Financial Institutions and Market
Structure, Growth and Innovation
Chapter 2
An Introduction to
Security Analysis
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Learning Objective
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Concept of Risk
RISK: the Chance that the expected or prospective
advantage, gain or return may not materialise
Actual ROI < Expected ROI
The greater the variability or dispersion in the
possible outcome return than the expected return,
the greater the risk
In Inflationary condition there is no asset with
certainty of real return or risk–free asset
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Types of Risk
Systematic Risk
Market Risk
Interest Rate Risk
Inflation Risk
Exchange Rate Risk
Country Risk
Unsystematic Risk
Business Risk
Financial Risk
Default Risk
Liquidity Risk
Maturity Risk
Call Risk
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Concept of Beta
Beta (β) indicates the extent to
which the risk of a given asset is
non-diversifiable
It is the covariance of a security’s
return with that of the market for a
security class
A measure of relative risk of a
security
It is the slope of the regression line
relating to the security
return with the market
return
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Concept of Return or Yield
Total Return on an investment =
Income (Periodic Cash Flow) Plus/minus Price
Appreciation/Depreciation
Internal Rate of Return is the rate of discount which
makes the present value of all the future cash flows
equal to the total cost of that Investment
Realised and Expected Return
Nominal and Real Return
Required Rate of Return
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Holding Period Yield/Return (HPY) measures the total
return from an investment during a given time period
of investment
HPY =
Any cash payment received + Price Changes over the holding Period
Price at which the asset is purchased (Beginning Price)
Holding Period Return = HPY + 1
Basic Yield
Current Yield
Redemption Yield
Dividend Yield
Earnings Yield
Gross and Net Yield 7
Required Rate of Return
Minimum Expected Rate of Return
The reward or price to forgo present consumption in
favour of Future consumption plus a premium for expected
inflation
Required Rate of Return(RRR) and market interest rates
are positively related
RRR = Pure Time Value of Money + Inflation Premium + Risk
Premium
= Risk free rate of Return + Risk Premium
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Return-Risk Trade Off
Return potential and risk
involved in financial asset:
Positive linear relation ship
(AB Line)
CML a special case of SML
Market portfolio has beta = 1.0
SML estimates the return of
a single security relative to its
exposure to systematic risk
SML :To find out that whether the
expected return on the securities is
better than the risk which he is
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taking
Capital Asset Pricing Model (CAPM)
To determine appropriate required rate of return of an
asset, if that asset is to be added to an already well-
diversified portfolio, given that asset's non-
diversifiable risk i.e market risk
Unique risks can be diversified and Investors expect
compensation for market risk
Investors need to be compensated in two ways: time
value of money and risk
The model takes into account the asset's sensitivity to
non-diversifiable risk i.e beta (β)
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CAPM is based un certain assumptions as follows:
All investors aim to maximise utilities
All investors are rational risk-averse
All the investors are price takers i.e. they can not
influence prices
They can lend and borrow unlimited under the risk free
rate of interest
Securities are all highly divisible into small parcels There
are no transaction or taxation costs incurred.
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The CAPM in equation:
E(Ri) = Rf + β (Rm – Rf)
= Risk Free Rate + Systematic risk x Market Risk Premium
Where,
E(R i ) = Expected return of individual security
R f = Risk free rate of return
R m = Market return
β = Market risk of individual
Security or Systematic risk
Alternative to the capital asset pricing model (CAPM)
Arbitrage Pricing Model (APT)
An asset's returns can be predicted using the relationship
between that same asset and many common risk factors
There are multiple factors representing systematic risk
Fama and French Three Factor Model
Expands CAPM by adding size and value factors in
addition to the market risk factor
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Valuation of Securities
Valuation of Bonds
Valuation of Preference Shares
Valuation of Convertible Securities
Valuation of Common Stock
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Common Stock Valuation
Broad Approaches:
The Efficient Market Hypothesis
Technical Analysis Approach
Fundamental Analysis Approach
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The Efficient Market Hypothesis
Weak-Form Efficient Market Hypothesis
Semi-Strong Form Efficient Market Hypothesis
Strong Form Efficient Market Hypothesis
Technical Analysis Approach
Strength of the Current Trend
Maturity or Stage of the Current Trend
Reward to Risk Ratio of new Position
Potential Entry Level for New- Long Positions
Fundamental Analysis Approach
Top Down Approach
Bottom-Up Approach
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Fundamental Analysis Approach
Top Down Approach
Economic Analysis
Industry Analysis
[Business Cycles, Monetary & Fiscal Policy, Economic
Indicators ]
Analysis of Individual Firm
i. Earnings Multiple
ii. Dividend Capitalisation Model
iii. Relative Valuation Model
iv. Fundamentals Vs. Comparables
v. Cross Sectional Versus Time Series
Bottom-Up Approach - Stock Pickers & not foolproof if
a company is more vulnerable to upheavals than the investor
believed 17