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ANNAMALAI UNIVERSITY
DIRECTORATE OF DISTANCE EDUCATION

Master of Commerce (M.Com.)

Third Semester

SECURITIES
SECURITIES ANALYSIS & PORTFOLIO MANAGEMENT
LESSON: 1 - 22

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 Master of Commerce (M.Com.)
Third Semester
SECURITIES ANALYSIS & PORTFOLIO MANAGEMENT

Editorial Board

Chairman
Dr. K. Vijayarani
Dean
Faculty of Arts
Annamalai University

Members
Dr.R. Singaravel Dr.P.Vijayan
Director Director
Directorate of Distance Education Directorate of Academic Affairs
Annamalai University Annamalai University

Dr. K. Govindarajan Dr. R.Elangovan

Professor and Head Professor and Co-ordinator
Department of Commerce Commerce Wing. DDE
Annamalai University Annamalai University

Internals
Dr. V. Suresh Dr. S. Suresh
Professor Professor
Department of Commerce Department of Commerce
Annamalai University Annamalai University

Externals
Dr. P. Natarajan Dr. Ganapathi
Professor Professor,
Pondicherry University Department of Management Studies.
Puducherry. Alagappa University
Karaikudi
Lesson Writer
Dr. E. Mahendiran
Assistant Professor of Commerce
A.M Jain College
Meenambakkam
Chennai
 i

Master of Commerce (M.Com.)

Third Semester
SECURITIES ANALYSIS & PORTFOLIO MANAGEMENT
SYLLABUS
Unit I: Introduction and Security Valuation
Meaning – Features – Objectives of Investment – Types of Financial Securities -
Risk – Meaning, Nature and Classification- Risk and Return Trade off - Valuation
Models for Equity, Preference and Debt Securities.
Unit II: Security Analysis
Approaches to Security Analysis – Fundamental – Technical – Random Walk
approaches
Unit III: Portfolio Management
Meaning – importance- objectives and various issues in portfolio construction-
revision of portfolio - Estimating rate of return and standard deviation of portfolio
returns- Effects of combining securities- Markowitz risk – Return optimisation.
Unit IV: Portfolio Theory
Portfolio total risk, portfolio market risk and unique risk; Sharpe’s
optimisation solution – Arbitrage pricing theory, principle of arbitrage, arbitrage
portfolios; two factor and multi factor models. Capital market line (CML) - Security
market line- Capital Asset Pricing Model (CAPM) – Characteristic Line
Unit V: Portfolio Performance Evaluation
Measure of return - risk adjusted measures of performance evaluation -
market timing, evaluation criteria and procedures.
Text Books:
1. BhallaV.K 2017, Investment Management, S. Chand and Co., New Delhi.
2. Prasanna Chandra 2013, Investment Analysis and Portfolio Management,
McGraw Hill, New Delhi
3. PunithavathyPandian 2015, Security analysis and Portfolio Management,
Vikas Publishing House, New Delhi
Supplementary Readings:
1. PrettiSingh , Investment Management, Himalaya Pub. Mumbai,2015
2. William F. Sharpe Investment, Prentice Hal of India, New Delhi, 2016
3. Fisher andJordan , Security Analysis and Portfolio Management, Prentice
Hall, New Delhi,2016,
4. Avadhani V.A. Security Analysis and Portfolio Management, Himalaya
Publishing House, Mumbai.2016,
5. Jayabal G.Nagarajan S, Security Analysis and Port Folio Management,
New Age Publications, Mumbai.2016
 ii

Master of Commerce (M.Com.)

Third Semester
SECURITIES ANALYSIS & PORTFOLIO MANAGEMENT

CONTENTS

Lesson No. Lesson Name Page No.

1 Investment 1

2 Security 9

3 Risk And Return 16

4 Valuation of Securities 28

5 Security Analysis 40

6 Fundamental Analysis 45

7 Technical Analysis 61

8 Efficient Market Theory 67

9 Portfolio Management 72

10 Portfolio Construction 78

11 Portfolio Revision 85

Estimating Rate of Return And Standard Deviation of

12 89
Portfolio Returns

13 Effects 0f Combining Securities 95

14 Portfolio- Markowitz Model 98

15 Portfolio Risk 101

16 The Share Index Model 107

17 Capital Asset pricing Model 114

18 Arbitrage Pricing Theory 122

19 Factor Model 126

20 Measure of Return 131

21 Risk Adjusted Measures of Performance Evaluation 135

22 Market Timing – Evaluation Criteria and Procedures 137

 LESSON 1

INVESTMENT
1.1. OBJECTIVES
After studying this unit, you should be able to understand
 The investment objectives
 How Investment is useful to business people and manage by in
 Important of risk factor make an investment
1.2. INTRODUCTION
The word "investment" can be defined in many ways according to different
theories and principles. It is a term that can be used in a number of contexts.
However, the different meanings of "investment" are more alike than dissimilar.
Generally, investment is the application of money for earning more money.
Investment also means savings or savings made through delayed consumption.
According to economics, investment is the utilization of resources in order to
increase income or production output in the future.
According to finance, the practice of investment refers to the buying of a
financial product or any valued item with anticipation that positive returns will be
received in the future. The most important feature of financial investments is that
they carry high market liquidity. The method used for evaluating the value of a
financial investment is known as valuation.
According to business theories, investment is that activity in which a
manufacturer buys a physical asset, for example, stock or production equipment,
in expectation that this will help the business to prosper in the long run.
1.3. CONTENTS
1.3.1 Definition
1.3.2 Characteristics
1.3.3 Features
1.3.4 Importance
1.3.5 Investment and Speculation
1.3.6 Investment Alternatives
1.3.1 DEFINITION
Investment is defined as the commitment of current financial resources in
order to achieve higher gains in the future. It deals with what is called uncertainty
domains. From this definition, the importance of time and future arises as they are
two important elements in investment. Hence, the information that may help shape
up a vision about the levels of certainty in the status of investment in the future is
significant. From an economic perspective, investment and saving are different;
saving is known as the total earnings that are not spent on consumption, whether
invested to achieve higher returns or not. Consumption is defined as one’s total
expenditure on goods and services that are used to satisfy his needs during a
 4

particular period. The values of investment or saving, as well as consumption, can

be determined at the macroeconomic level, or at the individual level, through
different statistical methods.
1.3.2 CHARACTERISTICS OR OBJECTIVES OF INVESTMENT
Main characteristics of investment are as follows:
a. Risk Factor
Every investment contains certain portion of risk. It is a key feature of
investment which refers to loss of principal, delay in payment of interest and capital
etc. Most investors prefer to invest in less riskier securities.
b. Expectation of Return
Return expectation is the main objective of investment. Investors expect
regularity of high and consistent income for their capital.
c. Safety
Investors expect safety for their capital. They desire certainty of return and
protection of their investment or principal amount.
d. Liquidity
Liquidity means easily sale or convert the capital or investment into cash
without any loss. So, most investors prefer liquid investments.
e. Marketability
It is another feature of investment that they are marketable. It means buying
and selling or transferability of securities in the market.
f. Stability of Income
Investors invest their capital with high expectation of income. So, return on
their investment should be adequate and stable.
1.3.3 FEATURES OF INVESTMENT
- Safety Of Principal
Every investment is subject to fluctuations in its price which is caused due to
changing market conditions. An investment tool is termed as adequate if it ensures
the safety of the principal to investors. It should possess an ability of redemption as
and when required as per the needs of the person. Proper evaluation of distinct
economic and industry trends should be done before deciding the type of
investments.
- Capital Appreciation
Capital appreciation is an important feature of every investment tool. Every
investment is expected to rise in its value over a period of time which is a key
determinant for making deploying funds in it. Investors should properly forecast
which assets are expected to appreciate in the future and make timely purchases of
them.
- Expectation of Return
The investment provides returns from time to time to investors which varies as
per the market conditions. It is the amount expected by people for deploying their
funds for a particular period of time in a set of assets. It is the main objective of
 5

every investment and every investor expects a stable and regular return from their
investment.
- Marketability
Marketability refers to the ease with which the investment securities can be
purchased and sold or can be transferred in the market. This feature of investment
tools determines their value as assets with better marketability are preferred more
by the people looking for the investment.
- Purchasing Power Stability
Every investor before making an investment considers the future purchasing
power of their funds. In order to maintain the stability of purchasing power, he
ensures that the money value of the investment should increase in accordance with
rising in price levels to avoid any chance of losing money.
- Tax Benefits
Tax implications on the income provided by investment programs are seriously
taken into consideration by investors. The real return earned by people is one that
is left after paying income tax. While deciding an investment option, the burden of
taxes on its income is an important determinant analyzed by investors. He should
choose such investment securities which put less tax burden and maximize its
return.
- Legality
Investment securities must be evaluated from legal aspects before selecting
them. Only such securities which are approved by law should be chosen as illegal
securities will land investor in trouble. The best way is to do investment in
securities issued by LIC, UTI, and Post office national saving certificates which are
legal and save investors from various troubles.
1.3.4 IMPORTANCE OF INVESTMENT
- Generates Income
Investment serves as an efficient tool for providing periodic and regular income
to people. Earning return in the form of interest and dividends is one of the
important objectives of the investment process. Investors analyses and invest in
those that provide a better rate of return at lower risk.
- Wealth Creation
Creation of wealth is another important role played by an investment activity.
It helps investors in wealth creation through appreciation of their capital over the
time. Investment helps in accumulating large funds by selling assets at a much
higher price than the initial purchase price.
- Tax Benefits
It enables peoples in availing various tax benefits and saving their incomes.
Under section 80C of income tax act, individuals can save up to a maximum limit of
Rs. 1,50,000. Many peoples prefer to go for an investment for taking numerous tax
exemptions.
 6

- Economic Development
Investment activities have an efficient role in the overall development of the
economy. It helps in efficient mobilization of ideal lying resources of peoples into
productive means. Investment serves as a mean for bringing together those who
have sufficient funds and one who are in need of funds. It enables in capital
creation and leads to economic development of the country.
- Meet Financial Goals
Investment activities support peoples in attaining their long term financial
goals. Individuals can easily grow their funds by investing their money in long term
assets. It serves mainly the purpose of providing financial stability, growing wealth
and keeping people on track at their retirement by providing them with large funds.
1.3.5 INVESTMENT & SPECULATION:
In speculation, there is an investment of funds with an expectation of some
return in the form of capital profit resulting from the price change and sale of
investment. Speculation is relatively a short term investment. The degree of
uncertainty of future return is definitely higher in case of speculation than in
investment. In case of investment, the investor has an intention of keeping the
investment for some period whereas in speculation, the investor looks for an
opportunity of making a profit and “exit- out” by selling the investment.
Differences in Investment & Speculation:
FACTOR INVESTEMENT SPECULATION
1. Degree of risk Relatively lesser Relatively higher
2.Basis of return Income and capital gain Change in market price
3. Basis for decision Analysis of fundamentals Rumors, tips, etc
4.Position of investor Ownership Party of an agreement
5.Investment period Long term Short term
1.3.6 INVESTMENT ALTERNATIVES
Physical assets like real estate, gold/jewelry, commodities etc. and/or
Financial assets /Non-Marketable financial assets such as fixed deposits with
banks, small saving instruments with post offices, insurance/provident/pension
fund etc. Marketable financial assets - securities market related instruments like
shares, bonds, debentures, derivatives, mutual fund etc.
Real Assets Financial Assets
1. Real Estate 1. Equity Claims
• Residential Apartments • Equity Shares
• Office Buildings • Mutual Funds
• Land • Convertible Debentures
• Convertible Preference Shares
 7

2. Gems and Metals 2. Redeemable Preference Shares

• Diamonds 3. Creditors Claims
• Gold • Debt Securities
• Silver • Commercial Paper
3. Antiques • Loans and Deposits
• Art Pieces • Savings Account
• Stamps
• Coins etc
Intangible Alternative Investments:
• Hedge funds
• Private equity
• Venture capital
• Derivatives
• Cryptocurrency

1.4. REVISION POINTS

1. Definition, Characteristics, Importance, Investment Alternatives, Investment
& Speculation.
1.5. INTEXT QUESTIONS
1. Explain the importance of investment.
2. What are the objectives of investment?
3. Explain the difference between investment and speculation.
1.6. SUMMARY
In this lesson, we have briefly touched upon the following points:
Investment is defined as the commitment of current financial resources in
order to achieve higher gains in the future. It deals with what is called uncertainty
domains. From this definition, the importance of time and future arises as they are
two important elements in investment. Hence, the information that may help shape
up a vision about the levels of certainty in the status of investment in the future is
significant. In speculation, there is an investment of funds with an expectation of
some return in the form of capital profit resulting from the price change and sale of
investment. Speculation is relatively a short term investment. The degree of
uncertainty of future return is definitely higher in case of speculation than in
investment. In case of investment, the investor has an intention of keeping the
investment for some period whereas in speculation, the investor looks for an
opportunity of making a profit and “exit- out” by selling the investment.
 8

1.7. TERMINAL EXERCISES

1. The money an investment earns is called ________________.
2. Investment made by the government is _________________ investment.
3. When an investment is made, the amount of money invested is called the
____________.
1.8. SUPPLEMENTARY MATERIALS
1. money.rediff.com money control.com amfiindia.com
2. NSE India
3. BSE India.com RBI.org.in
1.9. ASSIGNMENT
1. Describe the difference between long term and short-term investment
strategies.
1.10. REFERENCE BOOKS
1. M. Ranganathan and R. Madhumathi: Investment Analysis and Portfolio
Management, Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management, Vikas
Publishing House Pvt. Ltd., New Delhi.
3. Prasanna Chandra: Investment Analysis and Portfolio Management, TMH,
Delhi.
1.11. LEARNING ACTIVITIES
Collect data about the interest rates of various deposit schemes
and suggest a suitable deposit scheme.
1.12. KEY WORDS
Investment, Speculation, Tax benefits, Wealth.
 9

LESSON 2
SECURITY
2.0. OBJECTIVE
This lesson helps to learn about
 To Know Security Markets
 It aims to learn about online business activities and measures
 This helps to know about Financial Securities
2.1 NTRODUCTION
A security is a financial instrument, typically any financial asset that can be
traded. The nature of what can and can’t be called a security generally depends on
the jurisdiction in which the assets are being traded. A security is a certificate or
other financial instrument that has monetary value and can be traded. Securities
are generally classified into two categories. They are debt security and equity
securities. For a holder, a security represents an investment as an owner, creditor
or rights to ownership on which the person hopes to gain profits. When businesses
issues securities in the form of stocks and bonds, investors buy them, thereby
providing necessary funds that the company needs.
2.2 CONTENT
2.2.1 Key Characteristics of Securities
2.2.2 Security Markets
2.2.3 Quality of Security
2.2.4 Quality Investing
2.2.5 Characteristics
2.2.6 Quality investing vs Value Investing
2.2.7 Financial Securities
2.2.1. KEY CHARACTERISTICS OF SECURITIES
Before we understand what are securities markets let us first understand what
a Security is? A security could be a share / bond or any other financial instrument
that has value or is linked to an underlying instrument that has value. According to
the Securities Contracts Regulation Act (SCRA), a security is one that is exchange
tradable. Here are some key features of securities; as applicable to financial
markets.
• Securities represent the terms of exchange of money between two parties;
the buyer and the seller in this case.
• Securities can be issued by borrowers / equity funders to raise money at a
reasonable cost and gives security ownership to investors.
• Businesses issue securities to raise money from investor with surplus funds
through a regulated contract and a regulated and monitored mechanism.
 10

• While the issuer of the security provides the terms for raising capital,
investors have a claim to the rights represented by the securities.
• Securities can be broadly classified into equity (risk participation) or debt
(claim on cash flows).
• While debt securities are issued for a specific period, equity securities are
perpetual. Debt securities pay interest while equity pays out dividends, but
it is not assured.
2.2.2. SECURITY MARKETS: STRUCTURE AND PARTICIPANTS
Securities market can be broken up into three broad segments, although both are
very closely inter-related.
• Primary market refers to the segment of the market where the securities
are issued by companies either as a new issue or as an offer for sale. Both
equity and debt securities have a primary market where they are first
issued.
• Secondary markets are where the actual trading of these securities takes
place. Primary issues of debt and equity eventually get traded in the
secondary market for price discovery. The secondary market is the normal
trading market.
• Derivatives market deals in futures and options. Unlike equities that
signify ownership, derivatives are just contracts and are used to manage the
risk underlying in the security. Traders can also trade in derivative
contracts.
KEY PARTICIPANTS IN THE SECURITIES MARKET
- Investors are individuals or institutions with surplus funds which are used
to purchase securities. The objective of investors is to convert savings into
financial investments. Such investors can be retail or institutional.
- Issuers are the businesses or fund raisers looking to raise money by issuing
securities. They issue securities for short-term and long-term capital needs
of the business. Issuers include companies, governments, financial
institutions, PSUs, mutual funds etc.
- Other than the issuers and the investors who are the essential participants,
there are a number of intermediaries who make the smooth functioning of
securities market possible.
2.2.3. QUALITY OF SECURITY
Selecting the right quality of security is one of the most important factors to
consider in investing. Security refers to a negotiable financial instrument that holds
monetary value and represents an ownership stake in a publicly traded
corporation, either through stocks, bonds, or options.
The security ownership may be represented by a certificate, electronic record,
or book-entry only form. The company issuing the securities is referred to as the
issuer. The Securities and Exchange Commission (SEC) regulates securities trading
and protects investors from fraud.
 11

A security is a type of financial instrument that represents the holder’s

ownership stake in a publicly traded company. Investors follow a defined set of
criteria for identifying quality stocks based on the company’s quality
characteristics. The selection criteria consider factors such as the quality of the
balance sheet, valuation, and corporate governance.
2.2.4. QUALITY INVESTING
Quality investing is an investment strategy that involves picking stocks of
companies with superior quality characteristics. The concept was borrowed from
real estate and bond investing, where investments are determined based on expert
opinions and ratings from rating agencies. It was later adopted in the equities
market to select stocks with the highest potential to earn profits based on the
company’s quality characteristics.
The concept of quality investing was introduced in the 1930s by British-born
American economist, investor, and professor Benjamin Graham, who identified the
quality problem in equities. Graham grouped stocks into either low quality or high
quality, depending on the issuer’s quality characteristics. He noted that the greatest
losses resulted from buying low-quality stocks at a seemingly good value and not
from buying quality stocks at unreasonably high prices.
The concept of value investing also became popular in 2001 after the burst of
the dot-com bubble when large corporations like WorldCom and Enron collapsed,
resulting in huge losses in investor funds. With the insolvency of these companies,
investors gained awareness of security quality and started focusing their attention
on important characteristics such as earnings quality, balance sheet, and corporate
governance.
2.2.5. CHARACTERISTICS OF QUALITY SECURITIES
Investors have a defined set of criteria that they use to determine the quality of
securities. The selection criteria include the following factors:
- Financial strength
Companies with strong financial strength can withstand adverse financial
conditions or unexpected events in the markets. The company’s financial strength
can be demonstrated by a strong balance sheet, a high volume of sales and profits,
and the ability to generate sufficient cash flows to meet the operating costs of the
company. Also, strong companies tend to report consistent positive results for
several years in a row.
On the downside, companies burdened with debts will grow slowly since most
of the resources are diverted to pay the cost of liabilities. Investors can also use
financial ratios such as the debt-to-equity ratio and the interest coverage ratio to
determine a company’s financial strength.
- Economic moat
The term “economic moat” was coined by Warren Buffett to describe a
company’s competitiveness in the market vis-à-vis its competitors. Quality
companies possess an economic moat, and it allows them to take a leading market
 12

position. Also, the company can protect its market share by creating barriers to
entry to deter potential competitors from the market where it operates.
- Corporate governance
Corporate governance relates to how a company is controlled and operated.
Governance structures in a company determine how rights and responsibilities are
distributed among participants in the corporation and the procedures for making
decisions relating to the company. A quality company employs a professional
management team that can see potentially lucrative opportunities and capitalize on
them. Also, there should be low turnover rates among managers in the middle- and
upper-management levels.
- Attractive valuation
Valuation is an important factor in determining the quality of a company in its
specific industry. Companies with attractive valuations are characterized by a low
price-to-earnings ratio, price-to-book ratio, and a high discounted cash flow. A
company that’s been able to maintain an attractive valuation over time can offer
quality securities to investors looking for stable returns in the future.
- Dividend-paying stocks
When looking for potential companies to invest in, investors are more
interested in owning stocks in companies that pay dividends consistently. A history
of consistently paying dividends to shareholders shows that the company’s reported
enough revenues over the years to sustain its dividends pay-outs. Also, a history of
dividend growth is an added advantage to investors since they are assured of
regular and growing dividend payments over time.
2.2.6. QUALITY INVESTING VS. VALUE INVESTING
- Quality investing is an investment strategy that differs from value investing.
- Quality investing involves buying stocks from companies with outstanding
qualities, while value investing involves buying stocks that are considered
undervalued (trading below their intrinsic value).
- Value investors pick stocks that they think are undervalued since the stock
price movements do not correspond to the company’s long-term
fundamentals. The investors buy the undervalued stocks for the long-term,
with a plan to sell them later when their price appreciates.
2.2.7. FINANCIAL SECURITIES
2.2.7.1. DEFINITION
Financial security is a document of a certain monetary value. Traditionally, it
used to be a physical certificate but nowadays, it is more commonly electronic. It
shows that one owns a part of a publicly-traded corporation or is owed a part of a
debt issue. In the most common parlance, financial securities refer to stocks and
bonds which are negotiable. Derivatives are also considered a common type of
financial security, with their growing popularity in recent years. In current usage,
financial securities are no longer an evidence of ownership. Instead, they refer to
the financial product themselves, i.e., stock, bond, or other product of investment.
They are also known as financial instruments or financial assets.
 13

2.2. 7.2. FEATURES OF FINANCIAL SECURITIES

One of the most important features of financial securities is that they are
trade-able, i.e., one can convert them into cash quite easily. Holding financial
security gives a right to the holder to receive future monetary benefits under a
stated set of conditions. Except for derivatives, securities let you own the
underlying asset without physical possession. The price of the securities indicates
the value of an underlying asset. More the price, the higher the value of the asset.
2.2.7.3. TYPES OF FINANCIAL SECURITIES
There are four primary types of securities:
- Equity securities: An equity security is a share of ownership in a company,
trust, or partnership. Equity securities are usually shares of common stock,
but can also be preferred stock. When the issuer of equity security generates
a profit and retains earnings, the issuer often pays out some earnings to
shareholders by way of dividends. Equity securities can increase or decrease
in value depending on the performance of the company and the financial
markets.
For example, a company ABC plc wants to raise capital. It issues shares
100,000 shares for Rs. 10 each. By buying one share of ABC plc, you contribute Rs.
10 to its capital. The more shares you buy, the higher is your contribution to the
company’s capital. Since equity shareholders contribute to raising a company’s
capital, they become owners of the company. Thus, a share represents the value of
ownership in a company.
Like owners, equity shareholders have certain rights and duties. They are
entitled to the profits of the company. Also, they can participate in the company’s
operations by exercising their voting rights. However, if a company is incurring
losses, equity shareholders get no return. In case of bankruptcy, they are on the
losing end. They get paid for their contribution only after all obligations have been
discharged. Sometimes, they may not get anything in return on their investment.
Like equity shareholders, debenture holders, too, have certain rights. They are
entitled to interest for the amount lent and repayment of the entire principal at
maturity. Note that c company is liable to make such interest payments even if it is
not making adequate profits or incurring losses. In the case of the winding-up of
the company, holders of debt securities have the edge over common stockholders.
Before the proceeds of the company go to ordinary shareholders, debenture holders
get their share. This makes debt securities safer than equity securities. However,
their returns are also limited to fixed interest payments only. They do not get any
share in the profits of the company.
- Debt securities: Debt securities, also called fixed-income securities, allow
governments and corporations to raise money through publicly-traded loans
in exchange for regular payments of interest plus the repayment of the
principal loan. With debt securities, the investor is the lender and the issuer
is the borrower. An investor purchasing debt security receives interest
 14

payments from the issuer until the loan reaches its maturity date. At that
time, the issuer then repays their initial debt obligation, known as the
principal balance.
Examples of common debt securities include certificates of deposit (CDs),
corporate bonds, and government bonds, which include municipal bonds and
treasury bonds. Government bonds typically have a lower interest rate than
corporate bonds but have high liquidity, which makes it easy for the investor to
potentially resell on the secondary bond market.
ABC plc wants to purchase a commercial property. Due to the entire capital
invested in business operations, the company decided to raise a loan from the
market. For this, the issue debentures with the face value of Rs. 5,000,000 payable
after 10 years at 8%. In this way, ABC is able to raise funds for meeting its
expenses. However, they would have to pay a yearly interest of Rs. 400,000 (8% *
Rs. 5,000,000). Interest payments are charged to the Profit and Loss Account of the
company. ABC will have to repay the principal in full post 10 years.
1. Hybrid securities: Hybrid securities contain elements of both equity
securities and debt securities. One example of a hybrid security is
convertible bonds—corporate bonds that can be converted into shares of
stock for the issuing company. Another example is preference shares, which
are stock shares in a company that entitles the shareholder to receive a fixed
dividend before common stock dividends. Preference shares may even grant
shareholders voting rights in the company.
2. Derivatives: The value of a derivative security depends on the value of
another underlying asset (e.g., a barrel of oil). With derivative securities,
both parties involved in the contract are essentially betting on the
underlying asset's value changing in opposite ways. Examples of common
derivative securities include futures, forwards, swaps, and options. Self-
regulatory organizations, like the Financial Industry Regulatory Authority
(FINRA), help regulate derivative securities.
2.4. REVISION POINTS
1. Quality Security, Quality Investing, Quality investing vs Value investing,
Financial securities
2.5. INTEXT QUESTIONS
1. Explain the characteristics of quality securities.
2. What are the types of Financial Securities?
3. Explain the difference between quality investing and value investing.
2.6. SUMMARY
A security could be a share / bond or any other financial instrument that has
value or is linked to an underlying instrument that has value. According to the
Securities Contracts Regulation Act (SCRA), a security is one that is exchange
tradable. Here are some key features of securities; as applicable to financial
markets.
 15

Quality investing is an investment strategy that involves picking stocks of

companies with superior quality characteristics. The concept was borrowed from
real estate and bond investing, where investments are determined based on expert
opinions and ratings from rating agencies. It was later adopted in the equities
market to select stocks with the highest potential to earn profits based on the
company’s quality characteristics.
2.7. TERMINAL EXERCISES
1. A group of security is known as ________________.
2. The securing pattern of session and recovery is called the
____________________.
2.8. SUPPLIMENTARY MATERIALS
1. money control.com amfiindia.com
2.9. REFERENCE BOOKS
1. Punithavathy Pandian: Security Analysis and Portfolio Management,
2. Vikas Publishing House Pvt. Ltd., New Delhi.
3. Prasanna Chandra: Investment Analysis and Portfolio Management, TMH,
Delhi.
2.10. ASSIGNMENT
1. Discuss the role of securities and exchange board of India as a market
regulator.
2.11. LEARNING ACTIVITIES
Collect data about various security schemes available in
investments.
2.12. KEY WORDS
Security, Equity securities, Debt securities.
 16

LESSON 3
RISK AND RETURN
3.0. OBJECTIVE
After studying this topic you will understand the
 To learn about Systematic risk and Unsystematic risk
 It aims to learn about Other type of risk and Risk adjustment
3.1 INTRODUCTION
Since investment decision is based on future estimated returns which are
exposed to different kinds of risk, so forecasts cannot be made with certainty. Thus,
Risk and returns are closely related. A profitable investment may also be very risky.
So, an investor has to manage a trade-off between risk and return.
The variability of the actual return from the expected returns associated with
the given asset is defined as a risk. The greater variability is associated with the
risky securities like equity shares and the more certainty of return is associated
with the government securities like Treasury-Bills have lesser variability and thus
are less risky. Risks on investment like bank deposit are considered to be quite
safe, but rate of interest can change depending on the policy of RBI. Investments in
equity securities of a firm possess higher degree of risk as compared to govt
securities and bank deposits as they are surrounded by market risk, which is quite
uncontrollable because they are broad spectrum depending on market forces.
3.2 CONTENT
3.2.1. Risk
3.2.2 Systematic Risk
3.2.3 Unsystematic Risk
3.2.4 Other Type of Risk
3.2.5 Risk Adjustment
3.2.6 Risk Management
3.2.7 Spreads and Risk Free Investment
3.2.8 Investment Risk
3.2.9 Return
3.2.1 RISK
An investor has to take a decision in investing the firm’s funds in such a way
to optimize return along with minimization of risk. This combination is called the
risk return trade-off. This is the level where the market price of the share is
maximized. The balance brought about by matching risk and return help in
achieving the objectives of wealth maximization.
Investors invest for anticipated future returns, but these returns can be rarely
predicted. The difference between the expected return and the realized return and
latter may deviate from the former. This deviation is defined as risk. All investors
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generally prefer investment with higher returns, he has to pay the price in terms of
accepting higher risk too. Investors usually prefer less risky investments than risk
reinvestment. The government bonds are known as risk-free investments, while
other investments are risky investments.
The investor tries to reduce risk by understanding the risk environment. Risk
consists of two types of exposures i.e., systematic and unsystematic exposures.
SYSTEMATIC OR UNCONTROLLABLE
1. Market risk
2. Interest rate risk
3. Purchasing power risk
UNSYSTEMATIC OR CONTROLLABLE
1. Business risk
2. Financial risk
3.2.2 SYSTEMATIC RISK
Systematic risk is due to the broad spectrum of uncontrollable risk associated
with the business activities within a country. It generates out of macroeconomic
environmental factors such as demand, supply, inflation, change in interest rates,
and change in government policies backed by sociological and political factors in a
country. It is an uncontrollable risk as these forces are beyond the control of any
individual and thus cannot be minimized by a single firm. They have their strong
influence on the market conditions. Such risks are called market risk and interest
risk and purchasing power risk. These risks affect the cash inflows of a project. The
changes in cash inflows will also bring about change in the profitability of an
investment proposal.
It affects the entire market. It indicates that the entire market is moving in
particular direction. It affects the economic, political, sociological changes. This risk
is further subdivided into:
1. Market risk
2. Interest rate risk
3. Purchasing power risk
Market risk:
Jack Clark Francis defined market risk as “portion of total variability in return
caused by the alternating forces of bull and bear markets. When the security index
moves upward for a significant period of time, it is bull market and if the index
declines from the peak to market low point is called troughs i.e. bearish for
significant period of time. The forces that affect the stock market are tangible and
intangible events. The tangible events such as earthquake, war, political
uncertainty and fall in the value of currency. Intangible events are related to
market psychology.
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Interest rate risk:

It is the variation in single period rates of return caused by the fluctuations in
the market interest rate. Mostly it affects the price of the bonds, debentures and
stocks. The fluctuations in the interest rates are caused by the changes in the
government monetary policy and changes in treasury bills and the government
bonds. Interest rates not only affect the security traders but also the corporate
bodies who carry their business with borrowed funds. The cost of borrowing would
increase and a heavy outflow of profit would take place in the form of interest to the
capital borrowed. This would lead to reduction in earnings per share and
consequent fall in price of shares.
Purchasing power risk:
Variations in returns are due to loss of purchasing power of currency. Inflation
is the reasonable hind the loss of purchasing power. The inflation may be,
“demand-pull or cost-push“.
• Demand pull inflation, the demand for goods and services are in excess of
their supply .The supply cannot be increased unless there is an expansion of
labour force or machinery for production. The equilibrium between demand
and supply is attained at a higher price level.
• Cost-push inflation, the rise in price is caused by the increase in the cost.
The increase in cost of raw material, labour, etc makes the cost of
production high and ends in high price level. The working force tries to make
the corporate to share the increase in the cost of living by demanding higher
wages. Hence, Cost-push inflation has a spiraling effect on price level.
3.2.3 UNSYSTEMATIC RISK
Unsystematic risk is a unique risk related to the company pertaining to the
behaviour pattern or internal influence of a firm like the problems relating to
management, staff, expenses, losses, strikes and other issues directly affect the
company’s own operations. These are controllable risks and thus can be minimized
by diversification of investment portfolio.
Unsystematic risk stems from managerial inefficiency, technological change in
production process, availability of raw materials, change in consumer preference
and labour problems. They have to be analysed by each and every firm separately.
All these factors form Unsystematic risk. They are
1. Business risk
2. Financial risk
Business Risk:
It is caused by the operating environment of the business. It arises from the
inability of a firm to maintain its competitive edge and the growth or stability of the
earnings. The variation in the expected operating income indicates the business
risk. It is concerned with difference between revenue and earnings before interest
and tax. It can be further divided into:
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• Internal business risk

• External business risk
• Internal business risk - it is associated with the operational efficiency of
the firm. The efficiency of operation is reflected on the company’s
achievement of its goals and their promises to its investors. The internal
business risks are:
o Fluctuation in sales
o Research and development
o Personal management
o Fixed cost
o Single product
• External business risk –It is the result of operating conditions imposed on
the firm by circumstances beyond its control. The external business risk are,
o Social and regulatory factors
o Political risk
o Business cycle.
Financial Risk:
It is the variability of the income to the equity capital due to the debt capital.
Financial risk is associated with the capital structure of the firm. Capital structure
of firm consists of equity bonds and borrowed funds. The interest payment affects
the payments that are due to the equity investors .The use of debt with the owned
funds to increase the return to the shareholders is known as financial leverage.The
financial risk considers the difference between EBIT and EBT. The business risk
causes the variation between revenue and EBIT. The financial risk is an avoidable
risk because it is the management which has to decide how much has to be funded
with equity capital and borrowed capital.
3.2.4 OTHER TYPE OF RISKS
Below is a list of the most important types of risk for a financial analyst to
consider when evaluating investment opportunities:
- Systematic Risk – The overall impact of the market
- Unsystematic Risk – Asset-specific or company-specific uncertainty
- Political/Regulatory Risk – The impact of political decisions and changes
in regulation
- Financial Risk – The capital structure of a company (degree of financial
leverage or debt burden)
- Interest Rate Risk – The impact of changing interest rates
- Country Risk – Uncertainties that are specific to a country
- Social Risk – The impact of changes in social norms, movements, and
unrest
 20

- Environmental Risk – Uncertainty about environmental liabilities or the

impact of changes in the environment
- Operational Risk – Uncertainty about a company’s operations, including its
supply chain and the delivery of its products or services
- Management Risk – The impact that the decisions of a management team
have on a company
- Legal Risk – Uncertainty related to lawsuits or the freedom to operate
- Competition – The degree of competition in an industry and the impact
choices of competitors will have on a company
3.2.5 RISK ADJUSTMENT
Since different investments have different degrees of uncertainty or volatility,
financial analysts will “adjust” for the level of uncertainty involved. Generally
speaking, there are two common ways of adjusting: the discount rate method and
the direct cash flow method.
3.2.5.1. DISCOUNT RATE METHOD
The discount rate method of risk-adjusting an investment is the most common
approach, as it’s fairly simple to use and is widely accepted by academics. The
concept is that the expected future cash flows from an investment will need to be
discounted for the time value of money and the additional risk premium of the
investment.
3.2.5.2. DIRECT CASH FLOW METHOD
The direct cash flow method is more challenging to perform but offers a more
detailed and more insightful analysis. In this method, an analyst will directly adjust
future cash flows by applying a certainty factor to them. The certainty factor is an
estimate of how likely it is that the cash flows will actually be received. From there,
the analyst simply has to discount the cash flows at the time value of money in
order to get the net present value (NPV) of the investment. Warren Buffett is famous
for using this approach to valuing companies.
3.3.2.6 RISK MANAGEMENT
There are several approaches that investors and managers of businesses can
use to manage uncertainty. Below is a breakdown of the most common risk
management strategies:
- Diversification
Diversification is a method of reducing unsystematic (specific) risk by investing
in a number of different assets. The concept is that if one investment goes through
a specific incident that causes it to underperform, the other investments will
balance it out.
- Hedging
Hedging is the process of eliminating uncertainty by entering into an
agreement with a counterparty. Examples include forwards, options, futures,
swaps, and other derivatives that provide a degree of certainty about what an
investment can be bought or sold for in the future. Hedging is commonly used by
 21

investors to reduce market risk, and by business managers to manage costs or

lock-in revenues.
- Insurance
There is a wide range of insurance products that can be used to protect
investors and operators from catastrophic events. Examples include key person
insurance, general liability insurance, property insurance, etc. While there is an
ongoing cost to maintaining insurance, it pays off by providing certainty
certaint against
certain negative outcomes.
- Operating Practices
There are countless operating practices that managers can use to reduce the
riskiness of their business. Examples include reviewing, analyzing, and improving
their safety practices; using outside con
consultants
sultants to audit operational efficiencies;
using robust financial planning methods; and diversifying the operations of the
business.
- Deleveraging
Companies can lower the uncertainty of expected future financial performance
by reducing the amount of debt ttheyhey have. Companies with lower leverage have
more flexibility and a lower risk of bankruptcy or ceasing to operate.It’s important
to point out that since risk is two
two-sided
sided (meaning that unexpected outcome can be
both better or worse than expected), the abo above
ve strategies may result in lower
expected returns (i.e., upside becomes limited).
3.2.7 SPREADS AND RISK-FREE
FREE INVESTMENTS
The concept of uncertainty in financial investments is based on the relative
risk of an investment compared to a risk
risk-free rate, which
h is a government-issued
government
bond. Below is an example of how the additional uncertainty or repayment
translates into more expense (higher returning) investments.

As the chart above illustrates, there are higher expected returns (and greater
uncertainty) over time of investments based on their spread to a risk-free
risk rate of
return.
 22

3.2.8 INVESTMENT RISK

Investment risk is defined as the probability or uncertainty of losses rather
than expected profit from investment due to a fall in the fair price of securities
secur such
as bonds, stocks, real estate, etc. Each type of investment is exposed to some
degree of investment risk like the market risk i.e., the loss on the invested amount
or the default risk i.e., the money invested is never returned back to the investor.
invest

3.2.8.1. INVESTMENT RISKS

S TYPES
Let us look at different types of investment risks:
INVESTMENT-RISK
Market Risk: Market Risk is the risk of an investment losing its value due to
various economic events that can affect the entire market. The main types type of
market risk include:
- Equity Risk: This risk pertains to the investment in the shares. The market
price of the shares is volatile and keeps on increasing or decreasing based
on various factors. Thus, equity risk is the drop in the market price of the
shares.
- Interest Rate Risk: Interest rate risk applies to the debt securities. Interest
rates affect the debt securities negatively i.e., the market value of the debt
securities increases if the interest rates decrease.
- Currency Risk: Currency risk pertains to foreign exchange investments. The
risk of losing money on foreign exchange investments because of movement
in the exchange rates is currency risk. For example, if the US dollar
depreciates to Indian Rupee, the investment in US dollars will be of less
value
alue in Indian Rupee.
 23

Liquidity Risk: Liquidity risk is the risk of being not able to sell the securities
at a fair price and converting into cash. Due to less liquidity in the market, the
investor might have to sell the securities at a much lower price, thus, losing the
value.
- Concentration Risk: Concentration Risk is the risk of loss on the invested
amount because it was invested in only one security or one type of security.
In concentration risk, the investor loses almost all of the invested amount if
the market value of the invested particular security goes down.
- Credit Risk: Credit risk applies to the risk of default on the bond issued by
a Company or the government. The issuer of the bond may face financial
difficulties due to which it may not be able to pay the interest or principal to
the bond investors, thus, defaulting on its obligations.
- Reinvestment Risk: Reinvestment Riskis the risk of losing higher returns
on the principal or income because of the low rate of interest. Consider a
bond providing a return of 7% has matured, and the principal has to be
invested at 5%, thus losing an opportunity to earn higher returns.
- Inflation Risk: Inflation Risk is the risk of loss of purchasing power because
the investments do not earn higher returns than inflation. Inflation eats
away the returns and lowers the purchasing power of money. If the return
on investment is lower than the inflation, the investor is at a higher inflation
risk.
- Horizon Risk: Horizon Risk is the risk of shortening of investment horizon
due to personal events like loss of job, marriage or buying a house, etc.
- Longevity Risk: Longevity Risk is the risk of outliving the savings or
investments, particularly pertain to retired or nearing retirement individuals.
- Foreign Investment Risk: Foreign Investment Risk is the risk of investing
in foreign countries. If the Country as a whole is at risk of falling GDP, high
inflation, or civil unrest, the investment will lose money.
3.2.8.2 INVESTMENT RISK MANAGEMENT
Although there are risks in investment, these risks can be managed and
controlled. Various ways of managing the risks include:
- Diversification: Diversification includes spreading investment into various
assets like stocks, bonds, and real estate, etc. This helps the investor as he
will gain from other investments if one of them does not perform.
Diversification can be achieved across different assets and also within the
assets (e.g., investing across various sectors when investing in stocks).
- Investing Consistently (Averaging): By investing consistently i.e., investing
small amounts at regular intervals of time, the investor can average his
investment. He will sometime buy high and sometimes buy low and
maintain the initial cost price of the investment. However, if the investment
rises in the market price, he will gain on the whole investment.
- Investing for the Long Term: Long-term investments provide higher
returns than short-term investments. Although there is short-term volatility
 24

in the prices of securities, however, they generally gain when invested over a
longer horizon (5,10, 20 years).
3.2.9 RETURN
Return is associated with gain or loss on m money
oney invested in the market. The
rate of return on a security is the annual income received plus any change in the
market price of an asset. Return is required to maximize the market price of the
share but return is associated with risk because the greater the return, higher the
expectation of risk. An investor has to consider the risk of different financing
patterns to balance his decision between risk and return. Like the return is
expected to be high for investing in purchase of an equity share in the market,
ma but
such a return is associated with high risk. Govt securities have a low risk as they
provide stable return but at very low rate. Thus the investor has to pay the price in
term of loss of return in order to invest in safe securities having minimum risk.
3.2.9.1. RETURN ON INVESTMENT
TMENT (ROI)
Return on Investment (ROI) is one of the most popular performance
measurement and evaluation metrics. ROI analysis (when applied correctly) is a
powerful tool in making informed decisions on the acquisitions of information
in
systems ROI is a performance measure used to evaluate the efficiency of investment
or to compare the efficiency of a number of different investments. To calculate ROI,
the net benefit (return) of an investment is divided by the cost of the investment;
invest
the result is expressed as a percentage or ratio.
Return on investment (ROI) is a measure that investigates the amount of
additional profits produced due to a certain investment. Businesses use this
calculation to compare different scenarios for inve
investments
stments to see which would
produce the greatest profit and benefit for the company .However, this calculation
can also be used to analyze the best scenario for other forms of investment, such as
if someone wishes to purchase a car, buy a computer, pay for college, etc.
Simple ROI Formula
The simplest form of the formula for ROI involves only two values: the cost of
the investment and the gain from the investment. The formula is as follows:

The ratio is multiplied by 100, making it a percent. This way, a p person

erson is able
to see what percentage of their investment has been gained back after a period of
time. Some, however, prefer to leave it in decimal form, or ratio form.
3.2.9.2 MEASUREMENT OF RISK AND RETURN
Return measurement
Securities provide returns in the form of dividends or interests and it also
provides a return at the time of sale in the form of capital gain. These securities
have to be valued at different points of time. The returns at a particular point of
time are required to be calculated by dis
discounting
counting the returns at an appropriate
discount rate, which depends upon the individual’s own perception of risk. The
discount rate which is also called the required rate of return show the risk of the
 25

cash flows. It would also help to determine the value of the asset. The higher the
discount rate greater will be the risk level. Thus the value of an asset therefore
varies according to the risk perception and estimation of each individual. The
required rate of return can be calculated with the help of the following formula-
K= If+Rp
Where
K= required rate of return If= risk free rate
Rp= Risk premium
The risk free rate remains the same irrespective of any increase or decrease of
risk level. The risk premium which indicates the compensation for taking the risk
increases with increase in risk and decreases with decreasing risk. Thus the
required rate of return comprises of the risk free rate, the risk perception and risk
premium.
The risk associated with a security from both a behavioural and a
quantitative/statistical point of view. Different techniques are available to measure
these different risks. The behavioural view of risk can be measured by using
sensitivity analysis and probability distribution. The statistical measures of risk of
a security are standard deviation and coefficient of risk.
a. Sensitivity Analysis- It is a behaviour approach to assess risk by taking
into account a number of possible return estimates so that a sense of
variability among outcomes can be measured. In order to have a sense of
variability among return estimates, a possible approach is to estimate the
worst (pessimistic), the expected (most likely) and the best (optimistic) return
associated with the asset. The difference between the optimistic and
pessimistic outcomes is the range which according to sensitivity analysis is
the basic measure of risk. The greater range indicates the more variability of
the asset.
b. Probability distribution- The risk associated with an asset can be assessed
more accurately by the use of probability distribution than sensitivity
analysis. It is a model that relates probabilities to the associated outcomes.
The probability of an outcome represents the likelihood/percentage chance
of its occurrence. For example if the expectation is that a given outcome will
occur eight out of ten times, it can be said to have eighty percent chance of
occurrence. If it is certain to happen, the probability of happening is 100
percent. An outcome which has a probability of zero indicates that this
outcome will never occur. Based on the probabilities assigned to the rate of
return, the expected value of the return can be computed which is the
weighted average of all possible returns multiplied by their respective
probabilities. Thus, probabilities of the various outcomes are used as
weights. The expected return,
Re=∑sum of Ri*Pri
Where
Re= Expected Return
 26

Ri= Return for the ith possible outcome Pri=probability associated with its
return
N=number of outcomes considered.
c. Standard deviation of return- Risk refers to the dispersion of returns
around an expected value. The most common statistical measure of risk of
an asset is the standard deviation from the mean /expected value of return.
It represents the square root of the average squared deviations of the
individual returns from the expected returns, symbolically the standard
deviation
σ = √∑ ( − )2∗
where
=1
σ = Standard Deviation of Returns
Re= Expected Return
Ri= Return for the ith possible outcome Pri=probability associated with its
return N=number of outcomes considered.
The greater standard deviation of returns indicates the greater
variability/dispersion of returns and the greater risk of the investment. It is the
absolute measure of dispersion and does not consider the variability of return in
relation to the expected value.
d. Coefficient of variation- It is a measure of relative dispersion used in
comparing the risk of assets with differing expected returns. It is a measure
of risk per unit of expected return. It converts standard deviation of expected
values into relative values to enable comparison of risks associated with
assets having different expected values. The coefficient of variation is
computed by dividing the standard deviation for an asset by its expected
value.
CV= σr/Re
Where
CV= Coefficient of variation σr= Standard deviation of return
Re = Expected Return
The larger CV is associated with the largerrelative risk of the asset. The use of
coefficient of variation for comparing asset risk is the best since it considers the
relative size (expected value) of assets.
3.4. REVISION POINTS
1. Measurement of risk and return, Return of Investment, Return, Risk
Management, Investment Risk.
3.5. INTEXT QUESTIONS
1. Explain the meaning and definition of Systematic and Unsystematic risk.
2. What are the types of Investment Risk?
3. Describe risk and returns. Explain its types.
3.6. SUMMARY
Investors invest for anticipated future returns, but these returns can be rarely
predicted. The difference between the expected return and the realized return and
 27

latter may deviate from the former. This deviation is defined as risk. All investors
generally prefer investment with higher returns, he has to pay the price in terms of
accepting higher risk too. Investors usually prefer less risky investments than risk
reinvestments. The government bonds are known as risk-free investments, while
other investments are risky investments.
Systematic risk is due to the broad spectrum of uncontrollable risk associated
with the business activities within a country. It generates out of macroeconomic
environmental factors such as demand, supply, inflation, change in interest rates,
and change in government policies backed by sociological and political factors in a
country. It is an uncontrollable risk as these forces are beyond the control of any
individual and thus cannot be minimized by a single firm. They have their strong
influence on the market conditions. Such risks are called market risk and interest
risk and purchasing power risk. These risks affect the cash inflows of a project. The
changes in cash inflows will also bring about change in the profitability of an
investment proposal.
3.7. TERMINAL EXERCISES
1. Dividends _________________ the rate of return?
1. An example of a specific risk _______________.
2. Which type of risk does diversification help to manage?
a. Specific b. Market c. Both a and b d. Neither a nor b.
3.8. SUPPLIMENTARY MATERIALS
1. money.rediff.com
2. money control.com
3. amfiindia.com
4. bseindia.com
5. rbi.org.in
3.9. ASSIGNMENT
1. Discuss the difference between diversifiable risk and market risk, and
explain how each type of risk affects well-diversified investors.
3.10. REFERENCE BOOKS
2. M. Ranganathan and R. Madhumathi: Investment Analysis and Portfolio
Management, Pearson Education, New Delhi.
3. Punithavathy Pandian: Security Analysis and Portfolio Management, Vikas
Publishing House Pvt. Ltd., New Delhi.
4. Prasanna Chandra: Investment Analysis and Portfolio Management, TMH,
Delhi.
3.11. LEARNING ACTIVITIES
Collect data about the interest rates of various deposit schemes and suggest a
suitable deposit scheme.
3.12. KEY TERMS
Systematic risk, risk, return, operational risk, hedging.
 28

LESSON 4
VALUATION OF SECURITIES
4.0 OBJECTIVE
This lesson throws light on the following areas were covered
 Study about Security valuation
 To learn about various Securities
 To know the Framework
4.1 INTRODUCTION
Valuation of securities is a broad topic, since securities range from stocks and
bonds to derivative contracts of various types such as options. In terms of
accounting and valuation practice, these financial instruments may require
valuation for financial reporting, commercial, or regulatory purposes.
Security valuation is a process in which regulators assess the safety and risk
associated with the securities that an insurance company has on its books. The
purpose of doing this is to make sure that the insurance company is not exposed to
high levels of risk, thereby putting policyholders in danger of massive losses.
4.2 CONTENT
4.2.1 Securities Valuation in India
4.2.2 The three-Step Valuation Process
4.2.3 The General Valuation Framework
4.2.4 Valuation of Fixed Income Securities or Debt Securities
4.2.5 Valuation of Preference Shares
4.2.6 Valuation of Equity Shares
4.2.7 The P/E approach to Equity Valuation
MEANING
Security valuation is important to decide on the portfolio of an investor. All
investment decisions are to be made on a scientific analysis of the right price of a
share. Hence, an understanding of the valuation of securities is essential. Investors
should buy under priced shares and sell overpriced shares. Share pricing is thus
an important aspect of trading. Conceptually, four types of valuation models are
discernible.
They are:
1. Book value,
2. Liquidating value,
3. Intrinsic value,
4. Replacement value as compared to market price.
Book Value: Book value of a security is an accounting concept. The book
value of an equity share is equal to the net worth of the firm divided by the number
of equity shares, where the net worth is equal to equity capital plus free reserves.
 29

The market value may fluctuate around the book value but may be higher if the
future prospects are good.
Liquidating Value (Breakdown Value):If the assets are valued at their
breakdown value in the market and take net fixed assets plus current assets minus
current liabilities as if the company is liquida-ted, then divide this by the number of
shares, the resultant value is the liquidating value per share. This is also an
accounting concept.
Intrinsic Value:Market value of a security is the price at which the security is
traded in the market and it is generally hovering around its intrinsic value. There
are different schools of thought regarding the relationship of intrinsic value to the
market price. Market prices are those which rule in the market, resulting from the
demand and supply forces. Intrinsic price is the true value of the share, which
depends on its earning capacity and its true worth. According to the fundamentalist
approach to security valuation, the value of the security must be equal to the
discounted value of the future income stream. The investor buys the securities
when the market price is below this value.Thus, for fundamentalists, earnings and
dividends are the essential ingredients in determining the market value of a
security. The discount rate used in such present value calculations is known as the
required rate or return. Using this discount rate all future earnings are discounted
back to the present to determine the intrinsic value.
Replacement Value: When the company is liquidated and its assets are to be
replaced by new ones, their prices being higher, the replacement value of a share
will be different from the Breakdown value. Some analysts take this replacement
value to compare with the market price.
4.2.1. SECURITIES VALUATION IN INDIA:
In India, the valuation of securities used to be done by the CCI for the purpose
of fixing up the premium on new issues of existing companies. These guidelines
used by CCI were applicable upto May 1992, when the CCI was abolished. Although
the present market price will be taken into account a more rational price used to be
worked out by the CCI on certain criteria.Thus, the CCI used the concept of Net
Asset Value (NAV) and Profit-Earning Capacity Value (PECV) as the basis for fixing
up the premium on shares. The NAV is calculated by dividing the net worth by the
number of equity shares. The net worth includes equity capital plus free reserves
and surplus less contingent liabilities. The PECV is estimated by multiplying the
earnings per share by a capitalisation rate of 15% for manufacturing companies,
20% for trading companies and 17.5% in the case of intermediate companies.
Earnings Per Share (EPS) is calculated by dividing the three-year average post-tax
profits by the total number of equity shares. Thus, if EPS is Rs. 5 and if the price
earnings multiplier is 15, the price of share, which is reflected by the PECV, should
be Rs. 5 x 15 = 75 (if it is a manufacturing company).
 30

4.2.2 THE THREE-STEP VALUATION PROCESS

There are two general approaches to the valuation process when you make an
investment decision:
1. the top-down, three-step approach and
2. the bottom-up stock valuation, stock picking approach.
The difference between the approaches is the perceived importance of economy
and industry influence on individual firms and stocks. The three-step approach
believes that a firm's revenue is considerably affected by the performance of
economy and industry and thus, the first step in valuation of process is to examine
the economy and industry and their impact on the firm's cash flow. On the other
hand, bottom-up approach believes that it is possible to find stocks that offer
superior returns regardless of the market or industry outlook. In this unit, we will
primarily be discussing the three-step approach. Under this approach, the
performance of economy is first looked into to understand its impact on industries.
Then the analysis progress to industry level analysis to understand the likely
performance of the industries during the investment horizon. Once industries are
picked up, the analysis moves to individual stocks to examine the outlook of firms
in the selected industries. Thus, the three-step approach is also called economy-
industry-company (E-I-C) approach. Figure 4-1 illustrates the E-I-C approach.

Figure 4.1: The Investment Process (E-I-C Approach)

Economy Analysis
All firms are parts of the overall system known as the `general economy', which
witnesses ups and downs. It is logical to begin the valuation process with
projections of the `macro economy'. What you should grasp is the vast number of
influences that affect the `general economy'. To give only a few examples: Fiscal
policy affects spending both directly and through its multiplier effects. For example,
tax cuts can encourage spending whereas additional taxes on income or products
can discourage spending. Similarly an increase or decrease in government spending
 31

also influence the economy. For example, increases in road building increases the
demand for earthmoving equipment and concrete materials.
Employment created in road construction, earthmoving equipment
manufacturing and concrete materials manufacturing will in turn increase higher
consumer spending. This multiplier effect increase overall economic activity and
thus many investors and analysts consider government spending on plan
expenditure is critical for industrial activity.
Monetary policy affects the supply and cost of funds available to business
units. For instance, a restrictive monetary policy reduces money supply and thus
reduces the availability of working capital to business units. Such policy also
increases interest rates and thus increases the cost of funds to business units and
also increases required rate of return for the investors. Of course, it will also reduce
inflation and thus reduces the required rate of return. Monetary policy therefore
affects all segments of the economy and that economy's relationship with other
economies.
In addition to fiscal and monetary polices, political uncertainty, war, balance
of payments crisis, exchange rates, monetary devaluations, world opinion, and
several other international. factors affect the performance of the economy. It is
difficult to conceive any industry or company that can avoid the impact of
macroeconomic developments that affect the total economy. A well-informed
investor will first attempt to project the future course of the economy. If his
projections indicate conditions of boom, the investor should select industries most
likely to benefit from the expected prosperity phase. On the other hand, if the
outlook is not good or a recession is expected, investor should defer investments in
stocks or identify industries, called defensive industry, which are less affected by
the poor performance of the economy for investment in equities. Investment in fixed
income securities, particularly government securities, is preferred in such scenario.
Thus, the economic analysis helps investors first to allocate available surplus
amount between different types of securities (like government bonds, corporate
bonds and equities) and then select industries, which are expected to do well in a
given economic condition. Investors, like Foreign Institutional Investors (FIIs)
operating in several countries can use economic analysis to allocate funds to
different countries based on the economic outlook.
Industry Analysis
All industries are not influenced equally by changes in the economy nor they
are affected by business cycles at just one single point of time. For example, in an
international environment of peace-treaties and resolution of cold war, profits of
defence-related industries would wane. The upturn in construction industry
generally lags behind the economy. Similarly, a boom or expansion of the economy
is not likely to benefit industries subject to foreign competition of product
obsolescence. The equipment manufacturing industry will perform well towards the
end of economic cycle because the buyer firms typically increase capital
 32

expenditure when they are operating at full capacity. On the other hand, cyclical
industries such as steel and auto, typically do much better than aggregate economy
during expansion but suffer more during contractions. In contrast, non-cyclical
industries like food processing or drugs would show neither substantial increase
nor substantial decline during economic expansion and contraction.
In general, an industry's prospects within a global business environment will
determine how well or poorly an individual firm will fare. Thus industry analysis
should precede company analysis. A weak firm in booming industry might prove
more rewarding than a leader in a weak or declining industry. Of course, the
investor would continuously be through a search process so that the best firms in
strong industries are identified, and narrow down the area of search for investment
outlets. Industry analysis is also useful for investors to allocate funds for different
industries taking into account the future potential and current valuation.
Company Analysis
After determining that an industry's outlook is good, an investor can analyze
and compare individual firms' performance within the entire industry. This involves
examining the historical performance of the company, the firm's standing in the
industry and future prospects. The last one is critical for estimation of cash flows
and hence value. It should be noted that a good Stock or Bond for investment need
not come from the best firm or market leader in the industry because the Stock or
Bond of such firms may be fully valued or overvalued and hence there is no scope
for earning additional return. Thus, investors always look for firms whichare
undervalued for investments than looking for firms, which are best in respective
industries.
4.2.3. THE GENERAL VALUATION FRAMEWORK
Most investors look at price movements in securities markets. They perceive
opportunities of capital gains in such movements. All would wish if they could
successfully predict them and ensure their gains. Few, however, recognize that
value determines price and both changes randomly. It would be useful for an
intelligent investor to be aware of this process. The present section examines this
process in detail. We first present a brief outline of the basic valuation model and
then proceed to discuss the relationship of value with price via investor-market-
action. We shall also recall active and passive investment strategies and finally
figure out the dynamic valuation model.
4.2.3.1. THE BASIC VALUATION MODEL
Value of an asset is equal to present value of its expected returns. This is true
particularly when you expect that the asset you own, provides a stream of returns
during the period of time. This definition of valuation also applies to value of
security. To covert this estimated stream of return to value a security, you must
discount the stream of cash flows at your required rate of return. This process of
estimation of value requires (a) the estimated stream of expected cash flows and (b)
the required rate of return on the investment. The required rate of return varies
 33

from security to security on account of differences in risk level associated with

securities.
Given a risk-adjusted
adjusted discount rate and the future expected earnings flow of a
security in the form
rm of interest, dividend earnings, or cash flow, you can always
determine the present value as follows:

Where, PV = Present value

CF = Cash flow, interest, dividend, or earnings per time period upto `n'
number of periods.
adjusted discount rate (generally the interest rate)
r = risk-adjusted
Expressed in the above manner, the model looks simple. But practical
difficulties do make the use of the model complicated. For instance, it may be quite
difficult to assume that every investor in the market exactly measure theth value of
cash flows and risk adjusted required rate of return. Further, investors' expectation
on compensation for risk may also different between different types of investors. A
small change in these measures will also cause a change in the value. Thus, it may
not be possible to generate a single value.
4.2.3.2 VALUE-PRICE
PRICE RELATIONSHIP
Present value, also known as intrinsic value or economic value, determines
price. We have said this in the preceding section. But how does it happen? Again, a
hint to the answer for this question has been stated in the foregoing paragraph.
You should have noted the role of `buying and selling pressures' which make prices
more toward value. Now, you would ask: `what these pressures are and how do
they occur? You will briefly understand that `investor action' in the wake of
revisions of values spurs such pressures.
You would recall that investment strategies can be `passive' or `active'.
Following this, investors and investment managers can also be broadly grouped in
`passive' and` active' categories. You should note that buying and selling pressures
dominantly originate with active investors. And they follow certain rules of the game
which are outlined below:
Rule 1: Buy when value is more than price. This underlines the fact that
shares are underpriced and it would be a bargain to buy now and sell when prices
move up toward value.
Rule 2: Sell when value is less than price. In a situation like this, shares
would be overpriced and it would be advantageous to sell them now and avoid
a less
when price later moves down to the level of the value.
Rule 3: Don't trade when value is equal to price. This is a state when the
market price is in equilibrium and is not expected to change.
 34

4.3.3 THE COOTNER HYPOTHESIS

Cootner adds one more dimension to the general view of investor action and
buy-sell pressures. He classifies active investors further into two groups viz.,
`professional investors' and `unsophisticated investors’. The former are resourceful
enough to discover news and develop estimates of intrinsic value even before the
unsophisticated investors get the news. They will, therefore, be the first to
commence market action the moment a value-price mismatch is discovered.
`Unsophisticated investors' including hasty speculators who act on `hot tips'
would not get any news other than public news and will not have the skill to
interpret even such public news. They will however, act in the market but such an
action would be incompatible with true changes in intrinsic value. For instance,
some of them might have got retirement benefits and would desperately want to
invest in shares and securities. And unfortunately, such an action may come up at
a time when price is more than value. Likewise, some such investors may have to
finance a marriage in the family and would have to sell shares held by them even if
price is already ruling at a level lower than the intrinsic value. It is obvious that the
action of unsophisticated investors would cut against the trading pressures needed
to rectify the disequilibrium between value and price.
It is only when their irrational action takes prices to substantial `highs' or
`lows' that the professional investors re-enter the scene and pocket enormous
profits even while attempting to realign the errant prices to intrinsic values.
Paul Samuelson has supplemented the Cootner formulation of the valuation
model by stressing the state of continuous equilibrium. Such a situation would be
formed when prices adjust at high speed to values. Instantaneously adjusting
prices to `vibrating values' would be known as perfectly efficient prices, which
would be assumed to reflect all information. A security with perfectly efficient prices
would be in continuous equilibrium.
4.3.4 THE DYNAMIC VALUATION PROCESS
You should have by now understood the dynamic nature of valuation.
Estimates of present value, riskiness and discount rates, future income, and buy-
sell action have to be reviewed from time to time in response to new bits and sets of
information. Figure 4.2 depicts the dynamic valuation process which is an ever
continuing phenomenon. The investors start with their estimates of intrinsic value
using the present value procedure. Working on the trading rules, they buy sell or
don't trade. In the process, buying and selling pressures are generated and prices
either move up or down. In either case, Future return will be influenced by the
latest market price reacting to buying/selling pressures. This will require present
values to be reworked. The process will thus go on.
 35

• Figure4.2:The Dynamic Valuation Model

4.2.4. VALUATION OF FIXED INCOME SECURIT
SECURITIES OR DEBT SECURITIES
Debt securities issued by governments, government and quasi-government
quasi
organizations, and private business firms are fixed
fixed-income
income securities. Bonds and
debentures are the most common examples.
The intrinsic value of a bond or debenture is equal to the present value of its
expected cash flows. The coupon interest payments, and the principal repayment
are known and the present value is determined by discoun discounting
ting these future
payments from the issuer at an appropriate discount rate or market yield. The
usual present value calculations are made with the help of the following equation:

Where PV = the present value of the security today (i.e., time period zero)
C = coupons or interest payments per time period `t'
TV = the terminal value repayable at maturity; this could be at part,
premium, or even at discount (in extraordinary cases)
r = the appropriate discount rate or market yield
n = the number of years of maturity
4.4.1 ESTIMATING RETURNS O
ON FIXED INCOME SECURITIES
Several measures of returns on bonds are available. They are: the coupon rate,
the current yield, and the yield to maturity. The coupon rate is specified at the time
of issue and is all too obvious.
ous.
Current yield: This is calculated as follows:
 36

Current yield is a superior measure to coupon rate because it is based on the

current market price. However, it does not account for the difference between the
purchase price of the bond/debenture and its maturity value.
maturity (YTM): This is the most widely used measure of return on
Yield-to-maturity
fixed income securities. It may be defined as the indicated (promised) compounded
rate of return an investor will receive from a bond purchased at the current market
price and held to maturity. Computing Y YTM
TM involves equating the current market
price of a bond with the discounted value of future interest payments and the
terminal principal repayment; thus YTM equates the two values, viz., the market
price and the present value of future payments including tthe
he principal repayment.
4.2.5. VALUATION OF PREFERENCE SHARES
Preference shares are a hybrid security. They have some features of bonds and
some of equity shares. Theoretically, preference shares are considered a perpetual
security but there are convertibl
convertible,
e, callable, redeemable and other similar features,
which enable issuers to terminate them within a finite time horizon. In the case of
redeemable preference shares, legal mandates require creation of redemption
sinking funds and their earmarked investment
investments s to ensure funds for repayment.
Preference dividends are specified like bonds. This has to be done because
they rank prior to equity shares for dividends. However, specification does not
imply obligation, failure to comply with which may amount to default.
default Several
preference issues are cumulative where dividends accumulate over time and equity
dividends require clearance of preference arrears first.
Preference shares are less risky than equity because their dividends are
specified and all arrears must be p
paid
aid before equity holders get dividends. They are,
however, more risky than bonds because the latter enjoy priority in payment and in
liquidation. Bonds are secured also and enjoy protection of principal, which is
ordinarily not available to preference sha shares.
res. Investors' required returns on
preference shares are more than those on bonds but less than on equity shares. In
exceptional circumstances when preference shares enjoy special tax tax-shields
shields (like in
U.S., inter- corporate holdings of preference shares g get
et exemption on 80% of
preference dividends) required returns on such shares may even be marginally
below those on bonds.
Since dividends from preference shares are assumed to be perpetual
payments, the intrinsic value of such shares will be estimated from the following
equation valid for perpetuities in general:

Where Vp = the value of a perpetuity today

C = the constant annual payment to be received
KP = the required rate of return appropriate for the perpetuity.
 37

4.2.6. VALUATION OF EQUITY SHARES

You have known the basic features of equity shares in Unit 1. Unit 2
introduced the risk-return complexion of such securities. Calculating total return
for the holding period on equity shares was also explained and illustrated in Unit 2.
Factors affecting the riskiness of equity shares and other securities were also
discussed in Unit 2. This section of the present unit will confine attention to
valuation of equity shares using present value principles. The three broad
approaches to valuation viz., efficient market, technical, and fundamental will be
examined in detail in Block 3. However, much of what would be said and analyzed
here would relate to `fundamental approach to valuation of equity shares'.
4.2.6.1 THE PRESENT VALUE OF EXPECTED STREAM OF BENEFITS FROM EQUITY
SHARES
Fundamental analysis is centred on presented value, which is computed as the
discounted value of future stream of benefits. In the case of equity shares, the
future stream of earnings poses two problems. One, it is neither specified (as in the
case of preference shares) nor perfectly known in advance as an obligation (as in
the case of bonds and debentures). Consequently, future benefits and their timing
have both to be estimated in a probabilistic framework. Two, there are at least three
other variables which are used as alternative measures of such benefits viz.,
dividends, cash flows, and earnings.
Solution to the first problem is offered by past data, which is appropriately
modified for future projections. Of course, investors need to modify the past data by
taking into account the current reality and then measure the growth rate.
The second problem can also be viewed as a case of the three alternatives not
really conflicting with each other. The real question is: which cash flows are
appropriate in the valuation of equity shares? Now, if you buy equity shares and
place them all in a trust fund for your and your heir's perpetual benefit, what cash
flows will be received in the trust fund? The answer is `dividends' because this is
the only cash distribution, which a company makes to its shareholders. Even
though earnings per share in any year do belong to the shareholders, companies do
not distribute them all.
Does it mean we should ignore earnings in valuation? Probably, No. All
dividends are paid out of earnings. Moreover, a popular approach to valuation of
equity shares known as P/E ratio uses earnings as its basis. Hence, earnings are
important. Now, if all earnings are paid out as dividends, they will be accounted for
as dividends. In the event of a part of earnings being retained and reinvested, the
effect will be to increase future earnings and finally future dividends also. Present
value analysis should not count earnings reinvested currently and paid later as
dividends. It will lead to double counting. In fact, the two can be properly defined
and separated in which case the two variables viz., earnings and dividends would
produce the same results. Thus, it is always correct to use dividends as the
numerator of the present value equation used to estimate the intrinsic value of
equity shares. The present value model, which uses dividends as its variable
representing the cash flow stream, is known as the dividend valuation model. This
 38

model is discussed below and is followed by a discussion of the P/E approach to

equity shares valuation.
4.2.6.2 DIVIDEND VALUATION MODEL
Under dividend valuation model, future dividends are discounted at the
required rate to get the value of share. There are three possible situations on future
dividend.
- Dividends do not grow in future i.e., the constant or zero growth
assumption,
- Dividends grow at a constant rate in future, i.e., the constant-growth
assumption,
- Dividends grow at varying rates in future time periods i.e., multiple-growth
assumption.
The dividend valuation model is now discussed under the above three situations
- The zero-growth Case: The growth rate of dividend D at time `t' .
- The Constant Growth Case : When dividends grow in all future periods at a
uniform rate ‘g’,
- The Multiple-Growth Case: The multiple-growth assumption has to be made
in a vast number of practical situations. The infinite future time-period is
viewed as divisible into two or more different growth segments. The investor
must forecast the time `T' upto which growth would be variable and after
which only the growth rate would show a pattern and would be constant.
This would mean that present value calculations will have to be spread over
two phases viz., one phase would last until time ‘T’and the other would begin
after `T' to infinity.
4.2.7. THE P/E APPROACH TO EQUITY VALUATION
Unlike dividend capitalization model, the PIE approach is fairly simple and
widely followed in the stock market. The first step under this model is estimating
future earnings per share. Next, the normal price-earnings ratio will be found.
Product of these two estimates will give the expected price. The most practical way
of using PIE model is first computing the industry average P/E or PIE of similar
firm and then multiplying the same with the expected or actual earning of the
stock. P/E of an industry is expected to be high when the industry is in high
growth industry. P/E will be low if the industry or firm is expected to show a low
growth rate. PIE is also affected by the risk associated with the earnings.
4.4. REVISION POINTS
1. Valuation of equity shares, Valuation of Preference shares, Three step
valuation process
4.5. INTEXT QUESTIONS
1. What are the three step valuation processes?
2. Explain valuation of fixed income securities or debt securities.
3. What are the valuation of preference shares and equity shares?
4. Explain general valuation framework.
 39

4.6. SUMMARY
In India, the valuation of securities used to be done by the CCI for the purpose
of fixing up the premium on new issues of existing companies. These guidelines
used by CCI were applicable upto May 1992, when the CCI was abolished. Although
the present market price will be taken into account a more rational price used to be
worked out by the CCI on certain criteria.Thus, the CCI used the concept of Net
Asset Value (NAV) and Profit-Earning Capacity Value (PECV) as the basis for fixing
up the premium on shares.
Monetary policy affects the supply and cost of funds available to business
units. For instance, a restrictive monetary policy reduces money supply and thus
reduces the availability of working capital to business units. Such policy also
increases interest rates and thus increases the cost of funds to business units and
also increases required rate of return for the investors. Of course, it will also reduce
inflation and thus reduces the required rate of return. Monetary policy therefore
affects all segments of the economy and that economy's relationship with other
economies.
4.7. TERMINAL EXERCISES
1. The type of bonds that pay coupon interest are classified as:
a. Forward bond b. Payment bonds c. Coupon bond d. interest bonds
2. The bonds that does not pay any interest rate are considered as
a. interest free bond b. Zero coupon bond c. Price less coupon bond
useless price bonds
4.8 SUPPLIMENTARY MATERIALS
1. www.deasra.in, Microbloggin
4.9. ASSIGNMENT
1. A 5% Rs. 1000 bond paying interest at annual intervals and having 25 years
to maturity is currently selling for Rs. 816. It is anticipated that the market
yield is likely to decline 5.5%. Estimate the intrinsic value of the bond two
years hence.
4.10. REFERENCE BOOKS
1. M. Ranganathan and R. Madhumathi: Investment Analysis and Portfolio
Management, Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management, Vikas
Publishing House Pvt. Ltd., New Delhi.
3. Prasanna Chandra: Investment Analysis and Portfolio Management, TMH,
Delhi.
4.11. LEARNING ACTIVITIES
Collect information about valuations of security options and select best
option on the basis of your information. capacity.
4.12. KEY WORDS
Economy analysis, company analysis, Industry analysis
 40

LESSON 5
SECURITY ANALYSIS
5.0 OBJECTIVE
This lesson enlightens the following aspects.
 This topic is very useful to the students
 Relative market shares and different Technics
5.1 INTRODUCTION
Security analysis comprises of an examination and evaluation of the various
factors affecting the value of a security. Security analysis is about valuing the
assets, debt, warrants, and equity of companies from the perspective of outside
investors using publicly available information. The security analyst must have a
through understanding of financing statements, which are an important source of
this information. As such, the ability to value equity securities requires cross-
disciplinary knowledge in both finance and financial accounting. While there is
much overlap between the analytical tools used in security analysis and those used
in corporate finance, security analysis tends to take the perspective of potential
investors, whereas corporate finance tends to take an inside perspective such as
that of a corporate financial manager. The analysis of various tradable financial
instruments is called security analysis. Security analysis helps a financial expert or
a security analyst to determine the value of assets in a portfolio.
Security Analysis is the analysis of trade-able financial instruments called
securities. It deals with finding the proper value of individual securities (i.e., stocks
and bonds). These are usually classified into debt securities, equities, or some
hybrid of the two. Commodities or futures contracts are not securities. There are
many objectives of Security Analysis. They are - Capital appreciation, Regular
Income, the Safety of Capital, Hedge against Inflation, and Liquidity. Security
analysis is a method which helps to calculate the value of various assets and also
find out the effect of various market fluctuations on the value of tradable financial
instruments (also called securities).
5.2 CONTENT
5.2.1 Definition of Security Analysis
5.2.1 DEFINITION OF SECURITY ANALYSIS
For making proper investment involving both risk and return, the investor has
to make a study of the alternative avenues of investment– their risk and return
characteristics and make proper projection or expectation of the risk and return of
the alternative investments under consideration. He has to tune the expectations to
his preferences of the risk and return for making a proper investment choice. The
process of analysing the individual securities and the market as a whole and
estimating the risk and return expected from each of the investments with a view to
identifying undervalued securities for buying and overvalued securities for selling is
both an art and a science and this is what is called security analysis.
 41

Security Analysis in both traditional sense and modern sense involves the
projection of future dividend, or earnings flows, forecast of the share price in the
future and estimating the intrinsic value of a security based on the forecast of
earnings or dividends. Thus, security analysis in traditional sense is essentially
an analysis of the fundamental value of a share and its forecast for the future
through the calculation of its intrinsic worth of the share.
Modern security analysis relies on the fundamental analysis of the security,
leading to its intrinsic worth and also risk-return analysis depending on the
variability of the returns, covariance, safety of funds and the projections of the
future returns. If the security analysis is based on fundamental factors of the
company, then the forecast of the share price has to take into account inevitably
the trends and the scenario in the economy, in the industry to which the company
belongs and finally the strengths and weaknesses of the company itself- its
management, promoters’ track record, financial results, projections of expansion,
diversification, tax planning etc. all these studies are only a part of the total
security analysis that the investor should aim at.
EQUITY VALUE AND ENTERPRISE VALUE
The equity value of a firm is simply its market capitalization, that is, market
price per share multiplied by the number of outstanding shares. The enterprise
value, also referred to as the firm value, is the equity value plus the net liabilities.
The enterprise value is the value of the productive assets of the firm, not just its
equity value, based on the accounting identity.
Assets = Net liabilities + Equity
Note that net values of the assets and liabilities are used. Any cash and cast-
equivalents would be used to offset the liabilities and therefore are not included in
the enterprise value.
There are different types of securities are available to an investor for
investment. In Indian stock exchanges shares of more than 7000 companies are
listed. Traditionally, the securities were classified into ownership such as equity
shares, preference shares, and debt as a debenture bonds etc. Recently companies
to raise funds for their projects are issuing a number of new securities with
innovative feature. Convertible debenture, discount bonds, Zero coupon bonds,
Flexi bond, floating rate bond, etc. are some of these new securities. From these
huge group of securities the investors has to choose those securities, which he
considers worthwhile to be included in his investment portfolio. So for this detailed
security analysis is most important.
The aim of the security analysis in portfolio management is to find out
intrinsic value of a security. The basic value is also called as the real value of a
security is the true economic worth of a financial asset. The real value of the
security indicates whether the present market price is over- priced or under- priced
in order to make a right investment decision. The actual price of the security is
considered to be a function of a set of anticipated capitalization rate. Price changes,
 42

as anticipation risk and return change, which in turn change as a result of latest
information.
Security analysis in portfolio management refers to analysing the securities
from the point of view of the scrip prices, return and risks. The analysis will help in
understanding the behaviour of security prices in the market for investment
decision making. If it is an analysis of securities and referred to as a macro analysis
of the behaviour of the market. Security analysis entails in arriving at investment
decisions after collection and analysis of the requisite relevant information. To find
out basic value of a security “the potential price of that security and the future
stream of cash flows are to be forecast and then discounted back to the present
value.” The basic value of the security is to be compared with the current market
price and a decision may be taken for buying or selling the security. If the basic
value is lower than the market price, then the security is in the over- bought
position, hence it is to be sold. On the other hand, if the basic value is higher than
the market price the security’s worth is not fully recognized by the market and it is
in under bought position, hence it is to be purchased to gain profit in the future.
There are mainly three alternative approaches to security analysis, namely
fundamental analysis, technical analysis and efficient market theory.
1. FUNDAMENTAL ANALYSIS
The fundamental analysis allows for selection of securities of different sectors
of the economy that appear to offer profitable opportunities. The security analysis
will help to establish what type of investment should be undertaken among various
alternatives i.e. real estate, bonds, debentures, equity shares, fixed deposit, gold,
jewellery etc. Neither all industries grow at same rate nor do all companies. The
growth rates of a company depend basically on its ability to satisfy human desires
through production of goods or performance is important to analyse nation
economy. It is very important to predict the course of national economy because
economic activity substantially affects corporate profits, investors’ attitudes,
expectations and ultimately security price.
According to this approach, the share price of a company is determined by
these fundamental factors. The fundamental works out the compares this intrinsic
value of a security based on its fundamental; them compares this intrinsic value,
the share is said to be overpriced and vice versa. The mispricing security provides
an opportunity to the investor to those securities, which are under- priced and sell
those securities, which are overpriced. It is believed that the market will correct
notable cases of mispricing in future. The prices of undervalued shares will
increase and those of overvalued will decline. Fundamental analysis helps to
identify fundamentally strong companies whose shares are worthy to be included in
the investor’s portfolio.
2. TECHNICAL ANALYSIS
The second alternative of security analysis is technical analysis. The technical
analysis is the study of market action for the purpose of forecasting future price
 43

trends. The term market action includes the three principal sources of information
available to the technician — price, value, and interest. Technical Analysis can be
frequently used to supplement the fundamental analysis. It discards the
fundamental approach to intrinsic value. Changes in price movements represent
shifts in supply and demand position. Technical Analysis is useful in timing a buy
or sells order. The technical analysis does not claim 100% of success in predictions.
It helps to improve the knowledge of the probability of price behavior and provides
for investment. The current market price is compared with the future predicted
price to determine the extent of mispricing. Technical analysis is an approach,
which concentrates on price movements and ignores the fundamentals of the
shares.
3. EFFICIENT MARKET THEORY
A more recent approach to security analysis is the efficient market
hypothesis/theory. According to this school of thought, the financial market is
efficient in pricing securities. The efficient market hypothesis holds that market
prices instantaneously and fully reflect all relevant available information. It means
that the market prices of securities will always equal its intrinsic value. As a result,
fundamental analysis, which tries to identify undervalued or overvalued securities,
is said to be a useless exercise.
Efficient market hypothesis is direct repudiation of both fundamental analysis
and technical analysis. An investor can’t consistently earn abnormal return by
undertaking fundamental analysis or technical analysis. According to efficient
market hypothesis it is possible for an investor to earn normal return by randomly
choosing securities of a given risk level.
5.4. REVISION POINTS
1. Definition of security analysis
5.5. INTEXT QUESTIONS
1. What are the definitions of security analysis?
2. Explain the alternative approaches to security analysis.
5.6. SUMMARY
Security Analysis is the analysis of trade-able financial instruments called
securities. It deals with finding the proper value of individual securities (i.e., stocks
and bonds). These are usually classified into debt securities, equities, or some
hybrid of the two. Commodities or futures contracts are not securities. There are
many objectives of Security Analysis. They are - Capital appreciation, Regular
Income, the Safety of Capital, Hedge against Inflation, and Liquidity. Security
analysis is a method which helps to calculate the value of various assets and also
find out the effect of various market fluctuations on the value of tradable financial
instruments (also called securities).
 44

5.7. TERMINAL EXERCISES

1. _____ is the variability in a security’s returns resulting from fluctuations in
the aggregate market.
a. Market Risk b. Inflation risk c. Credit Risk d. Intend rate risk
2. The primary market is one in which a borrower issues new securities in
exchange for cash from an investor.
a. True b. False
5.8. SUPPLIMENTARY MATERIALS
1. https://egyankosh.ac.in/bitstream/123456789/6331/1/Unit-3.pdf
5.9. ASSIGNMENT
1. Explain the typical job description for an IT security analyst?
5.10. REFERENCE BOOKS
1. M. Ranganathan and R. Madhumathi: Investment Analysis and Portfolio
Management, Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management, Vikas
Publishing House Pvt. Ltd., New Delhi.
3. Prasanna Chandra: Investment Analysis and Portfolio Management, TMH,
Delhi.
5.11. LEARNING ACTIVITIES
Explain the alternatives approaches of security analysis.
5.12. KEY WORDS
Fundamental analysis, technical analysis, efficient market theory.
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LESSON 6
FUNDAMENTAL ANALYSIS
6.0 OBJECTIVE
After studying this units you should be able too understand
 To know about Security analysis, Economy analysis, Company analysis
 To analysis Economic forecasting techniques Industry analysis
6.1 INTRODUCTION
Security analysis is the basis for ration al invest men t decision s. If a
security’s estimated value is above its market price, the security analyst will
recommend buying the stock. If the estimated value is below the market price, the
security should be sold before its price drops. However, the values of the securities
are continuously changing as news about the securities becomes known. The
search for the security pricing involves the use of fundamental analysis. Under
Fundamental analysis, the security analysts studies the fundamental facts affecting
a stock’s values, such as company’s earnings, their management, the economic
outlook, the firm’s competition, market conditions etc.
Fundamental analysis is primarily concerned with determining the intrinsic
value or the true value of a security. For determining the security’s intrinsic value,
the details of all major factors (GNP, industry sales, firm sales and expense etc) is
collected or an estimates of earnings per share may be multiplied by a justified or
normal prices earnings ratio. After making this determination, the intrinsic value is
compared with the security’s current market price.
If the market price is substantially greater than the intrinsic value the security
is said to be overpriced. If the market price is substantially less than the intrinsic
value, the security is said to be under- priced. However fundamental analysis
comprises:
1. Economic Analysis
2. Industry Analysis
3. Company Analysis
6.2 CONTENT
6.2.1 Economic Analysis
6.2.2 Marco Economic Factor
6.2.3 Economic Forecasting Techniques
6.2.4 Industry Analysis
6.2.5 Company Analysis
6.2.6 Forecasting Earnings
6.2.1. ECONOMIC ANALYSIS
For the security analyst or investor, the anticipated economic environment,
and therefore the economic forecast, is important forma king decisions concerning
both the timings of an investment and the relative investment desirability among
the various industries in the economy. The key for the analyst is that overall
 46

economic activities manifest itself in the behaviour of the stocks in general. That is,
the success of the economy will ultimately include the success of the overall
market. For studying the Economic Analysis, the Macro Economic Factors and the
Forecasting Techniques are to be studied.
6.2.2 MACRO ECONOMIC FACTORS
The macro economy is the study of all the firms operates in economic
environment. The key variables to describe the state of economy are explained as
below:
1. Growth rate of Gross Domestic Product (GDP): GDP is a measure of the total
production of final goods and services in the economy during a year. It is indicator
of economic growth. It consists of personal consumption expenditure, gross private
domestic investment, government expenditure on goods and services and net export
of goods and services. The firm estimates of GDP growth rate are available with a
time lag of one or two years. The growth rate of economy points out the prospects
for the industrial sector and the return investors can expect from investment in
shares. The higher the growth rate of GDP, other things being equal, the more
favourable it is for stock market.
2. Savings and investment: Growth of an economy requires proper amount of
investments which in turn is dependent upon amount of domestic savings. The
amount of savings is favourably related to investment in a country. The level of
investment in the economy and the proportion of investment in capital markets
major area of concern for investment analysts. The level of investment in the
economy is equal to: Domestic savings +inflow of foreign capital - investment made
abroad.
Stock markets an important channel to mobilize savings, from the individuals
who have excess of it, to the individual or corporate, who have deficit of it. Savings
are distributed over various assets like equity shares, bonds, small savings
schemes, bank deposits, mutual fund units, real estates, bullion etc. The demand
for corporate securities has an important bearing on stock prices movements.
Greater the allocation of equity in investment, favourable impact it have on stock
prices.
3. Industry Growth rate: The GDP growth rate represents the average of the
growth rate of agricultural sector, industrial sector and the service sector. Publicly
listed company play a major role in the industrial sector. The stock market analysts
focus on the overall growth of different industries contributing in economic
development. The higher the growth rate of the industrial sector, other things being
equal, the more favourable it is for the stock market.
4. Price level and Inflation: If the inflation rate increases, then the growth rate
would be very little. The increasingly inflation rate significantly affect the demand of
consumer product industry. The industry which have a weak market and come
under the purview of price control policy of the government may lose the market,
like sugar industry. On the other hand the industry which enjoy a strong market
 47

for their product and which do not come under purview of price control may benefit
from inflation. If there is a mild level of inflation, it is good to the stock market but
high rate of inflation is harmful to the stock market.
5. Agriculture and monsoons: Agriculture is directly and indirectly linked with
the industries. Hence increase or decrease in agricultural production has a
significant impact on the industrial production and corporate performance.
Companiesusing agricultural raw materials as inputs or supplying inputs to
agriculture are directly affected by change in agriculture production.
6. Interest Rate: Interest rates vary with maturity, default risk, inflation rate,
productivity of capital etc. The interest rate on money market instruments like
Treasury Bills are low, long dated government securities carry slightly higher
interest rate and interest rate on corporate debenture is still higher. With the
deregulation interest rates are softened, which were quite high in regulated
environment. Interest rate affects the cost of financing to the firms. A decrease in
interest rate implies lower cost of finance for firms and more profitability and it
finally leads to decline in discount rate applied by the equity investors, both of
which have a favourable impact on stock prices. At lower interest rates, more
money at cheap cost is available to the persons who do business with borrowed
money, this leads to speculation and rise in price of share.
7. Government budget and deficit: Government plays an important role in the
growth of any economy. The government prepares a central budget which provides
complete information on revenue, expenditure and deficit of the government for a
given period. Government revenue come from various direct and indirect taxes and
government made expenditure on various developmental activities. The excess of
expenditure over revenue leads to budget deficit. For financing the deficit the
government goes for external and internal borrowings. Thus, the deficit budget may
lead to high rate of inflation and adversely affects the cost of production and
surplus budget may results in deflation. Hence, balanced budget is highly
favourable to the stock market.
8. The tax structure: The business community eagerly awaits the government
announcements regarding the tax policy in March every year. The type of tax
exemption has impact on the profitability of the industries. Concession and
incentives given to certain industry encourages investment in that industry and
have favourable impact on stock market.
9. Balance of payment, forex reserves and exchange rate: Balance of payment
is the record of all the receipts and payment of a country with the rest of the world.
This difference in receipt and payment may be surplus or deficit. Balance of
payment is a measure of strength of rupee on external account. The surplus
balance of payment augments forex reserves of the country and has a favourable
impact on the exchange rates; on the other hand if deficit increases, the forex
reserve depletes and has an adverse impact on the exchange rates. The industries
involved in export and import are considerably affected by changes in foreign
 48

exchange rates. The volatility in foreign exchange rates affects the investment of
foreign institutional investors in Indian Stock Market. Thus, favourable balance of
payment renders favourable impact on stock market.
10. Infrastructural facilities and arrangements: Infrastructure facilities and
arrangements play an important role in growth of industry and agriculture sector. A
wide network of communication system, regular supply or power, a well developed
transportation system (railways, transportation, road network, inland waterways,
port facilities, air links and telecommunication system) boost the industrial
production and improves the growth of the economy. Banking and financial sector
should be sound enough to provide adequate support to industry and agriculture.
The government has liberalized its policy regarding the communication, transport
and power sector for foreign investment. Thus, good infrastructure facilities affect
the stock market favourable.
11. Demographic factors: The demographic data details about the population
by age, occupation, literacy and geographic location. These factors are studied to
forecast the demand for the consumer goods. The data related to population
indicates the availability of work force. The cheap labour force in India has
encouraged many multinationals to start their ventures. Population, by providing
labour and demand for products, affects the industry and stock market.
12. Sentiments: The sentiments of consumers and business can have an
important bearing on economic performance. Higher consumer confidence leads to
higher expenditure and higher business confidence leads to greater business
investments. Allth is ultimately leads to economic growth. Thus, sentiments
influence consumption and investment decisions and have a bearing on the
aggregate demand for goods and services.
6.2.3 ECONOMIC FORECASTING TECHNIQUES
To estimate the stock price changes, an analyst has to analyze the macro-
economic environment. All the economic activities affect the corporate profits,
investor’s attitudes and share price. For the purpose of economic analysis and in
order to decide the right time to invest in securities some techniques are used.
These are explained as below:
1. Anticipatory Surveys: Under this prominent people in government and
industry are asked about their plans with respect to construction, plant and
equipment expenditure, inventory adjustments and the consumers about their
future spending plans. To the extent that these people plan and budget for
expenditure in advance and adhere to their intentions, surveys of intentions
constitute a valuable input in forecasting process. It is necessary that surveys of
intentions be based one elaborate statistical sampling procedures, the greatest
shortcoming of intentions, surveys is that the forecaster has no guarantee that the
intention will be carried out. External shocks, such as strikes, political turmoil or
government action can cause changes in intentions.
 49

2. Barometric or Indicator approach: Barometric technique is based on the

presumption that relationship can exist among various economic time series. For
example, industrial production overtime and industrial loans by commercial banks
over time may move in same direction. Historical data are examined in order to
ascertain which economic variables have led, lagged after of moved together with
the economy. A leading indicator may be leading because it measures something
that overshadows a change in production activity.
3. Diffusion Indexes: Some of the indicators appear in more than one class,
and then the problem of choice may arise. Furthermore, it is not advisable to rely
on just one of the indicators. This leads to the usage of what is referred to as the
diffusion index. A diffusion index copes with the problem of differing signals given
by the indicators. It is percentage of rising indicators. In this method a group of
leading indicators is initially chosen. Then the percentage of the group of chosen
indicators which have fallen (or, risen) over the last period is plotted against time to
get the diffusion index.
4. Money and Stock Prices: Monetary theory in its simplest form states that
fluctuations in the rate of growth of money supply are of utmost importance in
determining GNP, corporate profits, interest rates, stock prices etc. Monetarists
contend that changes in growth rate of money supply set off a complicated series of
events that ultimately affects share prices. In addition, these monetary changes
lead stock price changes. Thus, while making forecasts, changes in growth rate of
money supply should be given due importance. Some thinkers states that stock
market leads changes in money supply. However, sound monetary policy is a
necessary ingredient for steady grow hand stable prices.
5. Econometric Model Building: The econometric methods combine statistical
tools with economic theories to estimate economic variables and to forecast the
intended economic variables. The forecast made through econometric method are
much more reliable than those made through any other method. For applying
econometric technique, the user is to specify in a formal mathematical manner the
precise relation between the dependent and independent variable. In using
econometrics, the forecaster must quantify precisely the relationships and
assumptions he is making. This not only gives him direction but also the
magnitudes.
An econometric model may be a single-equation regression model or it may
consist of a system of simultaneous equations. Single equation regression serves
the purpose of forecasting in many cases. But where the relationship between
economic variables are complex and variable are so interrelated that unless one is
determined, the other cannot be determined, a single-equation regression model
does not serve the purpose. In that case, a system of simultaneous equations is
used to estimate and forecast the target variable.
6. Opportunistic Model Building: Opportunistic model building or GNP model
building or sectoral analysis is widely used forecasting method. Initially, the
 50

forecaster must hypothesize total demand and thus total income during the
forecast period. Obviously, this will necessitate assuming certain environmental
decisions, such as war or peace, political relationships among the level of interest
rates. After, this work has been done, the forecaster begins building a forecast of
the
e GNP figure by estimating the levels of the various component of GNP like the
number of consumption expenditures, gross private domestic investment,
government purchases of goods and services and net exports. After adding the four
major categories the forecaster
ecaster comes up with a GNP forecast. Now he tests this
total for consistency with an independently arrived at a priori forecast of GNP.
6.2.4 INDUSTRY ANALYSIS
The mediocre firm in the growth industry usually out performs the best stocks
in a stagnant industry.
ustry. Therefore, it is worthwhile for a security analyst to pinpoint
growth industry, which has good investment prospects. The past performance of an
industry is not a good predictor of the future
future- if one look very far into the future.
Therefore, it is important
portant to study industry analysis. For an industry analyst-analyst
industry life cycle analysis, characteristics and classification of industry is
important. All these aspects are enlightened in following sections:
6.2.4.1 INDUSTRY LIFE CYCLE
CLE ANALYSIS
Many industrial
trial economists believe that the development of almost every
industry may be analysed in terms of following stages:

1. Pioneering stage: During this stage, the technology and product is relatively
new. The prospective demand for the product is promising in this industry. The
demand for the product attracts many producers to produce the particular product.
This lead to severe competition and only fittest companies survive in this stage. The
producers try to develop brand name, differentiate the product an
andd create a product
image. This would lead to non
non-price
price competition too. The severe competition often
leads to change of position of the firms in terms of market share and profit.
2. Rapid growth stage: This stage starts with the appearance of surviving firms
fir
from the pioneering stage. The companies that beat the competition grow strongly
 51

in sales, market share and financial performance. The improved technology of

production leads to low cost and good quality of products. Companies with rapid
growth in this stage, declare dividends during this stage. It is always advisable to
invest in these companies.
3. Maturity and stabilization stage: After enjoying above-average growth, the
industry now enters in maturity and stabilization stage. The symptoms of
technology obsolescence may appear. To keep going, technological innovation in the
production process should be introduced. A close monitoring at industries events
are necessary at this stage.
4. Decline stage: The industry enters the growth stage with satiation of
demand, encroachment of new products, and change in consumer preferences. At
this stage the earnings of the industry are started declining. In this stage the
growth of industry is low even in boom period and decline at a higher rate during
recession. It is always advisable not to invest in the share of low growth industry.
6.2.4.2 CLASSIFICATION OF INDUSTRY
Industry means a group of productive or profit making enterprises or
organizations that have a similar technically substitute goods services or source of
income. Beside s Standard Industry Classification (SIC), industries can be classified
on the basis of products and business cycle i.e. classified according to their
reactions to the different phases of the business cycle. These are classified as
follows:
1. Growth Industries: These industries have special features of high rate of
earnings and growth in expansion, independent of the business cycle. The
expansion of the industry mainly depends on the technological change or an
innovative way of doing or selling something.
2. Cyclical Industries: The growth and profitability of the industry move along
with the business cycle. These are those industries which are most likely to benefit
from a period of economic prosperity and most likely to suffer from a period of
economic recession. These especially include consumer goods and durables whose
purchase can be postponed until persona financial or general business conditions
improve.
3. Defensive Industries: Defensive industries are those, such as the food
processing industry, which hurt least in the period of economic downswing.
4. Cyclical-growth Industries: These possess characteristics of both a cyclical
industry and a growth industry.
6.2.4.3 CHARACTERISTICS OF AN INDUSTRY ANALYSIS
In an industry analysis, the following key characteristics should be considered
by the analyst. These are explained as below:
1. Post sales and Earnings performance: The two important factors which play
an important role in the success of the security investment are sales and earnings.
The historical performance of sales and earnings should be given due
 52

consideration, to know how the industry have reacted in the past. With the
knowledge and understanding of the reasons of the past behaviour, the investor
can assess the relative magnitude of performance in future. The cost structure of
an industry is also an important factor to look into. The higher the cost component,
the higher the sales volume necessary to achieve the firm’s break-even point, and
vice-versa.
2. Nature of Competition: The numbers of the firms in the industry and the
market share of the top firms in the industry should be analysed. One way to
determine competitive conditions is to observe whether any barriers to entry exist.
The demand of particular product, its profitability and price of concerned company
scrip’s also determine the nature of competition. The investor before investing in
the scrip of a company should analyse the market share of the particular
company’s product and should compare it with other companies. If too many firms
are present in the organized sector, the competition would be sever. This will lead to
a decline in price of the product.
3. Raw Material and Inputs: Here, we have to look into the industries, which
are dependent upon imports of scarce raw material, competition from other
companies and industries barriers to entry of a new company, protection from
foreign competition, import and export restriction etc. An industry which has a
limited supply of materials domestically and where imports are restricted will have
dim growth prospects. Labour is also an input and industries with labour problems
may have difficulties of growth.
4. Attitude of Government towards Industry: It is important for the analyst or
prospective investor to consider the probable role government will play in industry.
Will it provide financial support or otherwise? Or it will restrain the industry’s
development through restrictive legislation and legal enforcement? The government
policy with regard to granting of clearance, installed capacity and reservation of the
products for small industry etc. are also factors to be considered for industry
analysis.
5. Management: An industry with many problems may be well managed, if the
promoters and the management are efficient. The management likes Tatas, Birlas,
Ambanies etc. who have a reputation, built up their companies on strong
foundations. The management has to be assessed in terms of their capabilities,
popularity, honesty and integrity. In case of new industries no track record is
available and thus, investors have to carefully assess the project reports and the
assessment of financial institutions in this regard. A good management also
ensures that the future expansion plans are put on sound basis.
6. Labour Conditions and Other Industrial Problems: The labour scenario in a
particular industry is of great importance. If we are dealing with a labour intensive
production process or a very mechanized capital intensive process where labour
performs crucial operations, the possibility of strike looms as an important factor to
be reckoned with. Certain industries with problems of marketing like high storage
 53

costs, high transport costs etc leads to poor growth potential and investors have to
careful in investing in such companies.
7. Nature of Product Line: The position of the industry in the lifecycle of its
growth- initial stage, high growth stage and maturing stage are to be noted. It is
also necessary to know the industries with a high growth potential like computers,
electronics ,chemicals, diamonds etc., and whether the industry is in the priority
sector of the key industry group or capital goods or consumer goods groups. The
importance attached by the government in their policy and of the Planning
Commission in their assessment of these industries is to be studied.
8. Capacity Installed and Utilized: The demand for industrial products in the
economy is estimated by the Planning Commission and the Government and the
units are given licensed capacity on the basis of these estimates. If the demand is
rising as expected and market is good for the products, the utilization of capacity
will be higher, leading to bright prospect sand higher profitability. If the quality of
the product is poor, competition is high and there are other constraints to the
availability of inputs and there are labour problems, then the capacity utilization
will be low and profitability will be poor.
9. Industry Share Price Relative to Industry Earnings: While making
investment the current price of securities in the industry, the risk and returns they
promise is considered. If the price is very high relative to future earnings growth,
the investment in these securities is not wise. Conversely, if future prospects are
dim but prices are low relative to fairly level future patterns of earnings, the stocks
in this industry might be an attractive investment.
10. Research and Development: For any industry to survive in the national
and international markets, product and production process have to be technically
competitive. This depends upon the research and development in the particular
industry. Proper research and development activities help in obtaining economic of
scale and new market for product. While making investment in any industry the
percentage of expenditure made on research hand development should also be
considered.
11. Pollution Standards: These are very high and restricted in the industrial
sector. These differ from industry to industry, for example, in leather, chemical and
pharmaceutical industries the industrial effluents are more.
6.2.5 COMPANY ANALYSIS
Fundamental analysis is the method of analysing companies based on factors
that affect their intrinsic value. There are two sides to this method: the quantitative
and the qualitative.
The quantitative side involves looking at factors that can be measured
numerically, such as the company’s assets, liabilities, cash flow, revenue and price-
to-earnings ratio. The limitation of quantitative analysis, however, Is that it does
not capture the company’s aspects or risks unmeasurable by a number - things like
 54

the value of an executive or the risks a company faces with legal issues. The
analysis of these things is the other side of fundamental analysis: the qualitative
side or non-number side. Although relatively more difficult to analyse, the
qualitative factors are an important part of a company. Since they are not
measured by a number, they more represent an either negative or positive force
affecting the company.
But some of these qualitative factors will have more of an effect and
determining the extent of these effects is what is so challenging. To start, identify a
set of qualitative factors and then decide which of these factors add value to the
company, and which of these factors decrease value. Then determine their relative
importance. The qualities one analyses can be categorized as having a positive
effect, negative effect or minimal effect. The best way to incorporate qualitative
analysis into evaluation of a company is to doit once you have done the quantitative
analysis. The conclusion come to on the qualitative side can put quantitative
analysis into better perspective. If when looking at the company numbers one saw
good reason to buy/invest in the company, but then found many negative qualities,
he may want to think twice about buying/investing. Negative qualities might
include potential litigations, poor R and D prospects or a board full of insiders.
The conclusions of qualitative analysis either reconfirm or raise questions
about the conclusions of quantitative analysis. Fundamental analysis is not as
simple as looking at numbers and computing ratios; it is also important to look at
influences and qualities that do not have a number value. The present and future
values are affected by the following factors:
1) Competitive Edge: Many industries in India are composed of hundreds of
individuals companies. The large companies are successful in meeting the
competition and some companies rise to the position of eminence and dominance.
The companies who have obtain the leadership position; have proven his ability to
withstand competition and to have a sizable share in the market. The
competitiveness of the company can be studied with the help of
a) Market share: The market share of the company helps to determine a
company’s relative position with in the industry. If the market share is high, the
company would be able to meet the competition successfully. The size of the
company should also be considered while analyzing the market share, because the
smaller companies may find it difficult to survive in the future.
b) Growth of annual sales: Investor generally prefers to study the growth in
sales because the larger size companies may be able to withstand the business
cycle rather than the company of smaller size. The rapid growth keeps the investor
in better position as growth in sales is followed by growth in profit. The growth in
sales of the company is analyzed both in rupee terms and in physical terms.
c) Stability of annual sales: If a firm has stable sales revenue, other things
being remaining constant, will have more stable earnings. Wide variation in sales
 55

leads to variation in capacity utilization, financial planning and dividends. This

affects the company’s position and investor’s decision to invest.
2) Earnings: The earning of the company should also be analyzed along with
the sales level. The income of the company is generated through the operating (in
service industry like banks- interest on loans and investment) and non-operating
income (ant company, rentals from lease, dividends from securities). The investor
should analyze the sources of income properly. The investor should be well aware
with the fact that the earnings of the company may vary due to following reasons:
• Change in sales.
• Change in costs.
• Depreciation method adopted.
• Inventory accounting method.
• Wages, salaries and fringe benefits.
• Income tax and other taxes.
3) Capital Structure: Capital structure is combination of owned capital and
debt capital which enables to maximize the value of the firm. Under this, we
determine the proportion in which the capital should be raised from the different
securities. The capital structure decisions are related with the mutual proportion of
the long term sources of capital. The owned capital includes share capital
a) Preference shares: Preference shares are those shares which have
preferential rights regarding the payment of dividend and repayment of capital over
the equity shareholders. At present many companies resort to preference shares.
The preference shares induct some degree of leverage in finance. The leverage effect
of the preference shares is comparatively lesser than that the debt because the
preference shares dividend are not tax deductible. If the portion of preference share
in the capital is large, it tends to create instability in the earnings of equity shares
when the earnings of the company fluctuate.
b) Debt: It is an important source of finance as it has the specific benefit of low
cost of capital because interest is tax deductible. The leverage effect of debt is
highly advantageous to the equity shareholders. The limits of debt depend upon the
firm’s earning capacity and its fixed assets.
4) Management: The basic objective of the company is to attain the stated
objectives of the company for the good of the equity holders, the public and
employees. If the objectives of the company are achieved, investor will have a profit.
Good management results in high profit to investors. Management is responsible
for planning, organizing, actuating and controlling the activities of the company.
The good management depends upon the qualities of the manager.
5) Operating Efficiency: The operating efficiency of the company directly affects
the earnings capacity of a company. An expanding company that maintains high
operating efficiency with a low breakeven point earns more than the company with
high break even point. If a firm has stable operating ratio, the revenues also would
be stable. Efficient use of fixed assets with raw materials, labour and management
 56

would lead to more income from sales. This leads to internal fund generation for the
expansion of the firm.
6) Financial Performance a) Balance Sheet: The level, trends, and stability of
earnings are powerful forces in the determination of security prices. Balance sheet
shows the assets, liabilities and owner’s equity in a company. It is the analyst’s
primary source of information on the financial strength of a company. Accounting
principles dictate the basis for assigning values to assets. Liability values are set by
contracts. When assets are reduced by liabilities, the book value of share holder’s
equity can be ascertained. The book value differs from current value in the market
place, since market value is dependent upon the earnings power of assets and not
their cost of values in the accounts.
b) Profit and Loss account: It is also called as income statement. It expresses
the results of financial operations during an accounting year i.e. with the help of
this statement we can find out how much profit or loss has taken place from the
operation of the business during a period of time. It also helps to ascertain how the
changes in the owner’s interest in a given period has taken place due to business
operations. Last of all, for analyzing the financial position of any company following
factors need to be considered for evaluating present situation and prospects of
company. The questions that need to be answered for company analysis are:
a) Availability and Cost of Inputs: Is the company well placed with respect to
the availability of basic raw materials, power, fuel and other production inputs?
What are the costs advantages/disadvantages of the company vis-à-vis its
competitors?
b) Order Position: What is the order position of the company? How many
months or years of production does it represent? Is the order position improving or
deteriorating?
c) Regulatory Framework: What is the licensing policy applicable to the
industry to which the firm belongs? Are there any price and/or distribution
controls applicable to the company? If so, what are their implications for
profitability?
d) Technological and Production Capabilities: What is the technological
competence of the firm? What is the state of its plant and machinery? Does the
company have unutilized capacity to exploit favourable market developments?
e) Marketing and Distribution: What is the image of the company in the
marketplace? How strong is the loyalty of its customers/clients? What is the reach
of the distribution network?
f) Finance and Accounting: What are the internal accruals? How much access
the companies have to external financing? What are the products in the portfolio of
the company? How competitive is the position of the company in these products?
g) Human Resource and Personnel: How competent and skilled is the
workplace of the company? Is the company over-staffed or under-staffed? What is
 57

the extent of employee turnover and absenteeism? What is the level of employee
motivation and morale?
6.2.4.1 COMPANY ANALYSIS: THE STUDY OFFINANCIALS STATEMENTS
Financial statement means a statement or document which explains necessary
financial information. Financial statements express the financial position of a
business at the end of accounting period (Balance Sheet) and result of its
operations performed during the year (Profit and Loss Account). In order to
determine whether the financial or operational performance of company is
satisfactory or not, the financial data are analyzed. Different methods are used for
this purpose. The main techniques of financial analysis are:
1. Comparative Financial Statements
2. Trend Analysis
3. Common Size Statement
4. Fund Flow Statement
5. Cash Flow Statement
6. Ratio Analysis
1) Comparative Financial Statements: In comparative financial statement, the
financial statements of two periods are kept by side so that they can be compared.
By preparing comparative statement the nature and quantum of change in different
Items can be calculated and it also helps in future estimates. By comparing with
the data of the previous years it can be ascertained what type of changes in the
different items of current year have taken place and future trends of business can
be estimated.
2) Trend Analysis: In order to compare the financial statements of various
years trend percentages are significant. Trend analysis helps in future forecast of
various items on the basis of the data of previous years. Under this method one
year is taken as base year and on its basis the ratios in percentage for other years
are calculated. From the study of these ratios the changes in that item are
examined and trend is estimated. Sometimes sales maybe increasing continuously
and the inventories may also be rising. This would indicate the loss of market share
of a particular company’s product. Likewise sales may have an increasing trend but
profit may remain the same. Here the investor has to look into the cost and
management efficiency of the company.
3) Common Size Statement: Common size financial statements are such
statements in which items of the financial statements are converted in percentage
on the basis of common base. In common size Income Statement, net sales may be
considered as 100percent. Other items are converted as its proportion. Similarly,
for the Balance sheet items total assets or total liabilities may be taken as 100
percent and proportion of other items to this total can be calculated in percentage.
4) Fund Flow Statement: Income Statement or Profit or Loss Account helps in
ascertainment of profit or loss for a fixed period. Balance Sheet shows the financial
position of business on a particular date at the close of year. Income statement
 58

does not fully explain funds from operations of business because various non-fund
items are shown in Profit or Loss Account. Balance Sheet shows only static
financial position of business and financial changes occurred during a year can’t be
known from the financial statement of a particular date. Thus, Fund Flow
Statement is prepared to find out financial changes between two dates. It is a
technique of analyzing financial statements. With the help of this statement, the
amount of change in the funds of a business between two dates and reasons
thereof can be ascertained. The investor could see clearly the amount of funds
generated or lost in operations. These reveal the real picture of the financial
position of the company.
5) Cash Flow Statement: The investor is interested in knowing the cash inflow
and outflow of the enterprise. The cash flow statement expresses the reasons of
change in cash balances of company between two dates. It provides a summary of
stocks of cash and uses of cash in the organization. It shows the cash inflows and
outflows. Inflows (sources) of cash result from cash profit earned by the
organization, issue of shares and debentures for cash, borrowings, sale of assets or
investments, etc. The outflows (uses)of cash results from purchase of assets,
investment redemption of debentures or preferences shares, repayment of loans,
payment of tax, dividend, interest etc. With the help of cash flow statement the
investor can review the cash movement over an operating cycle. The factors
responsible for the reduction of cash balances in spite of increase in profits or vice
versa can be found out.
6) Ratio Analysis: Ratio is a relationship between two figures expressed
mathematically. It is quantitative relationship between two items for the purpose of
comparison. Ratio analysis is a technique of analyzing financial statements. It helps
in estimating financial soundness or weakness. Ratios present the relationships
between items presented in profit and loss account and balance sheet. It
summaries the data for easy understanding, comparison and interpretation. The
ratios are divided in the following group:
a) Liquidity Ratios: Liquidity rations means ability of the company to pay the
short term debts in time. These ratios are calculated to analyze the short term
financial position and short term financial solvency of firm. Commercial banks and
short term creditors are interested in such analysis.
b) Turnover Ratios: These ratios show how well the assets are used and the
extent of excess inventory.
c) Profit Margin Ratios: Earning of more and more profit with the optimum
use of available resources of business is called profitability. The investor is very
particular in knowing net profit to sales, net profit to total assets and net profit to
equity. The profitability ratio measures the overall efficiency and control of firm.
6.2.6 FORECASTING EARNINGS
There is strong evidence that earnings have a direct and powerful effect upon
dividends and share prices. So the importance of forecasting earnings can not be
 59

overstated. These ratios are generally known as ‘Return on Investment Ratios’.

These ratio help in evaluating whether the business is earning adequate return on
the capital invested or not. With the help of the following ratios the performance of
the business can be measured. The earning forecasting ratios are:
• Return on Total Assets: Changes in reported earnings can result from
changes in methods of accounting, changes in the operations of the
business and/or in financing of business, that is, changes in productivity or
in resource base. This ratio represents the overall efficiency of capital
invested in business. This ratio can also be called as gross capital employed
ratio. The total assets here are combination of fixed assets and current
assets.
• Return on Equity: This ratio is calculated to evaluate the profitability of the
business from the point of view of the ordinary shareholders.
• Earnings and Role of Financing: Borrowing of money at a fixed cost and the
use of these funds to earn return on assets is known as employing leverage.
If one can earn more on borrowed money than you have to pay for it, the
leverage is to firm’s advantage. However, leverage should be used within
reasonable limits because excessive use of debt relative to equity increases
borrowing costs and also the cost of equity funds. The volatility of share
holders returns increases with the expansion of the degree of financial
leverage. The greater volatility of earnings owing to increased leverage can, at
certain levels of debt financing, cause the market to payless per rupee of
earnings. Further with the use of more debts it may become progressively
difficult to maintain (or improve) the rate of return on assets.
• Valuation Ratios: Earnings and Dividend Level
a) Book value per share: This ratio indicates the share of equity shareholders
after the company has paid all its liabilities, creditors, debenture holder and
preference shareholders.
b) Earnings per share (EPS): This ratio measures the earnings per share
available to ordinary shareholders. Equity shareholders have the right to all profits
left after payment of taxes and preference dividend.
c) Dividend per Share (DPS): All the profits after tax and preference dividend
available for equity shareholders are not distributed among them as dividend.
Rather, a part of it is related in business. The balance of profits is distributed
among equity shareholders. To calculate dividend per share, the profits distributed
as dividend among equity shareholders is divided by number of equity shares.
d) Dividend Pay-out Ratio (D/P ratio): This ratio establishes the relationship
between the earnings available for ordinary shareholders and the dividend paid to
them. In other words, it explains what percentage of profit after tax and preference
dividend has been paid to equity shareholders as dividend.
e) Dividend and Earnings Yield: These ratios are used to evaluate the
profitability from the stand point of ordinary shareholders. Earning per share (EPS)
 60

and Dividend per Share (DPS) are calculated on the basis of book value of share but
yield is always calculated on the basis of market value of shares.
6.4. REVISION POINTS
1. Economic analysis, Marco economic factor, Economic forecasting
techniques, Industry analysis, Company analysis, Forecasting earnings
6.5. INTEXT QUESTIONS
1. Explain macro-economic factors?
2. What are the techniques of economic forecasting?
3. Describe Industry life cycle analysis.
4. What is fundamental analysis?
6.6. SUMMARY
For the security analyst or investor, the anticipated economic environment,
and therefore the economic forecast, is important for making decision ns
concerning both the timings of an investment and the relative investment
desirability among the various industries in the economy. The key for the analyst is
that overall economic activities manifest itself in the behaviour of the stocks in
general. That is, the success of the economy will ultimately include the success of
the overall market. For studying the Economic Analysis, the Macro Economic
Factors and the Forecasting Techniques are to be studied.
6.7. TERMINAL EXERCISES
1. Which of the following is NOT a factor uses in Fundamental analysis?
a. Company information b. Industry standards c. Expert opinions
d. Economic factors
6.8. SUPPLIMENTARY MATERIALS
1. money.rediff.com
2. money control.com
3. amfiindia.com
4. szerodha.com
6.9. ASSIGNMENT
1. How to analyse and read the annual report of a company?
6.10. REFERENCE BOOKS
1. M. Ranganathan and R. Madhumathi: Investment Analysis and Portfolio
Management, Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management, Vikas
Publishing House Pvt. Ltd., New Delhi.
3. Prasanna Chandra: Investment Analysis and Portfolio Management, TMH,
Delhi.
6.11. LEARNING ACTIVITIES
Portfolio Management Securit analysis
6.12. KEY WORDS
Economic analysis, Macro economic, Industry analysis.
 61

LESSON 7
TECHNICAL ANALYSIS
7.0 OBJECTIVE
This lesson throws light on the following areas were covered
 To know the various Meaning of Technical analysis
 To learns the Tools of Technical analysis
7.1 INTRODUCTION
The technical approach is the oldest approach to equity investment dating
back to the late 19th century. It continues to flourish in modern times as well. As
an investor, we often encounter technical analysis because newspapers cover it;
television programmers routinely call technical experts for their comments and
investment advisory services circulate technical reports. As an approach to
investment analysis, technical analysis is radically different from fundamental
analysis. The basic differences are –
1. While the fundamental analysis believes that the market is 90percent logical
and 10percent psychological, the technical analysis assumes that the market is 90
percent psychological and 10 percent logical.
2. Like fundamental analysis, technical analysis does not evaluate the large
number of fundamental factors relating to the company, the industry and the
economy but in it, the internal market data is analyzed with the help of charts and
graphs.
3. Technical analysis mainly seeks to predict short-term price movement
appealing the short-term traders where fundamental analysis tries to establish
long-term values. Hence, it appeals to long tern investors.
4. The technical analysis is based on the premise that the history repeats
itself. Therefore, the technical analysis answers the question “What had happened
in the market” while on the basis of potentialities of market fundamental analysis
answers the question, “What will happen in the market”.
7.2 CONTNET
7.2.1 Meaning of Technical Analysis
7.2.2 Tools of Technical Analysis
7.2.3 Evaluation of Technical Analysis
7.2.1 MEANING OF TECHNICAL ANALYSIS
Technical analysis involves a study of market-generated datalike prices and
volumes to determine the future direction of price movement. It is a process of
identifying trend reversal at an earlier stage to formulate the buying and selling
strategy. With the help of several indicators, the relationship between price –volume
and supply-demand is analyzed for the overall market and individual stocks.
 62

7.2.2 TOOLS OF TECHNICAL ANALYSIS

Generally used technical tools to analyze the market data areas follows:
7.2.2.1 DOW THEORY
Originally proposed in the late nineteenth century by Charles H Dow, the
editor of Wall Street Journal, the Dow theory is per haps the oldest and best-known
theory of technical analysis. Dow developed this theory on the basis of certain
hypothesis, which are as follows:
a. No single individual or buyer or buyer can influence the major trends in the
market. However, an individual investor can affect the daily price movement by
buying or selling huge quantum of particular scrip.
b. The market discounts everything. Even natural calamities such as earth
quake, plague and fire also get quickly discounted in the market. The world trade
center blast affected the share market for a short while and then the market
returned back to normalcy.
c. The theory is not infallible and it is not a tool to beat the market but
provides a way to understand the market.
Explanation of the Theory
Dow described stock prices as moving in trends analogous to the movement of
water. He postulated three types of price movements over time:
1. major trends that are like tide in ocean,
2. intermediate trends that resemble waves, and
3. short run movements that are like ripples.
Followers of the Dow theory hope to detect the direction of the major price
trend (tide) known as primary trend, recognizing the intermediate movements
(waves) or secondary trends that may occasionally move in the opposite direction.
They recognize that a primary trend does not go straight up, but rather includes
small price declines as some investors decide to take profits. It means share prices
don’t rise or fall in a straight t manner. Every rise or fall in price experiences a
counter move. If a share price is increasing, the counter move will be a fall in price
and vice-versa. The share prices move in a zigzag manner. The trend lines are
straight lines drawn connecting either the top or bottoms of the share price
movement. To draw a trend line, the analyst should have at least two tops or
bottoms.
7.2.2.2 SUPPORT AND RESISTANCE LEVEL
A support level is the price range at which technician would expect a
substantial increase in the demand for a stock. Generally, a support level will
develop after a stock has enjoyed a meaningful price increase and the stock has
begun to experience profit taking. When the price reaches this support price,
demand surges and price and volume begin to increase again. A resistance level is
the price range at which the technician would expect an increase in the supply of
stock and any price increase to reverse abruptly. A resistance level tends to develop
 63

after a stock has experienced a steady decline from a higher price level. It is
reasoned that the decline in the price leads some investors who acquired the stock
at a higher price to look for an opportunity to sell it near their break even points.
Therefore, the supply of stocks owned by these investors is overhanging the market.
When the price rebounds to the target price set by these investors, this overhanging
supply of stock comes to the market and dramatically reverses the price increase on
heavy volume.
7.2.2.3 VOLUME OF TRADE
Dow gave special emphasis to volume. Technical analysts use volume as an
excellent method of confirming the trend. Therefore, the analyst looks for a price
increase on heavy volume relative to the stock’s normal trading volume as an
indication of bullish activity .Conversely, a price decline with heavy volume is
bearish. A generally bullish pattern would be when price increase are accompanied
by heavy volume and the small price increase reversals occur with the light trading
volume, indicating limited interest in selling and taking profits and vice-versa.
7.2.2.4. BREADTH OF THE MARKET
The breadth of the market is the term often used to study the advances and
declines that have occurred in the stock market. Advances mean the number of
shares whose prices have increased from the previous day’s trading. Decline
indicates the number of shares whose prices have fallen from the previous day’s
trading. This is easy to plot and watch indicator because data are available in all
business dailies. The net difference between the number of stocks advanced and
declined during the same period is the breadth of market. A cumulative index of net
differences measures the net breadth.
7.2.2.5 SHORT SELLING
Short selling refers to the selling of shares that you don’t have. The short
sellers are those who sell now in the hope of purchasing at a lower price in the
future to make a profit. A short seller behaves in this way because he feels that the
price of the stock will fall. And it is must for short sellers to cover their positions,
i.e. the purchase of shares. This buying activity increases the potential demand for
the stock. Therefore, rising short sales foretell future demand for the security and
increase the future prices. Monthly short selling for the month can be compared
with average daily volume for the preceding month. This ratio shows, how many
days of trading it would take to use up total short sales. If the ratio is less than one,
market is said to be weak or overbought and a decline can be expected. The value
between 1 and 1.5 shows neutral conditions of the market. Values above 1.5
indicate bullish trend and if it is above 2 the market is said to be oversold. At
market tops, short selling is high and at market bottoms short selling is low.
7.2.2.6 ODD LOT TRADING
Small investors quite often buy an odd lot (i.e. non tradable lot) and such
buyers and sellers are known as odd lotters. If we relate odd lot purchases to odd
lot sales, we get an odd lot index. The increase in odd lot purchase results in an
 64

increase in the index. Relatively more selling leads to fall in the index. It is generally
considered that the professional investor is more informed and stronger than the
odd lotters and they are less sensible to price change than retail investor. When the
professional investors dominate the market, the stock market is technically strong.
If the odd lotters dominate the market, the market is considered to be technically
weak. The notion behind is that odd lot purchase is concentrated at the top of the
market cycle and selling at the bottom. High odd lot purchase forecasts fall in the
market price and low purchases/sales ratios are presumed to occur toward the end
of bear market or at the beginning of bull market.
7.2.2.7 MOVING AVERAGE
The market indices don’t rise or fall in straight line. The upward and
downward movements are interrupted by counter moves. The underlying trends
can be studied by smoothening the data. To smooth the data, moving average is
used. The word moving means the body of data moves ahead to include the recent
observation. If it is the five-day moving average, on the six day the body of data
moves to include the sixth day observation eliminating the first day observation.
7.2.2.8 RELATIVE STRENGTH ANALYSIS
Relative Strength analysis is a oscillator used to identify the inherent technical
strength and weakness of a particular stock or market. It is based on the
assumption that prices of some securities rise rapidly during the bull phase but fall
slowly during the bear phase in relation to the market as a whole. Put differently,
such securities possess greater relative strength and hence out perform the market.
7.2.2.9 MUTUAL FUND LIQUIDITY
According to the theory of contrary opinion, it makes sense to go against the
crowd because the crowd is generally wrong. Based on this theory, several
indicators have been developed. One of them reflects mutual fund liquidity. If
mutual fund liquidity is low, it means that the mutual funds are bullish. So
contrarians argue that the market is at or near a peak and hence is likely to
decline. Thus low mutual fund liquidity is considered as a bearish indicator.
Conversely, when the mutual fund liquidity is high, it means that the mutual funds
are bearish. So, contrarians believe that the market is at or near a bottom and
hence is poised to rise because it is an indication of potential purchasing power
that can be injected into the market to lift it upward. Thus, high mutual fund
liquidity is considered as a bullish indication.
7.2.2.10 PUT/CALL RATIO
Another indicator monitored by technical analyst is the put/call ratio.
Speculators buy calls when they are bullish and buy puts when they are bearish.
Since speculators are often wrong, some technical analysts consider the put/call
ratio as a useful indicator. The put/call ratio is defined as Numbers of Puts
purchased Numbers of calls purchased
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7.2.3 EVALUATION OF TECHNICAL ANALYSIS

Technical analysis appears to be a high controversial approach to security
analysis. The analysts offer arguments as well as dis-arguments for this alternative
of security analysis. Among them few are as follows:
Arguments
1. Under the influence of crowd psychology, trends persist for quite some time.
Tools of technical analysis that help in identifying these trends early are helpful in
investment decision-making.
2. Shifts in demand and supply are gradual rather than instantaneous.
Technical analysis helps in detecting these shifts rather early and hence provides
clues to future price movements,
3. Fundamental information about a company is absorbed and assimilated by
the market over the period of time. Hence, the price movement tends to continue in
more or less in the same direction till the information is fully assimilated in the
market.
4. Charts provide a picture of what has happened in the past and hence give a
sense of volatility that can be expected from the stock. Further, the information on
trading volume, which is ordinarily provided at the bottom of a bar chart, gives a
fair idea of the extent of public interest in the stock.
Disagreements
1. Most technical analysts are not able to offer convincing explanations for the
tools employed by them.
2. Empirical evidence in support of the random walk hypothesis casts its
shadow over the usefulness of technical analysis.
3. By the time an up trend or downtrend may have been signaled by the
technical analysis, may already have taken place.
4. Ultimately, technical analysis must be a self-defeating proposition. As more
and more people employ it, the value of such analysis tends to decline.
5. There is a great deal of ambiguity in the identification of configurations as
well as trend lines and channels on the charts. The same chart can be interpreted
differently.
Despite these limitations, technical analysis is very popular. It is only in the
rational, efficient and well ordered technical analysis has no use. But given the
imperfections, inefficiencies and irrationalities that characterize real markets,
technical analysis can be helpful. Hence, it can be concluded that technical
analysis may be used, albeit to a limited extent, in conjunction with fundamental
analysis to guide investment decision-making, as it is supplementary to
fundamental analysis rather than substitute for it.
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7.4. REVISION POINTS

1. Meaning of Technical analysis, Tools of Technical analysis, Evaluation of
Technical analysis
7.5. INTEXT QUESTIONS
1. Explain Evaluation of Technical analysis.
2. What are the tools of technical analysis?
3. Explain and Describe Technical analysis.
4. Explain Dow Theory.
7.6. SUMMARY
Technical analysis involves a study of market-generated data like prices and
volumes to determine the future direction of price movement. It is a process of
identifying trend reversal at an earlier stage to formulate the buying and selling
strategy. With the help of several indicators, the relationship between price –volume
and supply-demand is analyzed for the overall market and individual stocks.
7.7. TERMINAL EXERCISES
1. When the price of the stock is up and closes above the opening trade, the
candlestick will usually be ____________and ______________.
a. White and clear b. Black and clear c. Red and unclear d.Black and
unclear
2. The _______________ plots a single value such as closing for a time interval.
a. All of these b. Bar chart c. Line chart d. Candlestick chart.
7.8. SUPPLIMENTARY MATERIALS
1. M. Ranganathan and R. Madhumathi: Investment Analysis and Portfolio
Management, Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management, Vikas
Publishing House Pvt. Ltd., New Delhi.
3. Prasanna Chandra: Investment Analysis and Portfolio Management, TMH,
Delhi.
7.9. ASSIGNMENT
1. Different types of technical indicators with examples.
2. What are Technical Indicators? Definition with Examples.
7.11. LEARNING ACTIVITIES
Select equity shares from small cap companies and rank them according to
Technical Analysis.
7.12. KEY WORDS
Technical analysis, Dow Theory, Moving average, Random walk theory
 67

LESSON 8
EFFICIENT MARKET THEORY
8.0 OBJECTIVE
This lesson helps to know about Market Theory’s
 Meaning of Technical analysis
 To know Random Walk Theory
8.1 INTRODUCTION
We may recall that in the fundamental approach, the security analyst or
prospective investor is primarily interested in analyzing factors such as economic
influences, industry factors, and pertinent company information such as product
demand, earnings, dividends, and management, in order to calculate an intrinsic
value for the firm’s securities. He reaches an investment decision by comparing this
value with the current market price of the security.
Technical analysts believe that they can discern patterns in price or volume
movements, and that by observing and studying the past behaviour patterns of
given stocks, they can use this accumulated historical information to predict the
future price movements in the security. Technical analysis, as we observed in the
preceding chapter, comprises many different subjective approaches, but all have
one thing in common- a belief that these past movements are very useful in
predicting future movements.
In essence, the technician says that it is somewhat an exercise in futility to
evaluate accurately a myriad of detailed information as the fundamentalist
attempts to do. He chooses not to engage in this type of activity, but rather to allow
others to do it for him. Thus, after numerous analysts and investors evaluate this
mountain of knowledge, their undoubtedly diverse opinions will be manifested in
the price and volume activity of the shares in question. As this occurs, the
technician acts solely on the basis of that price and volume activity, without
cluttering his mind with all the detail that he feels is super fluous to his analysis.
He also believes that his price and volume analysis incorporates one factor that is
not explicitly incorporated in the fundamentalist approach-namely, the psychology
of the market.
8.2 CONTENT
8.2.1. Random Walk Theory
8.2.2. The Efficient Market Hypothesis (EMH)
8.2.1. RANDOM WALK THEORY
Random walk theory poses a question- Can a series of historical stock prices
or rates of return be an aid in predicting future stock prices or rates of return? The
empirical evidence in the random-walk literature existed before the theory was
established. That is to say, empirical results were discovered first, and then an
attempt was made to develop a the or that could possibly explain the results. After
these initial occurrences, more results and more theory were uncovered. This has
 68

led then to a diversity of theories, which are generically called the random-walk
theory (Eugene F. Fama, 1970). A good deal of confusion resulted from the diversity
of the literature; and only recently has there been some clarification of the
proliferation of empirical results and theories .Our purpose here is to discuss
briefly the substantive differences among these theories.
Misconceptions of the Random Walk Model
Our generalisation of the random-walk model, then, says that previous price
changes or changes in return are useless in predicting future price or return
changes. That is, if we attempt to predict future prices in absolute terms using only
historical price-change information, we will not be successful.
Note that random walk says nothing more than that successive price changes
are independent. This independence implies that prices at any time will on the
average reflect the intrinsic value of the security.(Often one will find this intrinsic
worth referred to as the present value of the stock’s price, or its equilibrium value).
Furthermore, if a stock’s price deviates from its intrinsic value because, among
other things, different investors evaluate the available information differently or
have different insights into future prospects of the firm, professional investors and
astute non-professionals will seize upon the short-term of random deviations from
the intrinsic value, and through their active buying and selling of the stock in
question will force the price back toits equilibrium position.
It is unfortunate that so many misconceptions of the random-walk model
exist. It is, in point of fact, a very simple statement. The random-walk model says
nothing about relative price movements that is, about selecting securities that may
or may not perform better than other securities. It says nothing about decomposing
price movements into such factors as market, industry, or firm factors. Certainly, it
is entirely possible to detect trends in stock prices after one has removed the
general market influences or other influences; however, this is no way would refute
the random-walk model, for after these influences have been removed, we will in
fact be dealing with relative prices and not with absolute prices, which lie at the
heart of the random-walk hypothesis. Furthermore, these ‘trends’ provide no basis
for forecasting the future. In addition, it should be reemphasized that the empirical
results came first, to be followed by theory to explain the results; therefore,
discussions about a competitive market, or instantaneous adjustments to new
information, or knowledgeable market participants, or easy access to markets, are
all in reality not part of the random-walk model, but rather possible explanations of
the results we find when performing our empirical investigations. Also, there seems
to be a misunderstanding by many to the effect that believing in random walk
means that one must also believe that analyzing stocks, and consequently stock
prices, is a useless exercise, for if indeed stock prices are random, there is no
reason for them to go up or down over any period of time. This is very wrong. The
random walk hypothesis is entirely consistent with an upward or downward
 69

movement in price, for as we shall see, the hypothesis supports fundamental

analysis and certainly does not attack it.
8.2.2. THE EFFICIENT MARKET HYPOTHESIS (EMH)
Efficient market theory states that the price fluctuations are random and do
not follow any regular pattern. Fama suggested that efficient market hypothesis can
be divided into three categories. They are: (1)the weak form, (2) the semi strong
form, and (3) the strong form. The
level of information being considered in the market is the basis for this segregation.
8.2.2.1. WEAK FORM OF EMH
The weak form hypothesis says that the current prices of stocks already fully
reflect all the information that is contained in the historical sequence of prices.
Therefore, there is no benefit in examining the historical sequence of prices
forecasting the future. This weak form of the efficient market hypothesis is
popularly known as the random-walk theory. Clearly, if this weak form of the
efficient market hypothesis is true, it is a direct repudiation of technic alanalysis. If
there is no value in studying past prices and past price changes, there is no value
in technical analysis. As we saw in the preceding chapter, however, technicians
place considerable reliance on the charts of historical prices that they maintain
even though the efficient-market hypothesis refutes this practice. Now, we will
analyze statistical investigations of this weak form of the efficient-market
hypothesis.
8.2.2.2 SEMI STRONG FORM OF EMH
The semi-strong form of the efficient-market hypothesis says that current
prices of stocks not only reflect all informational content of historical prices but
also reflect all publicly available knowledge about the corporations being studied.
Further-more, the semi strong form say that efforts by analysts and investors to
acquire and analyze public information will not yield consistently superior returns
to the analyst.
In effect, the semi-strong form of the efficient market hypothesis maintains
that as soon as information becomes publicly available, itis absorbed and reflected
in stock prices. Even if this adjustment is not the correct one immediately, it will in
a very short time be properly analyzed by the market. Thus the analyst would have
great difficulty trying to profit using fundamental analysis. Furthermore, even while
the correct adjustment is taking place, the analyst cannot obtain consistent
superior returns.
8.2.2.3 STRONG FORM OF EMH
In the sub-sections, we have seen that the weak form of the efficient-market
hypothesis maintains that past prices and past price changes cannot be used to
forecast future price changes and future prices. Semi strong form of the efficient-
market hypothesis says that publicly available information cannot be used to earn
consistently superior investment returns. Some studies that tend to support the
semi strong theory of the efficient-market hypothesis were cited. Finally, the strong
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form of the efficient-market hypothesis maintains that not only is publicly available
information useless to the investor or analyst but all information is useless.
Specifically, no information that is available, be it public or ‘inside’, can be used to
earn consistently superior investment returns.
8.2.2.4 THE EFFICIENT-MARKET HYPOTHESIS AND MUTUAL-FUND PERFORMANCE
It has often been said that large investors such as mutual funds perform
better in the market than the small investor does because they have access to
better information. Therefore, it would be interesting to observe if mutual funds
earned above-average returns, where these are defined as returns in excess of those
that can be earned by a simple buy-and-hold strategy. The results of such an
investigation would have interesting implications for the efficient market
hypothesis.
Researchers have found that mutual funds do not seem to be able to earn
greater net returns (after sales expenses) than those that can be earned by
investing randomly in a large group of securities and holding them. Furthermore,
these studies indicate, mutual funds are not even able to earn gross returns (before
sales expenses) superior to those of the native buy-and-hold strategy. These results
occur not only because of the difficulty in applying fundamental analysis in a
consistently superior manner to a large number of securities in an efficient market
but also because of portfolio over diversification and its attendant problems- two of
which are high book-keeping and administrative costs to monitor the investments,
and purchases of securities with less favourable risk-return characteristics.
Therefore, it would seem that the mutual-fund studies lend some credence to the
efficient-market hypothesis.
8.4 REVISION POINT
1. Random walk model says that successive price changes are independent i.e.
previous price changes or changes in return are useless in predicting future
price or return changes
8.5 INTEXT QUESTIONS
2. How do technicians and random-walk advocates differ in their view of the
stock market?
3. Describe briefly the tests of weak form, semi-strong and strong form of
efficient market hypothesis.
4. What is the connection between the efficient-market hypothesis and the
studies of mutual-fund performance?
8.6 SUMMARY
The efficient market theory states that the stock market reacts very quickly to
new information, so at any given time the market contains the sum of all investors’
views of the market.
1. What sequence of events might bring about an ‘efficient market’?
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8.7 TERMINAL EXERCISE

1. ________have been developed as direct tests of specific mechanical
trading strategies to examine their validity and usefulness.
Ans: Filter Tests
8.8 SUPPLEMENTARY MATERIALS
1. money.rediff.com
2. money control.com
3. amfiindia.com
4. nseindia bseindia.com
5. rbi.org.in
8.9 ASSIGNMENTS
1. Explain the implications of the serial-correlation tests for

a. the random-walk theory,

b. technical analysis, and
c. fundamental analysis.
8.10 SUGGESTED READINGS
1. M. Ranganathan and R. Madhumathi: Investment Analysis and
Portfolio Management, Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management,
Vikas Publishing House Pvt. Ltd., New Delhi.
3. Prasanna Chandra: Investment Analysis and Portfolio Management,
TMH, Delhi.
8.11 LEARNING ACTIVITIES
Does the random-walk theory suggest that security price levels are
random? Explain.
8.12 KEY WORDS
Market hypothesis, efficient market, Distribution Pattern
 72

LESSON 9
PORTFOLIO MANAGEMENT
9.0 OBJECTIVE
This lesson gives information and knowledge about Diversity of investment
9.1 INTRODUCTION
“Never put all your eggs in one basket” is what is meant by diversification.
Instead of investing all funds in one asset, the funds be invested in a group of
assets.
Diversification helps in reducing the risk of investing. Total risk of one
investment is the sum of the impact of all the factors that might affect the return
from that investment. However, investors need not suffer risk inherent with
individual investments as it could be reduced by holding a diversity of investments.
For example, return from a single investment in a cold drink company is
subject to weather conditions. This investment is a risky investment. However, if a
second investment can be made in an umbrella company, which is also subject to
weather changes, but in an opposite way, the return from the portfolio of two
investments will have a reduced risk-level. This process is known as diversification.
Portfolio is the combination of securities or diversified investment in securities.
Diversification may be Random or Efficient diversification.
In Random diversification, an investor may randomly select the portfolio
without analyzing the risk and return of the securities.
In Efficient diversification, an investor may construct a portfolio by carefully
studying and analyzing the risk and return of individual securities and also of its
portfolio.
9.2 CONTENT
9.2.1 Meaning of Portfolio
9.2.2 Portfolio Management
9.2.3 Portfolio Management Process
9.2.4 Objective of Portfolio Management
9.2.5 Selection of Portfolio
9.2.6 Selection of Asset Mix
9.2.7 Approaches in Portfolio Construction
9.2.1 MEANING OF PORTFOLIO
Portfolio means combined holding of many kinds of financial security that is
shares, debentures, government bonds, units and other financial assets. The term
investment portfolio refers to the various assets of an investor which are to be
considered as a unit. It is not merely a collection of a un related assets but a
carefully blended asset combination within a unified framework. It is necessary for
investor to take all decisions as regards their wealth position in a portfolio context.
Making a portfolio putting gone’s egg in different baskets with varying elements of a
 73

risk and return. Thus, a portfolio is a combination of various instrument of

investment. It is also combination of securities with different risk return
characteristics. A portfolio is built up out of the wealth or income of the investors
over a period of time with a view to manage the risk return preferences. The
analysis of the risk return characteristics of individual securities in the portfolio is
made from time-to-time and changes that may take place in combination with other
securities are adjusted accordingly. The object of portfolio is to reduce risk by
diversification and maximize gains.
9.2.2 PORTFOLIO MANAGEMENT
Portfolio management may be defined as the process of construction,
maintenance, revision and evaluation of a portfolio. The objective of portfolio
management is to build a portfolio which gives a return commensurate with the
risk preference of the investor. Portfolio management specifically deals with security
analysis, analysis and selection of portfolio, revision of portfolio and evaluation of
portfolio.
Portfolio management means selection of securities and constant shifting of
the portfolios in the light of varying attractiveness of the constituents of the
portfolio. It is a choice of selecting and revising spectrum of securities to it in which
the characteristics of an investor. Marko Wiz analyzed the implications of the fact
that the investors, although seeking high expected returns, generally wish to avoid
risk. It is the basis of all scientific portfolio management. Although the expected
return on a portfolio is directly related to the expected return on component
securities, it is not possible to deduce a portfolio risk in simply by knowing the
riskiness of individual securities. The riskiness of portfolio depends upon the
attributes of individual securities as well as the interrelationship among securities.
A professional, who manages other people’s or institution’s investment portfolio
with the object of profitability, growth and risk minimization is known as portfolio
manager. He is expected to manage the investors assets prudently and choose
particular investment avenues appropriate for particular times aiming at
maximization of profit. Portfolio management includes portfolio planning, selection
and construction, review and evaluation of securities. The skill in portfolio
management lies in achieving a sound balance between the objectives of safety,
liquidity and profitability. Timing is an important aspect of portfolio revision.
Ideally, investors should sell at market tops and buy at market bottoms. They
should be guarded against buying at high prices and selling at low prices.
9.2.3 PORTFOLIO MANAGEMENT PROCESS
Portfolio management is a dynamic process which involves the following basic
steps:
(a) Identification of the objectives, constraints and preferences of investors for
formulation of investment policy.
(b) Develop and implement strategies in tune with investment policy
formulated. It will help the selection of asset classes and securities in each class
depending upon their risk return attributes.
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(c) Review and monitoring of the performance of the portfolio by continuous

overview of the market conditions and performance of the companies.
(d) Evaluation of the portfolio for the result to compare with targets and make
some adjustments for the future.
9.2.4 OBJECTIVES OF PORTFOLIO MANAGEMENT
The basic objective of portfolio management is to maximize yield and minimize
risk. The other objectives are as follows:
(a) Stability of income: An investor considers stability of income from his
investment. He also considers the stability of purchasing power of income.
(b) Capital growth: Capital appreciation has become an important investment
principle. Investors seek growth stocks which provide a very large capital
appreciation by way of right, bonus and appreciation in the market price of shares.
(c) Liquidity: An investment is a liquid asset. It can be converted into cash with
the help of a stock exchange. Investment should be liquid as well as marketable.
The portfolio should contain a planned proportion of high grade and readily
saleable investment.
(d) Safety: Safety means protection for investment against loss under
reasonably variations. In order to provide safety, a careful review of economic and
industry trends is necessary. In other words, errors in portfolio are unavoidable and
it requires extensive diversification.
(e) Tax incentives: Investors try to minimize their tax liabilities from the
investment. The portfolio manager has to keep a list of such investment avenues
along with the return risk, profile, tax implications, yield and other return.
9.2.5 SELECTION OF PORTFOLIO
The selection of portfolio depends upon the objectives of the investor.
The selection of portfolio under different objectives are dealt subsequently.
Objectives and asset mix:
If the main objective is getting adequate amount of current income, sixty per
cent of the investment is made in debt instruments and remaining in equity.
Proportion varies according to individual preference.
Growth of income and asset mix: Here the investor requires a certain per
centage of grow thus the income from the capital he has invested. The proportion of
equity varies from 60 to100% and that of debt from 0 to 40%. The debt may be
included to minimize risk and to get tax exemption.
Capital appreciation and Asset Mix: It means that value of the investment
made increases over the year. Investment in real estate can give faster capital
appreciation but the problem is of liquidity. In the capital market, the value of the
shares is much higher than the original issue price.
 75

Safety of principle and asset mix: Usually, the risk adverse investors are very
particular about the stability of principal. Generally, old people are more sensitive
towards safety.
Risk and return analysis: The traditional approach of portfolio building has
some basic assumptions. An investor wants higher returns at the lower risk. But
the rule of the game is that more risk, more return. So, while making a portfolio the
investor must judge the risk taking capability and the returns desired.
Diversification: Once the asset mix is determined and risk-return relationship
is analyzed the next step is to diversify the portfolio. The main advantage of
diversification is that the unsystematic risk is minimized.
9.2.6 SELECTION OF ASSET MIX
Asset Mix Meaning
The classification of all assets within a fund or portfolio. Assets are assigned to
one of the core asset classes: stocks (equities), bonds (fixed income), cash and real
estate. Other categories that are sometimes considered asset classes are
commodities, international investments, hedge funds and limited partnership
interests.
The asset mix is usually shown as the set of percentages every asset class
contributes to the total market value of the portfolio. It is a key determinant of the
risk/reward profile of the fund, which in turn is largely determinant of long-term
performance results.
Based on your objectives and constraints, you have to specify your asset
allocation, that is, you decide how much of your portfolio has to be invested in each
of the following asset categories:
1. Cash
2. Bonds
3. Stocks
4. Real estate
5. Precious metals
6. Other
The thrust of this article will be on determining the appropriate mix of ‘bonds’
and ‘stocks’ in the portfolio. Before we examine this issue, note the following:
The first important investment decision for most individuals is concerned with
their education meant to build their human capital. The most significant asset that
people generally have during their early working years is their earning power that
stems from their human capital. Purchase of life and disability insurance becomes
a pressing need to hedge against loss of income on account of death or disability.
The first major economic asset that individuals plan to invest in is their own
house. Before they are ready to buy the house, their savings are likely to be in the
form of bank deposits and money market mutual fund schemes. Referred to broadly
as ‘cash’ these instruments have appeal because they are safe and liquid.
 76

Once the investment in house is made and reasonable liquidity in the form of
‘cash’ is maintained to meet expected and unexpected expenses in the short-run,
the focus shifts to planning for the education of children, providing financial
security to the family, saving for retirement, bequeathing, wealth to heirs, and
contributing to charitable activities. In this context ‘stocks’ and ‘bonds’ become
important. Very broadly, we define them as follows:
‘Stocks’ include equity shares (which in turn may be classified into income
shares, growth shares, blue chip shares, cyclical shares, speculative shares, and so
on) and units/shares of equity schemes of mutual funds (like Master shares, Birla
Advantage, and so on).
‘Bonds’ defined very broadly, consist of non-convertible debentures of private
sector companies, public sector bonds, gilt edged securities, RBI Savings Bonds,
units/shares of debt-oriented schemes of mutual funds, National Savings
Certificates, Kisan Vikas Patras, bank deposits, post office savings deposits fixed
deposits with companies, deposits in provident fund and public provident fund
schemes, deposits in the Senior Citizen’s Savings Scheme, and so on. The basic
feature of these investments is that they earn a fixed or near fixed return.
9.2.7 APPROACHES IN PORTFOLIO CONSTRUCTION
1. Traditional Approach
2. Modern Approach
1. STEPS IN TRADITIONAL APPROACH:
Analysis of constraints: Analysing the constraints like, income needs, liquidity,
time horizon, safety, tax consideration and risk temperament of an investor.
Determination of objectives: The objective of the portfolio range from income to
capital appreciation. Investor has to decide upon the return which he gets from the
portfolio like, current income, growth in income, capital appreciation and so on.
Selection of Portfolio: a) Selecting the type of securities for investment i.e.
Shares and Bonds or Bonds or Shares, b) Calculating the risk and return of the
securities and c) Diversifying the investment by selecting the securities combination
and its proportion of investment in that securities.
2. MODERN APPROACH:
The traditional approach is a comprehensive job for the individual. In modern
approach, gives more attention on selecting the portfolio i.e. Markowitz Model as
well as CAPM.
9.3 REVISION POINT
1. Portfolio Construction: Portfolio is a combination of securities such as
stocks, bonds and money market instruments. The process of
blending together the broad asset classes so as to obtain optimum
return with minimum risk is called portfolio construction.
 77

9.4 INTEXT QUESTIONS

1. What are the steps in the traditional approach?
2. Explain the constraints in the formation of objectives.
9.5 SUMMARY
The portfolio is a collection of investment instruments like shares,
mutual funds, bonds, fixed deposits and other cash equivalents etc.
Portfolio management is the art of selecting the right investment tools in the
right proportion to generate optimum returns from the investment made.
Best portfolio management practice runs on the principle of minimum risk
and maximum return within a given time frame. A portfolio is built based
on investor’s income, investment budget and risk appetite keeping the
expected rate of return in mind.
9.6 TERMINAL EXERCISE
1. The selection approach: It is based on the premises that the market is
efficient and securities are properly prices.
Ans: Random
9.7 SUPPLEMENTARY MATERIALS
1. money.rediff.com
2. money control.com
3. amfiindia.com
4. nseindia
5. bseindia.com
6. rbi.org.in
9.8 ASSIGNMENTS
1. How would you formulate the asset mix according to the given
objectives?
2. What are the differences between the traditional approach and
modern approach?
9.10 SUGGESTED READINGS
1. M. Ranganathan and R. Madhumathi: Investment Analysis and
Portfolio Management, Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management,
Vikas Publishing House Pvt. Ltd., New Delhi.
3. Prasanna Chandra: Investment Analysis and Portfolio Management,
TMH, Delhi.
9.11 LEARNING ACTIVITIES
1. Markowitz Model as well as CAPM.
Can an investor ignore safety of principal? Why is knowledge of tax-
status importance for the investor?
9.12 KEY WORDS
Portfolio, traditional approach, modern approach
 78

LESSON 10
PORTFOLIO CONSTRUCTION
10.0 OBJECTIVE
After studying this unit, you should be able to understand
 Approaches in portfolio construction
 How it is useful to business investors
10.1 INTRODUCTION
Portfolio is a combination of securities such as stocks, bonds and money
market instruments. The process of blending together the broad asset classes so as
to obtain optimum return with minimum risk is called portfolio construction.
Individual securities have risk return characteristics of their own. Portfolios may or
may not take on the aggregate characteristics of their individual parts.
Diversification of investment helps to spread risk over many assets. A
diversification of securities gives the assurance of obtaining the anticipated return
on the portfolio. In a diversified portfolio, some securities may not perform as
expected, but others may exceed the expectation and making the actual return of
the portfolio reasonably close to the anticipated one. Keeping a portfolio of single
security may lead to a greater likelihood of the actual return somewhat different
from that of the expected return. Hence, it is a common practice to diversify
securities in the portfolio.
10.2 CONTENT
10.2.1. Benefits of Portfolios
10.2.2. Approaches in Portfolio Construction
10.2.3. Traditional approach
10.2.1 BENEFITS OF PORTFOLIOS
You know that expected return from individual securities carrying some degree
of risk. Risk was defined as the standard deviation around the expected return. In
effect we equated a security’s risk with the variability of its return. More dispersion
or variability about a security’s expected return meant the security was riskier than
one with less dispersion.
The simple fact that securities carrying differing degrees of expected risk lead
most investors to the notion of holding more than one security at a time, is an
attempt to spread risks by not putting all their eggs into one basket. Diversification
of one’s holdings is intended to reduce risk in an economy in which every asset’s
returns are subject to some degree of uncertainty. Even the value of cash suffers
from thein roads of inflation. Most investors hope that if they hold several assets,
even if one goes bad, the others will provide some protection from an extreme loss.
10.2.2. APPROACHES IN PORTFOLIO CONSTRUCTION
Commonly, there are two approaches in the construction of the portfolio of
securities viz. traditional approach and Markowitz efficient frontier approach. In the
traditional approach, investor’s needs in terms of income and capital appreciation
 79

are evaluated and appropriate securities are selected to meet the needs of the
investor. The common practice in the traditional approach is to evaluate the entire
financial plan of the individual. In the modern approach, portfolios are constructed
to maximise the expected return for a given level of risk. It views portfolio
constructionn in terms of the expected return and the risk associated with obtaining
the expected return.
10.2.3. TRADITIONAL APPROACH
The traditional approach basically deals with two major decisions. They are:
1. Determining the objectives of the portfolio.
2. Selection of securities to be included in the portfolio.
Normally, this is carried out in four to six steps. Before formulating the
objectives, the constraints of the investor should be analysed. Within the given
framework of constraints, objectives are formulated. Then based on the objectives,
securities are selected. After that, the risk and return of the securities should be
studied. The investor has to assess the major risk categories that he or she is trying
to minimise. Compromise on risk and non non-risk factors has to be carried out. Finally
relative portfolio weights are assigned to securities like bonds, stocks and
debentures and then diversification is carried out.

10.2.3.1. ANALYSIS OF CONSTRAINTS

ONSTRAINTS
The constraints normally discussed are income needs, liquidity, time horizon,
safety, tax considerations and the temperament. Income needs
needs- The income needs
depend on the need for income in constant rupees and current rupees. The need for
income incurrent rupees arises from the investor’s need to meet all or part of the
living expenses. At the same time inflation may erode the purchasing power, the
investor may like to offset the effect of the inflation and so, needs income in
constant rupees.
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(a) Need for current income: The investor should establish the income which
the portfolio should generate. The current income need depends upon the entire
current financial plan of the investor. The expenditure required to maintain a
certain level of standard of living and all the other income generating sources
should be determined. Once this information is arrived at, it is possible to decide
how much income must be provided for the portfolio of securities.
(b) Need for constant income: Inflation reduces the purchasing power of the
money. Hence, the investor estimates the impact of inflation on his estimated
stream of income and tries to build a portfolio which could offset the effect of
inflation. Funds should be invested in such securities where income from them
might increase at a rate that would offset the effect of inflation. The inflation or
purchasing power risk must be recognised but this does not pose a serious
constraint on portfolio if growth stocks are selected.
Liquidity- Liquidity need of the investment is highly individualistic of the
investor. If the investor prefers to have high liquidity, then fund should be invested
in high-quality short-term debt maturity issue such as money market funds,
commercial papers and shares that are widely traded. Keeping the funds in shares
that are poorly traded or stocks in closely held business and real estate lack
liquidity. The investor should plan his cash drain and the need for net cash inflows
during the investment period.
Safety of the principal- Another serious constraint to be considered by the
investor is the safety of the principal value at the time of liquidation, investing in
bonds and debentures is safer than investing in the stocks. Even among the stocks,
the money should be invested in regularly traded companies of longstanding.
Investing money in the unregistered finance companies may not provide adequate
safety.
Time horizon- Time horizon is the investment-planning period of the
individuals. This varies from individual to individual. Individual’s risk and return
preferences are often described in terms of his ‘lifecycle’. The states of the life cycle
determine the nature of investment. The first stage is the early career situation. At
the career starting point assets are lesser than their liabilities. More goods are
purchased on credit. His house might have been built with the help of housing loan
scheme. His major asset may be the house he owns. His priority towards
investments may be in the form of savings for liquidity purposes. He takes life
insurance for protecting him from unforeseen events like death and accidents and
then he thinks of the investments. The investor is young at this stage and has long
horizon of life expectancy with possibilities of growth in income, he can invest In
high-risk and growth oriented investments.
The other stage of the time horizon is the mid-career individual. At this stage,
his assets are larger than his liabilities. Potential pension benefits are available to
him. By this time he establishes his investment program. The time horizon before
him is not as long as the earlier stage and he wants to protect his capital
 81

investment. He may wish to reduce the overall risk exposure of the portfolio but, he
may continue to invest in high risk and high return securities.
The final stage is the late career or the retirement stage. Here, the time
horizon of the investment is very much limited. He needs stable income and once
he retires, the size of income he needs from investment also increases. In this stage,
most of his loans are repaid by him and his assets far exceed the liabilities. His
pension and life insurance programmes are completed by him. He shifts his
investment to low return and low risk category investments, because safety of the
principal is given priority. Mostly he likes to have lower risk with high interest or
dividend paying component to be included in his portfolio. Thus, the time horizon
puts restrictions on the investment decisions.
Tax consideration- Investors in the income tax paying group consider the tax
concessions they could get from their investments. For all practical purpose, they
would like to reduce the taxes. For income tax purpose, interests and dividends are
taxed under the head “income from other sources”. The capital appreciation is
taxed under the head “capital gains” only when the investor sells the securities and
realises the gain. The tax is then at a concessioanl rate depending on the period for
which the asset has been held before being sold. From the tax point of view, the
form in which the income is received i.e. interest, dividend, short term capital gains
and long term capital gains are important. If the investor cannot avoid taxes, he
can delay the taxes. Investing in government bonds and NSC can avoid taxation.
This constraint makes the investor to include the items which will reduce the tax.
Temperament- The temperament of the investor himself poses a constraint on
framing his investment objectives. Some investors are risk lovers or takers who
would like to take up higher risk even for low return. While some investors are risk
averse, who may not be willing to undertake higher level of risk even for higher level
of return? The risk neutral investors match the return and the risk.
10.2.3.2. DETERMINATION OF OBJECTIVES
Portfolios have the common objective of financing present and future
expenditures from a large pool of assets. The return that the investor requires and
the degree of risk he is willing to take depend upon the constraints. The objectives
of portfolio range from income to capital appreciation. The common objectives are
stated below:
• Current income
• Growth in income
• Capital appreciation
• Preservation of capital
The investor in general would like to achieve all the four objectives, nobody
would like to lose his investment. But, it is not possible to achieve all the four
objectives simultaneously. If the investor aims at capital appreciation, he should
 82

include risky securities where there is an equal likelihood of losing the capital.
Thus, there is a conflict among the objectives.
10.2.3.3. SELECTION OF PORTFOLIO
The selection of portfolio depends on the various objectives of the investor. The
selection of portfolio under different objectives are dealt subsequently. Objectives
and asset mix- If the main objective is getting adequate amount of current income,
sixty per cent of the investment is made on debts and 40 per cent on equities. The
proportions of investments on debt and equity differ according to the individual’s
preferences. Money is invested in short term debt and fixed income securities. Here
the growth of income becomes the secondary objective and stability of principal
amount may become the third. Even within the debt portfolio, the funds invested in
short term bonds depends on the need for stability of principal amount in
comparison with the stability of income. If the appreciation of capital is given third
priority, instead of short term debt the investor opts for long term debt. The period
may not be a constraint. Growth of income and asset mix- Here the investor
requires a certain percentage of growth in the income received from his investment.
The investor’s portfolio may consist of 60 to 100 per cent equities and 0 to 40 per
cent debt instrument. The debt portion of the portfolio may consist of concession
regarding tax exemption. Appreciation of principal amount is given third priority.
Capital appreciation and asset mix- Capital appreciation means that the value
of the original investment increases over the years. Investment in real estates like
land and house may provide a faster rate of capital appreciation but they lack
liquidity. In the capital market, the values of the shares are much higher than their
original issue prices.
Safety of principal and asset mix- Usually, the risk averse investors are very
particular about the stability of principal. According to the life cycle theory, people
in the third stage of life also give more importance to the safety of the principal. All
the investors have this objective in their mind. No one like to lose his money
invested indifferent assets. But, the degree may differ. The investor’s portfolio may
consist more of debt instruments and within the debt portfolio more would be on
short term debts.
10.2.3.4. RISK AND RETURN ANALYSIS:
The traditional approach to portfolio building has some basic assumptions.
First, the individual prefers larger to smaller returns from securities. To achieve
this goal, the investor has to take more risk. The ability to achieve higher returns is
dependent upon his ability to judge risk and his ability to take specific risks. The
risks are namely interest rate risk, purchasing power risk, financial risk and
market risk. The investor analyses the varying degrees of risk and constructs his
portfolio. At first, he establishes the minimum income that he must have to avoid
hardships under most adverse economic condition and then he decides risk of loss
of income that can be tolerated. The investor makes a series of compromises on risk
 83

and non-risk factors like taxation and marketability after he has assessed the
major risk categories, which he is trying to minimise.
10.2.3.5. DIVERSIFICATION
Once the asset mix is determined and the risk and return are analysed, the
final step is the diversification of portfolio. Financial risk can be minimised by
commitments to top-quality bonds, but these securities offer poor resistance to
inflation. Stocks provide better inflation protection than bonds but are more
vulnerable to financial risks. Good quality convertibles may balance the financial
risk and purchasing power risk. According to the investor’s need for income and
risk tolerance level portfolio is diversified. In the bond portfolio, the investor has to
strike a balance between the short term and long term bonds. Short term fixed
income securities offer more risk to income and long term fixed income securities
offer more risk to principal.
As investor, we have to select the industries appropriate to our investment
objectives. Each industry corresponds to specific goals of the investors. The sales of
some industries like two wheelers and steel tend to move in tandem with the
business cycle, the housing industry sales move counter cyclically. If regular
income is the criterion then industries, which resist the trade cycle should be
selected. Likewise, the investor has to select one or two companies from each
industry. The selection of the company depends upon its growth, yield, expected
earnings, past earnings, expected price earning ratio, dividend and the amount
spent on research and development. Selecting the best company is widely followed
by all the investors but this depends upon the investors’ knowledge and perceptions
regarding the company. The final step in this process is to determine the number of
shares of each stock to be purchased. This involves determining the number of
different stocks that is required to give adequate diversification. Depending upon
the size of the portfolio, equal amount is allocated to each stock. The investor has
to purchase round lots to avoid transaction costs.
10.4. REVISION POINTS
1. Steps in traditional approach.
10.5. INTEXT QUESTIONS
1. Explain the steps in traditional approach of portfolio construction.
10.6. SUMMARY
Liquidity need of the investment is highly individualistic of the investor. If the
investor prefers to have high liquidity, then funds should be invested in high-
quality short-term debt maturity issues such as money market funds, commercial
papers and shares that are widely traded. Keeping the funds in shares that are
poorly traded or stocks in closely held business and real estate lack liquidity. The
investor should plan his cash drain and the need for net cash inflows during the
investment period.
 84

10.7. TERMINAL EXERCISES

1. A group of security is known as:
a. Investment b. Portfolio c. Security d. Gambling
2. Under the weak form of EMH, technical analysis is use less
a. True b. False
10.8. SUPPLIMENTARY MATERIALS
1. money.rediff.com
2. money control.com
3. amfiindia.com
10.9. ASSIGNMENT
1. Different types of Portfolio constructions.
10.10 SUGGESTED READINGS
1. M. Ranganathan and R. Madhumathi: Investment Analysis and Portfolio
Management, Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management, Vikas
Publishing House Pvt. Ltd., New Delhi.
10.11. LEARNING ACTIVITIES
Explain portfolio constructions of a small company.
10.12. KEY WORDS
Portfolio, Growth in income, Capital appreciation
 85

LESSON 11
PORTFOLIO REVISION
11.0 OBJECTIVES
By learning this lesson you may be known of
 Portfolio Analysis and Selection
 The securities included in the portfolio
11.1 INTRODUCTION
In portfolio management, the maximum emphasis is placed on portfolio
analysis and selection which leads to the construction of the optimal portfolio.
Portfolio revision is important as portfolio analysis and selection .The financial
markets are continually changing. In this dynamic environment, a portfolio that
was optimal when constructed may not continue to be optimal with the passage of
time. It may have to be revised periodically so as to ensure that it continues to be
optimal.
A combination of various investment products like bonds, shares, securities,
mutual funds and so on is called a portfolio. In the current scenario, individuals
hire well trained and experienced portfolio managers who as per the client’s risk
taking capability combine various investment products and create a customized
portfolio for guaranteed returns in the long run.It is essential for every individual to
save some part of his/her income and put into something which would benefit him
in the future. A combination of various financial products where an individual
invests his money is called a portfolio.
In portfolio management, the maximum emphasis is placed on portfolio
analysis and selection which leads to the construction of the optimal portfolio.
Portfolio revision is important as portfolio analysis and selection.
Two variable determine the composition of a portfolio:
- The securities included in the portfolio, and
- The proportion of total funds invested in each security.
11.2 CONTENT
11.2.1 Portfolio Revision
11.2.2 Objectives of Portfolio Revision
11.2.3 Need for Portfolio Revision
11.2.4 Constraints in Portfolio Revision
11.2.1 PORTFOLIO REVISION
Portfolio revision involves changing the existing mix of securities. This may be
effected either by changing the securities currently included in the portfolio or by
altering the proportion of funds invested in the securities. New securities may be
added to the portfolio or some o the existing securities may be removed from the
portfolio. Portfolio revision thus leads to purchases and sales of securities.
 86

The art of changing the mix of securities in a portfolio is called as portfolio

revision. The process of addition of more assets in an existing portfolio or changing
the ratio of funds invested is called as portfolio revision.The sale and purchase of
assets in an existing portfolio over a certain period of time to maximize returns and
minimize risk is called as Portfolio revision.
11.2.2 OBJECTIVES OF PORTFOLIO REVISION
The objective o portfolio revision is the same as the objective of portfolio
selection like maximizing the return for a given level of risk or minimizing the risk
for a given level of return.
The ultimate aim of portfolio revision is:
- To maximize the returns and
- To minimize the risk.
11.2.3 NEED FOR PORTFOLIO REVISION
The primary factor necessitating portfolio revision is changes in the financial
markets since the creation of the portfolio.
The need for portfolio revisions may arise some because of some investor-
related factors also. These factors may be listed as:
A. Availability of additional funds for investment.
B. Change in risk tolerance.
C. Change in investment goals.
D. Need to liquidate a part of the portfolio to provide funds for some alternative
use.
The portfolio needs to be revised to accommodate the changes in the investor’s
position.
A. An individual at certain point of time might feel the need to invest more. The
need for portfolio revision arises when an individual has some additional
money to invest.
B. Change in investment goal also gives rise to revision in portfolio. Depending
on the cash flow, an individual can modify his financial goal, eventually
giving rise to changes in the portfolio i.e. portfolio revision.
C. Financial market is subject to risks and uncertainty. An individual might
sell off some of his assets owing to fluctuations in the financial market.
Thus, the need for portfolio revision may arise from changes in the financial
market or changes in then investors’ position, namely his financial status and
preferences.
11.2.4 CONSTRAINTS IN PORTFOLIO REVISION
Portfolio revision or adjustment necessitates purchases and sale of securities.
The practice of portfolio adjustment involving purchase and sale of securities gives
rise to certain problems that act as constraints in portfolio revision. Some of these
are as follows:
1. Transaction Cost: Buying and selling securities involve transaction costs
such as commission and brokerage. Frequent buying and selling of
securities for portfolio revision may push up transaction costs thereby
 87

reducing the gains from portfolio revision. Hence, the transaction costs
involved in portfolio revision may act as a constraint to the timely revision of
the portfolio.
2. Taxes: Tax is payable on the capital gains arising from sales of securities.
Usually, long term capital gains are taxed at a lower rate than short term
capital gains. To qualify as long term capital gain, a security must be held by
an investor for a period of not less than 12 months before the sale. Frequent
sale of securities in the course of periodic portfolio revision or adjustments
will result in short term capital gains which would be taxed at a higher rate
compared to long term capital gains. The higher tax on short term capital
gains may act as a constraint to frequent portfolio revisions.
3. Statutory Stipulations: The largest portfolios in every country are managed
by investment companies and mutual funds. These institutional investors
are normally governed by certain statutory stipulations regarding their
investment activity. These stipulations often act as constraints in timely
portfolio revision.
4. Intrinsic Difficulty: Portfolio revision is a difficult and time-consuming
exercise. The methodology to be followed for portfolio revision is also not
clearly established. Different approaches may be adopted for the purpose.
The difficulty of carrying out revision itself may act as a constraint to
portfolio revision.
11.2.5 PORTFOLIO REVISION STRATEGIES
Two different strategies may be adopted for portfolio revisions which are as follows:
1. Active Revision Strategy
Active Revision Strategy involves frequent changes in an existing portfolio over
a certain period of time for maximum returns and minimum risks. Active Revision
Strategy helps a portfolio manager to sell and purchase securities on a regular
basis for portfolio revision.
Active revision strategy involves frequent and sometimes substantial
adjustments to the portfolio. Active portfolio revision is essentially carrying out
portfolio analysis and portfolio selection all over again. It is based on an analysis of
the fundamental factors affecting the economy, industry, and company has also the
technical factors like demand and supply. Consequently, the time, skill, and
resources required for implementing an active revision strategy will be much
higher. The frequency of trading is likely to be much higher under active revision
strategy resulting in higher transaction costs.
2. Passive Revision Strategy
Passive Revision Strategy involves rare changes in portfolio only under certain
predetermined rules. These predefined rules are known as formula plans .According
to passive revision strategy a portfolio manager can bring changes in the portfolio
as per the formula plans only.
A passive revision strategy, in contrast, involves only minor and frequent
adjustments to the portfolio over time. The practitioners of passive revision strategy
 88

be live in market efficiency and homogeneity of expectation among investors. They

find a little incentive for actively trading revising portfolios periodically. Under
passive revision strategy, adjustment to the portfolio is carried out according to
certain predetermined rules and procedures designed as formula plans. These
formula plans help the investor to adjust his portfolio according to changes in the
securities market.
11.4. REVISION POINTS
1. Need for portfolio revision,
2. portfolio revision strategies,
3. Objectives of portfolio revision.
11.5. INTEXT QUESTIONS
1. Explain need for portfolio revision.
2. What are the portfolio revision strategies?
3. Explain objectives of portfolio revision.
11.6. SUMMARY
The objective of portfolio revision is the same as the objective of portfolio
selection like maximizing the return for a given level of risk or minimizing the risk
for a given level of return. The ultimate aim of portfolio revision is the maximization
of returns and minimization of risk.
11.7. TERMINAL EXERCISES
1. What is the need to rebalance the portfolio on regular basis?
a. Market movements may have shifted the weights in your portfolio
b. This is part of the contract you make with your broker
c. you need to sell quickly any share that have fallen in value
d. None of these
11.8. SUPPLIMENTARY MATERIALS
1. money.rediff.com
2. money control.com
3. amfiindia.com
11.9. ASSIGNMENT
1. What are the importance of portfolio revision.
11.10 SUGGESTED READINGS
1. M.Ranganathan and R. Madhumathi: Investment Analysis and Portfolio
Management, Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management, Vikas
Publishing House Pvt. Ltd., New Delhi.
11.11. LEARNING ACTIVITIES
Explain the meaning and definition of portfolio revision.
11.12. KEY WORDS
Active Revision Strategy, Passive Revision Strategy.
 89

LESSON 12
ESTIMATING RATE OF R
RETURN AND STANDARD DEVIATION
EVIATION OF
PORTFOLIO RETURNS
12.0 OBJECTIVE
After studying this chapter you may know about portfolio returns
 Estimating Rate of Return
 Using various statical tools
12.1 INTRODUCTION
A portfolio is a group of investments made by an individual which comprises
different investment instruments belonging to diverse industries – stocks,
debentures, commodities, cryptos or even real estate. DiveDiversification
rsification reduces the
risk of a downside, improving the probability of positive portfolio returns.
Compare investing to any other typical business – and imagine that you are
the owner of that business. Now, as the owner, you would be required to measure
your business’s profitability at constant intervals. Your profitability position will
help you take crucial management decisions, strengthening your business’s return
generating abilities. That is precisely how investing works as well. To calculate your
business
siness profit is tantamount to calculating your portfolio’s returns.
12.2 CONTENT
12.2.1 Calculating Portfolio Returns
12.2.2 Calculating the Return of a Security
12.2.3 Measuring the Rate of Return to a Portfolio
12.2.4 Risk Adjusted Performance Measure
12.2.1 CALCULATING PORTFOLIO
ORTFOLIO RETURNS
It’s not that difficult to calculate. The portfolio return formula is as follows:

w = weight of each asset forming a part of the portfolio

r = return generated by each asset
Given below are the steps that you must follow for calculating portfolio
returns:
 90

1. Calculate the return of every investment that is your portfolio’s component

(as discussed in detail below).
2. Find the weightage of each investment. This is a simple calculation – divide
the amount invested in that asset by the total portfolio’s investment amount.
You can leave the answer in decimal or convert it to a percentage.
3. Assign the weights to each asset by multiplying step 1 with step 2.
Remember, you have to do this calculation for each investment.
4. Add up weighted returns of all investments. (sum of step 3)
The resulting figure is the portfolio return. If these calculations get
overwhelming for you or you wish to make your work easier, you can use a
portfolio returns calculator, which should be readily available online.
CONSIDERING PERIOD OF TIME
The period over which the returns will be calculated is a personal choice – it
could be a week, month or even a year. But make sure that when you calculate
your portfolio’s returns, determine the return of every asset over the same period to
maintain consistency.
12.2.2 CALCULATING THE RETURN OF A SECURITY
Security returns are used in calculating the return of an entire portfolio. The
ROI metric, Return on Investment, is used by both amateurs and professionals as a
portfolio returns calculator. ROI is calculated as:
[(Current Market Value of Asset + Dividends earned + Interest earned – Initial
Investment) / Initial Investment] * 100
The initial investment includes all the expenses incurred to acquire the asset.
Remember to add the transaction costs to the purchase price – including
management fees, commissions, taxes, and brokerage charges.
For listed securities, the current market price of the asset should be readily
available online. However, for unlisted securities or for instruments whose fair
value is not readily available, you will have to work around your way to finding it.
See, the instrument’s market value is the most crucial element in calculating
portfolio returns and usually will also form a significant chunk of the calculation.
Hence, if the security is unlisted, you cannot let go of calculating the instrument’s
market value. There are several proven ways of arriving at the market or fair value
of unlisted securities – you can refer to the Indian Accounting Standards for Fair
Value Measurement for detailed guidance.
The resulting figure is the Step 1 value. After calculating the returns of all the
investments forming a part of your portfolio, follow the above mentioned steps to
get to your portfolio’s returns.
ESTIMATING THE FUTURE PERFORMANCE
The returns calculated can also be used to predict future returns from the
same portfolio. After incorporating the historical returns, you will also have to
account for any additional dividend or interest income you are expecting to be
received. Estimated returns might not be accurate as they are affected by several
factors – market sentiment, unexpected news announcements, and other political
 91

factors. Nonetheless, you must make these calculations as they help decide
investment
stment strategies and the action path.
ADJUST CASH FLOWS
If you deposit money into your account in the middle of the month under
consideration, then the NAV (net asset value) for that month
month-end
end will be higher by
the additional amount deposited. However, ththis
is addition in the NAV is due to mere
cash deposits and not earnings. Hence, the same should not be considered while
calculating the returns of your portfolio. You can use several methods to adjust
mid-term cash flows – the modified Dietz method is one suc
suchh formula that you can
use to calculate returns accurately.
ANNUALIZING RETURNS
Annualizing returns means converting the returns to an equivalent of returns
over one year. Annualisation is crucial to be able to compare the returns of different
portfolios. In reality, you would have earned the returns over a multi
multi-period
period tenure;
but the annualized return is a geometric average of the returns earned every year.
12.2.3 MEASURING THE RATE OF RETURN TO A PORTFOLIO
The rate of return of a portfolio is measured as the sum of cash received
(dividend) and the change in the portfolio’s market value (capital gain or loss)
divided by the market value of the portfolio at the beginning of the portfolio,
mathematically,

The rate of return is the most important outcome fr from

om any investment. It
works well for static portfolio. Managed portfolios receive additional amount to be
invested in the period(a month or a quarter) and their investors can also withdraw
fund from the portfolio. Suppose that the market value of a portfol
portfolio
io $ 1 million
invested for the period of a quarter and $1 million is added at the end of the first
month and then $1.5 million is withdrawn at the end of 2nd month.
There are two methods to calculate this return.
• Time Weighted rate of return
• Value Weighted rate of return
TIME WEIGHTED RATE OF
F RETURN
The first method is called time weighted rate of return. The time weighted rate
of return measures the performance of the portfolio manager. The amount of funds
invested is neutralized in the calculation of time weighted return because the funds
have deposits and withdrawals by the investors are not under the control of the
fund manager but their return are computed on the basis of cash distributions and
the changes in the market value of a single share iin
n the fund but the time weighted
return is calculated by dividing the beginning value of a share into the cash
distribution and the change in the value of a share during the period. However, to
calculate the time weighted rate of return, divide the portfol
portfolio
io into shares and
compute the return to a single share in the portfolio across the period. In the same
way we can calculate the rate of return of a mutual fund.
 92

VALUE WEIGHTED RATE OF RETURN

The second method is called value weighted rate of return. The time weighted
method ignored the deposits and withdrawal to and from the portfolio during the
period over which return to be measured but the value weighted method takes
deposits and withdrawal into its account. Suppose that W is a withdrawal at time T
and D is a deposit at time t and further assumed that cash (dividend) to the
portfolio are received at the end of the period. The value weighted rate of return r is
found by solving the following particular equation.

Here m is number of withdrawals, t is tthe

he length of time in years and n is
number of deposits during the period.
12.2.4 RISK ADJUSTED PERFORMANCE MEASURE (BASED ON CAPITAL ASSET
SET PRICING
MODEL)
Suppose that for a set of information relevant to any given stock, we can divide
this information into two major types.
Public information:
It is also called open end information. These pieces of information are
available to everyone and the manager can offer new shares at any time.
Private information:
This information is available for selected individu
individuals
als only. Suppose that if we
were to estimate the expected returns, variance and covariance based on the
analysis of the public available information alone, we would see the market portfolio
positioned on the capital market line shown in the following Figu
Figure
re and every stock
sand portfolio would be positioned on the security market line shown in the next
Figure.
 Consider two professionally managed portfolio, Alpha fund and Omega fund.
In the Alpha fund, the managers have private informatinformation
ion relating to a single
company and this private information is favourable in the sense that expected rate
of return to the stock is higher then we think about the public information alone.
Suppose that the managers of the Alpha fund invest 100% of money in their
portfolio in single stock of this company. If we plot the portfolio position based on
the public information alone. Its point label A in figures 4.1 and 4.2 as shown
above. Alpha fund plot at point A/ in the above two figures, based on the both
public
blic and private information and it is above the security market line.
With the 2% additional increment in its expected rate of return, its still
position inside the efficient set. In the Omega fund, the managers are more skillful
because they have able to acquire private information on many other companies.
Suppose in this case, the private information affects only in the estimate of
expected return but not in the estimate of risk. In the Figures 4.1 and 4.2 the
Omega is point at O and O/ based on public iinformation
nformation alone and both public and
private information respectively. Omega does not look like very special to those of
us who only have public information to make one estimates. The typical structure
of a risk adjusted performance measure is
Risk adjusted
d performance = performance / Risk
12.4. REVISION POINTS
1. Measuring the rate of return, Risk Adjusted performance Measure,
Measure Value
Weighted rate of return
12.5. INTEXT QUESTIONS
1. Explain measuring the rate of return to a portfolio
portfolio.
2. What are the Risk Adjusted performance Measure?
3. Explain the objectives of portfolio returns.
 94

12.6. SUMMARY
A portfolio is a group of investments made by an individual which comprises
different investment instruments belonging to diverse industries – stocks,
debentures, commodities, cryptos or even real estate. Diversification reduces the
risk of a downside, improving the probability of positive portfolio returns
The objective of portfolio revision is the same as the objective of portfolio
selection like maximizing the return for a given level of risk or minimizing the risk
for a given level of return. The ultimate aim of portfolio revision is the maximization
of returns and minimization of risk.
Public Information:
It is also called open end information. These pieces of information are
available to everyone and the manager can offer new shares at any time.
Private information:
This information is available for selected individuals only. Suppose that if we
were to estimate the expected returns, variance and covariance based on the
analysis of the public available information alone,
12.7. TERMINAL EXERCISES
1. What is the need to rebalance the portfolio on regular basis?
a. Market movements may have shifted the weights in your portfolio
b. This is part of the contract you make with your broker
c. you need to sell quickly any share that have fallen in value
d. None of these
12.8. SUPPLIMENTARY MATERIALS
1. money.rediff.com
2. money control.com
3. amfiindia.com
4. nseindia
5. bseindia.com
6. rbi.org.in
12.9. ASSIGNMENT
1. What are the modern approach to portfolio.
12.10 SUGGESTED READINGS
1. M.Ranganathan and R. Madhumathi: Investment Analysis and Portfolio
Management, Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management, Vikas
Publishing House Pvt. Ltd., New Delhi.
3. Prasanna Chandra: Investment Analysis and Portfolio Management, TMH,
Delhi
12.11. LEARNING ACTIVITIES
Explain the meaning and definition of portfolio investors
12.12. KEY WORDS
Time value of portfolio, Cash inflow
 95

LESSON 13
EFFECTS OF COMBINING SECURITIES
13.0 OBJECTIVES:
This lesson helps to learn about
 Combination of security
13.1 INTRODUCTION
The effect of two securities can also be studied when one security is more risky
when compared to the other security. The following example shows a return of 13%.
A combination of A and E will produce superior results to an investor rather than if
he was to purchase only Stock-A and one-third of stock consists of Stock-B, the
average return of the portfolio is weighted average return of each security in the
portfolio.
13.2 CONTENT
13.2.1 Domestic Stocks
13.2.2 Bonds
13.2.3 Short-Term Investments
13.2.1 DOMESTIC STOCKS
Stocks represent the most aggressive portion of your portfolio and provide the
opportunity for higher growth over the long term. However, this greater potential for
growth carries a greater risk, particularly in the short term. Because stocks are
generally more volatile than other types of assets, your investment in a stock could
be worth less if and when you decide to sell it.
13.2.2 BONDS
Most bonds provide regular interest income and are generally considered to be
less volatile than stocks. They can also act as a cushion against the unpredictable
ups and downs of the stock market, as they one behave differently than stocks.
Investors who are more focused on safety than growth often favour US Treasury or
other high-quality bonds, while reducing their exposure to stocks. These investors
may have to accept lower long-term returns, as many bonds especially high-quality
issues generally don't offer returns as high as stocks over the long term. However,
note that some fixed income investments, like high-yield bonds and certain
international bonds, can offer much higher yields, albeit with more risk.
13.2.3 SHORT-TERM INVESTMENTS
These include money market funds and short-term CDs (certificates of
deposit). Money market funds are conservative investments that offer stability and
easy access to your money, ideal for those looking to preserve principal. In
exchange for that level of safety, money market funds usually provide lower returns
than bond funds or individual bonds. While money market funds are considered
safer and more conservative, however, they are not insured or guaranteed by the
Federal Deposit Insurance Corporation (FDIC) the way many CDs, when you are
 96

invest in CDs though, you may sacrifice the liquidity generally offered by money
market funds.
The Fund may impose a fee upon the sale of your shares or may temporarily
suspend your ability to sell shares if the Fund's liquidity falls below required
minimums because of market conditions or other factors. An investment in the
fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or
any other government agency. Fidelity Investments and its affiliates, the fund's
sponsor, have no legal obligation to provide financial support to the fund, and you
should not expect that the sponsor will provide financial support to the fund at any
time.
INTERNATIONAL STOCKS
Stocks issued by non-US companies of ten perform differently than their US
counterparts, providing exposure to opportunities not offered by US securities. If
you're searching for investments that offer both higher potential returns and higher
risk, you may want to consider adding some foreign stocks to your portfolio.
SECTOR FUNDS
Although these invest in stocks, sector funds, as their name suggests, focus on
a particular segment of the economy. They can be valuable tools for investors
seeking opportunities in different phases of the economic cycle.
COMMODITY-FOCUSED FUNDS
While only the most experienced investors should invest in commodities,
adding equity funds that focus on commodity-intensive industries to you r portfolio
such as oil and gas, mining, and natural resources can provide a good hedge
against inflation.
REAL ESTATE FUNDS
Real estate funds, including real estate investment trusts (REITs), can also
play a role in diversifying your portfolio and providing some protection against the
risk of inflation.
ASSET ALLOCATION FUNDS
For investors who don't have the time or the expertise to build a diversified
portfolio, asset allocation funds can serve as an effective single-fund strategy.
Fidelity manages a number of different types of these funds, including funds that
are managed to a specific target date, funds that are managed to maintain a
specific asset allocation, funds that are managed to generate income, and funds
that are managed in anticipation of specific outcomes, such as inflation.
13.4. REVISION POINTS
1. Domestic stocks, Bonds, short term investments Real estate.
13.5. INTEXT QUESTIONS
1. Explain about domestic stocks.
2. What are different types of bonds?
3. Explain short-term investment.
 97

13.6. SUMMARY
It is believed that holding two securities is less risky than having only one
investment in a person's portfolio. When two stocks are taken on a portfolio and if
they have negative correlation, then risk can be completely reduced because the
gain on one can offset the loss on the other. Reduction of portfolio Risk through
diversification: The process of combining securities in a portfolio is known as
diversification. The aim of diversification is to reduce total risk without sacrificing
portfolio return.
Stocks issued by non-US companies of ten perform differently than their US
counterparts, providing exposure to opportunities not offered by US securities.
13.7. TERMINAL EXERCISES
1. Aggressive portfolio consist of bonds : stock in ratio of
a. 50:50 b. 40:60 c. 70: 30 d. 60:40
13.8. SUPPLIMENTARY MATERIALS
1. money.rediff.com
2. money control.com
3. amfiindia.com
4. nseindia
5. bseindia.com
6. rbi.org.in
13.9. ASSIGNMENT
1. What is stock and bond?
13.10 SUGGESTED READINGS
1. M.Ranganathan and R. Madhumathi: Investment Analysis and Portfolio
Management, Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management, Vikas
Publishing House Pvt. Ltd., New Delhi.
3. 3.Prasanna Chandra: Investment Analysis and Portfolio Management, TMH,
Delhi
13.11. LEARNING ACTIVITIES
International bond calculation of portfolio investment
13.12. KEY WORDS
Short-term security
 98

LESSON 14
PORTFOLIO- MARKOWITZ MODEL
14.0 OBJECTIVES
This lesson helps to learn about
 Protfolio Theory
 Markowttz Model
14.1 INTRODUCTION
Harry Markowitz opened new vistas to modern new vistas to modern portfolio
selection by publishing an article in the Journal of Finance in March 1952. His
publication indicated the importance of correlation among the different stocks
returns in the construction of a stock portfolio. Markowitz also showed that for a
given level of expected return in a group of securities, one security dominates the
other. To find out this, the knowledge of the correlation coefficients between all
possible securities combinations is required.
After the publication of his paper, numerous investment firms and portfolio
managers developed “Markowitz Algorithm” to minimize portfolio variance i.e risk.
Even today the term Markowitz diversification is used to refer to the portfolio
construction accomplished with the help of security co variances.
14.2 CONTENT
14.2.1 Simple Diversification
14.2.2 The Markowitz Model
14.2.3 Markowitz Efficient Frontier
14.2.1 SIMPLE DIVERSIFICATION
Portfolio risk can be reduced by the simplest kind of diversification. Portfolio
means the group of assets an investor owns. The assets may vary from stocks to
different types of bonds. Sometimes the portfolio may consist of securities of
different industries. When different assets are added to the portfolio, the total risk
tends to decrease. In the case of common stocks, diversification reduces the
unsystematic risk or unique risk. Analysts opine that if 15 stocks are added in a
portfolio of the investor, the unsystematic risk can be reduced to zero. But at the
same time if the number exceed 15, additional risk reduction cannot be gained. But
diversification cannot reduce systematic or undiversifiable risk. The naïve kind of
diversification is known as simple diversification. In the case of sample
diversification, securities are selected at random and no analytical procedure is
used. Total risk of the portfolio consists of systematic and unsystematic risk and
this total risk is measured by the variance of the rates of returns over time.
14.2.2 THE MARKOWITZ MODEL
Most people agree that holding two stocks is less risky than holding one stock.
For example, holding stocks from textile, banking, and electronic companies is
better than investing all the money on the textile company’s stock. But building up
the optimal portfolio is very difficult. Markowitz provides an answer to it with the
help of risk and return relationship.
 99

Assumptions
The individual investor estimates risk on the basis of variability of returns i.e.
the variance of returns. Investor’s decision is solely based on the expected return
and variance of returns only.
For a given level of risk, investor prefers higher return to lower return.
Likewise, for a given level of return investor prefers lower risk than higher risk.
The Concept
In developing his model, Markowitz had given up the single stock portfolio and
introduced diversification. The single security portfolio would be preferable if the
investor is perfectly certain that his expectation of highest return would turn out to
be real. In the world of uncertainty, most of the risk averse investors would like to
join Markowitz rather than keeping a single stock, because diversification reduces
the risk.
14.2.3 MARKOWITZ EFFICIENT FRONTIER
The risk and return of all portfolio plotted in risk-return space would be
dominated by efficient portfolios. Portfolio may be constructed from available
securities. All the possible combination of expected return and risk compose the
attainable set.
Utility Analysis Utility is the satisfaction the investor enjoys from the portfolio
return. An ordinary investor is assumed to receive greater utility from higher return
and vice-versa. The investor gets more satisfaction or more utility in X + 1 rupees
than from X rupee. If he is allowed to choose between two certain investments, he
would always like to take the one with larger outcome. Thus, utility increases with
increase in return.
The utility function makes certain assumptions about an investors taste for
risk. The investors are categorized into risk averse, risk neutral and risk seeking
investor. All the three types can be explained with the help of a fair gamble.
In a fair gamble which cost Rs1, the outcomes are A and B events. A event will
yield Rs 2. Occurrence of B event is a dead loss i.e.0. The chance of occurrence of
both the events are 50% and 50%. The expected value of investment is
(1/2)2+1/2(0)=Re1. The expected value of the gamble is exactly equal to cost.
Hence, it is a fair gamble. The position of the investor may be improved or hurt by
undertaking the gamble.
Risk averter rejects a fair gamble because the disutility of the loss is greater for
him than the utility of an equivalent gain. Risk neutral investor means that he is
indifferent to whether a fair gamble is undertaken or not. The risk seeking investor
would select a fair gamble i.e. he would choose to invest. The expected utility of
investment is higher than the expected utility of not investing.
14.3 REVISION POINTS
1. Markowitz Portfolio Theory deals with the risk and return of portfolio of
investments. Before Markowitz portfolio theory, risk & return concepts are
handled by the investors loosely. The investors knew that diversification is
 100

best for making investments but Markowitz formally built the quantified
concept of diversification. He pointed out the way in which the risk of
portfolio to an investor is reduced through diversification. The particular
measure of portfolio risk was first developed by the Markowitz and the
expected risk & return for portfolio are derived on the basis of the covariance
relationship.
14.4 INTEXT QUESTIONS
1. What are Assumptions of Markowitz Theory?
2. What Is Cut Off Rate
14.5 SUMMARY
Modern Portfolio Theory (MPT) is an investment theory whose purpose is to
maximize a portfolio’s expected return by altering and selecting the proportions of
the various assets in the portfolio. It explains how to find the best possible
diversification. If investors are presented with two portfolios of equal value that offer
the same expected return, MPT explains how the investor will prefer and should
select the less risky one. Investors assume additional risk only when faced with the
prospect of additional return.
14.6 TERMINAL EXERCISE
1. Investors are risk averse and try to minimise the risk and maximise return
is one of the assumption of
Ans: Markowitz Theory
14.7 SUPPLEMENTARY MATERIALS
1. money.rediff.com
2. money control.com
3. amfiindia.com
4. nseindia bseindia.com
5. rbi.org.in
14.9 ASSIGNMENTS
1. Define Markowitz diversification Explain the statistical methods used
by Markowitz to obtain the risk reducing benefit?
14.10 SUGGESTED READINGS
1. M.Ranganathan and R. Madhumathi: Investment Analysis and
Portfolio Management, Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management,
Vikas Publishing House Pvt. Ltd., New Delhi.
3. Prasanna Chandra: Investment Analysis and Portfolio Management,
TMH, Delhi.
14.11 LEARNING ACTIVITIES
How does the efficient frontier change when the short falling is not
allowed?
14.12 KEY WORDS
Expected Returns, Standard Deviation, Mean.
 101

LESSON 15
PORTFOLIO RISK
15.1 OBJECTIVES
After studying this chapter you may know of
 Portfolio Risk
15.2 INTRODUCTION
The risk and return are two basic determinants of investments in shares and
bonds for adding values to an investor’s wealth. Risk can be referred to as the
chance of loss. When an asset has greater chances of loss, the asset can be
considered as a risky asset. Return is a measure resulting from the total gain or
loss experienced by the owner with respect to an asset(share/bond), over a given
period of time. Because of the complexity in understanding and handling of risk
and return, specifically in portfolio management, this paper provides brief
explanations on them with illustrations and related tables and figures. It is believed
that this paper can contribute to make the reader to understand the relationship of
returns and risk, especially in handling of shares in a portfolio to reduce the risk
with diversification effects.
There are various sources of risk that affect both firms and their stakeholders.
a) Firm’s specific risk, such as business risk and financial risk
b) Shareholder specific risks, such as interest rate risk, liquidity risk, and
market risk.
c) Firm and shareholder risk, such as event risk, purchasing power risk, and
tax risk.
It is also possible to indicate that there are different behavioural attitudes of
investors towards risk. They are: risk (neutral) indifferent, risk averse, and risk
seeking. The risk (neutral) indifferent investors have concern over the returns they
expect, not about the risk level they face from an asset. However, the risk averse-
investors always expect reasonable return to the risk they face from an asset
(expect an increase in return for a given increase in risk) and the risk seeking
investors have concern over how they face the risk over an asset, irrespective of the
return they can gain (potentially a decrease in return for a given increase in risk).
Generally, most investors are risk averse, i.e., for a given increase in risk, they
accordingly acquire increase in return. Indicatively, if future returns were known
with certainty, there would be no risk. While investing, an investor often estimates
pessimistic, most likely, and optimistic returns based on the risk associated with
the assets. In this context, probabilities are in consideration as possible mechanism
for more accurately assessing the risk involved in an asset. The probability that an
event will occur may be viewed as the percentage chance of its occurrence
15.3 CONTENT
15.3.1 Return of an Investment
15.3.2 Risk of an Investment
15.3.3 Portfolio Formation
15.3.4 Risk and Return of a Portfolio
 102

15.3.1 RETURN OF AN INVESTMENT

When people buy the stock of a corporation, they expect to make money in two
ways from the appreciation in the value of the stock, and from the dividends. We
define the total return R of a common stock, for a certain holding period, as
p − p + D 1
R = 1 0

p 0

Here P0 is the price of the stock at the beginning of the period, P1 is the price at
the end of that period, and D1 is the dividend paid by the stock at the end of the
period. This return is the historical return, or ex-post return. If the returns over n
periods for a security are R1, R2, R3, ..., then we can find the arithmetic mean of the
returns by adding the returns for each of the periods, and dividing the sum by the
number of periods. That is,
1n
AM(R)=nåRi

i=1
For instance, if a stock gives a return of 5% in the first year and 15% in the
second year, the arithmetic mean return is 10%. Does it mean that the total return
for the two-year period is 20%? Not really, because if the initial stock price is $100,
then its value with the dividends reinvested, will be 100*(1.05)*(1.15) = $120.75 at
the end of two years. On the other hand, the 20% return over the two-year period
gives a final value of $120.00. This implies that the arithmetic average is not a
reliable measure of average rate of return for an investment.
Since the returns have a multiplicative effect on the final value of an
investment, the proper mean return should be the geometric mean. We can define
the geometric mean as
1/n
[ ]
GM(R)=(1 +R1)(1 +R2)(1 +R3)... −1

f we have to find the rate of growth of a mutual fund over a period of several
years, we should calculate the geometric mean of its annual returns. The
newspaper advertisements of various mutual funds also provide this number.
Further, GM(R) is always less than AM(R), which makes the advertised return to be
more conservative.
It is well known that the actual, or realized, returns from a stock are quite
random. There turns canal so be negative. Suppose we observe the price of a non-
dividend paying stock for a number of days, as P1, P2, P3... then the quantity
R=ln(Pi+1/Pi)

is seen to be approximately normally distributed. Here Pi is the price of the stock

on a given day, Pi+1is the price on the next trading day, and R is the continuously
compounded rate of return per day on the stock investment.
 103

15.3.2 RISK OF AN INVESTMENT

The concept of risk pervades throughout finance. This is especially true of
portfolio theory.
Everyinvestmentcarriesacertainamountofrisk.Whenwebuyastockweexpectto
make, say 12% on it in the next year. However, this 12% return is not guaranteed
by any means. We may end up making 20% on the investment, or we may even lose
20%.There are also risk-free securities available to the investors. One such example
of a risk-free investment is a Treasury bond.
The two main characteristics of a portfolio are its risk and return. Since the
return of any investment is uncertain, one should look at the expected return of a
portfolio. The expected return of a stock is more difficult to find. However, there are
various ways to estimate the future return of a stock. We shall consider them in
section7.
Although it is quite difficult to quantify risk, one useful measure of risk is the
standard deviation of there turns, designated by σ.
15.3.3 PORTFOLIO FORMATION
A portfolio is collection of projects, or securities, or investments, held together
as a bundle. For example you may buy 100 shares of Being, 200 hundred shares of
Microsoft, and 5 PP&L bonds in an account. This is your portfolio of investments.
Individual investors have a portfolio of investments that may include real estate (the
family residence), some stocks, bonds, or shares of mutual funds, and possibly
some money accumulated in a pension plan. A portfolio may also include less
tangible items as your professional education, or even a license to practice law. The
total value of your portfolio may fluctuate with time.
As an investor, you may open an account at a brokerage house by depositing
some cash. You may apply for margin privileges, meaning that you may buy
securities with borrowed money. At, present them a rate is 50%.This implies you
must put at least 50% of your own money to buy a certain number of shares of
stock. The brokerage house may have its own policies regarding the margin
account. If the value of the stock drops, you must deposit more funds to maintain
your margin. You may receive a margin call, if your part of the account value drops
below a certain level. Currently, the regulations require that you maintain the
margin at 35%, that is, your equity in the account should be at least 35%
Corporations also have a portfolio of different projects. They carefully select
profitable projects and invest in them. The banks loan money to individuals and
corporations. They have a loan portfolio, and they try to monitor the quality of their
portfolios. The quality of a loan portfolio can deteriorate if too many loans are non-
performing.
Why do people, or corporations, form a portfolio? The simple answer is
diversification. You do not want to risk everything on one endeavor. It is a good idea
to diversify your risk, and if some of the investments do not pan out, the others will
keep the value of the portfolio intact.
The two main features of a portfolio are its risk and expected return. In 1952,
Harry Markowitz first developed the ideas of portfolio theory based upon statistical
 104

reasoning. He showed that an investor could reduce the risk for a given return by
putting to get he run related or negatively correlated securities in a portfolio.
Section 5.4 gives a summary of Markowitz’ analysis.
15.3.4 RISK AND RETURN OF A PORTFOLIO
We start by looking at the simplest portfolio, the one that has only two
securities in it. For a two-security portfolio, the weights of the two securities w1 and
w2 must add up to one. This means
w1+w2= 1
The expected return of the portfolio is simply the weighted average of the
expected returns of the individual securities in the portfolio. For a two-security
portfolio, this comes out to be
E(Rp) =w1E(R1)+w2E(R2)

Here E(Rp)is the expected return of the portfolio, E(R1) and E(R2) are the
expected returns of the individual securities.
Combining the risk of the two securities, σ1 and σ2,we get the composite risk of
the portfolio σ (Rp) to be
σ(Rp)=
w12σ12+w22σ22+2w1w2σ1σ2r12
Here r12 is the correlation coefficient between the securities. The correlation
coefficient effectively measures the over lap,or in reaction ,between the two
securities. If the securities are highly correlated, they tend to mimic each other in
their performance. The value of the correlation coefficient lies somewhere between
+1 and −1. For any two completely unrelated securities, the correlation coefficient
between them is zero, rij= 0.For perfectly positively correlated securities, rij=1 ,and
for perfectly negatively correlated ones, r ij=−1.In real life, most of the securities are
partially positively correlated with one another.
By definition, the covariance between the returns of the securities i and j is
equal to the product of the correlation coefficient between these securities and the
standard deviations of the returns of these two securities, as seen in previous
section
Cov (i,j) = rijσiσj

Let us extend the previous results by constructing a portfolio with three

assets. The weights should add up to one,
w1+w2+w3=1

The expected return of the portfolio is still the weighted average of the expected
returns of the individual securities. We may express it as
E(Rp) =w1E(R1) +w2E(R2) +w3E(R3)
Like wise, we may construct the expression for the σ of a three-security
portfolio .First ,we have three terms containing the risk of the individual securities,
and then three more terms due to the interaction between the securities:
 105

σ(Rp)= w12σ12+w22σ22+w32σ32+2w1w2σ1σ2r12+2w1w3σ1σ3r13+2w2w3σ2σ3r23

In the above equation r12 is the correlation coefficient between the first and the
second security, r13 between the first and the third one, and r23 between the second
and the third one.
For a portfolio with n securities, we may generalize the above equations as
follows. First, the weights of all securities must add up to1. We write this as
n

åwi=1
i=1

Second, the expected return is still the weighted average of the returns of all
the securities expressed as
n

E(Rp)=åwiE(Ri)
i=1

The standard deviation of there turns of the portfolio is a measure o f the

uncertainty in the expected returns. This uncertainty will depend upon the
uncertainty in the performance of component securities ,the weights of these
securities ,and how are these securities correlated. Negatively correlated securities
will tend to cancel out the uncertainty in the portfolio. Even positively correlated
securities (except when they are 100% positively correlated) will tend to reduce
uncertainty in its portfolio. In general, we may express it as

n n 1/2

σ(Rp)=[ååwiwjcov(i,j)]
i=1j=1
Suppose we know the initial investments and expected returns in dollars,
rather than percentages, then we may write the above formulas as
n

E(Rp)=å E(Ri)

i=1

n ½

σ(Rp)=[ååcov(Ri,Rj)]

i=1j=1
 106

15.4. REVISION POINTS

1. Arithmatic mean, Geometric mean Risk and Return of a Portfolio
15.5. INTEXT QUESTIONS
1. Explain Risk and Return of a Portfolio.
2. What are the Risk of an Investment
15.6. SUMMARY
It is believed that holding two securities is less risky than having only one
investment in a person's portfolio. When two stocks are taken on a portfolio and if
they have negative correlation, then risk can be completely reduced because the
gain on one can offset the loss on the other. Reduction of portfolio Risk through
diversification: The process of combining securities in a portfolio is known as
diversification. The aim of diversification is to reduce total risk without sacrificing
portfolio return.
15.7. TERMINAL EXERCISES
1. Short term investments should mature within this time frame
a. 1 year b. 6 months c. 3 years d. 3 months
2. What is a key feature of shor-term investment?
a. It has a low return b. It has a low rist c. It is considered a liquid asset
d. All of the above
15.8 SUPPLEMENTARY MATERIALS
1. money.rediff.com
2. money control.com
3. amfiindia.com
4. nseindia bseindia.com
5. rbi.org.in
15.9. ASSIGNMENT
1. What are the importance of portfolio risk investment.
15.10. SUGGESTED READINGS
1. M.Ranganathan and R. Madhumathi: Investment Analysis and Portfolio
Management, Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management, Vikas
Publishing House Pvt. Ltd., New Delhi.
2. Prasanna Chandra: Investment Analysis and Portfolio Management, TMH,
Delhi.
15.11 LEARNING ACTIVITIES
Meaning and definition of risk and return.
15.12. KEY WORDS
Risk, bonds, investment
 107

LESSON 16
THE SHARE INDEX MODEL
16.1 OBJECTIVE
In this chapter learn
 Index model
 Various co efficient analysis
16.2 INTRODUCTION
The investor always likes to purchase a combination of stocks that provides
the highest return and has lowest risk. The investor wishes to maintain a
satisfactory reward to risk ratio. Traditionally, analysts paid more attention to the
return aspect of the stocks. These days risk has received increased attention and
analysts are providing estimates of risk as well as return.
The Markowitz model is adequate and conceptually sound in analyzing the risk
and return of the portfolio. The problem with Markowitz model is that a number of
co-variances have to be estimated. If a financial institution buys 150 stocks, it has
to estimate 11,175 i.e ( N2-N)/2 correlation co-efficients. Sharpe has developed a
simplified model to analyse the portfolio. He assumed that the return of a security
is linearly related to a single index like the market index. The market index should
consist of all the securities trading on the exchange. In the absence of it, a popular
index can be treated as a surrogate for the market index. For example, even though
BSE Sensex, BSE-100 and NSE-50 do not use all the scrips prices to construct
their indices, they can be used as surrogates. This would dispense the need for
calculating hundreds of co-variances. Any movement in security prices could be
understood with the help of index movement. Further, it needs 3N+2 bits of
information compared to (N+[N+3]/2) bits of information needed in the Markowitz
analysis.
16.3 CONTENT
16.3.1 Single Index Model
16.3.2 Corner Portfolio
16.3.3 Sharpe’s Optimal Portfolio
16.3.4 Construction of the Optimal Portfolio
16.3.1 SINGLE INDEX MODEL
Casual observation of the stock prices 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. Towards this purpose, the following equation can be used,
 108

Ri = αi + βi Rm+ ei
Where Ri = Expected Return on Security i
αi = Intercept of the straight line or alpha co-efficient.
βi = Slope of straight line or beta co-efficient.
Rm = The rate of return on market index.
ei = Error term.
As per the above 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. β1 indicates the sensitiveness of the stock return to the changes in the
market return. For example, βi of 1.5 means that the stock return is expected to
increase by 1.5% when the market index return increases by 1% and vice-versa.
Likewise, βi of 0.5 expresses that the individual stock return would change by 0.5
percent when there is a change of 1 percent in the market return. βi of 1 indicates
that the market return and the security return are moving in tandem. The
estimates of βi and αi are obtained from the 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 accounts the stocks
movement. The expected return, standard deviation and co-variance of the single
index model represent the joint movement of securities. The mean return is
Ri = αi + βi Rm+ ei
The variance of security’s return, σ2 = βi2 σ2m + σ2ei
The co-variance of returns between securities i and j is
σij = βi βj σ2m
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 as systematic risk. The unexplained variance is called residual
variance or unsystematic risk.
Systematic risk = βi2 x Variance of market index.
= βi2 x σ2m
Unsystematic risk = Total variance – Systematic risk
ei2 = σi2- systematic risk
Thus, the total risk= Systematic risk + Unsystematic risk
= βi2 σ2m + ei2
From this, the portfolio variance can be derived
σp2 = (∑ ) x m) + (∑ eix )
σ2= Variance of Portfolio
 109

σp2= Expected variance of index.

σ2m = Variation in security’s return not related to the market index.
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.
Rp = ∑ ( + Rm)
Portfolio return is the weighted average of the estimated return for each
security in the portfolio. The weights are the respective stock’s proportions 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.

Where, αp = value of the alpha for the portfolio

xi = proportion of the investment on security i
αi = value of alpha for security i
N = The number of securities in the portfolio.
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 weights.

ℎ ! " # $.

16.3.2 CORNER PORTFOLIO

The entry or exit of a new stock in the portfolio generates a series of corner
portfolio. In an one stock portfolio, it itself is the corner portfolio. In a two stock
portfolio, the minimum attainable risk (variance) and the lowest return would be
the corner portfolio. As the number of stocks increases in a portfolio, the corner
portfolio would be the one with lowest return and risk combination.
 110

Corner Portfolio
Rp

R B
2

14

A 15

0 S σp
In the above diagram, AB line shows the risk-return combinations of several
portfolios. Each number indicates the number of stocks in the portfolio. When the
number of stock increases, the risk and return decline. Tracing down the AB line
shows the corner portfolio. An efficient frontier may have one or two security
portfolio at the low or high extremes, if the percentages of allocation to stocks are
free to take any value.
16.3.3 SHARPE’S OPTIMAL PORTFOLIO
Sharpe had provided a model for the selection of appropriate securities in a
portfolio. The selection of any stock is directly related to its excess return-beta ratio
Ri - Rƒ

Where,
Ri = the expected return on stock i
Rƒ = the return on a riskless asset
= the expected change in the rate of return on stock i associated with one
unit change in the market return
The excess return is the difference between the expected return on the stock
and the riskless rate of interest such as the rate offered on the government security
or treasury bill. The excess return to beta ratio measures the additional return on a
security (excess of the riskless asset return) per unit of systematic risk or non-
diversifiable risk. This ratio provides a relationship between potential risk and
reward.
Ranking of the stocks are done on the basis of their excess return to beta.
Portfolio managers would like to include stocks with higher ratios. The selection of
the stocks depends on a unique cut-off rate such that all stocks with higher ratios
 111

of Ri – Rƒ/ are included and the stocks with lower ratios are left off. The cut-off
point is denoted by C.
The steps for finding out the stocks to be included in the optimal portfolio are given
below
i) Find out the “excess return to beta” ratio for each stock under consideration.
ii) Rank them from the highest to the lowest.
iii) Proceed to calculate Ci for all the stocks according to the ranked order using
the following formula.
σ²мΣᴺᵢ=1 (Ri – Rƒ)
Ci σ²ei
1+σ²m Σᴺᵢ=1
σ²ei
σ²м = variance of the market index
σ²ei = variance of a stock’s movement that is not associated with the
movement of market index i.e. stock’s unsystematic risk.
iv) The cumulated values of C start declining after a particular C and that point
is taken as the cut-off point and that stock ratio is the cut-off ratio C.
The Cᵢ can be stated with mathematically equivalent way.
& '((')(ƒ)
Cᵢ=
&

- the expected change in the rate of return on stock I associated with 1 per
cent change in the return on the optimal portfolio
Rp – the expected return on the optimal portfolio
βipand Rp cannot be determined until the optimal portfolio is found. To find
out the optimal portfolio, the formula given previously should be used. Securities
are added to the portfolio as long as
ᵢ− ƒ
> .ᵢ
ᵢ
Now we have,
Rᵢ-Rƒ>βᵢp (Rp-Rƒ)
The right hand side is the expected excess return on a particular stock based
on the expected performance of the optimum portfolio. The term on the left hand
side is the expected excess return on the individual stock. Thus, if the portfolio
manager believes that a particular stock will perform better than the expected
return based on its relationship to optimal portfolio, he would add the stock to the
portfolio.
 112

16.3.4 CONSTRUCTION OF THE OPTIMAL PORTFOLIO

After determining the securities to be selected, the portfolio manager should
find out how much should be invested in each security. The percentage of funds to
be invested in each security can be estimated as follows
/ᵢ
Xi =
∑ᴺ123 /ᵢ

&ᵢ (ᵢ)(ƒ)8∗
Zi = 7 9
4²6 &ᵢ

The first expression indicates the weight on each security and they sum upto
one. The second shows the relative investment in each security. The residual
variance or the unsystematic risk has a role in determining the amount to be
invested in each security.
16.4. REVISION POINTS
1. Corner Portfolio
2. Evaluation of Technical Analysis
3. Construction of the Optimal Portfolio
16.5. INTEXT QUESTIONS
1. Explain the Sharpe’s Optimal Portfolio.
2. What are the tools of technical analysis?
3. Explain and Describe the Construction of the Optimal Portfolio
16.6. SUMMARY
The investor always likes to purchase a combination of stocks that provides
the highest return and has lowest risk. The investor wishes to maintain a
satisfactory reward to risk ratio.
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 accounts the stocks
movement.
Sharpe had provided a model for the selection of appropriate securities in a
portfolio. The selection of any stock is directly related to its excess return-beta ratio
determining the securities to be selected, the portfolio manager should find out how
much should be invested in each security. The percentage of funds to be invested in
each security can be estimated
Ri – Rƒ __________
16.7. TERMINAL EXERCISES
1. The _______________ plots a single value such as closing for a time interval.
a. All of these b. Bar chart c. Line chart d. Candlestick chart.
 113

16.8. SUPPLEMENTARY MATERIALS

1. money.rediff.com
2. money control.com
3. amfiindia.com
4. nseindia bseindia.com
5. rbi.org.in
16.9. ASSIGNMENT
1. What is corner Portfolio
16.10 SUGGESTED READINGS
1. M. Ranganathan and R. Madhumathi: Investment Analysis and Portfolio
Management, Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management, Vikas
Publishing House Pvt. Ltd., New Delhi.
3. Prasanna Chandra: Investment Analysis and Portfolio Management, TMH,
Delhi.
16.11. LEARNING ACTIVITIES
Construction of the Optimal Portfolio
16.12. KEY WORDS
Corner and optimal portfolio
 114

LESSON 17
CAPITAL ASSET PRICING MODEL
17.1 OBJECTIVE
 This topic is useful learn about CAPM
17.2 INTROUDCTION
Harry Markowitz developed an approach that helps an investor to achieve his
optimal portfolio position. Hence, portfolio theory, in essence, has a normative
character as it prescribes what rational investors should do.
William Sharpe and others asked the follow – up question: If rational investors
follow the Markowitzian prescription, what kind of relationship exists between risk
and return? Essentially, the capital asset price in model (CAPM) developed by them
is an exercise in positive economics. It is concerned with two key questions:
• What is the relationship between risk and return for an efficient portfolio?
• What is the relationship between risk and return for an individual security?
The CAPM, in essence, predicts the relationship between the risk of an asset
and its expected return. This relationship is very useful in two important ways.
First, it produces a benchmark for evaluating various investments. For example,
when we are analyzing a security we are interested in knowing whether the
expected return from it is in line with its fair return as per the CAPM. Second, it
helps us to make an informed guess about the return that can be expected from an
asset that has not yet been traded in the market. For example, how should a firm
price its initial public offering of stock?
Although the empirical evidence on the CAPM is mixed, it is widely used
because of the valuable insight it offers and its accuracy is deemed satisfactory for
most practical application. No wonder, the CAPM is a centerpiece of modern
financial economics and William Sharpe, its principal originator, was awarded the
Nobel Prize in Economics.
This chapter discusses various aspects of the CAPM, explains the basics of
Arbitrage Pricing Theory (APT) and multifactor models which have been proposed as
an alternative to the CAPM, and finally describes the stock market as a complex
adaptive system.
17.3. CONTENT
17.3.1 Various CAPM
Basic Assumptions
The CAPM is based on the following assumptions:
• Individuals are risk averse.
• Individuals seek to maximize the expected utility of their portfolio over a
single period planning horizon.
• Individuals have homogeneous expectations-they have identical subjective
estimates of the mean, variances, and covariance’s among returns.
 115

• Individuals can barrow and lend freely at a riskless rate of interest.

• The market is perfect: there are no taxes; there are no transaction costs;
securities are completely divisible; the market is competitive.
• The quantity of risky securities in the market is given.
Looking at these assumptions, one may feel that the CAPM is unrealistic.
However, the value of a model depends not on the realism of its assumption, but on
the validity of its conclusion. Extensive empirical analysis suggests that there are
merits in the CAPM.
Capital Market Line
The rational investors would choose a combination of Rf and S(S represent the
point on the efficient frontier of risky portfolios where the straight line emanating
from Rf is tangential to the efficient frontier). If all investors attempt to purchase
the securities in S and ignore securities not included in S would rise and hence
their expected return will fall. This would shift S, along with other points which
share securities with S, downwards: On the other hand, prices of securities not
included in S will fall, leading to an increase in their expected return.
Consequently, points representing portfolios in which these securities are included
will shift upwards. As this process continues, the efficient frontier of risky
securities will flatten as shown in Exhibit 1. Finally, the set of prices reached
would be such that every securities will enter at least one portfolio on the linear
segment KML, of course, the market portfolio would itself be a point on that linear
segment.
Portfolios which have returns that are perfectly correlated with the market
portfolio are referred to as efficient portfolios. Obviously, these are portfolios that lie
on the linear segment.
Exhibit 1 Adjustment of the Efficient Frontier
Expected return, E(Rp)
z
M

K
Rf

Standard deviation, σP
 116

For efficient portfolios (which include the market portfolios) the relationship
between risk and return is depicted by the straight line Rf MZ. The equation for this
line, called the capital market line (CML), is:
E(Rί)=Rƒ+λσί
Where E(Rj) is the expected return on portfolio j, Rƒ is the risk-free rate,λ is
the slope of the capital market line, and σj is the standard deviation of portfolio j.
Given that the market portfolio has an expected return of E(Rм) and standard
deviation of σм, the slope of the CML can be obtained as follows:
λ = E (Rм) – Rƒ
σм
where λ, the slope of the CML, may be regarded as the “price of risk” in the market.
Security Market Line
There is a simple linear relationship between the expected return and standard
deviation. What about individual securities and inefficient portfolios? Typically, the
expected return and standard deviation for individual securities will be follow the
CML., reflecting inefficiency of undiversified holdings. Further, such points would
be found throughout the feasible region with no well-defined relationship between
their expected return and standard deviation. However, there is a linear
relationship between their expected return and the covariance with the market
portfolio. This relationship, called the Security Market Line (SML), is as follows:
E(Rί)=Rƒ + E(Rм)-Rƒσίм
σ²м
where E(Ri) is the expected return on security I,Rf is the risk free return,E(Rm)
is the expected return on market portfolio,σ2m is the variance of return on market
portfolio, and σim is the covariance of returns between security i and market
portfolio.
In words, the SML relationship says:
Expected return on security i=Risk-free return+ (price per unit of risk)Risk
The price per unit of risk is: E (Rм)-Rƒ
σ²м
The measures of risk is: σim
In the Equation, the risk of a security is expressed in terms of its covariance
with the market portfolio, σίм
Can we find a standardized measure of risk? Fortunately, we can find a
standardized measure of systematic risk, popularly called beta ( ), by taking
advantage of the relationship.
ί= σίм
σ²м
 117

i reflects the slope of a linear regression relationship in which the return on

security i is regressed on the return on the market portfolio.
Thus , the SML is popularly expressed as
E(Rί)= Rƒ+ [E(Rм)-Rƒ] ί
In words, SML relationship says:
Expected Return on security I = Risk-free return+ Market risk premium+ Beta
of security i
The SML which reflects the expected return-beta relationship is shown in
Exhibit 2. Note that the slope of the SML, is the market risk premium.
Exhibit 2 The Security Market Line
Return (%)

p SML
14

8 o

Assets which are fairly priced plot exactly on the SML. Underpriced securities
(such as P) plot above the SML, whereas overpriced securities (such as O) plot
below the SML. The difference between the actual expected return on security and
its fair return as per the SML is called the security’s alpha, denoted by .
Relationship between SML and CML
Note that the CML relationship is a special case of the SML relationship. This
point may be demonstrated as follows:
As per the SML
E(Rί) = Rƒ +(Rм)-Rƒσίм
σ²м
Since σίм = Pίмσίσм, Eq.(8.3) can be re-written as:

E(Rί) = Rƒ + E(Rм)RƒPίмσί
σм
If the returns on I and M are perfectly correlated (this is true for efficient
portfolio), Eq,(8.6) becomes:
 118

E(Rί) = Rƒ +E(Rм)-Rƒσίσм

This is nothing but the CML. Hence the CML is a special case of the SML.
INPUTS REQUIRED FOR APPLYING CAPM
To apply the CAPM, you need estimates of the following factors that determine
the CAPM line:
Risk – Free Rate
The risk-free rate is the return on a security (or portfolio of securities) that is
free from default risk and is uncorrelated with returns from anything else in the
economy. Theoretically, the return on zero-beta portfolio is the best estimate of the
risk-free rate. Constructing zero-beta portfolios, however, is costly and complex.
Hence, they are often unavailable for estimating the risk-free rate.
In practice, two alternatives are commonly used:
• The rate on a short-term govt, securities like the 364-days Treasury bill.
• The rate on a long-term govt, bond that has a maturity of 15 to 20 years.
Both the alternatives have their advantages and limitations. The choice may
depend largely on the judgement of the analyst.
Market Risk Premium
The risk premium used in the CAPM is typically based on historical data. It is
calculated as the difference between the average return on stocks and the average
risk-free rate. Two measurement issues have to be addressed in this context: How
long should the measurement period be? Should arithmetic mean or geometric
mean be used?
The answer to the first question is: Use the longest possible historical period,
absent any trends in risk premium over time.
Practitioners seem to disagree over the choice of arithmetic mean versus
geometric mean. The arithmetic mean is the average of the annual rate of returns
over the measurement period whereas the geometric mean is the compounded
annual return over the measurement period. The difference between the two may be
illustrated with a simple example where we have two years of returns:
Year Price Return
0 100
1 180 80%
2 135 -25%
The arithmetic mean over the two years is 27.5% [(80-25)/2], whereas the
geometric mean is only 16.2% (1.350.5-1=1.162). The advocates of arithmetic mean
argue that it is more consistent with the mean-variance frame work and can be
better predict the premium in the next period. The votaries of geometric mean argue
 119

that it takes into account compounding and can better predict the average
premium in the long term. It appears that the arithmetic mean is more appropriate.
What Drives the Market Risk Premium?
Three factors seem to influence the market risk premium, in the main:
• Variance in the Underlying Economy if the underlying economy is more
volatile, the market risk premium is likely to be large. For Example, the
market risk premiums for emerging markets, given their high-growth and
high-risk economies are larger than the market risk premiums for developed
markets.
• Political Risk market risk premiums are larger in markets subject to higher
political instability. Remember that political instability causes economic
uncertainty.
• Market Structure If the companies listed on the market are mostly large,
stable, and diversified, the market risk premium is smaller. On the other
hand, if the companies listed on the market are generally small and risky,
the market risk premium is larger.
Beta
The beta of an investment I is the slope of the following regression
relationship:
Rit = σi + i Rmt+ eίᵼ
Where Rίᵼ is the return on investment ί ( a project or a security) in period t, Rʍᵼ
is the return on the market portfolio in period t, ί is the intercept of the linear
regression relationship between Rίᵼ and Rʍᵼ ( is pronounced as alpha), ί is the
slope of the linear regression relationship between Rίᵼ and Rʍᵼ ( is pronounced as
beta)
The variance of Rίᵼ as per Eq. (8.8) is:
Var (Rίᵼ) = ²ί ʍ²+ Var(eίᵼ)
From the above equation, we find that the total risk associated with
investment i, as measured by its variance, is the sum of two components: i) The
risk associated with the responsiveness of the return on the investment to market
index: =2 and ii) The risk associated with the error term: var (eit). The first
component represents the systematic risk and the second, unsystematic risk.
Systematic risk stems from economy wide factors which have a bearing on the
fortunes of all firms whereas unsystematic risk emanates from firm-specific factors.
While systematic risk cannot be diversified away, unsystematic risk can be. Hence,
the relevant risk, as per the CAPM, is the systematic risk. It is also referred to as
non-diversifiable risk or market risk.
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17.4. REVISION POINTS

1. Risk – Free Rate
2. Capital Market Line
3. Relationship between SML and CML
4. Beta
17.5. INTEXT QUESTIONS
1. Explain the CAPM.
2. Distinguish between the capital market line and security market line
3. write short note on Beta factor
17.6. SUMMARY
The Markowitz model is adequate and conceptually sound in analyzing the risk
and return of the portfolio
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.
The rational investors would choose a combination of Rf and S(S represent the
point on the efficient frontier of risky portfolios where the straight line emanating
from Rf is tangential to the efficient frontier).
Expected return on security i=Risk-free return+ (price per unit of risk)Risk
The price per unit of risk is: E (Rм)-Rƒ
The risk premium used in the CAPM is typically based on historical data. It is
calculated as the difference between the average return on stocks and the average
risk-free rate.
The beta of an investment I is the slope of the following regression
relationship:
Rit = σi + i Rmt+ eίᵼ
17.7. TERMINAL EXERCISES
1. The stock above the security market line is
a) of high risk b appropriately c. over priced d. under priced
2. The security market line considers only
a. the systematic risk b. borrowing c. borrowing and lending d. independent
variable
17.8 SUPPLEMENTARY MATERIALS
1. money.rediff.com
2. money control.com
3. amfiindia.com
4. nseindia bseindia.com
5. rbi.org.in
 121

17.9. ASSIGNMENT
1. What Drives the Market Risk Premium?
17.10. SUGGESTED READINGS
1. M.Ranganathan and R. Madhumathi: Investment Analysis and Portfolio
Management, Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management, Vikas
Publishing House Pvt. Ltd., New Delhi.
3. Prasanna Chandra: Investment Analysis and Portfolio Management, TMH,
Delhi.
17.11 LEARNING ACTIVITIES
Capital Market Line Meaning and Workout formula.
17.12. KEY WORDS
CAPM, SML, CML
 122

LESSON 18
ARBITRAGE PRICING THEORY
18.1 OBJECTIVE
After studying this chapter you may know of
 Arbitrage Pricing Theory
 Arbitrage and Derivatives
 Assumption
18.2 INTRODUCTION
The Arbitrage Pricing Theory (APT) was developed primarily by Ross (1976a,
1976b). It is a one-period model in which every investor believes that the stochastic
properties of returns of capital assets are consistent with a factor structure. Ross
argues that if equilibrium prices offer no arbitrage opportunities over static
portfolios of the assets, then the expected returns on the assets are approximately
linearly related to the factor loadings. (The factor loadings, or betas, are
proportional to the returns’ covariances with the factors.)
Ross’ (1976a) heuristic argument for the theory is based on the preclusion of
arbitrage. This intuition is sketched out in Section 2. Ross’ formal proof shows that
the linear pricing relation is a necessary condition for equilibrium in a market
where agents maximize certain types of utility. The subsequent work, which is
surveyed below, derives either from the assumption of the preclusion of arbitrage or
the equilibrium of utility-maximization. A linear relation between the expected
returns and the betas is tantamount to an identification of the stochastic discount
factor (SDF).
The APT is a substitute for the Capital Asset Pricing Model (CAPM) in that both
assert a linear relation between assets’ expected returns and their covariance with
other random variables. (In the CAPM, the covariance is with the market portfolio’s
return.) The covariance is interpreted as a measure of risk that investors cannot
avoid by diversification. The slope coefficient in the linear relation between the
expected returns and the covariance is interpreted as a risk premium.
Unfortunately, the APT does not necessarily preclude arbitrage opportunities
over dynamic portfolios of the existing assets. Therefore, the applications of the APT
in the evaluation of managed portfolios contradict at least the spirit of the APT,
which obtains price restrictions by assuming the absence of arbitrage.
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 known as the
Arbitrage Pricing Theory. The APT theory explains the nature of equilibrium in the
asset pricing in a less complicated manner with fewer assumptions compared to the
CAPM.
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18.3 CONTENT
Arbitrage It is the process of earning profit by taking advantage of
differential pricing for the same asset. The process generates riskless profit. In the
security market, it is of selling security at a high price and the simultaneous
purchase of the same security at a relatively lower price. Since the profit earned
through arbitrage is riskless, the investors have the incentive to undertake this
whenever an opportunity arises. In general, some investors indulge more in this
type of activities than others. However, the buying and selling activity of the
arbitrageur reduce and eliminates the profit margin, bringing the market price to
the equilibrium level.
The Assumptions
1. The investors have homogenous expectations.
2. The investors are risk averse and utility maxi misers.
3. Perfect competition prevails in the market and there is no transaction cost.
The APT theory does not assume
a) Single period investment horizon
b) No taxes
c) Investors can borrow and lend at risk free rate of interest.
d) The selection of the portfolio is based on the mean and variance analysis.
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. He
also likes to keep the risk at the same level. For example, 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 or 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,
∆@A + ∆@# + ∆@. = 0
The Principle of Arbitrage
Arbitrage means taking advantage of price differences in different markets. In
well-functioning markets, arbitrage opportunities are quickly exploited, and the
resulting increased buying of underpriced assets and increased selling of overpriced
assets return prices to equivalence.
Arbitrage and Derivatives
Assume the risk-free rate is 5%. The current price of gold is $300 per ounce
and the forward price of gold is $330 in one year's time. Is there an arbitrage
opportunity?
Here is what you can do:
Borrow $300 at 5% today. Buy one ounce of gold (price $300).Enter into a
short forward to sell one ounce of gold for $330 in one year's time .After one year
 124

you sell the gold for $330, and repay the bank $300 plus $15 interest. Hence, a
profit of $15 can be made without any risk!
In fact, any delivery price above $315 will result in a risk-free profit using this
strategy .What if the delivery price is $310?
Sell one ounce of gold for $300.Deposit the $300 in the bank at 5% interest.
Enter into a forward to buy one ounce of gold in one year's time for the delivery
price ($310).After one year, buy one ounce of gold for $310 and keep the $5 profit.
Again, a profit of $5 can be made without any risk. Investors in the gold market will
take advantage of any forward price that is not equal to $315, eventually bring the
price to $315, which is known as the arbitrage-free price. The arbitrage principle is
the essence of derivative pricing models.
Arbitrage and Replication
A portfolio composed of the underlying asset and the riskless asset could be
constructed to have exactly the same cash flows as a derivative. This portfolio is
called the replicating portfolio. Since they have the same cash flows, they would
have to sell at the same price (the law of one price).Assume the forward price of gold
is $315 in one year's time, and the spot price is $300. You have $300.You can
deposit $300 in the bank at 5% interest. One year later you will get $315.You can
also buy one ounce of gold, and a forward contract to sell it in one year for $315.
One year later you will also get $315.
Why replicate?
• To explore pricing differentials
• Lower transaction costs
• Replication is the essence of arbitrage.
RISK AVERSION, RISK NEUTRALITY, AND ARBITRAGE-FREE PRICING
Risk-seeking investors give away a risk premium because they enjoy taking
risk. Risk-averse investors expect a risk premium to compensate for the risk. Risk-
neutral investors neither give nor receive a risk premium because they have no
feelings about risk.
Risk-neutral pricing: Suppose you want to price a derivative. The payoff of
this derivate can be replicated using the underlying asset and risk-free rate. The
market price of this derivative and the replicating strategy must be exactly the same
under the principle of no arbitrage, regardless of risk preferences.
To obtain the derivative price we should assume the investor is risk-neutral,
because an investor's risk aversion is not a factor in determining the derivative
price. Risk can be eliminated by dynamic hedging in a situation where there is no
arbitrage possible. Once risk is eliminated in this way the expected return becomes
equal to the risk-free rate for all investors. Assets can be assumed to grow at the
risk-free rate and also discounted at the risk-free rate.
 125

18.4. REVISION POINTS

1. Arbitrage and Assumption , Derivatives
18.5. INTEXT QUESTIONS
1. Explain the Risk Aversion, Risk Neutrality, and Arbitrage-Free Pricing.
2. What is Arbitrage and Derivatives
18.6. SUMMARY
The Arbitrage Pricing Theory (APT) was developed primarily by Ross (1976a,
1976b). It is a one-period model in which every investor believes that the stochastic
properties of returns of capital assets are consistent with a factor structure.
1. The investors have homogenous expectations.
2. The investors are risk averse and utility maxi misers.
3. Perfect competition prevails in the market and there is no transaction cost
A portfolio composed of the underlying asset and the riskless asset could be
constructed to have exactly the same cash flows as a derivative. This portfolio is
called the replicating portfolio.
Risk-seeking investors give away a risk premium because they enjoy taking
risk. Risk-averse investors expect a risk premium to compensate for the risk. Risk-
neutral investors neither give nor receive a risk premium because they have no
feelings about risk
18.7. TERMINAL EXERCISES
1. The _______________ plots a single value such as closing for a time interval.
a. All of these b. Bar chart c. Line chart d. Candlestick chart.
18.8. SUPPLIMENTARY MATERIALS
1. money.rediff.com
2. money control.com
3. amfiindia.com
4. nseindia bseindia.com rbi.org.in
18.9. ASSIGNMENT
1. Discuss various risk arbitrages.
18.10. SUGGESTED READINGS
1. M.Ranganathan and R. Madhumathi: Investment Analysis and Portfolio
Management, Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management, Vikas
Publishing House Pvt. Ltd., New Delhi.
3. Prasanna Chandra: Investment Analysis and Portfolio Management, TMH,
Delhi.
18.11. LEARNING ACTIVITIES
Risk Aversion, Risk Neutrality, and Arbitrage-Free Pricing
18.12. KEY WORDS
APT, Derivatives
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LESSON 19
FACTOR MODEL
19.1 OBJECTIVE
After study this lesson to know the factor model
 Factor Models are financial models
19.2 INTRODUCTION
Factor Models are financial models factors (macroeconomic, fundamental, and
statistical) to determine the market equilibrium and calculate the required rate of
return. Such models associate the return of a security to single or multiple risk
factors in a linear model and can be used as alternatives to Modern Portfolio
Theory.
Below are some of the functions related to factor models

• Maximization of the excess return, i.e., Alpha (α) (to be dealt in the later part
of this article) of the portfolio;
• Minimization of the volatility of the portfolio, i.e., the Beta (β) of the portfolio;
• Ensure sufficient diversification to cancel out the firm-specific risk.
19.3 CONTENT
19.3.1 Types of Factor Model
19.3.2 Multi-Factor Model
19.3.3 Advantages and Disadvantages of Factor Models
19.3.1 TYPES OF FACTOR MODEL
There are primarily two types
1. Single Factor
2. Multiple Factor
1 – Single Factor Model
The most common application of this model is the Capital Asset Pricing Model
(CAPM). The CAPM is a model that precisely communicates the relationship
between the systematic risk and the expected return of the stocks. It calculates the
required return based on the risk measurement. To do this, it relies on a risk
multiplier called the Beta coefficient(β).
Formula/structure
E(R)i = Rf+ β(E(Rm)- Rf)
Where E(R)I is the Expected return of investment
Rf is the Risk-Free Rate of Return defined as a theoretical rate of return with
zero risks.
β is the Beta of the Investment that represents the volatility of the investment
as compared to the overall market
E(Rm) is the Expected return of the market.
E(Rm)- Rf is the Market Risk Premium
 127

19.3.2 MULTI-FACTOR
FACTOR MODEL
A combination of various elements or factors that are correlated with asset
returns A multi-factor
factor mod
model
el is a combination of various elements or factors that
are correlated with asset returns. The model uses said factors to explain market
equilibrium and asset prices. In multi
multi-factor
factor models, different factors are associated
with certain characteristics (su
(such
ch as risk), and it helps determine the weight or
importance of that factor when computing asset price or return.

A typical measure of risk is beta, which measures the systemic risk of a

security relative to the market. Multi
Multi-factor models are commonly used
sed by asset
managers to make investment decisions and assess the relevant risk associated
with the investments.
TYPES OF MULTI-FACTOR
FACTOR MODELS
Multi-factor
factor models can be used in all industries, be it finance, economics, or
mathematics. Broadly, three types of multi-factor
factor models can be classified based on
the type of factors employed:
1. MACROECONOMIC FACTOR
TOR MODELS
In macroeconomic factor models, the factors are associated with surprises in
macroeconomic variables that help explain returns of asset classes. The surprise or
incremental return can be calculated as the actual value less the forecasted value,
and the mean of the return is typically zero.
2. FUNDAMENTAL FACTOR
R MODELS
In fundamental models, the factors are characteristics of stocks or companies
thatt can be used to explain the changes in stock prices. Examples of such factors
are price-to-earnings
earnings ratio, market capitalization, and financial leverage.
Fundamental factor models use asset returns, and after determining the factor
sensitivities, the returns
rns are calculated by running regressions.
3. STATISTICAL FACTOR
R MODELS
In statistical factor models, statistical methods are applied to historical data of
returns and are used to explain covariances in data.
THREE, FOUR, AND FIVE-FACTOR
FACTOR MODELS
The construction
ction of multi
multi-factor
factor models is an interesting process, and over
time, several different types of models have emerged in the field of finance. Below,
 128

we will discuss three different types of multi

multi-factor
factor models and their relevant
factors used to derive returns:
urns:
1. FAMA-FRENCH THREE-FACTOR
FACTOR MODEL
Fama-French
French uses the factors of size and value to derive asset returns. It is a
better approach than the Capital Asset Pricing Model (CAPM), as CAPM only
explains 70% of a portfolio’s diversified returns, whereas Fam
Fama-French
French explains
roughly 90%.
The Fama-French
French model employs three factors – namely SMB (small minus
big), HML (high minus low), and the portfolio return minus the risk
risk-free
free rate. SMB
characterizes publicly-traded
traded companies with small market caps that generate
gene
higher returns, and HML uses value stocks with high book
book-to-market
market ratios that
generate higher returns relative to the market.
The formula for the Fama-French
French three
three-factor
factor model is given in the equation below:

Where:
Rit = Total return of a stock or portfolio i at time t
Rft = Risk-free
free rate of return at time tRMt = Total market portfolio return at
time t
Rit – Rft = Expected excess return
RMt – Rft = Excess return on the market portfolio (index)
SMBt = Size premium (Small minus big)
HMLt = Value premium
mium (high munus low)
β = Factor coefficients
2. CHART FOUR-FACTOR
FACTOR MODEL
The Chart model builds onto the Fama Fama-French three-factor
factor model and
introduces a fourth factor called momentum. The concept of the momentum of an
asset can be used to predict future asset returns. It is a bit controversial, as it uses
risk-based,
based, as well as behavioural
behavioural-based,
based, explanations to determine returns. The
Chart model is considered a superior one, given its explanatory power of around
95%.
3. FAMA-FRENCH FIVE-FACTOR
FACTOR MODEL
The Fama-French
French five
five-factor model also builds on the three-factor
factor model and
introduces two more factors – Profitability (RMW) and Investment (CMA). It uses the
return of stocks with high operating profitability minus the return of stocks with
low or negative operating
perating profitability.
At times, the factor is replaced by a quality factor. The investment factor
recognizes the level of capital investment used to maintain and grow the business.
It is typically negatively correlated with the value factor. Given the number
nu of
factors, the Fama-French
French five
five-factor
factor model is, at times, not practical to be
implemented in certain economies.
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19.3.4 ADVANTAGES AND DISADVANTAGES OF FACTOR MODELS

Below are the points that explain the advantages and disadvantages for the
same:
ADVANTAGES
• Factor models help in pinpointing the cause of the change in the dependent
variables and identify the factors which are causing the same. Once the
cause and effect relationship is clearly defined, it is easier to harness and
predict such impacts in a structured manner.
• Investing can be made scientific and higher returns can be achieved using
the models with high predictive power and therefore algorithms can be
generated for automated trading. However, such automation is only used
when the stakes are not very high because this limits the losses which might
be very huge otherwise.
• Businesses can develop marketing and expansion strategies based on factor
models of their domain and thereby develop a plan to achieve higher profits
and then closely monitor the results. This helps them in aligning the goals
and objectives of the company as a whole.
DISADVANTAGES
• Identifying the right factors is not an easy task and there are many cautions
that need to be taken into consideration to draw a valid conclusion out of a
given model. If the data set is affected by multicollinearity or serial
correlations and other violation of regression assumptions, then the model
can become unstable and not have any consistent predictive power.
• Factor models are not highly cost-effective. They require the use of
sophisticated statistical techniques which in turn require expensive
technology and therefore cannot be used by smaller companies or retail
investors who don’t possess the required resources.
• These models require highly skilled human capital because these require
advanced mathematical acumen and therefore the people involved in such
research come at a high cost.
• At times adding more factors might not explain the effect on the dependent
variable and therefore the model might reach a particular limit and that
might not be too extensive to justify the time effort that goes into such
analysis.
19.4. REVISION POINTS
1. Factor Model ,Multi-Factor Models
19.5. INTEXT QUESTIONS
1. Explain the Advantages and Disadvantages of Factor Models
2. What are the Types of Multi-Factor Models
3. Explain the Types of Factor Model
19.6. SUMMARY
Factor Models are financial models factors (macroeconomic, fundamental, and
statistical) to determine the market equilibrium and calculate the required rate of
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return. Such models associate the return of a security to single or multiple risk
factors in a linear model and can be used as alternatives to Modern Portfolio Theory
Advantages
• Factor models help in pinpointing the cause of the change in the dependent
variables and identify the factors which are causing the same. Once the
cause and effect relationship is clearly defined, it is easier to harness and
predict such impacts in a structured manner.
Disadvantages
• Identifying the right factors is not an easy task and there are many cautions
that need to be taken into consideration to draw a valid conclusion out of a
given model. If the data set is affected by multicollinearity or serial
correlations and other violation of regression assumptions, then the model
can become unstable and not have any consistent predictive power
19.7. TERMINAL EXERCISES
1. The most common application of this model is the Capital Asset Pricing
Model (CAPM).
2. Multi-factor models can be used in all industries, be it finance, economics,
or mathematics
19.8. SUPPLIMENTARY MATERIALS
1. money.rediff.com
2. money control.com
3. amfiindia.com
4. nseindia
5. bseindia.com
6. rbi.org.in
19.9. ASSIGNMENT
1. Draw the chart of Multi-factor models.
19.10. SUGGESTED READINGS
1. M.Ranganathan and R. Madhumathi: Investment Analysis and Portfolio
Management, Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management, Vikas
Publishing House Pvt. Ltd., New Delhi.
3. Prasanna Chandra: Investment Analysis and Portfolio Management, TMH,
Delhi.
19.11. LEARNING ACTIVITIES
Financial Factor Model
19.12. KEY WORDS
Find various Models
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LESSON 20
MEASURE OF RETURN
20.1 OBJECTIVE
After studying this chapter you may know of
 Measure of return
 Kinds of Theory Ratio
20.2 INTRODUCTION
Once an investor selects a portfolio it is necessary that he evaluates its
portfolio periodically so as to achieve its financial goals. Performance evaluation is
one of the most critical areas of investment analysis. Performance results can be
used to assess the quality of the in investment
vestment approach and suggest changes that
might improve it.
For this it is necessary to have a benchmark or a standard portfolio against
which the performance of the portfolio will be evaluated. We have risk adjusted
measures to evaluate the performance o off the portfolios. These measures adjust the
return from a portfolio for the underlying risk. These measures are:
1. Sharpe ratio
2. Treynor’s ratio
3. Jensen’s alpha
20.3 CONTENT
20.3.1 Sharpe Ratio
20.3.2 Treynor’s Ratio
20.3.3 Jensen’s Alpha
20.3.1 SHARPE RATIO (OR INDEX)
Sharpe’s Measure is simply a ratio of the reward, defined as the realized
portfolio return (Rp) in excess of the risk
risk-free
free rate, to the variability of return as
measured by the standard deviation of return (op). Thus

Where,
Sp is Sharpe’s performance
ormance measure
Rp is ex-past
past or realized return of the portfolio Rf is risk
risk-free
free rate of return and
σp is standard deviation (Variability or risk) of portfolio return.
It measures the risk premium of portfolio (where the risk premium is the
excess return expected by the investors for the assumption of risk) relative to the
total amount of risk in the portfolio.
 132

Ranking of portfolio
We give high ranking to the one having high ratio and last rank to the one
having lowest ratio. Hence ranking is done in th
the descending order.
Whether outperformed or underperformed
If the sharpe ratio of the given portfolio is higher than the sharpe ratio of the
market portfolio (or any other benchmark portfolio) then, we say that the given
portfolio is an outperformer and vi
vice versa.
20.3.2 TREYNOR’S RATIO (OR
OR INDEX)
Treynor’s Measure is also, like Sharpe’s measure, a ratio of the reward defined
as the realized portfolio return (Rp) in excess of the risk
risk-free
free rate to the volatility of
return as measure by the beta
beta- coefficient of return (βp).Thus

Where,

Tp is Treynor’s performance measure

Rp is realized return of the portfolio
Rf is risk-free
free rate of return and βp is volatility of the portfolio returns.
It measures the risk premium relative to the systematic risk of the portfolio. It
is based on the premise that the unsystematic variability of returns is eliminated by
diversification and the portfolio as left with only the systematic risk. Thus, the
Treynor measure is the ratio of the reward, also defined as the rrealized ealized portfolio
return (Rp) in excess of the risk
risk-fee
fee rate (Rf), to the volatility of return as measured
by the portfolio beta (βp).
These two performance measures (Sharpe and Treynor) differ only in the
former consider total risk as measured by standard deviation, while the latter
consider only the market risk as measured by beta. The standard deviation as
measure of total risk is considered appropriate while evaluating the risk-return
risk
relationship for well- diversified portfolios.
Ranking of portfolios
Ranking of the portfolios here is also done in a descending order as in the
sharpe measure.
Whether outperformed or underperformed
If the treynor ratio of the given portfolio is higher than that of the market
portfolio ( or any other benchmark portfolio ) then, we say that the given portfolio
has outperformed the market and vice versa.
Can sharpe ratio and treynor’s ration give contradictory results?
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Sharpe ratio uses total risk (systematic and unsystematic both) while treynor’s
ratio uses only the systematic risk in the denominator. If there is no unsystematic
risk, then the total risk and the systematic risk will be same and hence sharpe and
treynor’s ratio will provide same result.However, it is possible that the total risk of
the portfolio is not equal to the systematic risk only, in such case the ratios may
provide contradictory results.
20.3.3 JENSEN’S ALPHA
Jensen Measure is an attempt to construct a measure of absolute performance
on a risk-adjusted basis. This provides a more definite standard against which
performance of various funds can be measured. This standard is aimed at
measuring the portfolio manager’s predictive ability. It is the ability to earn returns
through successful prediction of security prices, which are higher than those,
which we may expect, given the riskiness of his portfolio. In other words, it
attempts to determine if more than expected returns are being earned for the
portfolio’s riskiness. Accordingly, it is defined as.
Rp -Rf = α + βp (Rm -Rf) Where
Rp is portfolio realized return.
Rf is risk-free return
α is intercept that measure the fore casting ability of the portfolio managers.
βp is a measure of systematic risk and Rm is return on Market portfolio
Here alpha (α) value is of great relevance. A positive a value represents the
average superior extra return acquired on a particular portfolio. It must be noted
that the jensen’s alpha of the market portfolio is always zero because the beta
factor of the market portfolio is always 1.
Ranking of portfolios
We give first rank to the one having highest jensen’s alpha and the last rank to
the one having the lowest jensen’s alpha.
Whether outperformed or underperformed
If jensen’s alpha is positive then the portfolio has outperformed and if that is
negative then the portfolio is aid to be underperformed.
Treynor’s ratio and jensen’s alpha
Since both these measures use the systematic risk measure beta to evaluate
the performance of the portfolio, they always provide same results in terms of
ranking.
20.4. REVISION POINTS
1. Ranking of portfolios jensen’s alpha
20.5. INTEXT QUESTIONS
1. Explain the various theory of ratio.
2. What is Ranking of portfolio
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20.6. SUMMARY
For this it is necessary to have a benchmark or a standard portfolio against
which the performance of the portfolio will be evaluated. We have risk adjusted
measures to evaluate the performance of the portfolios. These measures adjust the
return from a portfolio for the underlying risk. These measures are:
1. Sharpe ratio
2. Treynor’s ratio
3. Jensen’s alpha
Ranking of portfolios
We give first rank to the one having highest jensen’s alpha and the last rank to
the one having the lowest jensen’s alpha.
Whether outperformed or underperformed
If jensen’s alpha is positive then the portfolio has outperformed and if that is
negative then the portfolio is aid to be underperformed.
Treynor’s ratio and jensen’s alpha
Since both these measures use the systematic risk measure beta to evaluate
the performance of the portfolio, they always provide same results in terms of
ranking.
20.7. TERMINAL EXERCISES
1. Ranking of the portfolios here is also done in a descending order as in the
sharpe measure.
20.8. SUPPLIMENTARY MATERIALS
1. money.rediff.com
2. money control.com
3. amfiindia.com
20.9. ASSIGNMENT
1. Different types of Theory Ratio.
20.10. SUGGESTED READINGS
1. M. Ranganathan and R. Madhumathi: Investment Analysis and Portfolio
Management, Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management, Vikas
Publishing House Pvt. Ltd., New Delhi.
3. Prasanna Chandra: Investment Analysis and Portfolio Management, TMH,
Delhi.
20.11. LEARNING ACTIVITY
Ranking of the portfolio
20.12. KEY WORDS
Sharpe
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LESSON 21
RISK ADJUSTED MEASURES OF PERFORMANCE EVALUATION
21.1 OBJECTIVE
 To study on Risk-adjusted performance measures
21.2 INTRODUCTION
Risk-adjusted performance measures are an important tool for investment
decisions. Whenever an investore valuates the performance of an investment he will
not only be interested in the achieved absolute return but also in the risk-adjusted
return – i. e. in the risk which had to be taken to realize the profit. The first ratio to
measure risk-adjusted return was the Sharpe Ratio introduced by William
F. Sharpe in 1966. Although being frequently used in theory and practice the
Sharpe Ratio has a major drawback as it is designed for the use in a µ-σ-
framework and thus requires returns to be normally distributed. The events of the
current financial crisis have shown clearly that this assumption does not hold true
and that especially events at the tails of the distribution – most importantly high
losses – are more likely than assumed by the normal distribution. As a result, the
Sharpe Ratio might lead to inaccurate investment decisions.
21.3. CONTENT
The need for Risk-Adjusted Performance Measurement
Risk-adjusted performance Measurement encompasses a set of concepts.
Those concepts may vary in detail depending on the context they are used in.
However, all risk adjusted performance measures have one thing in common: they
compare the return on capital to the risk taken to earn this return – i.e. some kind
of risk-adjustment Is adopted. Generally speaking, return in risk-adjusted
performance measures is measured either by absolute returns or by relative returns
(i.e. excess returns), whereas disagreement prevails in literature on how exactly risk
should be taken into account.This has given rise to the development of a
considerable number of alternative risk adjusted performance measures. Thus,
risk-adjusted performance measures can take many forms as shall be shown in the
following chapters.
In the past years risk-adjusted performance measures have gained great
importance. The first reason for this development is the emergence of investment
funds as an important investment category. Investors needed an effective tool to
evaluate there spective performance of the various funds compared to the risk
taken by the fund managers to choose the right option for capital allocation. The
second reason is the introduction of the Basel II regulatory framework, which
requires financial institutions to hold a certain amount of equity as a cushion
against unexpected losses for each risky position taken.
As a result, financial institutions have a great interest in efficiently allocating
capital not only according to the resulting return but also to the risk shouldered and
therefore, banks more and more turn to concepts based on risk-adjusted performance
measures like Risk-adjusted Return on Capital (RAROC) when evaluating their
business activities. Due to these developments, risk-adjusted performance measures
gradually replace traditional performance measures like Return on Equity (ROE) or
Return on Investment (ROI)when it comes to analyzing performance in financial
contexts as these traditional measures do not take into account risk.
As indicated above, risk-adjusted performance measurement has two major fields
of application- performance evaluation and capital allocation. In the field of
performance evaluation, risk-adjusted performance measures are used to rank competing
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investment strategies ex-ante and ex-post according to their respective risk-adjusted

returns. The investment with the highest return and the lowest risk ranks first.
A further application in this context is the design of compensation plans for
traders or asset managers. If their performance is assessed according to the raw
profits they make, they will seek to take risk to maximize their bonuses. In contrast, in
a risk-adjusted compensation framework, excessive risk-taking can be avoided as
employees are compensated according to their risk-adjusted profits.
Risk-adjusted performance measurement is also used to guide management in
efficient internal capital allocation. It helps the management of financial institutions to
evaluate the risk-adjusted performance of their business units, traders or investment
portfolios. Like this capital is only allocated to deals which are profitable from a risk-
adjusted performance point of view as equity is rare and expensive due to the
minimum capital requirements stated in the Basel II framework.
21.4. REVISION POINTS
1. Risk adjustment
21.5. INTEXT QUESTIONS
1. What is Risk-Adjusted Performance Measurement
21.6. SUMMARY
Risk-adjusted performance Measurement encompasses a set of concepts.
Those concepts may vary in detail depending on the context they are used in.
However, all risk adjusted performance measures have one thing in common: they
compare the return on capital to the risk taken to earn this return – i.e. some kind
of risk-adjustment
21.7 TERMINAL EXERCISES
1. When the price of the stock is up and closes above the opening trade, the candlestick will
usually be ____________and ______________.
a. White and clear b. Black and clear c. Red and unclear d.Black and unclear
2. The _______________ plots a single value such as closing for a time interval.
a. All of these b. Bar chart c. Line chart d. Candlestick chart.
21.8. SUPPLIMENTARY MATERIALS
1. money.rediff.com
2. money control.com
3. amfiindia.com
21.9. ASSIGNMENT
1. Risk and Returns
21.10. SUGGESTED READINGS
1. M. Ranganathan and R. Madhumathi: Investment Analysis and Portfolio Management,
Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management, Vikas Publishing House
Pvt. Ltd., New Delhi.
3. Prasanna Chandra: Investment Analysis and Portfolio Management, TMH, Delhi.
21.11. LEARNING ACTIVITIES
Portfolio Risk Analysis.
21.12. KEY WORDS
ROI
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LESSON 22
MARKET TIMING – EVALUATION CRITERIA AND PROCEDURES
22.1 OBJECTIVE
 To learns about Market Timing
22.2 INTRODUCTION
Market timing refers to an investing strategy through which a market participant
makes buying or selling decisions by predicting the price movements of a financial
asset in the future. Investors following the strategy aim to outperform the market by
taking a long position (buying) at market bottoms and a short position (selling) at
market tops.
The market timing strategy can be used to enter or exit markets or to choose
between different assets or asset classes while making trading decisions.
22.3 CONTENT
22.3.1 Objectives of Market Timing
22.3.2 Professional Market Timers
22.3.3 Analysis for Market Timing
22.3.1 OBJECTIVES OF MARKET TIMING
The three main objectives of market timing are:
First and foremost, to preserve your capital
Second, to absolutely evade and avoid large market downturns, and
Third, to equal or exceed the performance of a buy-and-hold portfolio on a risk-
adjusted basis.
22.3.2 PROFESSIONAL MARKET TIMERS
There are two types of professional market timers: the classic market timers and
the dynamic asset allocators.
Classic Market Timers
Classic market timers usually invest in mutual funds when they are invested
in the market, and they move their money into a money market fund or T-bills
when they are not invested in the market. A classic timer may decide to go from a
cash position to a 100 percent invested position or possibly to a 25 percent invested
position, in25 percent increments, until fully invested, based upon a particular
timing strategy. And he may decide to exit the same way, by selling 25 percent of
the investment, in 25 percent increments. Also, some classic timers may go short
instead of going into cash, to take full advantage of a market decline. Those timers
who go short the market may also use leveraged funds.
Dynamic Asset Allocators
Dynamic asset allocators, unlike classic market timers, are always 100percent
invested in some asset class, but they spread their investments among stocks,
bonds, gold, and cash in varying percentages. They either invest directly in those
instruments or they use index funds, sector funds, leveraged funds, or exchange-
traded funds that represent those asset classes. For those investors who prefer to
always be invested with wide diversification, the asset allocation approach fits the
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bill nicely. And typically, the overall risk of the portfolio is less than investing in one
specific investment vehicle such as equities.
Six Key Points about Market Timing
You should understand the following six points about market timing:
1. Market timing has nothing to do with forecasting the market’s future
direction. Samuel Goldwyn once said,“ Never make forecasts, especially about the
future.” What you are trying to accomplish with market-timing is to equal or exceed
the buy-and-hold strategy’s returns with less risk ,while protecting your principal
from erosion, above all else. Just because you received a market-timing buy or sell
signal does not mean that the market will continue in that direction for an extended
period of time. Nor does it mean that the signal will be a successful one all of the
time. Market timing has to do with putting the odds in your favor over multiple bull
and bear market cycles. Overall you will have satisfactory or better results without
having to guess where the market is going. Your signals will tell you when to buy
and when to sell.
2. Market timing assumes that stock prices are not that the stock market is
not efficient. These anomalies allow market timers to take advantage of trends in
the market. Of course, academicians have written extensively about the random
nature of stock prices and the efficient market hypothesis. But in the practical
world of professional investment management, academic theories are just that;
academic theories which cannot usually be substantiated by what goes on in actual
practice.
3. Market timing should be a mechanical, emotionless approach to investing.
Therefore, once you’ve decided to use a specific strategy that fits your specific
temperament, take all the signals and monitor your performance. Once a signal is
given, take it and then get ready for the next one. If the last trade was a loss, so be
it. Cut your losses short and let your profits run. Small losses are good. But large
losses are the killers. Ask anyone who stood pat with their investments from early
2000 through October 2002 how they would rate their investment skills. The
answers would not be printable! Unfortunately, most investors don’t know when to
sell, don’t cut their losses short, and don’t use a target price. An investor needs to
set a fixed exit price (for example, a fixed percent, such as 10 percent below his
purchase price) to limit his losses and he needs to honor it impeccably in the same
way he honor his father and mother. Investors who don’t use stop-loss orders to
limit their losses, and investors who are more worried about paying taxes on their
gains than protecting their principal are asking for trouble and sooner rather than
later, they will find it. These shortcomings are mostly psychological in nature, since
taking a loss is basically admitting to yourself that your judgment was wrong and
that you failed as an investor. Another common problem is that everyone is looking
to get back to breakeven after a loss.
4. With market timing you probably will under perform in a sustained bull
market. This outcome is to be expected, if the strategy you select has periodic sell
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signals in an up trending market. But with market timing you will hit the gravy
train in bear markets
5. Market timing provides the buy and sell signals to tellyou when to go long
and when to go short the market. You should understand that going short the
market is the exact opposite of going long. Either strategy has the same risk, as
long as you have the same tight exit rules for each one. With the availability of long
and short (called inverse) mutual funds such as the Rydex Funds family, you can
easily go long or short the market. You can also use exchange-traded funds called
ETFs to go long or short.
6. Market timing is not magic, is not 100 percent accurate, and is not for
everyone. They are all based on simple strategies, not complicated mathematical
equations with numerous variables. Hopefully, they will continue to work in the
future. Be aware that a strategy may provide profitable trades less than 50 percent
of the time and still be profitable overall. Market timing requires the critical
characteristics mentioned earlier. Many individual investors do not possess them
and therefore should not be self-directed market timers.
Use of Market Timing Strategy
It can be very difficult to regularly and effectively execute a market timing
strategy. Despite the fact, it appeals to investors primarily because of its potential
to amass a fortune overnight as compared to the long time horizon required by
most other approaches of value investing or formula acquisition.
Market timing’s provided success for professional day traders, portfolio
managers and other financial professionals who can devote considerable time to
analyze economic forecasts and effectively predict market shifts with such
consistency. For the average investor, however, following the market daily is rather
inconvenient, and it is more profitable for them to focus on investing in the long
term.
Market Timing Strategy Work
Market timing includes the timely buying and selling of financial assets based
on expected price fluctuations. The strategy can be applied to both long-term and
short-term time horizons, as per the risk and return preferences of the investor.
Usually, the trader would buy stocks when the markets are bullish and sell
them off at the onset of a bear market. It involves recognizing when there would be
a change in the trajectory of the price movements.
To do it, the investor must speculate how the price shall increase or decrease
in the future, rather than examining the value of the financial product. An active
allocation strategy, the market timing strategy aims at reaping the maximum
benefits out of price inequities prevailing in the markets.
22.3.3 ANALYSIS FOR MARKET TIMING
Under the market timing strategy, any buying or selling decisions are based on
either of the following two analysis techniques:
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1. Fundamental analysis
While performing fundamental analysis, an analyst takes into account certain
assumptions regarding variables that affect buying and selling decisions. Market
timing is the mathematical function of such variables. It is important to find out the
most accurate timing to make the decision. Fundamental analysis is used for a
mid-term to a long-term time horizon.
Fundamental analysis (FA) is a method of measuring a security's intrinsic
value by examining related economic and financial factors. Fundamental analysts
study anything that can affect the security's value, from macroeconomic factors
such as the state of the economy and industry conditions to microeconomic factors
like the effectiveness of the company's management.
The end goal is to arrive at a number that an investor can compare with a
security's current price in order to see whether the security is undervalued or
overvalued.
This method of stock analysis is considered to be in contrast to technical
analysis, which forecasts the direction of prices through an analysis of historical
market data such as price and volume.
Understanding Fundamental Analysis
All stock analysis tries to determine whether a security is correctly valued
within the broader market. Fundamental analysis is usually done from a macro to
micro perspective in order to identify securities that are not correctly priced by the
market.
Analysts typically study, in order, the overall state of the economy and then
the strength of the specific industry before concentrating on individual company
performance to arrive at a fair market value for the stock.
Fundamental analysis uses public data to evaluate the value of a stock or any
other type of security. For example, an investor can perform fundamental analysis
on a bond's value by looking at economic factors such as interest rates and the
overall state of the economy, then studying information about the bond issuer,
such as potential changes in its credit rating.
For stocks, fundamental analysis uses revenues, earnings, future growth,
return on equity, profit margins, and other data to determine a company's
underlying value and potential for future growth. All of this data is available in a
company's financial statements (more on that below).
Fundamental analysis is used most often for stocks, but it is useful for
evaluating any security, from a bond to a derivative. If you consider the
fundamentals, from the broader economy to the company details, you are doing
fundamental analysis.
Investing and Fundamental Analysis
An analyst works to create a model for determining the estimated value of a
company's share price based on publicly available data. This value is only an
 141

estimate, the analyst's educated opinion, of what the company's share price should
be worth compared to the current market price. Some analysts may refer to their
estimated price as the company's intrinsic value.
If an analyst calculates that the stock's value should be significantly higher
than the stock's current market price, they may publish a buy or overweight rating
for the stock. This acts as a recommendation to investors who follow that analyst. If
the analyst calculates a lower intrinsic value than the current market price, the
stock is considered overvalued and a sell or underweight recommendation is
issued.
Investors who follow these recommendations will expect that they can buy
stocks with favorable recommendations because such stocks should have a higher
probability of rising over time. Likewise, stocks with unfavorable ratings are
expected to have a higher probability of falling in price. Such stocks are candidates
for being removed from existing portfolios or added as "short" positions.
This method of stock analysis is considered to be the opposite of technical
analysis, which forecasts the direction of prices through an analysis of historical
market data such as price and volume. Those interested in learning more about
fundamental analysis and other financial topics may want to consider enrolling in
one of the best investing courses currently available.
Quantitative and Qualitative Fundamental Analysis
The problem with defining the word fundamentals is that it can cover anything
related to the economic well-being of a company. They obviously include numbers
like revenue and profit, but they can also include anything from a company's
market share to the quality of its management.
The various fundamental factors can be grouped into two categories:
quantitative and qualitative. The financial meaning of these terms isn't much
different from their standard definitions. Here is how a dictionary defines the terms:
Quantitative – "related to information that can be shown in numbers and
amounts."
Qualitative – "relating to the nature or standard of something, rather than to its
quantity."
In this context, quantitative fundamentals are hard numbers. They are the
measurable characteristics of a business. That's why the biggest source of
quantitative data is financial statements. Revenue, profit, assets, and more can be
measured with great precision.
The qualitative fundamentals are less tangible. They might include the quality of a
company's key executives, its brand-name recognition, patents, and proprietary
technology.
Neither qualitative nor quantitative analysis is inherently better. Many
analysts consider them together.
Qualitative Fundamentals to Consider
There are four key fundamentals that analysts always consider when regarding
a company. All are qualitative rather than quantitative. They include:
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The business model: What exactly does the company do? This isn't as
straightforward as it seems. If a company's business model is based on selling fast-
food chicken, is it making its money that way? Or is it just coasting on royalty and
franchise fees?
Competitive advantage: A company's long-term success is driven largely by
its ability to maintain a competitive advantage—and keep it. Powerful competitive
advantages, such as Coca-Cola's brand name and Microsoft's domination of the
personal computer operating system, create a moat around a business allowing it to
keep competitors at bay and enjoy growth and profits. When a company can
achieve a competitive advantage, its shareholders can be well rewarded for decades.
Management: Some believe that management is the most important criterion
for investing in a company. It makes sense: Even the best business model is
doomed if the leaders of the company fail to properly execute the plan. While it's
hard for retail investors to meet and truly evaluate managers, you can look at the
corporate website and check the resumes of the top brass and the board members.
How well did they perform in prior jobs? Have they been unloading a lot of their
stock shares lately?
Corporate Governance: Corporate governance describes the policies in place
within an organization denoting the relationships and responsibilities between
management, directors, and stakeholders. These policies are defined and
determined in the company charter and its bylaws, along with corporate laws and
regulations. You want to do business with a company that is run ethically, fairly,
transparently, and efficiently. Particularly note whether management respects
shareholder rights and shareholder interests. Make sure their communications to
shareholders are transparent, clear, and understandable. If you don't get it, it's
probably because they don't want you to.
It's also important to consider a company's industry: customer base, market
share among firms, industry-wide growth, competition, regulation, and business
cycles. Learning about how the industry works will give an investor a deeper
understanding of a company's financial health.
Financial Statements: Quantitative Fundamentals to Consider
Financial statements are the medium by which a company discloses
information concerning its financial performance. Followers of fundamental
analysis use quantitative information gleaned from financial statements to make
investment decisions. The three most important financial statements are income
statements, balance sheets, and cash flow statements.
Technical analysis
In technical analysis, market timing becomes a function of the historical
performance of the stock and the history of investor behavior. Technical analysis is
generally used for a short-term to mid-term investment horizon.
Tools of the Trade
The tools of the trade for day traders and technical analysts consist of charting
tools that generate signals to buy or sell, or which indicate trends or patterns in the
market. Broadly speaking, there are two basic types of technical indicators:
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Overlays: Technical indicators that use the same scale as prices are plotted
over the top of the prices on a stock chart. Examples include moving averages and
Bollinger Bands® or Fibonacci lines.
Oscillators: Rather than being overlaid on a price chart, technical indicators
that oscillate between a local minimum and maximum are plotted above or below a
price chart. Examples include the stochastic oscillator, MACD, or RSI. It will mainly
be these second kind of technical indicators that we consider in this article.
Traders often use several different technical indicators in tandem when
analyzing a security. With literally thousands of different options, traders must
choose the indicators that work best for them and familiarize themselves with how
they work. Traders may also combine technical indicators with more subjective
forms of technical analysis, such as looking at chart patterns, to come up with
trade ideas. Technical indicators can also be incorporated into automated trading
systems given their quantitative nature.
1. On-Balance Volume
First up, use the on-balance volume indicator (OBV) to measure the positive
and negative flow of volume in a security over time. The indicator is a running total
of up volume minus down volume. Up volume is how much volume there is on a
day when the price rallied. Down volume is the volume on a day when the price
falls. Each day volume is added or subtracted from the indicator based on whether
the price went higher or lower. When OBV is rising, it shows that buyers are willing
to step in and push the price higher. When OBV is falling, the selling volume is
outpacing buying volume, which indicates lower prices. In this way, it acts like a
trend confirmation tool. If price and OBV are rising, that helps indicate a
continuation of the trend. Traders who use OBV also watch for divergence. This
occurs when the indicator and price are going in different directions. If the price is
rising but OBV is falling, that could indicate that the trend is not backed by strong
buyers and could soon reverse.
2. Accumulation/Distribution Line
One of the most commonly used indicators to determine the money flow in and
out of a security is the accumulation/distribution line (A/D line).It is similar to the
on-balance volume indicator (OBV), but instead of considering only the closing
price of the security for the period, it also takes into account the trading range for
the period and where the close is in relation to that range. If a stock finishes near
its high, the indicator gives volume more weight than if it closes near the midpoint
of its range. The different calculations mean that OBV will work better in some
cases and A/D will work better in others. If the indicator line is trending up, it
shows buying interest, since the stock is closing above the halfway point of the
range. This helps confirm an uptrend. On the other hand, if A/D is falling, that
means the price is finishing in the lower portion of its daily range, and thus volume
is considered negative. This helps confirm a downtrend. Traders using the A/D line
also watch for divergence. If the A/D starts falling while the price is rising, this
signals that the trend is in trouble and could reverse. Similarly, if the price is
trending lower and A/D starts rising, that could signal higher prices to come.
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3. Average Directional Index

The average directional index (ADX) is a trend indicator used to measure the
strength and momentum of a trend. When the ADX is above 40, the trend is
considered to have a lot of directional strength, either up or down, depending on
the direction the price is moving. When the ADX indicator is below 20, the trend is
considered to be weak or non-trending. The ADX is the main line on the indicator,
usually colored black. There are two additional lines that can be optionally shown.
These are DI+ and DI-. These lines are often colored red and green, respectively. All
three lines work together to show the direction of the trend as well as the
momentum of the trend.
4. Aroon Indicator
The Aroon oscillator is a technical indicator used to measure whether a
security is in a trend, and more specifically if the price is hitting new highs or lows
over the calculation period (typically 25).The indicator can also be used to identify
when a new trend is set to begin. The Aroon indicator comprises two lines: an
Aroon Up line and an Aroon Down line. When the Aroon Up crosses above the
Aroon Down, that is the first sign of a possible trend change. If the Aroon Up hits
100 and stays relatively close to that level while the Aroon Down stays near zero,
that is positive confirmation of an uptrend. The reverse is also true. If Aroon Down
crosses above Aroon Up and stays near 100, this indicates that the downtrend is in
force.
5. MACD
The moving average convergence divergence (MACD) indicator helps traders
see the trend direction, as well as the momentum of that trend. It also provides a
number of trade signals. When the MACD is above zero, the price is in an upward
phase. If the MACD is below zero, it has entered a bearish period. The indicator is
composed of two lines: the MACD line and a signal line, which moves slower. When
MACD crosses below the signal line, it indicates that the price is falling. When the
MACD line crosses above the signal line, the price is rising. Looking at which side of
zero the indicator is on aids in determining which signals to follow. For example, if
the indicator is above zero, watch for the MACD to cross above the signal line to
buy. If the MACD is below zero, the MACD crossing below the signal line may
provide the signal for a possible short trade.
6. Relative Strength Index
The relative strength index (RSI) has at least three major uses. The indicator
moves between zero and 100, plotting recent price gains versus recent price losses.
The RSI levels therefore help in gauging momentum and trend strength. The most
basic use of an RSI is as an overbought and oversold indicator. When RSI moves
above 70, the asset is considered overbought and could decline. When the RSI is
below 30, the asset is oversold and could rally. However, making this assumption is
dangerous; therefore, some traders wait for the indicator to rise above 70 and then
drop below before selling, or drop below 30 and then rise back above before buying.
Divergence is another use of the RSI. When the indicator is moving in a different
direction than the price, it shows that the current price trend is weakening and
could soon reverse.
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7. Stochastic Oscillator
The stochastic oscillator is an indicator that measures the current price
relative to the price range over a number of periods. Plotted between zero and 100,
the idea is that, when the trend is up, the price should be making new highs. In a
downtrend, the price tends to make new lows. The stochastic tracks whether this is
happening.
The stochastic moves up and down relatively quickly as it is rare for the price
to make continual highs, keeping the stochastic near 100, or continual lows,
keeping the stochastic near zero. Therefore, the stochastic is often used as an
overbought and oversold indicator. Values above 80 are considered overbought,
while levels below 20 are considered oversold. Consider the overall price trend when
using overbought and oversold levels. For example, during an uptrend, when the
indicator drops below 20 and rises back above it, that is a possible buy signal. But
rallies above 80 are less consequential because we expect to see the indicator to
move to 80 and above regularly during an uptrend. During a downtrend, look for
the indicator to move above 80 and then drop back below to signal a possible short
trade. The 20 level is less significant in a downtrend.
Advantages of Using Market Timing Strategy
The benefits of market timing strategy are as follows:
Market timing is used to maximize profits and offset the associated risks with
high gains. It is the classic risk-return trade off that exists with respect to investment –
the higher the risk, the higher the return.
It enables traders to curtail the effects of market volatility.
It enables traders to reap the benefits of short-term price movements.
Disadvantages of Using Market Timing Strategy
Empirical research and real-life incidents show that the costs associated with the
market timing strategy greatly surpass the potential benefits given that:
It requires a trader to consistently follow up on market movements and trends.
It entails higher transaction costs and commissions and includes a substantial
opportunity cost. Market timers exit the market during periods of high volatility. Since
most market upswings occur under volatile conditions, active investors miss out on the
opportunities and ultimately earn less returns than buy-and-hold investors.
An investor who succeeds in buying low and selling high must incur tax
consequences on their gain. In case the security was held for less than a year, which is
mostly true for market timers, the profit is taxed at the short-term capital gains rate,
which is higher than the long-term capital gains rate.
Precisely timing market entries and exits may be difficult.
22.4. REVISION POINTS
1. Quantitative Fundamentals to Consider, Market Timing Strategy, Stochastic
Oscillator
22.5. INTEXT QUESTIONS
1. Explain the six key points about market timing.
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2. What are the Quantitative Fundamentals to Consider

3. Give Advantages and Disadvantage of Using Market Timing Strategy
22.6 SUMMARY
Market timing refers to an investing strategy through which a market participant
makes buying or selling decisions by predicting the price movements of a financial
asset in the future.
Financial statements are the medium by which a company discloses information
concerning its financial performance. Followers of fundamental analysis use
quantitative information gleaned from financial statements to make investment
decisions. The three most important financial statements are income statements,
balance sheets, and cash flow statements.
An investor who succeeds in buying low and selling high must incur tax
consequences on their gain. In case the security was held for less than a year, which is
mostly true for market timers, the profit is taxed at the short-term capital gains rate,
which is higher than the long-term capital gains rate.
Precisely timing market entries and exits may be difficult
22.7. TERMINAL EXERCISES
1. Classic Market Times usually invest in __________funds
2. Market timing helps to forecasting the ___________ future.
22.8. SUPPLIMENTARY MATERIALS
1. money.rediff.com
2. money control.com
3. amfiindia.com
22.9. ASSIGNMENT
1. Different types of Analysis for Market Timing
22.10. SUGGESTED READINGS
1. M. Ranganathan and R. Madhumathi: Investment Analysis and
Portfolio Management, Pearson Education, New Delhi.
2. Punithavathy Pandian: Security Analysis and Portfolio Management,
Vikas Publishing House Pvt. Ltd., New Delhi.
3. Prasanna Chandra: Investment Analysis and Portfolio Management,
TMH, Delhi.
22.11. LEARNING ACTIVITIES
Oscillators, Quantitative Fundamentals to Consider
22.12. KEY WORDS
ADX, MACD, RSI Dynamic Asset Allocators

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ANNAMALAI UNIVERSITY PRESS 2022 – 2023