Meaning of Investment:

Investment is the act of putting money into assets with the expectation of earning returns in
the future. It involves sacrificing current consumption to gain benefits later, such as income,
profit, or capital appreciation.

Nature of Investment:

1. Sacrifice of Present Income: When you invest, you give up spending money now.

2. Expectation of Returns: The main purpose is to earn income or profit in the future.

3. Risk Involved: Returns are not guaranteed; there is always some uncertainty.

4. Time Element: Investment is for a specific period, short-term or long-term.

5. Creation of Wealth: Investment aims to increase wealth over time.

Scope of Investment:

1. Financial Assets: Investments in shares, bonds, debentures, mutual funds, etc.

2. Real Assets: Investment in physical assets like land, gold, real estate, or machinery.

3. Short-term vs Long-term: Can be made for immediate gains (short-term) or future

growth (long-term).

4. Portfolio Management: Helps in planning, selecting, and managing different

investments to reduce risk and increase returns

Capital Market – Overview

Meaning:
The capital market is a financial market where long-term funds (more than 1 year) are raised
and traded. It helps companies, government, and institutions to raise money for investment in
productive assets.

Components:

1. Primary Market:

o Also called the “New Issue Market.”

o Companies raise fresh capital by issuing shares, debentures, or bonds.

o Example: IPO (Initial Public Offering).

 2. Secondary Market:

o Also called the “Stock Market.”

o Existing securities are traded among investors.

o Provides liquidity and marketability of securities.

o Example: NSE, BSE.

Functions of Capital Market:

1. Mobilization of Savings: Channels savings of individuals into productive

investments.

2. Facilitates Investment: Provides funds for business expansion and economic growth.

3. Liquidity to Investors: Investors can buy and sell securities easily.

4. Price Determination: Helps in fixing fair prices of securities through demand and
supply.

5. Risk Reduction: Diversification and market efficiency reduce investment risk.

Importance:

 Supports industrial growth and infrastructure development.

 Encourages public participation in corporate development.

 Strengthens overall economy by efficient allocation of resources.

Market of Securities

Meaning:
The market of securities is a platform where financial instruments like shares, bonds,
debentures, and other securities are issued and traded. It enables companies to raise funds
and provides investors an opportunity to earn returns.

Types of Securities Market:

1. Primary Market (New Issue Market):

o Companies issue new securities to raise capital.

o Investors purchase securities directly from the company.

 o Helps in capital formation.

o Example: IPO (Initial Public Offering).

2. Secondary Market (Stock Market):

o Existing securities are traded among investors.

o Provides liquidity and price discovery.

o Examples: NSE, BSE.

Features:

 Facilitates raising of long-term funds.

 Provides investment opportunities to investors.

 Ensures safety and liquidity of investments.

 Helps in determining fair prices of securities.

Importance:

 Promotes economic growth by mobilizing savings.

 Encourages entrepreneurship by providing funds.

 Allows investors to earn returns through dividends, interest, or capital gains.

Stock Exchange and New Issue Market

1. Stock Exchange

Meaning:
A stock exchange is a regulated market where existing securities like shares and bonds are
bought and sold. It provides liquidity to investors and helps in price discovery.

Nature:

 Deals in existing securities.

 Acts as a secondary market.

 Ensures safe and fair trading.

Structure:
 1. Members/Brokers: Registered brokers who trade on behalf of clients.

2. Listed Companies: Companies whose shares are allowed to be traded.

3. Regulatory Authorities: SEBI in India supervises stock exchanges.

Functioning:

 Securities are bought and sold through brokers.

 Prices are determined by demand and supply.

 Provides liquidity, safety, and transparency to investors.

Limitations:

 Market can be volatile.

 Risk of manipulation or speculation.

 Requires good knowledge to invest wisely.

2. New Issue Market (Primary Market)

Meaning:
The New Issue Market (NIM) is a market where companies issue new securities to the
public to raise funds.

Nature:

 Deals in newly issued securities.

 Capital is received directly by the company.

 Helps in capital formation and business growth.

Structure:

1. Issuer: Company issuing shares or bonds.

2. Investors: Individuals, institutions, or banks subscribing to the issue.

3. Intermediaries: Merchant bankers, underwriters, and brokers.

Functioning:

 Company announces the issue via prospectus.

  Investors apply and subscribe to shares.

 Funds collected go to the company for business use.

Limitations:

 Risk of capital loss if company fails.

 Requires investor knowledge to choose profitable issues.

 Subscription may be time-consuming and formal.

Trading of Securities: Equity and Debentures/Bonds

Meaning:
Trading of securities involves buying and selling financial instruments like equity shares and
debentures/bonds in the stock market. It provides liquidity, safety, and price discovery to
investors.

1. Trading of Equity (Shares)

Nature:

 Represents ownership in a company.

 Returns are dividends and capital gains.

 Prices are market-driven.

Trading Mechanism:

 Primary Market: Shares issued to investors for the first time via IPOs.

 Secondary Market: Existing shares are traded among investors through stock
exchanges (e.g., NSE, BSE).

 Trading is done through brokers or electronic platforms.

Features:

 High risk, but potential high returns.

 Investors have voting rights in the company.

 Provides market liquidity.

2. Trading of Debentures / Bonds

Nature:

 Represents loan/credit to the company or government.

 Returns are fixed interest (coupon).

 Lower risk compared to equity.

Trading Mechanism:

 Primary Market: Debentures issued to raise long-term funds.

 Secondary Market: Debentures/bonds can be traded among investors, either on stock

exchanges or OTC markets.

Features:

 Fixed income, safer than equity.

 No voting rights or ownership.

 Can be convertible or non-convertible.

Comparison of Trading: Equity vs Debentures

Feature Equity Debentures / Bonds

Nature Ownership Debt / Loan

Returns Dividend + Capital Gains Fixed Interest

Risk High Low to Moderate

Voting Rights Yes No

Market Primary & Secondary Primary & Secondary

Securities Trading – Types of Orders

Meaning:
In securities trading, an order is an instruction given by an investor to buy or sell a security
through a broker.

Types of Orders:
 1. Market Order:

o Buy or sell immediately at the current market price.

o Quick execution but price may fluctuate.

2. Limit Order:

o Buy or sell at a specified price or better.

o Execution happens only if price reaches the limit.

3. Stop Loss Order:

o Order to sell a security if price falls to a specific level.

o Helps limit losses.

4. Stop Buy Order:

o Order to buy a security if price rises to a specific level.

o Used to enter the market at upward trends.

5. Good Till Cancelled (GTC) Order:

o Valid until executed or cancelled by the investor.

o Useful for long-term target price.

Margin Trading

Meaning:
Margin trading allows investors to buy more securities than they can afford by borrowing
a portion of the funds from the broker.

Features:

 Investor pays a part of the amount (margin) and borrows the rest.

 Helps leverage investment, increasing potential profits.

 Also increases risk, as losses are magnified.

Example:

 If a share costs ₹100 and broker allows 50% margin:

 o Investor invests ₹50

o Broker lends ₹50

o Total investment = ₹100

Benefits:

 Can earn higher returns using borrowed funds.

 Helps enter larger positions in the market.

Limitations / Risks:

 Losses are amplified if prices fall.

 Interest must be paid on borrowed funds.

 Requires close monitoring of investments.

Clearing and Settlement Procedures

Clearing and settlement is the process of transferring securities and money between the
buyer and seller after a trade is executed in the stock market. It ensures that both parties
receive what they are entitled to safely and on time.

1. Clearing
Clearing is the process of matching buy and sell orders, calculating obligations, and
preparing for the transfer of securities and funds.

Functions of Clearing:

 Confirms trade details between buyer and seller.

 Netting of payments and securities to reduce the number of transactions.

 Risk management: ensures only valid trades are settled.

Clearing Agencies / Houses:

 Examples: NSCCL (National Securities Clearing Corporation Limited) in India.

 Acts as a guarantee between buyer and seller.

2. Settlement
Settlement is the actual exchange of securities and money between buyer and seller.
Methods of Settlement:

1. Delivery vs Payment (DvP): Securities are delivered only when payment is made.

2. T+2 or T+1 Settlement: Trade settlement occurs 2 days (T+2) or 1 day (T+1) after
trade date.

Types of Settlement:

 Physical Settlement: Transfer of physical share certificates and payment.

 Dematerialized / Electronic Settlement: Transfer of securities in electronic form

via NSDL or CDSL.

Importance of Clearing and Settlement:

 Ensures smooth and safe trading.

 Reduces default and settlement risk.

 Builds investor confidence in the market.

 Facilitates liquidity and efficiency in the capital market.

Regulatory Systems for Equity Markets

The regulatory system for equity markets refers to the rules, laws, and institutions that
govern the functioning of the stock market. Its main aim is to ensure fair trading, investor
protection, transparency, and market stability.

Objectives of Regulation:

 Protect investors’ interests

 Ensure fair and transparent trading

 Prevent fraud, manipulation, and insider trading

 Maintain confidence and efficiency in equity markets

Major Regulatory Authorities in Equity Markets (India):

1. SEBI (Securities and Exchange Board of India):

o Main regulator of the equity market.

o Frames rules for companies, brokers, and investors.

 o Controls IPOs, insider trading, and takeover activities.

2. Stock Exchanges (NSE & BSE):

o Ensure smooth and orderly trading.

o Monitor listed companies and brokers.

o Enforce listing and trading rules.

3. Depositories (NSDL & CDSL):

o Hold securities in dematerialized form.

o Ensure safe transfer and settlement of shares.

4. Clearing Corporations:

o Guarantee settlement of trades.

o Reduce counterparty risk.

Key Regulatory Measures:

 Listing requirements for companies

 Disclosure norms for financial information

 Surveillance systems to detect market manipulation

 Investor grievance redressal mechanisms

 Margin and risk management systems

Importance of Regulatory Systems:

 Builds trust among investors

 Promotes healthy market growth

 Reduces risk of financial scams and failures

 Ensures efficient capital formation

Types of Investors
 1. Retail Investors:
Retail investors are individual investors who invest small amounts of money in
shares, mutual funds, or bonds for personal savings and returns. They usually invest
for short or long-term goals and trade through brokers.

2. Institutional Investors:
Institutional investors are large organizations such as banks, insurance companies,
mutual funds, pension funds, and FIIs that invest large sums of money in the capital
market on behalf of others

Types of Investors

Investors are individuals or institutions that invest money in financial assets to earn returns.
Based on size, purpose, and nature, investors are classified as follows:

1. Retail Investors

 Individual investors investing small amounts.

 Invest in shares, mutual funds, bonds, etc.

 Aim for income, savings, or capital growth.

2. Institutional Investors

 Large organizations investing huge funds.

 Examples: Mutual funds, banks, insurance companies, pension funds, FIIs.

 Have professional management.

3. Individual Investors

 Invest their personal savings.

 Decisions based on risk and return preference.

4. Corporate Investors

 Companies investing surplus funds in financial securities.

 Aim to earn returns on excess cash.

5. Government Investors
  Government or public sector bodies investing for development and stability.

Types of Investors (On the Basis of Each)

1. On the Basis of Size of Investment

 Retail Investors: Invest small amounts; individual investors.

 Institutional Investors: Invest large funds; banks, mutual funds, insurance

companies, FIIs.

2. On the Basis of Risk Appetite

 Risk-averse Investors: Prefer safe investments with low risk (bonds, fixed deposits).

 Risk-seeking Investors: Willing to take high risk for high returns (equity shares).

 Moderate Investors: Balance between risk and return.

3. On the Basis of Investment Objective

 Income Investors: Focus on regular income (dividends, interest).

 Growth Investors: Aim for capital appreciation over time.

 Speculative Investors: Seek short-term gains from price fluctuations.

4. On the Basis of Investment Period

 Short-term Investors: Invest for a short duration (traders).

 Long-term Investors: Invest for long-term wealth creation.

5. On the Basis of Nature

 Individual Investors: Invest personal savings.

 Corporate Investors: Companies investing surplus funds.

 Government Investors: Government or public sector investments

Aim and Approaches of Security Analysis

Meaning of Security Analysis

Security analysis is the process of evaluating financial securities such as shares, bonds, and
debentures to determine their value, risk, and return before making investment decisions.
Aims of Security Analysis

1. To Estimate Fair Value

o To find out whether a security is overvalued or undervalued.

2. To Reduce Investment Risk

o Helps investors understand and manage risk factors.

3. To Maximize Returns

o Assists in selecting securities that offer best possible returns.

4. To Make Informed Investment Decisions

o Provides a scientific and systematic basis for investment.

5. To Assess Financial Strength of Company

o Evaluates profitability, stability, and growth potential.

6. To Plan Portfolio

o Helps in diversification and proper allocation of funds.

Approaches of Security Analysis

1. Fundamental Analysis

 Studies economic, industry, and company factors.

 Uses financial statements, ratios, earnings, and growth prospects.

 Suitable for long-term investors.

Example: Studying company profits, balance sheet, and industry position.

2. Technical Analysis

 Based on past price movements and trading volume.

 Uses charts and market trends.

 Suitable for short-term trading.

Example: Studying price charts to predict future movements.

3. Efficient Market Hypothesis (EMH)

 Belief that market prices reflect all available information.

 Difficult to consistently earn abnormal returns.

 Investors rely on market efficiency.

Factors Influencing Selection of Investment Alternatives

Investment alternatives refer to the different options available to an investor such as shares,
bonds, mutual funds, real estate, gold, etc. The choice of investment depends on several
factors.

1. Risk

 Risk is the possibility of loss.

 Investors select investments according to their risk-bearing capacity.

 Equity is high risk, while bonds and deposits are low risk.

2. Return

 Return is the income or profit earned from investment.

 Investors prefer alternatives that offer maximum return at acceptable risk.

3. Safety of Principal

 Safety means protection of the invested amount.

 Conservative investors prefer safe instruments like government bonds.

4. Liquidity

 Liquidity refers to how quickly an investment can be converted into cash.

 Shares and mutual funds are more liquid than real estate.

5. Time Period

 Investment choice depends on investment horizon.

 Long-term goals suit equity; short-term goals suit deposits.

6. Tax Benefits
  Some investments offer tax savings under income tax laws.

 Example: ELSS, PPF, tax-free bonds.

7. Inflation

 Inflation reduces purchasing power.

 Investors prefer investments that beat inflation, such as equities.

8. Investor’s Objectives

 Objectives may include income, growth, or capital appreciation.

 Investment is selected according to these goals.

9. Market Conditions

 Economic and market trends influence investment decisions.

 Bull and bear markets affect returns.

Fundamental Analysis – Overview of EIC Analysis Framework

Fundamental analysis is a method of evaluating securities by studying economic conditions,
industry performance, and company-specific factors. Its main purpose is to find out the
intrinsic (true) value of a security and compare it with the market price to make investment
decisions.

EIC Analysis Framework

Fundamental analysis is carried out in three stages known as the EIC framework:

1. Economic Analysis

Economic analysis studies the overall economic environment in which businesses operate.

Key Factors Studied:

 National income and GDP growth

 Inflation rate

 Interest rates

 Monetary and fiscal policies

 Business cycles (boom, recession, recovery)

Importance:
A strong economy supports business growth and higher corporate profits, while a weak
economy negatively affects investments.

2. Industry Analysis

Industry analysis evaluates the performance and future prospects of a particular industry.

Key Factors Studied:

 Nature of the industry (growth or declining)

 Demand and supply conditions

 Level of competition

 Government policies and regulations

 Technological changes
Importance:
Even a strong company may not perform well if the industry is weak.

3. Company Analysis

Company analysis focuses on the financial and operational strength of an individual

company.

Key Factors Studied:

 Financial statements (balance sheet, income statement)

 Profitability and growth

 Management efficiency

 Market share and competitive position

 Future expansion plans

Importance:
Helps investors identify financially strong and well-managed companies for investment.

Equity Valuation

Meaning

Equity valuation is the process of estimating the intrinsic (true) value of a company’s
equity shares. It helps investors decide whether a share is overvalued, undervalued, or
fairly priced in the market.

Objectives of Equity Valuation

 To determine the fair value of shares

 To support investment decisions (buy, hold, or sell)

 To reduce investment risk

 To maximize returns

Methods of Equity Valuation

1. Dividend Discount Model (DDM)

 Based on the present value of future dividends.

  Suitable for companies with stable dividend payments.

Formula:
Value of Share = D / (Ke – g)
Where:
D = Dividend per share
Ke = Cost of equity
g = Growth rate

2. Earnings Valuation / P-E Ratio Method

 Share value is estimated using earnings per share (EPS) and price-earnings ratio.

Formula:
Value of Share = EPS × P/E Ratio

3. Asset-Based Valuation

 Based on net assets of the company.

 Value = Total Assets – Total Liabilities

 Suitable for companies with large tangible assets.

4. Cash Flow Valuation

 Based on future cash flows discounted to present value.

 Focuses on the company’s cash-generating ability.

Factors Affecting Equity Valuation

 Company earnings and growth

 Dividend policy

 Risk and return expectations

 Economic and industry conditions

 Market sentiment

Equity Valuation Methods

Equity valuation helps in estimating the intrinsic value of a share and comparing it with the
market price to make investment decisions.
Dividend Discount Model (DDM)
Meaning:
DDM values a share based on the present value of future dividends expected from the
company.
Formula:
D
Value of Share=
K e −g
Where:
D = Dividend per share
Ke = Cost of equity
g = Growth rate of dividend
Use:
Best suited for companies with stable dividend payments.
2. Intrinsic Value and Market Price
 Intrinsic Value:
The true or real value of a share based on fundamentals.
 Market Price:
The price at which the share is currently traded in the market.
Investment Decision:
 Intrinsic Value > Market Price → Buy
 Intrinsic Value < Market Price → Sell
 Intrinsic Value = Market Price → Hold
3. Earnings Multiplier Approach
Meaning:
This method values shares based on company earnings and market expectations.
Formula:
Value of Share=EPS × Earnings Multiplier Where:
EPS = Earnings per share
Importance:
Simple and widely used for equity valuation.
4. P/E Ratio (Price–Earnings Ratio)
Meaning:
Shows how much investors are willing to pay for ₹1 of earnings.
Formula:
 Market Price per Share
P/E Ratio= Interpretation:
EPS
 High P/E → High growth expectations
 Low P/E → Undervalued or low growth
5. Price / Book Value Ratio (P/B Ratio)
Meaning:
Compares market price with book value of equity.
Formula:
Market Price per Share
P/B Ratio= Use:
Book Value per Share
Useful for asset-based companies like banks.
6. Price / Sales Ratio (P/S Ratio)
Meaning:
Measures share price relative to sales revenue.
Formula:
Market Price per Share
P/S Ratio= Use:
Sales per Share
Useful when companies have low or negative profits.

Dividend Discount Model (DDM)

Given:
Dividend per share (D) = ₹8
Cost of equity (Ke) = 14%
Growth rate (g) = 4%
Formula:
Value of Share = D / (Ke − g)
Solution:
= 8 / (0.14 − 0.04)
= 8 / 0.10
👉 Intrinsic Value = ₹80

2. Intrinsic Value vs Market Price

Given:
Intrinsic Value = ₹80
Market Price = ₹65
Decision:
Since Intrinsic Value > Market Price, the share is undervalued.
👉 Decision: BUY

3. Earnings Multiplier Approach

Given:
EPS = ₹12
Earnings Multiplier = 15
Formula:
Value of Share = EPS × Earnings Multiplier
Solution:
= 12 × 15
👉 Value of Share = ₹180

4. P/E Ratio
Given:
Market Price per share = ₹240
EPS = ₹12
Formula:
P/E Ratio = Market Price / EPS
Solution:
= 240 / 12
👉 P/E Ratio = 20 times

5. Price / Book Value Ratio (P/B Ratio)

Given:
Market Price per share = ₹150
Book Value per share = ₹100
Formula:
P/B Ratio = Market Price / Book Value
Solution:
= 150 / 100
👉 P/B Ratio = 1.5

6. Price / Sales Ratio (P/S Ratio)

Given:
Market Price per share = ₹120
Sales per share = ₹60
Formula:
P/S Ratio = Market Price / Sales per share
Solution:
= 120 / 60
👉 P/S Ratio = 2

Economic Value Added (EVA)

Meaning
Economic Value Added (EVA) is a measure of true economic profit earned by a company.
It shows whether a company is creating value or destroying value after covering the cost of
capital.
Formula of EVA
EVA=NOPAT−(Capital Employed × Cost of Capital)
Where:
 NOPAT = Net Operating Profit After Tax
 Capital Employed = Total funds invested in the business
 Cost of Capital = Weighted average cost of capital (WACC)
Interpretation
 EVA > 0 → Company is creating value
 EVA = 0 → Company is breaking even
 EVA < 0 → Company is destroying value
Numerical Example
Given:
NOPAT = ₹5,00,000
Capital Employed = ₹30,00,000
Cost of Capital = 12%
Step 1: Calculate Capital Charge
30 , 00,000 ×12 %=₹ 3 , 60,000
Step 2: Calculate EVA
EVA=5 , 00,000−3 ,60,000=₹1,40,000
Conclusion
Since EVA is positive, the company is creating economic value for shareholders.
Advantages of EVA
 Measures true profitability
 Considers cost of capital
 Useful for performance evaluation
 Helps in value-based management
Limitations of EVA
 Complex calculation
 Based on accounting data
 Difficult for small firms
Debentures / Bonds
Meaning
Debentures or bonds are long-term debt instruments issued by a company or government to
raise funds. Investors who buy debentures are lenders, not owners, and they receive fixed
interest on their investment.
Features / Nature
1. Fixed Income: Provide regular interest (coupon) payments.
2. No Ownership: Debenture holders are creditors, not shareholders.
3. Repayment of Principal: Issuer repays the face value at maturity.
4. Security: Can be secured (backed by assets) or unsecured (no collateral).
5. Convertibility: May be convertible into equity or non-convertible.
Types of Debentures/Bonds
1. Secured Debentures: Backed by company assets.
2. Unsecured / Naked Debentures: No collateral; higher risk.
3. Convertible Debentures: Can be converted into equity shares.
4. Non-Convertible Debentures: Cannot be converted; provide fixed interest.
5. Redeemable Debentures: Repaid at a fixed date.
 6. Irredeemable / Perpetual Debentures: No fixed maturity; interest paid forever.
Advantages for Investors
 Fixed and predictable income
 Safer than equity (especially secured debentures)
 Can be traded in secondary market for liquidity
Advantages for Issuer
 Raises long-term funds without giving up ownership
 Interest is tax-deductible
 Can attract different types of investors
Limitations / Risks
 Fixed interest must be paid even if company makes loss
 Unsecured debentures carry higher risk of default
 Interest rate changes in the market can affect market price
2. Valuation of Bonds/Debentures
Meaning: The value of a bond is the present value of future cash flows (interest +
principal) discounted at the required rate of return.
Formula (for simple annual coupon bond):
Coupon Payment Face Value
Value=∑ + Where:
( 1+ r ¿ t ( 1+r ¿n
r = required rate of return
t = time period
n = maturity
3. Yield to Maturity (YTM)
 Meaning: YTM is the annual rate of return earned if the bond is held till maturity.
 Importance: Shows the true return on bond investment.
YTM Formula (approximate for annual coupon bond):
F−P
C+
n
YTM ≈ Where:
F+ P
2
C = Annual Coupon, F = Face Value, P = Price, n = years to maturity
4. Term Structure of Interest Rates
 Refers to the relationship between interest rates (or yields) and bond maturities.
 Shown by yield curve:
o Normal: Longer maturities → higher yields
 o Inverted: Longer maturities → lower yields
 Helps in interest rate and investment planning.
5. Duration
 Duration measures bond’s price sensitivity to interest rate changes.
 Longer duration → more sensitive to interest rate changes.
 Useful for risk management and immunization of portfolio.
6. Risks in Bonds/Debentures
1. Interest Rate Risk: Bond price falls if market interest rises.
2. Credit Risk / Default Risk: Issuer may fail to pay interest or principal.
3. Reinvestment Risk: Future coupon payments may earn lower interest.
4. Liquidity Risk: Some bonds may be difficult to sell quickly.
5. Inflation Risk: Fixed interest may lose purchasing power.
Risk-Return Relationship
Meaning
 There is a direct relationship between risk and expected return in investments.
 Higher the risk, higher the expected return and vice versa.
 Helps investors decide which securities to choose based on risk tolerance.
Types of Risk
1. Systematic Risk (Market Risk):
o Affects the entire market (e.g., interest rate changes, inflation, recession).
o Cannot be diversified.
2. Unsystematic Risk (Specific Risk):
o Affects individual companies or sectors.
o Can be reduced through diversification.
Measurement of Risk
1. Beta (β)
 Measures a security’s sensitivity to market movements.
 Formula:
Covariance of stock with market
β= Interpretation:
Variance of market
 β = 1 → Moves with the market
 β > 1 → More volatile than market (high risk)
 β < 1 → Less volatile than market (low risk)
Example:
  If β = 1.2 and market goes up 10%, expected stock increase = 12%.
2. Standard Deviation (σ)
 Measures total risk or variability of returns.
 Higher σ → More volatile returns → Higher risk.
Formula (simplified):
σ =√ ∑ ¿ ¿ ¿Where:
R_i = actual return, 𝑅̄ = average return, n = number of observations
Example:
 Stock A has σ = 5%, Stock B has σ = 15% → Stock B is riskier.
3. Other Measures
 Coefficient of Variation (CV): σ / Expected Return → risk per unit of return
 R-squared (R²): Measures proportion of total risk explained by market movements

Risk-Return Trade-off
 Investors are compensated for taking higher risk with higher expected returns.
 Low-risk securities → Lower return (e.g., government bonds)
 High-risk securities → Higher return (e.g., equity)

DOW THEORY
Meaning
DOW Theory is a technical analysis approach that studies price movements and trends in
the stock market to predict future market behavior.
It is based on the work of Charles H. Dow, founder of the Wall Street Journal and co-creator
of the Dow Jones Industrial Average (DJIA).
Assumptions / Basic Principles of DOW Theory
 1. Market Discounts Everything:
All available information (economic, political, psychological) is reflected in stock
prices.
2. Market Moves in Trends:
Prices move in three types of trends:
o Primary Trend: Long-term trend (1–5 years)
o Secondary Trend: Medium-term correction within the primary trend (3
weeks – 3 months)
o Minor Trend: Short-term fluctuations (days to weeks)
3. Trends Have Three Phases:
o Accumulation Phase: Informed investors buy/sell
o Public Participation Phase: Majority of investors follow the trend
o Distribution Phase: Smart investors sell/buy to exit the market
4. Averages Must Confirm Each Other:
o Dow Industrial Average and Dow Transportation Average must confirm the
trend.
o If one index rises and the other falls, trend may be weak or doubtful.
5. Volume Confirms Trends:
o Higher trading volume strengthens a trend
o Low volume indicates weak trend
6. Trends Continue Until Reversal is Clear:
o A trend persists until signals indicate its reversal
Importance of DOW Theory
 Helps identify long-term and medium-term trends
 Assists in timing market entry and exit
 Forms the foundation of modern technical analysis
Limitations
 Mainly useful for trends, not exact price prediction
 May lag in fast-moving markets
 Requires confirmation from other technical tools
Support and Resistance Levels
Meaning
  Support Level:
The price level at which a falling stock tends to stop falling and may rebound.
It represents strong demand where buyers enter the market.
 Resistance Level:
The price level at which a rising stock tends to stop rising and may decline.
It represents strong supply where sellers dominate.
Key Features
1. Support Level:
o Acts as a floor for prices.
o If price falls below support → Breakdown occurs, further decline possible.
2. Resistance Level:
o Acts as a ceiling for prices.
o If price rises above resistance → Breakout occurs, further rise possible.
3. Dynamic:
o Support and resistance are not fixed; they change with market conditions.
Importance in Trading
 Helps traders identify entry and exit points
 Used to set stop-loss and target prices
 Helps in trend analysis and technical forecasting
Methods to Identify Support and Resistance
1. Historical Price Levels: Based on past highs and lows
2. Moving Averages: Prices often find support/resistance at moving averages
3. Trendlines and Channels: Lines connecting highs and lows indicate levels
4. Pivot Points: Calculated levels based on previous day’s price data
Types of Charts & Their Interpretations
Charts are used in technical analysis to study past price movements and predict future
trends in the market.
1. Line Chart
 Meaning: Plots closing prices of a security over time as a continuous line.
 Use / Interpretation:
o Shows the overall trend clearly.
o Easy to identify support and resistance levels.
 Limitation: Does not show daily high, low, or opening prices.
2. Bar Chart
 Meaning: Displays open, high, low, and close prices (OHLC) for each period as
vertical bars.
 Use / Interpretation:
o Shows price volatility and range.
o Useful for trend analysis and detecting reversals.
 Limitation: Can be complicated for beginners.
3. Candlestick Chart
 Meaning: Uses candlestick shapes to show OHLC prices for a period.
 Components:
o Body: Difference between open and close
o Wick / Shadow: High and low prices
 Use / Interpretation:
o Shows market sentiment: bullish or bearish
o Patterns indicate trend continuation or reversal (e.g., Doji, Hammer,
Engulfing)
4. Point & Figure Chart
 Meaning: Focuses only on price movements and ignores time. Uses Xs and Os to
represent price rise and fall.
 Use / Interpretation:
o Highlights breakouts and trend directions clearly
o Filters out minor fluctuations / noise
Importance of Charts in Technical Analysis
 Identify trend direction (uptrend, downtrend, sideways)
 Detect reversal and continuation patterns
 Locate support and resistance levels
 Assist in timing market entry and exit
Trend Line
A trend line is a straight line drawn on a price chart that connects two or more significant
price points to identify the direction of the market trend.
Types of Trend Lines
1. Uptrend Line
o Drawn by connecting two or more successive higher lows.
 o Indicates the market is in an upward trend.
o Acts as a support line; prices often bounce from it.
2. Downtrend Line
o Drawn by connecting two or more successive lower highs.
o Indicates the market is in a downward trend.
o Acts as a resistance line; prices often fall after touching it.
3. Horizontal / Sideways Trend Line
o Drawn when prices move in a range without clear direction.
o Indicates a consolidation phase in the market.
Importance of Trend Lines
 Helps identify the direction of the market (up, down, sideways).
 Acts as support or resistance for price movements.
 Useful for timing entry and exit points.
 Helps in predicting trend reversals when the price breaks the trend line.
Rules for Drawing Trend Lines
1. Connect at least two significant highs or lows.
2. For an uptrend, line must slope upwards; for a downtrend, line must slope
downwards.
3. The more times the line is tested by price, the stronger it is.
4. Avoid drawing lines through minor price fluctuations.
Gap Theory / Wave Theory
Meaning
 Gap Theory and Wave Theory are technical analysis tools used to study price
patterns and market trends.
 Wave Theory, also called Elliott Wave Theory, explains that market prices move
in repetitive waves driven by investor psychology.
 Gap Theory refers to the price gaps seen on charts when a security opens higher or
lower than the previous closing price, often indicating strong market sentiment or
trend continuation/reversal.
Wave Theory (Elliott Wave Theory)
 Developed by Ralph Nelson Elliott.
 States that market moves in repetitive cycles due to investor psychology.
 Structure of Waves:
 1. Impulse Waves (5 waves): Move in the direction of the main trend.
 Waves 1, 3, 5 → upward movement in a bull market
 Waves 2, 4 → minor corrections
2. Corrective Waves (3 waves): Move against the main trend.
 Labeled as A, B, C
Importance:
 Helps identify trend continuation or reversal.
 Useful for timing market entry and exit.
Gap Theory
 Definition: A gap occurs when opening price ≠ previous day’s closing price,
leaving a space on the chart.
 Types of Gaps:
1. Breakaway Gap: Signals start of a new trend
2. Runaway / Continuation Gap: Shows strong continuation of an existing
trend
3. Exhaustion Gap: Indicates trend reversal is near
Interpretation:
 Gaps are analyzed to predict short-term price movements.
 Traders use gaps to identify bullish or bearish signals.
Importance
 Helps in forecasting price trends.
 Assists in timing market trades.
 Reflects investor sentiment and psychology.
Relative Strength Analysis (RSA)
Meaning
Relative Strength Analysis is a technical analysis tool used to compare the performance of
a stock with the market or another stock over a period of time.
It helps investors identify strong (outperforming) and weak (underperforming) stocks.
Purpose
 To select stocks that are likely to perform well in the future
 To avoid investing in weak or underperforming stocks
 Helps in timing market entry and exit
Calculation / Formula
Relative Strength (RS) can be calculated as:
 Price Change of Stock
RS=
Price Change of Market Index or Benchmark
 RS > 1 → Stock outperforms the market
 RS < 1 → Stock underperforms the market
Steps in Relative Strength Analysis
1. Select the Stock and Benchmark: Choose the stock to analyze and a market index or
sector for comparison.
2. Determine Time Period: Typically 6–12 months.
3. Calculate Price Changes: Compute percentage change in stock price and
benchmark.
4. Compute RS Ratio: Divide stock price change by benchmark change.
5. Interpret RS: Higher RS → strong stock; Lower RS → weak stock.
Importance
 Identifies leading and lagging stocks in the market
 Helps investors maximize returns by investing in strong stocks
 Works well in both bull and bear markets
 Can be combined with other technical tools for better decisions
Oscillators
Meaning
Oscillators are technical indicators used to measure the momentum of a stock. They help
identify overbought and oversold conditions, signaling possible trend reversals.
 Oscillators oscillate between fixed levels (usually 0–100).
 Useful in markets that are trading sideways or lacking a clear trend.
Types of Oscillators
1. Relative Strength Index (RSI)
o Measures the speed and change of price movements.
o RSI values range from 0 to 100.
 RSI > 70 → Overbought (sell signal)
 RSI < 30 → Oversold (buy signal)
o Formula (simplified):
100
RSI =100−
1+ RS
RS = Average gain / Average loss
2. Stochastic Oscillator
 o Compares closing price with price range over a period.
o Values range from 0 to 100.
 %K and %D lines are used to generate buy/sell signals.
 Over 80 → Overbought, Under 20 → Oversold
3. MACD (Moving Average Convergence Divergence)
o Shows the relationship between two moving averages of prices.
o Helps identify trend direction, momentum, and reversals.
o Signal line crossovers indicate buy or sell opportunities.
4. Commodity Channel Index (CCI)
o Measures deviation from average price over a period.
o Helps detect overbought/oversold conditions and trend changes.
Importance of Oscillators
 Identify potential reversal points
 Signal overbought and oversold conditions
 Useful in range-bound markets
 Can be combined with trend analysis for better decisions
Moving Average Analysis
Meaning
A moving average (MA) is the average price of a security over a specific period,
calculated continuously to smooth out price fluctuations.
It helps identify trend direction and possible support/resistance levels.
Types of Moving Averages
1. Simple Moving Average (SMA)
o Average of closing prices over a fixed number of periods.
o Formula:
Sum of Closing Prices over n periods
SMA=
n
o Use: Shows general trend direction; signals buy/sell when price crosses SMA.
2. Exponential Moving Average (EMA)
o Gives more weight to recent prices, reacts faster to price changes.
o Use: Useful for short-term trend analysis and identifying trend reversals.
3. Weighted Moving Average (WMA)
o Assigns different weights to prices, usually more to recent prices.
 o Use: Similar to EMA but more sensitive to recent price changes.
Interpretation of Moving Averages
 Price > Moving Average: Bullish trend
 Price < Moving Average: Bearish trend
 Crossover Signals:
o Short-term MA crosses above long-term MA → Buy signal
o Short-term MA crosses below long-term MA → Sell signal
 Support/Resistance:
Moving averages often act as dynamic support or resistance levels.
Importance
 Smoothens price data and reduces noise
 Identifies trend direction and strength
 Helps in trend-following strategies
 Useful for timing entry and exit points
Efficient Market Hypothesis (EMH)
Meaning
The Efficient Market Hypothesis (EMH) states that stock prices fully reflect all available
information at any given time.
 In an efficient market, it is impossible to consistently achieve higher returns than
the market average through either technical analysis or fundamental analysis.
Types of EMH
1. Weak Form Efficiency
o Prices reflect all past market data (historical prices and volume).
o Implication: Technical analysis is useless, but fundamental analysis may
work.
2. Semi-Strong Form Efficiency
o Prices reflect all publicly available information (financial statements, news,
announcements).
o Implication: Both technical and fundamental analysis cannot consistently
earn abnormal returns.
3. Strong Form Efficiency
o Prices reflect all information, including private or insider information.
 o Implication: No investor can earn abnormal returns, even with insider
knowledge.
Implications for Investment Decisions
1. For Investors
o Stock prices are fairly valued, so it is difficult to beat the market
consistently.
o Focus should be on diversification and long-term investment rather than
market timing.
2. For Analysts
o Weak form: Technical analysis is not effective
o Semi-strong form: Fundamental analysis is not effective
o Strong form: Even insider information does not help
3. Portfolio Management
o Invest in well-diversified portfolios to reduce risk.
o Use passive strategies like index funds rather than active trading.
4. Market Efficiency Awareness
o Helps investors understand that market prices are largely unpredictable.
o Encourages discipline, long-term planning, and realistic expectations.
Random Walk Theory
Meaning
 The Random Walk Theory states that stock prices change randomly and
unpredictably, following a “random walk.”
 It implies that past price movements cannot predict future prices.
Key Features
 Price changes are independent of each other.
 Market is efficient, reflecting all available information.
 Supports weak form of EMH.
Implications
 Technical analysis is not useful for predicting prices.
 Investors should focus on long-term investment and diversification.
2. Event Study
Meaning
 Event study analyzes the impact of a specific event on stock prices.
  Events can include mergers, dividends, earnings announcements, or policy
changes.
Steps
1. Identify the event date
2. Determine stock price before and after the event
3. Calculate abnormal returns (difference between actual and expected returns)
4. Assess whether the event significantly affects stock prices
Importance
 Helps investors and analysts understand how quickly and accurately markets react
to new information.
 Tests semi-strong form of market efficiency.
3. Portfolio Study
Meaning
 Portfolio study examines the performance of a portfolio of securities rather than
individual stocks.
 Focuses on risk-return relationship and diversification benefits.
Key Concepts
 Measures average return and risk (standard deviation, beta) of the portfolio
 Evaluates whether the portfolio beats the market
 Tests EMH by analyzing abnormal returns across portfolios
Importance
 Helps in portfolio construction and performance evaluation
 Supports passive investment strategies in efficient markets
Portfolio Selection
Meaning
Portfolio selection is the process of choosing a mix of different securities (stocks, bonds,
etc.) to maximize returns for a given level of risk or minimize risk for a desired return.
It is a key concept in portfolio management and is based on the principle of
diversification.
Objectives
1. Maximize Return: Choose securities that offer the highest possible expected
return.
2. Minimize Risk: Reduce risk through diversification across assets, sectors, and
markets.
3. Align with Investor Goals: Ensure the portfolio matches investment horizon,
liquidity needs, and risk tolerance.
4. Efficient Portfolio: Construct a portfolio that optimally balances risk and return.
Principles of Portfolio Selection
1. Diversification:
o Spread investment across different securities and asset classes to reduce
unsystematic risk.
2. Risk-Return Tradeoff:
o Higher expected return usually comes with higher risk.
3. Asset Allocation:
o Decide how much to invest in equities, bonds, and other instruments.
4. Correlation:
o Select securities that are less correlated to reduce portfolio risk.
5. Liquidity Consideration:
o Ensure that the portfolio contains easily tradable securities.
Steps in Portfolio Selection
1. Define Investment Objectives: Return expectations, risk tolerance, and time horizon.
2. Estimate Expected Returns & Risk: Analyze historical data, market trends, and
financial statements.
3. Evaluate Correlation Among Securities: Identify securities that move differently
to reduce risk.
 4. Construct Portfolio: Decide weights of each security to achieve optimal risk-
return combination.
5. Monitor and Rebalance: Periodically adjust portfolio to maintain desired risk-
return profile.
Diversification and Portfolio Theories – Markowitz Model
1. Diversification
Meaning:
Diversification is the process of investing in a variety of securities to reduce overall risk
without necessarily reducing expected returns.
Key Points:
 Reduces unsystematic risk (specific to a company or industry)
 Achieved by investing in different assets, sectors, or markets
 Helps smoothen portfolio returns and protect against losses
Example:
Investing in both pharma and IT stocks reduces risk compared to investing only in IT
stocks.
2. Portfolio Theories
Portfolio theories guide investors in constructing efficient portfolios. The most widely used
is the Markowitz Model, also called the Mean-Variance Model.
3. Markowitz Model (Harry Markowitz, 1952)
Meaning:
The Markowitz Model suggests that investors should choose portfolios that maximize
expected return for a given level of risk, or minimize risk for a desired return.
Assumptions of Markowitz Model
1. Investors are risk-averse.
2. Returns of securities are normally distributed.
3. Portfolio risk depends on:
o Variance/standard deviation of individual securities
o Correlation between securities
4. Investors prefer higher return for lower risk.
Key Concepts
1. Expected Return of Portfolio:
E(R p)=∑wi Ri
Where:
 w i= weight of security i in portfolio
 Ri = expected return of security i
2. Portfolio Risk (Standard Deviation):
σ p=√ ∑ w 2i σ 2i +∑ ∑ wi w j σ i σ j ρij
Where:
 σ i= standard deviation of security i
 ρij = correlation coefficient between securities i and j
3. Efficient Frontier:
 The set of portfolios offering maximum return for each level of risk.
 Portfolios below the frontier are sub-optimal, and those above are unattainable.
Importance
 Provides quantitative approach to portfolio selection
 Emphasizes risk-return tradeoff
 Encourages diversification to reduce unsystematic risk
 Forms the basis of modern portfolio theory (MPT)
Efficient Frontier
Meaning
 The Efficient Frontier is a set of optimal portfolios that offer the maximum
expected return for a given level of risk, or the minimum risk for a given level of
return.
 It is a key concept in Modern Portfolio Theory (MPT), developed by Harry
Markowitz.
Key Features
1. Risk-Return Tradeoff:
o Portfolios on the frontier provide the best possible return for each level of
risk.
2. Diversification Benefit:
o Achieved by combining assets with low or negative correlation, reducing
overall portfolio risk.
3. Optimal Portfolios:
o Any portfolio below the frontier is sub-optimal (lower return for same risk).
o Portfolios above the frontier are unattainable with current assets.
 4. Graphical Representation:
o Risk (standard deviation) on X-axis
o Expected return on Y-axis
o Frontier forms a convex curve upward and to the left
Importance
 Helps investors choose portfolios that align with their risk tolerance.
 Guides in efficient allocation of funds across assets.
 Forms the basis for capital market line (CML) and Sharpe ratio analysis.
Capital Asset Pricing Model (CAPM)
Meaning
CAPM is a financial model that describes the relationship between expected return and
risk of a security.
It helps investors determine the required rate of return on an asset, considering its
systematic risk.
 Developed by William Sharpe, John Lintner, and Jan Mossin in the 1960s.
 Based on Modern Portfolio Theory (MPT).

Assumptions
1. Investors are rational and risk-averse.
2. Markets are efficient, with no transaction costs or taxes.
3. Investors can lend/borrow at a risk-free rate.
4. Only systematic (market) risk is rewarded; unsystematic risk can be diversified.
5. Single-period investment horizon.
CAPM Formula
E(R i)=R f + β i ( E(R m)−R f )
Where:
 E(R i)= Expected return of the security
 R f = Risk-free rate of return
 β i= Beta of the security (systematic risk)
 E(R m) = Expected return of the market portfolio
 ( E (Rm )−R f )= Market risk premium
Interpretation
1. Risk-Free Rate ( R f ): Minimum return for zero-risk investment.
 2. Beta ( β ): Measures sensitivity of the asset to market movements.
o β = 1 → Moves with market
o β > 1 → More volatile than market
o β < 1 → Less volatile than market
3. Expected Return ( E(R i)): Return an investor requires for taking the asset’s risk.
Importance
 Determines fair expected return for a security
 Helps in portfolio selection and asset pricing
 Evaluates whether a security is overvalued or undervalued
 Used in corporate finance for cost of equity estimation
Arbitrage Pricing Theory (APT)
Meaning
 APT is a multi-factor model used to determine the expected return of a security.
 It assumes that asset returns are influenced by multiple macroeconomic factors,
unlike CAPM which considers only market risk.
 Developed by Stephen Ross (1976).
 Based on the principle of arbitrage – the idea that no riskless profit opportunity
should exist in efficient markets.
Key Features
1. Multi-Factor Model: Returns depend on several factors such as:
o Inflation rate
o Interest rates
o Industrial production
o Exchange rates
2. Linear Relationship: Expected return is a linear function of sensitivities to these
factors.
3. Arbitrage-Free: If pricing is off, arbitrage opportunities will bring it back to
equilibrium.
4. Focus on Systematic Risk: Only factor-related (systematic) risk is rewarded;
idiosyncratic risk is diversified.
APT Formula
E(R i)=R f +b i 1 F 1+ bi 2 F 2+ ⋯+ b¿ F n
Where:
  E(R i)= Expected return of security i
 R f = Risk-free rate
 b ij= Sensitivity of security i to factor j
 F j= Risk premium associated with factor j
Importance
 More realistic than CAPM as it considers multiple factors.
 Helps investors in pricing securities and constructing optimal portfolios.
 Useful in risk management by analyzing sensitivity to different economic factors.
 Supports diversification and arbitrage strategies in portfolio management.
Single Index Model (SIM)
Meaning
 The Single Index Model is a simplified version of the multi-factor Arbitrage
Pricing Theory.
 It assumes that the returns of all securities are influenced by a single common
factor, usually the market index.
 Developed by William Sharpe (1963).
Key Features
1. Single Factor Dependence:
o Security returns are affected by overall market movements (market index).
2. Decomposition of Risk:
o Total risk = Systematic risk (market risk) + Unsystematic risk (unique to
the security)
o Unsystematic risk can be diversified away in a portfolio.
3. Simplifies Computation:
o Easier to estimate expected returns and variances for large portfolios.
Model Formula
Ri=α i + β i R m +ϵ i
Where:
 Ri = Return of security i
 α i= Stock’s expected return independent of market
 β i= Sensitivity of stock i to market returns (systematic risk)
 Rm= Return of the market index
 ϵ i= Random error (unsystematic risk)
Importance
1. Portfolio Construction: Helps in estimating risk and return of a portfolio.
2. Diversification: Identifies unsystematic risk that can be diversified.
3. Performance Evaluation: Used in CAPM and other asset pricing models.
4. Simplified Analysis: Reduces computation complexity compared to multi-factor
models.
Multi-Factor Models
Meaning
 Multi-Factor Models are portfolio and asset pricing models that explain security
returns using multiple factors.
 Unlike the Single Index Model (SIM), which uses only the market index, multi-
factor models consider several systematic risk factors affecting returns.
 Developed to provide a more realistic view of risk and return than CAPM or SIM.
Key Features
1. Multiple Factors:
o Returns are influenced by several macroeconomic or firm-specific factors,
such as:
 Inflation
 Interest rates
 Industrial production
 Exchange rates
2. Linear Relationship:
o Expected return is a linear function of factor sensitivities and risk
premiums.
3. Risk Decomposition:
o Total risk = Systematic risk (factor-related) + Unsystematic risk
(diversifiable)
4. Arbitrage-Free Pricing:
o If a security is mispriced relative to the model, arbitrage opportunities exist,
which get corrected in efficient markets.
Model Formula
Ri=α i +b i1 F1 +b i 2 F 2+⋯+ b¿ F n+ ϵ i
Where:
  Ri = Return of security i
 α i= Return independent of factors
 b ij= Sensitivity of security i to factor j
 F j= Risk premium for factor j
 ϵ i= Random error (unsystematic risk)
Importance
 Explains more variation in returns than single-factor models.
 Helps in portfolio construction and risk management.
 Used to estimate expected return and evaluate asset pricing.
 Guides investment decisions in multi-dimensional risk environments.
Constructing an Optimal Portfolio
Meaning
 Constructing an optimal portfolio means selecting the best combination of assets to
maximize expected return for a given level of risk, or minimize risk for a desired
return.
 Two popular approaches are the Markowitz Model and the Single Index Model
(SIM).
1. Markowitz Model (Mean-Variance Model)
Steps
1. Estimate Expected Returns ( E(R i)) for each security.
2. Calculate Risk (Variance/Standard Deviation) (σ 2i ) for each security.
3. Determine Correlation/Covariance ( ρij ) between securities.
4. Calculate Portfolio Expected Return:
E(R p)=∑ wi Ri
5. Calculate Portfolio Risk (σ_p):
σ p=√ ∑ w 2i σ 2i +∑ ∑ wi w j σ i σ j ρij
6. Construct Efficient Frontier: Select portfolios offering maximum return for given
risk.
Importance
 Helps achieve optimal diversification.
 Reduces unsystematic risk.
 Identifies efficient portfolios on the risk-return curve.
2. Single Index Model (SIM)
Concept
 Simplifies Markowitz approach by assuming all security returns are influenced by
a single factor (market index).
Steps
1. Estimate Alpha (α i), Beta ( β i), and Residual Risk (σ ϵ ) for each security.
i

2. Calculate Expected Return:

E(R i)=α i + β i E (Rm )
3. Estimate Portfolio Expected Return: Weighted sum of expected returns.
4. Estimate Portfolio Risk:
2
σ p=¿
 First term = systematic risk, second term = unsystematic risk.
5. Construct Optimal Portfolio: Maximize return for given risk using weights w i.
Importance
 Reduces computation complexity for large portfolios.
 Still accounts for diversification and risk-return tradeoff.
Comparison
Feature Markowitz Model Single Index Model (SIM)
Number of factors Multiple (uses covariances) Single (market index)
Complexity High Low
Risk Considered Total portfolio risk Systematic + unsystematic risk
Use Efficient frontier, precise diversification Large portfolio optimization

Performance Revision Strategies: Active vs Passive

Meaning
Performance revision strategies describe how investors monitor and adjust their portfolios
over time to achieve investment goals.
Two main approaches are Active Management and Passive Management.
1. Active Portfolio Management
Concept
 Investors actively buy and sell securities to beat the market or achieve higher
returns than a benchmark.
 Based on market analysis, stock selection, and timing strategies.
Characteristics
 1. Focus on superior returns
2. Frequent trading and rebalancing
3. Requires research, monitoring, and professional management
4. Relies on technical and fundamental analysis
Advantages
 Potential for higher returns than the market
 Can take advantage of market inefficiencies
 Flexible to respond to economic or market changes
Disadvantages
 Higher transaction costs and taxes
 Risk of underperformance if predictions are wrong
 Time-consuming and requires expertise
2. Passive Portfolio Management
Concept
 Investors replicate a market index or a benchmark to achieve market returns.
 No frequent trading; focus is on long-term holding.
Characteristics
1. Minimal trading and management
2. Mirrors index performance (e.g., Nifty 50, S&P 500)
3. Reduces management fees and transaction costs
Advantages
 Lower costs and taxes
 Predictable performance (matches the market)
 Less time and expertise required
Disadvantages
 Cannot beat the market
 Limited flexibility to respond to market changes
Comparison Table
Feature Active Management Passive Management
Objective Beat the market Match market return
Trading Frequency High Low
Cost High (research + transaction) Low
Risk Higher (if strategies fail) Lower (market risk only)
Feature Active Management Passive Management
Returns Potentially higher Average (market)

Formula Plans in Portfolio Management

Meaning:
Formula plans are systematic investment strategies used to maintain a desired proportion
of assets (usually equity and debt) in a portfolio.
They help investors manage risk and returns automatically by following pre-defined rules.
1. Constant Dollar Plan
Concept
 Invest a fixed amount of money in a particular asset (usually equity) at regular
intervals, regardless of market price.
 If price falls, you buy more shares; if price rises, you buy fewer shares.
Formula / Rule
Investment Amount=Fixed Dollar Amount (per period)
Advantages
 Simple and disciplined approach
 Reduces risk by buying more in dips and less at peaks
Disadvantages
 Does not maintain a fixed proportion between assets
 Risk of overexposure in falling markets
2. Constant Ratio Plan
Concept
 Maintain a constant proportion (ratio) of equity and debt in the portfolio.
 Requires periodic selling of over-performing assets and buying of under-performing
ones to maintain the ratio.
Formula
Equity Value=k × Total Portfolio Value
Where k = target equity ratio (e.g., 60% equity, 40% debt)
Advantages
 Maintains desired risk level
 Encourages buy low, sell high discipline
Disadvantages
 Requires frequent monitoring and rebalancing
  Transaction costs can be high

3. Variable Ratio Plan

Concept
 The equity proportion is adjusted according to market conditions.
 Equity allocation increases when market rises and decreases when market falls.
 More aggressive than constant ratio; less fixed, more flexible.
Advantages
 Adapts to market trends
 Can maximize returns during bull markets
Disadvantages
 Higher risk in volatile markets
 Requires active management and monitoring
Comparison Table
Feature Constant Dollar Plan Constant Ratio Plan Variable Ratio Plan
Equity Allocation Fixed amount Fixed proportion Varies with market
Market Adaptation No Partial Yes
Risk Moderate Controlled Higher
Rebalancing Required Less Frequent Very frequent
Cost Low Moderate High

Portfolio Revision
 Portfolio revision is the process of reviewing and adjusting a portfolio to maintain
the desired risk-return profile or improve performance.
 It ensures the portfolio aligns with investment objectives, market conditions, and
investor risk tolerance.
Types of Portfolio Revision
1. Active Revision
o Frequent changes based on market predictions, economic analysis, or
company performance.
o Aim: Beat the market.
2. Passive Revision
o Minimal adjustments, mainly to maintain original asset allocation.
 o Aim: Match market returns with lower cost.
Reasons for Portfolio Revision
 Changes in risk-return objectives of investor
 Market movements affecting asset values
 Changes in economic or industry conditions
 Addition or withdrawal of funds
 Performance evaluation results
Performance Evaluation of Managed Portfolios
Meaning
 Performance evaluation measures how well a portfolio manager has achieved
investment objectives relative to a benchmark or market index.
Key Measures
1. Absolute Return
o Actual return of the portfolio over a period.
2. Risk-Adjusted Measures
o Sharpe Ratio:
R p −Rf
Sharpe Ratio=
σp
Where R p= portfolio return, R f = risk-free rate, σ p= portfolio standard deviation
o Treynor Ratio:
R p −Rf
Treynor Ratio=
βp
Where β p= portfolio beta (systematic risk)
o Jensen’s Alpha:
α =R p −[ Rf + β p (Rm−R f )]
Measures excess return over CAPM expected return
3. Comparison with Benchmark
o Compare portfolio performance with market index or peer portfolios.
Importance
 Identifies strengths and weaknesses of the portfolio
 Helps in decision-making for revision
 Ensures portfolio meets investor objectives
 Evaluates manager’s skill and efficiency
Portfolio Performance Measurement
Portfolio performance measurement evaluates how well a portfolio has performed
compared to a benchmark or market index.
It considers return, risk, and risk-adjusted return to judge the efficiency of portfolio
management.
1. Sharpe Ratio
 Purpose: Measures risk-adjusted return using total risk (standard deviation).
 Formula:
R p−R f
Sharpe Ratio (S)=
σp
Where:
 R p= Portfolio return
 R f = Risk-free rate
 σ p= Portfolio standard deviation
 Interpretation: Higher Sharpe Ratio → better risk-adjusted performance.
2. Treynor Ratio
 Purpose: Measures risk-adjusted return using systematic risk (beta).
 Formula:
R p−R f
Treynor Ratio (T)=
βp
Where:
 β p= Portfolio beta (market-related risk)
 Interpretation: Higher Treynor Ratio → portfolio performed well relative to market
risk.
3. Jensen’s Alpha
 Purpose: Measures excess return earned by the portfolio over the expected return
predicted by CAPM.
 Formula:
α =R p −[ Rf + β p ( R m−R f ) ]
Where:
 Rm= Market return
 β p= Portfolio beta
 Interpretation:
 o α > 0 → Portfolio outperformed expectations
o α < 0 → Portfolio underperformed
4. Fama’s Net Selectivity Ratio
 Purpose: Measures portfolio manager’s ability to select securities that
outperform the market.
 Formula:
Net Selectivity=R p−(Beta-adjusted market return)
 Interpretation:
o Positive → Good stock selection
o Negative → Poor selection
Comparison Table
Measure Risk Considered Benchmark Key Use
Sharpe Ratio Total risk (σ) Risk-free rate Risk-adjusted return overall
Treynor Ratio Systematic risk (β) Market risk Performance vs market risk
Jensen’s Alpha Beta (systematic) CAPM expected Excess return over CAPM
Fama’s Net Selectivity Beta-adjusted market Market Stock selection ability