UNIT

1
INVESTMENT DECISIONS
CONTENTS
1.0 Aims and Objectives

1.1 Introduction

12 Nature and Scope of Investment Decisions

1.2.1 Investment

1.2.2 Speculation

1.2.3 Gambling and Investment

1.2.4 Investment Objectives

1.2.5 Investment Process

13 Investment Attributes/ Factors Influencing Selection of Investment

13.1 Investment Alternatives

1.3.2 Negotiable Securities

1.3.3 Non-negotiable Securities

14 Components of Investments Risk

14.1 Systematic Risk

14.2 Non-systematic Risk

and Non-systematic Risk
14.3 Different Types of Systematic

14.4 Minimising Risk Exposure

1.4.5 Measurement of Risk

14.6 Risk and Expected Return

1.4.7 Risk-Return Relationship

14.8 Portfolio and Security Returns

15 Let us Sum up

1.6 Lesson End Activity

1.7 Keywords
1.8 Questions for Discussion

1.9 Suggested Readings

1.0 AIMS AND OBJECTIVES

After studying this unit, you should be able to understand:

Nature and scope of Investment Decisions

Componentsof Investment
Evaluation of Securities
6
Security Analysis and 1.1 INTRODUCTION
Portfolio Management
Investment involves making ofa sacrifice in the present with the hope of deriving
future
[Link] has many meanings and facets. Two most important features of an
investment are current sacrifice and future benefit. We can identify a variety of activities
which display the two features of investment. For example. A
Portfolio manager buys
10,000 shares of ITCLtd for his mutual fund:
your relative may have subscribed to the
6-year Post Office Monthly IncomeScheme.A corporate firm may spend Rs. 5 crores
for expansion programmers; a middle aged man with a family decides to sped Rs. 10
lakhs to buy an apartment in a city and so on. All these constitute investment activities
because they involve current sacrifice of consumption and hope of future gain.
Perhaps,
an investment in an apartment for the purpose ofliving in it may involve, partially at least

certain,current consumption but because the family will continuc to live in the house for

a very long period of time, the act of purchasing a house or apartment may be taken as
an investment activity.

We can now give a simple yet a broad definition of investment. We can define investment
as “Postponed Consumption".

When you postpone consumption, sacrifice takes place in the present and is certain

whereas the benefits occur in future and are uncertain. Therefore, Risk and Expected
return from the investment are the two key determinants of Investment process.

Atthis point, it is necessary to distinguish between certain activities which are in the

nature of gambling and those which are genuine investments. For instance, if you buy
Rs. 1000 worth of lotteryticket you may be sacrificing current consumption in the hope
of winning a handsome return but you are not really investing. In gambling or change

games,winning involves a lot of luck and the outcome as largely very uncertain. A buyer
not win and that the
of lottery tickets knows that he will lose the noney spent if he does
act of winning is not in his hands. However, an investor, not being a speculator, does not

proceed with the assumption that he would lose his money because
the act of investment
have an
decision making isa well-thoughtout process. Genuine investors would always
the risk profile ofthe investor,
appropriate [Link] which is analyzed. In relative to
and thereafter the actual investment avenue is selected. However, in real life, it is very
motives
difficultto draw a very clear demarcating line to separate speculative or gambling
genuine investment motives and the difference is purely a matter of opinion.
firm the

In other words investment refers to a commitment of funds to one or more assets that

will be held over some future time period. Almost all individuals have wealth of some
kind, ranging from the value of their services in the workplace to tangible assets
to

future use can be considered

monetary assets. Anything not consumedtoday and saved for
an investment. For our purposes, investment will mean a measurable asset retained in

order to increase one's personal wealth.

Why Invest

We invest to improve our future welfare. Fundsto be invested come from assets already

OWned, money, and savings or foregone [Link] foregoing

borrowed
Consumption and investing the savings, we expect to enhance our tuture
today
nmption possibilities, Anticipated future consumption may be by other family members,
Suen as education funds for children or by ourselves. possibly in
retirement when we are
ess aoie to work and produce for our daily needs. Regardless of why we
should all seek invest we
to manage
our wealth effectively, obtaining the most fromit. This includes
protecting our assets from
inflation, taxes and other factors.
 Investment Decisions
Invest
HOw Do We wealth, it
directly affect our future
decisions today that will
Jfwe are making investment Surprisingly, the
we a plan to help guide our decisions.
wOuld make sense that utilize
plan. Taking
offormalized investment
majority of people do not have in place anytype First, let's
tremendous benefits.
a financialplan can reap
some time to put together
planning.
define financial

through the proper management

Financial planning is the process ofmeeting your life goals
child's education
of vour finances. Life goals can include buying a home, saving for your

or planning for retirement.

It allows
planning provides direction and meaning to your financial decisions.
Financial
decision you make affects other areas of your
vou to understand how each financial
investment product might help youpay off
finances. For example, buying
a particular

retirement significantly. By viewing each

your mortgage faster or it might delay your
on
of a whole, you can consider its short and long-term
effects
financial decision as part
changes and feel more secure that
your life goals. Youcan also adapt more easily to life

your goals are on track.

1.2 NATURE AND SCOPE OF INVESTMENT DECISIONS

an interesting activity that attracts people from all
Investing in various types of assets is

of their occupation, economic status, education and family

walks of life irrespective

money than he requires for current consumption,

background. When a person has more
The investor who is having extra cash could
he would be coined as a potential investor.
or could simply deposit
invest it in securities or in any other assets like gold or real estate
have extra income may like to invest their
it bank account. The companies that
in his
or undertake new venture. All of these
firm
money in the extension of the existing
activities in a broader sense mean investment.

1.2.1 Investment

the emplovment of funds on assets with the aim of earning income or

Investment is

has two attributes namely time and risk. Present

capital appreciation. Investment
The sacrifice that has to be borne
is sacrificed to get a return in the future.
Consumption
may be This attribute of investment
but the return in the future uncertain.
IS certain

undertaken with a view reap some return from the

Indicates the risk factor. The risk is to

For. a layman, investment means some monetary

commitment. A person's
Investment.
an investment from his
commitment to or a house for his personal use may be
buya flat
as it involves sacrifice
point of view. This cannot be considered as an actual investment
but does not yield any financial return.

1.2.2 Speculation
term gain.
means taking up the business risk in the hope of getting
short
Speculation

and with the expectation of getting

Speculation essentially involves buying selling activities

profit from the price fluctuations. This can be explained with an example. If a spouse

If she buys
Duys a stock for its dividend, she may be termed as an investor. with the

anticipation of price rise in the near future and the hope of selling it at a gain price she

would be termed as a speculator. The dividing line between speculation and investment
Is very thin because people buy stocks for dividends and capital appreciation.

Ihe time factor inyolved in the speculation and investment The investor
is different.
is
Interested in consistent good rate of return fora longer period. He is primarily concerned
WIth the direct benefits provided by the securities in the long run. The speculator is
 interested getting abnormal return i.e, extremely
in
Sccurity Anasis and high rate of return than the normial
otfatio return in the short run. Speculator's investments are
Manngement made for short-term.
The speculator is more interested in the market actíon and
its price movement. The
investor constantly evaluates the worth
security whereas the speculator evaluates the
of
price movement. He is not worried about the
fundamental factors like his counterpart.
the investor.

The investor would try to match the risk and return. The speculator would like to assume
greater risk than the investors. Risk refers to the possibility of incurring lossin a financial
transaction. The negative short term fluctuations affect the speculators in a worse manner
than the investors. The risk factor involved in the investment is also limited. A fter studying
the factors related with the concerned company's
stock, the investor buys itand hence
the risk exposure is limited. The investor likes to invest in securities wherehis principal
would be safe.

Exhibit 1.1: Difference Between the Investorand the Speculator

Investor
Speculator

Time Plans for a longer time

Plans for avery short period. Holding
horizon period
horizon. His holding period varies from few days to months.
may be from onc ycar to few
ycars.

Risk Assumes moderate risk.

Willing to undertake high risk.

Return Likes to have moderate rate of Like to have high returns for assuming high
return associated with limited risk.
risk.

Decision Considers fundamental factors

Considers inside information.
and evaluates the performance heresays and
market behaviour.
of the comnpany regularly.

Funds Uses his own funds and avoids Uses borrowed funds to
borrowed funds. supplement his
personal resources.

1.2.3 Gambling and Investment

A gamble is usually a very
short term
differentfrom speculation and investment in game or chance. Gambling is a
shorter than speculation
investment.
time horizon The
and investment. The involved in gambling is
the turn ofa results are
card. Secondly, determined by the roll of
people gamble as a dice or
incomes would be the way to entertain
secondary factor. themselves, earning
risk of the Thirdly, the risk in
investment. Gambling gambling is different
employs artificial risks from the
present in the whereascommercial
investment activity. risks are
and the negative There is no risk
and return trade
outcomes are expected. off in the
risk and But in the gambling
return. Positive returns are investment there is
expected by the
an analysis of
analysis does not
reduce the risk [Link], the
proportion involved in financial
the
gambling.
1.2.4
InvestmentObjectives
The main
investment objectives
Other objectives are
increasing the rate
like safety, of return and
subsidiary
liquidity and hedge reducing the risk.
objectives: against inflation
canbe considered
as
Return:
Investors always
Rate of return expect a good rate of
could be return from
defined asthe their
holding period total
income investnents.
stated asa the
the holding period. investor receives during
percentage ofthe the
purchasing price at
the
beginning of
 Return =(End period value - Beginning period value + Dividend) /(Beginning Investment Decisions
period value) x 100

Rate of return is stated semi-annually or annually to help comparison among the

different investment alternatives. Ifit is astock, the investor gets the dividend as
well as the capital appreciation as returns. Market return of the stock indicates the

price appreciation for the particular stock. If a particular share is purchased in

1998 at Rs.50, disposed at Rs.60 in 1999 and the dividend yield is Rs.5, then the
return would be calculatedas follows:

Return =(Capital appreciation & dividend /Purchase price) x 100

Return =(10+ 5) 50 x 100 =30% /

2 Risk: Risk of holding securities is related with the probability of actual return

becoming less than the expected return. The word risk is synonymouswith the
phrase variability of return. Investments' risk is just as important as measuring its
expected rate of return because minimising risk and maximising the rate of return

are interrelated objectives in the investment management. An investment whose

rate of return varies widely from period to period is risky than whose return that
does not change [Link] investor likes to reduce the risk of his investment by
proper combination of different securities.

3 Liguidity: Marketability of the investment provides liquidity to the investment.

The depends upon the marketing and trading facility. Ifa portion of the
liquidity
investment could be converted into cash without much loss of time, it would help
the investor meet the emergencies. Stocks are liquid only if they command good
market by providing adequate return through dividends and capital appreciation.

4 Hedge against inflation: Since there is inflation in almost all the economy, the

should ensure a cover againstthe inflation. The return rateshould be

rate of return

higher than the rate of inflation, otherwise the investor will have loss in real terms.

Growth stocks would appreciate in their values overtime and provide a protection
against inflation. The return thus earned should assure the safety of the principal
amount, regular flow of incomeand be a hedge against inflation.
5. Safety: The selected investment avenue should be under the legal and regulatory
frame work. If it is not under the legal frame work, it is difficult to represent the

grievances, if any. Approval ofthe law itselfadds a flavour of safety. Even though
approved by law, the safety of the principal differs from one mode of investment to

another. Investments done with the government assure more safety than with the
private party. From the safety point of view investments can be ranked as follows:

bank deposits, government bonds, UTI units, non-convertible debentures, convertible

debentures, equity shares, and deposits with the non-banking financial companies.

1.2.5 Investment Process

oftheinvestment decision
After understanding the concept of investment and the nature
you might now know as to how does an investor go about the task or business of
like to

investing? How much to invest at any moment? And when to make or unmake the
investment? These questions essentially relate to the investment process which is briefly

outlined in this section. A typical investment decision undergoes a five step procedure
which, in turn, formsthe basis of the investment process, these steps are:

Determine the investment objectives and policy

1
2 Undertake security analysis
3 Construct a portfolio
 4.
Analysis and Review the portfolio
Management S.
Evaluate the performance ofthe portfolio

Investrnent Analysis Valuatfon Portfolio Portoio

Pollcy Construction Evatuation

nvestible Market Hntrinsic Diversification

Appralsat
fund value
- Industry Selection & Revision

.Objectives
Knowledge Company
-Future

value
allocation

Figure 1.1: Investment Process

You may note at the very outset that this five-step
procedure is relevant not only for an
individual who on the threshold of taking his
is
own investment decisions but also for
individuals and institutions who have to aid and
work out investment decisions for others
i.e., for their clients. The investment process is a key-process
entailing the whole body
of security analysis and portfolio
management. Let us understand the each of the
five
element in the investment
process:
1
Investment Objectives andPolicy:The
investor will have to work out his
first and then evolve a objectives
policy with the amountof
investible wealth at his command.
An investor might say that his
objective is to havelarge money'.
that this would be a wrong way of
You will agree
stating the [Link] would
recall that the
pursuit of 'large money' is not
possible without the risk oflarge
the objectives of an investor losses'. Hence,
must be defined in terms ofrisk and return.
The next step in formulating the
investment policyof an investor
would be the
identification ofcategories offinancial assets
he/she would be interested in. It is
obvious that they in turn,
would depend on the
objectives,amount of wealth, and
the tax status of the investor.
For example, a tax-exempt
investor with large investible
wealth like a
pension/provident fund would invest in
anything but tax-exempt
securities unless compelled by law to
do so. Similarly,
general, have low inclination individual investorswould, in
to invest in preference
shares.
2. Security Analysis: This step would consist of examining the
characteristics of individual risk-return
securities or groups of securities
one. The aim here identified under step
is to know if it
worthwhile to acquire these
is
securities for the
portfolio. Now,this would depend upon the
extent to which is mispriced",
there are two broad approaches And
to findingout the
securities. One approach is known as 'technical 'mispriced status' ofindividual
analysis'. The analysthere studies
part movements in prices of
securities he is interested in to determine the
and patterns that repeat. Then he trends
studies more recent price
about some emerging trend. The
movements to know
two are then integrated to predict if a
will repeat in future.
given trend
The current market price is compared
with the predicted price
and the extent 'mispricing' determined, You should note that
of
there would be
absence of'mispricing'only if the
current price is equal to the predicted price.
second approach is known as 'fundamental
The
approach'. The analyst here works out
 a true or intrinsic value of a security and compares it with the current market price.
Investment Decisions
The intrinsic value isthe present value of all cash flows that the
owner of the
securityexpects to receive during and at the end of his holding period.
Thus, in effect, involves a two-step exercise: first, forecast the cash-flow i.e.,
expected stream of dividends (in the case of equity shares) for which a forecast of
earnings of the company and its payout ratios would have to be obtained. Also
would be needed a forecast of the resale price of the security at the end of the
holding period. This would, then be followed by a discounting of these forecast
cash flows at some rate of discount which may correspond to the
investor's required
rate of return. The fundamental analyst now compares the intrinsic value with the
current market price as already observed. If the current market price is more than
the true value, the share is overvalued and vice versa. Fundamental analysts believe

that notable cases of mispricing will be corrected by the market in future which
implies that prices of undervalued shares will increase and those of overvalued
shares will decline.

3.
Portfolio Construction: This consistsof identifying the specific securities in which
to invest and determining the proportion of the investor's wealth to be invested in
each. For example, a conservative may decide to invest, say, 70 per cent
individual

of hiscash in 30 per cent in equity shares. On the

debentures and the remaining
other hand, an individual who is prepared to assume greater risk may like to put,
say 70 per cent of his cash in equity shares with the expectationof getting, say, 30
per cent dividends on an average (note that this expectation may or may not
materialise)and the balance 30per cent in debentures with a relatively assured
return of, say, 14 per cent. And within these broad groups of equity shares and
debentures, he may specifically select specific firms, say, debentures of L&T or
equity shares of Reliance and so on. This problem of specific identification is known
as the problem of selectivity. It is obvious that the issue of selectivity will have to be
based on micro-level forecasts of expected cashflows from specific shares/
debentures of different companies. The investor will use security analysis approaches
for this. Then, he must determine the timing of his investment and for this he will

have to observe the forecasted price movementsof shares relative to debentures

he willmake all possible efforts to minimise his risk for
at the macro level. Finally,

ofaverage ofhis potential portfolio. This he would be

a given expected level return

able to achieve when the returns of shares and debentures which would comprise
his portfolio are not positively correlated to each other. The resultant portfolio would
be known as diversified'portfolio. Thus, portfolio constructionwould address itself

to three major problems via., selectivity, timing, and diversification. The related

questions would be which specific shares/ debentures to buy, when to buy, and
how best tocombinethen in a way that risk is reduced to a minimum for a given
level of expected return?

4
Portfolio Revision: As time passes, the investor would discover that securities

which once were very attractive have ceased to be so. Also, new securities with
promises of high returns and relatively low risk have emerged. In view of such

developments it would be necessary for him to review the portfolio. He would

liquidate the unattractive securities and acquire the new stars from the market. In

a way, he repeats the first three steps of the investment process. He sets new
investment policy, undertakes security analysis afresh, and re-allocates his cash

for the new portfolio. It must be observed that the transaction costs incurred in the

buy-sell activities relating to the new portfolioand also the extent of improvement
expected in the future outlook of new securities would be important considerations
in the revision of given portfolio.
 constantly examine
investor would
12 Evaluation: A rational fordoing somust
5. Portfolio Performance and risk. Measures
return
Security Analysis and both for average be compared with
positions must
portfolio
his chosen
Portfolio Management risk-return acquires
the calculated
be developed. Also, step in the investment
process, thus,
This
yardsticks or norms. measurement

of
certain are quantitative
since the tasks involved
considerable significance norms.
against objective
actual risk
and return their evaluation

ATTRIBUTES/ FACTORS
1.3INVESTMENT OF INVESTMENT
INFLUENCING SELECTION definite ideas regarding
features
will need
investments, investors be consistent with the
features should
choosing specific
In
should possess. These all the incidental
should afford them
portfolios
which their
objectives and, in addition, For evaluation
general the circumstances.
are possible under
investors'
and advantages which
conveniences are relevant:
the following attributes
an investment avenue,
Returns

2 Capital Appreciation

(a) Conservation

() Aggressive Growth

(ii) Speculation

(b)

)
Form of Return

(i)
Periodic Cash Receipts

Capital Gain

Funds
3. Safety and Security of

(a) Risk

(b) Liquidity

(c) Tax Considerately

(d) Conveyance

(e) Conceivability

investment is not absolute or complete:

(a) Safety of Principal: The safety sought in

loss under reasonably likely conditions or

it rather implies protection against
variations.

has today become an important principle.

(b) Capital Growth: Capital appreciation
corporation and industry growth and very
Recognising the connection between
large capital investors and their advisers constantly are seeking"growth
appreciation,

stocks".

(c) Tax Benefits: To plan an investment programme without regard to one's tax status

may be costly to the investor. There are really two problems involved here, one
concerned with the amount of income paid by the investment and the other wiu

the burden of incometaxes upon that income.

(d)Conceivabiliy:
unacceptable levels
To be
of
safe from social disorders
taxation, property
,govenment
must be concealable and leave
confiscatiol,
no record
of incomereceived been
from its use or sale. Gold and precious stones have long
esteemed for these purposes

(e) Adequate Liquidityand Collateral Value: An investment is a liquid asset lt

be conyerted into cash without delay at full market
value in any quantity. ro
investment to be liquid it must be (1) reversible or (2) marketable.
 () Stability of Income:Stability of income must be looked at in different waysjustas Investment Decisions
was security of principal.

1.3.1InvestmentAlternatives

The problem of surplus gives rise to the question ofwhere to invest. In the
past, investment
avenues were limited to real assets, schemes of the post
office and banks. At
present, a
wide varietyof investment avenues are open to the
investors to syit their needs and
nature. A knowledge about the different avenues enables the investors
to choose
investmentintelligently. The required level of return and the risk
tolerance level decide
the choice of the investor. The investment
alternatives ranges from financial securities
to traditional non-security investments. The financial securities may be
negotiable or
non-negotiable.

The negotiable securities are financial that are transferable.

securities The negotiable
securities may yield variable income or income. Securities
fixed like equity shares are
Variable income securities. Bonds, debentures, Indra Vikas Patras, Kisan Vikas Patras,
Government securities and money market securities yield a fixed income.

The non-negotiablefinancial investment as the name itself suggests is not transferable.

This is also known as non-securitised investments. Deposit schemes offeredby
financial

the post offices, banks, companies, and non-banking financial companies are of this
category. The tax-sheltered schemes such as public provident fund, national savings
certificate and national savings schemeare also non-securitisedfinancial investments.
Mutual fund is another investment alternate. It is of recent origin in India. Within a short
Span of time several financial institutions and banks have floated varieties of mutual
funds. The investors with Iimited funds can invest in the mutual funds and can have the
benefits of thestock market and money market investments as specified by the particular
fund.

The real assets always find a place in the portfolio. They are gold, silver, arts, property
and antiques. These are non-financialinvestment.

Investment Alternatives Include:

Equity
1
2 Preference shares

3 Debentures

4 Bonds or fixed income securities

(a) Government securities

(b) Savings bonds

(c) Private sector debentures

(d) PSU bonds

(e) Preference shares

5.
Money market
instruments
(a) Treasury
bills

(b)
Certificates ofdeposits
(c)
Commercial paper
(d)
Repos
14
6. Non-marketable financial assets
Security Analysis and
Portfolio Management
(a) Bank deposits

(b) Post Office Time Deposits (POTD)

Post Office (MISPO)
(c) Monthly IncomeScheme of the
(d) Kisan Vikas Patra (KVP)

(e) National Savings Certificate

() Company Deposits

Employees Provident Fund Scheme

(g)

(h) Public Provident Fund Scheme

7. Real estate

(a) Residential House

(b) Sources of Housing Finance

Loans
(c) Features of Housing

(d) Guidelines for Buying a Flat

(e) Commercial Property

Land
() Agricultural

(g) Suburban Land

(h) Time Share in a Holiday Resort

8 Precious objects

(a) Gold and Silver

(b) Precious Stones

(c) Art Objects

9. Insurance policies

(a) Endowment Assurance

(b) Money Back Plan

(c) Whole Life Assurance

(d) Unit Linked Plan

(e) Term Assurance

() Immediate Annuity

(g) Deferred Annuity

1.3.2 Negotiable Securities

Variable Income Securities

The equity shares the interest of many. In the early nineties,

(a) Equity shares: attract

the stock market was the best and safest place for the common individual to invest.

Since 1996 the share market prices have been low. This made the retail investors

to turn away from the stock market.

 15
The stock market classifies shares into Growth shares. Income shares, Defensive Investment Decisions
shares,Cyclical shares and Speculative shares.

Growth shares: The stocks that have higher rate of growth than the industrial

growth rate in profitability are referred to as growth shares. For example, the
list of major gainers for 1999 is dominated by software sector stocks. The
HCL and Infosystems share prices increased sharply.

() Income shares: These stocks belong to companies that have comparatively

stable operations and limited growth opportunities. The bank shares and some
of the fast moving consumer goods stocks such as Cadburys, Nestle and
Hindustan Lever may be termed as income shares.

(ii) Defensive shares: Defensive stocks are relatively unaffected by the market
movements. For example, a host of pharmaceutical stocks posted returns in

excess of50 per cent in [Link] pharmaceutical industry owing to its inherent

nature of demand is not affected by the down turn in the economy.

(iv) Cyclical shares: The business cycle affects the cyclical [Link] upward
and downwardmovements of thebusinesscycle affect the business prospects
of certain companies and their stock prices. Such shares provide low to

moderate current yield. Capital gain may be highly variable. For example, the
automobile sector stocks are affected by the business cycles.

(v) Speculative shares: Shares that have lot of speculative trading in them are
referred to as speculative shares. During the bull and bear phases of the
market, this type of shares attracts the attention of the traders.

The stocks, which fall under one category in one period may switch over to another
category in another period. The classification should not be considered rigid. For

example, growth shares may be speculative shares.

Fixed Income Securities

(a) Preference shares: A preference shares are no longer regarded as inferior to the
equity capital. Corporate like Siemens has placed Rs. 150 cr. worth of preference

[Link] tax paying companies or investors prefer to subscribe to the preference

shares and investors with a low tax burden would prefer to goin for debt instruments.

The conversion options provided in the by preference shares also make it attractive.
The biggest advantage is the tax-exempt status of the preference share's dividend.
(b) Debentures: Corporate debentures are an option available to the investors who
are willing to sacrifice liquidity for higher return. Manufacturing companies like

Gujarat Industries Power and TISCO have issued debentures. If the detbentures
are not activelytraded in the debt segment of the capital market, the investorsmay
have to hold the instrument till maturity. If theinstruments were actively traded in
the secondary market, it would have perhaps changed hands at a considerable
premium, thereby lowering the yield on par with the present interest rate. These
reasons contribute towards high coupon rates on debentures.

(c) Bonds:Bonds are similarto the debentures but they are issued by the public sector
undertakings. The value of the bond in the market depends upon the interest rate

and the [Link] coupon rate is the nominal interest rate offered on the bonds.
Thecoupon rate is contractual involving the terms and conditions of theissuance
of the debt security. Being contractual it cannot be changed during the tenure of

the instrument. The investors are not affected by lowering of the bank rates, When
the bank rates are lowered, actually, the value of the bonds, which are carrying
 have issued
IDBIandICICI discount
would appreciate. are deep
interest rates above the bank rate Some of them
ofthe investors.
arity Analysis and to suit the needs and index bond.
Management
various bonds benefit bond the
folio
benefit bond. retirement office
with
bond, education issued by the post arc in
certificates The 1VPs
IVPs and KVPs: These are saving Vikas Patra (KVP). of
(d)
Vikas Patra
(IVP)and Kisan are in the
denomination
name S000. TheKVPs return of
with the
Indira
500. 1000
and
of Rs. in 5.5 years
value doubled
the face The capital is and therefore
5000 and 10000. by hand delivery
Rs, 1000, transferable concession
IVPs are like bearer
bonds, No incometax
13.47%. cash transactions.
who prefer
to the persons
are attractive
of investment. Government
for this type
is available Central, State
issued by the or gilt edged
The securities securities
(e) Government
securities:
are known as Government it is a
agencies in the Government,
and QuasiGovernment security is a claim
capital. The
securities.
As Government guaranteedguarantees the income and the
instrument, which oftheir high
liquidity
secured financial is relatively
lower because
on these securities
rate of interest

and safety. maturity

have very short term
Money market securities are:
() Money market securities: money market instruments
a year. Common
than
say less

Treasury bills

Commercial paper

Certificate ofdeposit
borrowing
an instrument of short term
Treasury bills: A treasury
bill is basically

To develop the treasury bill market and provide

by the Government of India. and to
short-term maturities
investors with financial instruments of varying
of the
requirements of various segments
facilitate the cash management
bills of varied maturities were introduced.
economy, in April 1997 treasury
14-day treasury bill on a weekly basis was introduced from June 6, 1997. In
the second halfof 1997-98, treasury bill of 2 8-day
was introduced on auction
basis. Further, it was decided to reintroduce 182-day treasury bills through

auctions. Generally, treasury bills are of 91-days. Since the interest rates

offered on the treasury bills are very low, individuals very rarely invest in

them.

(i) Commercial papers:Commercial paper is a short-term negotiable instrument

with fixed maturity period. It is an unsecured promissory note issued by the
company either directly or througlh bank/merchant banks. The maturity period
of commercial paper was originally three(minimum) tosix (maximum) months
from the date of issue. In Oct 1993, the maximum
period was extended to
one year. The commercial papers are sold at a
discount and redeemed at
their face value. The
discounted value implicates the
interest rate. The
denomination of commercial paper is
high. Mostly the companies and
institutional investors favour
them. Th minimum
maturity ofCP was brought
down from 3 months to 30days.
(ü) of deposit: The
Certificate
certificate of deposit is a
funds deposited in a marketable receipt of
bank for a fixed period
at a specified rate
They are bearer
documents and readily
of interest.
negotiable.
The denominations of
the CD and the
interest rate on them are high.
preferred by institutional It is mainly
investors and companies
rather than the
individuals.
 sizee of the certificate
minimum
The is Rs101akh. The
ofRs Slakh.
multiples additional
in amountis issued
Investment Decisions

Securitics
1.3.3 Non-negotiable

Deposits
fixed rate of return. Even though
earn deposits bank
Deposits resemble fixed
they are nottnegotiable instruments. Some ofthe income
securities deposits are dcalt
subscquently.
It is the simple investment
Bank deposits: avenue open for the
(a) investors. He has
an accounttand deposit the money.
the banks offered Traditionally
to open current
nt savings account and Tixed deposit
account. Current accountdoes not
acco terestrate. The drawback of having large
amounts in savings accounts
ie that the return is just 4.5 per cent. The savings account interest rate is reoulated
Daserve Bank of India and kept low because of the high cost of servicing.

hom The savings account is more liquid and convenient to handle. The fixed

high interest rate and the money is locked up for a fixed period.
carries
account
With inereasing competition among the banks, the banks have bundlcd the nlain
account to cater to the needs of the small savers
eavingsaccount with the fixed

the Exhibit 1.2.

below in
Some of the hybrid accounts are given

by Somne Banks
Exhibit 1.2: Hybrid Accounts Offered

Min. Dep Other benefits

Product
Nature
Bank (Rs.)

5.000 ATM card, Internet

Savings account
ICICI Maxi cash banking and assistance
savings with Auto
investing funds
in
Bank in
through
sweep facility money market
which standing
instruments, anywhere
can be
instructions
banking and chcque
issued to transfer
book.
surplus funds of FD.

25,000
ATM card, Anywhere
FD linked to savings
banking, Internet
Quantum

Optima
account with Auto
Banking, & overdrat
sweep Reverse-sweep. facility.
Auto Renewal
facilities.

25,000 Cheque book and

account with
Acount Savings facility.
Induslnd2-in-1 overdraft
Bank link to FD.
Cheque book.
FD 25,000
Cluster Savings linked

Deposits with Auto-sweep and

Reverse-sweep.
cheque book,
Overdraft,
to FD. 25,000
HDFC Super saver Savings linked
ATM and phone
Bank account banking.

book and
25,000
ATM, Cheque
Sweep-in Savings linked to FD
phone banking.
account with Reverse-Sweep
and add-on-deposit.

because of the RBI regulation.

The deposits in the banks are considered to besafe
The risk averse investors prefer the bank deposits.
facility
fixed deposit
also offers
(b) Post office deposits: Likethe banks, post office a popular
Scheme is
and monthly income scheme. Post office Monthly Income term of the
The
13% monthly.
scheme for the retired. An interest rate of paid
is
 yield
is paid.
Theannualised
of which
a bonusof 10% closure
the end years, premature
18 years, at After three of 5% is
schemeis 6 per annum. penalty
Sccurity Analysis and works out to be 15.01% is after
one year, a
to maturity the elosure
Management penalty, If
without any
Portfolio

IS allowed in the
increase
charged. been a significant
years, there has process of financial
In recent in the
NBFC deposits: companies The amendment
(C) of the RBI.
financial
of non-banking the purview
for the NBFCs.
under
Importance
NBFC comes
The compulsory
intermediation. made registration It varies
to five years.
of RBI
Act in Jan 1997, from few months the
ranges Finance.
The maturity period the Birla
Global
from
(i) Period: For example, with maturity
to company.
from company accepts deposits
Birla group
to Aditya
companybelonging on the
been based
3-5 years.
acceptance
of deposit has of RS
limit for net owned funds
limit: The not having
(ii) Maximum The NBFCs
of the company.
credit rating deposits.
to accept
25 lakh are not entitled bank on
higher than the commercial
rate is

(ii) Internet:
NBFCs offer interest differs according to maturity period. There
rate with the
The interest
public deposit.
rate among the
companiesin accordance similar
with
in the interest the companies
a disparity
the companies. Even
deposits. Generally.í
of
and policies
credit ratings
interest rates for their the
rates to cover
provide different
credit ratings interest
credit ratings offer higher
lower by some of the
companies with rates offered
Table l.1shows the interest
risk. The following
as on July 2004.
finance companies
by Finance Companies
Rates on Deposits Offered
Table 1.1: Interest
Amount
2years 3years
1 year
Company 25,000
6.50
Bajaj Auto Finance
6.50 20, 000
6.25
6.00
Birla Home Finance |
25,000
6.79 7.04
Canbank Factors

5.50 5.75 5,000

Fin Homes 5.25
Can

7.50 10,000
6.50 7.00
Chola Finance |||

6.60 10,000
6.10 6.35
Dewan Housing Finance

6.75 50,000
HUDCO 6.25 6.50

HDFC 5.55 5.80 6.05 10,000

HDBI 5.50 5.75 6.25 25,000

Lakshni General Finance 6.00 6.50 7.00 10,000

M&M Financial Services 6.50 7.00 7.50 10,000

PNB Housing Finance 5.75 6.00 6.00 20,000

SRF 7.00 7.00 7.00 10,000

Sundaram Finance 6.00

6.50 7.00 10,000

Sundaram Home 6.00 6.25 6.50 10,000

TN Power Finance
6.54 7.23 10,000
 (iv) Secrity: Security of the deposits of the NBFCs is much lower than the 19

Investment Decisions
deposits with banks. To improve the liquidity of
NBFCs the percentage of
liquid assets required to be maintained by them has been enhanced from 12.5
percent to 15 percent with effect from April 1999 respectively. Company
Law Board is authorised to direct the defaulting NBFCs to repay the deposits.
In spite ofthe strict rules and regulations laid down by RBI the default rate is
high in the case of NBFCs. Lately, on January 3, 2009, RBI reduces repo
rate to 5.5%,an eight-and-a-halfyear low.

Tux Sheltered SavingsScheme

Tax sheltered savings schemes are of great importance to the investors in the tax-paying

category. The tax sheltered savings schemes offer tax relief to those who participate in

their schemes according to the income tax laws. The important tax sheltered savings
schemes are:

Public Provident Fund Scheme

National Savings Scheme

National Savings Certificate VIIl series

(a) Public Provident Fund Scheme(PPF):PPF earns an interest rate of 12 percent

per year, which is exempted from the income tax under sec 88. The individuals and

Hindu undivided families can participate in this scheme. The maximum limit per
annum for the deposit is Rs 60,000. The interest is accumulated in the deposit. It

from 7h year and every year thereafter, the

provides early withdrawal faciliti
has an option withdraw 50 per cent of the balance to his credit 4
account holder to

year ago whichever is lower. The facility makes PPF a self-sustaining

years ago or l

account from 7h year onwards.

the tax payment.

(b) National SavingsScheme (NSS):This scheme helps in deferring

Individuals and HUF are eligible to open NSS account in the designated post office.

rebate but the interest as well as the

The NSS-87 gives 100 per cent income tax

in the NSs
capital are fully taxable if withdrawn during their lifetime. Investments
scheme, with a lock in period of 4 years qualify for a rebate of 20 per cent under

Section 88of the IncomeTax Act, subject to a maximum of Rs 12,000. The

investment also earns an interest rate of 11 per cent per year covered by Sec 80L.

savings' instruments the return offered by this scheme is

Compared to other tax

lower.

four years from

On the liquidity aspect, withdrawal is permitted at any time after
the end of the financial year in which the account is opened. The entire amountcan
be withdrawn. The account can be closed on the expiry of 4 years. There is no

fixed tenure for investment. One can also keep the account alive and earn interest

at 11 percent per annum.

after 4 years is the only interesting
As a tax saving instrument “anytime" withdrawal
feature to the prospective investor. The tax deduction at source at the rate of 20

percent on the entire amount withdrawn has proved too costly to the investors.

(c) National (
SavingsCertificate 6 yrs.)-III: This scheme is offered by the post
office. These certificates come in the denominations of Rs 500, 1,000, 5,000 and
Sec
10,000. The contribution and the interest for the first 5 years are covered by
88. The interest is cumulative at the rate of 12% per annum and payable biannually
is covered by Sec 80L. No withdrawals are
permitted. There is no deduction at

maturity.
 (or
person assurcd
Life Insurance money to the of
of a sum insured against
ccurity Analysis and
for payment of event
is a contract the happening
ortfolio Management insurance on date of
Life the same) amount on
the maturity or at
to receive ofan
the person entitled
the payment Among other thi
for death occurs.
provides h
Usually the contract or if unfortunate
intervals to the corporation
dates at periodic of premium periodically
specified for the payment
also provide risk.
the contracts eliminates below:
Life insurance are given
holders.
the policy oflife insurance
The major advantages full protection
againe

(a) Major Advantage: guarantees in otk

life insurance whereas
Saving through assured
sum is paid,
Protection:
saver. The
(i) full

risk of
death of the
saved is paid.
the amount are
schemes only savings' schemes
people the salary
method of
pavment
For the salaried facility
(ii) Easy payments: is an easy
instalment
there
or yearly mode.
Further,
introduced.
quarterly,
halfyearly
through monthly, policy.
security of the
raised on the
Loans can be for amounts
(i) Liquidity: Tax is available
in Income Tax and Wealth in force.
(iv) Ta relief: Tax relief
subject to the
tax rates

for life insurance

of premium
paid by way the needs of the
a wide range of schemes to suit
(b) Schemes of
LIC: LICoffers
individual investor.
sum
plan where the
a lowcost insurance
lifeassurance
pla: It is
() Whole
the life assured and
premiumsare payable
on the death of
assured is payable
throughout life.
is payable on
the sum assured
assurance plan: Under this plan,
(ii) Endowment if earlier.
death of the life assured,
of maturity or on the
the date
the premiums for a
with the facility ofpaying
Both these plans are available
limited period.

Plans:
(üi) Term Assurance

plan: Under this plan, term

assurance
Two- Yeartemporary assurance
assured is payable only on the death
for two years is [Link] sum
of the life assured during the term.

Convertible tern assurance plan: It provides term assurance To

Whole
to 7 years with an option to purchase a new, Limited Payment
Life Policy or an Endowment Assurance Policy at the end oftheselecieu

term; provided the policy is in fullforce.

with the provision

(iv) Bima sandesh: This is basically a Term Assurance Plan

for return of premiums paid, on the life assured surviving the term.

(V) Bima kiran: This plains an improved version of Bima Sandesh with :
h anadded
attraction of loyalty addition, in-built accident cover and Free Term Cover
after maturity, provided the policy is then in full force.

(vi) Plans for Children: Various children's Deferred Assurance Plans

is a plan
available viz, Jeevan Balya, and Jeevan Kishore. Jeevan Sukanya is
Plan
specially designed for girls. The Children's Money Assurance
Back with
w
specially designedtoprovide for children's higher educational expenses
 21
loyalty additions
fguaranteed additions,
of d optionsl faniky
fevestmest Decisions
attractions
added

benefit.
for either immediate or deferred pension
Plans:
These plans provide
Pension
r made till the death of the annuitant (unless
(vii)
The pension payments are
for life. Both the Deferred
of guarantced period), Annuity
has provision
the policy
are available e with the return ofthe GIVE anount
plans
and Immediate Annuity
vesting under the Jeevan Dlhara Plan and returnof Purchase
On death after
Akslhay Plan,
Price on death under the Jeevan
plan
survivor-annuity-cum-assurance
vim) Jeevan Sarita: This is a Joint-life-last
where the claim amountis payable partly in lumpsum
(for husband and wife)
on the death
annuity. Balance sum is assured

of
and partly in the form of an
the survivor.

deductions are allowed up

to

(ix) Tax Benefits fromLife Insurance: Atpresent,

of medical treatment of handicapped
Rs. 15.000/- u/s 80 DD in respect
of
Rs. 20,000/- u/s 80 DDA in respect
dependents and another amountup
to

under any scheme

deposit made for maintenance
of handicapped dependents
Aadhar".
framed for their behalf by LIC i.e., “Jeevan

for any amountpaid or deposited by him in the

A deductionto an individual

(from a fund set up by the

Jeevan Suraksha Plan for receiving pension
is allowed. The deduction will
be restricted to Rs. 10,000/-.
Corporation)
payable on the total taxable
Accordingto Section 88, the amountof income-tax
income can be reduced by 20% (25% in case of author, playwright etc.) of
premium subject to the maximum of
the aggregate amount paid towards
Rs. 70,000/- in case of an individual and HUF. Premiums paid to effect or to

keep in force an insurance policy on the life of the assessee or on the life of
the wife or husband or any child (whether nminor or major) of the assessee,
irespective of the status of thechild are also eligible for income tax deduction.

Premiums paid under an insurance policy effected jointly on the lives of a husband
and wife or in the case of a Hindu Undivided Family jointly on the lives of two or
more members of thefamily are eligible for the prescribed deduction under Section
88. However, such relief is not
available on premiums paid on policies singly or
jointly on the lives of
other relatives.

Mutual Funds

Investment t companies or investment trusts obtain funds from large number of investors
uirough sale of units. The funds collected from the investors are placed under
management for
professional
the benefit of the investors.
Into
open-ended schemeand
The mutual funds are broadly classified

close-ended scheme.
(a)
Oppen-endedSchemes:
The open-ended scheme offers its units on a continuous
basis andl
accepts funds from
investors
continuously. Repurchase is carried out on
a
continuing
In other
basisthus,

words,there is an
,
helping the investorsto
withdraw their money at any time.
end scheme uninterrupted
entry and exit into the funds. The open-
has a
maturity period and
Investor can
deal
they are not listed in the stock exchanges.
Idirectly with the
The
open-endedfund
mutual fundfor investment as well as redemption.
is provides liquidity
available. to theinvestors since the repurchase facility
Repurchase price is
T998 the fixed onthe basis
open-ended schemes of net asset value of the unit. In
have crossed 80
in number.
urity Analysis and (b) Closed-ended Funds: The close-ended funds have a fixed maturity period. The
rtlolio
Management first time investments are made when the close end scheme is kept open for a

limited period. Once closed,the units are listed on a stock exchange. Investors can

buy and sell their units only through stock exchanges. The demand and supoh
factorsinfluencethe prices of the [Link] investor's expectation also affects the

unit prices. The market price may not be the same as the net asset value

Sometimes mutual funds with the features of close-ended and open-ended schemes
are launched, known as interval funds. They can be listed in the stock exchange or

may be available for repurchase during specific periods at net asset value or related
prices.

Other Classification

The open-ended and close-ended schemes are classified on the basis of their objectives.

Some of them are given below:

Growth scheme:Aims to provide capital appreciation over medium to long term.

Generally these funds invest their money in equities.

(ii) Incomescheme:This schemeaims toprovide a regular return to its unit holders.

Mostly these funds deploy their funds in fixed incomesecurities.

(iii) Balanced scheme:A combination of steady return as well as reasonable growth.

The funds of these schemes are invested in equities and debt instruments.

(iv) Money market schene:This type of fund invests its money on money market
instruments like treasury bills, commercial paper, etc.

(v) Tax saving schemes:This type of scheme offers tax rebates to investors. Equity
linked saving schemes and pension schemesprovide exxemption from capital gains
on specificinvestment.

(vi) Indexscheme:Here investment is made on the equities of the index. Benchmark

index is BSE Sensex or [Link] returns are approximately equal to the return

on the index.

Basis for Selection

Investors can choose the [Link] on the basis of the

Net assets

Portfolio composition

Income composition

Gross incomeas a percentage ofnet assets

Expense ratio

Realised gains per unit

Unrealised appreciation
per unit

SEBIRegulations
The SEBI(Mutual Funds) Regulations,
mutual
1996 were amended in January 1998. Itprohibied
funds from investing and
in unlisted or associate
group companies of privately placed securities by
the sponsors.
A limit 25 percent
of
the net asset value of
of #
listed securities
thefund was imposed on its investment 0
the groupof
fully disclose companies of the
their portfolioin sponsors. Mutual funds are required
with minimum annual reports. Draft
disclosure Standard Offer Document make
requirements is laid down to
to enable the investors
 23
informed investment decisions. SEBIdecided that all the open-ended schemes including Investment Decisions

Unit Scheme-64 of Unit Trust of India should declare their net asset value on a daily

basis.

Real Assets

Gold and Silver: For ages, gold andsilver have been considered as a form of investment.

They are considered as best hedge against inflation. This is a favourite form of investment
amongst the rural and semi- urban population. Besides, investors tend to invest in jewellery

instead of puregold. As a result, when they buy jewellery,the price realisation is usually

less than total purchase price (this is due to higher making charge of jewellery). The
price of gold has declined in the later part of the
Gold prices are suppressed nineties.

because of large supplies overtaking the demand. The government has allowed imports
of gold to certain banks and agencies and they have huge stocks of gold. The gold prices
remained depressed in the international markets too in the late nineties. The following
reasons are cited for the low price of gold in the international market:

Weak demand from Asian countries which are the largest consumers of gold

Continuing pressure on central banks to dishoard gold

Legislative measure like the Swedish Government move to delink gold from Swiss

1.4 COMPONENTS OF INVESTMENTS RISK

Risk can be defined as the probability that the expected return from the security will not
that make future investment returns
materialize. Every investment involves uncertainties
risk prone. Uncertainties could be due to the political, economic and industry factors.

the source of it. Systematic risk is for

Risk could be systematic in future depending upon
to an industry or the company
the market as a whole, while unsystematic risk is specific

below are systematic in nature and the

individually. The first three risk factors discussed
risk could be whether it affects the market as whole or
rest are unsystematic. Political

justa particular industry.

the systematic risk and unsystematic risk. The

Risk consists of two components,
systematicrisk is caused by factors external to the particular
uncontrollable companyand
the market as a whole. In the case of
by the company. The systematic risk affects
to the particular industry or
unsystematic risk the factors are specific, unique and related
Company.

1.4.1 SystematicRisk
the entire Often we read in the newspaper that the
The systematic risk affects market.

the bear hug or in the bull grip. This indicates that the entire market is
stock market is in

moving in a particulardirection either downward or upward.

The economicconditions,
political situations and the sociological changes affect the security market. The recession

in the economy affects the profit prospect of the industry and the stock market. The
countries has affected the
1998 recession experienced by developed and developing
the world. The South East Asian crisis has affected the stock
stock markets all over
the corporate and the investor.
market world wide. There factors are beyond the control of
the point that the systematic
They cannot be entirely avoided by the investor. It drives home
risk is unavoidable.

1.4.2 Non-systematic Risk

The variability in a security's total returns not related to overall market variability is

unique to a particular security

called the non-systematic (non-market)risk. This risk is
24

and is and financial risk as well as

Security Analysis and
associated withsuch tactors as business liquidity risk.
it is
risk,
Portfolio Management Although all securities tend to have some non-systematic generally
connectef
with common stocks.

is attributable to
Systematic (Market)
Risk broad
Remember
factors affecting
the Difference:

allsecurities. Non-systematic (Non-Market) Risk is attributable to fe

macrs

unique to a security.

1.4.3Different Types of Systematicand Non-systematic Risk

are explained as under:
Different types of systematic and unsystematic
risk

of fotsi
Jack Clark Francis has defined market risk as that
portion
1. Market Risk:
and bear markets
variability of return caused by the alternating forces of bull
index moves upward haltingly for a significant period time. it
When the security

of
is known as bull market. Inthe bull market, the index moves from a low level to the
declines haltingh
peak. Bear market is just a reverse to the bull market; the index
from the peak to a market low pointcalled trough for a significant period of time
During the bull and bear market more than 80 per cent of the securities' prices rise

or fall along with the stock market indices.

The variability in a security's returns resulting from fluctuations in the aggregate

market is known as market risk. All securities are exposed to market risk including

recessions, wars, structural changes in the economy, tax law changes, even changes

inconsumer preferences. Market risk is sometimes used synonymously with

systematic risk.

2 Interest Rate Risk: Interest rate risk is the variation in the single period rates of

return caused by the fluctuations in the market interest rate. Most commonlyinterest
rate risk affects the price of bonds, debentures and stocks. The fluctuations in the

interest are caused by the changes in the government

rates
monetary policy and
the changes that occur in the interest rates of
treasury bills and the government
bonds. The bonds issued by the government
and quasi-government are considered
to be risk free. Ifhigher interest
rates are offered, investor would like to switch his
investments from private sector bonds to public
sector bonds. the government te
If
tide over the deficit in
the budget floats a new
loan/bond ofa higher rate of interest
therewould be a definite shift in
the funds from low
bonds and from stocks to bonds. yielding bondsto high yielding

Likewise, if the stock market is in a depressed condition, investors would

shift their money to the bond like lo
market, to have an assured
of return. The best rate
example is that in April 1996,
most of the initial publice
remained undersubscribed offerings of many companie
but IDBI and IFC
assured rate of return
bonds were oversubseribed
The
attracted the investors from
market. the stock market
to the bud

The rise or fall in the

rate affects
interest
money mnarket the cost of
rate changes, borrowing. When the call
affects the badla
it
trade in the stock rate too, Most of
market with the the stock tdu
margin affects the borrowed funds. The
increase in the cus
profitability ofthe traders. This
speculative traders who
use the borrowed would dampen the
would lead to a fall funds, The fall sprnt o
in the in the demand
value ofthe for secu
stock index.
Interest rates
not only affect
the security
carry their traders but also
business with the corporate bodies who
and a heavy borrowed funds.
The cost of
outtlowof profit would inerease
wouldtake place borrowing
in the form
of
interest to the cap
 borrowed. This would lead to a 25
reduction in earnings per share and a consequent
fall in the price of share.
Investment Decisions

The variability in a security's return resulting from changes in the level of interest
rates is referred to as interest rate risk. Such changes generally affect securities
inversely; that is, otherthings being equal, security
prices move inversely to interest
rates. The reason for this movement is tied up with the
valuation of securities.
Interest rate risk affects bonds more directly than common stocks and is a major
risk faced by all bondholders. As interest rates change, bond prices change in the
pposite direction .

3. Purchasing Power Risk: A factor affecting all securities is purchasing

power risk
also known as inflation risk. This is the chance that the purchasing
power of invested
dollars will decline. With uncertain inflation, the real (inflation-adjusted) return
involves risk even if the nominal return is safe (e.g., a Treasury bond). This risk is
relatedto interest rate risk, since interest rates
generallyrise as inflation increases,
because lenders demand additional inflation premiums to compensate for the loss
ofpurchasing power.

4 Regulation Risk: Someinvestments can be relatively attractive to other investments

because of certain regulations or tax laws that give them an advantage
of some
kind. Municipal bonds, for example pay interest
that is exempt from local, state and
federal taxation. As a result of that special tax exemption, municipals can price
bonds to yield a lower interest rate since the net after-tax yield may still make them

attractive to investors. The risk of a regulatorychange that could adversely affect

thestature of an investment is a real danger. In 1987, tax law changes dramatically

lessened the attractiveness of many existing limited partnerships that relied upon
special tax considerations as part of their total return. Prices for many limited
partnershipstumbled when investors were left with different securities, in effect,

than what they originally bargained To make matters worse, there was not an
for.

extensive secondary market for these illiquid securities and many investors found
themselves unable to sell those securities at anything but “firesale prices if at all.

5. Business Risk: The risk of doing business in a particular industry or environment

is called business risk. For example, as one of the largest steel producers, U.S.
Steel faces unique problems. Similarly, General Motors faces unique problems as a
result of such developments as the global oil situation and Japanese imports.
6 Reinvestment Risk: The YTM calculation assumes that the investor reinvests all

coupons received from a bond at a rate equal to the computed YTM on that bond.
thereby earning interest on interest over the life of the bond at the computed YTM
rate. In effect, this calculation assumes that the reinvestment rate is the yield to
maturity.

Ifthe investor spends the coupons, or reinvests them at a

rate different from the
assumed reinvestment rate of 10percent, the realized
yield that will actually be
earned at the termination ofthe investment in the
bond will differ from the promised
YTM. And, in fact, coupons almost always will be reinvested at rates higher or
lower than the computed YTM, resulting in a realized yield that differs from the
promised yield. This gives rise to reinvestment rate risk.

This interest-on-interest concept significantly affects the potential total dollar return.
The exact impact is a function of coupon and time to maturity, with reinvestment
becoming more important as either coupon or time to maturity, or both, rises.
Specifically:
 the maturity of a
urity Analysis
and (a) Holding everything else constant, the longer bond,the
greater
tfolio
Management the reinvest:nent risk.

(b) Holding everything else constant, the higher the coupon rate, thegreater
the
of the total dollar return fromthe bond on the reinvestment
dependence of

the coupon payments.

under different assumed reinvestment rates

Let's look at realized yields fora1)
value. If the
percent non-callable 20-year bond purchased at face reinvestment
wouldIrealize aa
rate exactlyequals the YTMof 10 percent, the investor 10 percent

compound return when the bond is held to maturity, with $4,040 of the total dolt.

return from the bond attributable to interest on At a 12 percent reinvestme

interest.
e
rate, the investor would realize a 11.14 percent compound return, with almoe
return coming from interest
the total on interest (S5,73 8/$7.738) W
percent of

(spending them as received), the investorwould achies

no reinvestiment coupons of

only a 5.57 percent return. In all cases, the bond is held

to maturity.

Clearly, the reinvestment portion of the YTM concept is critical. In fact, for long.

term bonds the interest-on-interest component of the total realized yield may account
for more than three-fourths of the bond's total dollar return.

7. Bull- Bear Market Risk: This risk arises from the variability in the market returns

resulting from alternating bull and bear market forces. When security index rises

fairly consistently from a low point, called a trough, over a period of time, this

upward trend is called a bull The bull market ends when the market index
market.
reaches a peak and starts a downward trend. The period during which the market
declines to the next trough is called a bear market.

8
Management Risk: Management,all said and done, is made of people who are
mortal, fallible
and capable of making a mistake or a poor decision. Errors made
the management can harm those who invested in their firms. Forecasting errors is
difficult work and may not be the effort and, as a result, imparts a needlessy
skeptical outlook.

An agent-principal principle relationship exists when the shareholder owners delegate

the day to day decision making authority to managerswho are hired employees
rather than substantial owners. This theory suggests that owners will work harder
tomaximize the value of the company than
employees will. Various researches n
the field indicate that investors can
reduce their losses to
difficult-to-analyse
management errors by buying shares in those corporations in which the executives
have significant equity
investments.
9.
Default Risk: Is that portion of
an investment's total riskthat
in the financial results from chang.
integrity of the investment? For
example, when a company i
issues securities moves either further away from
bankruptcy or closer to it, thes
changes in the firm's
financial integrity will be reflected in
the market price o
securities. The variability ofreturn that
in the
investors eXperience as a result of chay
creditworthinessofa firm in
which they invested is their
Almost all the default risk.
losses suffered by
investors as a result the
result of actual default risk are not
and / or
of
defaults
usually bankruptcies. Investor losses from default risk
result fromsecurity
prices falling asthe
weakness-market prices of financial lintegrity ofac corporation
to near the troubled firm's
zero. However, securities will already havee declined
this is not
in firms
like ENRON,
alwaysthe case
-'creative accounting practices
maintain
WorldCom, Arthur
quoted prices of Andersa and Associates may
stock even asthe Computer
company's net worth gets completely
 eroded. Thus, the bankruptcy losses would be only a small part 27
of the total losses Investnent Decisions
resulting from the process of financial deterioration.
10. International Risk: International Risk can include both Country risk and Exchange
Rate risk:

(a) Exchange Rate Risk: AIlinvestors who invest internationally in today's

increasingly global investment arena face the prospect of uncertainty in the
returns after they convert the foreign gains back to their own currency. Unlike

the past when most U.S. investors ignored international investing alternatives,

investors today must recognize and understand exchange rate risk, which
can be defined as the variability in returns on securities caused by currency
fluctuations. Exchange rate risk is sometimes called currency risk.

For example, a U.S. investor who buys a German stock denominated in marks
must ultimately convert the returns from this stock back to dollars. If the
exchange rate has moved against the investor, losses from these exchange
rate movements can partially or totally negate the original return earned.
Obviously, U.S. investorswho invest only in U.S. stocks on U.S. markets do
not face this risk, but in today's global environment where investors increasingly

consider alternatives from other countries, this factor has become important.
Currency risk affects international mutual funds, global mutual funds, closed

end single country funds, American Depository Receipts, foreign stocks, and
foreign bonds.

(b) Country Risk: Country risk, also referred to as political risk, is an important
risk for investors today. With more investors investing internationally, both
directly and indirectly, the political, and therefore economic, stability and viability

of a country's economy need to be considered. The United States has the

lowest country risk, and other countries can be judged on a relative basis
using the United States as a benchmark. Examples of countries that needed
careful monitoring in the 199Os because of countryrisk included the former

Soviet Unionand Yugoslavia, China, Hong Kong, and South Africa.

11. Liquidity Risk: Liquidity risk is the risk associated with the particular secondary

market in which a security trades. An investment that can be bought or sold quickly

and without significant price concession is considered liquid. The more uncertainty

about the time element and the price concession, the greater the liquidity risk. A
Treasury bill has little or no liquidity risk, whereas a small OTC stock may have
substantial liquidity risk.

It is that portion of an asset's total variability of return which results from price

discounts given or sales concessions paid in order to sell the asset without delay.

Perfectly liquid assets are highly marketable and suffer no liquidation costs. Illiquid

assets are not readily marketable and suffer no liquidation costs. Illiquid assets are

not readilymarketable -
either price discounts must be given or sales commissions
must be paid, or both the costs must be incurred by the seller, in order to find new a

investor for a illiquid asset. The more illiquid the asset is, the larger the price discounts

or the commissions that must be paid to dispose of the assets.

12. PoliticalRisk: It arises from the exploitation of a politically weak groupfor the
benefit ifa politically strong group, with the efforts of various groups to improve

their relative positions increasing the variability of return from the affected assets.

Regardless of whether the changes that cause political risk are sought by political
or by economic interests, the resulting variability of return is called political risk if

through legislative judicial or administrative branches of the

it is accomplished
government.
vsis
nnd Domestic
anapement
political risk arises from changes in environmental I
requirements, fees, licenses, and most frequently taxes, regulations,
and indirect. Some types of
Taxescould be 7oning
securities and certain both
categories of direct
privileged tax status. investors
enjoya
International political risk takes the
form ofexpropriation ofnon
foreign exchange controls residents ase
that won't let foreign
investors withdraw their
disadvantageous tax and tariff fund
treatments, requirements that
givepartial ownership to local non residents investoe
residents,and un-reimbursed
owned assets by hostile destruction of forei
residents of the foreign
country.
13. Industry
Risk: An industry
may be viewed as groupof
with each other to
market a homogeneous companies that compete
n investment's total
variability
product. Industry risk is
of return caused by
that portion of
and firms that make up events that affect the
an industry. For products
down will effect all the example,commodity prices
commodity producers, though not going up or
Thestage of the industry's life equally.
cycle, international
tariffs and/or
produced by an industry, quotas on the
product/industry related taxes products
labour union problems, ([Link]),
environmental restrictions, industry wide
factors interact with and raw material
affect all the firms availability, and similar
in an industry
these common simultaneously. As a result of
features,the prices
torise and fall together. of the securities
issued by the
competing firms tend
Theserisk factors do
not make upan exhaustive
major list but are
classifications only
involved. All the representative of the
or the total uncertaintiestaken together
variability of return. make up the total risk.

1.4.4
Minimising Risk
Exposure
Every investor wants
to guard
the nature of himself from the
theriskand risk. This
careful planning.
can be done by
protecting the The following understanding
investors fromthe paragraphs give an
differenttypes of agenda for
Market Risk risks.
Protection
(a) The investor has to
study the price
itselfeven though behaviour of the
it is not stock. Usually
in perfect history repeats
may continue to [Link] stock
do so for some that shows a
growth pattern to
more period. The growth patterm
continue for some Indian stock
more market expects the
depressing time in
conditions to information
cyclical stocks. It continue in the technology stock and
is textile related
better to avoid stock. Some
(b) The such type of stocks. stocks may be
standard deviation
and beta indicate
deviation andbeta the volatilityof
are available the stock.
National Stock forthe stocks
that are
The standard
ExchangeNews included in the
beta values, bulletin provides indices. The
the investor this
to his can gaugethe information.
risk risk Looking at the
tolerance. factor and
make wise
(c) decision
Further,the accordng
investor should
reap the be prepared
benefits of the to hold
the stock
timings ofthe rising trends for period a
leveland purchase and sale of
in the
ntarket. He
should
oftime
be caretul
o
should exit at
ahigher [Link] stock,
He
shouldpurchase nthe
it at the
Protection Against lower
Interest Rate
(a) Risk
Often suggested
in the middle
solution for
due to fall in this istohold the
heavy loss. the investment to
interestrate, Ifhe sells it
the capital maturity.
invested
woulddexperiencea
 (b) The investors can also buy treasury bills and
bonds of short maturity. The portfolio
manager can invest in the treasury bills and the Investment
money can be reinvested in the Deci

market to suit the prevailing interest rate.

(c) Another suggested solution is to invest

in bonds with different
maturity dates. When
the bonds mature in different
reinvestment can be done according to the
dates,

changes in the investment climate. Maturity

diversification can yield the best results.

Protection against Inflation

(a) The general opinion is that the bonds or debentures with fixed return cannot solve
the problem. If the bond yield is 13 to 15 per cent with low risk factor, they would
provide hedge againstthe inflation.

(b) Another way to avoid the risk is to have investment in short term securities and to
avoid long term investment. The rising consumer price index may wipe
offthe real
rate of interest in the long term.

(c) Investment diversification can also solve problem to

this a certain extent. The
investor has to diversify his investment in real estates, precious metals, arts and
antiques along with the investment in securities. One cannot assure that different

types of investments would provide a perfect hedge against inflation. It can minimise
the loss due to the fall in the purchasing power.

Protection against Business and Financial Risk

(a) To guard against the business risk, the investor has to analyse the strength and
weakness oftheindustryto which the companybelongs. weaknessof the industry
If
is too much of government interference in the way of rules and regulations, it is

better to avoid it.

(b) Analysing the profitability trend of the company is essential. The calculation of
standard deviation would yield the variability of the return. If there is inconsistency
in the earnings, it is better to avoid it. The investor has to choose a stock of consistent
track record.

(c) The financial risk should be minimised by analysing the capital structure of the
company. If the debt equity ratio is higher, the investor should have a sense of
caution. Along with the capital structure analysis, he should also take into account
of the interest payment. In a boom period,the investor can select a highly levered
company but not in a recession.

1.4.5 Measurement of Risk

Volatility

Ofallthe ways to describerisk, the simplestand possiblymost accurate is the uncertainty

of a future outcome". The anticipated return for some future period is known as the
expected return. The actual return over some past period is known as the realized
return. The simple fact that dominates investing is that the realized return on an asset
with any risk it may be different from what was expected. Volatility
attached to may be
described as the range of movement (or price fluctuation)from the expected level of
return. The more a stock, for example, goes up and down in price, the more volatile that
stock is. Because wide price swings create more uncertainty of an eventual outcome,
increased volatility can be equated with increased risk. Being able to measure and
determine the past volatility of a security is important in that it provides some insight into

the riskiness ofthat securityas an investment.

 Standard Deviation
ysis and
at least somewhat familiar with
the study of probability
Investors and analysts should be
agement
not known, it must
investor will earn from investing is
[Link] the return an
TR (total return) on a particular security to be
be estimated. An investor may expect the
"point estimate."
but in truth this is only a
10 percent for the coming year,

Probability Distributions
need to think explicitly about a security's
returns, investors
To deal with the uncertainty

of
keep in mind that, although
of probable TRs. Inother
words, investors need to
distribution a one-point
for example, this is only
to return 10percent,
they may expect a security must deal with the
of possibilities. Given that investors
estimate of the entire range
of possible returns
can, and will, occur.
uncertain future, a number
payment will
rate of interest, the interest
In the case of a
Treasury bond paying a fixed The
barring a financial collapse of the economy.
be made with, 100 percent certainty the possibility
of occurrence is 1.0, because
no other outcome is possible. With
probability
common stocks, each possible likely
which is the norm for
of two or more outcomes,
of its occurrence assessed. The result
of
be considered and a probability
outcome must
and their probabilities together is a probability distribution
considering these outcomes and the probabilities
ofthe specification of the likely returns that may occur
consisting

with these likely returns.

associated

of variousoutcomes and are

typically expressed as
Probabilities represent the likelihood
The sum of the probabilities ofall possible
a decimal. (Sometimes fractions are used.)
all the (perceived) likely
outcomes must be 1.0, because they must completely describe
and associated outcomes obtained? In the
occurrences. How are these probabilities

somefuture
involves uncertainty, and therefore subjective
period
final analysis, investing for
(frequencies) may be relied on heavily to estimate
estimates. Although past occurrences
expected in the future.
the probabilities, the past must be modified for any changes
can be either discrete or [Link] a discrete
probability
Probability distributions

each possible outcome. With a continuous

distribution, a probability is assigned to

number of possible outcomes exist. The most familiar

probability distribution an infinite

is the normal distribution depicted by the well-known bell-shaped

continuousdistribution
a two-parameter distribution in that the mean and the
curve often used in statistics. It is

variance fully describe it.

To describe the single most likely outcome from a particular probabilitydistribution, it is

necessary to calculate its expected value. The expected value is the average of all

possible return outcomes, where each outcome is weighted by its respective probability
of occurrence. For investors, this can be described as the expected return.

We have mentioned that it's important for investors to be able to quantify and measure
risk. To calculate the total risk associated with the expected return, the variance or
standard deviation is [Link] is a measure of the spread or dispersion in the probability
distribution; that is, a measurement of the dispersion of a random variable around its

[Link] going into further details, justbe awarethat the larger this dispersion, the

larger the variance or standard deviation. Since variance, volatility and risk can in thiS

context be used synonymously, remember that the larger the standard deviation, the
the outcome.
more uncertain

Calculatinga standard deviation using probability distributions involvesmaking subjective

and the likely returns, such
estimates of the probabilities However, we cannot avoid
future returns are based
are uncertain. The prices of securities on
estimates because
about tthe future. The
expectations relevant standard deviation in this situation
investors'
ante standard I deviation and not the ex post based on realized returns.
is the ex
 though standard deviations based on realized returms are often used as proxies for ex
Investment
ante standard deviations, investors should be careful to remember that the past cannot

always be extrapolated into the future without modifications. Ex post standard deviations

may be convenient, but they are subject erors. One important point about the estimation
to

of standard deviation is the distinction between individual securities and portfolios. Standard
deviations for well- diversified portfolios are reasonably steady across time, and therefore

historical calculations may be fairly Moving from well

reliable in projecting the future.
diversified portfolios to individual securities, however, makes historical calculations much
less reliable. Fortunately, the number one rule of portfolio management is to diversify
and hold a portfolio of securities, and the standard deviations of well-diversified portfolios

may be more stable.

Something very important to remember about standard deviation is that it is a measure of

the total risk of an asset or a portfolio, including therefore both systematic and
unsystematic risk. It captures the total variability in the asset's or portfolio's return,

whatever the sources of that variability. In summary, the standard deviation of return

measures the total risk of one security or the total risk of a portfolio of securities. The
historical standard deviation can be calculated for individual securities or portfolios of
securities using total returns for some specified period of time. This ex post value is

useful in evaluating the total risk for a particular historical period and in estimating the
total risk that is expected to prevail over some future period.

The standarddeviation, combined with the normal distribution, can provide some useful
the
information about the dispersion or variation in returns. In a normal distribution,

probability that a particular outcome will be above (or below) a specified value can be
determined. With one standard deviation on either side of the arithmetic mean of the

distribution, 68.3 percent of the outcomes will be encompassed; that is, there is a 68.3

percent probability that the actual outcome will be within one (plus or minus) standard
deviation of the arithmetic mean. The probabilities are 95 and 99 percent that the actual

outcome will be within two or three standard deviations,respectively, of the arithmetic

mean.

Beta

Beta is a measure of the systematic risk of a security that cannot be avoided through
diversification. Beta is a relative measure ofrisk-the risk of an individual stock relative

to the market portfolio of all stocks. If the security's returns move more (less) than the
market's returns as the latter changes, the security's returns have more (less)volatility
(fluctuations in price) than those of the market. It is important to note that beta measures

a security's volatility, or fluctuations in price, relative to a benchmark, the market portfolio

of all stocks.

Securities with different slopes have different sensitivities to the returns of the market

index. If the slope of this relationship for a particular security is a 45-degree angle, the
beta is 1.0. This means that for every one percent change in the market's return, on

average this security's returns change 1 percent. The market portfolio has a beta of 1.0.

A security with a beta of 1.5, indicatesthat, on average, security returns are 1.5 times as

Volatile as market returns, both up and down. This would be considered an aggressive
Security because when the overallmarket return rises or falls 10 percent, this security,
On average, would rise or fall 15 percent. Stocks having a beta of less than l.0 would be
considered more conservative investments than the overall market.

beta is useful for comparing the relative systematic risk ofdifferent stocks and, in practice,

S Used by investors to judge a stock's riskiness. Stocks can be ranked by theirbetas.

because the variance of the market is a constant [Link] securities for a particular