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[FINANCIAL INVESTMENT ANALYSIS]

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INVESTMENT ANALYSIS AND

PORTFOLIO MANAGEMENT
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DEPARTMENT OF DISTANCE AND CONT

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INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

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Assistant Professor, School of Open Learning, University of Delhi
Ms. Manisha Yadav
Assistant Professor, School of Open Learning, University of Delhi

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 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

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Disclaimer Dr. Ruhee Mittal
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Department of Commerce
Keshav Mahavidyalaya
University of Delhi

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 Contents

PAGE
UNIT-I
Lesson 1: Basics of Risk and Return 3–18

Lesson 2: Fixed-Income Securities 19–33

Lesson 3: Fundamental Analysis 34–48

UNIT-II
Lesson 4: Valuation Models 51–68

Lesson 5: Technical Analysis 69–86

UNIT-III
Lesson 6: Portfolio Analysis and Management 89–117

Lesson 7: Portfolio Management 118–129

UNIT-IV
Lesson 8: Asset Pricing Models 133–157

Lesson 9: Mutual Funds 158–185

Glossary 187–192

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 UNIT - I

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 L E S S O N

1
Basics of Risk and Return
Kanwaljeet Singh
Assistant Professor
Sri Aurobindo College of Commerce and Management
Ludhiana
Email-Id: kanwaljeet255@[Link]

STRUCTURE
1.1 Learning Objectives
1.2 Introduction
1.3 Concept of Risk
1.4 Concept of Return
1.5 Risk and Return Trade-off
1.6 Application of Standard Deviation in Risk and Return
1.7 Concept of Alpha and Beta in Risk and Return
1.8 Summary
1.9 Answers to In-Text Questions
1.10 Self-Assessment Questions
1.11 References
1.12 Suggested Readings

1.1 Learning Objectives

‹ To understand the concept of risk.
‹ To understand the various types of risks.
‹ To understand the concept of return and its types.
‹ Concept of Risk-Return trade-off.
‹ Applications of standard deviation in risk and return.
‹ Understand the concept of alpha and beta in risk and return.

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 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

Notes
1.2 Introduction
The trade-off between risk and return is at the heart of every financial
decision-making. Any decision-making process has both advantages and
disadvantages. A farmer works the soil and plants seeds in the hopes of
obtaining a higher crop. He seldom knows whether his hopes have been
fulfilled until the crop is mature and he has the opportunity to enjoy the
harvest. A multitude of elements interact between expectation and actuality.
Using the farmer as an example, important factors like the climate, seeds,
fertilizer, and farm management practices are what allow expectations to
become a reality. There is a chance that any of the factors will deteriorate,
which would increase the difference between expectations and reality. An
investment manager, a business, and any other person or organization that
must make a decision can all relate to the uncertainty.

1.2.1 Definition
An investment’s risk is the unpredictability or fluctuation of its returns.
It is the potential for an investment’s real returns to deviate from those
projected.

1.3 Concept of Risk

1.3.1 Meaning
One way to conceptualize risk is as the potential for something bad to
happen. If there are more significant departures from the expected, we
view those circumstances as dangerous. Whether or not a certain situa-
tion is risky relies on how accurately we can predict the likelihood that
a specific event will occur. The following three possible states are raised
by this:
A. Confidence
B. Unpredictability
C. Danger
A state of certainty is one in which there is no variation from the predicted
outcome of a specific occurrence. When it comes to some “All Truths,”
there won’t be any exceptions, similar to how the sun rises in the east
and how death is inevitable. In a similar vein, near certainty might be
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 Basics of Risk and Return

included in some commercial scenarios. Supposing that, as a monopolist, Notes

you will sell a specific quantity of bags of rice in a community where
rice is the main crop grown there.
Prediction is challenging when there is uncertainty. It’s possible that one
cannot precisely predict when a given event will occur. People frequently
find it challenging to forecast the weather. Occasionally, the meteoro-
logical department is also involved. It is very difficult and dangerous to
attempt to describe uncertainty with any degree of rigor in conceptual and
mathematical terms. Since nothing can be predicted in practice, dealing
with unknown situations can also be challenging.
A circumstance that falls between the first two levels of certainty and
uncertainty is referred to as the third state of possibility, or risk. The
easiest way to conceptualize this is as a continuum with risk occupying
the middle ground and confidence and uncertainty on each end.

In the language of statistics, a scenario that involves known future events

and the probability that go along with them is referred to as risk. Stated
differently, it can be thought of as a subjective probability distribution’s
dispersion. In actuality, a businessman can only confront a risky scenario
with confidence.
Making decisions in a position of certainty won’t be tough, and in an
uncertain circumstance, he won’t be exact, no matter how sophisticated
the tools are. As a result, a manager can only act reasonably in risky
situations. As a result, the theory of finance acknowledges the importance
of risk in making final decisions.
Ex-ante and Ex-post Risk: The concept of risk can be understood in
two ways: ex-ante and ex-post.
Ex-ante risk is a decision variable that shows the likelihood that a choice
taken today may result in unfavorable outcomes down the road. Ex-post
risk is the term used to describe observable variance in past periods’
results. This danger has a past. The most challenging task in financial

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 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

Notes decision-making is estimating and evaluating future outcomes based on

available data. Since a finance manager deals with the former, the ex-ante
idea of risk is deemed to be more valuable in the financial literature than
the ex-post version.

1.3.2 Types of Risk

There is always some risk involved in investing, and being aware of the
many kinds of hazards is essential to making wise choices. The following
are some typical categories of hazards connected to investments:
Systematic Risk/Market Risk: Often known as market risk, Systematic
Risk/Market Risk is associated with the general movement of the market.
A number of variables can have an effect on the value of investments and
the market as a whole, including interest rates, the state of the economy,
political developments, and market mood.
Interest Rate Risk: Variations in interest rates may have an impact on
how much particular investments are worth. For instance, a rise in in-
terest rates may result in a decline in the value of current bonds and an
increase in the cost of borrowing for businesses.
Risk of Inflation/Purchasing Power Risk: Over time, inflation reduces
the purchasing power of money. The real worth of an investment may
decline if the rate of return on it does not exceed inflation.
Credit Risk: This risk results from the potential for a debt security’s
issuer to fail to make payments as agreed. It is especially important when
investing in bonds because the creditworthiness of the issuer is crucial.
The ease with which an investment can be acquired or sold on the market
without significantly altering its price is referred to as liquidity risk. Less
liquid assets could be more difficult to sell rapidly, which could result
in increased transaction costs or price swings.
Currency Risk: Often known as exchange rate risk, currency risk is
the possibility that returns on foreign investments will be impacted by
exchange rate movements. Lower returns may occur if the currency used
to denominate an investment depreciates in relation to the investor’s
home currency.
Political and Regulatory Risk: The value of investments may be im-
pacted by modifications to laws, rules, or political unrest. This risk is
especially important in developing economies.
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 Basics of Risk and Return

Business or Firm Risk: This risk relates specifically to a stock’s per- Notes
formance and stability as issued by the firm issuing it. The company’s
financial health can be impacted by variables like industry trends, com-
petition, and management choices.
Reinvestment Risk: It is the possibility that investment cash flows won’t
be able to be reinvested at the same rate of return. For instance, future
cash flows could need to be reinvested at lower rates if interest rates
decrease.
Event Risk: Unpredicted events that affect the value of investments
include natural catastrophes, geopolitical crises, and other unforeseen
occurrences.
To build a diverse portfolio that fits their unique circumstances and
preferences, investors frequently need to evaluate their risk tolerance,
time horizon, and investing goals. Partially offset by diversification
among various asset classes and geographical areas is the potential for
risk mitigation.

1.4 Concept of Return

1.4.1 Meaning
In the context of investing, returns are the monetary gains or losses that
an investor experiences over a given time frame. Returns are a crucial
indicator used to evaluate the success of an investment. They can be
stated as a percentage or as a monetary value.

1.4.2 Types of Returns

Returns can take many different forms and metrics, such as:
1. Total Refund: The term “total return” refers to increases in the
investment’s value as well as any income (interest or dividends) that
may be received. It offers a thorough evaluation of the performance
of investments overall.
2. Gain in Capital: The rise in an investment’s value over its acquisition
price is known as a capital gain. It is computed by deducting the
current market value from the purchase price at the outset.
3. Yield on Dividends: The annual dividend income produced by an
investment, expressed as a percentage of the current market price,
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 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

Notes is known as dividend yield. It is computed by dividing the share

price at the current market value by the annual dividend per share.
4. Interest Earnings: The money received as interest on fixed-income
assets, like bonds, is referred to as interest income. It increases the
investment’s overall return.
5. Payments with Coupons: Bond issuers pay bondholders interest
on a periodic basis through coupons. The overall return on bond
investments is influenced by these payments.
6. Gains and Losses, Realized and Unrealized: When an investment
is sold and the true profit or loss is realized, realized gains or
losses take place. Changes in the value of an investment that has
not been sold are represented by unrealized profits or losses.
7. Calculated Annualized Return: The average rate of return per
year over a given time period is known as the annualized return.
Comparing the performance of assets with varying holding periods
might be helpful.
8. Adjusted Return for Risk: The amount of risk connected with an
investment is taken into account in risk-adjusted return. Well-liked
metrics that modify returns according to the volatility or systematic
risk of an investment are the Treynor and Sharpe ratios.
9. Comparing Money-Weighted with Time-Weighted Returns: Time-
weighted returns are frequently used to assess how well investment
portfolios are performing because they take time into account.
Money-weighted returns provide an indication of the real experience
of the investor by taking into account the timing and volume of
cash flows into and out of an investment.
10. Benchmark Returns: When evaluating an investment’s performance,
benchmark returns are utilized to compare it to a certain market
index or other pertinent benchmarks.
Investors must comprehend the numerous components and return mea-
surements in order to assess the performance of their portfolios and make
wise decisions. It’s crucial to remember that past performance does not
guarantee future outcomes. When evaluating returns, investors should
take their time horizon, risk tolerance, and investing goals into account.

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 Basics of Risk and Return

However, the word “return” has multiple meanings, including the following: Notes
(i) Return on Book versus Return on Market;
(ii) Return on Single Period versus Return on Multi Period;
(iii) Expected versus Actualized ex-ante Return
(iv) Portfolio Return Compared to Security
Return on Book versus Return on Market: Book return is the amount
of return determined by taking the company’s assets and profits from its
books. The Return on Assets (ROA) is typically used as a book return
indicator. Different factors such as capital employed, net worth, capital
invested, earnings per share, and dividends per share can also be used to
calculate several different returns. These returns are entirely a reflection
of past performance.
On the other hand, market return is determined by the asset’s market
value. Assuming that X purchases Rs. 100 worth of ABC firm stock at
face value of Rs. 10, with the firm earning Rs. 1 per share, X’s book
return is 10% and his market return is 1%.
Return on Single Period versus Return on Multi Period: The com-
putation of return is contingent upon a specific time frame. The rate of
return is 3% if a Rs. 100 investment generates an income of Rs. 3 over
a period of 3 months. The return is also 3% if an additional investment
generates revenue of Rs. 3 during a 12-month period. However, unless
the measures pertain to a particular time frame, they seem nonsensical.
Rates of return are typically calculated annually. As a result, the two
investments mentioned above would have respective rates of return of
12% and 3%.
The calendar period during which the return on investment is earned may
or may not coincide with the time period utilized to determine the rate
of return. Regardless of whether they made the investment within the
calendar period or not, investors would typically be interested in seeing
what rate of return they were able to achieve. To calculate the return on
an asset for a certain holding period, one can use the following analogy.
Expected versus Actualized Ex-ante Return: Before the fact is referred
to as ex-ante, and after the fact as ex-post. In terms of security returns,
these two differ significantly from one another. The return an investor

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 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

Notes intends to receive on his investment is known as the ex-ante return. There
is no assurance that an investor’s dreams will materialize. The real or
realized return is what is meant to be returned ex post. The predicted
return and actual return can differ significantly depending on whether the
markets are in a bullish or bearish state. The straightforward formulas
for calculating both returns are as follows.
Ex Ante Return = Anticipated Dividend + Anticipated End Price / Initial
Investment
Ex Post Return = Actual Dividend Received + Actual End Price / Initial
Investment
Security versus Portfolio Return
This is in relation to investing in one asset or security as opposed to a
collection of assets or securities. Any type of instrument, including stocks,
preference shares, and debentures, can have a standard valuation process.
However, when it comes to the appraisal of stocks, financial writers have
put forth certain models that rely on either earnings or dividends.
Historical Returns for a Single Period
Rate of Return (R) = Dividend Yield + Capital Gain
D1
Where Dividend Yield =
Po
P1 − Po
Capital Gain =
Po
D1 P1 − Po
so R = +
Po Po
D1 + ( P1 − Po )
or R =
Po
Here, D1 = Dividend paid during the year
P1 = Price at the end of the period
Po = Price at the beginning of the year
Let’s consider the following information about a certain equity share:
Po = Rs. 600
D1 = Rs. 24
P1 = Rs. 660
The rate of return = 24+ (660 – 600)/600 = 14%
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 Basics of Risk and Return

Return of a Security for More Than One Period Notes

The return of a single security for more than one period can be calculated
by taking the arithmetic mean of the returns of different periods for a
particular security. The formula is as under:
1 n
A= ∑ ai
n i =1
a + a +  + an
ai = 1 2
n
a1, a2, ..., an = security returns for period n
n = No. of periods

1.5 Risk and Return Trade-off

Risk and returns always go hand in hand. These are inseparable, so the
investment process must be considered in terms of both risk and return.
All types of investment have some form of risk attached to it. Even ‘safe’
investments (such as bank deposits) are not without some element of
risk. Moreover, the relationship between risk and return is positive, i.e.,
the higher the risk, the higher is the possibility of earning a good return
and vice-versa. Thus, there is need to achieve a risk-return tradeoff. The
risk-return tradeoff is the balance an investor must decide on between the
desire for the lowest possible risk for the highest possible returns.. The
overall idea is that investments with reduced risk often have lower potential
returns, whereas investments with higher risk typically have larger poten-
tial returns. When making investing selections, investors need to consider
these aspects in order to match their risk tolerance and financial goals.
The following are important details about the risk-return trade-off:
1. Return and Risk Have a Positive Correlation: Higher degrees of
risk are typically associated with investments that have the potential
for larger returns. On the other hand, lesser risk investments usually
have smaller potential profits.
2. Tolerance for Risk: People differ in how much risk they can
tolerate depending on their goals, comfort level with uncertainty,
and financial status. Comprehending one’s level of risk tolerance
is essential to assembling an investing strategy that suits personal
tastes.
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 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

Notes 3. Asset Classes and Profiles of Risk and Return: The risk-return
profiles of various asset classes (such as stocks, bonds, and real
estate) differ. For instance, while historically providing larger long-
term returns than bonds, stocks are typically regarded as riskier.
4. Increasing Variety: Investing in a variety of assets helps to diversify
a portfolio and lower overall risk. Because diversified portfolios
contain assets with different levels of sensitivity to market conditions,
they can aid in the balance between risk and return.
5. Horizon in Time: The time horizon of an investor, or the amount
of time they intend to hold investments, affects their capacity to
withstand brief swings in portfolio value. Given that they have more
time to recover from market downturns, investors with longer time
horizons may be able to assume greater risk.
6. Risk Assessment Tools: Statistical metrics like beta, standard deviation,
and other measurements are frequently used to quantify risk. These
metrics offer information about an investment’s historical volatility
and correlation with respect to a benchmark.
7. Juggling Return and Risk: Achieving a balance between managing
associated risks and pursuing bigger returns is crucial for investors.
Investors can build a portfolio more intelligently by evaluating an
investment’s possible risk and reward.
8. Personal Investment Objectives: Personal financial goals and
aspirations, including retirement savings, college finance, or wealth
preservation, are important factors in figuring out how risky an
investment portfolio should be.
In the end, investors use the risk-return trade off as a compass to navigate
the financial markets. Through a thorough comprehension and evaluation
of this correlation, investors can make well-informed choices that corre-
spond with their financial goals and risk appetite.

1.6 Application of Standard Deviation in Risk and Return

A statistical tool used to quantify the degree of variation or dispersion in
a collection of data points is the standard deviation. Standard deviation
is frequently used in the context of investing to evaluate the risk and

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 Basics of Risk and Return

volatility connected to a particular investment or portfolio. The standard Notes

deviation is used in the following ways to assess risk and return:
Volatility Calculation: The standard deviation is a crucial factor in deter-
mining volatility. It is frequently used in finance to calculate a financial
instrument’s return volatility. Greater volatility is indicated by a higher
standard deviation, which suggests higher risk.
Modeling Risk: A key component of many risk models, such as those
that calculate Value at Risk (VaR), is standard deviation. VaR accounts
for the past volatility of an investment to determine the greatest possible
loss within a certain time horizon and confidence level.
Risk to Portfolio: The use of standard deviation in portfolio analysis can
aid in determining the overall risk of a collection of assets. By combining
assets with lower or negatively linked returns, diversification can be utilized
to lower portfolio risk by influencing the entire portfolio’s standard deviation.
Risk-Adjusted Return: Risk-adjusted return measures like the Sharpe
ratio are computed using standard deviation. The excess return on an in-
vestment per unit of risk (standard deviation) is measured by the Sharpe
ratio. Better risk-adjusted performance is indicated by a greater Sharpe
ratio.
Construction of a Diversified Portfolio: An essential tool for evaluat-
ing the advantages of portfolio diversification is the standard deviation.
A more favourable risk-return profile can be achieved by an investor by
reducing the overall standard deviation of the portfolio by combining
assets with lower or negatively correlated returns.
Evaluation of Risk Tolerance: Investors that are evaluating their risk
tolerance frequently take standard deviation into account. Having a solid
understanding of the standard deviation, which represents possible vola-
tility, enables investors to better match their investing decisions to their
risk tolerance.
Comparative Evaluation of Risk: Investors can compare the risk profiles
of various investments or portfolio’s using standard deviation. Higher
standard deviations are often regarded as riskier than smaller standard
deviations, which indicate that investments with lower standard deviations
are generally less risky.

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 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

Notes Investor Communication

Disclosure of Risk: The standard deviation is frequently used to convey
the historical volatility of an investment in financial reports and invest-
ment disclosures. It gives investors a numerical representation of the
possible range of returns.
In conclusion, standard deviation is a useful instrument in the finance
industry that is essential for risk assessment and management, portfolio
construction, and well-informed investment choices. It provides to a more
thorough understanding of the risk-return trade off and aids investors in
quantifying the uncertainty surrounding returns.

1.7 Concept of Alpha and Beta in Risk and Return

1.7.1 Alpha
When we talk about risk and return in finance, two key concepts often
come up: alpha and beta. These are especially important when evaluating
how well an investment is performing, and they play a central role in
models like the Capital Asset Pricing Model (CAPM).

What is Alpha?
Think of alpha as a measure of how well an investment has done
compared to expectations. More specifically, it tells us how much an
investment has outperformed—or underperformed—its benchmark, after
adjusting for risk.
In simple terms:
‹ If your investment did better than what was expected based on its
risk level, you have a positive alpha.
‹ If it fell short, you have a negative alpha.

Important Points
Alpha Positive: Given its degree of risk, an investment that has a positive
alpha has surpassed its expected return. It implies that the investment
manager has produced returns higher than those that the market or the
selected benchmark would have projected.
Alpha Negative: Underperformance in relation to the anticipated return
for the degree of risk is indicated by a negative alpha. It implies that

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 Basics of Risk and Return

the results on the investment have not been in line with the amount of Notes
risk assumed.
Compute: The capital asset pricing model’s expected return is subtracted
from the investment’s actual return to determine alpha.
Alpha = Actual Return − Expected Return

1.7.2 Beta
The sensitivity of an investment’s returns to shifts in the benchmark or
the market as a whole is measured by beta. It shows the level of market
risk, also known as systematic risk, that is present in an investment.

Important Points
Beta is equal to 1: An investment with a beta of 1 is said to have a
tendency to move in tandem with the market. It is anticipated that the
investment’s returns will resemble those of the entire market.
Beta > 1: Higher volatility in relation to the market is indicated by a
beta value larger than 1. It is anticipated that the investment will move
more than the market does.
Beta < 1: In comparison to the market, reduced volatility is indicated
by a beta of less than 1. It is anticipated that the investment will move
more subtly in relation to the market.
Compute: Regressing the investment’s historical returns against the returns
of the market or a selected benchmark yields the beta value.
Beta = Covariance (Return of Investment, Return of Market)/ Variance
(Return of Market)

1.7.3 Relationship between Alpha and Beta

When evaluating the risk and return characteristics of an investment,
‹ Alpha and Beta are frequently utilized in tandem.
‹ An investment may have surpassed its expected return if its alpha
is positive; underperformance is indicated by a negative alpha.
‹ A measure of an investment’s systemic risk, or how closely its returns
are correlated with those of the market as a whole, is called beta.

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 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

Notes ‹ A combination of a high alpha, which denotes adept management,

and a suitable beta, which corresponds to their investment goals
and risk tolerance, may be sought after by investors.
To sum up, alpha and beta are useful tools that help investors and portfolio
managers assess the performance of their investments, comprehend the
risks associated with them, and decide how best to allocate their assets
and build their portfolios.

IN-TEXT QUESTIONS
1. What does the word “risk” mean when it comes to investing?
(a) Returns that are certain and assured
(b) The unpredictability of possible
(c) Only favorable results
(d) Transient variations
2. Which kind of risk is linked to the movement of the market
as a whole and cannot be removed by diversification?
(a) Market Risk (Systematic Risk)
(b) Credit Risk
(c) Risk to Liquidity
(d) Risk to Business
3. What does the performance of an investment look like when the
alpha is positive?
(a) The return has fallen short of expectations
(b) The return has exceeded expectations
(c) Its beta value is 1
(d) There is no danger involved
4. A portfolio’s diversification among several asset types primarily
aims to:
(a) Return maximization
(b) Risk minimization
(c) Market risk elimination
(d) Liquidity enhancement

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 Basics of Risk and Return

5. What does a reduced investment standard deviation mean in the Notes

risk-return trade-off?
(a) Increased risk
(b) Decreased risk
(c) No risk
(d) Predictable returns
(e) There is no danger involved

1.8 Summary
A return is offered by all securities, although most of them carry some
risk or uncertainty. The profit or gain that an investment generates is
known as return. It consists of two parts: capital appreciation and con-
sistent income in the form of dividends or interest (current yield). When
investment returns are less than anticipated, there is a risk. It is the
return that deviates from the average. Typically, the standard deviation
of historical returns or the average returns on a particular investment is
used to measure it.
Systematic and unsystematic risk are the two types of risk. Systematic
(market) risk is the variation in a security’s total returns that is direct-
ly linked to overall changes in the economy or market. Unsystematic
(non-market) risk is the variation in a security’s total returns that is
unrelated to general market volatility. Returns and risk are constantly
correlated. Because of their inseparability, risk and return must be taken
into account while making investments.

1.9 Answers to In-Text Questions

1. (b) The unpredictability of possible
2. (a) Market Risk (Systematic Risk)
3. (b) The return has exceeded expectations
4. (b) Risk minimization
5. (b) Decreased risk

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Notes
1.10 Self-Assessment Questions
1. “No investment is risk-free.” In view of statement write the meaning
and types of investment risk. Can this risk be eliminated or minimised?
2. Can Risk and Return be quantified? Explain how they can be measured
using statistical techniques.
3. What do you mean by risk? Discuss in detail various types of risk.

1.11 References
‹ Fabozzi, Frank. (2009). Bond Markets, Analysis and Strategies (7th
ed.). Prentice-Hall Publishing.
‹ Reilly, F. K. & Brown, K.C. (2012) Analysis of Investments and
Management of Portfolios (12th edition), Cengage India Pvt. Ltd.
‹ Fischer, D.E. & Jordan, R.J. (2006) Security Analysis & Portfolio
Management (6th edition), Pearson Education.
‹ Ranganathan, M., & Madhumathi, R. (2006). Investment analysis
and portfolio management. New Delhi: Pearson Education.

1.12 Suggested Readings

‹ Fabozzi, Frank. (2009). Bond Markets, Analysis and Strategies (7th
ed.). Prentice-Hall Publishing.
‹ Reilly, F. K. & Brown, K.C. (2012) Analysis of Investments and
Management of Portfolios (12th edition), Cengage India Pvt. Ltd.
‹ Fischer, D.E. & Jordan, R.J. (2006) Security Analysis & Portfolio
Management (6th edition), Pearson Education.
‹ Ranganathan, M., & Madhumathi, R. (2006). Investment analysis
and portfolio management. New Delhi: Pearson Education.

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 L E S S O N

2
Fixed-Income Securities
Anand Kumar Singh
Assistant Professor (Guest)
Shaheed Rajguru College of Applied Sciences for Women, DU
Email-Id: anandsinghvns123@[Link]

STRUCTURE
2.1 Learning Objectives
2.2 Introduction
2.3 Fixed-Income Securities: Corporate
2.4 Other Fixed-Income Securities
2.5 Bond Yields
2.6 Valuation of Bonds
2.7 Risks in Bonds
2.8 Summary
2.9 Answers to In-Text Questions
2.10 Self-Assessment Questions
2.11 References
2.12 Suggested Readings

2.1 Learning Objectives

‹ Describe the features of fixed-income securities.
‹ List the types of corporate and other securities in which investors desirous of regular
and assured return can invest.
‹ Explain the ideas of basic yield, yield to maturity, yield to call, etc. and their role
in investment decisions.
‹ Distinguish between (i) annual and semi-annual interest rate and required rate
vis-à-vis the coupon rate and (ii) time to maturity and resultant valuation.
‹ Discuss the sources of risk in fixed-income securities.

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Notes
2.2 Introduction
In this lesson, you will learn about the features and qualities of various
types of fixed-income securities. Two major types of securities available in
the capital market are:
1. Fixed-income or fixed-cost securities like debentures and government
securities; and
2. Variable income or variable cost securities like equity shares.

2.3 Fixed-Income Securities: Corporate

The securities that provide a fixed amount of revenue to the holder of the
securities are called fixed income securities. These are classified as ‘Debt’
in the capital structure of a firm. Examples of fixed income securities
include Bonds, Debentures, Government securities etc. These are good
investment options for the investors who do not want to undertake high
risk. All investments have some degree of risk; however, fixed-income
assets have comparatively low risk.
Investing in fixed income securities/assets is preferred by conservative
investors, who are typically risk averse and interested in consistent income
from their assets.
Features: Two categories of fixed-income/cost-securities exist in the
corporate world:
‹ Bonds and debentures, also called debt instruments; and
‹ Preference shares.
The main features of bonds and debentures are as follows:
1. Another name for bonds and debentures is creditor-ship securities.
Its holders are the company’s creditors and are referred to as
debt holders. These securities’ holders are not eligible to vote
within the company. As a result, they are not involved in making
decisions.
2. Interest is paid to debt holders at a nominal rate, often known as
a coupon rate. This rate is determined by taking the face value of
the security and fixing it in accordance with the terms of the debt

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instrument. The zero coupon bonds, on which the bearer receives Notes
no monthly interest, are an exception to this rule.
3. Both the face value and the redemption value of bonds and debentures
are stated on the document itself. These two could be the same or
dissimilar. The bond may be redeemed by conversion into equity
shares if the debentures are convertible debentures.
4. Debt holders receive paid at the firm’s liquidation before equity owners
and other unsecured creditors, such as preference shareholders.

2.3.1 Types of Bonds and Debentures

As we noted above, bonds and debentures are two of the three types of
corporate securities (the other one being preference shares). Of these three,
bonds and debentures represent the most important types of fixed-income
securities serving as investment vehicles for persons dependent on fixed
regular income. Let us first note the various types of debentures. There
are three types of debentures classified as follows:
1. Secured and Unsecured Debentures: Secured debentures are
linked to the company’s assets. This means, in case of default
by the company, these assets can be used to pay off the dues or
debts. Unsecured debentures do not have any such link over the
assets of the company. They are issued on the strength of general
creditworthiness of the issuer.
2. Convertible and Nonconvertible Debentures: A convertible debenture
is one that is converted into the equity shares of the issuing
company. The conversion is done on or before the maturity date
and it is done as per the terms of issue. These debentures may be
either compulsorily convertible or optionally convertible. In case
of optionally convertible debentures, the holder has the option to
exercise the option, if considered worthwhile, or to continue the
investment in the form of debentures itself. In case of compulsorily
convertible debentures, the investor has no such choice.
Besides, the convertible debentures may be fully or partially convertible.
In case of partially convertible debentures, a part of the face value
is converted into equity shares. The rest of the investment remains
in the form of debentures. Convertible debentures are considered

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Notes a more attractive form of investment. Usually, firms offer a lower

nominal rate of interest as compared to nonconvertible debentures.
3. Redeemable and Irredeemable Debentures: Almost all debentures are
redeemable with a fixed period of maturity. This period is mentioned
on the face of the instrument. Irredeemable, also called perpetual
debentures, are issued without any maturity date. Investors will keep
receiving the periodical interest throughout, that is, perpetually as
long as the issuing company is alive. Let us now turn to bonds.
There are five types of bonds as outlined below.
(a) Zero Coupon Fully Convertible Bonds: These bonds do not
carry any fixed rate of interest. They are fully and compulsorily
convertible on a specified date from the date of issue. Till
conversion, no interest is paid to the debenture holders. Such
issues require credit rating by an approved credit rating agency.
(b) Deep Discount Bonds: It is a variant of zero coupon bonds. In
this, there is an issue price, a maturity period, and a prespecified
maturity amount. There is no coupon rate of interest and no
interest is payable during the tenure of the bond. An enlightened
investor will calculate the implicit rate of interest, compare
it with the return available on other investment avenues, and
will invest if the rate of return on such bonds is at least equal
to other securities as per his consideration.
(c) Callable Bonds: In case of callable bonds, the company reserves
the right to retire the bond at any time after a stipulated period.
The investor will have to accept the redemption value when
the company decides to retire it. The company may exercise
this option if it has excess capital at any stage or if the rate
of interest in the market has fallen and cheaper funds are
available.
(d) Putable Bonds: In case of putable bonds, the holder has an
option to redeem the bonds with the company any time after
an initial lock-in period. The investor may exercise this right
if the coupon rate being offered by the company has fallen
lower than the market rate. The bondholder will redeem the
bond with the company and may reinvest his money at a
higher rate of interest.

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(e) Floating Rate Bonds: As against the common connotation of Notes

fixed-income securities, the coupon rate in case of floating
rate bonds is not fixed. It is tied to some other interest rate
called a benchmark. The rate at which the company will pay
interest will vary with variation in this benchmark. Such bonds
are not popular in India.

2.3.2 Preference Shares

In case of preference shares, dividend is payable at a fixed rate as
appropriation of profits. However, the company may not pay preference
dividend if it does not have divisible profits or enough liquidity. Investors,
on the other hand, expect dividends and there are adverse implications if
this dividend is not paid. The reputation of the company will be affected
and it may not be able to raise capital in future. Besides the preference,
shareholders under this acquire voting rights at par with the equity share-
holders. This will be as per the provisions of the Companies Act. As a
result of this, control over the firm may get diluted.

2.4 Other Fixed-Income Securities

Now let us consider some other types of fixed-income securities.

2.4.1 Fixed Deposits

For fixed returns, these are the most popular and regarded as the safest
options. These could be fixed deposits made with postal services or com-
mercial banks. Depending on the needs and requirements of the depositor,
the investor deposits a specific amount of money for a predetermined period
of time and earns interest that is payable on a regular basis or at maturity.
Fixed deposits, often known as term deposits, come in a variety of forms,
including flexi-recurrent deposits (RDs) and recurrent deposits. For a
predetermined period of time, the deposit must be kept (e.g., one year).
A penalty can apply if you withdraw early. The majority of banks offer
the option to automatically renew deposits as they mature.

2.4.2 Treasury Bonds or Government Securities

These are also called sovereign bonds. Treasury bonds are issued by
the government of a country. These may involve a periodic payment of

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Notes interest at a defined rate with repayment on maturity. Or, it may be in

the form of zero coupon bonds or as deep discount bonds. The proceeds
are usually used by the government to finance its developmental projects.
These are risk-free bonds as the governments do not default in meeting
the commitments.

2.4.3 Municipal Bonds

They are issued to fund infrastructure projects, such as building schools,
hospitals, bridges, and highways. These were initially implemented
in India in 1997. Investors had not been very fond of these bonds in
the beginning. In 2015, SEBI released guidelines pertaining to these
bonds.

2.4.4 Tax-Free Bonds

These bonds are issued by the government, its departments or entities
owned by it (like NTPC, Power Finance Corporation, etc.). Interest
proceeds are exempt from income tax and, thus, provide an attractive
investment avenue for investors falling in high-income bracket. These
bonds have long-term maturity up to 20 years and bear very low or
almost zero risk of default.

2.5 Bond Yields

The percentage return that an investor receives on his bond investment
is referred to as the bond yield. It might not be the same as the needed
rate of return or the market rate of interest. Yield gives the bond’s actual
return and facilitates reasoned decision-making. Yields are consistently
stated annually.
The following are some examples of yield types that are helpful in the
investment process:

2.5.1 Current Yield

Another name for this is basic yield. It is computed by dividing the
annual interest by current market price of the bond.
Method: Interest/BO × 100 equals current yield, where BO is the bond’s
current market price.

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There is inverse relationship between current yield and current market Notes
price of the bond.
The market price of the bond affects the current yield. The following
picture demonstrates how yield falls as market price rises and vice
versa.
Example 1
For Rs. 90, Mr. A bought a bond from the market that had a 10% yield
on its face value of Rs. 100. What is the yield currently? What is the
current yield if it is bought for Rs. 120? By looking at the market price
and the par value, one can conclude about the current yield vis-à-vis the
coupon rate.
(a) If bond is selling at a discount, current yield will be more than the
coupon rate.
(b) If the bond is selling at a premium, current yield will be less than
the coupon rate.
(c) If market price is equal to par value, current yield and the coupon
rate will be the same.

2.5.2 Yield to Maturity (YTM)

The Yield to Maturity (YTM) is the rate of return that can be obtained
by buying a bond at the present market price and holding it until it
matures. YTM is the discount rate which equates the current market
price of a bond with the present value of cash inflows that will be
generated by the bond in the form of interest income and redemption
price. It is also called internal rate of return of a bond. There are two
ways to find the YTM:
(a) A trial-and-error Method: In this, we find out the rate of discount
that equates the present value of cash flows (interest) and the current
market price. It may require interpolation to arrive at the accurate
YTM. It is complex and time consuming method.
(b) Short-cut Method: This gives the approximate YTM.
I + ( RvV− P)/N
YTM =
RvV + P
2

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Notes Where, I = Annual Interest

RV = Redemption Value
P = Current Market Price
N = No. of Years till Maturity

2.5.3 Yield to Call (YTC)

For callable bonds, the maturity period (n) is not relevant as the company
may retire it before maturity. Hence, in case of callable bonds, need to
calculate YTM does not arise. For such bonds, Yield to Call (YTC) is
calculated for the period up to the date the bond can first be called and
redeemed.
For example, a bond has a maturity of 10 years but the bond can be
retired any time after June 30th, 2021. Mr. A purchased this bond on
July 1st, 2018. The company can exercise this option on July 1st, 2021.
So YTC, that is, YTC will be calculated for three years.
YTC is calculated the same way as YTM is calculated by trial-and-error
method with interpolation or through the short-cut method. The period,
however, will be up to the date on which the call can first be exercised.

2.5.4 Holding Period Return

An investor may not hold bond till the maturity and offload it anytime
for a variety of reasons. YTM will not be relevant for such investors
since (i) his holding period is less than the total maturity period and
(ii) YTM does not consider the market value before maturity. The investor
would be interested in knowing the return over his actual holding period.
For Holding Period Return (HPR), the interest and capital gain (or loss)
will be expressed as a percentage of the purchase price.
Holding Period Return (HPR) is the total income earned on an asset in-
cluding interest as well as the capital gain or loss expressed as a % of
the purchase price, i.e.,
Total Intrest Income + ( SP − PP)
= HPR ×100
PP
SP = Selling Price
PP = Purchase Price

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Notes
2.6 Valuation of Bonds
Valuation refers to the real worth of the financial asset. It represents its
intrinsic value. In this context, some important concepts of valuation are
as follows:
1. Book Value: Book value of an asset can be found from the
balance sheet of the firm. For example, book value of debenture
is the face value stated in the balance sheet. For book value of
equity share, net worth is divided by the number of equity shares
outstanding.
2. Market Value: This refers to the price for which the asset is traded.
For listed securities, market value is available from the stock
exchange quotes. For unlisted securities, market value is not so
readily available.
3. Liquidating Value: This is the difference between the realizable
value of the assets less the total value of external liabilities.
4. Capitalized Value: This is the most realistic concept of valuation.
It is arrived at by considering the cash flows that the assets are
capable of generating. It is the sum of present value of the cash flows
generated by the security. It requires to be applied a discount rate
which is the minimum required rate of return of the investors. This
rate depends on the risk tolerance of the investor and the premium
for the risk. This rate therefore varies from investor to investor.
It is the rate that will prompt the investor to acquire the security.

Annual Versus Semi-Annual Interest

Given a choice between annual and semi-annual interest, what should
be the decision of the investor? The following clues should be used
by an investor: If the required rate of return is greater than the cou-
pon rate then: bond value in case of annual interest should be greater
than the bond value in case of semi-annual interest, and if the required
rate of return is less than the coupon rate, then bond value in case of
annual interest should be less than the bond value in case of semi-an-
nual interest.

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Notes Time to Maturity and Valuation of Bond

If the required rate of return and coupon rate are different, the remaining
time to maturity also becomes relevant for the valuation of the bond. In
such cases, the value of bond will behave as follows:
� When the required rate of return is less than the coupon rate, the
bond value will be higher than the par value but will decline and
converge to the par value on maturity.
‹ When the required rate of return is equal to the coupon rate, the
bond value will remain equal to the par value throughout.
‹ When required rate of return is more than the coupon rate, the bond
value will be less than the par value but will increase and will
be equal to the par value on maturity. The investors are therefore
advised to:
� Not buy the bond at a high premium near the maturity as the value
of the bond will keep declining as the maturity approaches; and
� Not sell the bond at a discounted price near the maturity as the
value of the bond will be increasing as the maturity approaches.

2.7 Risks in Bonds

Against the common belief, investment in bonds is also subject to risks.
However, investment in bonds has less risk as compared to equity shares.
Some major sources of risk in bonds are as follows:
1. Interest Rate Risk: It is the most important source of risk in bonds
as also in other fixed-income securities. If interest rates change, there
will be a change in the market price of the bonds. For example, a rise
in interest rate will depress the market price of the bonds as there is
an inverse relationship between bond price and interest rate. On the
other hand, as the interest rate declines, bond price will increase.
When interest rate rises in the market (say from 10% to 12%), the
bond carrying a fixed coupon rate (of say, 10%) becomes unattractive
for the investors as new bonds in the market are available at a higher
rate (12%). The reverse will be the case when the rate of interest in
the market declines.

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The current investment in bond will become attractive as it will Notes

provide a higher interest income.
2. Reinvestment Rate Risk: Bonds pay periodic interest which the
investor may reinvest. If the interest rates in the market fall, there
is a risk that the investor will have to reinvest their interest at a
lower rate. Investors having bonds with longer maturity and in
which the company is paying regular and higher interest will be
more exposed to this risk. On the other hand, if the rate of interest
in the market increases, the investor will benefit with an opportunity
to invest interest at a higher rate.
Combining interest rate risk and the reinvestment rate risk, the
investor is exposed to two types of risks that work in opposite
directions. Thus, when interest rate rises, bond price will fall. The
bondholder will get an opportunity to earn a higher return on rein-
vestment of interest. The gain will reduce the amount of loss due
to fall in bond price.
When interest rate declines, bond price will increase. Bondholder
will be able to earn a lower return on reinvestment of interest. This
loss will reduce his gain due to increase in bond price.
3. Inflation Risk: Interest rates on bonds are defined in nominal
terms, whereas what is more relevant is the real rate of interest.
Since the purchasing power of money declines due to inflation,
real income from the bond will not be the same as its nominal
income. The longer the maturity period, the greater is the inflation
risk.
4. Default Risk: The issuer of the bond may lose his capacity to pay
interest and the principal amount on time. One can get an idea of
the default risk by seeing its credit rating. Bonds with high default
risk will have a low credit rating and vice versa.
5. Call Risk: When the interest rate declines, the issuer may exercise
the call option in case of callable bonds. The investor will have
to accept the premature redemption and will have to reinvest at a
lower rate.

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Notes 6. Liquidity Risk: Most debt instruments do not have a very liquid
market. This makes it difficult for investors to offload their investment
in debt instruments. They may have to accept a discount over the
quoted price.
7. Event Risk: Sometimes, for reasons like natural calamities, a government
change, takeover, or restructuring, etc., there might be a change in
the firm’s ability to pay interest and the principal payments.

IN-TEXT QUESTIONS
1. Which of the following securities has the most possible risk as
well as the highest potential return?
(a) Preferred stocks
(b) Commercial paper
(c) Derivative securities
(d) Bonds
2. The ability to convert an asset rapidly and without influencing
its price is referred to as __________.
(a) Scalability
(b) Liquidity
(c) Marketability
(d) Minimal risk
3. Horse racing, card games, and the lottery are all instances
of __________.
(a) Investing
(b) Gambling
(c) Speculating
(d) Arbitrage
4. __________ is associated with buying low and selling high,
resulting in a significant capital gain.
(a) Speculation
(b) Gambling

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 Fixed-Income Securities

(c) Investing Notes

(d) Arbitrage
5. Amount of money paid to a company’s shareholders on a regular
basis.
(a) Bonds
(b) Profit
(c) Cashback
(d) Dividends

2.8 Summary
The section focused on bonds and debentures while outlining some key
characteristics of fixed-income instruments. It clarified how bonds, other
securities, and corporate fixed-income securities were categorized.
The idea of yield and the different kinds of it that provide crucial guide-
lines for wise investment choices were described. Numerous illustrations
are provided to further clarify each subject.
It becomes crucial for an investor to value bonds using the required rate
of return in order to make wise investment choices. The capitalized value
is the finest valuation model among them all. The unit uses the balance
time to maturity to illustrate when it makes no sense to sell at a discount
or to acquire at a premium.

2.9 Answers to In-Text Questions

1. (c) Derivative securities

2. (c) Marketability
3. (b) Gambling
4. (a) Speculation
5. (d) Dividends

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Notes
2.10 Self-Assessment Questions
1. What are the important features of fixed-income securities?
2. What does yield to maturity (YTM) mean? What distinguishes it
from holding period return (HPR) and yield-to-call (YTC)?
3. Explain bond yield. In the event that the bond is selling at a premium,
what is the projected bond yield in relation to the coupon rate?
4. What does the term “financial asset valuation” mean to you? What
does “capitalized value” mean? Why is it regarded as a practical
approach to valuation?

2.11 References
u Choudhry, M. (2001). Bond Market Securities. Prentice Hall, New York.
u Choudhry, M. (2001). Bond and Money Markets: Strategy, Trading
and Analysis. Butterworth-Heinemann, Woburn, MA.
u Fabozzi, F. J. (Ed.). (2000). The Handbook of Fixed Income Securities,
6th ed. McGraw-Hill, New York.
u Youngdahl, J., Stone, B., & Boesky, H. (2001). Implications of a
disappearing treasury debt market. Journal of Fixed Income, 10(4),
75-86.

2.12 Suggested Readings

u Chandra, P. (2017). Investment Analysis and Portfolio Management.
Tata McGraw Hill Education, New Delhi.
u Chaturvedi, S., Kaur, G., Singh, A., & Kaur, J. (2021). Investing in
Stock Markets. Scholar Trust Press.
u Kevin, S. (2022). Security Analysis and Portfolio Management. PHI
Learning, Delhi.
u Kumar, V., Kumar, N., & Sethi, R. (2021). Investing in Stock Markets.
Ane Books.
u Pandian, P. (2012). Security Analysis and Portfolio Management.
Vikas Publishing House, New Delhi.

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u Ranganatham, M., & Madhumathi, R. (2012). Security Analysis and Notes

Portfolio Management. Pearson Education, India.
u Singh, J. K., & Singh, A. K. (2017). Investing in Stock Markets.
A. K. Publications, New Delhi.
u Tripath, V., & Pawar, N. (2022). Investing in Stock Markets. Taxmann
Publications.

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 L E S S O N

3
Fundamental Analysis
Vishal Sharma
Assistant Professor
Shaheed Rajguru College of Applied Science for Women
Email-Id: [Link]@[Link]

STRUCTURE
3.1 Learning Objectives
3.2 Introduction
3.3 Economic Analysis
3.4 Industry Analysis
3.5 Company Analysis
3.6 Summary
3.7 Answers to In-Text Questions
3.8 Self-Assessment Questions
3.9 References
3.10 Suggested Readings

3.1 Learning Objectives

‹ To understand the meaning of fundamental analysis.
‹ To understand EIC framework and economic analysis.
‹ To understand the concept of industry analysis.
‹ To understand the process of company analysis.

3.2 Introduction
The fundamental analysis is the examination of the factors that determine a security’s fair value.
Fundamental analysis is based on the premise that in the long run, true or fair value of an
equity share is equal to its intrinsic value which is the present value of all expected future cash
inflows from an asset. Broadly there are two approaches to fundamental analysis – Top-down

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approach and Bottom-up approach. The “top-down approach” is a more Notes

comprehensive framework for fundamental analysis, though. The Economic-
Industry-Company Approach (EIC) is another name for this strategy,
which aims to investigate the industry position, company expectations,
and economic conditions. The investor in the EIC approach begins
with the market and economy as a whole before moving on to industry
prospects. The investor proceeds to a specific company analysis based
on the encouraging signals provided by the economic analysis and the
particular sectors/industries noted by the industry analysis. Fundamental
analysis at the corporate level looks at financial variables. The forces
of supply and demand for the offered product would be examined at
the industry level.

3.3 Economic Analysis

The top-down approach prioritizes the comprehensive assessment of the
overall economy. The study of the factors influencing the economy as a
whole is the focus of economic analysis. The anticipated path of the econ-
omy must be investigated in the security analysis since business profits
and investor expectations are influenced by general economic conditions
and economic activity, which in turn affects capital market security prices.
Making investment decisions involves considering the effects of economic
analysis. Investors who see a robust and dynamic economy in the eco-
nomic analysis will purchase shares with the hope of realizing capital
gains in the future. The economic analysis aids in determining whether
or not the general state of the economy is favorable to the expansion of
businesses. It is crucial to remember that all industries are supposed to
prosper when the economy expands. Weak economies make it difficult
for industries to thrive. Important factors to consider when examining
the national economy include: (a) GDP; (b) inflation; (c) interest rates;
(d) fiscal policy; (e) monetary policy; (f) business cycles; and so on. It
is a challenging task to forecast and analyze these variables, and it takes
a lot of information and experience.

3.3.1 Variables and Techniques for Economic Analysis

Businesses function within the nation’s overall economic environment.
Numerous social, political, and economic developments occurring in the

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Notes economy influence and shape the economic environment. In most cases, a
firm has no control over these changes. It must, however, make an effort
to adapt to these forces, some of which are as follows:
(a) A rise in consumption.
(b) An increased competition in free markets.
(c) A growing trend towards privatization.
(d) A rise in population migration to cities.
(e) An increase in globalization and international trade.
(f) An increase in the employment of women and their presence in other
fields, and so on.
The status of the economy can be determined using a number of indicators.
Knowing these factors will help in estimating the expected performance of
the economy, which will therefore have an impact. An understanding of
these variables will help to make an idea as to how economy is expected
to perform which in turn will affect the future earnings and financial
position of the companies. Some of the variables are discussed hereunder.
Gross Domestic Product (GDP): GDP stands for gross domestic prod-
uct, which is the market value of the goods and services produced in an
economy over a given time period, usually one year. The market values
of all the finished goods and services produced during the time can be
added to determine it. The GDP is a crucial indicator of economic activity.
GDP is regarded as a suitable indicator of a nation’s economic growth.
Change in GDP is caused by:
(a) A shift in resource availability.
(b) A shift in how these resources are used.
(c) An adjustment in how effectively production factors are employed.
GDP provides information about how the economy performed during
that time. An increasing trend in GDP tells about an expanding economy
which provides a lot of opportunities to the firms to increase the level
of activities and to increase the earnings. There are two other measures,
gross national product and net national product which are also indicators
of economic activity.
Business Cycles: The phrase “business cycle” refers to the cyclical varia-
tions in a country’s total economic activity. Every stage that a developing

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economy goes through is referred to as a business cycle component. The Notes

terms recession, boom, recovery, and depression are frequently used to
describe these phases. The great depression is the lowest point in eco-
nomic activity. The economy is experiencing very little demand. There
is a high rate of interest rates and inflation. These affect the overall
profitability of the corporate sector. Economic crises are affecting busi-
nesses in different ways. Dividend payments and reinvestment activities
are declining because their profitability is severely strained. Companies
might even have to shut down a few of their plants.
The recession’s later stages are when the economy starts to rebound. The
degree of demand starts to rise. In general, the state of the economy is
improving. Rising demand leads to growing production, which is reflect-
ed in the improved income statement bottom lines of business firms.
There is an increasing trend in new investment from corporate entities.
This stage is known as “recovery.” The economy shows indications of a
boom, which is characterized by high levels of demand, production, and
profits, after several years of steady recovery. Overall economic growth
is occurring, and corporate entities are increasing their investments.
Generally, the boom phase cannot continue for very long it slows down,
bringing about the recession. Nearly every economy experiences phases
of expansion and contraction, or the various stages of a business cycle.
These cycles could be irregular, and the length and depth could vary.
The points at which cycles change are categorized as Peaks (P) and
Troughs (T). They are designated as P and T. “T” denotes the bottom of
the depression and a sign of recovery towards growth, while “P” denotes
the change from the growing phase to the beginning of the recession.
It should be mentioned that different industries exhibit distinct response
patterns. Certain industries have the potential to exhibit superior per-
formance compared to the overall economy. These include sectors that
produce capital goods like consumer durables.
During a recession, there is typically a delay in the demand for these
goods. However, the demand pattern beats the overall level of demand
during the recovery. On the other hand, sectors that deal with necessities
like food are less responsive during that time. However, during a recession,
these sectors would typically perform better than the overall market. An
investor will benefit greatly from having a solid understanding of busi-

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Notes ness cycles. Investments in the essential goods industry should be made
if there are signs of a recession; on the other hand, investments in the
capital goods industry may be preferred if there are signs of a recovery.
An investor will benefit greatly from having a solid understanding of
business cycles.
Inflation: A general upward trend in prices is referred to as inflation.
Consumer purchasing power is impacted by inflationary pressure in the
economy, which has a major effect on business performance and profit-
ability. An expansionary phase may be indicated by a low inflation rate,
while a high inflation rate may be interpreted as a sign of a slower growth
rate. There is a connection between the capital market and inflation. The
nominal required rate of return for investors increases during inflation,
which lowers the price of bonds and stocks. The consumer price index
or the wholesale price index can be used to calculate inflation. These
indices’ analysis will reveal the anticipated state of the economy.
Interest Rates: The cost of financing for the industry is directly impacted
by interest rates. Elevated interest rates raise the expense of borrowing
money, thereby reducing the earnings of businesses. Conversely, low-
er interest rates result in higher profit because they lower the cost of
borrowing money. Interest rates can fluctuate for a number of reasons,
including changes in the inflation rate, monetary and fiscal policies, and
so on. The economy’s investment pattern is impacted by interest rate
changes, regardless of the underlying causes of those changes. Bond
and equity prices are impacted by interest rates because they also have
an impact on investors’ opportunity cost. Consequently, variations in
interest rates affect both the market prices and the companies’ profits.
There are several indicators of interest rates. These are interest rates in
the call money market or the bank rate or the prime lending rate of the
lending institutions.
Monetary Policy, Money Supply and Liquidity: The money supply,
which is controlled by the government’s monetary policy, determines the
amount of liquidity in the economy. The Reserve Bank of India (RBI)
has implemented various strategies to control the amount of money in
circulation and liquidity within the economy. Funds are needed by busi-
nesses for projects involving expansion. The economy’s liquidity position
has an impact on the ability to raise capital from the market. The goal

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 Fundamental Analysis

of the monetary policy is to keep the liquidity position in balance. It Notes

is not desirable to have shortages or excess liquidity. Interest rates will
typically rise in response to a liquidity shortage, while an excess will
lead to inflation. By altering the discount rate, the monetary environment
and supply have an impact on share prices. It is anticipated that an easy
monetary policy will cause the discount rate to decline. A change in the
money supply could be a signpost for the start of a new stage in the
business and economic landscape. The real economy is also impacted by
the money supply because (a) the growth of the supply position and (b)
the change in the growth of the demand level. A change in the money
supply could be a signpost for the start of a new stage in the business
and economic landscape. India’s money supply is indicated by a number
of variables. The two crucial metrics are M3 and M1. The total amount of
money in circulation, plus demand deposits held by banks and additional
deposits held by the RBI, is known as the M1.
Additional Factors: In addition to the previously listed elements, there
exist additional factors that must be included in the comprehensive eco-
nomic analysis. Among these are:
(a) Total and sectoral industrial growth rates.
(b) Rainfall patterns and agricultural output.
(c) The government’s fiscal policy.
(d) Reserves of foreign exchange.
(e) The expansion of infrastructure.
(f) Worldwide industrial connections.
(g) Confidence and the global economic scenario.
(h) Overall economic feelings and economic confidence.
(i) Political and economic constancy.
Leading and Lagging Indicators: Leading and lagging indicators refer
to distinct metrics that represent the degree of economic activity and its
fluctuations. The leading indicators are those that experience their peaks
and troughs well ahead of the overall economic activity. Conversely,
lagging indicators are those that indicate a turn in the economy after it
has already occurred. The following are a few examples of leading and
trailing indicators:

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Notes Leading Indicators

(a) Money supply.
(b) Industrial production.
(c) Average weekly hours of production.
(d) New orders with the manufacturers.
(e) Order for capital goods.
Lagging Indicators
(a) Industrial loans outstanding.
(b) Average duration of employment (unemployment).
(c) Average prime lending rates.
(d) Average ratio of inventories (stock levels) to sales.
(e) Ratio of consumer credit outstanding to personal income.
The direction of change in overall economic activity can be inferred
from the analysis of leading and lagging indicators. Put differently, it is
possible to pinpoint the moments when the volume of economic activity
began to decline. It should be noted, though, that the analysis provides
no information regarding the length or extent of the change.
The following pattern can be used for economic forecasting:
(a) To determine the fundamental economic environment, a trend analysis
of the GDP and other key economic indicators should be conducted.
(b) Leading indicators of the economy should be examined in order to
predict when the business cycle will shift in phase.
(c) A study of the effects of a business cycle shift should be conducted
using lagging indicator analysis.
An investor should further break down the economy into different industry
groups, after developing a scenario for the overall economy. Different
industries are impacted differently by national and international conditions.
The industry analysis, which is the next component of the EIC approach,
must come before the economic analysis.

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3.4 Industry Analysis Notes

The above economic analysis may help determine the direction of the
shift in the capital market. The analyst must understand, though, that
various industries react to changes in the capital market in different
ways. For instance, consumer goods companies may grow at a faster rate
than heavy industries under favorable economic conditions. The analyst
needs to understand that various industries react to changes in the capi-
tal market in different ways. The goal of every investment analyst is to
identify and separate investment opportunities with favorable risk-return
characteristics. He might need to respond to multiple questions:
(a) Do different industries have varying risk profiles?
(b) Does a certain industry’s risk level fluctuate or stay the same?
(c) Do returns from different industries vary over a given time frame?
(d) Would a sector of the economy do well going forward?
(e) Would a company’s performance in a given industry remain consistent
over time?
For the same reasons economic analysis is significant and pertinent, so
too is industry analysis. Just as it is challenging for an industry to thrive
in a down economy, it is also challenging for a company to prosper in
a troubled industry. Thus, an industry analysis is necessary following an
economic analysis. Understanding (a) the major industries and (b) the
relative strengths and weaknesses of each industry with regard to eco-
nomic activity are essential for conducting an industry analysis.
(i) Product Line: Automobiles, steel, cement, textiles, and so on.
(ii) Sector Wise: Agriculture, mining, construction, manufacturing, IT
services, transportation, and so on.
(iii) Business Cycle Wise: Growth, cyclical, and defensive. Growth industries
are those which show high growth rate irrespective of the business
cycle. Software industry may be classified as a growth industry. Cyclical
industries are those which move with the business cycles. These are
benefited as well as have to suffer with the change in phase of the
business cycle in the economy. Defensive industries are those which
are virtually non-sensitive to business cycles. For example, industries
dealing with essential commodities such as food, are defensive industries.

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Notes Once the status of the economy has been predicted, the implications of that
prediction for the particular industry must be ascertained. It has already been
mentioned that not all industries are affected by business cycles and the
state of the economy in the same way. While certain industries are highly
resilient to business cycles, others are essentially autonomous. Even though
economic growth is predicted, some groups are probably going to gain more
than others. By focusing on the groups most likely to profit from the current
or anticipated economic climate, an investor can refine their analysis. The
food and spice industry, for instance, is largely unaffected by the business
cycle. However, the market for luxury goods is extremely erratic.
(a) Sensitivity of Sales: Business cycles and the state of the economy
function in the same way. While certain industries are highly resilient
to business cycles, others are essentially autonomous. Even though
economic growth is predicted, some groups are probably going to gain
more than others. By focusing on the groups most likely to profit from
the current or anticipated economic climate, an investor can refine
their analysis. The food and spice industry, for instance, is largely
unaffected by the business cycle. However, the market for luxury
goods is extremely erratic.
Profits in those industries which have high fixed costs will swing
more widely with sales because costs do not move to offset sales
changes.
(b) Financial Leverage: The individual company is important; however,
it cannot be denied that the industry group is likely to exert as much
influence on the share price. Prices typically move in unison when
they do. Investors ought to favor sectors of the economy that are
less susceptible to business cycles. Investments in industries with
greater sensitivity will carry greater risk.
Important Elements of Industry Analysis: To determine the industries
where investments can be made, a number of important factors and char-
acteristics should be taken into account in an industry analysis. Among
these elements are:
1. The Industry’s Historical Performance: To predict future earnings,
sales, and earnings for a given year can be analyzed in the past.
To investigate the industry’s leverages, one may also examine its
cost structure.

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2. The Durability of Industry Technology and Products: If an Notes

analyst believes that a certain industry’s product demand will
soon disappear, they should not make any investments there. The
degree of permanence has grown in importance in this era of rapid
technological obsolescence in the industry analysis.
3. The Government’s Function in the Sector: Investors ought to
make an effort to determine the likely role of the state. Will it
limit the expansion of the industry? Will it offer monetary or other
forms of assistance? For instance, import restrictions on various
electronic items were lifted in India a few years ago, but this had
a significant impact on the country’s manufacturers.
4. Industry-specific labor conditions.
5. Market conditions that are competitive.
The following queries should be kept in mind when analyzing the indus-
try’s competitive conditions:
(i) Whether there is a threat or barrier to new businesses entering the
market. An industry’s prices and profits are under pressure from
new competitors.
(ii) The level of competition among current participants is an additional
factor. When there is fierce competition, the margins will inevitably
shrink. Businesses in slow-growing industries are in this situation
because they want to grow at the expense of their competitors’
market share.
(iii) Is there a product that can take the place of the specified product?
A substitute product’s availability undoubtedly influences the price
that can be charged to the customer and, in turn, influences the
profit margin.
6. Interlinkages with Other Industries: In the industry analysis,
the interdependence and interlinkages of one industry with other
industries should be considered. For instance, the auto industry’s
position affects the auto-ancillary industry’s position. In a similar
vein, the government’s infrastructure budget affects the demand for
the cement industry.

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Notes IN-TEXT QUESTIONS

1. GDP helps in estimation of earnings of a company. (True/False)
2. Business cycle and industry life cycle are two sides of the same
coin. (True/False)
3. Analysis of leading and lagging factors helps in estimating the
earnings of a company. (True/False)
4. In ‘EIC’ approach, E stands for earnings of the company.
(True/False)

3.5 Company Analysis

The company analysis is the third component of the EIC fundamental
analysis approach. The economy analysis and industry analysis in the
previous discussion have tried to demonstrate how they affect a single
company’s earnings. While sales in some industries, like automobiles,
follow business cycles, sales in other industries, like food, do not. A busi-
ness cycle’s impact on a specific company might differ from that on the
sector as a whole. A company’s product mix may cause its sales revenue
and earnings to fluctuate between being more or less proportionate to the
effects of the microeconomic and industry conditions. The link between
revenue and expenses is the main focus of the company analysis.
Before moving forward with a thorough examination, an investor would
prefer to reduce the list of companies. An astute investor would be curi-
ous to learn who the group’s innovators and leaders are. Finding higher
performing companies within an industry is the main goal of company
analysis. These businesses are chosen for investment because they are
probably in a competitive position relative to other businesses. A multi-
step procedure could be used to achieve the goal. Here are some of the
steps that are involved:
1. An analysis of the company’s management to determine how
reliable it is, and how well-equipped it is to handle any unfavorable
circumstances in the sector.
2. Evaluation of the business’s financial performance in order to project
its potential earnings in the future.

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3. Assessment of the company’s long-term goals and plans in light of Notes

its organizational capacity and available resources.
4. Examination of the firm’s relative strength in relation to a critical
success factor for a given industry.
The following are the goals of the company analysis, which is predicated
on the completion of the economic and industry analyses: (i) Analyzing
the company’s expected earnings; and (ii) determining the fair value
(intrinsic value).
A company’s ability to make money is influenced by a number of fac-
tors, including sales, profit margin, tax rate, percentage of debt, asset
utilization, and so on. The earnings have an impact on and determine
the fair value of the share, along with other factors like future growth
rate, and so on. The final goal of company analysis is to determine the
share’s fair value. However, the analysis of the firm’s expected earnings
is the only topic covered in this chapter.
Informational Sources: The firm’s annual financial statements are the
main source of information and data needed for an analysis of the earnings
of the company. The balance sheet, also known as the position statement,
the income statement, also known as the profit and loss account, and the
cash flow statement are among the financial statements.
Balance Sheet (BS): The BS is thought to be a company’s most
important and fundamental financial statement. A company creates the
BS to give an overview of its financial situation at a specific moment,
usually the end of the fiscal year. It displays the company’s situation
at a specific moment in time. It displays the company’s resources,
assets, and liabilities, along with the owners’ contributions and the
company’s obligations to third parties. In actuality, the BS balances
the company’s assets against its financing, which may consist of debt
and owner funds. In other words, the total value of the assets must
equal the total amount of claims made against the company. This can
be expressed as follows:
Liabilities + Shareholders Equity = Total Assets − Total Claim (Debt +
Shareholders)
It should be mentioned that the BS is pertinent at a specific moment in
time. It resembles a financial snapshot taken at a specific moment in time,

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 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

Notes both before and after which the situation might have changed. The BS is
therefore a status report.
Income Statement (IS): The IS, sometimes referred to as the profit and
loss A/C or the statement of earnings, provides a summary of the com-
pany’s expenses and revenue for a given accounting period. It provides a
thorough overview of the firm’s sources overtime. Income and expenses
are included, and as a result, the operating results of the company for
a given time period are summarized. It compares the revenues to the
expenses incurred in producing the revenues and displays the difference as
the net profit or loss realized for the given time period. The IS displays
the outcomes of the company’s operations over a given time period. As a
result, the IS is a flow report in comparison to the BS, which is a stock
or status report. The IS shows the company’s earning potential in terms
of net profit. It facilitates comprehension of the company’s performance
during the relevant time frame.
Statement of Change in Cash Position or Cash Flow Statement: Known
as traditional financial statements, the BS and IS are two typical financial
statements. The IS displays the net results of the company’s operations
over a specific time period, while the BS shows the financial position at
a specific point in time. However, neither of these financial statements
reveals how the financial position changed during the period. Understand-
ing the cash movement during the period is crucial for comprehending
the financial positions. Another financial statement called the cash flow
statement, which details how the company made and used cash during
the period, may be prepared for this purpose. It presents the cash flow
that the company experienced during that time. It serves as a historical
record of the source and application of the funds. The company may have
obtained funds from a variety of sources, and the funds may have been
utilized for a variety of purposes. It should be mentioned that the cash
flow statement is prepared on a cash basis, but the BS and IS are pre-
pared on an accrual basis. For instance, even though depreciation doesn’t
involve any cash flow, it is an expense for IS but isn’t displayed in CFS.
Analysis of Financial Statements: Researchers and investment analysts
typically use the data from the company’s annual financial statements as
the foundation for their company analyses. This is primarily because the
Institute of Chartered Accountants of India (ICAI) publishes a number
of accounting standards that must be adhered to in the preparation of
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the annual financial statements. These standards are audited and follow Notes
a set of guidelines. Companies include a summary of the financial high-
lights for a period of time, say five or ten years, in their annual report
to shareholders in addition to their annual financial statements. An
investment analyst can utilize the data in annual financial statements to
understand on:
(i) The company’s profitability; (ii) liquidity; (iii) solvency; and
(iv) activity level.

3.6 Summary
The significance of the EIC approach, as the discussion above suggests,
is that an investor should take the time to research the forces at play in
the industry and the economy in order to determine share valuation. The
rationale is that industry position, corporate profit, and security prices are
all impacted by the nation’s economic climate, which makes forecasting it
crucial. A positive and optimistic economic outlook may be a reliable sign
of the company’s increasing profits. The prices of securities reflect the
overall optimism. Conversely, a weakening economic climate naturally leads
to pessimism and prices, which in turn causes a decline in corporate profits
and security prices. There is a clear and significant relationship between
the security prices and the economic environment. An investor can choose
where and when to invest with the aid of the EIC approach. A sane investor
would want to determine when it is right to invest in the stock market. It
could be argued that choosing an industry is more significant than choosing
a company. Every member firm is impacted by the growth or decline of a
specific industry. It should be mentioned, though, that certain businesses
consistently outperform others. However, another viewpoint might hold
that the industry is irrelevant and that only the choice of company matters.
However, the truth is that a sane investor would find a promising industry
first, and then purchase the cheap shares in that industry.

3.7 Answers to In-Text Questions

1. False 3. False
2. False 4. False

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Notes
3.8 Self-Assessment Questions
1. What do you mean by industry analysis? What factors would you
look for in analysis of a particular industry?
2. What are the techniques of economic analysis? How is the economic
analysis useful for investment decision?
3. Differentiate between economic analysis and industry analysis.

3.9 References
u Dr. R. P. Rustagi, Investment Analysis and Portfolio Management.
u Prasanna Chandra, Investment Analysis and Portfolio Management.

3.10 Suggested Readings

u Frank K. Reilly and Keith C. Brown, Investment Analysis and
Portfolio Management.
u Gerald R Jensen and Charles P. Jones, Investments Analysis and
Management.

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 UNIT - II

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 L E S S O N

4
Valuation Models
Ms. Juhi Jham
Assistant Professor
School of Open Learning
University of Delhi
Email-Id: [Link]@[Link]

STRUCTURE
4.1 Learning Objectives
4.2 Introduction to Valuation
4.3 Dividend Discount Models
4.4 Relative Valuation
4.5 Relative Valuation Multiples
4.6 Relative Valuation Model
4.7 Summary
4.8 Answers to In-Text Questions
4.9 Self-Assessment Questions
4.10 References
4.11 Suggested Readings

4.1 Learning Objectives

‹ Comprehending various approaches to valuation.
‹ Understanding dividend discount model of valuation.
‹ Learning to value companies as per market-based approaches.
‹ Understanding comparable company using widely used multiples.

4.2 Introduction to Valuation

Valuation means estimating the value of asset, division or an entire business based on esti-
mated earnings, cash flows and risks associated. The process of evaluating or determining
the worth of certain assets, such as real or intangible, securities, liabilities, and a particular

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Notes business as a going concern, as well as any listed or unlisted company,

partnership, or sole proprietorship, is known as valuation. Valuation can
be seen as both science and art. Valuation process is scientific as it is
based on corporate finance theories and principles. Valuation is an art as
valuers can paint stories about companies’ future and bring them in their
projections. Values assigned for a business or an enterprise is only an
estimate and cannot be precisely accurate. Valuers need to acquire both
number skills and storytelling skills to ace at valuation.
Valuation is an important part of investment process.
Valuation is used pervasively across investment banking industry for
valuing securities and target companies. In merger and acquisition deals,
investment bankers value company’s equity worth for public/private place-
ment of their securities. Managers deploy valuation while acquiring or
divesting a business. It is further deployed by equity research companies
and portfolio managers for identifying undervalued or overvalued stocks.
Financial institutions investing in companies in form of debt or equity
also value the companies to assess the deal.
Valuation of bonds or other fixed income securities has already been
explained in the previous chapter. The present chapter explains the val-
uation of variable income securities, i.e., equity shares.
Valuation of a company can be conducted via discounted cash flow-based
approaches or market-based approaches.
Discounted Cash Flow method (DCF) involves estimating intrinsic value
of the firm by finding the present value of all cash flows company is
expected to make till perpetuity. Discounted cash flow method is an
intrinsic value method. It is a financial model which assesses the value
of an investment by projecting future cash flows. The foundation of a
DCF model is the notion that an organization’s worth is established by
its capacity to produce future cash flows for its shareholders.
DCF = CF1/(1 + r)1 + CF2/(1 + r)2 + ………………+ CFn/(1 + r)n
CF₁ = Initial period cash flow
CF₂ = The second period’s cash flow
CFₙ = Cash flow for the course of “n”
n = The total number of time periods
r = The discount rate.
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The DCF model can be deployed to compute equity value or firm value. Notes
The DCF model is based on the following propositions:
Proposition 1: An asset must have positive projected cash flows at some
point during its existence in order to be valued.
Proposition 2: Early-generating assets will be more valuable than lat-
er-generating assets, even though the latter may have faster growth and
cash flows to make up for it.
This method works best for assets (businesses) whose cash flows are
positive at the moment, can be reasonably projected for future periods,
and have access to a risk proxy that can be used to calculate discount
rates. It is most effective for investors who have a long-time horizon,
giving the market time to correct its valuation errors and allow price to
return to “true” value.
Free Cash Flow-Based DCF Method: The DCF model is used to conduct
firm valuation and equity valuation. In firm valuation, the entire business
is valued by discounting free cash flow for firm. Free cash flow for firm
is the cash flow before considering debt payments, while after taking out
taxes and after considering the reinvesting needs of the business. In equity
valuation, free cash for equity is discounted back at cost of equity, where
free cash flow to equity is cash flow after considering debt payments and
after considering the reinvesting needs of the business.
Dividend Discount Model estimates equity value of a company by discounting
dividends expected to be distributed by the company till perpetuity. The
discount rate used to find the present value is the cost of equity, i.e., the
expected rate of return by equity shareholders.
Relative valuation model is market-based approach of valuation. The
method estimates values on the basis of the price of similar assets in
the market. To value a company, one needs to identify similar companies
and standardized measure of value. If the assets or businesses are not
perfectly comparable, one may need to control for differences. Relative
valuation model can be used to value equity, firm, i.e., valuing both equity
and debt or valuing operating assets (equity and debt value excluding
value of cash).
The dividend discount model and relative valuation are elaborated in
length in the chapter.

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Notes
4.3 Dividend Discount Model
The Dividend Discount Model (DDM) is an estimation method where
the entire expected dividend payments are discounted at a cost of eq-
uity to estimate the intrinsic value of a stock. This model is applicable
for companies having history of regular dividend payments and is also
expected to continue same in future. The basic idea is that intrinsic
value of stock is reflected through present value of expected dividends.
Dividend discount model has several variations to its model depending
upon growth rate of dividends. Dividend discount models discussed on
the basis of growth rate variations are discussed as follows:

4.3.1 Zero Growth Model

This model makes the assumption that a firm will always pay the same
amount of dividends every year—i.e., the dividends will not increase
during the course of the company’s existence. In this scenario, the equity
value can be determined as follows:

D1
P0 =
Ke
Where,
P0 = Value per share
Ke = Cost of equity
D1 = Dividend expected at the end of year 1

4.3.2 Constant Growth in Dividends

Since Myron Gordon introduced the constant growth model in 1956, it is
sometimes referred to as the Gordon growth model. This model assumes
that the cost of stock exceeds the company’s growth rate and that dividends
will increase steadily. Dividends in this model are increasing, but at a
set yearly rate. In this case, a stock’s value can be calculated as:
D1
P0 =
Ke − g

P0 = Value per share

Ke = Cost of equity
D1= Dividend expected at the end of year 1
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g = growth rate of dividends Notes

Growth in cash flows can either be induced by achieving efficiency or in-
fusing new capital to fund new projects. Efficiency induced growth cannot
be sustained as the company can only be so much efficient. Sustainable
growth is the growth induced by capital infusion in every period. Hence,
growth is computed on the basis of how much is invested and how well the
capital is invested, i.e., g = b*r where b is reinvestment rate or retention
ratio in case of dividend discount model and r is return on equity.

Illustration 4.1: Estimating Cost of Equity Through DDM

TT Ltd. has declared dividend in 2023 of $1.36 on the Earnings Per Share
(EPS) of $3.06. The firm is assumed to maintain a return on equity of
12% in perpetuity. Assuming that beta of the firm is 0.8, risk premium
is 4% and currently prevailing risk-free rate is 4.5%. Estimate the value
per share if the stock was trading at $150 in early 2023.
Solution:
DPS 1.36
Payout Ratio = = = 44.44%
EPS 3.06
Retention Ratio = 1 − Payout Ratio
Retention Ratio = 1 − 0.4444 = 55.56%
Expected growth rate in EPS = Return on Equity × Retention Ratio
= 12% × 0.5556 = 6.66%
Cost of Equity = Risk free Rate + Beta × Risk Premium
= 4.5% + 0.8 × 4% = 7.7%
D1 1.36(1 + 0.0666)
Value of Equity per share = = = 139.47
ke − g 0.077 − 0.0666

The stock was trading at $150 in early 2023, whereas the value per share
obtained through the dividend discount model is $140 (approx.). Thus,
it can be stated that stock is overvalued.

4.3.3 Variable Growth Rate Model

A valuation technique used to determine the intrinsic value of a stock
where dividend growth is anticipated to occur at varying rates is the vari-
able growth rate model of dividends. For instance, the growth rate may
be 10% annually for the first five years, 8% annually for the following
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Notes five, and so on for an endless amount of time, with dividend increases at
the rate of 6% annually. Since the Gordon Growth Model is less flexible
than the constant growth model and is appropriate for businesses with
variable dividend growth rates, the variable growth rate model is used
in this situation. The variable market value of equity under a variable
growth rate can be computed as:
D0 (1 + g1 )i 10 D5 (1 + g 2 )
i-5
∞ D10 (1 + g 3 )
i-10
P0 = ∑ i =1 ∑ i =6 (1 + K e )i ∑ i =11 (1 + K e )i
5
+ +  +
(1 + K e )i
Where,
P0 = Value per share
Ke = Cost of equity
D0 = Current year dividends
D5 = Dividends expected at the end of 5th year
D10 = Dividend expected at the end of 10th year
g1, g2, g3, = Growth rate of dividends in different periods
Illustration 4.2: Valuing a Firm with Two-Stage DDM
Vanguard Finance is a leading investment bank. Current payout ratio of bank
is 10.07% and current Return on Equity (ROE) is 17.49%. Bank maintains a
high growth rate for first 5 year, with risk-free rate of 5.5%, risk premium
of 5% and beta of 1.2. Beyond 5 years, the beta of bank becomes 1. Also,
after high growth period, bank stabilizes and maintains ROE at 13% with
a stable growth rate of 5% for an indefinite period. If current earnings per
share (EPS) is 12.05, estimate the value of equity at Vanguard Finance.
Also, comment if the current share of Vanguard Finance is trading at $128.
Solution:
Value of Vanguard Finance can be estimated using two-stage dividend
discount model:
Expected growth in earnings per share = Return on equity × Retention ratio
= 17.49% × (1 − 0.1007) = 15.72%
g 0.05
Stable period payout ratio 1 = = 1− = 61.54%
ROE 0.13
Cost of equity in high growth phase = 5.5% + 1.2(5%) = 11.5%
Cost of equity in stable growth phase = 5.5% + 1(5%) =10.5%
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Estimating present value of dividends for first 5 years; Notes

Year EPS DPS PV @11.5%

1 13.94 1.40 1.25
2 16.14 1.63 1.31
3 18.67 1.88 1.36
4 21.60 2.17 1.40
5 25.00 2.52 1.46
Sum 6.78

Estimating terminal price during stable growth phase;

D6
Terminal price =
K e , st − gn

Expected EPS6 = $12.05 × (1 + 0.1572)5 × 1.05 = $26.26

Expected DPS6 = EPS6 × Stable period payout ratio = $26.26 × 0.6154 = $16.16

Dividends6 $16.16
Terminal price = = $293.81
K e, st − g 0.105 − 0.05

$293.81
Present value of terminal price = $170.49
(1.115)5

Value of equity = Present value of dividends + Present value of terminal price

= $6.78 + $170.49 = $177.27
Currently, Vanguard Finance is trading at $128; thus it can be stated that
company is significantly undervalued.

IN-TEXT QUESTIONS
1. When you value assets, you are implicitly assuming that
(a) The market is always right
(b) The market is always wrong
(c) The market is sometimes wrong, but that it corrects itself
eventually
(d) The market is sometimes wrong, and that it does not correct
itself eventually
(e) None of the above
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Notes 2. Valuation is a skill set that is necessary only for

(a) Investment bankers who may want to assess the value of
acquisitions or IPOs
(b) Management consultants who want to provide good corporate
finance advice
(c) CFOs who want to understand what drives the value of
their businesses
(d) Investors who want to find cheap and expensive stocks
(e) Entrepreneurs who have to negotiate with buyers and VCs
about the values of their businesses
(f) All of the above

4.4 Relative Valuation

Relative valuation model is market-based approach of valuation. The method
estimates values on the basis of the price of similar assets in the market.
By comparing a company’s earnings, book value, revenue, and cash flows
to those of other businesses, relative valuation determines the value of the
former. The two most used relative valuation methods are comparable com-
pany and prior transaction analysis. Comparable companies, also known as
comps, are used to evaluate enterprises in light of similarly oriented pub-
licly traded organizations. On the other hand, a firm’s worth is determined
by looking at previous merger and acquisition transactions in which the
entire company was either purchased or sold in prior transaction analysis.

Figure 4.1: Steps in Relative Valuation

A comparison of an asset’s value with what the market would pay for
similar or comparable assets is known as relative valuation. Relative val-
uation uses multiples of sales, book value, or earnings to normalize the
pricing of the assets (a collection of similar or identical businesses). The
price-to-earnings (P/E) ratio is a widely used multiple that is employed
to determine the relative value of a business.
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Finding comparable assets (often businesses) and learning their market Notes
values are the first steps in the relative valuation process. Next, price
multiples based on the market values are estimated and compared. Com-
parable companies aren’t always in the same sector or industry; they can
be comparable while operating in quite different markets yet sharing
similar risk, growth, cash flow, or other essential traits.
Relative valuation aids in determining a company’s value and gives investors
a more accurate head-to-head assessment of several possible investments.
Compared to the discounted cash flow technique, it is computed using fewer
assumptions, is easier and faster for clients and businesses to grasp, and is a
better representation of the state of the market at the moment. Many multiples
are computed using the company’s critical financial data and compared to
that of similar companies in order to determine the value of a business.

4.5 Relative Valuation Multiples

Values of similar enterprises in the market are compared by standard-
izing them in relation to the firm’s revenues, book value, earnings, or
other financial metrics. Then, we refer to them as multiples. The market
prices are normalized by multiples. These are instruments for measuring
finances that assess a company’s value and contrast it with those of other
companies. To make organizations more comparable, they are typically
expressed as a ratio of one financial statistic to another. Multiples show
differences in performance between an organization and its rivals. They
aid in determining whether businesses add greater value than others in
the sector and are positioned strategically in the market. Enterprise value
multiples and equity value multiples are two forms of multiples that are
commonly used to value businesses.
There must be a significant link between the numerator and denominator
in any multiple. For example, since enterprise value is equal to equity
value plus net debt, enterprise value multiples are calculated using the
denominator that matters to stakeholders (stock and debt). Thus, earnings
in the denominator should be the one computed before considering interest
expenses, preference dividends, and minority interest. The earnings should
reflect the income belonging to equity and debt holders. Conversely, equity
value multiples frequently employ denominators that are exclusive to equity
stakeholders. Thus, after interest, preference dividend, and minority interest,
the relevant denominator will be computed. Even though multiples like EV/
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Notes Net Income and Market Capitalization/EBITDA are useless because they
don’t show a clear correlation between the numerator and the denominator,
any multiple can be created to offer insight into the valuation and financial
performance of a company with a better understanding of this correlation.
4.5.1 Enterprise Value (EV) Multiples
Enterprise value is market value of equity plus debt value minus cash.
Enterprise value multiples are more suitable in assessing a merger and
acquisition transaction as they eliminate the effect of debt financing. The
following are some common enterprise value multiples:
‹ EV/EBITDA: A commonly used ratio compares a company’s
enterprise value (EV) to its earnings before interest, tax, depreciation,
and amortization (EBITDA). It tells investors how many times
EBITDA they need to pay to acquire the business. This multiple is
used to determine the multiple at which the company is currently
trading, compare the valuation of different businesses, negotiate
the acquisition of a business, and calculate the target price for a
company. This is the most preferred multiple while performing
valuation of capital-intensive businesses.
‹ EV/EBIT: A ratio compares a company’s enterprise value to
earnings before interest and taxes while incorporating depreciation
and amortization. EV/EBIT usually varies from 10x to 25x. A
high ratio indicates that a company’s stock is overvalued, while
a low ratio indicates that the company’s stock is undervalued.
Moreover, a low EV/EBIT indicates a more financially stable and
secure company; however, the ratio provides a better picture of the
company’s financial state and actual worth when used with other
ratios. While EV/EBIT is a widely used multiple, it may not be
appropriate for companies which are capital-intensive in nature and
thus have high depreciation and amortization.
‹ EV/Sales: EV/Sales multiple is obtained by dividing the company’s
enterprise value by annual revenue. It is commonly used in companies,
usually early-stage and high-growth companies, whose operating cost
exceeds revenues. This multiple is useful when EBITDA is negative
or almost zero to value a business. EV/Sales ratio usually varies from
1x to 3x. A low EV/Sales indicates that a company is undervalued
and may be an attractive investment for investors. Using EV/Sales
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multiple is the most appropriate option while valuing companies Notes

with negative net income, EBITDA, and cash flows.
‹ EV/UFCF: Unlevered Free Cash Flow (UFCF) is a cash flow
available to all equity and debt holders after all the operating
expenses, capital expenditures, and investments in working capital
are made. EV/UFCF indicates how much investors are willing to
pay for the company for each rupee of UFCF it generates. A high
EV/UFCF ratio indicates that a more significant premium is attached
to the rupee of UFCF generated by the company.

4.5.2 Equity Value Multiples

Equity value is equity value minus net debt. Investors often use equity
value multiples for equity valuation. The following are some common
equity value multiples:
‹ Price/EPS (P/E): P/E is the most commonly used valuation metric,
which is the ratio of the market price of the stock to earnings per share.
P/E usually varies from 15x to 30x. Companies growing faster typically
have higher P/E ratios, which indicate that investors are willing to pay a
higher price for the company’s share due to higher growth expectations.
‹ Price/Book Value per Share (P/B): P/B is expressed as the ratio
of market price per share to book value per share. The P/B ratio
usually assesses the value of companies in manufacturing or real
estate industries. The book value represents the net asset value of
a company, which is the difference between assets and liabilities.
‹ P/E/Growth (PEG Ratio): The Price Earnings to Growth (PEG)
ratio is P/E divided by the expected EPS growth rate. It goes
beyond the P/E ratio and factors in future growth earnings potential
to value a company’s price. In other words, it values a company’s
share by considering its market price, earnings, and future growth
prospects. The PEG ratio usually varies from 0.5x to 3x. It facilitates
comparison between companies at different stages of life cycles.
The ratio indicates that any company that is expected to grow its
revenues, earnings, and cash flows at a high rate is more valuable
than a company with fewer growth prospects.
‹ Dividend Yield: It is the annual dividend per share divided by the
stock’s market price per share. This multiple is more suitable for

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Notes comparison between companies operating in similar industries. A low

or high dividend yield depends on the industry and the company’s
business life cycle. Fast-growing companies may reinvest in the
business and report low yields, whereas mature companies may
report high yields due to a lack of high growth opportunities.
Table 4.1: Relative Valuation Multiples
Multiple Formula
EnterpriseValue ( MV of Equity + Debt − Cash)
EV/EBITDA
Earnings Before Interest , Taxes, Depreciation, and Amortization

EnterpriseValue
EV/EBIT
Earnings � Before
� Interest � and
� Taxes

EnterpriseValue
EV/Sales
Sales
Market � Price
� Per � Share
P/E
Earnings � Per� Share
Market � Price
� Per � Share
P/B
Book Value
� � Per � Share
Price / EPS
PEG
Earnings � Per
� ShareGrowth
�

4.6 Relative Valuation Model

Relative valuation approaches are used to value a business by comparing
it to other businesses based on certain financial metrics. A business can be
valued using comparable companies analysis or precedent transaction analysis.

4.6.1 Comparable Companies’ Analysis

Comparable companies’ analysis or trading comps is commonly used
method to value companies by comparing their to the current stock
price of publicly traded companies having similar operating businesses.
A multiple, like market price per share to earnings per share (P/E pre-
cisely), may be used to find the target company’s worth in relation to
comparable publicly traded companies. Under comparable companies’

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analysis, a target company’s operating metrics and valuation multiples Notes

are compared with those of public comparables within the compara-
ble asset universe. Comparable companies’ analysis involves valuing
private companies or securities and identifying if a public company is
undervalued, overvalued, or correctly valued compared to the market.

Figure 4.2: Steps in Performing Comparable Companies’ Analysis

Illustration 4.3: Following is the Relative Valuation Schedule for Bajaj
Auto Ltd. Computed in 2021

Comparable
Companies BAJAJ AUTO
HERO MOTORCOP
TVS MOTORS
ATUL AUTO
SCOOTERS INDIA

Described
Multiples EV/EBITDA EV/REVENUE

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Notes Application COMPANY EV/EBITDA EV/REVENUE

BAJAJ AUTO 14.4 10.50
HERO MOTORCOP 12.6 5.80
TVS MOTORS 19.4 8.28
SCOOTERS INDIA 17.4 52.17
Average 15.95 19.19

EBITDA of Revenue of
Bajaj Auto 7,442.43 Bajaj 10,203
(1/2*EBITDA
(BAJAJ)* Industry
Average of EV/
EBITDA) +
Computed (1/2*Revenue*
EV of Bajaj Industry Average of
Auto EV/Revenue)
59,353.38368 97,896.18721

Computed EV
of Bajaj Auto 1,57,249.5709

4.6.2 Precedent Transaction Analysis

Usage of comparable companies’ analysis is relatively easy; however,
at times, it is difficult to find comparable public companies where the
target company operates in a niche sector. Moreover, the valuation under
comparable companies’ analysis does not consider any premiums paid.
Precedent transaction analysis overcomes such challenges and assists in
understanding multiples and premiums paid in a specific industry. It also
helps in understanding how buyers/sellers assess private market valuations.
‹ Precedent transaction analysis or precedents involves valuation
of companies by looking at the historical merger and acquisitions
transactions where the entire companies were bought or sold. Such
transactions indicate how much an investor was willing to pay for
purchasing the entire business of the company. Though precedents are
useful in valuing a business, however such information may not always
be easy to find and it quickly becomes out of date. Under precedent
transaction analysis, the value of a company is estimated by analyzing
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the price paid by different acquirers of similar companies under similar Notes
circumstances. Precedents also provide information on the premium
paid in previous acquisitions to gain control of the target, called control
premium. Because of this, transaction multiples are usually higher in
the case of precedents than trading comps. The analysis includes the
identification of relevant transactions on the basis of industry and
financial characteristics, deal size, transaction-specific characteristics,
timing, etc. Data gathering is required for relevant transaction. Transaction
multiples are then calculated and value is computed.
To conclude, while comparable company analysis uses current market
values to calculate the target company’s valuation, precedent transaction
analysis relies on historical sale prices of similar companies to estimate
the same value. In other words, comparable company analysis looks at
how the market values a company right now, and precedent transaction
analysis looks at how the companies were valued in the past when they
were bought and sold. So, eventually, both approaches estimate the value
of a company in relation to a comparable group of peers. However, they
use different benchmarks (current vs. historical prices).
Lastly, comparable company analysis is more suitable in technology,
retail, and financial service industries, where detailed financial informa-
tion, transparent reporting, and accounting practices are available. On
the other hand, precedent transaction analysis is relevant in industries
like healthcare, technology, and finance, which often experience multiple
mergers and acquisitions, and where companies do not rely on public
market valuation and a significant number of transactions happen privately.
IN-TEXT QUESTIONS
3. When you use relative valuation, you are trying to price assets
based upon what similar assets are being priced at. In comparing
across these assets, which of the following do you have to do?
(a) Find similar or comparable assets, with trading prices
(b) Standardize the prices to a common variable available for
all assets
(c) Control the standardized prices for differences across the
assets
(d) All of the above
(e) None of the above
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Notes 4. In precedent transaction analysis, valuation is based on:

(a) Historical merger and acquisitions transactions
(b) Comparison between target company’s operating metrics
and valuation multiples with those of public companies
(c) Present value of expected future cash flows
(d) Share price of a comparable public company

4.7 Summary
The proceeding chapter enables us to develop an understanding about
the different models of valuation of companies based on dividends and
free cash flows. The basic difference between dividend discount model
and free cash flows model is definition of cash flows—dividend discount
model uses cash flows that are distributed to equity holder’s, i.e., potential
dividends on stock, whereas free cash flows model expands the definition
of cash flows and includes cash flows available to a firm. Both models
have subvariations depending on growth rates. Though estimating divi-
dends is easier than estimating free cash flows as FCFF and FCFE are
complicated to obtain, but provide a better approximation of intrinsic
value as they consider factors related to operations of the firm. Thus
giving a true perspective on the value of the firm.

4.8 Answers to In-Text Questions

1. (c) T
 he market is sometimes wrong, but that it corrects itself
eventually
2. (f) All of the above
3. (d) All of the above
4. (a) Historical merger and acquisition transactions

4.9 Self-Assessment Questions

1. TCS Ltd. is the second largest IT company in the world with global
revenues of over INR 25,00,000 Mn and current earnings per share

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 Valuation Models

of Rs. 103. TCS is expected to yield a high growth rate for the next Notes
3 years, and it is assumed that it will maintain its current payout ratio
of 25% and current return on equity of 30% in this period. Beyond
3 years, it is expected that the return on equity will come down to
20% and the growth rate will come down to 6%. The firm will have
a beta of 1.47 for a high growth period and beta of 1.0 thereafter.
The risk-free rate and risk premium of the market is 5% and 5.7%,
respectively. Estimate the intrinsic value of equity using a two-stage
dividend discount model and comment on the path that its market
price can follow if the company is currently trading at Rs. 3,500.
2. Sun Pharmaceutical Industries Ltd. is the fourth largest specialty
generic pharmaceutical company in the world with global revenues
of over US$5.1 billion and current earnings per share of Rs. 13.72.
Sun Pharma is expected to yield a high growth rate for the next
3 years and it is assumed that it will maintain its current payout ratio
of 15% and current return on equity of 25% in this period. Beyond
3 years, it is expected that the return on equity will come down to
20% and the growth rate will come down to 6%.The firm will have
beta of 1.47 for high growth rate period and beta of 1.0 thereafter.
The risk-free rate and risk premium of market is 5% and 5.7%,
respectively. Estimate the intrinsic value of equity using two-stage
dividend discount model and comment on the path that its market
price can follow if the company is currently trading at Rs. 112.
3. NESTLÉ India manufactures products of truly international quality under
internationally famous brand names, such as NESCAFÉ, MAGGI,
MILKYBAR, KIT KAT, BAR-ONE, MILKMAID, and NESTEA,
and in recent years, the company has also introduced products of
daily consumption and use, such as NESTLÉ Milk, NESTLÉ SLIM
Milk, NESTLÉ Dahi, and NESTLÉ Jeera Raita. NESTLÉ India is
a responsible organization and facilitates initiatives that help to
improve the quality of life in the communities where it operates.
Mr. Manoj is fascinated to compute the value of Nestle Ltd. with
the help of relative valuation approach using following information.
Mr. Manoj feels that 30% weightage should be given to earnings
in the valuation process, sales may be given 30% weightage, and
book value may be given 40% weightage. The valuer has identified
3 firms which are comparable to operations of Nestle Ltd.
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Notes (In Crores)

Particulars Pepsi Co General Pioneer Nestle
Ltd. Mills Inc. Foods Ltd. Ltd.
Sales 18,200 20,100 15,400 16,700
EBITDA 12,455 14,167 10,280 11,540
Book Value 5,600 6,200 3,800 4,500
Enterprise Value 14,700 24,100 27,800 32,000

4.10 References
u Damodaran, A. Damodaran on Valuation, Security Analysis for
Investment and Corporate Finance (2nd ed.). Wiley India Pvt. Ltd.
u K. G., CA, & Sehrawat, N. K. Handbook on Valuation—Concept
& Cases. New Delhi, Bharat Law House Pvt. Ltd, ISBN: 978-93-
5139-497-6.

4.11 Suggested Readings

u Damodaran. Investment Valuation, Tools and Techniques for Determining
the Value of Any Asset (3rd ed.). Wiley India Pvt. Ltd.
u Damodaran. Corporate Finance (2000), Theory and Practical (2nd
ed.). Wiley India Pvt. Ltd.
u K. G., CA, & Sehrawat, N. K. Handbook on Valuation—Concept
& Cases. New Delhi, Bharat Law House Pvt. Ltd, ISBN: 978-93-
5139-497-6.

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 L E S S O N

5
Technical Analysis
Dr. Rajdeep Singh
Assistant Professor
Department of Commerce
University of Delhi
Email-Id: rajdeepsingh@[Link]
Ms. Juhi Jham
Assistant Professor
School of Open Learning
University of Delhi
Email-Id: [Link]@[Link]

STRUCTURE
5.1 Learning Objectives
5.2 Introduction
5.3 Meaning
5.4 Assumptions of Technical Analysis
5.5 Difference Between Fundamental and Technical Analysis
5.6 Price Indicators
5.7 Volume Indicators
5.8 Resistance and Support Levels
5.9 Technical Charts and Patterns
5.10 Summary
5.11 Answers to In-Text Questions
5.12 Self-Assessment Questions
5.13 References
5.14 Suggested Readings

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Notes
5.1 Learning Objectives
After reading this lesson, you will be able to:
‹ Understand what technical analysis is.
‹ Understand the difference between fundamental and technical analysis.
‹ Understand the various price and volume indicators.
‹ Know various technical charts and patterns used in technical analysis.

5.2 Introduction
Analyzing actions in the financial markets by looking at historical pric-
ing alongside volume data is referred to as technical analysis. Technical
analysis is based on the premise that history repeat itself and therefore
it is assumed that the stock price movements follow an established
trend which can be derived from the past price and volume data Unlike
fundamental analysis which focuses more on core reasoning, technical
analysis places emphasis on charts, technical indicators, support and re-
action levels, trend lines, chart patterns, and any other forecasting tools
that aid in identifying potential trading opportunities. This approach
employed by traders analyzes market sentiment, follows the momentum,
and makes distinct decisions on acquiring or dispensing a financial in-
strument. Although technical analysis is one of the most preferred tools,
it has not come without objection. A good number of traders, however,
prefer using technical analysis along with basic research to widen their
scope when analyzing the market.

5.3 Meaning
The assessment and forecasting of stock prices is accomplished using past
prices and trading activity data with technical analysis which utilizes a
step-wise method. Unlike basic components like corporate profitability and
economic data, technical analysis is primarily concerned with the study
of various indicators, patterns, trends, and charts. To recognize the most
likely price changes, traditional analysts try to uncover valuable market
patterns to assist in making optimal trading decisions. According to tech-
nical analysts, specific systems will always repeat themselves within price

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movements, and thus, with this knowledge, they focus on constructing Notes
such systems in hopes of successfully forecasting market price changes.
Important components of technical analysis are the ability to identify and
define trends, identify support and resistance levels, understand patterns in
graphical representation of data known as charts, and make use of various
technical tools known as indicators such as cumulative moving averages,
oscillators, and volume. Most technical analysts try to take advantage of
changes in market sentiment to earn profits. Their decisions are usually
based on the assumption that there is some information in the current
prices of the assets which have been calculated using their past prices.
Analyzing past data to anticipate future performance of financial markets
is the core of technical analysis. Traders who depend on graphical and
statistical signs understand the vital role of technical analysis in strate-
gizing trades.

5.4 Assumptions of Technical Analysis

Technical analysis is based on a collection of fundamental principles
which are explained below:
1. Everything is Discounted through Price: The principle indicates
that technical analysts embrace that the price of an asset captures all
relevant information, including economic, political, and psychological
factors, useful to that asset. Accordingly, the relevant and available
information on an asset is already factored into the market price.
2. Price Moves in Trends Correlation: A core component of technical
analysis is the presence of trends which signify that there is a
general tendency for prices to move in a particular direction for a
specific duration. It is essential to monitor these trends in order to
make profitable trades.
3. History Repeats Itself: Expectations are that past price movements
and price action remains prone to repeating itself. Through the study
of the available market data, analysts aim to identify trends that
are likely to repeat and use them for making predictive analyses
on shift in future prices.
4. Extreme Moves: Technical analysts develop focus on price action
in the financial market profoundly deeply rather than formulating
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Notes theories or hypothesis about the market, and such a focus leads to
not only trading but also crafting many different techniques from
utilizing simple price movements.
5. Confirming Trends from Volume Data: Volume, which refers to the
level of trading activity measured in shares or contracts, is considered
a validating factor for trends. Heightened trading activity during
a period of upward price movement is frequently perceived as an
indication of robust demand, hence strengthening the probability of
the trend persisting.
6. Recognising Support and Resistance Level: Technical analysts posit
the presence of support and resistance levels in markets. Support
level refers to a price level beyond which stock price often stops
falling, whereas resistance is a level beyond which it typically stops
increasing. These levels are crucial for determining the points at
which to enter and exit.
7. Momentum Effect: Technical analysts believe that markets are
inclined to maintain their present trajectory rather than undergo a
reversal.
IN-TEXT QUESTIONS
1. Which of the following is NOT an assumption of technical
analysis?
(a) Market discounts everything
(b) Prices move in trends
(c) Market is always efficient
(d) History tends to repeat itself
2. A line connecting higher highs and higher lows represents a:
(a) Support level
(b) Resistance level
(c) Downtrend
(d) Uptrend

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Notes
5.5 Difference Between Fundamental and Technical Analysis

Aspect Fundamental Analysis Technical Analysis

Basis of Analysis Focuses on economy, indus- Utilises previous price
try and company analysis and volume data, patterns,
to evaluate the intrinsic and technical indicators
value of an asset to forecast future price
fluctuations.
Time Horizon Long Term Perspective Short Term to Medium
Term Perspective
Information For analysis, uses financial For analysis, it primarily
Sources reports, economic statistics, employs charts, technical
news, and other external indicators, and historical
elements. price and volume data.
Decision-Making Examines variables such Focuses on analysing
Factors as profits, dividends, price patterns, trends,
economic circumstances, support and resistance
and competitive strengths levels, as well as technical
of a company. indicators, in order to
make informed trading
decisions.
Market Participants Preferable to investors with Commonly preferred
a long-term perspective and by individuals engaged
value investors who are in short-term trading,
looking for assets that are day traders, and trend
currently undervalued. followers seeking to
exploit brief fluctuations
in prices.
Risk Consideration Focuses on comprehending Uses stop-loss orders and
an investment’s potential other technical techniques
for long-term success or frequently to emphasise
failure as well as its inherent risk management within
dangers. the context of individual
trades.

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Notes Aspect Fundamental Analysis Technical Analysis

Applicability Often employed in stock Commonly utilised in the
investing, specifically for trading of several finan-
value-focused methods. cial items, including as
equities, commodities,
currencies, and crypto-
currencies.
Market Efficiency Believes that markets Believes that market prices
may exhibit imperfec- inherently incorporate all
tions in efficiency, hence pertinent information,
presenting possibilities to hence posing a challenge
identify assets that are either to continually outperform
undervalued or overvalued. the market.

5.6 Price Indicators

In finance, price indicators relate to numerous instruments and measure-
ments used to analyse and evaluate historical fluctuations in the prices of
financial instruments. These indicators provide important insights about
market movements, volatility, momentum, and probable areas of reversal.
Traders and analysts use price signals to make decisions about whether
to buy or sell particular assets.

5.6.1 Dow Theory

This is a basic aspect in technical analysis which was put forward by
Charles H. Dow, a pioneer of Dow Jones & Company – the Dow theory
offers significant guidance in understanding price movements of stocks
and the general movement of stock prices. Fundamental principles of the
Dow Theory include:
1. “The Market Discounts Everything”: This principle makes it clear
that it is assumed by the Dow Theory that the entire available
information is subsumed and reflected in prices. Everything that
could influence the price of certain financial instruments, including
economic trends, political events, and public sentiments, has already
been provided in the current market prices accepted.

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2. The price movement may be classified as: Notes

Primary Trend: The trend that extends over a long term can either
be bullish, bearish, or range-bound.
Secondary Trend: The trend that extends over an intermediate term
that is reversal of primary trend.
Daily Fluctuations: It refers to the short-term, daily changes in
prices.

Figure 5.1: Phases of Market Movements as per Dow Theory

3. Validation of a Trend Using the Averages: Dow Jones Industrial
Average (DJIA) and Dow Jones Transportation Average (DJTA) are
computed to confirm trends. A trend is deemed strong when both
averages move in the same direction.
4. Volume serves as a great resource in confirming trends which are
vital in the Dow Theory. According to the Theory, the trading
volume must support the main trend. In this case, volume must
increase in a bullish trend when prices rise and drop during
corrections.
5. Persistence of Trend: Trends persist until clear signs of reversal
emerge, which is in accordance with Dow Theory. In this case,
trend reverse signs can be seen by observing the Trendlines, chart
patterns, and volume patterns.

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Notes The Dow theory is one of the basic principles of modern technical anal-
ysis because it gives basic insight of the market operations. Sometimes,
the ideas from the Dow theory are blended using other technical tools to
have a holistic approach towards analyzing the market trends and market
investment opportunities.

5.6.2 Advances and Declines

For technical analysis purposes, the terms advances and declines refer to
the total number of stocks or securities that experienced increase (advances)
or decrease (declines) in their prices for a given time. Following are the
various aspects of the concept:
(a) Market Breadth Evaluation: Advances and Declines reflect the
extent of participation in a price change. A significant quantity
of rising stocks indicates a strong market, while a frequency of
declining stocks may signal weakness.
(b) Bull and Bear phases in the market may be confirmed using these
measures. Significant number of advancing issues confirms the
upward trend, while a growing number of decreasing issues supports
a bearish trend.
(c) Detecting Overbought and Oversold Conditions: Abnormal levels
of advances and falls might be indicative of overbought or oversold
conditions.
(d) Detecting Changes in Trends: The relationship between advances
and declines predict potential changes in trends. During uptrend
movements, the lack of an improvement in advancements may
indicate worsening trend.
(e) Sentiment Assessment: This data assesses the state of how the market
feels. For instance, while there is a major drop in the market, a
greater number of advanced issues might suggest that there are
resilient industries that have a favorable outlook.
Combining advances and declines with the analysis of volume increases
their effectiveness. Large increases in price direction with increasing
volume will further confirm the strength of the upward movement of the
trend, while decreases of greater volume will indicate that it is likely
to reverse the trend. It is important to advance and dip movements with

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other scientific methods in technical analysis. They can aid in assessing Notes
the overall strength of the market; however, they fall short offering de-
tailed estimates on how much the prices will shift.

5.6.3 New Highs and New Lows

The term “new highs and new lows” is often used to refer to the
maximum value and minimum value reached by an asset, market in-
dex, or any other finance term in question over a specific period of
time. New High signals strong sentiment and optimism in the stock
market. A new market high may be viewed positively by investors and
treated as a sign of a booming. New Low marks market weakness and
a generally negative sentiment. Declining to record levels raises the
possibility of some significant challenges in the market or in certain
stocks around which investors may have to rethink their decision in
the long run.

Figure 5.2: Higher Highs and Lower Lows

Understanding higher highs and lower lows is vital for conducting market
analysis. The ratio of number of stocks reaching their highest price over
a recent period to number of stocks reaching their lowest price over the
same period offer valuable insights into the overall market’s condition.
Following depicts what the ratio, new high and new low data points
indicate:

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Notes Condition What It Indicates

Ratio > 1 (more highs than Bullish signal – Market strength and
lows) positive momentum
Ratio < 1 (more lows than Bearish signal – Market weakness and
highs) negative sentiment
Uptrend confirmation, strong buying
Sharp Increase in New Highs
pressure
Possible start of a downtrend, selling
Sharp Increase in New Lows
pressure
Caution needed; market may be unstable
Ratio is Volatile or Diverging
or near reversal

5.6.4 Circuit Filters

Circuit breakers also known as circuit filters are the measures that are
deployed by regulators to halt or restrict trading for a duration of time
during market turmoil or excessive volatility. These procedures are spe-
cifically employed to evade chaotic market conditions and provide a short
timeframe for investors to evaluate information, control the selling panic,
and avoid rapid withdrawal of liquidity in the market. Circuit filters are
designed to protect investors from sharp price swings that can happen in
a matter of seconds. Every stock exchange has its own set of regulations
regarding the trigger and circuit breaker levels. The main purpose of these
laws is to regulate and restrict the market’s erratic behavior. The Securities
Exchange Board of India (SEBI) makes the decisions regarding circuit
filters in India. This depends on the closing prices of the previous day.

5.7 Volume Indicators

All types of charts and indicators discussed so far use only past price
information of stocks to have an idea about the short-term price move-
ments. However, besides past stock prices, the stock’s past volume data
also provides useful insights into short-term price movements of the
stock. Volume indicators are instruments that calculate the quantity of
trading activity linked to a particular asset over a predetermined period.
They offer hints regarding the strength or weakness of price changes.
Volume indicators allow traders and analysts to verify price movements,
identify possible reversals, and gauge the mood of the market. A deeper

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understanding of the market’s workings can be gained by examining the Notes

correlation between price and volume changes.

5.7.1 Role of Volume in Dow Theory

Volume plays a pivotal role in Dow Theory, since it is regarded as a
vital factor in validating trends and evaluating the overall robustness of
market movements.
The integration of volume into Dow Theory is as follows:
(i) Volume Confirmation: As per Dow Theory, a trend is deemed real
only if it is supported by a noticeable increase in trade volume. For
example during a period of declining prices, an increase in volume
validates the bearish trend.
(ii) Volume Expansion During Major Trend: According to Dow Theory,
it is expected that there would be an increase in volume throughout
the major trend. Consequently, when prices align with the trend,
there should be a corresponding surge in trading volume.
Integration of volume analysis within the Dow Theory philosophy at-
tempts to improve understanding why the market moves the way it does.
This said, it has been observed that sharp price changes accompanied by
significant changes in trading volume are more likely to persist, while
price changes in low trading volume usually experience a lot of suscep-
tibility to reversal.

5.7.2 Institutional Activity as Volume Indicator

Institutional investors stock activity is important because of the sheer size
of their trades and their transactions as volume indicators. Monitoring
the trading volumes of institutional investors has the potential to uncover
important market trends or shifts in sentiment while simultaneously pro-
viding valuable, deeper analysis of the intricacies of the market. Here are
a few ways through which these investors operate as volume indicators:
(i) Size of Transactions: As compared to individual or retail investors,
institutional investors are more active at the market and have more
available funds which translates to financial activity in the form
of larger-than-average transaction. Increased total trading activity,
especially in large chunk trades is likely to suggest institutional
interest in the market.

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Notes (ii) Effect on Liquidity: The volume of trades carried out by institutions
has a decidedly large impact on liquidity levels available in the
market for trading financial securities. Any increase in the level of
activity in the market which is perceived to be initiated by these
investors is capable of bringing about price changes and therefore
liquidity conditions in the market.
(iii) Market Sentiment: The merged judgment of insights, trades, and
perceptions undertaken by practitioners within an institution tends to
influence the stand taken by the entire institution as a single unit.
Therefore, any change in the volumes of their trades can give an
indication of the market sentiment.
(iv) Sector Rotation: It describes the behavior of investment managers
adjusting their portfolio by changing the sectors in which the funds
are allocated because of their views regarding the economy and the
market.
(v) Trend Confirmation: Consistent patterns accompanied by rising
institutional trading volumes may suggest robust and enduring
market movements. This information might be highly beneficial for
traders who are seeking confirmation of trends.
Although institutional activity serves as a substantial measure of trading
volume, it is crucial to take into account additional elements and use a
comprehensive approach to market analysis. Individual investors frequently
include institutional trading volumes, technical indicators, chart patterns,
and fundamental analysis into their investing decision-making process to
ensure educated choices.

5.8 Resistance and Support Levels

Resistance and Support levels are most popularly used measures to iden-
tify stock entry and exit timing.
(i) Support Level: In technical analysis, a support level is a price level at
which a security tends to stop falling and may reverse direction. It’s
a zone where buying interest is strong enough to overcome selling
pressure. During a downturn, prices decline due to an imbalance when
the supply surpasses the demand. As prices decrease, they become
more appealing to potential buyers who have been observing from

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the sidelines. Eventually, the demand that was previously growing Notes
gradually will reach a point where it equals the supply. At this
juncture, prices will cease to decline. This is support.
Support may appear as either a specific price level or a range of
prices on a chart. Support, in the context of a price chart, refers to
a specific area where buyers demonstrate their readiness to purchase.
At this particular level, the demand typically surpasses the supply,
resulting in an end and reversal of price drop.

Figure 5.3(a): Support and Resistance Level

(ii) Resistance Level: Resistance can be defined as the opposite of support.
Prices increase due to a higher demand relative to the available
supply. As prices increase, there will be a threshold where the urge
to sell surpasses the urge to acquire. There are other factors that
contribute to this occurrence. Traders may have concluded that prices
are excessively high or have reached their desired level. Buyers may
be hesitant to enter new holdings at high valuations. It could be due
to various different factors. However, a specialist will easily identify
on a price chart a point at which the amount of supply starts to
surpass the amount of demand. This represents resistance. Similar
to assistance, it can refer to either a level or a zone.
Technical analysts utilise support and resistance levels to pinpoint cer-
tain price points on a chart where the likelihood of a temporary halt
or reversal of an ongoing trend is higher. Support is a level where a
downward trend is anticipated to temporarily halt because there is a
high concentration of buyers who are willing to purchase the asset at
that price. Resistance arises when there is a temporary halt in an upward
trend, caused by a significant accumulation of supply. Market psychology
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Notes significantly influences traders and investors as they recall previous events
and respond to evolving circumstances in order to predict future market
trends. Trend lines as well as moving averages can be utilised on charts
to identify support and resistance regions.

Figure 5.3(b): Resistance Level Becoming Support Level

5.9 Technical Charts and Patterns

Technical charts, frequently employed in the practice of technical analysis,
visually depict the past price fluctuations of financial instruments, such
as commodities, stocks, or currencies. These charts assist traders and
analysts in identifying patterns, trends, and probable points of reversal,
enabling them to make well-informed investment choices.

5.9.1 Types of Technical Charts

(i) Line Chart: A line chart is a simple and fundamental tool of technical
analysis that illustrates the historical price movements of a financial
instrument by joining the closing prices for a specified time period
with a line. It provides a clear and easily comprehensible picture
of the underlying pattern in the worth of an item.
(ii) Bar Chart: A bar chart is a popular and versatile technical analysis
tool that graphically represents the price movement of financial assets
over a specified time period. Bar charts provide a more complete
presentation than line charts since they include the open, high, low,
and closing prices for each interval.

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(iii) Candlestick Chart: Candlestick chart pattern as displayed in Figure Notes

5.4(a) exhibits opening, closing, high, and low prices of a stock
or an index. Depending on whether the closing price is higher or
lower than the opening price, the candle’s body is either filled or
blank. Green or filled candle represents price rise. Figure 5.4(b)
represents the identification of opening, closing, high, and low
prices of a stock. Trader can get a candlestick pattern representing
the price change over a chosen time period. Trader can create a
1-minute candlestick chart or a 3-minute candlestick or choose a
different time period for the same.

Figure 5.4(a): Candlestick Chart Pattern

Figure 5.4(b): Candlestick Chart Pattern: Identifying Open,

Close, High and Low Price

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Notes (iv) OHLC Chart: An OHLC chart gives the representation of Open,
High, Low, and Close prices. The chart presents information about
the opening, highest, lowest and closing prices over an interval of
time.
(v) Point and Figure Chart: Point and figure charts streamline the technical
analysis process by displaying price movements as columns of Xs
that signals an upward trend and Os that signals a falling trend. They
provide clear focus on significant price changes, identifying trends
and reversal points by disregarding the time component. Because
they are simple to use and provide clear insights into market trends,
point and figure charts are widely used. They support traders in
making well-informed choices regarding potential market entry and
exit points.

Figure 5.5: Point and Figure Chart

5.10 Summary
By looking at past price and volume patterns, traders and investors can
use technical analysis, a methodical approach, to evaluate financial markets
and make informed decisions. It disregards the application of fundamental
analysis, which comprises assessing the economic indicators and financial
health of a business. Rather, it focuses on trends, patterns, and statistical
measurements derived from historical market activity. Technical analysis’s
fundamental components include:

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Identifying Trends: The process of recognizing and understanding market Notes

trends, whether they are horizontal, descending, or ascending. The price
points at which an asset’s price is most likely to either find support or
run into resistance are referred to as support and resistance levels. These
levels can provide important insight into potential future price changes.
In order to forecast future price movements, chart patterns analyze vari-
ous patterns produced by price fluctuations on charts, such as triangles,
flags, and head and shoulders.
Technical Measures: Identifying potential trading opportunities by using
a variety of mathematical calculations and statistical measures based on
price and volume data, including moving averages, oscillators and volume
analysis tools. Technical analysis traders aim to make money by taking
advantage of patterns and trends they have found. Their foundation is
the idea that market prices take into account all available information,
including historical data, and that past pricing trends may provide valu-
able insights into future market trends. Since it provides a methodical
framework for understanding market dynamics and identifying possible
trading opportunities, technical analysis is essential to the decision-making
process of many traders and investors.

5.11 Answers to In-Text Questions

1. (c) Market is always efficient
2. (d) Uptrend

5.12 Self-Assessment Questions

1. What is Technical Analysis? Explain the assumptions of technical
analysis.
2. Explain in detail the Dow Theory.
3. What is the difference between fundamental analysis and technical
analysis?

5.13 References
‹ Chandra, P. (2017). Investment Analysis and Portfolio Management.
Delhi: McGraw Hill Education.
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Notes ‹ Elton, E. J., Gruber, M. J., Brown, S. J. & Goetzmann, W. N.

(2014). Modern Portfolio Theory and Investment Analysis. USA:
John Wiley & Sons.
‹ Fischer, D. E. & Jordan, R. J. (1995). Security Analysis and Portfolio
Management. New Delhi: Pearson Education.

5.14 Suggested Readings

‹ Chandra, P. (2017). Investment Analysis and Portfolio Management.
Delhi: McGraw-Hill Education.
‹ Elton, E. J., Gruber, M. J., Brown, S. J. & Goetzmann, W. N.
(2014). Modern Portfolio Theory and Investment Analysis. USA:
John Wiley & Sons.
‹ Fischer, D. E. & Jordan, R. J. (1995). Security Analysis and Portfolio
Management. New Delhi: Pearson Education.

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 UNIT - III

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 L E S S O N

6
Portfolio Analysis and
Management
Ms. Iti Verma
Assistant Professor
Gargi College
University of Delhi
Email-Id: itivermadsedu123@[Link]

STRUCTURE
6.1 Learning Objectives
6.2 Introduction
6.3 Concept of Financial Portfolio
6.4 Portfolio Management
6.5 Portfolio Analysis – Concept of Portfolio Risk, and Return
6.6 Relationship Between Coefficient of Correlation, Portfolio Risk and Diversification
6.7 Portfolio Theories
6.8 Solved Illustrations
6.9 Summary
6.10 Answers to In-Text Questions
6.11 Self-Assessment Questions
6.12 References
6.13 Suggested Readings

6.1 Learning Objectives

‹ Understand the concept and process of portfolio management.
‹ Comprehend the idea of portfolio risk and return.
‹ Understand the relationship between the coefficient of correlation, portfolio risk,
and diversification.
‹ Understand the relevance of portfolio theories.

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Notes
6.2 Introduction
Different investments have distinct risk and return characteristics, with
expected future returns being inherently variable and the uncertainty
of returns known as risk. Investors typically avoid investing all their
savings in a single security or asset. Rather, they spread their money
across different types of financial securities simultaneously, adhering
to the principle of Warren Buffet “Don’t put all eggs in one basket”.
The aim is to diversify and mitigate risk, ensuring that gains in others
can compensate for losses in one security. The concept of constructing
a portfolio is based on investing money in various securities to maxi-
mise returns with a minimum level of risk; The combination of assets
or securities in which the investor makes his investment is known as
Portfolio. The present chapter discusses the process of portfolio man-
agement and its theories that construct an optimal portfolio and offer
maximum satisfaction along with the best combination of risk and return.

6.3 Concept of Financial Portfolio

A portfolio is a collection of different kinds of financial securities such
as shares, bonds, debentures, mutual funds, and other assets, together for
investment. It is not merely a mix of unrelated financial assets; rather,
it is a thoughtfully integrated combination of assets within a unified
framework. Making a portfolio is putting one’s egg in different baskets
with varying degrees of risk and return. For instance, an investor
might decide to allocate his funds solely to the shares of XYZ Ltd.
Alternatively, he could distribute his funds to shares of five different
companies equally. In the former case, he would be exposed to high
risk as expected returns depend solely on XYZ Ltd.’s performance.
Conversely, in the latter scenario, the risk would be diversified across
various companies. Hence, the losses that occur in the shares of one
company may be compensated by profits earned in others; ultimately,
portfolio risk will be reduced. There can be numerous portfolios con-
structed from a given set of securities. A prudent investor always seeks
the most efficient portfolio to meet his investment goals. An efficient
portfolio attempts to maximise returns at a given risk tolerance of the
investor.

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6.4 Portfolio Management Notes

Portfolio management involves formulating, maintaining, revising, and

continuously evaluating a portfolio to maximise returns with the given
risk profile of the investor. The steps involved in managing the combina-
tion of various securities in a portfolio can be understood with the help
of the flowchart shown in Figure 6.1. The five steps of the process for
portfolio management are described below:

Figure 6.1: Process of Portfolio Management

(a) Security Analysis: The initial step involves analysing the risk,
return, and price level of a large number of available securities in
the financial market. These securities, categorised as equity shares,
bonds, debentures, GDRs, ADRs, and derivatives are some of
them. Now, the investor needs to decide the financial security for
investment. The decision is based on the risk and return profile of
the individual securities. Three methods for security analysis have
been employed, i.e., fundamental analysis, technical approach, and
the Efficient Market Hypothesis (EMH).
(b) Portfolio Analysis: The next step is to build an infinite number of
possible portfolios using information gathered from security analysis.

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Notes The portfolio analysis is crucial to select the optimal portfolio. The
objective of portfolio analysis is to evaluate the effectiveness of
various portfolios concerning their risk and return characteristics.
It helps in identifying portfolios that provide maximum returns for
a given level of risk or the least risk for a given level of return.
(c) Selection of Portfolio: In this step, an investor selects the efficient
portfolio that optimises his utility based on risk and return preferences.
For portfolio selection, an investor constructs the indifference curves
that measure his utility scores. The optimal portfolio is determined
by selecting the point on the indifference curve that offers the
highest utility. Two popularly known portfolio theories, i.e., the
Harry Markowitz Model and Capital Market Theory are used by
an investor to select an optimal portfolio.
(d) Revision of Portfolio: Portfolio management is a continuous and
dynamic process that requires ongoing monitoring to enhance the
expected returns of the portfolio. This involves tracking changes
taking place in the risk and return profiles as well as the price
levels of individual securities, in response to shifts in the financial
environment. Adjustments to the portfolio are essential to adapt to
alterations in the financial goals or investors’ preferences, as well
as when additional funds are invested.
(e) Evaluation of Portfolio: The evaluation of a portfolio is the last
step as well as an integral part of the portfolio management process.
It helps to determine whether the selected efficient portfolios are
gaining the desired returns. Various widely recognised techniques
such as Jensen’s alpha, Sharpe’s ratio, Treynor’s ratio, etc. are
employed to assess portfolio performance.

IN-TEXT QUESTIONS
1. A combination of various financial assets for investment purposes
is called:
(a) Portfolio
(b) Gambling
(c) Speculation
(d) Investment

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Notes
2. In the context of portfolio management, what does the term
“diversification” aim to achieve?
(a) Increasing portfolio risk
(b) Allocate funds in a single asset
(c) Reducing overall risk through a variety of investments
(d) Maximizing short-term returns
3. Portfolio revision is one of the steps in the process of portfolio
management.
(a) True
(b) False
(c) Partially True or False
(d) None of the above

6.5 Portfolio Analysis – Concept of Portfolio Risk and

Return
The importance of portfolio risk and return lies in their crucial role in
investment decision-making, risk management, wealth management, and
the pursuit of financial goals. The determination of the expected return and
risk of the portfolio is designated as the first step in portfolio analysis.

6.5.1 Expected Portfolio Return

The return on the portfolio is defined as the weighted average of the
returns of individual assets/securities that are held in the portfolio. The
weights are determined based on the individual securities’ proportion in
the overall portfolio composition.
Therefore, the formula to determine the expected return on the portfolio
is shown below:
n
E ( R p ) = ∑ wi × E ( Ri ),
i =1

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Notes Where,
E(Rp) = Expected return on portfolio
Wi = Proportion of funds invested in ith security
E(Ri) = Expected return on ith security
n = Number of securities in the portfolio.
For example, if an investor invests 60% of their total funds in equity
shares P, which has an expected return of 40%, and allocates the remaining
40% to equity shares Q, with an expected return of 20%, the expected
portfolio return, E(Rp), is determined by multiplying the respective weights
of each share by its expected return and summing the results.
Portfolio Return = Weight of Security P × Return of Security P + Weight
of Security Q × Return of Security Q
Symbolically,
E(Rp) = (.60 × .40) + (.40 × .20)
= 32%

6.5.2 Portfolio Risk

Portfolio risk, also termed investment risk, refers to the collective risk
associated with all the securities that are held in a portfolio. It measures
the degree to which the actual returns of a portfolio will deviate from
the expected returns. To calculate the risk of a portfolio, the weighted
average of the standard deviations of individual securities along with
covariance is used. Covariance is a statistical metric that measures the
interactive risk among the securities that form a portfolio. It captures how
the returns of two securities are related and move in tandem.
The formula to calculate risk (variance) in a 2-security case, i.e., X and
Y is as follows:
σxy = √wx2σx2 + wy2σy2 + 2wxwyCovxy
Where,
σp = Portfolio risk consisting of securities X and Y
wx = Percentage/weight of total funds invested in security X
wy = Percentage/weight of total funds invested in security Y
σX = Standard deviation of the returns of security X

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σY = Standard deviation of the returns of security Y Notes

CovXY = Covariance between security X and Y.
Example 1: An investor is investing in securities R and S, whose details
are given below:

Security R Security S
E(R) 13% 20%
Risk (σ) 5% 10%
Weight (W) 40% 60%

The covariance between the returns of the securities is 100. Find out the
portfolio’s risk and return.

Solution:
(a) Portfolio Return
n
E ( R p ) = ∑ wi × E ( Ri )
i =1

E(Rp) = .40 × 13 + .60 × 20

E(Rp) = 17.2%

(b) Portfolio Risk

σxy = √wx2σx2 + wy2σy2 + 2wxwyCovxy
σxy = √(0.4)2 (5) 2 + (.6) 2 (10) 2 + 2 (.4) (.6) 100
σxy = 9.38%
The term covariance between two variables is the multiplication of their
correlation coefficients by the standard deviations of both securities. The
coefficient of correlation is a relative measure whose range lies between
−1 and +1. A correlation coefficient of +1 indicates a perfect positive cor-
relation, meaning that the returns of portfolio securities move in the same
direction. Conversely, a correlation coefficient of −1 signifies a perfect
negative correlation, indicating opposite movements in securities returns.
The formula is shown below:
Covxy = ρxy σx σy

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Notes Alternatively,
ρxy = Covxy/σx σy
Where, ρxy = Coefficient of correlation between securities X and Y.
Hence, the formula to calculate risk (variance) in a 2-security case in
terms of the correlation coefficient is as follows:
σxy = √wx2σx2 + wy2σy2 + 2wxwy ρxy σx σy

Based on the above discussion, portfolio return depends on the percent-

age of total funds invested in each asset and the return of each security.
However, the portfolio risk depends on the proportion of funds invested
in available security, the riskiness (σ) of each security, and the coefficient
of correlation or covariance between the securities.
Example 2: An investor is investing in securities X and Y. Calculate
portfolio’s risk and return.
Security X Y
E(R) 15% 7%
Risk (σ) 5% 3%
Weight (W) 70% 30%
ρxy between X and Y = 0.90

Solution:
(a) Portfolio Return
n
E ( R p ) = ∑ wi × E ( Ri )
i =1

E(Rp) = .70 × 15 + .30 × 7

E(Rp) = 12.6%

(b) Portfolio Risk

σxy = √wx2σx2 + wy2σy2 + 2wxwy ρxy σx σy

σxy = √(0.7)2 (5)2 + (.3)2 (3)2 + 2(.7) (.3) (.90) (5)(3)

σxy = 4.33%

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Notes
6.6 Relationship Between Coefficient of Correlation,
Portfolio Risk, and Diversification

6.6.1 Relationship Between Coefficient of Correlation and Portfolio

Risk
The degree of correlation between the returns of securities directly affects
the portfolio’s risk. A lower correlation results in reduced risk, while when
securities are highly correlated, the risk will be higher. The impact of perfectly
correlated, uncorrelated, or negatively correlated returns on the overall risk
of the portfolio can be explained with the help of a numerical given below:
Example 3: Suppose an investor invests in securities X and Y in equal
proportion. The risk and return of the securities are as follows:

Security E(R) σ
X 10 4
Y 15 5

Calculate and examine the portfolio risk if the coefficient of correlation

is −1, −0.4, 0, 0.4, or 1.
Solution:
(a) Portfolio Return
n
E ( R p ) = ∑ wi × E ( Ri )
i =1

E(Rp) = .50 × 10 + .50 × 15

E(Rp) = 12.5%
Hence, it is important to note that the expected portfolio return will
be the same in all five cases.

(b) Portfolio Risk

σxy = √wx2σx2 + wy2σy2 + 2wxwy ρxy σx σy

σxy = √(0.5)2 (4) 2 + (.5) 2 (5) 2 + 2(.5) (.5) ρxy (4) (5)
σxy = √10.25 + 10ρxy

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Notes Case 1: ρxy = −1

σxy = √10.25 + 10 ρxy
= √10.25 + 10(−1)
= 0.5

Case 2: ρxy = −0.4

σxy = √10.25 + 10 ρxy
= √10.25 + 10 (−0.4)
= 2.5

Case 3: ρxy = 0
σxy = √10.25 +10 ρxy
= √10.25 + 10(0)
= 3.2

Case 4: ρxy = 0.4

σxy = √10.25 + 10 ρxy
= √10.25 + 10 (0.4)
= 3.78

Case 5: ρxy = 1
σxy = √10.25 + 10 ρxy
= √10.25 + 10 (1)
= 4.5
We can conclude that the portfolio risk is minimal when the correlation
coefficient is perfectly negative. It increases with an increase in the
coefficient of correlation and becomes maximum when the returns on
securities are perfectly positively correlated.

6.6.2 Relationship Between Coefficient of Correlation and Diversification

Diversification is based on the notion of spreading funds across different
investment avenues to mitigate risk. The benefits of diversification can
be reaped when the returns of the securities that are held in a portfolio

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exhibit a less than perfect positive correlation. A lower correlation co- Notes
efficient indicates more effective diversification for investors, helping
to avoid unsystematic risk. When the returns of two securities forming
a portfolio are negatively correlated, this is termed hedging. However,
when the coefficient of correlation is perfectly negative, i.e., −1, such
securities are termed hedge assets. The relationship among diversification,
correlation coefficient, and portfolio risk has been summarised below.

Coefficient of Diversification Portfolio Risk

correlation
ρAB = +1 No diversification or Portfolio risk is not reduced.
naive diversification. Only Risk averaging is there.
0 < ρAB < 1 Diversification is possible. Portfolio risk can be reduced.

ρAB = 0 Diversification is possible Portfolio risk can be further

and better than the previous reduced.
case.
-1 < ρAB < 0 Not only diversification, but Portfolio risk will be lower.
hedging is also possible.
ρAB = -1 Perfect hedging is possible. Portfolio risk is least
and it is the case when
0 risk portfolio is possible.

6.7 Portfolio Theories

Every investor in the marketplace is risk-averse, yet they vary in terms
of their attitude towards risk and return. Some investors are conservative,
while others are less risk-averse in terms of holding risk. The utility or
satisfaction derived from the same security can differ among investors
depending upon the degree of risk possessed by them. The main objec-
tive for every investor is to maximise his utility scores by constructing
an optimal portfolio that offers maximum return and minimises overall
portfolio risk. Modern portfolio theories, such as Portfolio Theory, Capital
Market Theory, etc., were proposed to guide the selection and construc-
tion of portfolios. These theories have been explained in detail in the
following sections.

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Notes 6.7.1 Portfolio Theory: The Harry Markowitz Model

Harry Markowitz’s pioneering work, titled “Portfolio Selection” was
published in the Journal of Finance in 1952. He discussed the analytical
and conceptual foundation for selecting an optimal portfolio by a rational
investor, popularly known as the Markowitz Model or Mean-Variance
Optimisation Model.

Assumptions for the HM Model are as follows:

‹ Investors are conservative, and inclined to avoid unnecessary risks.
‹ Portfolio analysis is conducted based on risk and return.
‹ Investors are rational, choosing those securities that provide maximum
return with a minimum degree of risk.
‹ The decision to select an optimal portfolio is dependent on means
(returns) and variance (risk).
‹ The utility scores of every investor are affected based on their
different preferences towards risk and return.
‹ The financial markets are efficient, and investors have easy access to
all the available information related to returns, risks, and coefficient
of correlation between the securities.

Steps in Optimal Portfolio Selection

(a) Setting the Risk–Return Opportunity Set: The initial step is to
create an investment opportunity set from the available securities
in the financial market, offering an infinite number of possible
portfolios. An investor’s portfolio opportunity set depicts expected
returns and associated risks for all the possible combinations that
are formed from a set of available securities. A large number of
portfolios can be constructed even with two securities by adjusting
their weights only. As the number of securities increases, the possible
portfolios will also grow exponentially.

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(Rp) Notes

(σp)

Figure 6.2: Investment Opportunity Set

Figure 6.2 shows a shaded region PVWP, known as the investment

opportunity region, which depicts the risk and returns for all the possible
sets of portfolios, e.g., combination R represents x1 level of risk and
y1 level of return. Each point within this region represents a particular
portfolio. The region has many feasible portfolios in which investors can
invest based on their risk appetite. Investors can invest in portfolio P,
which has a minimum degree of risk, or in portfolio W, which provides
maximum returns, or select another portfolio based on their minimum
return expectations concerning their risk appetite.
(b) Determining the Efficient Set of Portfolios: The subsequent step
involves identifying the efficient set of portfolios. The efficient set
of portfolios is subject to two propositions:
u Among all the possible portfolios offering an equal expected
return, an investor consistently opts for the one with the lowest
degree of risk.
u Among all the possible portfolios having the same degree of
risk, an investor consistently opts for the one with the highest
expected return.
The collection of efficient portfolios is known as Efficient Frontier. In
simple words, the efficient frontier is the graphical representation of all
the optimal portfolios among the feasible portfolios. All efficient portfo-
lios are feasible but all feasible portfolios are not efficient due to their

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Notes risk–return profile. In Figure 6.2, the points aligning along the boundary
PQSVW collectively form the efficient frontier. Portfolios to the right of
this boundary are deemed inefficient as they possess a greater risk for the
given level of return. Conversely, portfolios positioned at lower levels of
the boundary are suboptimal, offering fewer returns for a given level of
risk. Portfolio S dominates all other portfolios lying below it. All three
portfolios, i.e., S, T, and U are providing the same degree of risk, x2 at
different levels of returns. However, portfolio S has the highest return,
i.e., y2 at x2 level of risk, and hence, it is called an efficient portfolio.
(c) Constructing Indifference Curves (IC) of the Investor: Every
investor aims to select an optimal portfolio for maximum utility.
The indifference curve is used to analyse the level of satisfaction
of an investor. The indifference curve (IC) assesses an investor’s
satisfaction level, revealing the risk–return trade-off. Investors are
generally risk-averse, showing upward-sloping indifference curves.
The slope of the IC varies with an investor’s risk preference; a
steeper slope indicates higher risk aversion, while a flatter slope
suggests lower risk aversion. The main characteristic feature of an
investor’s utility curves is that they never intersect with each other
and remain parallel. In Figure 6.3, an investor has three ICs, C1,
C2, and C3, denoting different levels of risk and return. The utility
on C1 is lowest and on C3 is highest. Points S1 and S2 are on the
same IC, i.e., IC1, so they provide the same amount of utility.

(Rp)

(σp)

Figure 6.3: Indifference Curves of a Risk-Averse Investor

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If the satisfaction increases, an investor will move to the higher IC, i.e., Notes
IC2 and IC3. The higher the IC, the more will be the utility.
(d) Selecting the Optimal Portfolio: The final step in portfolio selection
involves choosing the optimal portfolio, aiming to maximise the
investor’s utility, i.e., to attain the highest IC. The optimal portfolio
is the one that satisfies the following conditions:
u The portfolio must lie on an efficient frontier and
u The satisfaction of the investor is maximised.
Figure 6.4 shows the efficient frontier PRW on the indifference map.
The indifference curves C1 and C2 are attainable but inferior, while C3
represents the desired satisfaction level. On C3, portfolios R and X offer
the same level of satisfaction. However, X is not lying on the efficient
frontier; hence, it is not an efficient portfolio. Therefore, R would be the
best/optimal portfolio, as it is on the efficient frontier as well as providing
the maximum level of satisfaction to the investor.

(Rp)

(σp)

Figure 6.4: Selecting the Optimal Portfolio

Limitations of the HM Model

Firstly, the model requires an extensive amount of input data to assess a
portfolio’s risk and reward. If there are N securities in the portfolio, then
N estimates of return, N standard deviations, and N(N − 1)/2 covariances
are required. Handling such a huge quantum of data poses a significant
challenge. Furthermore, the model suggests that there are as many optimal
portfolios as there are number of investors. However, this limitation is
mitigated by incorporating a risk-free asset into the capital market.

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Notes 6.7.2 Capital Market Theory Model

The Capital Market Theory is an extension of the Portfolio Theory
introduced by Sharpe in 1964, which incorporates risk-free lending and
borrowing.

Assumptions for the Capital Market Theory are as follows:

‹ Investors behave rationally and assess risk and return to make
investment decisions.
‹ Infinitely divisible securities.
‹ No limits on short sales/selling.
‹ A large number of investors and their buying or selling behaviour
do not affect the price of the security.
‹ Frictionless markets, i.e., no transaction costs or taxes.
‹ The presence of risk-free assets along with risky assets in the market.
‹ Investors have uniform or identical expectations of returns, return
variances, and covariances for all the security pairs. This is an
important assumption for ensuring a unique efficient frontier.

(Rp)

(σp)

Figure 6.5: Capital Market Line

Figure 6.5 shows that the efficient frontier is concave in shape. When a
risk-free asset is introduced in the capital market, the efficient frontier
transforms into a straight line originating from the risk-free return on the
Y axis. This straight line is known as the Capital Market Line, which is
tangent to the original efficient frontier at point M.

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The CML is given by the following equation: Notes

R f + σ p *( ERm − R f )
E ( Rp ) =
σm
Where,
E(Rp) = expected return of a portfolio
Rf = risk-free rate of interest
E(Rm) = expected return on the market portfolio
σp = standard deviation of the portfolio
σm = standard deviation of the market portfolio.
The capital market line shows the return of the portfolio is equal to the
risk-free rate plus a risk premium. The higher the risk, the higher the
expected return.
The Characteristic Features of CML are as Follows:
‹ The CML shows a direct relationship between portfolio risk (σp)
and expected return E(Rp).
‹ CML originates from Rf, hence the slope of CML is determined by
the risk-free rate.
‹ It represents the reward-to-variability ratio, measured as [E(Rm) − Rf]/
σ m.
‹ CML is tangent to the original efficient frontier at point M, i.e.,
the optimal portfolio of risky assets or the market portfolio.
‹ Only efficient portfolios lie on CML consisting of risk-free assets
and portfolios of risky assets.

Example 4: The information on the portfolios is available to an investor:

Portfolio E(R) σ
P 8% 3%
Q 12% 5%
R 11% 4%
It is given that the risk-free interest rate is 4% and the estimated market
return is 12%. The market portfolio has a risk of 5%. Find out whether
these portfolios are efficient or not.

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Notes Solution:
To check if these are efficient portfolios, we have to calculate the
expected return as per CML.

R f + σ p *( ERm − R f )
E ( Rp ) =
σm

Portfolio E(R) E(R) as per CML Efficient

(given) Portfolio or not
P 8% 4 + (12 − 4)3/5 = 8.8% Not efficient
Q 12% 4 + (12 − 4)5/5 = 12% Efficient
R 11% 4 + (12 − 4)4/5 = 10.4% Not efficient

Portfolio Q is considered efficient as its estimated return is equal to the

return calculated by the Capital Market Line (CML). Both P and R are
not efficient portfolios in the capital market. Portfolio P, with an actual
return of 8% below the CML estimate, is considered overpriced. Con-
versely, Portfolio R, with an actual return of 11% exceeding the CML
estimate, is considered underpriced.

6.7.3 Capital Asset Pricing Model (CAPM)

CAPM was discussed independently by Sharpe (1964), Lintner (1965),
and Mossin (1966) in their research papers. CAPM is an extension of
Capital Market Theory, which is used to predict the expected return on
a security or portfolio. It helps assess whether a security is outperform-
ing or underperforming in comparison to the expected return. CAPM
establishes a direct link between the expected return and systematic risk,
denoted by β. With two types of risks, systematic and unsystematic risk
(already discussed in Chapter 2), the latter can be diversified through
portfolio construction while the former cannot. Hence, as per this model,
an investor must be rewarded for bearing the systematic risk only and
that reward is called risk premium.
CAPM is given by the following equation:

E(Ri) = Rf + [E(RM) − Rf] βi

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Where, Notes
E(Ri) = Expected return from security or asset
Rf = Risk-free rate of return
E(RM) = Expected return on a market portfolio
βi = Beta coefficient of security i, a measure of systematic risk

According to CAPM,
Expected Return = Risk-free rate + Market risk premium
In other words, it can be written as:
Expected Return = Reward for Time + Reward for Risk

Example 5: Calculate the expected return for a security X using CAPM.

The required information is given below:
Rf = 7% RM = 14% βi = 0.70

Solution:
E(RX) = Rf + [E(RM) − Rf] βx
= 0.07 + (.14 – 0.07) * .70
= 11.9%
The graphical representation of CAPM is done through the security market
line. It is a straight line, which shows a linear relationship between the
expected return on security and the systematic risk. The slope of SML
is the market risk premium, i.e., [E(RM) − Rf].

Figure 6.6: Security Market Line

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Notes As shown in Figure 6.6, all the fairly priced securities are plotted on the
SML. The assets above the line are undervalued because, for a given amount
of risk (beta), they earn a higher return. The assets below the line are
overvalued because, for a given amount of risk, they earn a lower return.

Example 6: From the information given below, find out which of the
securities are underpriced or overpriced in terms of the SML equation:

Security Actual Return (%) Beta

A 8 0.5
B 20 1.2
C 15 1.0
D 22 1.6
E 24 2.0

The return on the market index is 15% and the return on risk-free assets
is 6%.
Solution: As per SML,
E(Rx) = Rf + [E(RM) − Rf] βx

Security Actual Beta Return as per SML Underpriced/

Return (%) Overpriced
A 8 0.5 6 + (15 − 6) *0.5 Overpriced
= 10.5
B 20 1.2 6 + (15 − 6) *1.2 Underpriced
= 16.8
C 15 1.0 6 + (15 − 6) *1.0 Fairly priced
= 15
D 22 1.6 6 + (15 − 6) *1.6 Underpriced
= 20.4
E 24 2.0 6 + (15 − 6) *2 Fairly priced
= 24
Security A is overpriced as its actual return is lower than the SML-
calculated return, thus it is recommended to be sold. However, securities
B and D are underpriced and advisable for purchase. Securities Q and

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S have actual returns equal to the CAPM return, and therefore, they are Notes
correctly priced.

IN-TEXT QUESTIONS
4. If two assets in a portfolio have a correlation coefficient of −1,
what does this imply?
(a) The assets have no relationship
(b) The assets move in the same direction
(c) The assets move in opposite directions
(d) The correlation coefficient cannot be −1
5. In the CAPM, what happens to an asset’s expected return if its
beta increases?
(a) Increase
(b) Decreases
(c) No change in expected return
(d) Cannot be determined
6. In the CAPM formula, Rf + [E(RM) − Rf] βi
(a) Market risk premium
(b) Risk-free rate
(c) Beta coefficient
(d) Total risk

6.8 Solved Illustrations

Question 1: An investor allocates his funds in securities S and T, whose
details are given below:

Security S Security T
E(R) 7% 20%
Risk (σ) 8% 14.9%
Weight (W) 30% 70%
The covariance between the returns of the securities is 90. Find out the
portfolio’s risk and return. Also, find the correlation between the returns
of X and Y.
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Notes Solution:
(a) Portfolio Return
n
E ( R p ) = ∑ wi × E ( Ri )
i =1

E(Rp) = .30 × 7 + .70 × 20

E(Rp) = 16.1%

(b) Portfolio Risk

σxy = √wx2σx2 + wy2σy2 + 2wxwyCovxy

σxy = √(0.3)2 (8)2 + (.7)2 (14.9)2 + 2 (.3) (.7) 90

σxy = 12.34%

(c) Correlation between the Returns:

Covxy = ρxy σx σy
90 = ρxy (8) (14.9)
ρxy = 0.75

Question 2: Consider a portfolio with two assets, P and Q, with the

following details:
Asset A - E(R): 10% σ: 15% Weight of Security A: 0.6
Asset B - E(R): 12% σ: 18% Weight of Security A: 0.4
ρxy = 0.4

Solution:
(a) Portfolio Return
n
E ( R p ) = ∑ wi × E ( Ri )
i =1

E(Rp) = .60 × 10 + .40 × 12

E(Rp) = 10.8%
(b) Portfolio Risk
σxy = √wx2σx2 + wy2σy2 + 2wxwy ρxy σx σy

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σxy = √(0.6)2 (15)2 + (.4)2 (18)2 + 2 (.6) (.4) (0.4) (15) (18) Notes
σxy = 13.6%

Question 3: Mr. Modi is investing in securities X and Y, whose details

are given below:
Security X Security Y
E(R) 10% 15.5%
σ 3% 7%
Weight 40% 60%
Find out the expected return, minimum risk, and maximum risk of the
portfolio.

Solution:
(a) Portfolio Return
E(Rp) = .40 × 10 + .60 × 15.5
E(Rp) = 13.3 %

(b) Portfolio Risk

Case 1: Portfolio has minimum risk when ρxy = −1

σxy = √wx2σx2 + wy2σy2 + 2wxwy ρxy σx σy

σxy = √(0.4)2 (3)2 + (.6)2 (7)2 + 2 (.4) (.6) (−1) (3) (7)
σxy = 3%
Case 2: Portfolio has minimum risk when ρxy = +1
σxy = √(0.4)2 (3)2 + (.6)2 (7)2 + 2 (.4) (.6) (1) (3) (7)
σxy = 5.4%
Question 4: The expected return and risk of X and Y are given below:
Security X Security Y
E(R) 10% 12%
σ 20% 24%
The coefficient of correlation between the returns of two securities is
0.3. An investor has to decide about the portfolio of X and Y as 20% +
80% or 80% + 20%. Which one should he accept?
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Notes Solution:
For 80% + 20% portfolio of X and Y:
E(Rxy) = WXRX + WYRY
E(Rxy) = .80 × 10 + .20 × 12
E(Rxy) = 10.4%

σxy = √wx2σx2 + wy2σy2 + 2wxwy ρxy σx σy

σxy = √(0.80)2 (20)2 + (.20)2 (24)2 + 2 (.80) (.20) (0.3) (20) (24)
σxy = 18.03%

For 20% + 80% portfolio of X and Y:

E(Rxy) = WXRX + WYRY
E(Rxy) = .20 × 10 + .80 × 12
E(Rxy) = 11.6%

σxy = √wx2σx2 + wy2σy2 + 2wxwy ρxy σx σy

σxy = √(0.20)2 (20) 2 + (.80) 2 (24) 2 + 2 (.20) (.80) (0.3) (20) (24)
σxy = 20.75%
An investor will choose the one which is less risky by calculating the
coefficient of variation.
CV(80,20) = σxy/R
= 18.03/10.4
= 1.73
CV(20,80) = σxy/R
= 20.75/11.6
= 1.79
It is concluded that the investor should prefer the portfolio having weights
of 80% + 20% respectively. The CV of the other portfolio is slightly
higher, hence making it a risky investment.
Question 5: The information on three portfolios is available to an investor.
Comment on whether these portfolios are efficient or not.

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Portfolio E(R) σ Notes

A 19% 16%
B 40% 30%
C 29% 18%
Rf = 7% Rm = 18% σm = 10%

Solution: An efficient portfolio lies on CML. To check if these are

efficient portfolios, we have to calculate the expected return as per CML.

R f + σ p *( ERm − R f )
E ( Rp ) =
σm

Portfolio E(R) (given) E(R) as per CML Efficient

Portfolio or not
A 19% 7 + (18 − 7)16/10 Not efficient
= 24.6%
B 40% 7 + (18 − 7)30/10 Efficient
= 40%
C 29% 7 + (18 − 7)18/10 Not efficient
= 26.8%

Portfolio B is considered efficient as its estimated return is equal to the

return calculated by the Capital Market Line (CML). Both A and C are
not efficient portfolios in the capital market. Portfolio A, with an actual
return of 19% below the CML estimate, is considered overpriced. Con-
versely, Portfolio C, with an actual return of 29% exceeding the CML
estimate, is considered underpriced.

Question 6: The risk-free rate of interest is 5% and the return on the

market portfolio is 17%. The risk of the market portfolio is 10%. An
investor has constructed a portfolio having a risk of 8%. Find out the
expected return as per CML.

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Notes Solution:
R f + σ p *( ERm − R f )
E ( Rp ) =
σm
5 + (17 − 5) * 8
=
10
= 5 + 9.6
= 14.6%

Question 7: The risk-free rate is 5% and the market risk premium is

10%, and the beta of the security is 1.3. What is the expected return of
the security under CAPM?

Solution:
E(Rx) = Rf + [E(RM) − Rf] βx
= 5 + (10) *1.3
= 18%

Question 8: Find out the expected return of the following securities if

the prevailing interest rate on Govt. securities is 7% and the rate of re-
turn on the market index is 10%. The beta factors of security A, B, and
C are 1, 1.25, and 1.50, respectively.

Solution:
E(R) = Rf + [E(RM) − Rf] β
Expected Return for Security A
= 7 + (10 − 7) *1
= 10%
Expected Return for Security B
= 7 + (10 − 7) * 1.25
= 10.75%
Expected Return for Security C
= 7 + (10 − 7) * 1.50
= 11.50%

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Notes
6.9 Summary
Portfolio management involves diversifying investments across various
financial securities to minimise risk. This process includes formulating,
maintaining, revising, and continuously evaluating a portfolio. It starts
with portfolio analysis, which assesses the efficiency of different portfo-
lios in terms of risk and return profile of the investor. Portfolio theories,
i.e., Harry Markowitz Model and Capital Market Theory are discussed
in the literature and have been used by an investor to select an optimal
portfolio. Continuous monitoring of the portfolio to track changes in the
financial environment takes place. Finally, the evaluation of a portfolio
is the last step as well as an integral part of the portfolio management
process. Portfolio evaluation is a dynamic process aimed at determining
whether the selected efficient portfolios have been reaping the desired
return or not.

6.10 Answers to In-Text Questions

1. (a) Portfolio
2. (c) Reducing overall risk through a variety of investments
3. (a) True
4. (c) The assets move in opposite directions
5. (a) Increase
6. (a) Market risk premium

6.11 Self-Assessment Questions

1. Define a portfolio. Explain its significance in investment.
2. What is portfolio management? Outline the steps involved in
managing a portfolio.
3. How do the coefficient of correlation, portfolio risk, and diversification
contribute to the informed decision-making process?
4. Explain Harry Markowitz Theory along with its assumptions and
limitations.
5. Explain the distinctive features of the Capital Market Line.

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Notes 6. Explain the Capital Asset pricing model along with its assumptions
and limitations.
7. The expected return and risk of M and N are given below:
Security M Security N
E(R) 20% 15%
σ 15% 8%
The coefficient of correlation between the returns of two securities
is 0.7. An investor has to decide about the portfolio of X and Y as
75% + 25%.
(Ans. – Portfolio return = 18.75%, Portfolio risk = 12.73%)
8. Mr. Keshav has two securities for his portfolio, whose details are
given below:
Security X Security Y
E(R) 15% 19%
σ 5% 7%
If he invested 40% in X and 60% in Y, find the expected returns
and maximum and minimum risks of such portfolios.
(Ans. – Portfolio return = 17.4%, Maximum risk = 6.2%, Minimum
risk = 2.2%)
9. An investor has two stocks: A and T. The risk is 0.25 for A and
0.14 for T. The correlation between the two securities is 0.1285.
Calculate the covariance between the returns of A and T.
(Ans. – CovarianceST = 0.0045)
10. An investor has two stocks: A and B. The risk is 30% for A and
20% for B. The covariance between the returns of A and B is 0.01.
Calculate the coefficient of correlation.
(Ans. – ρAB = 0.167)
11. The risk and return of the market portfolio are 28% and 14%,
respectively. The risk-free rate is 10% and the standard deviation
of the portfolio is 37%. Find out the expected return of the investor
as per CML.
(Ans. – E(Rp) = 15.28%)
12. From the data given below, find out which of the securities are
underpriced or overpriced in terms of the SML equation:
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Security E(R) Beta Notes

A 15 1.9
B 25 3
C 18 1.2
D 10 0.5
E 15 1.6
The return on the market index is 12% and the return on risk-free
assets is 8%.
(Ans. – A is overpriced, B, C, and E are underpriced, and D is fairly
priced)

6.12 References
u Baldrige, R. (2023). Understanding Modern Portfolio Theory. Forbes
ADVISOR. Retrieved from: [Link]
modern-portfolio-theory/.
u Bodie, Z., Kane, A., & Marcus, A. J. (2017). Investments. New York:
McGraw-Hill Education.
u Rustagi, R. P. (2021). Investment Management: Theory and Practice.
New Delhi: Sultan Chand & Sons.

6.13 Suggested Readings

u Bodie, Z., Kane, A., & Marcus, A. J. (2017). Investments. New York:
McGraw-Hill Education.
u Chandra, P. (2017). Investment Analysis and Portfolio Management.
Delhi: McGraw-Hill Education.
u Fischer, D. E. & Jordan, R. J. (1995). Security Analysis and Portfolio
Management. New Delhi: Pearson Education.
u Ranganathan, M. & Madhumathi, R. (2012). Investment Analysis
and Portfolio Management. Delhi: Pearson Education.
u Sehgal, S. (2005). Asset Pricing in Indian Stock Market. Delhi: New
Century Publications.

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 L E S S O N

7
Portfolio Management
Monika Saini
Assistant Professor
Department of Commerce
PGDAV College
Email-Id: [Link]@[Link]

STRUCTURE
7.1 Learning Objectives
7.2 Introduction
7.3 Traditional Portfolio Management for Individuals
7.4 Factors Affecting Traditional Portfolio Management for Individuals
7.5 Approaches to Asset Allocation
7.6 Summary
7.7 Answers to In-Text Questions
7.8 Self-Assessment Questions
7.9 References
7.10 Suggested Readings

7.1 Learning Objectives

Reading this lesson will enable students to:
‹ Understand the concept of Traditional Portfolio Management for Individuals.
‹ Examine the objectives of Traditional Portfolio Management.
‹ Familiarize with different approaches of Asset Allocation.
‹ Differentiate between Active and Passive Portfolio Management services.

7.2 Introduction
Portfolio management is basically the art and science of making smart investment choices
to reach specific financial goals. It’s about choosing a mix of investments—like stocks,

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bonds, real estate, or even gold—based on your personal comfort with risk, Notes
how long you plan to invest, and what kind of returns you’re aiming for.
The main goal? To get the best possible returns while keeping risk under
control. This is done through strategies like diversification (spreading
your money across different assets), asset allocation (deciding how much
to invest in each asset class), and regularly checking and adjusting your
portfolio as needed.
The concept goes way back to economist Markowitz, who showed that
most investors want high returns but also want to avoid risk. That idea
became the foundation of modern portfolio management.
At the heart of it is a simple principle: don’t put all your eggs in one
basket. Instead, invest in a mix of assets so that if one goes down, others
might still hold up. This mix helps reduce overall risk and is known as
diversification.
A smart investor aims to build the most efficient portfolio possible—
that means getting the best return for a given level of risk. Managing a
portfolio involves weighing different options: debt vs. equity, local vs.
international, growth vs. stability, and so on. It’s really a constant balanc-
ing act, like doing a personal SWOT analysis—understanding strengths,
weaknesses, opportunities, and threats—to make the best choices for your
financial future.

7.3 Traditional Portfolio Management for Individuals

Traditional Portfolio Management recognises the importance of risk and
return. The traditional approach of portfolio management involves fol-
lowing two decisions:
1. Determination of Portfolio objectives
2. Selection of Securities
Traditional portfolio management for individuals involves a hands-on
approach by either the individual investor or a financial advisor. It often
includes:
1. Asset Allocation: Asset allocation means finding the right combination
of assets on the basis of investor’s risk tolerance, financial goals,
and time horizon.

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Notes 2. Diversification: Diversification is the process in which investment is

divided into different categories of asset, industries, or geographic
regions in order to minimise risk. Investors can diversify their
portfolio on the basis of their risk appetite and income needs.
3. Security Selection: The process of portfolio selection is dependent
on investors’ objectives. Different investors have different investment
strategy. An investor should choose those stocks, bonds, mutual funds,
or other asset class which align with his/her investment strategy. For
example, if the main target of investment is to earn regular income,
the investor will invest more in debt or fixed income securities. If
capital appreciation is the main objective of the investment, then
investor will invest in long-term debt.
4. Monitoring and Rebalancing of Portfolio: Portfolio once created,
need to be reviewed frequently. Periodic monitoring and rebalancing
of the portfolio will ensure that it remains aligned with the investor’s
objectives. Investor can make necessary adjustment in the portfolio
as and when required.
5. Risk Management: Employing strategies to mitigate risks and
potentially hedge against market downturns.
6. Performance Evaluation: Assessing the portfolio’s performance
against benchmarks or goals and making changes accordingly.
This approach often requires active decision-making and ongoing
management to adapt to changing market conditions and investor
circumstances.

7.4 Factors Affecting Traditional Portfolio Management

for Individuals
1. Objectives: Understanding the investor’s goals, whether it’s wealth
accumulation, retirement planning, income generation, or capital
preservation.
2. Constraints: Identifying limitations or restrictions such as risk
tolerance, legal or regulatory constraints, and ethical considerations
that may impact investment choices.
3. Time Horizon: Assessing the period over which the investor plans
to achieve their financial goals—short-term (less than 3 years),
intermediate (3-10 years), or long-term (10+ years).
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4. Current Wealth: Evaluating the investor’s existing assets, income, Notes

liabilities, and expenses to determine the available resources for
investment.
5. Tax Considerations: Considering the impact of taxes on investment
returns and employing strategies to minimize tax liabilities, such
as utilizing tax-advantaged accounts or tax-efficient investment
vehicles.
6. Liquidity Requirements: Assessing the need for access to funds
in the short term and ensuring a balance between investments that
offer potential returns and those that provide immediate liquidity.
7. Anticipated Inflation: In order to preserve the real value of
investment over time, it is very important to acknowledge the effect
of inflation on purchasing power. An investor should invest in assets
where the real return after accounting for inflation is higher.
The investor should keep in mind the above factors while constructing
portfolio. These factors will help the investor in creating a portfolio that
is aligned with the investors’ objectives.

IN-TEXT QUESTIONS
1. The main objective of portfolio is to reduce __________ by
diversification.
(a) Return
(b) Risk
(c) Uncertainty
(d) Percentage
2. A combination of various investment products like bonds, shares,
securities, mutual funds and so on is called as __________.
(a) Portfolio
(b) Investment
(c) Speculation
(d) Gambling

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Notes
7.5 Approaches to Asset Allocation
Asset allocation is the process where money is allocated into different
asset classes, such as shares, bonds, cash, gold and alternative invest-
ments. Two common approaches to asset allocation are the asset allocation
pyramid and the investor life cycle approach.
1. Asset Allocation Pyramid
‹ This approach visualizes asset allocation in a hierarchical pyramid.
The bottom of the pyramid consists of the largest portion of the
portfolio. This base includes low-risk assets with stable income
such as cash and fixed-income securities. The base of the pyramid
is the foundation of the pyramid since everything is above it.
It needs to be the strongest part and includes those investments
which has low risk.
‹ In the next level of the pyramid, the allocation of assets shifts
towards higher risk and potentially higher return-generating
assets. These assets can be equities or real estate. The middle
part of the pyramid includes medium-risk investments. These
investments offer stable return with capital appreciation. Although
these investments are relatively riskier as compared to the base
of the pyramid but these investments are still considered safer.
‹ In order to provide stability, the pyramid has foundation of less
volatile assets. From there, it builds upward with riskier assets
with higher returns are included. The top area of the pyramid is
the smallest area with the highest investment risk.

Figure 7.1: Asset Allocation Pyramid

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2. Investor Life Cycle Approach Notes

‹ This approach adjusts the allocation of assets allocation on the
basis of investor’s stage in life. It divides an investor’s life
into stages such as early career, mid-career, pre-retirement and
retirement.
‹ In early stages, when an investor has a longer time horizon, there
might be a higher allocation to growth-oriented assets like stocks.
‹ As the investor ages and approaches retirement, the allocation
tends to shift towards more conservative assets to preserve wealth
and generate income, often favoring fixed-income securities.
Both of the above approaches have the objective of balancing the risk
and return keeping in mind the risk tolerance, time period of investment
and financial goals of the investors. The choice between these methods
often depends on an individual’s preferences, risk appetite and investment
objectives.

7.5.1 Passive Portfolio Management Strategies

Passive strategies involve making investment decisions which result in
minimum transaction costs as well as time spent in managing the port-
folio. It is generally believed that passive strategies do not outperform
the market. Passive investors believe in the theory of efficient markets.
They accept the current market price as the best estimate of a security’s
value. According to Efficient Market Hypothesis, security prices are
always near their fair/ intrinsic value or justified economic value. Eco-
nomic value is calculated by investors’ expectations about risks, earnings
etc. In an Efficient Market, when a new information is out, price adjusts
quickly to that information. All available information is incorporated in
the share prices.

A. Index Funds
A stock index is a statistical indicator that represents the performance
of a specific group of stocks, generally the companies within a particu-
lar sector or region. These funds aim to replicate the performance of a
specific market index (e.g., S&P 500, FTSE 100) by holding the same
securities in the same proportions as the index. They offer broad market
exposure at low costs.

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Notes 1. Diversification: Index funds provide exposure to a wide range of

stocks or securities that constitute the index they track. This inherent
diversification helps spread risk across multiple assets and reduces
the impact of individual stock performance on the overall portfolio.
2. Low Cost: Index funds aim to mirror or replicate the performance
of a specific market index. In index funds, there’s no need for
a team of analysts making active trading decisions. This results
in lower trading costs and lower management fees. Reduction in
these costs can have significant impact on overall return of the
investment.
3. Consistent Performance: Index funds don’t try to beat the market—
they try to be the market. That means their returns closely follow
the performance of the index they’re tracking. While you won’t get
outsized gains, you also avoid the risk of underperforming due to
poor stock picks. It’s a reliable and steady approach for long-term
investors.
4. Transparency: With index funds, what you see is what you get.
Because they mirror well-known indices, it’s easy to see exactly
which stocks or assets the fund holds. This level of transparency
gives investors a clear understanding of where their money is going.
5. Long-Term Strategy: Index funds are ideal for those with a long-
term investment mindset. Instead of constantly buying and selling,
the strategy here is to stay invested and let the market work for
you over time. If you’re patient and think long-term, index funds
can be a powerful tool for building wealth.
6. Passive Management: These funds don’t require constant oversight,
which makes them great for investors who prefer a “set-it-and-
forget-it” approach. Since the fund’s job is simply to follow an
index, there’s less need for active decisions, making it a convenient
choice for busy or beginner investors.
7. Historical Performance: Over time, many index funds have performed
as well—or even better—than actively managed funds, especially
after accounting for fees. They may not outperform the market,
but by closely tracking it, they offer dependable and competitive
returns.

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8. Systematic Investment Plans (SIPs): SIPs are all about building Notes
a habit. You invest a fixed amount regularly—like every month—
regardless of what’s happening in the market. It’s a smart and
stress-free way to invest over time.

Benefits of SIPs
1. Regular Investments: SIPs make investing simple as well as automatic.
In SIPs a fixed amount is set aside at regular intervals. This leads
to discipline in investment. When an investor puts money in SIPs,
he or she needs not to worry about daily price fluctuations.
2. Rupee Cost Averaging: Rupee cost averaging is the concept in
investment where a fixed amount is invested on a regular basis.
In SIPs also same amount is invested regularly, more units can
be purchased when the prices are low. When prices are higher,
lesser units are purchased. This results in averaging the effect of
purchase price over a period of time. This investment strategy is
very beneficial in volatile markets.
3. Risk Mitigation: SIPs provide protection of your investment from
market fluctuations. Short-term fluctuations in the market do not
impact your investment since money is invested consistently in
SIPs. When markets are unpredictable, SIPs are considered as a
good investment strategy.
4. Long-Term Wealth Creation: With patience and consistency, SIPs
can help an investor build significant wealth over time. They’re
a great choice for anyone looking to gradually grow their money,
whether it’s for retirement, a child’s education, or any other long-
term goal.
7.5.2 Active Portfolio Management Strategies
The investors, who don’t accept the Efficient Market Hypothesis (EMH) or
have doubts, use active investment strategies. They believe in identification
of undervalued stocks and lag in market’s adjustment of these stock’s
prices to new and better information. Such investors incur more search
costs and transaction costs. These investors believe that the benefits will
outweigh the marginal costs incurred. Quest of active strategies assumes
that investors have some advantages in the form of superior analytical
or judgement skills, superior information compared to other investors.

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Notes A. Market Timing

Market timing is the strategy where investment decisions are based
on anticipations about the future market movements. The buy and sell
decision is made at the optimal times to take advantage of anticipated
market trends. However, it’s challenging to consistently predict market
movements accurately.
This is also called Dynamic Asset Allocation. In this strategy, one pur-
chases stocks/bonds before these assets have positive returns and sell
them prior to the time when they have negative returns.
Examples of Market Timings
1. Buying Low and Selling High: An investor might try to time the
market by buying stocks when prices are perceived to be low,
anticipating future appreciation, and selling them when prices are
high to lock in gains.
2. Sector Rotation: Some investors try to predict which sectors will
outperform the market and shift their investments accordingly. For
instance, moving investments from technology stocks to healthcare
stocks based on market predictions.
3. Market Corrections: During market corrections or downturns,
investors might attempt to time the market by purchasing stocks at
what they believe to be the bottom of the market cycle to benefit
from the potential rebound.

B. Style Investing
Investors using this approach focus on specific styles or factors like val-
ue, growth, momentum, or size when selecting investments. For instance,
value investing targets undervalued stocks while growth investing focuses
on companies with strong growth potential.

Some Common Styles in Style Investing

1. Value Investing: This style focuses on identifying undervalued stocks
or assets that are trading below their intrinsic value. Value investors
seek companies with low price-to-earnings ratios, low price-to-book
ratios, or strong fundamentals compared to their market price.
2. Growth Investing: Growth investors target stocks or assets of
companies expected to have above-average growth rates in earnings,
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revenue, or cash flow. These companies might reinvest earnings Notes

rather than paying dividends to fuel further growth.
3. Quality Investing: Quality investors look for companies with strong
fundamentals, stable earnings, low debt, consistent profitability, and
robust management. These companies are typically considered to
have resilient business models.
4. Momentum Investing: Momentum investors focus on stocks or assets
that have demonstrated strong recent performance. They believe that
assets that have performed well recently will continue to do so in
the short term.
5. Dividend Investing: Dividend investors prioritize stocks of companies
that regularly pay dividends. They seek stable and consistent dividend-
paying companies to generate income from their investments.
6. Contrarian Investing: Contrarian investors go against prevailing
market trends. They seek opportunities in assets or sectors that are
undervalued or unpopular due to market sentiment but have the
potential for future growth.

IN-TEXT QUESTIONS
3. Pursuit of an __________ strategy assumes that investors possess
some advantage relative to other market participants.
4. The asset allocation decision refers to the allocation of __________
assets to __________ asset markets.
5. The foundation of the investment pyramid represents the
__________ portion.

7.6 Summary
A portfolio is simply a collection of financial assets—things like shares,
debentures, and government securities. In fact, most people, whether
they realize it or not, already have a portfolio. It might not just include
financial assets like stocks and bonds, but also real assets like a house,
a car, or even a refrigerator.
Sometimes, a portfolio comes together by chance—buying things here
and there without much thought. Other times, it’s the result of careful,

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Notes deliberate planning. Either way, how you design and manage your port-
folio, especially how you allocate your assets, plays a huge role in how
your investments perform over time.
In fact, it’s not so much which individual stocks you pick or when
you buy them that drives your long-term returns. It’s mainly how
you spread your money across different types of assets—like stocks,
bonds, or money market instruments—that makes the biggest difference.
This crucial decision, called asset allocation, involves deciding what
percentage of your total investment goes into each broad asset class. If
this decision is properly made, better results in terms of risk and return
can be assured.

7.7 Answers to In-Text Questions

1. (b) Risk
2. (a) Portfolio
3. Active
4. Portfolio, broad
5. Strongest

7.8 Self-Assessment Questions

1. Why is asset allocation considered a critical factor in portfolio
performance?
2. What is the traditional approach of Portfolio Management? What
are the factors affecting it?
3. Differentiate between Active and Passive Portfolio Management
Strategies?
4. What are the approaches to Asset Allocation?
5. Explain the following:
(a) Style Investing
(b) SIP
(c) Market Timing
(d) Index Funds

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Notes
7.9 References
‹ Edwin J. Elton, M. J. (2014). Modern portfolio theory and investment
analysis. United States of America: JohnWiley & Sons, Inc.
‹ ICSI. Financial and Strategic Management. New Delhi: The Institute
of Company Secretaries of India.
‹ Nishikant Jha, R. S. (2016). Investment Analysis and Portfolio
Management. Mumbai: Himalaya Publishing House Pvt. Ltd.
‹ Sarva, M. K. Security Analysis and Portfolio Management. New
Delhi: Excel Books Pvt. Ltd.

7.10 Suggested Readings

‹ Sudhindra Bhat, Security Analysis and Portfolio Management, Excel
Books. Delhi.
‹ Preeti Singh, Security Analysis and Portfolio Management.
‹ V.A. Avadhani, Investment Management.
‹ M.Y. Khan, Fianacial Services.
‹ V.K. Bhalla, Financial Services.
‹ G.S. Batra, Financial Services and Markets.
‹ Mahana Rao, Financial Services, Cases and Strategies.
‹ L. M. Bhole, Financial Markets and Services.

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 UNIT - IV

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 L E S S O N

8
Asset Pricing Models
Manisha Yadav
Assistant Professor
School of Open Learning
University of Delhi
Email-Id: [Link]@[Link]

STRUCTURE
8.1 Learning Objectives
8.2 Introduction
8.3 Risk
8.4 Capital Asset Pricing Model (CAPM)
8.5 Assumptions of CAPM
8.6 Limitations of CAPM
8.7 The CAPM and the Efficient Frontier
8.8 Security Market Line (SML)
8.9 Arbitrage Pricing Theory (APT)
8.10 Summary
8.11 Answers to In-Text Questions
8.12 Self-Assessment Questions
8.13 Suggested Readings

8.1 Learning Objectives

After reading this lesson, students should be able to:
‹ Understand the importance of asset pricing models and their role in investment
decisions.
‹ Explore key models like the Capital Asset Pricing Model (CAPM) and Arbitrage
Pricing Theory (APT), including their assumptions, applications, and limitations.
‹ Analyze how risk influences asset pricing, and how concepts like the Efficient
Frontier and Security Market Line (SML) help in making better investment choices.

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Notes
8.2 Introduction
Investing is all about balancing two things — risk and reward. But how
do investors know if the price they’re paying for a stock, bond, or any
other asset actually makes sense? That’s where asset pricing models come
in. Think of them as a set of guiding tools that help investors estimate
the “fair value” of different financial assets. These models draw a con-
nection between the amount of risk an investment carries and the return
an investor should reasonably expect in return for taking that risk. In
simple terms, asset pricing models help investors make smarter choices —
ensuring they are not overpaying for risk and are positioning themselves
for the best possible returns. Whether you’re investing in a single stock
or building an entire portfolio, understanding how these models work is
key to making informed and confident financial decisions.
There are several well-known models that try to explain how asset prices
are determined. Let’s look at some of them in simple terms:
1. “Capital Asset Pricing Model (CAPM)”: This is one of the most
popular models. It helps investors understand the expected return
on an investment based on its risk compared to the overall market.
CAPM uses a measure called “beta,” which tells us how much an
asset moves in relation to the market. The formula looks like this:
Expected Return = Risk-Free Rate + (Beta × Market Risk Premium)
In simple terms, this means the expected return depends on the
safest possible return (like a government bond), plus an extra return
for taking on more risk.
2. Arbitrage Pricing Theory (APT): This model is an alternative to
CAPM. Instead of using just one market-based risk factor, APT
considers multiple factors that can influence an asset’s return, such
as inflation, interest rates, and economic growth. This model gives
investors more flexibility in understanding risks from different sources.
3. Fama-French Three-Factor Model: This model improves upon
CAPM by adding two extra factors:
‹ Size factor (SMB - Small Minus Big): Small companies tend
to perform differently from large ones.
‹ Value factor (HML - High Minus Low): Stocks that are undervalued
(cheap stocks) behave differently from high-priced stocks.
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4. Carhart Four-Factor Model: This builds on the Fama-French model Notes

by adding a fourth factor:
‹ Momentum (UMD - Up Minus Down): Stocks that have performed
well in the recent past often continue to do well for some time.
5. Black-Scholes Model: This model is mostly used to price options
(a type of financial contract) rather than stocks. It assumes that
market conditions, like stock price changes, follow a predictable
pattern with constant risk levels.
6. Multi-Factor Models: Some investors create models with even more
factors to capture risks specific to certain industries or investment
strategies.
In this lesson, we’ll focus on two key models: CAPM and APT, as they
are the most commonly used in financial decision-making.

8.3 Risk
When you invest money, there’s always some level of uncertainty about
how much you’ll get in return. Risk simply means that your actual returns
might be different from what you expected—sometimes higher, sometimes
lower, and in the worst case, you could even lose your investment.
Each investor has a different comfort level with risk. Some people are
okay with taking bigger risks in the hope of earning higher returns,
while others prefer safer options with lower returns. Generally, the more
risk you take, the more return you expect in exchange for handling that
uncertainty.
Is There Such a Thing as a Risk-Free Investment?
Not really. Every investment carries some risk, but some are considered
very low-risk. Examples include:
‹ “Treasury Bills (T-bills)”: These are one of the safest investments,
as these are issued by the government.
‹ “Public Provident Fund (PPF)”: It is a long-term savings scheme
which is backed by the government.
‹ Other Low-Risk Securities: Bonds and fixed deposits fall into
this category.
Even these investments aren’t completely risk-free, but the chances of
losing money are extremely low.
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Notes Types of Risk

1. “Systematic Risk (Market Risk)”
‹ This type of risk comes from broader economic factors like
inflation, interest rate changes, or a financial crisis.
‹ It affects all investments and cannot be avoided by simply
diversifying your portfolio.
‹ Example: If the entire stock market crashes, almost all stocks
will lose value, no matter how well a particular company is doing.
‹ Measured using beta (β)—a number that tells us how much a
stock moves vis-a-vis the market.
2. Unsystematic Risk (Company-Specific Risk)
‹ This risk comes from factors within a company, like poor
management decisions, financial troubles, or production failures.
‹ Unlike systematic risk, this can be reduced by diversifying your
investments.
‹ Example: If you own stocks in multiple industries, a problem
in one company won’t significantly hurt your entire portfolio.
Understanding Beta (β) – A Measure of Market Risk
Beta helps investors understand how much a stock moves compared to
the overall market:
‹ β > 1 → The stock is more volatile than the market (higher
risk, but potentially higher returns).
‹ β < 1 → The stock is less volatile than the market (lower risk,
but also lower potential returns).
‹ β = 0 → A risk-free investment, like a government bond.
‹ Market portfolio β = 1→ The market itself always has a beta
of 1.
Example: If a stock has a beta of 0.90, it means that if the overall mar-
ket increases by 10%, the stock is expected to rise by 9%. If the market
drops by 10%, the stock would likely decrease by 9%.
B of a security can be calculated as:
cov( S,M )
Cov
β=
σM 2

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Illustration 8.1: Following information is available in respect of a se- Notes

curity G and the market portfolio M.
Probabilities Security G Market Portfolio M
0.3 10 12
0.4 12 15
0.3 14 18
Find out β of security G.
Solution:
Pi G M PiG PiM Pi(G – Pi(M – Pi(G – exp
exp G)2 exp M)2 G)(M – exp
M)
0.3 10 12 3 3.6 1.2 2.7 1.8
0.4 12 15 4.8 6 0 0 0
0.3 14 18 4.2 5.4 1.2 2.7 1.8
Σ =12 Σ =15 Σ =2.4 Σ =5.4 Σ =3.6
The above table shows that:
Mean return of G = 12%, Mean market return = 15%, Variance of G =
2.4 sq %, Variance of M = 5.4 sq %, Covariance = 3.6 sq %.
β = Cov/ Market Variance = 3.6/5.4 = 0.67
Hence beta of security G is 0.67.

Figure 8.1: No. of Securities and Risks

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Notes
8.4 Capital Asset Pricing Model (CAPM)
It helps investors figure out how much return they should expect from
an investment based on its risk. In other words, it answers the question:
“Is this investment worth it?”
This model is widely used to estimate returns on stocks, portfolios, or
any other asset. It helps businesses and investors decide where to put
their money.

How CAPM Works

The main idea behind this model is that an investor should be compen-
sated for two things:
1. Time Value of Money: This is covered by the risk-free rate (Rf),
which is the return you get on an absolutely safe investment like
a government bond.
2. Risk Premium: This is the extra return investors expect for taking
on additional risk. It’s calculated as (Market Return - Risk-Free
Rate) and is adjusted by a risk factor called Beta (β).

8.4.1 Key components of the CAPM

Expected Return (Ri): The model calculates the expected return of an
investment, or a portfolio based on three components:
‹ The Risk-free Rate (Rf): The return on an investment with no
risk, usually approximated using government bonds. This part of
the risk accounts for time value of money.
‹ The Market Risk Premium (Rm - Rf): The excess return expected
from the overall market compared to the risk-free rate. It is the
extra return that an investor anticipates for shouldering extra risk.
‹ Beta (β): A measure of the investment’s systematic risk, representing
its sensitivity to market movements. Beta indicates how much the
investment’s returns are expected to move in relation to the overall
market.
The formula for expected return (Ri) is given by:
E(Ri)=Rf+β×(Rm-Rf)

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Illustration 8.2: Rf = 5%, E(Rm) = 11%, and β of a security T is 1.5. Notes

Then what will be the expected return of the security?
Solution: E(Ri)=Rf+β×(Rm-Rf)
E(Ri) = 0.05 + (0.11 - 0.05)(1.5)

8.4.2 Purpose of CAPM

1. Helps Companies Estimate Their Cost of Capital
‹ Businesses use CAPM to determine the return they need to
provide to investors to make their stock attractive.
2. Guides Investment Decisions
‹ Investors use CAPM to see if a stock’s expected return is worth
the risk. If the return is too low for the risk level, they may
look for a better investment.
3. Improves Portfolio Management
‹ CAPM helps investors build diversified portfolios by balancing
risk and return efficiently.
4. Assists in Corporate Finance Decisions
‹ Companies use CAPM to evaluate investment projects. If a
project’s return is less than the required return, the company
may reject it.
While CAPM provides a useful framework for understanding the relation-
ship between risk and return, it has some limitations and assumptions,
such as the assumption of a single-period investment horizon, perfect
capital markets, and constant beta over time, which may not always hold
true in real-world situations.

8.5 Assumptions of CAPM

1. Perfect Market Conditions
‹ CAPM assumes that markets are fair and efficient—meaning
there are no taxes, no transaction costs, and no hidden fees
when buying or selling stocks.
‹ Everyone has equal access to information, and buying or selling
doesn’t affect the price of a stock.

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Notes 2. Investors are Rational

‹ The model assumes that all investors think logically and make
decisions purely to maximize their profits.
‹ Investors don’t let emotions influence their decisions, and they
always consider risks and returns before investing.
3. One-Time Investment Period
‹ CAPM assumes that investors make investment decisions for a
single time period and don’t think about long-term compounding
or multiple investment periods.
4. Everyone Has the Same Expectations
‹ CAPM assumes that all investors see the future the same
way—they expect the same returns, risks, and other financial
details about stocks.
‹ In reality, investors have different opinions, which affects stock
prices.
5. Risk-Free Investment Option is Available
‹ The model assumes that investors can put their money in a
completely safe investment (like government bonds) that gives
a guaranteed return with zero risk.
6. Stocks Can Be Bought in Any Amount
‹ Investors can buy or sell any fraction of a stock. This means
you can invest exactly how much you want without limitations.
‹ In reality, stocks come in whole units, and not all securities are
easily divisible.
7. No Borrowing or Lending Limits
‹ Investors can borrow or lend as much money as they want at
the risk-free rate.
‹ There are no restrictions on taking loans or short selling stocks
(betting against them).
‹ In real life, banks and brokers limit borrowing, and there are
rules on short selling.

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8. Stock Relationships Stay Constant Notes

‹ CAPM assumes that the way stocks move in relation to each
other stays the same over time.
‹ However, in reality, stock correlations change due to economic
conditions, company performance, and global events.
9. Investors Use a Risk-Reward Balance
‹ CAPM assumes that investors always balance risk and return to
build the best portfolio.
‹ They either try to maximize returns for a given risk or minimize
risk for a desired return.
10. Only Systematic Risk Matters
‹ The model assumes that investors always hold a well-diversified
portfolio that eliminates company-specific risks.
‹ The only risk that matters is systematic risk (market-wide risks
like inflation, economic slowdown, or political events).
It’s important to recognize that these assumptions are simplifications, and
real-world financial markets may deviate from these idealized conditions.
The limitations of these assumptions should be considered when applying
CAPM in practical situations.

8.6 Limitations of CAPM

1. It Makes Unrealistic Assumptions
‹ CAPM assumes that all investors think the same way and that
financial markets work perfectly without any restrictions, taxes,
or extra costs.
‹ In reality, markets are complex, investors have different opinions,
and there are many barriers like trading fees and government
regulations.
2. It Only Looks at One Type of Risk
‹ CAPM only considers market risk (how the overall stock market
moves) and ignores other risks like economic changes, political
events, or company-specific issues.

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Notes ‹ In reality, many factors influence an asset’s performance, not

just market movements.
3. It Uses Beta as the Only Risk Measure
‹ The model assumes that beta (a measure of how much a stock
moves compared to the market) is the only way to measure risk.
‹ However, beta doesn’t always capture the true risk of an investment,
especially for stocks that behave unpredictably.
4. The Risk-Free Rate is Not Really Stable
‹ CAPM uses government bond yields as the risk-free rate,
assuming it stays constant.
‹ But in reality, these yields change daily, causing fluctuations in
the expected return calculations.
5. It Assumes Stock Prices Always Reflect All Information
‹ CAPM assumes that the stock market is always efficient, meaning
all available information is instantly reflected in stock prices.
‹ In reality, investors sometimes overreact or underreact due to
emotions, rumors, or delays in getting information.
6. It Ignores Changing Risks Over Time
‹ CAPM assumes that risk stays the same, but in real life, risk can
change due to economic downturns, inflation, new government
policies, or market sentiment shifts.
7. It Assumes Everyone Thinks the Same
‹ The model assumes that all investors expect the same returns
and risks for a stock.
‹ In reality, different investors have different opinions, strategies,
and information, leading to different stock prices.
8. It’s Hard to Predict Future Returns
‹ To use CAPM, you need to estimate the expected return of the
overall market.
‹ But predicting the future market return is difficult, and different
methods can lead to different results, making the model less
reliable.

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Notes
8.7 The CAPM and the Efficient Frontier
1. Efficient Portfolios: These are feasible portfolios with the highest
expected return for a given level of risk, measured by portfolio
standard deviation. Graphically, efficient portfolios start with the
global minimum variance portfolio and are located above and to
the right of it on the Markowitz bullet.
2. Inefficient Portfolios: These portfolios have the same risk as another
feasible portfolio but a lower expected return. Graphically, inefficient
portfolios are below and to the right of the global minimum variance
portfolio.

Figure 8.2: Efficient and Inefficient Portfolios

Figure 8.2 shows the efficient and inefficient portfolios. The efficient
portfolios are those that have the highest expected return for a given
standard deviation value. These portfolios are the green dots starting
with the global minimum variance portfolio at the tip of the Markowitz
bullet. The inefficient portfolios are the red dots below the global min-
imum variance portfolio. For example, Figure 8.2 shows two feasible
portfolios, portfolio 3 and portfolio 11, with the same standard deviation
value but different expected return values. Portfolio 11 has the highest
expected return, and so is the efficient portfolio. Portfolio 3, with the
lower expected return, is an inefficient portfolio.

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Notes 8.7.1 Optimal Portfolios

Given the efficient set of portfolios as described in Figure 8.2, which
portfolio will an investor choose? Of the efficient portfolios, investors
will choose the one that accords with their risk preferences. Very risk-
averse investors will want a portfolio that has low volatility (risk) and
will choose a portfolio very close to the global minimum variance port-
folio. In contrast, very risk-tolerant investors will ignore volatility and
seek portfolios with high risk.

8.7.2 Efficient Portfolios with a Risk-Free Asset

In the preceding section, we constructed an efficient set of portfolios
involving two risky assets. Now, we consider what happens when we
introduce a risk-free asset. In the present context, a risk-free asset is
equivalent to a default-free pure discount bond that matures at the end of
the assumed investment horizon. The risk-free rate, rf, is then the nom-
inal return on the bond. For example, if the investment horizon is one
month, then the risk-free asset is a 30-day Treasury bill (T-bill), and the
risk-free rate is the nominal rate of return on the T-bill. If our holdings
of the risk-free asset are positive, then we are “lending money” to the
government at the risk-free rate, and if our holdings are negative, then
we are “borrowing” from the government at the risk-free rate.
The assumption that investors can borrow and lend at the same risk-free
rate is unrealistic in the real world due to investors’ differing creditwor-
thiness. Investors can certainly buy T-Bills and receive the risk-free rate.
However, most investors can only borrow funds at rates much higher
than the T-Bill rate.

8.7.3 Portfolios with One Risky Asset and One Risk-Free Asset
In this sub-section, we consider portfolios of a single risky asset with
random return R~N(p,o2) and a risk-free asset with non-random return
rf. Since the risk-free rate is fixed over the investment horizon it is not
a random variable. As a result, it has some special properties summarized
in the following Proposition.
Let rf denote the fixed non-random risk-free rate, and let R denote the
random return on a risky asset with E[R]=μ and var (R)= σ2
Then
E[rf]=[rf]
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var(rf)=E[(rr – E|rf|2)] = 0, coy(R, rf)=E[(rf – E[rf])(R – E[R])]=0. Notes

Consider an investment in the risky asset and the risk-free asset (hence-
forth referred to as a T-bill). Let x denote the share of wealth in the
risky asset, and xf denote the share of wealth in T-bills such that x+xf=l.
Using xf=l-x, the portfolio return can we written as:
Rp= xf rf + xR = (1 – x)rf + xR = rf + x(R – rf).
The quantity R-rf is called the excess return (over the return on T-bills)
on the risky asset. The portfolio expected return is then:
μp = rf + x(E[Rl] – rf) = rf + x(μ – rf),
Where the quantity (μ-rf) is called the expected excess return or risk pre-
mium on the risky asset. The risk premium is typically positive indicating
that investors expect a higher return on the risky asset than the safe asset
(otherwise, why would investors hold the risky asset?). We may express the
risk premium on the portfolio in terms of the risk premium on the risky asset:
μp – rf = x(μ – rf).
The more we invest in the risky asset the higher the risk premium on
the portfolio of T-Bills and the risky asset.
Because the risk-free rate is constant, the portfolio variance only depends
on the variability of the risky asset and is given by:
2
σ
= var
= ( Rp ) var
= ( xR) x 2σ 2
p
The portfolio standard deviation is therefore proportional to the standard
deviation on the risky asset.
σ p =| x | σ .
Finally, the expected return for a portfolio of the risk-free asset and a
risky asset is expressed as the risk-free rate plus the product of the share
of wealth in the risky asset and the expected excess return on the risky
asset. The portfolio variance depends only on the variability of the risky
asset and is given by the square of the share of wealth in the risky asset
multiplied by the variance of the risky asset.

8.7.4 Criticisms of the Efficient Frontier

The Efficient Frontier and Modern Portfolio Theory (MPT) help investors
build the best possible portfolio by balancing risk and return. However,

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Notes these theories are based on several assumptions that don’t always hold
true in the real world. Let’s break them down:
1. The Model Assumes Stock Returns Are Predictable
‹ MPT assumes that stock returns follow a normal distribution
(a bell-shaped curve where most returns fall near the average).
‹ But in reality, stock prices can be unpredictable and sometimes
experience extreme highs or lows that go far beyond what the
model expects. This is called tail risk—big, unexpected price
swings.
2. Investors Are Not Always Rational
‹ The theory assumes that all investors are rational—meaning
they always make logical decisions to maximize their returns
while minimizing risk.
‹ But in reality, some investors act emotionally, take unnecessary
risks, or make irrational decisions based on fear, greed, or
market trends.
3. Big Players Can Influence the Market
‹ The model assumes that no single investor is powerful enough
to affect stock prices.
‹ However, large institutional investors like mutual funds, hedge
funds, and big corporations can move the market by buying
or selling in large volumes.
4. Not Everyone Can Borrow or Lend Money Freely
‹ MPT assumes that all investors can borrow and lend money
at the same interest rate (risk-free rate).
‹ But in real life, borrowing costs vary depending on your
creditworthiness, and not everyone has unlimited access to loans
at low interest rates.

8.8 Security Market Line (SML)

It is a simple way to visualize risk and return in investing. It is a straight-
line graph that helps investors figure out whether an investment is worth
it based on how risky it is.

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Let’s break it down: Notes

Key Parts of the SML
1. Expected Return (Y-Axis - The Vertical Line)
‹ This tells you how much return you might get from an investment.
‹ The higher the return, the better—but return depends on how
much risk you’re willing to take.
2. Beta (X-Axis - The Horizontal Line)
‹ Beta is a number that shows how risky an investment is compared
to the overall stock market.
‹ A beta of 1 means the investment moves exactly like the market.
‹ A beta higher than 1 means the investment is riskier and moves
more than the market.
‹ A beta lower than 1 means the investment is less risky and
moves less than the market.
3. Risk-Free Rate (Starting Point of the SML)
‹ The SML starts at the risk-free rate, which is the return on a
risk-free investment, like government bonds.
‹ This is the minimum return you should expect without taking
any risk.
4. Market Risk Premium (Slope of the SML)
‹ This is the extra return investors demand for taking on risk.
‹ The higher the risk, the more return an investor expects.
How to Use the SML
‹ If an investment’s expected return falls above the SML, it might
be undervalued— meaning it’s a good opportunity.
‹ If an investment’s expected return falls below the SML, it might
be overvalued— meaning it may not be worth the risk.
‹ Securities which lie on SML are efficiently priced in the market. For
such securities actual return (or expected return based on probability
distribution) is equal to expected return based on CAPM.

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Notes ‹ If a security lies below SML then it is inefficiently priced, in

fact overpriced in the market. Such a security provides an actual
return which is lower than the expected return based on CAPM. A
prospective investor should not invest in such a security.

Figure 8.3: Security Market Line

‹ If a security lies above SML then also it is inefficiently priced,
but it is underpriced in the market. Such a security provides an
actual return which is higher than the expected return based on
CAPM. A prospective investor should invest in such a security.
Illustration 8.3: You are given the following information about two
securities P and Q.
Security P Q
Actual Return% 12 16
β 0.7 1.3
Risk-free rate is 5% and Expected Return on market portfolio is 15%.
Do you think that securities A and B are efficiently priced in the market?
Do they lie on SML?
Solution: Here we need to calculate expected return as per CAPM
E(Ri) = Rf + [(E(RM) – Rf] βi
Expected return from A = 5 + (15 – 5)(0.7) = 12%
Expected return from A = 5 + (15 – 5)(1.3) = 18%

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Since actual return of P is same as expected return under CAPM, Security Notes
A is efficiently priced, and it will lie on SML.

IN-TEXT QUESTIONS
1. What does the Capital Asset Pricing Model (CAPM) consider
as the risk-free rate?
(a) Market interest rate
(b) Expected return on risky assets
(c) Rate of return with no risk
(d) Historical average return
2. In the context of the Efficient Frontier, what is the significance
of combining risky and risk-free assets?
(a) Reducing the overall portfolio risk
(b) Maximizing the portfolio return
(c) Achieving the highest possible return
(d) Eliminating the need for risk-free assets
3. Which assumption is a key feature of the single-period classical
CAPM model?
(a) Perfect competition in financial markets
(b) Constant risk-free rate over time
(c) Unlimited investment horizon
(d) Predictable market fluctuations
4. What does the term “overvalued assets” imply in the context
of CAPM?
(a) Expected return is higher than required return
(b) Expected return is equal to required return
(c) Expected return is lower than required return
(d) Required return is undefined

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Notes
8.9 Arbitrage Pricing Theory (APT)
Arbitrage Pricing Theory (APT) is a financial model that helps estimate
how much return an investment (like a stock) should generate based on
multiple factors that affect its performance. Unlike the Capital Asset
Pricing Model (CAPM), which looks at only one risk factor (market
risk or beta), APT takes a broader view and considers several different
risks that might impact an investment.

Key Ideas of APT in Simple Terms

1. APT Looks at Multiple Factors
‹ CAPM assumes only one factor (market risk) determines an
asset’s return.
‹ APT considers several factors that may influence an investment,
such as:
‹ Interest rates
‹ Inflation
‹ Economic growth
‹ Industry trends
‹ Other market forces
2. These Factors Represent Systematic Risks
‹ The factors in APT are big-picture risks that affect many
investments, not just one.
‹ Example: If inflation increases, it might lower the value of
many stocks, not just a single company’s stock.
3. Sensitivity to Each Factor (Beta Coefficients)
‹ APT assigns a beta (a sensitivity measure) to each factor.
‹ If a stock has a high beta for interest rates, it means the stock
is highly affected by interest rate changes.
4. No Free Money (Arbitrage-Free Pricing)
‹ APT is based on the idea that there are no easy, risk-free profits
in a well-functioning market (also called arbitrage).

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‹ If a stock is mispriced (trading at the wrong value), traders will Notes

quickly buy or sell it until the price adjusts to the correct level.
5. Linear Relationship
‹ APT assumes that a stock’s expected return is a combination
of different factors and their betas.
‹ If inflation and interest rates go up, the return of a stock will
change based on how sensitive it is to these factors.
6. No Need for a Risk-Free Rate
‹ Unlike CAPM, which always includes a risk-free return (like
government bond yields), APT does not require it.
‹ This makes APT useful in situations where there isn’t a clear
risk-free rate available.
7. Based on Real Data
‹ APT doesn’t assume which factors matter—it relies on statistical
analysis and historical data to determine the most relevant
factors.
8. More Flexible Than CAPM
‹ APT is more adaptable because it looks beyond market risk.
‹ It can work in different economic conditions and changing
market environments.
The general form of the Arbitrage Pricing Theory (APT) formula is ex-
pressed as follows:
E (Ri) = Rf+βi1 × RP1 + βi2 × RP2 + __________ +βiK × RPk
Where:
‹ E(Ri) is the expected return of asset i,
‹ Rf is the risk-free rate of return,
‹ βi1, βi2, __________, βiK are the beta coefficients representing the
sensitivity of asset i to each of the K risk factors,
‹ RP1 RP2, __________, RPK are the expected excess returns of K
risk factors.
In this formula, the expected return of an asset is modeled as the sum
of the risk-free rate and the product of each beta coefficient and its cor-
responding risk factor’s expected excess return.
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Notes It’s important to note that the beta coefficients in APT are determined
empirically through statistical analysis of historical data rather than be-
ing assumed as in the Capital Asset Pricing Model (CAPM). Analysts or
researchers may use factor analysis or other techniques to estimate the
beta coefficients and identify the relevant risk factors for a particular
set of assets.
The flexibility’ of APT allows for the consideration of multiple factors,
making it a useful tool for asset pricing in various economic conditions.
However, the success of APT depends on the accurate identification and
measurement of relevant risk factors in a given market or industry.

8.9.1 CAPM vs APT

Both Capital Asset Pricing Model (CAPM) and Arbitrage Pricing
Theory (APT) are financial models that help investors estimate how
much return they should expect from an investment based on its risk.
However, they use different approaches to do this. Let’s break them
down in simple terms.
1. The Main Idea Behind Each Model
‹ CAPM: Think of CAPM as a simple rule that says, “The riskier
the investment, the higher the return you should expect.” It
assumes only one risk factor, which is how much the investment
moves with the overall market (measured by beta).
‹ APT: APT is more detailed. Instead of just looking at market risk,
it says, “There are many factors that can affect an investment’s
return, not just the market.” These could be things like inflation,
interest rates, or industry trends.
2. How Many Risk Factors Do They Consider?
‹ CAPM: Only looks at one risk factor—market risk (measured
by beta).
‹ APT: Considers multiple risk factors that might influence an
investment’s return.
3. Assumptions They Make
‹ CAPM:
‹ Assumes there is a risk-free return (like government bonds).

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‹ Assumes the market includes all possible risky investments. Notes

‹ Assumes a straight-line relationship between risk and return.
‹ APT:
‹ Assumes that several factors influence an investment’s
return.
‹ Doesn’t assume a single market portfolio.
‹ Doesn’t require a risk-free rate.
4. What Is Beta?
‹ CAPM: Beta is a fixed number that measures how much an
investment moves with the overall market.
‹ APT: Beta is different for each factor and is found using real
data analysis.
5. Where Are They Used?
‹ CAPM:
‹ Popular because it’s simple and easy to use.
‹ Used in finance for pricing stocks, setting return expectations,
and portfolio management.
‹ APT:
‹ More flexible but also more complex to apply.
‹ Used when investors need a more detailed risk analysis.
6. Which One Is More Flexible?
‹ CAPM: Less flexible because it only considers one risk factor.
‹ APT: More flexible because it allows many factors to explain
investment returns.
IN-TEXT QUESTIONS
5. According to CAPM, what is the relationship between expected
return and beta?
(a) Positive correlation
(b) Negative correlation
(c) No correlation
(d) Exponential correlation
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Notes 6. How does the Arbitrage Pricing Theory (APT) differ from CAPM?
(a) APT considers only one factor, while CAPM considers
multiple factors
(b) APT assumes perfect competition, while CAPM does not
(c) APT uses historical data, while CAPM uses future
projections
(d) APT does not rely on the concept of beta
7. In APT, what is the role of arbitrage in asset pricing?
(a) Arbitrage eliminates the need for asset pricing models
(b) Arbitrage ensures equal expected and required returns
(c) Arbitrage creates opportunities for risk-free profits
(d) Arbitrage is irrelevant in APT
8. What is the primary difference between expected return and
required return in the context of CAPM?
(a) Expected return includes risk premium, while required
return does not
(b) Expected return is investor-specific, while required return
is market-based
(c) Expected return is calculated retrospectively, while required
return is forward-looking
(d) Expected return is always higher than required return
9. How is the Efficient Frontier related to portfolio optimization?
(a) It represents portfolios with the maximum return and
minimum risk
(b) It includes all possible asset combinations, regardless of
risk and return
(c) It focuses on high-risk, high-return portfolios
(d) It is unrelated to the concept of portfolio optimization

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10. What is a common criticism of both CAPM and APT? Notes

(a) They rely too heavily on historical data

(b) They assume unrealistic market conditions
(c) They ignore the concept of risk
(d) They are not applicable to diversified portfolios

8.10 Summary
Here’s a concise summary of the key points covered:
‹ Explored the definition and significance of Asset Pricing Models
in the realm of finance.
‹ Emphasized their role in aiding investment decisions.
‹ Examined the concept of risk in financial markets, highlighting its
importance in the investment process.
‹ Identified various types of risks associated with investments.
‹ Unpacked the principles of the CAPM, providing a foundational
understanding of its structure.
‹ Outlined the components of the CAPM formula used to calculate
expected returns.
‹ Discussed the assumptions underpinning the CAPM and their
implications.
‹ Evaluated the limitations and criticisms associated with the model.
‹ Explored the relationship between the CAPM and the Efficient
Frontier.
‹ Considered how incorporating the CAPM contributes to portfolio
construction strategies.
This lesson serves as a comprehensive exploration of Asset Pricing Mod-
els, equipping students with the knowledge needed to critically analyze
investments, assess risks, and make informed decisions in the dynamic
world of finance.

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Notes
8.11 Answers to In-Text Questions
1. (c) Rate of return with no risk
2. (a) Reducing the overall portfolio risk
3. (a) Perfect competition in financial markets
4. (a) Expected return is higher than required return
5. (a) Positive correlation
6. (a) APT considers only one factor, while CAPM considers multiple
factors
7. (c) Arbitrage creates opportunities for risk-free profits
8. (a) Expected return includes risk premium, while required return
does not
9. (a) Itrepresents portfolios with the maximum return and minimum
risk
10. (b) They assume unrealistic market conditions

8.12 Self-Assessment Questions

1. Explain the concept of the Efficient Frontier in the context of
portfolio theory. How does the combination of risky and risk-free
assets contribute to the construction of portfolios along the Efficient
Frontier? Provide a numerical example to illustrate the principles.
2. Discuss the assumptions underlying the single-period classical Capital
Asset Pricing Model (CAPM). How does the model incorporate the
concept of systematic risk and the risk-free rate? Critically evaluate
the real-world applicability of these assumptions in financial markets.
3. Compare and contrast the Capital Asset Pricing Model (CAPM)
and the Arbitrage Pricing Theory (APT) as asset pricing models.
Highlight the key differences in their approaches, assumptions, and
the factors influencing asset prices. Provide examples to illustrate
the application of each model.
4. Define and explain the terms “overvalued” and “undervalued” assets
within the framework of the Capital Asset Pricing Model (CAPM).
How are these concepts determined, and what implications do they

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have for investors in making investment decisions? Discuss the Notes

limitations and criticisms associated with using CAPM for asset
valuation.
5. Analyze the role of multiple factor models in asset pricing, focusing
on the Arbitrage Pricing Theory (APT). How does APT differ from
the single-factor CAPM in its treatment of risk factors? Discuss the
advantages and challenges of using APT compared to CAPM in
explaining asset returns and pricing in real-world financial markets.

8.13 Suggested Readings

‹ Reilly, F. K. & Brown, K. C. (2012). Analysis of Investments and
Management of Portfolios (12th edition), Cengage India Pvt. Ltd.
‹ Singh, Rohini (2017). Security Analysis and Portfolio Management
(2nd edition). Excel Books.

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 L E S S O N

9
Mutual Funds
Manisha Yadav
Assistant Professor
School of Open Learning
University of Delhi
Email-Id: [Link]@[Link]

STRUCTURE
9.1 Learning Objectives
9.2 Introduction
9.3 Mutual Funds
9.4 Evolution of Mutual Funds in India
9.5 Apparatus of Mutual Funds
9.6 Advantages of Investing in Mutual Funds
9.7 Disadvantages of Investing in Mutual Funds
9.8 Classification of Mutual Funds
9.9 Latest Developments Regarding Mutual Funds
9.10 Performance Evaluation of Managed Funds
9.11 Risk-Adjusted Methods
9.12 Performance Evaluation of Mutual Funds
9.13 Summary
9.14 Answers to In-Text Questions
9.15 Self-Assessment Questions
9.16 Suggested Readings

9.1 Learning Objectives

After going through this lesson, students will be able to:
‹ Understand the concept, advantages, and limitations of Mutual Funds.
‹ Comprehend the trajectory of Mutual Funds in India.

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‹ Acquaint themselves with different types of mutual funds schemes. Notes

‹ Evaluate the performance of Managed Funds.
‹ Gauge the return from an investment after accounting for the risk
associated with it.

9.2 Introduction

CASE STUDY
Smart Investment Choices
Four friends—Aryan, Riya, Rahul, and Neha—had just started work-
ing at a multinational company (MNC). Each of them had different
financial goals and comfort levels with risk.
‹ Aryan wanted to build long-term wealth.
‹ Riya looked for a balance between safety and growth.
‹ Rahul was ready to take high risks for aggressive growth.
‹Neha preferred stability and a steady income.
When they started exploring investment options, they found many
mutual funds available but felt confused about making the right
choice, but this also taught them valuable lessons in risk management
and smart investing.
Aryan leaned toward equity funds for high returns, while Neha
preferred debt funds for safety. To make better decisions, the group
consulted a financial advisor. The advisor understood their financial
goals, risk tolerance, and time horizon before suggesting a suitable
mutual fund for each of them:
‹ Aryan was advised to invest in a mix of large-cap and mid-cap
equity funds, which suited his long-term wealth-building goal.
‹ Riya was recommended a balanced fund, which invested in
both stocks and bonds to provide stability along with growth.
‹ Rahul was suggested a sectoral fund, which focused on specific
industries with high growth potential.
‹ Neha was advised to invest in debt and hybrid funds, which
offered stability and low-risk income.

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Notes Over time, the friends learned the benefits of mutual funds:
‹ Diversification – Investing in multiple assets helped spread risk.
‹ Professional Management – Fund managers made informed
investment decisions.
‹ Liquidity – They could withdraw money when needed.
They also realized the importance of reviewing their investments
regularly. They monitored their funds’ performance and made adjust-
ments when needed to keep up with market changes and personal
financial goals.
This experience not only gave them a well-managed investment
portfolio but also taught them valuable lessons in risk management
and smart investing.
Questions:
1. What are mutual funds?
2. What are the benefits of mutual funds?
3. What are the different types of mutual funds?
4. Why is it important to regularly monitor and make adjustments
to one’s fund investments?
Imagine you and your friends want to grow your money by investing in
the stock market. But picking the right stocks can be tricky and time-con-
suming. That’s where a mutual fund helps!
Think of a mutual fund as a big money pool where many people (includ-
ing you and your friends) contribute their money. Instead of each person
worrying about where to invest, a professional fund manager—an expert
in finance—handles everything for you. They decide the best places to
invest, whether in stocks, bonds, or other options.
When you invest in a mutual fund, you receive units, which represent
your share of the total fund. The more money you invest, the more units
you get. The fund manager uses this pooled money to invest in a vari-
ety of things, reducing the risk of losing money by spreading it across
different investments (this is called diversification).

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If the investments make a profit—either through dividends or by selling Notes

stocks at a higher price—everyone in the mutual fund benefits. Your
earnings depend on how many units you own. On the other hand, if the
investments don’t perform well, there might be losses, but because the
fund is diversified, the impact is usually lower than investing in a single
stock.
The mutual fund company charges a small fee for managing your invest-
ments. This fee pays for the experts, administrative costs, and smooth
operation of the fund.
In India, all mutual funds are regulated by SEBI (Securities and Exchange
Board of India). SEBI ensures that mutual funds follow rules and protect
investors like you.
So, investing in a mutual fund is like being part of a team where an
expert helps grow your money while minimizing risks!

9.3 Mutual Funds

9.3.1 Definition
A mutual fund is a professionally managed investment scheme, usually run
by an Asset Management Company (AMC), that brings together a group
of people and invests their money in stocks, bonds, and other securities.
SEBI (Mutual Fund) Regulations, 1996 defines a mutual fund as under:
“Mutual Fund means a fund established in the form of a trust to raise
monies through the sale of units to the public or a section of the public
under one or more schemes for investing in securities including money
market instruments or gold related instruments or real estate assets.”

9.3.2 Mutual Funds are an Indirect Mode of Investment

Mutual Funds: An Indirect Way to Invest
Imagine you and your friends putting money into a shared piggy bank.
Instead of deciding what to buy yourself, an expert (let’s call them the
fund manager) takes care of investing that money in different things, like
stocks and bonds. You own a part of the piggy bank based on how much
you contribute. Since the manager spreads the money across different
investments, your risk is lower.

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Notes Direct Investment: A Hands-On Approach

Now, think about going to a candy store with your own money. You
pick exactly which candies to buy based on your preference. No one
else decides for you. This is like direct investment—you choose which
stocks, bonds, or other assets to invest in, and you’re fully in charge of
your decisions.

Key Differences Between the Two

1. Who Makes the Decisions?
‹ Mutual Funds: A professional fund manager makes the investment
choices for you.
‹ Direct Investment: You make all the investment decisions yourself.
2. Diversification (Spreading Out the Risk)
‹ Mutual Funds: Your money is combined with others and invested
in different things, reducing risk.
‹ Direct Investment: You choose what to invest in, but if you
don’t spread your money wisely, you could face higher risks.
3. Level of Control
‹ Mutual Funds: You don’t pick specific investments—the fund
manager does.
‹ Direct Investment: You have full control and decide exactly
where to invest.
4. Expert Guidance
‹ Mutual Funds: Managed by professionals who have experience
in investing.
‹ Direct Investment: You need to do your own research and
manage everything yourself.

Which One is Better?

It depends on your preference! If you want professional management
and lower risk, mutual funds are a great option. But if you enjoy re-
searching and making your own decisions, direct investment gives you
full control.

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IN-TEXT QUESTIONS Notes

1. What is a mutual fund?

(a) A personal savings account
(b) A professionally managed investment scheme
(c) A real estate investment trust
(d) A fixed deposit in a bank
2. Which regulatory body in India oversees and approves mutual
funds?
(a) RBI (Reserve Bank of India)
(b) AMFI (Association of Mutual Funds in India)
(c) SEBI (Securities and Exchange Board of India)
(d) IRDAI (Insurance Regulatory and Development Authority
of India)

9.4 Evolution of Mutual Funds in India

Mutual funds in India have come a long way, evolving through different
phases with new rules, more players, and growing investor awareness.
Let’s break it down into four key stages.
1. The Beginning (1963-1987)
‹ Mutual funds started in India in 1963 with the launch of Unit
Trust of India (UTI), which was backed by the Reserve Bank
of India (RBI) and managed by State Bank of India (SBI).
‹ UTI was the only mutual fund company at the time and introduced
its first scheme in 1964.
2. More Public Sector Players Enter (1987-1993)
‹ In 1987, Public Sector Banks and Insurance Companies like
LIC and GIC were allowed to start mutual funds.
‹ SBI Mutual Fund was the first non-UTI mutual fund in 1987,
followed by Canbank Mutual Fund, PNB Mutual Fund, and others.

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Notes 3. Private Companies Join the Industry (1993-2003)

‹ 1993: The government passed the SEBI Act, introducing rules
for mutual funds.
‹ Private companies were now allowed to enter the industry.
Kothari Pioneer (later merged with Franklin Templeton) was
the first private mutual fund in India.
‹ 1994: Morgan Stanley became the first foreign mutual fund in
India.
‹ 1996: SEBI introduced new rules for better regulation, making
this phase a turning point for the industry.
4. Growth & Innovation (2003-Present)
‹ 2003: UTI was split into two parts:
1. Specified Undertaking of UTI, which follows government rules.
2. UTI Mutual Fund, backed by SBI, PNB, BOB, and LIC,
which follows SEBI regulations.
‹ 2013: SEBI introduced Direct Plans, allowing investors to invest
directly without intermediaries. Companies like Axis Mutual
Fund and Franklin Templeton supported this change.
‹ 2018: SEBI re-categorized mutual funds, making it easier for
investors to understand different schemes.
IN-TEXT QUESTIONS
3. What does a mutual fund’s net asset value (NAV) represent?
(a) Total assets minus liabilities
(b) Total number of unit holders
(c) Total returns earned by the fund
(d) Total units held by the fund
4. In which phase did private sector players enter the mutual fund
industry in India?
(a) Introduction (1963-1987)
(b) Entry of Other Public Players (1987-1993)
(c) Entry of Private Players (1993-2003)
(d) Fourth Phase (2003-present)
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Notes
9.5 Apparatus of Mutual Funds
Mutual funds operate with a three-tier structure:
1. Sponsor – The Creator of the Mutual Fund: Imagine the sponsor
as the person who comes up with the big idea, like the founder of
a company. They are the ones who decide to set up a mutual fund
and take the first steps to make it happen.

Here’s what they do:

‹ They approach SEBI (the Securities and Exchange Board of India)
to get official approval and submit all the necessary documents.
‹ They set up a trust and appoint trustees to oversee things, and also
bring in a fund management company (called an Asset Management
Company, or AMC) to actually manage the investments.
But not just anyone can become a sponsor. SEBI has set a few important
rules:
‹ The sponsor must have at least five years of experience in financial
services.
‹ They should have been financially stable during the last five years.
‹ They need to have made profits in at least three out of the last
five years.
‹ They must invest at least 40% of the AMC’s net worth.
‹ They must have a clean track record, meaning no involvement in
fraud or serious legal violations.
2. Trust and Trustees – The Watchdogs
‹ The trust is like a guardian of the mutual fund. It is created by the
sponsor and is legally responsible for protecting investors’ money.
‹ Trustees are the watchdogs – they ensure that the AMC follows
the rules and manages the fund properly.
‹ At least two-thirds of the trustees must be independent, meaning
they shouldn’t have ties to the sponsor to avoid conflicts of interest.
‹ Trustees handle customer complaints, review transactions, and
submit reports to SEBI.

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Notes 3. Asset Management Company (AMC) – The Fund Manager

‹ The AMC is like the CEO and management team of a company.
It is appointed by the trustees and is responsible for managing the
mutual fund’s investments.
‹ The AMC has a board of directors and operates under SEBI regulations.
‹ It makes decisions on where to invest, whether in stocks, bonds,
or other assets, and ensures that investments align with the fund’s
objectives.
‹ If the trustees or 75% of investors vote against an AMC, they can
remove it.
‹ The AMC must only focus on financial services and cannot run
other businesses.
‹ At least half of the AMC’s directors should not be linked to the
sponsor or trustees to maintain fairness.
4. Other Important Participants in a Mutual Fund: Apart from the
main three layers, there are other key players involved:
1. Custodians: Store securities in electronic (demat) form and
handle fund records.
2. Registrar & Transfer Agents (RTAs): Act as a bridge
between investors and the AMC. They handle unit purchases,
redemptions, and account statements. CAMS and Karvy
manage 80% of mutual fund transactions in India.
3. Fund Accountant: Calculates the Net Asset Value (NAV) of
the mutual fund daily, which determines the price per unit.
4. Auditor: Checks financial records, ensures transactions follow
regulations, and detects fraud.
5. Broker: Licensed by SEBI, helps attract investors and sell
mutual fund units.
6. Dealers: Facilitate buying and selling of securities in the capital
and money markets.

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Notes

Figure 9.1: Structure of Mutual Funds

(Source: BSE)

9.6 Advantages of Investing in Mutual Funds

Mutual funds are a great way to invest money smartly without needing ex-
pert knowledge of the stock market. Here’s why they are a popular choice:
1. Risk Diversification:
‹ When you invest in a mutual fund, your money is combined
with other investors’ money and invested in different stocks,
bonds, or assets.
‹ This reduces risk because even if one investment performs
poorly, others may perform well, balancing things out.
Example: Imagine you invest in a fund that includes companies from
IT, healthcare, and finance. If the IT sector struggles, the profits
from healthcare and finance can reduce the impact of losses.
2. Professional Management:
‹ Mutual funds are run by professional fund managers who study
the market and choose investments wisely.
‹ These experts handle everything, so you don’t need to track
stocks daily.
Example: The HDFC Equity Fund is managed by experienced
professionals who decide where to invest money for the best returns.

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Notes 3. Affordability and Convenience:

‹ You don’t need lakhs of rupees to invest. Mutual funds allow
small investments, making them accessible to everyone.
‹ You can also buy and sell units easily at the day’s price (called
NAV – Net Asset Value).
Example: With just ₹500, you can start investing in SBI Bluechip
Fund through a Systematic Investment Plan (SIP).
4. Liquidity:
‹ Need cash? You can withdraw your mutual fund investment
quickly, usually in two working days (T+2 days).
Example: If you invest in ICICI Prudential Liquid Fund, you can
withdraw your money when needed, and it will reach your bank
account in two days.
5. Well Regulated:
‹ Mutual funds in India are strictly regulated by SEBI (Securities
and Exchange Board of India).
‹ This ensures fairness, transparency, and investor protection.
Example: SEBI requires all mutual funds to regularly disclose
where they are investing, so you always know what’s happening
with your money.
6. Tax Benefits:
‹ Some mutual funds help you save tax under Section 80C of
the Income Tax Act.
‹ Equity Linked Saving Schemes (ELSS) allow you to claim
deductions on your taxable income.
Example: If you invest in Axis Long Term Equity Fund (ELSS),
you can save tax while growing your money. However, there is a
3-year lock-in period.
7. Automated Investments:
‹ You can set up a Systematic Investment Plan (SIP) where a
fixed amount is invested automatically every month.
‹ This method is good because you invest regularly without worrying
about market ups and downs.

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Example: You can set up a SIP in Mirae Asset Emerging Bluechip Notes
Fund, where every month, a fixed amount is automatically invested.
8. Lower Expenses:
‹ Because mutual funds pool money from many investors, they
can reduce costs (called the expense ratio).
‹ This makes them cheaper than managing individual stocks
on your own.
Example: The Aditya Birla Sun Life Frontline Equity Fund has
an expense ratio of just 1%, which means you pay very little to
have your money professionally managed.
In conclusion, mutual funds offer a range of advantages that cater to
different investor needs and preferences. These advantages contribute to
the popularity and widespread adoption of mutual funds in the Indian
investment landscape.

IN-TEXT QUESTIONS
5. Which entity initiates the formation of a mutual fund, requires
SEBI approval, and appoints the asset management company
(AMC)?
(a) Trust and Trustees
(b) Sponsors
(c) Unit Holders
(d) Custodians
6. What is a key advantage of mutual funds in terms of risk
management?
(a) High concentration in individual stocks
(b) Limited diversification across assets
(c) Pooling money for risk diversification
(d) Lack of regulatory oversight

9.7 Disadvantages of Investing in Mutual Funds

While mutual funds offer many benefits, they also have some drawbacks.
Here are a few things you should consider before investing:
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Notes 1. You Don’t Have Full Control

‹ When you invest in a mutual fund, a professional fund manager
decides where your money goes.
‹ Unlike direct stock investing, you cannot pick individual stocks
or bonds in the fund.
Example: If you prefer to choose your own stocks and make
investment decisions, mutual funds might feel restrictive.
2. Performance Depends on the Fund Manager
‹ The fund’s success depends on the skill of the fund manager.
‹ If the manager makes bad investment choices or fails to adjust
to market changes, your returns can suffer.
Example: A poorly managed fund may underperform, even when
the market is doing well.
3. Fees and Charges Reduce Returns
‹ Mutual funds charge fees for management and administration.
‹ Some funds have entry (front-end) or exit (back-end) fees,
which reduce your returns.
Example: If a fund charges 2% as an expense ratio, your total
return will be lower because of these costs.
4. CAGR May Not Show the Full Picture
‹ CAGR (Compounded Annual Growth Rate) is a way to measure
returns, but it doesn’t consider taxes, inflation, or market ups
and downs.
‹ The actual returns you get may be different from what the CAGR
suggests.
Example: A fund may show a 10% CAGR, but after taxes and
inflation, your actual gain could be lower.
5. Lock-in Period Limits Flexibility
‹ Some funds, like ELSS (Equity Linked Saving Scheme), have
a 3-year lock-in period.
‹ This means you cannot withdraw your money before three
years, even if you need it.

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Example: If you invest in an ELSS fund and need cash urgently, Notes
you won’t be able to withdraw it before the lock-in period ends.

9.8 Classification of Mutual Funds

Mutual funds come in different types, based on their structure, investment
goals, and management style. Here’s a breakdown in simple terms:

A. Based on Structure (How They Operate)

1. Open-Ended Funds – Always Open for Investment
‹ These funds do not have a fixed maturity period.
‹ You can buy or sell units anytime, based on the fund’s daily
price (NAV - Net Asset Value).
Example: HDFC Equity Fund, ICICI Prudential Bluechip Fund.
‹ Good for: People who want flexibility in buying and selling.
2. Closed-Ended Funds – Fixed Time & Fixed Units
‹ These funds have a fixed maturity period and a fixed number
of units.
‹ You can only invest during the initial offer period (NFO). After
that, you can sell units only on the stock exchange.
Example: SBI Small Cap Fund - Series II, ICICI Prudential Value
Fund - Series 18.
‹ Good for: Investors willing to lock in their money for a fixed
period.
3. Interval Funds – Buy/Sell at Fixed Intervals
‹ A mix of open-ended and closed-ended funds.
‹ You can only buy or sell at specific intervals (monthly, quarterly,
yearly, etc.).
Example: IDFC Yearly Series Interval Fund, Reliance Yearly Interval
Fund.
‹ Good for: Investors who don’t need immediate liquidity but
want periodic access.

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Notes B. Based on Investment Objective (What They Aim to Achieve)

1. Debt Funds – Focus on Safe Returns
‹ Invest in bonds and fixed-income securities.
‹ Aim to provide stable returns with lower risk.
Example: HDFC Short Term Debt Fund, ICICI Prudential Corporate
Bond Fund.
‹ Good for: Conservative investors who want steady income and
safety.
2. Equity Funds – Focus on Growth
‹ Invest mainly in stocks (equities).
‹ Aim for long-term capital growth (but come with higher risk).
Example: SBI Bluechip Fund, Reliance Large Cap Fund.
‹ Good for: Investors looking for high returns over the long term.
3. Hybrid Funds – A Mix of Stocks & Bonds
‹ Also called Balanced Funds, they invest in both stocks and bonds.
‹ Aim to balance risk and returns by spreading investments.
Example: ICICI Prudential Balanced Advantage Fund, HDFC Hybrid
Equity Fund.
‹ Good for: Investors who want a balance between risk and safety.
C. Based on Investment Style (How They Are Managed)
1. Passive Funds – Just Follow the Market
‹ These funds simply copy a stock market index, like Nifty or
Sensex.
‹ Low fees because fund managers do not make active decisions.
Example: Nippon India ETF Nifty BeES, UTI Nifty Index Fund.
‹ Good for: Investors who want low-cost, steady growth without
active management.
2. Active Funds – Aim to Beat the Market
‹ Fund managers actively select stocks to try and earn higher returns.
‹ Higher risk and fees, but potential for better performance.
Example: Kotak Standard Multicap Fund, Aditya Birla Sun Life
Frontline Equity Fund.
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‹ Good for: Investors who want higher returns and don’t mind Notes
some risk.

Figure 9.2: Classification of Mutual Funds

(Source: BSE)

IN-TEXT QUESTIONS
7. Which type of fund has a fixed maturity period and a fixed
number of units that can only be purchased during the initial
offer period?
(a) Open Ended Funds
(b) Closed Ended Funds
(c) Interval Funds
(d) Hybrid Funds
8. What is the primary goal of Debt Funds?
(a) Capital appreciation over the long term
(b) Balance between capital appreciation and income
(c) Regular income and capital preservation
(d) Replication of market index performance

9.9 Latest Developments Regarding Mutual Funds

1. Exchange Traded Funds (ETF): Exchange-traded funds (ETFs) are
investment funds that are traded on stock exchanges, similar to
individual stocks. They are designed to track the performance of a

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Notes specific index, commodity, bond, or basket of assets. ETFs provide

investors with a way to gain exposure to a diversified portfolio of
assets without having to buy each individual security separately.
2. Fund of Funds (FoF): A Fund of Funds (FoF) is a type of mutual
fund that invests in multiple other mutual funds instead of directly
investing in stocks or bonds. It provides diversification by spreading
investments across different funds, reducing risk for investors.
Why Investors Choose FoFs:
1. Diversification: Spreads money across different funds to reduce risk.
2. Professional Management: Experts handle fund selection on behalf
of investors.
3. Hands-Off Approach: Ideal for people who do not want to research
and manage individual funds.

Figure 9.3: Exchange Traded Funds (ETF)

(Source: NSE)

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Things to Keep in Mind: Notes

1. Higher Costs: Since an investor is investing in multiple funds, they
pay fees for both the FoF and the underlying mutual funds.
2. Performance Depends on Other Funds: Returns depend on how
well the selected mutual funds perform.
For example, an Equity Fund of Funds spreads an investor’s money
across different stock mutual funds rather than individual stocks.
3. Systematic Investment Plan (SIP) – Investing Small Amounts
Regularly
A Systematic Investment Plan (SIP) is a way of investing in mutual
funds where an investor contributes a fixed amount regularly, usually
every month. This approach helps in disciplined investing and reduces
the risk of market fluctuations.

How It Works:
1. An investor selects a mutual fund and decides how much to invest
regularly.
2. The chosen amount is deducted from their bank account and used
to buy units of the mutual fund.
3. Over time, the investment grows, benefiting from market appreciation
and compounding.

Why SIPs Are Popular:

1. Affordable: Investors can start with a small amount.
2. Encourages Regular Savings: Promotes financial discipline.
3. Rupee Cost Averaging: Investors buy more units when prices are
low and fewer when prices are high, balancing the cost over time.
4. Power of Compounding: Returns earned are reinvested, helping
wealth grow over time.
For example, if an investor starts a monthly SIP of two thousand
rupees in an equity mutual fund, their money grows steadily over
the years without worrying about daily market fluctuations.

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Notes 4. Systematic Withdrawal Plan (SWP) – Getting Regular Income

from Investments
A Systematic Withdrawal Plan (SWP) allows an investor to withdraw a
fixed amount from their mutual fund investment at regular intervals, such
as monthly or quarterly. It is often used to generate a steady income,
particularly for retirees.

How SWP Works:

1. The investor first invests a lump sum in a mutual fund.
2. A fixed amount is withdrawn at regular intervals.
3. The remaining investment stays in the mutual fund and continues
to grow based on market performance.

Why People Use SWP:

1. Provides a regular income stream.
2. Allows investment to continue growing instead of withdrawing the
entire amount at once.
3. More tax-efficient compared to withdrawing everything at once.
For example, if an investor places ten lakh rupees in a mutual fund and
sets up an SWP of ten thousand rupees per month, they will receive this
amount regularly while the remaining investment continues to grow.
5. Systematic Transfer Plan (STP) - Moving Money from One Fund
to Another
A Systematic Transfer Plan (STP) allows an investor to transfer money
regularly from one mutual fund to another, usually to balance risk or
take advantage of better growth opportunities.

How STP Works:

1. The investor initially invests in a mutual fund, typically a safer one
like a debt fund.
2. A fixed amount is transferred to another mutual fund, often an
equity fund, at regular intervals.
3. This gradual shift reduces the risk of investing a large sum in
volatile markets.

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Why People Use STP: Notes

1. Helps reduce market risk by spreading out investments over time.
2. Provides better returns compared to keeping money in a savings
account or fixed deposit.
3. Can be used for tax planning by distributing investments gradually.
For example, if an investor receives a five lakh rupee bonus and does
not want to invest it all in stocks at once, they can put it in a debt mu-
tual fund and set up an STP to move twenty thousand rupees per month
into an equity fund.

9.10 Performance Evaluation of Managed Funds

Portfolio management involves two primary approaches: Passive Man-
agement and Active Management. According to the Efficient Market
Hypothesis (EMH), passive management is deemed the most efficient
strategy, as consistently outperforming the market is unattainable by
any fund manager. In an ideal efficient market, securities are accurate-
ly valued at their intrinsic worth, leaving no room for undervalued or
overvalued stocks.
However, the real-world market is not perfectly efficient, allowing for the
viability of active management. Investors must regularly assess investment
performance and adapt to changing needs and market conditions.
Evaluation of portfolio performance encompasses a variety of methods
categorized into Absolute Return and Risk-Adjusted methods.
1. Absolute Return Methods: Under this approach, the absolute return
of each portfolio, as well as a benchmark portfolio, is measured.
The portfolio yielding the highest return is considered superior. For
instance, if Portfolio X generates a 15% return while Portfolio Y
achieves 10%, Portfolio X is deemed better.
However, a critical limitation of absolute return methods is then
failure to account for the varying risk levels associated with different
portfolios. Without considering risk, a portfolio with a higher return
may not necessarily be the better choice. For example, if Portfolio
X has a 20% risk and Portfolio Y only 2%, a simple comparison
of returns won’t accurately reflect their relative efficiency.

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Notes 2. Risk-Adjusted Methods: These methods address the limitation

of absolute return methods by adjusting returns for underlying
risk. Prominent risk-adjusted methods include the Sharpe ratio,
Treynor’s ratio, and Jensen’s Alpha. These measures provide a more
comprehensive assessment of portfolio performance by factoring in
the associated risk.
In essence, while absolute return methods offer a straightforward com-
parison based on returns alone, risk-adjusted methods provide a more
nuanced evaluation, considering the crucial element of risk. Investors can
use these tools to make informed decisions based not only on returns but
also on the risk-adjusted efficiency of their portfolios.

9.11 Risk-Adjusted Methods

1. Sharpe’s Ratio (or Sharpe Index or Reward to Volatility Ratio):
The Sharpe Ratio measures the excess return of a portfolio in terms
of per unit of risk (volatility). Formula: Sharpe Ratio = (Rp-Rf)/
σp, Where:
‹ Rp is the portfolio’s return.
‹ Rf is the risk-free rate.
‹ σp is the portfolio›s standard deviation (volatility).
Sharpe’s Ratio converts risk premium into risk premium per unit of risk.
The higher the Sharpe’s ratio, the better it is.
When we must rank the portfolios, the one having the highest Sharpe’s
ratio triumphs all other.
2. Treynor’s Ratio (or Treynor’s Index): The Treynor Ratio evaluates
the excess return of a portfolio per unit of systematic risk (beta).
Formula: Treynor Ratio = (Rp-Rf)p, Where:
‹ Rp is the portfolio’s return.
‹ Rf is the risk-free rate.
‹ βp is the portfolio’s beta, representing systematic risk.
3. Jensen’s Alpha: Jensen’s Alpha assesses the risk-adjusted performance
by comparing the actual portfolio return with the expected return
based on the Capital Asset Pricing Model (CAPM).

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Formula: Jensen’s Alpha = Rp - [Rf+βp.(Rm-Rf)], Where: Notes

‹ Rp is the portfolio’s return.
‹ Rf is the risk-free rate.
‹ βp is the portfolio’s beta.
‹ Rm is the market return.
Illustration 9.1: The following information is available about two port-
folios S and W. Market Index and Risk-free asset.
Portfolio Actual Return Beta S.D. of returns
(%) (%)
S 21 1.1 20
W 26 1.8 25
Risk-free Asset 7 0 0
Market Index 19 1.00 16
(i) Rank the portfolios S and W on the basis of the Sharpe ratio and state
whether they have outperformed or underperformed the market index.
(ii) Rank the portfolios S and W on the basis of Treynor’s ratio and
state whether they have outperformed or underperformed the market
index.
(iii) Is there any difference in the results stated in (i) and (ii) above? Why?
Solution: Sharpe ratio (Sp) and Treynor’s ratio(Tp) are calculated as
follows:
Sp = [Rp-Rf]/σp
Tp = [Rp-Rf]/bp
(i)
Portfolio Rp σp Sharpe ratio(Sp) Rank
S 21 20 [21-7]/20 = 0.70 2 Underperformed as Sp<Sm
W 26 25 [26-7]/25 = 0.76 1 Outperformed as Sp>Sm
Market Index 19 16 [19-7]/16 = 0.75
(ii)
Portfolio Rp βP Treynor ratio(Tp) Rank
S 21 20 [21-7]/20 = 0.70 1 Outperformed as Tp>Tm
W 26 25 [26-7]/25 = 0.76 2 Underperformed as Tp<Tm
Market Index 19 16 [19-7]/16 = 0.75

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Notes (iii) The rankings provided by Sharpe ratio and Treynor’s ratio is
different. As per Sharpe ratio portfolio W is better than portfolio
S. As per Treynor’s ratio, portfolio S is better than portfolio W.
This is because of the difference in the measure of risk. In the
case of the Sharpe ratio, we consider total risk, while in the case
of Treynor’s ratio, we consider only systematic risk.
Illustration 9.2: The following information is available about three port-
folios P1, P2 and P3. The market index provided a return of 20% over
the same period while returns on Treasury bills were 6%.
Portfolio Actual Return (%) Beta
P1 15 0.60
P2 30 1.80
P3 27 1.5
Calculate Jensen’s alpha for each portfolio and state whether they have
outperformed or underperformed the market index.
Solution: Jensen’s alpha is calculated as follows:
α = Actual Return - Expected return as per CAPM
Expected return as per CAPM is calculated as follows:
E(Rp) = Rf + [Rm-Rf]βp

Portfolio Actual Beta CAPM returns α

Return(%)
P1 15 0.60 6 + [20 – 6](0.6) 15 – 14.40 = 0.60
= 14.4
P2 30 1.80 6 + [20 – 6](l .80) 30 – 31.20 = –1.20
= 3.12
P3 27 1.5 6 + [20 – 6](1.5) 27 – 27 = 0
= 27
Portfolio P1 has outperformed the market as its Jensen’s alpha is posi-
tive. Portfolio P2 has underperformed the market as its Jensen’s alpha is
negative. Portfolio P3 is efficiently priced in the market and has neither
outperformed nor underperformed. Its actual performance is same as
expected.

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 Mutual Funds

IN-TEXT QUESTIONS Notes

9. Which ratio measures the excess return of a portfolio per unit

of systematic risk (beta)?
(a) Sharpe’s Ratio
(b) Treynor’s Ratio
(c) Jensen’s Alpha
(d) Expense Ratio
10. What is a limitation of absolute return methods in portfolio
evaluation?
(a) They ignore the portfolio’s systematic risk
(b) They provide a comprehensive assessment of risk
(c) They are not influenced by benchmark portfolios
(d) They accurately account for varying risk levels

9.12 Performance Evaluation of Mutual Funds

A mutual fund is essentially a curated portfolio of securities, and its per-
formance can be assessed through absolute returns and various risk-adjusted
metrics such as the Sharpe ratio, Treynor’s ratio, and Jensen’s alpha. To
comprehend the return from a mutual fund, it’s crucial to delve into the
calculation of Net Asset Value (NAV) and the associated costs.
1. Net Asset Value (NAV): NAV represents the amount a unit holder
would receive per unit if the mutual fund were to be liquidated. It
is derived from the net assets of the fund, calculated as the market
value of investments, receivables, accrued income, and other assets
minus accrued expenses, payables, and other liabilities. The NAV
per unit is determined by dividing the Net Asset Value of the Fund
by the number of units outstanding.
Net Asset Value of the Fund
NAV per unit =
[Link] Units Outstanding

Where Net Assets = Market Value of Investments + Receivables + Ac-

crued Income + Other Assets – Accrued Expenses – Payables – Other
Liabilities.

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Notes 2. Costs Incurred by Mutual Fund: “In the mutual fund field, costs
assume a tremendous importance for the long-term investor. Other
things held equal, lower costs mean higher returns.” - John Bogle.
Costs in the mutual fund arena are pivotal for long-term investors, with
lower costs translating to higher returns. These costs encompass initial
expenses for setting up the scheme and ongoing recurring expenses
(management expenses). The management expense ratio, expressed
as a percentage of average assets under management, includes expert
investment analyst costs, administration expenses, and advertising costs.
It is computed as below:
Expenses
Expense Ratio =
Average assets under management
1. Return from Mutual Fund: Returns from a mutual fund can be
dividends, capital gains disbursement, or changes in NAV over a
specified period. The return formula incorporates dividends, realized
capital gains, and the change in NAV, expressed as a percentage of
the NAV at the beginning of the period.
Div1i + CG12 + [ NAV1 − NAV0 ]
Return = x 100
NAV0
Where,
‹ Div1 = dividends for the period
‹ CG1 = Capital gains realised
‹ NAV1 = NAV at the end of the year
‹ NAV0 = NAV at the beginning of the year
2. Performance Evaluation of Mutual Funds: Once the return from
a mutual fund is calculated, we can also determine its total risk
by calculating standard deviation of returns. Further beta of a
mutual fund can also be determined to capture the sensitivity of
a mutual fund scheme to market portfolio returns. Once we have
actual return, risk, and beta factor of the mutual fund, we can
apply the following measures for performance evaluation of a
mutual fund:

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 Mutual Funds

(i) Absolute return Notes

(ii) Risk adjusted Measures: This includes;
(a) Sharpe ratio
(b) Treynor’s ratio
(c) Jensen’s alpha
Illustration 9.3: Find out NAV per unit from the following information:
Size of the scheme Rs. 10,00,000
Face value of shares Rs. 10
Number of outstanding shares Rs. 1,00,000
Market value of fund’s investment Rs. 18,00,000
Bills receivable Rs. 20,000
Liabilities Rs. 10,000
Solution:
Total Assets = Market Value of Investment + Bills Receivable = Rs.
I8,00,000 + Rs. 20,000 = Rs. 18,20,000 Liabilities = Rs. 10,000
Net Assets = Rs. 18,20,000 – Rs.10,000 = Rs.18,10,000
Net Asset Value of the Fund Rs. 18,10, 000
NAV per unit = =
No. of Units outstanding 1, 00, 000
= Rs. 18.1 per share

9.13 Summary
The lesson provides an overview of mutual funds, covering various as-
pects such as their definition, types, historical evolution in India, and
the three-tier structure involving sponsors, trusts, and asset management
companies. The lesson emphasizes the professional management, risk
diversification, and regulatory oversight offered by mutual funds, making
them an attractive investment option.
The lesson further delves into the structure of mutual funds, categorizing
them based on open-ended, closed-ended, and interval funds, as well as
their investment objectives (debt, equity, hybrid) and investment styles
(passive and active funds). It discusses the advantages of mutual funds,
including risk diversification, professional management, affordability,
liquidity, and regulatory compliance.
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 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

Notes However, the lesson also addresses the limitations of mutual funds, such
as the lack of individual control, dependence on fund managers, associated
costs, lock-in periods, and potential impact on returns. Despite these
drawbacks, mutual funds offer a range of benefits tailored to different
investor preferences and financial goals.
The lesson concludes with an exploration of portfolio management, distin-
guishing between passive and active management approaches. It introduces
absolute return and risk-adjusted methods for evaluating portfolio perfor-
mance, including Sharpe’s Ratio, Treynor’s Ratio, and Jensen’s Alpha.
These measures help investors make informed decisions by considering
both returns and risk in their portfolio analysis. The summary highlights
the importance of using these ratios in conjunction with other metrics
for a comprehensive assessment of portfolio performance.

9.14 Answers to In-Text Questions

1. (b) A professionally managed investment scheme
2. (c) SEBI (Securities and Exchange Board of India)
3. (a) Total assets minus liabilities
4. (c) Entry of Private Players (1993-2003)
5. (b) Sponsors
6. (c) Pooling money for risk diversification
7. (b) Closed Ended Funds
8. (c) Regular income and capital preservation
9. (b) Treynor’s Ratio
10. (a) They ignore the portfolio’s systematic risk

9.15 Self-Assessment Questions

1. Trace the historical evolution of mutual funds in India through
different phases. Discuss the key milestones, regulatory changes,
and industry developments that shaped the mutual fund landscape
from its introduction in 1963 to the present day.

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 Mutual Funds

2. Compare and contrast the advantages and disadvantages of investing Notes

in mutual funds.
3. Describe the various types of mutual funds based on their structure,
investment objectives, and investment styles. Provide examples for
each category and explain how these classifications cater to different
investor needs and preferences.
4. Examine the methods used for evaluating portfolio performance,
distinguishing between absolute return methods and risk-adjusted
methods. Discuss the significance of Sharpe’s Ratio, Treynor’s Ratio,
and Jensen’s Alpha in assessing the efficiency and risk of a portfolio.

9.16 Suggested Readings

‹ Reilly, F. K. & Brown, K. C. (2012). Analysis of Investments and
Management of Portfolios (12th edition), Cengage India Pvt. Ltd.
‹ Singh, Rohini (2017). Security Analysis and Portfolio Management
(2nd edition). Excel Books.

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 Glossary

Adaptation and Learning: Being responsive to changing market conditions, economic

trends, and personal circumstances allows for the adaptation of the portfolio strategy.
Alpha: A measure of an investment’s performance compared to a benchmark, considering
risk factors.
APT (Arbitrage Pricing Theory): APT is an alternative to CAPM and suggests that an
asset’s return can be modeled as a linear function of various macroeconomic factors.
Asset Allocation: Asset allocation is all about distributing your money across different
types of investments such as stocks, bonds, real estate, or gold. Finding the ideal combina-
tion which helps in capital appreciation while minimising the risk is the core idea behind
asset allocation. The asset allocation decision is influenced by different factors such as
financial goals, risk tolerance and market conditions.
Asset Management Companies (AMCs): AMCs are the companies that trustees or the
sponsor appoints, and they are responsible for managing the fund’s portfolio and the
securities in which they invest. They have their board of directors and work under
the supervision of trustees and SEBI.
Bar Charts: A chart that has open, high, low, and close data sets in a vertical line in the
form of a bar. It’s also referred to as an open-high-low-close (or OHLC) chart.
Beta (β): An investment’s sensitivity to market fluctuations is measured by its beta; a
beta of more than one suggests higher volatility than the market, while a beta of less than
one indicates reduced volatility.
Bond Valuation: The process of figuring out a bond’s theoretical fair value is known as
bond valuation. Bond valuation involves figuring out the face value, or par value, of the
bond at maturity as well as the present value of the bond’s future interest payments, or
cash flow.
Bond’s Yield: The return an investor anticipates earning on a bond over the course of its
term until maturity is known as the yield. The bond yield, for the investor who bought
the bond, is an overview of the total return that takes into consideration the principle and
interest that will remain after the bond’s purchase price.
Broker: Attracts new investors, holds SEBI license, acts as an intermediary.

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Notes CAGR: Compounded Annual Growth Rate.

Candlestick Charts: A chart that has open, high, low, and close data
sets in a candle form.
CAPEX: Expenditure incurred for property, plant, and equipment.
Capital Market Line: The efficient portfolios are created by combining
the optimal portfolio of risky assets with risk-free lending or borrowing.
Capital Market: A financial marketplace that facilitates the trading of
financial assets having a maturity period of more than one year.
CAPM (Capital Asset Pricing Model): Is a financial model that estab-
lishes a relationship between the expected return on an investment and
its systematic risk.
Closed-Ended Funds: These funds have a fixed maturity period and a
fixed number of units, which can only be purchased during the initial
offer period. Once the NFO (New Fund Offer) period ends, investors
cannot purchase or redeem units of a closed-ended fund. Investors can
sell units on the stock exchange if there is enough liquidity.
Covariance: It is a statistical tool which measures the degree of inter-
action between two random variables.
Custodians: Hold securities in demat form and handle back-office
bookkeeping.
DCF: Discounted cash flow analysis.
DDM: Dividend discount model.
Dealers: Facilitate deals in capital and money market instruments.
Diversification: A strategy to minimise risk by investing in different
investment options.
Downtrend: Stocks are in a downtrend when they’re making lower highs
and lower lows.
EBIT: Earnings before interest and taxes.
Efficient Frontier: The set of efficient portfolios.
Efficient Portfolios: These are feasible portfolios with the highest
expected return for a given level of risk, measured by portfolio standard
deviation.

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 Glossary

Exchange Traded Funds (ETF): are investment funds that are traded on Notes
stock exchanges, similar to individual stocks. They are designed to track
the performance of a specific index, commodity, bond, or basket of assets.
FCFE: Free cash flows to equity.
FCFF: Free cash flows to firm.
Fixed-Income Securities: An investment that yields a return through
fixed periodic interest payments and the eventual repayment of principle
upon maturity is known as a fixed-income security. In contrast to
variable-income securities, which have payments that fluctuate according
to an underlying metric like short-term interest rates, fixed-income
securities have known returns.
Fund of Funds (FoF): Industry is a type of investment fund that pri-
marily invests in other mutual funds rather than directly in individual
securities like stocks or bonds.
Indifference Curve: It shows the utility score of an investor in terms
of expected returns and risk. All the points on a particular IC represent
different levels of risk and return with the same amount of satisfaction.
Inefficient Portfolios: These portfolios have the same risk as another
feasible portfolio but a lower expected return.
Interval Funds: These funds combine features of both open-ended and
closed-ended funds. Investors can buy or sell units at predefined intervals
(monthly, quarterly, annually, etc.) at NAV-related prices.
Investment Selection: Portfolio managers select specific investments
within each asset class, considering factors like company fundamentals,
market trends, and potential returns.
Line Chart: A single line that connects stock prices is called a line chart.
Liquidity Management: Balancing the need for liquidity with long-term
investment goals ensures that investors can meet short-term financial
needs while maximizing long-term growth.
Market Risk Premium: It is the excess return expected from the overall
market above the risk-free rate.
Market Risk: The risk of losses in financial markets due to factors such
as economic downturns, interest rate changes, and geopolitical events.

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Notes Mutual Fund: A mutual fund is a professionally managed investment

scheme, usually run by an Asset Management Company (AMC), that
brings together a group of people and invests their money in stocks,
bonds, and other securities.
Net Asset Value (NAV): NAV represents the amount a unit holder would
receive per unit if the mutual fund were to be liquidated.
Non-Cash Working Capital: Working capital of firm excluding cash.
Objective Setting: Investors define their financial goals, whether it’s
wealth accumulation, retirement planning, or risk mitigation, aligning
these objectives with their risk tolerance and investment horizon.
Open Ended Funds: These funds do not have a fixed maturity period.
Investors can buy and sell units at any point, and the fund continuously
issues and redeems units based on the net asset value (NAV).
Optimal Portfolio: The point of tangency between an efficient set and
an investor’s indifference curve.
Patterns: Price patterns are trends that occur in stock charts. The patterns
form recognizable shapes.
Performance Evaluation: Investors regularly assess portfolio perfor-
mance against benchmarks and goals, making adjustments as necessary
to optimize returns.
Regular Monitoring and Rebalancing: Portfolios are continuously mon-
itored to ensure they remain aligned with investors’ goals. Rebalancing
involves adjusting the allocation periodically to maintain the desired
risk–return profile.
Relative Strength Index: The Relative Strength Index (or RSI) is a
measure of the overbought and oversold position of a stock.
Resistance Level: Price level where an uptrend may stall or reverse due
to increased selling pressure.
Resistance: A straight line that connects three or more of a stock’s data
points. It usually indicates the stock is going up.
Risk in Bonds: Although bonds are regarded as secure investments, there
are certain risks associated with them, including call, reinvestment, interest
rate, inflation, and default risks. Risk-taking investors typically generate more
money, but they may experience anxiety when the stock market declines.

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 Glossary

Risk Management: Portfolio managers assess and manage risks associated Notes
with investments, aiming to strike a balance between risk and return.
Diversification across assets and industries helps mitigate risks.
Risk: It is the deviation or change in actual returns from the expected
returns.
Risk-Averse Investor: An investor who prefers minimal risk, and con-
sequently, tends to avoid investment in relatively risky financial assets.
Risk-Free Asset: An asset whose returns are certain and known at the
beginning of the holding period.
Risk-Return Ratio: The relationship between the potential for higher
returns and the level of risk associated with an investment.
Setting Objectives: Investors define their financial objectives such as
wealth accumulation, retirement planning, or risk mitigation. These
objectives need to be matched with the risk tolerance and investment
horizon of the investors.
Sideways Trend: Stocks that trade in a range are in a sideways trend.
Simple Moving Average: An average of the closing price of the stock
over a specified number of periods.
SML (Security Market Line): It is a graphical representation of the
Capital Asset Pricing Model (CAPM).
Sponsor: Initiates the mutual fund, requires SEBI approval, and submits
necessary documents.
Support Level: A price level where a downtrend can be expected to
pause due to a concentration of buying interest.
Support: A straight line that connects three or more of a stock’s data
points. It usually indicates the stock is going down.
Systematic Investment Plans (Sip): It allows investors to contribute a
fixed amount regularly (usually monthly) to a selected mutual fund scheme.
Systematic Risk: It emanates from factors beyond the control of
individual companies. It is also known as a non-diversifiable risk.
Systematic Transfer Plans (STP): It is a financial investment strategy
that allows an investor to transfer a fixed amount of money regularly
from one mutual fund scheme to another within the same fund house.

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Notes Systematic Withdrawal Plans (Swp): It is a facility offered by mutual

funds that allows investors to withdraw a specific amount of money at
regular intervals from their investment in the fund.
Tax Efficiency: Investors consider tax implications when making
investment decisions, utilizing tax-advantaged accounts or strategies to
minimize tax burdens.
Trend: The directional movement of a stock price.
Trendline: A straight line drawn on a chart to connect a series of price
points, showing the direction of the trend (upward, downward, or sideways).
Trust and Trustees: Formed under the Indian Trust Act of 1882, they
oversee fund activities to ensure compliance.
Unsystematic Risk: It is influenced by factors within a company’s con-
trol. It is also known as diversifiable risk.
Uptrend: Stocks are in an uptrend when they’re making higher highs
and higher lows.
Volume: The measure of the number stock’s shares traded on the stock
exchange in a day or a period of time.

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