RETURN ! ! ! ! ! ! ! ! !

!
Reward for sacrificing present
consumption component
Current Return :
periodic cash flows such as
dividend, interest
Capital Return :
return due to price appreciation
TOTAL RETURN = CURRENT RETURN +
CAPITAL RETURN

Measures
of
Holding Period Return / Ex- post
Return
Return

Any Cash Payment Received + Price Gain

Price Paid to acquireCthe
asset
1 (P1 P0 )
HPR
Or
P0
Or, we can write it as,

C1 ( P1 P0 )
HPR

P0
P0
Current
Return

Capital
Return

Expected Returns/ ExAnte Returns

Expected returns are based on the
probabilities of possible outcomes
In this context, expected means
average if the process is repeated
many times
The expected return does not
n
even have to be a
possible return

E ( R)

pR
i 1

WHAT IS RISK !!!

Possibility of Loss !!!!!!!!

Probability of non realization of

expected return !!!!!!!!

Variability of returns!!!!!!!!!!

TYPES OF RISK

TYPES CONT..

TYPES CONT..
SYSTEMATIC RISK

TYPES CONT..
UNSYSTEMATIC RISK

TYPES CONT..
UNSYSTEMATIC RISK

Measurement of Risk

For Historical or Realized Risk

Standard Deviation : measures
the

deviations from the mean return

n

(R
i1

R) 2

n 1

Where,
= Return from the stock
Ri
in period i
R
= Average Return
n = No. of Period

Variance
Square of the Standard Deviation
n

(R
i 1

R)

n 1

Expected Variance and

Standard Deviation
Variance and standard deviation
still measure the volatility of
returns
Using unequal probabilities for
the entire range of possibilities
Weighted average of squared
n
deviations
2
2

pi ( Ri E ( R))
i 1

Measurement of
Systematic Risk

Systematic Risk is measured by coefficient.

coefficient is measured by the following equation
:

R i = i + iR m + e i
Where, Ri = Return of ith stock

i = Intercept, i.e. risk free return

i = Systematic Risk
Rm = Return of Market Index
ei = Error Term

Ri

Todays Price Yesterdays Price

Yesterdays Price

Todays Index Yesterdays Index

RM
Yesterdays Index
can be calculated as,
n XY X Y
i
i
2
2
n X X

i Y i X
X = Todays Market Index Yesterdays Market Index
Y = Todays Individual Stock Price Yesterdays Price

Interpretation of < 1
y

<1

Stock is less volatile as compared to market

Interpretation of = 1
y

=1

Stock is as volatile as Market Return

Interpretation of > 1
y

>1

Stock is more volatile & risky

Co movements In Security
Return
Covariance
reflects the degree to which the returns of
the securities vary or change together

Correlation Coefficient
reflects the direction of change

Correlation

XY

n XY X Y

n X X
2

n Y Y
2

Covariance
n

Cov XY

( X X )(Y Y )
i 1

n 1

Cov XY XY X Y

ANALYSIS OF SECURITIES

Two Approaches :
(a) Fundamental Analysis
(b) Technical Analysis

FUNDAMENTAL ANALYSIS

Fundamental Analysis seeks to determine a

companys outlook based on factors related to
the company itself

the practice of evaluating the information

contained in financial statements, industry
reports, and economic factors to determine the
intrinsic value of a firm

Fundamental Analysis cont

A good deal of reliance is placed on
annual and quarterly earnings reports,
the economic, political and competitive environment
facing the company,
as well as any current news items or rumors relating to
the company's operations.
Simply put,

fundamental analysis concerns itself

with the "basics" of the business in
assessing the worth of a stock or
say, mispriced and correctly priced
stock.

Fundamental Analysis
cont.
Fundamental analysis may be
the preferred method to use for
mid to longer term investors.
However, it is not suitable for
use by day traders because of
the amount of research required,
and the fact that trades are
entered into and exited within a
very short time frame.

Fundamental Analysis
cont.
ASSUMPTION :

Market price of a security is

different from the price as justified
by its fundamental factors called
intrinsic value & marketplace
provides an opportunity for an
investor
to
detect
such
discrepancy. The moment such a
description is made, a decision to
invest or disinvest is made.

Fundamental Analysis cont.

Decision Criteria

INTRINSIC VALUE > MARKET PRICE, Buy the Sec.

INTRINSIC VALUE < MARKET PRICE, Sell the Sec.

INTRINSIC VALUE = MARKET PRICE, No Action

Fundamental Analysis cont.

Fundamental Analysis includes :

ECONOMIC ANALYSIS

INDUSTRY ANALYSIS

COMPANY ANALYSIS

Fundamental Analysis
cont.

ECONOMIC
ANALYSIS

Prices of securities have an impact

of macro economic factors

If level of economy is high, prices

will be high & vice versa

Money Supply
GDP
Savings & investment
Inflation
Industrial Production
Unemployment
Budget
Tax Structure

Balance of Payment
Interest Rates
Infrastructural
Facility
Trends in Capital
Market
Stages of Business
Cycle

Economic Analysis cont.

Economic indicators
(A) Leading economic indicators
Economic measures that tend to move prior
to, or precede, movements in the business
cycle
Indicates what is going to happen in
economy
Eg. Monetary policy,
fiscal policy, productivity,
rainfall, capital investment,
stock indices etc

(B) Lagging economic indicators

measures that tend to move after, or
follow, movements in the general
economy (business cycles)
Eg. unemployment, CPI, flow of foreign funds
etc

Economic indicators cont.

Economic indicators cont..

Coincident indicators
economic measures that tend to mirror, or
move at the same time as, business cycles
Indicates what economy is
Eg, industrial production, personal income,
GDP, GNP, interest rates etc

Coincidental Indicator

Leading Indicator

Lagging Indicator

INDUSTRY
ANALYSIS

What is Industry?????

A homogeneous group of industry

producing same type production through
same production process

Industry Classification

Classification by product

(a) Defensive (beverages, food,

household products and
pharmaceuticals)
Classification
by Trade
(b) Growth
Cycle
(c) Cyclical (automobile
manufacturing, homebuilding, heavy
machinery)
(d) Declining

Classification on the basis of the

state of economy
Sunrise Industry
Sunset Industry

Life Cycle Approach

(a)Pioneering Stage/ Start up Stage
(b)Growth/ Expansion Stage
(c)Maturity & Stabilization Stage
(d)Declining Stage

Life Cycle Stages & Investment

Approach
Maturity & Stabilization

Expansion/ Growth
Invest
Pioneering Stage

Declining Stage
Disinvest

Pioneering Stage
Highly Risky
Start up phase
Due to promising return many
entrepreneurs enter
Chaotic competition
New technology, new product
Low rate of return

Growth / Expansion Stage

Rapid Growth
High Return
High Demand of the product
Good investment opportunities

Maturity & Stabilization Stage

Industry grows with the economy
Obsolete technology & product
Returns are comparatively low
Sign of disinvestment

Declining Stage
Low Demand
Negligible Return

Industry Analysis Factors

Structure of Industry

Past Sales & Earning Performance

Attitude of Govt.

Nature of Competition

Industry Analysis Factors

Cont.

Cost Efficiency & Profitability

Labor Confidence

Performance of Industry

Stages of industry Life Cycle

Industry Analysis Factors

Cont.

Technology & Research

Availability Of Inputs

Stability

Michael Porters
Five Forces
Model

Michael Porter
An industrys profit
potential is largely
determined by the intensity
of competitive rivalry
within that industry.

Porters Five Forces

Portfolio Analysis
Strategy at the time
(1970s) was focused on two
dimensions of the portfolio
grids
Industry Attractiveness
Competitive Position

Michael Porter
By using a framework rather
than a formal statistical model,
Porter identified the relevant
variables and the questions that
the user must answer in order to
develop conclusions tailored to a
particular industry and company.

Porters Five Forces

* Threat of Entry
* Bargaining Power of Suppliers
* Bargaining Power of Buyers
* Development of Substitute
Products or Services
* Rivalry among Competitors

Barriers to Entry
large capital requirements or
the need to gain economies of
scale quickly.
strong customer loyalty or
strong
brand preferences.
lack of adequate distribution
channels or access to raw
materials.

Power of Suppliers
high when
* A small number of dominant,
highly
concentrated suppliers
exists.
* Few good substitute raw materials
or
suppliers are available.
* The cost of switching raw materials
or suppliers is high.

Power of Buyers
high when
* Customers are concentrated, large
or
buy in volume .
* The products being purchased are
standard or undifferentiated making
it easy to switch to other suppliers.
* Customers purchases represent a
major portion of the sellers total
revenue.

Substitute products
competitive strength high when
* The relative price of substitute
products declines .
* Consumers switching costs
decline.
* Competitors plan to increase
market penetration or production
capacity.

Rivalry among
competitors
intensity increases as
* The number of competitors
increases
or they become equal
in size.
* Demand for the industrys products
declines or industry growth slows.
* Fixed costs or barriers to leaving
the industry are high.

Summary
As rivalry among
competing firms
intensifies, industry profits
decline, in some cases to
the point where an
industry becomes
inherently unattractive.

The Experience Curve

an entry barrier
as
Unit costs associated with
economies of scale, the learning
curve for labor, and capital-labor
substitution decline with
experience, and this creates a
barrier to entry, as new
competitors with no experience
face higher costs than established
ones.

However
If a new entrant has built the
newest, most efficient plant, it
will not have to catch up.
Technical advances purchased
by new entrants free from the
legacy of heavy past Investments
may provide those companies a
cost advantage over the leaders.

In addition
The experience curve barrier can
be nullified by product or
process innovations that create
an entirely new experience curve
one to which leaders may be
poorly positioned to jump, but to
which new entrants can alight as
they enter the market .

Strategic Groups
Firms that face similar threats
or opportunities in an industry
but which differ from the threats
and opportunities faced by other
sets of firms in the same
industry (e.g., in the beverage
industry: soft drinks group
versus alcoholic beverages).

Strategic Groups
Rivalry generally is more
intense within strategic groups
than between them because
members of the same group
focus on the same market
segments with similar products,
strategies and resources.

Company
Analysis

Divided into two parts:

Financial Aspects

Non Financial Aspects

Financial Aspects/
Financial Analysis

EPS
Capital Budgeting
Cost of Capital
Return on Investment
Dividend Payout Ratio
P/E Ratio
Market Capitalization
Turnover
Margin of Sales

Non Financial Aspects/

Non Financial Analysis
Management of Company
Employee Absenteeism
Employee Turnover
Technical Know - How
Research & Development
Training Method
Infrastructure
State of Competition

Corporate Image
Future plans of Expansion / Diversification
Product Range
Industrial Relation Scenario
Product Life Cycle Stage

TECHNICAL
ANALYSIS

A form of security analysis that attempts

to forecast price changes based on
historical price and volume trends

Technicians (also known as quantitative

analysts or chartists) usually look at
price, volume and psychological
indicators over time.

They are looking for trends and patterns

in the data that indicate future price
movements.

Underlying Assumptions of
Technical Analysis

The market value of any good or service is

determined solely by the interaction of supply and
demand
Supply and demand are governed by numerous
factors, both rational and irrational
Disregarding minor fluctuations, the prices for
individual securities and the overall value of the
market tend to move in trends, which persist for
appreciable lengths of time

 Prevailing trends change in reaction to shifts in

supply and demand relationships and these shifts
can be detected in the action of the market
Stock market is dominated by the institutional
investors & follow the policy of Following the
Leader

Typical Stock Market Cycle

Stock
Price

Typical Stock Market Cycle

Stock
Price
Declining
Trend
Channel

Peak
Flat Trend Channel
Sell Point
Rising Trend
Channel Declining
Buy Point
Trend

Trough

Channel

Trough

Buy Point

Fundamental Analysis v/s

Technical Analysis
Orientation/ Perspective
Profit Earning Policy
Total Gains
Basis of Forecasting Prices
Tools for forecasting

Theories of Technical
Analysis

DOW THEORY

ELLIOT WAVE THEORY

DOW THEORY

Charles Dow
known as the
Godfather of TA

Dow Theory
pieced together
from the writings
of Charles Dow
over several years

Dow (and later Hamilton and Rhea)

believed that market trends forecast trends
in the economy.

A change in the trend of the DJIA must be

confirmed by a trend change in the DJTA in
order to generate a valid signal.

Six basic tenets of Dow

Theory

The market has three

movements

The "main movement", primary movement or major trend may last

from less than a year to several years. It can be bullish or bearish.

The "medium swing", secondary reaction or intermediate reaction

may last from ten days to three months and generally retraces from
33% to 66% of the primary price change since the previous
medium swing or start of the main movement.

The "short swing" or minor movement varies with opinion from

hours to a month or more. The three movements may be
simultaneous, for instance, a daily minor movement in a bearish
secondary reaction in a bullish primary movement.

Market trends have three

phases

Accumulation phase
- period when investors "in the know" are actively buying (selling)
stock against the general opinion of the market.
- the stock price does not change much
Public participation phase
- a rapid price change occurs.
- This occurs when trend followers and other technically oriented
investors participate.
- This phase continues until rampant speculation occurs
Distribution phase
- At this point, the astute investors begin to distribute their
holdings to the market

Public Participation
Phase

Accumulation
Phase

Distribution
Phase

The stock market

discounts all news

Stock prices quickly incorporate

new information as soon as it
becomes available. Once news is
released, stock prices will change
to reflect this new information. On
this point, Dow Theory agrees with
one of the premises of the efficient
market hypothesis.

Stock market averages

must confirm each other

The two averages (DJIA & DJTA) should

be moving in the same direction.

When the performance of the averages

diverge, it is a warning that change is in the
air.

Trends are confirmed by

volume

when price movements are

accompanied by high volume, Dow
believed this represented the
"true" market view

Trends exist until definitive

signals prove that they have
ended

Dow Theory Trends

Primary Trend

Secondary Trend

Day to day fluctuations

Primary Trend

Called the tide by Dow, this is the trend that

defines the long-term direction .

a primary trend will generally last between one

and three years but could vary in some instances

Regardless of trend length, the primary trend

remains in effect until there is a confirmed
reversal.

An Uptrend: Each peak in the rally must reach a higher

level than the previous rally's peak, and each low in the
rally must be higher than the previous rally's low.

A downtrend: each new low in the sell-off must be lower than the previous sell-off's low and the peak in
the sell-off must be lower then the peak in the previous sell-off.

Secondary Trend

Called the waves by Dow, this is shorter-term

departures from the primary trend (weeks to months)

a secondary trend moves in the opposite direction of

the primary trend, or as a correction to the primary
trend.

its moves are often more volatile than those of the

primary move.

A secondary trend with a primary

uptrend

Daily Trend/ Minor Trend

market movement lasting less than
three weeks
minor trend is generally the
corrective moves within a
secondary move, or those moves
that go against the direction of the
secondary trend.

Dow Theory Trends

Dow theory is based on

two indices
Dow Jones Industrial Averages
Shows the industrial average production

Dow Jones Transportation

Averages
Shows the position of transportation
facilities

A major reversal from a bull or

bear market cannot be signaled

DJTA act as a signal of trend

reversal i.e. signal to buy or sell

DJIA act as the confirmation of the

signal

DJIA

BUY
Average

DJIA

Signal
Confirmation

DJTA
DJTA

Buy Signal
Time

SELL
Signal
Confirmation
Average

DJIA

Sell Signal
DJTA
Time

SELL (Since
DJIA is decreasing)

Average

Signal not
Confirmed

DJIA

DJTA
Buy Signal
Time

BUY (Since DJIA is increasing)

Average

Signal Not
Confirmation

DJIA

Sell Signal
DJTA
Time

DJIA

DJTA

Elliot Wave Theory

The Elliot Wave Theory was developed
by Ralph Nelson Elliot.
This theory is based on the premise that
market behavior is based on waves
rather than random timing.

Elliot Wave Theory

Elliot believed that prices fluctuated in a
series of waves

Elliot Wave Theory

The market rises in a series of 5 waves
and that a market declines in a series of 3
waves.

Elliot Wave Theory

According to the theory, on the first
wave a market rises, on wave two it
declines, begins to rise again on the third
wave. The third wave is followed by a
period of decline known as the fourth
wave, and finally completes the rise on
the fifth wave.

Elliot Wave Theory

There is a correction period following the
five wave sequence. This declining
period is referred to as a three-wave
correction. During this time the market
theoretically declines for wave A, begins
to rise for wave B, and falls again for
wave C.

Elliot Wave Theory

Simplified
Wave one: Normally very short and
easy to miss.

Wave two: A retracement wave, usually

gives back all or most of what the first
one gained.

Elliot Wave Theory

Simplified
Wave three: Usually very prominent, as
it follows a period of what appears as
consolidation, most people trade this
wave.

Elliot Wave Theory

Simplified
Wave four: Noted to be very intricate yet
still a consolidation. One of Elliots main
rule is that in a 5-wave advance cycle,
wave 4 cant overlap wave 1.
Wave five: Often very active, yet at some
point declines and leads to the 3 wave
corrective cycle.

Elliot Wave Theory

Simplified
Three Wave Decline:
Wave A: Normally seen as a minor pullback,
of wave 5 of the advance cycle.
Wave B: Follows Wave A of the uptrend, and
is often hard to spot but should result in a
third wave continuing down.
Wave C: Usually quite significant and many
traders see this selling opportunity.

Elliot Wave
Example

Elliot Wave Theory

Drawbacks to the wave counting strategy:
One mans wave one, is anothers wave
three. In other words the starting point is
somewhat ambiguous.
It is easy to count the waves after they occur,
but difficult to identify them as they are
occurring.

Techniques of
Trading Rules

Contrary-Opinion Rules
Many analysts rely on rules developed from
the premise that the majority of investors
are wrong as the market approaches peaks
and troughs
Technicians try to determine whether
investors are strongly bullish or bearish and
then trade in the opposite direction
These positions have various indicators

Contrary-Opinion Rules

Mutual fund cash positions

Buy when the mutual fund cash position is high, sell
when low
Assumes that mutual fund managers are poor judges of
market turning points

Credit balances in brokerage accounts

Buy when credit balances increase, sell when credit
balances fall

Investment advisory opinions

Buy when advisory firms become more bearish

Follow the Smart Money

While contrary-opinion rules assume that most

investors are not smart, these indicators seek to
follow the path of sophisticated, and assumed
smart, investors
The Barrons Confidence Index
Measures the yield spread between high-grade bonds
and a large cross section of bonds
Declining (increasing) yield spreads increase (decrease)
this index, and are a bullish (bearish) indicator

Follow the Smart Money

Debit balances in brokerage accounts

Such balances represent buying on margin,
which is assumed to be done by largely
sophisticated investors
Increases are a bullish signal

Other Market Indicators

Breadth of market
Advance-decline (number of advancing minus the
number of declining issues)

Volume of trade
Large volume with rise in price indicates bull market

Short Sales
Increased short selling, bearish market

Odd Lot Trading

High odd lot purchases, fall in market price & vice versa

Charting the Market

Chartists use bar charts, candlestick, or point
and figure charts to look for patterns which
may indicate future price movements.
They also analyze volume and other
psychological indicators (breadth, % of bulls
vs % of bears, put/call ratio, etc.).
Strict chartists dont care about fundamentals
at all.

Types of Charts: Bar Charts

This is a bar (open, high, low, close or OHLC) chart

Drawing Bar Charts

Each bar is composed of 4

elements:
High
Open
High
Low
Close

High
Close

Open

Open

Close
Low

Standard
Bar Chart

Low

Japanese
Candlestick

Standard
Bar Chart

Japanese
Candlestick

Types of Charts: Japanese Candlesticks

This is a Japanese Candlestick (open, high, low, close)

chart of AMAT from early July to mid October 2001

Drawing Candlestick Charts

The candlestick body

is empty (white) on up
days, and filled (some
color) on down days
Sticks present the
highest & lowest price
Height of candle
represent the difference
between the opening
and closing price

Up days

Down days

Drawing Point & Figure Charts

Point & Figure charts are

independent of time.
An X represents an up
move.
An O represents a down
move.
The Box Size is the number
of points needed to make an
X or O.
The Reversal is the price
change needed to recognize
a change in direction.

X
X
X X O
X X O
XO O
XO O
X

Chart Types: Point & Figure

Charts

Trend Lines

TREND CHHANELS :

There are three basic

kinds of trends:
An Up trend where prices
are generally increasing.
A Down trend where
prices are generally
decreasing.
A Trading Range.

Support & Resistance

Support and
resistance lines
indicate likely ends
of trends.
Resistance results
from the inability to
surpass prior highs.
Support
Support results from
the inability to break
below to prior lows.

Breakout

Resistance

Price/ Chart Patterns

Technicians look for many patterns

in the historical time series of prices.

These patterns are reputed to provide
information regarding the size and
timing of subsequent price moves.

Head and Shoulders

This formation is
characterized by two
small peaks on either
side of a larger peak.
This is a reversal
pattern, meaning that
it signifies a change
in the trend.

H&S Top

Head

Right Shoulder

Left Shoulder

Neckline

H&S Bottom
Neckline

Left Shoulder

Right Shoulder

Head

Sell Signal

Minimum Target Price

Based on measurement rule

Double Tops and Bottoms

These formations are
similar to the H&S
formations, but there is
no head.
These are reversal
patterns with the same
measuring implications
as the H&S.

Double Top

Target
Target

Double Bottom

Triangles

Triangles are continuation Ascending

formations.
Three flavors:
Ascending
Descending
Symmetrical

Typically, triangles
should break out about
half to three-quarters of
the way through the
formation.

Symmetrical
Symmetrical

Descending

Rounded Tops & Bottoms

Rounding
formations are
characterized by a
slow reversal of
trend.

Rounding
Bottom

Rounding Top

Broadening Formations
These formations
are like reverse
triangles.
These formations
usually signal a
reversal of the
trend.

Broadening Bottoms

Broadening Tops

Technical Analysis
Moving averages:

Simple Moving Average

Exponential Moving Average
(a) Linear Weighted Average
(b)Moving Average Convergence/Divergence
(MACD)

Indicators and Oscillators:

Aroon Oscillators
Relative Strength Index (RSI)

MACD

MACD was developed by Gerald Appel as a way to keep

track of a moving average crossover system.
Appel defined MACD as the difference between a 12-day and
26-day moving average. A 9-day moving average of this
difference is used to generate signals.
When this signal line goes from negative to positive, a buy
signal is generated.
When the signal line goes from positive to negative, a sell
signal is generated.
MACD is best used in choppy (trendless) markets, and is
subject to whipsaws (in and out rapidly with little or no
profit).

MACD Example Chart

Relative Strength Index (RSI)

RSI was developed by Welles Wilder as an oscillator to

gauge overbought/oversold levels.
RSI is a rescaled measure of the ratio of average price
changes on up days to average price changes on down
days.
The most important thing to understand about RSI is that a
level above 70 indicates a stock is overbought, and a level
below 30 indicates that it is oversold (it can range from 0
to 100).
Also, realize that stocks can remain overbought or
oversold for long periods of time, so RSI alone isnt
always a great timing tool.

RSI Example Chart

Overbought

Oversold

Efficient
Market
Hypothesis

Definition
The efficient market hypothesis (EMH)

is the theory supporting the notion that

market prices are in fact fair, there is
no need of fundamental and technical
analysis
Prices always move in the random
direction
History do not repeat itself.

Definition of Efficient
Markets

An efficient capital market is a market that is

efficient in processing information.
The market quickly and correctly adjusts to new
information.
In an informationally efficient market, the prices
of securities observed at any time are based on
correct evaluation of all information available
at that time.
Therefore, in an efficient market, prices
immediately and fully reflect available
information.

Definition of Efficient
Markets (cont.)

Professor Eugene Fama, who coined the phrase

efficient markets, defined market efficiency

"In an efficient market, competition among the

many intelligent participants leads to a situation
where, at any point in time, actual prices of
individual securities already reflect the effects of
information based both on events that have
already occurred and on events which, as of
now, the market expects to take place in the
future. In other words, in an efficient market at
any point in time the actual price of a security
will be a good estimate of its intrinsic value."

History

Prior to the 1950s it was generally believed that the use

of fundamental or technical approaches could beat the
market (though technical analysis has always been seen
as something akin to voodoo).
In the 1950s and 1960s studies began to provide
evidence against this view.
In particular, researchers found that stock price changes
(not prices themselves) followed a random walk.
They also found that stock prices reacted to new
information almost instantly, not gradually as had been
believed.

The Efficient Markets

Hypothesis

The Efficient Markets Hypothesis

(EMH) is made up of three
progressively stronger forms:
Weak Form
Semi-strong Form
Strong Form

Efficient Markets and

Information Sets
Weak Form
Semi Strong
Form

Strong
Form

The Weak Form

The

weak form of the EMH says

that past prices, volume, and
other market statistics provide
no information that can be used
to predict future prices.

The Weak Form cont

If

stock price changes are

random, then past prices
cannot be used to forecast
future prices.

The Weak Form cont

Price

changes should be
random because it is
information that drives
these changes, and
information arrives
randomly.

The Weak Form cont

Prices

should change very

quickly and to the correct
level when new information
arrives.

The Weak Form cont

This

form of the EMH, if

correct, repudiates technical
analysis.

The Weak Form cont

Most

research supports the

notion that the markets are
weak form efficient.

Tests of the Weak Form

Serial correlations
Runs tests.
Filter rules.

Serial correlations
To test the independence between
successive price changes
If price of time t is followed by the
price of period t+1 , market is not
efficient

__
2

a Y b XY n Y

__
2

nY

XY n X Y
X n X
2

a Y bX
Where, X & Y are price changes

Runs Test
A runs test is a nonparametric statistical

technique to test the likelihood that a

series of price movements occurred by
chance.

167

Run Test Cont

A run is an uninterrupted sequence of the
same observation
A runs test calculates the number of ways
an observed number of runs could occur
given the relative number of different
observations and the probability of this
number

Conducting A Runs Test

Rx
Z

where R number of runs

2n1n2
x
1
n1 n2

2n1n2 (2n1n2 n1 n2 )

n1 n2

(n1 n2 1)

n1 , n2 number of observations in each category

Z standard normal variable

169

Semi-Strong Form

The semi-strong form of the EMH

states that security prices fully
reflect all publicly available
information
E.g., past stock prices, economic
reports, brokerage firm
recommendations, investment
advisory letters, etc.
170

Semi-Strong Form
(contd)

Academic research supports the semistrong form of the EMH by investigating

various corporate announcements, such
as:
Stock splits
Cash dividends
Stock dividends

This means investor are seldom going to

beat the market by analyzing public
news
171

Test of Semi Strong Form

of Market
Event Study
By calculating CAAR
CAAR = AAR

1
ARit
AARt n
1
If market is semi strong,i CAAR
should
be close to zero

Strong Form
The strong form of the EMH states
that security prices fully reflect all
public and private information
This means even corporate
insiders cannot make abnormal
profits by using inside information

173

Implications for Investors

If EMH holds:
Published reports of financial Analysts
may not be valuable
Market tips are not valuable
Technical analysis is worthless with weakform efficiency
Fundamental analysis is worthless with
semi-strong efficiency
There should be low returns to active
portfolio management

Evidence in favor of EMH

Fundamental analysts and technical analysis does not

persistently beat the market.
Stock prices appear to reflect publicly available
information: anticipated announcements do not
appear to affect stock prices.
Having performed well in the past does not indicate
that the investor will perform well in the future.
If information is already publicly available, a positive
announcement does not, on average, cause stock
prices to rise
Stock prices follow a random walk

Evidence against EMH

Small-firm effect
Small firms have abnormally high returns

January effect
Abnormal price rise from December to January
(small firms)

Market overreaction to news announcements

Weekend Effect
New information is not always immediately
incorporated into stock prices

BOND VALUATION

What is a Bond?

A bond is a security that obligates the

issuer to make specified interest and
principal payments to the holder on
specified dates.

Coupon rate
Face value (or par)
Maturity (or term)

Bonds are also called fixed income

securities.

Bond Features
Fixed Maturity Period
Fixed Coupon
Indenture
Call Feature

Bonds differ in several respects:

Repayment type
Issuer
Maturity
Security
Priority in case of default

Repayment Schemes

Pure Discount or Zero-Coupon Bonds

Pay no coupons prior to maturity.
Pay the bonds face value at maturity.
Coupon Bonds
Pay a stated coupon at periodic intervals prior to
maturity.
Pay the bonds face value at maturity.
Floating-Rate Bonds
Pay a variable coupon, reset periodically to a
reference rate.
Pay the bonds face value at maturity.

Repayment Schemes Cont.

Perpetual Bonds
No maturity date.
Pay a stated coupon at periodic intervals.
Annuity or Self-Amortizing Bonds
Pay a regular fixed amount each payment
period.
Principal repaid over time rather than at
maturity

Bond Valuation: Zero Coupon

Bonds
B
F
i
N
R
m

= Market price of the Bond of bond

= Face value
= Effective periodic interest rate; i=R/m
= Number of compounding periods; N = T*m
= Annual percentage rate
= compounding period (annual m = 1, semiannual m =
2,)
T = Maturity (in years)

1 i

Current Yield =
Annual Coupon Payment
Current Market Price

Yield To Maturity
Issue price - Face value
Coupon
Years to Maturiry
YTM
Market Price Face Value
2

Present Value of Bond =

n

Pn
Coupon

t
t
1 y
t 1 1 y

PVof Bond Coupon PVIFA (y,t) Pn PVIF( y ,t )

y = yield to maturity
t= years to maturity
Pn = Current market value

BOND PORTOLIOS
MANAGEMENT
Passive Strategy
rests on the belief that bond markets are
semi-strong efficient
current bond prices viewed as accurately
reflecting all publicly available information

Active Strategy
rests on the belief that the market is not so
efficient
some investors have the opportunity to earn
above-average returns
186

BOND PRICING
THEOREMS

Bond value depend upon

(i) Coupon Rate
(ii) Years To Maturity
(iii) Yield to Maturity

187

THEOREM 1
If a bonds market price
increases, then its yield
must decline & vice versa

Particulars

Bond A

Bond B

Par Value (PV)

Rs. 1000

Rs. 1000

Coupon Rate (CR)

10%

10%

Maturity Period (MP)

2 years

2 years

Current Market Price

Rs. 1050

Rs. 950

Yield to Maturity

12.195%

12.82%

With the same PV, CR,MP

Yield of Bond A < Bond B

THEOREM 2

If a bonds yield doesnt change over

its life, then the size of the discount
or premium will decrease as its life
shortens

Particulars

Bond A

Bond B

Par Value (PV)

Rs. 1000

Rs. 1000

Coupon Rate (CR)

10%

10%

Yield to Maturity

10%

10%

Maturity Period (MP)

2 years

3 years

Current Market Price

Rs. 918.71

Rs. 885.86

Discount

Rs. 81.29

Rs. 114.14

The bond with short term maturity sells at a lower

discount than bond with a long term maturity

191

THEOREM 3
If a bonds yield does not change
over its life then the size of its
discount or premium will decrease at
an increasing rate as its life shortens

Particulars

Bond A

Bond B

Par Value (PV)

Rs. 1000

Rs. 1000

Yield to Maturity

10%

10%

Coupon Rate (CR)

7%

7%

Maturity Period (MP)

5 years

4 years

Current Market Price

Rs. 620.90

Rs. 683.0

Discount

Rs. 379.10

Rs. 317.00

Difference

Rs. 62.10

Rs. 68.30

THEOREM - 4
A decrease in a bonds yield will raise
the bonds price by an amount that
is greater in size than the
corresponding fall in the bonds
price that would occur if there were
an equal-sized increase in the bonds
yield , i.e. the price-yield relationship
is convex

Par Value (PV)

Maturity Period

Coupon Rate

Rs. 1000

5 years

10 %

(i) If yield decreases by 2%, i.e. reduces from 10% to

8%, then
Bond Price = Rs. 1079.87
(ii) If yield increases by 2%
Bond Price = Rs. 927.88
Price rise = Rs.79.87
Price Fall = Rs. 72.2

THEOREM 5
The percentage change in a
bonds price due to a change
in its yield will be smaller if the
coupon rate is higher

Particulars

Bond A

Bond B

Par Value (PV)

Rs. 100

Rs. 100

Yield to Maturity

8%

8%

Coupon Rate (CR)

10%

8%

Maturity Period (MP)

2 years

2 years

Current Market Price

Rs. 105.15

Rs. 100

Yield Raise

1%

1%

Price after Yield Raise

Rs. 102.53

Rs. 97.47

Percentage Change

2.4 %

2.53%

CONVEXITY
CONVEXITY DEFINITION:
a measure of the curvedness of the
price-yield relationship

CONVEXITY

THE PRICE-YIELD RELATIONSHIP

Price

YTM

CONVEXITY

THEOREM 1 TELLS US
price and yield are inversely related but
not in a linear fashion (see graph)
an increase in yield is associated with a
drop in bond price
THEOREM 4 TELLS US
the size of the change in price when
yield rises is greater than the size of the
price change when yield falls

Yield Curve

Relationship b/w yield to maturity

& years to maturity

Yield

Years to Maturity

DURATION

DEFINITION:
measures the average maturity of a
stream of bond payments
it is the weighted average time to full
recovery of the principal and interest
payments

DURATION

FORMULA
D

PV (C ) t
PV (C )
t 1

where
PV(Ct )= the present value of the
coupon payments
t = time periods

IMMUNIZATION

DEFINITION: a bond portfolio

management technique which
allows the manager to be relatively
certain of a given promised cash
stream

204

IMMUNIZATION

HOW TO ACCOMPLISH
IMMUNIZATION
Immunization
calculate the duration of the promised
outflows
invest in a portfolio of bonds with identical
durations

205

EQUITY VALUATION : Two

Methods

Basic Valuation Method :

i) Single Period Valuation Method
Where the investor expects to hold the equity
share for one year
D1
P1
P0

1 ke
1 ke
P0 Current Price of Equity Shares
D1 Expected Dividend
P1 Price of the share expected after one year
k e Rate of Return Required on the equity share

ii)

Multi- Period Valuation Method:

P0

i 1

Dt
t
1 k e

(a) Zero Growth Model

Dividend growth is zero

D0
P0
Ke
D0

= Dividend for the present year

(b) Constant Growth

Model
D0 (1 g )
P0
ke g
g Growth Rate

(c) Variable Growth Model

D0 (1 g s )
Dn 1
1
P0

t
n
(1 ke )
ke g n (1 ke )
t 1
t

g s Super Normal Growth

g n Constant Growth
Dn 1 D n (1 g n )
Dn D0 (1 g s )

2) EARNING MULTIPLIER
APPROACH
P E ( Price Earning Ratio)
0
1
E1 Estimated Earning
1- b
Price Earning Ratio
r -g
1 - b Dividend payout ratio
b Retention Ratio
r Required Rate of Return
g Expected growth rate

Those assets whose value is determined from

the value of some underlying assets.
Underlying asset may be equity, commodity
or currency

Types of Derivatives:
Three main derivatives are:
(i)Options Contract
(ii)Futures Contract
(iii)Forward Contract

OPTION

Right , but not the obligation, to

buy or sell the underlying asset on
a specified date at a specified price

Option Terminology

Option Seller/ Writer:

One who gives/writes the option. He has an
obligation to perform, in case option buyer
desire to exercise

Option Buyer :
One who buys , has the right to exercise not
obligation

Terminology
Continues..
Strike Price/ Europeon Price
Price at which option is to exercised
Expiration Date:
Date on which option expires
Exercise date:
Date on which the option gets exercised by the option
holders/ buyer
Premium:
The Price paid by buyer of the option to the seller or
writer of the option.

Two Types of Options

Put and Call Options
Put Option:
The right to sell a futures contract

Call Option:
The right to buy a futures contract

Calls
Long a call. Person buys the right (a contract)
to buy an asset at a cretin price.
Short a Call. Person sells the right (a contract)
to someone that allows them to buy a asset at a
certain price.

PUTS
Long a Put. Buy the right to sell an asset at a
pre-determined price.
Short a Put. Sell the right to someone else. This
will allow them to sell the asset at a specific
price.

INTRINSIC VALUE/ PAY OFF

Positive difference between the
strike price and the underlying
commodity futures price.

FOR A CALL OPTION

Stock Price strike price

FOR A PUT OPTION

strike price Stock Price

Call Option
In-the-Money (ITM)
Strike price < Spot price(current price)
At-the-Money (ATM)
Strike price = Spot price
Out-of-the-Money (OTM)
Strike price >Spot price

Put Option
In-the-Money (ITM)
Strike price > Spot price
At-the-Money (ATM)
Strike price = Spot price
Out-of-the-Money (OTM)
Strike price < Spot price

Pay off of Call Option

Buyer

Pay off of Call Option

Seller

Pay off of Put Option

Buyer

Pay off of Put Option

Seller

Valuation Of Option
BLACK SCHOLES OPTION PRICING
MODEL
Based on the assumptions:
(a) Stock underlying the call option provides no dividends
or other distributions during the life
(b) There is no transaction cost
(c) The risk free rate of interest is constant & known
(d) The option is European option
(e) There is no restriction or penalties in short selling

V P{N ( d1 )} e RT {N ( d 2 )}
V Current value of the option
P Current price of underlying stock
S Striking Price
R Risk free interest rate
T Option Period
ln(P/S) (R 0.5 2 )T
d1
T
d 2 d1

S tan dard Deviation

e Exponential Function
N(d1 ) & N ( d 2 ) Area under a standard Normal Function

FUTURE CONTRACT
It involves an obligation on both the parties i.e
the buyer and the seller to fulfill the terms of the
contract(i.e. these are pre-determined contracts entered
today for a date in the future)

Obligation to buy or sell

Stated quantity
At a specific price
Stated date (Expiration Date)
Marked to Market on a daily basis

Valuation of Future

Cost & Carry Model

V P (1 R )

V Value of future
P Current market price of stock
R Risk free Interest Rate
T Time period of Future
If stock is paying any dividend
V P(1 R - d)

Forward Contracts
Same as futures but not
standardized
Default risk is involved
No obligation of any party to
exercise

Difference B/W Futures &

Forwards
Features

Forward

Futures

Operational Mechanism

Not Traded on Exchange

Traded on Exchange

Contract Specification

Customized

Standardized

Default Risk

Exist

Exist, but assumed by

clearing house

Liquidity

Poor Liquidity

Very high liquidity