SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT

MODULE 1: INTRODUCTION TO PORTFOLIO MANAGEMENT

Meaning of Investment

Investment is the employment of funds with the aim of achieving additional income or
growth in value. It must be clearly established that investment involves long term
commitment.

 Commitment of Funds

 Period of Time

 Derive future Income

 Capital Appreciation

 Returns should compensate the Investor:

i. Time

ii. Inflation

iii. Risk

Meaning of Savings

Savings, in its most simple terms, is defined as an excess of income over expenditure. Be
it an individual or a nation as a whole, income is earned to meet the expenditure on
consumption. When all that is earned is not spent economic surplus results. This is
known as savings.

 Excess of income over expenditure

 Significant to meet unexpected expenditure, as an inducement for investment, to

achieve a feeling of satisfaction, children’s education…..

 All savers are not investors

 Various Investors
Significance of Investment-

 Longer Life Expectancy- Investment decisions have become significant as people

retire between the age of 60 and 65. Also, the trend shows longer life expectancy.
The earnings from employment should be calculated in such a manner that a
portion is put away as savings. Savings by themselves do not increase wealth;
these must be invested in such a way that principal and income will be adequate
for a greater number of retirement years.

The importance of investment decisions is enhance by the fact that there is an

increasing number of women are working in organizations. Men and women
will be responsible for planning their own investments during their working life
so that after retirement they are able to have a stable income.

 Taxation- It is one of crucial factors in any country which introduces an element

of compulsion in a person’s savings. There are various forms of savings outlets in
our country in the form of investments which help in bringing down the tax
level.

 Interest Rates- The level of interest rates is another aspect which is necessary for
a sound investment plan. Interest rates vary between one investment and
another. These may vary between risky and safe investments; they may also
differ due to different benefit schemes offered by the investments. These aspects
must be considered before allocating any amount in investments. A high rate of
interest may not be the only factor favouring the outlet for investment. The
investor has to include in his portfolio several kinds of investments. He/she
must maintain a portfolio with high and high return as well as low risk and low
return. Stability of interest is as important as receiving a high rate of interest.
This book is concerned with determining that the investor is getting and
acceptable return commensurate with the risks that are taken.

 Inflation- every developing economy is phased with the problem of rising prices
and inflationary trends. In India, inflation has become a continuous problem
since the last decade. In these years of rising prices, several problems are
associated coupled with a falling standard of living. Before funds are invested,
erosion of the resources will have to be carefully considered in order to make the
right choice of investments. The investor will try and search an outlet which will
give him a high rate of return in the form of interest to cover any decrease due to
inflation. He will also have to judge whether the interest or return will be
 continuous or there is a likelihood or irregularly. Coupled with high rates of
interest, he/she will have to find an outlet which will ensure safety of principal.
Besideshigh rate of interest and safety of principal, an investor has to always
bear in mind the taxation angle. The interest earned through investment should
not unduly increase his taxation burden. Otherwise, the benefit derived from
interest will be reduced by an interest in taxation.

Financial & Economic meaning of Investment-

Investment is the allocation of monetary resources to assets that are expected to yield
some gain or positive return over a given period of time. These assets range from safe
investments to risky investments. Investments in this form are also called Financial
Investments.

To the economist Investment means the net addition to the economy’s capital stock
which consists of goods and service that are used in production of other goods and
services.

Financial Sense Economic Sense

1. Commitment of funds to gain some 1. Net additions to capital stock

money 2. Production of assets – capital
2. Transfer of assets formation
3. Individuals and Institutions are 3. Primarily by Institutions
involved 4. Generates goods & services and
4. Generates financial instruments augments industrial activities

Investment v/s Speculation

1. Time Horizon Long term time framework Short term planning holding
beyond 12 months. assets even for one day with
the objective.

It has limited risk. There are high profits &

2. Risk gains.

It is consistent and moderate High returns, though risk of

3. Return over a long period. loss is high.

Own funds through savings.

Own and borrowed funds.
4. Use of funds Safety, liquidity,
profitability & stability
considerations 7 Market behavior
5. Decisions performance of companies information, judgments on
movement in the stock
market.

Hedging-

 It means reducing risk of loss caused by price fluctuations.

 Insurance against negative event.
 Taking a position in the futures market that is opposite to the one in the physical
market.

Arbitrage-

 Arbitrage is mechanism of keeping one’s risk to the minimum through hedging

and taking advantage of price differences in different markets. The simultaneous
purchase of the same or similar security in two different methods would be an
arbitrage transaction.
 Arbitrage transactions help in enhancing efficiency and liquidity in the stock
market and in increasing the volume of trade.

Gambling-

Gambling is quite opposite of investment. It connotes high risk and the expectation of
high returns. It consists of uncertainty and high stakes for thrill and excitement.
Gambling is based on tips, rumours and hunches, it is unplanned, non scientific and
without knowledge of the exact nature of risk.

What is a Portfolio?

 It a combination of securities

 Carefully selected after considering certain goals

 Securities of varying risk – return measures

 A distinct entity with measureable characteristics and is not just the sum of its
component parts

Portfolio Management-

A Portfolio Management refers to the science of analyzing the strengths, weaknesses,

opportunities and threats for performing wide range of activities related to one’s
portfolio for maximizing the return at given risk. It helps in making selection of Debt vs
Equity, Growth vs Safety and various other tradeoffs.

Process-

1. Objectives: The objectives of investments should be understood before initiating the

process of investment. Selection of investments should rather be based on research of
various factors. The major objectives of investment in securities are as follows:

a. Income: The major objective of every investment is to earn income in the form of
dividend, yield or interest. Suitable securities are those whose prices are relatively
stable but still pay reasonable dividends or interest, such as blue chip companies. The
investment should earn reasonable and expected return on the investments. Certain
investments like bank deposits, debentures, bonds etc carry fixed rate of return payable
periodically. On investments made in shares of companies, the periodic payments are
not assured but it may ensure higher return from fixed income securities; but these
investments carry higher risk than fixed income securities.

b. Capital Appreciation: The other important objective is appreciation in the capital

invested over a period of time. It can be achieved in the following three ways:

-Conservative Growth. Investors who seek to achieve conservative growth seek to

build an investment portfolio that will make money over the long term by capital
appreciation known as wealth building over time
- Aggressive Growth. Investors who seek to achieve short term and long term capital
gains opt for aggressive growth in stocks. Current income from dividends is of a low
priority and the investors are risk seekers.

-Speculation. An investor with speculation as an objective wants to maximize returns by

buying and selling shares and securities so often solely to make profit from short term
price fluctuations. Speculators do not expect to hold securities for long periods. High
rate of risk is involved with this objective

c. Capital Preservation: is a conservative investment strategy where the primary goal is

to preserve capital and prevent loss in a portfolio. This strategy would necessitate
investment in the safest short-term instruments, such as Treasury bills and certificates
of deposit.

2. Constraints: the constraints imposed on individual investors are subject to wide

variance

a. Time Horizon: This is the investment planning period for individuals. It is highly
variable from individual to individual. Individuals who are early in their life cycle have
a long horizon, one which can absorb and smooth out the ups and downs of risky
combinations of assets like common stock portfolios. These individuals can build
portfolios of riskier assets and can use riskier investment strategies. Later in life
individuals have a much shorter horizon and should therefore tend toward less volatile
portfolios, typically consisting of more bonds than stocks with the former of higher
quality and shorter duration (maturity/coupon combination) and the latter of higher
quality and lower volatility

b. Risk: The level of risk depends on the object of investment. An investor who expects
greater return should be prepared to take greater risk. By careful planning and
periodical review of the market situation, the investor can minimize his risk on the
investments.

c. Liquidity: The liquidity of investments is another consideration to be kept in mind by

the investor. Before making the investment, the investor should consider the degree of
liquidity required. Certain securities are capable of being sold in the readily
availablemarket and some securities may not be so liquid. The investors generally
prefer securities which ensure liquidity and marketability.

d. Tax Considerations: Individuals are subject to a wide range of marginal tax rates.
High bracket investors should consider investing the fixed-income portion of their
portfolio in a diversified group of municipal bonds if their taxable equivalent expected
return exceeds that of taxable issues of equal risk. These same investors no doubt will
look to investing the equity portion of their portfolios in a diversified group of stock
with large capital gains components relative to dividend income for a given level of
risk.

3. Decide the Asset Mix: It is the proportion of Stock & Bond – according to investor’s
requirements i.e. objectives & constraints Asset mix is the breakdown of all assets
within a portfolio. Broadly, assets can be assigned to one of the core asset classes:
stocks, bonds, cash and real estate. An asset mix breakdown helps investors understand
the composition of a portfolio.The asset mix of a portfolio is an important consideration
for investors. It can be a key determinant of the risk/reward profile of the fund. It can
also provide insight on the long-term performance expectations.

4. Decide Investment Strategy:

- Passive Investment: These strategies comprise of portfolios that do not respond to any

changes in expectations. Buy and hold and indexing are examples of such passive
strategies.

- Active Investment: These strategies respond much more to changing expectations.

They aim to benefit from the differences between the beliefs of a portfolio manager
concerning the valuations and those of the marketplace. Making investments according
to a particular style of investment and generating alpha are examples of such active
investments.

5. Portfolio Selection: The expectation of the capital markets is combined with decided

investment allocation strategy to choose specific assets for the investor’s portfolio.
Generally, the portfolio managers use fundamental or technical analysis while deciding
the portfolio composition.

- Fundamental Analysis is an attempt to identify the underpriced and overpriced shares

in the market place so that the investment decisions- buying and selling can be made. It
views investments as a long term decision. The end objective of this analysis is to avoid
the risk of loss from buying an overpriced stock and selling an underpriced stock.

- Technical Analysis is directed towards predicting the price of a security. The price at
which a buyer and seller settle at a deal considered to be the one precise figure which
synthesizes, weighs and finally expresses all factors, rational and irrational quantifiable
and non-quantifiable and is the figure that counts. Thus, the technical analysis provides
a simplified and comprehensive picture of what is happening to the price of a security.
-Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held
until it matures. Yield to maturity is considered a long-term bond yield but it is
expressed as an annual rate. In other words, it is the internal rate of return (IRR) of an
investment in a bond if the investor holds the bond until maturity, with all payments
made as scheduled and reinvested at the same rate.

-Credit rating is an assessment of the creditworthiness of a borrower in general terms or

with respect to a particular debt or financial obligation. A credit rating can be assigned
to any entity that seeks to borrow money- an individual, corporation, state or provincial
authority, or sovereign government.

6. Portfolio Implementation: Once the portfolio composition is finalized, the portfolio

is executed. Portfolio executions are equally important as high transaction costs can
reduce the performance of the portfolio. Transaction costs include both explicit costs
like taxes, fees, commissions, etc. and implicit costs like bid-ask spread, opportunity
costs, market price impacts, etc. Hence, the execution of the portfolio needs to be
appropriately timed and well-managed.

7. Performance Evaluation and Revision: Any changes required due to the feedback
are analyzed carefully to make sure that they are as per the long-run considerations.
The portfolio manager needs to monitor and evaluate risk exposures of the portfolio
regularly. This is required to ensure that investment objectives and constraints are being
achieved. The manager monitors the investor’s circumstances, economic fundamentals
and market conditions. Both absolute returns and relative returns can be used as a
measure of performance while analyzing the performance of the portfolio. Periodic
rebalancing of the portfolio is required to accommodate fluctuations in prices and
unattractive securities have to be eliminated from the portfolio and new and more
attractive securities have to be included.

What is a Security?

 Financial asset

 Claims on money

 Promissory note

 Intangible investment

 Marketable

What is Security Analysis?

  In the traditional sense, it involves the projection of future dividend, earnings,
forecast of the future share price and estimating the intrinsic value of the security

 According to the modern theories, it also includes the risk-return analysis

depending on the variability of the returns, a study on the strengths and
weaknesses of the company, projections of expansion, tax planning, etc.

 Purpose is to identify:

 Undervalued securities for buying and

 Overvalued securities for selling

MODULE 2: INTRODUCTION TO SECURITY ANALYSIS

Characteristics of Investments
All investments are characterised by certain features. Let us analyse these characteristic
features of investments.

Return

All investments are characterised by the expectation of a return. In fact, investments are
made with the primary objective of deriving a return. The return may be received in the
form of yield plus capital appreciation. The difference between the sale price and the
purchase price is capital appreciation. The dividend or interest received from the
investment is the yield. Different types of investments promise different rates of return.
The return from an investment depends upon the nature of the investment, the maturity
period and a host of other factors.

Risk

Risk is inherent in any investment. This risk may relate to loss of capital, delay in
repayment of capital, non-payment of interest, or variability of returns. While some
investments like government securities and bank deposits are almost riskless, others are
more risky. The risk of an investment depends on the following factors.

1. The longer the maturity period, the larger is the risk.

2. The lower the credit worthiness of the borrower, the higher is the risk.

3. The risk varies with the nature of investment. Investments in ownership securities
like equity shares carry higher risk compared to investments in debt instruments like
debentures and bonds

Risk and return of an investment are related. Normally, the higher the risk, the higher is
the return.

Safety

The safety of an investment implies the certainty of return of capital without loss of
money or time. Safety is another feature which an investor desires for his investments.
Every investor expects to get back his capital on maturity without loss and without
delay.

Liquidity/Marketability

An investment which is easily saleable or marketable without loss of money and

without loss of time is said to possess liquidity. Some investments like company
deposits, bank deposits, P.O. Deposits, NSC, NSS, etc. are not marketable. Some
investment instruments like preference shares and debentures are marketable, but there
are no buyers in many cases and hence their liquidity is negligible. Equity shares of
companies listed on stock exchanges are easily marketable through the stock exchanges
An investor generally prefers liquidity for his investments, safety of his funds, a good
return with minimum risk or minimisation of risk and maximisation of return.

Tax Benefits

Certain financial instruments have tax benefits, such instruments would be preferred
by investors. However, tax benefits change according to government policies. The
investor has to evaluate from time to time to find out which bonds or instruments are
tax free, so that he can invest in them.

Maturity

There are different kinds of maturities. Bonds and debt securities have a maturity date
whereas equity shares do not have a maturity date. Bonds have a stable return through
interest. Equity shares provide stability through dividends but they also have risk
attached to them. Investors find equity shares attractive because they have capital
appreciation. However, equity shares also have risks and losses due to fall in prices,
therefore investors have to keep on their portfolio, securities having a maturity date as
well as those which do not have such a feature.

Thus financial instruments must be carefully analysed to achieve the objectives of the
investors

Factors Influencing Investment Decisions.

Risk Tolerance

Risk refers to the volatility of portfolio’s value. The amount of risk the investor is
willing to take on is an extremely important factor. While some people do become more
risk averse as they get older; a conservative investor remains risk averse over his life-
cycle. An aggressive investor generally dares to take risk throughout his life. If an
investor is risk averse and he takes too much risk, he usually panic when confronted
with unexpected losses and abandon their investment plans mid-stream and suffers
huge losses.

Return Needs

This refers to whether the investor needs to emphasize growth or income. Most
younger investors who are accumulating savings will want returns that tend to
emphasize growth and higher total returns, which primarily are provided by equity
shares. Retirees who depend on their investment portfolio for part of their annual
income will want consistent annual payouts, such as those from bonds and dividend-
paying stocks. Of course, many individuals may want a blending of the two Þ some
current income, but also some growth.

Investment Time Horizon

The time horizon starts when the investment portfolio is implemented and ends when
the investor will need to take the money out. The length of time you will be investing is
important because it can directly affect your ability to reduce risk. Longer time horizons
allow you to take on greater risks with a greater total return potential because some of
that risk can be reduced by investing across different market environments. If the time
horizon is short, the investor has  greater liquidity needs some attractive opportunities
of earning higher return has to be sacrificed and the result is reduced in return. Time
horizons tend to vary over the life-cycle. Younger investors who are only accumulating
savings for retirement have long time horizons, and no real liquidity needs except for
short-term emergencies. However, younger investors who are also saving for a specific
event, such as the purchase of a house or a child’s education, may have greater liquidity
needs. Similarly, investors who are planning to retire, and those who are in retirement
and living on their investment income, have greater liquidity needs.

Income group (Financial Positions)

The income group of an investor evokes responses to the available investment outlets.
The higher the income of an investor the greater will be his desire for purchasing assets
which will give him a favourable tax treatment. The source of income usually has a
bearing on deduction of tax. Certain sources of income are taxed like ordinary income.
Other income may be exempted from income tax. The investments must be geared in a
manner that combines the features of low risk and low taxation to the maximum
benefit.

Tax Positions

Most investors in India are also taxpayers . The maximum tax payable is 33 % of the
total income. Every individual would like to take the advantage of tax concessions.
There are certain tax-free securities like UTI Bonds, Dividends paid by Indian
Companies and investments in equity shares of Indian Companies. The investor would
be attracted towards such securities. However, there are other securities, which are
subject to tax. The investor must find out the after tax rate of return on these securities.
Interest received is not taxable except on specified security

Investor's Perception and Attitude Towards Risk and Return

Understanding and measuring risk and return is fundamental to the investment process
and increases an awareness of the investment problem. Investor's perception and
attitude towards risk and return must be analyzed before preparing a portfolio of
investments. Most investors are 'risk averse. They must be aware of the risks in different
investments whether they are confronted with high, moderate or low risk and the kinds
of risks investments are exposed to before paid making their investments.

Investment Avenues

Classification based on

1) Tangibility

 Physical Assets
 Financial Instruments

2) Marketability

 Marketable
 Non Marketable

3) Nature of Investment

 Direct Investment
 Indirect Investment

Classification based on Tangibility

1) Physical Assets/Securities

• Real Assets

• Commodities

2) Financial Securities

• Shares

• Debentures

• Bonds

• Derivatives

Classification based on Marketability

3) Marketable Securities
 • Shares

• Debentures

• Bonds

• Derivatives

• ADR, GDR, ETFs

• Commodities

4) Non-Marketable Investments

• PO Deposits

• Bank Deposits

• Fund Schemes (EPF, PPF, Pension F, Mutual F, Hedge F)

• Unit Linked Insurance Plans (partially)

Classification based on Nature of Investment

1) Direct Investing

• PO & Bank Deposits

• Shares, Debentures, Bonds

• Derivatives

• Commodities

2) Indirect Investments

• ADR, GDR, ETFs

• Fund Schemes (EPF, PPF, Pension F, Mutual F, Hedge F)

• Unit Linked Insurance Plans (ULIPs)

Post Office Savings Account

 Safe investments since backed by the Government of India

  Helps individuals, house-wives, minors and others in inculcating a habit of thrift
in themselves

 A minimum of Rs.50 and a max. of Rs.1,00,000/Rs.2,00,000 can be invested

 Interest rate is around 3.5%

 Not suitable for regular returns and does not guard against inflation

 Interest income is exempt from tax u/s 10(15)(i)

 Other schemes are PO Recurring Deposit, PO Senior Citizens Savings, PO Time

Deposit Schemes

Kisan Vikas Patra (KVP)

 KVPs are sold through Post Offices

 Doubles the money in 7 yrs. 3 mon.

 Certificates are available in denominations of Rs.100, 500, 1000, 5,000, 10,000 and
50,000

 Interest is 9.75% - compounds annually

 Fixed rate of return – does not safeguard against inflation

 No tax incentives which is its major drawback

 Has been discontinued by Govt. of India w.e.f. 1.12.2011

o National Savings Certificate (NSC)

 Long term, tax saving option

 Minimum investment is Rs.500, no maximum limit

 Interest is 8% compounds semi-annually

 Qualifies for rebate u/s 80C

Bank Deposits – Savings Bank Account/FDs/Recurring Bank Deposits

 Bank FD does not provide regular income

  Interest is calculated monthly, quarterly, half-yearly or annually

 Bank interest do not guard against inflation

 Can be used as a collateral

 FDs are liquid to some extent

 Interest income qualifies for exemption u/s 80L

 Interest Rates: SB A/C – 4.5%, FD – 9% to 11%

Employees Provident Fund Scheme (EPF)

 Aim is to safeguard interests of the middle and lower income group of private
sector employees

 Employer and employee contribute towards the fund

 Compulsory savings scheme which is beneficial after retirement

o Public Provident Fund (PPF)

 It is a general investment & can be made by anyone

 Long term savings plan – 15 yrs.

 PPF a/c can be opened in any Post Office and Nationalised Banks

 Interest grows @8% p.a. and is guaranteed by the govt.

 Interest earned and maturity amount is completely tax free

Bonds

 It is a marketable, long-term, debt security which the issuer is obliged to repay

with coupon (interest)

 Bonds have a maturity period after which it is redeemed by the issuer

 Holders do not have an equity stake, they are only lenders to the issuing
company

 Bonds have to be rated by specialised credit rating agencies

  They are more secure than debentures but carry lower interest rates

 Different types are: Deep Discount/Zero Coupon B, Guaranteed B, Callable and

Putable B, Floating Rate B, High-Yield/Junk Bonds

Mutual Funds

 It is a financial intermediary which acts as an instrument of indirect investment

 It is a pool of financial resources of small amounts

 The collected resources are professionally managed by experts

 Investment in MF is not borrowing-lending relationship

 Investors who cannot participate in capital market or who cannot undertake

specialised investment analysis can use the medium of MFs

 Various types of MFs: Open-ended, Closed-ended, Growth, Debt, Load, No

Load, MMMFs, Index Schemes, and so on

ETF – Exchange traded funds

 An ETF holds assets such as stocks, commodities, or bonds in ‘creation units’

which are large blocks of tens of thousands of ETF shares  

 These creation units are traded close to their net asset value

 Attraction lies in the low cost, tax efficiency and stock like features i.e. investors
can sell short, use a limit order, use a stop-loss order or buy on margin

 ETFs can be bought and sold at current market prices at any time during the
trading day, unlike mutual funds which can only be traded at the end of the
trading day

Hedge funds

 A hedge fund is a pooled investment administered by a professional

management firm employing extensive risk management strategies which gives
high returns

 These are made available only to certain sophisticated or accredited investors

and cannot be offered or sold to the general public
  They generally avoid direct regulatory oversight, bypassing licensing
requirements also

 Investment in HF is illiquid as they often require the investors to keep their

money in the funds for at least one year

 Some of the strategies used by the fund managers are short selling using
arbitrage, trading in derivatives, investing in anticipation of a specific event, junk
bonds and so on

Money Market Instruments

 MM includes financial institutions which handle the purchase and sale or

transfer of short term credit instruments

 It is a place where short term surplus (maximum period of one year) investible
fund is transferred to borrowers

 Major players in the MM – RBI, Financial Inst., Commercial Bk., Fund Schemes,
etc.

 The commercial banks need not depend on RBI for funds

 It requires a well developed communications system since most of the

transactions are conducted over phone

 It helps the economy by providing liquidity

 Major MM instruments – Call Money, Commercial Bills, CBs, TBs, CPs

Other Investments

 Real Estate

 Antiques

 Wine

 Coins & Stamps

 Gold, Silver & other commodities

 Derivatives
Risk

It is the chance that the actual return from an investment differs from its expected
return. The expected return is the uncertain future return that the investor expects to get
from his investment. The realized/actual return, on the contrary, is the certain return
that an investor has actually obtained from his investment at the end of the holding
period

An investment whose returns are fairly stable is considered to be a low risk investment,
whereas an investment whose returns fluctuate significantly is considered to be a high
risk investment. Equity shares whose returns fluctuate widely are considered risky
investments. Government securities whose returns are fairly stable are considered to
possess low risk.

Risk is contributed by fluctuations in the prices caused by demand and supply forces.
These fluctuations are caused by other factors like changes in the bank interest rates and
so on .Investors are generally risk-averse i.e. they prefer to take less risk.

Risk is measured by the deviation of returns from the average expected returns i.e. Std.
Deviation

Types of Risk

a)Systematic Risk

As the society is dynamic, changes occur in the economic, political and social systems
constantly. These changes have an influence on the performance of companies and
thereby on their stock prices. But these changes affect all companies and all securities in
varying degrees. For example, economic and political instability adversely affects all
industries and companies. When an economy moves into recession, corporate profits
will shift downwards and stock prices of most companies may decline. Thus, the impact
of economic, political and social changes is system-wide and that portion of total
variability in security returns caused by such system-wide factors is referred to as
systematic risk. Systematic risk is further subdivided into interest rate risk, market risk,
and purchasing

i)Interest Rate Risk

Interest rate risk is a type of systematic risk that particularly affects debt securities like
bonds and debentures. A bond or debenture normally has a fixed coupon rate of
interest.
The issuing company pays interest to the bond holder at this coupon rate. A bond is
normally issued with a coupon rate which is equal to the interest rate prevailing in the
market at the time of issue. Subsequent to the issue, the market interest rate may change
but the coupon rate remains constant till the maturity of the instrument. The change in
market interest rate relative to the coupon rate of a bond causes changes in its market
price.

The market price of bonds and debentures is inversely related to the market interest
rates. As a result, the market price of debt securities fluctuates in response to variations
in the market interest rates. This variation in bond prices caused due to the variations in
the interest rates is known as interest rate risk.

ii)Market Risk

Market risk is a type of systematic risk that affects the shares. Market prices of shares
move up or down consistently for some time periods.

The stock market is seen to be volatile. This volatility leads to variations in the returns
of investors in shares. The variation in returns caused by the volatility of the stock
market is referred to as the market risk.

iii)Purchasing Power Risk

It refers to the variation in investors returns caused by inflation. Inflation results in

lowering of the purchasing power of money. When an investor purchases a security, he
foregoes the opportunity to buy some goods or services.

The two important sources of inflation are rising costs of production and excess of
demand for goods and services in relation to their supply.

In an inflationary economy, rational investors would include and allowance for the
purchasing power risk in their estimate of expected rate of return from an investment.

b)Unsystematic risk

The returns from a security may sometimes vary because of certain factors affecting
only the company issuing such security. Examples are raw material scarcity, labour
strike, management inefficiency. When variability of returns occurs because of such
firm-specific factors, it is known as unsystematic risk. This risk is unique or peculiar to a
company or industry and affects it in addition to the systematic risk affecting all
securities. The unsystematic-or-unique risk affecting specific securities arises from two
sources (a) business risk and (b) financial risk.

i)Business Risk
Every company operates within a particular operating environment. This operating
environment comprises both internal environment and external environment. The
impact of these operating conditions is reflected in the operating costs of the company
that can be segregated into fixed and variable costs.A larger proportion of fixed costs is
disadvantageous to a company. If the total revenue of such a company declines due to
some reason or the other, there would be a more than proportionate decline in its
operaing profits because it would be unable to reduce its fixed costs. Such a firm is said
to face a larger business risk.

Business risk is thus a function of the operating conditions faced by a company and is
the variability in operating income caused by the operating conditions of the company

ii)Financial Risk

Financial risk is a function of financial leverage which is the use of debt in the capital
structure. The presence of debt in the capital structure creates fixed payments in the
form of interest which is a compulsory payment to be made whether the company
makes profit or loss. This fixed interest payment creates more variability in the earnings
per share (EPS) available to equity share holders

This variability in EPS due to the presence of debt in the capital structure of a company
is referred to as financial risk. This is specific to each company. Financial risk is an
avoidable risk in so far as a company is free to finance its activities without resorting to
debt.

Construction of Portfolio using Life Cycle Approach

Lifecycle theory of investing:

The traditional theory of Lifecycle investing, documented by Modigliani and Miller, is

that each individual will go through various lifecycle stages, in which the investment
needs are different. First, when younger, there is the’ accumulation phase’ (age 20’s and
30’s), when the individual is able to invest in higher risk assets and follow an aggressive
investment strategy, designed to achieve maximum longer term growth. Second, comes
the ‘consolidation phase’, in mid-life (age 40’s and 50’s), in which the individual is in
mid-career, has accumulated assets to cover the important needs of housing and living
expenses and is now looking for opportunities to increase wealth generation. In this
phase, the individual would have more resources to devote to investment, but might
want to take a less risky approach. The third phase is the ‘de-accumulation phase’, (age
60’s and 70’s) during which the individual is no longer working and is living on the
income and capital accumulated in the first two phases. Finally, there is the ‘gifting’
phase, (age 80’s and 90’s) in which individuals who have accumulated far more wealth
than they will need for their own lifetimes, decide to pass some of their assets on to
others – perhaps as an inheritance, or charitable donations. The theory suggests that, as
individuals move through these lifecycle phases, their investment needs and objectives
change significantly and, while being able to hold mostly risk bearing assets when
young (the theory relies on holding mostly equities, to maximise long term growth), the
individual needs to eliminate most investment risk as they grow old.