Module -1

Introduction to Investment
Investment Avenues, Attributes, Investor V/s speculator, Features of a good Investment,
Investment Process. Financial Instruments: Money Market Instruments, Capital Market
Instruments, Derivatives.
Securities Market: Trading and Settlement Procedure, Stock Market Indicators- Indices of Indian
Stock Exchanges (only Theory).

Savings:
Saving is the act of not consuming all of one’s current income. Saving are that part of our
income that we do not spend. In other words, income not spent on consumption is defined as
saving.

Investment:
Investment is the allocating resources, usually money, with the expectation of generating an
income or profit. In other words, investment is the employment of funds on assets with the aim
of earning income or capital appreciation.
In simple to put money into a scheme, stock or other financial item or to buy something with the
expectation that it will increase in value.

Investment Avenues:
An investment avenue means investing money in something. It is often referred to as investment
alternatives or investment strategies. There are numerous methods to categories investing
possibilities. Investment avenues are the different ways that you can invest your money.

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Speculation:
Speculation is about taking up the business risk in the hope of achieving short-term gain.
Speculation essentially involves buying and selling activities with the expectation of making a
profit from price fluctuation. Speculation is the purchase of an asset with the hope that it will
become more valuable shortly.
If a person buys a stock for its dividend, he may be termed as investor. If he buys with the
anticipation of a price rise in the near future and the hope of selling it at gain, he would be
termed a speculator.

 Interested in abnormal return

 High rate of return in short-run
 More interested in price movements
 Involves greater risk

Gambling:
A gamble is usually a very short term investment in a game or chance. Gambling is different
from speculation and investment. First, the time horizon involved in gambling is shorter. The
results are determined by the roll of a dice or the turn of a card. Secondly, people gamble to
entertain themselves. Earning an income from gambling is a secondary factor.

Difference between investor, speculator and gambler:

Distinction Investor Speculator Gambler

Time Longer time horizon Plans for short period. Plans for very short period

Risk Moderate High risk Artificial risk

Return Moderate High return Negative outcomes are

expected

Duration Year or more Month or few months Fraction of time. (roll of dice
or turn of coin)

Fund Own fund and avoids Own and borrowings Own fund
borrowings

Decisions Analyses company Market action Entertainment

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Investment Attributes / Features of a good Investment
Every investor has certain specific objectives to achieve through his long term/short term
investment. Such objectives may be monetary/financial or personal in character. The objectives
include safety and security of the funds invested (principal amount), profitability (through
interest, dividend and capital appreciation) and liquidity (convertibility into cash as and when
required).
 Maximization of return
 Minimization of risk
 Liquidity
 Hedging again Inflation
 Safety
 Saving tax
 Duration
1. Maximization of return: Investor always expects a good rate of return from their
investments. Rate of return could be defined as the total income the investor receives
during the holding period stated as a percentage of the purchasing price at the beginning
of the holding period. The rate of return comprises of 2 parts, namely the annual income
and the capital gain or loss.

2. Minimization of risk: The risk of an investment refers to the variability of the rate of return.
To explain further, it is the deviation of the outcome of an investment from its expected
value. Risk is a normal feature of every investment as an investor has to part with his money
immediately and has to collect it back with some benefit in due course. The risk may be more
in some investment avenues and less in others. The risk in the investment may be related to
non-payment of principal amount or interest thereon. It is always desirable to select an
investment avenue where the risk involved is minimum/comparatively less.
3. Liquidity: The liquidity depends upon the marketing and trading facility. If a portion of the
investment could be converted into cash without much loss of time, it would help the investor
meet the emergencies. Stocks are liquid only if they command good market by providing
adequate return through dividends and capital appreciation.
4. Hedging against inflation: The rate of return should ensure a cover against inflation to
protect against a rise in prices and fall in purchasing value of money. The return rate should
be higher than the rate of inflation; otherwise the investor will have loss in real terms.
Growth stocks would appreciate in their values overtime and provide a protection against
inflation. The return thus earned should assure the safety of the principal amount, regular
flow of income and be a hedge against inflation.

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5. Safety: The degree of risk varies across investment types, all investments bear risk. It is
important to determine how much risk is involved in an investment. The average
performance of an investment normally provides a good indicator. However, past
performance is merely a guide to future performance - not a guarantee.
6. Saving tax: tax is unavoidable. Different income levels and investment options attract
different tax rates. The tax rate may vary with the period of investment for a specific option.
Certain investment offer tax incentives. The investor tries to minimize the tax outflow and
maximize tax returns.
7. Duration: Investments typically have a longer horizon than cash and income options. The
duration of an investment - particularly how long it may take to generate a healthy rate of
return- is a vital consideration for an investor. The investment horizon should match the
period that your funds must be invested for or how long it would take to generate a desired
return. A good investment has a good risk-return trade-off and provides a good return-
duration trade-off as well.

Investment Process:

Investment
process

Investment Portfolio Portfolio

Analysis Valuation
policy constructions evaluation

1. Investment policy: The government or the investor before proceeding into investment
formulates the policy for the systematic functioning. The essential ingredients of the policy
are the investible funds, objectives and the knowledge about the investment alternatives and
market.
 Investible funds: The entire investment procedure revolves around the availability of
investible funds. The fund may be generated through savings or from borrowings. If the
funds are borrowed, the investor as to be extra careful in the selection of investment
alternatives. The return should be higher than the interest pays. Mutual funds invest their
owners’ money in securities.
 Objectives: The objectives are framed on the premises of the required rate of return, need
for regularity of income, risk perception and the need for liquidity. The risk taker’s
objective is to earn high rate of return in the form of capital appreciation, whereas the
primary objective of the risk averse is the safety of principal.
 Knowledge: The knowledge about the investment alternatives and markets plays a key
role in the policy formulation. The investment alternatives range from security to real

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 estate. The risk and return associated with investment alternatives differ from each other.
Investment in equity is high yielding but has more risk than the fixed income securities.
The tax sheltered schemes offer tax benefits to the investors.

2. Analysis: After formulating the investment policy, the securities to be bought have to be
scrutinized through the market, industry and company analysis.
 Market analysis: The stock market mirrors the general economic scenario. The growth in
gross domestic product and inflation are reflected in the stock prices. The recession in the
economy results in a bear market. The stock prices may be fluctuating in the short run but
in the long run they move in trends i.e. either upwards or downwards. The investor can fix
his entry and exit points through technical analysis.
 Industry analysis: The industries that contribute to the output of the major segments of
the economy vary in their growth rates and their overall contribution to economic activity.
Some industries grow faster than the GDP and are expected to continue in their growth.
The economic significance and the growth potential of the industry have to be analyzed.
 Company analysis: The purpose of company analysis is to help the investors to make
better decisions. The company’s earnings, profitability, operating efficiency, capital
structure and management have to be screened. These factors have direct bearing on the
stock prices and the return of the investors. Appreciation of the stock value is a function of
the performance of the company. Company with high product market share is able to
create wealth to the investors in the form of capital appreciation.

3. Valuation: The valuation helps the investor to determine the return and risk expected from
an investment in the common stock.
 Intrinsic value: The intrinsic value of the share is measured through the book value of the
share and price earnings ratio. Simple discounting models also can be adopted to value the
shares. The stock market analysts have developed many advanced models to value the
shares. The real worth of the share is compared with the market price and then the
investment decisions are made.
 Future value: Future value of the securities could be estimated by using a simple
statistical technique like trend analysis. The analysis of the historical behaviour of the
price enables the investor to predict the future value.

4. Construction of portfolio: A portfolio is a combination of securities. The portfolio is

constructed in such a manner to meet the investor’s goals and objectives. The investor should
decide how best to reach the goals with the securities available. The investor tries to attain
maximum return with minimum risk. Towards this end he diversifies his portfolio and
allocates funds among the securities.
 Diversification: The main objective of diversification is the reduction of risk in the loss of
capital and income. A diversified portfolio is comparatively less risky than holing a single
portfolio there are several ways of diversifying the portfolio:
i. Debt and equity diversification
ii. Industry diversification
iii. Company diversification

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  Selection & Allocation: Based on the diversification level, industry and company analyses
the securities have to be selected. Funds are allocated for the selected securities. Selection
of securities and the allocation of funds seal the construction of portfolio.

5. Evaluation: The portfolio has to be managed efficiently. The efficient management calls for
evaluation of the portfolio. This process consists of portfolio appraisal and revision.
 Appraisal: The return and risk performance of the security vary from time to time. The
variability in returns of the securities is measured and compared. The developments in the
economy, industry and relevant companies from which the stocks are bought have to be
appraised. The appraisal warns the loss and steps can be taken to avoid such losses.
 Revision: Revision depends on the results of the appraisal. The low yielding securities
with high risk are replaced with high yielding securities with low risk factor. To keep the
return at a particular level demands investor to revise the components of the portfolio
periodically.

Financial Instruments:
Financial instruments can be real or virtual documents representing a legal agreement involving
any kind of monetary value. Financial instruments are assets that can be traded, or they can also
be seen as packages of capital that may be traded. Most types of financial instruments provide
efficient flow and transfer of capital all throughout the world's investors. These assets can be
cash, a contractual right to deliver or receive cash or another type of financial instrument, or
evidence of one's ownership of an entity.

Money Market
A market can be described as a money market if it is composed of highly liquid, short-term
assets. Money market is a place where instruments with high liquidity and very short term
maturities are traded. It refers to an activity, which involves borrowing and lending of short term
funds. Money market consists of various financial institutions and dealers, who seek to borrow or
loan securities. It is the best source to invest in liquid assets.

Money market instruments:

1. Treasury Bills (T-Bills): Treasury Bills are one of the safest money market instruments as they
are issued by Central Government. They are zero-risk instruments, and hence returns are not that
attractive. The Central Government issues T-Bills at a price less than their face value and the
difference between the buy price and the maturity value is the interest earned by the buyer of the
instrument. The buy value of the T-Bill is determined by the bidding process through auctions.
Treasury bills are the short term promissory note issued by the RBI on behalf of the government, in
order to meet the temporary deficit of the government. They are issued with three-month, six-month
and one-year maturity periods which may also be referred as 91-day, 182-day and 364-day treasury
bills.

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2. Certificate of Deposits (CDs): Certificate of Deposit is like a promissory note issued by a bank in
form of a Certificate entitling the bearer to receive interest. It is similar to bank term deposit account.
The certificate bears the maturity date, fixed rate of interest and the value. These certificates are
available in the tenure of 3 months to 5 years. The returns on certificate of deposits are higher and
restrict the holders to withdraw funds on demand. However, on payment of certain penalty the money
can be withdrawn on demand also.

3. Commercial Papers (CPs): Commercial Paper is the short term unsecured promissory note issued
by corporate and financial institutions at a discounted value on face value. They come with fixed
maturity period ranging from 1 day to 270 days. These are issued for the purpose of financing of
accounts receivables, inventories and meeting short term liabilities. It is a low-cost alternative to bank
loans.

4. Call / notice money market: Call/Notice money is the money borrowed or lent on demand for
a very short period. When money is borrowed or lent for a day, it is known as Call
(Overnight) Money. Intervening holidays and/or Sunday are excluded for this purpose. Thus
money, borrowed on a day and repaid on the next working day, (irrespective of the number
of intervening holidays) is "Call Money". When money is borrowed or lent for more than a
day and up to 14 days, it is "Notice Money". No collateral security is required to cover these
transactions.
5. Repurchase Transactions (REPOs or reverse REPO): Repurchase Agreements which are
also called as Repo or Reverse Repo are short term loans that buyers and sellers agree upon
for selling and repurchasing. Repo or Reverse Repo transactions can be done only between
the parties approved by RBI and allowed only between RBI-approved securities such as state
and central government securities, They are usually used for overnight borrowing.
Repurchase agreements are sold by sellers with a promise of purchasing them back at a given
price and on a given date in future. On the flip side, the buyer will also purchase the
securities and other instruments with a promise of selling them back to the seller.
6. Commercial bills: It is a short term credit investment created by a non financial firm and
guaranteed by a bank to make payment. It is simply a bill of exchange drawn by a person and
accepted by a bank. It is a buyer’s promise to pay to the seller a certain specified amount at
certain date. The same is guaranteed by the banker of the buyer in exchange for a claim on
the goods as collateral. The most common term for these instruments is 90 days. However,
they can vary from 30 days to180 days.

Capital Market:
The capital market is the market for securities, where companies and the government can raise
long-term funds. It includes institutions and mechanism for the effective pooling of long term
funds from individuals and institutional investors and making them available to industrial and
commercial undertakings. Capital market, in short, deals with shares, debentures, bonds etc. It is
an imperative in economic development as it mobilizes funds on a large scale and distributes the
same to places where it is needed in an economy.

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Capital market instrument:
1. Shares: A share is a single unit that represents a proportion of the share capital. In other words
the total capital of a company may be divided into small units called shares. According to
section 2(46) of the companies act, 1956 defines it as “A share in the share capital of the
company, and includes stock except where a distinction between stock and share is
expressed or implied.”
a) Equity shares: Equity shares are also known as ordinary shares or common shares represent
the owners’ capital in a company. It signifies ownership in a corporation and represent claim
over the financial assets and earnings of the corporation. Equity shareholders enjoy voting
rights and the right to receive dividends; however in case of liquidation they will receive
residuals, after all the creditors of the company are settled in full.
b) Preference shares: The preference shares are market instrument issued by the companies to
raise the capital. Preference shares are different from ordinary equity shares. Preference share
holders have high preference than equity share holders. Preference shares have the
characteristics of both equity shares and debentures. Fixed rate of dividends are paid to the
preference share holder as incase of debentures, irrespective of the profits earned company is
liable to pay interest to preference shareholders.

2. Debentures: A debenture is an acknowledgment of debt, taken either from the public or a

particular source. A debenture may be viewed as a loan, represented as marketable security.
The rate of interest payable on debentures is fixed at the time of issue and is recovered by a
charge on the property or assets of the company, which provide the necessary security for
payment. The company is liable to pay interest even if there are no profits. Debentures are
mostly issued to finance the long-term requirements of business and do not carry any voting
rights.
3. Derivatives: Derivatives are instruments whose value is derived from one or more
underlying asset. The underlying instrument could be a financial security, indexes and
commodities or some combination of securities. A derivative is a financial product whose
value is derived from the value of underlying (another) asset, such as an equity, bond or
commodity. Major derivatives include Forwards, Futures, Options and Swaps.
a) Forward: contracts mean two parties come together and enter into an agreement to
buy and sell an underlying asset set at a fixed date and agreed on a price in the future.
In simpler words, it is an agreement formed between both parties to sell their asset on
an agreed future date.
b) Future: Future contracts are similar to forward contracts. Future contracts mean an
agreement made by the two parties to buy or sell an underlying instrument at a fixed
price on a future date. Future contracts do not allow the buyer and seller to meet and
enter into an agreement. In fact, the deal gets fixed through exchange mode.
c) Options: Options may be defined as a contract between two parties — a buyer and a
seller — whereby the buyer of the option has the right but not the obligation, to buy or
sell a specified currency at a specified exchange rate, on or before a specified date,
from the seller of the option. There are two types of options:
 Call option - gives the buyer the right to buy a specified currency at a specified
exchange rate, at or before a specified date.

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  Put option - gives the buyer the right to sell a specified currency at a specified
exchange rate, at or before a specified date.
d) Swap: Swaps are the agreements which are used to merely exchange cash flows so as
to gain from the difference. Interest Swaps involve exchange of interest obligations
between two parties. Currency Swaps involves exchange of principal and interest
payment of receipts and payments in one currency with that of another currency.

Primary Market
The primary market deals with the new securities which were not previously available to the
investing public i.e., the securities that are offered for the first time to the investing public. The
market therefore makes available a new block of securities for public subscription.

Modes of raising funds

a. Public Issue: When a company raises funds by selling (issuing) its shares (or debenture /
bonds) to the public through issue of offer document (prospectus), it is called a public issue.
 Initial Public Offer (IPO): When a (unlisted) company makes a public issue for the
first time and gets its shares listed on stock exchange, the public issue is called as initial
public offer.
 Follow-on public offer (FPO): When a listed company which has already issued share
makes another public issue to raise capital, it is called follow-on offer (FPO).
b. Rights Issue: When the company issues shares to the existing shareholders to raise its
capital, on pro-rata basis (Based on their previous holdings) such issue is called as rights
issue. The offer document for a rights issue is called as the Letter of Offer.
c. Private Placement: Under this method, the company sells securities to the institutional
investors or brokers instead of selling them to the general public. This method is
preferred as it is a cheaper method of raising funds as compared to a public issue.
Investors involved in private placements are usually large banks, mutual funds, insurance
companies and pension funds

Secondary market
The Secondary market deals in securities previously issued. It is a market for old securities or
second hand securities, where existing securities are traded. The securities which are already
issued in the primary market, is traded in the secondary market. The secondary market enables
those who hold securities to adjust their holdings in response to charges in their assessment of
risk and return. They also sell securities for cash to meet their liquidity needs.

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Players of secondary market
There are different types of buyers and sellers in the market who act through authorized brokers
only. Brokers represent their clients who may be individuals, institutions like companies, banks
and other financial institutions, mutual funds, trusts etc.
i. Client brokers - These do simple broking business by acting as intermediaries between
the buyers and sellers and they earn only brokerage for their services rendered to the
clients.
ii. Bulls - These are the optimistic people who expect prices to rise and as a result keep on
buying. Also called ' Tejiwalas'
iii. Bears - These are the pessimistic people who expect the prices to fall and as a result keep
on selling. Also called 'Mandiwalas.’
iv. Arbitragers: Arbitragers are those brokers who buy securities in one market and sell in
another market to take advantage of price differences prevailing in different markets for
the same scripts.
v. Jobbers - A jobber is a professional independent broker who deals in securities on his
own behalf. they are wholesalers doing both buying and selling of selected scrip's. They
earn from the margin between buying and selling rates. In other words he purchases and
sells securities in his own name his main aim is to earn a margin of profit due to price
variation of securities.
vi. Stags - They are those members who neither buy or sell securities in the market. They
simply apply for subscription to new issues expecting to sell them at higher prices later
when these issues are quoted on the stock exchange.
vii. Badla Financiers /Badliwallas: Badla Financiers are those members whose main function
is to give finance for carry forward deals in specified securities, in return for interest.
This interest rate is called badla rate.
viii. Wolves - They are fast speculators. They perceive changes in the trends of the market and
trade fast and make a fast buck.
ix. Lame Ducks - These are slow bears who lose in the market as they sell securities without
having shares.
x. Investors-Retail Investors, Institutional Investors, Foreign Institutional Investors
xi. Stock Exchange Members/ Brokers

Trading
Each stock exchange has certain listed securities and permitted securities which are traded on it.
Members of the exchange alone are entitled to the trading privileges. Investors interested in

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buying and selling securities should place their orders with the members (brokers) of the
exchange.
There are two way of organizing the trading activity:
1. Open Outcry System: As the itself suggests, under the open outcry system, traders shout
and resort to signals on the trading floor of the exchange which consists of several 'notional'
trading posts for different' securities. A member (or his representative) wishing to buy or
sell a certain security reaches the trading post where the security is traded. Here, he comes
in contact with others interested in transacting in that security. Buyers make their bids and
sellers make their offers and bargains are closed at mutually agreed-upon prices. Open
outcry was a popular method for communicating trade orders in trading pits before 2010.
The verbal and hand signal communication used by traders at stock, option, and futures
exchanges are now rarely employed, replaced by faster and more accurate electronic order
systems.
2. Screen-based System: In the screen-based system, the trading ring is replaced by the
computer screen and distant participants can trade with each other through the computer
network. A large number of participants, geographically separated, can trade
simultaneously at high speeds.

Trading and settlement procedure:

1. Locating and selecting the Broker:
Shares are bought through a stock broker, who is a licensed member of a stock exchange. So
whenever you want to buy shares, you should locate/select a broker. Two types of accounts are
required to trade in shares and securities in a stock exchange namely, Trading Account and
Demat account.
a. Trading Account – As the name itself suggest this account facilities trading
(Buying/Selling)
b. Demat Account – Demat = Dematerialization. Demat account holds your securities in
electronic form.
Dematerialization is the process of converting physical share certificates into electronic share
certificates.

2. Placing the Order

Once the primary obligation of trading are complete and the investor has both the trading and
Demat accounts he can start buying and selling of shares and other securities through brokers by
placing the orders with them. The order should clearly specify the name of the company and the
type of securities (equity share, preference share, or debenture)

3. Execution of the Order

On receiving your order, the broker will feed the same on his terminal (computer). Once the
order is executed, the broker will inform you and send a contract note. Representing evidence of

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the transaction, the contract note contains the details of the transactions like, name of the
company, number of shares bought/sold, price at which they are bought/sold, date and time of
trade.

4. Clearing and Settlement

The buyer has to hand over the money and receive securities, the seller on the other hand has to
hand over the securities and receive money. This process of transfer of securities and cash is
known as settlement of the trade.
The settlement process of delivering securities and receipt of cash is done through a separate
agency known as clearing house which functions in each stock exchange.
The stock exchanges now follow a settlement procedure known as Compulsory Rolling
Settlement (CRS). The earlier procedure settlement procedure was called as account period
settlement

Stock market Indicators:

A stock market index acts as the indicator of the performance of the overall market. Market
indexes are intended to represent an entire stock market and thus track the market's changes over
time. Stock market indicators represent the movement of stock prices in the market, when the
stock market indicator is up that means most of the stock prices in the market have gone up and
vice-versa

Types of stock market Indices

1. Price-weighted Index: A price-weighted index is an index reflecting the sum of the
prices of the sample stocks on a certain date in relation to a base date. The price weighted
index assumes that the investor buys one share of each stock included in the index. Track
changes in the stock market based on the per share price of an individual stock.
2. Equal-weighted Index: An equal-weighted index is an index reflecting the simple
arithmetic average of the price relatives of the sample stocks on a certain date in relation
to a base date. An equal-weighted index assumes that the investor invests an equal
amount of money in each stock included in the index.
3. Value-weighted Index: A value-weighted index is an index reflecting the aggregate
market capitalization of the sample stocks on a certain date in relation to a base date. A
value-weighted index assumes that the investor allocates money across various stocks
included in the index in such a way that the weights assigned to various stocks are
proportional to their market capitalization.

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Indices of Indian Stock Exchanges
SENSEX
 SENSEX is the stock index of Bombay Stock Exchange(BSE)
 BSE SENSEX was launched on1986
 It is composed with 30 stocks - representing a sample of large, well established and
financially sound companies selected from different industry groups.
 Base year of BSE SENSEX is1978-79
 Base value is100
 Basis of calculation is free-float market capitalization
 BSE SENSEX is a Value-weighted Index

NIFTY
 Also called as S&P CNX Nifty
 NIFTY is he stock index of National Stock Exchange(NSE)
 Calculated with a well diversified sample of 50 stocks representing 23 sectors of the
economy
 Base year of NSE nifty is1995
 Base value is1000
 Nifty is managed by India Index Services and Products Ltd. (IISL) which is a joint
venture between NSE and CRISIL.
 The index is known as S&P CNX Nifty because IISL has consulting and licensing
agreement with Standard and Poor’s (S&P), who are world leader in index services.

Other Indices of Indian stock Exchange are as follows:

i. CNX Nifty Junior
ii. S&P CNX 500
iii. CNX Midcap200
iv. S&P CNX Defty

Leading Stock Exchanges in India

1. Bombay Stock Exchange (BSE)
2. National Stock Exchange (NSE)
3. Calcutta Stock Exchange (CSE)
4. Metropolitan Stock Exchange (MSE)
5. India International Exchange (India INX)
6. NSE IFSC Limited

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 Module -2
Concept of Risk, Causes of Risk, Types of Risk- Systematic risk Market Price Risk, Interest Rate
Risk, Purchasing Power Risk, Unsystematic Risk- Business risk, Financial Risk, Insolvency
Risk, Risk-Return Relationship, Concept of diversifiable risk and non diversifiable risk.
Calculation of Return and Risk of Individual Security & Portfolio (Theory & Problems).

CONCEPT OF RETURN AND RISK

There are different motives for investment. The most prominent among all is to earn a return on
investment. However, selecting investments on the basis of return in not enough. The fact is that
most investors invest their funds in more than one security suggest that there are other factors,
besides return, and they must be considered. The investors not only like return but also dislike
risk. So, what is required is:
i. Clear understanding of what risk and return are
ii. What creates them, and
iii. How can they be measured?

Return:
There turn is the basic motivating force and the principal reward in the investment process. The
return may be defined in terms of (i) realized return, i.e., the return which has been earned, and
(ii) expected return, i.e., the return which the investor anticipates to earn over some future
investment period. The expected return is a predicted or estimated return and may or may not
occur. The realized returns in the past allow an investor to estimate cash inflows in terms of
dividends, interest, bonus, capital gains, etc, available to the holder of the investment. The return
can be measured as the total gain or loss to the holder over a given period of time and may be
defined as a percentage return on the initial amount invested. With reference to investment in
equity shares, return is consisting of the dividends and the capital gain or loss at the time of sale
of these shares.

Risk:
Risk in investment analysis means that future returns from a investment are unpredictable. The
concept of risk may be defined as the possibility that the actual return may not be same as
expected. In other words, risk refers to the chance that the actual outcome (return) from an
investment will differ from an expected outcome. With reference to a firm, risk may be defined
as the possibility that the actual outcome of a financial decision may not be same as estimated.
The risk may be considered as a chance of variation in return. Investments having greater
chances of variations are considered more risky than those with lesser chances of variations.
Between equity shares and corporate bonds, the former is riskier than latter. If the corporate
bonds are held till maturity, then the annual interest inflows and maturity repayment. Investment
management is a game of money in which we have to balance the risk and return.

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Causes of Risk:

1. Wrong Decision: Wrong decision of what to invest in.

2. Wrong Timing: Wrong timing of investments.
3. Nature of Instruments: Nature of instruments invested such as shares or bonds, chit funds,
benefit funds are highly risky than bank deposits or P.O. certificates, etc.
4. Creditworthiness of Issuer: Securities of government and semi-government bodies are more
creditworthy than those issued by the corporate sector.
5. Maturity Period or Length of Investment: Longer the period, the more risky is the
investment normally.
6. Amount of Investment: Higher the amount invested in any security the larger is the risk.
7. Method of Investment: Method of investment, namely, secured by collateral or not.
8. Terms of Lending: Terms of lending such as periodicity of servicing, redemption periods,
etc.
9. Nature of Industry: Nature of industry or business in which the company is operating.
10. National and International Factors: National and international factors, acts of god, etc.

Types of Risk:

Types of Risk

Systematic Risk Unsystematic Risk

Market Interest Purchasing Business Financial

Risk Rate Risk Power Risk Risk Risk

Internal External
Risk Risk

Systematic Risk

Systematic risk is also referred as uncontrollable risk. Systematic risk is non-diversifiable and is
associated with the securities market as well as economic, sociological, political and legal

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considerations of the prices of all securities in the economy. The effect of these factor is to put
pressure on all securities in such a way that the prices of all stocks will move in the same
direction. For example, during a boom period, prices of all securities will rise and indicate that
the economy is moving towards prosperity.

1. Market Risk: Market risk as that portion of total variability of return caused by the
alternating forces of bull and bear markets. When the security index moves upward haltingly
for a significant period of time, it is known as bull market. In the bull market, the index
moves from a low level to the peak. Bear market is just is a reverse to the bull market, the
index declines haltingly from the peak to a market low point called trough for a significant
period of time. During the bull and bear market more than 80 per cent of the securities' prices
rise or fall along with the stock market indices.
Ways used in minimizing market risk
a. Study the market trends consistently
b. Avoid investing in highly volatile stocks
c. Portfolio construction will minimize the risk
d. Timing the market
e. Be a rational Investor (long-term investment)

2. Interest Rate Risk: Interest rate risk is the variation in the single period rates of return
caused by the fluctuations in the market interest rate. Most commonly interest rate risk
affects the price of bonds, debentures and stocks. The fluctuations in the interest rates are
caused by the changes in the government monetary policy and the changes that occur in the
interest rates of treasury bills and the government bonds. The bonds issued by the
government and quasi-government are considered to be risk free. If higher interest rates are
offered, investor would like to switch his investments from private sector bonds to public
sector bonds. If the government to tide over the deficit in the budget floats a new loan/bond
of a higher rate of interest, there would be a definite shift in the funds from low-yielding
bonds to high yielding bonds and from stocks to bonds.
Minimization
a. Never liquidate the investment before maturity
b. If commitments are short-term, plan for short term maturity bonds and T-bills
c. Plan your investment horizon (varying maturity dates)

3. Purchasing Power Risk: Variations in the returns are caused also by the loss of purchasing
power of currency. Inflation is the reason behind the loss of purchasing power. The level of
inflation proceeds faster than the increase in capital value. Purchasing power risk is the
probable loss in the purchasing power of the returns to be received. The rise in price
penalizes the returns to the investor, and every potential rise in price is a risk to the investor.
The inflation may be demand-pull or cost-push inflation.
Minimization

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 a. In a highly inflationary economy, try avoiding long-term investment.
b. Diversifying the investment

Unsystematic Risk

Unsystematic risk is also referred as controllable risk. Unsystematic risks stems from managerial
inefficiency, technological change in the production process, non-availability of raw material,
changes in the consumer preference, and labor problems. The nature and magnitude of the above
mentioned factors differ from industry to industry, and company to company. They have to be
analyzed separately for each industry and firm. The changes in the consumer preference affect
the consumer products like television sets, washing machines, refrigerators, etc., more than they
affect the iron and steel industry. Technological changes affect the information technology
industry more than that of consumer product industry. Thus, it differs from industry to industry.
Financial leverage of the companies that is debt-equity portion of the companies differs from
each other. The nature and mode of raising finance and paying back the loans involve a risk
element. All these factors form the unsystematic risk and contribute a portion in the total
variability of the return.

a. Business Risk: The risk that a business will experience a period of poor earnings and
resultant failure. Business risk is greatest for firms in cyclical or relatively new industries.
Business risk affects holders of stocks and bonds, since a firm may be unable to pay
dividends and interest. The risk that a company will go bankrupt. Business risks are of two
types:
i) Internal Risk: Internal Risks arise from the events taking place within the business
enterprise or risks. Such risks arise during the ordinary course of a business and that
they can be forecasted and the probability of their occurrence can be determined.
Since these risk can be pre-determined and therefore, they can be controlled by the
entrepreneur to an appreciable extent.
ii) External Risk: External Risks are those risks which arise due to the events occurring
outside the business organization. Such events are generally beyond the control of an
entrepreneur and therefore the resulting risks cannot be forecasted and the probability
of their occurrence cannot be determined, such types of events generally happens
suddenly and are therefore very difficult to manage and control.

b. Financial Risk: The risk that a firm will be unable to meet its financial obligations. This risk
is primarily a function of the relative amount of debt that the firm uses to finance its assets. A
higher proportion of debt increases the likelihood that at some point the firm will be unable
to make the required interest and principal payments.

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Minimization of Business and Financial risk:

 Invest a company that has consistent in earnings & profits.

 Better understanding the company’s capital structure

 Industry level understanding.

Types of Return:

1. Realized Return: This is ex-post (after the fact) return, or return that was or could have been
earned. For example, a deposit of 1,000 in a bank on January 1, at a stated annual interest rate
of 10% will be worth 1,100 exactly a year later. The historical or realized return in this case
is 10%.
2. Expected Return: This is the return from an asset that investors anticipate or expect to earn
over some future period. The expected return is subject to uncertainty, or risk, and may or
may not occur. The investor compensates for the uncertainty in returns and the timing of
those returns by requiring an expected return that is sufficiently high to offset the risk or
uncertainty.

Components of Return

1) Current Return: The first component that often comes to mind when one is thinking about
return is the periodic cash flow (income), such as dividend or interest, generated by the
investment. Current return is measured as the periodic income in relation to the beginning
price of the investment.
2) Capital Return: The second component of return is reflected in the price change called the
capital return - it is simply the price appreciation (or depreciation) divided by the beginning
price of the asset. For assets like equity stocks, the capital return predominates.

Thus, the total return for any security (or for that matter any asset) is defined as:

Total return = Current return + Capital return

The current return can be zero or positive, whereas the capital return can be negative, zero or
positive.

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Risk and Return Relationship

Risk and return trade-off give the direct relationship between risk and return, investors are able
to measure this relationship and use that measurement to build a portfolio with appropriate risk
and return trade –off.

Risk trade-off = Excess expected return/ Standard deviation

Risk Measurement:

I. Variance: Variance (σ 2 ) is a measure of the dispersion of a set of data points around

their mean value. In other words, variance is a mathematical expectation of the average
squared deviations from the mean. It is computed by finding the probability weighted
average of squared deviations from the expected value. Variance measures the variability
from an average (volatility). Volatility is a measure of risk, so this statistic can help
determine the risk an investor might take on when purchasing a specific security.
Standard Deviation
Standard deviation can be defined in two ways:
- A measure of the dispersion of a set of data from its mean. The more spread apart the
data, the higher the deviation. Standard deviation is calculated as the square root of
variance.
- In finance, standard deviation is applied to the annual rate of return of an investment to
measure the investment's volatility. Standard deviation is also known as historical
volatility and is used by investors as a gauge for the amount of expected volatility.
Standard deviation is a statistical measurement that sheds light on historical volatility.
For example, a volatile stock will have a high standard deviation while a stable blue chip
stock will have a lower standard deviation. A large dispersion tells us how much the
fund's return is deviating from the expected normal returns.
Standard Deviation of scrip return: It measures the total risk associated with the
individual scrip.

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II. Beta of scrip [Systematic risk]: It describes the relationship between Stock return and
Market return. It is slope of a regression line. It describes % increment and decrement in
a stock return for a given amount of change in the Index return.
- Beta > 1 indicates High systematic risk.
- Beta < 1 indicates Low systematic risk
- Beat =1 indicates Linearity

What is Alpha and Beta in Stock Market?

Every investment involves two important aspects returns and risk. And every investor wants to
get the maximum returns with minimum risk. In this post is described the significance of Alpha
and Beta parameters of the stock portfolio that are used to describe the two main risks inherent in
investing in stocks. Alpha relates to factors affecting the performance of an individual stock or
the fund manager’s skill in selecting the stocks while beta relates to market risks.

Alpha: Alpha is the risk-adjusted return on an investment. It is excess return of a stock portfolio
or fund over a given benchmark and hence is usually used to measure the performance of fund
manager in managing the fund portfolio. So usually an investor’s strategy should be to buy
securities with positive alpha as these may be undervalued.

If an investment outperformed the benchmark, that means more reward for a given amount of
risk. In that case α > 0.

If an investment underperformed the benchmark; that means the investment has earned too little
for its risk. In that case α < 0. For efficient markets, the expected value of the alpha is zero. i.e α
= 0 and the investment has earned a return adequate for the risk taken. Fund managers are rated
according to how much alpha their fund generates. It is thus a measure of the fund manager’s
ability to generate profits in excess of market returns. Fund managers are usually paid in
accordance to how much alpha their fund generates. Higher the alpha, the higher is their fees.

Beta: Beta is a measure of a volatility of a stock and expresses the relation of movement of stock
with the movement of market as a whole. The S & P 500 Index is assigned a Beta of 1. So a
stock can have positive or negative value of beta.

If Beta = 1; that means security’s price will move in sync with the market.

If Beta is positive; that means stock moves more than the market and is more volatile.

If Beta is negative; that means stock moves less than the market and is less volatile.

High-beta stocks are generally riskier being more volatile but provide a potential for higher
returns as these are in the early stages of growth. On other side low-beta stocks pose less risk and

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hence lower returns. Usually utilities stocks have a beta of less than 1 while high-tech stocks
have a beta of greater than 1.

Having gone through the fundamentals of alpha and beta; it can be inferred that low beta and
high alpha stocks are good. But blindly following this concept is not desirable because these
parameters are calculated based on historical data and history is never the indicator of future
performance of a stock portfolio.

Stock
Return

Market Return

Correlation

Correlation can be defined as: “…what is known as the correlation coefficient, which ranges
between -1 and +1. Perfect positive correlation (a correlation co-efficient of +1) implies that as
one security moves, either up or down, the other security will move in lockstep, in the same
direction. Alternatively, perfect negative correlation means that if one security moves in either
direction the security that is perfectly negatively correlated will move in the opposite direction. If
the correlation is 0, the movements of the securities are said to have no correlation; they are
completely random.”

Correlation simply describes how two things are similar or dissimilar to each other. Specifically
how two investments move in relation to each other, how tightly they are linked or opposed.
Correlation between historically dissimilar investments (think stocks and bonds) is never static,
it’s not uncommon for the correlation of investments to change, especially during volatile or
crashing markets. In fact, seemingly the only thing that goes up in a down market is in fact
correlation. I use correlation measurements in advanced portfolio management to better manage
risk. To me, higher correlation theoretically means higher risk to the bottom line. The higher the
correlation of your investments the higher of the “doubling-down” effect you get, in other words
you have a greater opportunity for gains or financial ruin. One particular ripe investment class

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for high correlation are mutual funds because both bond funds AND stock funds trade on the
stock market, thus your bond funds become more correlated with stock funds during volatile
markets.

Definition of 'R-Squared'

A statistical measure that represents the percentage of a fund or security's movements that can be
explained by movements in a benchmark index. For fixed-income securities, the benchmark is
the T-bill. For equities, the benchmark is the S&P 500.

R-squared values range from 0 to 100. An R-squared of 100 means that all movements of a
security are completely explained by movements in the index. A high R-squared (between 85
and 100) indicates the fund's performance patterns have been in line with the index. A fund with
a low R-squared (70 or less) doesn't act much like the index. A higher R-squared value will
indicate a more useful beta figure. For example, if a fund has an R-squared value of close to 100
but has a beta below 1, it is most likely offering higher risk-adjusted returns. A low R-squared
means you should ignore the beta.

Definition of 'Characteristic Line'

A line formed using regression analysis that summarizes a particular security or p ortfolio's
systematic risk and rate of return. The rate of return is dependent on the standard deviation of the
asset's returns and the slope of the characteristic line, which is represented by the asset's beta.

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 Module -3
Valuation of Securities: Bond – Meaning, features, types, determinants of interest rates, Bond
Valuation, Bond Duration, Bond Management Strategies. Preference Shares- Concept,
Valuation. Equity Shares- Concept, Valuation, Dividend Valuation Models, P/E Ratio valuation
model. (Theory & Problems).

Bond:

A bond is a contract that requires the borrower to pay an interest income to the lender. It
resembles the promissory note and is issued by governments and/or corporations. The par value
of the bond indicates the face value of the bond, i.e., the value stated on the bond paper.
Generally, the face values of bonds are ₹1,000, ₹2,000, ₹5,000 and the like. Most bonds offer
fixed interest payments till their maturity. This specific rate of interest is known as the coupon
rate. Coupons are paid quarterly, semiannually and annually. At the end of the maturity period,
the value is repaid.

Features of bonds:

1. Indenture: The indenture is a long, complicated legal instrument containing the restrictions,
pledges and promises of the contract. Bond/ fixed income instrument indenture involves
three parties. The first party is the debtor corporation that borrows the money, promises to
pay interest, and promises to repay the principal borrowed. The bond holders are the second
party; they lend the money. They automatically accept the indenture by acquiring their
bonds/ fixed income instrument. The trustee is the third party with whom the bond contract is
made. The trustee ensures that the corporation keeps its promises and follows the provisions

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 contained in the indenture. In other words, the trustee does the "watchdog" job for all the
bondholders.
2. Repayment of Principal: Bonds are issued in denominations of ₹1,000 but there are also
bonds of values of ₹500 and 100 and of values as high as ₹5,000 and ₹10,000. Financial
institutions are known to buy corporate bonds bearing higher values. The value of the bond is
called the 'face value, par value or maturity value'. The face value of the bond represents the
promise to repay the amount to the bondholder at the end of the specified period. This, in
other words may be called the most important feature of bond, return of the principal to the
lender on a fixed date specified earlier.
3. Maturities/Specified Time Period: Maturities vary widely. Bonds are usually grouped by
their maturity classes. Shop term bonds are usually bonds maturing within 5 years. They may
be secured or unsecured. These are common industrial financing. Medium-term bonds
mature in 5 to 10 years. If a bond is originally issued on a medium-term bond it is usually
secured by a real estate or equipment mortgage, or it may be backed by other security. Long-
term bonds may run 20 years or more. Capital-intensive industries with long expectation of
equipment life are the greatest users of this form of bond financing.
4. Interest Payment: Bond/ fixed income instrument interest is usually paid semi-annually,
though annual payments are also popular. The method of payment depends upon whether the
bond/ fixed income instrument is a coupon (bearer) or registered.
5. Call: Bonds have an additional feature of 'call". This is a privilege to the issuing company to
re-purchase bonds at anslightly higher price above the par value. For example, a bond of face
value of ₹1,000 and maturity of 20 years yields an interest of 270 annually. After the first
five years of issue, the market rate of interest on bonds falls considerably. The ruling rate
being 5%, the company may choose to use the call feature and buy back the bond for 1,050.
This is a little higher than the face value of ₹1,000. By calling the bonds, the company saves
money. It may call back the bonds yielding interest of ₹70 and issue fresh bonds which will
yield 250 per year. The firm has been able to save 20 per year per bond for the next 15 years
till the maturity of the bond. By paying ₹50 higher than the face value on the bond for early
redemption of the bond, the company saves a much higher amount. The bondholder is on the
losing side because he gets the return of the principal amount earlier than he expected.
6. Pledge of Security: The issuing company sometimes promises to pay to the bondholder by
offering some security like property. The pledge of security is a promise to the bondholders
in writing and signed under seal and presented to the trustee by the company. A simple
promise to pay without the proper formalities is not considered as a pledge of security

Types of bonds

 Premium Bonds: Premium Bonds are those bonds which are sold at the price above the par
value of the same. Suppose, a bond has a par value of 100. Now, if an investor sells this bond

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 in the market at a rate above the ₹100, say ₹150, and then this bond would be regarded as the
Premium Bond. In such a case the bond would be said to have been sold at a premium of
₹50.
 Convertible Bonds: Convertible Bonds are the bonds which entitle its holders to convert
their bonds to the share equities during a particular time span. This conversion from bond to
the equity shares can be done by the holder on some pre-determined fixed ratio. When these
convertible bonds remain as a bond then they give their holders with an income which is
fixed. But if these bonds are converted into the shares then the features of the bond changes
to those of the equity ones. These convertible bonds are different from the ordinary bonds
because they can be converted by the holder of the same from the bond character to the
equity share of the same company. This conversion is generally done on a specified ratio
known as the Conversion Ratio
 Discount Bonds: Discount Bonds are those bonds which have been sold by a customer at a
price below the face value of the same. Suppose, a bond has a par value of 100. Now, if an
investor sells this bond in the market at a rate below ₹100. say ₹50, then this bond would be
regarded as the Discount Bond. In such a case the bond would be said to have been sold at a
discount of 50. There are many bonds which are issued with an associated coupon rate which
is below the ongoing rate of interest in the market. In such a situation, the issuer has to offer
the bond at such a price which is below the current bond price. These types of bonds are also
known as the Discount Bonds. One of the examples of such Discount Bonds are the Zero
Coupon Bonds where the issuing company offers no coupon rate to the investors.
 Mortgage Bonds: Mortgage bonds are secured bonds and the underlying for the same could
be real estate or fixed assets such as machinery. As these are secured by the mortgage of the
underlying, the risk associated with such investments are considered to be low.
 High Yield Bonds: High yield bonds are the bonds for which the rate of interest offered are
higher. These bonds are also called as Junk Bonds. The risk of credit associated with this
type of bond is generally higher and is rated by the grading agencies as speculative in nature.
They also consider this asset type to be below the level of investment because it is not
evident that in the long-run or for a specified time period this locked money would
appreciate.
 Fixed Income Bonds: Fixed income bonds are the types of bonds which generate a fixed
income for its investors and are dispersed to the investors at a regular period of interval.
These interest payments associated with such a bond is generally low because the risk
associated with it is almost nil. The most popular Fixed Income Bonds in the bond market are
the ones which are issued by the governments such as the Government Bonds. Another form
of the Fixed Income Bonds is the GIBs (i.e., Guaranteed Income Bonds).
 Government Bonds: Government bonds are those debt instruments that are issued by the
domestic governments for its residents only. Generally, the phenomenon of a government
going bankrupt is not observed naturally. Hence, the risk associated with the government
bonds are the least. This almost nil default risk makes this bond a highly secured one. Thus,

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 the compensation for holding such a bond is also very low in comparison to the other debt
instruments, Government issuing this bond offers the prospective investors a fixed yield for
holding this bond.
 Corporate Bonds: Companies, like the governments, borrow money by issuing bonds called
corporate bonds (also called corporate debentures). Internationally, a secured corporate debt
instrument is called a corporate bond whereas an unsecured corporate debt instrument is
called a corporate debenture. In India, corporate debt instruments have traditionally been
referred to as debentures, although typically they are secured. For the sake of simplicity, we
will refer to all corporate debt instruments as corporate bonds.
 Municipal Bonds: Municipal bonds are the bonds issued by states, cities or other
corporations. These may be issued for a specific purpose and necessary funds may be raised.
For example, Konkan Railway Development Corporation Limited issued bonds to public for
raising funds required for its railway line between Mumbai to Mangalore. Central
Government had issued Narmada Sarovar Bond, Jala Nigam Bond etc. for funding various
projects.

Bond Valuation:

Bond valuation is the process of determining the fair price/theoretical price/intrinsic value of a
bond. Bond (also term as debenture) is long term loan (Instrument of debt) which pay periodical
interest and also principal amount upon maturity.

- A long-term debt instrument

- A contract where a borrower agrees to make interest and principal payments on specific dates

Bond Risk

 Interest rate risk: When interest rates rise, bond prices fall. When interest rates fall, bond
prices rise. This is a risk if you need to sell a bond before its maturity date and interest rates
are up. You may end up selling the bond for less than you paid for it.
 Inflation risk: This is the risk that the return you earn on your investment doesn’t keep pace
with inflation. If you hold a bond paying 2% interest and inflation reaches 3%, your return is
actually negative (-1%), when adjusted for inflation. You’ll still get your principal back when
your bond matures, but it will be worth less in today’s dollars. Inflation risk increases the
longer you hold a bond.
 Market risk: This is the risk that the entire bond market declines. If this happens, the price
of your bond investments will likely fall regardless of the quality or type of bonds you hold.
If you need to sell a bond before its maturity date, you may end up selling it for less than you
paid for it.

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 Credit risk/ Default risk: If you buy bonds from a company or government that isn’t
financially stable, there’s more of a risk you’ll lose money. This is called credit risk or
default risk. Sometimes, the issuer can’t make the interest payments to investors. It’s also
possible the issuer won’t pay back the face value of the bond when it matures.
 Reinvestment Risk: Another danger that bond investors face is reinvestment risk, which is
the risk of having to reinvest proceeds at a lower rate than the funds were previously earning.
One of the main ways this risk presents itself is when interest rates fall over time and callable
bonds are exercised by the issuers.
 Liquidity Risk: While there is almost always a ready market for government bonds,
corporate bonds are sometimes entirely different animals. There is a risk that an investor
might not be able to sell his or her corporate bonds quickly due to a thin market with few
buyers and sellers for the bond.

Bond Return

- Yield to Maturity (YTM): The rate of return earned on a bond if it is held to maturity. Yield
to Maturity is the discount rate kd that equates the PV of all expected interest payments and
the repayment of principal from a bond to the present bond price. In other words: it is the
return that you are going to get if you hold the bond until maturity.
- Current Yield: Takes into account only the interest payment portion of the return. Current
yield (CY) = Annual coupon payment /Current price
- Holding period return: The holding period is the investment period and return over this
period is known as holding period return. It is the % return of total holding period and not for
one year period. Holding period return = [Interest payment+ [value at end of the period-
value at beginning of the period]]/ bond value at the beginning of the period.

Bond Pricing Theorems

Theorem 1: if the market price of the bond increases, the yield would decline and vice versa. i.e.
Bond Price Increases YTM Decreases, Bond Price Decreases YTM Increases.
Theorem 2: if the bond’s yield remains the same over its life, the discount or premium depends
on the maturity period. i.e. Bond Premium or Discount depends on the Maturity period.
Theorem 3: if a bond’s yield remains constant over its life, the discount or premium amount will
decrease at an increasing rate as its life gets shorter. i.e. Discount or Premium will decrease at an
increasing rate when life becomes shorter
Theorem 4: a rise in the bond’s price for a decline in the bond’s yield is greater than the fall in
the bond’s price for a rise in the yield. i.e. Price raise for given decline in YTM > Price decrease
for given increase in YTM

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Theorem 5: The change in the price will be less for a percentage change in the bond’s yield if its
coupon rate is higher. i.e. % Change in Price will be lesser for a change in YTM if a bond has
higher coupon rate.

Concept of Stock Return:

- It is a return which includes current income and capital gain that is caused by increase in the
price.
- The current income and capital gain are expressed as a percentage of the money invested in
the beginning.
- An investor before investing in securities must properly analyze the returns associated with
the securities.

Determinants of Interest rates:

1. Risk-Free Rate of Return: The concept of a (nominal) risk-free rate of return (r) refers to
the return available on a security with no risk of default. In the case of debt securities, no
default risk means that promised interest and principal payments are guaranteed to be made.
Short-term Government securities, such as treasury bills, are generally considered to be risk-
free investments. The risk-free rate of return (r), is equal to the sum of a real rate of return
and an expected inflation premium: r = Real Rate of Return + Expected Inflation Premium
a. Real Rate of Return: The real rate of return is the return that investors would require
from a security having no risk of default in a period of no expected inflation. It is the
return necessary to convince investors to postpone current, real consumption
opportunities. The real rate of return is determined by the interaction of the supply of
funds made available by savers and the demand for funds for investment. Historically, the
real rate of return has been estimated to average in the range of 2 to 4 per cent.
b. Inflation Premium: The second component of the risk-free rate of return is an inflation
premium or purchasing power loss premium, Investors require compensation for
expected losses in purchasing power when they postpone current consumption and lend
funds. Consequently, a premium for expected inflation is included in the required return
on any security. The inflation premium is normally equal to investors' expectations about
future purchasing power changes. For example, if inflation is expected to average 4 per
cent over some future period, the risk-free rate of return on treasury bills (assuming a real
rate of return of 3 per cent) should be approximately equal to 3 per cent + 4 per cent = 7
per cent. By extension, if inflation expectations suddenly increase from 4 to 6 per cent,
the risk-free rate should increase from 7 to 9 per cent (3 per cent real return plus 6 per
cent inflation premium). At any point in time, the required risk-free rate of return on any
security can be estimated from the yields on short term government securities, such as

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 90-day treasury bills. When considering return requirements on all types of securities, it
is important to remember that increases in expected inflation rates normally lead to
increases in the required rates of return on all securities.
2. Default Risk: The default risk is a major determinant of the general structure of interest rates
and it refers to the possibility of the failure to meet the terms of a loan agreement, of delay in
payment, of total non-payment, of partial not payment of interest and/or principal amount.
All financial assets, except government securities, are subject to some degree of default risk
although they differ in their degree of risk. These differences in risk levels cause differences
in interest rates (yields) on financial claims. The more risky the security, the higher the
interest rate it has to offer. Given the attitude of the investors towards absorption of risk and
given the risk in investment projects that borrowers wish to undertake, the yield on risky
assets will rise to an equilibrium position which will be higher than the yield on assets that
have no risk of default. The difference between these two yields is called the default risk
premium. The default risk is determined by the internal financial and business position of the
borrower, and the external environment or economic climate within which he operates.
3. Maturity Risk Premium: If interest rates rise, lenders may find themselves stuck with long-
term loans paying the original rate prevailing at the time the loans were made, whereas other
lenders are able to make new loans at higher rates. On the other hand, if interest rates go
down, the same lenders will be pleased find themselves receiving higher interest rates on
their existing long-term loans than the rate at which other lenders must make new loans.
Lenders respond to this risk that interest rates may change in the future in two ways:
i) If lenders think interest rates might rise in the future, they may increase the rate they
charge on their long-term loans now and decrease the rate they charge on their short-term
loans now to encourage borrowers to borrow short-term
ii) Conversely, if lenders think interest rates might fall in the future, they may decrease the
rate they charge on their long-term loans now and increase the rate they charge on their short-
term loans now to encourage borrowers to borrow long-term (locking in the current rate).
The up or down adjustment that lenders make to their current interest rates to compensate for
the uncertainty about future changes in rates is called the maturity risk premium. The
maturity risk premium can be either positive or negative.

Bond Duration

Duration measures the time structure of a bond and the bond's interest rate risk. The time
structure of investment in bonds is expressed in two ways. The common way is to state how
many years an investor has to wait until the bond matures and the principal money is paid back.
This is known as asset time to maturity or its years to maturity. The other way is to measure the
average time taken for all interest coupons and the principal to be recovered. This is called
Macaulay's duration. Duration is defined as the weighted average of periods to maturity, with the
weights being present values of the cash flow in each period. The formula for duration is

Department of MBA SIET Page 29

D = ∑Pv(Ct) x t
Po

PREFERENCE SHARES

Meaning of Preference

Shares Preference shares are those, which enjoy the following two preferential rights:

1. Dividend at a fixed rate or a fixed amount on these shares before any dividend on equity
shares.
2. Return of preference share capital before the return of equity share capital at the time of
winding up of the company. Preference shares also have a right to participate or in part in
excess profits left after been paid to equity shares, or has a right to participate in the premium
at the time of redemption. But these shares do not carry voting rights.

Features of Preference Shares:

Preference shares are long-term source of finance.

The dividend payable on preference shares is generally higher than debenture interest.
Preference shareholders get fixed rate of dividend irrespective of the volume of profit.
It is known as hybrid security because it also bears some characteristics of debentures.
Preference dividend is not tax deductible expenditure.
Preference shareholders do not have any voting rights.
Preference shareholders have the preferential right for repayment of capital in case of
winding up of the company.
Preference shareholders also enjoy preferential right to receive dividend.

Types of Preference Shares

1. Cumulative Preference Shares: When unpaid dividends on preference shares are treated as
arrears and are carried forward to subsequent years, then such preference shares are known as
cumulative preference shares. It means unpaid dividend on such shares is accumulated till it
is paid off in full.
2. Non-cumulative Preference Shares: Non-cumulative preference shares are those type of
preference shares, which have right to get fixed rate of dividend out of the profits of current
year only. They do not carry the right to receive arrears of dividend. If a company fails to pay
dividend in a particular year then that need not to be paid out of future profits.

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3. Redeemable Preference Shares Those preference shares, which can be redeemed or repaid
after the expiry of a fixed period or after giving the prescribed notice as desired by the
company, are known as redeemable preference shares. Terms of redemption are announced at
the time of issue of such shares.
4. Non-redeemable Preference Shares Those preference shares, which cannot be redeemed
during the life time of the company, are known as non-redeemable preference shares. The
amount of such shares is paid at the time of liquidation of the company.
5. Participating Preference Shares Those preference shares, which have right to participate in
any surplus profit of the company after paying the equity shareholders, in addition to the
fixed rate of their dividend, are called participating preference shares.
6. Non-participating Preference Shares Preference shares, which have no right to participate on
the surplus profit or in any surplus on liquidation of the company, are called non-
participating preference shares.
7. Convertible Preference Shares Those preference shares, which can be converted into equity
shares at the option of the holders after a fixed period according to the terms and conditions
of their issue, are known as convertible preference shares.
8. Non-convertible Preference Shares Preference shares, which are not convertible into equity
shares, are called non-convertible preference shares.

Advantages:

a. Advantages from company point of view

- Fixed return
- No voting rights
- Flexibility in Capital structure
- No burden on finance
- No charge on assets
- Widens capital market
b. Advantages from Investors point
- Regular fixed income
- Preference rights
- Voting right for safety interest
- Lesser capital losses
- Fair security

Disadvantages:

a. Demerits for company

- Higher rate of dividend

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- Financial Burden
- Adverse effect on credit worthiness
- Tax disadvantage
b. Demerits for investors
- No voting right
- Fixed income
- No claim over surplus
- No guarantee of assets

Difference between preference shares and equity shares

Preference share Equity share

Rate of dividend Paid at fixed rate May vary depending upon the
profits
Arrears of dividend Get accumulated for cumulative No accumulation
preference shares
Preferential rights Before equity shares After equity shares
Winding up Have a right to return of capital Only paid when preference share
before equity shares. This means capital is paid fully
they are safer
Voting rights No voting rights Has Voting rights
Right to participate in Have no right Can participate in management
management

EQUITY SHARES

Equity shares, also known as ordinary shares or common shares represent the owners' capital in a
company. The holders of these shares are the real owners of the company. They have a control
over the working of the company. Equity shareholders are paid dividend after paying it to the
preference shareholders. The rate of dividend on these shares depends upon the profits of the
company. They may be paid a higher rate of dividend or they may not get anything.

Features of Equity Shares

1) Maturity: Equity shares provide permanent capital to the company, which is not under
contractual obligation to refund it during its lifetime. Shareholders can demand their capital
only if the event of liquidation and that too when funds are left after covering all prior claims.
Company can also not force the shareholders to sell back their shares if they were fully paid-
up and shareholders were not engaged in business competitive to the business of the
company. Shareholders can, indeed, be persuaded to sell their shares.

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2) Claims on Income: Equity shareholders are residual owners whose claim on income arises
only when claims of creditors and preferred stock- owners are met. In many instances,
residual owners do not get anything if income of the firm was just sufficient to satisfy the
claim of creditors. Even if the company has sufficient income left meeting after all
obligations, equity shareholders cannot legally force the company to pay individuals to them.
Distribution of the profits is left to the discretion of internal management of the company.
The management has full right to utilize business income in whatever manner it likes.
3) Cost of Equity: The cost of equity capital is higher than any other long-term source of
finance. Firstly, since the equity dividends are not tax-deductible expenses as the interest is,
and secondly the high cost of issue and the risk factor associated with it makes the cost of
equity higher.
4) Claims on Asset: Being residual owners, equity shareholders are the last claimants to assets
of the firm. In the event of winding up of the firm's business assets are disposed off to satisfy
the claims of the creditors and also preferred stockholders prior to equity stockholders. They
are, however, entitled to receive all left after meeting the business obligations. Being last in
the priority of claims, "equity shareholders" capital provides a cushion for creditors to absorb
losses on liquidation.
5) Control: The risk of loss associated with equity share is compensated to some extent by
controlling power that rests with residual owners. Equity shareholders have unchallenged
voice in management. Whatever control the stockholders retain is exercised primarily
through the voting privilege Every equity shareholders has the right to vote on every
resolution placed before the company and his voting right on a poll is in proportions to this
share of paid-up capital of the company. Although board of directors who control and direct
the affairs of the organization manages a company, supreme control is endowed with equity
shareholders. It is they who have power to elect the directors of the enterprise and remove or
any all of them if they so wish.
6) Pre-emptive Right: To safeguard the interest of equity shareholders and enable them
maintain their ownership, section 18 of the companies Act, 1956 provides that whatever a
public limited company proposes to increase its subscribed capital by the allotment of further
shares, after the expiry of two years from the formation of the company or the expiry of one
year from the first allotment of the shares in the company, whichever earlier, such shares
must be offered to holders of existing equity shares in proportion, as nearly as circumstances
admit, to the capital paid up on these shares. Shares so offered to existing shareholders are
called to right shares and their prior right to such is known as pre-emptive right.
7) Limited Liability: Another distinct feature of equity shares is limited liability. Thus,
although, equity shareholders are the real owners of the company, their liability is limited to
the value of shares they have purchased.

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Dividend discount Models

- Single period valuation model

- Multi period model
- Constant growth model
- Two-stage growth model
- Three stage growth model
- Valuation through P/E ratio

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 Module-4
Fundamental & Technical Analysis: Macro-Economic and Industry Analysis: Fundamental
analysis-EIC Frame Work, Economy Analysis, Industry Analysis, Company Analysis- Financial
Statement Analysis. Market Efficiency: Efficient Market Hypothesis, Forms of Market
Efficiency, Empirical test for different forms of market efficiency. Technical Analysis –
Concept, Theories- Dow Theory, Eliot Wave theory. Charts-Types, Trends and Trend Reversal
Patterns. Mathematical Indicators –Moving Average Convergence-Divergence, Relative Strength
Index (Theory only).

Fundamental Analysis:
It is the examination of various factors such as earnings of the company, growth rate and risk exposure
that affects the value of shares of a company. The intrinsic value of an equity share depends on various
factors. The earnings of the company, the growth rate & the risk exposure of the company have a direct
impact on the price of the share. These factors in turn rely on many other factors like economic
environment in which they function, the industry they belong to and finally companies own performance.
The fundamental school of thought appraised the intrinsic value of shares through EIC frame work-
 Economic Analysis
 Industry Analysis
 Company Analysis

Economic Analysis:
It is the analysis of various macro economic factors that have a significant bearing on the stock market.
The level of economic activity has an impact on investment in many ways. If the economy grows rapidly,
the industry can also be expected to show rapid growth & vice versa. When the level of economic activity
is low, stock prices are low & when the economic activity is high, stock prices are high reflecting the
prosperous outlook for sales & profits of the firms. The commonly analyzed macro economic factors are:
1. Gross Domestic Product: GDP indicates the rate growth of the economy. GDP represents the
aggregate value of the goods & services produced in the economy. GDP consist of personal
consumption expenditure, gross private domestic investment & government expenditure on goods &

Department of MBA SIET Page 35

 services & net export of goods& services. The GDP estimates are available on an annual basis.
2. Saving &Investment: It is obvious that growth requires investment which in turn required
substantial amount of domes savings. Stock market is a channel through which the savings of the
investors are made available to corporate bodies. Savings are distributed over various assets like
equity shares, deposits, mutual funds units, real estate & bullion. The savings & investment patterns
of the public affect the stock to great extent.
3. Inflation: Along with the growth of GDP, if the inflation rate also increases, then the real rate of
growth would be very little. The demand in the consumer product industry is significantly affected.
The industries which come under the government price control policy may lose the market, for
example sugar. The government control over this industry affects the price of sugar & thereby the
profitability of the industry itself.
4. Interest Rates: The interest rates affect the cost of financing the firms. A decrease in the interest
rate implies lower cost of finance for firms & more profitability. More money is availability of
cheap fund encourages speculation & rise in the price of shares.
5. Budget: The budget draft provides an elaborate account of the government revenues &
expenditures. Deficit budget may lead to high rate of inflation & adversely affect the cost of
production. Surplus budget may result in deflation. Hence, balanced budget is highly favorable to
the stock market.
6. The Tax Structure: Every year in March, the business community eagerly awaits the government’s
announcement regarding the tax policy. Concessions & incentives given to a certain industry.
Encourage investment in that particular industry. Tax relieves are given to encourage savings. The
type of tax exemption has impact on the profitability of the industries.
7. The Balance of Payment: The balance of payment is a record of a countries, money receipts from
& payments abroad. The difference between receipts & payments may be surplus or deficit. Balance
of payment is a measure of the strength of rupee on external accounts. If the deficit increases, the
rupee may depreciate against other currencies, thereby, affecting the cost of impacts. A favorable
balance of payment renders a positive effect on the stock market.
8. Monsoon &Agriculture: Agriculture is directly & indirectly linked with industries. For example,
sugar, cotton, textile and food processing industries depend upon agriculture for raw material.
Fertilizer & insecticide industries are supplying inputs to the agriculture. A good monsoon leads to a
higher demand for input and results in the bumper crop.
9. Infrastructure Facilities: Infrastructure facilities are essentials for growth of the industrial and
agriculture sector. A wide network of communication system is a must for the growth of the
economy. Regular supply of power without any power cut would boost the production. Banking and
financial sectors also should be sound enough to provide adequate support to the industry and
agriculture. Good infrastructure facilities affect the stock favorably. In India even through
infrastructure facilities have been developed, still they are not adequate. The government has
liberalized its policy regarding the communication, transport and the power sector.
10. Demographic Factors: The demographic factors provide details about the popularity by age,
occupation, literacy and geographic location. This is needed to forecast the demand for the
consumer goods. The population by age indicates the availability of able work force.
11. Economic Forecasting: To estimate the stock price changes, an analyst has to analyze the
macroeconomic environment and the factors peculiar to the industry he is concerned with. The
economic activities affect the corporate profits, investors, attitude and the share prices.
12. Economic Indicators: The economic indicators are the factors that indicate the present status,
progress or slowdown of the economy. They are capital investment, business profits, money supply,
GNP, interest rate, unemployment rate etc. The economic indicators are grouped into leading,
coincidental and lagging indicators.
13. Diffusion Index: Diffusion index is a composite or consensus index. The diffusion index consists
of leading, coincidental and lagging indicators, this type of index has been constructed by the
National Bureau of Economic Research is USA.

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 14. Econometric Model Building: For model building several economic variables are taken into
consideration. The assumptions underlying the analysis are specified. The relationship between the
independent and depends variables is given mathematically. While using the model, the analyst has
to think clearly all the inter relationship between the variables.

Industry Analysis
An industry is a group of firm that has similar technological structure of production & production similar
products. For the convenience of the investors, the board classification of industry is given in financial
details and magazines companies are distinctly classified to give a clear picture about their manufacturing
process and products. These industries can be classified on the basis of business cycle. They are,

1. The growth industries have special features f high rate of earnings and growth in expansion,
independent of the business cycle. The expansion of the business industry mainly depends on the
technological changes. For instance, invite of the decision in the Indian economy in 1997-98 there
was a spurt in growth of information technology industry. It defines the business cycle and continued
grow.
2. Cyclical industry: The growth and the profitability of the industry move along with the business
cycle. During the boom period they enjoy growth and during depression they suffer a setback. For
example, the white goods like fridge, washing machine and kitchen range products command a good
market in the boom period and the demand for them slackens during the recession.
3. Defensive Industry: Defensive industry defines the movement of the business cycle. For example,
shelter is the basic requirements of humanity. The food industry withstands recession and depression.
The stocks of the defensive industries can be held by the investor for income earning purpose. They
expand and earn income in the depression period too, under the government’s umbrella of protection
and counter cyclical in nature.
4. Cyclical growth industry: This is a new type of industry that is cyclical and at the same time growing.
For example, the automobile industry experiences periods of stagnation, decline but grow
tremendously. The changes in technology and introduction of new models help the automobile
industry to remain their growth path.

Industry life cycle:

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1. Introduction / Startup stage: The prospective demand for the product is promising in this stage and
the technology of the product is low. The demand for the product attracts many produce the particular
product. There would be severe competition and only fittest companies survive this stage. The severe
competition often leads to the change of position of the firms in terms of market shares and profit. In
this situation, it is difficult to select companies for investment because the survival rate is unknown.
2. Rapid growth stage: This stage starts with the appearance of surviving firms from the pioneering
stage. The companies that have withstood the competition grow strongly in market share & financial
performance. The technology of the production would have improved resulting in low cost of
production & good quality products. The companies have stable growth rate in this stage & they
declare dividend to the shareholders. It is advisable to invest in the shares of these companies. In this
stage the growth rate is more than the industry’s average rate.
3. Maturity and stabilization stage: In the stabilization stage, the growth rate tends to moderate and
the rate of growth would be more or less equal to the industrial growth rate or the gross domestic
product growth rate. Symptoms of obsolescence may appear in the technology. To keep going,
technological innovations in the production process & products should be introduced. The investors
have to closely monitor the events that take place in the maturity stage of the industry.
4. Decline stage: In this stage, demand for the particular product & the earnings of the companies in the
industry decline. Innovation of new products & changes in consumer preferences lead to this stage.
The specific feature of the declining stage is that even in the boom period; the growth of the industry
would be low & decline at a higher rate during the recession. It is better to avoid investing in the
shares of the low growth industry even in the boom period. Investment in these types of companies
leads to erosion of capital.

An investor must analyze the following factors:

Past sales and earnings performance

Permanence / Existence

Attitude of government towards Industry

Labor Conditions

Competitive conditions

Industry share prices relative to its earnings

Economic Variables - demographic, lifestyle, technology, politics and regulations

Company analysis
In the company analysis the investor assimilates the several bits of information related to the company &
evaluates the present & future values of the stock. The risk & return associated with the purchase of the
stock is analyzed to take better investment decisions. The valuation process depends upon the investor’s
ability to elicit information from the relationship & interrelationship among the company related
variables. The present & future values are affected by number of factors & they are given below

1. Competitive edge of the company: Major industries in India are composed of hundreds of individual
of individual companies. In the information technology industry even though the number of

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 companies is large, few companies like Tata InfoTech, Infosys, NUT etc., control the major market
share. Once the companies obtain the leadership position in the market, they seldom to lose it. Over
the time they would have proved their ability to withstand competition and to have a sizeable share in
the market. The competitiveness of the company can be studied with the help of the market share, the
growth of annual sales, and the stability of annual sales.
2. Earnings of the company: Sales alone do not increase the earnings but the costs and expenses of the
company also influence the earnings of the company. Even though there is a relationship between
sales and earnings, it is not a perfect one. Sometimes, the volume of sales mat decline but the earnings
may improve due to the rise in the unit price of the article. Hence, the investor should not depend only
on the sales, but should analyze the earnings of the company.
3. Capital structure: The equity holder’s return can be increased manifold with the help of financial
leverage, i.e., using debt financing along with equity financing. The effect of financial leverage is
measured by computing leverage ratios.
4. Management: Good and capable management generates profit to the investors. He management of
the firm should efficiently plan, organize, actuate and control the activities of the company. The basic
objective of management is to attain the stated objectives of company for the good of the equity
holders, the public and the employees.
5. Financial performance: The best source to analyze the company’s financial performance is its own
financial statements. Financial statement analysis is the study of a company’s financial statement
from various viewpoints. The statement gives the historical and current information about the
company’s operations; historical financial statement helps to predict the future. The current
information aids to analyze the present status of the company. The two main statements used in the
analysis are: Balance sheet, Profit and Loss account.
6. Operating efficiency: The operating efficiency of a company directly affects the earnings of a
company. An expanding company that maintains high operating efficiency with a low breakeven
point earns more than the company with high break-even point. Efficient use of fixed assets with raw
materials, labor and management would lead to more income from sale. This leads to internal fund
generation for the expansion of the firm. A growing company should have low operating ratio to meet
the growing demand for its product.

Objectives and beliefs of fundamental analysts:

Fundamental analysis is performed on historical and present data, but with the goal of making financial
forecasts. There are several possible objectives:

 To conduct a company stock valuation and predict its probable price evolution

 To make a projection on its business performance,

 To evaluate its management and make internal business decisions,

 To calculate its credit risk.

Financial Analysis:
Financial Statement Analysis:
- Income Statement (P&L)
- Balance sheet

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 - Statement of cashflow
 It involves analyzing the financial statements of the company.

 The financial statements of the company include:

 Balance sheet: It shows the status of a company’s financial position at the end of the year.

 Profit and loss account: It shows the profit and loss made by the company during a
period.

Analysis of Financial Statements

It helps the investor in determining the financial position and progress of the company. The various
simple analyses that are performed to ascertain the financial position of the company are:

1. Comparative financial statement: In this, data from the current year’s balance sheet is compared
with similar data from the previous year’s balance sheet.

2. Trend analysis: It shows the growth and decline of sale and profit over the years.

3. Common size income statement: It shows each item of expense as a percentage of net sales.

4. Fund flow analysis: It is a statement of the sources and application of funds.

5. Cash flow analysis: It shows cash inflow and outflow of a company during the year.

6. Ratio analysis: It is the numerical relationship between the two items.

Ratio Analysis:
- Liquidity ratio
- Profitability Ratio
- Leverage ratio
- Activity ratio

Non-Financial Indicators:

1. Business of the Company: The investor should know whether the company is a well-established
one, whether it has a good product range and whether its lines of business have considerable potential
to grow.
2. Top Management: The quality of top management team, particularly, the competence and the
commitment of the Chief Executive Officer matters a lot in shaping the destiny of the company.
3. Product Range: Progressive companies like ITC and Hindustan Lever create competition for their
existing products by launching new products with regular frequency. Hence, investors must examine
whether the company under review belongs to this group or not.
4. Diversification: An issue related to that of product range is diversification. To reduce the degree of
business risk and improve profitability, many companies resort to diversification. Hence, this issue is
to be carefully examined by the investor.

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5. Foreign Collaboration: Where a company has entered into technical collaboration with a foreign
company, the investor must find out more about the nature of the collaboration agreement
6. Availability of Cost of Inputs: If the company depends upon imported raw materials, it is important
for the investors to assess the raw material position, because any shortage of the raw material and/or
escalation in the cost of raw material will adversely affect the profitability.
7. Research and Development. Progressive companies spend substantial sums of money on R&D to
upgrade their existing products, introduce new products, adapt foreign technology to suit the local
conditions, achieve import substitution, etc.
8. Governmental Regulations: The investor must assess the implications of governmental regulations
such as MRTP Act. FERA, etc., for the company under review ) Pattern of Shareholding and Listing:
The pattern of shareholding has a bearing on the floating stock available in the market and the trading
volume of these issues will have an effect on the company, hence it will be analyzed by the investor
before taking any investment decision.

Sources of Information

a. Internal Information: It involves data and events made public by the company regarding its
operations. The principal source of internal information about a company is its financial statements.
Apart from financial statements, internal information may also come from annual reports, public and
private statements of the managers, etc.
b. External information: Information may be obtained through external sources such as newspapers,
journals and magazines, filings with regulators such as SEBI or stock exchange, financial websites,
etc.

TECHNICAL ANALYSIS
The fundamental approach analyses the share prices on the bases of economic, industry and company
statics. If the price of the shares is lower than its intrinsic value, investor buys it. But, if he finds the price
of the share higher than the intrinsic value he sells and gets profit.

The technical analyst mainly studies the stock price movement of the security market. It is a process of
identifying trend reversals at an earlier stage to formulate the buying and selling strategy. With the help of
several indicators they analyze the relationship between price- volume and supply demand for the overall
market and the individual stock. Volume is favorable in the upswing i.e., the number of shares traded is
greater than before and on the downside the number of shares traded dwindles. If it is the other way
round, trend reversals can be expected.

Dow-Theory
Technical analysis has come a long way over the years and one can employ various methods to
arrive at their trading decisions. But the foundation of technical analysis dates back to the early
1900s based on the collected work of Charles Dow.
His observations which are currently known as Dow Theory are still used by the market participants
to base their investment/trading decisions. In this article, we will explore the 6 Basic Tenets Of
Dow Theory and get a better understanding of them.
6 Basic Tenets Of Dow Theory

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1. The Market Discounts Everything:
The Dow Theory functions on the efficient market hypothesis (EMH), which states that asset prices
reflect all available information. This means that price trends will change in response to new
information that is available. Competitive advantage, earnings potential, management competence—
all of these and other criteria are priced into the market, even if everyone is aware of all or all of
them.
2. Markets consist of three types of trends
This is one of the significant tenants of Dow Theory that explains the movements in the market with
three main trends
 Primary Trend:
The primary trend is the main trend in the market that can last for more than a year. This trend can
either be bullish or bearish and indicates long-term movement in the market. The other two trends
will be formed within the primary trend. Dow refers to it as tides in the sea.

 Secondary Trend:
The secondary trend is the one that runs counter to the primary trend. It is assumed to be a correction
of the primary trend, causing the primary trend to lose two-thirds of its value. This trend can last from
a duration of three weeks to a few months. Charles Dow calls it waves in the sea.

 Minor Trend:
The minor trend is a small pullback of the secondary trend that can last anywhere between a few days
to a few months. Dow considers these trends as market noise.

3. The market trends have three phases

As per Dow Theory, the market is marked by three phases irrespective of whether it is in an upward
or downward trend.
The phases in the upward trend consist of:

Phase 1- Accumulation phase: This is the beginning of an uptrend where the investor/traders enter the
market to buy the securities against the common market conception.

Phase 2- Public participation phase: Also referred to as the response phase, the public participation
phase is when retail and average investors begin to notice the upward trend and join in. It is the
important and longest phase of a trend.

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 Phase 3- Excess phase: This is a phase where signs of instability appear and experienced investors
and traders begin closing their positions. The larger average investing population, on the other hand,
continues to add to their investments. This will be followed by a fall in the security.

The phases in the downward trend consist of:

Phase 1- Distribution phase: This is the beginning of an uptrend where the investor/traders sell the
securities against the common market conception.

Phase 2- Public participation phase: Retail investors notice the downtrend and start selling stocks and
exiting positions to reduce losses. It is again the longest phase in the market

Phase 3- Panic phase: Investors have given up hope of a correction or full reversal and are continuing
to sell at a large scale which has caused the security to fall significantly.

4. Indices Must Confirm Each Other

As per Charles Dow, the trends must confirm with each other in order to determine if the trend has
been established. Meaning, the movement of one index must correspond to the movement of all other
indices in the market. Only then can we call the market bullish or bearish.
Suppose, the NIfty 50 is primarily moving in an uptrend, but the other indices in the market like the
Nifty 500, and NIFTY Midcap are in a downtrend. In this situation, it is not accurate to consider that
markets are bearish, as the NIfty 50 is bullish. According to Dow, only when all of the indices move
in the same direction can the trend be identified concretely.
5. Volume Must Confirm the Trend
Trading volume increases when the price goes in the direction of the primary trend and falls when it
moves against it. Low volumes indicate a weakness in the trend. For instance, Buying volume should
increase as the price rises during a bullish primary trend and should the selling volume should fall
during secondary pullbacks. If selling volume increases during a pullback, it may indicate that more
market participants are becoming bearish.
6. Trends Persist Until a Clear Reversal Occurs
Charles Dow noticed that secondary trends might be easily confused with trend reversals. This is
because both of these price fluctuations go in the opposite direction of the primary trend. Assume the
market is currently predominantly bearish. A brief rise may appear to be a trend reversal. However, it
is possible that this is merely a secondary tendency. As per Dow theory, even if the market is

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 temporarily up, you must continue to consider it bearish until it is evident that the upward momentum
has been established.

Elliott wave theory

Another theory that attempts to explain long term pattern in price behavior is the Elliott wave theory.
Basic proposition of this theory is that the stock prices in the market can be described as a set of wave
patterns. It states that the long term major patterns may consist of five successive steps on five waves. In
each case of bull market, the set of five waves is as follows: the first wave is upward, the second is
downward, the third is upward, the fourth is downward and the fifth is upward. In case of bear market, the
reverse pattern follows i.e., downward, upward, downward, upward and downward.

Elliott Wave Principle

This market theory attempts to forecast market trends by identifying the extremes in trader’s collective psychology
that create the highs and lows in price action. It looks for areas of exhaustion by buyers and sellers inside trends with
inverse swings in price action.

Elliott Five Wave Pattern

Wave 1: Wave one is rarely obvious at the beginning. When the first wave of a new bull market begins, the
fundamental news is almost universally negative. The previous trend is considered still strongly in force.
Fundamental analysts continue to revise their earnings estimates lower; the economy probably doesn’t look strong.
Sentiment surveys are decidedly bearish, put options are popular, and implied volatility in the options market is
high. Volume might increase a bit as prices rise, but not by enough to alert many technical analysts.

Wave 2: Wave two corrects wave one, but can never extend beyond the starting point of wave one. Typically, the
news is still bad. As prices retest the prior low, bearish sentiment quickly builds, and the majority reminds everyone
through social media and television that the bear market is still deeply in place. Still, some positive signs appear for
those who are looking: volume should be lower during wave two than during wave one, prices usually do not retrace
more than 61.8% of the wave 1 gains, and prices should fall in a three wave pattern.

Wave 3: Wave three is usually the largest and most powerful wave in a trend, although some research suggests that
in commodity markets, wave five is the largest. The news is now positive and fundamental analysts start to raise
earnings estimates. Prices rise quickly, corrections are short-lived and shallow. Anyone looking to get in on a
pullback will likely miss the move. As wave 3 starts, the news is probably still bearish, and most market players

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remain negative; but by wave 3’s midpoint, the crowd will often join the new bullish trend. Wave 3 often extends
wave 1 by a ratio of 1.618:1.

Wave 4: Wave four is typically clearly corrective. Prices may meander sideways for an extended period, and wave
four typically retraces less than 38.2% of wave 3. Volume is well below than that of wave 3. This is a good place to
buy a pull back if you understand the potential ahead for wave 5. Still, 4th waves are often frustrating because of
their lack of progress in the larger trend.

Wave 5: Wave five is the final leg in the direction of the dominant trend. The news is almost universally positive
and everyone is bullish. Unfortunately, this is when many average investors finally buy in, right before the top.
Volume is often lower in wave 5 than in wave 3, and many momentum indicators start to show divergences, prices
reach a new high but the indicators do not reach a new peak. At the end of a major bull market, bears may very well
be ridiculed, recall how forecasts for a top in the stock market during 2000, 2007, and 2020 were all rejected.

Wave A: Corrections are typically harder to identify than impulse moves. In wave A of a bear market, the
fundamental news is usually still positive. Most analysts see the drop as a correction inside an active bull market.
Some technical indicators that accompany wave A include increased volume, rising implied volatility in the options
markets and possibly a turn higher in open interest in related futures markets.

Wave B: Prices reverse higher, which many see as a resumption of the now long-gone bull market. Those familiar
with classical technical analysis may see the peak as the right shoulder of a head and shoulders reversal pattern. The
volume during wave B should be lower than in wave A. By this point, fundamentals are probably no longer
improving, but they most likely have not yet turned negative.

Wave C: Prices move impulsively lower in five waves. Volume picks up, and by the third leg of wave C, almost
everyone realizes that a bear market is firmly entrenched. Wave C is typically at least as large as wave A and often
extends to 1.618 times wave A or beyond.

Charts
Charts are graphic presentations of the stock prices. These also have the following uses:

 Spots the current trend for buying and selling

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  Indicates the probable future action of the market by projection

 Shows the past historic movement

 Indicates the important areas of support and resistance

Types of charts:
Point and Figure Charts

To predict the extent and direction of price movements of a stock or the stock market indices, technical
analysts use point and figure (PF) charts. These charts are one-dimensional without any indication of time
or volume. They show price changes in relation to previous prices. The change in the direction of prices
can be interpreted. The charts are drawn on ruled paper.

 These charts are one-dimensional and there is no indication of time or volume.

 The price changes in relation to previous prices are shown.

 The change of price direction can be interpreted.

Some inherent disadvantages are:

 They do not show the intra-day price movement.

 Only whole numbers are taken into consideration, resulting in loss of information regarding
minor fluctuations.

 Volume is not mentioned in the chart.

Bar Charts

One of the basic tools of technical analysis is the bar chart, where the open, close, high, and low prices of
stocks or other financial instruments are embedded in bars, plotted as a series of prices over a specific
time period. Bar charts are often called OHLC charts (open-high-low-close charts) to distinguish these
charts from more traditional bar charts used to depict other types of data. Bar charts allows traders to see
patterns more easily. In other words, each bar is actually just a set of 4 prices for a given day, or some
other time period, connected by a bar in a specific way — called a price bar.

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Line Chart

Line charts are used to show price movements. The line chart is a simplification of the bar chart. Here, a
line is drawn to connect the successive closing prices. Line chart is another type of a basic chart. The line
chart is a simplest presentation of movement in any variable. The ‘x’ axis depicts the time where as the
‘y’ axis shows variable. The value of the variable for different dates are plotted on the graph, all the
points are then joined ay a line. This is known as the variable line.

Japanese Candlestick Chart

According to records, the candlestick chart is the oldest of price prediction charts. In the 1700s, people
used candlesticks to forecast rice prices. During this era in Japan, use of candlestick charts helped
Munehisa Homma, a rice merchant from Sakata, make a fortune and become a prominent rice trader. The
application of candlesticks helped him execute more than 100 consecutive winning trades. To create a
candlestick chart, one needs four elements, namely, open, high, low and closing prices for a given period

Just like a bar chart, a daily candlestick shows the market's open, high, low, and close prices for the day.
The candlestick has a wide part called the "real body." This real body represents the price range between
the open and close of that day's trading. When the real body is filled in or black (also red), it means the
close was lower than the open. If the real body is white (or green), it means the close was higher than the
open.

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Chart Pattern
Charts reveal certain patterns that are of predictive value. They are used as a supplement to other
information and as confirmation of signals provided by trend lines. Some of the most widely
used and easily recognizable chart patterns are discussed here.
1. V Formation: As the name indicates, in the 'V' formation, there is a long sharp decline and a
fast reversal. The 'V' pattern occurs mostly in popular stocks where the market interest
changes quickly from hope to fear and vice versa. In the case of an inverted 'V', first the rise
occurs and then the decline. There can also be extended 'V's. In it, the bottom or top moves
more slowly over a broader area

2. Top and bottom

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3. Double top and bottom

This formation signals the end of one trend and the beginning of another. The double top is formed when
a stock price rises to a certain level, falls rapidly, rises again to the same height or more, and turns down.
Its pattern resembles the letter 'M'. The double top may indicate the onset of the bear market. The result
should be confirmed with share volumes and trends. In a double bottom, the price of the stock falls to a
certain level and increases with diminishing activity. Then it falls again to the same or to a lower price
and then goes up to a higher level. The double bottom resembles the letter 'W'. Technical analysts view
double bottom as a sign of a bull market.

4. Head and Shoulder and Inverted head and shoulders

This pattern is easy to identify and the signal generated by it is considered to be reliable. In the head and
shoulder pattern, there are three rallies resembling the left shoulder, a head and a right shoulder. A
neckline is drawn connecting the lows of the tops. When the stock price cuts the neckline from above, it
signals a bear market. The upward movement of the price for some duration creates the left shoulder. At
the top of the left shoulder, people who bought during the upward trend begin to sell, resulting in a dip.

5. Triangle

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6. Rounding bottom

7. Cup and handle

Indicators
Volume of Trade

 Volume expands along with the bull market and narrows down in the bear market.

 Technical analyst use volume as an excellent method of confirming the trend.

Breadth of the Market

• The net difference between the number of stock advanced and declined during the same period is the
breadth of the market.

• A cumulative index of net differences measures the market breadth.

Short sales

 This is a technical indicator also known as short interest.

 It refers to the selling of shares that are not owned.

 They show the general situations.

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Mathematical Indicators
Moving Average

The market indices do not rise or fall in straight line. The word moving means that the body of data
moves ahead to include the recent observation. It is the five day moving average, on the sixth day the
body of data moves to include the sixth day observation eliminating the first day’s observation in moving
average closing price of the stock issued.

Oscillators

Oscillator shows the share price movement across a reference point from one extreme to another. The
momentum indicates:
 Overbought and oversold conditions of the scrip or the market.
 Signaling the possible trend reversal.
 Rise or decline in the momentum.

Relative Strength Index [RSI]

Relative Strength index [RSI] was developed by wells wilder. It is an oscillator used to identify the
inherent technical strength and weakness of a particular scrip or market.
 RSI was developed by Wells Wilder.

 Measures the speed and change of price movement

 Identifies the inherent technical strength and weakness of a particular scrip or market. RSI can be
calculated for a script by adopting the following formula

Rate of Change (ROC)

The Rate-of-Change (ROC) indicator, which is also referred to as simply Momentum, is a pure
momentum oscillator that measures the percent change in price from one period to the next. As a
momentum oscillator, ROC signals include centerline crossovers, divergences and overbought-over sold
readings.
 Measures the rate of change between the current price and the price ‘n’ number of days in the past.
 ROC helps to find out the overbought and oversold positions in a scrip.
 ROC can be calculated by two methods.
 In the first method current closing price is expressed as a percentage of the 12 days or weeks in past.

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  In the second method, the percentage variation between the current price and the price 12 days in
the past is calculated.

Relative Strength Analysis [RSA]

Relative strength analysis is based on the assumption that prices of some securities rise rapidly during the
bull phase but falls slowly during the bear phase in relation to the market as a whole. Such securities
possess greater relative strength.

Market Efficiency:
When money is put into the stock market, the goal is to generate a return on the capital invested. Many
investors try not only to make a profitable return, but also to outperform, or beat, the market.

Efficient market Hypothesis

Capital market is a market for long-term financial assets and securities, i.e., the shares and the debentures.
These securities are regularly transacted, i.e., sold and purchased at the prevailing price which is supposed
to reflect all the information relating to the issuing company. To understand how these share prices are
adjusted, and how securities are valued or priced in the market, it is necessary to have an understanding of
the concept of efficient markets. The market prices of shares and debentures fluctuate widely on a regular
basis.

Why does this occur? At least a part of the answer is that new information about the company pours in
continuously, and the investors reassess their valuation based on this information. All new and material
information relating to the company is reflected in the movement of prices of the securities of the
company. However, the speed at which this movement in prices appears and the speed at which the prices
of the securities reach an equilibrium level depends upon the efficiency of the capital market. The
efficiency of a capital market is often defined in terms of its ability to reflect the impact of all relevant
information in the prices of the securities.

An efficient market is one which ensures that the prices of the securities quickly adjust to new
information and reflect it in the market prices of the securities. The information is reflected in share prices
with such speed that there are no opportunities for investors to profit from publicly available information.
An efficient market is one in which any new information is rapidly processed so that securities are
properly priced.

1. Weak Form of Market Efficiency: In the weak from of efficiency, the security prices reflect all
past data, i.e., all historical information about the company is already reflected in the current prices.
This version of market efficiency implies that historical prices and data are of no use to predict
future prices. The trend analysis of security prices is useless. The security prices may move
randomly and no sure prediction about the future prices of shares can be made on the basis of past
or existing prices. The weak form of efficiency is also known as Random Walk Theory which states
that the securities prices move as a result of inflow of news which randomly enters the market. Any
publicly available information including information on industry plans or management, that can be
used to forecast share prices, should already be reflected in share prices in the market. The reason
being that if there is any information indicating that the share, is underpriced [or over-priced0, t will
make the investors to buy [or sell] immediately and thus bringing the price to a fair level where only

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 normal; rate of return can be expected. So, if the prices bid to be at fair level, then the prices
increase or decrease only in response to the new information which is obviously unpredictable. If it
could be predicted, then the prediction would be a part of today’s information. As, the information
is random, the security prices behave randomly.

2. Semi-strong Form of Market Efficiency: In the semi strong form of market efficiency, the current
prices in the capital market not only reflect the historical information but are also able to rapidly
adjust to all the publicly known information. Semi-strong form maintains that as soon as
information becomes publicly available, it is absorbed in the prices. So, the security prices reflect all
the publicly available information. This information may be available in the form of financial
statements or other publications issued by the company. Such information may relate to product
line, quality of management, earnings forecast, patents, merger proposals, etc. As soon as
information is available, the investors will buy or sell the securities on the basis of the type and
nature of information and soon the impact would be reflected in the share prices. As all public
information is already reflected in the value of a security, no one can use the fundamental analysis
to determine whether a stock is overvalued or undervalued. The semi-strong form supports the view
that there is no learning lad among the investors. Whenever new information is generated, all the
participants in the market access the information with equal speed and efficiency. No investor
would be able to out-perform the market which quickly incorporates all the available information. It
may be noted that the semi-strong form of efficiency encompasses the weak form also, because the
past data are a part of publicly known and available information.

3. Strong Form of Market Efficiency: In the strong form of market efficiency, the securities prices
reflect all information, whether published or unpublished and even private inside information. All
the information that can be known about a company including privileged inside information that
might be available to only select few insiders is reflected in prices. In such a market, no investor
would be able to earn abnormal return by using any information because that information is already
reflected in the securities prices. Strong form of efficiency maintains that not only publicly available
information is useless to the investor but all information is useless. No groups of market participants
or investors have monopolistic access to information and consequently, cannot be expected to show
superior return under any circumstances.

Empirical Tests for Different Forms of Market Efficiency:

Random Walk Hypothesis: This test involves examining whether past price movements are
independent of future price movements, which would support the weak-form efficiency of the market.
One common test for this is the Runs Test, which analyzes sequences of positive and negative returns
to determine if they are random or exhibit patterns.
Event Studies: Event studies analyze how asset prices react to specific events, such as earnings
announcements, mergers, or economic releases. If asset prices adjust rapidly and fully to new
information, it supports the semi-strong form efficiency of the market.
Insider Trading Studies: These studies examine whether insiders, who have access to non-public
information, consistently earn abnormal returns. If insider trading does not consistently outperform
the market, it suggests strong-form efficiency.
Long-term Performance Analysis: Researchers may analyze the performance of actively managed
mutual funds or hedge funds over the long term to see if they outperform their respective benchmarks
consistently. If they do not, it supports the semi-strong or strong form efficiency of the market.
Market Anomalies: Research may identify anomalies or patterns in asset prices that seem to persist
over time. These anomalies, such as the January effect or the size effect, may challenge the efficiency
of the market and prompt further investigation into the underlying causes.

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 Module-6

Modern Portfolio Theory: Markowitz Model -Portfolio Selection, Opportunity set, Efficient
Frontier. Beta Measurement and Sharpe Single Index Model Capital Asset pricing model: Basic
Assumptions, CAPM Equation, Security Market line, Extension of Capital Asset pricing Model -
Capital market line, SML VS CML. Arbitrage Pricing Theory: Arbitrage, Equation, Assumption,
Equilibrium, APT and CAPM.

Portfolio

Portfolio is a combination of securities such as stocks, bonds and money market instruments. The process
of blending together the broad asset classes so as to obtain optimum return with minimum risk is called
portfolio construction. Diversification of investments helps to spread risk over many assets.

Approaches in Portfolio Construction

- Traditional approach evaluates the entire financial plan of the individual.

- In the modern approach, portfolios are constructed to maximize the expected return for a given level
of risk.

Traditional Approach

 The traditional approach basically deals with two major decisions:

 Determining the objectives of the portfolio
 Selection of securities to be included in the portfolio

Analysis of Constraints

 Income needs
 Liquidity
 Need for current income
 Need for constant income
 Safety of the principal
 Time horizon
 Tax consideration
 Temperament

Determination of Objectives

Current income
Growth in income
Capital appreciation
Preservation of capital

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Selection of Portfolio

Objectives and asset mix

Growth of income and asset mix
Capital appreciation and asset mix
Safety of principal and asset mix
Risk and return analysis

Diversification

According to the investor’s need for income and risk tolerance level portfolio is diversified.
In the bond portfolio, the investor has to strike a balance between the short term and long term bonds.

Stock Portfolio Modern Approach

Modern approach gives more attention to the process of selecting the portfolio.
The selection is based on the risk and return analysis.
Return includes the market return and dividend.
Investors are assumed to be indifferent towards the form of return.
The final step is asset allocation process that is to choose the portfolio that meets the requirement of
the investor.

Managing the Portfolio

Investor can adopt passive approach or active approach towards the management of the portfolio.
In the passive approach the investor would maintain the percentage allocation of asset classes and
keep the security holdings within its place over the established holding period.
In the active approach the investor continuously assess the risk and return of the securities within the
asset classes and changes them accordingly.

Simple Diversification

Portfolio risk can be reduced by the simplest kind of diversification.

In the case of common stocks, diversification reduces the unsystematic risk or unique risk.
But diversification cannot reduce systematic or undiversifiable risk.

Diversification and Portfolio Risk Problems of Vast Diversification

Purchase of poor performers

Information inadequacy
High research cost
High transaction cost

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The Markowitz Model Assumptions:

 The individual investor estimates risk on the basis of variability of returns.

 Investor’s decision is solely based on the expected return and variance of returns only.
 For a given level of risk, investor prefers higher return to lower return.
 Likewise, for a given level of return investor prefers lower risk than higher risk.

Markowitz Efficient Frontier

Utility Analysis

 Utility is the satisfaction the investor enjoys from the portfolio return.

 The investor gets more satisfaction of more utility in X + 1 rupees than from X rupee.

 Utility increases with increase in return.

Fair Gamble

 In a fair gamble which costs Re 1, the outcomes are A and B events.

 Event ‘A’ will yield Rs 2.

 Occurrence of B event is a dead loss i.e. 0.

 The chance of occurrence of both the events is 50: 50.

 The expected value of investment is

(½)2 + ½(0) = Re 1.

Type of Investors

 Risk averse investor rejects a fair gamble because the disutility of the loss is greater for him than the
utility of an equivalent gain.

 Risk neutral investor is indifferent to the fair gamble.

 The risk seeking investor would select a fair gamble i.e. he would choose to invest. The expected
utility of investment is higher than the expected utility of not investing.

Leveraged Portfolios

 To have a leveraged portfolio, investor has to consider not only risky assets but also risk- free assets.

 Secondly, he should be able to borrow and lend money at a given rate of interest.

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Risk Free Asset

The features of risk free asset are:

 Absence of default risk and interest risk.

 Full payment of principal and interest amount.

 The return from the risk free asset is certain and the standard deviation of the return is nil.

Need for Sharpe Model

 In Markowitz model a number of co-variances have to be estimated.

 If a financial institution buys 150 stocks, it has to estimate 11,175 i.e., (N2 – N)/2 correlation
coefficients.

 Sharpe assumed that the return of a security is linearly related to a single index like the market index.

 It needs 3N + 2 bits of information compared to [N (N + 3)/2] bits of information needed in the

Markowitz analysis.

Single Index Model

Stock prices are related to the market index and this relationship could be used to estimate the return of
stock.

The CAPM Theory

Markowitz, William Sharpe, John Lintner and Jan Mossin provided the basic structure for the CAPM
model. It is a model of linear general equilibrium return. The required rate return of an asset is having a
linear relationship with asset’s beta value i.e., undiversifiable or systematic risk.

Assumptions

 An individual seller or buyer cannot affect the price of a stock.

 Investors make their decisions only on the basis of the expected returns, standard deviations and
covariance of all pairs of securities.
 Investors are assumed to have homogenous expectations during the decision-making period.
 The investor can lend or borrow any amount of funds at the riskless rate of interest.
 Assets are infinitely divisible.
 There is no transaction cost.
 There is no personal income tax.
 Unlimited quantum of short sales is allowed.

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Lending and Borrowing

It is assumed that the investor could borrow or lend any amount of money at riskless rate of interest

Market Portfolio The market portfolio comprised of all stocks in the market. Each asset is held in
proportion to its market value to the total value of all risky assets.

Return: The expected return of an efficient portfolio is

Expected return = Price of time + (Price of risk × Amount of risk)

Price of time is the risk free rate of return

Price of risk is the premium amount higher and above the risk free return

Security Market Line

Capital market line does not show the risk-return trade off for other portfolios and individual securities.
Standard deviation includes the systematic and unsystematic risk. Unsystematic risk can be diversified
and it is not related to the market. Systematic risk could be measured by beta. The beta analysis is useful
for individual securities and portfolios whether efficient or inefficient.

Evaluation of Securities with SML

The stocks above the SML yield higher returns for the same level of risk.

Empirical Tests of the CAPM

The studies generally showed a significant positive relationship between the expected return and the
systematic risk. But the slope of the relationship is usually less than that of predicted by the CAPM. The
risk and return relationship appears to be linear. Empirical studies give no evidence of significant
curvature in the risk/return relationship. The CAPM theory implies that unsystematic risk is not relevant,
but unsystematic and systematic risks are positively related to security returns. The ambiguity of the
market portfolio leaves the CAPM untestable. If the CAPM were completely valid, it should apply to all
financial assets including bonds.

Present Validity of CAPM

 CAPM provides basic concepts which are truly of fundamental value.

 The CAPM has been useful in the selection of securities and portfolios.

 Given the estimate of the risk free rate, the beta of the firm, stock and the required market rate of
return, one can find out the expected returns for a firm’s security.

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Arbitrage

 Arbitrage is a process of earning profit by taking advantage of differential pricing for the same asset.

 The process generates riskless profit.

 In the security market, it is of selling security at a high price and the simultaneous purchase of the
same security.

The Assumptions

 The investors have homogenous expectations.

 The investors are risk averse and utility maximizes.

 Perfect competition prevails in the market and there is no transaction cost.

Arbitrage Portfolio

According to the APT theory, an investor tries to find out the possibility to increase returns from his
portfolio without increasing the funds in the portfolio. He also likes to keep the risk at the same level.

Factor Sensitivity

The factor sensitivity indicates the responsiveness of a security’s return to a particular factor. The
sensitiveness of the securities to any factor is the weighted average of the sensitivities of the securities.

The APT Model

According to Stephen Ross, returns of the securities are influenced by a number of macroeconomic
factors. The macro economic factors are: growth rate of industrial production, rate of inflation, spread
between long term and short term interest rates and spread between low grade and high grade bonds.

APT and CAPM

 The simplest form of APT model is consistent with the simple form of the CAPM model.

 APT is more general and less restrictive than CAPM.

 The APT model takes into account of the impact of numerous factors on the security.

 The market portfolio is well defined conceptually. In APT model, factors are not well specified.

 There is a lack of consistency in the measurements of the APT model.

 The influences of the factors are not independent of each other.

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 Module 7

Portfolio Management: Diversification- Investment objectives, Risk Assessment, Selection of

asset mix, Risk, Return and benefits from diversification. Mutual Funds:, Mutual Fund types,
Performance of Mutual Funds-NAV. Performance evaluation of Managed Portfolios- Treynor,
Sharpe and Jensen Measures Portfolio Management Strategies: Active and Passive Portfolio
Management strategy. Portfolio Revision: – Formula Plans-Rupee Cost Averaging

Portfolio Evaluation
Portfolio manager evaluates his portfolio performance and identifies the sources of strength and
weakness.

- The evaluation of the portfolio provides a feed back about the performance to evolve better
management strategy.

- Evaluation of portfolio performance is considered to be the last stage of investment process.

Sharpe’s Performance Index

- Sharpe index measures the risk premium of the portfolio relative to the total amount of risk in the
portfolio.
- Risk premium is the difference between the portfolio’s average rate of return and the riskless rate of
return.

Treynor’s Performance Index

- The relationship between a given market return and the fund’s return is given by the
characteristic line.
- The fund’s performance is measured in relation to the market performance.
- The ideal fund’s return rises at a faster rate than the general market performance when the
market is moving upwards.
- Its rate of return declines slowly than the market return, in the decline.

Jensen’s Performance Index

- The absolute adjusted return measure was developed by Michael Jensen

- The standard is based on the manager’s predictive ability.

Portfolio Revision

Beta co-efficient of portfolio

- The investor should have competence and skill in the revision of the portfolio.

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 - The portfolio management process needs frequent changes in the composition of stocks and
bonds.

- Mechanical methods are adopted to earn better profit through proper timing.

- Such type of mechanical methods is Formula Plans and Swaps.

Passive Management

Passive management refers to the investor’s attempt to construct a portfolio that resembles the overall
market returns. The simplest form of passive management is holding the index fund that is designed to
replicate a good and well defined index of the common stock such as BSE-Sensex or NSE-Nifty.

Active Management

Active Management is holding securities based on the forecast about the future. The portfolio managers
who pursue active strategy with respect to market components are called ‘market timers’. The managers
may indulge in ‘group rotations’.

The Formula Plans

The formula plans provide the basic rules and regulations for the purchase and sale of securities. The
aggressive portfolio consists more of common stocks which yield high return with high risk. The
conservative portfolio consists of more bonds that have fixed rate of returns

Assumptions of the Formula Plan

 Certain percentage of the investor’s fund is allocated to fixed income securities and common stocks.

 The portfolio is more aggressive in the low market and defensive when the market is on the rise.

 The stocks are bought and sold whenever there is a significant change in the price.

 The investor should strictly follow the formula plan once he chooses it.

 The investors should select good stocks that move along with the market.

Advantages of the Formula Plan

 Basic rules and regulations for the purchase and sale of securities are provided.

 The rules and regulations are rigid and help to overcome human emotion.

 The investor can earn higher profits by adopting the plans.

 It controls the buying and selling of securities by the investor.

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 It is useful for taking decisions on the timing of investments.

Disadvantages of the Formula Plan

 The formula plan does not help the selection of the security.
 It is strict and not flexible with the inherent problem of adjustment.
 Should be applied for long periods, otherwise the transaction cost may be high.
 Investor needs forecasting.

Rupee Cost Averaging

Stocks with good fundamentals and long term growth prospects should be selected. The investor should
make a regular commitment of buying shares at regular intervals. Reduces the average cost per share and
improves the possibility of gain over a long period.

Constant Rupee Plan

 A fixed amount of money is invested in selected stocks and bonds.

 When the price of the stocks increases, the investor sells sufficient amount of stocks to return to the
original amount of the investment in stocks.

 The investor must choose action points or revaluation points.

 The action points are the times at which the investor has to readjust the values of the stocks in the
portfolio.

Constant Ratio Plan

 Constant ratio between the aggressive and conservative portfolios is maintained.

 The ratio is fixed by the investor.

 The investor’s attitude towards risk and return plays a major role in fixing the ratio.

Variable Ratio Plan

At varying levels of market price, the proportions of the stocks and bonds change. Whenever the price of
the stock increases, the stocks are sold and new ratio is adopted by increasing the proportion of defensive
or conservative portfolio. To adopt this plan, the investor is required to estimate a long term trend in the
price of the stocks.

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Mutual Funds

Mutual funds are in the form of Trust (usually called Asset Management Company) that manages the pool
of money collected from various investors for investment in various classes of assets to achieve certain
financial goals. We can say that Mutual Fund is trusts which pool the savings of large number of investors
and then reinvests those funds for earning profits and then distribute the dividend among the investors. In
return for such services, Asset Management Companies charge small fees. Every Mutual Fund / launches
different schemes, each with a specific objective. Investors who share the same objectives invest in that
particular Scheme. Each Mutual Fund Scheme is managed by a Fund Manager with the help of his team
of professionals (One Fund Manage may be managing more than one scheme also).

Types of Mutual Funds

Mutual Funds can be classified into various categories under the following heads:-

A. According To Type Of Investments: - While launching a new scheme, every Mutual Fund is
supposed to declare in the prospectus the kind of instruments in which it will make investments of the
funds collected under that scheme. Thus, the various kinds of Mutual Fund schemes as categorized
according to the type of investments are as follows :- (A) Equity Funds / Schemes (B) Debt Funds /
Schemes (Also Called Income Funds) (C) Diversified Funds / Schemes (Also Called Balanced Funds)
(D) Gilt Funds / Schemes (E) Money Market Funds / Schemes (F) Sector Specific Funds (G) Index
Funds

B. According To The Time Of Closure Of The Scheme : While launching new schemes, Mutual
Funds also declare whether this will be an open ended scheme (i.e. there is no specific date when the
scheme will be closed) or there is a closing date when finally the scheme will be wind up. Thus,
according to the time of closure schemes are classified as follows: -

(A) Open Ended Schemes (B) Close Ended Schemes

Open ended funds are allowed to issue and redeem units any time during the life of the scheme, but
close ended funds cannot issue new units except in case of bonus or rights issue. Therefore, unit
capital of open ended funds can fluctuate on daily basis (as new investors may purchase fresh units),
but that is not the case for close ended schemes. In other words we can say that new investors can join
the scheme by directly applying to the mutual fund at applicable net asset value related prices in case
of open ended schemes but not in case of close ended schemes. In case of close ended schemes, new
investors can buy the units only from secondary markets.

C. According to Tax Incentive Schemes: Mutual Funds are also allowed to float some tax saving
schemes. Therefore, sometimes the schemes are classified according to this also: - (a) Tax Saving
Funds (b) Not Tax Saving Funds / Other Funds

D. According to The Time Of Payout: Sometimes Mutual Fund schemes are classified according to the
periodicity of the pay outs (i.e. dividend etc.). The categories are as follows: - (a) Dividend Paying
Schemes (b) Reinvestment Schemes

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Functions of Investment Companies

An investment company is a financial services firm that holds securities of other companies purely for
investment purposes. Investment companies come in different forms: exchange-traded funds, mutual
funds, money-market funds, and index funds. Investment companies collect funds from institutional and
retail investors, and are entrusted with making investments in financial instruments according to the
strategies that were previously agreed with the investors.

1. Collect Investments: Investment companies collect funds by issuing and selling shares to investors.
There are basically two types of investment companies: close-end and open-end companies. Close-
end companies issue a limited amount of shares that can then be traded in the secondary market--on a
stock exchange--whereas open-end company funds, e.g. mutual funds, issue new shares every time an
investor wants to buy its stocks.

2. Invest in Financial Instruments: Investment companies invest in financial instruments according to

the strategy of which that they made investors aware. There are a wide range of strategies and
financial instruments that investment companies use, offering investors different exposures to risks.
Investment companies invest in equities (stocks), fixed-income (bonds), currencies, commodities and
other assets.

3. Pay Out the Profits: The profits and losses that an investment company makes are shared among its
shareholders. Depending on the type--close-end or open-end--and the structure of the investment
company, investors can redeem their shares for cash from the company, sell the shares to another firm
or individual, or receive capital distributions when assets held by the investment company are sold.

4. Classification of Investment companies Unit Investment Trusts (UITs): A unit investment trust,
or UIT, is a company established under an indenture or similar agreement. It has the following
characteristics:

- the management of the trust is supervised by a trustee.

- Unit investment trusts sell a fixed number of shares to unit holders, who receive a proportionate
share of net income from the underlying trust.

- The UIT security is redeemable and represents an undivided interest in a specific portfolio of
securities.

- the portfolio is merely supervised, not managed, as it remains fixed for the life of the trust. In
other words, there is no day-to-day management of the portfolio.

5. Face Amount Certificates: A face amount certificate company issues debt certificates at a
predetermined rate of interest. Additional characteristics include:

- Certificate holders may redeem their certificates for a fixed amount on a specified date, or for a
specific surrender value, before maturity.
- Certificates can be purchased either in periodic installments or all at once with a lump-sum
payment.
- Face amount certificate companies are almost nonexistent today.

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6. Management Investment Companies The most common type of Investment Company is the
management investment company, which actively manages a portfolio of securities to achieve its
investment objective. There are two types of management investment company: closed-end and open-
end. The primary differences between the two come down to where investors buy and sell their shares
- in the primary or secondary markets - and the type of securities they sell. Closed-End Investment
Companies: A closed-end investment company issues shares in a one-time public offering. It does
not continually offer new shares, nor does it redeem its shares like an open-end investment company.
Once shares are issued, an investor may purchase them on the open market and sell them in the same
way. The market value of the closed-end fund's shares will be based on supply and demand, much
like other securities. Instead of selling at net asset value, the shares can sell at a premium or at a
discount to the net asset value. Open-End Investment Companies: Open-end investment companies,
also known as mutual funds, continuously issue new shares. These shares may only be purchased
from the investment company and sold back to the investment company. Mutual funds are discussed
in more detail in the Variable Contracts section.

Performance of Mutual funds

Mutual Fund Performance

Mutual Fund Research Tool For a 360-degree analysis of Indian mutual funds, CRISIL offers an
advanced Mutual Fund Research tool that comes with the most updated database providing all kinds of
complex calculations, analysis, reports and updates on the click of a mouse. The Mutual Fund Research
Tool allows the client to view details, compare performance, monitor portfolio, and customize queries on
more than 6500 mutual fund schemes at the click of a button.

Wealth Management Tool The wealth management tool provides robust performance features as well as
scalability as it covers all asset classes along with mutual funds. It provides client-wise summaries of the
portfolio holdings in various asset classes, industry/company wise holdings, and the gain/loss on the
client's portfolio. Besides it has a Transaction import facility and can be installed on the Intranet and
made available to all Relationship Managers across India.

Financial Planning Tool CRISIL's Financial Planning model includes various modules designed to
generate a scientific Financial Plan for an individual. It includes sections for risk profiling, analysis of
needs, retirement planning, assessment of insurance requirement and cash flow analysis. The Financial
Planner is backed by a comprehensive Asset Allocation Model, which combines Strategic and Tactical
Asset Allocation models. While the model is scalable to meet unique specifications, CRISIL can also
offer technology development support to deploy the model in the form of an online interface to the
customer based on client specifications.

Attribution Tool Performance Attribution is a technique that helps fund managers understands the causes
for variability in performance in the course of pursuing benchmark levels. It helps them take corrective
action in their portfolios. For equity portfolios, Performance Attribution explains the excess return
(positive or negative) in terms of sector allocation and security selection strategies. In case of debt
portfolios, the performance is attributed to the duration and credit strategies.

Department of MBA SIET Page 65

Net Asset Value

A mutual fund's price per share or exchange-traded fund's (ETF) per-share value. In both cases, the per-
share dollar amount of the fund is calculated by dividing the total value of all the securities in its
portfolio, less any liabilities, by the number of fund shares outstanding.

In the context of mutual funds, NAV per share is computed once a day based on the closing market prices
of the securities in the fund's portfolio. All mutual funds' buy and sell orders are processed at the NAV of
the trade date. However, investors must wait until the following day to get the trade price. Mutual funds
pay out virtually all of their income and capital gains. As a result, changes in NAV are not the best gauge
of mutual fund performance, which is best measured by annual total return.

Because ETFs and closed-end funds trade like stocks, their shares trade at market value, which can be a
dollar value above (trading at a premium) or below (trading at a discount) NAV.

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