the market is on downtrend and our investor waits for the right time to invest
in the market. Once the NIFTY, which tracks broad market trend, penetrates 25-day
Moving Average from the bottom, she transfers 3 lakhs from the bond fund to the equity
mutual fund scheme. She transfers another Rs. 4 lakhs to an equity fund if the market
continues to move upward and NIFTY penetrates 50-day Moving Average. Finally, she
transfers the balance Rs. 3 lakhs once the NIFTY clears the 100-day moving average.
NIFTY 2016-2017 & Moving Averages
11,000.00
10,500.00
10,000.00
9,500. 00
9,000. 00
8,500. 00
8,000. 00
7,500. 00
7,000. 00
6,500. 00
6,000. 00
01 6
01 16
01 6
01 16
01 6
01 16
01 6
01 6
01 16
01 6
01 16
01 6
01 7
01 17
01 7
01 17
01 7
01 17
01 7
01 7
01 17
01 7
01 17
17
1
1
1/
2/
3/
4/
5/
6/
7/
8/
9/
0/
1/
2/
1/
2/
3/
4/
5/
6/
7/
8/
9/
0/
1/
2/
/0
/0
/0
/0
/0
/0
/0
/0
/0
/1
/1
/1
/0
/0
/0
/0
/0
/0
/0
/0
/0
/1
/1
/1
01
NIFT Y 25-day MA 50-day MA 100-day MA

Like the phased entry strategy, she can exit from equity fund and transfer funds to a bond
fund when NIFTY starts moving downward and penetrates 25-day, 50-day and 100-day
moving averages. This way, funds enter into the equity market only during the bullish
phase but manage to avoid the bearish phase.
Moving averages can also be used to learn whether the markets are overheated or not.
Price and moving averages are expected to move together. If the price starts moving far
away from the moving average, then one can expect a correction in the market. An
analogy will be useful to understand why such corrections are expected. Assume you are
walking in a park with your 3-year-old niece. She would like to walk alone without your
support and you allow her to be on her own. However, you keep an eye on her
movement. The moment she starts moving away from you, you will pull her back and
then allow her to move freely again. Here, you are like moving average and your niece is
the price line. You can observe this price correction whenever the price line deviates
from the moving averages.
Many analysts use the exponential moving average instead of the simple moving average.
Simple moving average gives equal weight for all data points. The exponential moving
average gives more weight for recent data and less weight to old data. Exponential
moving average is computed as follows:
EMAt = (Price at time ‘t’ * EMP) + EMAt-1 (1-EMP)

Where Exponential Moving Percentage (EMP): 2/(time+1)
Since recent price gets more weight, EMA is bit close to the price line compared to
DMA. Though these two values show difference, they are close to each other at the
decision points. That is, there may be at best two- or three-days delay in getting buy or
sell decisions between the two moving averages. Hence, there is no recommend either
simple moving average or exponential moving average.
Some technical analysts believe when two moving averages cross over each other, there
will be an acceleration in the uptrend or downtrend. That is, if 50-day moving average
(DMA or EMA) penetrates the 100-day moving average (DMA or EMA), the uptrend is
expected to gain momentum. If you subscribe to this belief, then the action point is
investing more funds in the market for a brief time or taking long position in futures or
options market to benefit from the momentum.
Moving Average Convergence and Divergence (MACD)
Moving Average Convergence and Divergence (MACD) is a medium-term indicator used

by investors who are neither day-traders nor long-term investors. MACD is equal to the
difference between the 12-day EMA and 26-day EMA. The indicator is based on the
belief that market will converge and diverge from its mean value and the best time to
invest is when 12-day EMA declines below the 26-day EMA. Another belief is the
market takes about 26 days on average to complete an uptrend and 12 days to correct
itself before venturing into another uptrend such that the long-term trend of the market is
always upward. The 12-day correction period includes investors over action by short-
selling the stock on seeing a downtrend and driving down the prices.
Price, Moving Average and MACD of Reliance Industries Ltd.
If the MACD value is negative, it means the 12-day EMA value is lower than the 26-day
EMA and that zone is called the oversold zone. Similarly, if the MACD value is positive,
it means the market is in the overbought zone. Investors buy in the oversold zone and sell
in the overbought zone.
As a standard practice, whenever the trading rule is not giving any objective decision
rule, technical analysts draw the moving average of the base indicator and take decisions
based on the crossover. In this case, the 9-day EMA of MACD is computed and drawn
along with the MACD line. If the MACD line cuts its own 9-day EMA line in the
oversold region, it gives a buy signal. Similarly, if the MACD line cuts the 9-day EMA
in the overbought region, it gives a sell signal. If an investor follows MACD for buying
and selling stocks, they would perform about 8 to 10 round trades in a year. While many
such trades may not yield profit, few trades give decent return provided the investor
follows the rule consistently.
Oscillators or Indicators
Oscillators or Indicators are short-term tools used by short-term investors and day-
traders. There are many such indicators based on various assumptions. A few of them
are discussed below:
Relative Strength Index (RSI): RSI is based on the belief that stock moves upward for
certain days and then corrects itself for few days before taking fresh uptrend. Analysts
use 14-days cycle for computing the RSI value. The RSI is based on the number of up-
ticks and down-ticks during this 14-day period.
RSI = 100 - (100*X)

where, X = D/(U+D)
U = Average of upward price change in the last 14 days
D = Average of downward price change in the last 14 days
Sell
Sell
Buy
Buy
RSI oscillates between 0 and 100. The RSI value will approach zero if the market is on
the downside for most of the days and it will be close to 100, if it is in upswing for most
of the days during the window period. If the value is above 70, it means the market is in
the overbought zone and one can expect a downtrend in the near future. If it is below 30,
it means the market is in the oversold region and an uptrend is expected in the near
future. Analysts use the 14-day RSI for predicting the future trend. To get an objective
action point, the 9-day moving average value of RSI is computed and plotted along with
the RSI value. The decision rule is: Buy when the RSI cuts its moving averages in a zone
below 30 and sell when it cuts its moving averages in a zone above 70 points.
Stochastic Oscillators: The oscillator is based on the belief that if a stock is close to the
lowest value of a given period, then it will increase in the near future. Similarly, if the
stock is close highest value of a given period, there will be a downtrend or correction in
the price. Investors use the 9-day period to compute the oscillator as follows:
Consider a period interval (say 9 days)

Find the difference between today’s close and lowest low of the period (A)
Compute high-low difference (B)
Get the ratio of the above two (A/B)
Oscillates between 0 and 100
Sell above 80 and buy below 20 or apply moving average.
Hindustan Unilever: Stochastic Oscillator
A 5-day moving average of the stochastic oscillator is computed and plotted along with
the stochastic oscillator. If the moving average penetrates the stochastic oscillator line in
the oversold region (below 20), a buy decision is initiated. Similarly, if the penetration
happens in the overbought zone (above 80), a sell decision is initiated.
Willam’s Advance/Decline Indicator: An interesting indicator, also called Willam’s

%R, tracks the cumulative appreciation in the stock price to measure the underlying
trend. The value is computed using a complex formula, as shown below.
CXt = CXt-1 + Xt
Where, Xt = Today’s close - TRL if Ct > Ct-1

Today’s close - TRH if Ct < Ct-1
Zero otherwise
TRH = Max (Ct-1, Ht);
TRL = Min (Ct-1, Lt)
C=Closing price; H = Highest price; L = Lowest price
Hindustan Unilever: William %R
The indicator measures how far the stock price is above the lowest price and below the
highest price of the period. The belief is if the price is close to the highest value of a
period, it will see some resistance. Similarly, if the price is close to the lowest price of
the period, it will get some support. To derive an objective decision, the 9-day moving
average value of William %R is plotted along with William %R and the interpretation is
similar to the normal moving average analysis. That is, buy when William %R penetrates
its 9-day moving average from bottom and sell when it happens from the top.
Chaikin Volatility Index: A simple measure of volatility of price series is its range.
The high and low difference is one measure of volatility. If the difference is large, it
means the market had a large swing on that day. The Chainkin Volatility Index computes
daily difference and then plots its moving average.
SBI 2007 - 2008:Chaikin Volatility
20
18
16
14
12
10
8
6
4
2
0
17
17
17
17
17
17
18
13 8
18
18
18
18
1
7/
8/
9/
0/
1/
2/
1/
2/
3/
4/
5/
6/
/0
/0
/0
/1
/1
/1
/0
/0
/0
/0
/0
/0
13
13
13
13
13
13
13
13
13
13
13
The period of moving average is normally 10 days. If we plot the 10-day moving
average of the high and low difference, we observe changes in volatility. The
interpretation of the indicator is that an increase in volatility over a short period indicates
the end of bear market. A decline in volatility over a long period indicates the end of the
matured bull market. Analysts look for sudden change in Chaikin’s volatility value to
shortlist securities for active trading. The indicator is not used for taking buying or
selling decisions.
Dow and Elliot Wave Theories
Charles H Dow (1900) wrote series of articles in the Wall Street Journal explaining how
charts can be used for taking investment decisions. He created three indices for this
purpose and believed that averages discount everything. According to Dow, market has
three movements, where primary or long-term movement will last from a few months to a
few years. The secondary or intermediate phase ranges between few weeks to months
and retraces 1/3rd to 2/3rd of the primary market. Finally, daily fluctuations or short-term
movements range from few days to weeks and it is difficult to track them. An uptrend or
downtrend requires confirmation from volume. That is, an uptrend without increase in
volume is unreliable. Similarly, a sharp decline in volume in an uptrend or downtrend
signals its reversal. Dow was the first to define how investors can determine bullish and
bearish trends in the market. According to his theory, market is in the bullish phase when
a new peak is reached every time and this trend ends when it fails to create a new peak.
Similarly, the bearish phase begins when a new low is reached every time and it ends
when price fails to create a new low. He finally required that all averages must confirm
an uptrend or downtrend for reliability.
Around the same time but a little later, Elliott wrote a few articles explaining his version
of the market trend. His focus was more on explaining how the market unfolds over a
period of time instead prescribing how to take investment or trading decisions. He
believed market moves in five waves. Of the five waves, the first, third and fifth waves
are mono waves and one of the mono waves is the impulse wave, which is the longest.
The second and fourth waves are corrective waves. Elliott wrote a few rules describing
the mono, impulsive and corrective waves. Since he wrote these articles at different
points of time, there was no cohesiveness in those rules. Some of them are contradictory
and difficult to reconcile2. The supporters of Elliott spend considerable time in counting
and debating on waves without any decision rule.
Summary
Investors broadly follow two approaches in taking investment decisions. Fundamental

analysis is based on examining economic, industry and company data to estimate fair
value of the stock. If the market price is lower than the face value, they buy those
undervalued stocks. They sell the stock once it reaches its fair value. Technical analysts,
on the other hand, use only the market data like price and volume data. They believe that
through charts, it is possible to assess the underlying trend in the market. Once the
uptrend or downtrend is confirmed, long and short positions are created in the market.
Among various tools, moving averages are popular and widely used. In addition to
moving averages, technical analysts use a number of indicators to get long-term and
short-term view of the market. Technical analysis can be applied to several stocks
simultaneously and they are amenable for program trading. Though it looks easy to apply
and practice technical analysis, there are many challenges. One of the important
challenges is following the rule consistently in different market conditions.
2
Read Fred Gehm, Who Is R.N. Elliott and Why Is He Making Waves? Financial Analysts Journal
Vol. 39, No. 1 (Jan. - Feb., 1983), pp. 51-58 for such contradictions.
Backtesting Trading
Strategies
1
Backtesting
Backtesting is determining how a trading strategy would have
performed in the past. Backtesting is an essential element of
developing an effective trading system. It can be done manually
or systemically, and it aims to establish whether a trading
strategy is worth implementing in the live market.
The underlying principle is that a strategy that worked successfully in
the past can be trusted to deliver profitability in the future. This
assumes that price patterns in the markets tend to repeat
themselves. However, this may always not be the case because
markets are always dynamic and ever-changing.
2
Backtesting
A historical simulation designed to test the performance of a set of

trading and risk management rules on historical data.
• Provides quantified performance of a strategy that can be used for
comparison with other strategies.
• Outlines likely capital requirements, trade frequency and risk to a
portfolio.
3
Strategies
Strategies could vary from simple to very complex

Fundamental or technical analysis based
Based on common sense or purely data driven
AI /ML Algorithms based
Single factor or multiple factors
4
Backtesting Strategies
Phase 1
Decide on the strategy
Collect enough data to cover a number of cycles
Make sure that the data period has both bullish and bearish periods
If automated system being created, develop filtering screens to
collect data
Divide the data into estimation and testing parts (training and test
data in analytics parlance)
Estimate the models using the estimation data
5
Backtesting Strategies
Phase 2
Use the estimated model and apply it to the test data.
Evaluate the results
If required, go back to phase 1 to check the models
Phase 3
Repeat the process
6
Stock Selection
Pros:
Anecdotal evidence suggests ~80% of stock picking is done ‘by
hand’ (individuals making calls on fundamentals)
Relies heavily on talent (or luck) of individual analyst
Individuals can only process so much information (sector
focus)
Human nature suggests cognitive biases likely
Market structure may perpetuate mis-pricings (Street incentives,
value weighted benchmarks, short sale restrictions)
Little academic research on subject (trade rather than publish)
Evidence suggests that investors systematically over-pay for
‘growth’
Quantitative selection is scalable
7
Quant Stock Selection
Cons:
Black box nature of model
Explain approach without revealing too much information
Attribution analysis – must be able to explain performance
Protecting against common modeling errors
Credibility of simulated results
Adapting to individual client restraints
8
Backtesting Methodology
Hypothesize
Develop candidate list of potential factors that may assist in
predicting stock returns (valuation, growth, etc.)
Priors’ reduce data mining
Back Test
Decide on “universe” for testing (capitalization, index, sector,
etc.)
Use sorting or regressions to test individual candidate
variables
Rebalance
Periodically rebalance portfolios (monthly, annually, etc.)
9
Backtesting Methodology
Analyze Results
Consider factor performance and consistency (both long and
short candidates) in predicting returns balanced against
turnover
Select most promising factors for inclusion in the model
Weight
Once individual factors selected must decide on weights for
final model by either:
a) ‘Eye balling’ best factors and assigning weights for a
scoring model
b) Pushing individual factor portfolios into a risk-return
analysis
10
Back Testing Pitfalls
Market regime shift - Regulatory change, macroeconomic events,
“black swans”
• Transaction costs - Unrealistic handling of slippage, market impact
and fees
• Liquidity constraints
• Optimization Bias - Over-fitting a model too closely to limited data
• Survivorship Bias - Only using instruments which still exist
(incorrect sample)
• Lookahead Bias - Accidental introduction of future information
into past data
• Interference - Ignoring strategy rules “just this once” because “I
know better”
11
Types of Back Testing
Research Phase
Rapid prototyping
Many strategies/parameters can be tested quickly.
Identifying statistical relationships
Coding (Python, MatLab, R etc.).
Often unrealistic (inflated) performance
Implementation Phase
Extensive development and testing time.
Full Order Management System (OMS).
Often event-driven or CEP (complex event processing)
Code-reuse between live implementation and backtesting.
More realistic performance.
12
Evaluation Criteria
Average Returns
Average Risk
Average Excess Return – Benchmark
Average Return per Unit of Risk
Sharpe Ratios
Information Ratio
Excess return / std. dev. of excess returns
Maximum Drawdown
Fall in the returns from the peak to immediate trough
13
Example
14
Winner-Loser Effect
Investors generally over-react to information
Over-reaction Hypothesis
Current winners could underperform and current losers could
outperform
Winner-Loser Effect
Part of behavioral finance
15
Winner-Loser Effect
186 companies data used for the analysis
Weekly excess return over market calculated
Cumulative excess return for 52 weeks
Stocks are then ranked on the basis of cumulative excess returns
Stocks that rank top 10 form the winner portfolio
Stocks that rank bottom 10 form the loser portfolio
Buy loser portfolio and sell winner portfolio
Performance of this portfolio are tested during the next year.
The process continued for all the years
Average excess return on the tested portfolios calculated
16
Winner-Loser Effect
Cumulative and Average Excess Returns
* The results are given for arbitrage portfolio ERL - ERW.

@ The results are given for arbitrage portfolio CERL - CERW.
17
Another Example
18
Risk-Return Analysis
Can portfolio based on return and risk analysis provide expected
results
High risk-high return
120 stocks during 1987 to 1995
Portfolio formation period – 2 years
Stocks ranked on the basis of returns, risk and return per unit of
risk
Created 10 portfolios based on the ranking
Performance evaluation – next quarter, half-year and full year
Delete the initial quarter data, add new quarter data
Process repeated for each new data set
Average performance evaluated
19
Average Risk-Return Relationship
20
21
22
Average Return Per Unit of Risk
23
24
25
Hedge Funds
1
What are hedge funds?
“Hedge funds are investment pools that are relatively

unconstrained in what they do. They are relatively
unregulated (for now), charge very high fees, will not
necessarily give you your money back when you want it,
and will generally not tell you what they do. They are
supposed to make money all the time, and when they fail at
this, their investors redeem and go to someone else who
has recently been making money. Every three or four years
they deliver a one-in-a-hundred year flood. They are
generally run for rich people in Geneva, Switzerland, by
rich people in Greenwich, Connecticut.”
-Cliff Asness, Journal of Portfolio Management 2004.
2
The History of Hedge Funds
In 1949, Alfred Jones established the first hedge fund in the U.S.
At its beginning, the defining characteristic of a hedge fund was that
it hedged against the likelihood of a declining market.
Two speculative tools were merged into a conservative form of
investing:
1. leverage was used to obtain higher profits.
2. short selling was employed to hedge against the downside risk.
By combining long and short positions, Jones exploited the relative
pricing of stocks, while minimizing his exposure to the overall
market.
To align the manager/investor incentives, Jones employed
performance based fee compensation. He also kept all of his own
money in the fund.
3
The History of Hedge Funds
While mutual funds were the darlings of Wall Street in the 60’s,
Jones’ hedge fund was outperforming the best mutual funds
even after the 20% incentive fee deduction. The news of Jones’
performance created excitement, and by 1968, approximately
200 hedge funds were in existence.
During the 60s bull market, many of the new hedge fund man-
agers stopped hedging the downside risk, and went into the
bear market of the early 70s with long, leveraged positions.
Many were put out of business.
During the next decade, only a modest number of hedge funds
were established.
Over the past 10 years, however, the number of funds has
increased at an average rate of 25 74% per year.
4
Size of Hedge Funds
($ Billions)
5
Size of US Mutual Funds
($ Trillions)
6
Overview of the Hedge Fund Industry
Generally speaking, a hedge fund is an organizational structure for
managing private investment capital in a relatively unrestricted
manner. Unlike the mutual fund industry, which typically imposes
severe restrictions on investment activities (e.g., short sale
constraints, leverage restrictions)—hedge funds generally face
fewer or no such restrictions.
Hedge funds are usually classified in the alternative asset category in
a portfolio’s strategic asset allocation.
Formally, a hedge fund is a managed portfolio that attempts to
preserve invested capital, reduce volatility, and provide positive
returns under all market conditions. Hedge fund managers attempt
to accomplish these goals by taking long and short positions in
various securities, using leverage and derivatives, employing
arbitrage strategies, and taking positions in virtually any security
in which a superior return opportunity is attainable. 7
Overview of the Hedge Fund Industry
Sometimes hedge funds are categorized under the more general
heading of absolute return investment strategies because they
seek to provide investors with positive returns regardless of
the direction of general market movements. However, it is
important to recognize that there are a wide variety of
investment strategies under the hedge fund umbrella,
representing a significant range of the investment risk
spectrum.
8
Overview of Hedge Fund Strategies
Arbitrage Strategies
Convertible Arbitrage Global Macro
Fixed Income Arbitrage Emerging Markets
Event Driven Managed Futures
Merger Arbitrage Systematic Trading
Distressed/High Yield Securities Discretionary Trading
Regulation D
Equity Based Strategies
Long/Short Equity
Equity Market Neutral
Dedicated Short-Bias
9
Hedge Fund Strategies
Arbitrage Strategies
In using arbitrage hedging strategies a manager generally seeks to
profit from perceived mispricing in a specific asset of a market
or security. With each position held in the portfolio, the
manager attempts to isolate and capitalize on a feature of an
asset or combination of assets that is mispriced according to a
theoretical fair value or equilibrium relationship. The assets
most commonly traded based on arbitrage strategies include
convertible bonds, convertible preference shares and fixed
income. The degree of leverage used in arbitrage strategies will
vary with the composition of long positions and portfolio
objectives, usually between 2x and 10x equity.
10
Convertible Arbitrage
This strategy aims to profit from mispricing opportunities within
convertible bonds and other hybrid debt/equity securities. These
securities are a combination of various instruments and the
parcel as a whole may be a different price to the sum of the
component parts. If the price is different there exists an
opportunity to buy (sell) the parcel and sell (buy) the various
component parts to lock in a profit. Therefore the generation of
‘alpha’ is independent from the general direction of markets. A
typical investment is to be long (buy) the convertible bond and
short (sell) the common stock of the same company to take
advantage of the price volatility of the stock.
11
Convertible Arbitrage - Example
Here the manager believes a convertible bond to be undervalued
relative to its current market price and at the same time views
equity of the company to be overvalued, expecting the market
price of equity to fall. The manager will buy the convertible
bond and short the stock of the same issuer to eliminate the
stock price risk embedded in the convertible bond. When
executing a strategy of long convertible bonds and short equity,
the manager will need to consider the credit risk associated with
the trade. Asset swaps can be used to strip out the credit risk
from convertible bonds.
12
Fixed Income Arbitrage
The fixed income arbitrageur aims to profit from price anomalies
between related interest rate securities. Most managers trade
globally with a goal of generating steady returns with low
volatility. This category includes interest rate swap arbitrage, US
and non-US government bond arbitrage, forward yield curve
arbitrage, and mortgage-backed securities arbitrage. Leverage
will depend on the types of positions taken in the portfolio.
Positions such as basis trades that are more simple and stable will
be leveraged higher than trades that have yield curve exposure
and are therefore considered to be higher risk. Types of positions
can include basis trading, intermarket spreads, yield curve
trading, relative value options strategies and financing strategies.
13
Fixed Income Arbitrage - Example
A simple example of a fixed income arbitrage strategy is a basis
trade. A basis trade involves the purchase or sale of a futures
contract and the concurrent offsetting purchase or sale of an
instrument that is deliverable into the futures contract. This can
be illustrated with the following transaction:
Simultaneously Purchase a government bond
Sell a futures contract on that bond
Profit opportunities Uncertainty in the composition of
bonds required in the delivery
option of the bond futures
Shifts in the supply and demand for
the underlying bonds.
14
Event Driven
This strategy is designed to capture price movement generated by a
significant pending corporate event such as a merger, corporate
restructuring, liquidation, bankruptcy or reorganization.
Merger Arbitrage
Merger arbitrageurs exploit merger activity to capture the spread
between current market values of securities and their values in the
event of a merger, restructure or other corporate transaction. Before
entering into a merger arbitrage strategy, the manager will analyze
the probability of the deal closing, the likelihood of it closing at or
above the bid price, and the timeframe to the closing date. The
probability of success of the takeover directly influences the size of
positions the manager will take as the profitability of the trade
depends on the success of the merger.
15
Merger Arbitrage - Example
In mergers where shareholders in the target company are offered
stock in the acquiring company, the spread is the difference
between the current values of the target company’s stock and the
acquiring company’s stock. The spread is captured where the
arbitrageur buys the stock of the target company and shorts the
stock of the acquiring company.
Takeover Announcement Company A Company B
Offer 20% premium of current market price
Market Reaction No immediate Change
Manager Expectation Stock price Decline Stock price Rise
Manager Response Short (sell) Company A stock Buy Company B Stock
Profit Where Takeover completed successfully and stock prices converge so that
Company A stock price declines and Company B stock prices rise. An alternative suitor,
Company E makes a bid for Company B for a higher price than offered by Company A.
The manager then switches the short position from Company A to Company E.
16
100
200
400
500
600
300
0
Jan-22
Jan-22
Feb-22
Feb-22
Mar-22
Mar-22
Apr-22
May-22
May-22
Jun-22
Jun-22
Jul-22
Aug-22
Aug-22
NDTV Takeover
Sep-22
Sep-22
NDTV Stock Price - 2022
Oct-22
Oct-22
Nov-22
Dec-22
17
Mindtree – L&T Hostile Takeover
Mindtree vs. L&T

1700 2000
LT Mindtree Offer
1500 1500
1300
1000
1100
900 500
700 0
Nov-20
Jan-19
Jan-20
Jan-21
Nov-19
Mar-19
Jul-19
Mar-20
Jul-20
Sep-19
Sep-20
May-19
May-20
18
Mindtree – L&T Hostile Takeover
Mindtree vs. L&T Infotech

4200 1900
LTI Mindtree Offer
3700 1700
3200 1500
2700 1300
2200 1100
1700 900
1200 700
700 500
Nov-20
Jan-19
Jan-20
Jan-21
Nov-19
Mar-19
Jul-19
Mar-20
Jul-20
Sep-19
Sep-20
May-19
May-20
19
HDFC-HDFC Bank Merger
HDFC and HDFC Bank

2800 1700
HDFC HDFC Bank
1600
2600
1500
2400
1400
2200
1300
2000 1200
Dec-22
Apr-22
Jul-22
Mar-22
Sep-22
Jun-22
Feb-22
Nov-22
Aug-22
Jan-22
May-22
Oct-22
20
Distressed/High Yield Securities
Managers are active in fixed interest and equity markets basing their
strategies on the actual or anticipated occurrence of a particular
event such as a bankruptcy announcement or corporate
reorganization as a result of severe operating or financial
difficulties such as defaulting on debt. Distressed or high yield
securities require a high level of due diligence to take advantage of
the inexpensive prices at which they are trading.
Performance depends on how well the managers analyze event-
specific situations, rather than on the direction of the stock or bond
markets. Managers investing in distressed or high yield securities
will vary in terms of the level of capital structure, the stage of the
restructuring process and the degree to which they become actively
involved in negotiating the terms and management of restructuring.
21
Distressed/High Yield Securities - Example
A financial institution makes a loan to a borrower, say a Retail co.
Retail then finds itself in financial difficulty, resulting in
bankruptcy or being close to it. Retail has defaulted on its debt
resulting in a fall in the value of the loan. A Distressed Debt
specialist analyses the situation for possible investment either in
the debt or equity of the company considering questions such
as: Does the business have value? Is the company in trouble
because of problems, such as over-leveraging, that can be
rectified? What class of debt will have the most power in the
restructuring?
Investors in distressed securities are seeking capital appreciation of
the debt rather than an income stream. They can be active or
passive investors.
22
Regulation D
Regulation D is a form of capital raising, essentially representing
investments in micro and small capitalization public companies
that are raising money in private capital markets. A manager
will make a short term or medium term investment in
companies that are in need of large capital injection within a
relatively short time frame. This allows small firms to raise
capital quickly and relatively cheaply and managers aim to
benefit from free equity options embedded in the financial
transaction. Investments usually take the form of a convertible
security with an exercise price that floats or is subject to a look-
back provision that insulates the investor from a decline in the
price of the underlying stock.
23
Regulation D - Example
Buy A floating convertible instrument
in a small company listed on the
stock exchange
Option The option in the security is to convert
to the small company stock at say 15%
discount to the company’s stock price
after a minimum holding period of
18 months.
Profit To purchase the company stock
Opportunity at a discount and the ability to sell at a
higher price, that is the market price.
24
Equity Based Strategies
Managers will base the investment decision on their view of the degree by
which individual securities are under or over valued relative to current
market prices. These strategies are heavily reliant on the skill of the
manager and may use quantitative tools, however the final investment
decision is usually a subjective one.
Strategies combine long and short positions thereby reducing or eliminating,
directional market risk and generating returns based on the price
movements in securities. This may involve borrowing securities that are
overvalued and selling them with expectation of price reversal when the
fund has to buy the securities back to return them to the brokers.
These funds take positions along the whole risk-return spectrum and try to
distinguish their performance from that of the asset class as a whole.
Returns will therefore deviate substantially from the underlying market
return. Portfolios will also tend to be more concentrated than those of
traditional long-only managers.
25
Long/Short Equity
Managers employing this strategy will hold both long and short
positions with a net long exposure. The objective is not to be
market neutral. This means that at all times more than 50% of
assets should be held as long (buy) positions. This category
excludes long only portfolios. To be considered a hedge fund,
the manager’s strategy must include short positions while
maintaining an absolute return objective. Managers have the
ability to shift from value to growth and from small to medium
to large capitalization stocks. Managers may use futures and
options to hedge. The focus may be regional, such as long/short
US or European equity, or sector specific, such as long and short
technology or healthcare stocks.
26
Long/Short Equity - Example
The manager will take both long and short positions, depending on their
market outlook. Portfolios may shift between, large cap and small cap,
and across sectors within a particular market. The following example
highlights some typical trades that may be present in a portfolio that
trades within and across sectors. The portfolio will usually consist of
many more trades than displayed here. The portfolio has a net long
position of 60% with 40% held in short positions.
Expected % of
Industry Change Position Stock Portfolio
Up Long Astrazeneca 15%
Healthcare Down Short Merck 13%
Up Long Novartis 16%
Down Short HP 13%
Technology
Down Short Dell 14%
Consumer Up Long Target 15%
Discretionary Up Long Wal Mart 14%
27
Equity Market Neutral
This investment strategy is designed to exploit equity market
inefficiencies and usually involves simultaneously long and
short matched equity portfolios of the same size. The manager
will aim to position the portfolio to be cash or beta neutral, or
both. Typically the portfolio will exhibit a small or nil net
market exposure. Well-designed portfolios typically control for
industry, sector, market capitalization, and other market factors.
This translates to a near 50:50 balance to long and short
positions. Leverage is often applied to enhance returns.
No need to look at direction of market movement, as one is looking
at relative performance
28
Equity Market Neutral - Example
A pair trade in a dual listed company is a good example of an
equity market neutral strategy. This involves the purchase of one
share category and the sale of another on the same stock.
Investment Themes in Equity Market Neutral
29
Dedicated Short-Bias
In employing this strategy, a hedge fund manager will maintain a
net short bias against the market. Managers look for securities
that they perceive to be overvalued and short those stocks or use
derivatives to profit from a declining share price. They may
achieve better results in bearish markets.
This is a directional trading strategy
There are ETFs like ProShares UltraShort 20+ Year Treasury,
Invesco DB US Dollar Index Bearish, Short Dow30 ProShares
30
Global Macro
This strategy involves opportunistically allocating capital among
a wide variety of strategies and capital or derivative markets.
Strategies or themes may be directional or non-directional,
traditional or hedged. This is the most flexible of investment
strategies, with the manager often taking a top-down thematic
approach and investing on an opportunistic basis, moving
between countries, markets and instruments based on the
manager’s forecasts of changes in factors such as interest rates,
exchange rates and liquidity. A number of different trading
strategies are often used depending on the opportunities
identified. Most funds invest globally in both developed and
emerging markets.
31
Global Macro - Example

A manager will attempt to exploit global trends and market
movements by entering into irregular, directional positions that
are highly leveraged. If for example a manager expects interest
rate spreads between Australia and the USA to widen as a
result of interest rates rising in Australia. Hedge positions may
be taken in interest rates or currencies of the two countries; Bet
on $A/USD with the expectation that the $A will rise against
the USD following the increase in Australian interest rates.
32
Emerging Markets
The emerging markets strategy used by hedge funds involves
equity or fixed income investing in emerging markets around
the world. Because many emerging markets do not allow short
selling, nor offer viable futures or other derivative products
with which to hedge, emerging market investing often employs
a long-only strategy. As the currency of many emerging
markets cannot be hedged through the use of derivatives, an
investment in an emerging market results in exposure to the
movements in currency of the underlying country.
33
Managed Futures
Managed futures managers usually invest in a portfolio of futures
contracts comprising stock index futures, commodity futures,
foreign currency futures, and fixed income futures. The
managers are usually referred to as Commodity Trading
Advisors, (CTAs) or Commodity Pool advisors (CPOs), which
are generally regulated in the U.S. by the Commodity Futures
Trading Commission (CFTC) through National Futures
Association before they can offer services to the general
public.
34
Trading strategies you can use on a managed futures investment:
• Trend Following Strategy (Momentum): This trading
strategy involves buying assets in higher-trending markets and
selling short in lower-trending markets.
• Market-Neutral Strategy: Involves making investments that
aren’t affected by the stock and bond markets. With this
strategy, the portfolio manager makes long and short-term
investments simultaneously.
• Discretionary Strategy: It’s an approach where the
commodity trading advisor (or any other fund manager) makes
an investment decision based on real-time market data.
• Systematic Strategy: Involves making an investment decision
based on trends or patterns observed in historical charts.
35
Hedge Fund Performance
Hedge Fund Performance H1 2022(%)

-15 -10 -5 0 5 10
Arbitrage
Manged Futures
Distressed Debt
Event-Driven
Fixed Income
Long-Short Equity
Macro
Multi-Strategy
Relative value
36
The LTCM Case
37
LTCM Case: Summary
In 1994, John Meriwether, the famed Salomon Brothers bond
trader, assembled an all-star team of traders and academics in an
attempt to create a fund that would profit from the combination
of the academics' quantitative models and the traders' market
judgement and execution capabilities. Sophisticated investors,
including many large investment banks, flocked to the fund,
investing $1.3 billion at inception. But four years later, at the
end of September 1998, the fund had lost substantial amounts of
the investors' equity capital and was teetering on the brink of
default. To avoid the threat of a systemic crisis in the world
financial system, the Federal Reserve orchestrated a $3.5 billion
rescue package from leading U.S. investment and commercial
banks. In exchange the participants received 90% of LTCM's
equity.
38
LTCM Case: Lessons
The lessons to be learned from this crisis are:
• Market values matter for leveraged portfolios
• Liquidity itself is a risk factor
• Models must be stress-tested and combined with judgement
• Financial institutions should aggregate exposures to

common risk factors.
39
LTCM Case: Lessons
LTCM's main strategy was to make convergence trades.
These trades involved finding securities that were mispriced
relative to one another, taking long positions in the cheap
ones and short positions in the rich ones. There were four
main types of trade:
• Convergence among US, Japan, and Emerging Sovereign
bonds
• Convergence among European Sovereign bonds
• Convergence between on-the-run and off-the-run US
Government bonds
• Long positions in emerging markets Sovereigns, hedged
back to dollars
40
LTCM Case: Lessons
Because these differences in values were tiny, the fund
needed to take large and highly-leveraged positions in
order to make a significant profit. At the beginning of
1998, the fund had equity of $5 billion and had borrowed
over $125 billion — a leverage factor of roughly thirty to
one. LTCM's partners believed, on the basis of their
complex computer models, that the long and short
positions were highly correlated and so the net risk was
small.
41
LTCM Case: Events
1994: Long-Term Capital Management is founded by John
Meriwether and accepts investments from 80 investors
who put up a minimum of $10 million each. The initial
equity capitalization of the firm is $1.3 billion.
End of 1997: After two years of returns running close to 40%,
the fund has some $7 billion under management and is
achieving only a 27% return — comparable with the return
on US equities that year.
Meriwether returns about $2.7 billion of the fund's capital
back to investors because "investment opportunities were
not large and attractive enough".
42
LTCM Case: Events
Early 1998: The portfolio under LTCM's control amounts to well over
$100 billion, while net asset value stands at some $4 billion; its
swaps position is valued at some $1.25 trillion notional, equal to
5% of the entire global market. It had become a major supplier of
index volatility to investment banks, was active in mortgage-
backed securities and was dabbling in emerging markets such as
Russia.
17 August 1998: Russia devalues the Ruble and declares a
moratorium on 281 billion Rubles ($13.5 billion) of its Treasury
debt. The result is a massive "flight to quality", with investors
flooding out of any remotely risky market and into the most secure
instruments within the already "risk-free" government bond
market. Ultimately, this results in a liquidity crisis of enormous
proportions, dealing a severe blow to LTCM's portfolio.
43
LTCM Case: Events
1 September 1998: LTCM's equity has dropped to $2.3
billion. John Meriwether circulates a letter which discloses
the massive loss and offers the chance to invest in the fund
"on special terms". Existing investors are told that they
will not be allowed to withdraw more than 12% of their
investment, and not until December.
22 September 1998: LTCM's equity has dropped to $600
million. The portfolio has not shrunk significantly, and so
its leverage is even higher. Banks begin to doubt the fund's
ability to meet its margin calls but cannot move to liquidate
for fear that it will precipitate a crisis that will cause huge
losses among the fund's counterparties and potentially lead
to a systemic crisis.
44
LTCM Case: Events
23 September 98: Goldman Sachs, AIG and Warren Buffett
offer to buy out LTCM's partners for $250 million, to inject
$4 billion into the ailing fund and run it as part of
Goldman's proprietary trading operation. The offer is not
accepted. That afternoon, the Federal Reserve Bank of
New York, acting to prevent a potential systemic
meltdown, organizes a rescue package under which a
consortium of leading investment and commercial banks,
including LTCM's major creditors, inject $3.5-billion into
the fund and take over its management, in exchange for
90% of LTCM's equity.
45
LTCM Case: Events
Fourth quarter 1998: The damage from LTCM's near-demise
was widespread. Many banks take a substantial write-off as
a result of losses on their investments. UBS takes a third-
quarter charge of $700 million, Dresdner Bank AG a $145
million charge, and Credit Suisse $55 million.
Additionally, UBS chairman Mathis Cabiallavetta and
three top executives resign in the wake of the bank's losses.
Merrill Lynch's global head of risk and credit management
likewise leaves the firm.
April 1999: President Clinton publishes a study of the LTCM
crisis and its implications for systemic risk in financial
markets, entitled the President's Working Group on
Financial Markets
46
LTCM Case: Analysis
The Proximate Cause: Russian Sovereign Default
The proximate cause for LTCM's debacle was Russia's default on
its government obligations (GKOs). LTCM believed it had
somewhat hedged its GKO position by selling rubles. In theory,
if Russia defaulted on its bonds, then the value of its currency
would collapse and a profit could be made in the foreign
exchange market that would offset the loss on the bonds.
Unfortunately, the banks guaranteeing the ruble hedge shut down
when the Russian ruble collapsed, and the Russian government
prevented further trading in its currency. While this caused
significant losses for LTCM, these losses were not even close to
being large enough to bring the hedge fund down. Rather, the
ultimate cause of its demise was the ensuing flight to liquidity.
47
LTCM Case: Analysis
The Ultimate Cause: Flight to Liquidity
The ultimate cause of the LTCM debacle was the "flight to
liquidity" across the global fixed income markets. As Russia's
troubles became deeper and deeper, fixed-income portfolio
managers began to shift their assets to more liquid assets. In
particular, many investors shifted their investments into the U.S.
Treasury market. While the U.S. Treasury market is relatively
liquid in normal market conditions, this global flight to liquidity
hit the on-the-run Treasuries like a freight train. The spread
between the yields on on-the-run Treasuries and off-the-run
Treasuries widened dramatically: even though the off-the-run
bonds were theoretically cheap relative to the on-the-run bonds,
they got much cheaper still (on a relative basis).
48
LTCM Case: Analysis
What LTCM had failed to account for is that a substantial
portion of its balance sheet was exposed to a general
change in the "price" of liquidity. If liquidity became more
valuable (as it did following the crisis) its short positions
would increase in price relative to its long positions. This
was essentially a massive, unhedged exposure to a single
risk factor.
As an aside, this situation was made worse by the fact that the
size of the new issuance of U.S. Treasury bonds has
declined over the past several years. This has effectively
reduced the liquidity of the Treasury market, making it
more likely that a flight to liquidity could dislocate this
market.
49
LTCM Case: Analysis
Systemic Risk: The Domino Effect
The near-failure of LTCM threatened the stability of the
global financial markets, because several investors had
similar positions.
This pushed the US government to arrange a bail out by a
group of banks.
50
HFT and Algo Trading
51
High-frequency traders (HFTs)
Proprietary trading at a rapid rate
Focus on low latency
Typically short (intraday) holding periods
Three broad categories of trading strategies:
Market‐making (formally or informally)
High‐frequency relative‐value trading
Index arbitrage (futures vs. ETFs vs. single stocks)
Pairs trading (home market vs. ADRs, GM vs. Ford)
Directional trading on public signals
Order flow
Newswire releases
52
While there is no real definition - because HFT it is not about a
type of activity but about the frequency and speed of it - The
execution of trading strategies based on algorithms to capture
opportunities that may be small or exist for a very short period
of time.
Typical Characteristics (but not always)
– Very high number of orders & Rapid order cancellation
– Proprietary trading, Profit from buying and selling (as middleman)
– Very short holding periods
– No significant position at end of day (flat position)
– Extracting very low margins per trade
– Ultra Low latency requirement, use of co-location/proximity services and
individual data feeds
– Use computerized quantitative models
All High Frequency Trading is Algorithmic BUT not all
Algorithmic Trading is High-Frequency. 53
Algo Trading
What exactly is Algorithmic Trading?
Algorithmic Trading (AT) may be defined as electronic trading
whose parameters are determined by strict adherence to a
predetermined set of rules aimed at delivering specific
execution outcomes.
Characteristics of Algorithmic Trading
1. Pre-designed trading decisions
2. Used by professional traders
3. Observing market data in real-time
4. Automated order submission
5. Automated order management
6. Without human intervention
7. Use of direct market access
54
HFT, Colo, Algo. Are these all the
same thing?
Algorithmic Trading (AT) - any form of trading using sophisticated
‘algorithms’ to automate all or some part of the trade cycle.
High-frequency Trading (HFT) - execution of computerized trading
strategies is characterized by extremely short position-holding
periods involving trading speeds in excess of a few milliseconds.
Ultra Low-latency Trading (CoLo) - refers to HFT execution in
sub-millisecond times through co-location of servers at
exchanges, direct market access, or individual data feeds offered
by exchanges and others to minimize network and other types of
latencies.
Sponsored (or Naked) Access (SA) - buy side is enabled to route its
orders to the market directly using a registered broker‘s member
ID without using the broker’s infrastructure or risk controls.
55
The economics behind HFT
Potential benefits
Increased competition in market‐making
Cost reduction via technology
Some potential costs
Front‐running persistent order flow could discourage others
from participating
Faster‐take‐all could lead to an unproductive arms race
Additional temporary volatility (no evidence, though)
Greater complexity imposes costs on others
Greater complexity makes it easier for bad actors to hide
56
HFT is not a strategy per se but rather a technologically more
advanced method of implementing particular trading
strategies. The objective of HFT strategies is to seek to
benefit from market liquidity imbalances or other short-term
pricing inefficiencies
HFTs like higher volatility – potential to make profits quickly,
irrespective of whether market moves up or down
57
Example: Pairs Trading
ICICI Bank vs. Axis Bank

1000 1000
ICICI Bank Axis Bank 900
800 800
700
600
600
400 500
400
200 300
Jun-20 Dec-20 Jun-21 Dec-21 Jun-22 Dec-22
58
Concerns about HFT Trading
1. HFT firms stop providing liquidity in volatile markets
2. HFT firms benefit from flash orders
3. HFT increases volatility
4. HFT algorithms are going berserk
5. HFT often involves front running
6. HFT provides phantom liquidity
7. HFT firms profit from slowing down trading by quote stuffing
strategies
8. HFT has an unfair competitive advantage by using sponsored
access
9. HFT has an unfair competitive advantage by using co-location
10. HFT firms benefit from fee structures
59
Are HFTs Gaming the Market?
Gaming Concerns
1. Order discovery strategies (hidden liquidity)
2. Order triggering strategies (stop orders)
3. Spoofing (lowering the best offer)
4. Wash sales (fictitious orders)
5. Front running (insider info)
6. Quote stuffing (denial of service)
7. Stub quoutes (too far from market)
60
Algo Trading Market
The global algorithmic trading market reached a value of US$
13.0 Billion in 2021. Looking forward, IMARC Group
expects the market to reach US$ 24.0 Billion by 2027,
exhibiting a CAGR of 11.4% during 2022-2027
61
Algo Trading Market
62
Spoofing and Layering
“Spoofing” and “layering” are both forms of market manipulation
whereby a trader uses visible non-bona fide orders to deceive other
traders as to the true levels of supply or demand in the market.
“layering” to describe entering multiple non-bona fide orders at
multiple price tiers, and “spoofing” to describe entering one or
more non-bona fide orders at the top of the order book only.
In spoofing patterns, a trader enters a single visible order, or a series
of visible orders, that either creates a new best bid or offer or adds
significantly to the liquidity displayed at the existing best bid or
offer. During the lifespan of that first order(s), or within a short
time after it is cancelled, the same trader executes a trade on the
opposite side of the market. The pattern is manipulative because
the execution occurs at a more favorable price than the trader was
likely to obtain in the absence of the first order(s).
63
Layering is a variant of spoofing where the trader enters multiple
visible orders on one side of the market at multiple price tiers,
which cause the midpoint of the spread to move away from
those multiple orders, and the same trader executes a trade on
the opposite side of the market. Again, the pattern is
manipulative because the execution occurs at a more favorable
price than the trader was likely to obtain in the absence of the
first orders.
64
2010 Flash Crash
65
2010 Flash Crash
Use audit trail data to classify S&P500 futures (e‐mini) traders:
High‐frequency traders (HFTs)
Fundamental Sellers
Fundamental Buyers
On 2010 May 6, 16 HFTs traded over 1,455,000 contracts, almost 1/3
of total trading volume.
During the Flash Crash:
HFTs initially bought, providing liquidity as prices fell
HFTs overwhelmed after a few minutes, sold as decline continued
Eventually, Fundamental Buyers were attracted by the rapidly falling
prices to step in and buy.
“Because net holdings of the HFTs were so small relative to the selling
pressure from the Fundamental Sellers on May 6, HFTs could have
neither caused nor prevented the fall in prices...”
66
2010 Flash Crash
Detailed investigations revealed that HFTs might not have been

the reason behind flash crash.
A London based trader who did spoofing orders on S&P 500 E-
Mini Futures contracts worth $200 million
He was arrested and pleaded guilty
Spoofing, Layering etc. are banned now
67
NSE Co-location Scam
NSE allowed some traders co-location facilities from Jan 2010

Unfair access to some of the members, who got access to the
system ahead of others
With support from insiders, some players were gaming the
system and front running
Whistle blower letter and subsequent action by SEBI, CBI etc.
68
HFT and Algo Trading
1
Proprietary trading at a rapid rate
Focus on low latency
Typically short (intraday) holding periods
Three broad categories of trading strategies:
Market‐making (formally or informally)
High‐frequency relative‐value trading
Index arbitrage (futures vs. ETFs vs. single stocks)
Pairs trading (home market vs. ADRs, GM vs. Ford)
Directional trading on public signals
Order flow
Newswire releases
2
While there is no real definition - because HFT it is not about a
type of activity but about the frequency and speed of it - The
execution of trading strategies based on algorithms to capture
opportunities that may be small or exist for a very short period
of time.
Typical Characteristics (but not always)
– Very high number of orders & Rapid order cancellation
– Proprietary trading, Profit from buying and selling (as middleman)
– Very short holding periods
– No significant position at end of day (flat position)
– Extracting very low margins per trade
– Ultra Low latency requirement, use of co-location/proximity services and
individual data feeds
– Use computerized quantitative models
All High Frequency Trading is Algorithmic BUT not all
Algorithmic Trading is High-Frequency. 3
Algo Trading
What exactly is Algorithmic Trading?
Algorithmic Trading (AT) may be defined as electronic trading
whose parameters are determined by strict adherence to a
predetermined set of rules aimed at delivering specific
execution outcomes.
Characteristics of Algorithmic Trading
1. Pre-designed trading decisions
2. Used by professional traders
3. Observing market data in real-time
4. Automated order submission
5. Automated order management
6. Without human intervention
7. Use of direct market access
4
HFT, Colo, Algo. Are these all the
same thing?
Algorithmic Trading (AT) - any form of trading using sophisticated
‘algorithms’ to automate all or some part of the trade cycle.
High-frequency Trading (HFT) - execution of computerized trading
strategies is characterized by extremely short position-holding
periods involving trading speeds in excess of a few milliseconds.
Ultra Low-latency Trading (CoLo) - refers to HFT execution in
sub-millisecond times through co-location of servers at
exchanges, direct market access, or individual data feeds offered
by exchanges and others to minimize network and other types of
latencies.
Sponsored (or Naked) Access (SA) - buy side is enabled to route its
orders to the market directly using a registered broker‘s member
ID without using the broker’s infrastructure or risk controls.
5
Potential benefits
Increased competition in market‐making
Cost reduction via technology
Some potential costs
Front‐running persistent order flow could discourage others
from participating
Faster‐take‐all could lead to an unproductive arms race
Additional temporary volatility (no evidence, though)
Greater complexity imposes costs on others
Greater complexity makes it easier for bad actors to hide
6
HFT is not a strategy per se but rather a technologically more
advanced method of implementing particular trading
strategies. The objective of HFT strategies is to seek to
benefit from market liquidity imbalances or other short-term
pricing inefficiencies
HFTs like higher volatility – potential to make profits quickly,
irrespective of whether market moves up or down
7
Concerns about HFT Trading
1. HFT firms stop providing liquidity in volatile markets
2. HFT firms benefit from flash orders
3. HFT increases volatility
4. HFT algorithms are going berserk
5. HFT often involves front running
6. HFT provides phantom liquidity
7. HFT firms profit from slowing down trading by quote stuffing
strategies
8. HFT has an unfair competitive advantage by using sponsored
access
9. HFT has an unfair competitive advantage by using co-location
10. HFT firms benefit from fee structures
8
Are HFTs Gaming the Market?
Gaming Concerns
1. ORDER DISCOVERY STRATEGIES (hidden liquidity)
2. ORDER TRIGGERING STRATEGIES (stop orders)
3. SPOOFING (lowering the best offer)
4. WASH SALES (fictitious orders)
5. FRONT RUNNING (insider info)
6. QUOTE STUFFING (denial of service)
7. STUB QUOTES (too far from market)
9
Algo Trading Market
The global algorithmic trading market reached a value of US$
13.0 Billion in 2021. Looking forward, IMARC Group
expects the market to reach US$ 24.0 Billion by 2027,
exhibiting a CAGR of 11.4% during 2022-2027
10
Algo Trading Market
11
“Spoofing” and “layering” are both forms of market manipulation
whereby a trader uses visible non-bona fide orders to deceive other
traders as to the true levels of supply or demand in the market.
“layering” to describe entering multiple non-bona fide orders at
multiple price tiers, and “spoofing” to describe entering one or
more non-bona fide orders at the top of the order book only.
In spoofing patterns, a trader enters a single visible order, or a series of
visible orders, that either creates a new best bid or offer or adds
significantly to the liquidity displayed at the existing best bid or offer.
During the lifespan of that first order(s), or within a short time after it
is cancelled, the same trader executes a trade on the opposite side of
the market. The pattern is manipulative because the execution occurs
at a more favorable price than the trader was likely to obtain in the
absence of the first order(s).
12
Layering is a variant of spoofing where the trader enters multiple
visible orders on one side of the market at multiple price tiers,
which cause the midpoint of the spread to move away from
those multiple orders, and the same trader executes a trade on
the opposite side of the market. Again, the pattern is
manipulative because the execution occurs at a more favorable
price than the trader was likely to obtain in the absence of the
first orders.
13
2010 Flash Crash
14
2010 Flash Crash
Use audit trail data to classify S&P500 futures (e‐mini) traders:
High‐frequency traders (HFTs)
Fundamental Sellers
Fundamental Buyers
On 2010 May 6, 16 HFTs traded over 1,455,000 contracts, almost 1/3
of total trading volume.
During the Flash Crash:
HFTs initially bought, providing liquidity as prices fell
HFTs overwhelmed after a few minutes, sold as decline continued
Eventually, Fundamental Buyers were attracted by the rapidly falling
prices to step in and buy.
“Because net holdings of the HFTs were so small relative to the selling
pressure from the Fundamental Sellers on May 6, HFTs could have
neither caused nor prevented the fall in prices...”
15
2010 Flash Crash
Detailed investigations revealed that HFTs might not have been
the reason behind flash crash.
A London based trader who did spoofing orders on S&P 500 E-
Mini Futures contracts worth $200 million
He was arrested and pleaded guilty
Spoofing, Layering etc. are banned now
16
NSE Co-location Scam
NSE allowed some traders co-location facilities from Jan 2010
Unfair access to some of the members, who got access to the
system ahead of others
With support from insiders, some players were gaming the
system and front running
Whistle blower letter and subsequent action by SEBI, CBI etc.
17

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Fixed Income Products:

Receivables Subscription to securities

Contractual debtor to Originator

Set up specifically for transaction

Banker for the deal. Manages

Credit Provides credit enhancement

As structurer for designing &

Legal & Tax Provide key opinions on the

Appointed for conducting due

Appointed for safe custody of the

Originate and hold till maturity

NBFCs / Banks NBFCs / Banks /

Banks, MFs, Insurance

Bonds, debentures, trading, interest rate views

⚫ For banks with limited disbursement capabilities,

⚫ Generates AAA credit to match the market

Solution – Securitize auto/mortgage/corporate loans

1991 – 1997: Sporadic issuances

1998 – 2000: Dormant market

Asset sale at par on Default

Citi buys asset and will be able to receive par value in

y must be more than 20

Largest ETFs - AUM (Rs. Crore)

0 20,000 40,000 60,000 80,000 1,00,000 1,20,000 1,40,000 1,60,000

0.00 50.00 100.00 150.00 200.00 250.00 300.00 350.00 400.00

Fin Private PSU

1896 – First price weighted index

3,000 Assets ($ billion) Net flows ($ billion) 2,661

1,500 1,314 1,370

# of ETFs 1,269 1,681 2,141 2,618 3,038 3,463 4,006

Active Investments Passive Investments

▪ Potential to underperform index ▪ Less scope for outperformance

These limitations have led to the

Excessive risk concentration

Smart Beta ETFs: The Intersection

Can potentially help achieve a Enhanced

1960s 1970s 1990s 2000s

U.S. Smart vs. Non-Smart Beta ETF Asset Growth

Net flows (in $billion)

Year 2008 2009 2010 2011 2012 2013 2014

Assets Under Management - Largest Smart Beta

Active Strategies Smart Beta Strategies Passive Strategies

▪ Aim to provide returns ▪ Aim to generate higher

▪ Have the potential to

▪ Is a measure of stocks that trade at lower

▪ Ranks securities to its peers, utilizing the

Factor Behavioral explanation Risk premia explanation

▪ Investors’ overreaction to bad news

Moment Low Moment Moment

Moment Moment Low Low Low Low Moment

Low Low Moment Moment Low Low

Difference between top and bottom performing Smart Beta factors

Despite the historical long term outperformance of each of these factors,

Multi-factor Smart Beta strategies

U.S. Multi-factor Smart Beta ETF Asset Growth and Flows

Net Flows (in $billion)

Year 2010 2011 2012 2013 2014

# of U.S. Multi-factor Smart Beta ETFs 31 45 54 57 72

Multi-factor strategy performance during bull and bear markets

Bull markets Bear markets

Combining factors can provide improved risk adjusted performance

Reduce volatility / beta Lack of history / track record

Exposure to specific assets Prefer active management

Decision makers have not