UNIT IV TECHNICAL ANALYSIS

Difference between fundamental analysis and technical analysis

Meaning of Fundamental Analysis
Fundamental analysis is a method of evaluating securities by examining economic, industry, and company-
specific factors. It attempts to determine the intrinsic or true value of a security.
 Focuses on financial statements, management quality, and economic conditions
 Helps identify undervalued or overvalued securities
 Mostly used for long-term investment decisions
Meaning of Technical Analysis
Technical analysis is a method of evaluating securities by studying past market data, mainly price and
trading volume, to predict future price movements.
 Based on charts and statistical indicators
 Assumes prices move in trends
 Useful for timing buy and sell decisions
Assumptions of Fundamental Analysis
 Each security has an intrinsic value
 Market prices may differ from intrinsic value in the short run
 In the long run, market prices move towards intrinsic value
Assumptions of Technical Analysis
 Market price reflects all available information
 Prices move in identifiable trends
 History tends to repeat itself
Difference between fundamental analysis and technical analysis

Basis of Fundamental Analysis Technical Analysis

Difference

Meaning Analysis of securities based on economic, Analysis of securities based on past

industry, and company-related factors to find price movements and trading volume
intrinsic value

Objective To determine the true or intrinsic value of a To predict future price movements
security and market trends

Focus Area Financial performance and overall health of the Price patterns, trends, and market
company behavior

Data Used Financial statements, economic indicators, Price charts, volume data, and market
management quality indicators
Time Long-term investment perspective Short-term to medium-term trading
Horizon perspective

Basis of Comparison of market price with intrinsic value Identification of trends and patterns in
Decision prices

Tools Used Ratio analysis, balance sheet, income statement, Charts, moving averages, oscillators,
cash flow analysis and indicators

Nature of Both qualitative and quantitative Mainly quantitative

Analysis

Suitability Suitable for long-term investors Suitable for traders and short-term
investors

TECHNICAL ANALYSIS
Dow Theory – Detailed Explanation
Dow Theory is one of the oldest and most important theories of technical analysis. It was developed by
Charles H. Dow, who believed that the stock market reflects the overall condition of the economy. This
theory helps investors understand market trends, price movements, and investor behaviour.
Meaning of Dow Theory
Dow Theory states that stock prices do not move randomly. Instead, they move in clear trends, and by
studying these trends, investors can predict the future direction of the market. The theory mainly focuses on
market averages, price movements, and volume.
Basic Philosophy of Dow Theory
 The stock market is a barometer of economic activity
 Prices move in trends
 Trends continue until there are clear signals of change
 Market behaviour reflects investor psychology
Assumptions of Dow Theory
Dow Theory is based on the following key assumptions:
1. Market Discounts Everything
All available information—economic, political, and psychological—is already reflected in market
prices.
2. Market Moves in Trends
Prices do not move randomly; they follow identifiable trends.
3. Trends Have Three Phases
Each major trend develops in three distinct stages.
4. Averages Must Confirm Each Other
Different market indices must move in the same direction to confirm a trend.
 5. Volume Confirms the Trend
Trading volume should increase in the direction of the prevailing trend.
6. Trend Continues Until Reversal
A trend remains in force until clear signals indicate a reversal.
Types of Market Trends
Dow Theory classifies market trends into three types:
1. Primary Trend
o Long-term trend lasting several months to years

o Represents the overall direction of the market

o Can be a bull market (rising prices) or bear market (falling prices)

2. Secondary Trend
o Short-term corrections within the primary trend
o Lasts from a few weeks to a few months
o Moves opposite to the primary trend
3. Minor Trend

o Very short-term movements

o Lasts from a few days to weeks
o Considered market noise
Price
|
| Primary Trend (Bull Market)
| /\
| / \ Secondary Trend
| / \ /\
| / \ / \
|_______/ \/ \________ Time
Minor Trends
 Primary Trend: Long-term upward or downward movement of the market
 Secondary Trend: Temporary corrections against the primary trend
 Minor Trend: Short-term fluctuations within secondary trends
Phases of a Primary Trend (Bull Market)
1. Accumulation Phase
 Informed investors start buying or selling
  Market sentiment is generally pessimistic
 Prices remain relatively stable
2. Public Participation Phase
 Majority of investors enter the market
 Prices move strongly in the direction of the trend
 Volume increases significantly
3. Distribution Phase
 Smart investors begin to exit their positions
 Public participation is at its peak
 Prices show signs of slowing down
Price
|
| Distribution Phase
| ____________
| / \
| / \
| / \
|__________/ \____ Time
Accumulation Public Participation
 Accumulation Phase: Smart investors begin buying at low prices
 Public Participation Phase: General public enters; prices rise rapidly
 Distribution Phase: Informed investors sell; prices stop rising
Phases of a Primary Trend ( Bear Market)
1. Distribution Phase
o Smart investors sell their holdings
o Prices start falling slowly
2. Public Participation Phase

o Panic selling by the public

o Prices fall sharply with high volume
3. Accumulation Phase
o Prices stabilize at low levels
o Smart investors start buying again
Price
|
|__________ Accumulation Phase
| \ /
| \ /
| \________/
| Distribution Public Participation Time
 Distribution Phase: Smart investors exit at high prices
 Public Participation Phase: Panic selling by the public
 Accumulation Phase: Prices stabilize; informed buying begins

Volume Confirmation in Dow Theory

Price ↑ Volume ↑ → Bull Market Confirmation

Price ↓ Volume ↑ → Bear Market Confirmation
Price ↑ Volume ↓ → Weak Trend
Price ↓ Volume ↓ → Weak Trend
 Volume should increase in the direction of the trend
 Rising prices with high volume indicate a strong bull market
 Falling prices with high volume confirm a strong bear market
 Low volume indicates a weak or false trend
Limitations of Dow Theory
 Gives signals after the trend has started
 Not suitable for short-term trading

 Does not provide exact buy or sell points

 Ignores company-specific fundamentals

Charting Methods

Charting methods are an important part of technical analysis. They help investors and traders study price
movements, identify trends, and predict future price behaviour. Charts present market data in a visual form,
making it easier to understand price patterns and market direction

Meaning of Charting

Charting is the graphical representation of price movements of a security over a period of time. Prices are
plotted on the vertical axis and time on the horizontal axis.

Classification of Charting Methods

Charting methods can be combined and classified into two main categories:
1. Time-Based Charts (Charts where price is plotted against time)
  Line Chart
 Bar Chart
 Candlestick Chart
 Heikin-Ashi Chart
 Volume Chart
 Tick Chart
2. Price-Based Charts (Charts based only on price movement, ignoring time)
 Point & Figure Chart
 Renko Chart
 Kagi Chart
1. Line Chart
Meaning
A line chart is the simplest form of price chart. It shows the closing prices of a security over a specific period
of time. The closing prices are plotted as points and connected with a continuous line.
Explanation
 Only one price (closing price) is considered
 Eliminates daily price fluctuations
 Provides a clear view of the overall trend
2. Bar Chart
Meaning
A bar chart is a chart that displays four important price points for each trading period—opening price,
highest price, lowest price, and closing price.
Explanation
 Vertical line shows the price range (high–low)
 Left horizontal line shows opening price
 Right horizontal line shows closing price
 Gives complete information about price movement
3. Candlestick Chart
Meaning
A candlestick chart is a visual representation of price movement that shows open, high, low, and close prices
using candle-shaped symbols.
Explanation
 Candle body shows difference between opening and closing prices
  Upper and lower shadows show price extremes
 Colour indicates price rise or fall
 Reflects market psychology and sentiment
4. Heikin-Ashi Chart (avg price)
Meaning
Heikin-Ashi chart is a modified form of candlestick chart that uses average price values instead of actual
prices to reduce market noise.
Explanation
 Smoothens price movement
 Makes trends easier to identify
 Reduces false signals during volatile markets
5. Volume Chart
Meaning
A volume chart shows the number of shares or contracts traded during a particular time period.
Explanation
 Displayed as vertical bars below the price chart
 High volume indicates strong buying or selling pressure
 Used to confirm price trends
6. Tick Chart( Transaction-based chart)
Meaning
A tick chart is a chart that plots price movement based on a fixed number of trades (ticks) instead of time.
Explanation
 New bar forms after a set number of transactions
 Shows real market activity
 Very sensitive to market movements
Price-Based Charts
7. Point & Figure Chart
Meaning
Point & Figure chart is a price-based chart that records only significant price changes, ignoring time and
minor fluctuations.
Explanation
 Uses X to represent price rise
 Uses O to represent price fall
  Helps identify support and resistance clearly
8. Renko Chart
Meaning
Renko chart is a chart that represents price movement using bricks, formed only when price moves by a
predetermined amount.
Explanation
 Ignores time and small price movements
 New brick appears only after fixed price change
 Removes market noise
9. Kagi Chart
Meaning
Kagi chart is a trend-based chart that shows price movement using vertical lines, changing direction when
price reverses beyond a fixed level.
Explanation
 Line thickness changes with trend strength
 Highlights important trend reversals
 Ignores time factor

Chart Trends and Chart Patterns

In technical analysis, charts help investors understand price movement. By studying trends and
patterns, investors can predict the future direction of prices and make better investment decisions.
PART A: CHART TRENDS
Meaning of Trend
A trend is the general direction in which the price of a security moves over a period of time.
 Prices usually move in one direction for some time
 Identifying the trend helps investors decide when to buy or sell
Types of Chart Trends
1. Uptrend
Meaning: An uptrend occurs when prices are continuously rising over time.
Characteristics
 Each new high is higher than the previous high
 Each new low is higher than the previous low
Example
If a share price moves from ₹100 → ₹110 → ₹120 → ₹130, it is an uptrend.
Investor Action
 Buy the security
 Hold existing investments
2. Downtrend
Meaning: A downtrend occurs when prices are continuously falling over time.
Characteristics
 Each new high is lower than the previous high
 Each new low is lower than the previous low
Example
If a share price moves from ₹300 → ₹280 → ₹260 → ₹240, it is a downtrend.
Investor Action
 Sell the security
 Avoid buying
3. Sideways (Horizontal) Trend
Meaning : A sideways trend occurs when prices move within a narrow range without clear upward or
downward direction.
Characteristics
 Prices move between support and resistance
 No clear trend direction
Example
If a share price moves between ₹500 and ₹520 for many days, it is a sideways trend.
Investor Action
 Wait and observe
 Trade only if breakout occurs
PART B: CHART PATTERNS
Meaning of Chart Patterns
Chart patterns are specific shapes formed by price movements on charts. These patterns reflect investor
psychology and help predict future price behaviour.
Classification of Chart Patterns
1. Reversal Patterns – indicate change in trend
2. Continuation Patterns – indicate continuation of existing trend
Reversal Chart Patterns ( trend reversal pattern)
1. Head and Shoulders Pattern
Meaning: This pattern shows that an uptrend is coming to an end and a downtrend may begin.
Structure
 Left shoulder
 Head (highest price)
 Right shoulder
Example
A stock rises to ₹200 (shoulder), then to ₹220 (head), then again to ₹200 (shoulder) and falls—this signals
reversal.
Investor Signal
 Sell the stock
2. Inverse Head and Shoulders
Meaning: This pattern shows that a downtrend is ending and an uptrend may begin.
Example
A stock falls to ₹150, then ₹130, then again ₹150 and starts rising—indicating reversal upward.
Investor Signal
 Buy the stock
3. Double Top Pattern
Meaning: This pattern occurs when price reaches a high level twice but fails to break it.
Example
Price rises to ₹300 twice and falls both times—showing resistance.
Investor Signal
 Trend may reverse downward
4. Double Bottom Pattern
Meaning: Occurs when price reaches a low level twice but does not fall further.
Example
Price falls to ₹100 twice and rises after that—indicating strong support.
Investor Signal
 Trend may reverse upward
Continuation Chart Patterns
1. Flag Pattern
Meaning
A flag pattern shows a short pause after a strong price movement.
Example
Price jumps from ₹100 to ₹150, moves sideways for some time, then rises again.
Investor Signal
 Trend will continue
2. Pennant Pattern
Meaning: A pennant is formed when price moves sharply and then forms a small triangle.
Example
Price rises quickly, pauses briefly, then continues upward.
Investor Signal
 Trend continuation
3. Triangle Pattern
Types and Meaning
 Ascending Triangle: Price makes higher lows, resistance remains same (bullish)
 Descending Triangle: Price makes lower highs, support remains same (bearish)
 Symmetrical Triangle: Price narrows on both sides (breakout expected)
Example
Price moves within narrowing range before breaking out upward or downward.

Trend Line Break

Meaning: A trend line connects higher lows in an uptrend or lower highs in a downtrend.
Reversal Signal
 Breaking an upward trend line → bearish reversal
 Breaking a downward trend line → bullish reversal
3. Support and Resistance Break
Meaning
 Support: Price level where buying pressure is strong
 Resistance: Price level where selling pressure is strong
Reversal Signal
 Support breakdown → downtrend begins
 Resistance breakout → uptrend begins
4. Volume Confirmation
Meaning: Volume shows the strength of price movement.
Reversal Signal
 Price change with high volume confirms reversal
 Price change with low volume may be false signal
5. Moving Average Crossover
Meaning: Moving averages smooth price data.
Reversal Signal
 Short-term MA crossing above long-term MA → bullish reversal
 Short-term MA crossing below long-term MA → bearish reversal
6. Momentum Indicators
Common Indicators
 RSI (Relative Strength Index)
 MACD (Moving Average Convergence Divergence)
Reversal Signal
 Overbought condition → price may fall
 Oversold condition → price may rise

Market Indicators
Introduction
Market indicators are an important part of technical analysis. They help investors and analysts understand
the overall condition of the stock market, identify market trends, measure market strength, and predict future
price movements. By using market indicators, investors can take better buy, sell, or hold decisions.
Meaning of Market Indicators
Market indicators are statistical and technical tools that analyse market data such as price, volume, and
number of stocks traded to assess the direction, strength, and sentiment of the market.
Objectives of Market Indicators
 To identify the direction of the market trend
 To measure the strength or weakness of the market
 To predict trend reversal
 To confirm price movements
 To assist investors in decision-making

Types of Market Indicators

Market indicators are broadly classified into the following categories:
1. Market Breadth Indicators
2. Momentum Indicators
3. Volume Indicators
4. Sentiment Indicators
1. Market Breadth Indicators
Meaning: Market breadth indicators show how many stocks are participating in a market movement. They
help determine whether a market rise or fall is broad-based or limited to a few stocks.
(a) Advance–Decline Line
Meaning: The advance–decline line shows the difference between the number of advancing stocks and
declining stocks in the market.
Interpretation:
 Rising A–D line indicates a strong bullish market
 Falling A–D line indicates a weak or bearish market
(b) Advance–Decline Ratio
Meaning: It is the ratio of advancing stocks to declining stocks.
Interpretation:
 High ratio indicates bullish sentiment
 Low ratio indicates bearish sentiment
2. Momentum Indicators
Meaning: Momentum indicators measure the speed and strength of price movement. They help identify
overbought and oversold conditions.
(a) Relative Strength Index (RSI)
Meaning: RSI measures the strength of recent price changes on a scale of 0 to 100.
Interpretation:
 RSI above 70 indicates overbought condition
 RSI below 30 indicates oversold condition
(b) Moving Average Convergence Divergence (MACD)
Meaning: MACD shows the relationship between two moving averages of prices.
Interpretation:
 MACD above signal line indicates bullish trend
 MACD below signal line indicates bearish trend
(c) Rate of Change (ROC)
Meaning: ROC measures the percentage change in price over a period of time.
Interpretation:
 Rising ROC shows strong momentum
 Falling ROC shows weak momentum
3. Volume Indicators
Meaning: Volume indicators analyse trading volume to confirm the strength of price movements.
(a) On-Balance Volume (OBV)
Meaning: OBV relates volume to price changes.
Interpretation:
 Rising OBV shows buying pressure
 Falling OBV shows selling pressure
(b) Volume Oscillator
Meaning: Compares short-term and long-term volume trends.
Interpretation:
 High volume confirms a strong trend
 Low volume indicates a weak trend
4. Sentiment Indicators
Meaning: Sentiment indicators measure the psychological attitude of investors toward the market.
(a) Put–Call Ratio
Meaning: It is the ratio of put options to call options traded.
Interpretation:
 High ratio indicates bearish sentiment
 Low ratio indicates bullish sentiment
(b) Volatility Index (VIX)
Meaning: VIX measures the expected volatility (price fluctuations) of the market.
Interpretation:
 High VIX indicates fear and uncertainty
 Low VIX indicates market confidence

Moving Average
Meaning of Moving Average
A Moving Average (MA) is the average price of a security over a specific period of time, which moves
forward as new price data is added. It reduces market noise and shows the overall trend of price movement.
It helps investors understand the trend direction by smoothing out short-term price fluctuations. Moving
averages are used to identify trends, generate buy and sell signals, and confirm trend reversals.
Types of Moving Averages
Moving averages are mainly classified into the following types:
1. Simple Moving Average (SMA)
Meaning
Simple Moving Average is calculated by adding the prices of a security over a certain period and dividing by
the number of periods.
Explanation
 All prices are given equal weight
 Easy to calculate and understand
 Responds slowly to sudden price changes
Example
If the closing prices of a stock for 5 days are ₹100, ₹102, ₹104, ₹106, ₹108 5-day. SMA = (100 + 102 + 104
+ 106 + 108) ÷ 5 = ₹104
2. Weighted Moving Average (WMA)
Meaning
Weighted Moving Average assigns more importance to recent prices and less importance to older prices.
Explanation
 Recent prices influence the average more
 Reacts faster than SMA
 Reduces lag in trend detection
Example
In a 5-day WMA, the most recent day may be given the highest weight, such as 5, while the oldest day is
given weight 1.
3. Exponential Moving Average (EMA)
Meaning
Exponential Moving Average gives more weight to recent prices using a mathematical formula, making it
more responsive to price changes.
Explanation
 Reacts faster than SMA and WMA
 Widely used by traders
  Suitable for short-term analysis
Uses of Moving Average
1. Trend Identification
 Price above moving average → Uptrend
 Price below moving average → Downtrend
2. Buy and Sell Signals
 Buy signal when price crosses above moving average
 Sell signal when price crosses below moving average
3. Moving Average Crossover
 Short-term MA crossing above long-term MA → Bullish signal
 Short-term MA crossing below long-term MA → Bearish signal

Exponential moving Average Oscillators

Meaning of Exponential Moving Average (EMA)
An Exponential Moving Average (EMA) is a type of moving average that gives greater weight to recent
prices compared to older prices. As a result, EMA reacts faster to price changes than a simple moving
average.
Meaning of Oscillator
An oscillator is a technical indicator that moves within a fixed range and helps identify overbought and
oversold conditions in the market.
Meaning of Exponential Moving Average Oscillator
An Exponential Moving Average Oscillator measures the difference between two EMAs of different time
periods. It shows whether short-term price momentum is stronger or weaker than long-term momentum.
Types of Exponential Moving Average Oscillators
The most commonly used EMA-based oscillators are:
1. Moving Average Convergence Divergence (MACD)
2. EMA Oscillator
1. Moving Average Convergence Divergence (MACD)
Meaning: MACD is a popular EMA-based oscillator that shows the relationship between two exponential
moving averages of prices.
Construction of MACD
 MACD Line = Difference between short-term EMA and long-term EMA
 Signal Line = EMA of the MACD line
 Histogram = Difference between MACD line and signal line
Interpretation of MACD
 MACD above signal line → Bullish signal
 MACD below signal line → Bearish signal
 MACD crossing zero line → Trend change signal
Example
If short-term EMA rises faster than long-term EMA, MACD becomes positive, indicating upward
momentum.
2. EMA Oscillator
Meaning
EMA Oscillator measures the difference between two exponential moving averages plotted as a line or
histogram.
Interpretation
 Positive value → Short-term EMA above long-term EMA (bullish)
 Negative value → Short-term EMA below long-term EMA (bearish)
 Rising oscillator → Strengthening trend
 Falling oscillator → Weakening trend
Buy and Sell Signals Using EMA Oscillators
Buy Signal
 Short-term EMA crosses above long-term EMA
 Oscillator moves from negative to positive
 Confirmed by rising volume
Sell Signal
 Short-term EMA crosses below long-term EMA
 Oscillator moves from positive to negative
 Confirmed by falling prices

Relative Strength Index (RSI)

Meaning:
The Relative Strength Index (RSI) is a momentum oscillator that measures the speed and magnitude of price
movements of a stock or market index. It helps investors understand whether a stock is overbought (too
much buying) or oversold (too much selling), which can indicate potential reversals in price trends.
Scale:
RSI values range from 0 to 100.
 0 means extremely weak momentum (oversold)
  100 means extremely strong momentum (overbought)
Interpretation
RSI > 70 → Overbought → Possible price decline
RSI < 30 → Oversold → Possible price rise
RSI around 50 → Neutral trend

Rate of Change (ROC)

Meaning:
The Rate of Change (ROC) is a momentum indicator that measures the percentage change in a stock’s price
over a specific period. It helps investors understand how fast the price is moving and the strength of the
current trend.
In simple words:
ROC tells you whether a stock is gaining or losing momentum and can hint at potential trend reversals.
Formula:
Current Price – Price as periods ago
��� = × 100
Price n periods ago

Where:
 Current Price = Price today
 Price as periods ago = Price at the start of the period (e.g., 10 days ago)
 n = Number of periods
Interpretation
 Positive ROC → Upward momentum
 Negative ROC → Downward momentum
 Sudden spike or drop → Possible trend reversal
Example
Stock rises from ₹100 to ₹120 in 10 days:
120 − 100
��� = × 100 = 20% (strong momentum)
100

Moving Average Convergence Divergence (MACD)

Meaning
MACD is a trend-following momentum indicator that shows the relationship between two exponential
moving averages (EMAs) of price.
Components
1. MACD Line – Difference between short-term EMA and long-term EMA
2. Signal Line – EMA of MACD line
 3. Histogram – Difference between MACD line and signal line
Interpretation
 MACD Line crosses above Signal Line → Bullish signal (buy)
 MACD Line crosses below Signal Line → Bearish signal (sell)
 MACD crosses zero line → Trend reversal
Example
If MACD line rises above signal line while price is trending upward, it confirms strong buying momentum.
Uses
 Confirm trend direction
 Generate buy/sell signals
 Measure momentum

Efficient Market Theory (EMT)

Introduction
The Efficient Market Theory (EMT), also called the Efficient Market Hypothesis (EMH), is a financial
theory which states that financial markets are efficient and that security prices fully reflect all available
information at any given time.
 Developed by Eugene F. Fama (1965)
 Suggests that it is impossible to consistently beat the market through either technical analysis or
fundamental analysis
Meaning
Efficient Market Theory implies:
 Prices of securities always incorporate all available information
 Any new information is quickly reflected in the security price
 No investor can consistently achieve abnormal returns without taking extra risk
Features of Efficient Market Theory
1. Information Efficiency: Prices reflect all available information.
2. Random Price Movement: Prices change randomly as new information arrives.
3. No Arbitrage Opportunities: Investors cannot earn abnormal profits consistently.
4. Rational Investors: Investors act rationally, using information to make decisions.
Forms of Market Efficiency
Market efficiency refers to the extent to which security prices reflect all available information. Based on the
type of information incorporated, market efficiency is classified into three forms:
1. Weak Form Efficiency
Meaning
 In weak form, security prices reflect all past market data such as historical prices, volumes, and
trends.
 Prices do not reflect new public or private information.
Implication
 Technical analysis (studying past prices to predict future prices) cannot consistently generate excess
returns.
 Investors cannot beat the market by studying historical data alone.
Example

 A stock that has been rising steadily cannot be predicted to continue rising just based on its past price
pattern.
2. Semi-Strong Form Efficiency
Meaning
 In semi-strong form, prices reflect all publicly available information, including:
o Financial statements
o News releases

o Economic and industry data

Implication
 Fundamental analysis cannot consistently generate abnormal profits, because all public information
is already reflected in prices.
 Only new information can change prices, and it is instantaneously incorporated.
Example
 If a company announces higher-than-expected profits, the stock price adjusts immediately. An
investor cannot buy before the adjustment to earn extra profit.
3. Strong Form Efficiency
Meaning
 In strong form, prices reflect all information, including public and private (insider) information.
Implication
 Even insiders with confidential information cannot consistently earn abnormal returns.
 Markets are perfectly efficient, and no one can gain an advantage.
Example
 Insider knowledge of a company’s merger does not guarantee profit because the market price already
reflects this information.
Form of Information Can Technical Can Fundamental Example
Efficiency Reflected Analysis Work? Analysis Work?

Weak Form Past price & No Yes Stock trends based on

volume past prices

Semi-Strong All public info No No Price adjusts

Form immediately to news

Strong Form All public + No No Insider info cannot

private info generate abnormal profit

Empirical Tests of Market Efficiency

Empirical tests are practical studies conducted to check if markets are efficient in reflecting information in
security prices. These tests examine whether investors can earn abnormal profits consistently.
Types of Empirical Tests
1. Tests of Weak Form Efficiency
 Purpose: To check if past price and volume data can predict future prices.
 Methods:
o Serial correlation test – checks if returns are correlated with past returns
o Run test – checks randomness of price changes
 Finding:
o If prices follow a random walk, past price data cannot predict future prices
 Example: Stock prices moving randomly despite past trends

2. Tests of Semi-Strong Form Efficiency

 Purpose: To check if publicly available information is quickly reflected in stock prices
 Methods:
o Event studies – examine market reaction to announcements (earnings, dividends, mergers)
 Finding:
o Prices adjust immediately to new public information, leaving no room for abnormal profit
 Example: Stock price rises instantly after better-than-expected quarterly results
3. Tests of Strong Form Efficiency
 Purpose: To check if all information, including insider information, is reflected in prices
 Methods:
o Comparing returns of insiders vs. average investors
 Finding:
 o Insider trading often generates abnormal returns, suggesting strong form efficiency may not
hold fully
 Example: Executives trading before merger announcements and earning profits
Applications of Market Efficiency
1. Investment Strategy

o In efficient markets, passive investing (e.g., index funds) is preferred

o Active stock picking provides no consistent advantage

2. Portfolio Management
o Efficient market assumption helps in diversification to reduce risk
o Focus shifts from selecting individual stocks to asset allocation
3. Pricing of Securities
o Security prices are considered fair and reflective of all available information
o Helps investors avoid overpaying
4. Risk Assessment

o Efficient market theory implies returns are based on risk, not arbitrage opportunities

o Investors are rewarded for taking extra risk

5. Policy and Regulation
o Regulators can monitor market transparency
o Ensures fair and timely dissemination of information

UNIT V PORTFOLIO ANALYSIS

Portfolio Analysis
Meaning of Portfolio Analysis
 Portfolio Analysis is the process of evaluating and managing a collection of investments (portfolio)
to achieve specific financial objectives.
 It involves examining risk, return, and the diversification of assets in the portfolio.
 Aim: To maximize returns while minimizing risk through optimal asset allocation.
Objectives of Portfolio Analysis
1. Risk Management – Identify and control the level of risk in the portfolio.
2. Return Optimization – Maximize expected returns relative to the investor’s risk tolerance.
3. Diversification – Reduce unsystematic risk by investing across different assets or sectors.
4. Performance Evaluation – Assess whether the portfolio meets investment goals.
5. Resource Allocation – Decide how to distribute funds among different securities effectively.
Steps in Portfolio Analysis
1. Setting Investment Objectives

o Determine the investor’s risk tolerance, time horizon, and financial goals.
2. Selection of Securities
o Choose securities (stocks, bonds, mutual funds) that match the investment objectives.
3. Portfolio Construction
o Combine different securities to form a portfolio considering risk-return trade-off.
4. Risk and Return Analysis
o Calculate expected returns and measure risk (standard deviation, beta, etc.).
5. Portfolio Optimization
o Use techniques like Markowitz’s Mean-Variance Optimization to select an optimal portfolio.
6. Performance Evaluation

o Evaluate portfolio performance using measures like Sharpe Ratio, Treynor Ratio, Jensen’s
Alpha.
7. Portfolio Revision

o Periodically review and adjust the portfolio in response to market changes or changes in
investor objectives.
Techniques of Portfolio Analysis
1. Single-Index Model
 This model analyzes how a security’s returns move in relation to a market index (like NIFTY or S&P
500).
 Helps investors estimate expected return and risk efficiently without analyzing every correlation
between individual stocks.
 Simple Example: If a stock moves closely with NIFTY, its performance can be predicted using
NIFTY’s movement.
2. Markowitz Portfolio Theory (Modern Portfolio Theory)
 Focuses on diversification to reduce risk for a given level of expected return.
 Uses expected returns, variance, and covariance of assets to build an optimal portfolio.
 Key Idea: Don’t put all eggs in one basket; combining low-correlated assets reduces overall portfolio
risk.
 Example: Combining stocks from IT, Pharma, and FMCG sectors to lower risk.

3. Capital Asset Pricing Model (CAPM)

  Determines the expected return of a security based on its systematic risk (beta) and the overall
market return.
 Helps investors choose securities that are consistent with their risk-return preferences.
 Key Formula:
Expected Return = �� + �(�� − �� )

Where �� = risk-free rate, �= stock’s beta, �� = market return.

 Example: A stock with beta 1.2 is more volatile than the market, so CAPM will suggest a higher
expected return to compensate for risk.
4. Risk-Return Analysis
 Measures the portfolio’s risk (using standard deviation or variance) and its expected return.

 Helps assess whether the portfolio matches the investor’s risk tolerance and investment goals.
 Example: A portfolio with 15% expected return and 10% standard deviation is riskier than one with
12% return and 5% deviation; investors choose according to their risk appetite.
Example of Portfolio Analysis
 Investor Goal: Moderate risk, 12% expected return.
 Portfolio Construction:

o 50% in large-cap stocks

o 30% in government bonds
o 20% in mutual funds
 Analysis:
o Expected Portfolio Return = Weighted Average of Individual Returns
o Portfolio Risk = Combined Standard Deviation Considering Diversification

Portfolio Selection
Meaning of Portfolio Selection
 Portfolio Selection is the process of choosing the best combination of assets to achieve the investor’s
desired balance of risk and return.
 It involves selecting securities that maximize expected return for a given level of risk or minimize
risk for a given level of return.
Objectives of Portfolio Selection
1. Maximize Returns – Achieve the highest possible return for a given level of risk.
2. Minimize Risk – Reduce exposure to unsystematic and systematic risks through diversification.
3. Optimal Asset Allocation – Determine the proportion of funds to invest in different securities.
 4. Align with Investor Goals – Ensure that the portfolio meets the investor’s financial objectives and
risk tolerance.
Principles of Portfolio Selection
1. Risk-Return Trade-Off
o Higher returns are usually associated with higher risk.

o Portfolio selection aims to find an optimal balance.

2. Diversification
o Spread investments across different securities, sectors, or asset classes to reduce unsystematic
risk.
3. Expected Return Analysis

o Estimate the return of each security and the overall portfolio.

4. Risk Analysis
o Measure portfolio risk using variance, standard deviation, or beta.
5. Correlation of Assets

o Combine assets with low or negative correlation to reduce portfolio risk.

Portfolio Selection Process
1. Determine Investment Objectives
o Identify investor’s risk appetite, time horizon, and expected returns.
2. Analyze Investment Alternatives
o Evaluate individual securities based on historical returns, risk, and other financial metrics.
3. Construct Feasible Set of Portfolios
o Use combinations of securities to create a set of portfolios with different risk-return
characteristics.
4. Identify Efficient Portfolio
o Use Mean-Variance Optimization to select portfolios that lie on the efficient frontier.
5. Select Optimal Portfolio

o Choose the portfolio that matches the investor’s indifference curve, balancing risk and return.
Models Used in Portfolio Selection
1. Markowitz Portfolio Theory
2. Markowitz Portfolio Theory (Modern Portfolio Theory)
3. Capital Asset Pricing Model (CAPM)

Capital Asset Pricing Model (CAPM)

Meaning of CAPM
  CAPM is a financial model used to determine the expected return on an asset based on its risk
relative to the market.
 It links systematic risk (market risk) with expected return, helping investors in portfolio selection.
 Developed by William Sharpe and John Lintner in the 1960s.
Assumptions of CAPM
1. Investors are risk-averse and aim to maximize returns for a given level of risk.
2. All investors have the same expectations regarding asset returns, risk, and correlations.
3. Markets are perfectly competitive – no taxes, transaction costs, or restrictions on short-selling.
4. Investors can lend and borrow at a risk-free rate.
5. The market portfolio contains all risky assets in proportion to their market value.
CAPM Formula
Expected Return of Asset (E(Ri)) = �� + �� (�� − �� )

Where:
 (E(R_i)) = Expected return on the asset
 (R_f) = Risk-free rate of return
 (R_m) = Expected return of the market portfolio
 (\beta_i) = Beta of the asset (measure of systematic risk)
 (R_m - R_f) = Market risk premium
Beta (β)
 Definition: Beta measures the sensitivity of an asset’s returns to the overall market returns.
 Interpretation:

o β = 1 → Asset moves in line with the market.

o β > 1 → Asset is more volatile than the market.

o β < 1 → Asset is less volatile than the market.
o β = 0 → Asset has no correlation with the market (risk-free).
Uses of CAPM
1. Estimate Expected Return
o Helps investors know the return required for the risk taken.
2. Portfolio Selection
o Identifies assets that fit within the efficient frontier.
3. Performance Evaluation

o Compare actual returns with CAPM-predicted returns to evaluate portfolio performance.

 4. Cost of Equity
o Firms use CAPM to calculate the cost of equity for capital budgeting.
Advantages of CAPM
 Simple and widely used for risk-return analysis.
 Provides a quantitative measure for expected return.
 Helps in comparing assets based on systematic risk.
Example of CAPM Calculation
 Given:
o Risk-free rate (Rf) = 5%
o Expected market return (Rm) = 12%
o Asset beta (β) = 1.2
 Expected Return (E(Ri))

�(��) = 5% + 1.2(12% − 5%) = 5% + 1.2(7%) = 5% + 8.4% = 13.4%

 Interpretation: Investor should expect a 13.4% return for the risk level of this asset.

Arbitrage Pricing Theory (APT)

Meaning of Arbitrage Pricing Theory
 APT is a multi-factor model used to determine the expected return of an asset based on various
macroeconomic factors.
 Unlike CAPM, which considers only market risk, APT considers multiple sources of systematic risk
affecting an asset’s return.
 Developed by Stephen Ross in 1976.
Key Assumptions of APT
1. Investors are risk-averse and prefer higher returns for given risk levels.
2. Returns are influenced by multiple macroeconomic factors (e.g., inflation, interest rates, GDP
growth).
3. There is no arbitrage opportunity – prices adjust to eliminate risk-free profits.
4. The model works in well-diversified portfolios, where unsystematic risk is negligible.
APT Formula

�(�� ) = �� + �1 �1 + �2 �2 + ⋯ + �� ��

Where:

 �(�� )= Expected return of the asset

  �� = Risk-free rate

 �1 , �2 , …, �� = Risk premiums of different macroeconomic factors

 �1 , �2 , …, �� = Sensitivity of the asset to each factor (factor loadings)

Steps in Applying APT

1. Identify Relevant Factors

o Choose macroeconomic variables that influence asset returns.

o Common factors: interest rate changes, inflation, industrial production, exchange rates.
2. Estimate Factor Sensitivities
o Determine how sensitive the asset is to each factor (b1, b2, …, bn).
3. Determine Factor Risk Premiums
o Measure the expected return associated with each factor.
4. Calculate Expected Return
o Use the APT formula to compute the expected return.
5. Construct Portfolio

o Combine assets to achieve desired risk-return balance while considering factor exposures.
Differences Between CAPM and APT

Feature CAPM APT

Risk Factors Single factor (market risk) Multiple macroeconomic factors

Assumptions Strict assumptions (perfect market, single- Flexible assumptions, works with multiple
period) factors

Feature CAPM APT

Focus Systematic risk via beta Systematic risk via factor sensitivities

Practical Simple and widely used More realistic, useful for diversified
Use portfolios

Example of APT
 Assume:

o Risk-free rate (Rf) = 4%

o Factor 1 (Interest Rate Risk) = 3%, factor loading (b1) = 0.5

o Factor 2 (Inflation Risk) = 2%, factor loading (b2) = 1.2
 Expected Return (E(Ri))

�(��) = 4% + 0.5(3%) + 1.2(2%) = 4% + 1.5% + 2.4% = 7.9%

 Interpretation: The asset is expected to yield 7.9% considering exposure to multiple risk factors.
Portfolio Revision
Meaning of Portfolio Revision
 Portfolio Revision is the process of reviewing and adjusting an existing investment portfolio to
maintain the desired risk-return balance.
 Purpose: To ensure that the portfolio continues to meet the investor’s objectives in response to
market changes or changes in investor needs.
Objectives of Portfolio Revision
1. Maintain Desired Risk-Return Ratio
o Adjust the portfolio to align with the investor’s risk tolerance and expected return.
2. Profit Booking

o Sell securities that have appreciated significantly to realize gains.

3. Loss Minimization
o Reduce holdings in underperforming securities to limit losses.
4. Rebalancing
o Correct deviations from the target asset allocation due to price movements.
5. Take Advantage of Market Opportunities

o Invest in undervalued securities or emerging sectors.

Need for Portfolio Revision
 Market conditions are dynamic, and asset prices fluctuate.
 Investor’s financial goals or risk profile may change over time.
 To maintain diversification and avoid overexposure to a single asset or sector.
 To respond to new investment opportunities or regulatory changes.
Methods of Portfolio Revision
Portfolio revision is the process of modifying a portfolio to maintain the desired level of risk and return or to
respond to changing market conditions. It ensures that the portfolio remains aligned with the investor’s
objectives over time.
1. Active Revision (Rebalancing)
Meaning:
Active revision involves frequent monitoring and adjustment of the portfolio to maximize returns or
minimize risk. Investors actively buy or sell securities based on their performance, market conditions, or
changes in valuation.
Key Points:
 Focuses on optimizing returns.
 Involves selling overvalued securities and buying undervalued securities.
  Requires regular market analysis and review.
Example:
 An investor holds Stock A and Stock B.
 Stock A rises sharply and becomes overvalued, while Stock B falls below its intrinsic value.
 The investor sells part of Stock A and buys more of Stock B to rebalance the portfolio.
2. Passive Revision (Buy and Hold)
Meaning:
Passive revision is a long-term investment strategy where the investor holds securities with minimal changes.
Adjustments are made only if there are major changes in investment objectives or fundamentals.
Key Points:

 Focuses on long-term growth.

 Less frequent trading, mainly for portfolio maintenance.
 Reduces transaction costs and avoids market timing risks.
Example:
 An investor buys shares of a well-diversified index fund.
 They hold the fund for 5–10 years, making changes only if their risk tolerance or financial goals
change
Techniques of Portfolio Revision
Portfolio revision techniques are methods used by investors to adjust their portfolios to maintain desired
risk-return balance or to take advantage of market conditions. These techniques are broadly divided into
Formula Plans and Opportunistic Revision
1. Formula Plans
Formula plans use pre-determined rules or formulas to decide how much to buy or sell in a portfolio.
a) Constant Ratio Plan (CRP)
 Meaning: Maintain a fixed proportion between risky assets (like stocks) and risk-free assets (like
bonds).
 Action: Adjust the portfolio by selling or buying assets to restore the target ratio whenever market
prices change.
 Example:
o Target ratio: 60% stocks, 40% bonds
o Due to a stock market rise, stocks now form 70% of the portfolio
o Investor sells some stocks and buys bonds to restore 60:40 ratio
b) Variable Ratio Plan (VRP)
 Meaning: The ratio of risky and risk-free assets varies based on market conditions.
  Advantage: Offers more flexibility than CRP, allowing investors to take advantage of market trends.
 Example:

o Market is bullish → increase proportion of stocks

o Market is bearish → increase proportion of bonds

o Helps capitalize on rising markets and protect during downturns
c) Constant Dollar Plan (CDP)
 Meaning: Invest a fixed amount of money regularly in securities, regardless of market price.
 Advantage: Encourages discipline and cost averaging.
 Example:
o Investor decides to invest ₹10,000 every month in a stock
o When prices are high → buys fewer shares

o When prices are low → buys more shares

o Reduces the impact of market volatility

2. Opportunistic Revision
 Meaning: Make portfolio revisions based on market trends or special opportunities rather than fixed
rules.
 Example:
o A sudden dip in a fundamentally strong stock presents a buying opportunity
o Investor revises the portfolio by purchasing that stock
o Similarly, if a sector shows signs of slowing growth, investor may sell overvalued assets
Summary Table

Technique Meaning Example

Constant Ratio Plan Maintain fixed risky:risk-free Adjust 60:40 stocks-bonds to restore ratio after
(CRP) ratio market moves

Variable Ratio Plan Adjust ratio based on market Increase stocks in bull market, bonds in bear
(VRP) conditions market

Constant Dollar Plan Invest fixed amount regularly ₹10,000/month investment, buy more when
(CDP) price falls

Opportunistic Revision Adjust based on market Buy undervalued stock after market dip
opportunities

Portfolio Evaluation
Meaning of Portfolio Evaluation
  Portfolio Evaluation is the process of assessing a portfolio’s performance to determine if it meets the
investor’s financial objectives.
 Focuses on returns, risk, and risk-adjusted performance compared to benchmarks.
Objectives
1. Assess whether the portfolio achieves the expected return.
2. Measure the risk taken to achieve that return.
3. Compare the portfolio with a benchmark index or similar portfolios.
4. Identify underperforming assets for portfolio revision.
5. Ensure alignment with investor’s goals and risk appetite.

Risk-Adjusted Performance Measures

1. Sharpe Index (Sharpe Ratio)
 Purpose: Measures how much extra return the portfolio gives per unit of total risk.
 Risk considered: Total risk (standard deviation), which includes both market (systematic) and
individual (unsystematic) risks.
 Formula:
�� − ��
�=
��

Where:

Rp = Portfolio return

�� = Risk-free rate (e.g., return on government bonds)

�� = Standard deviation of portfolio returns (total risk)

 Explanation:
o (R_p - R_f) = The excess return over a risk-free investment.

o (\sigma_p) = Total risk of the portfolio.

o Sharpe tells you how efficiently the portfolio converts risk into return.
 Example:
o Portfolio return = 12%, Risk-free rate = 5%, Standard deviation = 8%
o Sharpe Ratio = ((12 - 5)/8 = 0.875)
o Interpretation: For each unit of total risk, the portfolio earns 0.875% of return.
 Use: Good for comparing portfolios regardless of how diversified they are.
2. Treynor Index (Treynor Ratio)
 Purpose: Measures portfolio performance per unit of market risk (systematic risk).
 Risk considered: Beta ((\beta_p)), which measures sensitivity to market movements.
 Formula:
�� − ��
�=
��

Where:

�� = Portfolio return

�� = Risk-free rate

�� = Portfolio beta

 Explanation:

o Focuses on risk that cannot be diversified away.

o Useful for well-diversified portfolios, where unsystematic risk is minimal.

 Example:
o Portfolio return = 12%, Risk-free rate = 5%, Beta = 1.2
o Treynor Ratio = ((12 - 5)/1.2 = 5.83%)
o Interpretation: The portfolio earns 5.83% for each unit of market risk taken.
 Use: Helps compare diversified portfolios based on their market-related performance.
3. Jensen’s Index (Jensen’s Alpha)
 Purpose: Measures portfolio performance relative to what CAPM predicts.
 Risk considered: Systematic risk (beta) only.
 Formula:

� = �� − [�� + �� (�� − �� )]

Where:
�� = Portfolio return

�� = Risk-free rate

�� = Portfolio beta

�� = Market return

 Explanation:
o (R_f + \beta_p(R_m - R_f)) = Expected return according to CAPM.
o (\alpha) = Extra return achieved by the portfolio manager over what CAPM predicts.

o Positive α → Manager added value; Negative α → Manager underperformed.

  Example:
o Portfolio return = 12%, Risk-free rate = 5%, Beta = 1.1, Market return = 10%

o Expected CAPM return = (5 + 1.1(10 - 5) = 10.5%)

o Alpha = (12 - 10.5 = 1.5%)

o Interpretation: Portfolio outperformed the expected return by 1.5%.
 Use: Measures the effectiveness of the portfolio manager in adding value.
Key Differences Between the Three

Measure Risk When to Use Interpretation

Considered

Sharpe Total risk (σ) Any portfolio How well the portfolio converts total risk into return
Ratio

Treynor Market risk (β) Well-diversified How well the portfolio converts market risk into
Ratio portfolios return

Jensen’s Market risk (β) Well-diversified Portfolio performance relative to CAPM expectations
Alpha portfolios (manager’s value addition)

 Sharpe = Risk-adjusted return per total risk.

 Treynor = Risk-adjusted return per market risk.
 Jensen = Extra return over CAPM prediction (manager skill).

Mutual Funds
Meaning of Mutual Funds
 A mutual fund is a financial institution that collects money from investors and invests it in a
diversified portfolio of stocks, bonds, and other securities.
 Investors receive units representing their share in the fund.
 Managed by professional fund managers to achieve specific investment objectives.
Features of Mutual Funds
1. Diversification – Investment spread across multiple securities to reduce risk.
2. Professional Management – Managed by trained fund managers.
3. Liquidity – Units can be bought or sold at Net Asset Value (NAV).
4. Affordability – Allows small investors to invest in large portfolios.
5. Transparency – Regular disclosure of holdings and performance.
Objectives of Mutual Funds
 Wealth Creation – Long-term growth of capital.
 Income Generation – Regular income through dividends or interest.
  Capital Preservation – Protect principal investment with low-risk funds.
 Liquidity – Provide easy access to invested money.
Types of Mutual Funds