(approved by aicte, new delhi. & affiliated to sri

AKSHARA INSTITUTE OF MANAGEMENT & TECHNOLOGY.

(Approved by AICTE, New Delhi. & Affiliated to Sri Venkateswara University, Tirupati.)

Prepared by: Dr. M.A.Dhandapani., M.Com., MBA., M.Phil., Ph.D I-CET CODE :AMTT

UNIT – I

INVESTMENT MANAGEMENT

Who is investor: The investor who is having extra cash could invest it in securities or in any

other assets like gold or real estate or could simply deposit in his bank account. The person who

invest his savings in to company investment.

Objective of Investor:

To minimize the risk involved in investment and maximise the return

Investment:

In General Sense,

“Investment as the process of sacrificing something now for the prospect of gaining something later”

The above definition we can infer that it contains three dimensions to an investment.

Time

Today’s sacrifice and

Prospect of gain.

Investment:

Investment is the employment of funds on assets with the aim of earning income or capital

appreciation.

To the Economist,

Investment is the net addition made to the nation’s capital stock that consists of goods

and services that are used in the production process. example:- new constructions of

plants and machines, inventories and etc .

Financial Investment

It is the allocation of money to assets that are expected to yield some gain over a period of

time. It is an exchange of financial claims such as stocks and bonds for money. They are expected to

yield returns and experience capital growth over the years.

Financial and Economic Meaning of Investment

In the financial sense investment is the commitment of a person’s fund to derive future income

in the form of income. dividend premium , pension benefit , or appreciation , in the value of their

capital example :- purchasing of shares , debentures , post office saving certificates , insurance

policies are all investments in the financial sense such investment generates financial assets.

Classification of Investment:

A Major classification is physical and financial investment.




Physical Investment:

If saving are used to acquired Physical assets, useful for consumption or production. It cannot

be marketability. Physical investment are fixed and movable assets. Such as house, Land, building,

flats, gold, silver and other consumer durables.

Financial Investment:

It is nothing but different types of investments. It consist of marketable and non – marketable

securities. It can be easily transferable.

Marketable Securities: can be easily converted to cash such as government bonds, common stock or

certificates of deposits etc.

Non – Marketable Securities: cannot be easily converted to cash like Bank deposits, Provident Fund

and pension Funds etc.

Characteristics of Investment:

The Characteristics of investment are:

Risk

Return

Safety

Liquidity

Marketability

Risk: at the time of investment. The investor gathering information regarding how much risk

involved in the investment.

Return: The difference between purchasing price and selling price is called capital appreciation or

income or Return.

Safety: the safety of capital is the certainty of return on capital, without loss of money or time

involved.

Liquidity: Investment can be easily realizable, saleable or marketable. Then it said to be liquidity.

Marketability: this refers to transferability or saleability of an assets.

SPECULATION

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

Speculation essentially involves buying and selling activities with the expectation of getting profit

from the price. This can be explained with an example. If a spouse buys a stock for its dividend, she

Investment

Physical Investment Financial Investment




may be termed as an investor. If she buys with the anticipation of price rise in the near future and the

hope of selling it at a gain price she would be termed as a speculator. The dividing line between

speculation and investment is very thin because people buy stocks for dividends and capital

appreciation.

Difference between the Investor and the Speculator

Investment Speculation

Time Horizon Plans for a longer time horizon. His holding

period may be from one year to few years.

Plans for a very short period. Holding Period

varies from few days to months

Risk Assumes moderate Risk Willing to undertake high Risk

Return Likes to have moderate rate of return

associated with limited risk

like to have high returns ofr assuming high risk

Decision

Considers fundamental factors and

evaluates the performance of the company regularly.

Considers inside information, here says and market behaviour

Funds Uses his own funds and avoids borrowed

funds.

Uses borrowed funds to supplement his

personal resources.

Objectives of Investment:

The main investment objectives are increasing the rate of return and reducing the risk. Other

objectives like Liquidity, Safety and Hedge against inflation.

Return: investors always expect a good rate of return from their investment. Rate of return could be

defined as the total income the investor receives during the holding period stated as a percentage of

the purchasing price at the beginning of the holding period.

Return =

Risk: Related with the probability of actual return. Investment risk is as important as measuring its

expected rate of return.

Liquidity: Marketability of the investment provides the liquidity to the investment. The liquidity

depends on the marketing and trading facility.

Hedge against Inflation: Since there is inflation in almost all the economy. The rate of return should

ensure a cover against the inflation. The return rate should be higher than the rate of inflation.

Safety: The selected Investment avenues should be under the legal and regulatory framework.

Approval of law itself adds a flavour of safety.




Real and Financial Assets:

Financial Assets:

Cash

Bank Deposits

Provident Fund

LIC Schemes

Post Office

Certificate &

Deposits

Saver

Investor

Real Assets:

House, Land,

Buildings and Flats.

Gold, Silver and

other Metals

Consumer Durables Marketable Assets:

Shares, Bonds & Govt. Securities etc.,

Mutual Funds Schemes, UTI Units etc.,

Stock & Capital Market

Primary Market – New Issue Shares

Secondary Market – Secondary sale of

securities.




Characteristics of Real and Financial Assets:

Currency: Financial assets are exchange documents with an attached value. Their values are

dominated in currency with determined by the Govt. Of an economy. A note or a coin

representing cash or money is a financial asset with an attached face value and is represented

in terms of the currency unit of a country.

Convertibility: financial assets are convertible into any other type of assets.

Divisibility: Financial instruments are divisible into smaller units. The total value is

represented in terms of divisions that can be handled in a trade.

Reversibility: This implies that a financial instrument can be exchanged for any other assets

and logically the so formed asset may be transferred back into the original financial

instrument.

Liquidity: This is the immediate need value of the financial instrument.

Cash Flow: The holding of the financial instrument results in a stream of cash flows that are

the benefits. Accruing to the holder of the financial instrument. Example: 1) A deposit with a

bank gives an inflow of interest to the deposit holder. 2) Shares give the holder dividend or

bonus.

Financial Markets:

A financial market is a market in which people trade financial securities, commodities, and

value at low transaction costs and at prices that reflect supply and demand. Securities include stocks

and bonds, and commodities include precious metals or agricultural products.

Financial market can be refers to those centres and arrangements which facilitate to buying

and selling of financial assets, claims and services.

Financial Markets

Capital Market:

Capital Market is market for financial assets which have a long or indefinite maturity.

Generally, it deals with long term securities which have a maturity period of above one year. Capital

market may be further divided into three namely:

Industrial Securities Market:

As the very name implies, it is a market for industrial securities namely – Equity shares or

Capital Market Money Market

Industrial

Securities market

Govt. Securities

Market

Long Term

Loan Market

Call Money

Market

Short- Term

Market

Commercial

Bill Market

Treasury

Bill Market Primary Market Secondary Market




Ordinary shares, Preference shares and Debentures or bonds. It is a market where industrial concerns

raise their capital or debt by issuing appropriate instruments. It can be further subdivided into two.

They are: 1. Primary Market or New Issue Market.

2. Secondary Market or Stock exchange.

Government Securities Market:

Government Securities Market are traded in govt. In india many kinds of securities like Short

term and long term securities are traded in this market and short term securities are traded in money

market. The govt. Securities are issued by Central Government, State Government and semi

Government like city corporation authorised by government.

Stock Certificates

Promissory Note

Bearer Bonds etc..

Long – Term Loan Market:

Development banks and commercial banks play a significant role in this market by supplying

long term loans to corporate customers. Long – term loans market may further be classified into:

Term loans Market

Mortgages Market

Financial Guarantees Market

Money Market:

Money Market is a market for dealing with financial assets and securities which have a

maturity period of up to one year. In other words it is a market for purely short term funds. The

Money Market may sub divided in to four. They are:

Call Money Market

Commercial Bills Market

Treasury Bills Market

Short Term Loan Market

Call Money Market:

Call Money Market is a market for extremely short period loans. So one day to fourteen days.

So it is highly liquidity.

Commercial Bills Market:

It is market for bills of exchange arising out of genuine trade transactions. In case credit sales

seller draw a bill of exchange on the buyer. Time period are – 3 Months or 6 Months.

Treasury Bills Market:

It is market for treasury bill which have short term maturity. A Treasury bill is a promissory

Bill or financial bill issued by Government.

Short Term Loan Market:




It is market where short term loan are given to corporate customer for meeting their working

capital requirements.

Taxation of Income from Investments:

The taxation of your investment income depends on several factors, including the type of investment

income you have (e.g., tax exempt, ordinary, capital gain, or tax deferred).

While investing in a tax-saving instrument or for that matter any investment, it's important to keep an

eye on the taxability of its income. If the income earned is taxable, the scope to build wealth over

long term gets constrained as taxes will eat into the returns.

In the tax saving instruments such as National Savings Certificate (NSC), Senior Citizen Savings

Scheme (SCSS), 5-year time deposits in bank and post office, the interest amount gets added to one's

income and hence is liable to be entirely taxable. so, even though they help you save tax for the

current year, the interest income becomes a tax liability in each year till the tenure ends. Anil Rego,

CEO & Founder of Right Horizons, says, "One must note that (taxable tax savers) instruments will

help in saving the tax to an eligible limit both on investments and on maturity. Since they provide the

tax benefits, the returns on them are likely to be below the market returns."

The post-tax return in them, therefore, comes down after factoring in the tax. For example, for

someone who pays 30.9 percent tax, the post-tax return on a 5-year bank FD of 7 per cent is 4.8 per

cent per annum!

They can still be tax-exempt income if even after adding the interest income, the individual's total

income remains within the exemption limit as provided by income tax rules. Illustratively, a taxpayer

between ages 60-80 earns only interest income from such taxable investments of about Rs 3 lakh a

year. Since the income for such individuals is exempted till Rs 3 lakh, even the interest earned from

investment in taxable products does not translate into tax liability for them.

But, for most others especially those earning a salary or having income from business or profession,

choosing tax savers that come with E-E-E status helps. The investment in these get EEE benefit i.e.

exempt- exempt- exempt status on the income earned. The principal invested qualifies for deduction

under Section 80C of the Income Tax Act, 1961 and the income in all of them is tax exempt under

Section 10.

Here are few such tax savers that not only help you save tax but also help you save tax but also help

you earn tax-free income. But, not all are the same in terms of features and asset-class, so making the

right choice is essential.

TRADING ON STOCK EXCHANGES:

STOCK EXCHANGE

Definition of Stock Exchange: The securities regulation act of 1956 defined stock exchange

as “an association , organization , or a individual which is established for the purpose of assisting ,

regulating , and controlling business in buying ,selling and dealing in securities.”

Meaning: This comes under treasury sector, which provides service to stock brokers & traders to

trade stocks, bonds and securities. A stock exchange helps the companies to raise their fund.

Therefore the companies needs to list themselves in the Stock Exchange and the shares will be

issued which is known as equity or a ordinary share and these shareholders are the real owners of the

company the Board of Directors of the Company are elected out of these Equity Shareholders only.




FEATURES OF STOCK EXCHANGE

It is an organized market

It is a securities market

It is an important constituent of capital market i.e., market for long- term finance

It is a voluntary association of persons desirous of dealing in securities

Stock exchange is a voluntary association, its membership is not open to everybody

In a stock exchange, only the members can deal in i.e., buy & sell securities

The members of a stock exchange can buy and sell securities either as brokers for & on behalf

of their clients

The dealings in a stock exchange are under certain accepted code of conduct i.e., rules

and regulations

IMPORTANT FUNCTION OF STOCK EXCHANGE

Provide central and convenient meeting places for sellers and buyer of securities

Increase the marketability and liquidity of securities

Contribute to stability of prices of securities

Equalization of price of securities

Smoothen price movement

Help the investors to know the worth of their holdings

Promote the habit of saving and investment

Help capital formation

Help companies and government to raise funds from the investors

Provide forecasting service

History of Stock Exchange

th The stock exchange was established by “East India company” in 18 century . In India it

was established in 1850 with 22 stock brokers opposite to town hall Bombay .This stock exchange is

known as oldest stock exchange of Asia.

Broker and Jobber:

BROKER:He is one acts as a intermediary on behalf of others. A broker in a stock exchange is a

commission agent who transacts business in securities on behalf of non members.

JOBBER:He is not allowed to deal with the public directly .He deals with brokers who are engaged

with the investors. Thus, the securities are bought by the jobber from members and sells to members

who are operating on the stock exchange as broker.

Jobber Broker

1

A jobber is an independent dealer in securities,

purchasing or selling securities on his own

account

A broker deals with the jobber on behalf of his clients.

in other words, a broker is a middleman between a

jobber and clients

2

A jobber deals only with the brokers, does not deal with the general public

A broker is merely an agent, buying or selling securities on behalf of his clients.




3

A jobber earns profit from his operations i.e.,

buying and selling activities

A broker gets only commission for his dealings

4 Each jobber specializes in certain group of

securities

The broker deals in all types of securities

Speculation and Speculator:

SPECULATION:It is the transaction of members to buy or sell securities on stock exchange

with a view to make profits to anticipated raise or fall in price of securities.

SPECULATOR: The dealer in stock exchange who indulge in speculation are called

speculator. They do not take delivery of securities purchased or sold by them , but only pay or

rescue the difference between the purchase price and sale price . The different types of

speculators are

o BULL

o BEAR

o STAG

o LAME DUCK

Bull:

He is speculator who expects the future raise in price of securities he buys the securities to

sell them at future date at the higher price.

He is called as bull because his activities resembles as a bull , as the bull tends to throw its

victims up in the air through its horns. In simple the bull speculator tries to raise the price of securities

by placing a big purchase orders.

Bear:

He is speculator who expects future fall in prices, he does an agreement to sell securities at

future date at the present market rate. He is called as bear because his altitude resembles with bear , as

the bear tends to stamp its victims down to earth through its paws . In simple the bear speculator forces

of prices of securities to fall through his activities.

Stag:

He operates in new issue of market. He is just like a bull speculator . He applies large number

of shares in the issue market only by paying, application money and allotment money. He is not a

genuine investor because, he sells the allotted securities at the premium and makes profit. In simple

he is cautious in his dealings. He creates an artificial rise in prices of new shares and makes profits.

Lame Duck:

He is speculator when the bear operator finds it difficult to deliver the securities to the

consumer on a particular day as agreed upon , he struggles as a lame duck in fulfilling his

commitment . This happens when the prices do not fall as expected by the bear and the other party is

not willing to postpone the settlement to the next period.

Largest stock exchanges:

IN THE WORLD:

London Stock Exchange

New York Stock Exchange




Shanhai Stock Exchange

Australia Stock Exchange

Tokyo Stock Exchange

Hong Kong Stock Exchange

Toronto Stock Exchange

Deutsche Borse

Bm&F Bovespa

Nasdaq Omx Stock Exchange

London Stock Exchange

IN INDIA

National Stock Exchange

Bombay Stock Exchange

Calcutta Stock Exchange

Cochin Stock Exchange

Multi Commodity Exchange

Derivatives Exchange

Otc Exchange

Pune Stock Exchange

Interconnects Exchange

London Stock Exchange:

It was the first stock exchange established by east India company in 18th century in London.

The top gainer of LONDON STOCK EXCHANGE is “Blue chip shares.

Bombay Stock Exchange:

It is oldest and first stock exchange of India established in the year 1875. First it was started

under baniyan tree opposite to town hall of Bombay over 22 stock brokers. The top gainer in BSE is

100 companies in that GMR infra is first

National Stock Exchange of India (NSE Or NSEI):

The NSE of India is the leading stock exchange of India, covering 370 cities and towns in the

country. It was established in1994 as a TAX company. It was established by 21 leading financial

institutions and banks like the IDBI, ICICI, IFCI, LIC, SBI, etc...

Features of NSEI:

Nationwide coverage i.e., investors from all over country

Ring less i.e., it has no ring or trading floor

Screen-based trading i.e., trading in this stock exchange is done electronically.

Transparency, i.e., the use of computer screen for trading makes the dealings in securities

transparent.

Professionalization in trading, i.e., it brings professionalism in its functions

Securities and Exchange Board of India(SEBI):

The SEBI was constituted on 12th April, 1988 under a resolution of the Government of India.




On 31st january,1992, it was made a statutory body by the Securities and Exchange board of India

Act,1992.

The Companies (Amendment) Act, 2000 has given certain powers to SEBI as regards the

issues and transfer of securities and non-payment of dividend.

Function of SEBI:

Regulating the business in stock exchange and any other securities markets.

Promoting and regulating self-regulatory organization.

Registering and regulating the work of collective investment scheme, incluing mutual funds.

Prohibiting fraudulent and unfair trade practices relating to securities market.

Promoting education, and training of intermediaries of securities market

Power of SEBI:

Power to approve the bye-laws of stock exchange

Power to inspect the books of accounts

Power to grant license to any person for the purpose of dealing in certain areas.

Power to delegate powers exercisable by it.

Power to try directly the foliation of certain provision of the company Act

How To Deal and Invest In Stock Exchange:

In order to deal with a securities one as to have an account called Demat a/c or Trading a/c. It

is just like a bank account. Same procedure of opening the bank account is followed to open the a/c.

But all the banks does not give this facility of opening the account, only few banks provide this

facility. After demat a/c or Trading a/s is opened then the securities is bought and sold. The banks

which gives facility of demat a/c in India is

ICICI Bank,

Citi Bank, and

Bank of Baroda etc..

Market Prices:

Market Price (Market Value) = The price at which buyers and sellers trade the item in an open

market place.

Definition: Unique price at which buyers and sellers agree to trade in an open market at a particular

time. In formal markets (such stock exchanges):

The offer Price (selling price) which is higher and

Bid Price (buying price) that is lower.

The difference between these two price is called margin.

The price established in the market where buyers and sellers meet to buy and sell similar products a

In economics, market price is the economic price for which a good or service is offered in

the marketplace. It is of interest mainly in the study of micro economics. Market value and market

price are equal only under conditions of market efficiency, equilibrium, and rational expectations.




price determined by factors of supply and demand rather than by decisions made by management.

Market Price per Share and calculate:

The market price per share of stock or the price per share of stocks is a current measure of price not

an accounting or historical measure of the value of stock like the book value per share. Which is

based on the information from a company’s balance sheet.

The market price per share is a financial metric that inventors use to determine whether or not to

purchase a stock.

Calculation of Market Price per share:

There are several steps you must take in order to calculate the market price per share.

The First Step: is to determine the date on which you want to calculate the market price per share.

The Second Step: is to find the price on that particular date. You can look at the company’s

monthly, Quarterly or annual report to get the stock price on that particular date.

The Third Step: you must consider the preferred stock if any, that this company owns, if the

company owns and has paid dividends on its preferred stock subtract those dividends from the stock

price you have found form the financial report.

The Fourth Step: Determine the number of shares of stock. Outstanding by looking at the

Company’s quarterly or annual report.

Market Price Per Share =

the adjusted closing price is often used when examining historical returns or a stock’s price is

typically affected by supply and demand of market participants.

The difference between the cash dividends and stock dividend: examining historical return or

performing.

DIVIDEND:

The dividend paid to the shares holders are out of the firm’s profits. Dividends in a firm are

paid according to the policies and decisions of the management. Regarding the retained earnins of the

firm.

The directors of a firm to retain some part of the income and to give the other part of the income and

to give the other part as dividends to the owners of the firm called shareholders.

Which can be classified as:

Cash Dividend

Stock Dividend

Scrip Dividend

Property Dividend

Bond Dividend

Special Dividend

Optional Dividend




Depreciation Dividend

Dividends from capital surplus

Dividend from Appreciation

Liquidation Dividend

If the company does not find sufficient amount to pay cash dividend. Effective technique of raising

capital. It also helps in raising future dividends of existing shareholders.

Stock Splits:

When the company pays a stock dividend it may also offer the stock split up. Effective stock

split up is only an increase in the number of shares that are outstanding. The change does not affect

the stated value of a stock or its surplus.

Reduction of the market Price

Future Growth

Reverse split

Re – Purchase of stock

Right Issue:

Right issue is an offer to the existing shareholders to subscribe for more shares, in proportion to their

existing shareholding usually at a relatively chep price.

In these rights offerings companies grant shareholders a chance to buy new shares at a discount to the

current trading price.

A rights issue is an invitation to existing shareholders to purchase additional new shares in the

company.

Ex: Mr. A have 100 shares of X company @ rs. 400 = 40, 000 1:1 subscription right issue at offring

price of Rs 200 offer price is 100 shares @ Rs. 100 = 20, 000 Average price cost of acquisition for

the 200 shares to Rs. 300 shares.

=40, 000 + 20,000/200 = 300.

Ad of right issue: it gives existing shareholders securities called “Rights” which give the shareholders

the right to purchase new shares at a discount to the market price.

Bonus Issue:

The term bonus in relation to share capital refers to an extra dividend to the shareholders from

surplus profits. When a company has accumulated profits which are in excess of its need then the

excess amount can be distributed by way of bonus share among existing shareholders.

What is an 'Adjusted Closing Price'

An adjusted closing price is a stock's closing price on any given day of trading that has been amended

to include any distributions and corporate actions that occurred at any time prior to the next day's

open. The adjusted closing price is often used when examining historical returns or performing a

detailed analysis on historical returns.

A stock's price is typically affected by supply and demand of market participants. However, there are

some corporate actions that affect a stock's price, which needs to be adjusted in the event of these




actions. The adjusted closing price is a useful tool when examining historical returns because it gives

analysts an accurate representation of the firm's equity value beyond the simple market price. It

accounts for all corporate actions such as stock splits, dividends/distributions and rights offerings.

Investors should understand how corporate actions are accounted for in a stock's adjusted closing

price.

Adjusting Prices for Stock Splits

A stock split is a corporate action that is usually done by companies to make their share prices more

marketable. A stock split does not affect a company's total market capitalization, but it does affect the

company's stock price. Consequently, a company undergoing a stock split must adjust its closing

price to depict the effect of the corporate action.

For example, a company's board of directors may decide to split the company's stock three-for-one.

Therefore, the company's shares outstanding increase by a multiple of three, while its share price is

divided by three. If a stock closed at $300 the day prior to its stock split, the closing price is adjusted

to $100, or $300 divided by 3, per share to show the effect of the corporate action.

Adjusting for Dividends

Common distributions that affect a stock's price include cash dividends and stock dividends. The

difference between cash dividends and stock dividends is shareholders are entitled to a predetermined

price per share and additional shares, respectively. For example, assume a company declared a $1

cash dividend and is trading at $51 per share on the ex-dividend date. On the ex-dividend date, the

stock price is reduced by $1 and the adjusted closing price is $50.

Adjusting for Rights Offerings

A stock's adjusted closing price also reflects rights offerings that may occur. A rights offering is an

issue of rights given to existing shareholders, which entitles the shareholders to subscribe to the

rights issue in proportion to their shares. For example assume a company declares a rights offering, in

which existing shareholders are entitled to one additional share for every two shares owned. Assume

the stock is trading at $50 and existing shareholders are able to purchase additional shares at a

subscription price of $45. On the ex-date, the adjusted closing price is calculated based on the

adjusting factor and the closing price.




UNIT – II

FIXED INCOME SECURITES

A fixed income security is an investment that provides a return in the form of fixed periodic

payments and the eventual return of principal at maturity. Unlike a variable-income security, where

payments change based on some underlying measure such as short-term interest rates, the payments

of a fixed-income security are known in advance.

Security is an evidence of property right. Like equity shares, preference shares, debentures, bonds

and other marketable instruments are called as securities.

Classification of Securities are:

Fixed Income Securities – Earn interest / dividend at fixed rate.

Variable Income Securities – Earn dividend at variable rate.

Fixed Income Securities:

FI Securities are investment where the cash flows are according to a pre determined amount

of interest, paid on a fixed schedule. Unlike a variable-income security, where payments

change based on some underlying measure such as short term interest rates, the payments of

a fixed-income security are known in advance. Popularly known as Debt instrument

Types of Fixed income securities:

The different types of fixed income securities include government securities, corporate bonds,

Treasury Bills, Commercial Paper, Strips etc.

Bank Deposits

Company Deposits

Small Saving Schemes

Debentures / Bonds

Bank Deposits: - Fixed deposit in the bank

Safest

Highly liquid as they can be encashed premature at 1% less on interest rate.

Neither tradable and nor transferable

Nomination facility.

Company Deposits:

Her, instead of deposits with bank, we deposit with NBFC’s and Manufacturing companies

Offer max interest rate than bank.

Neither secured nor guaranteed by RBI

Neither tradable nor transferable

No Nomination facilities is available

Small Saving Schemes:

Initial investment get double in 5 – 6 years

Neither tradable

Accepted as collateral




Debentures or Bonds:

Long term debt instruments

Higher rate of interest

Safer or unsafe (credit rating agency loss to decide)

Liquidity is very light

Tradable and transferable

Advantages of Fixed income securities:

Max return (revenue gain), Capital gain

Less risk

Tax advantages

Disadvantages of fixed income securities:

Return is fixed. Cannot earn more

Due to inflation, fixed return become very less in real value

Difficult to sell at attractive price

Real and Rates of Return:

A real rate of return is the annual percentage return realized on an investment, which is

adjusted for changes in prices due to inflation or other external effects. This method expresses

the nominal rate of return in real terms, which keeps the purchasing power of a given level of capital

constant over time. Adjusting the nominal return to compensate for factors such as inflation allows

you to determine how much of your nominal return is actually real return.

Nominal Interest Rate:

Nominal interest rate refers to the interest rate before taking inflation into account. Nominal can also

refer to the advertised or stated interest rate on a loan, without taking into account any fees or

compounding of interest. Finally, the federal funds rate, the interest rate set by the Federal Reserve,

can also be referred to as a nominal rate.

Difference between Nominal and Real Interest Rates

Unlike the nominal rate, the real interest rate takes the inflation rate into account. The equation that

links nominal and real interest rates can be approximated as:

Nominal rate = Real interest rate + Inflation rate,

or

Nominal rate - Inflation rate = Real rate.

Nominal & Real Rates of Return:

Investors are more concerned with the real rate of return – the return adjusted for the effects

of inflation. Inflation affects the value of money by reducing spending power. Thus:




Real Return = Nominal Rate – Annual calculated Rate of Return

Example: Assume the return is 100% taxable, an investor with a return of 10%, having a tax rate of

30%, would have an after tax return of 7%, calculated as 10% X (100% – 30%).

Taking inflation into account (at 2%), the investor’s approximate real return would be 5% (7% –

2%).

Computation of Risk and Return:

Risk:

Risk is a measure of future uncertainties in achieving program performance goals and objectives within

defined cost, schedule and performance constraints. Risk can be associated with all aspects of a program

(e.g., threat, technology maturity, supplier capability, design maturation, performance against plan,) as

these aspects relate across the Work Breakdown Structure (WBS) and Integrated Master Schedule (IMS).

Risk addresses the potential variation in the planned approach and its expected outcome. While such

variation could include positive as well as negative effects, this guide will only address negative future

effects since programs have typically experienced difficulty in this area during the acquisition process.

Risk is the possibility of loss or injury

Investor thinks minimize the risk and maximise the Return

Risk is inter changeable used with uncertainty

Components of Risk Risks have three components:

A future root cause (yet to happen), which, if eliminated or corrected, would prevent a

potential consequence from occurring,

A probability (or likelihood) assessed at the present time of that future root cause occurring,

and

The consequence (or effect) of that future occurrence.

A future root cause is the most basic reason for the presence of a risk. Accordingly, risks should be tied to future root causes and their effects.

Risk mainly consists of two components:

RISK

Systematic Risk:

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

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

particular direction either upward and downward.

The economic conditions, political situations and Sociological changes affect the security

market.

Systematic Risk Unsystematic Risk

Market Risk Business Risk Financial Risk

Intangible Events Tangible Events

Purchasing Power Risk Interest Rate Risk




1988 recession experienced by developed and developing countries has affected the stock

market all over the world.

The systematic risk is further sub – divided into:

Market Risk

Interest Rate Risk

Purchasing Power Risk

Market Risk:

Jack Clark Francis defied market risk is portion of total variability of return caused by the

alternating forces of Bull and Bear Markets.

When the security index moves upward haltingly for a significant period of time, it is known

as Bull Market.

When the security index moves downward, it is known as Bear Market. Bear market is just a

reverse to the bull market.

Market risk can be sub divided into:

Tangible Events – it is Real events like Earthquakes, war, political uncertainty and fall in the

value of currency as the Recession time.

Intangible Events – Market Psychology – 1994 LPG due to market psychology is positive

and 1988 it is a recession at the time Market psychology is negative.

1998 recession at this time market is falls down – Rush to sell the share in the market in this the price

of the scrip’s fall below their intrinsic values.

Interest Rate Risk:

The variation in the single period rate of returns caused by the fluctuation in the market

interest Rates.

The most commonly interest rate risk affects the price of bonds, debentures and stocks.

The fluctuations in the interest rate are caused by the changes in Govt. Monetary Policy.

Change interest rates of Treasury bills and govt. bounds etc..

Purchasing Power Risk:

The Variation in the returns an caused also by the loss of purchasing power of currency.

Inflation is the reason behind the loss of purchasing power.

Purchasing power risk is the probable loss in the purchasing power of the returns to be

received.

The inflation may be Demand pull or cost push inflation.

Unsystematic Risk:

It is the factors are specific, unique and related to the particular industry or company.

Unsystematic risk stems from managerial inefficiency, technological change in the production

process, availability of raw material, changes in the consumer preference and labour problem.

Unsystematic risk can be classified into:

Business Risk

Financial Risk

Business Risk:

Business risk is that portion of the unsystematic risk caused by the operating environment of

the business. Variation that occurs in the operating environment is reflected on the operating income

and expected dividends.

Business risk can be sub – divided into:

Internal Business Risk

External Business Risk

Internal Business risk:




Fluctuations in the sales

Research and Development

Personnel Management

Fixed cost

Single product

External Business Risk:

Social and regulatory factors

Political risk

Business Cycle

Financial Risk:

It refers to the variability of the income to the equity capital due to the debt capital. Financial

risk in a company is associated with the capital Structure of the company.

Capital Structure of the company consists of Equity funds and borrowed funds.

The presence of debt and preference capital results in a commitment of paying interest or pre

fixed rate of dividend.

Return:

Return is the primary motivating force that drives investment. It represents the reward for

undertaking investment. Since the game of investing is about returns (after allowing for risk),

measurement of realised (historical) returns is necessary to assess how well the investment manager

has done. In addition, historical returns are often used as an important input in estimating future

(prospective) returns.

It is a Reward for the undertaking investment.

Measurement of realised return

The return of an investment consists of two components:

Current Return

Capital Return

Current Return:

The first component that often comes to mind when one is thinking about return is the

periodic cash flow (income or interest), such as dividend or interest, generated by the investment.

Current return is measured as the periodic income in relation to the beginning price of the investment.

Capital Return:

The second component of return is reflected in the price change called the capital return. It is

simply the price appreciation or depreciation divided the beginning price of the asset. For assets like

equity stocks, the capital return predominates.

The total return for any security is defined as:

Total return = Current return + Capital return

The current return can be zero or positive, whereas the capital return can be negative.

Measuring Historical Return:

The total return on an investment for a given period is:

Total Return =




Where:

C= Cash inflow PE

= Ending price

PB = Beginning Price

BOND:

A Bond is a contract that requires the borrower to pay the interest income to the lender. It

resembles the promissory note and issued by the government and corporate. The par value of the

bond indicates the face value of the bond. i.e. the value stated on the bond paper.

Most of the bonds make fixed interest payment till the maturity period. This specific rate of interest is

known as coupon rate paid quarterly, semi – annually and annually. At the end of the maturity period

the value is repaid.

A long-term debt instrument (a legal contract) in which a borrower agrees to make payments

of principal and interest, on specific dates, to the holders of the bond.

It is a Debt instrument issued by Govt. and Public Sector companies.

Features of Bonds:

The features of bonds are:

1. Face Value:

a. Value printed on the bond

b. Basis for payment of interest

c. We may or not issue at face value or par, premium and Discount value.

2. Redemption Value:

a. Value of buying back of the bonds

b. Max the face value – premium, less than face value – discount and equal to face value

– Re demand at par

3. Coupon rate:

a. Rate of interest to be paid

4. Maturity Period:

a. Period for which bond is issued

b. Pay interest only to maturity period

c. After that no interest is paid

5. Collateral:

a. Security against which the bonds an issued to the bond holder. If interest is not paid

then “bond trustee” dispose this collateral to pay interest.

6. Bond Indent:

a. Agreement among – bond holders, company and bond trustee.

Contains terms and conditions on the above said features and rights of the each party.

TYPES OF BONDS:

Bonds are classified as:

1. Convertible Bonds: - bond for some time than it become convertible to shares. Ex: after 5




years the bond can be convertible bond Rs. 100. With coupon rate 10% which will be

converted into 2 equity shares of Rs, 50. Each.

2. Non – Convertible Bonds: - Continue as bond through the maturity period.

3. Redeemable Bonds: - Specified about the redemption period then it will buy back at

Premium or discount

4. Irredeemable bonds: - No Specification about maturity to bond holders get interest till the

company buys it back.

5. Secured Bond:- company mortgagers some of it assets. Ex: building, land etc. With the

trustee if co. fails to pay interest, trustee will sell these assets to make payment.

6. Unsecured Bond:- No such a mortgages

7. Callable Bonds: - company has the right redeem before maturity period. When market

interest rate < coupon.

8. Put able Bonds: - Bond holders have the right to redeem before maturity period. When

market interest rate >Coupon rate

9. Junk Bonds:- high coupon rate and not secured by an asset. More risk of default, speculators

prefer than bonds.

10. Zero Bonds:- no coupon rate but compulsory converted into equity share. Within the 3 years

of issue.

11. Deep Discount bonds: - it is a zero coupon bond without compulsion to convert, issue at

discount.

BOND CHARACTERISTICS:

A bond obligates the issuer to make specified payments (interest and principal) to the

bondholder. There are: -

Par value,

Coupon Rate and

Maturity Data.

Par Value: the par value is the value stated on the face of bond. It represents the amount the issuer

promises to pay at the time of the maturity.

Coupon Rate: the coupon rate is the interest rate payable to the bond holder.

Maturity Date: the maturity date is the date when the principal amount is payable to the bond

holder.

BOND YIELD:

Bond yield is the return on a bond made up of 3 components.

Coupon Rate

Capital Gain

Interest on Maturity

Generally classified in to 2 components

Capital Gain

Revenue Gain

Factors affecting bond yield or Bond Risk:

Generally stocks are considered to be risky but bonds are not. This is not fully correct. Bonds

do have risk but the nature and types of risks may be different. The risks are interest rate, default,

marketability and call ability risk.

Interest rate risk:

o Variability in the return from the debt instruments to investors is caused by the changes in the market interest rate.

o This is known as interest rate risk. changes that occur in interest rate affect the bonds more directly then the equity.




o There is a relationship between the coupon rate and market interest rate.

o If the market interest rate move up, the price of the bond declines and vice versa. Inflation rate risk:

o The uncertainty over the future value of our investment o Suppose bond is of Rs. 100 and offers 12% P.A and have a maturity of 1 year then be

gets rs.112 after one year.

Default Risk:

o If the company which has issued bond and fails to pay interest or pay redemption value.

o Due to micro and macro environmental factors. Call Risk:

o If the bond is callable bond, then the company has the option to call the bonds before maturity period.

o We lose the opportunity to earn

o This happen when interest rate in the market > coupon rate. Liquidity Risk:

o Few bonds are not preferred by the investor to buy or when we want to sell. So it is difficult to exit from their debt investment.

Reinvestment Risk:

o When a bond pays periodic interest there is a risk that the interest payments may have to be reinvested at a lower interest rate. Called reinvestment risk.

Foreign Exchange Risk:

o If a bond has payments that are denominated in a foreign currency its repee cash flows are uncertain.

Methods or Measures of Bond Yield:

The methods of Bond Yield are:

Current Yield

Holding Period Yield

Yield to Maturity

Approximate Yield to Maturity

Yield to Call

Current Yield:

it is the current return on the investments

Holding Period Yield:

Holding period return an investor buy a bond and sells it after holding for a period. The rate of return

in that holding period is:




Where:

I = Interest/ income/ coupon

amount P0= Current Market Price

Pn= Redemption Value or par Value

Yield to Maturity (YTM):

It is the rate at which NPV (net present value) of the bond = 0 or it is the discount rate at

which present value of cash inflow (PVCI) of bond in feature = PV Of cash outflow of bond PVCO.

Approximate Yield to Maturity:

It is a lengthy process to find the YTM by using IRR Method. Hence an approximation is

made to it in the form of a formula. It is called AYTM.

Where:

I = Interest or income or coupon

amount. P0= Current market price

Pn= Redemption value / Par value

N = Maturity Period

Where:

RL = Lower Rate

RH = High Rate

VL = Value at lower rate VH

= Value at Higher rate O = Out flow

Yield to Call (YTC):

If the bond is callable then the issuer has the right to redeem before maturity period.

YTC formula is some as AYTM but n = call period ≠ Maturity period.




I = Interest or income or coupon

amount. P0= Current market price

Pn= Redemption value / Par value N = Callable Period

BOND PRICE:

The value of bond or any asset, real or financial is equal to the present value of the cash flows

expected from Bond.

The value of a bond requires:

An estimate of expected cash flows

As estimate of the required returns

Bond Valuation:

It refers to the process of determining the value or price of a bond.

As the cash flows are spread over a period of years in the future. All the future cash flow have

to be converted into present to determine the value of the bond.

Where:

T= time period when the payment is

received P = Value of the bond at present.

C = Coupon rate or annual interest

payment M = Maturity value

N = no – of years

R = Discount rate or interest rate in the market.

Where:

P=value of bond




C/2=semi annual interest

payment r/2=the discount rate of

year

m= maturity value

2n= maturity

period

T=time period when the payment is received

YIELD CURVE:

The bond portfolio manager is often concerned with two aspects of interest rates: the level of

interest rate and the term structure of interest rate. The relationship between the yield and time or

years to maturity is called term structure.

The term structure is also known as yield curve. In analysing the effect of maturity on yield all other

influences are held constant. Usually pure discount instruments are selected to eliminate the effect of

coupon payments.

The bonds chosen do not have early redemption features. The maturity date are different but the

risks, tax liabilities and redemption possibilities are similar.

Its shows YTM is related to term to maturity for bonds that are similar in all aspects excepting

maturity.

The following data for government securities:

Face

Value

Interest

rate

Maturity

years

Current

Price YTM

100000 0 1 88.968 12.40

100000 12.75 2 99.367 13.13

100000 13.50 3 100.352 13.35

100000 13.50 4 99.706 13.60

100000 13.75 5 99.484 13.90

BOND DURATION:

Duration of a bond is generally mean that maturity period. But it is a wrong measure because

Zero coupon bond and 10% coupon bond of same maturity and have some duration but 10% coupon




bond recover “Purchase Price” Exactly the Zero Coupon.

There four measure of life of a bond must consider not only timing of cash flows but also size

of cash inflow.

Fredrick R Maculay: in 1983 has given such a measure for life of a bond and it is popularly known

as Maculay’s Duration of a bond.

Definition:

Maculay’s Duration is the weighted average maturity of a bonds cash flows on a present value basis.

MD’s is number of years needed to fully recover purchase price of a bond taking present values of its

cash inflows.

Procedure to Calculate Maculay’s Duration:

1. List out the years in which cash inflows are realized.

2. List out cash flows realized in respective years.

3. List out present value factor’s for each years cash flow taking discount rate (YTM).

4. Multiply (PVF) and (CF) to get present value of each cash flow

5. Then add all PVCI i.e. ∑ PVCI (present value cash inflow) = P0

6. Find the weight of patch cash flow in ∑ PVCI. Wt =

7. Multiply weight and years of cash inflow 8. Add all the above (weight X years) to get maculay’s Duration.

Maculay’s Duration (MD) = ∑Wt (t) Where:

Wt = Weight of cash flow T

= time period in years

Years CI PVAF PVCI PVCI /

P0 = Wt

Wt X t

P0 MD = ?

IMMUNISATION:

Immunisation is a technique that makes the bond portfolio holder to be relatively certain

about the promised stream of cash flows. The bond interest rate risk raises form the changes in the

market interest rate.

The market rate affects the coupon rate and the price of the bond. In the immunisation

process, the coupon rate risk and the price of the bonds fall.

At the same time the newly issued bonds offer higher interest rate.

The coupon can be reinvested in the bonds offering higher interest rate and losses that occur

due to the fall in the price of bond can be offset and the portfolio is said to be immunized.

The process the bond portfolio manager or investor has to calculate the duration of the promised

outflow of the funds and invest in a portfolio of bonds which has an identical duration.

The bond portfolio duration is the weighted average of the durations of the individual bonds

in the portfolio.

For Example: if an investor has invested equal amount of money in three bonds namely A,B

and C with a duration of 2, 3 and 4 years respectively, then the bond portfolio duration is




D = 1/3 x 2 + 1/3 x3 + 1/3 x 4

= 0.66 + 1+1.33

D = 2.99 or 3 years.

By matching the outflow duration with cash inflow duration from bond investment the bond manager

can offset the interest rate risk and price risk. the portfolio of money to be invested between the

different types of bonds also can be found. The equation is:

Investment outflow = (X1 x Duration of bond1) + (X2 x Duration of bond2)

X1, X2 is the proportion of the investment on bond 1 and 2.

(X1 x D1) + (X2 x D2) = 2

Where:

X1 = the proportion of the investment on bond A X2 = the proportion of the investment on bond B D1 = Duration of bond A

D2 = Duration of Bond B

Duration (MD) = ∑Wt (t) Where:

Wt = Weight of cash flow T = time period in years

Years CI PVAF PVCI PVCI / P0 = Wt Wt X t

P0 MD = ?




Index Means:

UNIT – III

INDEX MODELS

pared By: | M.Subramanyiam Reddy., MBA., P h.D., Assistant Professor, RITS Pre 30

Alphabetically arranged list of items (such as names or terms) given at the end of a printed

text with page numbers on which the item can be found.

Indexes (indices) also measure up and down movement of industrial production, and of the

market prices of bonds, commodities, shares, etc. See also indexation.

An index is a statistical measure of the changes in a portfolio of stocks representing the

overall market.

What is Index:

An Index is a statistical aggregate that measures change. It is and indicator. Sensex and Nifty are

large capital index in India.

Uses of Index:

Indicator of market movement/returns

It reflects highly up-to-date information

Lead indicator of the economy

Stock Market:

A stock market is a physical place, where brokers gather to buy and sell stocks and other

securities. It enables the trading of stocks. Stock market indexes are meant to capture the overall

behaviour of equity markets

Types of Stock Index:

There are mainly three types of stock index

Market capitalization weighted index

Free-float market capitalization weighted index

Price weighted index

Index Futures: Index futures is one of the most successful financial innovation of financial market.

In 1982, the stock index futures is the futures contract made on the major stock market index. The

stock index futures has the following characteristics.

It is an obligation and not an option

Settlement value depends

o On the value of stock index and the price at which the original contract is struck and o On the specified time the difference between the index value at the last closing day of

the contract and the original price of the contract

Basis of the stock index futures is the specified stock market index. No physical delivery of

stock is made.

Importance of Index

Easy location

Save times and efforts

Efficiency Cross reference

Reduce cost

An index is a statistical measure of the changes in a portfolio of stocks representing the overall

market.

Risk Premium:


A risk premium is the return in excess of the risk-free rate of return an investment is expected

to yield; an asset's risk premium is a form of compensation for investors who tolerate the extra risk,

compared to that of a risk-free asset, in a given investment. For example, high-quality corporate

bonds issued by established corporations earning large profits have very little risk of default.

Therefore, such bonds pay a lower interest rate, or yield, than bonds issued by less-established

companies with uncertain profitability and relatively higher default risk

Investors expect to be properly compensated for the amount of risk they undertake in the form

of a risk premium, or additional returns above the rate of return on a risk-free investment such as U.S.

government-issued securities. In other words, investors risk losing their money because of the

uncertainty of a potential investment failure on the part of the borrower in exchange for receiving

extra returns as a reward if the investment turns out to be profitable. Therefore, the prospect of

earning a risk premium does not mean investors can actually get it because it is possible the borrower

may default absent a successful investment outcome.

Portfolio Risk:

Portfolio Management is management of large investible funds with a view to maximizing

return and minimizing risk.

Though return of portfolio is the weighted average return of individual assets in the portfolio.

But risk of a portfolio is not a weighted average risk of individual assets. Because overall risk is

reduced by combining assets into one portfolio.

When two or more securities or assets are combined in portfolio, their covariance or interactive risk

is to be considered. Thus if the returns on two assets more together their co-variance is positive and

the risk is more on such portfolio. If on the other hand the returns more independently or in opposite

directions the co – variance is negative and the risk in total will be lower.

Where:

Cov xy = Covariance

Rx= Return on Security x1

Ry = Return on Security y1

Rx = Expected Return x Ry

= Expected Return y

N = No – of – Observations.

The co – efficient of correlation is another measure designed to indicated the similarity or

dissimilarity in the behaviour of two variables.

Correlation co – efficient of x and y as:


Where:

The correlation of co – efficient indicates the similarity or dissimilarity in the behaviour of x

and y stocks. In correlation, co – variance is not taken as an absolute value but relative to the standard

deviation of individual securities. It shows, how much x and y vary together as a proportion of their

combined individual variations measured by Standard Deviation of x and standard deviation of y. In

our example the correlation co – efficient is -1.0 which indicates that there is a perfect negative

correlation and the returns move in the opposite direction. If the correlation is 1, means perfect

positive correlation exists between the securities and they tend to move in the same direction. If the

correlation co-efficient is Zero, the securities returns are independent. Thus, the correlation between

two securities depends upon the covariance between the two securities and the standard deviation of

each security.

Now, let us proceed to calculate the portfolio risk. Combination of two securities reduces the risk

factor if less degree of positive correlation exists between them.

Expected Return on Portfolio:

Where:

Rp = Return on the Portfolio

X1 = Proportion of total portfolio invested in security 1

R1 = Expected return of Security 1

Where:

MARKOWITZ PORTFOLIO SELECTION:


Portfolio means:

A portfolio is a grouping of financial assets such as stocks, bonds, cash equivalents as well as

their mutual, exchange –traded and closed-fund counterparts. His choice depends upon the risk-return

characteristics of individual securities.

Phases of Portfolio Management

Building a Portfolio:

Step-1 : Use the Markowitz portfolio selection model to identify optimal combinations.

Step-2 : consider borrowing and lending possibilities.

Step-3 : choose the final portfolio based on your preferences for return relative to risk.

PORTFOLIO SELECTION:

• Goal: finding the optimal portfolio

• OPTIMAL PORTFOLIO: Portfolio that provides the highest return and lowest risk.

• Method of portfolio selection: Markowitz model

The proper goal of portfolio construction would be to generate a portfolio that provides the

highest return and the lowest risk is called optimal portfolio. The process of finding the optimal

portfolio is described as Portfolio selection.

Efficient Set of Portfolio:

The concept of efficient portfolio - let us consider various combinations of securities and

designated them as portfolio 1 to n.

The risk of these portfolios may be estimated by measuring the standard deviation of portfolio

returns.

Feasible set of portfolio:

Also known as portfolio opportunity set.

With a limited no of securities an investor can create a very large no. of portfolios by

combining these’s securities in different proportions.

EFFICIENT PORTFOLIO

Portfolio

No

Expected

Return

Standard

Deviation

Portfolio Management

Security

Analysis

Portfolio

Analysis

Portfolio

Selection

Portfolio

Revision

Portfolio

Evaluatio

1. Fundamental Analysis

2. Technical Analysis

3. Market Hypothesis

Diversification 1. Markowitz Model

2. Sharpe’s Single

Index Model

3. CAPM

4. APT

1. Formula

Plans

2. Rupee Cost

Averaging

1. Sharpe’s Index

2. Treynor’s Measure

3. Jenson’s Measure

4. M2 Measure


1 5.6 4.5

2 7.8 5.8

3 9.2 7.6

4 10.5 8.1

5 11.7 8.1

6 12.4 9.3

7 13.5 9.5

8 13.5 11.3

9 15.7 12.7

10 16.8 12.09

Compare 4 & 5 which have same standard deviation:

Portfolio

No

Expected

Return

Standard

Deviation

1 5.6 4.5 Higher return?? Pf no.5 gives higher

expected return which is more efficient

portfolio then Pf no. 4.

2 7.8 5.8

3 9.2 7.6

4 10.5 8.1

5 11.7 8.1

6 12.4 9.3

Compare 7 & 8 which have same Expected Return:

Portfolio

No

Expected

Return

Standard

Deviation

1 5.6 4.5

2 7.8 5.8

3 9.2 7.6

Lower standard deviation?? Pf no.7

which is more efficient portfolio then Pf

no. 8.

4 10.5 8.1

5 11.7 8.1

6 12.4 9.3

7 13.5 9.5

8 13.5 11.3 9 15.7 12.7

10 16.8 12.09

CRITERIA: EFFICIENT PROTFOLIO

Given 2 portfolio with the same expected return, the investor would prefer the one with the

lower risk.

Given 2 portfolio with the same risk, the investor would prefer the one with the higher

expected return.

Prepared By: | M.Subramanyiam Reddy., MBA., Ph.D., Assistant Professor, RITS 35

Grouping of financial stocks :

Stock

1

Stock

2

Compare Result

E F Same return but E has Less risk then F E has preferred C has minimum

risk and B has

maximum risk C E Same risk but E offer more return E has preferred Based on these

we drawing

efficient frontier

C A Same return but C less risk C has preferred

A B Same level of risk but B has higher

return.

B has preferred

Harry Max Markowitz Model:

Harry Max Markowitz (born August 24, 1927) is an American economist. He is best known for his

pioneering work in Modern Portfolio Theory. Harry Markowitz put forward this model in 1952.

Studied the effects of asset risk, return, correlation and diversification on probable investment

portfolio returns.

Essence of Markowitz Model “Do not put all your eggs in one basket”

An investor has a certain amount of capital he wants to invest over a single time horizon.

He can choose between different investment instruments, like stocks, bonds, options,

currency, or portfolio. The investment decision depends on the future risk and return.

The decision also depends on if he or she wants to either maximize the yield or Minimize the

risk.

Markowitz model assists in the selection of the most efficient by analysing various possible


portfolios of the given securities.

By choosing securities that do not 'move' exactly together, the HM model shows investors

how to reduce their risk.

The HM model is also called Mean-Variance Model due to the fact that it is based on

expected returns (mean) and the standard deviation (variance) of the various portfolios.

Diversification and Portfolio Risk:

Diversification is a technique of reducing the risk involved in investment and in portfolio

management. This is a process of conscious selection of assets, instruments and scrips of

companies/government securities, in a manner that the total risks are brought down. This process

helps in the reduction of risk, under category of what is known as unsystematic risk and promotes the

optimisation of returns for a given level of risks in portfolio management.

Market risk versus Unique risk:

The portfolio risk does not fall below a certain level, irrespective of how wide the

diversification is why?. The answer lies in the following relationship which represents a basic insight

of modern portfolio theory.

Total Risk = Unique risk + Market Risk

The unique risk of a security represents that portion of its total risk which stems from firm – specific

factors like the development of a new product, a labour strike, or the emergence of a new competitor.

Events of this nature primarily affect the specific firm and not all firms in general. Hence the unique

risk of a stock can be washed away by combining it with other stocks. In a diversified portfolio,

unique risks of different stocks tend to cancel each other – a favourable development in one firm may

offset an adverse happening in another and vice versa. Hence, unique risk is also referred to as

diversifiable risk or unsystematic risk.

The Market Risk of a stock represents that portion of its risk which is attributable to economy – wide

factors like the growth rate of GNP, the level of government spending, money supply, interest rate

structure, and inflation rate. Since these factors affect all firms to a greater or lesser degree, investors

cannot avoid the risk arising from them, however diversified their portfolios may be. Hence, it is also

referred to as systematic risk or non – diversifiable risk.

Markowitz Model Assumptions:

An investor has a certain amount of capital he wants to invest over a single time horizon.

He can choose between different investment instruments, like stocks, bonds, options,

currency, or portfolio.

The investment decision depends on the future risk and return. The decision also depends on

if he or she wants to either maximize the yield or minimize the risk.

The investor is only willing to accept a higher risk if he or she gets a higher expected return.


Tools of Selection of Portfolio – Markowitz Model:

1. Expected return (Mean):

Mean and average to refer to the sum of all values divided by the total number of values.

The mean is the usual average, so:

(13 + 18 + 13 + 14 + 13 + 16 + 14 + 21 + 13) ÷ 9 = 15

Expected Return on Portfolio:

(OR)

Where:

ER = The expected return on Portfolio

E(Ri) = The estimated return in scenario i

Wi = Weight of security i occurring in the port folio.

Rp = Return on the Portfolio

X1 = Proportion of total portfolio invested in security 1

R1 = Expected return of Security 1

(OR)

Where:

Rp = The expected return on Portfolio

R1= The estimated return in Security 1

R2= The estimated return in Security 1

W1= Proportion of security 1 occurring in the port folio

W2 = Proportion of security 1 occurring in the port folio

2. Variance & Co-variance

The variance is a measure of how far a set of numbers is spread out. It is one of several descriptors of

a probability distribution, describing how far the numbers lie from the mean (expected value).

Co-variance

Covariance reflects the degree to which the returns of the two securities vary or change

together.

A positive covariance means that the returns of the two securities move in the same direction.

A negative covariance implies that the returns of the two securities move in opposite

direction


Where:

Cov xy = Co - variance Rx=

Return on Security x1 Ry =

Return on Security y1 Rx =

Expected Return x Ry =

Expected Return y

N = No – of – Observations.

The co – efficient of correlation is another measure designed to indicated the similarity or

dissimilarity in the behaviour of two variables

Correlation co – efficient of x and y as:

Where:

Portfolio Risk:

The riskiness of a portfolio that is made of different risky assets is a function of three different factors:

the riskiness of the individual assets that make up the portfolio

the relative weights of the assets in the portfolio

the degree of variation of returns of the assets making up the portfolio

The standard deviation of a two-asset portfolio may be measured using the Markowitz Model:

(OR)

Where:

Optimal Portfolio:


The optimal portfolio concept falls under the modern portfolio theory. The theory assumes that

investors fanatically try to minimize risk while striving for the highest return possible.

Single Index Model

The single index model (SIM) is a simple asset pricing model to measure both the risk and the

return of a stock. The model has been developed by William Sharpe in 1963 and is commonly used in

the finance industry. rmt is the return to the market portfolio in period t.

The investor always likes to purchase combination of stocks the highest return and as lowest

risk. - The Markowitz model

Sharpe has developed a simplified model to analyse the portfolio. He assumed that the return

of a security is linearly related to single index like the Market index.

The market index should consist of all the securities trading on the exchange. Ex: BSE-

sensex, BSE – 100 and NSE – 50.

Single index model casual observation of the stock process over a period of time reveals that

most of the stock prices move with the market index. When “the sensex increases, stock prices also

tend to increase and vice – versa”. This indicates that some underlying factors affect the market index

as well as the stock prices. Stock prices are related to the market index and this relationship could be

used to estimate the return on stock.

The following equation can be used:

Where:

Ri= Expected return on security i


i

m

According to the equation, the return of a stock can be divided into two components,

the return due to the market and

the return independent of the market.

Beta i indicates the sensitiveness of the stock return to the changes in the market return.

For example beta i of 1.5 means that the stock return is expected to increase by 1.5% when the

market index return increase by 1% and vice - versa. Likewise beat i of 0.5 expresses that the

individual stock return would change by 0.5 % when there is a change of 1 % in the market return.

Beta i of 1 indicates that the market return and the security return are moving in tandem. The

estimates of beta i and alpha i are obtained from regression analysis.

the single index model is based on the assumption that stocks vary together because of the common

movement in the stock market and there are no effects beyond the market (i.e. any fundamental factor

effects) that account the stocks co-movement. The expected return, standard deviation and co –

variance of the single index model represent the joint movement of securities. The mean return is

The variance of security’s return, σ2 = β2i σ

2m + σei

2

The covariance of returns between securities i and j

σij= βi β j σ2

The variance of the security has two components namely, systematic risk or market risk and

unsystematic risk or unique risk. The variance explained by the index is referred to systematic risk.

The unexplained variance is called residual variance or unsystematic risk.

Systematic risk = β2i x variance of market index

= β2i σ2

m

Unsystematic risk = Total variance – systematic risk

ei2 = σ 2 – systematic risk

thus the total risk = Systematic risk + Unsystematic risk

= β2i σ

2 + ei2

The Portfolio Variance:

Where:

Xi = The portion of stock i in the portfolio

Likewise expected return on the portfolio also can be estimated. For each security αi and βi Should be

estimated.

m


Portfolio return is the weighted average of the estimated return for each security in the portfolio. The

weights are the respective stocks proportion in the portfolio.

A portfolio’s alpha value is a weighted average of the alpha values for its component securities using

the proportion of the investment in a security as weight.

Similarly, a portfolio’s beta value is the weighted average of the beta values of its component stocks

using relative share of them in the portfolio as weight.

Where:

CAPITAL ASSET PRICING MODEL:

Investors are interested in knowing the systematic risk when they search for efficient

portfolios. They would like to have assets with low beta co – efficient i.e. systematic risk. investors

would opt for high bet co –efficient only if they provide high rates of return. The risk verse nature of

the investors is the underlying factor for this behaviour. The capital asset pricing theory helps the

investors to understand the risk and return relationship of the securities. The assets should be priced

in capital market.

No matter how much we diversify our investments, it's impossible to get rid of all the risk.

As investors, we deserve a rate of return that compensates us for taking on risk. The capital asset

pricing model (CAPM) helps us to calculate investment risk and what return on investment we

should expect.

Markowitz, William sharpe, John Lintner and jam Mossin Provided the basic structure for the

CAPM theory, the required rate return of an asset is having a linear relationship with asset’s beta

value i.e. undiversifiable or systematic risk.

CAPM Assumptions:

1. An individual seller or buyer cannot affect the price of a stock. This assumption is the basic

assumption of the perfectly competitive market.

2. Investors make their decisions only on the basis of the expected returns, standard deviations

and covariance of all pairs of securities.

3. Investors are assumed to have homogenous expectations during the decision – making period.


4. The investor can lend or borrow any amount of funds at the riskless rate of interest. The

riskless rate of interest is the rate of interest offered for the treasury bills or government

securities.

5. Assets are infinitely divisible. According to this assumption, investor could buy any quantity

of share i.e. they can even buy ten rupees worth of reliance industry shares.

6. There is no transaction cost i.e. no cost involved in buying and selling of stocks.

7. There is no personal income tax. Hence , the investor is indifferent to the form of return either

capital gain or dividend.

8. Unlimited quantum of short sales, is allowed. Any amount of shares an individual can sell

short.

The concept, CAPM according to all investors hold only the market portfolio and riskless securities.

The market portfolio is a portfolio comprised of all stocks in the market. Each asset is held in

proportion to its market value to the total value of all risky assets. For example, if reliance industry

share represents 20% of all risky assets, then the market portfolio of the individual investor contains

20% of reliance industry shares. At this stage, the investor has the ability to borrow or lend any

amount of money at the riskless rate of interest. The efficient frontier of the investor is given in

below

CAPM is model that describes the relationship between systematic risk and expected return for assets

particularly stock.

It is concerned with 2 key:

What is the relationship between risk and return for an efficient portfolio.

What is the relationship between risk and return for an individual securities.

CAPM is a model of linear general equilibrium return. The CAPM is an equilibrium model that

specifies the relationship between risk and required rate of return. For assets held in well –

diversified portfolios.

CAPM describes the relationship between risk and expected return. And it serves as a model for the

pricing of risky securities. CAPM says that expected return of a security or a portfolio equals the rate

on a risk free security + a risk premium.

The above efficient frontier of the investor. The investor prefers any point between B and C because,

The efficient frontier is the set of optimal portfolios that offers the highest expected return for a

defined level of risk or the lowest risk for a given level of expected return. Portfolios that lie below

the efficient frontier are sub-optimal, because they do not provide enough return for the level of

risk. Portfolios that cluster to the right of the efficient frontier are also sub-optimal, because they

have a higher level of risk for the defined rate of return.


with the same level of risky face on line BA, they are able to get superior profits. The ABC line

shows the investor’s portfolio of risky assets. The investors can combine riskless asset either by

lending or borrowing.

Capital Market Line:

In the 1950’s Harry Markowitz wrote his doctoral dissertation entitled “Portfolio Selection.” In it he

identified the efficient frontier which is the hypothetical set of all possible efficient portfolios. An

efficient portfolio is any portfolio with an expected return that is greater than any other portfolio with

the same risk level, and less risk (i.e., σ) than any other portfolio with the same return. However,

Markowitz’s study looked at the (massive) empirical record of investment returns but only

considered risky assets – it did not include risk-free assets (the risk-free asset is usually considered to

be the 90-day T-bill). Also, Markowitz’s study did not consider the use of leverage. The efficient

frontier and the CML use standard deviation (σ) to measure risk.

All efficient portfolios lie on the efficient frontier. But when an efficient portfolio consisting

of only risky assets is combined with a risk-free asset, the efficient portfolios no longer lie on the

curved efficient frontier. Instead, by combining a risk-free asset with the risky-asset portfolio, an

enhanced linear efficient frontier is realized: it is called the capital market line (CML). Theoretically,

there is only one CML.

The CML then extends linearly to a point where the CML is tangent to the efficient frontier.

This point is referred to as the market portfolio. The market portfolio includes all risky assets (and

only risky assets). The market portfolio contains only systematic risk; all non-systematic risk has

been diversified away. The risky assets are included in proportion to their market value, however

only risky assets with a positive market value are included (i.e., those assets for which there is a

demand). There are no risk-free assets in the market portfolio.

Every investor (presumably) wants to invest in the market portfolio and either lend money at

the risk-free rate (i.e., purchase T-bills) or borrow money at the risk-free rate (i.e., use leverage) to

purchase additional risky-assets. If the blended portfolio lies on the CML somewhere between the Rf

intercept (i.e., the risk-free rate) and point of tangency (i.e., the market portfolio), the investor’s

portfolio consists of a blend of T-bills and some proportion of risky assets. If the investor’s portfolio

lies on the CML beginning at the market portfolio or beyond, the investor’s portfolio consists only

risky at assets. Leverage is not utilized at the point of tangency (i.e., the market portfolio). But as the

investor moves beyond the market portfolio on the CML, leverage is utilized. An investor’s risk

preference will determine the investor’s portfolio position on the CML.

There is a direct correspondence between the proportion of risk-free assets and risky assets in

the investor’s portfolio and the portfolio’s risk (σ). For example, if an investor’s portfolio consists of


50% risk-free assets and 50% risky assets, the investor’s portfolio risk is 50% of the market

portfolio’s standard deviation (σ); if the investor’s portfolio consists of 20% risk-free assets and 80%

risky assets, the investor’s portfolio risk is 80% of the market portfolio’s standard deviation (σ), etc.

The CML Equation is:

]

CML = Rf + Risk Premium

E(Rp) = Rf + ]

Where:

E(Rp) = Portfolio’s expected rate of return

Rm = expected return on market portfolio

σm = standard deviation of market portfolio

Rf = Risk free Return

For a portfolio on the capital market line. The expected rate of return in excess of the risk free rate is

in proportion to the standard deviation of the market portfolio. The process of the risk is given by the

slope of the line. The slope equals the risk premium for the market portfolio Rm – Rf divided by the

risk or standard deviation of the market portfolio. Thus the expected return of an efficient portfolio is

Expected return = price of time + (price of risk x amount of risk)

Price of time is the risk free rate of return. Price of risk is the premium amount higher and above the

risk free return.

The clear conclusion of the CML equation is higher returns require additional risk.

Return of the portfolio is = Risk free return + Market risk premium. (Rm – Rf)

If SD of the market is grater then the risk premium will be large in creating the return of the portfolio.

The CML slope indicates the additional incremental returns expected by the market place. Only

efficient Portfolio are on the CML.

Inefficient portfolio (or) individual securities will not plot on the CML. It will be SML must be used.

Security Market Line:

The risk – return relationship of an efficient portfolio is measured by the capital market line.

But, it does not show the risk-return trade off for other portfolio and individual securities.

Inefficient portfolios lie below the capital market line and the risk – return relationship connot be

established with the help of the capital market line . Standard deviation includes the systematic and

unsystematic risk. unsystematic risk can be diversified and it is not related to the market.

If the unsystematic risk is eliminated then the matter of concern is systematic risk alone. This

systematic risk could be measured by beta. The beta analysis is useful for individual securities and

portfolios whether efficient or inefficient.

When an additional security is added to the market portfolio, an additional risk is also added

to it. The variance of a portfolio is equal to the weighted sum of the co – variance of the individual

securities in the portfolio. If we add an additional security to the market portfolio, its marginal


contribution to the variance of the market is the covariance between the security’s return and market

portfolio’s return.

If the security i is included, the covariance between the security and the market measures the

risk. covariance can be standardised by dividing it by standard deviation of market portfolio Cov

im/σ. This shows the systematic risk of the security. Then, the expected return of the security i is

given by the equation.

Ri – Rf = Cov im / σm

This equation can be rewritten as follows:

Ri – Rf = Rm - Rf

The first term of the equation is nothing but beta coefficient of the stock. The beta coefficient

of the equation of SML is same as the beta of the market (single index) model. In equilibrium, all

efficient and inefficient portfolios lie along the security market line. The SML line helps to determine

the expected return for a given security beta. In other words, when betas are given, we can generate

expected returns for the given securities.

E(Ri) = Rf + βi [E(Rm) – Rf]

SML is gives the risk and return relationship for individual stock.

If Beta = 1 stock is average risk

Beta > 1 stock is riskier than average

Beta < 1 Stock is less risky than average

The most stock have β in the range of 0.5 to 1.5.

Beta is individual securities are not good estimator of future risk. beta s of portfolio of 10 or

randomly selected stocks are reasonably stable. SML is not produce a correct estimation of Pi.

CAPM = Rf + β (Rm +Rf)

Where:

Rf = Risk free return


β = Market risk or standard deviation

portfolio. Rm = Expected return on market

portfolio.

ARBITRAGE PRICING THEORY:

Arbitrage pricing theory is one of the tools used by the investors and portfolio managers. The

capital asset pricing theory explains the returns of the securities on the basis of their respective betas.

According to the previous models, the investor chooses the investment on the basis of expected

return and variance.

The alternative model developed in asset pricing by Stephen Ross is know as Arbitrage Pricing

Theory (APT) – 1976. APT is explains the nature of equilibrium in the asset pricing a less

complicated manner with fewer assumptions compared to CAPM.

Arbitrage is a process of earning profit by taking advantage of differential pricing for the

same asset.

The process generates riskless profit.

It is of selling security at a high price and the simultaneous purchase of the same security

lower price.

The profit earned through arbitrage is riskless.

Buying and selling activities of the arbitrageur reduces and eliminates the profit margin,

bringing the market price to the equilibrium level.

APT Assumptions:

The investors have homogenous expectations.

The investors are risk averse and utility maximises.

Perfect competition prevails in the market and there is no transaction cost.

The APT theory does not assume:

Single period investment horizon

Not taxes

Investors can borrow and lend at risk free rate of interest

The selection of the portfolio is based on the mean and variance analysis

This assumption are present in the CAPN theory.

Arbitrage Portfolio:

According to the APT theory an investor tries to find out the possibility to increase returns

from his portfolio without increasing the funds in the portfolio.

The investor holds A, B and C securities and he wants to change the proportion of the

securities without any additional financial commitment. Now the change in proportion of

securities can be denoted by XA, Xb and XC.

The increase in the investment in security A could be carried out only if he reduces the

proportion of investment either in B and C because it has already stated that the investor tries

to earn more income without increasing his financial commitment.

Thus the changes in different securities will add up to Zero. This is the basic requirement of an

arbitrage portfolio.

If X indicates the change in proportion


Arbitrage pricing equation:

In a single factor model, the linear relationship between the return Ri and sensitivity bi can be given in

the following form.

Where:

Ri = Return from stock A

It indicates market price of risk and measures the risk return trade off in the security markets.

FUNDAMENTAL ANALYSIS:

Fundamental Analysis is to evaluate the lot information about the past performance and the

expected future performance of companies, industries and the economy as a whole before taking the

investment decision. Such evaluation or analysis is called fundamental analysis.

Fundamental analysis is really a logical and systematic approach to estimating the future dividends

and share price.

Fundamental analysis is performed on historical and present data, but with the goal of making

financial forecasts.

There are several possible objectives:

o To conduct a company stock valuation and predict its probable price evolution.

o To make a projection on its business performance.

o To evaluate its management and make internal business decisions,

o To calculate its risk.

Fundamental Analysis includes:

Economic analysis

Industry analysis

Company analysis


The Analysis of economy, industry and company constitute the main activity in the

fundamental approach to security analysis. And can be viewed as different stages in investment

decision making process.

Three tier analysis depict that company performance dependent not only on its own effort but

also on the general industry and economy factor.

Economy Analysis:

The Economy Analysis is classified to Boom Economy and Recession Economy

Boom Economy – income rise and demand for goods will increase the industries and companies in

general tend to be prosperous.

Recession Economy - income decline and demand for goods will decrease the industries and

companies in general tend to be bad performance.

Growth rates of national Income(GRNI):

GRNI is an important variable can be calculated by GDP, NNP, and GDP to analysis the growth rate

of economy.

Four stages of economy or economic cycle i.e

1. Depression

2. Recovery

3. Boom and

4. Recession

also impact on security performance.

Depression: At this stage demand is low and declining inflation often high and so are interest

rate, companies usually reduce activities and securities performance is poor.

Recovery: Economy begin to revive after depression, demand pick up leading, production

and activities increase.

Boom: High demand with high investment and production, companies earn more profit

Recession: Companies slowly begins downturn in demand, production and employment,

profits are also decline.

Economic Forecasting:

The technique of economic forecasting is to measure either short-term or longer – term

economic developments well in advance.

Forecasting Techniques

Surveys.

Economic Indicators.

Diffusion Indexes.

Economic Model Building .

Opportunistic Model Building.

Industry analysis:

Industry analysis is a type of investment research that begins by focusing on the status of an

industry or an industrial sector.


Why is this important?

Each industry is different, and using one cookie-cutter approach to analysis is sure to create

problems. Imagine, for example, comparing the P/E ratio of a tech company to that of a

utility. Because you are, in effect, comparing apples to oranges, the analysis is next to

useless.

Industry Analysis Looks At

Michael Porter’s 5 Force Model are:

a) Past sales and earnings performance

b) Labor condition within the industry

c) Attitude of government towards industry

d) Competitive condition

e) Stock prices of firm in the industry

Threat of New Entrants.

setting up a chip fabrication factory requires billions of dollars in investment.

Semiconductor companies are forming alliances to spread out the costs of manufacturing.

Meanwhile, the appearance and success of "fabless" chip makers suggests that factory

ownership may not last as a barrier to entry.

Power of Suppliers.

For the large semiconductor companies, suppliers have little power

many smaller chip makers are becoming increasingly dependent on a handful of large

foundries.

Power of Buyers.

Most of the industry's key segments are dominated by a small number of large players. This

means that buyers have more bargaining power.

Availability of Substitutes.

depends on the segment.

Copy-cat suppliers and reverse engg.

Competitive Rivalry.

Intense rivalries between individual companies

The result is an industry that continually produces cutting-edge technology while riding

volatile business conditions.

Company Analysis:

It involves a close investigative scrutiny of the company’s financial and non financial aspects with a

view to identifying its strength, weaknesses and future business prospects.

The financial and non financial aspects are as follows:

Marketing success

Accounting Policies

Profitability

Marketing Success:

The success of the market of the firm depends on The share of the company in the industry ,

Growth of its sales and stability of sales.

Accounting Policies:

A. Inventory Pricing

Cost/market value method


FIFO

LIFO

B. Depreciation methods

Straight line method

Sum of the years digit method

C. Non operating income

Dividend

Interest

D. Tax Carry over

Provision for taxation

Profitability:

A. (a) Gross profit Margin

(b) Net profit Margin

(c) Earning power

(d) Return on equity

(e) Earning per share

(f) Cash EPS

B. Financial Statement Analysis

• Trading, P& L A/C Analysis

• Balance Sheet Analysis

C. Ratio Analysis Liquidity Ratios

Leverage Ratios

Profitability Ratios

Activity / Efficiency Ratio

FUNDAMENTAL ANALYSIS OF A COMPANY


EQUITY VALUATION MODELS:

The main purpose of equity valuation is to estimate a value for a firm or security. A key

assumption of any fundamental value technique is that the value of the security (in this case an equity

or a stock) is driven by the fundamentals of the firm’s underlying business at the end of the day.

Valuation:

Valuation is the process of determining the fair market value of an asset or equity security. Equity

valuation use to estimate the intrinsic value of a Security.

The intrinsic value is the actual value of a company or an asset based on an underlying

perception of its true value including all aspects of the business, in terms of both tangible and

intangible factors. This value may or may not be the same as the current market value. The intrinsic

value is the fundamental value of the security or asset.

Estimate Value and Market Price:

Undervalued = intrinsic value > Market price

Fairly Valued = Intrinsic value = Market price

Over Valued = Intrinsic value < Market price

Techniques of fundamental Equity Valuation:

Balance sheet Techniques:

Book Value

Liquidation value

Replacement cost

Discounted Cash Flow

Techniques:

Dividend discount model

Free cash flow model

Relative Valuation Techniques:

Price – earnings ratio

Price – book value ratio

Price sales ratio


Balance sheet Technique:

Analysts often look at the balance sheet of the firm to get a handle on some valuation measures.

There are measures derived from balance sheet are:

Book Value:

Book value is also the net asset value of a company, The book value per share is simply the net worth

of the company divided by the number of outstanding equity shares.

Book Value =

Liquidation Value:

The liquidation value appears more realistic than the book value, there are two serious

problems in applying it. First, it is very difficult to estimate what amounts would be realized from the

liquidation of various assets. Second, the liquidation value does not reflect earning capacity.

The liquidation value per share is equal to

Liquidation Value =

Replacement Cost:

Another balance sheet measure considered by analysts in valuing a firm is the replacement

cost of assets less liabilities. The sue of this measure is based on the premise theat the market value

of a firm cannot deviate too much form its replacement cost.

Replacement Cost = Assets – Liabilities.

Dividend Discount Model:

It is used to value stock based on the net present value of the future dividend. The value of an

equity share is equal to the present value of dividend expected from ownership plus the present value

of the sale price expected when the equity share is sold.

Assumptions:

Dividends are paid annually.

The first dividend is received one year after the equity share Is brought.

Single Period Valuation Model:

Let us begin with the case where the investor expects to hold the equity share for one year. The price

of the equity share will be:

Growth:

Where:


Po = Current price of the equity.

D1= Expected Dividend

P1 = Market Price or expected equity price. R = rate of return

G = Growth rate.

Multi – Period Valuation Model:

It is easy to calculate the present value of the stock for a year. If the holding period is more

than a year, a separate formula is applied to find out the present value of the share.

Where:

G = annual expected growth in earnings, dividend and

price Eo = Most recent earnings per share

d/e = dividend payout

ratio R = required rate of

return P/E = price earnings

ratio N = holding period in

years

FREE CASH FLOW MODEL:

The free cash flow model broadly involves determining the value of the firm as a whole (this

value is called the enterprise value) by discounting the free cash flow to investors and then

subtracting the value of preference and debt to obtain the value of equity. It involves the following

procedure.

1. Divide the future into two parts, the explicit forecast period and the balance period.

The explicit forecast period (which is usually 5 to 15 years) represents the period during

which the firm is expected to evolve and finally reach a steady state – a state in which the return on

invested capital (or return on capital employed), growth rate and cost of capital stabilize.

2. forecast the free cash flow, year by year, during the explicit forecast period. The free cash

flow is the cash flow available for distribution to capital providers (shareholders and debtholders)

after providing for the investments in fixed assets and net working capital required to support the

growth of the firm.

The FCF is equal to : NOPAT – Net investment.

NOPAT is net operating profit adjusted for taxes. It is equal to profit before interest and tax (1 – tax

rate). Net investment is simply, change in net fixed assets + change in net working capital.

3. Calculate the weighted average cost of capital: the WACC is the blended post – tax cost of

equity, Preference and debt employed by the firm.

WACC = We re + Wp rp + Wd rd (1-t)

Where We, Wp and Wd are the weights associated with equity, preference and debt and re, rp and rd are


the costs associated with equity, preference, and debt Note that the cost of debt, rd is adjusted for

taxes because the interest on debt is a tax –deductible payment.

4. Establish the horizon value of the firm: The horizon value (VH) is the value placed on the firm at the end of the explicit forecast period (H years). Since the FCF is expected to grow at a constant rate

of g beyond H, the horizon value is equal to

5. Estimate the enterprise value: The enterprise value (EV) or the firm value is the present value of

the FCF during the explicit forecast period plus the present value of the horizon value.

Present value of the FCF during the explicit present value of

horizon forecast period value

6. Derive the equity value the equity value is:

Enterprise value – Preference value – Debt value

7. Compute the value per share the value per share is simply the equity value divided by the

number of outstanding equity shares.

TECHNICAL ANALYSIS:

Technical analysis is the attempt to forecast stock prices on the basis of market-derived data.

Technicians (also known as quantitative analysts or chartists) usually look at price, volume and

psychological indicators over time. They are looking for trends and patterns in the data that indicate

future price movements.

The Potential Rewards:

This chart, from Norman Fosbeck, shows how market timing can benefit your returns. The

only problem is that you have to be very good at it.

Alternative Market Strategies (1964 to 1984)

Strategy Avg. Annual Gain $10,000 Grows To

Buy and Hold 11.46% $ 87,500

Avoid Bear Markets 21.48% $ 4,89,700

Long and Short Major Swings 27.99% $ 13,91,200

Long and Short Every 5% Swing 93.18% $ 5,24,00,00,000

This chart, from Barron’s, shows the benefit of being smart enough to miss the worst 5 days

of the year between Feb 1966 and Oct 2001.


Charting the Market:

Chartists use bar charts, candlestick, or point and figure charts to look for patterns which may

indicate future price movements.

They also analyze volume and other psychological indicators (breadth, % of bulls vs % of

bears, put/call ratio, etc.).

Strict chartists don’t care about fundamentals at all.

Drawing Bar (OHLC) Charts:

Each bar is composed of 4 elements:

Open

High

Low

Close

Note that the candlestick body is empty (white) on up days, and filled (some color) on down

days

Note: You should print the example charts (next two slides) to see them more clearly

Open

High

Low

Close

Open

High

Low

Close

Standard Bar Chart

Types of Charts: Bar Charts

Japanese Candlestick

Standard Bar Chart

Japanese Candlestick

This is a bar (open, high, low, close or OHLC) chart of AMAT from early July to mid

October 2001.

Types of Charts: Japanese Candlesticks


Drawing Point & Figure Charts:

Point & Figure charts are independent of time.

An X represents an up move. An O represents a down move.

X

The Box Size is the number of XpoXints needed to X

X O

XOX O

make an X or O. O

XO O

X


The Reversal is the price change needed to recognize a change in direction.

Typically, P&F charts use a 1-point box and a

3-point reversal.

Chart Types: Point & Figure Charts

This is a Point & Figure chart of AMAT from

early July to mid October 2001.

Basic Technical Tools:

The Basic Technical Tools are:

Trend Lines

Moving Averages

Price Patterns

Indicators

Cycles

Trend Lines:

There are three basic kinds of trends:

An Up trend where prices are generally increasing.

A Down trend where prices are generally decreasing.

A Trading Range.

Support & Resistance:

Support and resistance lines indicate likely ends of trends.

Resistance results from the inability to surpass prior highs.

Support results from the inability to break below to prior lows.

What was support becomes resistance, and vice-versa.


Simple Moving

A moving average is simply the average price

(usually the closing price) over the last N periods.

They are used to smooth out fluctuations of

less than N periods.

This chart shows MSFT with a 10-day moving

average. Note how the moving average shows much less volatility than the daily stock price.

MSFT Daily Prices with 10-day MA

9/23/93 to 9/21/94

60

55

50

45

40

35

Price Patterns:

30

1 21 41 61 81 101 121 141 161 181 201 221 241

Date

Technicians look for many patterns in the historical time series of prices. These patterns are reputed to provide information regarding the size and timing of subsequent

price moves.

But don’t forget that the EMH says these patterns are illusions, and have no real meaning. In

fact, they can be seen in a randomly generated price series.

Pri

ce


Neckline

Head & Shoulders Example: Left Shoulder

Right Shoulder

Head

Head and Shoulders:

This formation is characterized by two small peaks on either side of a larger peak.

This is a reversal pattern, meaning that it signifies a change in the trend.

H&S Top

Head

H&S Bottom

Double Tops and Bottoms:

These formationsDaorueblseimToiplar to the H&S formations,

but there is no head.

These are reversal patterns with the same

measuring

implications as the H&S. Target

Target

Left Shoulder Right Shoulder

Neckline


Double Bottom Example:

Double Bottom

Ascending

Triangles:

Triangles are continuation formations.

Three flavors:

Ascending

Descending

Symmetrical

Typically, triangles should break out about half to three-quarters of the way through the

formation.

Rounded Tops & Bottoms:

Rounding formations are characterized by a slow reversal of trend.

Rounded Bottom Chart Example:

Rounding

Bottom

Rounding Top

Broadening Formations:

These formations are like reverse triangles.

These formations usually signal a reversal of the trend.

DJIA Oct 2000 to Oct 2001

Example:

Broadening Bottoms

Descending

Symmetrical

Symmetrical


Broadening Tops


Technical Indicators:

There are, literally, hundreds of technical indicators used to generate buy and sell signals.

We will look at just a few that I use:

Moving Average Convergence/Divergence (MACD)

Relative Strength Index (RSI)

On Balance Volume

Bollinger Bands

For information on other indicators see my Investments Class Links page under the heading

“Technical Analysis Links.” (http://clem.mscd.edu/~mayest/FIN3600/FIN3600_Links.htm)

MACD:

MACD was developed by Gerald Appel as a way to keep track of a moving average crossover

system.

Appel defined MACD as the difference between a 12-day and 26-day moving average. A 9-

day moving average of this difference is used to generate signals.

When this signal line goes from negative to positive, a buy signal is generated.

When the signal line goes from positive to negative, a sell signal is generated.

MACD is best used in choppy (trendless) markets, and is subject to whipsaws (in and out

rapidly with little or no profit).

http://clem.mscd.edu/~mayest/FIN3600/FIN3600_Links.htm


Relative Strength Index (RSI):

RSI was developed by Welles Wilder as an oscillator to gauge overbought/oversold levels.

RSI is a rescaled measure of the ratio of average price changes on up days to average price

changes on down days.

The most important thing to understand about RSI is that a level above 70 indicates a stock is

overbought, and a level below 30 indicates that it is oversold (it can range from 0 to 100).

Also, realize that stocks can remain overbought or oversold for long periods of time, so RSI

alone isn’t always a great timing tool.

A technical analysis tool that is banded between two extreme values and built with the

results from a trend indicator for discovering short term overbought and over sold conditions. As

the value of the oscillator approach the upper extreme value the asset is seem to be over brought

and as it is approaches to be lower extreme as it seems to be over sold.

RSI Example Chart:

On Balance Volume:

On Balance Volume was developed by Joseph Granville, one of the most famous technicians

of the 1960’s and 1970’s.

OBV is calculated by adding volume on up days, and subtracting volume on down days. A

running total is kept.

Granville believed that “volume leads price.”

To use OBV, you generally look for OBV to show a change in trend (a divergence from the

price trend).

If the stock is in an uptrend, but OBV turns down, that is a signal that the price trend may

soon reverse.

OBV Example Chart:


Bollinger Bands:

Bollinger bands were created by John Bollinger (former FNN technical analyst, and regular

guest on CNBC).

Bollinger Bands are based on a moving average of the closing price.

They are two standard deviations above and below the moving average.

A buy signal is given when the stock price closes below the lower band, and a sell signal is

given when the stock price closes above the upper band.

When the bands contract, that is a signal that a big move is coming, but it is impossible to say

if it will be up or down.

In my experience, the buy signals are far more reliable than the sell signals.

Bollinger Bands Example Chart:

Dow Theory:

This theory was first stated by Charles Dow in a series of columns in the WSJ between 1900

and 1902.

Dow (and later Hamilton and Rhea) believed that market trends forecast trends in the

economy.

A change in the trend of the DJIA must be confirmed by a trend change in the DJTA in order

to generate a valid signal.

Dow Theory Trends:

Primary Trend

Called “the tide” by Dow, this is the trend that defines the long-term direction (up to

several years). Others have called this a “secular” bull or bear market.

Secondary Trend

Called “the waves” by Dow, this is shorter-term departures from the primary trend

(weeks to months)

Day to day fluctuations

Not significant in Dow Theory

Does Dow Theory Work?

According to Martin Pring, if you had invested $44 in 1897 and followed all buy and sell

signals, by 1981 you would have accumulated about $18,000.

If you had simply invested $44 and held that portfolio, by 1981 you would have accumulated

about $960.

Elliot Wave Principle:

R.N. Elliot formulated this idea in a series of articles in Financial World in 1939.


B

A

3 C

4 1

2

Elliot believed that the market has a rhythmic regularity that can be used to predict future

prices.

The Elliot Wave Principle is based on a repeating 8-wave cycle, and each cycle is made up of

similar shorter-term cycles (“Big fleas have little fleas upon their backs to bite 'em - little

fleas have smaller fleas and so on ad infinitem”).

Elliot Wave adherents also make extensive use of the Fibonacci series.

5

Fibonacci Numbers:

Fibonacci numbers are a series where each succeeding number is the sum of the two

preceding numbers.

The first two Fibonacci numbers are defined to be 1, and then the series continues as follows:

1, 1, 2, 3, 5, 8, 13, 21…

As the numbers get larger, the ratio of adjacent numbers approaches the Golden Mean:

1.618:1.

This ratio is found extensively in nature, and has been used in architecture since the ancient

Greeks (who believed that a rectangle whose sides had the ratio of 1.618:1 was the most

aesthetically pleasing).

Technical analysts use this ratio and its inverse, 0.618, extensively to provide projections of

price moves.

Does Elliot Wave Work?

Who knows? One of the biggest problems with Elliot Wave is that no two practitioners seem

to agree on the wave count, and therefore on the prediction of what’s to come.

Robert Prechter (the most famous EW practitioner) made several astoundingly correct

predictions in the 1980’s, but hasn’t been so prescient since (he no longer gets much press

attention).

For example, in 1985 he predicted that the market would peak in 1987 (correct), but he

thought it would peak at 3686 (± 100 points).

The DJIA actually peaked on 25 August 1987 at 2722.42, more than 960 points lower.

Too Many Others To List:

As noted, there are literally hundreds of indicators and thousands of trading systems.

A whole semester could easily be spent on just a handful of these.

To close, just note that there is nothing so crazy that somebody doesn’t use it to trade.

For example, many people use astrology, geometry (Gann angles), neural networks, chaos

theory, etc.

There’s no doubt that each of these (and others) would have made you lots of money at one

time or another. The real question is can they do it consistently?

As the carneys used to say, “You pays your money, and you takes your chances.”


UNIT – IV

EVALUATION OF PORTFOLIOS

The portfolio performance evaluation primarily refers to the determination of how a particular

investment portfolio has performed relative to some comparison benchmark. The evaluation can

indicate the extent to which the portfolio has outperformed or under-performed, or whether it has

performed at par with the benchmark.

The evaluation of portfolio performance is important for several reasons.

First, the investor, whose funds have been invested in the portfolio, needs to know the

relative performance of the portfolio. The performance review must generate and provide information

that will help the investor to assess any need for rebalancing of his investments.

Second, the management of the portfolio needs this information to evaluate the performance

of the manager of the portfolio and to determine the manager’s compensation, if that is tied to the

portfolio performance. The performance evaluation methods generally fall into two categories,

namely conventional and risk-adjusted methods.

Conventional Methods

Conventional methods can be classified as two types:

Benchmark Comparison

Style Comparison

Benchmark Comparison:

The most straightforward conventional method involves comparison of the performance of an

investment portfolio against a broader market index. The most widely used market index in the

United States is the S&P 500 index, which measures the price movements of 500 U.S. stocks

compiled by the Standard & Poor’s Corporation.

If the return on the portfolio exceeds that of the benchmark index, measured during identical

time periods, then the portfolio is said to have beaten the benchmark index. While this type of

comparison with a passive index is very common in the investment world, it creates a particular

problem. The level of risk of the investment portfolio may not be the same as that of the benchmark

index portfolio.

Higher risk should lead to commensurately higher returns in the long term. This means if the

investment portfolio has performed better than the benchmark portfolio, it may be due to the

investment portfolio being more risky than the benchmark portfolio. Therefore, a simple comparison

of the return on an investment portfolio with that of a benchmark portfolio may not produce valid

results.

Style Comparison

A second conventional method of performance evaluation called ”style-comparison”

involves comparison of return of a portfolio with that having a similar investment style. While there

are many investment styles, one commonly used approach classifies investment styles as value

versus growth.


The “value style” portfolios invest in companies that are considered undervalued on the basis

of yardsticks such as price-to-earnings and price-to-topic value multiples. The “growth style”

portfolios invest in companies whose revenue and earnings are expected to grow faster than those of

the average company.

In order to evaluate the performance of a value-oriented portfolio, one would compare the

return on such a portfolio with that of a benchmark portfolio that has value-style. Similarly, a growth-

style portfolio is compared with a growth-style benchmark index. This method also suffers from the

fact that while the style of the two portfolios that are compared may look similar, the risks of the two

portfolios may be different. Also, the benchmarks chosen may not be truly comparable in terms of

the style since there can be many important ways in which two similar style-oriented funds vary.

Reilly and Norton (2003) provide an excellent disposition of the use of benchmark portfolios and

portfolios style and the issues associated with their selection. Sharpe (1992), and Christopherson

(1995) have developed methods for determining this style.

Risk-adjusted Methods

The risk-adjusted methods make adjustments to returns in order to take account of the

differences in risk levels between the managed portfolio and the benchmark portfolio. While there are

many such methods, the most notables are:

Sharpe Measure (S),

Treynor Measure (Tn),

Modigliani and Modigliani (M2).

These measures, along with their applications, are discussed below.

SHARPE MEASURE (SHARPE, 1966):

Sharpe’s performance index gives a single value to be used for the performance ranking of

various funds or portfolios. Sharpe’s Measures the risk premium of the investment portfolio per unit

of total risk of the portfolio. The risk premium, also known as excess return, is the return of the

portfolio less the risk-free rate of interest as measured by the yield of a Treasury security. The total

risk is the standard deviation of returns of the portfolio. The numerator captures the reward for

investing in a risky portfolio of assets in excess of the risk-free rate of interest while the denominator

is the variability of returns of the portfolio. In this sense, the Sharpe measure is also called the

“reward-to-variability” ratio. The index assigns the highest values to assets that have best risk –

adjusted average rate of return.

Where:

S = The Sharpe Measure,

Rp = Portfolio average return

Rf = The risk-free rate of interest,

= The standard deviation of returns of the portfolio.


TREYNOR’S MEASURE:

The Treynor ratio (Treynor, 1965) computes the risk premium per unit of systematic risk. The

risk premium is defined as in the Sharpe measure. The difference in this method is in that it uses the

systematic risk of the portfolio as the risk parameter. The systematic risk is that part of the total risk

of an asset which cannot be eliminated through diversification. It is measured by the parameter

known as ‘beta’ that represents the slope of the regression of the returns of the managed portfolio on

the returns to the market portfolio. The Treynor’s Measure is given by the following equation:

Where:

Tn = Treynor’s Measure

Rp = The return of the portfolio,

Rf = The risk-free rate of Interest

= The beta Co – efficient of portfolio.

MODIGLIANI AND MODIGLIANI MEASURE (M2):

Modigliani risk-adjusted performance (also known as M2, M2, Modigliani–Modigliani

measure or RAP) is a measure of the risk-adjusted returns of some investment portfolio. It measures

the returns of the portfolio, adjusted for the risk of the portfolio relative to that of some benchmark

(e.g., the market). It is derived from the widely used Sharpe ratio, but it has the significant advantage

of being in units of percent return (as opposed to the Sharpe ratio – an abstract, dimensionless ratio of

limited utility to most investors), which makes it dramatically more intuitive to interpret.

In 1997, Nobel-prize winner Franco Modigliani and his granddaughter, Leah Modigliani,

developed what is now called the Modigliani risk-adjusted performance measure. They originally

called it "RAP" (risk-adjusted performance). They also defined a related statistic, "RAPA"

(presumably, an abbreviation of "risk-adjusted performance alpha"), which was defined as RAP

minus the risk-free rate (i.e., it only involved the risk-adjusted return above the risk-free rate). Thus,

RAPA was effectively the risk-adjusted excess return.

The Sharpe ratio is not easy to interpret. In the example, the Sharpe ratio for the managed

portfolio is 0.50, while that for the market is 0.45. We concluded that the managed portfolio

outperformed the market. The difficulty, however, is that the differential performance of 0.05 is not

an excess return. Modigliani and Modigliani (1997) measure, which is referred to as M2, provides a

risk-adjusted measure of performance that has an economically meaningful interpretation. The M2 is

given by:

Where:

M2 = The Modigliani-Modigliani Measure,

Rp= The return on the adjusted portfolio.

Rm = The return on the market portfolio.


The adjusted portfolio is the managed portfolio adjusted in such a way that it has the same

total risk as the market portfolio. The adjusted portfolio is constructed as a combination of the

managed portfolio and risk-free asset.

Where weights are specified as in Equations are:

Where:

Wrp = Represents the weight given to the managed portfolio

= The standard deviation of the market portfolio.

= The standard deviation of the managed portfolio.

Wrf = The weight on the risk-free asset.

MORNINGSTAR’S RATINGS:

The Morningstar risk rating is a ranking given to publicly traded mutual funds and exchange-

traded funds (ETF)s by the investment research firm Morningstar. The ratings range from one to five

stars, with one being the poorest rank and five being the best. Morningstar's risk ratings, also called

star ratings, are designed to help investors quickly identify funds to consider for their portfolios.

Debuted in 1985, Morningstar risk ratings are based on the fund's past performance, the fund

manager's skill, risk- and cost-adjusted returns, and performance consistency. Morningstar assigns a

one-star rating to 10% of the funds it evaluates, a two-star rating to 22.5% of funds, a three-star rating

to 35% of funds, a four-star rating to 22.5% of funds. and a five-star rating to 10% of funds. The

Morningstar ratings are intended to be a starting point for further research and are not buy or sell

recommendations.

While Morningstar ratings are considered essential in guiding investors toward quality

investment decisions, they are not immune to criticism. Some financial analysts have criticized these

ratings because they only compare funds to other funds, in isolation from the greater marketplace. As

a result, a fund's rating may reflect its suitability for the particular market more than its overall

viability and potential.

For example, as prices are rising in a bull market, funds with historically safe stocks from

companies such as AT&T tend to perform well. Conversely, when prices are falling in a bear market,

funds featuring speculative stocks from companies such as Tesla Motors and Charles Schwab tend to

do better. As a result, some investors prefer ratings that keep the market conditions in mind, such as

the ratings generated by Forbes.

You’re probably familiar with Morningstar and their one- to five-star mutual fund ratings. Many

investors rely on Morningstar for stock and mutual fund research, and mutual fund

companies love using Morningstar ratings in their marketing materials. But is there any value in a

five-star Morningstar rating? (Disclosure: I use Morningstar software sold to investment advisors

almost every day.)


The Morningstar ratings for one of the funds J.D. owns.

Fortunately for us, researchers recently looked into these ratings and published their results.

They compared Morningstar ratings to fund expense ratios as a predictor of future performance.

The expense ratio is the annual fee for investing in a fund. This fee is charged by the mutual

fund manager, and it’s one of my favourite metrics. If you assume that mutual fund managers have

no value — which I find to be a very good approximation — you would expect lower costs to predict

better performance. And the report found just that:

Expense ratios are strong predictors of performance. In every asset class over every time period, the

cheapest quintile produced higher total returns than the most expensive quintile.

What about Morningstar ratings? Five-star ratings predicted better performance than one-star

ratings in 13 of 20 observations — a success rate of just 65%. That sounds pretty good on its own,

but it’s still worse than a metric that anyone can look up in seconds.

Since Morningstar uses prior performance (after fees) to calculate its ratings, the ratings already

include information about expense ratios indirectly. So what is Morningstar adding with its fancy

algorithm? Let’s use a little high-school algebra to find out. (Geek Alert!)

Morningstar Rating = Expense Ratio + Morningstar’s Additional Analytics

And we just found out that:

Expense Ratio > Morningstar Rating

Finally, using my graduate degree in math, I get this:

Morningstar’s Additional Analytics < 0

Yes, Morningstar’s algorithm is horrible. And that’s not all.

Morningstar reserves its five- and one-star ratings for the top and bottom 10% of funds.

However, the researchers conducting this study divided expense ratios into quintiles — or, as normal

people would say, 20% buckets. The expense ratios were handicapped by using 20% buckets instead

of 10%, and still beat Morningstar ratings. Ouch!

Well, there’s one thing I forgot to tell you. People have performed this evaluation many times

with similar results, so it isn’t news to serious students of investing.

The interesting part of the report I quoted is the publisher: Morningstar. If you read its report,

it sounds like a politician answering a tough question — uncomfortable. Independent thinkers can go

directly to the results here.

STYLE ANALYSIS:

To investigate Sharpe's (1988, 1992) investment style model of managed portfolios in terms

of asset allocation (style), using the Solver function. Style analysis (or asset allocation) models are a


valuable tool for investors, plan sponsors, and consultants. Investors want to know the investment

style so they can create an effective mix of assets that fits their tastes. Plan sponsors and consultants

are interested in how well the portfolio manager meets the investment objectives.

Sharpe (1992) defines the asset allocation of a mutual fund as the way in which the fund manager

allocates his assets across a number of major asset classes.

Consider the following equation:

Ri = bi1F1 + bi2F2 + ….+ bin Fn+ ei

Where:

Ri = the mutual fund return,

Fn = the value of the nth

factor, bin = the factor

sensitivities, and ei = the

unsystematic residual.

It could be helpful for investors to know how the style changes over time so that they can

rebalance or reallocate their portfolios of mutual funds.

MUTUAL FUND:

A Mutual Fund is a trust that pools together the savings of a number of investors who share a

common financial goal. The money thus collected is then invested in capital market instruments such

as shares, debentures and other securities.

History of the Indian Mutual Fund Industry

The mutual fund industry in India started in 1963 with the formation of Unit Trust of India, at

the initiative of the Government of India and Reserve Bank.

The history of mutual funds in India can be broadly divided into four distinct phases:

First Phase – 1964-87:

Unit Trust of India (UTI) was established on 1963 by an Act of Parliament. It was set up by

the Reserve Bank of India and functioned under the Regulatory and administrative control of the

Reserve Bank of India.

The first scheme launched by UTI was Unit Scheme 1964. At the end of 1988 UTI had

Rs.6,700 crores of assets under management.

Second Phase – 1987-1993 (Entry of Public Sector Funds):

1987 marked the entry of non- UTI, public sector mutual funds set up by public sector banks

and Life Insurance Corporation of India (LIC) and General Insurance Corporation of India (GIC).

SBI Mutual Fund was the first non- UTI Mutual Fund established in June 1987.

Third Phase – 1993-2003 (Entry of Private Sector Funds):

With the entry of private sector funds in 1993, a new era started in the Indian mutual fund

industry, giving the Indian investors a wider choice of fund families.

In 1993 was the year in which the first Mutual Fund Regulations came into being, under


which all mutual funds, except UTI were to be registered and governed.

Fourth Phase – since February 2003:

In February 2003, following the repeal of the Unit Trust of India Act 1963 UTI was divided into two

separate entities.

One is the Specified Undertaking of the Unit Trust of India with assets under management of

Rs.29,835 crores as at the end of January 2003.

The second is the UTI Mutual Fund Ltd, sponsored by SBI, PNB, BOB and LIC. It is registered with

SEBI and functions under the Mutual Fund Regulations.

The flow chart below describes the working of a Mutual Fund:

TYPES OF MUTUAL FUNDs:

Maturity Period:

A mutual fund scheme can be classified into open-ended scheme or close-ended scheme


depending on its maturity period.

Open-ended Fund: An open-ended Mutual fund is one that is available for subscription and

repurchase on a continuous basis. These Funds do not have a fixed maturity period.

Close-ended Fund: A close-ended Mutual fund has a stipulated maturity period e.g. 5-7 years. The

fund is open for subscription only during a specified period at the time of launch of the scheme.

Investment Objective:

A scheme can also be classified as growth fund, income fund, or balanced fund considering

its investment objective.

Growth / Equity Oriented Scheme: The aim of growth funds is to provide capital appreciation over

the medium to long- term. Such funds have comparatively high risks. These schemes provide

different options to the investors like dividend option, capital appreciation, etc.

Income / Debt Oriented Scheme: The aim of income funds is to provide regular and steady income

to investors. Such schemes generally invest in fixed income securities such as bonds, corporate

debentures, Government securities and money market instruments. Such funds are less risky

compared to equity schemes.

Balanced Fund: The aim of balanced funds is to provide both growth and regular income as such

schemes invest both in equities and fixed income securities in the proportion indicated in their offer

documents. These are appropriate for investors looking for moderate growth.

Money Market: These funds are also income funds and their aim is to provide easy liquidity,

preservation of capital and moderate income. These schemes invest exclusively in safer short-term

instruments such as treasury bills, commercial paper and government securities, etc. These funds are

appropriate for corporate and individual investors as a means to park their surplus funds for short

periods.

Gilt Funds: These funds invest exclusively in government securities. Government securities have no

default risk.

Index Funds: This schemes invest in the securities in the same weightage comprising of an index.

This schemes would rise or fall in accordance with the rise or fall in the index.

Advantages of Mutual Funds:

Professional Management

Minimization of risk

Return Potential

Low Costs Liquidity

Choice of schemes

Tax benefits

Various Mutual Funds in India

State Bank of India mutual fund

ICICI prudential mutual fund

TATA mutual fund

HDFC mutual fund

Birla sun life mutual fund

Reliance mutual fund

Kotak Mahindra mutual fund etc..

FUND OF FUNDS: A fund of funds (FOF) - also referred to as a multi-manager investment - is an investment


strategy in which a Fund invests in other types of funds. This strategy invests in a portfolio that

contains different underlying assets instead of investing directly in bonds, stocks and other types of

securities.

A "fund of funds" (FOF) is an investment strategy of holding a portfolio of other investment

funds rather than investing directly in stocks, bonds or other securities. This type of investing is often

referred to as multi-manager investment. A fund of funds may be "fettered", meaning that it invests

only in funds managed by the same investment company, or "unfettered", meaning that it can invest

in external funds run by other managers.

The fund of funds (FOF) strategy aims to achieve broad diversification and appropriate asset

allocation with investments in a variety of fund categories that are all wrapped into one fund. These

are fund of funds characteristics that attract small investors who want to get better exposure with

fewer risks compared to directly investing in securities. However, if the fund of funds carries

an operating expense, investors are essentially paying double for an expense that is already included

in the expense figures of the underlying funds. Historically, a fund of funds showed an expense

figure that didn't always include the fees of the underlying funds. As of January 2007, the SEC began

requiring that these fees be disclosed in a line called "Acquired Fund Fees and Expenses" (AFFE).

They would keep a close eye on where you are invested, sell funds that were failing and buy

new ones that are about to soar.

It sounds ideal — and it is possible. Increasing numbers of investors are turning to a ‘fund of funds’,

a type of investment where one fund manager picks a whole range of funds for you based on how

much risk you are willing to take.

Typically, the money is invested in between 10 and 30 other investment funds — these in turn

invest in 20 to 30 other companies. These types of funds help you take less risk because your cash is

spread across a greater number of funds and companies.

So if one fund’s performance starts to fall off a cliff, you should, in theory at least, be able to

rely on some of the others to prop it up.

Of course, the fund manager isn’t actually working just for you — but you and a host of other

like-minded investors.

‘For many investors, a fund of funds take away the headache of deciding on which funds to

buy and which to sell,’ says investor, head of investment at wealth manager. ‘Instead you hand those

decisions over to a full-time fund manager.’

Fund of Funds Advantages


Investing in a FOF gives the investor professional financial management services.

This experience allows the investor to test investing in professionally managed funds before

they take on the challenge of going for individual fund investing.

Most FOFs require a formal due-diligence procedure for their fund managers. Applying

managers' backgrounds are checked, which ensures the portfolio handler's background and

credentials in the securities industry.

Investing in an FOF also allows investors with limited capital to tap into diversified portfolios

with different underlying assets, which are hard to access through individual investment.

EXCHANGE TRADED FUND (ETF):

ETF stands for exchange-traded fund. To keep things simple, you can think of it like mutual

fund that can be traded like stock. It is made up of a basket of securities and experiences changes in

price throughout the day as it is bought and sold.

In general, an ETF will trade at the same level or very close to the net asset value of an

underlying asset. But because you can trade it like stock, its own net asset value is not calculated

every day, opposite of how it applies to mutual fund.

ETFs in India:

An exchange-traded fund that is based on a basket of securities listed on various exchanges in

India. India ETFs aim to capture the major sectors of the Indian economy by owning a diversified

mix of major companies that represent the majority of the total market capitalization of the Indian

economy.

Types of ETFs:

Index ETFs

Commodity ETFs or ETCs

Bonds ETFs

Currency ETFs

Actively managed ETFs

Exchange Trade Grantor Trusts

Leveraged ETFs

Features of ETFs:

Buying and Selling ETFs can be good for the small investor

Treatment of Dividends

Transparency

Tax Efficiency

Fees and Commissions

Options

ETF offers the advantages of both mutual fund and stock, which can be understood from the

following figure:

Mutual Funds Stock

Simplicity

Transparency

Risk Control

Diversification

No tenure or size

limitation (open ended

fund)

+

On exchange intraday trading

Trading flexibility

Trading Strategies (Hedging,

diversified exposure to

market, buying and holding,

investing)

=

ETF


How ETFs Differ with Mutual Fund:

Forecast ETFs Mutual Funds

Trading Time Trade during trading day Trade at closing NAV

Cost Low operating expenses Operating expenses vary

investment amount No investment minimums Most have investment minimums

Tax efficiency Tax-efficient Less tax-efficient

Sales Load No sales loads May have sales Load

Advantages of ETFs:

Buy and sell just like a share

Buy and sell at real time prices

Like an index fund, they are very transparent

Cost Advantage : The only costs for an investor are brokerage commissions, management

fees and taxes

Minimum trading lot just one unit

Provides Diversification

Returns on par with Market/Index

No STT on some ETFs(Gold, Oil)

Arbitrage in Future and Cash Market

Disadvantages of ETFs:

Investors need to have a de-mat and a trading account

They have to pay a brokerage (usually around 0.50%). This is considered high for a new short

term Investor

Advantages in Local ETF disappear in Foreign ETFs

Have to place a fresh order every month

ETFs are conveniently tradable, people tend to trade more in ETFs as compared to

conventional funds which pushes up the costs.

You can't automatically re-invest your dividends.

Inverse Funds:

An inverse exchange-traded fund is an exchange-traded fund (ETF), traded on a public stock

market, which is designed to perform as the inverse of whatever index or benchmark it is designed to

track. These funds work by using short selling, trading derivatives such as futures contracts, and

other leveraged investment techniques.

An inverse ETF is an exchange-traded fund (ETF) constructed by using various derivatives

for the purpose of profiting from a decline in the value of an underlying benchmark. Investing in

inversion ETFs is similar to holding various short positions, or using a combination of advanced

investment strategies to profit from falling prices. Also known as a "Short ETF," or "Bear ETF."

Inverse ETFs vs. Short Selling

One advantage of inverse ETFs is that they do not require the investor to hold a margin

account as would be the case for investors looking to enter into short positions. There are several

inverse ETFs that can be used to profit from declines in broad market indexes, such as the Russell

2000 or the Nasdaq 100. In addition, it is possible to buy inverse ETFs that focus on a specific sector,

such as financials, energy or consumer staples. Most investors look to purchase inverse ETFs so they

can hedge their portfolios against falling prices.

In addition to a margin account, short selling requires a stock loan fee paid to a broker for

borrowing the shares necessary to sell short. Stocks with high short interest may result in difficulty


finding shares to short, which drives up the cost of short selling. in many cases, the cost of borrowing

shares to short could be 3% or more of the amount that is borrowed. Inverse ETFs often have expense

ratios of less than 2%, and can be purchased by anyone with a brokerage account.

Double and Triple Inverse Funds

While there are many ETFs available that are designed to profit from the decline in a sector or

market, several add leverage to their objectives. Fund providers such as Direxion and ProShares are

popular for their leveraged ETFs. These funds, such as the Direxion Daily S&P 500 Bear 3x Shares

ETF, use derivatives to provide double and triple the daily return of a given index.

Like others derivatives-based ETFs, these funds are used primarily by speculators and

momentum players that frequently hold on to these positions for no more than a few days.

Investment in foreign countries:

Foreign investment involves capital flows from one country to another, granting extensive

ownership stakes in domestic companies and assets. Foreign investment denotes that foreigners have

an active role in management as a part of their investment.

Types of Foreign Investment:

Meaning of FDI:

1. FDI stands for Foreign Direct Investment, a component of a country's national financial

accounts.

2. Foreign direct investment is investment of foreign assets into domestic structures, equipment,

and organizations.

3. It does not include foreign investment into the stock markets.

4. FDI is thought to be more useful to a country than investments in the equity of its companies

because equity investments are potentially "hot money" which can leave at the first sign of

trouble, whereas FDI is durable and generally useful whether things go well or badly.

5. FDI‘ Means Investment By Non-resident Entity/Person Resident Outside India In The Capital

Of An Indian Company Under Schedule 1 Of Foreign Exchange Management (Transfer Or

Issue Of Security By A Person Resident Outside India)

Meaning of FII: (Foreign Institutional Investment)


FII denotes all those investors or investment companies that are not located within the

territory of the country in which they are investing.

“SEBI’s definition of FIIs presently includes foreign pension funds, mutual funds,

charitable/endowment/university funds etc. as well as asset management companies and other

money managers operating on their behalf.”

Foreign Institutional Investor‘(FII) means an entity established or incorporated outside India

which proposes to make investment in India and which is registered as a FII in accordance

with the SEBI (FII) Regulations 1995.

Significances of Foreign Investment:

Expansion In Employment

Consumer Benefit

Technological Improvement

Cultural Improvement

Import Export

Growth In Economy

Government Benefits

Competition

Managerial Revolution

Global Exposer

Global Relationship

What are Foreign Investors looking for?

Good projects

Demand Potential

Revenue Potential

Stable Policy Environment/ Political Commitment

Optimal Risk Allocation Framework

Impact of Global Diversification:

Global diversification is a type of geographical diversification that consists of adding foreign

asset classes, such as stocks and bonds, to a domestic portfolio. The goal of global diversification

can be to increase the expected return, decrease the risk, or both, although whether such goals will

be achieved cannot be known in advance.

Impact of currency exposure:

Global diversification brings foreign currency exposure into the mix. Canadians generally are

well aware of the range of fluctuation of the Canadian dollar versus the US dollar, particularly in the

short term. Over the longer term, currency fluctuations tend to average themselves out and therefore

reduce the impact of currency exposure.

Global diversification in equities:

Each investor has to evaluate the pros and cons of global diversification for equities, taking

into account his/her personal situation, but the arguments in favour of at least some global

diversification for equities seem convincing. Nevertheless, Financial Wisdom Forum members have

indicated allocations to Canada ranging from 0% to 100% within the equity part of their portfolios,

showing that different approaches can work for different people.

Diversification as expected to reduces the risk and also the covariance between the asset and


the market portfolio of all assets in the economy.

Arguments for global diversification:

The Canadian stock market is highly concentrated in three sectors (energy, materials,

financials) which are quite cyclical, and has significant under-representations in information

technology, health care, consumer staples and consumer discretionary, relative to the rest of

the world. See diversification.

Issuer concentration. The Canadian market has 36% of its capitalisation in the top-ten stocks,

compared to 17% for the US market.

Global equity diversification can reduce the volatility of returns because the correlations

coefficients between Canada and global stocks are less than one (rolling 36-month correlation

coefficients have varied between 0.37 and 0.87 over the period 1972-2014).

Arguments against global diversification:

The dividend tax credit applies to Canadian stocks but not foreign ones (relevant for

unregistered accounts only)

Apart from the US and parts of Europe, there may be corporate governance issues for

overseas companies

(Historically) high costs to access foreign securities

Multinational companies provide international diversification (this is truer for US and

European investors)

Implementation:

Global equities are typically divided into US equities, international equities and emerging

markets; these articles suggest ways to access these asset classes using exchange-traded

funds (ETFs), index funds, and perhaps individual stocks. One-ETF-solutions for global equities (i.e.,

equity funds covering the whole world except Canada) are mentioned in Simple index portfolios:

three ETFs.

For a "balanced" portfolio, an easy approach is to split the equities into three thirds: Canadian

equities, US equities and international equities; this is what the model portfolios at Canadian Couch

Potato do. Investors preferring a stronger home bias may instead divide the equities into half

Canadian and half global, for example: this is what the FPX indices do.

Global diversification in fixed income:

For fixed income investments, it appears that avoiding global diversification (i.e., keeping it

all domestic) is largely justified for most Canadian investors: the "cons" largely outweigh the "pros".

One exception may be for large bond-heavy portfolios, as explained in foreign bonds.

Arguments for global diversification:

Adding some foreign bonds to a bond-heavy portfolio would theoretically lower its volatility.

Lowers the "country risk" related to investing most of one’s assets in a single country, even a

developed and stable one like Canada.

Arguments against global diversification:

Keeping all fixed income domestic is more simple, and avoids higher management expense

ratios (MERs)

Better investor knowledge of domestic markets

Foreign bonds imply exposure to foreign currencies, which would add greatly to the volatility

of fixed income investments; hedging the currency exposure is possible, but adds to costs

The domestic (Canadian) fixed income market is well diversified by issuer type (federal


government and agencies, provinces, municipalities, corporate), term (short, medium, long),

and credit rating (see Canadian vs. global bonds), so there is no need to venture elsewhere

The domestic market has historically provided returns and volatilities comparable to

developed markets as a whole

Advantages of Diversification:

Increase the scope of diversification

Higher returns compare to domestic market

Larger investment owners

Favorable economic trends and business cycle

Disadvantages of Diversification:

Political risk

Liquidity risk in the market

Currency effects

Factors affecting the Indian investor:

Framework of investment in India

Inflation

Taxation

Stock market Conditions

Manipulation of share price

DEPOSITORY RECEIPTS

DR’s are traded on stock exchanges in the US, Singapore, Luxembourg, London etc.

Depository Receipts listed and traded in US Markets are known as American Depository Receipts

(ADRs) and those listed and traded elsewhere are known as Global Depository Receipts (GDRs) and

Indian Depository Receipts in Indian context, DRs are treated as FD.

Depository receipts are instruments issued by international depositories (ODB), and they

represent an interest in the underlying shares held by them in the issuer company (Indian Company).

The shares are usually held by a domestic custodian on behalf of the depositories in turn issue the

depository receipts, which entitle the holder of the receipts to get the underlying shares on demand.

Global Depository Receipts (GDRs)


A bank certificate issued in more than one country for shares in a foreign company. The

shares are held by a foreign branch of an international bank. The shares trade as domestic shares, but

are offered for sale globally through the various bank branches.

A financial instrument used by private markets to raise capital denominated in either U.S.

dollars or Euros.

The voting rights of the shares are exercised by the Depository as per the understanding

between the issuing company and the GDR holders.

Types of GDR

Rule 144A GDRs

Rule 144A GDRs are privately placed depositary receipts which are issued and traded in

accordance with Rule 144A. This rule was introduced by the SEC in April 1990 in part to

stimulate capital raising in the US by non-US issuers.

Non-US companies now have ready access to the US equity private placement market and

may thus raise capital through the issue of Rule 144A GDRs without complying with the

stringent SEC registration and reporting requirements.

Regulation S

With the global integration of the major securities markets, it is now commonplace to have

fungible securities listed and cleared in more than one market.

Just as ADRs allow non-US issuers to access the important US market, GDRs allow issuers to

tap the European markets.

AMERICAN DEPOSITORY RECEIPTS

ADR is a dollar-denominated negotiable certificate. It represents a non-US company’s

publicly traded equity. It was devised in the late 1920s to help Americans invest in overseas

securities and to assist non-US companies wishing to have their stock traded in the American

Markets.

ADR were introduced as a result of the complexities involved in buying shares in foreign

countries and the difficulties associated with trading at different prices and currency values.

Types of ADR: SPONSORED ADR UNSPONSORED ADR

Issued with cooperation of the company whose stock will underlie the ADR.

Issued by – broker/dealer or depository bank

without the involvement of company whose stock underlies the ADR

Comply with regulatory reporting. No regulatory reporting

Listing on international Stock Exchanges allowed. Trade on OTC market

Levels of ADRs:

Level 1 ADRs:

Level 1 ADRs are the lowest level of sponsored ADRs and also the simplest method for

companies to access the US capital markets.

Level 1 ADRs are traded in the over-the –counter (OTC) market.

The issuing company does not have to comply with US generally accepted accounting

principles (GAAP) or provide US Securities and Exchange Commission (SEC) disclosure.


Level 1 ADRs essentially enable a company to obtain the benefits of a US publicly traded

security without altering their current reporting process.

Companies that have level 1 ADRs may upgrade to level II or level III ADR program.

They require minimal SEC registration.

Level II ADRs:

Level II ADRs enable companies to list their ADRs on Nasdaq, the American Stock

Exchange, the New York Stock Exchange and the OTC bulletin board, thereby offering

higher visibility in the US market, more active trading and greater liquidity.

Level II ADRs require full registration with the Securities and Exchange Commission.

Companies must also meet the requirements of the appropriate stock exchange.

Level II ADRs require a form 20-F and form F-6 to be filled with the SEC, as well as meeting

the listing requirements and filing a listing application with the designated stock exchange.

Upon F-6 effectiveness and approval of the listing application, the ADRs begin trading.

Level III ADRs:

Level III ADRs enable companies to list their ADRs on NASDAQ, the Amex, the NYSE or

the OTC Bulletin Board and make a simultaneous public offering of ADRs in the united

states.

The benefits of level III ADRs are substantial; it allows the issuer to raise capital and leads to

much greater visibility in the U.S market.

Level III ADR programs must comply with various SEC rules, including the full registration

and reporting requirements of the SEC's Exchange Act.

Difference between ADR & GDR

ADR GDR

American depository receipt (ADR) is Global depository receipt (GDR) is

compulsory for non –us companies to trade

in stock market of USA.

compulsory for foreign company to access in

any other country’s share market for dealing

in stock.

ADRs can get from level 1 to level III. GDRs are already equal to high preference

receipt of level II and level III.

ADRs up to level –I need to accept only

general condition of SEC of USA.

GDRs can only be issued under rule 144 A

after accepting strict rules of SEC of USA .

ADR is only negotiable in USA . GDR is negotiable instrument all over the

world

Investors of USA can buy ADRs from New

York stock exchange (NYSE) or NASDAQ. Investors of UK can buy GDRs from London

stock exchange and luxemberg stock

exchange and invest in Indian companies

without any extra responsibilities.


Process to Issue ADR/GDR:

Advantages of ADR/GDR:

Can be listed on any of the overseas stock exchanges /OTC/Book entry transfer system.

Freely transferable by non-resident.

They can be redeemed by ODB.

The ODB should request DCB to get the corresponding underlying shares released in favor of

non resident of investors. (Shareholders of issuing companies).

INDIAN DEPOSITORY RECEIPTS

These are financial instrument that allows foreign companies to mobilize funds from Indian

capital market.

IDRs are the depository receipts dominated by Indian issued by the domestic ₹ depository

receipt.

Represents interest in the share of non-Indian company’s equity.

Like equity shares, these are unsecured instruments & negotiable from one to another

investors.

It provides chance to Indian investors to hold equity shares of foreign company’s.

Who can Invest?

Any person who is resident in India as defined under FEMA.

NRIs.

SEBI registered foreign institutional investor including their sub accounts.

Eligibility Criteria:

As per the companies IDR rules

Criteria Requirements

Capital Pre issue paid up capital and free reserve are at least US$50 Million

Market Capitalization Minimum average market capitalization (during the last 3 years) in

its parent country of at least US$ 100 million

Operation History Continuous trading record or history on a stock exchange in its

parent country at least 3 immediately preceding years.

Track Record of

distributable profits Track record of distributable profits in terms of section 205 of the

companies act. 1956 for at least 3 out of immediately preceding 5

years.

Other Requirements Fulfil such other eligibility criteria as may be laid down by SEBI

from time to time in this behalf.

Issuing Company

(RIL)

Domestic Custodian

Bank (SBI)

Foreign Depository

(Morgan Stanley)

GDR / ADR Holders

(Bank of America)

Clearing Agency

(Euro Clear)

Foreign Stock

Exchange (NYSE)


Introduction: UNIT - V MARKET EFFICIENCY

An efficient capital market is a market that is efficient in processing information. In other

words, the market quickly and correctly adjusts to new information. In an information of efficient

market, the prices of securities observed at any time are based on “correct” evaluation of all

information available at that time. Therefore, in an efficient market, prices immediately and fully

reflect available information.

Efficient market: Market in which prices correctly reflect all relevant information.

Definition:

"In an efficient market, competition among the many intelligent participants leads to a

situation where, at any point in time, actual prices of individual securities already reflect the effects

of information based both on events that have already occurred and on events which, as of now, the

market expects to take place in the future. In other words, in an efficient market at any point in time

the actual price of a security will be a good estimate of its intrinsic value."

- Professor Eugene Fama,

States that all relevant information is fully and immediately reflected in a security's market

price, thereby assuming that an investor will obtain an equilibrium rate of return. In other words, an

investor should not expect to earn an abnormal return (above the market return) through

either technical analysis or fundamental analysis. Three forms of efficient market hypothesis

exist: weak form (stock prices reflect all past information in prices), semi - strong form (stock prices

reflect all past and current publicly available information), and strong form (stock prices reflect all

relevant information, including information not yet disclosed to the general public, such

as insider information).

Efficient Market Hypothesis

A market theory that evolved from a 1960's Ph.D. dissertation by Eugene Fama, the efficient

market hypothesis states that at any given time and in a liquid market, security prices fully reflect all

available information. The EMH exists in various degrees: weak, semi-strong and strong, which

addresses the inclusion of non-public information in market prices. This theory contends that since

markets are efficient and current prices reflect all information, attempts to outperform the market are

essentially a game of chance rather than one of skill.

The weak form of EMH assumes that current stock prices fully reflect all currently available security

market information. It contends that past price and volume data have no relationship with the future

direction of security prices. It concludes that excess returns cannot be achieved using technical

analysis.

The semi-strong form of EMH assumes that current stock prices adjust rapidly to the release of all

new public information. It contends that security prices have factored in available market and non-

market public information. It concludes that excess returns cannot be achieved using fundamental

analysis.

The strong form of EMH assumes that current stock prices fully reflect all public and private

information. It contends that market, non-market and inside information is all factored into security

prices and that no one has monopolistic access to relevant information. It assumes a perfect market

and concludes that excess returns are impossible to achieve consistently.

Why Efficient Market Hypothesis?


To test the form of market – extent of efficiency.

To make sure that one can accurately forecast the market, discover the market trend and help

investors to make critical decisions .

What is Efficient Market:

A market where there are large numbers of rational profit maximizers actively competing,

with each trying to predict future market values of individual securities, and where important

current information is almost freely available to all participants.

Securities prices always fully reflect all available, relevant information about the security.

Note the key words of the definition “always” “Fully” and “information”.

WHAT IS AN EFFICIENT MARKET

• An Efficient Market is one in which the Market Price of a Security is an Unbiased Estimate

of its Intrinsic Value.

• Market Efficiency is Defined in Relation to Information that is Reflected In Security Prices.

Eugene Fama “the father of the efficient-market hypothesis”. Distinguishes Three Levels Of Market

Efficiency.

INTRINISIC VALUE:

• Weak-form efficiency

• Semi-strong form efficiency

• Strong-form efficiency

The actual value of a company or an asset based on an underlying perception of its true value

including all aspects of the business, in terms of both tangible and intangible factors. This value may

or may not be the same as the current market value. Value investors use a variety of analytical

techniques in order to estimate the intrinsic value of securities in hopes of finding investments where

the true value of the investment exceeds its current market value.

Strong Form

Sem – Strong

All Information, Public and Private

All Public Information

All Historical Price and Returns



Prepared by: M. Subramanyiam Reddy., MBA., (PhD)., | I – CET CODE: AMTT 86

Weak Form

EMH.. Implies… Market Has Perfect Forecasting.

As Prices Tend to Fluctuate They Cannot Reflect Fair Value.

Inability of Institutional Portfolio Managers to Achieve Superior

Investment Performance Implies that they Lack Competence.

The Random Movement of Stock Prices Suggests That The Stock Market Is

Irrational.

Efficient Market Index:

In finance, the efficient-market hypothesis (EMH) assets that financial markets are

"informationally efficient". That is, one cannot consistently achieve returns in excess

of average market returns on a risk-adjusted basis, given the information available at

the time the investment is made.

There are three major versions of the hypothesis: "weak", "semi-strong", and

"strong". Weak EMH claims that prices on traded assets (e.g:- stocks, bonds, or

property) already reflect all past publicly available information.

Semi-strong EMH claims both that prices reflect all publicly available information

and that prices instantly change to reflect new public information.

Strong EMH additionally claims that prices instantly reflect even hidden or "insider"

information. There is evidence for and against the weak and semi-strong EMHs,

while there is powerful evidence against strong EMH.

Weak - Form Efficiency:

In weak-form efficiency, future prices cannot be predicted by analyzing

prices from the past. Excess returns cannot be earned in the long run by using

investment strategies based on historical share prices or other historical data.

Technical analysis techniques will not be able to consistently produce excess

returns, though some forms of fundamental analysis may still provide excess

returns.

Share prices exhibit no serial dependencies, meaning that there are no

"patterns" to asset prices.

This implies that future price movements are determined entirely by

information not contained in the price series. Hence, prices must

follow a random walk.

This 'soft' EMH does not require that prices remain at or near

equilibrium, but only that market participants not be able to

systematically profit from market 'inefficiencies'..

However, while EMH predicts that all price movement (in the absence of

change in fundamental information) is random (i.e., non-trending), many




studies have shown a marked tendency for the stock markets to trend over

time periods of weeks or longer and that, moreover,

there is a positive correlation between degree of trending and length of time

period studied (but note that over long time periods).

Semi -Strong-Form Efficiency :

• In semi-strong-form efficiency, it is implied that share prices adjust to

publicly available new information very rapidly and in an unbiased fashion,

such that no excess returns can be earned by trading on that information.

• Semi-strong-form efficiency implies that neither fundamental analysis nor

technical analysis techniques will be able to reliably produce excess returns.

• To test for semi-strong-form efficiency, the adjustments to previously unknown

news must be of a reasonable size and must be instantaneous.

• To test for this, consistent upward or downward adjustments after the initial

change must be looked for. If there are any such adjustments it would suggest

that investors had interpreted the information in a biased fashion and hence in

an inefficient manner.

Strong - Form Efficiency:

• In strong-form efficiency, share prices reflect all information, public and

private, and no one can earn excess returns.

• If there are legal barriers to private information becoming public, as with

insider trading laws, strong-form efficiency is impossible, except in the case

where the laws are universally ignored.

• To test for strong-form efficiency, a market needs to exist where investors

cannot consistently earn excess returns over a long period of time. .

IMPLICATIONS FOR INVESTMENTS

Substantial evidence in favour of randomness suggests that technical analysis is of

dubious value. Routine and conventional fundamental analysis is not of much help in

identifying profitable courses of action. The key levers for earning superior rates of

returns are:

Early action on any new development.

Sensitivity to market imperfections and anomalies.

Use of original, unconventional, and innovative modes of analysis.

Access to inside information and its sensible interpretation

An independent judgment that is not affected by

market psychology. SUMMING UP




Stock prices appear to follow a random walk. The randomness of stock prices is

the result of an efficient market.

It is useful to distinguish three levels of market efficiency :

Weak form efficiency, semi-strong form efficiency, and strong form

efficiency. The weak form efficient market hypothesis says that the current

price of a stock reflects all information found in the record of past prices and

volumes.

The semi-strong form efficient market hypothesis holds that stock prices

adjust rapidly to all available public information.

The strong form efficient market hypothesis holds that all available

information, public and private is reflected in stock prices.

Empirical evidence seems to provide strong support for weak-form efficiency,

mixed support for semi-strong form efficiency, and weak support for strong-

form efficiency.

The efficient market hypothesis is an imperfect and limited description of

the stock market. however, at least for the present, there does not seem to be

a better alternative.

The key implications of the efficient market hypothesis are that

technical analysis is of dubious value and routine fundamental analysis

is not of much help.

RANDOM WALK

Maurice Kendall found that stock prices followed a random walk, implying

that successive price changes are independent of one another. A number of researchers

have employed ingenious methods to test the randomness of stock price behaviour.

Academic researchers concluded that the randomness of stock prices was the result of

an efficient market. The theory that stock price changes have the same distribution and

are independent of each other, so the past movement or trend of a stock price or

market cannot be used to predict its future movement.

(approved by aicte, new delhi. & affiliated to sri

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